Streetwise Professor

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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March 29, 2014

Margin Sharing: Dealer Legerdermain, or, That’s Capital, Not Collateral.

Concerns about the burdens of posting margins on OTC derivatives, especially posting by clients who tend to have directional positions, have led banks to propose “margin sharing.”  This is actually something of a scam.  I can understand the belief that margin requirements resulting from Frankendodd and Emir are burdensome, and need to be palliated, but margin sharing is being touted in an intellectually dishonest way.

The basic idea is that under DFA and Emir, both parties have to post margin.  Let’s say A and B trade, and both have to post $50mm in initial margins.  The level of margins is chosen so that the “defaulter (or loser) pays”: that is, under almost all circumstances, the losses on a defaulted position will be less than $50mm, and the defaulter’s collateral is sufficient to cover the loss.  Since either party may default, each needs to post the $50mm margin to cover losses in the event it turns out to be the loser.

But the advocates of margin sharing say this is wasteful, because only one party will default.  So the $50mm posted by the firm that doesn’t end up defaulting is superfluous.  Instead, just have the parties post $25mm each, leaving $50mm in total, which according to the advocates of margin sharing, is what is needed to cover the cost of default.  Problem solved!

But notice the sleight of hand here.  Under the loser pays model, all the $50mm comes out of the defaulter’s margin: the defaulter pays,  the non-defaulter receives all that it is owed, and makes no contribution from its own funds.  Under the margin sharing model, the defaulter may pay only a fraction of the loss, and the non-defaulter may use some of its $25mm contribution to make up the difference.   Both defaulter and non-defaulter pay.

This is fundamentally different from the loser pays model.  In essence, the shared margin is a combination of collateral and capital.  Collateral is meant to cover a defaulter’s market losses.  Capital permits the non-defaulter to absorb a counterparty credit loss.  Margin sharing essentially results in the holding of segregated capital dedicated to a particular counterparty.

I am not a fan of defaulter pays.  Or to put it more exactly, I am not a fan of mandated defaulter pays.  But it is better to confront the problems with the defaulter pays model head on, rather than try to circumvent it with financial doubletalk.

Counterparty credit issues are all about the mix between defaulter pays and non-defaulter pays.  Between collateral and capital.  DFA and Emir mandate a corner solution: defaulter pays.  It is highly debatable (but lamentably under-debated) whether this corner solution is best.  But it is better to have an open discussion of this issue, with a detailed comparison of the costs and benefits of the alternatives.  The margin sharing proposal blurs the distinctions, and therefore obfuscates rather than clarifies.

Call a spade a spade. Argue that there is a better mix of collateral and capital.  Argue that segregated counterparty-specific capital is appropriate.  Or not: the counterparty-specific, segregated nature of the capital in margin sharing seems for all the world to be a backhanded, sneaky way to undermine defaulter pays and move away from the corner solution.  Maybe counterparty-specific, segregated capital isn’t best: but maybe just a requirement based on a  firm’s aggregate counterparty exposures, and which doesn’t silo capital for each counterparty, is better.

Even if the end mix of capital and collateral that would result from collateral sharing  is better than the mandated solution, such ends achieved by sneaky means lead to trouble down the road.  It opens the door for further sneaky, ad hoc, and hence poorly understood, adjustments to the system down the line.  This increases the potential for rent seeking, and for the abuse of regulator discretion, because there is less accountability when policies are changed by stealth.  (Obamacare, anyone?)  Moreover, a series of ad hoc fixes to individual problems tends to lead to an incoherent system that needs reform down the road-and which creates its own systemic risks.  (Again: Obamacare, anyone?)  Furthermore, the information produced in an honest debate is a public good that can improve future policy.

In other words, a rethink on capital vs. collateral is a capital idea.  Let’s have that rethink openly and honestly, rather than pretending that things like margin sharing are consistent with the laws and regulations that mandate margins, when in fact they are fundamentally different.

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March 11, 2014

CCP Insurance for Armageddon Time

Matt Leising has an interesting story in Bloomberg about a consortium of insurance companies that will offer an insurance policy to clearinghouses that will address one of the most troublesome issues CCPs face: what to do when the waterfall runs dry.  That is, who bears any remaining losses after the defaulters’ margins, defaulters’ default fund contributions, CCP capital, and non-defaulters’ default fund contributions (including any top-up obligation) are all exhausted.

Proposals include variation margin haircuts, and initial margin haircuts.  Variation margin haircuts would essentially reduce the amount that those owed money on defaulted contracts would receive, thereby mutualizing default losses among “winners.”  Initial margin haircuts would share the losses among both winners and losers.

Given that the “winners” include many hedgers who would have suffered losses on other positions, I’ve always found variation margin haircutting problematic: it would reduce payoffs precisely in those states of the world in which the marginal utility of those payoffs is particularly high.  But that has been the industry’s preferred approach to this problem, though it has definitely not been universally popular, to say the least.  Distributive battles are never popularity contests.

This is where the insurance concept steps in.  The insurers will cover up to $6 to $10 billion in losses (across multiple CCPs) once all other elements of the default waterfall-including non-defaulters’ default fund contributions and CCP equity-are exhausted.  This will sharply limit, and eliminate in all but the most horrific scenarios, the necessity of mutualizing losses among non-clearing members via variation or initial margin haircutting.

Of course this sounds great in concept.  But one thing not discussed in the article is price.  How expensive will the coverage be?  Will CCPs find it sufficiently affordable to buy, or will they decide to haircut margins in some way instead because that is cheaper?

As I say in Matt’s article, although this proposal addresses one big headache regarding CCPs in extremis, it does not address another major concern: the wrong way risk inherent in CCPs.  Losses are likely to hit the default fund in crisis scenarios, which is precisely when the CCP member firms (banks mainly) are least able to take the hit.

It would have been truly interesting if insurers would have been willing to share losses with CCP members.  That would have mitigated the wrong way risk problem.  But the insurers were evidently not willing to do that.   This is likely because they are concerned about the moral hazard problems.  Members would have less incentive to mitigate risk if some of that risk is offloaded onto insurers who don’t influence CCP risk management and margining the way member firms do.

In sum, the insurers are taking on the risk in the extreme tail.  This of course raises the question of whether they are able to bear such risk, as it is likely to crystalize precisely during Armageddon Time. The consortium attempts to allay those concerns by pointing out that they have no derivatives positions (translation: We are not AIG!!!)  But there is still reason to ponder whether these companies will be solvent during the wrenching conditions that will exist when potentially multiple CCPs blow through their entire waterfalls.

Right now this is just a proposal and only the bare outlines have been disclosed.  It will be fascinating to see whether the concept actually sells, or whether CCPs will figure it is cheaper to offload the risk in the extreme tail on their customers rather than on insurance companies in exchange for a premium.

I’m also curious: will Buffett participate.  He’s the tail risk provider of last resort, and his (hypocritical) anti-derivatives rhetoric aside, this seems like it’s right down his alley.

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March 4, 2014

Derivatives Priorities in Bankrutpcy: A Hobson’s Choice?

And now for something completely different . . . finance.  (More Russia/Ukraine later.)

The Bank of England wants to put a stay on derivatives contracts entered into by an insolvent bank, thereby negating some of the priorities in bankruptcy accorded to derivatives counterparties:

he U.K. central bank wants lenders and the International Swaps and Derivatives Association Inc., an industry group, to agree to temporarily halt claims on banks that become insolvent and need intervention, Andrew Gracie, executive director of the BOE’s special resolution unit, said in an interview.

“The entry of a bank into resolution should not in itself be an event of default which allows counterparties to start accelerating contracts and triggering cross-defaults,” Gracie said. “You would get what you saw in Lehmans — huge amounts of uncertainty and an uncontrolled cascade of closeouts and cross defaults in the market.”

The priority status of derivatives trades is problematic at best: although it increases the fraction of the claims that derivatives counterparties receive from a bankrupt bank, this effect is primarily redistributive.  Other creditors receive less.  On the plus side, in the absence of priorities, counterparties could be locked into contracts entered into as hedges that are of uncertain value and which may not pay off for some time.  This complicates the task of replacing the hedge entered into with the bankrupt bank.   On balance, given the redistributive nature of priorities, and the fact that some of those who lose due to the fact that derivatives are privileged may be systemically important or may run, there is something to be said for this change.

But the redistributive nature of priorities makes me skeptical that this will really have that much effect on whether a bank gets into trouble in the first place.  In particular, since runs and liquidity crises are what really threatens the stability of banks, the change of priorities likely will mainly just affect who has the incentive to run on a troubled institution, without affecting all that much the overall probability of a run.

Under the current set of priorities, derivatives counterparties have an incentive to stick longer with a troubled bank, because in the event it becomes insolvent they have a priority claim.  But this makes other claimants on a failing bank more anxious to run, because they know that if the bank does fail derivatives counterparties will get a lion’s share of the remaining assets.  By reducing the advantages that the derivatives couunterparties have, they are more likely to run and pull value from the failing firm, whereas other claimants are less likely to run than under the current regime.  (Duffie’s book on the failure of an OTC derivatives dealer shows how derivatives counterparties can effectively run.)

In other words, in terms of affecting the vulnerability of a bank to a destabilizing run, the choice of priorities is something of a Hobson’s choice.  It affects mainly who has an incentive to run, rather than the likelihood of a run over all.

The BoE’s initiative seems to be symptomatic of something I’ve criticized quite a bit over the past several years: the tendency to view derivatives in isolation.  Triggering of cross-defaults and accelerating contracts is a problem because they can hasten the collapse of a shaky bank.  So fix that, and banks become more stable, right? But maybe not because it changes the behavior and decisions of others who can also bring down a financial institution. This is why I am skeptical that these sorts of changes will affect the stability of banks much one way or the other.  They might affect where a fire breaks out, but not the likelihood of a fire overall.

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January 26, 2014

Disconnected About Interconnections: Regulators Still Don’t Get the Systemic Risks in Central Clearing

A board member of the ECB, Benoît Cœuré, gave a speech that discussed “the new risks associated with central clearing.” It is evident that Cœuré is a proponent of central clearing, though it is annoying to see him identify multilateral netting as the main benefit (<holds head in hands>).  But it is good to see yet again that central bankers are aware that central clearing does create new risks, and that regulators must be proactive in addressing them.

The problem is that he overlooks the most important risks.  Reading between the lines, like most regulators, Cœuré focuses on the solvency risks of CCPs, and about policy tools that can limit the probability of CCP insolvency and mitigate the adverse impacts of such an insolvency.

But as I’ve written repeatedly in the past, it’s not the insolvency risk per se that should keep people up at night.  Indeed, the measures taken to address the solvency risk can actually exacerbate the real risk a dramatic expansion of central clearing creates for the financial system: liquidity risk.

Liquidity crises are what threaten to bring down financial systems.  For most financial institutions, there is a connection between liquidity risk and solvency: banks become illiquid because (in a world of imperfect information) people believe they might become insolvent.  Maturity mismatches plus imperfect information plus possibility of insolvency combine to create liquidity crises.

CCPs don’t have the maturity mismatches, and they aren’t leveraged.  They cannot experience liquidity crises in the same way banks can.  The direct liquidity risk of CCPs is related to their ability to turn collateral into cash in the event of a member default.

But as I’ve said over and over, clearing affects the needs for liquidity by market participants.  Central clearing can be a source of, or accelerant of, liquidity crises.  Big price moves lead to big margin calls lead to spikes in liquidity demand. These are most likely to occur during periods of financial stress, and can greatly exacerbate that stress.  Moreover, failure of a CCP is most likely to occur due to the inability of traders to fund margin calls due to the shortage of liquidity.   This old article by Andrew Brimmer discusses two episodes I’ve analyzed on several occasions-the Hunts in silver and Black Monday-and shows how it is liquidity/credit/funding of margin calls for CCPs that can create stresses in the financial system.

This is where the systemic risk of clearing arises.  But the subject is totally absent from Cœuré’s speech.  Which is worrisome.

There is also the fallacy of composition problem.  The measures that Cœuré advocates to make CCPs stronger do NOT necessarily make the system stronger.  Strengthening CCPs can actually exacerbate the liquidity problems that clearing causes during a crisis.  The CCP may survive, due to these measures, but the stresses communicated to the rest of the system (and the stress has to go somewhere) can cause other institutions to fail.

This is what scares the bejeezus out of me.  Regulators don’t seem to get the fallacy of composition, and aren’t focused on the liquidity implications of greatly expanded central clearing.

These fears are heightened by reading this DTCC report about collateral and collateral management.

It contains this heading that should make every central banker and financial regulator soil his armor:

Margin Call activity to increase By up to 1000%

Then there’s this:

Operational Capabilities and Settlement Exceptions Management: The potential ten-fold increase in margin call volumes, and the resulting complexity due to market changes, could overwhelm the current operational processes and system infra-structures within banks, buy-side firms and their administrators. As a result, firms will need to invest in technology and also reengineer the settlement, exceptions management and dispute resolution processes in place today. According to a 2011 De- loitte paper, investments in operations required to build and sustain advanced collateral capabilities is estimated at upwards of $50 million annually for top-tier banks.

Be afraid.  Be very, very, very afraid.

The dramatic increase in the scope of clearing substantially increases the operational complexity of the system.  More importantly, it increases the system’s operational rigidity, because cash has to flow quickly, and according to a very precise schedule.  From client to FCM to CCP to FCM to client.  Any failures in that chain can bring down the entire system.

I say again.  Systemic risk in financial systems is largely due to the fact that these systems are tightly coupled.  Clearing increases tight coupling.  This almost certainly increases systemic risk.

More players have to move more money in more jurisdictions as a result of clearing mandates.  As the DTCC report makes plain, this is a new responsibility for many of these players, and they do not have the capability or experience or systems.  Greater operational complexity involving more parties, many of whom are relatively inexperienced, creates grave risks in a tightly coupled financial system.

The irony of all this is that the evangelists of clearing, including notably Timmy! and GiGi in the US, argued that central clearing would reduce the interconnectedness of the financial markets.  Wrong. Wrong. Wrong. Wrong.

It reconfigures the interconnections.  The entire collateral management system the DTCC document describes is a dense web of interconnections.  And to reiterate: under central clearing (and the mandate to margin and mark-to-market uncleared derivatives) these connections (couplings) are tighter than in the old system.  Both old and new systems are highly interconnected.  The connections in the new system are tighter, and are more vulnerable to failure as a result.

I’ll tell you what makes me have to go change my armor: the regulators seem oblivious to this.  To the extent they are focused on collateral, they are focused on initial margin. No! It is variation margin calls during periods of large market movements that will threaten the stability of the system. Now there will be more such calls–1000 pct more, according to DTCC–and more participants are involved, meaning that there are more links and nodes.  The tightly coupled nature of the system means that the breakdown of a few links can bring down the entire thing.

In other words, there seems to be a disconnect on interconnections, most specifically on how clearing has not reduced interconnections but reshaped them, and how the new system’s interconnections are much more rigid, tightly coupled, and time-sensitive.

Not to pick on Cœuré: his speech is just one example of that disconnect.  The thing is that most speeches by regulators and central bankers exhibit the same disconnect.  Target fixation on making CCPs invulnerable does not address the main systemic risk that an expansion of clearing creates.  That systemic risk involves the financial/funding and operational risks of meeting large margin calls in a stressed environment on a precise time schedule.

It’s about liquidity, liquidity, liquidity.  Clearing transforms credit/solvency risk into liquidity risk.  The operational aspects of clearing-the need to move cash and collateral around in large amounts on a tight time schedule-affects the demand for liquidity, and also create points of failure that can cause the liquidity mechanism to seize up, threatening the entire system.

This is what should be the focus, but I’m seeing precious little evidence that it is.  Someday we’ll pay the price.

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November 22, 2013

All Pain, No Gain: The CFTC’s Rule on CCP Qualifying Liquid Resources

Matt Leising had a nice article a few days back about the CFTC’s rule that does not treat US Treasury securities as “qualifying” liquid resources for CCPs.  Instead, under new regulation 33-33 they must obtain “prearranged and highly reliable funding.” Based on Fed rules, this means that a CCP must get  committed line of credit from banks.   This imposes a substantial cost on CCPs, because under new Basel III rules, committed lines impose a large capital charge on the issuing banks.  For purposes of calculating capital, the banks have to assume that the lines are fully drawn.  This capital cost will be passed onto CCPs.

It is ironic that outgoing (resisting the great urge to snark) Chairman Gary Gensler repeatedly argued that one of the main benefits of the Frankendodd clearing mandate is that it would reduce the interconnectedness of the financial markets, especially interconnectedness through derivatives contracts.  Now he has pushed through a regulation that mandates an interconnection among major financial institutions via a derivatives channel: the lines connect derivatives CCPs to major banks.   I have long pointed out that Gensler’s claim that clearing would reduce interconnectedness was grossly exaggerated, and arguably deceptive.  Instead, I pointed out that the mandate would reconfigure-and is reconfiguring-the topology of the network of connections between financial firms.  What the CFTC has done is dictate what that form of interconnection will be.  This particular dictate is extremely problematic.

A CCP needs access to liquidity in the event of a default of a clearing member.  The CCP needs to pay obligations to the winning side of the market, in cash, in a very tight time window.  Failing to make these variation margin payments could impose financial distress on those expecting the cash inflow, and more disturbingly, call into question the solvency of the clearinghouse.  This could spark a run in which parties try to close positions in order to reduce exposure to the CCP.  Given that this is likely to occur in highly unsettled market conditions, such fire sales (and purchases) will inevitably inject substantial additional volatility into price that can exacerbate pressures on the clearing mechanism.

A CCP holding Treasuries posted as IM by the defaulting CM can sell them to raise the cash.  Alternatively, it could repo them out.  During most periods of financial turbulence-and financial crisis-which is likely to be either the cause or effect of the default of one or more large CMs, there is a “flight to quality” and Treasury security prices rise and there is a rush to buy them by investors seeking a safe haven.  Moreover, under such circumstances the Fed will perform its lender of last resort function, and readily accept Treasuries as collateral: even if CCPs could not access the Fed directly*, they could access it indirectly.   Thus, in “normal” crises, Treasuries should be highly liquid, and a ready source of cash that can be used to meet variation margin obligations.

Put differently, from a liquidity perspective, Treasuries are a negative beta asset: they become more liquid when overall market liquidity declines-or verges on collapse.  This is a highly desirable attribute.  Another way to characterize it is that from a liquidity perspective, Treasuries have right way risk.

Bank lines are very different.  Banks become stressed during crisis situations, and face a higher risk of being unable to perform on credit lines under these circumstances.  (Indeed, what if the defaulter is one of the suppliers of a committed line?) Banks fighting for survival but which can perform might try to evade this performance during stressed market conditions, which in a tightly coupled system (and clearing is a source of tight coupling) can be extremely disruptive: a few minutes delay in performing could cause a huge problem.  And if the banks do perform, doing so poses the substantial risk of increasing their risk of financial distress.  That is, committed lines are positive beta from a liquidity perspective: that is, they pose wrong way risks.   If drawn upon, these lines can be an interconnection that is a source of contagion from a derivatives default to systemically important banks, precisely at the time that they are least able to withstand the shock.

In the event, a CCP that does collect Treasuries as IM can likely use these right way assets to raise the cash need to meet its obligations, and can avoid drawing down on its committed line.  But that would mean that the committed line is superfluous, and imposes unnecessary costs on the CCP, and hence on the users of the clearing system.

I also conjecture that having met its liquidity requirements with a committed line, pursuant to the CFTC reg, CCPs would  have a weaker incentive to take Treasuries as collateral, and a stronger incentive to permit the posting of lower quality assets (or incentivizing such posting by reducing haircuts assessed to such collateral) for IM. This would mitigate the cost impact to users that results from the CCP having to secure the committed line, and pay for it (the cost being passed onto the users), thereby reducing the loss of trading/clearing volume and the associated revenues.  This would increase the odds that the line will be drawn on (because the lower quality assets pose a substantial risk of becoming illiquid during a crisis situation-they embed wrong way risk too).  I’ll have to think this through more, because the situation is somewhat complex: it depends on the pricing of the line, which will depend on the likelihood it will be drawn against, and the market conditions at the time it is.  This will depend in part on the quality of collateral that the CCP collects.  I’m not sure of what the equilibrium outcome will be, but I suspect that mandating the obtaining of lines will undermine incentives to demand the posting of high quality collateral.  If it does, this is a bad outcome that increases wrong way and systemic risks.  If it doesn’t, then the cost of the lines is superfluous and a burden on clearing and derivatives trading.

There is one scenario in which Treasuries would not be good collateral: if the financial crisis (and default of a CM or CMs) was the result of a fiscal crisis in the US, or a default (real or technical)  of the kind feared during the last (but the last, most likely) debt ceiling standoff.  But that’s an Armageddon scenario in which banks are likely to be highly stressed and unable to perform, or in which they would incur exceptional and arguably existential costs if they did.  Put differently, there’s likely no good source of liquidity in this scenario, and the CFTC rule will hardly make a difference.

In sum, it is highly unlikely that bank lines are a better source of liquidity, especially under crisis situations, than Treasuries.  Indeed, they are plausibly worse, and actually create an interconnection that can transmit a shock to the derivatives market (and the CCP that clears it) to systemically important banks: this is the exact opposite of what clearing was supposed to achieve. The cost of the lines, which is likely to be substantial, particularly given their necessary size, is a deadweight burden on the markets: all pain, no gain.

Other than that, the rule is great.  And a fitting parting shot from Gensler.

* Frankendodd makes it difficult for US CCPs to obtain Fed liquidity support.  This is a serious mistake that could come back to haunt us in some future crisis.  To work effectively, the LOLR must be able to direct liquidity to where it’s needed,  quickly and efficiently.  CCPs could be a major source of liquidity demand in future crises, which makes isolating them from the Fed highly dangerous, and the invitation to an ad hoc response in some future crisis.

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October 28, 2013

Moral Hazard, Defaulter Pays, and the Relative Costs of Cleared and Uncleared Derivatives Trades

I’ve been beavering away at the clearing section of my next book, which will be titled Market Macrostructure.  It’s been something of a struggle, because there are so many aspects to this issue that it is challenging to organize the material in a logical fashion.  I analogize it to trying to write a history of a complicated battle, where many things are happening simultaneously over space, and these things interact.  Inevitably, the narrative must jump around in either space or time or both, and the writer must summarize some material about one action at one time to relate it to the narrative of what is going on at another place at another time.

So it is with writing an analysis of clearing.  There are many moving parts that interrelate and interact, so there is always the challenge of relating detailed analyses of important pieces to one another, and to clearing as a whole, and to the trading process (execution and clearing) as a whole.

One virtue of this struggle, however, is that it can lead  the writer to new insights.  Conceptualization at a fairly highly level facilitates organization, and the process of conceptualization can lead to new ways of understanding.  So it is, I hope anyways, with the clearing analysis.

This post is my first attempt to crystalize those thoughts; indeed, one of the original purposes of the the blog was to provide a place where I could think out loud and commit to pixels some early thoughts to be refined going forward in more formal writing.

The issue that I have been grappling with is why are some trades cleared, and others not?  Why do we see exchanges that trade cleared contracts operate side by side with bilateral markets trading similar contracts (and sometimes nearly identical ones) that aren’t cleared?  What determines the division of trade between these alternatives?

This is an issue that I’ve been looking at since the ’90s, and I identified some factors, but I was never completely satisfied.  But putting together some pieces that I have written about before, I think I’ve come up with a more complete explanation that captures some of the salient aspects of the economics of clearing and counterparty risk generally.

The first piece is that in theory-and indeed, in most theoretical treatments of clearing by academics (including yours truly)-clearing can operate as a classical risk pooling/insurance mechanism, in which market participants pool counterparty risk.  To the extent that this risk is idiosyncratic, such pooling allocates risk more efficiently and makes risk-averse participants better off.

But as I pointed out in my earliest work, and emphasized more in some later papers, like any risk sharing arrangement, mutualization of counterparty risk creates the potential for adverse selection and moral hazard problems.  Moral hazard problems are likely to be particularly acute.  Clearing participants can affect the distribution of the default losses they impose on the mutualization pool by adjusting the riskiness of their trading positions in the cleared derivatives.  They can also do so by adjusting the risks of their balance sheets, through, for instance, adjusting their trades in non-cleared derivatives (or in derivatives cleared at another CCP), changing their leverage, or adjusting the risk of other assets on their balance sheets

The prospect for moral hazard will inevitably lead to limits on the amount of insurance provided through the clearing mechanism.  That is, not all default risk will be mutualized.

Clearinghouses use margins to limit the amount of risk that is mutualized.  Only losses on defaulted positions in excess of margin posted by the defaulter are mutualized.  The higher the margin cover, the lower the level of risk sharing.

In practice, CCPs utilize a “defaulter pays” model in which margin covers losses on defaulted positions with extremely high probability, e.g., 99.7 percent of the time.  In a defaulter pays model, the amount of risk mutualization is very low.  CCPs are not, therefore, primarily an insurance mechanism.  They insure only tail risks (which has important implications for systemic risk and wrong way risk).

Note LCH.Clearnet’s boast that it had collected far more margin than necessary to cover the realized losses on the Lehman’s derivatives positions that it cleared.   The CME also had more than enough Lehman margin to cover losses on its positions (although there were shortfalls on some product segments that were covered by excessive margins on others).

At the Paris conference I attended in September, the head of Eurex Clearing, Thomas Book, was adamant that the goal of his CCP, and of CCPs generally, was to avoid mutualizing risk if at all possible.  His answer surprised Bruno Biais, whose model of clearing in the paper he presented focuses on the role of the CCP as a default risk insurer.

I confess that I have been inadequately appreciative of this point as well.  Understanding its implications has important consequences, as I hope to show in a bit.

To summarize.  CCPs generally operate on a defaulter pays basis: this is also sometimes referred to as a “no credit” system.  That term will help illuminate the differences between cleared and uncleared markets.  The defaulter pays system means that the amount of risk shared through a CCP is extremely limited.  This limitation on risk sharing is best explained as the consequence of moral hazard.

In contrast to a cleared market operating on the no credit model, dealers in bilateral OTC markets historically extended credit to derivatives counterparties.  Put differently, OTC deals often bundled a derivatives trade with credit provision.  That is, dealers often willingly took on exposure to a default loss when entering into a derivatives deal with a customer.  (This is not true for all types of customers.  For instance, hedge funds typically had to post margin.)  Taking credit exposure is equivalent to extending credit to the counterparty.

Now consider whether a firm will prefer to trade a cleared derivative, requiring the posting of a high margin and which thus embeds no credit, or prefers instead to trade an otherwise identical OTC product that does embed credit.  To fix ideas originally, let’s consider a firm that is cash constrained.  Therefore, if it wants to trade the cleared product, it must borrow to fund the initial margin.  The cleared derivative is a no credit transaction, but that doesn’t mean that moving to clearing necessarily reduces the amount of credit the firm obtains: it can borrow the money needed to post margin, and indeed, may have to borrow it.

One source of credit is dealer banks.  So the firm could either enter into an uncleared bilateral trade with a dealer, or borrow money from the dealer bank to fund the IM.  (The argument doesn’t really depend on dealing with the same bank on the derivatives deal and the borrowing: this just facilitates the exposition.)

Here’s were the loser pays aspect of margin comes in.  Let’s say that the firm is selling a derivatives contract with payoff P. If the firm defaults, the OTC counterparty’s exposure is max[P,0].  But in a loser pays model, the margin M is almost always greater than max[P,0].  Thus, the borrowing from bank to fund margin almost always exceeds the default loss that the bank would incur if it entered into a bilateral deal with the firm.

I can show formally that if the firm already has debt outstanding, under standard pro rata/pari passu default loss allocation mechanisms, holding everything equal,  the bank’s default losses if it extends credit to the firm to fund margin almost always exceed, and never are smaller than*, the default losses that it would incur if it had entered an uncleared bilateral trade with the firm.  This, in turn, will make the cleared transaction more expensive for the cash-constrained firm, and it will prefer to trade the OTC product.

There are at least a couple of reasons why the cleared transaction can be more expensive.  One is what is effectively a debt overhang problem.  In order to induce the bank to lend the margin for posting at the CCP, the firm must promise it higher payments in non-default states than it has to promise the bank in these states when it trades OTC instead.  Since the firm’s managers, acting in the interest of equity, only care about payoffs in non-default states, this means that returns to shareholders are lower when it borrows to fund margin than when it deals OTC.  This can be seen another way.  I can also show formally that the payoffs to the firm’s other creditors are almost always higher, and never lower, if it borrows to fund margin than if it trades OTC.  Thus, the value of the the firm’s non-margin-related debt is higher if it trades a cleared product and funds the margin by borrowing, than if the firm uses the OTC product.  Since the value of the firm’s assets doesn’t differ in the cleared vs. uncleared cases, and since value is conserved, this means that equity is less valuable when the firm trades cleared products than bilateral ones.   Some of the benefit of borrowing to fund margin flows to other creditors; this is where the analogy to debt overhang comes in.

This is most easily seen in the following scenario.  The firm can become insolvent when max[P,0]=0, i.e., the bilateral contract is out of the money to the bank, and the bank suffers no loss due to default, and all the losses of insolvency would fall on other creditors.  However, if the bank had lent the firm money to fund margin, it would suffer a loss on the margin loan in this circumstance.  This loss would reduce the loss suffered by the other creditors.

OTC is cheaper than cleared products in other models of capital structure.  For instance, moral hazard (or adverse selection) mean that the firm will be credit constrained: the amount it can borrow is limited by its collateral, and/or the amount of cash flows that it can credibly pledge to lenders.  The same formal analysis implies that more cash flows in non-default states must go to supporting a margin loan in a defaulter pays clearing model than in a bilateral transaction.  This leaves less cash flows to support other borrowing, so by borrowing to fund margin loans the firm must borrow less to support other investments (which, in this sort of model, it has insufficient equity to fund itself).  Thus, borrowing to fund margins on cleared transactions crowds out borrowing to fund positive NPV investments.

This analysis implies that this cash constrained firm will choose to trade OTC rather than cleared products with defaulter pays margins funded with loans.  The bank is indifferent, because it will price the product or the loan to cover its costs, but the firm is always better off  with the bilateral trade because it has to pay the bank less if it trades OTC than if it borrows to fund margin.

Moreover, the analysis implies that if the firm is forced to clear, it will either scale back its derivatives trading (because the cleared transaction is more expensive), and/or reduce its investments in positive NPV projects. Cutting back derivatives trading is costly if this trading reduces the deadweight costs of debt, for instance.  Indeed, I can show that the cost of margin is especially high when the derivatives trade is a “right way” risk, as would occur when the firm is hedging.

Clearing mandates are therefore expensive for such firms, and there is a legitimate reason to exempt such firms from clearing requirements.  (Note that even if these firms are exempted, other rules affecting dealer banks, e.g., punitive capital charges on OTC derivatives trades, can induce an inefficient use of cleared transactions.)

This analysis explains the preference of many firms, especially corporate end users, for uncleared OTC trades that embed credit, as opposed to cleared transactions that must be funded by increased borrowing.  This, in turn, can explain the growth of OTC markets relative to exchange traded markets from the 1980s onwards.

It is useful to step back a bit here, and understand what is really going on.  In essence, in this model clearing is expensive because it causes one agency problem to exacerbate another.  CCPs adopt defaulter pays because of an agency problem: the moral hazard associated with risk sharing.  Debt is expensive or constrained for firms because of agency problems (e.g., debt overhang problems, or constraints on borrowing due to moral hazard).  Effectively, the firm must obtain more credit to support a cleared position than an uncleared one, and  the cost of debt arising from agency problems makes this higher level of credit more expensive.

This analysis raises the question of why firms would ever choose to clear.  There are a couple of answers to that.

First, there may be other (private) benefits.  For instance, netting economies may be greater with clearing.  Of course, the efficiency effects of netting are equivocal (because netting primarily has the effect of redistributing losses among creditors), but as a positive matter is is pretty evident that netting offers private benefits, and thus the mulitilateral netting that can occur in clearing, but not to the same degree in bilateral trades, could induce some traders to prefer clearing.

Second, the analysis started from the assumption that the firm at issue is cash constrained and hence has to borrow to fund margin on the cleared trade.  Some firms are not.  One example would be an ETF like USO or USNG, which collect the entire notional value of derivatives in cash from their investors.  These firms do not require any credit to meet margins.  Large real money funds, like a Pimco, that collect cash from investors and use derivatives to gain exposure to price risks would be another.

Even many hedgers may not suffer from cash constraints that limit their ability to trade cleared contracts.  Consider commodity trading firms.  They typically use derivatives to hedge inventories of commodities.  Banks, in turn, are willing to lend against these inventories as collateral.  Thus, the commodity trader can fund margin using borrowings secured by commodity inventories, and the lender does not share in default losses pro rata with other creditors.  This type of borrowing is fundamentally different than the borrowing considered above, in which the firm borrows against its balance sheet and default losses are shared with other creditors.

Thus, the simple models would predict that whereas cleared derivatives used to hedge liquid inventories are as cheap or cheaper than uncleared derivatives, it is much more expensive to use cleared derivatives to hedge cash flows on illiquid assets, or to hedge broad balance sheet risks.  This is largely consistent with my understanding of the pattern of usage of cleared and uncleared derivatives.

This model, which combines a model of the cost of risk sharing at a CCP with a model of the capital structure of firms, has both positive and policy implications.  In particular, it can explain the adoption of defaulter pays by CCPs.  It can also explain the disparities between OTC and cleared markets when CCPs utilize defaulter pays.  Moreover, it demonstrates that clearing mandates can be inefficient if they are applied too broadly.  One source of this inefficiency is that the mandate leads to a perverse interaction between agency problems.

Of course, a rationale for clearing mandates is that clearing reduces systemic risk.  Anyone who has read my work will know that I am dubious of that rationale on many grounds, but it is worthwhile to consider the implications of the foregoing analysis for systemic risk.

The model is too sparse to make very strong conclusions, but one consideration does stand out.   If firms borrow from OTC dealer banks to fund margins, holding the rest of the firm’s liabilities and assets constant, these banks suffer larger losses when the firm goes bankrupt if they lend to them to fund margins on  derivatives trades than if they enter into identical uncleared OTC derivatives trades.  As noted before, there is a distributive effect: other creditors suffer smaller losses.  The systemic implications of this redistribution depend on the relative systemic importance of the banks and the other creditors.  Dealer banks are definitely systemically important, but other creditors may be too.  Therefore, it is not evident how this cuts, but if one believes that large financial institutions that serve as OTC dealers are especially crucial for systemic stability, moving to cleared trades would tend to increase systemic risk because clearing actually increases their credit exposures to customers.

But again, caution is warranted here.  The redistribution result holds capital structure and derivatives trades constant, but of course these will be different if firms have to clear than if they don’t.  These changes are difficult to predict, and the systemic riskiness of different configurations is even more difficult to compare given how little we really know about the sources of systemic risk.   But the fact that clearing can lead to adverse interactions between agency problems should raise concerns about the systemic implications of forcing clearing.

*To be more precise.  When P>M, the CCP and the lender suffer default losses, and the sum of these default losses is the same as the bilateral counterparty would incur on an uncleared trade.  Relatedly, other creditors of the bankrupt firm suffer the same default losses in the cleared and uncleared cases when this condition holds.  They suffer smaller losses whenever this condition does not hold and the firm goes bankrupt.

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October 23, 2013

I See Your Footnote 88, and Raise You Footnote 513, Or, Kafka Squared

In September, the CFTC’s new SEF rule threw swap market participants into a panic when they realized that footnote 88 buried within the rule would require instruments that were thought to have been outside the scope of the rule to be traded on the new SEFs:

Further muddying the waters is a footnote that was written into the margins of the final rules that could end up having a major impact. Footnote 88 requires certain entities that offer trade execution of swaps on a multiple-to-multiple basis to register as SEFs, even if they only execute or trade swaps that are not subject to the trade execution mandates.

This could lead to a significantly expanded SEF universe, which is already expected to be crowded. Trading participants would have to code and test to these various SEFs, some of which will have hastily assembled their platforms in order to be compliant. The on-boarding process will be rushed for participants in order to generate needed liquidity at the Oct. 2 starting point.

“For some of our members who have decided that they’re going to connect to each one of the platforms that’s available, they’re going to need this unique coding and connectivity to these new platforms,” Nevins says. “That’s a lot of work in a very short period of time.”Those who don’t want to connect to each venue will have to decide quickly which SEFs they want to work with, and they still need to hurry the coding and connection of pipes to the SEFs.

But two can play the footnote game.  Today Bloomberg reports that the banks have found a footnote in the rule that allows them to shelter some trades from the SEF execution mandate.  Footnote 513.  (The number itself should give an indication of how bloated and complex the rule is.)

Wall Street, trying to preserve profits from swap trading in the face of tougher scrutiny from Washington, has found a new way to keep some of its overseas deals private. It’s called Footnote 513.

Banking lawyers have seized on the wording of the footnote, contained in an 84-page policy statement issued in July by the main U.S. regulator of derivatives. The largest banks told swap brokers in late September that the language means certain swaps still don’t fall under the agency’s new trading rules, according to three people briefed on the discussions.

London-based ICAP Plc (IAP), one of the largest swap brokers, told the banks it didn’t agree with their interpretation, said the people, who spoke on condition of anonymity because the discussions weren’t public. Other brokers accepted the banks’ position and have been trading billions of dollars in contracts outside the new regulatory system, the people said.

The deals in question include swaps for foreign clients that are arranged by U.S.-based traders or brokers and then booked through a U.S. bank’s overseas affiliate. Bank lawyers say that if the trade goes through an affiliate it can stay private and doesn’t need to be handled on one of the public electronic trading platforms approved by the Commodity Futures Trading Commission, two people said.

Other than lawyers, who thinks this Duel of Footnotes is anyway to run a railroad?  (I know, I know: most lawyers think this is stupid too.  It’s just that they’ll be about the only ones that profit from it.)

And remember it’s not just footnotes.  It’s commas too.  As I wrote about a year ago, the decision overturning the CFTC’s position limit rule hinged in part on the placement of commas.

The whole structure is still under construction, and it is already requiring a plethora of ad hoc fixes, in the form of exemptions and no action letters, which Commissioner Scott O’Malia trenchantly criticized.

And it’s not just in the US.  The rules and paperwork are metastasizing in Europe too.  As one commentator puts it, “Regulation descends into a Kafkaesque bureaucracy.”  Yeah.  This will work.  Especially when their Kafkaesque bureaucracy clashes with our Kafkaesque bureaucracy.  Kafka squared. Woot!

And it’s not just derivatives.  It’s hedge funds.  And I could go on.

The hedge fund article also points out something I’ve been hammering on for years now: perversely, since compliance costs have a huge fixed cost element, the regulatory onslaught creates scale economies that favor concentration and consolidation, and which can potentially reduce competition.  You are seeing it in hedge funds.  You are seeing it in banking.  You are seeing it in FCMs.

And I do mean perverse, because among the ostensible purposes of these regulations were mitigating the too big to fail problem, and promoting competition.  The dramatic increase in regulatory overhead that favors the big over the small is completely at odds with these purposes.

Moreover, don’t forget another point that I’ve made.  These rules are systemic in nature, in the sense that they affect myriad financial market participants, and in pretty much the same way.  Meaning that if one of the rules is fatally flawed, it could lead to a serious systemic problem.

Which raises the question: what footnote-or what comma-in what rule will create a future crisis?  Perhaps that’s a little hyperbolic, but not outrageously so.

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October 7, 2013

A Tower of Babel: OTC Derivatives Edition

Filed under: Derivatives,Economics,Financial crisis,Financial Crisis II,Regulation — The Professor @ 6:39 pm

Linking to a speech by Benoit Coeuré of the ECB (who gave the keynote at the Paris conference I spoke at a month ago), ISDA’s Derivativiews blog points out how the reporting of derivatives transactions has been totally botched due to jurisdictional fragmentation:

Mr. Coeuré asks an important question about transparency in his speech: “Does…the supervisor responsible for the supervision of a large cross-border financial institution at a consolidated level have direct and immediate access to information on OTC derivatives transaction that encompass all transactions entered into by all entities of this group? Is the information accessible, in other words can it be easily aggregated across trade repositories and jurisdictions?”

He then goes on to say: “My answer would be a clear no!”

And we agree.

Mr. Coeuré went on to discuss privacy laws, blocking statutes and indemnification clauses in several jurisdictions which restrict access to the detail of OTC derivatives transactions; the inability to aggregate data across trade repositories and jurisdictions; and differences in the type and level of information required for reports across jurisdictions. He ultimately broke the problem into three main issues: information gaps, data fragmentation across trade repositories and jurisdictions and obstacles impeding authorities’ access to data.

ISDA notes that this mess was predictable, and predicted.  I agree: I was one of those who predicted this years back, based in part on my experience with attempting to create an energy data hub in 2003-2004.  Both commercial and political pressures have led to the proliferation of repositories.  Market participants and regulators have beavered away erecting a derivatives Tower of Babel, a collection of databases that serve as a barrier to the sharing of information, rather than a means of sharing information.

I would further note that there are other, deeper problems that call the entire exercise into question.  It may do more harm than good.

First, OTC derivatives represent only a subset of exposures, and therefore even if one had a single, unified database of all derivatives trades one would still have an incomplete picture of interconnections in the system as a whole.

Second, and more fundamentally,  even if regulators were to know the totality of interconnections with only a slight degree of imprecision, what could they do with that information?   The financial system is complex, and it is impossible to know how the system will react to the failure of one node (or several nodes) in that system, or even the threatened failure of some nodes.  Indeed, the actions of market participants depend on their beliefs; the stability of the system depends on how market participants behave; and the beliefs of these market participants is unknowable.  Meaning that even an accurate map of all interconnections is not sufficient to understand the susceptibility of the system to crisis: one has to know about the expectations and beliefs of market participants.

Moreover, if one views a crisis as a period when the financial system goes chaotic (in the technical sense of the term), even the slightest imprecision in measuring the state of the system (where the state includes actual interconnections/exposures and beliefs about these interconnections and the beliefs of others and beliefs about how people will act on those beliefs and on and on) means that one cannot predict how the system will behave: the defining characteristic of a chaotic system is extreme sensitivity to initial conditions, so if you measure those conditions with even the slightest error, you will not be able to predict its evolution, or its response to a shock.  Moreover, it means that one cannot predict the effect of interventions in the system when (a) the system is chaotic or on the cusp of chaos, and (b) one cannot measure the state of the system with near perfect precision.

In other words, even if the Tower of Babel problem is corrected, and one measures derivatives exposures with considerable accuracy, one can have little confidence that regulators will have the information necessary to identify an incipient systemic event, or how their interventions will affect the system.  Indeed, in crisis situations, a little knowledge can be a dangerous thing: interventions in a chaotic system based on an imprecise measurement of the state of the system, let alone an incomplete understanding of the dynamics of the system, can make things worse, not better.

This suggests that the entire enterprise of attempting to map the system is futile, and perhaps even dangerous.   This enterprise is predicated on a mechanical view, a view that characterizes the financial system as stable and predictable if you have enough information.  If instead the system is complex and on the edge of chaos, this view is completely misguided because no amount of information is enough.  Moreover, this view encourages hubris and can result in interventions that destabilize instead of stabilize.

This is the knowledge problem on krokodil.  Centralized intervention in a complex system based on imperfect knowledge is a very dangerous thing indeed.

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September 22, 2013

The BIS Swings and Misses

The BIS has been one of the major advocates for mandated clearing.  They have produced an analysis claiming that mandated clearing will increase GDP growth by .1 percent or more per annum.  I criticized this calculation claiming that it was predicated on a fallacy: namely, that multilateral netting and collateralization, result in a reduction in the costs of OTC derivatives borne by banks, and thereby reduce the risk that they will become dangerously leveraged.  In fact, these measures redistribute losses, and will not affect the overall leverage of a financial institution in the event of an adverse shock to its balance sheet.

Stephen Cecchetti, the head of the BIS’s Monetary and Economics Department has responded to this sort of criticism.  Here’s his argument regarding multilateral netting:

Before turning to the costs, I think it is worth responding to criticism of this approach. First, some critics have argued that, by focusing on derivatives exposures, the Group has ignored the impact of multilateral netting on other unsecured creditors. The main claim is that multilateral netting dilutes other unsecured creditors.

This is correct. Multilateral netting does dilute non-derivatives-related claims to some extent. However, this is neither new, nor is it unique to derivatives. In fact, repos, covered bonds and any other secured loans result in dilution and subordination. For repos, that counterparties can close out a position and seize collateral in default has led to comment and worry for some time. Given that this is all well known, I would think that it is already reflected in the pricing of the instruments involved. Presumably no one will be terribly surprised by this when it is applied to derivatives, and so the impact will be muted. It is a stretch to see how this redistribution of a part of the risk associated with OTC derivatives transactions increases systemic risk.

This argument totally fails to meet the criticism.

First, there has been some repricing, but it is incomplete.  Repricing only takes place to the extent that adoption of mandated clearing occurs, or is at least anticipated, and does not occur for derivatives contracts and other liabilities until they mature.  Since many derivatives and other liabilities have maturities extending well beyond the clearing implementation dates, these have yet to be repriced.

Yes, the most run-prone liabilities, such as short term debt, have been repriced, but that’s not all that important.  Even if banks adjust their capital structures to reflect the repricing, they will still have large quantities of such liabilities which are now more junior and which will pay off less in states of the world when a bank is insolvent.  The higher yield received in normal times compensates the creditors for the lower returns that they get in bad states of the world, and most notably in crisis times.  And it is exactly during these crisis times that these liabilities are a problem.  Due to repricing, there may be a lower quantity of such short term debt, but this debt will be more vulnerable to runs as a result of the subordination inherent in multilateral netting.  Excuse me if I don’t consider that a clear win for reduced systemic risk, and fear that it in fact represents an increased systemic risk.  That is no stretch at all.  None.  Cecchetti’s belief that it is a stretch reflects a cramped and incomplete analysis of the implications of subordination.

In terms of the BIS’s claim that will boost economic growth, Cecchetti’s argument does not rebut in any way what I have been saying.  The BIS argument is based on a belief that netting makes the pie bigger.  My argument is that it does not make the pie bigger, but just resizes the pieces, making some smaller and others bigger.  Nothing in what Cecchetti writes demonstrates the opposite, and in fact, his acknowledgement that netting dilutes other creditors is an admission that the effects of netting are redististributive.

Once that is recognized, the entire premise behind the BIS macroeconomic analysis of the OTC derivative reforms collapses, and the conclusions collapse right along with it.

Cicchetti mischaracterizes the critique when he insinuates that it means that netting increases systemic risk.  I’ve said that’s one possible outcome, but mainly have used the redistribution point to refute the claim (made by the BIS and others) that netting reduces systemic risk. The channel by which the BIS claims it will is predicated on the belief that netting reduces default losses rather than reallocates them.  If they only reallocate them-which Cicchetti effectively acknowledges-this channel is closed, and the asserted benefit does not exist.  It’s very simple.

Therefore, Cicchetti may “remain convinced that the Group’s analysis accurately captures the benefits of the  proposed reforms,” but his conviction is based on faith rather than economic reasoning: his attempted defense notwithstanding, the Group’s analysis is contrary to the economics.

Here’s what Cicchetti says about collateral:

A second concern that has been raised is that the regulatory insistence on increased collateralisation will simply redistribute counterparty credit risk, not reduce it. To see the point, take the simple example of an interest rate swap. The primary purpose of the swap is to transfer interest rate risk. But the mechanics of the swap mean that there is always a risk that the parties involved will not pay. This is a credit risk. In the case where the swap is completely uncollateralised, it is clear that the instrument combines these two risks: interest rate (or market) risk, and credit risk.

Now think of what happens if there is collateralisation. At first it appears that the credit risk disappears, especially if there is both initial margin to cover unexpected market movements and variation margin to cover realised ones. But the collateral has to come from somewhere. Getting hold of it by borrowing, for example, will once again create credit risk.

The point is that, by collateralising the transaction, the market and credit risk are unbundled. I would argue fairly strenuously that unbundling is the right thing to do. Unbundling forces both the buyer and the seller to manage both the interest rate and the counterparty credit risks embedded in a swap contract. In the past, some parties seem to have simply ignored the credit component. Unbundling sheds light on the pricing of the two components of the contract. A more transparent market structure with more competitive pricing will almost surely result in better decisions and hence better risk management, risk allocation and ultimately lower systemic risk. The AIG example is a cautionary tale that leads us in this direction.

I agree completely that clearing unbundles price and credit risks.  This is particularly true under a defaulter pays model, in which the CCP members bear very little default risk.   In fact, this is the focus of a chapter I’m writing for my next book.

But Cicchetti’s assertion that unbundling is a good thing begs a huge question: why were risks bundled in the first place?  By way of explanation, sort of, Cicchetti asserts, without a shred of evidence, that market participants often ignored credit risk bundled in derivatives trades.  Even if that’s true, why would they necessarily take it into consideration merely because it’s unbundled?  I think the most that can be said is that ex post it appears that market participants underestimated credit risk prior to the crisis.   And if they did this with derivatives, they did it with unbundled credits too: look at the massive repricing of corporate paper and the virtual disappearance of unsecured interbank lending starting in August 2007.

But more substantively, there can be good reasons for bundling market risk and credit risk.  I explore these reasons in detail in my Rocket Science paper, which has been around for years.  In particular, there can be informational synergies.  These are quite ubiquitous in banking, and explain a variety of phenomena, such as compensating balances which require firms that borrow from a bank to hold some portion of the loan in deposits at the same bank: this is a form of bundling.  Moreover, bundling can be a way of controlling a form of moral hazard, namely asset substitution/diversion.

At the very least, bundling is so ubiquitous in banking (and finance generally, e.g., trade credit) that it is extremely plausible that there are good economic reasons for it.  The reasons for this practice should be understood before implementing massive policy changes that forcibly eliminate it for massive quantities of contracts.  It is rather frightening, actually, that Cicchetti/the BIS are so cavalier about this issue, and are so confident that they know better than market participants.

And again, even if credit risk is priced more accurately in an unbundled world (which Cicchetti asserts rather than demonstrates), bank capital structures in an unbundled world can be fragile and a source of systemic risk.  For instance, collateral transformation trades used to acquire collateral to post as CCP margin are arguably very fragile and systemically risky even if they are priced correctly.

What’s needed is a comparative analysis of the fragility/systemic riskiness of the bundled and unbundled structures, and this BIS/Cicchetti do not provide.

Cicchetti’s speech suggests that BIS has heard the criticisms of clearing mandates, but doesn’t really understand them, or is so invested in clearing mandates that it refuses to take them seriously.  Regardless of the reasons, one thing is clear.  The BIS has taken a big swing at a rebuttal, and missed badly.

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