Streetwise Professor

November 20, 2008

Back to the Future, Futures Edition

Filed under: Commodities,Derivatives,Economics,Politics — The Professor @ 7:52 pm

Senator Thomas Harkin (D-for-don’t even need to ask, IA) has introduced legislation that would require all derivatives trading activity to take place on a futures exchange regulated by the CFTC.

That’s a really dumb idea, even from a senator.

The rationale for this move is somewhat inscrutable.   Harkin said:

The economic downturn in this country is forcing us to examine all contributing factors on our markets.   With the value of swaps at a high of some $531 trillion for the middle of this year — 8 1/2 times the world GDP [gross domestic product] of $62 trillion — it is long past time for accountability in the markets.

Can you say non sequitur?   I knew you could.

The Solon of the Sow Belt continued:

By regulating all futures contracts, the Derivatives Trading Integrity Act restores confidence in the markets and provides the soundness and integrity the financial system needs

And just how does it do that?   Does your assertion make it true, Senator?

Market participants and the instruments they trade are heterogeneous.   This heterogeneity can–and almost certainly does–make it efficient for multiple, differentiated trading platforms to exist side-by-side.   Heck, even the most homogeneous of financial instruments–the stock in a particular company–trade on different types of trading mechanisms in order to meet the diverse needs and preferences of investors with different information and preferences regarding the rapidity with which they want to trade.   Closely related instruments can trade on a variety of platforms.   For instance, cash Treasuries and Treasury futures trade using very different mechanisms.   In a nutshell, it is desirable to allow the development of a variety of different trading mechanisms (microstructures) to permit a discriminating match between the characteristics of the mechanism and the characteristics of the instruments and their traders.

Forcing a one-size-fits-all trading approach completely ignores this heterogeneity.     It will impose costs on market users, and may even serve to undermine their soundness and integrity.

I’ve argued repeatedly that with respect to clearing (i.e., default risk sharing) in particular, there is a strong case to be made that some instruments should be centrally cleared–but some should not.   Central clearing provides benefits, but it comes with costs due to asymmetric information.   Indeed, since market participants internalize most of the benefits from clearing, they have a strong incentive to adopt it unless there are even larger costs.

With respect to the soundness of the financial system, forcing central clearing can increase systemic risk.   Clearinghouses don’t price dealer balance sheet risk–dealer counterparties in bilateral OTC markets do.   Dealers typically have better information about the creditworthiness of their counterparties than a clearinghouse will.   Thus, they can price default risk more accurately.   Clearinghouses treat all members as if they are the same–even though they are not, having different balance sheet risks, for instance.   This equal treatment of the unequal tends to divert trading activity towards riskier firms more likely to default.   Reductions in collateralization reduce trading costs and encourage an expansion of trading activity.   At best, clearing redistributes the default losses, and this redistribution (away from derivatives counterparties to dealers’ other creditors) can exacerbate, rather than reduce systemic risks.

Market participants recognize all of these effects.   They imply that there are costs to central clearing, and the fact that OTC market participants have not adopted clearing for many derivative products is strong evidence that these costs exceed the benefits that clearing would provide them.   They certainly know more than a certain senator from Iowa.

There is a case to be made for creating a centralized database of derivatives trades.   This can be done, however, without forcing everything onto exchanges, or requiring clearing.

There is also zero evidence that the current financial problems were in any way caused by OTC derivatives trading.   Of all the implosions of financial firms, only AIG’s was directly attributable to derivatives trading.   Moreover, the much feared knock-on effects from the failure of a big derivatives dealer have yet to materialize, and won’t in my view.   The biggest problems in the financial system are attributable to securitization, and the collapse of real estate prices.   These, in turn, are traceable to a variety of sources (e.g., the Fed, lax banks)–none of which are the OTC derivatives market.   So, when bloviating about “contributing factors,” it would be worthwhile for the senator to take a serious look at what those contributing factors actually are, rather than reflexively blaming derivatives.   His criticism echoes the common descripton of derivatives as “financial weapons of mass destruction.”   (And, by the way, (a) if I hear or read that expression one more time as a QED-end-of-argument-substitute-for-analysis, I just may go postal, and (b) if Warren Buffet is so smart and has avoided taking undue risks, why has the CDS spread on Berkshire Hathaway blown out?)   The substitution of conventional wisdom for serious thought is intellectually lazy, and a recipe for policy failure.

The funny thing (in the laugh-to-keep-from-crying sense) about Harkin’s proposal is that it harkens (I’m so punny) back to Congress’s first regulations of derivatives markets in 1921-1922.   At that time, Congress required all grain futures to be traded on a “contract market”–i.e., an exchange–registered with and approved by the government (USDA at that time, later the CEA and still   later the CFTC.)   So, rather than come up with something new, Harkin resurrects an approach first trotted out when Ford was actually a vibrant concern–and Henry Ford I was running it.   I thought we were in the era of change–silly me.

That approach caused no end of problems as the pace of financial innovation picked up in the 1970s and 1980s, as it became increasingly clear that not everything SHOULD be traded on an exchange.   This led to a sequence of Rube Goldberg-esque attempts to reconcile the irreconcilable–the exchange trading requirement and the fact that not everything was most efficiently traded on exchanges. The passage of the much (and wrongly) maligned Commodity Futures Modernization Act eliminated the confusion and legal risk that the old approach had created.

In brief, forcing a one-size-fits-all approach is doomed to failure because it fails to take into account the heterogeneity of financial instruments and financial market participants.   We have the proof of experience that it is doomed to failure.   But nonetheless, Harkin is playing King Canute, trying to force markets to conform to his will.   Good luck with that.   All it will do is create opportunities for lawyers–and undermine the efficiency and arguably the soundness of our financial markets.

I am sure that it is just coincidence that Harkin is Chairman of the Senate Ag Committee, which has jurisdiction over the CFTC–which, under Harkin’s bill, would have regulatory authority over every derivative traded from sea to shining sea.   Think of the campaign contributions!   The thought never crossed his mind, I’m sure.

Like Lily Tomlin said, we try to be cynical, but it’s hard to keep up.

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8 Comments »

  1. Professor:

    What are your thoughts about the use of leverage in the trading of derivatives? Should the practice of super high leverage by restricted?

    Comment by Timothy Post — November 21, 2008 @ 1:24 pm

  2. Timothy–

    Leverage is essentially baked into derivatives. A forward/futures is equivalent to a levered position in the underlying. A call is a levered position in the underlying too.

    Re the issue of leverage generally, I think that it is futile to attempt to regulate leverage. Any attempt to control leverage is an inducement to a workaround. You ban one instrument or security because of its leverage characteristics, and you just increase the bonuses of financial engineers and the pay of lawyers who now have a reason to create a new product to circumvent the old ban. Moreover, the resulting increase in the complexity of the instruments that inevitably results has its own problems.

    Moreover, the banking literature (notably work by Doug Diamond) shows that attempts to control leverage at institutions that supply liquidity (through reserve requirements or capital ratios) can have perverse effects. The common criticism of highly levered institutions is that they are fragile. The Diamond work suggests that this fragility is a bug, not a feature–it is a method for disciplining liquidity supplying institutions. If capital structures are not fragile, a financial institution can opportunistically expropriate its creditors.

    In brief, I am skeptical that any attempt to restrict leverage is wise because (a) it is likely that any restriction is readily circumvented, and the substitutes may well be more problematic than the ones subject to the restriction, and (b) since leverage and capital structure can serve an important disciplining role, and since no regulator has any clue about what the “right” amount of leverage is, any restrictions are likely to impose substantial deadweight costs in terms of suboptimal capital structures.

    The ProfessorComment by The Professor — November 21, 2008 @ 3:21 pm

  3. I tend to agree with Sen. Harkin. Look again at the numbers: they are huge. If these are real numbers (and I guess there is some doubt) tell me me what assets these represent? You know as well as I do there are no underlying assets. These numbers represent mostly debt and pure speculation.

    You say “There is also zero evidence that the current financial problems were in any way caused by OTC derivatives trading.” With numbers these huge, even a relatively small correction would wipe out what is effectively the entire value of a nation. Let me ask this a different way: Tell me all of the things that could cause a collapse of the derivitive market.

    I didn’t think so.

    If this market went completely away I do not think that would be a bad thing.

    Comment by Cyberike — November 21, 2008 @ 3:34 pm

  4. The Harkin numbers are utter nonsense. A bank can take a 10 B long position and a 10 B short position in the same derivative (because they’re in the business of being market-makers, so someone wants to buy CDS protection on LEH and someone else wants to sell CDS protection on LEH, bank takes both trades… since the desks can only take limited outright views on the market). So, this will show up that the bank has 20 B exposure in this derivative, but its NET exposure is 0. The net exposure of the derivatives is likely to be a tiny fraction of the exposure Harkin cites. For example, LEH had 200 B of CDS notional (maybe even more, I don’t remember), but even at lower-than-planned-for recovery of < 10%, the CDS settled for a measly NET of 6 B.

    Comment by Gene2 — November 21, 2008 @ 5:37 pm

  5. Cyberike —

    “If this market went completely away I do not think that would be a bad thing.”

    Then you are leaving all sorts of people completely in the lurch when it comes to hedging. Lots of hedge funds who used LEH as a prime broker, used the CDS market to hedge their exposure to LEH bankrupcy. So yeah, it appears as though they bought naked CDS protection on LEH without holding the bond, but they had credit exposure to LEH in other ways. Think of what would happen if Boeing couldn’t hedge its credit exposure to the airlines, its biggest customers and debtors, the bankrupcy of an airline would crush Boeing, if that airline had pending orders or had credit lines with them. At the very least, it would tie up Boeing’s cash in massive bankrupcy proceedings that could take months or years (unless it’s prearranged). Sure, Boeing didn’t own AMR or UAL bonds, but they clearly have credit exposure to both.

    And that’s just the CDS market. Let’s not even get into IR and FX derivatives, which, I think, are even bigger than CDS.

    Comment by Gene2 — November 21, 2008 @ 5:41 pm

  6. [...] Professor opines, “That’s a really dumb idea, even from a senator,” and then he explains why. Digg It or FB [...]

    Pingback by Should all energy futures and derivatives contracts trade on regulated exchanges? | the daily john — November 23, 2008 @ 2:28 pm

  7. It seems that knowing prices and marking one’s books accordingly is part of efficiency. I’m not endorsing Harkin’s legislation, but focusing on the general efficiency of “heterogeneous microstructures” somewhat willfully ignores the specific mechanisms of this crisis.

    “The fact that OTC market participants have not adopted clearing for many derivative products is strong evidence that these costs exceed the benefits that clearing would provide them.”

    It is more about the pricing than the clearing, and the cost of centralized pricing that the OTC participants understood was not being able to bonus themselves on illusory paper profits. Also, if pricing is transparent, the clearinghouse legitimately doesn’t have to worry as much about traders’ balance sheets.

    Comment by Jason Ruspini — November 26, 2008 @ 3:05 pm

  8. test:

    Glenn // May 14, 2009 at 9:24 am
    Andrew, are you gay?

    Andrew // May 14, 2009 at 9:29 am
    I suspect you are the gay one (usually people insult others with what they fear in themselves).
    ————————

    Really? Very interesting… So, what do you fear in yourself, Andrew?

    ————————
    Andrew // January 17, 2010 at 12:55 pm
    Oh Arthur, just because you are uptight about your homosexuality…… Though maybe you are uptight about your homosexual tendencies because, like Putin, they involve little boys??

    Andrew // April 13, 2009 at 4:37 am
    BTW “I’m Russian” YOU show all the mental conditions of a paedophile, or most likely a pederast.

    Andrew // June 9, 2009 at 10:04 am
    You are the joke “free”, to much of a left wing paedophile to use your name in your post.

    Andrew // June 9, 2009 at 10:22 am
    free, stop going on about little boys. We all know the predilection those such as yourself have for underage males

    Andrew // May 14, 2009 at 9:29 am
    usually people insult others with what they fear in themselves.

    Andrew // April 19, 2009 at 9:40 am
    No Misha,…. pederast Lavrov stated publicly…

    Andrew // February 23, 2009 at 3:20 pm
    Well “Leonid V Marchenko, I am in a much better position to judge the opinion of Georgians than a pederast like you

    Andrew // November 26, 2009 at 4:48 am
    .. a racist little douchebag like yourself kgb pederast.

    Andrew // August 5, 2009 at 5:14 am
    Considering the overwhelming Russian tendency to pederasty and paedophilia I am sure AKM has a lot of experience in lubing up while waiting for it to come again.

    Andrew // May 14, 2009 at 9:29 am
    usually people insult others with what they fear in themselves.

    Andrew // May 8, 2009 at 5:23 pm
    military “officers” pimp out their conscripts to be raped by rich Russian pederasts.

    Andrew // March 27, 2009 at 4:11 pm
    Sphynx, are you a tranny? Or maybe a pederast?

    Andrew // September 12, 2009 at 5:06 am
    Butt-plug is the same sort of slimy, lying little pederast
    vermin like butt-plug

    Andrew // September 12, 2009 at 5:22 am
    Now butt-plug,….

    Andrew // September 12, 2009 at 4:46 am
    Try watching it butt-plug, or are you too busy molesting little boys?… more realisticly called butt-plug from now on… Once again butt-plug

    Andrew // December 31, 2009 at 8:47 am
    Looks like “Jason” is just the latest reincarnation of …. Bi-Gay-Curious Putin worshipper

    Andrew // May 9, 2010 at 3:49 pm
    No, read the report dima dickhead.

    Andrew // May 26, 2009 at 8:43 am
    Well Algymuff, it seems that buggery was pretty normal in Russia…. Medieval Russia was apparently very tolerant of homosexuality.

    Andrew // April 30, 2009 at 7:21 pm
    Hey Pedophile, I mean Russophile

    Andrew // August 11, 2009 at 5:48 pm
    Its a well known fact that those most insecure in their sexuality try the hardest to be “macho”.
    ————————

    Is that why you try the hardest to be “macho”, Andrew?

    ————————
    Andrew // January 16, 2010 at 5:08 am
    There are a lot more about the wonders of gay life in Russia…
    ————————

    Really? How much more? How did you become an expert on the “ wonders of gay life in Russia”, Andrew? Personal experience or nights spent drooling while surfing the gay internet?

    ————————
    Andrew // January 16, 2010 at 5:08 am
    you are the one who defends Putins pederastic tendencies.. Medieval Russia was apparently very tolerant of homosexuality

    Andrew // January 18, 2010 at 11:33 am
    However Russia does have a long and proud tradition of homosexual behaviour in General and pedophilia in particular.

    Andrew // January 18, 2010 at 10:29 am
    So you deny Putin is a paedophile despite film evidence of him kissing a boy on the stomach in public? Or are you and the MBLA still considering that normal behaviour?

    Andrew // June 27, 2010 at 3:39 pm
    you work as a male prostitute for gay Russian ex-pats, you end up in the trailer park….

    Andrew // August 11, 2009 at 5:48 pm
    Well, Medvedev and Putin probably do have THAT sort of relationship according to rumour. And those shirtless photo’s do have to make you wonder.
    ————————

    Images of a shirtless man “ make you wonder”, Andrew? Is that what you do when you go to public beaches in the summer: wonder?

    ————————
    Andrew // August 11, 2009 at 5:48 pm
    Russian gay chat rooms and blogs were particularly intrigued by the photos: some claimed that Putin, by stripping to his waist, was somehow pleading for more tolerance for homosexuality in Russia

    Andrew // January 16, 2010 at 5:08 am
    Medvedev obviously enjouys having another mans hand up his arse…..So you deny Putin is a paedophile… Well I do think that Medvedev and Putin have a passive active relationship. As shown by their somewhat “intense” relationship…However Russia does have a long and proud tradition of homosexual behaviour… the MBLA…

    Andrew // February 4, 2010 at 5:30 am
    Now Arthuretta, don’t project your homosexual fantasies onto others, we all know you get your jollies from perverted dreams of all boys schools, as evidenced by your homoerotic posts…..
    ————————

    ”Homoerotic posts”, eh? Please tell the readers what particular posts from Arthuretta further arose your homosexual erotic feelings, Andrew. Give an example of a sentence that you find “homoerotic”.

    Comment by vlad — March 23, 2014 @ 7:42 am

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