Streetwise Professor

I think it’s always worthwhile to work through the likely equilibrium effects of policy changes, to recognize that such changes will affect not only what is directly targeted, but will also induce other responses that can dampen, and even reverse, the intended effects of the policy change.

Let’s consider the unintended, equilibrium effects of Volker-Obama.  The V-O plan should affect big deposit taking institutions–universal banks–most acutely.  JP Morgan-Chase, Citi, BofA in particular.  The plan essentially forces firms to make a choice between being depository institutions or prop shops.  (Backdoor Glass-Stegall, if you will.)  The cost of becoming a prop shop would be very high for Morgan, etc.  So they are likely to jettison these operations, and become relatively old style banks again.  And that’s exactly what Obama and Volcker want.

But consider the effects of the exit of some players from prop trading.  They were presumably in the prop trading business because it was profitable.  Their exit creates a profit opportunity for somebody else.  In the first instance, potentially a Goldman or MOST that can become pure prop shops exempt from the restrictions at lower cost than Morgan, Citi, and BofA.  Moreover, currently smaller players may expand their prop trading, or new entrants will come in to take advantage of the opportunities.

In other words, someway, somehow, the exit of the deposit taking banks from prop trading will induce expansion and entry by others.  These others, in turn are likely to be quite large and systemically important.  Especially because VO doesn’t address the underlying source of TBTF–the government’s inability to commit NOT to intervene to bailout the creditors of a failing, interconnected, failing institution.  (Thought experiment: V-O is likely a boon to Citadel and D.E. Shaw.  Thinking back to LTCM, do you think that if one of these firms got into serious trouble, that some sort of government intervention would occur?  Yeah, the investors in the hedge funds would be wiped out, but that’s not the point.  To the extent that their counterparties, and the banks that finance their operations are convinced that they would be protected in the event of a big hedge fund collapse, they are willing to trade with and extend credit to them, permitting them to expand excessively.)

This means that equilibrium responses will undermine the effects of VO.  It is likely that VO will reduce the amount of prop trading, especially if there are synergies between this activity and other forms of intermediation offered by universal banks.  But it may lead to a greater concentration of what prop trading remains in the hands of a smaller number of less diversified firms.  Remember that the main casualties of the crisis were, in the first instance, Bear Stearns, Lehman, Merrill, and almost Morgan Stanley and Goldman.  If anything, the V-O plan would increase the number, size, and importance of these kinds of firms.  That’s hardly reassuring. Yes, these types of firms would not benefit from the deposit insurance system, but that doesn’t mean that they aren’t effectively guaranteed anyways if they become big enough.

Yes, we definitely need to do something to deal with moral hazard.  I’m just not convinced that the V-O framework does that.  Given that prop trading is apparently profitable, V-O will lead primarily to a shifting around of who does prop trading.  Yes, deposit taking institutions will do less of it, but others will swoop in to take advantage of their exit.  We’ll still be left with implicitly guaranteed institutions with an incentive to grow too large.

Hasn’t been anything major coming out of Russia that justified a post, but I’ve collected a few items that warrant some comment.

• The FSB first banned Oleg Kozlovsky from leaving Russia, then reversed itself after its action unleashed a storm of international protest.  Further evidence of the retrograde nature of Putinism, but an illustration of the difficulties of reverting to a full-blown police state when there are some channels of communication outside of the government’s control.  All the more evidence of the vital importance of keeping the internet independent in Russia–which, of course, will also serve as a spur to the authorities to strangle it.
• Russia announced that it would hold some of its currency reserves in Canadian dollars.  Although the desire to diversify is understandable, and there is no doubt a political component to this (given Russia’s strident rhetoric against the dollar), the choice of the $C is, well, a little loony.  (Sorry.  Couldn’t resist.)  Russia will most likely want to draw down on its reserves in response to a sharp decline in energy and other resource prices.  But those conditions will be adverse for the $C, meaning that $C assets will provide bad payoffs in the states when they are most needed, and good payoffs when they are least needed.  That’s a very poor investment strategy.
• Putin issued a ukase approving the reopening of a Deripaska-owned paper mill on Lake Baikal that will dump toxins into the world’s largest source of fresh water.  This disgusting outcome is, in large part, a manifestation of the Russian monogorod problem, as such a town is dependent on the mill.  This is a tragedy, and moreover, an illustration of the intellectual bankruptcy of the Russian government.  The monogrod problem is serious, and not going away.  It should be a priority issue, and is a ticking political time bomb. The mill was the major employer in the 17K town of Baikalsk, and supplies its heat.  Rather than viewing this as a perfect opportunity to come up with a new approach to monogords, the government just lurches along, zombie like, perpetuating the dead past.  The fact that this is also a sop to Deripaska makes the whole episode even more disgusting.  I guess all the Pikalyovo pen throwing is behind them now; that piece of theater has served its purpose, and Deripaska is back in Putin’s good graces.  One only wonders just what he’s done to get there, and what he’s doing to remain there.
• Russia eked out a population increase of 15K-25K in 2009, due to a combination of higher birth rates, lower death rates, and immigration.  Absent immigration, population would have declined, but the changes in the birth and death rates are good news for Russia.  The question is whether this is a temporary abatement in an inexorable decline, or a harbinger of a brighter demographic picture.  For a case of the former view, see this: “Anatoly Vishnevsky, director of the Moscow Institute of Demography, says, this year’s figure reflects a conjunction of positive developments that will not last and that within five years, Russia will again see its population fall, unless Russian can attract and are prepared to accept more immigrants.”  Vishnevsky also states that the country is on the “edge of a demographic abyss.”  For a more optimistic view, see, AK’s/SO’s/whateverhescallinghimselfthesedays’ extended post.
• Russia fired the head of its Ground Forces, and the commander of the North Caucasus Military District.  The commander of the 58th Army, which was the main force in the Russo-Georgian War is apparently also at risk of being sacked.  Predictably, Russia gave a risible official reason for the firings, claiming the two generals had reached the age limit for service–even though neither had, as anybody with access to their biographies would know.  Unofficially, it is rumored that the men were sacked for corruption, but that would be at most a pretext, for virtually everyone in the military or the Defense Ministry could be fired for corruption.  It is more likely that the terminations reflect intense dissatisfaction with the performance of the Russian military during the war with Georgia.  All the chest thumping about that glorious feat of arms evidently does not comport with reality, by a long shot.

Legally, anyways.  That was a key issue in the recent Supreme Court decision re McCain-Feingold.  I don’t have a lot to say about the specifics of the decision, as campaign finance law is way too arcane for me.  Suffice it to say that I am inherently skeptical about any regulation regarding elections designed by incumbent politicians.  People yammer about conflicts of interest all the time, but there’s a colossal one for you.

I just wanted to make a quick point about a debate between Stevens and Scalia carried out in the opinion and the dissent.  Stevens noted that the Founders were deeply skeptical of corporations.  Indeed so.  Scalia noted that there are so many corporations today.  Also true.  The interesting question is how we got from A (Stevens) to B (Scalia).

The story is told in the North, Wallis and Weingast natural state book Violence and Social Orders I’ve blogged about several times, mostly in the context of Russia.  The relevant chapter is primarily based on John Wallis’s work.  The basic story is that hostility to corporations–reflected very well in Adam Smith’s Wealth of Nations–was due to the fact that historically, English corporations were created by the crown, and were essentially very profitable favors provided to the politically connected.  They were, in NWW terms, part of the “closed order” of the natural state, in which access to certain contracting forms was limited to a select powerful few.  This animus towards corporations was inherited in the United States, but in the early years of the 19th century, state legislatures confronting issues associated with the financing of new infrastructure turned the corporate form into a prop of an open order system in which this contracting form was made available to all.  Rather than limit the right of incorporation to an elite, they made it available to everybody.  The system changed from one in which legislatures had to grant every incorporation, to one in which pretty much anybody could incorporate if they met a set of general, universally applicable requirements.  Hence, the proliferation of corporations.

Thus, Stevens was historically right, but his inference was wrong.  The kind of corporation that Adam Smith and the Founders detested was a quite different from the modern corporation that developed in the 19th century.  The name was the same, but the entire conceptual and legal basis for corporations old and new were completely different.  Indeed, almost inversions of one another.  The transformation of the corporation from a creation of the closed order to an essential element of the emerging open order explains the empirical phenomenon that Scalia cited.

This illustrates one of the dangers of assuming that the meanings and connotations of words in the 18th century (or any other time) remains unchanged to this day is quite dangerous.

I’m ambivalent, at best, about Obama’s just announced a proposal–and remember, now it is just that–to hive off prop trading and private equity from financial institutions that issue insured deposits or have access to the Fed discount window.  On the one hand, it is to be welcomed that efforts are being undertaken to grapple with the too big to fail (TBTF) problem.  Moreover, although some have vented on the unconscionability of mandating the forced separation of proprietary trading activities from other bank functions, the multi-tasking and influence cost literatures both show that information/measurement problems can make it efficient to preclude agents/entities from engaging in some types of activities.  This means that you can’t rule out a priori the efficiency of the types of restrictions contemplated in the Volcker-Obama plan.

That said, I am dubious about the prospects for this endeavor–in the unlikely event that it is implemented–because it does not strike at the root of the TBTF problem.  Obama is putting his finger in one hole of the dike, maybe, but the intense pressure generated by the underlying sources of TBTF makes it inevitable that new holes will appear in short order.

TBTF stems from two, quite different sources.  The first is the government’s very credible commitment to make whole insured depositors.  The second is the government’s inability to make credible commitments NOT to intervene to bail out the uninsured creditors of large, interconnected financial institutions.

Obama focused on the first source of TBTF in his remarks. He said that he wanted to insure that financial institutions don’t benefit from taxpayer-insured deposits while making speculative investments.”  He also decried “bank[s] backed by the American people” operating hedge funds.

In all honesty, I don’t think that deposit insurance is the main, current culprit in TBTF.  (I’d also note that deposit insurance needn’t lead to too big to fail institutions.  As the S&L crisis showed, deposit insurance can allow the proliferation of many small, high flying operations that individually are trivial in size, but which collectively can impose huge costs on the government.)

No, I think that the real source of TBTF that we face today is the second one: the widespread expectation that the government will intervene to protect uninsured creditors of huge financial institutions.  The government can’t tie itself to the mast, and say: we will not bail you out.  At least, no government has shown the ability to do so.  Knowing this, people are quite willing to lend money at low rates that do not reflect total risks to financial behemoths, because they are convinced that the taxpayers, not they, will bear the downside risk.  Note that during the crisis, a trivial fraction of bailout funds were devoted to protecting insured depositors.  Moreover, the institutions that received support directly or indirectly didn’t issue insured deposits, and weren’t eligible to borrow from the discount window.

I don’t think that the Volcker-Obama proposal does anything to address that big, looming problem.   TBTF exists because risk taking by large institutions is subsidized.  Yes, prop trading or running a hedge fund is one way to take on risk, but there are many other ways to do that too.  If there is a subsidy to take on risk if you are big enough, and one way to take on risk is foreclosed, there are myriad other ways to get your hands on the subsidy by taking on risky assets, using risky capital structures, etc.  Historically, banks have gotten into trouble the old fashioned way, by making highly risky loans.  It’s like trying to fight substance abuse by banning beer, but letting people buy scotch, or do meth.

Moreover, there are ways to restructure firms to escape the constraint that the V-O plan would impose.   Volcker is well-known to be nostalgic for Glass-Steagall, and this appears to be an attempt to implement a modified version of that.  Let’s say it works that way, and we’re in a back-to-the-future world with deposit-funded commercial banks that don’t do prop trading, and big investment banks that don’t issue insured deposits and don’t have access to the discount window, but can grow big funded by lenders confident that Uncle Sugar will save them in a pinch, and who do prop trading.   The fundamental problem would still exist.  As long as funders were convinced that the government would protect them if a big investment bank ran into trouble due to a prop trading blowup, the new IBs would have the incentive and ability to grow too big to take advantage of that subsidy.  Some firms would restructure to escape the limits, or new firms designed to avoid the constraint would form/grow.

Indeed, it’s quite possible that the restrictions could make things worse, by lulling Congress, regulators, and the public into the belief that the TBTF problem had been fixed.

In sum, the Volcker-Obama plan is fundamentally flawed, in my view, because it does not price the crucial risk at issue: the risks that TBTF institutions create would still be unpriced if the plan were implemented.  The plan, at best, just raises barriers to some ways of taking on risk, but there are so many close substitutes that that doesn’t help much at all.  The basic problem is the huge gravitational pull exerted by the government’s inability to commit credibly not to bail out the creditors of big, interconnected firms.  This means that the relevant risk is underpriced.

The Volcker-Obama plan is also odd, because it seems to pretend that the world ends at the borders of the US.  The likely result is to be a shifting around of activity among regulatory jurisdictions, with little overall impact on the total amount of risk in the system, or the composition of that risk.  Given the interconnectedness of the global financial system, this means that the effects of the change will be small, even on the US.

I am also somewhat skeptical of the plan because it is less of a policy proposal that could be seriously expected to address a major problem, than a transparent populist pivot rolled out precipitously in a desperate attempt to stem Obama’s political implosion post-Massachusetts.  The last thing we need right now is more economic and political uncertainty, and this proposal cranks up the uncertainty quite a bit.  Markets around the world fell pretty hard on the news, and the standard gauges of risk, like the VIX volatility index, spiked.  Given that the dismal employment news is attributable in part–and likely, in large part–to policy and economic uncertainty, this is unwelcome news.  Ironically, this means that a measure intended in part to secure a short-term political benefit actually undermines Obama politically over the longer term, because populist boob bait won’t do squat for his fortunes if the employment picture remains bleak.

I was in NY today, giving a press conference at NYMEX about my WTI study.  After that, I went down to the floor for a (taped) interview about the study with CNBC.

Wow.  How the world has changed.  I haven’t been on an exchange floor in a while; increased security post-9/11 has made it much more difficult.  But I spent a good deal of time on the floors in Chicago in the 80s, and in the 90s.  I was at the CBT the day the new trading floor was opened for a dry run: I remember watching hundreds of traders lining up at the entrance, like marathoners before a race, then sprinting to stake out a place in the new bond and note pits.   There was an indescribable energy on the floor.  It escapes my powers of description, really.  It’s something you had to experience.

And the operative thing there is the tense of “to have.”  You HAD to experience it, because you really can’t experience it anymore.  And that’s what I experienced first hand at NYMEX today.  I was taping right next to the crude oil pit.  Back in the day, there is no way you could have stood there, and conducted an interview to be played on TV: the noise would have made it impossible.  No problem today.  The few handfuls of traders in the pit were all reading newspapers.  I was there probably 15-20 minutes, and didn’t see one trade.  Not one.

Yeah, there was some action in the options pit, but the futures pits were essentially D-E-A-D dead.

Above the pits were many Trading Technology* screens, which were reporting the action from the electronic trading.  That’s where all the action was.  If there was a visual symbol of the dominance of electronic trading, that would be it.  The blinking blue and red screens, lording over the pit, almost mocking it with their continuous movement symbolizing a live, moving (but disembodied) market while the pit itself was almost funereally still.

I have mixed emotions about this.  In the early-to-mid-90s I was pretty outspoken in my opinions that electronic trading would make the floor obsolete.  I was ridiculed, publicly and in print, by the CEO of LIFFE, for my research showing that the electronic DTB Bund futures market was as liquid as the LIFFE’s floor market; he was not alone in his views.  I resisted the temptation to return the ridicule 4 years later when EUREX (the successor to DTB) wrested the Bund business from LIFFE.  So, in some respect, the eerie silence on the NYMEX floor is a professional vindication.

But still.  There is something–was something–truly special about the floors.  They were fascinating economic and social systems–true ecosystems.  The informal norms of floor trading–the institutions–were amazingly complex.  And highly, highly entertaining.  Moreover, the floors were a connection to history; trading on the CBT in 1995 wasn’t that much different from in 1895–at least at the pointy end, where trades were actually done.  A bunch of guys (yes, almost all guys, even in 1995) yelling and gesturing at one another.  As a student of history, there is a sense of loss when such a tangible connection to the past fades away.

There’s a new movie, Floored, that depicts life on the floors in Chicago in their twilight.  I haven’t seen it, as it’s just playing at an art house in Chicago, but hope to do so if/when it comes out on DVD.  Some folks in Chicago are ticked off (no pun intended–and you know inside baseball if you even know that COULD be a pun:) that the film (if it’s at an art house, it must be a “film,” right?) focuses on the sex,drugs, greed, and rock & roll aspects of floor trading.  Yeah, it’s undeniable that that’s part of the culture, but it’s not the whole thing, or even a big part of it, so I can understand that those who love the markets would be dismayed by such a one-dimensional portrayal.  Perhaps I will be dismayed too when I watch it.  But sex sells, and there has to be a better way to understand some of the social complexity of the floor than watching Trading Places.   One would hope, however, that a serious filmmaker would team up with some serious social scientists and do a documentary that explores the anthropology/sociology/economics of the floors.  Or that the Smithsonian captures memories of traders, like it does of old blues players and such.  Before all the old traders just fade away.  Because it’s happening before our eyes.

* Full disclosure: TT is a consulting client.

I sometimes disagree with Economics of Contempt, but he wrote a post yesterday that pretty much repeats my points that the fact that end users freely choose to trade on dealer markets despite the assiduous attempts of exchanges to woo them means that OTC trading must dominate exchange trading for a large group of firms:

More broadly, notice who the intended beneficiaries of all Mike’s preferred requirements are: not average taxpayers, mind you, but the end-users who trade OTC derivatives. These end-users are predominantly large institutions — bond managers, institutional investors, hedge funds, large corporates, etc. If pre-trade price transparency would be so beneficial to them, then why haven’t they already moved to exchanges? There’s absolutely nothing stopping them — the exchanges have been offering OTC lookalikes for years, with little success. The problem is that no one wants their products. And it’s not like there’s no competition in this space. To the contrary, the competition among the different trade execution venues (ECNs, dark pools, etc.) is incredibly fierce.

Even the price competition in the traditional OTC market is fierce, despite what journalists think. For example, according to Risk‘s 2009 survey of corporate end-users, 65.3% of end-users listed price as the most important factor in choosing a derivatives dealer. Fully 73.5% of end-users negotiated with 2-3 derivatives dealers before agreeing on a trade, and an additional 14.3% of end-users negotiated with 4-5 dealers.

I recommend reading the whole thing.

I don’t necessarily agree with EOC’s advocacy of requiring all trading in “standardized” derivatives go through clearinghouses.  Beyond all of the nettlesome issues relating to just what “standardized” is (and contractual standardization is clearly not a sufficient condition to make clearing practical), all of EOC’s arguments stated in this particular post can be achieved through mandatory reporting, which is different from clearing.  Clearing involves a mutualization of default risk; the informational advantages that EOC touts can be achieved without such (problematic) mutualization.

And one personal quibble.  (I know.  It’s always about me.)  EOC’s post responds to a Mike Konczal piece which is a direct response to something I wrote for FTAlphaville.  EOC:  Would it kill you to (a) acknowledge that, and (b) give some props for the fact that I made several of the arguments you advance in this post . . . before you did?  Just asking.

Juan Williams said something astounding on Fox News Sunday.  I quote from memory, but I know this is quite close to what he said: “The audience for the conversation about healthcare in Washington right now is NOT the American people.”  I repeat: “The audience for the conversation about healthcare in Washington right now is NOT the American people.”

This is no doubt a true statement.  Williams is well connected among Democrats, and the White House particularly.  Moreover, Nancy Pelosi’s statement that “[l]et’s remove all doubt.  We will have health care one way or the other,” the various machinations being considered to ram a bill through in the event of a Brown win in MA, Obama’s apparent intention to double down on his agenda, and myriad other things all provide support for the truth of this claim.

In other words, those who are under the Constitution supposedly the representatives of the American people are taking the attitude: “STFU.  We’ll ram this down your throat [that’s the family friendly version] when we’re damn well ready, and make you like it.”

What makes this elitist position particularly jarring is that it is served up with a huge dollop of populist rhetoric, a la The One’s repeated attacks on bankers and their paychecks, and Wall Street “fat cats.”  (Is it just me, or does the phrase “fat cats” sound comically retro?)  The populist rhetoric is all the more insulting, when it is used in the service of a profoundly elitist, anti-populist cause.

It is this disconnect between what is happening in Washington and the mood in the country at large that signals that the country is in a pre-pre-revolutionary situation.  An isolated and arrogant elite that attempts to force unpopular measures upon an unwilling citizenry by means foul and fouler can readily engender an unpredictable, and potentially violent, response.

We have, in essence, a crypto-Leninist element in Washington that intends to serve as a revolutionary vanguard in defiance of the convictions of a large majority of the American people because, in the vanguard’s view, said people do not have the requisite revolutionary consciousness.  That is a recipe for conflict.

The title to this post is a piece of doggrel (dating from the 1840s) that I had to memorize as a Midshipman at Navy.*  It comes to mind because it captures an element of what is happening in Washington right now.  Yes, the politicians tend to favor those in their own party (their “messmates”), but by and large, in ways large and small, the various factions of the political class stand with one another, as shipmates, against those outside the class.  People in Washington battle over who gets the power, and how it is used, but they are pretty much in agreement that the power is a good thing and government knows best.  In the eyes of that lot, those out there in flyover country rank somewhere around “dog” or “soldier” who are at best to be patronized, at worse to be demonized and marginalized.

In a republic, that is both wrong, and dangerous.  When those with such attitudes govern using corrupt bargain after corrupt bargain, a truly populist backlash is inevitable.  A long time ago, in the 1820s, such a backlash ushered in Jacksonian Democracy.  Today, there is no preternatural politician like Andrew Jackson to galvanize and lead this movement, but the raw material is there.  The lack of a main leader is a source of strength and weakness; coordination is more difficult in the absence of a dominant figure, but at the same time, like a guerrilla army, a broad, diffuse, organic, swarming movement lacks a center of gravity that the Leninist vanguard can readily attack.

In brief, there is a potential for a New Jacksonian Era without a Jackson.  A self-organizing populist swarm that wages asymmetrical warfare against a centralized conventional political class walled up in its citadel.  As long as Obama and the Congressional Democrats persist in their current course, which all indications suggest that they will, they will breathe life into that swarm.

As a result, the next months and years will be a truly epochal period in American history.

* Bitter Midshipmen at the just-established Naval Academy coined this phrase out of anger at being forced to perform infantry drill like soldiers.

In the aftermath of the crisis, clearing has been advanced first and foremost as a means of reducing systemic risk.  In my opinion, for the most part, these assertions reflect a superficial understanding of clearing, when they don’t reflect abject ignorance.

Things are actually quite complicated.  I thought it would be worthwhile to present a list (which is long, but probably not exhaustive) of some of the ways in which the adoption of a central counterparty can actually create or worsen systemic risks.  These are presented in no particular order.

1. The adoption of a CCP affects the priority among creditors.  In essence, netting positions improves the priority of the claims of derivatives counterparties (more exactly, of clearinghouse members via the clearinghouse) of a defaulting member.  It also worsens the priority of the claims of the bankrupt/defaulter’s other creditors.  It is not clear a priori that this reallocation of priority improves welfare, or reduces the likelihood of a systemic shock resulting from the default of a large derivatives trading firm.  For instance, worsening the position of those supplying short term credit will exacerbate their losses in bankruptcy/default.  These creditors (e.g., repo counterparties, corporate paper buyers) may be systemically important.  (EG, worsening the losses of CP buyers may result in runs on money market funds that hold CP.)  Moreover, worsening the position of some creditors will tend to make them more likely to run.  This can tip a shaky but surviving firm into failure.  Changing priority will affect capital structure and transactions costs in complex and unknown ways that could have systemic implications, as market participants adjust contracting behavior in response to the change in priorities.  Of course, changing priority in favor of derivatives counterparties could reduce systemic risks by reducing their incentive to run, and reducing the losses they suffer.  But it is by no means clear a priori how this cuts.  This is related to the general point that the first order effects of clearing are to change the allocation of risk, not its total amount.  It is not trivial, to say the least, whether these reallocations reduce or increase systemic risks.
2. A system with customer clearing (as in futures markets, and as is being proposed/advocated/adopted in some OTC clearing organizations) tends to increase the default losses that CCP members suffer, even holding total trading positions constant.  (Customer positions are likely to increase, moreover, as I discuss below.)  Since the CCP members are likely to be systemically important financial institutions, this would tend to exacerbate systemic risks. In a bilateral market, exposures to the default of firm A is limited to A’s counterparties, in relation to their trades with A.  Some end users who trade with A, who would not be members of a CCP, suffer from A’s default, as do other dealers likely to be CCP members.  In contrast, in a CCP with customer clearing, the obligations of A, as a CCP member, to non-members are transferred to other member firms.  That is, adoption of clearing tends to redistribute the burden of default losses from end users who are not CCP members to financial intermediaries who are.  (Indeed, this is one of the advertised virtues of CCPs.  For years, the Board of Trade Clearing Corporation touted the fact that no CUSTOMER had lost money as a result of default: that’s exactly because clearing insured customers by transferring the risk to clearing members, i.e., large financial intermediaries.)  Thus, clearing tends to increase the default losses borne by systemically important financial institutions.  Another example of the effects of clearing on risk allocation that plausibly increase systemic risk.
3. CCPs create a single point of failure, and a concentration of risk.  This can have a variety of effects beyond the obvious one of the systemic shock that would result if a CCP in fact fails.  It means that there is less diversification of the risk of errors, e.g., model risk, or other risks in the evaluation of default risk.  If a CCP’s model/methodology/information for evaluating performance risk is flawed, these flaws are almost by definition systemic because the pricing of risk in all deals is wrong.  In contrast, when multiple parties are evaluating each others’ performance risks using different models or different information, errors will be less correlated.
4. CCPs generally do not price balance sheet risk (due to informational and governance considerations), which can encourage more trading by weaker firms, and can also encourage firms to take on more balance sheet risk (e.g., by taking more risk on non-cleared positions/investments).  This tends to increase risk in the system, and not just in the derivatives market: it can increase risks in other markets too.  It also provides another mechanism by which risks in other parts of the financial system affect the derivatives markets.
5. CCPs mutualize default risk.  Mutual arrangements tend to encourage moral hazard and risk taking.  These can be controlled, but only at a cost.  Moreover, monitoring and control of risk are delegated to an agent typically subject to low powered incentives, and monitoring of the agent by the principals (CCP members) is subject to free riding because the benefits of monitoring accrue to all members but the costs fall completely on the member that incurs them.  In a CCP, deficient monitoring tends to have systemic consequences for reasons discussed above.
6. Clearing can result in the capture of scale economies, but sacrifice scope economies, in the allocation of default risk.  It is not evident that this trade-off, and its effects on the allocation on default risk, is beneficial.
7. The adoption of clearing is likely to have a tendency to increase total positions and trading volume.  This tends to increase overall market risks, and default risks along with them.  Position sizes are likely to rise for several reasons.  First, netting tends to reduce the capital required to support a given size of net position.  Expanding netting through clearing therefore tends to reduce the costs of maintaining positions, leading market participants to hold bigger ones–thereby taking on more risks.  (Another equilibrium effect.)  This cost reducing-position increasing effect is mentioned by advocates of clearing (I can provide cites) as one of its advantages.  More efficient use of capital is generally desirable, but it is important to note that bigger markets pose greater risks–including greater risks of default.  (The effects of netting on position sizes was actually advanced as a reason for not adopting clearing at the CBT in the 1910s-1920s: lack of clearing was said to “encourage conservatism” by limiting the size of positions–and hence risks–that firms could hold with a given level of capital.)  Second, by redistributing default risks from CCP non-members to CCP members, the adoption of a CCP tends to increase the derived demand to trade by end users.  This also encourages growth in market size, and via the channel discussed above, tends to increase the risks faced by systemically important institutions.  Put differently: do advocates of clearing really want derivatives markets to be bigger?  That’s a very likely consequence of clearing.
8. In times of market stress, and large price moves, the rigidity of CCP collateral mechanisms can exacerbate liquidity problems.  Daily and intra-day variation margin payments are financed to a considerable degree through the extension of credit.  Large variation margin obligations resulting from large market price moves therefore translate into large increases in credit demand in stressed market conditions.  As was demonstrated during the Crash of ’87, under these conditions banks may decline to extend credit due to heightened uncertainty and lack of information about who is solvent and who is not.  Failure to obtain credit to make a margin call may force closure of a clearinghouse (again, as almost happened to the CBT and the CME in October, 1987).  Given the systemic, bottleneck nature of a large CCP, this would almost certainly spark a systemic crisis; it would certainly put pressure on central banks to provide liquidity, just as would occur from the failure of a large dealer in the OTC market.  Moreover, the traders who need to make variation margin payments are likely to sell assets.  This can create a positive feedback mechanism with very negative effects, by accelerating and exaggerating asset price declines, thereby necessitating additional margin payments, etc., etc.

Like I said at the outset, this list isn’t exhaustive.  And I certainly don’t know how, on net, all the various effects of clearing would play out from a systemic risk perspective.

But the point is that the advocates of clearing don’t either.  I haven’t seen evidence that they’ve even inventoried the possible effects, let alone made reasoned judgments about the net effect, or if that is even possible given the complexity of the system, the likely complicated equilibrium effects (i.e., how people adjust their behavior in response to the new regime), and the inevitable lack of information necessary to estimate the effects.

In brief, the mandated adoption of clearing will have big effects on the allocation of risk, the total amount of risk in the system, and the incentives of firms and individuals to take on, manage, and monitor risk.  Many of these effects plausibly increase systemic risk.  There are plausibly offsetting effects, but suffice it to say that anyone (and that means you, Timmy!, Gary, et al) who sells mandated clearing as a surefire means to reduce systemic risk are guilty of false advertising, not to say outright fraud.

If I thought I might have been a little to rough and negative in my assessment of the Department of Defense’s report on the Fort Hood massacre, reading Ralph Peter’s jeremiad on the subject suggests if anything I was too lenient:

There are two basic problems with the grotesque non-report on the Islamist- terror massacre at Fort Hood (released by the Defense Department yesterday):

* It’s not about what happened at Fort Hood.

* It avoids entirely the issue of why it happened.

Rarely in the course of human events has a report issued by any government agency been so cowardly and delusional. It’s so inept, it doesn’t even rise to cover-up level.

. . . .

The report is so politically correct that its authors don’t even realize the extent of their political correctness — they’re body-and-soul creatures of the PC culture that murdered 12 soldiers and one Army civilian.

. . . .

Unquestionably, the officers who let Hasan slide, despite his well-known wackiness and hatred of America, bear plenty of blame. But this disgraceful pretense of a report never asks why they didn’t stop Hasan’s career in its tracks.

The answer is straightforward: Hasan’s superiors feared — correctly — that any attempt to call attention to his radicalism or to prevent his promotion would backfire on them, destroying their careers, not his.

Hasan was a protected-species minority. Under the PC tyranny of today’s armed services, no non-minority officer was going to take him on.

This is a military that imposes rules of engagement that protect our enemies and kill our own troops and that court-martials heroic SEALs to appease a terrorist. Ain’t many colonels willing to hammer the Army’s sole Palestinian-American psychiatrist.

. . . .

To be fair, there’s a separate, classified report on Maj. Hasan himself. But it’s too sensitive for the American people to see. Does it even hint he was a self-appointed Islamist terrorist committing jihad? I’ll bet it focuses on his “personal problems.”

In the end, the report contents itself with pretending that the accountability problem was isolated within the military medical community at Walter Reed. It wasn’t, and it isn’t. Murderous political correctness is pervasive in our military. The medical staff at Walter Reed is just where the results began to manifest themselves in Hasan’s case.

Once again, the higher-ups blame the worker bees who were victims of the policy the higher-ups inflicted on them. This report’s spinelessness is itself an indictment of our military’s failed moral and ethical leadership.

I agree with Peters pretty much 100 percent.  He is absolutely right that the essential question–and arguably the only one that matters–is the one question this report completely ignores: Why was Hasan even in a position to commit mass murder given all that was known about his jihadist sympathies?  It is hard to argue with Peters’s conclusion (and mine) that mindless political correctness is to blame.  But I’m willing to consider alternative views.

The very fact, however, that the report and its lead authors refuse even to consider in public the issue of political correctness, let alone advance a credible alternative explanation means that (a) it’s almost certain that PC was the primary culprit, and (b) it will continue to wreak havoc in our military in years to come.

Since the financial crisis began, and people began casting about for “solutions,” I’ve argued that central clearing is not a panacea; not the silver bullet; not the cure.  Over here, that’s the decided minority view, and the Treasury and the Fed and Congress and the SEC and the CFTC are all gung ho for clearing, and forcing its widespread use.

In Europe, however, they are having some second thoughts on the subject, as this article by Aline Vanduyn and Jeremy Grant in the FT makes plain:

In the months that followed the near-implosion of financial markets, regulators scrambled to figure out how to rein in the vast over-the-counter (OTC) derivatives markets that were seen as central to the crisis.

But, as numerous high-level meetings this week by central bankers and regulators show, the hunt for solutions has thrown up a fresh dilemma: new risks posed by clearing houses.

Clearing houses have been touted as the perfect shock absorbers for risks [sadly true, especially in the US] associated with the $600,000bn, privately-traded or OTC derivatives markets, since they guarantee that trades are completed even when a party to a trade – such as a derivatives dealer – defaults.

. . . .

‘Clear more, and faster’ is what we are being told to do,” says an executive at a derivatives dealer. Indeed, dealers who met regulators in New York yesterday are expected to sign up to just that. However, it is rapidly dawning [I wouldn’t call it rapid; “finally dawning” is more like it] on regulators that, while forcing more OTC derivatives into clearing houses removes systemic risks from one area of the financial system, it may at the same time be concentrating new risks in clearing houses themselves. [Eureka! They’ve finally figured out that clearing just reallocates risks, rather than making them disappear.]

Minds are being focused in recognition that many of the OTC products that look set to be cleared have never been handled by clearing houses before. [And I wonder why that is?  Better late to asking that question than never.]

. . . .

That concern is mirrored in Europe. Alexander Justham, director of markets at the UK’s Financial Service Authority, says: “We should be under no illusions that clearing houses are highly systemic, therefore what goes into them and the risk standards that apply must be extremely high.”

. . . .

They call for clearers to forge links with each other to facilitate cross-border clearing and give traders a choice over where to send their deals for clearing, rather than being tied to one monopoly clearer.

Yet regulators are now concerned that the creation of these links – a process called “interoperability” – could be the source of another systemic crisis. The worry is that the weakest in the chain could bring others down if it were involved in a default and was insufficiently capitalised to meet margin calls. [In other words, clearing doesn’t eliminate linkages, it just reconfigures the system of linkages.]

. . . .

Yet there are many other questions that need answering even before new rules are set. The complexities are so great that a new regulatory group has been created to tackle them. [Complexity?  Who knew?]

. . . .

Damian Carolan, a partner at Allen & Overy, warns: “There is a real risk that the focus on ensuring that CCPs are sufficiently robust to withstand these historically unseen risks is lagging behind the work to push derivatives through those clearing houses. The two have got to go hand in hand.” [Listen to the man.  First do no harm.  Too much clearing can be as systemically risky–or more so–than not enough.]

All true.  And there’s so much more.  I’m compiling a list of ways central clearing can actually increase systemic risk–the concentration and interlinkage issues mentioned in the article being only two.   Hopefully this will be the subject of a blog post in the coming week, travel and teaching schedule permitting.

But it is at least a relief that somebody, the Europeans in this instance, have disabused themselves of the notion that CCPs are “perfect shock absorbers.”  It is also a relief that some people finally recognize that the concentration of risk in a single entity that uses a single method to evaluate and price risk means that mistakes in this methodology are inherently systemic in nature.  (Think “rating agencies.”)

Fools rush in where angels fear to tread.  Grand constructivist schemes to re-engineer a vast, complex system like the OTC derivatives markets create a huge systemic risk–the risk that the scheme is ill-advised, or implemented badly.  If it doesn’t work, the resulting crisis in response to a shock could be devastating.

In the US especially, the attitude is a Red Queen-esque “Sentence first, verdict afterwards.” Or, “ready, fire, aim.”  It would be far better (as Vernon Smith might say) to understand the ecology of the OTC derivatives markets before attempting to reshape them; to view them from a biological perspective, rather than engineering one.  To understand how this complex order has emerged, before attempting to engineer a new one.

I’m reading a book titled The New Institutional Economics: A Guidebook, by my friends Eric Brousseau and Jean-Michel Glachant.  One thing that comes clear in the book, and in reading the NIE literature generally, is that it is very hard to reform complex systems and institutions.  Embeddedness, interconnections, path dependence, beliefs, and informational demands, to name just a few, affect institutional performance, and are very difficult to understand, let alone take into account when making wholesale changes.  The potential for adverse unintended consequences is huge.  I think that if you are an NIE scholar, you are predisposed towards humility and skepticism about the potential for root-and-branch restructuring of complex economic and social systems.  Hopefully the FT article and the views it reports are harbingers of a growing humility about the advisability of a grandiose restructuring of the OTC markets.

I’m sure that kudzu sounded like a good idea to somebody at one time.  (H/T SW Mom.)  The idea of bringing in the cats, then dogs, and then elephants all sounded good to the apocryphal Indian villagers infested by mice.  The problem in each case was that “solutions” to one problem were based on reductionist analyses that focused on that problem in isolation, didn’t take into account the ecological complexities, and ended up creating worse problems than the one they were intended to fix.

We are on the verge of making that error in financial market regulation.  But only on the verge.  The FT article gives some hope that we aren’t about to bring in the elephants just yet.