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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  1. For me clearing was always trading credit risk for more liquidity risk. Am I making a mistake in my thinking here or regulators are missing liquidity issue completely?
    My position in more detail here:

    Comment by Tomas — September 9, 2014 @ 2:13 am

  2. I believe the link in a comment had the comment deleted, however I would still appreciate a comment on tradeoffs between credit risk and liquidity risk in clearing. Thanks.

    Comment by Tomas — September 9, 2014 @ 5:38 am

  3. The arrogance of Gensler (and Massad) maybe the saving grace. The lack of international cooperation on CCPs will keep the derivative industry footloose, arb different jurisdictions, and stay alive. THe whole FrankenDodd/EMIR circus is a big pile of sh**, but rather than waiting for a shovel from Massad to clean it up, bureacratic infighting is better from a practical standpoint.

    Comment by scott — September 9, 2014 @ 11:46 am

  4. @scott – i hope you are right, but sometimes the tendency regulators degenerates to _ just don’t stand there, doe something” and the result is a complete mess and or another demonstration of the law of unintended consequences. I think the Perfesser’s point really is that we don’t like admitting that risk exists: a lot of the efforts suffer from the waterbed effect, suppress it here and it goes up somewhere else. On of Schumpeter’s points was that a relatively free market (one where what is not forbidden is permitted) will always develop ways around artificial restrictions. In this he was talking about credit, but it applies to the clearing process equally.

    Comment by Sotos — September 9, 2014 @ 1:15 pm

  5. @Tomas-Your earlier comment was caught in my spam filter. I’ve freed it.

    I view it as a trade-off between a redistribution of credit risk vs. more liquidity risk. Basically clearing reduces credit exposure in derivatives, but this does not reduce credit exposures overall, necessarily. Derivatives counterparties get promoted in the bankruptcy queue, but others get shoved to the back. The credit risk of some goes down, but the risk of others goes up.

    The nature of clearing does increase liquidity risk, unambiguously.

    Since most financial crises are at root liquidity crises, this is precisely why I am extremely dubious that clearing mandates reduce systemic risk.

    The ProfessorComment by The Professor — September 9, 2014 @ 5:47 pm

  6. @Tomas-I read your post. It’s good, and I agree that liquidity is the main issue.

    I just published an article in J. Financial Infrastructure on clearing and systemic risk. I focus on the liquidity issue.

    I will put up a link to the article.

    I have written about this issue over the years here on SWP. It should be getting much more attention from regulators than it does. They are focused on the credit issue, and get that wrong. They too often neglect altogether the liquidity demands that clearing creates, and the risks that poses.

    The ProfessorComment by The Professor — September 9, 2014 @ 10:27 pm

  7. Thank you for the coment. Looking forward for the link.

    Comment by Tomas — September 10, 2014 @ 12:42 am

  8. @Tomas. Liquidity risk is an effective risk-transfer channel associated with customized OTC derivatives . An end-user of a derivative, clearly values lower basis risk (with its customized geography and time components) to the higher liquidity risk inherent in it. Many corporate clients do not care about liquidity (typically only buyers), and the clearing mandate now forces them into plain vanilla contracts (with lower liquidity risk), or worse may not allow even regular futures (ie gas hedges for power price exposure), or prohibited all together from trading as “special entities”- (munis for example). In my view, the increase of systematic risk from the clearing mandate, and transmorgification of credit risk- outlined by SWP- has less impact than Soto’s waterbed effect of decimating the OTC industry all together. Recall that clearing houses originally arouse (in a schumpeter/hayekian way) from decentralized OTC trading, not the other way around. Dark, opaque and scary (ohhh) OTC trading did not arise from formal centralized futures trading- going rogue. That is completely backwards, and how most of the discussion around CCPs takes place. Instead OTC trading is the dog, and the tail is centralized futures trading- as a lower cost avenue for high volume trading (low liquidity risk). It is easy for regulators to measure futures contracts, and impossible for them to measure all the private transactions taking place in the economy. IMO, the impact of the clearing mandate will be felt in the economy writ large (higher transaction costs for risk transfer), and not in the academic discussion of systematic credit risk. Do I care that the CME and LCH are too big to fail? when dozens of companies including MetLife and Fidelity are on the same list. It is a sideshow to the waterbed effect of private institutions desire to manage risks. The best thing for derivatives industry may the collapse of a CCP, and the lessons will force institutions back to the importance of OTC trading, and keeping their own eye on credit risk- we know the outcome of outsourcing credit risk to the rating agencies and Fannie/Freddy. Why should CME/LCH be any better than those institutions at managing credit risk. “Liquidity risk”, not be be dismissed either, is an important component of risk for dealers (but rarely for corporate clients). It is just one of many categorized risks, such as “supply risk”, “demand risk”, “credit risk”, “tenor risk”, “operational risk”… Forcing all of these mulifaceted risks, which are expressed in tens of thousands of structured private transactions into a few hundred clean and clearable contracts is the tragedy- not the concentration of credit risk at the CCP

    Comment by scott — September 10, 2014 @ 2:10 am

  9. @scott. You raise an interesting point, though I think you’re referring to a different liquidity risk than the prof and Tomas — i.e. the liquidity of the contracts themselves. Trading high volume futures instead of bespoke OTC products increases liquidity risk (in the sense of creating greater demand for cash liquidity to meet variation margin calls) and decreases it (in the sense of being able to close out or change your position easily). Interesting as you note that the hedgers don’t really care much about the latter while they care a lot about the former. Speculators on the other hand have the reverse bias — they need contract liquidity to trade quickly, but they expect to face VM calls whether they trade OTC or cleared (dealers generally will not extend significant unsecured credit to anyone but corporate hedgers). So the move to centralized clearing likely increases speculative activity while suppressing hedging.

    Comment by nivedita — September 13, 2014 @ 7:52 am

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