Streetwise Professor

The European Commission is pushing for foreign currency derivatives to be cleared.  This is also a bone of contention here in the US.

It is interesting that those advocating clearing, and also exchange trading, have not attempted to explain the very pronounced cross sectional variation in trading and clearing practices across markets, and the time trends in particular markets.  Virtually all FX derivatives trading is OTC (with currency futures being the hair at the end of the tail of the dog).  The large bulk of linear interest rate derivative trading is OTC (even though the Eurodollar futures and similar markets are immense, they are dwarfed by the even more immense OTC interest rate swaps).  Equity derivatives and interest rate option trading is more evenly split between OTC and exchange.  Moreover, whereas in recent years a good portion of interest rate swap business has migrated to clearing naturally (accounting for about 50 percent of the interbank business), no OTC FX business is cleared.  A decent amount of OTC equity business is cleared.  A considerable part of OTC energy trading in the US is cleared–and was trending in that direction starting from about 2003 without anybody from the government telling market participants to do it.

The lack of clearing in OTC FX is pretty interesting, inasmuch as counterparty risk on an FX swap of a given amount and tenor is greater than that of a corresponding interest rate swap because principal is at risk in the former, but not the latter.  If clearing is such an economical way of allocating counterparty risk, why is it almost completely absent for products in which that risk is pronounced?  Similarly, due to the jump-to-default feature in CDS, these products pose large counterparty risks, but they weren’t cleared either until the dealers came under pressure to do so.  So, the instruments that arguably pose the greatest counterparty risks were not cleared voluntarily.

It would be nice of those who have the Olympian insight to dictate how markets should be structured could explain how they are structured.  If the European Commission is right, then the participants in the FX derivatives market are wrong.  Why?  And why should FX market participants choose a different mix of execution and counterparty risk allocation methods than participants in interest rate swaps and equity and energy derivatives?  Especially since there’s more than a little overlap between the participants in these various markets.

This is an interesting economic puzzle, the solution to which might, just might, be somewhat illuminating.  It might just shed some light on the economic trade-offs involved in clearing.  Just a guess.  But in the haste to prescribe–to dictate–market structure, our legislative and regulatory betters couldn’t be bothered to understand.  They just know.  So everybody should just shut up and get with the program.

Blanche Lincoln has expressed uncertainty as to whether the no Federal assistance clause in her bill will survive to become law.  (Here’s hoping, though the Republicans caved–I’m shocked!, shocked!–at holding up the Dodd bill which Steve Bainbridge rightly calls “evil.”)  Perhaps one reason for her uncertainty is that some anonymous Fed staffers threw some “comments” on the bill over the transom.  (Which raises the questions: why do these staffers feel the need to be anonymous?  Why hasn’t the Board, or Bernanke, taken a stand on this?) (We know with probability 1 that SWP’s cogent critiques had nothing to do with Lincoln’s uncertainty!)

Echoing my original take, the comments trashed the dreaded section 106:

1. Section 106 should be deleted.

a. Lending to financial market utilities. Section 106 would prohibit any federal assistance to swap dealers, major swap participants, swap exchanges, clearinghouses and central counterparties.  This would appear to override the provision of Title VIII that would allow the Federal Reserve to provide emergency collateralized loans to systemically important financial market utilities, such as clearinghouses and central counterparties, to maintain financial stability and prevent serious adverse effects on the U.S. economy.

i. As systemically important post-trade “choke points” in the financial system, it is imperative that these utilities be able to settle each day as expected to avoid systemic problems and allow for a wide range of financial markets and institutions to operate.  The failure of a systemically important utility to settle for its markets would not only call into question the soundness of the utility as a critical market infrastructure but could also create systemic liquidity disruptions for one or more  markets and potentially other financial market utilities.  The increased importance that Title VIII places on central counterparties and central clearinghouses to reduce risk in the financial system necessitates ensuring that short-term secured credit is available to these utilities in times of stress.

b.  “Push-out” of bank swap activities. Section 106 would in effect prohibit banks from engaging in derivative transactions as an intermediary for customers or to hedge the bank’s own exposures.

i. Title VI, which includes the so-called Volcker rule provisions, better addresses the problem of risks from derivatives activities by prohibiting any bank, as well as any company that owns a bank, from taking speculative, proprietary derivative positions that are unrelated to customer needs.

I would disagree only to the extent that I think the Volcker rule is inane too.

The interesting question is where this insanity came from.  In the months leading up to the announcement of the Lincoln bill, mandatory clearing was always on the table; mandatory exchange or exchange-like trading was constantly discussed; but the no Federal assistance provision was never broached.  How can it happen, so late in the day, that such a momentous provision, fraught with the potential for massive consequences (that are almost impossible to forecast with any precision), can appear in a piece of legislation like a bolt from the blue?  The cavalier attitude on display here is frightening.

I have another question, related to the consequences.  During the Crash of ‘87 clearinghouses didn’t have direct access to Fed assistance.  Nor do they now, for the most part.  But the Fed clearly provided liquidity support in 1987 that although not directed to CCPs or FCMs directly, indirectly supported them.  The Fed flooded the system with liquidity, and “persuaded” (the quotes are in Bernanke’s article about the event) banks to take the liquidity and lend it to securities firms and FCMs to make sure that they would be able to meet margin calls.  The Fed also permitted Continental Bank to inject capital into First Options, which probably saved OCC; Continental, I believe, received Fed liquidity.

Would it be legal for the Fed to do provide the same indirect support under Section 106?  It seems ambiguous.  The Fed’s actions in 1987 were clearly undertaken with the intent of saving clearinghouses, and had this effect.  Do we really want lawyers (or judges) trying to figure out whether such indirect assistance is legal when the financial system is on the brink?  Or will the fear of such a constraint lead to the kind of backroom dealing and cover-ups that occurred during and after the AIG bailout?  (And which, by the way, may get Timmy! in the legal crosshairs of the TARP Inspector General.)

Has anybody in the Senate even thought about this?

You know, when you play chess, or plan military strategies, you have to think several steps ahead.  You have to play “what if?”  I believe, with almost metaphysical certainty, that nobody who will be voting on this has done so.  More often, they are looking back, and learning false lessons about the past, or ignoring potentially informative experiences, or just engaging in pointless political posing and posturing.  Which bodes very ill for the next future, and the next crisis–when, and not if, it occurs.

Which is just one reason why Congress is the biggest systemic risk.

In some respects, the debate over clearing has been at cross purposes.  Those who advocate clearing, including many in the banking community, often focus on the chaotic events that accompany the default of a large OTC counterparty, such as Lehman or LTCM; advocates of clearing argue that a central counterparty can mitigate the disruptions associated with a large failure.  Those, like me, who are skeptical of mandates (but who are not averse to clearing if freely chosen by market participants, as has occurred in energy, freight forwards, and many interest rate swaps) focus on the incentive and information effects that affect behavior prior to a default.

I confess to being less than clear about the distinction, and therefore think it’s worthwhile to address these issues in more detail.

In essence, the distinction is between ex ante and ex post.  I have focused on the ex ante incentives, whereas others have focused on ex post issues.  Both are important.  (This parallels distinctions that transactions cost economists sometimes draw between agency theory and property rights models, which focus,  on ex ante incentives, and Williamsonian governance theories, which focus on the ex post management of contractual relationships.)

Of course, the ex ante and ex post issues are not unrelated.  Ex ante incentives affect the positions and risks that are undertaken, and hence affect the likelihood of a major default.  Resolution mechanisms affect the cost of dealing with default.  The expected cost of clearing vs. bilateral mechanisms for allocating counterparty risk is, roughly, given by the probability of a major default (which depends on the ex ante incentives) times the cost of such a default (which depends on the ex post resolution mechanism).  It is not evident a priori whether this product is larger under a cleared or uncleared system, hence the grounds for legitimate debate over the merits of clearing.

There is a colorable case that the combination of multilateral netting and the existence of a central counterparty that can coordinate the transfer and replacement of defaulted positions can reduce the cost conditional on a default occurring.  Multilateral netting reduces the magnitude of the positions that need replacing.  This reduces the stress on market liquidity resulting from a default.  Moreover, clearing facilitates the transfer of customer positions to solvent clearing members, thereby avoiding the necessity of replacing these positions via market transactions, further reducing said stress.  Moreover, the information that a CCP possesses about total positions, and its ability to coordinate the hedging/replacement of the defaulted risks can reduce uncertainty and mitigate price impact.  (Although it should be noted that the experience of the CME with the Lehman problem, as documented by the Valukas report, and as suggested by what I have learned from informed sources that the LCH unwind of the Lehman positions was not as breezy as LCH has suggested demonstrate that this is at best a relative statement.)

Some research that grew out of the ‘87 Crash sheds light on this last issue.  An interesting paper by Greenwald and Stein (JOB, 1988) shows that normal, continuous trading mechanisms can exhibit poor performance during periods of market stress caused by a large shock to the volume of transactions (especially when this shock is accompanied by an increase in fundamental uncertainty).  In essence, there are execution price risks under these circumstances that create negative externalities.  Potential replacement counterparties are reluctant to trade in these circumstances because of the extreme uncertainty about execution prices during periods of large volume shocks.  This tends to reduce liquidity, which tends to exacerbate the execution price risk.

This means that the uncoordinated replacement of large numbers of defaulted positions by a large number of firms through the use of ordinary, continuous market mechanisms (whether OTC or exchange) can lead to substantial price changes that are not fundamentally driven, but are microstructural in origin.  This can have further knock-on effects, as these (distorted) market prices affect collateral/margin calls, can induce asset fire sales, etc.

Thus, a plausible characterization of a key trade-off between bilateral and cleared structures is: (a) counterparty risks are more efficiently priced and shared in a bilateral setting, and hence moral hazards and adverse selection problems are less acute in that setting; (b) further, hub-and-spoke clearing networks create concentrated points of failure that are more problematic than more distributed (but still concentrated) bilateral networks; but (c) a cleared system reduces replacement cost risks/price impacts conditional on default.

Which raises the question: is it possible to obtain the information benefits associated with bilateral arrangements for some transactions, while mitigating the price impact of an uncoordinated replacement of defaulted positions? Can we have our cake and eat it too?

Put differently, clearing is a bundle of functions including inter alia: (1) the pricing of counterparty risks; (2) the mutualization of losses not covered by collateral; and (3) the management of risk associated with defaulted positions, and the replacement of these positions.  I argue that for many transactions and transactors, bilateral mechanisms are superior for (1) and (2); I recognize that CCPs may do (3) better.  Is there any way to get the benefits of (3), without incurring the disadvantages that CCPs arguably face with (1) and (2)?

I think that this could be possible.  In essence, it would involve pre-commitment to a suspension of normal, continuous trading activities in the event of a default by a large market participant (a dealer, such as Lehman, or a big hedge fund, such as LTCM), and its replacement with an auction-type mechanism.  (This is the essence of the Greenwald-Stein recommendation for “circuit breakers” that replace continuous trading with a call auction.  The key difference is that the Greenwald-Stein circuit breakers are price-contingent, which has some problematic features, whereas what I am proposing is default-contingent.)

ISDA implemented a “Big Bang” auction protocol to facilitate the settlement of CDS positions in the event of the default in a named credit.  Although as I predicted in my post on this subject some years back, this protocol has not eliminated all problems with pricing the debt of defaulted credits (as shown in a recent Markit Magazine article), it has greatly smoothed the process of handling CDS-triggering credit events.  Perhaps something similar could be designed and implemented to deal with a big derivatives default.

ISDA could of course play a central role in shepherding the creation of such a mechanism.  Similarly, regulators, notably the NY Fed, could also play a constructive role, perhaps in both the design and implementation.  I am pretty sure that ISDA would be quite willing to engage in such a cooperative endeavor.

The process would of course be facilitated by the development of robust trade repositories that permit rapid determination of the positions that are defaulted against.  I have supported the creation of such repositories (see my Regulation magazine piece) from the outset.

Just thinking out loud, here are some ideas of a potential structure.

First, a compression round whereby multilateral exposures are netted.  (This would have implications for bankruptcy priorities and bankruptcy law; these implications would have to be weighed carefully and addressed).

Second, an auction round for replacement of positions.  This auction round would follow a disclosure, based on the information in the trade repository, of all the positions, to the potential bidders.

The auction round raises several issues that need to be considered.  Who would be allowed to participate?  Permitting anyone to participate could just be a jump from the frying pan into the fire if some of the winning participants are themselves in dodgy financial condition.  (This is a dilemma that CME faced in its Lehman auction, and likely explains why it limited participation in the auction of Lehman positions).

Another issue is that the number of positions to replaced can be immense, and highly heterogeneous, with many non-standardized contracts.  Perhaps one way to deal with the latter would be to auction off shares of portfolios, e.g., USD interest rate (swap, swaption, etc.) positions; FX positions; equity derivatives; and so on.  This would mitigate cherry picking/adverse selection problems and simplify the bidding.  It would, however, mean the splitting of some individual contracts among multiple counterparties.  (It should be noted, though, that many of the positions would not be cleared or even clearable in any event, so this issue is not eliminated by a clearing mandate.)

Yet another issue is that those assuming positions would be taking on counterparty risk.  Thus, the repository would have to disclose the counterparties to the defaulted contracts to the potential bidders.

So, I realize that there are many thorny operational issues that must be addressed to implement this proposal.  But some would exist under a clearing mandate because not everything would be cleared in any event.  I further realize that FRBNY and the dealer community tried to do some of this on the fly in the “Lehman weekend,” and in LTCM years before.  The Lehman attempt foundered (as Theo Lubke of FRBNY, and several bankers I spoke to, indicated at the ISDA AGM).  But perhaps this is not surprising as extemporizing on the fly in those conditions faces faint chances of success, particularly given the lack of information available to the participants; a pre-planned mechanism that can rely on more complete information is almost certain to work better.  I would also note that in a cleared market something like this will have to be in place in any event.

The logic behind my approach is pretty straightforward.  Whenever things are bundled, the immediate question should be: can efficiency be enhanced by unbundling them?  (A lot of what goes on in finance involves unbundling things and allocating the pieces in a value-enhancing way.)  Sometimes you can’t: so be it.  But sometimes you can.

Clearinghouses bundle counterparty risk pricing, counterparty risk management (including the collateralization mechanism), mutualization, position information collection, and default resolution.  There is no logic that says that those functions have to be bundled.  Repositories can collect and aggregate information, perhaps more effectively than CCPs (because they can incorporate information on non-cleared positions, and information on positions held across CCPs).  CCPs are not always the best at counterparty risk pricing and collateralization mechanics.  Mutualization can have some extremely problematic features.  So why not an approach that unbundles, and allows specialization in these various functions?

Once repositories are created, the development of a robust, coordinated defaulted contract resolution/replacement mechanism would go a long way to improving the efficiency of the OTC derivatives market while permitting it to continue to do what it does best.  This would be an easier process (though not a simple one) than what will be set in motion by the vast expansion of CCPs as contemplated in the pending legislation.  CCPs will have to develop resolution procedures in any event.  Moreover, it is desirable to develop procedures to deal with contracts that are not cleared (which will be the most challenging ones in any event).  But force-fed CCPs will also have to grapple with challenging pricing, risk management, risk sharing, and governance issues as well.  And if there are multiple CCPs, there will have to be some coordination of the resolution procedures.  (If there isn’t there will be trouble.)  So, a mandated and extensive expansion of CCPs will have to solve many more problems than just the resolution mechanism.  So why not just focus on that?

I am sitting in the SF airport, on my way back to Houston after speaking at the ISDA Annual General Meeting.

Wikipedia states that “fin de siecle”

refers to the end of the 19th century, in Europe, France and/or Paris. It has connotations of decadence, which are seen as typical for the last years of a culturally vibrant period (La Belle Époque at the turn of the 20th century), and of anticipative excitement about, or despair facing, impending change, or both, that is generally expected when a century or time period draws to a close.

There was definitely a fin de siecle feel to this ISDA event.  Decadent?  No, but certainly more extravagant that what I am used to.  Anticipative excitement?  Definitely not, but certainly anxiety, bordering on despair, about the impending change facing the OTC derivatives business.

Yesterday, of course, Obama gave a populist speech at Cooper Union in New York, in which he demanded that Wall Street submit meekly to the regulatory proposals racing through the Senate.  Deputy Secretary of the Treasury Neal Wolin carried this message to ISDA.  He gave a hostile, our-way-or-the-highway speech.  I haven’t seen Wolin speak before, so I have no benchmark to compare to, but not only was his speech very sharp-edged, but his body English also communicated a certain hostility.

The audience reaction was as tepid as any I’ve ever seen.  I would probably be exaggerating if I said half the audience gave any applause, and even those clapping were making only the most perfunctory effort.

Mark Brickell, formerly of J. P. Morgan, asked a very provocative question, and one that needed asking.  He asked Wolin whether by forcing things into clearinghouses, weren’t the new proposals creating the ultimate too big to fail institutions, and effectively committing the government to future bailouts?  Wolin’s answer was basically just a flat denial, and did not truly engage the real issue that lay at the heart of the question.

Wolin was also asked about the Lincoln bill’s no Federal assistance provision, which would be the Volcker bill on steroids, requiring not only banks to exit proprietary trading, but customer-facing derivatives market making activities too.  Consistent with other administration voices, Wolin neither endorsed or criticized the measure.  He said something like “there’s a lot in these bills.”  Thanks for that insight.

I was on an academic panel chaired by Chris Culp (Chicago), with David Mordecai (Chicago), and David Mengle (UCLA, which was Chicago West in those days).  Mengle gave a nice talk about close out netting and its essential role in the OTC trading model.  David Mordecai gave a conceptual talk about the broad lessons of the crisis, in which he drew on the insights of Ronald Coase (always a good choice).

I gave the 20 minute Cliffs’ Note version of my case against clearing mandates.  My talk was largely well received, though not by everybody.  One of the things I focused on during my talk was the experience of the 1987 Crash, in which the CME clearinghouse was in serious jeopardy.  Somebody from CME clearing came up afterwards, and was pretty outraged at what I said.  He told me I was “feeding the dealer frenzy.”  No, I am trying to counter the legislative and regulatory frenzy with some back-to-basics analysis of the economics of risk sharing.  He also denied that the CME clearinghouse was in trouble in ‘87, which got me a little ticked.  I told him, hey, look, I was there, I lived it, and was told that very specifically by Brian Monieson, a CME board member, in the morning of 20 October, 1987; truth be told, when that was happening this gentleman was in grade school in India.  You can look at contemporary accounts, including the Brady report and the Bernanke article on clearing and settlement during the Crash, and learn the same thing.  You can also look at Tamarkin’s book The Merc.  I was told of the BOTCC problems on the 19th-20th by two well-respected FCMs.  This isn’t a secret.

In various conversations afterwards, many bankers asked me about the ‘87 Crash.  For the most part, they were not aware of the history, and were quite interested in it.  (Thanks for making me feel old, guys.)  Several are involved in various clearing efforts today, and found this history quite thought provoking.  That’s a big reason why I make such a big deal out of this.  People are so focused on the last crisis, and preventing a recurrence; regulators and legislators are most guilty of this.  It is important to make people aware that the last crisis was not the first crisis.  That there’s more historical experiences that can inform our current deliberations than what transpired in September, 2008.  The Crash of ‘87 is particularly valuable because it gives the lie to the widespread claims about the efficacy of clearing as a solution to systemic risk.

Went to the meeting knowing almost no one, walked away knowing quite a few people.

The reception/dinner last night was a very interesting, almost anthropological experience  Pretty much the sole subject of conversation was the pending legislation; that’s what gave things the fin de siecle feel.  Everyone knows big changes are coming; that a vibrant period is coming to a close; and that the future will be very different.  The only question is: how different?

I think that the prevailing sense is that yes, some regulatory changes are needed and desirable, but that the punitive-for-the-sake-of-being-punitive legislation will be extremely counterproductive.  There was also a sense of despair that their fate was in the hands of those not only with an animus and an agenda, but with only a limited understanding of the way the business really works, and the likely consequences of what is being proposed.

Substantively there was broad agreement that expanded clearing could provide benefits, but that pushing it too far could be a disaster.  (That’s basically my view.  My CME interlocutor might talk to some of his own members to learn that they share similar concerns.)  There was widespread amazement at the exchange trading requirements.  I made a brief comment about the inanity of the Lynch Amendment (which may also be introduced by Sherrod Brown in the Senate) which several people talked to me about; they, as I, cannot believe how anyone would expect that banks are expected to bear counterparty risk by capitalizing a clearinghouse and providing backstop funds without having a commensurate voice or control of the operations of the CCP.

One last note.  The reception last night was held at the Legion of Honor, a beautiful art museum, which has one of the biggest Rodin collections outside of France.  (It also hosts a Cartier exhibit, which reinforced the sense of extravagance.)  The Thinker dominates the entryway to the museum.  On my way out, I looked back at the sculpture.  The sky was crystal clear.  A brilliant half moon hung over The Thinker’s head.  Four stars, in a diamond shape, bracketed the moon.  Quite a sight.

Is the legislation currently working its way through Congress.  According to The Hill, Harry Reid wants the Lincoln derivatives bill incorporated into the Dodd legislation (replacing the “place-holder” derivatives title of the Dodd bill).  Great.

There are many bad features in the Lincoln bill.  Arguably the worst (though the competition is stiff!) is the proscription on any “Federal assistance”, including Fed lending, to financial institutions that trade derivatives, including clearinghouses.  Especially when combined with the mandated expansion of clearing, this is extremely dangerous.

Clearinghouses can blow up.  It has happened historically, and it almost happened with disastrous effects during the ‘87 crash.  Arguably the only thing that prevented that from happening was the intervention of the Fed.  I strongly suggest that Lincoln, or her staff, read the Brady report on the Crash to get some understanding of that.  Or better yet, read Bernanke’s “Clearing and Settlement During the Crash” (3 Rev. Financial Stud. 1990 at 133).  A few telling excerpts:

Let us put aside the possibility of government intervention for the moment. Then there seems to be a potential structural problem with the clearinghouse arrangement. The problem is not that some traders who thought they had a guaranteed contract would end up not being paid off; as we have said, perfect insurance against systemwide shocks is not possible. Rather, the problem is that a shock large enough to exhaust the clearinghouse’s capital and assessment powers would have a serious prospective effect on the ability of the clearinghouse and thus of the futures market itself to function. Presumably, over a period of time reorganization and recapitalization would occur. But in the shorter run the poor functioning or shutdown of the futures market might exacerbate the adverse conditions that precipitated the problem in the first place.

That is, the potential for failure of a clearinghouse–just the potential–can lead to a positive feedback mechanism that worsens the crisis.

Bernanke discusses the essential role of the Fed on 19-20 October:

The malfunctioning of the banking side of the clearing and settlements systems during this period is indisputable. [Emphasis added.]

. . . .

The official reports and other observers generally agree that the Federal Reserve’s attempts to alleviate the crisis were very constructive. On Tuesday morning, October 20, the Fed issued a brief statement: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the financial and economic system.” This statement was backed up by three types of actions: First, the Fed reversed its tight monetary stance of the previous weeks and flooded the system with liquidity. Second, the Fed “persuaded” the banks, particularly the big New York banks, to lend freely, promising whatever support was necessary. (The 10 largest New York banks nearly doubled their lending to securities firms during the week of October 19.) Finally, the Fed monitored the situation and took some direct actions where necessary, notably in the case of First Options of Chicago. When that large clearing firm was in danger of defaulting, Fed Chairman Greenspan acted quickly to enable its parent firm, Continental Illinois, to inject funds into its subsidiary; according to some observers, this action may have helped avoid the closing of the options exchange.

. . . .

In retrospect we may ask, what really were the dangers to the integrity of the financial markets posed by the crash? And what were
the benefits of the Federal Reserve’s actions? The technological problems of communications and information availability that plagued the system, while serious, did not in and of themselves threaten to bring down the markets. For the most part, information availability was a critical issue during the crash only in the sense that illiquidity is essentially a problem of imperfect information. (Clearly, though, improvements in these technologies should be made.)

It was the financial problems-the possibility of insolvency by major players-that were potentially the more serious. As we have emphasized, financial problems impaired the market’s functioning in at least two ways. First, concerns about solvency impeded the operation of the payments and clearing systems, contributing to financial “gridlock.” Second, the fear that major brokers, FCMs, or clearinghouses might default created uncertainty about the contract performance guarantee. Both aspects reduced market liquidity and disrupted trading. Conceivably these problems could have forced a market shutdown.

In response to this situation, the Federal Reserve, in its lender-of- last-resort capacity, performed an important protective function. The Fed’s key action was to induce the banks (by suasion and by the supply of liquidity) to make loans, on customary terms, despite chaotic conditions and the possibility of severe adverse selection of borrowers. In expectation, making these loans must have been a money-losing strategy from the point of view of the banks (and the Fed); otherwise, Fed persuasion would not have been needed. But lending was a good strategy for the preservation of the system as a whole.

The principal effect of the loans was to transfer some trader default risk from the clearinghouses and their members to money-center
banks. Under the presumption that the money-center banks were well capitalized, and that in any event their solvency would be guaranteed by the government, this transfer of risk reduced the overall hreat of insolvencies in the system. This allowed the payments process to begin to normalize; it also restored confidence in the clear- inghouse’s guarantee of futures contract performance. The resulting stabilization of the markets served the interest of the banks and the Fed in a wider sense, by avoiding any potential costs that a market breakdown might have imposed on the banking system and the general economy.

In performing its lender-of-last-resort function, the Fed redistributed risks in the system in a socially beneficial way. Conceptually, it
is as if the Fed had provided ex post insurance to the clearinghouse against a shock that it seemed possible would exhaust the insurance capability of the clearinghouse itself. Thus the Fed became the “insurer of last resort.”

What, pray tell, would have happened absent the Fed supplying liquidity to the system?  A disaster.

Note that Bernanke’s analysis recognizes that a clearinghouse’s financial resources are limited.  Would it that those flogging the clearinghouse cure would recognize this, and grapple with its implications in a serious way (as Bernanke did), rather than ignoring this brute fact as they do routinely: no, reflexively.

A dramatic expansion of clearing will increase, in a commensurately dramatic way, the potential for operational and financial failures in the clearing and payment system (like those observed in ‘87) during a large price move.  Any policy of mandates MUST acknowledge this, and make sure that mechanisms are in place to address this reality.  By cutting out derivatives, and clearinghouses, from the lender of last resort mechanism, but providing no replacement, the Lincoln bill is courting financial Armageddon.

(Perhaps the Fed would be able to intervene indirectly, by supporting banks and inducing them to support the clearinghouses financially, but constraining the means by which the Fed can supply liquidity to the clearing system increases the likelihood of a failure.)

Bernanke argued in his 1990 article that the Fed has a role in ensuring the integrated banking, clearing, and settlement systems can survive a shock like a stock market crash.  (Again–it is integrated: interconnected.)  Although the Lincoln bill attempts to hive off the derivatives markets from the broader financial system, this is an impossibility.  No, it is worse: it is an absurdity.  The banking and derivatives trading systems are inextricably linked.  Policy must be predicated on that fact.

Maybe the Fed is a flawed institution, but it’s the institution we have.  If Lincoln gets her way, and constrains the ability of the Fed to perform its LOLR function in support of a vastly expanded clearing system, without providing any alternative, she is indeed “reforming” derivatives markets in the worst way.

So I don’t have to?  Because it’s getting tiresome.

But it has to be done, so here goes.

Jeremiah’s latest gurgling appears on the oped page of today’s WSJ.  It starts with a non-sequitur, and careens downhill from there.  Gensler tells a story about his role in the LTCM situation, and then claims that to prevent a recurrence, or a repeat of AIG, it is necessary to reduce the “cancerous interconnections” (Jeremiah Recycled Bad Metaphor Alert!) in the financial system by, you guessed it, mandatory clearing.

Look.  This is very basic.  Do I have to repeat it?  CLEARING DOES NOT ELIMINATE INTERCONNECTIONS AMONG FINANCIAL INSTITUTIONS.  At most, it reconfigures the topology of the network of interconnections.  Anyone who argues otherwise is not competent to weigh in on the subject, let alone to have regulatory responsibility over a vastly expanded clearing system.  At most you can argue that the interconnections in a cleared system are better in some ways than the interconnections in the current OTC structure.  But Gensler doesn’t do that.   He just makes unsupported assertion after unsupported assertion.

If you have any doubts about how interconnected a clearing system is with the banks, just look in detail at what happened on 19-20 October, 1987.

Don’t believe me?  Then consider what Ben Bernanke wrote as an academic in his “Clearing and Settlement During the Crash” (3 Rev. Financial Stud. 1990 at 133):

A prominent part of the institutional structure is the interconnection of the clearing and settlement systems with the banking system.  This interconnection exists at several points.  First, banks are operationally a part of the clearing process. Clearinghouses typically maintain accounts at a number of “clearing banks. Member FCMs are required to maintain an account at a minimum of one of these banks and to authorize the bank to make debits or credits to the account in accord with the clearinghouse’s instructions. This facilitates the settling of accounts and the making of margin calls. Note that the bank’s role may exceed simple accounting if, for example, it must decide whether to permit an overdraft on an FCM’s account.

Second, banks are a major source of credit, especially very short-term credit, to all of the parties, including the customers, the FCMs, and the clearinghouse itself. As was noted above, bank letters of credit can in some cases be used as initial margin. Customers and FCMs often rely on bank credit to facilitate the speedy posting of variation margin, and FCMs would typically have to turn to banks to finance payments made necessary by customers’ defaults or slow payment. In equity markets, banks are often the ultimate source of credit for the purchase of securities on credit.

Finally, it should be noted that while, in the conventional language, most margin postings and settlement payments are made in “cash,” these transactions are, of course, not really made in cash but by the transfer of bank deposits. Thus, the smooth operation of the financial market clearing and settlement system is based at all times on the presumption that the banking system is sound and can satisfy demands for withdrawals of funds.

“A prominent part of the institutional structure is the interconnection of the clearing and settlement systems with the banking system.”  Does it get any clearer?  (No pun intended.)

Ben, would you please drop the “Gentle Ben” demeanor and slap some sense into Gensler?  You actually know something about the subject.  You’re a former educator.  And somebody needs some educatin’.

And consider the implications of a dramatic increase in the scope of the clearing system, including the clearing of many products with unique tail/jump to default risks that have not been cleared before, on the magnitude of the interdependence between the clearing system and the banking and payment systems.  The potential for operational and financial gridlock in the face of a substantial price shock will be greatly amplified if clearing is greatly expanded.

Bernanke goes on to argue that the systemic centrality of the clearing system means that it is highly desirable for the Fed to serve as the “insurer of last resort” to prevent the failure of a clearinghouse or clearinghouses.  So much for Gensler’s assertion that clearing would “greatly reduce . . . the need for future bailouts.”

This is very serious business.  Very serious.  It deserves serious consideration of the real implications of the effects of a vast expansion of clearing.  That consideration must be predicated on an understanding of the real interconnections inherent in a clearing system, not on unsupported and unsupportable denials of the existence of such interconnections.

If the basis for the policies Gensler advocates, and which Congress seems hell-bent on implementing, is a belief that clearing does not entail an intricate web of interconnections (and potentially fragile interconnections) among financial firms, then they are policies built on lies.  And all that a policy based on lies will do is sow the seeds for the next crisis.

Very bad.

Problem one is obviously the ban on “Federal assistance” to any “swaps entity” where “Federal assistance” includes a Fed loan.  It is ironic, and disturbing, that (a) the bill mandates extensive clearing, and thereby makes swaps clearinghouses a central pillar of the financial system, but (b) denies these entities the ability to access liquidity via the Fed.  This goes against the recommendations of Duffie et al in their policy piece for the FRBNY, the European Commission, and now the IMF:

Hence, those [CCPs] deemed to be systemically important should have access to emergency central bank liquidity.  However, any such emergency lending should be collateralized by the same high-quality liquid securities as those typically posted against monetary policy operations. Also, it should not be done in any way that might compromise the central bank’s monetary policy or foreign exchange policy operations. [IMF, Making the OTC Derivatives Markets Safer (April, 2010), p. 20.]

In short, Lincoln’s bill goes against the advice of virtually all those who have analyzed the implications of clearing mandates–including strong supporters of these mandates.

During periods of market stress, and ESPECIALLY in cleared markets, the demand for liquidity increases dramatically.  Firms need liquidity to meet margin calls in response to big price moves.  CCPs that can borrow on behalf of their members can facilitate this process.  Denying these entities access to central bank liquidity facilities is a major mistake, and will in effect make the markets like they were prior to the formation of the Fed in 1913.  Can you say “Panic of 1907″?  I knew you could.

And even allowing CCPs to access liquidity facilities, while denying swap dealers from the same option–effectively requiring banks to hive off derivatives dealing activities–will cause problems.  If the idea is to reduce systemic risks arising from counterparty risk, it is desirable to ensure that market participants, including derivatives market participants, have access to liquidity during periods of market stress.  A firm experiencing a liquidity shock, due, for instance, to a big collateral call, but which is solvent, would be forced by this provision into fire sales or defaults that would exacerbate systemic risks.  It would do so by threatening to transform liquidity shocks into crises.

Lincoln’s bill evidently mistakes a bailout for the exercise of lender of last resort functions.  The latter, if Bagehot’s basic framework is followed, eases liquidity crises by lending freely against good collateral.  (The Fed’s promise to do so in October, 1987 almost surely saved the CME and CBT clearinghouses during the crash).  A bailout transfers wealth from taxpayers to the claimants of an insolvent firm.  Lincoln’s provision threatens to turn liquidity shocks into full-blown crises.

In some respects, Lincoln’s confusion is understandable.  After all, the Bernanke Fed has clearly blurred the line between Bagehot-esque lender of last resort activities and bailouts.  That’s a serious issue, that should be addressed.  But Lincoln’s approach would be a very bad way of doing that.

The bill’s end user exemption is extremely, extremely limited.  That’s also a problem, for reasons I’ve discussed before.  What’s particularly amazing is that the end user exemption is basically limited to commodity producers and consumers (although firms like J. Aron or Morgan Stanley that handle physical commodities are expressly excluded from the exemption).  That means that a firm, say IBM or Merck that uses currency or interest rate swaps would not be eligible for the exemption.

Oi.

The bill also extends position limits to the OTC market.  More pain, without gain.

The proposal requires trading on either exchanges or swap execution facilities, and precludes voice brokerage.  It mandates pre-trade price transparency, and “real time” price reporting.  I’ve commented extensively on these ideas in the past, and find them no more reasonable now than I have before.

About to jump on a plane, so I will add more later.  One last thing.  The bill envisions a massive expansion of responsibilities for the CFTC.  To be honest, the CFTC does not have the capabilities to handle its current responsibilities, let alone the new and extremely complex ones it would have under the bill.  This is a setup for future regulatory failure, in a situation where the regulation is much more pervasive–and systemic. Regulators failed before. They will fail again. The likelihood of failure will be higher, and the consequences of failure more catastrophic, when regulatory responsibilities are expanded greatly and foisted onto an agency that is ill prepared to handle them. Even if the CFTC is funded much more generously, it will face daunting challenges in scaling up, and obtaining the expertise it needs to do a much expanded job. This is a train wreck ready to happen.

OK.  Time for one more thing, something that the bill doesn’t do.  Manipulation is a potential problem in derivatives markets, and existing law and regulation has proved problematic (at best) in deterring it.  I’ve advocated for years that a statutory fix is required, and this bill (or the Frank bill, or the Dodd bill) would present opportunities to do that, but they don’t.  So we have a bill (bills, actually) that does many things it shouldn’t and doesn’t do something it can and should.  Great.

No, it’s not that both can make you cry.  It’s that if Sen. Blanche Lincoln (D-AR), chair of the Senate Ag Committee has her way, futures trading on both will be banned.  Onion futures have been banned since 1958, and the passage of Public Law 85-839 (legislation spearheaded by Gerald Ford, by the way).  Since that time, onions have had the dubious distinction of being the only commodity in which futures trading is specifically banned.  Now, the draft of Lincoln’s derivatives regulation bill would give onions company, by proscribing futures trading on “motion picture box office receipts, or any index, measure, value, or data related to such receipts.”

Now you could make a case–a weak one, but a case nonetheless–for the onion ban.  There were periodic manipulations of onion futures in Chicago.  Onions are perishable, and short sellers would sometimes bring in a few extra carloads of onions and deliver them.  Due to the perishability, a modest enhancement in supply would crater the price, generating a profit for the futures short.  There are stories that the price of onions would fall below the cost of the bags they were delivered in.

That said, empirical studies of the effects of the ban have shown that the ban did not reduce the volatility of onion prices.  Thus, the ban didn’t have any measurably beneficial effect.  But the CME (where onions were traded) has moved onto other things, and the market isn’t big enough to make it worth anybody’s while to lobby Congress to get the ban lifted.  So it has remained, a quaint curiosity.

Given that movie futures haven’t even started to trade yet, dire stories of adverse effects are, pardon the pun, mere speculation.  But a visible, connected, and influential interest group, that just happens to give Democrats in particular large sums of money, supports a ban.  So it made it into Lincoln’s bill, and into the news, ironically, on the day that the CFTC gave initial approval for such contracts.

But oh, were this the worst part of the bill.  As it is, it is merely a visible, risible, symbol of just how bad the bill is.  I will blog more on it later, but it has all the bad things in the Dodd and Frank bills, and much more to boot; it is the Dodd bill on steroids–or meth.  It is chock-full of anti-bank populism.  Most notably, it precludes any swaps dealer from having access to the Fed window.  As if banks can’t get themselves in financial trouble the old fashioned way, with no derivatives involved.

(It would be interesting to hear an explanation of how, if derivatives dealing is as obscenely profitable as Timmy! and Gensler and various Congresspeople argue, depriving banks of this revenue is going to make them healthier and less likely to require government help.)

Moreover, although the Lincoln bill mandates clearing, and offers only very limited exemptions from the clearing requirement, it also denies clearinghouses access to the discount window.  Even those broadly supportive of wider use of clearing recognize the potential systemic issues, and recommend that clearinghouses have access to central bank liquidity facilities.  But Stella–I mean, Blanche–thinks differently.  (Maybe somebody should tell her about the near death of the CME and CBT clearinghouses on 20 October, 1987.)

Let’s see, Congress  creates systemically important institutions that concentrate risk by mandating clearing, and then deprives them of access to the lender of last resort whose responsibility is to provide liquidity to systemically important institutions in times of crisis.  Just how is that supposed to work?

It was widely thought that Lincoln’s bill would be more moderate than Dodd’s but the reverse turned out to be true.  Some reporting suggests that she was near a compromise with her committee’s ranking Republican, Saxby Chambliss, but that the White House pressured her to back off.  The administration certainly made derivatives regulation a centerpiece of its rhetoric last week, and has evidently decided that anti-bank, anti-derivatives populism is a winning political issue that will put Republicans in an uncomfortable position.  Lincoln is in trouble in her re-election bid, so she could use the populist cred too.

It has all the appearances of a good cop-bad cop routine.  Don’t like the Dodd bill?  Just look how bad the alternative is.   Sad to say, I think that this means that the Dodd bill, or something close to it, is likely to become law.

As derivatives legislation wends its way through the Senate, with the Dodd bill and another being written in the Senate Ag committee, the battlelines are pretty well drawn.  The administration in particular is still on the clearing bandwagon, and is overtly hostile to any proposals to exempt end users from the clearing requirement.  The most strident rhetoric on this issue emanates from Gary Gensler (go figure), but also from Treasury.  Deputy Treasury Secretary Neal Wolin said: “we will oppose all attempts to create loopholes or carve-outs.”

By “carve outs,” he is referring to end user exemptions, primarily.  Which is all so ironic.  If you think through how clearing works in futures markets, it is primarily a mechanism to shift default risks from end user customers (the buy side) to the clearinghouse members.  That is, it is a customer protection institution.  But here many customers are adamantly opposed.  Thus, there must be some costs that offset–and indeed, more than offset–the benefits associated with this customer protection.

But instead of an effort to step back, and ask “why” and consider in an intellectually serious way what are the costs and benefits of clearing, the administration and many on Capitol Hill plunge ahead.  When they attempt to explain end user opposition at all, they stoop to asinine conspiracy theories.  Gensler, for instance, attributes the end user opposition to their being waterboys for the dealer banks.

Yeah, Caterpillar, etc., are just creatures of the banks.  Whatever, Gary.

But this is all so odd.  Gensler argues that the dealer banks routinely rape their customers, by exploiting the purported lack of transparency in the OTC market to extract supercompetitive spreads.

So, why would the rape victims (in one of Gensler’s narratives) be the willing supplicants of the banks (in another)?  Stockholm Syndrome?  Battered Spouse Syndrome?

Can we please have a serious discussion, with some serious analysis of trade-offs, rather than these dueling, and facially inconsistent, morality tales?

Yeah, I know.

But I will say that in Europe they are being far more serious and adult.  (And it kills me to have to say that.)  For instance, Jeremy Grant reports that European regulators recognize the legitimacy of end user concerns:

Industrial companies have won recognition from European regulators that they should be granted exemptions from sweeping regulation of the over-the-counter derivatives markets.

It marks a partial victory amid fears that a crackdown on off-exchange derivatives markets, blamed by some for exacerbating the financial crisis, could unfairly penalise corporate users of such instruments.

. . . .

In a “discussion paper” from the European Commission’s directorate general for internal markets, regulators say that “in principle, non-financial institutions could be exempt from the clearing obligation”.

It says the main mechanism for transferring risk to the real economy during the crisis was through the financial sector. “This suggests that the appropriate boundary for a clearing obligation is between the financial sector and the non-financial sector.”

Richard Raeburn, chairman of the European Association of Corporate Treasurers, said: “This suggests that [the Commission] supports the need for an exemption for non-financial users. It is certainly the first time that we’ve seen such a clear statement.”

Eact in January sent a letter to Brussels, signed by 160 companies, warning that without exemptions there could be “a reduction in the amount of funds allocated to productive investment in the [European] economy”.

Just how to structure the exemption is still under discussion.  But at least there is a recognition that there are serious issues that deserve serious discussion.

Could somebody in Europe pick up the clue phone and give Gensler and Wolin and Dodd a call?

Grant also reports that the Europeans recognize that clearing is not the deus ex machina that will descend from the heavens and solve all the systemic risk problems.  Indeed, they understand that clearinghouses can create systemic risks, and hence it is advisable to proceed carefully in ordering a new market structure by fiat:

Watchdogs are concerned about the possibility that proposed linkages between clearing houses could pose fresh dangers to the financial system.

They fear two-way or three-way linkages between clearers could trigger a domino effect if one clearer was to default.

What?  You mean that clearing doesn’t eliminate interconnections in the financial system?  Who knew?  (I know who doesn’t know, sad to say.)

In fact, contrary to the bologna constantly ground out by Timmy! and Gensler et al, clearing creates a particular interconnection among financial institutions–the same financial institutions (by and large) that are too interconnected today in the OTC market.  Multiple clearinghouses creates another set of linkages.  These can by systemically problematic.

The Europeans haven’t sorted through all these issues yet.  But at least they recognize them.  We, alas, are governed by know nothings masquerading as know it alls.

Which suggests a new administration spokesman on derivatives market regulation.

Barney Frank stomped his little feet in anger at the fact that his former senior staffer Peter Roberson decamped to become a lobbyist for ICE.  Frank has barred Roberson from contacting staff for as long as he is head of the Committee.  House rules preclude Roberson from contacting staff for a year.  Wouldn’t it be sweet, I mean ironic, if the the year long bar, rather than the as-long-as-Frank-chairs-the-committee restriction turned out to be the binding constraint?

I had some dealings with Roberson late last summer.  He contacted me about my interest in, and availability for, testifying about OTC derivatives in front of the House Banking Committee.  I indicated that I would be interested and available, but about a week later Roberson told me that Frank did not want me to testify.  (Imagine that.)

Said personal rejection by Frank I wear as a badge of honor.