Streetwise Professor

This story is very bizarre, and I can’t figure out what is going on, exactly.  Or put differently, what has put a bee in the CFTC’s bonnet about CME Clearport’s Exchange of Futures for Swaps (EFS) facility after all these years.

The Commodity Futures Trading Commission has issued a “special call” asking Wall Street banks and other traders to provide documents that would prove recent derivatives transactions known as “exchanges of futures for swaps” were legal. Lawyers at the CFTC enforcement division are also scrutinising the trades for possible violations.

. . . .

The new inquiry centres on whether large traders and market-makers used unregulated over-the-counter swaps markets to trade what were in fact futures, strictly regulated contracts that are economically identical to swaps.

Trading futures off an exchange is illegal, and regulators are concerned that traders may have used these deals, known as EFSs, to agree prices that did not reflect the market.

“They’ve made information requests to everybody that’s ever traded an EFS. They’re saying, ‘prove to us that the swap was legitimate’,” said a recipient of a CFTC document request

The only thing that makes sense is that the CFTC believes that market participants engaged in EFS transactions without having a legally binding swap agreement in place first, meaning that the parties would have engaged in futures trades off-exchange.  Or something.

Note that even if the parties had entered a swap, it may have been in effect a very short period of time-just as long as it took to execute the deal and submit it to Clearport for clearing.

I also find it curious that the article mentions that the CFTC is looking only at deals done post-Frankendodd, even though deals have been done this way since the 2002 time frame, if memory serves.  One explanation is that CFTC believes the alleged conduct was permissible under CFMA, but not under DFA.  Another guess on my part.

If there is a violation here, it seems to be a highly technical one.  The end result is pretty much the same if they did or they didn’t execute a binding swap first: each party has futures positions obtained at a privately negotiated price.

CFTC has a lot on its plate already: is this really a priority? Really?

Moreover, the party that usually screams the loudest about off-exchange trading of futures is the futures exchange.  But Clearport is a CME system, and EFS is a CME procedure, and it seems that CME is totally fine with this.  Actually, if the following quote relates to the EFS issue (and it’s not clear that that’s the case from the article), CME is actually hacked at this:

Terry Duffy, CME executive chairman, said in a letter to CFTC last week: “In our view, nothing is served by piling on duplicative reporting mandates.”

For certain, though, CME was perfectly satisfied with the way market participants were doing EFS deals.

So who is the victim here?

It’s actually ironic that EFS was the CME’s way of implementing clearing for energy and metals.  And the CFTC is rah-rah about clearing.  But it is looking askance at the CME’s way of implementing clearing.  I guess it’s a case of that was then, this is now.

CFTC also effectively killed EFS as a mechanism for facilitating OTC clearing by determining that a swap, no longer how short its existence before conversion into futures, counted towards a firm’s annual $8 billion (to be reduced to $3 billion) de minimus swap volume for the purpose of determining whether it is a swap dealer.  As a result, market participants are moving to block futures trades rather than EFS to clear energy transactions: block futures trades that are negotiated away from the central market, just as the allegedly phantom swaps were. So this is last year’s war.  If traders weren’t doing papering officially a swap deal, they were effectively engaging in block futures trades, which is what they are doing now.  If it’s OK now, other than the technical violation, was it so horrible then that it requires a full blown investigation?

So what’s up?  A burdensome, intrusive “Special Call” to investigate a possible technical violation that the exchange that would be hurt by a violation doesn’t seem to care about, and which is of little relevance going forward.

Wow.  That seems like a totally reasonable use of scare resources-resources Gensler claims he doesn’t have nearly enough of.

There are reports that the CFTC will vote on the SEF rule next week.  The rule had been in limbo for months due to Gensler’s insistence that the rule require those requesting a quote solicit them from five potential counterparties.  Gensler has apparently relented because he could not get the new Democratic commissioner, Mark Wetjen, to join with Chilton and Gensler to vote out the 5 RFQ rule.

The compromise will require users to solicit two quotes for the next two years, and then three thereafter.

Whatever.

On the 1 year anniversary of the DFA, I named the SEF mandate as The Worst of Frankendodd. I haven’t changed my mind on that, though the competition is fierce.  And the RFQ requirement is the Worst of the Worst.  It is defended as a way of  improving competition.

This is at best paternalistic.  It presumes that those who want to enter into swaps don’t know their own interests.  Perhaps Gensler thinks that the buy side suffers from some sort of Stockholm Syndrome after years of captivity to the dealer banks.

In reality, buy side firms-most of whom are extremely experienced and sophisticated-are making trade-offs between competition and information leakage.  They are trying to minimize cost of execution, and have the information and incentive to do that.  Note too that they are required to do this for every trade, regardless of instrument, size, and other factors that may influence the trade-off.  But nope, one size fits all. They should be allowed to make that trade-off themselves, without any guidance from Gary.

RFQ5?  How about RFQ0?

Here’s an analogy.  How would you like it if the government told you how many stores you had to visit before making a purchase?  You know, to make sure that you get the best price.  Call it the CS5 rule.  You have to comparison shop at five stores before making a purchase.  On everything.   Of course, when deciding on whether to shop at one store or five, you trade-off the potential savings (which will depend on the value of the purchase, the good you are shopping for, and other factors) from shopping around more, against the cost (which will vary with the value of your time, how hurried you are, your income, the price of gas, where you live, etc.)  But none of that matters under the CS5 rule.  Want to buy a quart of milk?  Shop at five stores.  For your own good.

Yeah.  It’s that bad.  CS2 would be bad, but not that bad.

Once the SEF rule goes into effect it will be interesting to see how the structure of the industry involves.  There will be a land rush of new SEFs.  I predict there will be a shakeout, and there may well be only a single dominant SEF for each major instrument.  The SEF rule does not, as I understand it, require a SEF to send an order to another SEF offering a better quote.  Which means that the network effects of liquidity will tend to cause trading activity to “tip” to a single SEF for products big enough to support order book trading.

But the whole SEF landscape will also be shaped by the margin rules, the Bloomberg suit over those rules, block trading rules, and on and on.  The rule is not the beginning of the end, it is barely the end of the beginning.

The most recent controversy over HFT stems from this WSJ story about the CME.  In a nutshell, computerized traders receive confirmations of their trades before information about those trades is disseminated to the market at large.  As in a few milliseconds before.  But in an electronic world, a few milliseconds can be decisive.

One example of a particularly informative trade is when an away-from-the-market limit order is executed.  This means that a market order of sufficient size to blow through the quote size at the inside market was submitted.  Given that orders and communicate information, and that the bigger the order, the more informative it is, knowing before anybody else that such an order has been executed can provide valuable information.

The implications of this depend on how the information is used.  A trader (or, more accurately, a bot) that gets this information can use it to take liquidity aggressively.  For instance, it can use information gleaned from a big, price-moving crude oil buy to submit an aggressive order in heating oil or RBOB, thereby picking off resting limit orders that cannot adjust to the new information.  Or, as the WSJ article suggests, the bot can use the information derived from the NYMEX CL trade to take liquidity from ICE Brent or NYMEX lookalike futures.

This kind of trading exacerbates information asymmetries, and all else equal, increases spreads, reduces depth, and increases trading costs for the uninformed.

But the “all else equal” part of the statement doesn’t necessarily hold.  This presumes that the amount of capital devoted to HFT is constant.  But that’s not true in the long run.  If these sorts of advantages generate profits, that will attract more capital into HFT.  Moreover, note that the strategy just outlined involves placing limit orders, and then reacting when those limit orders are executed.  Competition to get the information advantage will lead to more aggressive quotes, and quotes in bigger size.  In the long run equilibrium, this competition will dissipate the rents from the information advantage.

Therefore, if there is any reason to reduce this speed advantage (either by slowing down some traders or speeding up the dissemination of trade execution information to the market at large), it is to prevent the investment of excessive capital into HFT.  The effect on spreads and depth in equilibrium is ambiguous.

Moreover, there are other possible uses of the information advantage that are clearly socially beneficial.  An HFT market maker-who is likely making markets in a variety of contracts-can utilize the information to revise limit orders either in the market in which the execution occurred, or in other markets, especially those that are closely related (again, consider the CL/HO or CL/RB example).  Using the speed/information advantage in this way reduces the HFT market maker’s vulnerability to getting picked off, and makes it willing to supply liquidity more aggressively.  This tends to reduce trading costs, and does not lead to the rent seeking that in the long run equilibrium tends to result in an inefficiently large HFT presence.

We also need some perspective here.  I consider it beyond hilarious that the WSJ has a video embedded in the online version of the story that has many images from the floor.  (And these days, one of the floor’s main functions is to provide visuals for stories on trading-especially the trader’s-head-in-his-hands shot on days when the market falls a lot.  Pictures of servers aren’t nearly so dramatic.)

Why hilarious?  Well, the floor was the epitome of time and space advantages to a select few.  A select few who paid for the privilege.  I remember distinctly a trader telling me: “Why do I spend $500,000 on a seat? Because I get to see the price before anybody else.”

Exactly.  The floor was the meat version of colocation.  Or the carbon based life form version, if you like.  Those on the floor could see the execution prices, and bids and offers, and order flows, that those off the floor could not.  They profited accordingly.  Which is why the marginal guy on the floor-the least efficient trader-was willing to pay hundreds of thousands of dollars in some cases to get on the floor.

In 2002 or so I wrote a paper titled “Upstairs, Downstairs” (still a working paper) which showed that floor traders earned a rent as a result of their time and space advantage: upstairs traders could not supply liquidity as effectively as floor traders due to their information disadvantage, and this meant that floor traders faced limited competition in supplying liquidity.  Moreover, exchange limits on membership meant that entry could not dissipate these rents.  But by reducing the time disparities between liquidity suppliers advantage, electronic trading increased liquidity supply: upstairs traders were no longer operating under a time and space handicap.  Trading costs and rents decline. And that decline in rents is precisely why floor traders fought electronic trading so fiercely for years.

So yes, in today’s electronic markets some traders have a speed advantage.  But this disparity is nothing when compared to that which existed in the floor days.

Which is why I can’t really get all that spun up over the WSJ story, or most of the other stories about how unfair markets are.  Everything is relative.  No, the playing field isn’t perfectly level today, and along the lines of yesterday’s post, it may be in the interest of the CME to take measures to make it more level.  They say that they are.  But arguably the field is more  level than it has ever been.  It’s certainly far more level than in the heyday of the trading floors.  Don’t get nostalgic for the days when market makers were meat, not machines.  The table was tilted in their favor, bigtime.  Much more than today.

There are all sorts of proposals out there to rein in HFT.  The Europeans in particular-and in particular, particular, the Germans-want to do so.

I’ve long argued that there is good HFT and bad HFT, and that trading platforms have an incentive and the information to adjust fee structures and trading protocols in order to mitigate the latter.  For example, some exchanges have cracked down on excessive cancellations or the entering and canceling of orders far away from the current inside market.

Today’s FT reports another example, and a rather dramatic one.  One of the biggest FX trading platforms, EBS, is jettisoning the venerable time priority (“first come-first served) system with continuous trading.  Instead, it will collect orders that arrive during a period lasting a few milliseconds, and then execute them in a batch.  Instead of a continuous market, it appears to be a high speed sequence of call markets.  This eliminates the advantage of getting your quote in a millisecond sooner than someone else.  Perhaps it will also deter forms of gaming, such as strategies that (allegedly) attempt to create and exploit latency.

Will it work?  Who knows?  But that’s the point.  Markets facilitate the process of discovery.  Market participants compete to find solutions to problems.  EBS has identified a problem, and are trying to fix it using a fairly innovative change to the matching process.  If they’re right that some kinds of HFT are detrimental to market performance (and thereby reduces the demand for to trade on the platform), and their replacement of continuous trading with high speed calls impedes this detrimental HFT without impeding the good kind, they’ll make money.  And others will likely imitate, or take the basic idea and try to improve on it.

Or maybe it won’t work as planned. In which case they can try something else, or lose business to a platform that devises a better protocol.  The point is that a trading platform identified a problem with HFT, and is doing something about it, on its own.

All of this is far superior to top-down, one-size-fits-all government mandated “solutions” that are driven by political economy considerations first, efficiency considerations second . . . or third . . . or Nth.  Trading platforms may not internalize all the costs and benefits of better trading rules and fee structures, but their information and incentives are far better than regulators or legislatures.  Between competition among HFT firms, and the efforts of trading platforms to optimize the demand for their services, it’s likely that HFT’s rough edges will be smoothed out.  And if trading platforms don’t adopt such measures, you have to doubt seriously whether there’s a problem in the first place.  Because if there is a problem, they’d be the ones in the best position to know, and the best position to fix it.

There’s lots of angst in Euroland over the plunging price of European Union CO2 Allowances.  Trading activity has crashed along with prices. And the Eurocrats are casting about ways to “fix” the “problem.”  And Eurocrats being Eurocrats, their mooted fixes are interventionist monstrosities that make a mockery of the idea of a “market” for CO2.

The reason for the price decline is blindingly obvious.  The European economy is sputtering, and lower industrial activity translates into lower output of CO2, and hence lower demand for emissions allowances.

In other words, the Europeans wanted to reduce CO2 emissions, and they got their wish.  Just not the way they intended: a bad economy accomplished their mission for them.   If they’re so intent on reducing CO2, you’d think they’d be happy.

But no, of course, they’re not.  They were hoping that economic activity would be robust, and that the resulting demand for allowances would keep the price high, thereby making powering this activity by fossil fuels more expensive.  This, in turn, would lead to greater reliance on no-carbon renewables like wind and solar.  In this version of Euro Disneyland, where wishes come true, windmills and solar panels would be powering a thriving economy: they would have their low carbon cake, and their economic growth ice cream too.

But no such luck. The sluggish economies, and the resulting low price of CO2, have delivered a body blow to the economics of renewables.

And that’s where much of the angst is coming from.  If it was all about reduced CO2 output, it shouldn’t really matter how you get there.  But of course investors in wind, solar, etc., want to support those investments, and the cratering of the CO2 price is very bad news for them.

So the angst is about protecting investments in renewables.

How are they going to go about this?  There have been proposals to delay the issuance of some new allowances for a couple of years to support the price, but these were shot down in the European parliament.  That delay-”backloading”-was considered by many to be prelude to canceling them altogether.

Such interventions make a mockery of the idea of a carbon market.  The man-made “supply” of allowances is subject to change at political whim, and becomes contingent on price, and how that price affects political constituencies.  This adds a huge element of risk to trading in this market.  It also adds a huge element of risk to any investment that depends on the price of CO2.  This can include not just wind and solar, but conventional power plants, and any other investment (e.g., refining or chemical manufacturing) that emits CO2.  And once the EU allows the economic interests of industries to drive supply decisions so as to affect price, all these affected parties have an incentive to influence the process.  That consumes real resources, and given the unpredictable and shifting nature of political equilibria, adds to the uncertainty over future supply.

In other words, these man-made carbon markets are not time consistent.  Unless the EU can commit not to change supply in the future, the “market” will largely involve speculation on future policy, with a huge degree of feedback.  Speculations about policy will affect prices, and prices will affect policy, which will affect prices, and on and on.  (Example: the price of CO2 allowances fell by 50 percent when the Euro Parliament rejected backloading.)

Which is wickedly ironic, given Euro attitudes about speculation.

That’s no way to make a market.  And come to think about it, any “market” that is a completely political construction is almost a contradiction in terms.  It can be at best a simulacrum of a market, at most a form of “market socialism”, but not the idealized market socialism of years past, but a market socialism buffeted by special interest politics and political economy considerations.

John Kemp of Reuters-accompanied by cheerleading by Izabella Kaminska at FT Alphaville-is going on about the “disconnect” between nearby and deferred Brent.  He blames-wait for it-hedge funds.  Natch.

The Brent market is currently in a steep backwardation.  I demonstrated empirically almost 20 years ago that backwardation is associated with low correlations between spot and futures prices for oil and a variety of other commodities.  Indeed, my 1994 criticism of the Metallgesellschaft 1992-1993 “hedging” strategy-which led to several confrontations with Merton Miller-was based on the fact that MG’s “hedge” of long the nearby against distant deferred short positions was in fact risk increasing due to the fact that MG implemented this strategy during a backwardation, and this reduced substantially correlations thereby making the MG position very risky.  My 2011 book provides a robust model that predicts exactly this result.

The intuition is quite straightforward-as I’ve been teaching for about 20 years too.  Inventory is what connects spot and futures prices.  When inventories are large, the market is in contango, and spot and futures prices move together: cash-and-carry arbitrage connects these prices.  In contrast, when inventories are low, the market is in backwardation, cash-and-carry arbitrage doesn’t link the spot and the futures, and the correlation between these prices can go very low.  Hence the association between contango and high correlations.

Note: hedge funds, speculation, yadda yadda yadda have nothing to do with this.

Kemp does note that there is physical tightness that does explain the backwardation:

Overlaying all these broader factors are continuing problems with production of the four North Sea crude streams (Brent, Forties, Oseberg and Ekofisk) that physically underpin the Brent futures prices. BFOE crudes remain in short supply, keeping the market in a steep backwardation, with futures prices tending to rise sharply in the run up to contract expiry.

But then he discards this fundamental fact, and mounts his favorite hobby horse of bashing hedge funds and speculation.

Note even in this paragraph there is a telling piece of information that contradicts his view: “with futures prices tending to rise sharply in the run up to contract expiry.”  Uhm, that’s exactly when hedgies and other speculators are liquidating-selling-their nearby contracts and rolling them into the deferred months.  This should put downward pressure on nearby prices, if the speculators were really  in command. Completely inconsistent with his assertion that hedge funds are driving the disconnect between spot and futures.

Kemp also makes a comparison to spot price and curve movements in 2008 to more recent movements.  But as I also show in my book, to explain commodity price dynamics you need multiple shocks of differing persistence.  Curve shape is driven mainly by transitory shocks: that’s what inventory is used to smooth out.  The level of the curve is largely driven by persistent, business-cycle type shocks.  This means that conditioning on price levels alone is insufficient to make an apples-to-apples comparison.  The 2007-2008 boom was driven more by long run, secular factors-namely the Asian/Chinese growth boom.  This resulted in a rise in the price level and only a modest increase in backwardation.  That is completely different from current conditions-hence the different behavior.

Similarly, the differences between high correlations pre-2010 and low correlations now are readily explicable.  The market was much more abundantly supplied in 2009-2010 due to the severe economic contraction following the financial crisis, and as a result, the market was in contango most of that time-at times in a “supercontango”.  Again, one would expect this to be associated with high spot-futures correlations.

Moreover, there is a big difference in the composition of shocks, and the magnitude of these shocks that also explains the observed declines in correlations.  The 2009-2011 period was dominated by macro uncertainty driven by the financial crisis and then the Eurozone crisis.  These shocks tend to be persistent, affecting both current and expected future economic conditions in the same way, thereby contributing to high correlations between points on the curve; moreover, they tend to affect all commodities and asset classes similarly, leading to high correlations across commodities and asset classes.

At that time, macro volatility-as measured by the VIX-was high.   In early ‘09, VIX was in the 30-50 percent range, and remained above 20 percent for most of 2010-2011, with spikes up to 35-40 percent.  Now VIX is tame, with levels in the low-teens, just like during the period of the “Great Moderation.”  High macro volatility tends to lead to high correlations along the curve and across commodities and between commodities and equities: common shocks dominate, especially when they are big.  The decline in macro volatility means that commodity-specific, relatively transient shocks tend to dominate: this tends to depress correlations along curves and across commodities, and between commodities and equities.  These are exactly the patterns observed in the past months.

That said, there are reasons to suspect the backwardation and the decline in correlations might be overdone, but not because of the malign influence of hedge funds.  Specifically, given the declining Brent supply base, it is reasonable to ask whether the backwardation is excessive.  At present, Forties is cheapest-t0-deliver, and this represents only about 350kbd of production.  Overall BFOE production is only about 1mmbpd.  Given the immense open interest in Brent futures and OTC derivatives, it is more that possible that large players are exercising market power by taking delivery of too much physical oil, thereby exacerbating the backwardation (i.e., creating an artificial scarcity).

If you want to identify who might be doing that, look at who is taking the physical cargoes.  Those parties would be the squeezers.  If hedge funds are the culprits, they should be taking a lot of physical supply.  Kemp certainly doesn’t provide any evidence of this, and his piece suggests these players are just playing with paper barrels, not wet ones: that’s my understanding too.  Historically, the Brent market has been the scene of many squeezes, but the squeezers have tended to be trading companies (e.g., Arcadia) or perhaps supermajors.

Brent was a squeezers paradise in the 1990s due to declining physical volumes and growing paper volumes.  Platts’s addition of Forties, Ekofisk and Oseberg to the delivery slate increased supply sufficiently to mitigate the manipulation problems.  But the decline in production has continued inexorably, and Brent is increasingly vulnerable to squeezes.  Which is why Platts and Shell have competing plans to tweak the pricing mechanism, namely by providing premiums for OE (Platts) or BOE (Shell), thereby reducing the delivery pressure on the cheapest-to-deliver Forties.

Squeeze-driven backwardation also tends to reduce spot-forward correlations.  The spot price is driven by squeeze-related technicals, the forward price by longer run fundamentals.  Squeezes also distort the inventory holding decision, and cause a breakdown in the cash-and-carry arb mechanism.  As I show in another book (and many articles).

So Brent may indeed be broken, but hedge funds haven’t broken it.  It is a classic problem in derivatives markets: a burgeoning derivatives market balancing on top of a declining deliverable supply.  I often analogize this to an inverted pyramid: and in Brent, the base of the pyramid (the paper market) is growing while its point (the physical market) is getting sharper.

Fixing Brent requires enhancing deliverable supply.  Not an easy thing to do.

Again contrast Brent and WTI.  Brent boosters have constantly bashed the WTI disconnect.  But this can be fixed by investments in infrastructure, which are being made, though not as fast as expected or as needed.  But building infrastructure is a helluva lot easier than building  a new Buzzard. Trust me on this.

So in the medium term, I expect Brent will get broker, and WTI will get better, leading to a shift of much futures and index trading activity (including hedge fund trades) back to WTI, which will no doubt lead John Kemp to saddle up his hobby horse and ride west into the Oklahoma sunset.

Frankendodd runs hundreds of pages.  The regulations written to bring it to life run to thousands more.  Every word on every page has the potential to wreak havoc: hell, apropos the position limit case, even the commas matter.

Case in point, the CFTC’s proposed rule on protection of customer funds, most particularly Section 1.22.  Some of the relevant language:

The Commission proposes to amend § 1.22 by clarifying that the prohibition on the FCM’s use of one futures customer’s funds to margin or secure the positions of another futures customer, or to extend credit to another person, applies at all times.

. . . .

Further, the Commission is proposing language providing a clear mechanism to ensure compliance with this prohibition, which is to require an FCM to maintain residual interest in segregated accounts in an amount which exceeds the sum of all margin deficits for futures customers.

This is very inside baseball, but has seismic implications.

The basic thing is that some customers are late in meeting margin calls.  This gives rise to margin deficits.  Under the traditional omnibus model used in futures markets for donkey years, futures commission merchants (brokers-”FCMs”) can cover customers’ margin deficits with the margins of other customers.  Effectively, customers lend one another money to address the timing issues that the rigorous mark-to-market and variation margin processes inevitably create.  Moreover, the FCM is ultimately on the hook to cover the losses of a defaulted customer.  The FCM’s customers can lose only if there is a default by a customer that the FCM can’t cover (resulting in an FCM default).

That is, customers effectively lend to one another, and thus there is “fellow customer risk”-a solvent customer can lose as a result of the default of another customer. The CFTC rule is intended to eliminate this risk.

Problem: the risk can’t really be eliminated, merely shifted around.  Related problem: the likely reaction to this attempt to shift risk.

The CFTC seems to want to shift the risk to the FCMs: the “residual interest” language means that the FCM has to have enough of its own money on hand to cover any margin deficits.  This will require the FCM to hold substantial precautionary balances, because (a) the magnitude of margin deficits is likely to be quite variable, and particularly will be large in the aftermath of a big price move (that can’t be predicted in advance), and (b) there are serious penalties to being undersegregated.  Alternatively, FCMs are likely to require customers to post margins far in excess of exchange margin levels, thereby reducing the likelihood that any customer’s account will have a margin deficit, and the amount of residual interest the FCM must hold to cover any such deficits.

Either way, there will be a substantial increase in the amount of cash tied up, and the needs for customers and FCMs to have access to contingent liquidity.  The omnibus model was an effective way for customers to supply liquidity to, and obtain liquidity from, other customers.  Yes, there are risks, but there are corresponding benefits: the near universality of the omnibus model in futures markets, and its survival for decades, provides compelling evidence that the benefits far exceed the costs.

But apparently that’s not good enough for GiGi and the Gang.

The clearing and collateral mandates-combined with Basel III and other regulatory measures-are already requiring substantial increases in the amount of collateral-liquid assets-that will be tied up to support derivatives trades.  This will just add to that.  And insofar as being a customer protection mechanism: uhm, customers will pay for it.  Don’t act as if your are doing them a big favor. (Raising the question if its so valued by customers, why hasn’t some FCM adopted voluntarily what the CFTC wants to impose by fiat?  If it’s so great, customers would flock to firms offering that model.)

It also comes at a terrible time for the FCM industry.  The economics of the business are terrible.  ZIRP has blown a hole in a major source of revenue, volume is down sharply, and competition is intense.  A recent Celent study details the carnage:

“The leading FCMs in the US are struggling with falling revenues and profits,” saysAnshuman Jaswal, PhD, Senior Analyst with Celent’s Securities & Investments Group and author of the report. “This puts them in an unenviable position, especially when we consider the overall impact and related costs of various regulatory implementations taking place in the next couple of years.”

Another data point: SocGen just wrote down its investment in big FCM Newedge.  This is not a thriving industry, and ladling more costs onto it won’t help it one bit.

The ostensible purpose of this new regulation is to prevent another MF Global or Peregrine situation.

Seriously?

MF Global broke every rule in the book about segregation and the treatment of customer money.  Peregrine’s owner ran a huge fraud for 20 years. So creating more rules for troubled or criminal FCMs to break will help?  If the CFTC or SROs couldn’t enforce the old rules and thereby prevent losses of customer funds, why should we expect they’ll do any better with the new ones?

It’s also hard to see how these rules, if they had been in place, would have prevented either the Peregrine or MFG situations.  Furthermore, there are other ways of attacking the exceptional-and MFG and Peregrine were exceptional-without imposing crushing burdens on the ordinary day-to-day operation of the markets, FCMs and their customers.  For instance, the Peregrine fraud could not have continued if Peregrines regulator (the NFA) had direct electronic access to the firm’s accounts, thereby preventing Wasendorf from altering the paper statements he sent on to regulators to cover up his fraud.  Hell, in the MFG case, having more excess margin in customer accounts would have just increased the money that Corzine could have tapped to cover the company’s losses and own margin calls: it is just that excess margin that disappeared somewhere, somehow.  I would further note that since an FCM is most likely to be tempted to get at customer funds when it is in financial jeopardy (which is what happened with MF), adding to its financial burdens could create more problems than it solves.

The cost-benefit analysis the CFTC advanced in support of the rule is just the kind of joke I’ve come to expect.  This is actually a problem that is amenable to calculation.  Collect data on the distribution of customer margin deficits under current rules.  Figure out the 99.9th percentile of this distribution.  (Importantly, condition this distribution on market conditions-find out what that percentile is during very volatile periods.)    Given the rigor of the rule, it is plausible to assume that additional funds equal to this 99.9th percentile will have to be held by customers, FCMs, or both will be held to ensure compliance.  Calculate the return on this sum lost because customers and FCMs are required to hold low-yielding assets in order to comply with the rule.  That’s one component of the cost.

Another cost is the additional operational cost required to ensure compliance.  This will not be trivial: indeed, one reason FCMs might require substantial increases in customer margins is to reduce the operational burdens required to maintain compliance.

One cost that is important is hard to quantify.  As I’ve written repeatedly, spikes in liquidity needs during periods of market stress can be systemically destabilizing.  This rule will: (a) restrict one vital source of liquidity, namely, intracustomer loans; (b) result in far more liquid assets being tied up in brokerage accounts; (c) lead to increases in liquidity demand during periods of high volatility, as FCMs will either have to hold more liquid assets, or will force customers to hold more excess margin, during high volatility periods in order to maintain compliance (i.e., the 99.9 percentile is much bigger during high volatility periods, requiring more margin to meet this threshold-the distribution of liquidity demand spikes caused by this could be calculated); and (d) result in position unwinds by those unwilling to incur the cost of the elevated margins.  All of these effects are pro-cyclical, and tend to exacerbate market instability/volatility.  Liquidity problems are what create or exacerbate crises.  Derivatives market “reforms” have already imposed substantial liquidity burdens: this will only add another.  That is systemically risky.

Benefits?  Uhm, hard to ascertain.  As noted above, the rule is ill-suited to address either a Peregrine or MFG problem, even though those are the examples the CFTC repeatedly invokes in their support.  Moreover, it must be noted that reducing the amount of loss arising from the default of fellow customers is not necessarily a benefit.  This is primarily a transfer of wealth from one party to another.  The relevant issue is whether one risk sharing rule is better than another.

This is another example of the pernicious effects of attempts to “fix” high profile problems such as MF Global and Peregrine.  In response to truly extraordinary episodes, we get “fixes” that (a) don’t really do anything to address the problems they are supposed to be fixing, and (b) impose substantial burdens on the ordinary operations of the markets, operations that have gone on swimmingly for decades under the old way of doing business, thank you very much.

As a rule of thumb, I think it wise to be very suspicious of rules designed to prevent recurrence of an extreme event or events.  That is especially true in this case.   Another example of all pain, no gain.

Is that the CFTC’s motto now?

Hint: collateral crunches are not an ab exercise.  Instead, regulators and legislators around the world are waking up to the reality of what they have wrought: that the regulations that they blithely decided to impose on the derivatives markets are likely to have severe adverse consequences.  Specifically, Europeans have awakened to the fact that clearing and collateral mandates will be extremely burdensome on firms that use derivatives to manage risk, but who pose no real systemic threat.  Thus, a committee of the European Parliament has voted to send clearing regulations back to the European Commission for reconsideration.  There is a realization that a “collateral crunch” is impending as a result of these various regulations:

This has led to talk of a “collateral crunch”, with most central counterparties accepting only government bonds or cash as collateral, assets that may not be readily available. This is more restrictive than at present, with corporate bonds and even equities often accepted as collateral in uncleared bilateral deals, if lodged in sufficient quantity.

The problem may be particularly acute for mutual funds, as an equity or corporate bond fund will simply not possess anything it can use as collateral. Instead it may have to use the securities lending or repo markets to secure suitable assets.

But many pension funds will also be hit. As Mr Haines points out, even the index-linked government bonds that pension funds do tend to hold in abundance are not generally accepted as collateral by central counterparties, even if conventional bonds issued by the same governments are.

Estimates of the cost of using the repo market to access the necessary collateral range from 50 basis points of a pension fund’s assets to several hundred basis points, Mr Haines adds. Alternatively, pension funds may feel pressured to alter their asset allocation so they do have sufficient in-house collateral.

Totally unpredictable, right?  Uhm, not really.

I find it particularly amusing that virtually every article on the effects of Frankendodd and Emir bewail the “unintended consequences.”  A million pardons, but that was a theme here on SWP, and in various presentations I made, before Frankendodd and Emir were actually adopted.  Unintended, but eminently foreseeable-and totally ignored.

The recent angst focuses on initial margin: the amount of capital that has to be tied up to support derivatives positions from the moment they are initiated.  Given that collateral is costly, the large increases in initial margin will require derivatives users to choose between continuing to use them to manage risk, but obtain lower returns, or to eschew derivatives and live with greater risk.

The benefit received in exchange for this very real cost?  Given that many entities so affected pose no systemic risk, it’s quite difficult to identify any gain.

Not that initial margin is unimportant, but the focus on it distracts attention from what I believe to be the true systemic risk inherent in clearing and collateral mandates: the contingent needs for liquidity to make variation margin payments.  Big price moves lead to big variation margin flows.  These will tend to occur when markets are stressed and liquidity becomes scarce.  Thus, the need to make variation margin payments will exacerbate stresses on the market, especially will stress liquidity supply mechanisms.  Given that financial crises are, typically, liquidity crises, this is a major systemic problem.

So by all means pay attention to the drag that the dramatic increase in initial margin requirements will impose.  This is a drag that will be experienced day after weary day.  But do not overlook the truly dangerous unintended consequence of the clearing and collateral mandates in Frankendodd and Emir.  The stress that these mandates will put on liquidity supply mechanisms at the precise instant that these mechanisms are at risk of failure.

What could go wrong?

I say again: regulate/legislate in haste, repent at leisure. The seeds for the next crisis are being sown in the alleged attempts to prevent a recurrence of the last one.  Legislative and regulatory generals fighting the last war.

This week’s big derivatives story was about a public workshop at the CFTC on the issue of futurization.  I was one of the first people to comment on this issue, last year when ICE announced it was converting all of its energy swaps into energy futures.

That was Futurization 1.0. The conversion merely consisted of renaming “swaps” “futures”.  In all economic dimensions (contract specs, execution, clearing) the contracts remained identical.  But the renaming allowed some energy swap users to escape the dreaded Swap Dealer designation.

Futurization 1.1 was the CME’s conversion.  This illustrates some of the silly impacts of Frankendodd.  The CME has cleared energy swaps for going on 10 years now.  The parties would execute a swap, and submit the swap for clearing through an Exchange of Futures for Swaps (EFS) trade.  So the originally executed swap existed only until it was submitted for clearing, when it was replaced with economically equivalent futures contracts.  But no matter how short the swap’s life, the fact that it was born a swap meant that it counted towards the volume of swaps activity used to determine whether someone was a swap dealer.  So the process has now changed, and market participants use (mainly) block trades of futures to create the positions they want, thereby cutting out the interim swap step.

The transformation of the energy derivatives landscape, and the launch of swap futures by CME and Eris are now raising the question of whether futurization will spread beyond energy.

One motive to eschew swaps in favor of futures is unlikely to exist in interest rates, credit and other financial derivatives: the biggest market participants are likely to trade enough bespoke swaps for which there are no futures equivalents, meaning that they will be treated as swap dealers regardless: this reduces their incentive to substitute futures for swaps.

The main driver of futurization outside of energy will be CFTC regulatory treatment of futures and swaps.  Differential treatment will affect the economics of futures vis a vis swaps, and the prospect of such differential treatment was the center of controversy at the CFTC meeting, and in the larger debate in the industry.

The main sources of differential treatment are execution and margining.  Swaps will have to be executed subject to (allegedly) soon-to-be announced SEF rules, and are subject to immediate reporting.  Most market participants who will substitute futures for swaps will execute these deals via privately negotiated block trades subject to exchange rules.  Crucially, reporting of block futures trades is delayed 15 minutes, a concession to fears that immediate reporting would impair liquidity because block positioners (those supplying liquidity to the block futures market) could find it difficult to lay off their risk if the fact they had just done a big trade was announced immediately.  This would induce them to require larger price concessions for doing block trades.

Which raises the question: why the difference between the futures goose and the swaps gander?  Similar considerations obtain for swaps.

Thus, this rule difference is likely to favor futures executed via block trades as opposed to swaps executed via traditional means (but with immediate post-trade transparency) or via SEFs.  (Economically material differences between the rules governing block trades and SEF trades could also affect the relative costs of trading in these disparate ways, and hence affect the choice between them.)

Margining will be different for swaps and futures.  Futures will be margined assuming a one- or two-day liquidation period (i.e., margins will be based on something analogous to a one- or two-day value at risk).  However, swaps-even cleared swaps-will require a minimum liquidation period of 5 days for calculating initial margin.

This substantially higher margin for swaps results in a substantial economic disadvantage to these contracts compared to futures contracts that generate the exact same cash flows (in the absence of default).   This will likely be another factor pushing the market towards futures-which is a major reason for the fury of swaps dealers.

This differential treatment of economically equivalent contracts just because one is called a “swap” (BAD!) and the other is called a “future” (GOOD!) makes little-or no-economic sense-and reflects the swap-o-phobia that pervades DC, and which was an animating principle behind Frankendodd.

The reason to set margins based on a liquidation period reflects the purchase of IM: it is intended to cover potential losses on a defaulted position before that position can be liquidated by the clearinghouse (i.e., the position can be assumed by another solvent market participant).  The less liquid an instrument,  the longer it takes the CCP to work out of the position, the more it is exposed to potential adverse price moves and hence the more margin cover it needs.

This liquidation period depends on the economic characteristics of the contract, how widely it is traded in the marketplace, the identity, number and capitalization of the firms that trade it, and market conditions at the time of liquidation. All of these conditions should be pretty much the same for two contracts that specify the same contingent cash flows, one of which is called a swap and the other a future.  Consider say a 10 year vanilla IRS and economically equivalent futures contracts that offer the same contingent cash flows.  Abstracting from margining differences, these contracts have identical price risks, and should attract the same kinds of users.  Why should liquidity of one differ from the liquidity of the other in the event of the default of the holder of a big position?

And don’t tell me that futures are traded in light markets and swaps are traded in dark ones.  As already noted, futures traded as substitutes for swaps are and will be typically traded in blocks outside the limit order book.

More importantly: in the event of the default of a big FCM or dealer that should be the reason to be concerned, the CCP is going to try to get rid of the defaulted portfolio in big chunks through some sort of auction process.  The firm winning the auction will then trade out of the position, likely using the central market and block trades.

This isn’t much different than how a swap CCP will handle the default process.  Indeed, LCH obligates its members to assume portions of a defaulted portfolio, and one reason for having stringent CCP membership requirements is to ensure that the members have the capital and trading expertise to manage big pieces of defaulted portfolios.

We actually have a case study of futures and swap default management processes.  When Lehman defaulted, CME auctioned off its interest rate, equity, currency, commodity, and energy positions.  These trades were done at differentials from market prices, to reflect the risk that those taking over the positions would assume and have to work off.  A couple of the positions were under-margined: the firms taking over the positions required the CME to provide more funds than the Lehman margin it had against those positions.  As it turned out, the other positions were over-margined, and across all positions the over-margining exceeded the under-margining, meaning that the CME clearinghouse did not suffer any loss as the result of the default.  But this illustrates the possibility that futures can be under-margined, and that even the putatively more liquid futures contracts can require substantial price concessions to get someone to assume them.

LCH.Clearnet handled the default of the Lehman IRS positions. These totaled $9 trillion in notional-bigger than the Lehman futures positions at CME, and arguably far larger in terms of risk.  ($1 trillion in notional of a 10 year IRS poses substantially more risk than $1 trillion in notional of Eurodollar futures.)  90 percent of the position was hedged within a week.  According to LCH.Clearnet, the costs of trading out of the defaulted position were “well within” the Lehman margins it held.

It’s hard to see much of an economic difference between the CME and LCH experiences.  It doesn’t appear that it was materially more difficult to manage the default of “swaps” than it was “futures.”   The Lehman default does not provide any evidence that swap-o-phobia is anything but a mental illness.

Further, this case study illustrates that there is no reason to believe that absent government regulation, swaps will be under-margined and futures will not.  Indeed, had the Lehman positions been held at 5 separate CCPs, two of them would have been under margined.

Indeed, there are serious reasons to be concerned that government regulations of the margining of economically similar (and in some respects identical) contracts will create systemic risks, rather than mitigate them.

The margin regulations-with larger IM imposed on swaps than futures-are a form of price control, in this case default risk price control.  And we know that price controls work out swell, especially when applied by regulators in a two-sizes-fits-all fashion across all different kinds of instruments posing different risks and cleared by CCPs with potentially disparate financial strength.

Moreover, this price control will tend to induce activity to move towards futures CCPs.  Whereas in the absence of the margin differential clearing activity in, say, interest rate derivatives would be split between futures CCPs and swap CCPs, under the differential regulation, business will tend to tip to the futures CCPs-most notably, CME.  This will tend to lead to greater concentration of credit risk.

Wasn’t the whole point of Frankendodd to reduce concentration? Just asking.

The whole conceit that regulators can set risk prices is quite dangerous, and is likely to be a source of systemic risk because these prices are set on the basis of highly limited information in a politicized process, and because mistakes in setting risk prices (especially price differences between similar products) tend to lead to crowded trades and risk concentration that is highly destabilizing during crisis periods (cf. Basel II).

The case for setting different margins (default risk prices) on very similar-and in some cases identical-derivatives contracts is particularly weak.  It is the characteristics of the products and those who trade them that will drive liquidity and liquidation periods: products called “futures” that share the same economic characteristics as products called “swaps” will pose virtually the same challenges to liquidate in the event of a large default.  Given this, the economics suggest that imposing differential margins based on a name difference-rather than economic differences-can’t make things better, and could well make them worse.

But the Sorcerer’s Apprentices know better. So futures are likely to get an artificial advantage, and swaps an artificial burden. Such distortions are quite dangerous.  My conclusion? Futurize in haste, repent at leisure.

There is an I-told-you-so tizzy going on about the revelation of the BATS exchange that a system (or programming) error had resulted in the execution of about 450,000 orders at prices worse than the best bid/offer (BBO).  Oh, the humanity!

A little perspective here.  According to BATS, the total loss (which is a wealth transfer, mind you) totaled . . . brace yourselves now . . . $420,000.  Excuse me.  $420,360.

There seems to be some presumption that there was a Golden Era of trading, before the invasion of the dreaded machines, when intermediaries had hearts of gold rather than a hunger for it.  When bids and offers were never violated.  When there were never trading errors.

Wrong.  There was no Golden Age.  Nirvana is still just a band.

Think that the BBO was never violated on exchange floors?  Think again.  Sometimes this was inadvertent in the chaos of the pits/trading posts during active markets.  Sometimes it was very advertent (is that a word?)  May I remind everyone of the FBI sting on the CME and CBT, which discovered that some brokers would collude with locals to execute customer orders at off-market prices, and split the proceeds, sometimes delivered by bagmen-literally, guys passing paper bags of bills.   Given the relatively crude time stamping of trading cards, it was very difficult to construct an accurate audit trail.  Trades couldn’t even be sequenced with precision, and since the bid/offer were not recorded continuously or time stamped, it was impossible to see whether  a trade violated the BBO.  There were pit monitors who tried to keep an eye on things, but no human monitoring was capable of detecting all violations.  Indeed, the sociology of the floor and the member domination of exchanges (a subject I’ll turn to shortly) meant that social pressure discouraged cracking down too aggressively, particularly on the most powerful.

Enforcing the BBO on the floor was in many ways constrained by a lack of data.  If anything, current market monitors have the exact opposite problem: they are drowning in a sea of data.  But as BATS shows, it is possible to go back through years of this data and pick up mistakes that cost customers about $1 per error.

Then shall we discuss out-trades?  Out-trades-trading errors, where trade terms submitted by the buyer and seller didn’t match-were common on the floor.  Brokers were on the hook for errors, and there were stories of brokers writing six figure checks to make a customer whole for a loss.  I would not be surprised that on an inflation adjusted basis, a single broker wrote a check to a customer that exceeded $420,000 in 2013 dollars.

But this reality of the way things were doesn’t stop the hue and cry about the fallen state of today’s computerized markets.  The biggest huer-and-crier (emphasis on the crying) is Jackass Joe Saluzzi of Themis Trading.  Here Joe outdoes himself, by suggesting that we need to go back to the days of non-profit exchanges in order to restore public confidence in broken markets. (h/t Blivy.)

JJ apparently believes the old mutual non-profit exchanges were freaking charities, like the March of Dimes or something.  Uhm, no.

Let’s look at the facts.  The old mutual exchanges were cartels of intermediaries.  They restricted membership in order to enhance the rents of those members.  For decades, most of them ran brokerage cartels that fixed commissions.  Some created monopoly privileges for some members (e.g., NYSE specialists).  Others (NASDAQ comes to mind) had order handling rules that basically precluded public customers from competing with member market makers in supplying liquidity: NASDAQ was also the nexus of a flagrant conspiracy among market makers to fix spreads at supercompetitive levels.

Non-profit status had nothing whatever to do with the charitable urges of old time brokers and market makers.  As I showed in research done just as the transition from non-profit to for-profit status was occurring, exchanges chose the non-profit form because the non-distribution constraint inherent in that form prevented the exchange from choosing pricing policies that transferred wealth among heterogeneous members with very specialized human capital.  (An abbreviated version of the argument is here.  The full version was published in J. Law & Econ. in 2000.)  Electronic trading undermined the rents and the specialized assets that drove the choice of non-profit form, so the move to electronic trading in turn impelled the transformation of exchanges to for-profit entities.

In other words, non-profit form was chosen by very greedy, profit-driven individuals to protect their profits.  And a good chunk of those profits resulted from the exercise of market power and the adoption of collusive arrangements by exchanges.

So spare me nostalgia.  Indeed, methinks that a good deal of the nostalgia-and the related criticism of modern electronic markets-is a shriek of rage by those who profited under the old system, and are furious that someone ruined their racket.

Joe does get one thing right (cf. blind hog, acorn).  He attributes the specific BATS problem, and the increased complexity of the equity markets, to RegNMS.  This is correct.  The information-and-linkages approach chosen by the SEC led it to adopt regulations that socialized order flow.  This was done with the explicit goal of encouraging competition among trading platforms.

Another example of “be careful what you ask for: you might get it.”  Pre-RegNMS, NYSE executed about 85 percent of the trades in its listed stocks, and the bulk of the remainder was executed in Third Markets which did not contribute to price discovery.  NYSE was essentially the natural monopoly supplier of price discovery.  Now, NYSE market share is in the low-20s, and executions are shared pretty much equally among a handful of platforms.

But this socialized order flow model requires linkages between the execution venues.  It is that necessity that accounts for the complexity of the current equity markets.  The interconnection imperative is directly responsible for the proliferation of order types that many find so vexing, and which indeed give advantages to specialized electronic traders.  Note that the BATS error was in an order type designed to ensure compliance with RegNMS rules relating to the BBO.

You can criticize this market structure.  But if you do so, you have to grasp the nettle of the fundamental trade-off.  The choice is binary.  You can choose to socialize order flow, or not.   If you do, you get something like the current equity market structure, with intense competition among execution venues linked by a complex web of fragile connections and a proliferation of order types.  If you don’t, you get something like the pre-RegNMS market structure, or futures market structure past and present.  A market that tips to a single execution venue that exercises market power, either by restricting access (the old mutual model) or by charging supercompetitive prices (the new for-profit exchange model).

Those are the choices.  But the debate is almost never framed that way.  Instead, bat sh*t crazy people like Saluzzi (enabled by folks like the CNBC talking head in the BATS Hit video) take up all the oxygen screaming about how bad the current market structure is and retailing myths about some Golden Age that never was.

Political economy considerations almost certainly ensure that the SEC is not going to go back on RegNMS, and it is truly invested in the information-and-linkages approach it chose.  So we are likely to see a continued series of controversies over problems that are inherent in the socialized order flow model.  The SEC will pull its chin, and deal with each problem as it appears in an ad hoc way, just adding to the complexity as the new games are devised to exploit the new rules implemented to stop the old games that exploited the old rules.  This will make for never ending media appearances for the likes of Joe Saluzzi, but  don’t buy his line about the good old days.  The good old days that existed when regulation effectively opted for the other binary choice (no socialization of order flow) weren’t all that great.  There was a different set of problems, and a different set of people and firms profiting off the inefficiencies that inhere in the network nature of financial trading.