Streetwise Professor

January 31, 2016

CCPs & RTGS: Devil Take the Hindmost?

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 6:37 pm

The frantic sewing of parachutes in a plane that is 30,000 feet in the air continues apace. Last week the Office of Financial Research (a Son of Frankendodd) released its 2015 Annual Report. This tome received attention mainly because it raised alarm about potential systemic risks arising from central clearing mandates. An improvement, I guess, but like most official evaluations of the systemic risks of CCPs, it misses the real problems.

It gets off on the wrong foot by misstating the real benefits of CCPs. According to OFR, the top two benefits of clearing are related to the ability of CCPs, and via them regulators, to get more complete, accurate, and timely information on derivatives positions and trading prices. But these can be achieved by transaction reporting alone, without going the full monty to clearing, which also entails collateralization (including both initial and variation margining) and mutualization of default risk. (Trade reporting has turned into a nightmare, which I will write about further soon. But the point is that you don’t need clearing to get the benefits OFR touts.)

But the main problem, yet again, is that OFR focuses on the “single point of failure”/interconnectedness/default loss contagion channel for CCP systemic risk. This is not immaterial, but it is not the main thing. The main thing is that CCPs create potentially massive contingent demands for liquidity, where the liquidity contingency is likely to occur precisely at the worst time–when the system is undergoing a financial crisis.

Further, OFR gets it wrong when it states that CCPs “reduce the risk of counterparty default.” CCPs redistribute the risk of the insolvency or illiquidity of a large financial institution away from its derivatives counterparties towards its other creditors. It protects one group of creditors at the expense of others.

It is very much open to question whether this reallocation is systemically stabilizing, or is instead a means whereby one relatively concentrated group of market participants can advantage themselves at the expense of others.

Reading Izabella Kaminska’s excellent FT Alphaville post on Real Time Gross Settlement (RTGS) mechanisms makes plain that this phenomenon of substituting liquidity risk for credit risk, and redistributing credit risk away from core banks, is not limited to derivatives clearing. RTGS replaced deferred net settlement (DNS) because of banks’ and central banks’ concern that in the latter, interbank credit balances could accumulate, resulting in a default loss to settlement banks in the event that an net payer bank failed before the next netting cycle. RTGS eliminates interbank credit exposure.

But, of course, this doesn’t make credit exposure go away. It redistributes it to settlement banks’ other creditors. To a first approximation, the total losses from the inability of a bank to meet its obligations are the same under RTGS and DNS. The difference is who gets a chair when the music stops. Settlement banks–and crucially, the central banks–like RTGS because they almost always are going to get a chair.

Furthermore, as even its proponents acknowledge, RTGS is much more liquidity intensive. To be able to make every payment in real time, a settlement bank either has to have the cash on hand, or the ability to borrow it on demand intraday from the central bank. Liquidity needs scale with gross payments, which are substantially larger than net payments. Thus, like CCPs, RTGS substitutes liquidity risk for default risk.

This risk is exacerbated by the fact that a prisoner’s dilemma problem exists in RTGS. Participants concerned about the creditworthiness of other banks have an incentive to delay payments and hoard liquidity, since once a payment goes into the system, it is final and the payer is at risk to loss of the entire gross amount if a bank that owes it fails before it pays. This can lead to a seizing up of the liquidity supply mechanism, as the prisoner’s dilemma logic kicks in and everyone starts to hoard.

Since holding cash in sufficient amounts to meet all payment obligations is extremely expensive, RTGS has evolved to permit central banks to lend intraday on a collateralized basis. But as was seen in the 2008 crisis, collateralization poses its own risks, including ballooning haircuts that can set off price spirals due to collateral fire sales. Further, due to the potential for the breakdown of long and large collateral chains, this creates an interconnection risk, and represents a further coupling of the system. And it is coupling, remember, that is at the root of most catastrophic accidents. Secured lending can create a false sense of security.

Izabella’s post also points out another problem with RTGS, which is common to central clearing. It creates a much more tightly coupled system that is very vulnerable to operational risk. This risk crystalized in October, 2014, when a seemingly innocuous change to the system (deleting a member bank) caused the failure of the UK’s CHAPS  settlement system for a day. Ironically, this was the result of an interaction between one part of the system, and another part (the Liquidity Savings Mechanism) that was intended to economize on the liquidity demands of RTGS, and essentially created an RTGS-DNS hybrid. As in most “normal accidents”, unexpected interactions between seemingly unrelated parts of a complex system led to its failure.

There is another way to see all of this. Both central clearing and RTGS are intended to create “no credit” systems. That is true only in a very limited sense–a profoundly unsystemic sense. Yes, CCPs and RTGS are designed so that participants in those arrangements don’t have credit exposure to one another. But those participants aren’t the entire system, just a part of it: the exposure is pushed away from them to others. Further, the method for reducing credit exposure among the participants is to require extensive reliance on liquidity mechanisms that are prone to breakdown in stressed market conditions. Further, these liquidity mechanisms are based on credit: banks (or the CCP) borrow from other banks, or from central banks in order to obtain liquidity. Further, the credit moves into shadowier places.

Not to sound like a broken record, but things like CCPs and RTGS redistribute and transform risks, rather than eliminate them altogether. Unfortunately, these transformations do not necessarily reduce the risk of a systemic crisis, and arguably increase it in some cases. The failure of officialdom, and large swathes of the banking sector, to recognize or address this reflects in large part a failure to take a systemic perspective. Perhaps cynically, this can be explained by the fact that the central banks and banks that drive these reform efforts mistake their own interests for the interest of the system as a whole: le système, c’est nous. As a result, “Devil take the hindmost” could well be applied as the motto of RTGS and central clearing.

This illustrates a broader problem in public policy. Government is too often invoked as a deus ex machina that internalizes externalities. But the fact that most regulatory change efforts are driven by, or ultimately controlled by, a small subset of interested parties who have the most concentrated stake in an issue. Given the diffuseness of other impacted parties this is inevitable. But it means that in practical terms internalizing externalities via regulation of something as complex as the financial system is a chimerical goal. The externality hot potato gets tossed from one segment of the financial sector to another. Government regulation, as opposed to self-regulatory initiatives, mainly affect the makeup of the subset of participants who are involved in influencing the process, and the distribution of the bargaining power. This works through the entire process, from the crafting of legislation, to the writing of regulations, to their implementation. This is why we get things like RTGS or CCP mandates, which make a certain set of participants better off, but which it is heroic indeed to believe are truly welfare increasing.

 

 

 

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January 26, 2016

Swaps Execution: The Dogs Still Don’t Eat the Dog Food When They Have the Choice

Filed under: Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 9:03 pm

The Bank of England has received a lot of attention for its just-released study on the liquidity impact of swap execution facilities (SEFs). It finds that:

as a result of SEF trading, activity increases and liquidity improves across the swap market, with the improvement being largest for USD mandated contracts which are most affected by the mandate. The associated reduction in execution costs is economically significant. For example, execution costs in USD mandated contracts, where SEF penetration is highest, drop, for market end-users alone, by $3 million–$4 million daily relative to EUR mandated contracts and in total by about $7 million–$13 million daily.

The basic methodology is to use a difference-in-difference approach to compare measures of liquidity pre-and-post SEF mandate, and which exploits the fact that non-US banks can avoid the mandate by avoiding trading with US banks: this avoidance issue will is important, and I will discuss it later.

The study is carefully done, but I am not persuaded. For one thing, the measures of liquidity employed are driven by data availability (transactions prices), and are not the ideal measures of liquidity. The primary liquidity measures employed are really measures of price dispersion, rather than preferred measures of liquidity such as bid-ask spreads, depth, or price impact (although greater (lower) price dispersion could be associated with lower (greater) price impact).

There is also the issue that transaction characteristics are endogenous. For instance, it may be the case that it is cheaper to do large deals off-SEF than on-SEF. These deals will tend to be done at prices that are further away from the mean price (or the end-of-day midpoint price), and in the volume-weighted measures employed in the paper, these deals get a bigger weight in the liquidity measures. Thus, price dispersion may be greater pre-mandate, and in Europe, where the mandate can be avoided not because SEFs improve liquidity, but because it is prohibitively costly to transact large deals on SEFs. That is, the results could be symptomatic of a loss of liquidity on some dimensions, rather than proof that the mandate improves liquidity.

The paper documents that there is less dealer intermediation where the mandate is binding. This could also reflect changes in transactions characteristics. Dealers are more likely to be needed to intermediate big deals, or deals that are exceptional on some other dimension.

The paper doesn’t break down transaction characteristics by mandate-impacted and non-mandate-impacted subsamples, and in particular doesn’t include a measure of the dispersion of transactions sizes. As a result, it’s not possible to determine whether the mandate has altered the mix of transaction characteristics.

This relates to another finding of the study: namely, that the mandate has led to the fragmentation of the interest rate swap markets along geographic/currency lines, with SEFs gaining far lower penetration in Euro-denominated swaps that are dominated by European banks who can avoid the mandate by trading with one another, and by trading with European end-users. There is confirmation of this result from Tabb Group, which finds that “European derivatives market continues to resist electronic trading.”

Well, this raises the dog food question: If the dog food is as great as the ads say, why don’t the dogs eat it? if SEFs are so much more liquid, why don’t traders flock to them?

When given a choice between a statistical finding, and revealed preference, I go with the latter. Those who actually internalize the cost of trading largely avoid SEFs. This suggests that they are actually costlier to use, at least for some users, such as those who want to trade in large size, or have other idiosyncratic needs. The choices of those who have the choice strongly suggests that the statistical evidence purportedly showing lower execution costs on SEFs is flawed and misleading.

With this in mind, it was gratifying indeed to see CFTC Chairman Massad stating that he favors allowing market participants to decide whether they transact swaps electronically or using traditional voice execution. There was never a compelling case-or even a weak one-for forcing diverse market users with diverse transactional needs to use a one-size-fits-all execution method. Massad’s free-to-choose approach is therefore a vast and welcome improvement over his predecessor Gary Gensler’s monomaniacal determination to bash everybody over the head with a CLOB.

Update. Here’s a more detailed description of the Tabb Group study I linked to above. One important takeaway: European end users really hate electronic execution, and really love voice execution:

Despite the cost benefits of e-trading, institutional investors still prefer to interact with their dealers via phone. Nearly 80 [!] per cent of the more than 200 European investors interviewed as part of the Greenwich Associates 2015 European Fixed-Income Study confirmed their trading protocol of choice was the phone.

“These trades often require white-glove treatment, and clients work with dealers that are best at limiting market impact and providing the support needed to get the trade done,” says Greenwich Associates Managing Director Andrew Awad (pictured). “As a result, clients still place a high value on the support provided by swaps salespeople in executing complex and large trades.”

This strongly suggests that there are likely to be considerable differences between deals done on SEFs and those done the old fashioned way. Not particularly the point about “limiting market impact.” Those who want to do trades that are “complex and large” go to dealers to trade bilaterally to avoid price impact. If they are not able to do that, because of an electronic execution mandate, they will almost certainly trade differently. Fewer big, complex trades. If that is correct, then the Bank of England study is comparing grapes to grapefruit. If so, the difference in price dispersion documented in the study does not demonstrate greater liquidity on SEFs: it demonstrates worse liquidity, at least for some kinds of trades.

Mind you: end users were the supposed beneficiaries of the SEF mandate. According to GiGi et al, they were being shamelessly exploited by dealers, and SEFs would set them free. Apparently they like their chains just fine, thank you very much.

Again: revealed preference rules. Believe it over a stat every time.

 

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January 10, 2016

Protectionism in the Oil Patch: When Someone Says “Fair Markets”, Check Your Wallet

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 9:28 pm

The decline in oil prices is producing a predictable political outcome: attempts to prop up the domestic US industry. Some initiatives would make sense regardless of the financial distress of the US upstream sector: the Clinton and Obama administrations in particular have imposed a variety of inefficient regulations and restrictions on US hydrocarbon production, and it would be desirable to roll these back, as is being proposed:

Among the proposals under discussion: Expediting the process for exporting liquefied natural gas, and upgrading infrastructure to move energy to market more quickly and cheaply.

Another top priority for the two Republicans is loosening environmental and other regulations.

But then there’s just the plain stupid:

Some lawmakers are floating the possibility of taking retaliatory trade measures against Saudi Arabia, which has flooded the market with cheap oil in what some analysts see as a bid to drive America’s growing shale oil industry out of business.

. . . .

North Dakota Rep. Kevin Cramer (R) said lawmakers could begin to mull retaliatory tariffs against Saudi Arabia in the future but emphasized he is not advocating for that yet.

“I’m very hesitant to go down that path at this time but clearly that would be a possible option should the Saudis not play fair. Because as much as I advocate for free and open markets, I also advocate for fair markets,” he said.

Saudi Arabia, taking advantage of its low extraction costs, has refused to curb oil production in a bid to expand market share and undercut competitors. This has raised the prospect of the U.S. government taking action to level the playing field for domestic companies.

“I’m not prone to a lot of government intervention in terms of propping industry up, per se. What would be the most helpful is to roll back regulations that get in the way of further development and profitability,” said Cramer, who cited the Endangered Species Act as one burdensome regulation.

“Obviously they have access to our market and I suppose to some degree there is a role that can be played there. I’m not at the point where I’m ready to advocate tariffs or restricting their access necessarily,” he added.

Any tariff on Saudi imports would be special interest protectionism pure and simple, tarted up in the usual rhetoric (and whining) used to justify protectionist measures. “Fair markets” is a sure tell. Anyone who says “I’m for free markets but they should be fair markets” is a liar, and should drop the pretense. Any such person is all about protecting a favored industry or firm. When someone, regardless of party, says “fair markets”, I strongly advise you to check your wallet, because they are trying to rob you.

And why should Saudi Arabia “refuse to curb oil production”? Indeed, “curbing oil production” is the exercise of market power, for which the US (rightly) criticized OPEC and the Saudis in the past. What’s more, low cost producers are the ones who should sustain output in the face of a demand decline: high cost producers are the ones who should cut back.

Furthermore, although North Dakota is an oil long, the US as whole is an oil short, still producing only about 1/2 of its consumption, despite the spurt in oil production in the past 5-6 years. So low oil prices are still in the interests of the US.

It should also be noted that the “flooding the market with cheap oil” meme is vastly overstated. Saudi output in June, 2014, right before the price collapse began, was about 10mm bpd. It is now about 10.5 mm bpd. That difference represents a whopping .5 percent of world output. Even given an elasticity of 10 (which is probably too high) that could cause at most at 5 percent decline in prices. As I write, Brent just went below $33/bbl, and hence is down almost exactly 70 percent off its pre-collapse levels. So this collapse is not the result of the Saudis flooding the market.

Nor are the Saudis engaged in some predatory pricing strategy. At least I doubt that they are, because such a strategy would be irrational.

The price decline is the result of increased output in a variety of places (including the US), but mainly due to a steep decline in demand growth, especially from China.

Yes, the upstream sector in the US is suffering severe financial distress. So be it. That’s the nature of the business, and the nature of a market system generally. Resources should exit sectors that suffer demand declines. They should not be propped up through trade restrictions, especially trade restrictions that will impose far greater costs on the US economy as a whole than they will benefit one sector in that economy.

It is also perversely ironic that the very same Republicans (I am speaking of the individual legislators, like Murkowski and Cramer, not the party as a whole) who pushed for ending the idiotic export ban are now mooting an equally idiotic restriction in imports. This makes it plain that it’s not about principle, in the least. It’s all special interest politics. That’s not surprising, but it’s not admirable. And it’s not any better when Republicans push it than when Democrats and Obama do.

So yes, eliminate or cut back inefficient restrictions that a relentlessly anti-hydrocarbon administration has imposed, in order to eliminate unnecessary burdens on US oil and gas production that hurt both US producers and consumers in the US and around the world. But don’t impose large costs on American consumers of oil in order to prop up the US upstream sector. The sector should shrink if the demand for its product declines due to increased production elsewhere, or reduced demand. So be it.

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December 29, 2015

Spoof Me Once, Shame on You: Spoof Me Twice, Shame on Me

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 6:41 pm

I’ve often written that HFT firms are the best able to detect spoofers, and to take preventative measures (which reduce the profitability of spoofing, and hence its prevalence). The whole business of HFT is extracting signals from orders and order flow, and trading accordingly. Spoofing is based on manipulating the order flow–in essence, injecting noise into it. HFT firms evaluate their executions, and attempt to identify patterns that predict both winning and losing trades. If spoofers systematically impose losses on HFT firms, eventually the latter will figure it out.

This is the first article that I’ve read that supports this contention:

Inside Ken Griffin’s $25 billion empire, Citadel’s cyber investigators had isolated a new enemy: spoofers.

It was late 2013, and at the firm’s Chicago headquarters, a team of researchers discovered that a rival company’s algorithm was outmaneuvering their automated trader. The algo was placing futures orders it had no intention of filling to entice firms like Citadel into the transactions, then canceling them, leaving Citadel with money-losing trades. Citadel’s plan: to pit its computers against the spoofer in a high-stakes duel over market manipulation.

. . . .

Vertex Analytics may have devised a way to make high-frequency trading more transparent and spoofing easier to detect. The Chicago-based technology firm can represent graphically every order and transaction on CME’s markets, obviating the need to go through pounds of paper searching for a telltale sequence of

Vertex’s approach was a revelation for Robert Korajczyk, a finance professor for more than 30 years at Northwestern University, where he’s studied asset pricing and liquidity.

“My first reaction to seeing the graphics capabilities was ‘This can’t be done,’” Korajczyk said. “However, Vertex can do it.”

. . . .

Citadel isn’t the only firm that took measures against spoofers without regulators’ help.

In 2012, Chicago-based HTG Capital Partners detected a pattern of large canceled orders followed by aggressive trades in the opposite direction that left them with losing positions, according to an affidavit released last month. The firm created tools to help identify when spoofing was taking place, the affidavit said.

Transmarket Group has created an “anti-manipulation guide” that tells traders how to spot spoofing, according to a copy seen by Bloomberg News. The Chicago-based firm lists specific examples of spoofing in the natural gas market on CME as part of the guide.

The article spends a lot of time discussing enforcement actions against spoofers, and the difficulties of making a case. Even ignoring my doubts (expressed in earlier posts) whether the social costs of spoofing really warrant expensive enforcement efforts, the fact that sophisticated and knowledgeable players have the incentive to detect this kind of conduct, and take defensive measures (and perhaps offensive–at least that’s what the description of Citadel “pit[ting] its computers” against spoofers suggests) means that the frequency and scale of spoofing activity is likely to decline significantly. It is a pathogen that found a niche, but the hosts’ immune systems are adapting, and it will become less dangerous in short order.

This isn’t true of all forms of manipulation, but the very nature of spoofing–which involves doing things that are intended to be detected–makes it vulnerable to detection and countermeasures. This means that the system tends to be self-correcting, and this mitigates the need for enforcement. Unfortunately, it appears that enforcement officials (both civil and criminal) think otherwise, and have prioritized the prosecution of spoofing. Combined with the outrageous overcharging and over-penalizing that I’ve mentioned before, this is a disturbing development.

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December 25, 2015

Four Corners Offense: The Social History of Commodity Corners

I’ve been spending something of a busman’s holiday, reading this and that about commodity market corners in days long past. I started out looking into some of the big cotton corners at the beginning of the last century, namely the Brown-Hayne corner of 1903 and the Patten corner of 1910. These are the subject of a new book, The Cotton Kings: Capitalism and Corruption in Turn-of-the-Century New York and New Orleans. The book is entertaining history, but could use some more economics. It is journalistic in style, rather than analytical.

Reading about Patten’s cotton corner led me to read about his wheat corner of 1909, his corn corner of 1908, and his oats corner of 1902. Mr. Patten was a busy man.

And a reviled one. He was known as “The Wheat King,” whom the The Literary Review accused of  “The Crime of Making Bread Dear.” He was the model for the villain in the very influential D. W. Griffith short film, “A Corner in Wheat.”

This early short was one of the first films, if not the first, to address a serious social subject. Its theme would be very familiar today: the two Americas, rich and poorSergei Eisenstein admired Griffith, and employed his “parallel editing” technique (which he referred to as Griffith’s “montage of collision”): some film historians consider Griffith’s technique more subtle and less heavy-handed than Eisenstein’s.

(Unbeknownst to me when I was growing up in Evanston, Illinois, Patten was a longtime resident of the city, and its former mayor. He built a mansion there, and funded the Patten Gymnasium, where I swam in the summers.)

Patten was a nationally known figure. The Justice Department indicted him under the Sherman Act for his cotton corner, and the case attracted front page attention in national newspapers, including the New York Times, when it went to the Supreme Court. (Patten was fined $4000, or less than .1 percent of what he allegedly made in his corner. Not much deterrence effect there, eh?)

Patten was not alone in being a figure of national renown–and infamy. Commodity speculators were the banksters of their day. The Matt Taibbi of the 1880s, Henry Demarest Lloyd, wrote about cornerers at the Chicago Board of Trade in a famous essay. Frank Norris wrote a famous roman à clef, The Pit, based on the Leiter wheat corner of 1898.

In sum, in the last third of the 19th century and the first quarter of the 20th, commodity markets generally, and commodity market corners in particular, were the subject of intense interest. In some respects, it is not surprising that commodity corners were the subject of close journalistic coverage, serious fiction, social critical literature, and film during this era. Agricultural commodities were much more central to Americans as both consumers and producers. In 1900, 41 percent of the American workforce was employed in agriculture: now it is under 2 percent, and agriculture represents less than .7 of GDP. Half of American consumption spending went to food and textiles in 1900: a century later, that figure was down to 20 percent. Relatively speaking, the commodity derivatives markets (the Chicago Board of Trade, the Minneapolis Chamber of Commerce, Kansas City Board of Trade, the New York and New Orleans cotton exchanges, etc.) were more important and more developed that the capital markets, including the New York Stock Exchange, than is the case today: by the 1990s, when I was researching commodity exchanges and doing work with some, the commodity traders lamented that the explosion of financial futures had led the managements of exchanges to lose touch with the realities of commodities.

That said, one can see many echoes of the distant debates about and social criticism of commodity trading and corners in current controversies over financial markets. Just as outrage over the alleged excesses of the 2000s gave birth to the spate of post-Crisis financial regulation, fury over the Leiters and Pattens and Browns led to the first major regulations of financial markets in the United States: the Cotton Futures Act of 1914, and the Grain Futures Act of 1922 (which morphed into the Commodity Exchange Act, which is still with us, and which was amended by Frankendodd). Both Acts followed major government studies, the Commissioner of Corporations’ Report on Cotton Exchanges, and the Federal Trade Commission’s Report on the Grain Trade. Both of these are very well done, and provide very detailed descriptions of both the cash and futures markets. They are priceless resources. In some respects, because of them, we know more about the operation of commodity markets in the first decades of the 20th century than we do of their operation in the first decades of the 21st.

Maybe someday I’ll write a book about all of this, one that integrates the economics, history, and political economy. It’s of great personal interest, but not highly valued in the economics or finance professions today. I was amused when I came upon the link to an AER article about the Cotton Futures Act: it is beyond imagining that something similar would appear there today. But as I hope the foregoing shows, plus ça change, plus c’est la même chose. Issues of the relationship between financial markets and the real economy, the political economy of financial markets, and the influence of financial titans on political and judicial institutions, are still with us. In 1909, a film like A Corner in Wheat grappled with the social impact of finance in a very provocative and arguably simplistic way: in 2009-2015 movies like Too Big to Fail, Margin Call, and The Big Short do the same.

Don’t hold your breath, but maybe someday you’ll read about this in depth in print, rather than superficially in pixels.

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December 21, 2015

Adam Smith Goes to Syria: How Bad Government Policies Turned Drought Into Famine

Filed under: Climate Change,Commodities,Economics,Energy,History,Politics,Regulation — The Professor @ 7:39 pm

The myth that global warming caused a drought which caused the civil war in Syria has been flogged repeatedly by the left, especially in the lead-up to the Paris farce: another example of the “elites” letting no good crisis go to (political) waste. As I discussed in March, there was indeed a drought in Syria, but no credible scientific evidence links the drought to climate change.

Droughts happen. What turned the drought into catastrophe in Syria was the depletion of groundwater by previous government-driven efforts to spur production:

Syria was such a successful producer that it became a net exporter of wheat for the better part of two decades — almost unheard-of in a region where most governments imported cheap wheat from abroad. According to ICARDA Director General Mahmoud Solh, the increased productivity netted the Syrian government more than $350 million a year . The country also kept a strategic reserve of wheat — usually about 3 million metric tons, enough to get it through a lean year or a price spike. In this most stable of dictatorships, nobody dreamed of a war.

But all that productivity came at a price. To produce these remarkable gains, Syria’s agricultural sector “mined” groundwater to irrigate farms. Experts predicted that this would lead to severe water Shortages. When a four-year drought struck in 2006, devastating 60 percent of Syria’s agricultural lands, the country’s groundwater was already depleted.

(This sounds a lot like Soviet agricultural malpractice.)

This brings to mind Adam Smith’s argument that bad government policy turns “dearths” caused by nature into famines:

The seasons most unfavourable to the crop are those of excessive drought or excessive rain. But as corn grows equally upon high and low lands, upon grounds that are disposed to be too wet, and upon those that are disposed to be too dry, either the drought or the rain which is hurtful to one part of the country is favourable to another; and though both in the wet and in the dry season the crop is a good deal less than in one more properly tempered, yet in both what is lost in one part of the country is in some measure compensated by what is gained in the other. In rice countries, where the crop not only requires a very moist soil, but where in a certain period of its growing it must be laid under water, the effects of a drought are much more dismal. Even in such countries, however, the drought is, perhaps, scarce ever so universal as necessarily to occasion a famine, if the government would allow a free trade.

It as not just the  Syrian government that contributed to spiraling food prices which created popular unrest in the Middle East that culminated in 2010-2011 (which the Muslim Brotherhood exploited in Egypt and Syria in particularly): US government policy contributed to the problem. In particular, US biofuels mandates that stimulated the production of ethanol drove up the price of corn by an estimated 30 percent, and as Brian Wright has shown, drove up all other grain prices as well (because corn is a substitute for other grains in both consumption and production). (I strongly recommend reading at least the introduction of the Wright paper: I’d quote in detail, but the online versions embed some devious feature that makes it impossible to copy-and-paste.)

It is sickly ironic that policies intended to reduce global warming pushed by the same crowd that falsely blame the Syrian drought and subsequent civil war on global warming (a) do nothing to reduce global warming, and (b) have done far more to exacerbate poverty and create social unrest  in the Middle East than global warming ever has or ever will.  Ethanol is an unmitigated disaster environmentally, economically, and socially. Yet the people Thomas Sowell trenchantly calls “the anointed” colluded with agricultural lobbies in the United States (encompassing both growers and processors) to inflict this monstrosity on the world.

How dare they–how fucking dare they–presume to lecture anyone on their obligations to “save the planet” and help the poor? Through biofuels policies alone they have inflicted huge misery and privation, and yet they have the audacity to try to exploit one of the consequences of these policies in order to ram more of their brilliant ideas down our throats.

Haven’t they done enough? Can they please now just go away?

Alas, we won’t be so lucky. These are our elites, after all, and we are stuck with them, like a case of malaria. And they are actually proud of stupid policies like biofuel mandates. There is no stupid that can equal the stupid of not just not learning from mistakes, but reveling in them.

Do you still wonder why the Trump phenomenon exists? The global reaction against the elites, of which Trump is just the most prominent example, is yet another baleful consequence of the failure of these so called elites. The reaction may be as bad as the disease, but let the blame fall where it should: squarely on the shoulders of those condescending fools whose allegedly good intentions have paved a superhighway to hell.

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December 20, 2015

The Crude Export Ban Is Gone, But Don’t Get Your Hopes Up

Filed under: Commodities,Energy,Politics,Regulation — The Professor @ 2:50 pm

Well, ding dong the wicked export ban is dead. The repeal was included in the wretched omnibus deal passed in the dead of the night last week.

As a matter of economic principle, banning the ban is a good thing. Trade restrictions are almost always inefficient, and the oil export ban was no exception to that rule. In the near term, however, the practical impact of the sunsetting of the ban will be limited. At present, Louisiana Light Sweet is trading about par with Brent on a spot basis, and at only a few cents discount on a forward basis. Even given the quality premium for LLS, the differential is too narrow to make it economical to transport oil to Europe. This situation differs dramatically from the conditions that sparked the move to eliminate the ban, namely, a double digit discount of US oil prices from Brent.

The narrowing of the spread was due to many factors, but probably the most important of these was the fact that although oil exports were banned, exports of refined products were not. The low domestic oil prices made refining, including refining for export, to be very profitable. This encouraged investment in refining capacity that increased the demand for US crude, which narrowed the spread.

The repeal of the ban essentially creates an option, and this option is valuable. Although exporting crude is not economic now, it will be in response to some economic shocks. For instance, a disruption of European supplies, a spike in US production, or a big refinery outage in the US would all tend to depress the US price relative to the price in Europe, and if the shock is big enough, this could open the arb.

As for those who think that the lifting of the ban will help US producers in their hour of need, get ready for disappointment. The price difference between the export and no-export worlds is capped by the no-export-world spread: if absent the ban the price difference is greater than transportation costs, lifting the ban raises the domestic price and lowers the foreign price until the spread equals the cost of transport. When the arb channel is closed (as is currently the case), lifting the ban has no effect. Any price effect from lifting in the ban will occur in the future, and will be contingent on future supply and demand conditions. My guess is that the elimination of the ban will periodically give a couple of bucks boost to the US oil price. Not a huge deal.

The lifting of the ban will help traders, to the extent that arbs periodically come into play. It will also periodically benefit infrastructure owners (e.g., pipelines, terminals, and ports) that hand exports. Refiners  will lose when the arbitrage opens: this is why the compromise included a modest tax break for refiners, to secure their support.

Perhaps the biggest losers are those who bet on the continuation of the ban by building condensate splitters: minimally processed crude and condensate could be exported, so the splitters were a way to circumvent the ban. They are now white elephants, as the crude can be exported directly.

All in all, the lifting of the ban is not a big deal. Perhaps the main effect of this development, at least in the short term, is to show that 239 years after the publication of the Wealth of Nations, bad arguments about trade survive and even thrive. But even this didactic effect is overshadowed by circumstances, because the continued success of Trump shows the same thing, and much more forcefully.

In sum, I’m glad to see the ban go, but am underwhelmed by the near-term effects of its demise.

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December 9, 2015

Guns, Laws, and Money

Filed under: Politics,Regulation — The Professor @ 8:49 pm

The San Bernardino massacre unleashed an all-too-common phenomenon: literally (and I am using the word properly) before the bodies were even cold, politicians, pundits, and the hoi polloi (especially on Twitter) were using the atrocity to advance their own preferred narrative. The most common of these on the left was the gun control narrative. Hillary Clinton was one of the first off the mark to use San Bernardino to call for more stringent gun control measures. You know, before anyone–most notably one Hillary Rodham Clinton–knew anything about what had happened, beyond the fact that more than a dozen people had died. Obama was actually somewhat reserved, by his standards on this issue, and unexpectedly soft-pedaled his gun control message in his Oval Office speech on Sunday. But on the left the gun control drum was pounded for all it was worth, notably in a New York Times front page editorial.

Mass shootings like San Bernardino and Colorado Springs catalyze a flurry of calls for further restrictions on gun ownership, though these calls are frequently lacking in specifics, and are often more like ritual acts and political signaling of right-thinking (or should I say left-thinking?) views than concrete proposals. Moreover, mass shootings also unleash a volley of bad and misleading statistics. So bad, in fact, that those using them are almost certainly doing so in bad faith.

This phenomenon is not limited to activists, or the left generally. Even allegedly reputable mainstream publications like The Economist also peddle agitprop. The MO is to claim that mass shootings occur almost daily in the US: when brought up in the context of a Newtown or Aurora, the clear intent is to suggest that these types of mass shootings are representative. But even a cursory look shows that this is definitely not the case.

The mass-shooting-a-day statistics are based on a very expansive definition of mass shooting, such as three or more victims (not necessarily fatalities). Moreover, they lump together a very heterogeneous collection of episodes, which differ materially from the mass shooting events like those that have occurred in San Bernardino and Colorado Springs. For instance, they include gang drive by shootings or the likely gang-related shooting at a park in New Orleans 3 weeks ago. They also include a brawls at biker bars and other such criminal mayhem involving more than two people.

The one-size-fits-all term “mass shooting” doesn’t fit such varied phenomena, and one-size-fits-all-policies are unlikely to work either.  Indeed, even the most deadly mass shootings that get the most attention, are highly idiosyncratic. Newtown is very different from Colorado Springs is very different from San Bernardino is very different from Charleston is different from Fort Hood in terms of the perpetrators, methods,  and targets.

Contrary The Economist’s risible claim that “such atrocities are still drastically underreported,” the attention that  they get may arguably overstates their importance. The Newtown-type attacks  kill about as many Americans in a year as the average daily homicide toll. The United States does have a high murder rate (both gun and non-gun) compared to other high-income nations, although the rate has about halved in the last two decades.

Furthermore, murder, including murder with firearms, is not uniformly distributed across the US. To the contrary, it is highly concentrated geographically, and demographically. The statistics are quite shocking.

About 75 percent of murders occur in 3 percent of the counties in the US. Demographically, the concentration is even more pronounced. It is not exclusively, but overwhelmingly, a young, black, male phenomenon. The white murder rate is about 2.5 per 100,000. That’s roughly double of European rates, but not nearly as anomalous as the US rate overall. Indeed, white murder rates outside the South and Southwest are pretty much the same as European rates.

The truly horrific rates are among young black urban males, with especially high rates in Southern cities. Whereas the US firearms homicide rate is about 4/100,000, among African American men 20-24, it is almost 90. Yes: more than 22 times higher.  Even black women in that age cohort have a high rate, 7 per 100,000, or about 5 times the white female murder rate.

In sum, gun laws are fairly uniform across the United States, and gun ownership is widespread, but gun murder is not: if anything gun laws are most restrictive in places where gun crime is most rampant. Therefore, relatively easy access to guns is not sufficient to explain America’s elevated (compared to other OECD countries) murder rate. The regional and demographic variation shows that cultural and socioeconomic factors are important drivers. (The fact that non-firearm murder rates in the US are high compared to other countries, and also exhibit similar geographic and demographic variations reinforces this point.) Again contrary to The Economist, it is not true that “the link between guns and gun violence” is obvious. There are a lot of guns where there’s not a lot of violence. Guns don’t exercise a malign mesmeric effect on anyone who touches them. There is a mixture of social and cultural factors and guns that produce violence.

This tends to undercut the proposition that increasing restrictions on gun ownership will have much of an impact on murder rates. That said, even if other factors drive murder rates, greater restrictions on guns could still be beneficial: guns are complements to these other factors in the production of violence, including mortal violence, and the taxation of complements can be a way of reducing the frequency and severity of bad conduct produced using them.

But it is highly doubtful whether any remotely politically possible law–that is a law that would not have large effects on the hundred million-plus law-abiding gun owners in America, many of whom are very politically active–will have a meaningful impact on the pathologies that inflict many communities in the US.

In brief, it is evident that those who commit crimes with guns are highly inelastic demanders. Most of the high-murder rate localities already have draconian gun control laws, which include substantial penalties for violations. Furthermore, those most likely to kill (and be killed) with firearms are engaged in illegal conduct (e.g., drug dealing) that is subject to severe legal sanctions, and believe that guns are necessary for them to engage in this conduct. Thus, those most likely to kill with a firearm possess them despite the fact that they incur a large cost to do so. Further restrictions are unlikely to induce them to adjust on either the intensive or extensive margin (e.g., by changing “careers”), because they will lead to only small increases in the cost they incur to possess and use weapons.*

(Those bent on mass mayhem, be they terrorists, or psychotics, or narcissists looking for fame, or racist losers looking to spark a race war, are also likely to be inelastic demanders. These acts are the productive of obsessions that will drive those in their grip to go to great lengths to circumvent any attempt to prevent them.)

And we know prohibitionism doesn’t work. It didn’t work with alcohol in the 20s and 30s. It hasn’t worked with narcotics for decades. It doesn’t work with guns now, even in places like France, where terrorists clearly have had no problem obtaining deadly arsenals. (Take a look at reports of how many guns French and Belgian police seized in raids in the days after Friday, November 13.) The world is awash in guns. Guns that are quite functional for criminals are quite easy to manufacture. (Anybody remember the days when “Saturday Night Specials,” not Glocks or AKs were the bane of society–back when murder rates were far higher, by the way?) Those who think that passing laws against guns, including outright bans, will keep them out of the hands of those most likely to commit crimes with them–including mass murder–has their eyes closed to reality.

It is also ironic that many of those who are most vocal in calling for draconian restrictions on guns are also loudest in their condemnations of how the burdens of drug prohibitionism fall most heavily on minorities, who are imprisoned at high rates for drug crimes. Whom, pray tell, do they expect will be most frequently imprisoned for gun possession or trafficking, given that the same demographic is responsible for a greatly disproportionate fraction of gun crimes?

It should also be noted that minority communities are not enthusiastic about gun control, and for understandable reasons. Gun laws in cities like Chicago and DC are (a) almost wholly ineffective in curbing gun crime, and (b) render law-abiding people, mainly minority, defenseless against the (illegally) armed predators that live among them.

Americans recognize all this for the most part. Even though Obama and Hillary and others on the left furiously attempt to exploit any mass slaying to advance the gun control agenda, a solid (and growing) majority of Americans disagree. Indeed, they tend to vote with their wallets: a mass shooting, and political posturing about gun control, is followed by a spike in gun sales as surely as day follows night. Some wags have suggested that Obama must own shares in Ruger and Smith & Wesson, because he is so good for business.

The gun debate has become repetitive and sterile, more of a political Punch & Judy show than a constructive conversation. It is particularly appalling that innocent victims are seldom no more than political props in these debates.

Gun murders, which range from crimes of passion to political terrorism, are too diverse and complex to be addressed with simplistic, one-size-fits-all solutions. Prohibitionism, or draconian restrictions that approach prohibition–to the law abiding–despite (or is it because of?) its popularity on the left, is particularly counterproductive.

Murder, including murder by firearms, has declined substantially in the past 20 years. We should be grateful for that, and focus on ways to extend that decline: revising drug laws and punishments is likely to be a more productive way to do this than revising gun laws. But progress will at best be incremental. And the most difficult area to make progress will be mass shootings, given the extreme motivation of the perpetrators, and the diversity of their motives.

* This is related to the “Mickey Mouse Monopoly” effect that Walter Oi wrote about years ago. Oi noted that the demand for tickets to Disneyland was highly inelastic because the ticket itself contributed a relatively modest amount to the total cost of going to Disneyland. For everyone but locals, trip to the park required extensive travel (e.g., a plane trip or long car trip), lodging for several nights, dining out, etc. If the price of a ticket represented say 10 percent of the total cost of the trip, doubling the cost of a ticket only increased the cost of the entire trip by 10 percent. This made the demand for tickets inelastic. If the demand for a visit to Disneyland had an elasticity of 1, the demand for tickets had an elasticity equal to 1 times the share of a trip represented by the ticket. So if that share was 10 percent, the elasticity for tickets was only .1, meaning that Disney could raise ticket prices substantially without reducing the number of visitors much at all.

 

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December 7, 2015

Clearing Mandates: Would That Regulators Had Remembered Takeoffs are Optional, But Landings Are Not

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 9:41 pm

ln 2010 and 2011 I was a clearing Cassandra, sounding warnings about the potential systemic risks arising from clearing mandates. Prominent among those dismissing my criticisms were “macro prudential” regulators, notably the Federal Reserve and the Bank of International Settlements.

Things are rather different now. Regulators, including notably the Fed and the BIS, are now making the rounds expressing recognition, and arguably concerns, about systemic risks in clearing.

Case number one: Fed Governor Daniel Tarullo:

However, as has been frequently observed, if the financial system is to reap these benefits, the central counterparties to which transactions are moving must themselves be sound and stable. Extreme but plausible events, such as the failure of clearing members or a rapid change in the value of instruments traded by a CCP, could expose it to financial distress. If the CCP has insufficient resources to deal with such stress, it may look to its clearing members to provide support. But if the problems arise during a period of generalized financial stress, the clearing members may themselves already have been weakened or, even if they remain sound, the diversion of their available liquidity to the CCP may prevent customers of the clearing members from accessing needed funding. If the CCP fails, the adverse effects on the financial system could be significant, including the prospect that the CCP’s default on its obligations could amplify the stress on other important financial institutions.

. . . .

While the question of what constitutes the optimal default fund standard needs more analysis and debate, I think there is little question that more attention must be paid to strengthening stress testing, recovery strategies, and resolution plans for significant CCPs. The typical CCP recovery strategy does not take a system-wide perspective and is premised on imposing losses on, or drawing liquidity from, CCP members during what may be a period of systemic stress. Many of these members are themselves systemically important firms, which will likely be suffering losses and facing liquidity demands of their own in anything but an idiosyncratic stress scenario at a CCP. Moreover, in at least some cases, uncertainty is increased by the difficulty of estimating with any precision the extent of potential liability of members to the CCP, thereby complicating both their recovery planning and efforts by the official sector to assess system-wide capital and liquidity availability in adverse scenarios.

The failure of regulators to take a “system-wide perspective” in their analysis of systemic risk generally, and in the effect of clearing mandates on systemic risk in particular, was one of my oft-expressed criticisms.

Tarullo is an interesting case. When I made a presentation  expressing my warnings about the systemic risks of clearing before the Fed Board of Governors in October, 2011, Tarullo was sitting right next to me at the big table in the Fed Board Room. He was, to put it mildly, dismissive of what I had to say.

Glad to see he’s coming around.

Case number two: Fed Governor Jerome Powell. I was particularly pleased to see that Powell recognizes that the picture that was repeatedly used to sell the benefits of clearing is highly misleading because it fails to take a system-wide approach: I criticized this picture in presentations as early as 2011, and also in some published work. Though I would say that Powell still omits many of the other connections between major financial institutions in a cleared world.

More from Powell:

I am a believer in the potential benefits of central clearing under the right circumstances. But central clearing is not a panacea. Charts similar to that in Figure 1 are often used to illustrate the netting of exposures and simplification that central clearing can bring to an OTC market. The tangled and highly opaque picture of a purely bilateral market is replaced by the neat hub-and-spoke network in which a CCP is buyer to every seller, and seller to every buyer, allowing netting and greater transparency for participants and regulators alike. Of course, reality is not so elegant, as Figure 2 illustrates. There are multiple CCPs, even within product classes, and major dealers act as clearing members across a broad network of CCPs. Clearing members also perform a range of services for CCPs, including custody, liquidity provision, and settlement. By design, increased central clearing will concentrate risks in CCPs; it is essential that, as these risks accumulate, the CCPs build up their ability to manage them. It is often noted that CCPs made it through the recent financial crisis without direct government assistance. But many of their major clearing members did receive such assistance. CCPs must now plan for a world in which these large firms will fail and be resolved without government support.

. . . .

All of these efforts are directly aimed at strengthening FMIs. But the strength and resilience of a CCP ultimately depends on the strength and resilience of its clearing members. I’d now like to shift focus to the relationship between these market utilities and the institutions that use them.

Barring an operational event, CCPs only face credit or liquidity risk when one of their members fails to make a payment when due. Thus, one effective way to make a CCP safer is to make its members safer. In that sense, the post-crisis reforms that have greatly strengthened our largest and most systemically important banking institutions have directly benefitted CCPs and other FMIs.

This last part, of course, raises the obvious question: would measures to “[strengthen] our largest and most systemically important banking institutions” been sufficient to address macro prudential concerns about OTC derivatives, making unnecessary clearing mandates?

But the biggest, and most surprising case is the BIS:

Clearing though a CCP creates a centralised network of trading exposures. Conceptually, this may influence systemic risk in two main ways. First, central clearing may affect the propagation of an (exogenous) shock through domino effects: the losses deriving from a counterparty default could trigger further defaults and spread the shock through the system. Second, central clearing, and the associated risk management practices, may affect the likelihood and impact of endogenous “run and deleveraging” mechanisms even in the absence of an initial default. While, in practice, both mechanisms may interact, considering them separately helps us to understand possible changes in the nature of systemic risk.

. . .

For example, the size of a shock would matter for systemic risk to the extent that defaults inflict a liquidity shortage on a CCP. If one or more clearing members fail to meet their clearing obligations, the CCP itself must provide liquidity in order to make timely payments to the original trading counterparties. The CCP’s own liquid assets and backup liquidity lines made available by banks may provide effective insurance against liquidity shocks resulting from the difficulties of one or a few clearing members. But they can hardly provide protection in the event of a systemic shock, when a large number of clearing participants – potentially including the providers of liquidity lines – become liquidity-constrained, thereby triggering domino effects.

. . . .

A centralised structure of trading exposures may also affect the likelihood and nature of endogenous shocks in the form of forced deleveraging, fire sales and runs. The critical issue in this regard is the interaction between CCPs’ risk management practices and those of clearing participants. On the one hand, if stringent risk management by a CCP replaces lax counterparty risk management in bilateral markets, central clearing would tend to reduce the risk of such procyclical behaviour. On the other hand, an unexpected tightening of CCP risk management could still lead to liquidity pressures on participants that could ultimately trigger fire sales and a self-reinforcing deleveraging (Morris and Shin (2008)).

. . . .

Turning to the risk of endogenous deleveraging, the assessment of the impact of post-crisis trends is similarly ambiguous. The fact that an increasing share of trading positions is subject to daily variation margin payments has arguably reduced the risk that counterparties are confronted with sudden big losses, as was for instance the case with AIG. However, the shift towards the centralised risk management of trading positions, including collateralisation and high-frequency margining, is also likely to affect market-wide liquidity dynamics. For example, extreme price movements in cleared financial instruments could result in large variations in the exposure of clearing members to the CCPs and therefore in the need for some of them to make correspondingly large variation margin payments. Such payments can be large, even if margin requirements remain unchanged. But they may be exacerbated if the CCP increases initial margins and/or tightens collateral standards in the face of unusually large price movements.

 

I made all of these points, or closely related ones, going back as far as 2008-2009, at times to the disdain of the BIS. One example occurred when made a presentation at the Notre Dame Financial Regulation Conference in May, 2011, where two BIS economists said I was being alarmist. Another was at a conference sponsored by the BofE, ECB, and Banque de France in September, 2013.

So it’s nice to see them come to their senses.

The last point in what I quoted is particularly amazing. One BIS position that I have ridiculed was that variation margin flows created no liquidity demands because they were zero sum: every dollar paid by the loser is received by the winner, allowing the collateral to be recycled. Presumably by having the winners lend to the losers. Even overlooking the operational impossibilities of this, what’s the point of variation margin (which reduces credit exposure in derivatives contracts) if variation margins are funded by credit? And there are operational issues. Liquidity is needed precisely because payments are not frictionlessly and instantaneously recycled. Timing mismatches create a need for liquidity and credit.

So it’s particularly nice to see the BIS get beyond its risible dismissal of the possibility that variation margins can create systemic risks via a liquidity channel, and recognize that this is a serious issue. Because it is. The most important risk in clearing, in my opinion, and one that becomes even more important when regulators take other measures to protect CCPs.

All in all, it’s good to see regulators starting to grapple with the potential systemic risks inherent in clearing. It is better than continued cheer-leading, as was the norm from 2009 until very recently.

But that said, the time to start worrying about potential major design flaws in an aircraft isn’t when it is just reaching cruising altitude. Takeoffs are optional, landings are not. It’s best to make sure that a safe landing, rather than a crash, is highly likely before taxiing down the runway. In their wisdom, legislators and regulators in a hurry didn’t do that. They rushed a new, complex, and untested design into the air. Let’s hope that the newfound awareness of the potential risks allows them to make in-flight repairs and adjustments that will make a crash unlikely.

 

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December 1, 2015

The Red Queen’s Race: Financial Regulation Edition

Filed under: Clearing,Derivatives,Economics,Financial crisis,Regulation — The Professor @ 8:44 pm

Well over four years ago, I raised concerns about clearing mandates leading to the rise of “collateral transformation” whereby those needing high-quality assets to pledge as collateral against derivatives trades would obtain them via repos collateralized by low-quality assets. I argued that these transactions were inherently fragile, and could go pear shaped during period of market stress.

If this were the only problem that post-crisis regulations created, how lucky we would be! Yesterday, the FT ran a nice (meaning scary) piece about other regulation-related driven spurts in securities lending that are collateral transformation on steroids.

One big driver is the Liquidity Coverage Ratio, which requires banks to hold one month’s stress period liquidity needs in liquid assets like government bonds. Rather than sell other less liquid assets to raise the cash to buy Treasuries, Gilts, Bunds, etc., banks are posting their less liquid assets (including equities) as collateral against borrowing of government securities.

Think of how this could work in a crisis. Yes, a bank can sell the borrowed guvvies to raise cash to meet deposit outflows or other cash needs in a crisis. But it borrowed these securities, so it has to buy them back, eventually. Perhaps its liquidity crisis will have passed before the loan matures, but perhaps not. What then, genius? Liquidity crisis deferred, not necessarily prevented.

There are other concerns. The lender of the government bond is likely to haircut the collateral more steeply during crisis periods, meaning that the stressed bank is going to have to come up with more collateral to support its loan precisely when it can least afford to do so. The cyclicality of the collateral mechanism is a concern, and it can create all sorts of vicious cycles that have spillovers throughout the financial system.

Furthermore, the article notes that asset managers like BlackRock are the major securities lenders. They lend out bonds purchased to back government bond ETFs, and take other securities as collateral. That is, the asset manager is engaged in a financial transformation in which there can be a mismatch between the assets underlying the ETF and its liabilities: swapping government bonds for equity (or other assets) creates such a mismatch. What happens if the ETF sponsor is it by a wave of redemptions–especially if the redemptions occur because investors become concerned because the value of the collateral the sponsor has collected has fallen, and may be substantially below the value of the assets lent out (which is what the fund is intended to track)? One possibility is fire sales of the collateral and “fire purchases” of the assets the fund has lent out. A more likely outcome is that this is the kind of event which will cause the fund to demand significantly more collateral from the security borrower, setting off the vicious cycles described above.

Oh joy.

The article states that another reason for the rise in securities lending is that banks get better capital treatment on the borrowed securities than the securities posted as collateral. If this is true, it is totally nuts. The borrowed security is not an asset to the bank: the assets posted as collateral for the loan are. The borrower has the asset in his hot little hands, but has an obligation to give it back: these things offset. At the end of the day, the bank still has the other assets posted as collateral. If capital regs treat the borrowed bond as an asset, and don’t treat the securities posted as collateral as an asset, and reduce risk weighted assets (and hence capital requirements) as a result, the regulations are even dumber than I had thought possible.

That is really saying something.

The third reason for the rise in securities lending is my old favorite, collateral transformation to obtain CCP-eligible collateral. This part of the article made me laugh:

There is a third plus, too, as another facet of post-crisis regulation gains momentum. With so much derivatives trading moving to central counterparty clearing, there is increasing demand for high quality assets to be used as collateral. And for that, government bonds — even borrowed ones — avoid punitive haircuts imposed on some equities.

I laugh because in a collateral transformation trade, there is a potentially punitive haircut on the equities (or whatever) posted in the collateral transformation trade.

Whenever I see things like this I keep coming back to the story about the Indian village that was infested by mice, so it brought in cats which then multiplied and became such pests that they brought in dogs to run off the cats, but then the dogs became such a problem that they brought in elephants to scare away the dogs, and when the elephants started wrecking the place they reintroduced the mice to scare away the elephants.

Things like the LCR and clearing mandates were introduced to solve one set of problems (or perceived problems) inherent in the financial transformations that banks provide. But these regulations have led to the proliferation of other kinds of transformations that are problematic in their own ways. These new transformations create new, potentially fragile, interconnections. They create new counterparty and liquidity risks even as they mitigate some old ones.

Or to invoke another metaphor, this is like the Red Queen, running at breakneck speed to stay in the same place:

“Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else—if you run very fast for a long time, as we’ve been doing.”

“A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

Yes. Very much like that indeed. Perhaps we haven’t quite stayed in one place, but the running over the past 5 plus years has not moved us nearly as far as the Frankendodd and EMIR and MiFID II pom-pom squad claim.  Risks have been shifted and transformed, rather than eliminated. In the attempt to banish the devil we knew, we’ve teamed up with some lesser-known demons. Sadly, we are likely to become much better acquainted, sooner or later.

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