Streetwise Professor

October 12, 2016

A Pitch Perfect Illustration of Blockchain Hype

Filed under: Clearing,Commodities,Derivatives,Economics,Regulation — The Professor @ 7:31 pm

If you’ve been paying the slightest attention to financial markets lately, you’ll know that blockchain is The New Big Thing. Entrepreneurs and incumbent financial behemoths alike are claiming it will transform every aspect of financial markets.

The techno-utopianism makes me extremely skeptical. I will lay out the broader case for my skepticism in a forthcoming post. For now, I will discuss a specific example that illustrates odd combination of cluelessness and hype that characterizes many blockchain initiatives.

Titled “Blockchain startup aims to replace clearinghouses,” the article breathlessly states:

Founded by two former traders at Societe Generale, SynSwap is a post-trade start-up based on hyperledger technology designed to disintermediate central counterparties (CCPs) from the clearing process, effectively removing their role in key areas.

“For now we are focusing on interest rate swaps and credit default swaps, and will further develop the platform for other asset classes,” says Sophia Grami, co-founder of SynSwap.

Grami explains that once a trade is captured, SynSwap automatically processes the whole post-trade workflow on its blockchain platform. Through smart contracts, it can perform key post-trade functions such as matching and affirmation, generation of the confirmation, netting, collateral management, compression, default management and settlement.

“CCPs have been created to reduce systemic risk and remove counterparty risk through central clearing. While clearing is key to mitigate risks, the blockchain technology allows us to disintermediate CCPs while providing the same risk mitigation techniques,” Grami adds.

“Central clearing is turned into distributed clearing. There is no central counterparty anymore and no entity is in the middle of a trade anymore.”

The potential disruptive force blockchain technology could have for derivatives clearing could bring back banks that have pulled away from the business due to heightened regulatory costs.

I have often noted that CCPs offer a bundle of many services, and it is possible to considering unbundling some of them. But there are certain core functions of CCP clearing that this blockchain proposal does not offer. Most importantly, CCPs mutualize default risk: this is truly one of the core features of a CCP. This proposal does not, meaning that it provides a fundamentally different service than a CCP. Further, CCPs hedge and manage defaulted positions and port customer positions from a defaulted intermediary to a solvent one: this proposal does not. CCPs also manage liquidity risk. For instance, a defaulter’s collateral may not be immediately convertible into cash to pay winning counterparties, but the CCP maintains liquidity reserves and lines that it can use to intermediate liquidity in these circumstances. The proposal does not. The proposal mentions netting, but I seriously doubt that the blockchain–hyperledger, excuse me–can perform multilateral netting like a CCP.

There are other issues. Who sets the margin levels? Who sets the daily (or intraday) marks which determine variation margin flows and margin calls to top up IM? CCPs do that. Who does it for the hyper ledger?

So the proposal does some of the same things as a CCP, but not all of them, and in fact omits the most important bits that make central clearing central clearing. To the extent that these other CCP services add value–or regulation compels market participants to utilize a CCP that offers these services–market participants will choose to use a CCP, rather than this service. It is not a perfect substitute for central clearing, and will not disintermediate central clearing in cases where the services it does not offer and the functions it does not perform are demanded by market participants, or by regulators.

The co-founder says “[c]entral clearing is turned into distributed clearing.” Er, “distributed clearing”–AKA “bilateral OTC market.” What is being proposed here is not something really new: it is an application of a new technology to a very old, and very common, way of transacting. And by its nature, such a distributed, bilateral system cannot perform some functions that inherently require multilateral cooperation and centralization.

This illustrates one of my general gripes about blockchain hype: blockchain evangelists often claim to offer something new and revolutionary but what they actually describe often involves re-inventing the wheel. Maybe this wheel has advantages over existing wheels, but it’s still a wheel.

Furthermore, I would point out that this wheel may have some serious disadvantages as compared to existing wheels, namely, the bilateral OTC market as we know it. In some respects, it introduces one of the most dangerous features of central clearing into the bilateral market. (H/T Izabella Kaminska for pointing this out.) Specifically, as I’ve been going on about for about 8 years now, the rigid variation margining mechanism inherent in central clearing creates a tight coupling that can lead to catastrophic failure. Operational or financial delays that prevent timely payment of variation margin can force the CCP into default, or force it or its members to take extraordinary measures to access liquidity during times when liquidity is tight. Everything in a cleared system has to perform like clockwork, or an entire CCP can fail. Even slight delays in receiving payments during periods of market stress (when large variation margin flows occur) can bring down a CCP.

In contrast, there is more play in traditional bilateral contracting. It is not nearly so tightly coupled. One party not making a margin call at the precise time does not threaten to bring down the entire system. Furthermore, in the bilateral world, the “FU Option” is often quite systemically stabilizing. During the lead up to the crisis, arguments over marks could stretch on for days and sometimes weeks, giving some breathing room to stump up the cash to meet margin calls, and to negotiate down the size of the calls.

The “smart contracts” aspect of the blockchain proposal jettisons that. Everything is written in the code, the code is the last word, and will be self-executing. This will almost certainly create tight coupling: The Market has moved by X; contract says that means party A has to pay Party B Y by 0800 tomorrow or A is in default. (One could imagine writing really, really smart contracts that embed various conditions that mimic the flexibility and play in face-to-face bilateral markets, but color me skeptical–and this conditionality will create other issues, as I’ll discuss in the future post.)

When I think of these “smart contracts” one image that comes to mind is the magic broomsticks in The Sorcerer’s Apprentice. They do EXACTLY what they are commanded to do by the apprentice (coder?): they tote water, and end up toting so much water that a flood ensues. There is no feedback mechanism to get them to stop when the water gets too high. Again, perhaps it is possible to create really, really smart contracts that embed such feedback mechanisms.

But then one has to consider the potential interactions among a dense network of such really, really smart contracts. How do the feedbacks feed back on one another? Simple agent models show that agents operating subject to pre-programmed rules can generate complex, emergent orders when they interact. Sometimes these orders can be quite efficient. Sometimes they can crash and collapse.

In sum, the proposal for “distributed clearing to disintermediate CCPs” illustrates some of the defects of the blockchain movement. It overhypes what it does. It claims to be something new, when really it is a somewhat new way of doing something quite common. It does not necessarily perform these familiar functions better. It does not consider the systemic implications of what it does.

So why is there so much hype? Well, why was a thing? More seriously, I think that there is an interesting sociological dynamic here. All the cool kids are talking about blockchain, and nobody wants to admit to not being cool. Further, when a critical mass of supposed thought leaders are doing something, others imitate for fear of being left behind: if you join and it turns out to be flop, well, you don’t stand out–everybody, including the smartest people, screwed up. You’re in good company! But if you don’t join and it becomes a hit, you look like a Luddite idiot and get left behind. So there is a bias towards joining the fad/jumping on the bandwagon.

I think there will be a role for blockchain. But I also believe that it will not be nearly as revolutionary as its most ardent proponents claim. And I am damn certain that it is not going to disintermediate central clearing, both because central clearing does some things “decentralized clearing” doesn’t (duh!), and because regulators like those things and are forcing their use.

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October 6, 2016

War Communism Meets Central Clearing

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 1:58 pm

I believe that I am on firm ground saying that I was one of the first to warn of the systemic risks created by the mandating of central clearing on a vast scale, and that CCPs could become the next Too Big to Fail entities. At ISDA events in 2011, moreover, I stated publicly that it was disturbing that the move to mandates was occurring before plans to recover or resolve insolvent clearinghouses were in place. At one of these events, in London, then-CEO of LCH Michael Davie said that it was important to ensure to have plans in place to deal with CCPs in wartime (meaning during crises) as well as in peace.

Well, we are five years on, and well after mandates have been in effect, those resolution and recovery authorities are moving glacially towards implementation. Several outlets report that the European Commission is finalizing legislation on CCP recovery. As Phil Stafford at the FT writes:

The burden of losses could fall on the clearing house or its parent company, its member banks; the banks’ customers, such as pension funds, or the taxpayer.

Brussels is proposing that clearing house members, such as banks, be required to participate in a cash call if the clearing house has exhausted its so-called “waterfall” of default procedures.

The participants would take a share in the clearing house in return, according to drafts seen by the Financial Times.

Authorities would also have the power to reduce the value of payments to the clearing house members, the draft says. In the event of a systemic crisis, regulators could use government money as long as doing so complies with EU rules on state aid.

Powers available to regulators would include tearing up derivatives contracts and applying a “haircut” to the margin or collateral that has been pledged by the clearing house’s end users.

Asset managers have long feared that haircutting margin would be tantamount to expropriating assets that belong to customers.

The draft is circulating in samizdat form, and I have seen a copy. It is rather breathtaking in its assertions of authority. Apropos Michael Davie’s remarks on operating CCPs during wartime, my first thought upon reading Chapters IV and V was “War Communism Comes to Derivatives.” One statement buried in the Executive Summary Sheet, phrased in bland bureaucratic language, is rather stunning in its import: “A recovery and resolution framework for CCPs is likely to involve a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders.”

In a nutshell, the proposal says that the resolution authority can do pretty much it damn well pleases, including nullifying normal protections of bankruptcy/insolvency law, transferring assets to whomever it chooses, terminating contracts (not just of those who default, but any contract cleared by a CCP in resolution), bailing in any CCP creditor up to 100 percent, suspending the right to terminate contracts, and haircutting variation margin. The authority also has the power to force CCP members to make additional default fund contributions up to the amount of their original contribution, over and above any additional contribution specified in the CCP member agreement. In brief, the resolution authority has pretty much unlimited discretion to rob Peter to pay Paul, subject to only a few procedural safeguards.

About the only thing that the law doesn’t authorize is initial margin haircutting. Given the audacity of other powers that it confers, this is sort of surprising. It’s also not evident to me that variation margin haircutting is a better alternative. One often overlooked aspect of VM haircuts is that they hit hedgers hardest. Those who are using derivatives to manage risk look to variation margin payments to offset losses on other exposures that they are hedging. VM haircutting deprives them of some of these gains precisely when they are likely to need them most. Put differently, VM haircutting imposes losses on those that are least likely to be able to bear them when it is most costly to bear them. Hedgers are risk averse. One reason they are risk aversion is that losses on their underlying exposures could force them into financial distress. Blowing up their hedges could do just that.

Perhaps one could argue that CCPs are so systemically important and the implications of their insolvency are so ominous that extraordinary measures are necessary–in its Executive Summary, and in the proposal itself, the EC does just that. But this just calls into question the prudence of creating and supersizing entities with such latent destructive potential.

There is also a fundamental tension here. The potential that the resolution authority will impose large costs on members of CCPs, and even their customers, raises the burden of being a member, or trading cleared products. This is a disincentive to membership, and with the economics of supply clearing services already looking rather grim, may lead to further exits from the business. Similarly, bail-ins of creditors and the potential seizure of ownership interests without due process will make it more difficult for CCPs to obtain funding. Thus, mandating expansion of clearing makes necessary exceptional resolution measures that lead to reduced supply of clearing services, and reduced supply of the credit, liquidity, and capital that they need to function.

It must also be recognized that with discretionary power come inefficient selective intervention and influence costs. The resolution body will have extraordinary power to transfer vast sums from some agents to others. This makes it inevitable that the body will be subjected to intense rent seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens. Rent seeking is costly. Furthermore, it will inevitably inject a degree of arbitrariness into the outcome of resolution. This arbitrariness creates additional uncertainty and risk, precisely at a time when these are already at heightened, and likely extreme, levels. Furthermore, it is likely to create dangerous feedback loops. The prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that pushes it over the edge.

To put it simply, if the option to resort to War Communism is necessary to deal with the fallout from a CCP failure in a post-mandate world, maybe you shouldn’t start the war in the first place.

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September 16, 2016

De Minimis Logic

CFTC Chair Timothy Massad has come out in support of a one year delay of the lowering of the de minimis swap dealer exemption notional amount from $8 billion to $3 billion. I recall Coase  (or maybe it was Stigler) writing somewhere that an economist could pay for his lifetime compensation by delaying implementation of an inefficient law by even a day. By that reckoning, by delaying the step down of the threshold for a year Mr. Massad has paid for the lifetime compensation of his progeny for generations to come, for the de minimis threshold is a classic analysis of an inefficient law. Mr. Massad (and his successors) could create huge amounts of wealth by delaying its implementation until the day after forever.

There are at least two major flaws with the threshold. The first is that there is a large fixed cost to become a swap dealer. Small to medium-sized swap traders who avoid the obligation of becoming swap dealers under the $8 billion threshold will not avoid it under the lower threshold. Rather than incur the fixed cost, many of those who would be caught with the lower threshold will decide to exit the business. This will reduce competition and increase concentration in the swap market. This is perversely ironic, given that one ostensible purpose of Frankendodd (which was trumpeted repeatedly by its backers) was to increase competition and reduce concentration.

The second major flaw is that the rationale for the swap dealer designation, and the associated obligations, is to reduce risk. Big swap dealers mean big risk, and to reduce that risk, they are obligated to clear, to margin non-cleared swaps, and hold more capital. But notional amount is a truly awful measure of risk. $X billion of vanilla interest rate swaps differ in risk from $X billion of CDS index swaps which differ in risk from $X billion of single name CDS which differ in risk from $X billion of oil swaps. Hell, $X billion of 10 year interest rate swaps differ in risk from $X billion of 2 year interest rate swaps. And let’s not even talk about the variation across diversified portfolios of swaps with the same notional values. So notional does not match up with risk in a discriminating way.  Further, turnover doesn’t measure risk very well either.

But hey! We can measure notional! So notional it is! Yet another example of the regulatory drunk looking for his keys under the lamppost because that’s where the light is.

So bully for Chairman Massad. He has delayed implementation of a regulation that will do the opposite of some of the things it is intended to do, and merely fails to do other things it is supposed to do. Other than that, it’s great!

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September 6, 2016

HKEx: Improving Warehousing in China, or Creating a Shadow Banking Vehicle?

Filed under: Clearing,Commodities,Derivatives,Economics,Regulation — The Professor @ 9:33 pm

I am on my last day in Singapore, where I participated in the rollout of Trafigura’s Commodities Demystified hosted by IE Singapore.  The event was very well attended (an overflow crowd) and the presentation and new publication (which builds off the conceptual framework of my 2013 white paper The Economics of Commodity Trading Firms) was well-received. It helps fill a yawning gap in knowledge about what commodity traders are and what they do.

In addition to that event, I spoke as a panelist at the FT’s Commodities Asia Summit. One of the main speakers was Charles Li, CEO of Hong Kong Exchanges and Clearing, who laid out his ambitions for plans in mainland China. Things started out well. Whereas expectations were that HKEx would create a modest spot metals trading platform in China (because it doesn’t have and is unlikely to receive a license for trading futures), Li stated that HKEx (which owns the LME) would attempt to create a “lookalike” LME metals warehousing system. In the aftermath of the Qingdao fiasco this could be a very salutary development.

I would suggest caution, however. This may be easier said than done. While Li was describing this, my mind immediately turned to a paper I wrote over 2 decades ago about the successes and failures of commodity exchanges. One of the signal failures occurred when the Chicago Board of Trade attempted to tame the depredations of grain warehouses in the 1860s. Public storage was rife with all sorts of fraud and illicit dealing. The quality and quantity of grain being stored was a mystery, and warehousemen played all sorts of games to exploit their customers. The CBT, acting in the interests of traders who relied on the warehouses, attempted to impose rules and regulations on them, but failed utterly. Eventually the State of Illinois had to pass legislation to rein in some of the warehousemen’s more outrageous actions. Furthermore, larger traders integrated into warehousing, and eventually public storage became primarily ancillary to futures trading (i.e., to facilitate delivery against futures).

The CBT’s problem is that it did not have an adequate stick to beat the warehousemen into compliance. They were kicked out of the exchange, but the gains of being able to trade futures were smaller than the gains from operating warehouses outside the CBT’s rules.

Public warehousing has proved problematic in commodities to the present day. The LME’s travails with aluminum warehousing are just one example, but others abound in commodities including coffee, cocoa, and cotton. In cotton, for instance, even though warehouses are subject to federal regulation, there are chronic complaints that warehousemen do not load out cotton promptly, in order to enhance storage revenues.

So I wish Mr. Li luck. He’ll need it, especially since lacking the ability to deny those violating the warehouse rules from futures trading, he won’t even have the stick that proved inadequate for the CBT. Public warehousemen has long proved to be a very recalcitrant group, over time, place, and commodity.

Li specifically criticized the speculative nature of China’s futures exchanges, and claimed that his new venture would be for physical players, and that it would not be “another financial speculation forum.” But his follow on remarks gave a sense of cognitive dissonance. He said the system would allow banks and hedge funds to participate in the market.

More disconcertingly, he highlighted the effects of financial repression in China (without using the phrase), which leads investors looking for higher returns than are available in the banking sector to turn to alternative investment vehicles. Li specifically mentioned wealth management products, and suggested that metals stored in the warehouses his new venture would oversee could form the basis for such products. I understood him to say that while the warehouses would facilitate the typical function of commodity storage, i.e., filling and emptying in order to accommodate temporary supply and demand shocks, there would also be the possibility that metal would be locked up for long periods to provide the basis for these wealth management products. What I envision is something like physical metal ETFs that have been introduced in the West. These are primarily in precious metals. JP Morgan proposed a similar vehicle for copper, but backed off due to the pressure from Carl Levin and others a couple of summers ago.

In other words, the new warehousing system would be part of the shadow banking system thereby providing a new speculative vehicle for Chinese investors desperate to circumvent financial repression. Hence my cognitive dissonance.

I would also note that even a purely physical spot exchange can be a speculative venue, through buying and selling and borrowing/carrying warehouse receipts. The New York Gold Exchange of Black Friday infamy was hugely speculative, even though it was purely a spot physical exchange.

I also heard Li to say that the venture would guarantee transactions, though I didn’t fully catch what would be guaranteed. Would the exchange be insuring those storing their metal against a Qingdao type event? If so, that’s a pretty audacious plan, and one fraught with risk.

This was just a speech at a conference. It will be interesting to see a fully-fleshed out plan. It will be particularly interesting to see how the enforcement mechanism for the warehouse regulation will work, and it will be especially particularly interesting to see whether this venture is indeed just viewed as a mechanism for improving the efficiency of the physical metals market in China, or whether it will be a clever way to tap into the intense interest of investors large and small in China to speculate and find better returns than those on offer in the banking system. That is, will this be another speculative venue, but one masquerading as a staid market for physical players. Given the way China works, I’d bet on the latter. Pun intended.

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August 20, 2016

On Net, This Paper Doesn’t Tell Us Much About What We Need to Know About the Effects of Clearing

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 4:26 pm

A recent Office of Financial Research paper by Samim Ghamami and Paul Glasserman asks “Does OTC Derivatives Reform Incentivize Central Clearing?” Their answer is, probably not.

My overarching comment is that the paper is a very precise and detailed answer to maybe not the wrong question, exactly, but very much a subsidiary one. The more pressing questions include: (i) Do we want to favor clearing vs. bilateral? Why? What metric tells us that is the right choice? (The paper takes the answer to this question as given, and given as “yes.”) (ii) How do the different mechanisms affect the allocation of risk, including the allocation of risk outside the K banks that are the sole concern in the paper? (iii) How will the rules affect the scale of derivatives trading (the paper takes positions as given) and the allocation across cleared and bilateral instruments? (iv) Following on (ii) and (iii) will the rules affect risk management by end-users and what is the implication of that for the allocation of risk in the economy?

Item (iv) has received too little attention in the debates over clearing and collateral mandates. To the extent that clearing and collateral mandates make it more expensive for end-users to manage risk, how will the end users respond? Will they adjust capital structures? Investment? The scale of their operations? How will this affect the allocation of risk in the broader economy? How will this affect output and growth?

The paper also largely ignores one of the biggest impediments to central clearing–the leverage ratio.  (This regulation receives on mention in passing.) The requirement that even segregated client margins be treated as assets for the purpose of calculating this ratio (even though the bank does not have a claim on these margins) greatly increases the capital costs associated with clearing, and is leading some banks to exit the clearing business or to charge fees that make it too expensive for some firms to trade cleared derivatives. This brings all the issues in (iv) to the fore, and demonstrates that certain aspects of the massive post-crisis regulatory scheme are not well thought out, and inconsistent.

Of course, the paper also focuses on credit risk, and does not address liquidity risk issues at all. Perhaps this is a push between bilateral vs. cleared in a world where variation margin is required for all derivatives transactions, but still. The main concern about clearing and collateral mandates (including variation margin) is that they can cause huge increases in the demand for liquidity precisely at times when liquidity dries up. Another concern is that collateral supply mechanisms that develop in response to the mandates create new interconnections and new sources of instability in the financial system.

The most disappointing part of the paper is that it focuses on netting economies as the driver of cost differences between bilateral and cleared trading, without recognizing that the effects of netting are distributive. To oversimplify only a little, the implication of the paper is that the choice between cleared and bilateral trading is driven by which alternative redistributes the most risk to those not included in the model.

Viewed from that perspective, things look quite different, don’t they? It doesn’t matter whether the answer to that question is “cleared” or “bilateral”–the result will be that if netting drives the answer, the answer will result in the biggest risk transfer to those not considered in the model (who can include, e.g., unsecured creditors and the taxpayers). This brings home hard the point that these types of analyses (including the predecessor of Ghamami-Glasserman, Zhu-Duffie) are profoundly non-systemic because they don’t identify where in the financial system the risk goes. If anything, they distract attention away from the questions about the systemic risks of clearing and collateral mandates. Recognizing that the choice between cleared and bilateral trading is driven by netting, and that netting redistributes risk, the question should be whether that redistribution is desirable or not. But that question is almost never asked, let alone answered.

One narrower, more technical aspect of the paper bothered me. G-G introduce the concept of a concentration ratio, which they define as the ratio of a firm’s contribution to the default fund to the firm’s value at risk used to determine the sizing of the default fund. They argue that the default fund under a cover two standard (in which the default fund can absorb the loss arising from the simultaneous defaults of the two members with the largest exposures) is undersized if the concentration ratio is less than one.

I can see their point, but its main effect is to show that the cover two standard is not joined up closely with the true determinants of the risk exposure of the default fund. Consider a CCP with N identical members, where N is large: in this case, the concentration ratio is small. Further, assume that member defaults are independent, and occur with probability p. The loss to the default fund conditional on the default of a given member is X. Then, the expected loss of the default fund is pNX, and under cover two, the size of the fund is 2X.  There will be some value of N such that for a larger number of members, the default fund will be inadequate. Since the concentration ratio varies inversely with N, this is consistent with the G-G argument.

But this is a straw man argument, as these assumptions are obviously extreme and unrealistic. The default fund’s exposure is driven by the extreme tail of the joint distribution of member losses. What really matters here is tail dependence, which is devilish hard to measure. Cover two essentially assumes a particular form of tail dependence: if the 1st (2nd) largest exposure defaults, so will the 2nd (1st) largest, but it ignores what happens to the remaining members. The assumption of perfect tail dependence between risks 1 and 2 is conservative: ignoring risks 3 through N is not. Where things come out on balance is impossible to determine. Pace G-G, when N is large ignoring 3-to-N is likely very problematic, but whether this results in an undersized default fund depends on whether this effect is more than offset by the extreme assumption of perfect tail dependence between risks 1 and 2.

Without knowing more about the tail dependence structure, it is impossible to play Goldilocks and say that this default fund is too large,  this default fund is too small, and this one is just right by looking at N (or the concentration ratio) alone. But if we could confidently model the tail dependence, we wouldn’t have to use cover two–and we could also determine individual members’ appropriate contributions more exactly than relying on a pro-rata rule (because we could calculate each member’s marginal contribution to the default fund’s risk).

So cover two is really a confession of our ignorance. A case of sizing the default fund based on what we can measure, rather than what we would like to measure, a la the drunk looking for his keys under the lamppost, because the light is better there. Similarly, the concentration ratio is something that can be measured, and does tell us something about whether the default fund is sized correctly, but it doesn’t tell us very much. It is not a sufficient statistic, and may not even be a very revealing one. And how revealing it is may differ substantially between CCPs, because the tail dependence structures of members may vary across them.

In sum, the G-G paper is very careful, and precisely identifies crucial factors that determine the relative private costs of cleared vs. bilateral trading, and how regulations (e.g., capital requirements) affect these costs. But this is only remotely related to the question that we would like to answer, which is what are the social costs of alternative arrangements? The implicit assumption is that the social costs of clearing are lower, and therefore a regulatory structure which favors bilateral trading is problematic. But this assumes facts not in evidence, and ones that are highly questionable. Further, the paper (inadvertently) points out a troubling reality that should have been more widely recognized long ago (as Mark Roe and I have been arguing for years now): the private benefits of cleared vs. bilateral trading are driven by which offers the greatest netting benefit, which also just so happens to generate the biggest risk transfer to those outside the model. This is a truly systemic effect, but is almost always ignored.

In these models that focus on a subset of the financial system, netting is always a feature. In the financial system at large, it can be a bug. Would that the OFR started to investigate that issue.

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July 6, 2016

Brexit: Breaking the Cartel of Nations. Could Position Limits Be a Harbinger?

Filed under: Clearing,Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 7:50 pm

One of the ideas that I floated in my first post-Brexit post was that freed from some of the EU’s zanier regulations, it could compete by offering a saner regulatory environment. One of the specific examples I gave was position limits, for as bad as the US position limit proposal is, it pales in comparison to the awfulness of the EU version. And lo and behold! Position limits are first on the list of things to be trimmed, and the FCA appears to be on board with this:

Britain-based commodity exchanges may have some leeway in the way they manage large positions after the UK exits the European Union, but they will still have to comply with EU rules from 2018, experts say.

Position limits, a way of controlling how much of an individual commodity trading firms can hold, are being introduced for the first time in the Markets in Financial Instruments Directive II (MiFID II) from January 2018.

Britain voted to leave the EU last month, but its exit has to be negotiated with the remaining 27 members, a process that is meant to be completed within two years of triggering a formal legal process.

“It is too early to say what any new UK regime will look like particularly given pressure for equivalence,” James Maycock, a director at KPMG, said, referring to companies having to prove that rules in their home countries are equivalent to those in the EU.

“But UK commodity trading venues may have more flexibility in setting position limits if they are not subject to MiFID II.”

. . . .

Britain’s Financial Conduct Authority (FCA) said in a statement after the Brexit vote that firms should continue to prepare for EU rules. But it has previously expressed doubts about position limits on all commodity contracts.

“We do not believe that it is necessary, as MiFID II requires, to have position limits for every single one of the hundreds of commodity derivatives contracts traded in Europe. Including the least significant,” said Tracey McDermott, former acting chief executive at the FCA in February this year.

“And I know there are concerns, frankly, that the practical details of position reporting were not adequately thought through in the negotiations on the framework legislation.”

Here’s hoping.

This could explain a major driver behind the Eurogarchs intense umbrage at Brexit. Competition from the UK, particularly in the financial sector, will provide a serious brake on some of the EU’s more dirigiste endeavors. This is especially true in financial/capital markets because capital is extremely mobile. Further, I conjecture that Europe needs The City more than The City needs Europe. Hollande and others in Europe are talking about walling off the EU’s financial markets from perfidious Albion, but the most likely outcome of this is to create a continental financial ghetto or gulag, A Prison of Banks.

If financial protectionism of the type Hollande et al dream of could work, French, German and Dutch bankers should be dancing jigs right now. But they seem to be the most despondent and outraged at Brexit.

A (somewhat tangential) remark. Another reason for taking umbrage is that the UK has served as a safety valve for European workers looking to escape the dysfunctional continental labor markets. This is especially true for many younger, high skill/high education French, Germans, etc. (especially the French). With the safety valve cut off, there will be more angry people putting pressure on European governments.

This could be a good thing, if it forces the Euros (especially the French) to loosen up their growth-and-employment-sapping labor laws. But in the short to medium term, it means more political ferment, which the Euro elite doesn’t like one bit.

This all leads to a broader point. Cooperation is a double edged sword. The EU’s main selling point is that intra-European cooperation has led to a reduction in trade barriers that has increased competition in European goods markets. But the EU has also functioned as a Cartel of Nations that has restricted competition on many dimensions.

I note that one major international cooperative effort spearheaded by the Europeans is the attempt to reduce and perhaps eliminate competition between nations on tax. “Tax harmonization” sounds so Zen, but it really means cutting off any means of escape from the depredations of the state. But tax is just one area where governments don’t like to compete with one another. Much regulatory harmonization and coordination and imposed uniformity is intended to reduce inter-state competition that limits the ability of governments to redistribute rents.

This is one reason to believe that Britain’s exit will have some big upsides, not just for the UK but for Europe generally. It will invigorate competition between jurisdictions that statists hate. And it is precisely these upsides which send the dirigistes into paroxysms of anger and despair. Feel their pain, and rejoice in it.


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June 30, 2016

Financial Network Topology and Women of System: A Dangerous Combination

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 7:43 pm

Here’s a nice article by Robert Henderson in the science magazine Nautilus which poses the question: “Can topology prevent the next financial crisis?” My short answer: No.  A longer answer–which I sketch out below–is that a belief that it can is positively dangerous.

The idea behind applying topology to the financial system is that financial firms are interconnected in a network, and these connections can be represented in a network graph that can be studied. At least theoretically, if you model the network formally, you can learn its properties–e.g., how stable is it? will it survive certain shocks?–and perhaps figure out how to make the network better.

Practically, however, this is an illustration of the maxim that a little bit of knowledge is a dangerous thing.

Most network modeling has focused on counterparty credit connections between financial market participants. This research has attempted to quantify these connections and graph the network, and ascertain how the network responds to certain shocks (e.g., the bankruptcy of a particular node), and how a reconfigured network would respond to these shocks.

There are many problems with this. One major problem–which I’ve been on about for years, and which I am quoted about in the Nautilus piece–is that counterparty credit exposure is only one type of many connections in the financial network: liquidity is another source of interconnection. Furthermore, these network models typically ignore the nature of the connections between nodes. In the real world, nodes can be tightly coupled or loosely coupled. The stability features of tightly and loosely connected networks can be very different even if their topologies are identical.

As a practical example, not only does mandatory clearing change the topology of a network, it also changes the tightness of the coupling through the imposition of rigid variation margining. Tighter coupling can change the probability of the failure of connections, and the circumstances under which these failures occur.

Another problem is that models frequently leave out some participants. As another practical example, network models of derivatives markets include the major derivatives counterparties, and find that netting reduces the likelihood of a cascade of defaults within that network. But netting achieves this by redistributing the losses to other parties who are not explicitly modeled. As a result, the model is incomplete, and gives an incomplete understanding of the full effects of netting.

Thus, any network model is inherently a very partial one, and is therefore likely to be a very poor guide to understanding the network in all its complexity.

The limitations of network models of financial markets remind me of the satirical novel Flatland, where the inhabitants of Pointland, Lineland, and Flatland are flummoxed by higher-dimensional objects. A square finds it impossible to conceptualize a sphere, because he only observes the circular section as it passes through his plane. But in financial markets the problem is much greater because the dimensionality is immense, the objects are not regular and unchanging (like spheres) but irregular and constantly changing on many dimensions and time scales (e.g., nodes enter and exit or combine, nodes can expand or contract, and the connections between them change minute to minute).

This means that although network graphs may help us better understand certain aspects of financial markets, they are laughably limited as a guide to policy aimed at reengineering the network.

But frighteningly, the Nautilus article starts out with a story of Janet Yellen comparing a network graph of the uncleared CDS market (analogized to a tangle of yarn) with a much simpler graph of a hypothetical cleared market. Yellen thought it was self-evident that the simple cleared market was superior:

Yellen took issue with her ball of yarn’s tangles. If the CDS network were reconfigured to a hub-and-spoke shape, Yellen said, it would be safer—and this has been, in fact, one thrust of post-crisis financial regulation. The efficiency and simplicity of Kevin Bacon and Lowe’s Hardware is being imposed on global derivative trading.


God help us.

Rather than rushing to judgment, a la Janet, I would ask: “why did the network form in this way?” I understand perfectly that there is unlikely to be an invisible hand theorem for networks, whereby the independent and self-interested actions of actors results in a Pareto optimal configuration. There are feedbacks and spillovers and non-linearities. As a result, the concavity that drives the welfare theorems is notably absent. An Olympian economist is sure to identify “market failure,” and be mightily displeased.

But still, there is optimizing behavior going on, and connections are formed and nodes enter and exit and grow and shrink in response to profit signals that are likely to reflect costs and benefits, albeit imperfectly. Before rushing in to change the network, I’d like to understand much better why it came to be the way it is.

We have only rudimentary understanding of how network configurations develop. Yes, models that specify simple rules of interaction between nodes can be simulated to produce networks that differ substantially from random networks. These models can generate features like the small world property. But it is a giant leap to go from that, to understanding something as huge, complex, and dynamic as a financial system. This is especially true given that there are adjustment costs that give rise to hysteresis and path-dependence, as well as shocks that give rise to changes.

Further, let’s say that the Olympian economist Yanet Jellen establishes that the existing network is inefficient according to some criterion (not that I would even be able to specify that criterion, but work with me here). What policy could she adopt that would improve the performance of the network, let alone make it optimal?

The very features–feedbacks, spillovers, non-linearities–that can create suboptimality  also make it virtually impossible to know how any intervention will affect that network, for better or worse, under the myriad possible states in which that network must operate.  Networks are complex and emergent and non-linear. Changes to one part of the network (or changes to the the way that agents who interact to create the network must behave and interact) can have impossible to predict effects throughout the entire network. Small interventions can lead to big changes, but which ones? Who knows? No one can say “if I change X, the network configuration will change to Y.” I would submit that it is impossible even to determine the probability distribution of configurations that arise in response to policy X.

In the language of the Nautilus article, it is delusional to think that simplicity can be “imposed on” a complex system like the financial market. The network has its own emergent logic, which passeth all understanding. The network will respond in a complex way to the command to simplify, and the outcome is unlikely to be the simple one desired by the policymaker.

In natural systems, there are examples where eliminating or adding a single species may have little effect on the network of interactions in the food web. Eliminating one species may just open a niche that is quickly filled by another species that does pretty much the same thing as the species that has disappeared. But eliminating a single species can also lead to a radical change in the food web, and perhaps its complete collapse, due to the very complex interactions between species.

There are similar effects in a financial system. Let’s say that Yanet decides that in the existing network there is too much credit extended between nodes by uncollateralized derivatives contracts: the credit connections could result in cascading failures if one big node goes bankrupt. So she bans such credit. But the credit was performing some function that was individually beneficial for the nodes in the network. Eliminating this one kind of credit creates a niche that other kinds of credit could fill, and profit-motivated agents have the incentive to try to create it, so a substitute fills the vacated niche. The end result: the network doesn’t change much, the amount of credit and its basic features don’t change much, and the performance of the network doesn’t change much.

But it could be that the substitute forms of credit, or the means used to eliminate the disfavored form of credit (e.g., requiring clearing of derivatives), fundamentally change the network in ways that affect its performance, or at least can do so in some states of the world. For example, it make the network more tightly coupled, and therefore more vulnerable to precipitous failure.

The simple fact is that anybody who thinks they know what is going to happen is dangerous, because they are messing with something that is very powerful that they don’t even remotely understand, or understand how it will change in response to meddling.

Hayek famously said “the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Tragically, too many (and arguably a large majority of) economists are the very antithesis of what Hayek says that they should be. They imagine themselves to be designers, and believe they know much more than they really do.

Janet Yellen is just one example, a particularly frightening one given that she has considerable power to implement the designs she imagines. Rather than being the Hayekian economist putting the brake on ham-fisted interventions into poorly understood symptoms, she is far closer to Adam Smith’s “Man of System”:

The man of system, on the contrary, is apt to be very wise in his own conceit; and is often so enamoured with the supposed beauty of his own ideal plan of government, that he cannot suffer the smallest deviation from any part of it. He goes on to establish it completely and in all its parts, without any regard either to the great interests, or to the strong prejudices which may oppose it. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it. If those two principles coincide and act in the same direction, the game of human society will go on easily and harmoniously, and is very likely to be happy and successful. If they are opposite or different, the game will go on miserably, and the society must be at all times in the highest degree of disorder.

When there are Men (or Women!) of System about, and the political system gives them free rein, analytical tools like topology can be positively dangerous. They make some (unjustifiably) wise in their own conceit, and give rise to dreams of Systems that they attempt to implement, when in fact their knowledge is shockingly superficial, and implementing their Systems is likely to create the highest degree of disorder.

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June 29, 2016

Will the EU Cut Off Its Nose to Spite Its Face on Clearing, Banking & Finance?

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 7:45 pm

French President Francois Hollande is demanding that clearing of Euro derivatives take place in the Eurozone. Last year the European Central Bank had attempted to require this, claiming that it could not be expected to provide liquidity to a non-Eurozone CCP like London-based LCH.

The ECB lost that case in a European court, but now sees an opportunity to prevail post-Brexit, when London will be not just non-Eurozone, but non-EU. Hollande is cheerleading that effort.

It is rather remarkable to see the ECB, which was only able to rescue European banks desperate for dollar funding during the crisis because of the provision of $300 billion in swap lines from the Fed, claiming that it can’t supply € liquidity to a non-Eurozone entity. How about swap lines with the BoE, which could then provide support to LCH if necessary. Or is the ECB all take, and no give?

Hollande (and other Europeans) are likely acting partly out of protectionist motives, to steal business for continental entities from London (and perhaps the US). But Hollande was also quite upfront about the punitive, retaliatory, and exemplary nature of this move:

“The City, which thanks to the EU, was able to handle clearing operations for the eurozone, will not be able to do them,” he said. “It can serve as an example for those who seek the end of Europe . . . It can serve as a lesson.” [Emphasis added.]

That will teach perfidious Albion for daring to leave the EU! Anyone else harboring such thoughts, take note!

The FT article does not indicate the location of M. Hollande’s nose, for he obviously just cut it off to spite his face.

In a more serious vein, this is no doubt part of the posturing that we will see ad nauseum in the next two plus years while the terms of the UK’s departure are negotiated. Stock up with supplies, because this is going to take a while, since (1) everything is negotiable, (2) almost all negotiations go to the brink of the deadline, or beyond, and (3) these negotiations will be particularly complicated because the Eurogarchs will be conducting them with an eye on how the outcome affects the calculations of other EU members contemplating following Britain out the door–and because immigration issues will loom over the negotiations.

When evaluating a negotiation, it’s best to start with the optimal, surplus maximizing “Coasean bargain” (a term which Coase actually didn’t like, but it is widely used). This, as Elon Musk would say, is a no brainer: allow € clearing in London, through LCH. That is, a maintenance of the status quo.

What are the alternatives? One would be that € clearing for those subject to EU regulation and some non-EU firms would take place in the Eurozone (say Paris or Frankfurt), some € clearing might take place in London or the US, and most dollar and other non-€ clearing would take place in London and the US.  This would require the EU to permit its banks to clear economically in the UK or US, by granting equivalence to non-EU CCPs for non-€ trades, or something similar.

There are several inefficiencies here. First, it would fragment netting sets and increase the probability that one CCP goes bust. For instance, if a bank that is a member of an EU and a non-EU CCP (as would almost certainly be the case of the large European banks that do business in all major currencies) defaulted, it is possible that it could have a loss on its € deals and a gain on its non-€ deals (or vice versa). If those were cleared in a single CCP, the gain and loss could be offset, thereby reducing the CCP’s loss, and perhaps resulting in no loss to the CCP at all: this is what happened with Lehman at the CME, where losses on some of its positions were greater than collateral, but losses on others were smaller, and the total loss was less than total collateral. However, if the business was split, one of the CCPs could suffer a loss that could potentially put it in jeopardy, or force members to stump up additional contributions to the default fund during a time when they are financially stressed.

Second, default management would be more difficult, risky and costly if split across two or more CCPs. It would be easier to put in place dirty hedges for a broader portfolio than two narrower ones, and to allocate or auction off a combined portfolio than fragmented ones. Moreover, it would be necessary to coordinate default management across CCPs in a situation where their interests are not completely aligned, and indeed, where interests may be strongly in conflict. Furthermore, there would be duplication of personnel, as CCP members would be required to dispatch people to two different CCPs to manage the default.

Third, even during “peacetime,” fragmented clearing would sacrifice collateral and capital efficiencies and increase operational costs and complexity.

But it could be worse! Maybe the Europeans will cut off their noses and ears (and maybe some other parts lower down), and deny a UK CCP equivalence for any transaction undertaken by an EU bank. The outcome would be EU banks clearing in Europe, and most everybody else clearing outside of Europe. This would result in multiple inefficiently small CCPs clearing in all currencies that would exacerbate all of the negative consequences just outlined: netting set inefficiencies would be even worse, default risk management even more difficult, and peacetime collateral, capital, and operational efficiencies would be even worse.

Oh, and this alternative would require the ECB to obtain dollar and sterling (and other currency) liquidity lines to allow it to provide non-€ liquidity to its precious little CCP. How hypocritical is that? (Not that hypocrisy would cost Hollande et al any sleep. It hasn’t yet.)

The fact is that CCPs exhibit strong economies of scale and scope, and although mega-CCPs concentrate risk, fragmentation creates its own special problems.

So the wealth-maximizing outcome would be for the EU to come to an accommodation on central clearing that would effectively perpetuate the pre-Brexit status quo. Wealth maximization exercises a strong pull, meaning that this is the most likely outcome, although there will likely be a lot of posturing, bluffing, threatening, etc., before this outcome is achieved (and at the last minute).

I would expect that EU banks would support the Coasean bargain, further increasing its political viability. Yes, Deutsche Borse would be pushing for a EU-centric outcome, and some Europols would take pride at having their own (sub-scale and/or sub-scope) CCP, but the greater cost and risk imposed on banks would almost certainly induce them to put heavy pressure behind a status quo-preserving deal.

This raises the issue of negotiation of banking and capital market issues more generally. There has been a lot of attention paid to the fact that British banks would probably lose passporting rights into the EU post-exit, and this would be costly for them. But European banks actually rely even more on passporting to get access to London. Since London is still almost certain to remain the dominant financial center (especially since the UK government will have a tremendous incentive to facilitate that), European banks would suffer as much or more than UK ones if the passporting system was eliminated (and a close substitute was not created).

Thus, if the negotiations were only about clearing, banking, and capital markets, mutual self-interest (and political economy, given the huge influence of the finance sector on policymakers) would strongly favor a deal that would largely maintain the status quo. But of course the negotiations are not about these issues alone. As I’ve already noted, the EU may try to punish the British even if it also takes a hit because of the effect this might have on the calculations of others who might bolt from the Union.

Furthermore, the most contentious issue–immigration–is very much in play. Merkel, Hollande, and others have said that to obtain a Norway-style relationship with the EU, the UK would have to agree to unlimited movement of people. But that issue is the one that drove the Leave vote, and agreeing to this would be viewed as a gutting of the referendum, and a betrayal. It will be hard for the UK to agree to that.

Perhaps even this could be finessed if the EU secured its borders, but Merkel’s insanity on this issue (and the insanity of other Eurogarchs) makes this unlikely, short of a populist political explosion within the EU. But if that happens, negotiations between the EU and the UK will likely be moot, because there won’t be much of the EU left to negotiate with, or worth negotiating with.

In sum, if it were only about banking and clearing, economic self-interest would lead all parties to avoid mutually destructive protectionism in these areas. But highly emotional issues, political power, and personal pride are also present, and in spades. Thus, I am reluctant to bet much on the consummation of the economically efficient deal on financial issues. The financial sector is just one bargaining chip in a very big game.


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April 22, 2016

Schrödinger’s Clearinghouse?

Filed under: Clearing,Derivatives,Exchanges,Regulation — The Professor @ 6:31 pm

Three weeks ago I wrote about, and criticized, LSE CEO Xavier Rolet’s statement that “We can cross margin our over-the-counter clearing with their listed derivatives without merging the clearinghouses, and without comingling the risk-management framework. [Emphasis added.]”  Then three days ago I read Philip Stafford’s article in the FT stating “Deutsche Börse and LSE plan to link clearing houses“:

The two sides are working on common risk management and default frameworks for their market utilities, which risk manage billions of dollars of derivatives trades on the market every day. [Emphasis added.]

The exchanges’ long-term aim is for each customer to become a member of both the LSE-controlled LCH and Deutsche Börse’s Eurex clearing houses. The customers, which are typically banks, would agree to hand over their trading data in return for better risk management of their derivatives, according to two people familiar with the talks.

The planned London-based holding company would instruct the two clearing houses on how to proceed with a default after consultations with central banks, one of the people said. The two sides are discussing their plans with their regulators and customers, one person said.

So how do you have a “common risk management framework” without “commingling the risk-management framework”? Is there some fine verbal distinction I am missing? Or perhaps this is like Schrödinger’s CCP, in a state of quantum superposition, both commingled and uncommingled until someone opens the box.

In my post, I mentioned default management as one reason to integrate the CCPs:

Another part of the “risk management framework” is the management of defaulted positions. Separate management of the risk of components of a defaulted portfolio is highly inefficient. Indeed, part of the justification of portfolio margining is that the combined position is less risky, and that some components effectively hedge other components. Managing the risks of the components separately in the event of a default sacrifices these self-hedging features, and increases the amount of trading necessary to manage the risk of the defaulted position. Since this trading may be necessary during periods of low liquidity, economizing on the amount of trading is very beneficial.

Apparently the recent experience with the default of Maple Bank brought home the benefits of such integration:

One person familiar with the talks highlighted problems created by February’s default of Frankfurt-based bank Maple, which was a member of both exchanges’ clearing houses.

“Right now what you have is a blind process — the liquidation of positions is conducted without co-ordination,” the person said. “Therefore it has a negative price impact in the market as you have two guys running out liquidating positions in the name.”

Huh. Go figure.

“Commingling” makes sense. Coordination is vital, both in daily operations (e.g., setting margins and monitoring to reduce the risk of default) and in extremis (during a default).

Perhaps Rolet was trying to deceive regulators who are so obsessed with too big to fail (sorry, both Eurex and LCH are TBTF already!) and who are blind to the benefits of coordination. If the regulators need to be deceived thus, we are doomed, because then it would be clear they have no clue about the real issues.

One wonders if they will recognize coordination and commingling even after they look in the box. Apparently Rolet thinks not. If they do, Xavier will have a lot of ‘splainin’ to do.

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April 2, 2016

The Rube Goldberg Approach to Integrating CCPs: A Recipe for Disaster

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 12:38 pm

As noted in earlier posts (and by others commenting on the proposed Eurex-LSE merger) the main potential benefit to exchange customers* is the capital and margin savings from netting efficiencies between Eurex futures and LCH swaps. However, regulators and others have expressed concerns that the downside is the creation of an bigger too big to fail clearing entity. A couple of weeks back Silla Brush and John Detrixhe reported that the merger partners are trying to square that circle by cross-margining, but not merging the CCPs:

LCH.Clearnet and Eurex held 150 billion euros ($169.5 billion) of collateral on behalf of their members as of Dec. 31, according to the merger statement. The London-based clearer is developing a system that allows traders to offset their swap positions at LCH.Clearnet with their futures holdings at Eurex. The project, which works even though the two clearinghouses are separate, should enable customers to reduce the total amount of collateral they must set aside.

“We can cross margin our over-the-counter clearing with their listed derivatives without merging the clearinghouses, and without comingling the risk-management framework,” LSE Group CEO Xavier Rolet said in a Bloomberg Television interview on Wednesday. Rolet will step aside if the companies complete their merger.

The devil will clearly be in the details, and I am skeptical, not to say suspicious. In order for the separate but comingled system to work, Eurex’s CCP must have a claim on collateral held by LCH (and vice versa) so that deficiencies in a defaulter’s margin account on Eurex can be covered by excess at LCH (and vice versa). (As an illustration of the basic concept, Lehman had five different collateral pools at CME Clearing–interest rate, equity, FX, commodities, energy. There were deficiencies in two of these, but CME used collateral from the other three to cover them. As a result there was no hit to the default fund.)

How this will work legally is by no means evident, especially inasmuch as this will be a deal across jurisdictions (which could become even more fraught if Brexit occurs). Further, what happens in the event that one of the separate CCPs itself becomes insolvent? I can imagine a situation (unlikely, but possible)  in which CCP A is insolvent due to multiple defaults, but the margin account at A for one of the defaulters has excess funds while its margin account at CCP is deficient. Would it really be possible for B to access the defaulter’s collateral at bankrupt CCP A? Maybe, but I am certain that this question would be answered only after a nasty, and likely protracted, legal battle.

The fact that the CCPs are going to be legally separate entities suggests their default funds will be as well, and that they will be separately capitalized, meaning that the equity of one CCP will not be part of the default waterfall of the other. This increases the odds that one of the CCPs will exhaust its resources and become insolvent. That is, the probability that one of the separate CCPs will become insolvent exceeds the probability that a truly merged one would become so. Since even the separate CCPs would be huge and systemically important, it is not obvious that this is a superior outcome.

I am also mystified by what Rolet meant by “without comingling the risk management framework.” “Risk management framework” involves several pieces. One is the evaluation of market and credit risk, and the determination of the margin on the portfolio. Does Rolet mean that each CCP will make an independent determination of the margin it will charge for the positions held on it, but do so in a way that takes into account the offsetting risks at the position held at the other CCP? Wouldn’t that at least require sharing position information across CCPs? And couldn’t it result in arbitrary and perhaps incoherent determinations of margins if the CCPs use different models? (As a simple example, will the CCPs use different correlation assumptions?) Wouldn’t this have an effect on where firms place their trades? Couldn’t that lead to a perverse competition between the two CCPs?+ It seems much more sensible to have a unified risk model across the CCPs since they are assigning a single margin to a portfolio that includes positions on both CCPs.

Another part of the “risk management framework” is the management of defaulted positions. Separate management of the risk of components of a defaulted portfolio is highly inefficient. Indeed, part of the justification of portfolio margining is that the combined position is less risky, and that some components effectively hedge other components. Managing the risks of the components separately in the event of a default sacrifices these self-hedging features, and increases the amount of trading necessary to manage the risk of the defaulted position. Since this trading may be necessary during periods of low liquidity, economizing on the amount of trading is very beneficial.

In other words, co-mingling risk management is a very good idea if you are going to cross margin.

It seems that Eurex and LSE are attempting to come up with a clever way to work around regulators’ TBTF neuroses. But it is not clear how this workaround will perform in practice. Moreover, it seems to sacrifice many of the benefits of a merged CCP, while creating ambiguities and legal risks. It also will inevitably be more complex than simply merging the two CCPs. Such complexity creates systemic risks.

One way to put this is that if the two CCPs are legally separate entities, under separate managements, relations between them (including the arrangements necessary for cross margining and default management) will be governed by contract. Contracts are inevitably incomplete. There will be unanticipated contingencies, and/or contingencies that are anticipated but not addressed in the contract. When these contingencies occur in practice, there is a potential for conflict, disagreement, and rent seeking.

In the case of CCPs, the relevant contingencies not specified in the contract will most likely occur during a default, and likely during stressed market conditions. This is exactly the wrong time to have a dispute, and failure to come to a speedy resolution of how to deal with the contingency could be systemically catastrophic.

One advantage of ownership/integration is that it mitigates contractual incompleteness problems. Managers/owners have the authority to respond unilaterally to contingencies. As Williamson pointed out long ago, efficient “selective intervention” is problematic, but in the CCP context, the benefits of managerial fiat and selective intervention seem to far outweigh the costs.

I have argued that the need to coordinate during crises was one justification for the integration of trade execution and clearing. The argument applies with even greater force for the integration of CCPs that cooperate in some ways (e.g., through portfolio margining).

In sum, coordination of LCH and Eurex clearing through contract, rather than through merger into a single entity is a highly dubious way of addressing regulators’ concerns about CCPs being TBTF. The separate entities are already TBTF. The probability that one defaults if they are separate is bigger than the probability that the merged entity defaults, and the chaos conditional on default, or the measures necessary to prevent default, probably wouldn’t be that much greater for the merged entity: this means that reducing the probability of default is desirable, rather than reducing the size of the entity conditional on default. Furthermore, the contract between the two entities will inevitably be incomplete, and the gaps will be discovered, and extremely difficult to fill in-, during a crisis. This is exactly when a coordination failure would be most damaging, and when it would be most likely to occur.

Thus, in my view full integration dominates some Rube Goldberg-esque attempt to bolt LCH and Eurex clearing together by contract. The TBTF bridge was crossed long ago, for both CCPs. The complexity and potential for coordination failure between separate but not really organizations joined by contract would create more systemic risks than increasing size would. A coordination failure between two TBTF entities is not a happy thought.

Therefore, if regulators believe that the incremental systemic risk resulting from a full merger of LCH and Eurex clearing outweighs the benefits of the combination, they should torpedo the merger rather than allowing LSE and Eurex to construct some baroque contractual workaround.

*I say customers specifically, because it is not clear that the total benefits (including all affect parties) from cross margining, netting, etc., are positive. This is due to the distributive effects of these measures. They tend to ensure that derivatives counterparties get paid a higher fraction of their claims in the event of a default, but this is because they shift some of the losses to others with claims on the defaulter.

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