The European Commission released its “Communication to a Cast of Thousands” on “Ensuring efficient, safe and sound derivatives markets: Future Policy Actions.” It is, at best, a series of policy proposals based on nothing more than assertions delivered from on high. These assertions are both logically dubious and completely empirically unsupported.
The main policy recommendations are to force the bulk of derivatives trades into centrally cleared platforms and exchange trading. This will be accomplished by margin and capital requirements, and mandates.
At one level, the EC report identifies the appropriate objective: to encourage market structures that “allow markets to price risks properly” (p. 2). However, it provides neither theoretical nor empirical support for its assertions that its policy actions will in fact improve risk pricing. At root, its argument is that centralized price setting dominates decentralized price setting.
As has been known since Hayek and his peers, the relative efficiency of centralized vs. decentralized price setting depends crucially on the information available to those setting the prices. Recognition of the crucial issue of information is completely lacking in the EC document.
The Olympian tone of the document is well summarized by the statement that it is adopting a new regulatory approach “where legislation allows markets to price risks properly” (p. 2). In other words, it is legislation that is the essential determinant of whether markets price risks properly or not. As if.
The document states “the proposed measures will shift derivative markets from predominantly OTC bilateral to more centralised clearing and trading.” Putting all this together means that the EC is asserting that the existing market structure is history’s greatest market failure. One would think that such a sweeping claim would require some supporting evidence and theory. The EC document provides none whatsoever.
The assertion that markets have systematically failed to price risks occurs throughout the document. For instance, it says: “the function of prices to allocate resources must be restored: derivatives should be appropriately priced in relation to the systemic risk they entail.” The necessity of a “restoration” implies that: (a) the market has done a bad job in pricing these risks in the past, and (b) regulators can do better going forward. Although one may agree with (a), it is essential to avoid the Nirvana fallacy: the crucial element of a policy recommendation is the comparative performance of imperfect markets and imperfect regulators. Thus (b) is the crucial issue. Sadly, the EC consistently falls prey to the Nirvana fallacy, and asserts without providing the least support that of course regulators will do it better than markets.
The document reeks of the Olympian disdain of Eurocrats in love with their own superiority. It is the Nirvana fallacy distilled into 9 pages of text.
For instance, we get pearls like: “Such contracts will continue to be cleared bilaterally with counterparties exchanging collateral to cover their exposure. However, current collateral levels are too low.” What is the basis for such an assertion? Who knows? And, even granting the possibility that some collateral levels may be too low, there is also the possibility of setting them too high.
You’ll search in vain trying to find any reasoned discussion of (a) the relative costs of excessive or deficient collateralization, or (b) the information available to regulators and market participants that they can use to set these levels.
The document suggests that initial margin levels “will be specific to counterparty characteristics.” This has to mean measurable characteristics. But what information does a regulator have to measure the counterparty characteristics necessary to set initial margin levels? Is that information better or worse than the kind of information that large dealers have? I have very strong priors on the answer to that question: the dealers.
If you think differently, fine. But before you decide, I suggest that you consider the entire credit rating agency fiasco, in which credit risk evaluations based on measurable characteristics were made by a small number of (centralized) entities. Not only were these evaluations systematically flawed (thereby raising similar concerns that regulatory decisions regarding initial margin levels will be so too), crucially they were extremely brittle because of the lack of diversity in evaluations and the information on which they were based. Thus, the errors the agencies made had broad systematic effects. In contrast, a more diffuse mechanism for establishing initial margins, in which multiple agents possessing different information evaluate counterparty risk and price it appropriately is less susceptible to such systematic errors. Since systematic errors can translate into systemic risk–as the AAA CDO disaster demonstrated–this is a very serious concern.
Bad pricing of relative counterparty risks across transactors will lead to a misallocation of trading activity and counterparty risk exposure across them. Those whose counterparty risks are underestimated will trade too much; those whose risks are overestimated will trade too little. These errors are inevitable, so the crucial question is what sort of market arrangement will minimize the costs of these errors.
This depends on the information available to those making the decisions. In my view, major dealers will almost inevitably have more information individually than would a central regulator or clearinghouse. Moreover, since in a market structure like that has evolved heretofore numerous entities are collecting information and making these judgments, there is the possibility of the aggregation of diffuse private information. This possibility is absent in a highly centralized structure.
Put differently: the EC (and its American counterparts) are acting as if they had never heard of the socialist calculation controversy. (Which is probably true–all the worse for them if so.) Namely, how does a central agent set prices in a world with diffuse private information about costs and value? Information about counterparty risk is highly diffuse, and largely private. How can a central agent set the “right” prices in such an environment? Can markets do it better (even if not perfectly)?
We have all too much experience with the defects of central price setting as compared to decentralized price setting in markets (cf. the USSR) to be at all confident with the relative superiority of centralized counterparty risk pricing. At the very least it is incumbent on the advocates of such a centralized approach to address seriously the possibility (demonstrated by vast experience in many contexts) that centralized price setting in derivatives markets will founder on the same information problem that has wreaked havoc with other efforts to set prices centrally. Tragically, they don’t even acknowledge the problem, let alone provide a convincing analysis supporting the contention that centralized pricing will dominate private, decentralized pricing.
Similar problems are inherent in the EC’s recommendation of differential capital charges for cleared and non-cleared derivatives contracts. Again, what is the basis to believe that the regulators have the information to set this differential (or the levels) properly? This ability is blithely assumed in the EC report; again this crucial issue is not even acknowledged.
It does not inspire confidence that the EC paper invokes the authority of the Basel Committee on Banking Supervision as the model for the setting of capital charges. That would be the source of the same Basel rules that made it very attractive for systemically important financial institutions to load up on AAA CDOs. We all know how that worked out. Another illustration of the socialist calculation problem in action.
Beyond the complete failure to engage the fundamental informational questions, the paper says things that cast serious doubt on the competence of the EC to make such sweeping changes to financial markets. For instance, there is a statement in the paper that strongly, strongly suggests that the EC does not understand the first thing it is talking about.
Specifically, on p. 6, it asserts, in a completely conclusory way, with no supporting evidence or argument whatsoever, that counterparty risks of “contracts that are cleared on a CCP” are lower than “the counterparty credit risks of those [contracts] where clearing is done bilaterally.”
If one defines counterparty credit risk as being the probability distribution of default losses, this statement is completely wrong. Holding positions and the portfolios of the transacting parties constant, the probability distribution of default losses is the same between centrally cleared and bilateral contracts. All central clearing does is change the allocation of those default losses across market participants. That is, holding the market and credit risk exposures of market participants constant, the total dollar amounts of defaults is the same in every state in the world in cleared and bilateral markets. Clearing changes the allocation of these given dollar losses across market participants, not their magnitude, or their probability distribution.
It is possible that this re-allocation of risk can be efficiency enhancing, but that is not a given. Moreover, the fact that the EC apparently believes that CCPs somehow make counterparty risk magically disappear, it is almost certain that it has not thought seriously about the efficiency implications of this reallocation. Why think about allocation of something that you believe won’t exist due to some form of financial alchemy?
This raises very serious concerns. Read literally, the EC document implies that the Commission believes that clearing makes default risk disappear. This is wrong, wrong, wrong. It is understandable that someone operating under such a delusion would be very enthusiastic about clearing. It should also be understood, however, that the enthusiasm of someone operating under a delusion is very, very dangerous.
The foregoing analysis assumed that positions would be the same in cleared and bilateral regimes. However, the adoption of central clearing will almost certainly affect the sizes of positions that market participants take. This, in turn, will affect overall default risks, and the allocation of these risks. Indeed, given that clearing involves the mutualization (i.e., socialization) of risk, there is the distinct possibility that the effect of these changed positions will be to increase total default exposures; mutualization means moral hazard, and moral hazard tends to encourage risk taking. Although CCPs can control this risk taking through margins, this is costly. I have pointed out in my academic work that clearing can lead to increased overall risk exposures for other reasons as well. Not that you would know this from reading what the EC–or any American official–has said on the subject.
Nor would you know that under certain types of structures, default losses borne by systemically important institutions can be higher under clearing because under these structures, CCP members guarantee customer trades, whereas in a bilateral market customer counterparties of a defaulting firm suffer default losses. This is part of the allocational aspect of clearing, and means that systemically important institutions that backstop CCPs can actually suffer greater default losses in a cleared market than they would absent clearing.
I must say again: the case for forcing changes in market structure, most notably forcing adoption of clearing through either carrots (differential margin and capital charges) or sticks (mandates) has not been made. Not in the least. The key issues have not even been raised, let alone addressed. The informational challenges that clearing poses have been assumed away. Policies based on ignoring core issues do not inspire confidence, to say the least.
Sad to say, the Olympian, arrogant, government-knows-best attitude embodied in the EC paper is also manifest in the pronouncements of US regulators. Most notably, Gary Gensler of the CFTC has come out in favor of trying to force virtually all trading onto exchanges and clearing. And none of the arguments he makes in support of this view–none–grapple with the fundamental informational issues.
Unless and until those advocating a radical restructuring of the financial infrastructure, complete with implicit and explicit government pricing of counterparty risk, acknowledge and address the informational and incentive challenges associated with such a change, there can be no confidence that the change will be a beneficial one. Indeed, given the sorry experience with centralized, hierarchical, regulatory price setting mechanisms in environments where information is private and diffuse, the odds favor the opposite result.
When make cartoon arguments for clearing (and for exchange trading), I have a sinking suspicion that the results will be anything but funny.
By all appearances, both the US and Europe are on the fast track to a complete restructuring of the financial system based on a shockingly incomplete understanding of the true trade-offs. In so doing, we are laying the groundwork for the next crisis, and a loss of efficiency until that crisis materializes. Heaven help us.