Streetwise Professor

December 15, 2013

Frankendodd Shifts Risk Around, Rather Than Making It Disappear! Who Knew?

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 5:20 pm

According to one of my industry contacts, this article in the Fiscal Times has “created a lot of unwanted buzz” in DC.  Because our betters find it so very inconvenient when reality intrudes on their fantasies.

The article focuses on the clearing mandate.  It points out that the main effect of the mandate is to shift risk around, and concentrate it in CCPs.  The risk doesn’t go away.  It moves.

Let me think.  Who was pointing this out five years ago?  Modesty prevents me from naming names.

Clearing was sold-most notably by my bêtes noire Geithner and Gensler*-as a magic box that made counterparty risk disappear.  This was a false claim, and arguably a dishonest one.  I find it hard to believe that Gensler, for instance, really believed what he said.  And the alternatives are ugly.  He (and other advocates of the clearing mandate) either made arguments he (they) knew to be untrue, or was (were) utterly ignorant of the implications of the policies that he (they) was (were) implementing and supporting.  Choices: (A) Idiot. (B) Liar. (C) There is no choice (C).

In reality, clearing mainly shifts around counterparty risk, and creates new risks, most notably liquidity risks.

All of these things were foreseeable, and foreseen-by some. Who were ignored, and at times reviled.

Why did this happen? It seems to me that in the heated days of the crisis, there was a desperation to find a solution.  For a variety of reasons, most notably the fact that the major cleared markets dealt with the Lehman situation without much problem, policymakers seized on clearing as the panacea.  And once they had done that, getting the clearing mandate passed became an end in itself.  The decision had been made, all doubts had to be suppressed.

But where does that leave us? With the growing recognition that the alleged panacea was nothing of the sort.  With the creeping recognition that the mandate has created a new set of risks.  A new set of potential sources of systemic instability.  So now policymakers are scrambling to address and to mitigate these problems.

It would have been so much better had these problems been anticipated, in advance, and the law drafted accordingly.

This is not Monday morning quarterbacking. I and others anticipated these problems at noon on Sunday.  But we were left on the sidelines, while the geniuses called and ran the plays. We are going to be dealing with the consequences of that for years to come.

*One blessedly departed from government “service”, and the other blessedly about to do so.

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  1. Professor, leaving aside for a moment the rest of the issues raised by you, I’d like to zero-in on your argument of the creation of liquidity risk.
    I absolutely share this observation with you. The emergence of liquidity risk makes markets more complex and imposes paradigm shift imperatives. If in the past people have more or less successfully could deal with the management of price risk, now as a result of the magnification of the liquidity risk volumetric risk has become a major issue – especially in an automated trading environment.

    All a trader has control over is what orders he sends for execution. As a result, until the orders are filled, under the best case scenario he has an estimate of the expected value of the anticipated portfolio. Now that liquidity is far from being perfect, that expected value depends not only on the price dynamics, but also on how the orders are filled or not filled, or what I would call the Liquidity Defect. If he sends and order of Fill or Kill type, he risks not having the order filled at all – not an uncommon thing in our days. If he allows partial filling, he has no handle over the expected value of his portfolio as hedging volumetric risk is harder than that of price risk.

    Now, a more mature trader should be cognizant of both volumetric/liquidity and price risk. An HFT and UHFT trader perhaps can reduce the price risk in his portfolio by constantly getting in and out until the price dynamics has substantially changed the value of his portfolio (except the market is in a crash mode, of course, when even the HFT and UHFT trader may stop being able to manage the price risk from some point on). But unless there is a significant HFT and UHFT activity, even the latter would be exposed to volumetric risk. Basically, the system may enter an unstable mode and small perturbation of the system may induce large deviations in the parameters of portfolio – not something that we have not observed.

    Furthermore, when the liquidity risk grows it affects the relevant covariance matrixes which start converging to degenerate states, i.e. they tend to becoming non-positive definite. That introduces the likelihood of generation of shock waves in the market, i.e. wave-phenomenon with a finite-time blowup of wave fronts – we know of this phenomenon from aerodynamics.

    All this means that the very fundamental assumptions on the theory of quantitative finance and the underlying stochastic equations need to be revisited as they are too simplistic to remain descriptive.

    Under the stated circumstances the price dynamics alone doesn’t define the state of the system. The whole concept of the efficiency of markets if it was not so before now becomes just an academic exercise. This situation also demonstrates what a BS all the jump-diffusion or fat-tail distribution theories are – they do not explain the basic liquidity driven phenomenon and are implemented just because the “light under that pole is better.”

    But I think a positive can be found in this as well. The failure of the traditional quantitative finance and financial engineering framework to remain descriptive may make the market participants more receptive towards its upgrade. Surely, being a multibillion dollar conservative industry with a huge inertia it will resist any upgrade for as long as it can. But I think there is no path leading back to where the markets were 4-5 years ago and the necessity will force the industry to revisit its paradigms.

    Comment by MJ — December 16, 2013 @ 1:39 am

  2. As well as creating new risks it also extends both these and the old ones into asset classes previously not affected by them: commodities, most obviously.

    It is impossible to think of any commodity player whose abrupt demise would imperil even the markets it plays in, much less the global economy. Metallgesellschaft fell over and the world survived; ditto Enron; ditto Amaranth. Yet all these players and their industries are now drawn into and exposed to the same CCP risk as that faced by players as significant as Lehman.

    Nice moves by the great and the good there.

    Putting yourself forward as a suitable person to drive financial regulation when you are not intellectually up to it seems to me to be on a par, morally, with putting yourself up to drive everyone home from the party when you are even more inebriated than they are.

    Comment by Green as Grass — December 16, 2013 @ 6:37 am

  3. What we are talking about here, and what our overlords fail to note, is that at some point there is a law of conservation as to risk: once incurred, it can be changed but not eliminated.

    I would propose a second law in honor of Milton Friedman’s comment that there is no problem that the Federal Government cannot make worse:

    Almost every attempt to channel risk into regulated markets makes it worse than it was otherwise, particularly when the law was authored by two corrupt and now departed (but alas not dead) political hacks. This is further compounded when it gives latitude to innumerate regulators who are torn between doing SOMETHING to keeping their “phony baloney jobs” (courtesy of Mel Brooks’ Gov. LePtomaine), hiding under their desks until retirement and promoting jobs for themselves in the industries they nominally regulate.

    I agree With Green as grass’ comments as to intellectual inadequacy, but don’t underestimate the mind set of many people drawn to regulation: being power-mad, risk adverse and lazy. This will cripple the brightest.

    Comment by sotos — December 16, 2013 @ 11:30 am

  4. Frankendodd. I like it! Thanks.

    Comment by SamuelCyrus — December 16, 2013 @ 9:45 pm

  5. @SamuelCyrus. Thanks. I’ve been using that for almost 4 years now. As I say, like the Mary Shelley character, Frankendodd is a monster that has escaped the control of its creator, and is now roaming the world, wreaking havoc.

    The ProfessorComment by The Professor — December 16, 2013 @ 10:34 pm

  6. SWP, care to make a prediction on the coming derivative exchange battle in Europe?

    Comment by scott — December 17, 2013 @ 11:48 am

  7. @scott. Thanks for that. I’d missed it. Well, it’s a reprise of WWII, Germany vs. UK, with one twist: US on the side of the Germans this time around. I can’t say that handicapping EU politics and regulatory machinations is my comparative advantage, but if you made me place a wager, I’d bet on the silo surviving.

    The ProfessorComment by The Professor — December 17, 2013 @ 12:22 pm

  8. love how they are going after hedge funds. It’s exactly what some warned about. that they would go after accounts that were deemed by somebody somewhere to be too risky and could destabilize the entire market.

    Frankendodd did less then the Sarbox legislation. Both are bad.

    Comment by Jeff — December 17, 2013 @ 3:59 pm

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