Streetwise Professor

April 29, 2016

Rounding Up the Usual Suspects, With Chinese Characteristics

Filed under: China,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 8:32 pm

Commodity prices on Chinese exchanges, especially for ferrous metals, have been skyrocketing in recent weeks. Rebar, iron ore and coking coal have been particularly active, but thermal coal and cotton have been jacked too.

In response, the Chinese authorities are cracking down on speculation.  Exchanges have raised margins in order to attempt to rein in trading. The government is making ominous statements about speculation and manipulation. And we know what can happen to speculators who fall afoul of the government.

Ironically, prices never appear to be just right, by the lights of the Chinese authorities. Last summer, and earlier this year, speculators were allegedly causing stock prices and commodity prices to be too low. Now they are causing commodity prices to be too high.

This is a case of the Chinese authorities playing Claude Rains in Casablanca, and ordering a roundup of the usual suspects. Speculators make convenient targets, and they appear to be the proximate cause: after all, their trades produce the rapidly rising prices.

But the speculators are merely the messengers. If the Chinese authorities want to find the real culprits, they need to look in the mirror, for the speculators are responding to the most recent lurch in Chinese economic policy.

Put simply, after the economic slowdown of the second half of 2015 (a slowdown masked by fraudulent official statistics, but evident nonetheless), the government pushed the panic button and fell back on its standard remedy: injecting a burst of credit.  Some estimates put the Chinese debt to GDP at 237 percent. Since GDP is likely also an overstated measure of national income, due to fraudulent statistics and the fact that the losses on past investments have not been recognized (in part because much of the credit is pumped  into zombie companies that should be bankrupt) this ratio understates the true burden of the debt.

The surge in credit is being extended in large part through extremely fragile and opaque shadow banking channels, but the risk is ending up on bank balance sheets. To engage in regulatory arbitrage of capital rules, banks are disguising loans as “investments” in trust companies and other non-bank intermediaries, who then turn around and lend to corporate borrowers.  Just call a loan a “receivable” and voila, no nasty non performing loan problems.

There is one very reasonable inference to draw from this palpably panicked resort to stimulus, and the fact that many companies in commodity intensive industries are in desperate financial straits and the government is loath to let them go under: today’s stimulus and the implied promise of more in the future whenever the economy stutters will increase the demand for primary commodities. The speculators are drawing this inference, and responding accordingly by bidding up the prices of steel, iron ore, and coal.

Some commentors, including some whom I respect, point out that the increase does not appear to be supported by fundamentals, because steel and coal output, and capacity utilization, appear to be flat. But the markets are forward looking, and the price rises are driven by expectations of a turnaround in these struggling sectors, rather than their current performance. Indeed, the flat performance is one of the factors that has spurred the government to action.

When the Chinese responded to the 2008-2009 crisis by engaging in a massive stimulus program, I said that they were creating a Michael Jackson economy, one that was kept going by artificial means, to the detriment of its long term health. The most recent economic slowdown has engendered a similar response. Its scale is not quite as massive as 2008-2009, but it’s just begun. Furthermore, the earlier stimulus utilized a good portion of the nation’s debt capacity, and even though smaller, the current stimulus risks exhausting that capacity and raising the risk of a banking or financial crisis. It is clear, moreover, each yuan of stimulus today generates a smaller increase in (officially measured) output. Thus, in my view, the current stimulus will only provide a temporary boost to the economy, and indeed, will only aggravate the deep underlying distortions that resulted from past attempts to control the economy. This will make the ultimate reckoning even more painful.

But the speculators realize that the stimulus will raise commodity demand for some time. They further recognize that the stimulus signals that the authorities are backsliding on their pledges to reorient the economy away from heavy industry and investment-driven growth, and this is bullish for primary materials demand going forward: the resort to credit stimulus today makes it more likely that the authorities will continue to resort to it in the future. So they are bidding up prices today based on those predictions.

In other words, as long as the Michael Jackson economy lives and stays hooked, its suppliers will profit.

So yet again, commodity markets and the speculators who trade on them are merely a lurid facade distracting attention from the underlying reality. And the reality in China is that the government cannot kick the stimulus habit. The government may scream about (and worse) the usual suspects, but it is the real cause of the dizzying rise in Chinese commodity prices, and the burst of speculation.

April 22, 2016

Schrödinger’s Clearinghouse?

Filed under: Clearing,Derivatives,Exchanges,Regulation — The Professor @ 6:31 pm

Three weeks ago I wrote about, and criticized, LSE CEO Xavier Rolet’s statement that “We can cross margin our over-the-counter clearing with their listed derivatives without merging the clearinghouses, and without comingling the risk-management framework. [Emphasis added.]”  Then three days ago I read Philip Stafford’s article in the FT stating “Deutsche Börse and LSE plan to link clearing houses“:

The two sides are working on common risk management and default frameworks for their market utilities, which risk manage billions of dollars of derivatives trades on the market every day. [Emphasis added.]

The exchanges’ long-term aim is for each customer to become a member of both the LSE-controlled LCH and Deutsche Börse’s Eurex clearing houses. The customers, which are typically banks, would agree to hand over their trading data in return for better risk management of their derivatives, according to two people familiar with the talks.

The planned London-based holding company would instruct the two clearing houses on how to proceed with a default after consultations with central banks, one of the people said. The two sides are discussing their plans with their regulators and customers, one person said.

So how do you have a “common risk management framework” without “commingling the risk-management framework”? Is there some fine verbal distinction I am missing? Or perhaps this is like Schrödinger’s CCP, in a state of quantum superposition, both commingled and uncommingled until someone opens the box.

In my post, I mentioned default management as one reason to integrate the CCPs:

Another part of the “risk management framework” is the management of defaulted positions. Separate management of the risk of components of a defaulted portfolio is highly inefficient. Indeed, part of the justification of portfolio margining is that the combined position is less risky, and that some components effectively hedge other components. Managing the risks of the components separately in the event of a default sacrifices these self-hedging features, and increases the amount of trading necessary to manage the risk of the defaulted position. Since this trading may be necessary during periods of low liquidity, economizing on the amount of trading is very beneficial.

Apparently the recent experience with the default of Maple Bank brought home the benefits of such integration:

One person familiar with the talks highlighted problems created by February’s default of Frankfurt-based bank Maple, which was a member of both exchanges’ clearing houses.

“Right now what you have is a blind process — the liquidation of positions is conducted without co-ordination,” the person said. “Therefore it has a negative price impact in the market as you have two guys running out liquidating positions in the name.”

Huh. Go figure.

“Commingling” makes sense. Coordination is vital, both in daily operations (e.g., setting margins and monitoring to reduce the risk of default) and in extremis (during a default).

Perhaps Rolet was trying to deceive regulators who are so obsessed with too big to fail (sorry, both Eurex and LCH are TBTF already!) and who are blind to the benefits of coordination. If the regulators need to be deceived thus, we are doomed, because then it would be clear they have no clue about the real issues.

One wonders if they will recognize coordination and commingling even after they look in the box. Apparently Rolet thinks not. If they do, Xavier will have a lot of ‘splainin’ to do.

April 18, 2016

Corn is Chicken Feed, But the Losses from Chinese Malinvestment Aren’t

Filed under: China,Commodities,Economics,Politics — The Professor @ 6:34 pm

The WSJ reports that China could face a $10 billion write-down on the huge corn stocks that it accumulated as part of its efforts over the past years to prop up prices for farmers. Corn is chicken feed, but $10 billion ain’t.

But I think that the moral of this story goes far beyond corn. Chinese agricultural price supports are just one example of the myriad policies that the country has adopted over recent years that distort prices and lead to misallocations of resources. Indeed, the deadweight losses from ag price supports are probably chicken feed in comparison with the waste resulting from distortions in the capital and credit markets that have led to massive malinvestment in industrial capacity (note the huge overcapacity in industries like steel), infrastructure, and housing.

Perhaps the main difference is that the corn inventories are being written down. The corn counted towards national income when it was produced, and writing down the inventories will reduce national income. Alas, the vast bulk of the malinvestments elsewhere will not be marked to market, and reported Chinese national income will be too high as a result.

What’s particularly important is that although the Chinese are apparently recognizing that their agricultural policies were inefficient, they cannot wean themselves from the credit stimulus habit. About 2 years ago I gave talks where I said China faced three alternatives, two of which were bearish for commodities: hard landing, transition to a more market-based, consumer-oriented system, or continued reliance on credit stimulus to keep measured growth high. I further opined that the latter alternative would just defer the choice between the first two for some time.

I did not venture a strong opinion on which alternative would happen, because I believed (and believe) that the choice is ultimately political, and I am in no position to predict with confidence Chinese politics. My sense was (and is), however, that sustaining the status quo was (and is) the most likely outcome. This would involve cranking up the stimulus in the face of any slowdown.

Recent experience suggests that’s the case:

China’s economy slowed further in the beginning of the year, though Beijing’s policies to revive growth with old-style tools such as lending and construction appeared to gain traction in March.

China’s gross domestic product expanded by 6.7% year-over-year in the first quarter, down from a 6.8% gain in the previous quarter, the National Bureau of Statistics said Friday. The figure, the slowest quarterly growth for China since the height of the financial crisis in 2009, was in line with forecasts.

In the past month, some confidence has returned to the world’s second-largest economy, fueled in part by sharp property-price rises in China’s major cities as well as some lessening of currency volatility and capital outflows that spilled over onto global markets last year and early in 2016. In March, China’s foreign-exchange reserves grew for the first time in five months.

Friday’s data release provided signs that a host of stimulus measures put in place over the past 15 months are having some impact—or are at least delivering some short-term gains. Industrial output, retail sales and property investment rose more than expected in March after a weak performance in January and February. Fixed-asset investment also improved.

And lending soared. Chinese financial institutions issued 1.37 trillion yuan ($211.3 billion) in new yuan loans in March, rocketing well past economists’ expectations of around 1.1 trillion yuan, and almost twice February’s volume.

This means more new malinvestment, and more papering over (with credit) the write down (and hence recognition) of past malinvestments.

This credit splurge helps explain the commodities rebound in recent months. But it also shows how tenuous the foundations of that rebound are. It is an artifact of artificially stimulated investment. Eventually, inevitably, the accumulated waste and distortions will bring the entire Chinese economy to a shuddering halt, and perhaps a crash. Eventually the accumulation of distortions becomes so great that a shakeout and rationalization is necessary, and inevitable. China is at best delaying the reckoning.

Corn is a small part of a much bigger picture. But it is a revealing part. It shows how perverse pricing policies lead to inefficient accumulations of capital that eventually become worth far less than the amount invested. Corn is relatively easy to value, and the cost of the malinvestment in corn stocks looks to be about $10 billion. When one considers how many other wasteful investments have been made in China as a result  of its interventionist policies, and the imagination staggers at what the losses would be.

Put differently, China’s performance would look far less stellar if national income accounting was accurate, and realistically marked its past investments to market. Of course, it is this very fact that induces the Chinese authorities to use every trick in the book to prevent that from happening. But there will come a day, because losses this large cannot be concealed forever.

April 13, 2016

You Can’t Handle the Truth! Censoring Politically Inconvenient Research at the CFTC

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 2:29 pm

I had missed that the CFTC’s Office of the Inspector General had found that the Office of the Chief Economist had “prohibited relevant but potentially controversial research” on position limits. According to the OIG, during a routine interview with a CFTC staff economist, without being asked, the economist told the OIG that s/he had been prevented from doing research on position limits. According to the OIG, “several OCE economists identified position limits as an example of a topic on which economic research is no longer permitted.” One said: ”you can’t write a report on something that destroys three years of (CFTC) work.”

The basic conclusion is damning:

Several other economists confirmed their impression that OCE is now censoring research topics that might conflict with the official positions ofthe CFTC. Some ofthis censorship occurs on the part ofindividual staffeconomists themselves-when selecting potential topics, they now choose non-controversial ones. However, multiple OCE economists also reported that the Chief Economist has declined to permit research on certain topics relevant to the CFTC mission, including position limits.

Some OCE economists expressed uncertainty as to the purpose of OCE’s research program if the Office is prevented from studying topics relevant to current CFTC rulemaking. Yet OCE economists reported that the Chief Economist has rejected or delayed research paper topic ideas if tey were related to pending rulemaking or could challenge the validity of agency regulations. One OCE economist described the policymaking process as one in which a decision is made and then analysis is done in a fashion designed to support the decision. There is a perception within OCE that the ChiefEconomist is “more Commission-friendly,” and that he discourages research that might offend Commissioners.

During “multiple” discussions with the OIG, the Chief Economist at first admitted that this was so, then backtracked:

He agreed that he had initially rejected a research proposal on position limits on the basis that it was politically controversial. The Chief Economist later stated his belief that the CFTC did not have the data or the in-house expertise to do this project in any event. The Chief Economist explained that this was a matter of discretion, and that he did in fact permit research into politically controversial topics. He provided an example ofresearch into high-frequency trading and instances ofself-trading. When asked, the Chief Economist agreed that the Chairman actively supported this line ofresearch. The Chief Economist also stated that he wanted to be able to take to the Chairman and Commissioners anything he or OCE did.


Chairman Massad has recently rejected the OIG’s conclusion, the statements of multiple staff economists, and the initial gaffe (i.e., truth telling) by the Chief Economist. It wasn’t politics, you see. It was priorities:

“Our Office of the Chief Economist has many excellent economists, the morale there is very good and the work they produce is very good. They often produce things that might conflict with the views I have and the views other commissioners have, but we don’t have any kind of political screen on what we do,” said Massad, testifying before the Senate Committee on Appropriations on April 12.

“We do have, however, priority setting. It’s a small division and we must set priorities. We can’t always have a staff person just do the research they would like to do, as opposed to research we really need to focus on. That’s the only way in which we focus their work,” he added.

To state the obvious: priorities are inherently political. The statement about priorities therefore does not refute the belief of the staff economists that the decision to forbid research on position limits was ultimately political.

Chairman Massad’s assertion also is flatly inconsistent with the opinions expressed by multiple individuals, including his own Chief Economist (before he got his mind right, anyways). Thus, there is certainly a widespread perception in the OCE that permissible research means politically correct research. Either this perception is correct, or Chairman Massad has done a poor job of communicating to the economists the criteria by which research resources are allocated.

In a Washington where everything is politicized, and in particular where Senator Elizabeth Warren clearly attempts to censor those expressing dissenting opinions, and attempts to intimidate and slander those who dare to express such opinions, it is utterly plausible that the economists’ perceptions are very well grounded in reality. I view the economists’ complaint as facially valid, but potentially rebuttable. Mr. Massad’s testimony does not even come close to rebutting their assertions. Indeed, knowing how to decode words like “priorities” from GovSpeak, if anything his testimony buttresses the complaint, rather than rebuts it.

But let me suspend disbelief for a moment, and take Chairman Massad at his word. Just what does that imply?

First, it implies that a position limits initiative that would impose substantial burdens on the industry is of insufficient importance to justify a researcher or two to spend a portion of their time to study. Not to denigrate the value of the economists’ time, but in the scheme of things this does not represent a huge expenditure of resources. If position limits are of that little importance, what is the potential benefit of the regulation? Why does the Commission persist in pushing it if it is not even worth the time of a few staff economists?

Second, what does this say about the Commission’s commitment to carrying out its statutory obligation to conduct a cost-benefit analysis of the regulation?

Third, and relatedly, if the Chief Economist is correct and his staff does not possess “the data or the in-house expertise to do this project” how would it even be possible for the OCE, and the Commission, to perform a valid cost-benefit analysis? In particular, since the proposed research appears to speak to the issue of the benefits and necessity of limits, how can the Commission generally, and Chairman Massad in particular, credibly claim that they have determined that limits offer sufficient benefit to make them necessary, or to exceed their cost, if its own Chief Economist claims that his office has neither the data nor the expertise to perform valid research on the effects of limits?

Position limits have been a political project from Day 1. They remain a political project, as Senator Warren’s recent jeremiad (directed substantially at yours truly) demonstrates. The economic case for them remains dubious at best. Given this history and this context, the assertion that prohibiting CFTC staff economists from researching the issue was politically motivated is all too plausible.

The Risk article that I linked to quotes Gerry Gay, who was Chief Economist under Wendy Gramm in the Bush I administration. Gerry notes that prior to 1993, economics and economists had pride of place within the CFTC. It was viewed as “an economist’s shop.”

That is a fair statement. What happened in 1993? The Clinton administration took over, and (as Gerry notes) de-emphasized economics. I remember distinctly an article in Futures Magazine that solicited the opinion of many industry figures as to the changes the new administration would bring. Ex-CFTC Commissioner Philip McBride Johnson’s statement sticks in my mind. This is almost an exact quote, though it is from memory: “We can now get rid of the economists and put the lawyers back in charge.”

That’s exactly what happened then, and with a few exceptions during the Bush II years, has remained true ever since. Just as Clemenceau said that war is too important to be left to the generals, the DC set established that regulating the markets is too important to be left to the economists. What’s more, particularly in the Obama administration, starting with Gensler’s tenure as head of the Commission, it was determined that certain kinds of lawyers had to be in charge, and they had to follow marching orders from politicians. Do not forget that Gensler was only able to overcome skepticism about his Goldman background by pledging fealty to the Democratic senators on the relevant committees, and to their agenda. Truly independent regulators get crushed. (Remember the fate of FCC head Tom Wheeler when he strayed just a little bit off the party line on net neutrality?)

Keep that in mind when attempting to determine the true story of the disapproved research on position limits. It has been determined that you can’t handle the truth.

Update: Note well that the CFTC economists’ concerns about acceptable research extend beyond position limits. It is clear that several believe that policy-relevant research is discouraged, at least if it could contradict existing or pending regulations. If that’s in fact true, it would be fair to ask why the hell the CFTC has economists anyways. Economics has a vital role in informing policy on markets. The economists could pay their lifetime salaries many times over by stopping or correcting one misguided regulation, or even one misguided piece of a broader regulation. (I recall a quote from Coase that an economist could pay for his lifetime salary by just delaying a bad regulation a day.) The only real reason to have economists at the CFTC or any agency is to provide critical evaluation of pending or existing rules and regulations. It is beyond absurd to preclude economists from working on exactly those things, when they could upset some politically-driven regulation.

April 10, 2016

What Happens in Panama Doesn’t Stay in Panama, Apparently

Filed under: Politics,Russia — The Professor @ 9:01 am

The media has been aflutter during the last week over the Panama Papers. Much of the excitement has focused on Putin’s presence-or lack thereof, actually-in the Biggest Leak Ever.

My reaction: BFD.

Insofar as what about Russia is actually in the leak: can you honestly say that it provided you with any new information? Hardly. Offshoring of dirty Russian money has been a thing since the USSR collapsed. Before, actually. Putin has actually made an issue of it. To the extent that the leak reveals anything, it shows the hypocrisy and political nature of Putin’s anti-offshoring drive. The politically favored can still do this, although with the knowledge that the Sword of Damocles hangs over their heads. If favor turns into disfavor, the offshoring can be used to destroy them.

At most, the leaks regarding Russia provide some interesting information as to how the offshoring works in practice. But this mere detail which provides no new insight on the nature of the Russian system.

The hypocrisy is also evident in China, where family members of anti-corruption crusader CCP General Secretary Xi Jinxing have been disclosed to have offshore shell corporations. But again, the hypocrisy should not be a surprise. As has been the case with autocrats since time immemorial, Xi’s anti-corruption drive has been more of a means of extending his power and control, than an idealistic effort to clean up China’s government and economy.

Insofar as Putin is concerned personally, why would anyone expect his name to be on any document detailing ownership of anything? Do you think he’s that stupid?

For all the hyperventilating by Bill Browder and others of Putin’s alleged massive fortune (which Browder puts at $200 billion), a little common sense is sufficient to discount these stories. Actually formally/legally owning things provides little benefit to Putin, but poses risks. It is all downside, with no upside.

If evidence of such a massive fortune was uncovered, it would be an embarrassment, or worse, for Putin: his very pretense of being a servant of the people who earns a very modest salary demonstrates that he believes that being revealed definitively as a plutocrat (rather than merely an autocrat) would be dangerous for him politically.

And what does he gain by having his name on some legal papers documenting ownership of vast amounts of wealth? Absolutely nothing. In this current role, he has practical ownership of pretty much everything in Russia. That is, if you view ownership as a bundle of rights to use assets, Putin has ownership, regardless of whether his name is on pieces of paper or not. If he wants use of this asset or that, who is going to deny his request? Further, there are myriad ways that he can use the power of the Russian state to direct wealth to those he favors (e.g., through massively corrupt contracting practices for projects like Sochi, or through Gazprom), who in turn direct some of that to people or purposes that Putin requests. And all of this can be done with Putin not having formal legal ownership of anything.

Furthermore, Putin realizes that formal ownership would not secure him a quiet retirement of opulent luxury. His informal ownership rights exist only so long as he is in power, and as soon as he is out of power any formal ownership rights over vast assets would be too tempting a target for his successor to resist. He could never enjoy the benefits of such wealth when out of power, and doesn’t need it when in it. So what’s the point?

So I would put a different spin on it: the very absence of Putin’s name in the Panama Papers is exactly what is informative. It reveals that he is not leaving power in a vertical posture, of his own volition, because when he does, his practical ownership rights evaporate with his power. This also makes it plain why he is doing things to secure domestic control in advance of the 2017 Duma election and the 2018 presidential “contest”. The creation of a National Guard under his personal control, for instance.

As to speculation regarding who leaked and why: meh. These parlor games bore me, and are essentially forms of ad hominem argument that have no bearing on the truth or falsity of the information.

The claims by Russian authorities (including Putin personally) and Julian Assange (who first praised the leak then turned on it) that it is a CIA/State Department/Soros plot to undermine Putin and Russia are implausible. If anything, the leak was very helpful to Putin. By far the biggest casualty of the leak has been Ukrainian president Poroshenko, who was revealed to have been negotiating moving his assets overseas at the same time his army was being slaughtered in the Donbas. The already divided and shaky Ukrainian polity has become even more so as a result of the revelations, and this redounds to Putin’s benefit. Most of the other casualties have been western democratic politicians, notably David Cameron. In other words, if this was a CIA/State Department plot, it was an epic miscalculation.

Following this cui bono logic, others have swung to the opposite extreme. Most notably, Brooking’s Clifford Gaddy mooted that since Putin has benefited, this may be a Russian operation. I agree that despite the initial frenzy Putin has been a beneficiary, but believe that it is far more likely that it is just another episode in his recent streak of good luck.

As for the ethics of the leak, and how the material has been handled, the entire episode points out the ambiguities and dilemmas of this means of holding public officials and private individuals accountable. Unlike Wikileaks, the entire set of material is under control of a set of journalists and publications, and is not open for search by the public. This creates the potential for manipulative select disclosure. This is problematic, and this very possibility also creates a narrative that can be used to discredit the entire project. But since innocent private individuals’ information is also in the database, open access would impose huge collateral damage. The choice is binary (selective disclosure controlled by a group of self-selected gatekeepers who may have an agenda, or open access), and the severe downsides to either alternative call into question the utility of leaking as a means of revealing (and perhaps punishing) misconduct by government officials, or private individuals.

It also shows the costs of privacy and transparency, which highlights a fault line in the current debate. In that debate, Privacy and Transparency are both praised as ideals even though they are obviously in substantial tension. What information should be private and what should be transparent, and whose information should be private, whose information should be transparent, and who should make these choices are extremely difficult questions. Even if one can identify the ideal boundaries in the abstract, respecting them in practice is devilish hard. The Panama Papers case reveals that in spades.




April 4, 2016

Barbarian at the Gate, Exchange Edition

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 11:04 am

ICE’s Jeffrey Sprecher has a way of getting inside the heads of his competitors. He is obviously in the head of LSE CEO Xavier Rolet, before he’s even formally announced a rival offer for the LSE:

The boss of the London Stock Exchange has dismissed the owner of the New York Stock Exchange as a “slash and burn” organisation which would throw parts of the British bourse “in the bin”.

. . . .

He branded ICE’s ownership of Euronext, the pan-European exchange, as a “disaster,” claiming it had “eviscerated” the four-country exchange platform for cost-cutting.

Mr Rolet, who acknowledged that the LSE’s board would consider any “serious proposal,” made clear that he is not interested in a bid from an “interloper”.

“I don’t want just anyone, particularly not some ‘slash and burn’ type  organisation, to come in and kill all of the stuff we’ve done over the last few years,” he said.

“It is not a company based in Atlanta… that is going to worry about the financing of European industry… It’s just not going to be part of their strategy.

“Which is why they chucked out Euronext. They kept the clearing business that they had, and they kept the derivatives engine. And that is not a strategy for British industry. I doubt that this [Aim] would be part of the strategy of any frankly global exchange…Our 1000 Companies programme, that costs money. Our Elite programme, that costs money. All that stuff would be chucked in the bin.”

Rolet sounds like the typical 1980s CEO quaking in fear of a hostile takeover, fussing over every little piece of the empire he built. Which is exactly why everything about Sprecher that Rolet condemns as a bug is a feature.

ICE has an excellent record at making acquisitions work. A crucial reason for that is that Sprecher focuses ruthlessly on value and value creation, and doesn’t have sentimental attachments to particular businesses, especially those that are inefficient and bloated, and which don’t fit strategically within the organization he has built.

He recognized that Euronext was an excessively costly firm in a low margin commoditized business that didn’t offer any synergies to his core derivatives business. So he acquired EuronextLiffe, put Euronext on a diet, and spun it off for a decent price. He kept LIFFE and Euronext’s clearing business and integrated them into the ICE structure in a way that should make other acquirers (I’m looking at you, UAL!) green with envy.

As for sentimental musings about “financing European industry”, if it is so valuable, it would pay. If it doesn’t pay, it’s not valuable. No evident externalities here, and if there are, it’s fantasy to believe that any individual company will be able to internalize it.

As for programs that “cost money”: the question is if they generate an adequate return on that investment. If Aim, or the 1000 Companies program, or the Elite program don’t generate a compensatory return, they deserve to be binned or restructured. If they can earn a compensatory return, believe me, Sprecher won’t bin them. Rolet’s lament bears all the signs of a man who is personally invested in pet projects that he knows don’t pass the value creation test.

Rolet, in other words, sees Sprecher as a latter day Barbarian at the Gates. But if you give it even a superficial look, it is evident that by every measure ICE has been singularly successful at creating value in a very dynamic and competitive exchange and clearing space. If Jeff Sprecher is a barbarian, then civilized CEOs are vastly overrated. Give me the barbarians any day.

April 2, 2016

The Rube Goldberg Approach to Integrating CCPs: A Recipe for Disaster

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 12:38 pm

As noted in earlier posts (and by others commenting on the proposed Eurex-LSE merger) the main potential benefit to exchange customers* is the capital and margin savings from netting efficiencies between Eurex futures and LCH swaps. However, regulators and others have expressed concerns that the downside is the creation of an bigger too big to fail clearing entity. A couple of weeks back Silla Brush and John Detrixhe reported that the merger partners are trying to square that circle by cross-margining, but not merging the CCPs:

LCH.Clearnet and Eurex held 150 billion euros ($169.5 billion) of collateral on behalf of their members as of Dec. 31, according to the merger statement. The London-based clearer is developing a system that allows traders to offset their swap positions at LCH.Clearnet with their futures holdings at Eurex. The project, which works even though the two clearinghouses are separate, should enable customers to reduce the total amount of collateral they must set aside.

“We can cross margin our over-the-counter clearing with their listed derivatives without merging the clearinghouses, and without comingling the risk-management framework,” LSE Group CEO Xavier Rolet said in a Bloomberg Television interview on Wednesday. Rolet will step aside if the companies complete their merger.

The devil will clearly be in the details, and I am skeptical, not to say suspicious. In order for the separate but comingled system to work, Eurex’s CCP must have a claim on collateral held by LCH (and vice versa) so that deficiencies in a defaulter’s margin account on Eurex can be covered by excess at LCH (and vice versa). (As an illustration of the basic concept, Lehman had five different collateral pools at CME Clearing–interest rate, equity, FX, commodities, energy. There were deficiencies in two of these, but CME used collateral from the other three to cover them. As a result there was no hit to the default fund.)

How this will work legally is by no means evident, especially inasmuch as this will be a deal across jurisdictions (which could become even more fraught if Brexit occurs). Further, what happens in the event that one of the separate CCPs itself becomes insolvent? I can imagine a situation (unlikely, but possible)  in which CCP A is insolvent due to multiple defaults, but the margin account at A for one of the defaulters has excess funds while its margin account at CCP is deficient. Would it really be possible for B to access the defaulter’s collateral at bankrupt CCP A? Maybe, but I am certain that this question would be answered only after a nasty, and likely protracted, legal battle.

The fact that the CCPs are going to be legally separate entities suggests their default funds will be as well, and that they will be separately capitalized, meaning that the equity of one CCP will not be part of the default waterfall of the other. This increases the odds that one of the CCPs will exhaust its resources and become insolvent. That is, the probability that one of the separate CCPs will become insolvent exceeds the probability that a truly merged one would become so. Since even the separate CCPs would be huge and systemically important, it is not obvious that this is a superior outcome.

I am also mystified by what Rolet meant by “without comingling the risk management framework.” “Risk management framework” involves several pieces. One is the evaluation of market and credit risk, and the determination of the margin on the portfolio. Does Rolet mean that each CCP will make an independent determination of the margin it will charge for the positions held on it, but do so in a way that takes into account the offsetting risks at the position held at the other CCP? Wouldn’t that at least require sharing position information across CCPs? And couldn’t it result in arbitrary and perhaps incoherent determinations of margins if the CCPs use different models? (As a simple example, will the CCPs use different correlation assumptions?) Wouldn’t this have an effect on where firms place their trades? Couldn’t that lead to a perverse competition between the two CCPs?+ It seems much more sensible to have a unified risk model across the CCPs since they are assigning a single margin to a portfolio that includes positions on both CCPs.

Another part of the “risk management framework” is the management of defaulted positions. Separate management of the risk of components of a defaulted portfolio is highly inefficient. Indeed, part of the justification of portfolio margining is that the combined position is less risky, and that some components effectively hedge other components. Managing the risks of the components separately in the event of a default sacrifices these self-hedging features, and increases the amount of trading necessary to manage the risk of the defaulted position. Since this trading may be necessary during periods of low liquidity, economizing on the amount of trading is very beneficial.

In other words, co-mingling risk management is a very good idea if you are going to cross margin.

It seems that Eurex and LSE are attempting to come up with a clever way to work around regulators’ TBTF neuroses. But it is not clear how this workaround will perform in practice. Moreover, it seems to sacrifice many of the benefits of a merged CCP, while creating ambiguities and legal risks. It also will inevitably be more complex than simply merging the two CCPs. Such complexity creates systemic risks.

One way to put this is that if the two CCPs are legally separate entities, under separate managements, relations between them (including the arrangements necessary for cross margining and default management) will be governed by contract. Contracts are inevitably incomplete. There will be unanticipated contingencies, and/or contingencies that are anticipated but not addressed in the contract. When these contingencies occur in practice, there is a potential for conflict, disagreement, and rent seeking.

In the case of CCPs, the relevant contingencies not specified in the contract will most likely occur during a default, and likely during stressed market conditions. This is exactly the wrong time to have a dispute, and failure to come to a speedy resolution of how to deal with the contingency could be systemically catastrophic.

One advantage of ownership/integration is that it mitigates contractual incompleteness problems. Managers/owners have the authority to respond unilaterally to contingencies. As Williamson pointed out long ago, efficient “selective intervention” is problematic, but in the CCP context, the benefits of managerial fiat and selective intervention seem to far outweigh the costs.

I have argued that the need to coordinate during crises was one justification for the integration of trade execution and clearing. The argument applies with even greater force for the integration of CCPs that cooperate in some ways (e.g., through portfolio margining).

In sum, coordination of LCH and Eurex clearing through contract, rather than through merger into a single entity is a highly dubious way of addressing regulators’ concerns about CCPs being TBTF. The separate entities are already TBTF. The probability that one defaults if they are separate is bigger than the probability that the merged entity defaults, and the chaos conditional on default, or the measures necessary to prevent default, probably wouldn’t be that much greater for the merged entity: this means that reducing the probability of default is desirable, rather than reducing the size of the entity conditional on default. Furthermore, the contract between the two entities will inevitably be incomplete, and the gaps will be discovered, and extremely difficult to fill in-, during a crisis. This is exactly when a coordination failure would be most damaging, and when it would be most likely to occur.

Thus, in my view full integration dominates some Rube Goldberg-esque attempt to bolt LCH and Eurex clearing together by contract. The TBTF bridge was crossed long ago, for both CCPs. The complexity and potential for coordination failure between separate but not really organizations joined by contract would create more systemic risks than increasing size would. A coordination failure between two TBTF entities is not a happy thought.

Therefore, if regulators believe that the incremental systemic risk resulting from a full merger of LCH and Eurex clearing outweighs the benefits of the combination, they should torpedo the merger rather than allowing LSE and Eurex to construct some baroque contractual workaround.

*I say customers specifically, because it is not clear that the total benefits (including all affect parties) from cross margining, netting, etc., are positive. This is due to the distributive effects of these measures. They tend to ensure that derivatives counterparties get paid a higher fraction of their claims in the event of a default, but this is because they shift some of the losses to others with claims on the defaulter.

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