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Streetwise Professor

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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Nationalize the Clearinghouses?

Filed under: Clearing,Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 3:48 pm

Stephen Lubben has garnered a lot of attention with his recent paper “Nationalize the Clearinghouses.” Don’t get nervous, CME, ICE, LCH: he doesn’t mean now, but in the event of your failure.

A few brief comments.

First, I agree-obviously, since I’ve been saying this going back to the 90s-that the failure of a big CCP would be a catastrophic systemic event, and that a failure is a set of positive measure. Thus, planning for this contingency is essential. Second, I further agree that establishing a procedure that lays out in advance what will be done upon the failure of a CCP is vital, and that leaving things to be handled in an ad hoc way at the time of failure is a recipe for disaster (in large part because how market participants would respond to the uncertainty when a CCP teeters on the brink). Third, it is evident that CCPs do not fit into the recovery and resolution schemes established for banks under Frankendodd and EMIR. CCPs are very different from banks, and a recovery or resolution mechanism designed for banks would be a bad, bad fit for clearers.

Given all this, temporary nationalization, with a pre-established procedure for subsequent privatization, is reasonable. This would ensure continuity of operations of a CCP, which is essential.

It’s important not to exaggerate the benefits of this, however. Stephen states: nationalization “should provide stakeholders in the clearinghouses with strong incentives to oversee the clearinghouse’s management, and avoid such a fate.” I don’t think that the ex ante efficiency effects of nationalization will be that large. After all, nationalization would occur only after the equity of the CCP (which is pretty small to begin with) is wiped out, and the default fund plus additional assessments have been blown through. Shooting/nationalizing a corpse doesn’t have much of an incentive effect on the living ex ante.

Stephen recommends that upon nationalization that CCP memberships be canceled. This is superfluous, given the setup of CCPs. Many CCPs require members to meet an assessment call up to the amount of the original contribution to the default fund. Once they have met that call, they can resign from the CCP: that’s when the CCP gives up the ghost. Thus, a CCP fails when members exercise their option to check out. There are no memberships to cancel in a failed CCP.

Lubben recommends that there be an “expectation of member participation in the recapitalization of the clearinghouse, once that becomes systemically viable.” In effect, this involves the creation of a near unlimited liability regime for CCP members. The existing regime (which involves assessment rights, typically capped at the original default fund contribution amount) goes beyond traditional limited liability, but not all the way to a Lloyds of London-like unlimited liability regime. Telling members that they will be “expected” to recapitalize a CCP (which has very Don Corleone-esque overtones) essentially means that membership in a CCP requires a bank/FCM to undertake an unlimited exposure, and to provide capital at times they are likely to be very stressed.

This is problematic in the event, and ex ante.

Stephen qualifies the recapitalization obligation (excuse me, “expectation”) with “once that becomes systemically viable.” Well, that could be a helluva long time, given that the failure of a CCP will be triggered by the failure of 2 or more systemically important financial institutions. (And let’s not forget that given the fact that FCMs are members of multiple clearinghouses, multiple simultaneous failures of CCPs is a very real possibility: indeed, there is a huge correlation risk here, meaning that surviving members are likely to be expected to re-capitalize multiple CCPs.) Thus, even if the government keeps a CCP from failing via nationalization, the entities that it expects to recapitalize the seized clearinghouse will will almost certainly be in dire straits themselves at this juncture. A realistic nationalization plan must therefore recognize that the government will be bearing counterparty risk for the CCP’s derivatives trades for some considerable period of time. Nationalization is not free.

Ex ante, two problems arise. First, the prospect of unlimited liability will make banks very reluctant to become members of CCPs. Nationalization plus a recapitalization obligation is the wrong-way risk from hell: banks will be expected to pony up capital precisely when they are in desperate straits. My friend Blivy jokingly asked whether there will soon be more CCPs than clearing firms. An “expectation” of recapitalizing a nationalized CCP is likely to make that a reality, rather than a joke.

Second, the nationalization scheme creates a moral hazard. Users of CCPs (i.e., those trading cleared derivatives) will figure that they will be made whole in the event of a failure: the government and eventually the (coerced) banks will make the creditors of the CCP whole. They thus have less incentive to monitor a CCP or the clearing members.

Thus, other issues have to be grappled with. Specifically, should there be “bail-ins” of the creditors of a failed CCP, most notably through variation margin haircutting? Or should there be initial margin haircutting, which would intensify the incentives to monitor (as well as spread the default risk more broadly, and not force it disproportionately on those receiving VM payments, who are  likely to be hedgers) ? Hard questions, but ones that need to be addressed.

It is good to see that serious people like Stephen are now giving serious consideration to this issue. It is unfortunate that the people responsible for mandating clearing didn’t give these issues serious consideration when rushing to pass Frankendodd and EMIR.

Again: legislate in haste, repent at leisure.

 

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July 11, 2014

25 Years Ago Today Ferruzzi Created the Streetwise Professor

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,HFT,History,Regulation — The Professor @ 9:03 am

Today is the 25th anniversary of the most important event in my professional life. On 11 July, 1989, the Chicago Board of Trade issued an Emergency Order requiring all firms with positions in July 1989 soybean futures in excess of the speculative limit to reduce those positions to the limit over five business days in a pro rata fashion (i.e., 20 percent per day, or faster). Only one firm was impacted by the order, Italian conglomerate Ferruzzi, SA.

Ferruzzi was in the midst of an attempt to corner the market, as it had done in May, 1989. The EO resulted in a sharp drop in soybean futures prices and a jump in the basis: for instance, by the time the contract went off the board on 20 July, the basis at NOLA had gone from zero to about 50 cents, by far the largest jump in that relationship in the historical record.

The EO set off a flurry of legal action. Ferruzzi tried to obtain an injunction against the CBT. Subsequently, farmers (some of whom had dumped truckloads of beans at the door of the CBT) sued the exchange. Moreover, a class action against Ferruzzi was also filed. These cases took years to wend their ways through the legal system. The farmer litigation (in the form of Sanner v. CBT) wasn’t decided (in favor of the CBT) until the fall of 2002. The case against Ferruzzi lasted somewhat less time, but still didn’t settle until 2006.

I was involved as an expert in both cases. Why?

Well, pretty much everything in my professional career post-1990 is connected to the Ferruzzi corner and CBT EO, in a knee-bone-connected-to-the-thigh-bone kind of way.

The CBT took a lot of heat for the EO. My senior colleague, the late Roger Kormendi, convinced the exchange to fund an independent analysis of its grain and oilseed markets to attempt to identify changes that could prevent a recurrence of the episode. Roger came into my office at Michigan, and told me about the funding. Knowing that I had worked in the futures markets before, asked me to participate in the study. I said that I had only worked in financial futures, but I could learn about commodities, so I signed on: it sounded interesting, my current research was at something of a standstill, and I am always up for learning something new. I ended up doing about 90 percent of the work and getting 20 percent of the money :-P but it was well worth it, because of the dividends it paid in the subsequent quarter century. (Putting it that way makes me feel old. But this all happened when I was a small child. Really!)

The report I (mainly) wrote for the CBT turned into a book, Grain Futures Contracts: An Economic Appraisal. (Available on Amazon! Cheap! Buy two! I see exactly $0.00 of your generous purchases.) Moreover, I saw the connection between manipulation and industrial organization economics (which was my specialization in grad school): market power is a key concept in both. So I wrote several papers on market power manipulation, which turned into a book . (Also available on Amazon! And on Kindle: for some strange reason, it was one of the first books published on Kindle.)

The issue of manipulation led me to try to understand how it could best be prevented or deterred. This led me to research self-regulation, because self-regulation was often advanced as the best way to tackle manipulation. This research (and the anthropological field work I did working on the CBT study) made me aware that exchange governance played a crucial role, and that exchange  governance was intimately related to the fact that exchanges are non-profit firms. So of course I had to understand why exchanges were non-profits (which seemed weird given that those who trade on them are about as profit-driven as you can get), and why they were governed in the byzantine, committee-dominated way they were. Moreover, many advocates of self-regulation argued that competition forced exchanges to adopt efficient rules. Observing that exchanges in fact tended to be monopolies, I decided I needed to understand the economics of competition between execution venues in exchange markets. This caused me to write my papers on market macrostructure, which is still an active area of investigation: I am writing a book on that subject. This in turn produced many of the conclusions that I have drawn about HFT, RegNMS, etc.

Moreover, given that I concluded that self-regulation was in fact a poor way to address manipulation (because I found exchanges had poor incentives to do so), I examined whether government regulation or private legal action could do better. This resulted in my work on the efficiency of ex post deterrence of manipulation. My conclusions about the efficiency of ex post deterrence rested on my findings that manipulated prices could be distinguished reliably from competitive prices. This required me to understand the determinants of competitive prices, which led to my research on the dynamics of storable commodity prices that culminated in my 2011 book. (Now available in paperback on Amazon! Kindle too.)

In other words, pretty much everything in my CV traces back to Ferruzzi. Even the clearing-related research, which also has roots in the 1987 Crash, is due to Ferruzzi: I wouldn’t have been researching any derivatives-related topics otherwise.

My consulting work, and in particular my expert witness work, stems from Ferruzzi. The lead counsel in the class action against Ferruzzi came across Grain Futures Contracts in the CBT bookstore (yes, they had such a thing back in the day), and thought that I could help him as an expert. After some hesitation (attorneys being very risk averse, and hence reluctant to hire someone without testimonial experience) he hired me. The testimony went well, and that was the launching pad for my expert work.

I also did work helping to redesign the corn and soybean contracts at the CBT, and the canola contract in Winnipeg: these redesigned contracts (based on shipping receipts) are the ones traded today. Again, this work traces its lineage to Ferruzzi.

Hell, this was even my introduction to the conspiratorial craziness that often swirls around commodity markets. Check out this wild piece, which links Ferruzzi (“the Pope’s soybean company”) to Marc Rich, the Bushes, Hillary Clinton, Vince Foster, and several federal judges. You cannot make up this stuff. Well, you can, I guess, as a quick read will soon convince you.

I have other, even stranger connections to Hillary and Vince Foster which in a more indirect way also traces its way back to Ferruzzi. But that’s a story for another day.

There’s even a Russian connection. One of Ferruzzi’s BS cover stories for amassing a huge position was that it needed the beans to supply big export sales to the USSR. These sales were in fact fictitious.

Ferruzzi was a rather outlandish company that eventually collapsed in 1994. Like many Italian companies, it was leveraged out the wazoo. Moreover, it had become enmeshed in the Italian corruption/mob investigations of the early 1990s, and its chairman Raul Gardini, committed suicide in the midst of the scandal.

The traders who carried out the corners were located in stylish Paris, but they were real commodity cowboys of the old school. Learning about that was educational too.

To put things in a nutshell. Some crazy Italians, and English and American traders who worked for them, get the credit-or the blame-for creating the Streetwise Professor. Without them, God only knows what the hell I would have done for the last 25 years. But because of them, I raced down the rabbit hole of commodity markets. And man, have I seen some strange and interesting things on that trip. Hopefully I will see some more, and if I do, I’ll share them with you right here.

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July 1, 2014

What Gary Gensler, the Igor of Frankendodd, Hath Wrought

I’ve spent quite a bit of time in Europe lately, and this gives a rather interesting perspective on US derivatives regulatory policy. (I’m in London now for Camp Alphaville.)

Specifically, on the efforts of Frankdodd’s Igor, Gary Gensler, to make US regulation extraterritorial (read: imperialist).

Things came to a head when the head of the CFTC’s Clearing and Risk  division, Ananda K. Radhakrishnan, said that ICE and LCH, both of which clear US-traded futures contracts out of the UK, could avoid cross-border issues arising from inconsistencies between EU and US regulation (relating mainly to collateral segregation rules) by moving to the US:

Striking a marked contrast with European regulators calling for a collaborative cross-border approach to regulation, a senior CFTC official said he was “tired” of providing exemptions, referring in particular to discrepancies between the US Dodd-Frank framework and the European Market Infrastructure Regulation on clearing futures and the protection of related client collateral.

“To me, the first response cannot be: ‘CFTC, you’ve got to provide an exemption’,” said Ananda Radhakrishnan, the director of the clearing and risk division at the CFTC.

Radhakrishnan singled out LCH.Clearnet and the InterContinental Exchange as two firms affected by the inconsistent regulatory frameworks on listed derivatives as a result of clearing US business through European-based derivatives clearing organisations (DCOs).

“ICE and LCH have a choice. They both have clearing organisations in the United States. If they move the clearing of these futures contracts… back to a US only DCO I believe this conflict doesn’t exist,” said Radhakrishnan.

“These two entities can engage in some self-help. If they do that, neither [regulator] will have to provide an exemption.”

It was not just what he said, but how he said it. The “I’m tired” rhetoric, and his general mien, was quite grating to Europeans.

The issue is whether the US will accept EU clearing rules as equivalent, and whether the EU will reciprocate. Things are pressing, because there is a December deadline for the EU to recognize US CCPs as equivalent. If this doesn’t happen, European banks that use a US CCP (e.g., Barclays holding a Eurodollar futures position cleared through the CME) will face a substantially increased capital charge on the cleared positions.

Right now there is a huge game of chicken going on between the EU and the US. In response to what Europe views as US obduracy, the Europeans approved five Asian/Australasian CCPs as operating under rules equivalent to Europe’s, allowing European banks to clear though them without incurring the punitive capital charges. To emphasize the point, the EU’s head of financial services, Michael Barnier, said the US could get the same treatment if it deferred to EU rules (something which Radhakrishnan basically said he was tired of talking about):

“If the CFTC also gives effective equivalence to third country CCPs, deferring to strong and rigorous rules in jurisdictions such as the EU, we will be able to adopt equivalence decisions very soon,” Barnier said.

Read this as a giant one finger salute from the EU to the CFTC.

So we have a Mexican standoff, and the clock is ticking. If the EU and the US don’t resolve matters, the world derivatives markets will become even more fragmented. This will make them less competitive, which is cruelly ironic given that one of Gensler’s claims was that his regulatory agenda would make the markets more competitive. This was predictably wrong-and some predicted this unintended perverse outcome.

Another part of Gensler’s agenda was to extend US regulatory reach to entities operating overseas whose failure could threaten US financial institutions. One of his major criteria for identifying such entities was whether they are guaranteed by a US institution. Those who are so guaranteed are considered “US persons,” and hence subject to the entire panoply of Frankendodd requirements, including notably the SEF mandate. The SEF mandate is loathed by European corporates, so this would further fragment the swaps market. (And as I have said often before, since end users are the alleged beneficiaries of the SEF mandate-Gary oft’ told us so!-it is passing strange that they are hell-bent on escaping it.)

European US bank affiliates with guarantees from US parents have responded by terminating the guarantees. Problem solved, right? The dreaded guarantees that could spread contagion from Europe to the US are gone, after all.

But US regulators and legislators view this as a means of evading Frankendodd. Which illustrates the insanity of it all. The SEF mandate has nothing to do with systemic risk or contagion. Since the ostensible purpose of the DFA was to reduce systemic risk, it was totally unnecessary to include the SEF mandate. But in its wisdom, the US Congress did, and Igor pursued this mandate with relish.

The attempts to dictate the mode of trade execution even by entities that cannot directly spread contagion to the US via guarantees epitomizes the overreach of the US. Any coherent systemic risk rationale is totally absent. The mode of execution is of no systemic importance. The elimination of guarantees eliminates the ability of failing foreign affiliates to impact directly US financial institutions. If anything, the US should be happy, because some of the dread interconnections that Igor Gensler inveighed against have been severed.

But the only logic that matters her is that of control. And the US and the Europeans are fighting over control. The ultimate outcome will be a more fragmented, less competitive, and likely less robust financial system.

This is just one of the things that Gensler hath wrought. I could go on. And in the future I will.

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June 18, 2014

SWP Itoldyasopalooza

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 8:22 pm

While I’m doing the SWP Itoldyasopalooza, three more items.

First, the CFTC has reopened comments on the position limits proposed rule. The CFTC has taken intense incoming fire on the issue of hedge exemptions in particular, and with good reason. There are many problems, but the most egregious is the restriction on “cross hedges” (e.g., using gas futures as a hedge against electricity price risk).

I discussed this issue in my comment letter to the CFTC. Here’s the gist of the problem. The CFTC calculates the hedging effectiveness (measured by the R2 in a regression) of nearby NG futures for spot electricity prices. It finds the effectiveness is low (i.e., the R2 in the relevant regression is small). Looking past the issue of how some risk reduction is better than nothing, this analysis betrays a complete misunderstanding of electricity pricing and how NG futures are used as hedges.

Spot electricity prices are driven by fuel prices, but the main drivers are short term factors such as load shocks (which are driven by weather) and outages. However, these spot-price drivers mean revert rapidly. A weather or outage shock damps out very quickly.

This means that forward power prices are primarily driven by forward fuel prices, because fuel price shocks are persistent while weather and outage shocks are not. So it makes perfect sense to hedge forward power price exposure with gas futures/forwards. The CFTC analysis totally misses the point. Firms don’t use gas forwards/futures to hedge spot power prices. They are using the more liquid gas futures to hedge forward power prices. This is a classic example of hedgers choosing their hedging instrument to balance liquidity and hedging effectiveness. Gas forwards provide a pretty good hedge of power forward prices, and are are more liquid than power forwards. Yes, power forwards may provide a more effective hedge, but that’s little comfort if they turn out to be roach motels that a hedger can check into, but can’t leave if/when it doesn’t need the hedge any more.

The CFTC  ignores liquidity, by the way. How is that possible?

Market participants have strong incentives to make the liquidity-hedging effectiveness trade off efficiently. They do it all the time. Hedgers live with basis risk (e.g., hedging heavy crude with WTI futures) because of the liquidity benefits of more heavily traded contracts. The CFTC position limit rule substitutes the agency’s judgment for that of market participants who actually bear/internalize the costs and benefits of the trade-off. This is a recipe for inefficiency, made all the more severe by the CFTC’s utter failure to understand the economics of the hedge it uses to justify its rule.

As proposed, the rule suggests that the CFTC is so paranoid about market participants using the hedge exemption to circumvent the limit that it has chosen to sharply limit permissible hedges. This is beyond perverse, because it strikes at the most important function of the derivatives markets: risk transfer.

(This issue is discussed in detail in chapter 8 of my 2011 book. I show that the “load delta” for short term power prices is high, but it is low for forward prices. Conversely, the “fuel price delta” is high for power forward prices, precisely because load/weather/outage shocks damp out quickly. The immediate implication of this is that fuel forwards can provide an effective hedge of forward power prices.)

Second, Simon Johnson opines that “Clearing houses could be the next source of chaos.” Who knew? It would have been nice had Simon stepped out on this 5 years ago.

Third, the one arguably beneficial aspect of Frankendodd and Emir-the creation of swaps data repositories-has been totally-and I mean totally-f*cked up in its implementation. Not content with the creation of a single Tower of Babel, American and European regulators have presided over the creation of several! Well played!

Reportedly, less than 30 percent of OTC deals can be matched by the repositories.

This too was predictable-and predicted (modesty prevents me from mentioning by whom). Repositories are natural monopolies and should be set up as utilities. A single repository minimizes fixed costs, and facilitates coordination and the creation of a standard. I went through this in detail in 2003 when I advocated the creation of an Energy Data Hub. But our betters decided to encourage the creation of multiple repositories (suppositories?) with a hodge-podge of reporting obligations and inconsistent reporting formats.

This brings to mind three quotes. One by Ronald Reagan: “‘I’m from the government and here to help you’ are the 8 scariest words in the English language.” The other two by Casey  Stengel. “Can’t anybody play this game?” and “He has third base so screwed up, nobody can play it right.”

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The Klearing Kool Aid Hangover

Back in Houston after a long trip to Turkey, France, Switzerland, and the Netherlands speaking about various commodity and clearing related issues, plus some R&R. Last stop on the tour was Chicago, where the Chicago Fed put on a great event on Law and Finance. Clearing was at the center of the discussion. Trying to be objective as possible, I think I can say that my critiques of clearing have had an influence on how scholars and practitioners (both groups being well-represented in Chicago) view clearing, and clearing mandates in particular. There is a deep  skepticism, and a growing awareness that CCPs are not the systemic risk safeguard that most had believed in the period surrounding the adoption of Frankendodd. Ruben Lee’s lunch talk summarized the skeptical view well, and recognized my role in making the skeptic’s case. His remarks were echoed by others at the workshop. If only this had penetrated the skulls of legislators and regulators when it could have made a major difference.

And the hits keep on coming. Since about April 2010 in particular, the focus of my criticism of clearing mandates has been on the destabilizing effects of rigid marking-to-market and variation margin by CCPs. I emphasized this in several SWP posts, and also my forthcoming article (in the Journal of Financial Market Infrastructure, a Risk publication) titled “A Bill of Goods.” So it was gratifying to read today that two scholars at the LSE, Ron Anderson and Karin Joeveer, used my analysis as the springboard for a more formal analysis of the issue.

The Anderson-Joeveer paper investigates collateral generally. It concludes that the liquidity implications of increased need for initial margin resulting from clearing mandates are not as concerning as the liquidity implications of greater variation margin flows that will result from a dramatic expansion of clearing.

Some of their conclusions are worth quoting in detail:

In addition, our analysis shows that moving toward central clearing with product specialized CCPs can greatly increase the numbers of margin movements which will place greater demands on a participant’s operational capacity and liquidity. This can be interpreted as tipping the balance of benefits and costs in favor of retaining bilateral OTC markets for a wider range of products and participants. Alternatively, assuming a full commitment to centralized clearing, it points out the importance of achieving consolidation and effective integration across infrastructures for a wider range of financial products. [Emphasis added.]

Furthermore:

A system relying principally on centralized clearing to mitigate counter-party risks creates increased demand for liquidity to service frequent margin calls. This can be met by opening up larger liquidity facilities, but indirectly this requires more collateral. To economize on the use of collateral, agents will try to limit liquidity usage, but this implies increased frequency of margin calls. This increases operational risks faced by CCPs which, given the concentration of risk in CCPs, raises the possibility that an idiosyncratic event could spill over into a system-wide event.

We have emphasized that collateral is only one of the tools used to control and manage credit risk. The notion that greater reliance on collateral will eliminate credit risk is illusory. Changing patterns in the use of collateral may not eliminate risk, but it will have implications for who will bear risks and on the costs of shifting risks. [Emphasis added.]

The G-20 stampede to impose clearing focused obsessively on counterparty credit risk, and ignored liquidity issues altogether. The effects of clearing on counterparty risk are vastly overstated (because the risk is mainly shifted, rather than reduced) and the liquidity effects have first-order systemic implications. Moving to a system which could increase margin flows by a factor of 10 (as estimated by Anderson-Joeveer), and which does so by increasing the tightness of the coupling of the system, is extremely worrisome. There will be large increases in the demand for liquidity in stressed market conditions that cause liquidity to dry up. Failures to get this liquidity in a timely fashion can cause the entire tightly-coupled system to break down.

As Ruben pointed out in his talk, the clearing stampede was based on superficial analysis and intended to achieve a political objective, namely, the desire to be seen as doing something. Pretty much everyone in DC and Brussels drank the Klearing Kool Aid, and now we are suffering the consequences.

Samuel Johnson said “Marry in haste, repent at leisure.” The same thing can be said of legislation and regulation.

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