Streetwise Professor

April 11, 2015

The Risks of Clearing Finally Dawn on Tarullo: Better Late Than Never, I Guess

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 10:11 pm

In October, 2011 I was in a group of academics invited to meet the Board of Governors of the Fed to discuss our research. The theme was network industries, and I was to make a presentation on the network aspects of clearing and its implications for systemic risk.

My most vivid memory of the meeting has little to do with my presentation. Instead, it relates to Ben Bernanke, who sat facing me, directly across the massive boardroom table. Bernanke obviously had a headache. He was rubbing his temples, and he asked a staffer to bring him a cold can of Diet Mountain Dew, which he held against his forehead while closing his eyes. Figuring that a Bernanke headache would portend bad financial news, I was sorely tempted to excuse myself to call my broker to sell the hell out of the S&P.

Sitting next to me was Governor Daniel Tarullo. Truth be told, I was not impressed by his questions, which seemed superficial, or his mien, which was rather brusque, not to say grouchy.

He was definitely not sympathetic to my warning about the potential systemic risks of clearing: he made some skeptical, and in fact dismissive, comments. It was quite evident that he was a believer in clearing mandates.

It appears that Tarullo is still struggling with the idea that CCPs are a risk, but at least he’s open to the possibility:

JPMorgan Chase & Co. and BlackRock Inc. have argued for years that a key response to the last financial crisis could help fuel the next one. [What? No mention of SWP? I was way ahead of them!] Global regulators are starting to heed their warnings.

At issue is the role of clearinghouses — platforms that regulators turned to following the 2008 meltdown to shed more light on the $700 trillion swaps market. A pivotal goal was ensuring that losses at one bank don’t imperil a wide swath of companies, and the broader economy.

Now, Federal Reserve Governor Daniel Tarullo is quizzing Wall Street after big lenders and asset managers said clearinghouses pose their own threats, said three people with knowledge of the discussions who weren’t authorized to speak publicly. Among the concerns raised by financial firms: Relying on clearinghouses shifts risk to just a handful of entities, and the collapse of one could lead to uncapped losses for banks.

. . . .

Tarullo, the Fed’s point man on financial regulation and oversight, has publicly conceded that it’s hard for banks to determine their own market risks if they can’t evaluate how badly they would be hit by the failure of a clearinghouse. It’s “worth considering” whether clearinghouses have enough funds to handle major defaults, he said in a Jan. 30 speech.

Tarullo’s speech is here. Although he is still obviously a clearing fan, at least he is starting to recognize some of the problems. In particular, he acknowledges that it necessary to consider the interaction between CCPs and the broader financial system. Though I must say that since he mentions multilateral netting as the primary reason why CCPs contribute to financial stability, and margins as the second, it’s painfully evident that he doesn’t grasp the fundamental nature of clearing. In the first instance, netting and collateral just redistribute losses, and it is not clear that this redistribution enhances stability. In the second instance, although he acknowledges the problems with margin pro cyclicality, he doesn’t explicitly recognize the strains that large margin flows put on liquidity supply, and the destabilizing effect of these strains.

So it’s a start, but there’s a long way to go.

Tarullo pays most attention to the implications of CCP failure, and to measures to reduce the likelihood of this failure. Yes, failure of a large CCP would be catastrophic, but as I’ve oft written, the measures designed to save them can be catastrophic too.

Tarullo would be well-advised to read this short piece by Michael Beaton, which summarizes many of the issues quite well. The last few paragraphs are worth quoting in full:

In general, I think what we need to take away from all of this is that systemic risk can be transferred – it’s arguable whether or not it can be reduced – but it certainly can’t be eliminated, and the clearing model that we are working towards is a hub and spoke which concentrates risk on a very, very small number of names.

A decentralised network is arguably stronger than a hub and spoke model, mainly because open systems are generally regarded as more robust than closed ones. The latter is what the clearing model operates on and you have that single, glaring point of failure, and there’s really no escape from that.

So, going back to the original questions – do I think the proposals are enough?  I think it goes a long way, but fundamentally I don’t think it will ever resolve the problem of ‘too big to fail’.  I’m just not convinced it’s a problem that is capable of resolution. [Emphasis added.]

Exactly. (The comparison of open vs. closed systems is particularly important.)

Since clearing mandates create their own systemic risks, the Fed, and other central banks, and other macroprudential regulators, must grasp the nettle and determine what central bank support will be extended to CCPs in a crisis. Greenspan extemporized a response in the Crash of ’87, and it worked. But the task will be orders of magnitude greater in the next crisis, given the massively increased scope of clearing. It’s good that Tarullo and the Fed are starting to address these issues, but the mandates are almost 5 years old and too little progress has been made. Faster, please.

 

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April 3, 2015

BATS in the OCC’s Belfry?, or The Perils of Natural Monopoly Regulation, CCP Edition

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 11:13 am

The Options Clearing Corporation (“OCC”) and the exchanges that own it (Chicago Board Options Exchange, Incorporated, International Securities Exchange, LLC, NASDAQ OMX PHLX LLC, NYSE MKT LLC, and NYSE Arca) are embroiled in a dispute with virtually everyone else in the options business regarding its new capital plan. Pursuant to its designation as a “Systemically Important Financial Market Utility” (“SIFMU”) under Frankendodd, OCC was required to boost capital from $25 million to nearly $250 million. Part of this will be obtained through retained earnings, with an additional $150 million via a capital injection from the four owner-exchanges. In addition, CBOE et al promise to inject up to $117 million in the event of “unexpected losses”, which would be most likely to occur during a financial crisis.

In return, the owner-exchanges receive in essence preferred stock, which pays a dividend in perpetuity. The exact amount of the dividend is not known publicly, but those objecting to the plan (including BATS and KCG) claim that it could be as much as 16-19 pct, at least in the first few years of the plan’s operation.

Non-owner exchanges like BATS and market users like KCG are furious, claiming that the the capital plan allows OCC’s owners to “monetize” the rents accruing to its status as the monopoly clearer for options transactions in the US. They believe that OCC will pay for the dividend by charging super competitive fees that will impair competition among exchanges (advantaging the owner exchanges over the non-owners) and will burden market users.

This is a difficult issue, the nature of OCC. Here are some thoughts:

1. OCC is a regulated monopoly, and arguably a natural monopoly.This creates the traditional conflict between the owners of the utility and its customers, which include other exchanges that aren’t owners (like BATS) and clearing firms and market users (like KCG). This is in many ways very similar to a dispute between a traditional electric utility and its ratepayers heard before a state utility commission, with the exception that this is before the SEC.

2. Like a traditional are case involving a regulated utility, the dispute here is over what is a fair rate of return on capital. BATS and KCG are objecting to the rate of return the 4 exchange owners of OCC are being promised for their capital contribution, and the process by which the SEC approved this rate of return.

3. It is particularly challenging to determine a “fair” rate of return on this capital because of the unique risks that the OCC exchanges are assuming. This capital is at risk of taking a big hit, and the owner-exchanges are potentially obligated to make additional capital contributions, during periods of financial crisis (the “dire circumstances”) referred to in BATS’s letter to the SEC. This tends to make this capital very expensive, and it should therefore earn a relatively high rate of return (high dividend). Capital that has bad returns when the market is doing poorly overall-“high beta”, if you will-is expensive capital. The type of capital being provided is fraught with wrong-way risk: it is likely to take a hit precisely when the capital suppliers are least able to afford it. Determining how much of a risk premium is warranted is a challenge, because of the exceptional nature of the risk. In essence, the exchanges are assuming tail risk, i.e., the risk of exceptional events, and it is inherently difficult to evaluate and price these risks.

4. The other exchanges and firms like KCG benefit from the risk bearing capital supplied by the owner exchanges. Otherwise, they would have to bear the risk. But of course they would like to underpay for this benefit, just as the owner exchanges might want to overcharge for it.

5. In other words, this situation is tailor made for disputes. Monopoly rate setting to determine fair rates and a fair rate of return on capital with very unusual and hard to evaluate risks.

6. The fears about the effects of pricing on inter-exchange competition in execution service are misdirected. Yes, it is possible that the owner exchanges will capture monopoly rents accruing to the OCC’s dominant position, but traditional “one monopoly rent” analysis implies that they don’t have an incentive to use OCC pricing power to advantage their competitive position in execution services. Indeed, the opposite is true.

This also highlights some organization, ownership and governance issues that I addressed in my research on exchanges that culminated in my 2000 JLE piece. Exchanges (and clearinghouses) have market power, and serve disparate and heterogeneous interests. They can use pricing to redistribute rents (which accrue in part due to market power) from one group of intermediaries to another. Not-for-profit status and mutual ownership (having the exchange or CCP operate as a non-profit “utility” serving disparate intermediary-owners is a way of reducing rent seeking and mitigating the use of pricing to redistribute rents.

But non-profit, mutual organization comes at a cost. It requires highly participative, committee-heavy governance that slows decision making and often creates gridlock that makes it difficult for the exchanges/CCPs to respond to technology, regulatory, or market shocks. (Look at the CBT in the 1990s and early-2000s if you want an example.) If everybody has a voice and a vote, it is very difficult to get things done.

In sum, “financial market utility” pricing and governance is inherently messy and controversial.  It has all of the problems associated with public utility regulation, and then some. The problems are particularly daunting when it comes to capitalizing, allocating and pricing the systemic and wrong way risks that CCPs bear. Given these complexities, I won’t venture an opinion here, except to say that (a) I can see both sides of the argument here, and (b) this ain’t going away anytime soon.

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March 30, 2015

An Elegant Answer to the Wrong Question (or an Incomplete One)

Filed under: Clearing,Derivatives,Economics,Financial crisis,Regulation — The Professor @ 1:14 pm

Rodney Garrett and Peter Zimmerman of the NY Fed have produced a paper studying the effect of clearing on derivatives counterparty risk exposures. It is basically an extension of the Duffle-Zhu paper from a few years ago. It studies more realistic networks and a more diverse set of scenarios than D-Z. It demonstrates that with a variety of network structures, clearing actually reduces netting efficiency and increases counterpart risk exposures. This is especially true with “scale free” or “core-periphery” networks, which are more realistic representations of actual derivatives markets than the all-to-all structure in D-Z. They show that when the system relies on relatively few crucial nodes, as is the case in most dealer structures, clearing reduces netting efficiency. This, as Garrett and Zimmerman note, could explain why clearing has not been adopted voluntarily. It also raises doubts about the advisability of clearing mandates, inasmuch as the alleged benefit of clearing is a reduction in counterparty credit exposures.

A few comments. The results, taken on their own terms, make sense. In particular, networks connecting dealers and customers via derivatives transactions, are endogenous. And although network structures are not necessarily efficient due to network externalities and path dependence, there are forces that lead to minimizing credit exposures. thus, although it would be Panglossian to assert that existing structures minimize these exposures, it should not be surprising that interventions that lead to dramatic alterations to networks increase counterparty risk exposures as existing networks are configured at least in part to reduce these exposures.

More importantly, though, there is the issue of whether counterparty risk exposure in derivatives transactions is the proper metric to evaluate the effect of clearing mandates. As I have noted for  years (as has Mark Roe), when participants in derivatives transactions have other liabilities, changes in netting efficiency in derivatives primarily redistribute wealth to or from one group of creditors (derivatives counteparties) from or to other creditors (e.g., unsecured lenders, commercial paper purchasers, deposit insurers). Netting and offset essentially privilege the creditors that can use them, at the expense of others who cannot. So telling me policy A reduces counterparty risk exposures by netting provides me very little information about the systemic effects of the policy. To understand the systemic effects, you need to understand the distributive effects across the full set of creditors impacted by the change in derivatives netting efficiency induced by the policy–and that would be every creditor of derivatives market participants. This paper, like all others in the area, does not do that.

Put another way. Papers in this literature say little about systemic risk because they only analyze a piece of the system. The derivatives-centric approach is of little value in assessing systemic risk. To analyze systemic risk, you need to analyze the system, not a piece of it.

What’s more, shuffling around credit risk is probably not the most important effect of clearing mandates, even though it receives the vast bulk of the attention. As I’ve written repeatedly in the past, including here, clearing reduces credit risk by increasing liquidity risk, most notably, through variation margining which results in the need to obtain cash in a hurry to meet margin calls, which can be large when there are large market shocks. The expansion of clearing to OTC markets which dwarf listed derivatives potentially leads to orders-of-magnitude increases in liquidity needs.

It is these liquidity demands which create huge potential systemic risks. Financial crises are usually liquidity crises: mechanisms such as clearing increase demands for liquidity in stressed market conditions, and do so in a way that increases the rigidity and tightness of the coupling in the financial system. This is extremely dangerous. Tight coupling in particular is associated with system failure in a variety of real world systems including both financial and non-financial systems.

Indeed, all of the attempts to make CCPs invulnerable all tend to exacerbate these problems. This raises the possibility that CCPs could be bastions surviving in the midst of a completely rubbled financial system.

In sum, papers like the Garrett-Zimmerman work are very elegant and technically sophisticated, and help answer a question: Does clearing reduce derivatives counterparty risk exposures? But all the elegance and technical sophistication is likely for naught given that the question is the wrong question, or a very incomplete one.

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February 4, 2015

Turn Out the Lights, The Party’s Over

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,History — The Professor @ 8:12 pm

What party, you ask? The one with the mosh pit at LaSalle and Jackson in Chicago.  The one held in the building that’s in the background image of this page.

That’s right. Today the CME Group announced it was ending floor trading of futures (with the exception of the S&P 500) in Chicago and New York. Floor trading of options will continue.

As a Chicagoan who knew the floor in its glory days, this is a sad day. The floor was an amazing place. (Even though the floors will remain open until July, the past tense is appropriate in that sentence.)  A seemingly chaotic place full of shouting and gesticulating men (and yes, it was an overwhelmingly male place). Despite the chaos, it was an extraordinarily efficient way to buy and sell futures. In the bond pit in the 80s and 90s, $100,000,000 notional could be bought in sold with a shout and a wave. Over and over and over.

The economics of the pits were fascinating, but the sociology was as well. They were truly little societies. There were the exchange rules that were in the book, and there were the rules not written in any book that you adhered to, or else. Face-to-face interactions day after day over periods of years created a unique dynamic and a unique culture with its own norms and hierarchies and rituals. And soon it will be but a memory.

Even though I am wistful at the passing of this remarkable institution, I was ahead of the curve in predicting its eventual demise. I worked at an FCM in 1986, when the CME, CBT, and Reuters announced the initial Globex initiative. This got me interested in electronic trading, and when I became an academic a few years later, I researched the subject. In 1994 I wrote one of the early papers documenting that electronic markets could be as liquid and deep as floor-based markets, and I conjectured that parity in liquidity and superiority in speed and cost of access would result in the ultimate victory of computers over the floor. The collective response in the industry was scorn: everyone knew the floor was more liquid, and always would be. The information environment on the floor could never be duplicated on the screen, they said. This view was epitomized by the CEO of LIFFE, Daniel Hodgson, who ridiculed me in the FT as an ivory tower academic.

The first sign that the floor’s days were numbered occurred in 1998, when computerized Eurex wrested the Bund futures contract from LIFFE. (Eurex used my research as part of its marketing push.) LIFFE suffered a near death experience, barely surviving by shutting the floor and going fully electronic. (Mr. Hodgson was shown the door, and I resisted the temptation of sending him a certain FT clipping.)

Computerized trading was only slowly making inroads in the US at the time, in part because the incumbent exchanges resisted its operation during regular floor trading hours. But the fear of the machines was palpable by the mid-1990s. The CBT built its massive trading floor in 1997 in part because the members believed that if it spent so much on a new building the exchange couldn’t afford to render it useless by going electronic. Ironic that a group of traders who lived and breathed real world economics would fall victim to the sunk cost fallacy, and be blind to the gales of competition and creative destruction.

The floor continued to thrive, but inexorably the machines gained on it. By the early-2000s electronic volumes exceeded floor volumes for most contracts, especially in the financials. By the end of the first decade of the millennium, the floors were almost vacant. I remember going to the crude oil pit in NY in early-2009, and where once well over 100 traders stood, engaged in frenzied buying and selling, now a handful of guys sat on the steps of the pit, reading the Post and the Daily News.

When the CME demutualized, and when it acquired CBT and NYMEX, it made commitments to keep the floors open for some period of time. But the commitments were not in perpetuity, and declining floor volumes made it evident that eventually the day would come that the CME would shut down the floors.

Today was that day.

This was inevitable, but in the 80s and 90s the floor trading community, and the futures business generally, couldn’t possibly imagine that machines could ever do what they did. But the technology of the floor was essentially static. Yes, the technology of getting orders to the pit evolved along with telecommunications, but once the orders got there, they were executed in the same way that they had been since 1864 or so.* That execution technology was highly evolved and efficient, but static. In the meantime, Moore’s Law and innovation in hardware, software, and communications technology made electronic trading faster and smarter. Electronic trading lacked some of the information that could be gleaned looking in the eyes of the guy standing across the pit, or knowing who was bidding or offering, but it made accessible to traders vast sources of disparate information that was impossible to absorb on the floor. By the late-00s, HFT essentially computerized what was in locals’ heads, and did it faster with more information and fewer errors and less emotion. Guys that were all about competition were displaced by the competition of a more efficient technology.

Floor trading will live on for a while, in the options pits. Combination trades in options are complex in ways that there are efficiencies in doing them on the floor. But eventually machines will master that too. ICE closed its options pits a couple of years ago (four years after it closed its futures pits), and one day the CME will do so too.

The news of the CME announcement reminded me of something that happened almost exactly 10 years ago, 21 February 2005. Around that time, the management of  the International Petroleum Exchange was discussing the closure of the floor. (It decided to do so on 7 March.) Floor traders were very anxious about their future. Totally oblivious to this, Greenpeace decided to mount a protest on the IPE floor to commemorate the Kyoto Protocol. Bad decision. Bad timing. The barrow boys of the London floors, already in a sour mood, didn’t take kindly to this invasion, and mayhem ensued. Punches were thrown. Bones were broken. Furniture was thrown. There was much comedy:

“The violence was instant,” reported one aggrieved recipient of a rain of blows to the head. “I’ve never seen anyone less amenable to listening to our point of view.”

You can’t make that up.

From what I understand, the response was much more subdued in Chicago and New York today. But then again, Occupy or GMO protesters didn’t attempt to sally onto the floor to flog their causes. If they had, they just might have caught a flogging like the enviros did in London a decade back.

Being of a historical bent, I will look back on the floors with fascination. I am grateful to have known them personally, and to have known many who trod the boards in the pit in their colorful jackets, shouting themselves hoarse and at constant risk of being stabbed in the neck with a pencil wielded by a hyperactive peer.

Today is a good day to watch Floored or The Pit. Or even play a game of Pit. The films will give you something of a feel, but just a bit.

2015. The year Chicago lost Ernie Banks and the floor. But life moves on. Machines do not have the color of the floor, but they perform the markets’ vital functions more efficiently now. And not everything has changed in Chicago. The Cubs are still horrible.

*The exact beginning of floor trading on the CBT is unknown. The Board of Trade of the City of Chicago was formed in 1848, but futures trading proper probably did not begin until the Civil War. Sometime in the 1862-1864 period floor trading as we know it today-or should I say knew it?-developed. The first formal trading rules were promulgated in 1867. If you look at pictures from the 19th century or early-20th century, other than the clothes things don’t look much different than they did in the 1980s or 1990s. Electronic boards replaced chalk boards, but other than that, things look very similar.

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December 6, 2014

Hit the Road, State Street

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 11:51 pm

Following the lead of Bank of New York, State Street announced that it is exiting the swaps clearing business:

State Street (STT) Corp. is closing down its swaps business after clients said new regulations steered them away for using the products.

The bank will shutter its U.S. business for clearing swaps early next year and will shelve plans to start a similar operation in Europe, Anne McNally, a spokeswoman for the Boston-based company, said in an e-mail statement today.

State Street will instead focus on trading other types of derivatives, particularly more traditional exchange-traded futures, that have not been subject to broad new regulations imposed since the 2008 financial crisis.

“Due to market and regulatory factors, our clients have largely evolved their investment strategies towards the use of futures and away from” over-the-counter derivatives, McNally said in the statement.

From even before Frankendodd was passed, I predicted that the swap clearing firm business would be highly concentrated and dominated by the major dealers who had dominated the OTC market. Indeed, I argued that the regulatory overhead created by Frankendodd would actually tend to increase scale economies and make the clearing services business more concentrated and connected.

But Gensler, with the vocal support of BNY, State Street, and Ken Griffen of Citadel-and also MF Global-argued that there was a clearing cabal of dealer firms that was was creating unnecessary barriers to entry into clearing. BNY and State Street claimed that the dealers were forcing ICE Clear to require members to have excessively large amounts of capital, an this prevented them from becoming clearing members. Tear down those walls, and doughty entrants like BNY and State Street and Newedge and others would make the clearing business far more competitive.

This view was channeled in a NY Times story written by Louise Story almost exactly four years ago: I criticized Story’s story pretty harshly. Reflecting this view, the CFTC rules substantially eased the capital requirements and other requirements to become clearing members. Gensler, BNY, STT, etc., thought that this would lead to a much less concentrated, much more competitive clearing business.

But this was to misunderstand the economics of clearing, clearing firm scale and scope economies, and how the complicated regulatory structure CFTC put in place exacerbated these scale economies. Even futures clearing (which is substantially simpler than swaps clearing) has become much more concentrated over the years. Only the truly huge can survive.

BNY and State Street tried, and failed. They couldn’t overcome their inadequate scale even though they could offer complementary collateral management and custodial services. They were just too small.

State Street announced that it was going to focus on futures clearing, but even here it faces problems. It just lost its biggest customer (Pimco). Moreover, there are scope economies between futures clearing and swap clearing. State Street will be at a disadvantage relative to say Goldman, which can offer customers who trade both swaps and futures one stop shopping for clearing services at lower cost because of these scope economies.

So much for clearing mandates making the financial markets less concentrated and less interconnected: instead we (predictably and predicted) have a derivatives marketplace dominated by a small number of CCPs each dominated by a small number of large bank clearing members who are members of all major CCPs, which makes entire world clearing space concentrated and highly interconnected. That anybody thought the post-crisis regulations would reduce concentration and interconnections in swaps markets is illuminating. It demonstrates that those primarily responsible for implementing Frankendodd didn’t really understand the economics of what they were attempting to regulate, and as a result, they didn’t really know what they were doing.  They thought they were striking a blow against too big to fail and a collusive dealer oligopoly. They were wrong, and State Street’s abandonment of its swaps clearing effort is just further proof of how wrong they were.

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October 13, 2014

You Might Have Read This Somewhere Before. Like Here.

The FT has a long article by John Dizard raising alarms about the systemic risks posed by CCPs. The solution, in other words, might be the problem.

Where have I read that before?

The article focuses on a couple of regulatory reports that have also raised the alarm:

No, I am referring to reports filed by the wiring and plumbing inspectors of the CCPs. For example, the International Organization for Securities Commissions (a name that could only be made duller by inserting the word “Canada”) issued a report this month on the “Securities Markets Risk Outlook 2014-2015”. I am not going to attempt to achieve the poetic effect of the volume read as a whole, so I will skip ahead to page 85 to the section on margin calls.

Talking (again) about the last crisis, the authors recount: “When the crisis materialised in 2008, deleveraging occurred, leading to a pro-cyclical margin spiral (see figure 99). Margin requirements also have the potential to cause pro-cyclical effects in the cleared markets.” The next page shows figure 99, an intriguing cartoon of a margin spiral, with haircuts leading to more haircuts leading to “liquidate position”, “further downward pressure” and “loss on open positions”. In short, do not read it to the children before bedtime.

This margin issue is exactly what I’ve been on about for six years now. Good that regulators are finally waking up to it, though it’s a little late in the day, isn’t it?

I chuckle at the children before bedtime line. I often say that I should give my presentations on the systemic risk of CCPs while sitting by a campfire holding a flashlight under my chin.

I don’t chuckle at the fact that other regulators seem rather oblivious to the dangers inherent in what they’ve created:

While supervisory institutions such as the Financial Stability Oversight Council are trying to fit boring old life insurers into their “systemic” regulatory frameworks, they seem to be ignoring the degree to which the much-expanded clearing houses are a threat, not a solution. Much attention has been paid, publicly, to how banks that become insolvent in the future will have their shareholders and creditors bailed in to the losses, their managements dismissed and their corporate forms put into liquidation. But what about the clearing houses? What happens to them when one or more of their participants fail?

I call myself the Clearing Cassandra precisely because I have been prophesying so for years, but the FSOC and others have largely ignored such concerns.

Dizard starts out his piece quoting Dallas Fed President Richard Fisher comparing macroprudential regulation to the Maginot Line. Dizard notes that others have made similar Maginot Line comparisons post-crisis, and says that this is unfair to the Maginot Line because it was never breached: the Germans went around it.

I am one person who has made this comparison specifically in the context of CCPs, most recently at Camp Alphaville in July. But my point was exactly that the creation of impregnable CCPs would result in the diversion of stresses to other parts of the financial system, just like the Maginot line diverted the Germans into the Ardennes, where French defenses were far more brittle. In particular, CCPs are intended to eliminate credit risk, but they do so by creating tremendous demands for liquidity, especially during crisis times. Since liquidity risk is, in my view, far more dangerous than credit risk, this is not obviously a good trade off. The main question becomes: During the next crisis, where will be the financial Sedan?

I take some grim satisfaction that arguments that I have made for years are becoming conventional wisdom, or at least widespread among those who haven’t imbibed the Clearing Kool Aid. Would that have happened before legislators and regulators around the world embarked on the vastest re-engineering of world financial markets ever attempted, and did so with their eyes wide shut.

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October 5, 2014

Damage Control at the CFTC

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 7:39 pm

The WSJ recently ran an article describing the ongoing standoff between the EU and the CFTC over swaps clearing. The Europeans have refused to certify any US clearinghouse as being subject to regulations equivalent to those under which European CCPs do. For its part, the CFTC has refused to recognize EU CCPs. The Europeans have pointedly recognized CCPs from a variety of other nations, including Japan, Hong Kong and India: things are so bad between the US and Europe that I wouldn’t be surprised if the Euros certified a North Korean CCP before they did the same for CME or another US CCP.

Failure to certify will mean that it will become prohibitively expensive for US firms to clear swaps in Europe, and vice versa. This will exacerbate the already worrisome fragmentation of swaps markets along jurisdictional lines.

The Euros are furious at the US’s rather imperialistic attitude on derivatives regulation, especially under the Gensler chairmanship of the CFTC. As new commissioner Christopher Giancarlo points out in a scathing speech delivered at the recent FIA meetings in Geneva, this imperialism was not limited to clearing issues alone. It also involved attempts to dictate how trades are executed, that is, the “Worst of Frankendodd” SEF mandate:

Making things worse, the CFTC swaps trading rules contain a host of peculiar limitations based on practices in the US futures markets that have not been adopted in the EU11 or anywhere else. Several of these peculiar CFTC swaps trading rules are contrary to common practice in global markets and are unlikely to be replicated by non-US regulators, including:

  • Trading only on order books and request for quote (RFQ) systems to TWO then THREE counterparties;12
  • Exchange-certified “made available to trade” determinations;13
  • Swap Execution Facility (SEF) position-limit maintenance and enforcement;14
  • Limitations on counterparty transparency;15 and
  • 10 CFTC Staff Advisory No. 13-69 (Nov. 14, 2013), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/13-69.pdf.

Now I have long been a critic of these rules. And so my criticism is not new and is not directed at the staff of the CFTC who worked hard to adapt existing trading models to meet greatly expedited implementation deadlines.

Here’s the key paragraph:

The avowed purpose of the CFTC’s broad assertion of jurisdiction is to insulate the United States from systemic risk. Yet, on the ostensible grounds of ring-fencing the US economy from harm, the CFTC purports to tell global swaps markets involving US persons to adopt particular CFTC trading mechanics that do almost nothing to reduce counterparty risk. In the words of one former senior CFTC advisor, the Interpretative Guidance “yoked together rules designed to reduce risk with rules designed to promote market transparency. Yet it provided almost no guidance about how to think about the extraterritorial application of market transparency rules independent of risk. As a result, [the CFTC prescribed] how to apply US rules abroad based on considerations that are tangential to the purposes of those rules.”

How do like them apples? (Those who remember the Gensler regime will know what I’m referring to.) As Giancarlo notes, a US obsession with swaps execution, that has nothing to do with reducing systemic risk, is causing jurisdictional fragmentation that likely increases systemic risk. What’s more, I would add that this is nuts even on its own terms. The idea behind SEFs was to increase competition in swaps execution. But fragmenting the market between the US and Europe reduces competition.

Giancarlo also rightly criticizes the fact that the CFTC issued an “Interpretive Guidance” and a “Staff Advisory” rather than a formal rule. In theory firms could disregard this “guidance”, but in practice that would be a very dangerous and risky thing to do. Meaning that the CFTC has effectively imposed an indefensible policy without going through the processes that are intended to mitigate policy mistakes. Unfortunately, a federal judge recently ruled against an industry legal challenge to the CFTC’s imposition of its dictates through such procedural legedermain.

Giancarlo has a concrete proposal to eliminate the impasse:

But we can go further. I intend to do everything I can to encourage the CFTC to replace its cross-border Interpretative Guidance with a formal rulemaking that recognizes outcomes-based substituted compliance for competent non-US regulatory regimes. As part of that effort, I will seek the withdrawal of the CFTC staff’s November 2013 Advisory that fails not only the letter and spirit of the “Path Forward,” but also contradicts the conceptual underpinnings of the CFTC’s Interpretive Guidance.

I hope that happens, but the question is whether it will happen in time. Unless the impasse is resolved soon, the “Balkanization” that Giancarlo laments will only get worse. Once that division becomes established, it will be difficult to reverse later, even if the the US and EU eventually recognize the equivalence of each other’s CCPs.

The good news here is that new Chair Timothy Massad also appears to be substantially less rigid, dictatorial, and imperious than his predecessor Gensler. Perhaps we shall see a more reasonable approach to derivatives regulation, especially on cross-border issues. This will not be sufficient to undo the many defects of Frankendodd, but it may at least mitigate the damage.

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September 29, 2014

McNamara on Pirrong & Clearing: Serious, Fair, But Ultimately Unpersuasive

Stephen Lubben passed along this paper on central clearing mandates to me. It would only be a modest overstatement to say that it is primarily a rebuttal to me. At the very least, I am the representative agent of the anti-clearing mandate crowd (and a very small crowd it is!) in Steven McNamara’s critique of opposition to clearing mandates.

McNamara’s arguments are fair, and respectfully presented. He criticizes my work, but in an oddly complimentary way.

I consider it something of a victory that he feels that it’s necessary to go outside of economics, and to appeal to Rawlsian Political Theory and Rawls’s Theory of Justice to counter my criticisms of clearing mandates.

There are actually some points of commonality between McNamara and me, which he fairly acknowledges. Specifically, we both emphasize the incredible complexity of the financial markets generally, and the derivatives markets in particular. Despite this commonality, we reach diametrically opposed conclusions.

Where I think McNamara is off-base is that he thinks I don’t pay adequate attention to the costs of financial crises and systemic risk. I firmly disagree. I definitely am very cognizant of these costs, and support measures to control them. My position is that CCPs do not necessarily reduce systemic risk, and may increase it. I’ve written several papers on that very issue. The fact that I believe that freely chosen clearing arrangements are more efficient than mandated ones in “peacetime” (i.e., normal, non-crisis periods) (something McNamara focuses on) only strengthens my doubts about the prudence of mandates.

McNamara addresses some of the arguments I make about systemic risk  in his paper, but it does not cite my most recent article that sets them out in a more comprehensive way.  (Here’s an ungated working paper version: the final version is only slightly different.) Consequently, he does not address some of my arguments, and gets some wrong: at least, in my opinion, he doesn’t come close to rebutting them.

Consider, for instance, my argument about multilateral netting. Netting gives derivatives priority in bankruptcy. This means that derivatives counterparties are less likely to run and thereby bring down a major financial institution. McNamara emphasizes this, and claims that this is actually a point in favor of mandating clearing (and the consequent multilateral netting). My take is far more equivocal: the reordering of priorities makes other claimants more likely to run, and on balance, it’s not clear whether multilateral netting  reduces systemic risk. I point to the example of money market funds that invested in Lehman corporate paper. There were runs on MMFs when they broke the buck. Multilateral netting of derivatives would make such runs more likely by reducing the value of this corporate paper (due to its lower position in the bankruptcy queue). Not at all clear how this cuts.

McNamara mentions my concerns about collateral transformation services, and gives them some credence, but not quite enough in my view.

He views mutualization of risk as a good thing, and doesn’t address my mutualization is like CDO trenching point (which means that default funds load up on systemic/systematic risk). Given his emphasis on the risks associated with interconnections, I don’t think he pays sufficient concern to the fact that default funds are a source of interconnection, especially during times of crisis.

Most importantly, although he does discuss some of my analysis of margins, he doesn’t address my biggest systemic risk concern: the tight coupling and liquidity strains that variation margining creates during crises. This is also an important source of interconnection in financial markets.

I have long acknowledged-and McNamara acknowledges my acknowledgement-that we can’t have any great certainty about how whether clearing mandates will increase or reduce systemic risk. I have argued that the arguments that it will reduce it are unpersuasive, and often flatly wrong, but are made confidently nonetheless: hence the “bill of goods” title of my clearing and systemic risk paper (which the editor of JFMI found provocative/tendentious, but which I insisted on retaining).

From this “radical” uncertainty, arguing in a Rawlsian vein, McNamara argues that regulation is the right approach, given the huge costs of a systemic crisis, and especially their devastating impact on the least among us. But this presumes that the clearing mandate will have its intended effect of reducing this risk. My point is that this presumption is wholly unfounded, and that on balance, systemic risks are likely to increase as the result of a mandate, especially (and perhaps paradoxically) given the widespread confidence among regulators that clearing will reduce it.

McNamara identifies me has a hard core utilitarian, but that’s not quite right. Yes, I think I have decent formal economics chops, but I bring a Hayekian eye to this problem. Specifically, I believe that in a complex, emergent system like the financial markets (and derivatives are just a piece of that complex emergent system), top down, engineered, one-size-fits-all solutions are the true sources of system risk. (In fairness, I have made this argument most frequently here on the blog, rather than my more formal writings, so I understand if McNamara isn’t aware of it.) Attempts to design such systems usually result in major unintended consequences, many of them quite nasty. In some of my first remarks on clearing mandates at a public forum (a Columbia Law School event in 2009), I quoted Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

I’ve used the analogy of the Sorcerer’s Apprentice to make this point before, and I think it is apt. Those intending to “fix” something can unleash forces they don’t understand, with devastating consequences.

At the end of his piece, McNamara makes another Rawlsian argument, a political one. Derivatives dealer banks are too big, to politically influential, corrupt the regulatory process, and exacerbate income inequality. Anything that reduces their size and influence is therefore beneficial. As McNamara puts it: clearing mandates are “therefore a roundabout way to achieve a reduction in their status as ‘Too Big to Fail,’ and also their economic and political influence.”

But as I’ve written often on the blog, this hope is chimerical. Regulation tends to create large fixed costs, which tends to increase scale economies and therefore lead to greater concentration. That clearly appears to be the case with clearing members, and post-Frankendodd there’s little evidence that the regulations have reduced the dominance of big banks and TBTF. Moreover, more expansive regulation actually increases the incentive to exercise political influence, so color me skeptical that Dodd-Frank will contribute anything to the cleaning of the Augean Stables of the American political system. I would bet the exact opposite, actually.

So to sum up, I am flattered but unpersuaded by Steven McNamara’s serious, evenhanded, and thorough effort to rebut my arguments against clearing mandates, and to justify them on the merits. Whether it is on “utilitarian” (i.e., economic) or Rawlsian grounds, I continue to believe that arguments and evidence weigh heavily against clearing mandates as prudent policy.  But I am game to continue the debate, and Steve McNamara has proved himself to be a worthy opponent, and a gentleman to boot.

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September 8, 2014

Cleaning Up After the Dodd, Frank & Gensler Circus

A lot of CFTC news lately. Much of it involves the agency, under new chairman Timothy Massad, dealing with the consequences of Frankendodd and the overzealous efforts of his predecessor Gary Gensler to implement it.

One of Massad’s priorities relates to clearinghouses (CCPs):

CFTC Chairman Timothy Massad said in a Sept. 5 interview that his agency will bolster examinations of clearinghouses, which process trillions of dollars in transactions and are potentially vulnerable to market shocks or cyber attacks. The agency is working with the Federal Reserve on the effort, he said.

New rules requiring banks and other firms to use clearinghouses owned by LCH.Clearnet Group Ltd., CME Group Inc. (CME) and Intercontinental Exchange Inc. (ICE) have been “a great thing” and have helped regulators “monitor and mitigate risks, but it doesn’t eliminate risk,” according to Massad.

“We’ve got to be very focused on the health of clearinghouses,” he said.

It’s nice to see that the CFTC, as well as prudential regulators, recognize that CCPs are of vital systemic importance. But as I’ve said many times, on four continents: In a complex, interconnected financial system, making CCPs less likely to default  does not necessarily increase the safety of the financial system. Making one part of the system safer does not make the system safer. It can prevent one Armageddon scenario, but increase the likelihood of others.

Gensler babbled repeatedly about the clearing mandate reducing the interconnectedness of the financial system. In fact, it just reconfigures the interconnections. The very measures that are intended to ensure CCPs get paid what they are owed even in periods of crisis can redirect crushing stresses to other vulnerable parts of the financial system. CCPs may end up standing, surrounded by the rubble of the rest of the financial system.

CCPs are deeply enmeshed in a complex web of credit and payment relationships. Mechanisms intended to reduce CCP credit exposure-multilateral netting, high initial margins, rigorous variation margining-feed back into other parts of that web.

There are so many interconnected parts. Today Risk ran an article about how LCH relies heavily on two settlement banks, JPM and Citi. Although LCH will not confirm it, it appears that these two banks process  about 85 percent of the payments between clearing members and LCH. This process involves the extension of intraday credit. This creates exposures for these two big SIFIs, and makes the LCH’s viability dependent on the health of these two banks: if one of them went down, this could cause extreme difficulties for LCH and for the clearing members. That is, OTC derivatives clearing adds a new way in which the financial system’s health and stability depend on the health of big banks, and creates new risks that can jeopardize the health of the big banks.

So much for eliminating interconnectedness, Gary. It’s just been moved around, and not necessarily in a good way.

Again, mitigating systemic risk requires taking a systemic perspective. The fallacy of composition is a major danger, and a very alluring one. The idea that the system gets safer when you make a major part of it safer is just plain wrong. The system is more than just the sum of its parts. Moreover, it can actually be the case that making one part of the system stronger, but more rigid, as clearing arguably does, makes the system more vulnerable to catastrophic failure. Or at least creates new ways that it can fail.

Another issue on Massad’s plate is addressing the conflict between his agency and Europe on giving regulatory approval to each other’s CCPs. It looks like this issue will not get resolved by the drop dead date in December. This will result in substantially higher costs (primarily in the form of higher capital requirements and higher margins), the fragmentation of OTC derivatives markets, and greater counterparty concentration (as US firms avoid European CCPs and vice versa).

The CFTC is also trying to fix its fundamentally flawed position limit proposal, and particularly the defective, overly restrictive, and at times clueless hedging exemptions. Mencken defined Puritanism as “The haunting fear that someone, somewhere, may be happy.” The CFTC’s hedging exemption, as currently constituted, reflects a sort of financial Puritanism: “The haunting fear that someone, somewhere, may be speculating.” To avoid this dread possibility, the exemptions are so narrow that they eliminate some very reasonable risk management strategies, such as using gas forwards to hedge electricity price exposures.

This has caused an uproar among end users, including firms like Cargill that have been hedging since the end of the freaking Civil War. Perhaps their survival suggests they might know something about the subject.

In the “be careful what you ask for” category, the CFTC is wrestling with a very predictable consequence of one of its decisions. In an attempt to wall off the US from major shocks originating overseas, the Gensler CFTC adopted rules that would have subjected foreign firms dealing with foreign affiliates of US banks to US regulations if the parents provided guarantees for those affiliates. Foreign firms definitely didn’t want to be subjected to the tender mercies of the CFTC and Frankendodd regs. So to maintain this business, the parents stripped away the guarantees.

Problem solved, right? The elimination of the guarantee would eliminate a major potential channel of contagion between the dodgy furriners and the US financial system, right? That was the point, right?

Apparently not. The CFTC has major agida over this:

Timothy Massad, the new CFTC chairman, said in an interview he is concerned aboutrecent moves by several large Wall Street firms to sidestep CFTC oversight by changing the terms of some swap agreements made by foreign affiliates.

“The concern has always been that activity that takes place abroad can result in the importation of risk into the U.S.,” Mr. Massad said. He said there is a concern that a U.S. bank’s foreign losses would ultimately find their way to U.S. shores, infecting the parent company in possibly destabilizing ways.

. . . .

The moves mean any liability for those swaps lies solely with the offshore operation, which the banks have said will protect the U.S. parent from contagion. Yet without that tie to the U.S. parent, the contracts won’t fall under U.S. jurisdiction and so won’t be subject to strict rules set by the 2010 Dodd-Frank financial-overhaul law, including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms [i.e., the SEF mandate].

By de-guaranteeing, the US banks have eliminated the most direct channel of contagion from over there to over here. But apparently the CFTC is worried that unless its regulations are followed overseas, there will be other, albeit more indirect, backdoors into the US.

In essence, then, the CFTC believes its regulations are by far superior to those in Europe and elsewhere, and that unless its regulations are implemented everywhere, the US is at risk.

Not too arrogant, eh?

A few observations should make you question this arrogance, and in a  big way.

First, note that the most likely effect of the CFTC getting its way of exporting its regulations into any transaction and any entity involving any affiliate of a US financial institution is that foreign entities will just avoid dealing with any such affiliate. This will balkanize the global derivatives market: ‘mericans will deal with ‘mericans, and Euros with Euros, and never the twain shall meet. This will likely result in greater counterparty concentration. Such developments would create systemic vulnerabilities, and even though the direct counterparty credit channel could not bring that risk back to US banks, the myriad other connections between foreign banks and American ones would.

Second, note the last sentence of the quoted paragraph: “including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms.” So apparently attempts to avoid the SEF mandate infuriate the CFTC. But the SEF mandate has nothing to do with systemic risk. For this reason, and others, I named this mandate “The Worst of Frankendodd.” But so intent is the CFTC on pursuing this systemically irrelevant unicorn that it is questioning moves by US banks that actually reduce their exposure to problems in foreign markets.

Timothy Massad has the unwelcome task of cleaning up after the elephant parade at the Dodd, Frank & Gensler Circus. Clearing mandates, coordinating with overseas regulators, position limits, and the elimination of affiliate guarantees are only some of the things that he has to clean up. I hope he’s got a big shovel and a lot of patience.

 

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August 17, 2014

This Never Happens, Right?: Regulators Push a Flawed Solution

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 6:06 pm

Regulators are pushing ISDA and derivatives market participants really hard to incorporate a stay on derivatives trades of failing SIFIs. As I wrote a couple of weeks ago, this is a problem if bankruptcy law involving derivatives is not changed because the prospect of having contracts stayed, and thus the right of termination abridged, could lead counterparties to run from a weak counterparty before it actually defaults. This is possible if derivatives remain immune from fraudulent conveyance or preference claims.

Silla Brush, who co-wrote an article about the issue in Bloomberg, asked me a good question via Twitter: why should derivatives counterparties run, if they are confident that their positions with the failing bank will be transferred to a solvent one during the resolution process?

I didn’t think of the answer on the fly, but upon reflection it’s pretty clear. If counterparties were so confident that such a transfer will occur, a stay would be unnecessary: they would not terminate their contracts, but would breathe a sigh of relief and wait patiently while the transfer takes place.

If regulators think a stay is necessary, it is because they fear that counterparties would prefer to terminate their contracts than await their fate in a resolution.

So a stay is either a superfluous addition to the resolution process, or imposes costs on derivatives counterparties who lack confidence in that process.

If this is true, the logic I laid out before goes through. If you impose a stay, if market participants would prefer to terminate rather than live with the outcome of a resolution process, they have an incentive to run a failing bank, and find a way to get out of their derivatives positions and recover their collateral.

This can actually precipitate the failure of a weak bank.

I say again: constraining the actions of derivatives counterparties at the time of default can have perverse effects if their actions prior to default are not constrained.

This means that you need to fix bankruptcy rules regarding derivatives in a holistic way. And this is precisely the problem. Despairing at their ability to achieve a coherent, systematic fix of bankruptcy law in the present political environment, regulators are trying to implement piecemeal workarounds. But piecemeal workarounds create more problems than they correct.

But of course, the regulators pressing for this are pretty much the same people who rushed clearing mandates and other aspects of Frankendodd into effect without thinking through how things would work in practice.

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