Streetwise Professor

October 28, 2014

Convergence to Agreement With Matt Levine

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 10:10 am

Matt Levine graciously led his daily linkwrap with a response to my post on his copper column:

It’s not that hard to manipulate copper.

Craig Pirrong, who knows a lot more about commodities markets than I do [aw, shucks], objects to my take on copper. My view is sort of efficient-markets-y: If one person buys up all the copper in the LME warehouses and then tries to raise the price, the much much greater supply of copper that’s not in those warehouses will flow into the warehouses and limit his ability to do that. And I still think that’s broadly true, but broadly true may not be the point. Pirrong quite rightly points out that there’s lots of friction along the way, and the frictions may matter more than the limits in actual fact.

. . . .

So there are limits to cornering, but they may not be binding on an actual economic actor: You can’t push prices up very much, or forvery long, but you may be able to push them up high enough and for long enough to make yourself a lot of money.

I agree fully there are limits to cornering. The supply curve isn’t completely inelastic. People can divert supplies (at some cost) into deliverable position. The cornerer presents the shorts with the choice: pay me to get out of your positions, or incur the cost of making delivery. Since those delivery costs are finite, the amount the cornerer can extract is limited too.

I agree as well that corners typically elevate prices temporarily: after all, the manipulator needs to liquidate his positions in order to cash out, and as soon as that happens price relationships snap back. But that temporary period can last for some time. Weeks, sometimes more.

What’s more, when the temporary price distortions happen matters a lot. Some squeezes occur at the very end of a contract. This is what happened in Indiana Farm Bureau in 1973. A more recent example is the expiry of the October, 2008 crude oil contract, in which prices spiked hugely in the last few minutes of trading.

The economic harm of these last minute squeezes isn’t that large. There are few players in the market, most hedgers have rolled or offset, and the time frame of the price distortion is too short to cause inefficient movements of the commodity.

But other corners are more protracted, and occur at precisely the wrong time.

Specifically, some corners start to distort prices well before expiration, and precisely when hedgers are looking to roll or offset. Short, out-of-position hedgers looking to roll or offset try to buy either spreads or outrights. The large long planning to corner the market doesn’t liquidate. So the hedgers bid up the expiring contract. Long still doesn’t budge. So the shorts bid it up some more. Eventually, the large long relents and sells when prices and spreads get substantially out of line, and the hedgers exit their positions but at a painfully artificial price. I have documented price distortions in some episodes of 10 percent or more. That’s a big deal, especially when one considers the very thin margins on which commodity trading is done. Combine that price distortion with the fact that a large number of shorts pay that distorted price to get out of their positions, and the dollar damages can be large. Depending on the size of the contract, and the magnitude of the distortion, nine or ten figures large.  (I analyze the liquidation/roll process theoretically in a paper titled “Squeeze Play” that appeared in the Journal of Alternative Investments a few years ago.)

But this is all paper trading, right, so real reapers of wheat and miners of copper aren’t damaged, right? Well, for the bigger, more protracted squeezes that’s not right.

Most hedgers are “out-of-position” they are using a futures contract to hedge something that isn’t deliverable. For example, shippers of Brazilian beans or holders of soybean inventories in Iowa use CBT soybean futures as a hedge. They are therefore long the basis. Corners distort the basis: the futures price rises to reflect the frictions and bottlenecks and technical features of the delivery mechanism, but the prices of the vastly larger quantities of the physical traded and held elsewhere may rise little, if at all. So the out-of-position hedgers don’t gain on their inventories, but they pay an inflated price to exit their futures.

This is why corners are a bad thing. They undermine  the most vital function of futures markets: hedging/risk transfer. Hedgers pay the biggest price for corners precisely because the delivery market is only a small sliver of the world market for a commodity, and because the network effects of liquidity cause all hedging activity to tip to a single market (with a very few exceptions). Thus, the very inside baseball details of the delivery process in a specific, localized market have global consequences. That’s why temporary and not very big and localized are not much comfort when it comes to the price distortions associated with market power manipulations.

 

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October 27, 2014

Matt Levine Passes Off a Bad Penny

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 5:36 pm

Bloomberg’s Matt Levine is usually very insightful about markets, and about financial skullduggery. Alas, in his article on developments in the copper market, Matt is passing off a bad penny.

The basic facts are these. A single firm, reportedly well-known (and arguably infamous) metals trading fund Red Kite, has accumulated upwards of 50 percent (and at times as much as 90 percent) of copper in LME warehouses that is deliverable against LME futures contracts. Such an accumulation can facilitate a corner of the market, or could be a symptom of a corner: a large long takes delivery of virtually the entire deliverable stock (and perhaps all of it) to execute a corner. So the developments in LME copper bear the hallmarks of a squeeze, or an impending one.

What’s more, the price relationships in the market are consistent with a squeeze: the market is in backwardation. I have not had time to determine whether the backwardation is large, controlling for stocks (as would occur during a corner), but the sharp spike in backwardation in recent days is symptomatic of a corner, or fears of a corner.

Put simply, there is smoke here. But Matt Levine seems intent on denying that. Weirdly, he focuses on the allegations involving Goldman’s actions in aluminum:

Loosely speaking, the problem of aluminum was that it was in deep contango: Prices for immediate delivery were low, prices for future delivery were high, and so buying aluminum and chucking it in a warehouse to deliver later was profitable. So people did, and the warehouses got pretty jammed up, and other people who wanted aluminum for immediate use found it all a bit unsporting.

. . . .

The LME warehouse system is an interesting abstract representation of a commodity market, but you can get into trouble if you confuse it with the actual commodity market. One example of the trouble: Goldman and its cronies were accused of manipulating aluminum prices up by putting too much aluminum in LME warehouses.

Well, yes. But the point is that there are many different kinds of manipulation. Many, many different kinds. An Appeals Court in the US opined in the Cargill case that they number of ways of manipulating was limited only by the imagination of man. Too true. The facts in aluminum and the facts in copper are totally different, and the alleged forms of manipulation are totally different, so the events in aluminum are a red herring (although it is copper that is the red metal)

Levine also makes a big, big deal out of the fact that the amount of copper in LME warehouses is trivial compared to the amount of copper produced in the world, let alone the amount of copper that remains in the earth’s crust. This matters hardly at all.

What matters is the steepness of the supply curve into warehouses. If that supply curve is upward sloping, a firm with a big enough futures position can corner the market, and distort prices, even if the amount of copper actually in the warehouses, or attracted to the warehouses by a cornerer’s artificial demand, is small relative to the size of the world copper market.

Case in point. In December 1995 Hamanaka/Sumitomo cornered the LME copper contract holding a position in LME warrants that was substantially smaller than what one firm now owns. Hamanaka’s/Sumitomo’s physical and futures positions were small relative to the size of the world copper market, measured by production and consumption. But they still had market power in the relevant market because it was uneconomic to attract additional copper into LME warehouses.

Another example. Ferruzzi cornered the CBT soybean contract in July, 1989, owning a mere 8 million bushels of beans in Chicago and Toledo. But since it was uneconomic to move additional supplies into those delivery points, it was profitable for, and possible for, Ferruzzi to corner the expiring contract.

World supply may have an effect on the slope of the supply curve into warehouses, but that slope can be positive (thereby creating the conditions necessary to corner) even if the share of metal in warehouses is small. The slope of the supply curve depends on the bottlenecks associated with getting metal into warehouses, and the costs of diverting metal that should go to consumers into warehouses. These bottlenecks and costs can be acute, even if the amount of warehoused metal is small. Diverting copper that should go to a fabricator or wire mill to an LME warehouse is inefficient, i.e., costly. It only happens, therefore, if the price is distorted sufficiently to offset this higher cost.

Levine ends his post thus:

One example of the trouble: Goldman and its cronies were accused of manipulating aluminum prices up by putting too much aluminum in LME warehouses.The worries about copper — that it could be cornered, pushing prices up — stem from there being too little copper in those warehouses. Both of those things can’t be true.

Yes they can, actually. Different commodities at different times with different fundamental conditions are vulnerable to different kinds of manipulation. It is perfectly possible for it to be true that aluminum was vulnerable to a manipulative scheme that exploited the bottlenecks of taking the white metal out of warehouses starting some years ago, and that copper is vulnerable to a manipulative scheme that exploits the bottlenecks of getting the red metal into warehouses now. No logical or factual contradiction whatsoever.

I know you are better than this, Matt. Don’t let your justifiable skepticism of allegations of manipulation make you a poster child for the Gresham’s Law of Internet Commentary.

 

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October 13, 2014

You Might Have Read This Somewhere Before. Like Here.

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

Where have I read that before?

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

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

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

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

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

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

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

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

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

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

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

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October 7, 2014

The Crude Export Ban: Moot For Now, But That’s Not Necessarily a Good Thing

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 7:55 pm

Markets are wondrous things.

Consider the crude oil market. Remember the debate about the US crude export ban? Well, in a few months, that has turned out to be a moot issue. Due to the collapse of demand in Europe, and the freeing up of Nigerian supplies formerly exported to the US, price relationships have changed dramatically. Whereas Louisiana Light Sweet had recently traded at a big discount to Brent, it is now at a sufficiently high premium that it is economical to import Brent to the US, especially to the East Coast. Jones Act tankers expected to take crude from the Gulf to the East Coast are swinging at anchor because it is now economical to feed the EC refineries with Brent.

What’s more, the US crude glut fattened domestic refining margins. So how did US refiners respond? By increasing capacity, and reducing maintenance schedules by 30 percent. This has increased the demand for domestic crude, which has in turn helped close, and at times reverse, the US price discount. This investment in capacity and adjustment of maintenance schedules is arguably inefficient: it’s better to direct some of the crude to underutilized European refineries than to expand refining capacity in the US. But the point is that this inefficiency is attributable to inefficient laws: the laws on oil export have stood still, but the markets have moved on to mitigate the damage.

Meaning at present, price differentials are such that it would not be profitable to export crude even if it were permitted.

This may be true now, but of course it is not destined to be true forever. Therefore, it is still desirable to eliminate the ban, if only to eliminate the incentives to use scarce resources to take advantage of the price distortions that the ban can sometimes cause.  The ban might be a moot issue for now, but that’s not necessarily a good thing.

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Manipulation Prosecutions: Going for the Capillaries, Ignoring the Jugular

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 7:32 pm

The USDOJ has filed criminal charges against a trader named Michael Coscia for “spoofing” CME and ICE futures markets. Frankendodd made spoofing a crime.

What is spoofing? It’s the futures market equivalent of Lucy and the football. A trader submits buy (sell) orders above (below) the inside market in the hope that this convinces other market participants that there is strong demand (supply) for (of) the futures contract. If others are so fooled, they will raise their bids (lower their offers). Right before they do this, the spoofer pulls his orders just like Lucy pulls the football away from Charlie Brown, and then hits (lifts) the higher (lower) bids (offers). If the pre-spoof prices are “right”, the post-spoof bids (offers) are too high (too low), which means the spoofer sells high and buys low.

Is this inefficient? Yeah, I guess. Is it a big deal? Color me skeptical, especially since the activity is self-correcting. The strategy works if those at the inside market, who these days are likely to be HFT firms, consider the away from the market spoofing orders to be informative. But they aren’t. The HFT firms at the inside market who respond to the spoof will lose money. They will soon figure this out, and won’t respond to the spoofs any more: they will deem away-from-the-market orders as uninformative. Problem solved.

But the CFTC (and now DOJ, apparently) are obsessed with this, and other games for ticks. They pursue these activities with Javert-like mania.

What makes this maddening to me is that while obsessing over ticks gained by spoofs or other HFT strategies, regulators have totally overlooked corners that have distorted prices by many, many ticks.

I know of two market operations in the last ten years plausibly involving major corners that have arguably imposed mid-nine figure losses on futures market participants, and in one of the case, possibly ten-figure losses. Yes, we are talking hundreds of millions and perhaps more than a billion. To put things in context, Coscia is alleged to have made a whopping $1.6 million. That is, two or three orders of magnitude less than the losses involved in these corners.

And what have CFTC and DOJ done in these cases? Exactly bupkus. Zip. Nada. Squat.

Why is that? Part of the explanation is that previous CFTC decisions in the 1980s were economically incoherent, and have posed substantial obstacles to winning a verdict: I wrote about this almost 20 years ago, in a Washington & Lee Law Review article. But I doubt that is the entire story, especially since one of the cases is post-Frankendodd, and hence the one of the legal obstacles that the CFTC complains about (relating to proving intent) has been eliminated.

The other part of the story is too big to jail. Both of the entities involved are very major players in their respective markets. Very major. One has been very much in the news lately.

In other words, the CFTC is likely intimidated by-and arguably captured by-those it is intended to police because they are very major players.

The only recent exception I can think of-and by recent, I mean within the last 10 years-is the DOJ’s prosecution of BP for manipulating the propane market. But BP was already in the DOJ’s sights because of the Texas City explosion. Somebody dropped the dime on BP for propane, and DOJ used that to turn up the heat on BP. BP eventually agreed to a deferred prosecution agreement, in which it paid a $100 million fine to the government, and paid $53 million into a restitution fund to compensate any private litigants.

The Commodity Exchange Act specifically proscribes corners. Corners occur. But the CFTC never goes after corners, even if they cost market participants hundreds of millions of dollars. Probably because corners that cost market participants nine or ten figures can only be carried out by firms that can hire very expensive lawyers and who have multiple congressmen and senators on speed dial.

Instead, the regulators go after much smaller fry so they can crow about how tough they are on wrongdoers. They go after shoplifters, and let axe murderers walk free. Going for the capillaries, ignoring the jugular.

All this said, I am not a fan of criminalizing manipulation. Monetary fines-or damages in private litigation-commensurate to the harm imposed will have the appropriate deterrent effect.

The timidity of regulators in going after manipulators is precisely why a private right of action in manipulation cases is extremely important. (Full disclosure: I have served as an expert in such cases.)

One last comment about criminal charges in manipulation cases. The DOJ prosecuted the individual traders in the propane corner. Judge Miller in the Houston Division of the  Southern District of Texas threw out the cases, on the grounds that the Commodity Exchange Act’s anti-manipulation provisions are unconstitutionally vague. Now this is only a district court decision, and the anti-spoofing case will be brought under new provisions of the CEA adopted as the result of Dodd-Frank. Nonetheless, I think it is highly likely that Coscia will raise the same defense (as well as some others). It will be interesting to see how this plays out.

But regardless of how it plays out, regulators’ obsession with HFT games stands in stark contrast with their conspicuous silence on major corner cases. Given that corners can cause major dislocations in markets, and completely undermine the purposes of futures markets-risk transfer and price discovery-this imbalance speaks very ill of the priorities-and the gumption (I cleaned that up)-of those charged with policing US futures markets.

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October 5, 2014

Damage Control at the CFTC

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

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

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

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

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

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

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

Here’s the key paragraph:

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

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

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

Giancarlo has a concrete proposal to eliminate the impasse:

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

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

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

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September 29, 2014

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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September 10, 2014

SEFs: The Damn Dogs Won’t Eat It!

Filed under: Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 8:37 pm

There’s an old joke about a pet food manufacturer that mounts an all out marketing campaign for its new brand of dog food. It pulls out all the stops. Celebrity endorsements. Super Bowl Ad. You name it. But sales tank. The CEO calls the head of marketing onto the carpet and demands an explanation for the appalling sales. The marketing guy  answers: “It’s those damn dogs. They just won’t eat the stuff.”

That joke came to mind when reading about the CFTC’s frustration at the failure of SEFs to get traction. Most market  participants avoid using central limit order books (CLOBs), and prefer to trade by voice or Requests for Quotes (RFQs):

“The biggest surprise for me is the lack of interest from the buyside for [central limit order books or CLOB],” Michael O’Brien, director of global trading at Eaton Vance, said at the International Swaps and Derivatives Association conference in New York. “The best way to break up the dual market structure and boost transparency is through using a CLOB and I’m surprised at how slow progress has been.”

About two dozen Sefs have been established in the past year, but already some of these venues are struggling to register a presence. Instead, incumbent market players who have always dominated the swaps market are winning under the new regulatory regime, with the bulk of trading being done through Bloomberg, Tradeweb and interdealer brokers including IcapBGC and Tradition.

“It’s still very early,” Mr Massad told the FT. “The fact that we’re getting a decent volume of trading is encouraging but we are also looking at various issues to see how we can facilitate more trading and transparency.”

Regulators are less concerned about having a specific numbers of Sefs since the market is still sorting out which firms can serve their clients the best under the new regulatory system. What officials are watching closely is the continued use of RFQ systems rather than the transparent central order booking structure.

Not to say I told you so, but I told you so. I knew the dogs, and I knew they wouldn’t like the food.

This is why I labeled the SEF mandate as The Worst of Dodd Frank. It was a solution in search of a non-existent problem. It took a one-sized fits all approach, predicated on the view that centralized order driven markets are the best way to execute all transactions. It obsessed on pre-trade and post-trade price transparency, and totally overlooked the importance of counterparty transparency.

There is a diversity of trading mechanisms in virtually every financial market. Some types of trades and traders are economically executed in anonymous, centralized auction markets with pre- and post-trade price transparency. Other types of trades and traders-namely, big wholesale trades involving those trading to hedge or to rebalance portfolios, rather than to take advantage of information advantages-are most efficiently negotiated and executed face-to-face, with little (or delayed) post-trade price disclosure. This is why upstairs block markets always existed in stocks, and why dark pools exist now. It is one reason why OTC derivatives markets operated side-by-side with futures markets offering similar products.

As I noted at the time, sophisticated buy siders in derivatives markets had the opportunity to trade in futures markets but chose to trade OTC. Moreover, the buy side was very resistant to the SEF mandate despite the fact that they were the supposed beneficiaries of a more transparent (in some dimensions!) and more competitive (allegedly) trading mechanism. The Frankendodd crowd argued that SEFs would break a cabal of dealers that exploited their customers and profited from the opacity of the market.

But the customers weren’t buying it. So you had to believe that either they knew what they were talking about, or were the victims of Stockholm Syndrome leaping to the defense of the dealers that held them captive.

My mantra was a diversity of mechanisms for a diversity of trades and traders.  Frankendodd attempts to create a monoculture and impose a standardized market structure for all participants. It says to the buy side: here’s your dinner, and you’ll like it, dammit! It’s good for you!

But the buy side knows what it likes, and is pushing away the bowl.

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Family Feud: Lifting the Oil Export Ban

Filed under: Commodities,Energy,Politics,Regulation — The Professor @ 7:42 pm

Larry Summers has called for an end to the crude oil export ban in the US. This is pretty much a no-brainer for even a pedestrian economist, let alone one of Summers’s intelligence, not to say one as intelligent as Summers thinks he is.

No-brainer or not, eliminating the ban (which isn’t a total ban, in any event) will have only modest effects. This is because although crude cannot be exported freely, refined products can be. Lifting the ban will mainly entail a substitution of crude exports for product exports, which will result in modest impacts on final product prices.

Here’s a crude outline of how opening up exports will play out (pun intended).

  1. The price of crude in the US will rise, and the price in Europe (notably Brent) will fall, until the price differential is approximately equal to transport costs of a buck or two, in contrast to the current differential of approximately $6.50. This isn’t immaterial, but it’s not a huge change either, given current prices in the $90s.
  2. The amount of crude refined in the US will decline, and the amount of crude refined overseas will rise. Refining margins in Europe will rise and those in the US will fall. The differentials in product prices will remain about the same, because products will be exported after the ban is lifted just as they are now, though export volumes will decline. Prices will differ by transportation costs post-lifting, just as they do now.
  3. The effect on product prices in the US (e.g., the price of gasoline) is a priori impossible to sign, because there are offsetting effects. US refiner input prices will rise, but margins will fall. The net price effect of higher costs and lower margins can’t be determined a priori.
  4. One factor will definitely lead to lower product prices. Post-free trade in crude, there will be a better match between crude slates and refineries. US refineries are more complex, and optimized to process heavier crudes from Mexico and Venezuela. Most are not optimized to process the large quantities of very light crudes that are flowing from Eagle Ford and the Bakken. In contrast, European refineries are better able to process lighter crudes. This better match of refineries to crude will reduce costs and increase productivity, which tends to reduce product prices.
  5. The main factor that will determine whether product prices rise or fall will be the effect of the lifting of the ban on the total output of crude: if more crude is produced, more products will be produced, and prices will decline. The lifting of the ban will reduce Brent prices, which will reduce North Sea output (and Nigerian output too). The lifting of the ban will increase US prices, which will cause US output to rise. The net effect on total crude output depends on the relative elasticities of supply. If, for instance, Brent supply is very elastic and US supply is very inelastic, total crude output could well fall, which would tend to increase gasoline and distillate prices in the US. If the elasticities are reversed, total supply would likely rise leading to lower product prices.
  6. If I had to guess, I would say that given that the product price changes will be negative but small, and hard to detect in the normal fluctuations of prices. The combined price effect shared between the US and non-US markets for light crudes is relatively small (on the order of 5 percent of price) and the offsetting effect on foreign and domestic output leaves a net effect on output (and hence prices) that will be relatively small.
  7. Tom Friedman supports lifting the ban, which makes me think twice. Friedman also says that lifting the ban will cause crude prices to drop by $25/bbl and thereby crush Putin and Iran and ISIS, thereby saving Ukraine and the MIddle East. Tom Friedman is an idiot. Pay no attention.

There will be one major effect, which Summers alludes to, and which I have emphasized when I teach about the export restriction in my Energy Policy course for EMBAs: the main effect of the change in policy will be to redistribute rents within the domestic oil industry. It will reduce the profitability of US refiners, especially some independents who are feasting on the abundant supply of light crude. It will increase the profitability of domestic crude producers.

In other words, contrary to a lot of the rhetoric, this isn’t about “big oil” vs. main street. It’s about Downstream Medium Oil vs. Upstream  Medium Oil. The big integrated majors basically see money shifted from one pocket to the other: since the lifting of the ban will increase total surplus in the energy market, the integrated majors will benefit, but the benefit will be smallish. The independent refiners will be losers, and pure upstream companies will be winners.

This is, in other words, a sort of family feud. A battle between different branches of the US energy sector family. But as any cop called to the scene of a domestic dispute will tell you, these can be pretty intense.

In sum, ending the ban would make the pizza slightly bigger, but you won’t notice it much at the pump, if you notice it at all. The main effect would be to change the size of the slices. But since conflicts over how the pizza is divided drive politics, the export ban will generate  political battles of an intensity out of proportion to its modest effects  on overall wealth and welfare.

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September 8, 2014

Cleaning Up After the Dodd, Frank & Gensler Circus

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Apparently not. The CFTC has major agida over this:

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

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

. . . .

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

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

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

Not too arrogant, eh?

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

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

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

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

 

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