Streetwise Professor

My most recent clearing post explored the possibility that the formation of a clearinghouse for OTC derivatives is efficient, but that distributive considerations and collective action problems have heretofore prevented its formation. In this post, I consider the possibility that the costs of formation of an OTC clearinghouse (for CDSs, for instance) exceed the benefits.

A central counterparty (CCP) is a default risk sharing mechanism. In a typical CCP setup, a group of intermediaries who trade on their own account and as agents for customers share default risk among themselves. If a customer defaults, the intermediary through whom that customer clears bears the loss. The risk sharing mechanism kicks in only if the one of the CCP member firms defaults.

Two factors drive the default risk that the CCP members share. The first is the riskiness of the instruments that are cleared. The second is the riskiness of the balance sheets of the member firms. A default occurs only if (a) a member firm incurs a loss on its position(s), and (b) this loss exceeds the value of the other assets (net of liabilities) that the firm can draw upon (e.g., sell) to cover this loss. Thus, the members of a CCP take on an option-like exposure, where the option is a complex one with a payoff that depends on multiple factors, namely, the prices of the instruments cleared and the values of the other assets and liabilities in each member’s portfolio.

Recent events (though not in the context of a CCP) indicate that both sources of risk are important in determining the likelihood of default. Lehman and Bear Stearns defaulted on their derivative obligations not because of losses incurred on these derivatives, but because of losses incurred on other investments (primarily mortgage securities). In contrast, AIG collapsed because the huge losses on derivative positions overwhelmed the capital on its otherwise healthy balance sheet.

To operate effectively, any risk sharing mechanism must price risks appropriately. Mispricing of risks provides perverse incentives. If the default risk posed by a particular member of a CCP is underpriced, that member will trade excessively, thereby imposing excessively large risks of loss on the other members.

It should be noted that in practice CCPs typically do not charge different members different fees to reflect differential risks. That is, there is no “experience rating” of clearing fees. Instead, CCPs price risk indirectly by choosing collateral (margin) levels and capital requirements. Since the CCP is effectively a risk sharing mechanism, where the risks are not priced directly and “premiums” do not flow from one member to another, a CCP ideally sets collateral and capital levels so that the expected default cost is the same across all members. By doing so, there are no wealth transfers across members. Failure to do so leads to a transfer of wealth from one set of members to another.

Even though CCPs do not price default risk through insurance premia, as a convenient shorthand I will refer to the pricing of default risk by the CCP, with the understanding that this pricing is indirect through the setting of collateral.

Information asymmetries challenge any risk pricing/insurance mechanism. If the insured (i.e., a clearing member) has better information about his risks than the insurer (i.e., the CCP), he will trade too much and hold positions that are too big when his information indicates that the insurance is underpriced, and trade too little and hold positions that are too small when his information indicates that the insurance is overpriced. Asymmetric information problems usually result in incomplete insurance of risks. In the extreme, information asymmetries and the associated adverse selection and moral hazard problems can make risk sharing inefficient altogether.

In the context of a CCP, asymmetric information about the instruments traded and the balance sheets of the dealer firms that trade them–and who would be the members of a CCP–impedes the sharing of default risk. The severity of these information problems can vary by instrument, and by the nature of the firms that intermediate the trading of these instruments. An examination of CDSs in particular, and more exotic derivatives in general, strongly suggests that asymmetric information about both risks is likely to be acute. This tends to reduce the net benefit of introducing a CCP for these products, and may make this net “benefit” negative, especially when the costs of establishing and operating a CCP are considered.

First consider the issues relating to the risks of a particular type of instrument. To price risk, a CCP uses information on (a) the risk-return characteristics of this instrument, and (b) the current price/value of the instrument. Given the current value of the instrument, and holding the (true economic) capital of a member firm constant, the likelihood of default depends on the probability distribution of returns on the instrument and the size of the position. Therefore, margin setting/risk pricing depends on information regarding the price behavior of the instrument. Moreover, information about the current price of the instrument is important. A CCP uses an estimate of market price to adjust collateral. Using an incorrect price leads to an incorrect estimate of the gain or loss on a position, and therefore to an incorrect determination of the risk exposure, and relatedly, the collateral level.

For homogeneous, linear, traditional instruments traded in liquid, transparent markets, a CCP is likely to have information on these variables that is nearly as good as, and perhaps better than, that in possession of its members. For an actively traded instrument (e.g., S&P 500 futures), transactions are numerous and observed, so positions can be marked to current value with no difficulty. Moreover, extensive historical data is readily available to calibrate risk models, and “rocket science” modeling is not necessary to estimate these risks. Thus, for such instruments, centralized clearing is unlikely to face severe adverse selection problems, and risks can be priced correctly. One would expect to observe central clearing for such instruments–and one does.

Things are quite different for exotic instruments. These instruments are traded less frequently, and so current market price information is harder to come by. Indeed, at times, there may be no transactions, so it is necessary to “mark-to-model” rather than “mark-to-market.” Moreover, sophisticated modeling is necessary to quantify and understand the risks of these instruments.

This pricing complexity is likely to be an important issue for credit derivatives, especially on individual names. The products are relatively new. Often they are not traded in high volumes in liquid transparent markets. Marking to market is not a trivial exercise as a result. Moreover, understanding the risks of these things is difficult. This is particularly true for portfolios of these instruments, due to the potential for default dependence between different instruments (i.e., the unconditional risk of default of a single instrument is not sufficient to determine the risk posed by a CCP member with positions in multiple instruments; you need to know about the correlations across instruments, and these dependencies are especially tricky to model and calibrate with credit products).

Big dealer firms specialize in developing models designed to quantify and characterize these risks. Moreover, these dealers expend resources to develop the data to calibrate and test these models. They have strong incentives to develop good models, as with better models they can manage their own risks better, and perhaps generate higher trading profits. Therefore, it is highly, highly likely that for a product like CDSs, dealer firms that engage in proprietary trading of these instruments will have better models and better information than a CCP.

To reiterate something I’ve said in previous posts, this is not to say that these models are great in some absolute sense. The key issue in risk sharing is asymmetry, which depends on the relative quality of information. If a CCP member has a better model than the CCP, there is an information asymmetry problem, even if the former’s model is, well, pretty bad. As I’ve said before, the one eyed man is king in the land of the blind.

(For an illustration at the problems associated with third party’s attempts to evaluate the risks of heterogeneous, complicated, non-linear derivatives, consider the rating agencies’ disastrous experience with CDOs, and monoline insurers.)

Thus, in my view, it is almost certainly the case that for exotic derivatives, and for CDSs in particular, dealer firms that make markets in these products have much better information about their values and risks than would a CCP. This creates the potential for adverse selection, which reduces the benefit of default risk sharing through a CCP.

It should also be noted that big dealer firms that (a) are the primary intermediaries in exotic derivatives and CDS products, and (b) would be the members of any OTC derivatives clearinghouse, are very complex financial firms with relatively opaque balance sheets. They are in the business of providing information intensive intermediation, through their loans, investments, and trading. As a result of this information intensity, it is challenging for third parties to appraise their balance sheets, and quantify the risks associated with those balance sheets. It is certainly the case that the intermediaries (banks and investment banks and in some cases insurance companies) have better information than third parties about the value of the assets and liabilities on their balance sheets, and the risks of those assets and liabilities–including the correlations between those asset and liability values and the values of derivatives positions on its books.

This means that if a CCP’s members are complex dealer firms engaged in information intensive intermediation, the potential for asymmetric information about balance sheet values is acute.

Put these two things together, and it is evident that the formation of a CCP to clear exotic products, including credit derivatives, and which has big financial institutions with complex balance sheets who supply information intensive intermediation, faces far more daunting challenges than a CCP clearing “vanilla” products and which has simpler firms has members. The pricing of risk is almost certainly far more difficult, and more importantly, the potential for information asymmetries is far greater. Thus, adverse selection problems would almost certainly be far more acute if the big dealer firms formed a CCP to share default risks for credit derivatives and other exotic products.

This suggests caution is in order in moving towards a CCP structure in CDS products in particular. Myriad regulators, market participants, commentators, and legislators have seized on central clearing as the panacea for these products. There has been little–if any–recognition in the public debate of the special challenges that these kinds of products and the institutions that trade them would impose on a central clearing mechanism. Thus, it is quite possible that a CCP has not been adopted for these products is not due to the selfishness of dealers who fear that clearing would increase competition for them, but instead reflects a sober appraisal of the greater costs of sharing default risks for these products.

A couple of other points are worth noting. First, traditional CCPs typically do not vary risk pricing (i.e., collateral levels) to reflect the balance sheet risks specific to each member firm. CCPs typically set collateral levels based on the risks of the instruments held in each member’s portfolio of cleared products, and two members with the same portfolio would post the same collateral even if their balance sheet risks are quite different. CCPs do impose some constraints on balance sheets, but normally through capital requirements that are simply a function of collateral levels. For instance, the CME clearinghouse sets minimum member capital equal to a multiple of the member’s margin level. Importantly, it does not vary capital requirements or collateral levels based on assessments of the balance sheet risks of member firms. Thus, in most CCPs balance sheet risks are not priced.

This may not be a big problem when CCP members are relatively simple–and relatively homogeneous–firms with relatively simple and transparent balance sheets. Many futures commission merchants and securities firms that are clearing members fit this characterization. Some are subsidiaries of complex, broad-based intermediaries, but from the perspective of the clearinghouse, the relative simple balance sheets of the actual member firms are what matters.

If big banks and investment banks continue to dominate intermediation of CDS and exotic derivatives, the members of any clearinghouse for these products will inevitably be firms with complex, opaque balance sheets, for which asymmetric information is likely to be quite acute. Simply adopting futures and options CCP practices will not be adequate for this business. Moreover, I have serious concerns that the difficulties in assessing and pricing balance sheet risk will seriously impair the effectiveness of a CCP for credit derivatives.

The second point is that it is incorrect to say that default risks are not shared among dealers in a bilateral OTC structure. Dealers trade with dealers. I daresay that big dealer firms had the biggest exposures to Lehman, Bear, and AIG. Inter-dealer trade means that default risks are shared among the dealers who would be the members of a clearinghouse even in a formally bilateral market.

This has an important implication. Specifically, the choice between a “bilateral” and “centrally cleared” market structure is a choice between different ways of sharing default risks among dealers (and between dealers and customers); it is NOT a choice between interdealer sharing and no interdealer sharing.

Thus, it is imperative to analyze the comparative costs and benefits of these alternative sharing mechanisms. This is a multi-faceted problem, but I will focus on one issue, one that I think is of primary importance.

In a CCP structure, the CCP is responsible for evaluating the balance sheet and product specific risks of each member firm. That is, there is a centralized risk evaluation and risk pricing mechanism. In contrast, in a “bilateral” market, each dealer firm makes individualized assessments of the product specific and balance sheet risks posed by each counterparty. Moreover, since dealers trade with one another, each dealer assesses and monitors the counterparty risks of each of the other dealers.

Centralized monitoring has one clear benefit–there is no duplicative monitoring. Each dealer is evaluated once. In contrast, in a bilateral market, each dealer assesses and monitors every other dealer, meaning that for N dealers there are 2 to the power N monitoring costs incurred.

However, decentralized monitoring likely has a substantial benefit when complex financial institutions trading complex products are involved. These firms interact with one another in many markets, and have various sources of hard and soft information about the balance sheet risks of its counterparties. This information is almost certainly superior to what a clearinghouse is likely to collect. Moreover, since due to the complexity of the balance sheets of the big dealer firms, any individual firm’s assessment of the balance sheet risks of another is likely quite noisy. Multiple signals should be more precise than a single one. Therefore, monitoring by multiple counterparties generates information that is likely to be collectively far more precise than the information collected by any one. If this information can be aggregated in some way, multiple counterparty risk assessments in a bilateral market can be far more efficient than a single risk assessment by a CCP. (The mechanism for aggregation is a complicated subject in itself. Dealers will make inferences from the actions of others. If dealer A cuts back on trading with B, or decides not to trade with B altogether, dealers C, D, etc., will make inferences about A’s information regarding B’s performance risk. One issue that deserves study is whether this aggregation method encourages information cascades that can lead to inefficient outcomes.)

Furthermore, dealers in bilateral markets can–and do–charge counterparty-specific prices for balance sheet risk. Specifically, they require different counterparties to post different amounts of collateral, where variations in collateral levels across counterparties reflect both product-specific risks and the particular balance sheet risks of each counterparty.

(Member-specific collateral levels in a CCP setting would also put tremendous stress on the governance of a clearinghouse. Each member would have an incentive to influence the CCP to impose higher collateral requirements on competitors. Heterogeneity puts stress on collective/cooperative bodies such as clearinghouses. Even though institutional mechanisms such as the non-profit form can mitigate heterogeneity-driven rent seeking in such organizations, it cannot eliminate it, and these rent seeking costs are typically greater when members are heterogeneous.)

This analysis raises the question of whether it is efficient to bundle the trading of these instruments with the supply of information intensive intermediation. Big banks and investment banks with opaque balance sheets (due to the information intensity of their various financing and trading activities) pose greater balance sheet risks than would simple, “vanilla” intermediaries that specialize in trading these derivatives and eschew other activities.

But we don’t see such simple, vanilla, boutique intermediaries. I think that for a variety of reasons this makes sense, as there are likely scope economies between trading things like CDSs and offering other forms of financial intermediation. After all, banks specialize in evaluating credit risk, and the resources and skills used to do this in lending and underwriting can be put to use in valuing and assessing the risk of derivatives, and most particularly, credit derivatives. Moreover, there are scope economies in modeling and risk evaluation. Thus, I think a strong case can be made that bundling of intermediation of complex derivatives (and especially credit derivatives) with the supply of other information intensive financial intermediation activities is efficient.

In sum, before charging ahead with a CCP for credit derivatives and other exotic products, it is worthwhile to step back and ask why this hasn’t happened before now. Sure, it may reflect inefficient strategic behavior by dealers and collective action problems. But it may be the result of high costs of centralized risk sharing for complex products traded by firms who supply information intensive intermediation, and therefore have somewhat inscrutable balance sheets and balance sheet risks.

I have serious reservations about the efficiency of a CDS clearinghouse consisting of big banks/investment banks. Balance sheet risks are a big deal when such firms are involved, and traditional CCPs have not priced these risks (or have priced them in a very, very crude way.) Moreover, the risks of the instruments themselves will be difficult for a CCP to quantify. Indeed, sometimes it will be difficult for the CCP just to determine the market value of these instruments. (Which is why firms like Markit are included in CDS CCP proposals.) Given the instruments, and the firms trading them that would be in a clearinghouse, risk pricing will be extremely difficult, and beset by asymmetric information problems. To me, it is by no means clear that centralized assessment, pricing and sharing of position and balance sheet risks is more efficient than decentralized, “bilateral” assessment, pricing and sharing of these risks.

This argument may seem somewhat Panglossian–to some it may appear that I am suggesting that we live in the best possible world, and intervention to change performance risk sharing mechanisms is therefore unwarranted. I would disagree with that characterization. Suffice it to say that starting from the basics of risk sharing economics, and analyzing the specifics of credit derivatives and other exotic products, a strong argument can be made that a bilateral OTC market structure is efficient relative to alternative structures, including a CCP-based system. To put things in legal terms, I should think that the burden of proof should lie on those who implicitly or explicitly assert that the existing market structure is inefficient compared to a realistic alternative.

And I will close by noting that some practitioners with skin in the game share reservations similar to those I have expressed here. This Bloomberg article by Matt Leising quotes “electronic trading pioneer” Thomas Peterffy’s objections to the CME’s proposal to clear CDS products. Long time Chicago broker Chris Hehmeyer (CEO of FCM Penson GHCO) is also “balking at” this initiative. Peterffy “doubts that the exchange will be able to determine CDS pricing because they trade infrequently.” Although neither Peterffy nor Hehmeyer (or David Rutter, also quoted in the article) mention the very different balance sheet risk posed by big CDS dealers, I wouldn’t be surprised if that’s a concern as well. Though they aren’t quoted as saying so, these gentlemen have to realize that when the big dealers clear CDS products, the other members of the clearinghouse–firms like theirs–not only bear the risks associated with the CDSs, but also the risks associated with subprime, or CDOs, or whatever happens to be floating the banks’ boats at the moment. This cannot be a comforting thought.

So, before we rush in to create a CDS clearinghouse, it behooves us to examine carefully the risks of doing so. Not all instruments and not all intermediaries are created equal. Some are well-suited for the sharing of default risk through a central clearing mechanism. Others are more problematic. Credit derivatives are among the most problematic of all. Creating a central counterparty without a full assessment of the unique challenges that these products pose is itself a risk–a risk of a train wreck somewhere down the line when the mispricing of default insurance encourages excessive risk taking, and a member (or members) of the clearinghouse defaults. Conditional on the probability of default, a central counterparty is probably the efficient way to bear risk. But if the CCP prices risk wrong, it could increase the probability of default and actually create more problems than it solves.

Do I know this will happen for certain? No, I don’t. But I do think there is considerable basis to conclude that it is a serious possibility. So before venturing down the CDS CCP road, it would be advisable to (a) give this issue serious attention, and (b) design the CCP to mitigate these problems.

I don’t have systematic statistics at hand, but a handful of sources allow me to piece together that Moscow real estate prices rose 288 percent from 2000 to 2005, and 30 percent in the first half of this year. (Haven’t found a good source for 2006-2007, but what I have found suggests that the rate of appreciation was smaller during that period.) In Moscow, rental yields at the beginning of 2008 were around 5.2 percent (i.e., rent divided by price) and by this June had fallen to 5.03 percent; yields are somewhat higher (around 9 percent) in St. Petersburg. But given that inflation is running at around 15 percent, even the higher St. Petersburg real yields are substantially negative. This suggests that prices are capitalizing an expectation of substantial continued growth in future prices. Moscow real estate is the third most expensive in Europe behind only London and Monaco.

All of these statistics are suggestive of a bubble, and in fact a more extreme bubble than occurred in the US and UK. The latter two bubbles have burst, clearly and painfully. There is some anecdotal evidence of a housing slowdown in Moscow, and with the current banking situation there, those stories are credible, and the situation is likely to get worse. A key question (to which I do not know the answer) is how leveraged Moscow real estate is. My guess is that, especially for the premier properties, the leverage is quite high.

A combination of a bubble with high leverage with financial turmoil is quite dangerous–as we have all observed up close and personal recently. I don’t know enough about the Russian (especially Moscow) real estate situation to do anything more than say that the situation there seems suggestive of Japan circa the late-80s, and the US, UK, and some other markets (e.g., Spain) circa mid-2000s. That is hardly good company to be in.

I’d appreciate comments from anyone with more detailed knowledge of the Russian/Moscow housing markets, and housing finance there, as to whether (in your opinion) there is a danger of a substantial price decline there, and whether such a price decline would pose a broader systemic challenge.

Today’s New York Times discusses the challenges posed by falling oil prices to Venezuela, Iran, and Russia. Here is an excellent, one sentence description of a natural state dependent on natural resource rents to maintain political stability: “At home, oil money allowed Iran’s ideological hard-liners to preserve their monopoly on power, to buy political allegiances and to offset the fiscal damage of their economic policies.” When resource rents fall, it is much harder for authoritarian (and worse) natural states to maintain cohesion.

Of the three states, Venezuela is probably the most vulnerable. Although the oil industries in Russia and Iran have faced problems maintaining output, Chavez has done an especially good job at kneecapping his country’s oil business, by politicizing the operations of national oil company PDVSA (including the firing of many of the most knowledgeable and skilled employees, whom Chavez considered a political threat) and seizing four private oil projects in the Orinoco River region. Venezuela also faces challenges because its heavy crude is notoriously hard to process, so the know-how of the BPs and Exxons and Chevrons is especially vital.

This article from Novye Izestia (with a translation obtained from Johnson’s Russia List) pertains to the debate that has been going on in the comments section for the past week or so:

Novye Izvestia
No. 192
October 20, 2008
POOR AND POORER

Russia’s poverty levels are far higher than official statistics indicate Federation Council discusses poverty levels and the economic crisis Author: Andrei Dolgikh [Federation Council Speaker Sergei Mironov: “Official statistics underreport the scale of poverty in Russia to a substantial degree. In reality, at least a third of Russian citizens are
living in poverty.”]

On October 17, International Day for Eliminating Poverty, Federation Council Speaker Sergei Mironov admitted: “Official statistics underreport the scale of poverty in Russia to a substantial degree. In reality, at least a third of Russian citizens are living in poverty.” But according to the Federal State Statistics Agency (Rosstat), 18.9 million citizens were below the poverty line in 2007 – 13.4% of the population. To use Rosstat’s terminology, they had incomes below the subsistence minimum. This minimum is set separately for each region. In the city of Moscow, it is 6,659 rubles per person per month; in the Tambov region, it is 3,347 rubles; in Chukotka it is 9,965 rubles. The average nationwide subsistence minimum is between 4,000 and 6,000 rubles a month. According to Mironov, 42-45 million Russian citizens have incomes lower than this level.

The specialists we approached for comments explained the “trick” in official calculations. Oksana Dmitrieva, member of the Duma’s Budget and Taxes Committee, said: “Russia uses a lower subsistence minimum figure for old-age pensioners (20-30% below the minimum for working-age citizens – editor’s note). Due to this, pensioners are artificially excluded from the category of the poor. The actual incomes of most pensioners are extremely low, and the number of people living below the poverty line exceeds Rosstat’s figures by 20 million.”

Several years ago, the authorities announced their goal of reducing poverty nationwide. They started forgetting this goal long before the global financial crisis reached Russia. It was far more pleasant to talk of rising real incomes. Indeed, real incomes have been rising – but these figures are rather like the average temperature of patients in a hospital. This is indicated by the
growth of the decile coefficient, which indicates the gap between the richest 10% and the poorest 10%. According to Rosstat, this coefficient was 13.9 in 2000 and 16.8 in 2007. Independent analysts speak of a 25-fold difference.

According to the Federation Council, almost half of Russian citizens are seeing their incomes grow more slowly than prices. Mironov offered a grim forecast: “Given the growth of food prices, utilities rates, transport and communications costs since the start of this year, real incomes next year will be lower than this year.” According to Dmitrieva, state-sector employees and pensioners are already worse off: “Indexation of pensions and other payments from the state has been based on an inflation figure of 10.5%, but inflation will reach 15% by the end of the year.”

And now there is the financial crisis to contend with, on top of inflation. Yevgeny Gontmakher, head of the Social Policy Center (Economics Institute, Russian Academy of Sciences), told us that Russia could be facing a lengthy period when the number of people living in poverty will increase. Gontmakher said: “Some citizens may lose their jobs and their incomes. The state has enough money to cover state-sector employees for a year or two, but this money could run out in five years or so.”

This seems like perfect material for another set of tennis between Michel and DR in particular. The article seems to support quite strongly several points that Michel has made. Over to you, guys.

Two articles suggest that the Putinist “natural state” cartel is under strain, and that the informal agreement among competing interests among the elite held together by the glue of rents is fraying. First, Pavel Baev from Eurasia Daily Monitor:

Putin’s major political achievement was securing firm support from many different groups of the elite: from successful entrepreneurs to empowered bureaucrats, from pompous top brass to ambitious artists. This elite consensus was sustained through the uncertain period of power transfer and the establishment of the Putin-Medvedev duumvirate, but now it is being tested by the crisis, which for the most part was completely unexpected. The abrupt end of a petro-prosperity that had been taken for granted has revealed and exacerbated divergences and clashes of interests among various groups of loyalists, who suspect that their “social contracts” have been revised without their consent.

Baev also notes the opacity of the process for doling out money and support. Basic cartel theory (which is applicable in this context, because the model I have in mind for the Russian state is a repeated prisoner’s dilemma) states that lack of information about defections from agreements can induce a breakdown of tacit cooperation. The lack of transparency that characterizes the bailout process is conducive to suspicions of double dealing and violations of previous understandings; these mere suspicions can produce conflict, and an unraveling of the cooperative structure.

Paul Goble reports on an article by the Indem Foundation’s Gyorgy Saratov that argues that the popular quiescence with the government is also not assured. Saratov argues, as I did in a previous post, that the high expectations that Putin has inculcated in the populace is a double edged sword. The population will remain loyal and supportive (or apathetic, which is just fine with the government) as long as those expectations are met. Disappointment of these expectations, however, could engender a backlash.

The prospect of a merging of elite and popular discontent is a nightmare to Putin et al. It is now only a possibility, and Saratov’s argument seems a little hyperbolic and premature. But these articles make it clear that it is becoming more widely recognized that the stability of the Putinist system is vulnerable to an economic slowdown. Given that Russia’s economic prospects and the flow of rents that glues the system together are highly dependent on the price of oil and the support of external capital flows, this stability is largely out of control of the government, as the course of the world financial crisis, and its consequent effects on the demand for energy and the availability of capital, are clearly well beyond its control.

Today is the SWP’s birthday, and for some reason, this song keeps popping into my head.   Along these lines, I have at least been able to avoid getting a real job, and hence haven’t had to cut my beard.   Like I say, TGFA.

I take a break from clearing blogging to discuss Russia for a moment. Nothing original. Instead, I will merely be Charlie McCarthy and James H. Billington will play Edgar Bergen, as we recite an excerpt from The Icon and the Axe, Billington’s magisterial history of Russian culture. (Billington is now Librarian of Congress.) Although Billington is writing of Muscovy, and its initial contact with the West in the 15th and 16th centuries, much of what he says is very apropos to today.

Few problems have disturbed Russians more than the nature of their relationship with the West. Concern about this question did not begin either in the salons of the imperial period or in the mists of Slavic antiquity, but in Muscovy from the fifteenth to the early seventeenth century. This account will attempt to suggest both that there was an over-all psychological significance for Muscovy in the rediscovery of the West in the early modern period, and that there were a number of different “Wests” with which important contact was successively established. A consideration of how the west came to Russia may throw some light not only on Russian but on general European history.

The general psychological problem posed by confrontation with the west was in many ways more important than any particular political or economic problem. It was rather like the trauma of adolescence. Muscovy had become a kind of raw youth: too big to remain in childhood surroundings yet unable to adjust to the complex world outside. Propelled by the very momentum of growth, Muscovy suddenly found itself thrust into a world it was not equipped to understand. Western Europe in the fifteenth century was far more aggressive and articulate than it had been in Kievan times, and Russia far more self-conscious and provincial. The Muscovite reaction of irritability and self-assertion was in many ways that of a typical adolescent; the Western attitude of patronizing contempt, that of the unsympathetic adult. Unable to gain understanding either from others or from its own resources, Muscovy prolonged its sullen adolescence for more than a century. The conflicts that convulsed Russia throughout the seventeenth century were part of an awkward, compulsive search for identity in an essentially European world. The Russian response to the inescapable challenge of Western Europe was split–almost schizophrenic–and this division has to some extent lasted down to the present.

Although many of the historical particulars are certainly different (Russia and the West have been in close contact since the 15th century; Europe is no longer aggressive, to name two), as Billington notes there are clear parallels between Muscovite attitudes then and now. (Stephen Blank, a UC trained historian of Russia now at the Army War College also draws parallels between Muscovy and Putin’s Russia.)

In particular, there is a psychological dimension that is more pronounced in Russia and its relations with others than is the case with most other nations I can think of. Although Russia has certainly progressed past adolescence (and, at least demographically, is well on its way to senescence), there is still today a palpable “awkward, compulsive search for identity in an essentially European world” and a schizophrenia in its reaction to the outside world. Russians, collectively, and many individually, cannot make up their minds whether they want to be Europeans or not; insiders or outsiders. The dominant tendency veers back and forth, erratically, driven by events.

There are obviously many differences between Russia and “The Wests” (plural, as Billington has it). The biggest, most enduring asymmetry, however, is that whereas Russia is always defining itself in reference to the West, the West never defines itself in reference to Russia. Europeans (and Americans) never ask if they want to be like Russians or something different. Russians often ask whether they want to be Europeans, or something different. To the West, Russia is a reality; it exists; it must be dealt with, some times more than others. But it is almost never (with the exception, perhaps, of short periods in the 20s and 30s) a role model to be emulated or rejected. Western identity is relatively secure, and its insecurities are its own. Russian identity seems more fluid, more in flux; engaged in an ongoing wrestling match between external attractions and deeply rooted cultural traditions. This contributes to a “irritability and self-assertion” as plainly evident today as during Muscovite times.

In the midst of the credit crisis, it has become conventional wisdom that OTC derivatives, especially credit derivatives, should be centrally cleared. Like Dudley Dooright, the central counterparty (CCP) will come in and save the day. Given that this idea is supported by many people who had probably never heard of clearing until quite recently, there is room for doubt that these high expectations are grounded in a firm understanding of what clearing is and what it entails.

I will explore various aspects of OTC clearing in several posts, of which this is the first.

The motivation behind these posts is a simple question: If clearing is so obviously wonderful,why has it not been adopted before this?

I think there are two answers to this question, answers which are not mutually exclusive. The first is that clearing would be welfare enhancing, but as a result of some collective action problem it has not been implemented. The second is that there are costs and benefits to clearing, that these costs and benefits vary by product, and for some products, the costs exceed the benefits.

The public policy implications of the two alternatives are obviously quite different. The first provides a justification for robust government intervention: the second does not. I think that both factors have an element of truth. This implies that there is a basis for government involvement, but that considerable care should be exercised.

I have explored both questions in my academic work, and will draw upon that work in drafting these posts. I have recently done more work on the collective action issue, and will report the results of that analysis for the first time in the blog; I will write up the results of the analysis more formally in the coming weeks.

This post focuses on the collective action issue. If clearing is welfare enhancing, but it has not been adopted due to transactions costs/collective action problems, then arguably a case can be made for regulatory or legislative initiatives to encourage–or even force–its creation. Indeed, one can argue that the NY Fed’s frantic efforts in recent weeks to push market participants towards creation of a CCP reflects such a belief.

I first mooted the possibility that CCPs were not adopted due to some sort of collective action problem in a working paper in 1997. I also mentioned this idea in a more recent paper. The basic idea was that clearing could have distributive effects, most particularly, redistributing wealth from well capitalized firms to less well capitalized ones. This could occur if clearing leveled the competitive playing field by eroding the competitive advantage held by well-capitalized OTC dealers.

In my earlier work, this argument was made verbally. It is not an easy thing to formalize it, but I have made some progress in that direction. The model is a relatively simple one. There is a representative agent hedger, with CARA utility. The hedger has an endowment of a risky asset. There are two risk neutral dealer firms. These dealers are risk neutral, and have no endowment of the risky asset, but they have limited capital. Their capital is also risky. Therefore, if they enter into derivatives contracts, they may default as their losses on their derivatives positions may exceed their capital.

The two dealers have different starting capitals. There is a large dealer and a small one. The volatilities of the firms’ capitals can also differ. The dealer capitals are imperfectly correlated.

The dealers incur operational costs to execute derivatives transactions. For simplicity, these costs are quadratic in the quantity of contracts executed. Although the dealers have different capitals, I assume that they are equally operationally efficient. That is, their costs of execution are the same for a given number of transactions.

It is well known that a defaultable derivatives contract, such as a forward or swap, is effectively an option. In this model, the hedger that buys a forward contract from a dealer actually enters into contract with a payoff equal to the minimum of the payoff on a non-defaultable contract, and the counterparty-dealer’s capital.

Due to this optionality, the problem is inherently non-linear, and even assuming CARA utility, must be solved numerically. Therefore, since that nettle has already been grasped, there is no need to make the drunk-looking-for-his-wallet-under-the-lamppost assumption of normality in the distribution of the price of the risky asset, or the values of the dealers’ capitals. Normality facilitates the determination of closed form solutions in linear problems, but since this problem is non-linear that is of no help. I therefore utilize more realistic assumptions. I allow for heavy-tailed and skewed price distributions, by assuming that returns on the risky asset are characterized by a negatively skewed normal inverse Gaussian distribution. (This means that crashes are more likely that upward spikes in prices, as is the case for equity indices.) I assume that dealer capitals are characterized by fat-tailed Student-t distributions. Skewness and kurtosis are realistic features of real markets, and may provide an important reason to hedge and affect the likelihood of default. The world is not normal, and non-normality is especially important in this context.

I first solve for equilibrium in a bilateral OTC market. I assume that all parties are price takers. The resulting equilibrium is quite sensible. The hedger trades more with the firm with the greater capital, and sells at a higher price to the less-well capitalized firm. That is, since the deals are negotiated individually, and since the counterparties are heterogeneous, the terms of trade and quantities of trade differ. The hedger sells more at a lower price to the advantaged well-capitalized firm.

I next solve for equilibrium in a cleared market. In the cleared market, the two dealers form a CCP and share default risk. If one firm defaults, the other party covers the loss, up to the amount of its capital. The hedger suffers from a default only if the dealers’ collective losses on their trades is larger than the sum of their capitals.

The details of possible sharing arrangements under a CCP are complex, and potentially varied, so I simplify matters by assuming that the CCP allocates trades among the two so as to maximize joint profits. This would require some sort of pricing mechanism, or some other means of allocation, which is not modeled specifically. I do turn attention to the possible pricing issues later.

Due to the equal operational efficiency of the two firms, the efficient outcome is for the output of the two dealers to be equal. In the clearing equilibrium, (a) the hedger trades more, (b) the output of the small capital dealer goes up, and (c) the output of the large capital dealer goes down. Moreover, the price at which the large dealer buys goes up slightly, and the price at which the small dealer sells goes down. The hedger’s expected utility rises, and joint profits of the dealers are higher because (a) total output is higher, and (b) total costs go down due to a more efficient allocation of output across the dealers. There is also a more efficient allocation of risk, and the incidence of default falls, even though the scale of trading rises, because of the diversification of the dealers’ capital risks.

In brief, the formal model, solved numerically, generates results along the lines of what I laid out informally in the earlier working papers.

The implications are quite striking, and important. Implementation of a first-best risk sharing mechanism improves welfare (obviously) but redistributes wealth from the large dealer to the small dealer. The small dealer’s smaller capital makes him a less desirable trading party for the hedger, even though from a social perspective diversification and operational costs make it efficient for the hedger to split his trades between the two dealers. That is, from a welfare perspective, pooling of the dealers’ capitals is efficient as it facilitates efficient allocation of output across dealers. (This raises the question of why don’t the dealers just merge? Well, merger of all the dealers into one would effectively create a clearinghouse. Moreover, there may be sources of diseconomies of scale and scope not captured in the simple, formal model that mean that sharing of risk via a clearinghouse is a more effective way of pooling capital for default mitigation purposes than a formal merger.)

Since the joint profits of the dealers are higher under clearing, the small dealer’s profits rise more than the large dealer’s profits fall. In the absence of transactions costs, the dealers would execute a Coasean bargain that would make both better off, and one would expect the CCP to form.

However, it is well known (see particularly Libecap’s work–some done with Steve Wiggins–on the creation of property rights in natural resources), that distributive effects can interfere with the creation of efficient property rights. The common pool problem in oil (which I discussed in earlier SWP posts) is a classic example of this. Even though unitization of oil fields–the efficient allocation of output across potential producers–maximizes joint profits, it has proved devilishly complicated in practice for competing drillers to consummate this wealth-enhancing bargain, due to the tussle over rents.

Moreover, due to the complexities in bargaining, and the potential costs of enforcing any arrangement among the firms, the dealers may arrive at a pricing or trade allocation structure that limits the distributive impact of the formation of a CCP. In the stark model, however, any such deals reduce welfare. Thus, even if a CCP is formed, it may not achieve the efficient outcome. Alternatively, the feasible bargaining outcomes may not include the efficient outcome. If there are fixed costs to implementing the CCP, it may not form.

In particular, as I have shown in my work on exchanges (JSTOR access privileges required), coalitions of heterogeneous firms create the potential for redistributive rent seeking. As a result, organizational form and governance structures for coalitions of heterogeneous firms are usually crafted to mitigate the potential for such redistribution. The resulting structures and pricing mechanisms may not be first best.

It should also be noted that even though CCPs are typically formed as coalitions of dealers, some of the benefits flow to (in the model) hedgers. That is, CCPs are usually coalitions of sell-side firms, but the benefits of CCPs spillover to buy side firms. Again, since the CCP is first best (in the model), there is a potential grand bargain that makes the buy side and the sell side firms better off. This only expands the bargaining complications, however.

Thus, one explanation for the failure to adopt a CCP in OTC derivatives is that even though it is efficient, collective action and bargaining problems have impeded, and in some cases precluded, its creation. Distributive effects can preclude the adoption of efficient organizations and institutions. The model shows that the adoption of clearing can have pronounced distributive effects. Therefore, the failure to adopt clearing may reflect the effects of distributive effects and rent seeking behavior that impede collective action.

In this situation, government action (and essentially, government can serve as a mechanism to reduce the costs of collective action) can improve welfare to the extent that it reduces transactions/coordination costs.

In essence, government is just another mechanism through which parties can act and bargain to achieve a given outcome. Government possesses coercive powers. Moreover, especially in democratic/republican polities, a broad array of interests can influence/bargain through the government. This can be important, and sometimes result in enhanced efficiency–though it can reduce efficiency at other times. In the present instance, for example, buy side firms that would benefit from the formation of a CCP can exert influence on various government entities (the Fed, Treasury, the legislature), and beseech the government to employ its coercive powers to advance the interests of these firms. It may be cheaper for these firms to bargain through the government, than directly with the sell side firms.

This analysis reflects the strongest case for government intervention to, ahem, encourage the formation of a CCP for credit derivatives, and other products traded OTC. But one must be careful. Clearing is a risk sharing arrangement, and it is well known that risk sharing arrangements are often plagued by adverse selection and moral hazard costs. These costs can vary depending on the type of risk being insured. These costs reduce the amount of risk sharing, and in some cases, can make it better not to share risks at all. Thus, the failure to form a CCP that shares default risks for some products may also be due to the fact that moral hazard and adverse selection costs are so large as to make risk sharing inefficient. I will consider that possibility in the next post, and argue that this possibility is particularly pertinent for products like credit derivatives. Thus, the benefits of the formation of a CCP for these types of products may be substantially smaller, and the case for government intervention weaker, than the collective action problem-focused analysis of this post suggests.

There are at last count five major initiatives to create a credit derivatives clearinghouse. The two leading contenders are a CME-Citadel (CIG) initiative, and a collaboration between the Clearing Corporation (and hence the major banks that own it) and ICE (further proof that ICE is firmly aligned with the major banks, as its CBT foray also indicated). This Reuters article gives the CME-CIG venture the inside track. I don’t handicap things quite the same way.

I see two big obstacles to the CME, both essentially political in nature. First, the big banks and CME have been in a cage match for the last couple of years, and the banks will resist transfer of additional power to the CME. The CME will have to depend on buy side support, b/c the buy side hates the banks worse than the CME.

Citadel’s alliance with CME very interesting in this regard. CIG is with the banks in the ELX initiative to compete with the CME in futures trading , but with the CME and against the banks in this effort to compete with the latter. It seems that CIG is trying to play balance-of-power games here, leaning against the dominant party in the exchange and OTC spaces.

Second, the DOJ concerns about CME market power (expressed in the infamous February letter) will become more acute. Their precedent in the CBT merger tied their hands in NYMEX, but it would not do so in contesting CME market dominance in OTC clearing.

The big bank opposition to the CME is probably the biggest hurdle. All of CME’s OTC clearing initiatives have focused on the buy side, and probably for good reason. But support from the big OTC dealers–as long as any of the latter exist–is probably vital for any venture to succeed. But at the same time, the CME has a lot more credibility than the major dealers and the (until recently moribund) Clearing Corp. I would therefore expect some sort of uneasy alliance involving both CME and the dealers and important buy side participants, perhaps resulting from a shotgun wedding arranged by the NY Fed and the Treasury.

It is also interesting to note that both the CME/CIG and CC/ICE ventures plan an execution platform piece to go along with the clearing piece. The execution platform is probably more essential for the CME venture because it has to pry away transactions from the dealers to succeed.

A more transparent pricing and execution system is also an important element of a successful clearing venture. As I have laid out in my academic work, and will discuss further in soon-to-follow SWP posts, clearinghouses don’t create price transparency, they depend on price transparency. Clearinghouses can improve position transparency by collecting and aggregating position information. But clearinghouses use prices determined in the execution market. They do not create these prices. Price information is vital for marking positions and managing collateral, and also for calibrating risk models used to establish collateral levels and monitor clearing member risk. Therefore, initiatives to improve price information are essential to making clearing work. One way to do that is to move trading onto centralized platforms. Another is to centralize the collection and dissemination of price information through the creation of a data hub, a subject I’ve discussed on SWP before.

It will be interesting to see how this will all play out. There will be a political component here, as the sums at stake are immense–as the Reuter’s article discusses. Moreover, the economic issues are quite fascinating. Over the next couple of days I will focus on those issues in more detail in upcoming SWP posts.

Today’s musical selection is Queen’s I Go Crazy. (Some may dispute the verb, or the tense thereof.) What is making me go crazy? The continuing stream of conclusory assertions that someway, somehow, OTC derivatives are at the root of the current financial crisis, and that some past opportunity to regulate these monsters was missed, thereby paving the way for our current difficulties.

This WaPo article is a classic in the genre. Inasmuch as I am quoted in it, perhaps I seem an ingrate to criticize, but criticize I must–although it is better than most. In this narrative, ardent free marketers and patriarchial figures Alan Greenspan, Arthur Levitt, Robert Rubin, and Larry Summers crush the Quixotic crusade of valiant CFTC chair Brooksley Borne to regulate OTC derivatives. If fair Brooksley’s advice had been taken, the article suggests, what went wrong wouldn’t have gone wrong.

That is, to say the least, a very debatable proposition. One thing worth noting is that the focus at the time was interest rate swaps, instruments that have played no role in the collapse of any financial institution. Credit derivatives were in their infancy at the time discussed in the article. Indeed, they were barely a gleam in their inventors’ eyes.

More importantly, although Born warned of the systemic risk posed by OTC derivatives, discussion of how any specific regulation she proposed would have affected current events is completely absent. Nor was Born herself particularly specific at the time.

The article discusses clearing, but importantly misses a key point. The Commodity Exchange Act (CEA) requires contracts for future delivery to be traded on a designated contract market, i.e., and exchange regulated by the government. The concern at the time was that the legal status of OTC swaps ambiguous given this language. Were swaps futures? If they were, any swap not traded on an exchange would potentially be legally unenforceable. This was a major, major concern. In response to this, during this time period the CFTC proposed a set of criteria to distinguish futures–that had to be traded on exchanges–from non-futures, that were exempt from the contract market provision of the CEA. One of the criteria that would have made something a future was centralized clearing. That is, a centrally cleared product was more likely to be considered a future than one that was not centrally cleared.

Thus, if anything, CFTC policy ideas at the time militated AGAINST moving to central clearing of OTC instruments. In essence, the Born-era CFTC approach tied the means of execution (on an exchange) to the means of sharing credit risk (central clearing.) The Commodity Futures Modernization Act (CFMA) essentially avoided this pernicious bundling constraint, and thereby made it more likely that OTC clearing would develop.

There is no reason to force all trading into a particular model, e.g., to force all transactions to occur on exchanges. Many important markets are dealer markets–the Treasury market being a prime example. A CEA-type link between trading mechanism (on exchange) and performance risk sharing mechanism (clearing) creates an unnecessary constraint that raises costs. It requires a one size fits all approach despite the fact that a diversity of trading and risk sharing mechanisms satisfying heterogeneous and diverse needs is likely to be efficient.

The article also denigrates the elimination from the CFMA of a provision calling for federal oversight of a clearinghouse. But, as the article notes, the OTC clearing idea “sat dormant.” If it wasn’t adopted with less onerous regulations, is it reasonable to conclude the industry would have started one if more strict regulations were in place?

The reasons for the dormancy of OTC clearing are important to understand, and not completely understood. I have a slew of clearing-related posts coming, so I will defer fuller discussion until then. For now, suffice it to say that Brooksley Born’s defeat at the hands of the patriarchy had nothing to do with it. As I already noted, the Born ultimatum approach would have actually impeded the development of clearing. It should also be noted that the article’s narrative is contradictory; the article specifically states that Treasury pushed for the idea of an OTC clearinghouse even though Treasury Secretary Rubin is portrayed as one of Born’s antagonists.

Moreover, the article states that the failure of AIG was attributable to its large losses in credit derivatives, and implies that if credit derivatives had been better regulated then (a) AIG’s failure might have been avoided, and (b) the financial crisis would have not been as bad as it is. The latter proposition is the important one, and the basis for it is completely lacking in the article, and in most discussions of the issue.

Ultimately, AIG’s failure is attributable to the fact that it insured against losses on mortgage securities, and these mortgage securities plummeted in value. It is exactly analogous to an insurance company that insured against earthquakes, only to be bankrupted when a trembler of unprecedented power occurred.

That is, in the first instance AIG’s losses on credit derivatives were a symptom of, rather than a cause of, the financial tremors. And as I have written before, it is plausible that (a) AIG was the efficient bearer of this risk, and (b) as a result, the same tremor would have wreaked even greater havoc on less-well capitalized institutions had they not purchased insurance from AIG. No insurance company should be so well capitalized that the probability of default is zero. Thus, the fact that an insurance company failed does NOT imply that constraints on its issuance of insurance would have been welfare improving. In fact, the opposite conclusion is far more likely to be true; constraining or eliminating even incomplete insurance would have almost certainly been inefficient.

To make OTC credit derivatives the villain of the piece requires a more complex argument. One would have to argue that the existence of insurance for mortgage derivatives contributed to the proliferation of subprime debt, and tranched securities created atop it, and to the housing bubble. For these mortgage/real estate factors are at the root of the current difficulties. This causal link is inherently indirect, and very hard (and perhaps impossible) to prove. Moreover, any contribution of credit derivatives is almost certainly of second or third order as compared to the direct causes–loose monetary policy, political encouragement and subsidization (via Freddie and Fannie) of subprime lending, agency problems, rating agency failures, etc.–that fed the housing bubble and the proliferation of subprime debt.

I again reiterate that one needs to be specific as to the content of regulations before passing judgment on their likely effects. In particular, it is very difficult to demonstrate how most regulatory proposals, which frequently focus on various fraud, disclosure, trading mechanism, and manipulation-related issues, mitigate systemic risks.

Furthermore, I would suggest that any attempts to regulate instruments per se are almost inevitably doomed to failure. Regulate one instrument, and in a trice financial engineers will figure out a workaround. This is almost certainly a wealth-reducing arms race. (Were I speaking completely self-interestedly, I would advocate such regulatory efforts, for it would increase the derived demand for my services.) A functional regulatory approach is preferable under these circumstances, but the basic distinction between functional regulation and regulation of particular instruments has been completely overlooked in most of the public debate.

In sum, I go crazy because the public treatment of regulatory issues surrounding derivatives is largely built on myths, incomplete history, and a failure to understand the basic vulnerabilities of any regulatory system. A Reuter’s article aptly states that credit derivatives are “vilified as a major contributor to the current financial crisis.” This is true, but the argument behind the vilification is largely–and arguably completely–nothing but an assertion, repeated over and over again, with little supporting argument and less supporting evidence. This is the perfect hothouse environment in which to grow bad policies and bad regulations that will have serious, adverse unintended consequences down the line.

What is needed is a sober appraisal of the costs and benefits of specific financial innovations, and proposals to regulate their use and development. What we have instead is knee-jerk reactions based on bad analysis. Virtually everyone is calling for more regulation, details to follow. Having seen how regulation often works, I reply: Be damned careful what you ask for.