Streetwise Professor

Jeremy Grant wrote a piece on the no Federal assistance of clearinghouses section of the Lincoln bill in today’s FT.  He noted that both Gensler and SEC head Mary Shapiro came out in support of this provision.  He also argued that their position is quite wrong.

That Gensler is wrong is no surprise; I’ve thrown out watches that were right more often than he is.

Gensler and Shapiro are jumping on the “no bailout” populist bandwagon.  Now I also oppose bailouts, but one of my main criticisms of this section, and the arguments raised in its support, is that they confuse the operation of the Fed as a lender of last resort against good collateral, and a true bailout which uses taxpayer money to protect creditors. It is a crucial distinction, and one that Gensler and others apparently either don’t understand or are deliberately ignoring.

I noted in my earlier post on this subject that Bernanke’s Fed has certainly created confusion by pushing the LOLR concept beyond all previous limits.  But that’s reason to put limits on the Fed generally; it’s not a reason to cut off CCPs and other crucial derivatives intermediaries from access to even legitimate LOLR functions.  Section 106 throws out the baby with the bath.  It prevents creditor saving bailouts, but also does not permit systemically stabilizing use of LOLR powers.

The IMF supports central bank lending to CCPs backed by good collateral.  The Europeans recognize it too: note that some European CCPs, notably Eurex and LCH.Clearnet SA (the French part of LCH.Clearnet) have access to the ECB.

It’s important to recognize fundamental distinctions.  The Lincoln bill doesn’t.  Nor do its cheerleaders, Gensler and Shapiro.  This failure will have serious consequences if the provision becomes law.

It’s also interesting to note that on Monday Gensler refused to come out one way or another on the provision. In fact, he was so evasive that he even acknowledged that he was not answering the question.  What changed between Monday and Wednesday, when he said he supported the Lincoln provision?  Orders from on high?  Or a calculation on the direction of the political winds?  (Note that I exclude reasoned consideration of the economic issues from the possible explanations.  Why waste time on sets of measure zero?)

[Added bonus from the last link: Gensler Metaphor Alert!:

“Just like a street light protects you from dark and dangerous highways, we need something to protect us from the dark and dangerous market that is right now is OTC derivatives,” Gensler said.

Ever notice that Gensler appears to be really, really afraid of the dark?]

One last interesting story.  Senator Judd Gregg blew a gasket, accusing Gensler of a power grab:

CFTC Chairman Gary Gensler answered questions about the bill and its impact at the committee’s “mark-up” of the bill last week, which Gregg called an “affront” and a “pretty heavy sign” that he was leading the charge on the reforms.

“It’s trying to consolidate as much power as possible … in-house, and give the chairman of the CFTC basically massive authority over this market at levels never seen before,” Gregg said.

Gregg said Lincoln’s proposals, the bulk of which Dodd has agreed to merge with his bill once debate begins, are meant to penalize large players in OTC derivatives whose risky trades have been blamed for part of the recent financial crisis.

“I thought I’d woken up in Argentina in 1950,” Gregg said, describing his reaction to the Lincoln proposal.

“That bill is essentially a document that is written by people who do not believe in markets, do not believe in capitalism, and hate profit, and basically see … government as being the correct arbiter of almost anything that has to do with markets,” Gregg said.

Though I take pretty much anything any senator has to say with a huge grain of salt, I have to say that Gregg is pretty much on the money.  Yeah, the don’t cry for me Argentina thing is hyperbole, but the fact that the entire legislative effort is driven by people who do not believe in markets is spot on.  As is the assertion that Gensler is engaged in a massive power grab.

The sad things are that (a) he’ll probably succeed, (b) his agency is completely incapable of responsibly and effectively exercising those swollen powers (especially with Gensler at the controls), and (c) (a)+(b)=a future crack up that is appalling to contemplate.

Blanche Lincoln has expressed uncertainty as to whether the no Federal assistance clause in her bill will survive to become law.  (Here’s hoping, though the Republicans caved–I’m shocked!, shocked!–at holding up the Dodd bill which Steve Bainbridge rightly calls “evil.”)  Perhaps one reason for her uncertainty is that some anonymous Fed staffers threw some “comments” on the bill over the transom.  (Which raises the questions: why do these staffers feel the need to be anonymous?  Why hasn’t the Board, or Bernanke, taken a stand on this?) (We know with probability 1 that SWP’s cogent critiques had nothing to do with Lincoln’s uncertainty!)

Echoing my original take, the comments trashed the dreaded section 106:

1. Section 106 should be deleted.

a. Lending to financial market utilities. Section 106 would prohibit any federal assistance to swap dealers, major swap participants, swap exchanges, clearinghouses and central counterparties.  This would appear to override the provision of Title VIII that would allow the Federal Reserve to provide emergency collateralized loans to systemically important financial market utilities, such as clearinghouses and central counterparties, to maintain financial stability and prevent serious adverse effects on the U.S. economy.

i. As systemically important post-trade “choke points” in the financial system, it is imperative that these utilities be able to settle each day as expected to avoid systemic problems and allow for a wide range of financial markets and institutions to operate.  The failure of a systemically important utility to settle for its markets would not only call into question the soundness of the utility as a critical market infrastructure but could also create systemic liquidity disruptions for one or more  markets and potentially other financial market utilities.  The increased importance that Title VIII places on central counterparties and central clearinghouses to reduce risk in the financial system necessitates ensuring that short-term secured credit is available to these utilities in times of stress.

b.  “Push–out” of bank swap activities. Section 106 would in effect prohibit banks from engaging in derivative transactions as an intermediary for customers or to hedge the bank’s own exposures.

i. Title VI, which includes the so-called Volcker rule provisions, better addresses the problem of risks from derivatives activities by prohibiting any bank, as well as any company that owns a bank, from taking speculative, proprietary derivative positions that are unrelated to customer needs.

I would disagree only to the extent that I think the Volcker rule is inane too.

The interesting question is where this insanity came from.  In the months leading up to the announcement of the Lincoln bill, mandatory clearing was always on the table; mandatory exchange or exchange-like trading was constantly discussed; but the no Federal assistance provision was never broached.  How can it happen, so late in the day, that such a momentous provision, fraught with the potential for massive consequences (that are almost impossible to forecast with any precision), can appear in a piece of legislation like a bolt from the blue?  The cavalier attitude on display here is frightening.

I have another question, related to the consequences.  During the Crash of ’87 clearinghouses didn’t have direct access to Fed assistance.  Nor do they now, for the most part.  But the Fed clearly provided liquidity support in 1987 that although not directed to CCPs or FCMs directly, indirectly supported them.  The Fed flooded the system with liquidity, and “persuaded” (the quotes are in Bernanke’s article about the event) banks to take the liquidity and lend it to securities firms and FCMs to make sure that they would be able to meet margin calls.  The Fed also permitted Continental Bank to inject capital into First Options, which probably saved OCC; Continental, I believe, received Fed liquidity.

Would it be legal for the Fed to do provide the same indirect support under Section 106?  It seems ambiguous.  The Fed’s actions in 1987 were clearly undertaken with the intent of saving clearinghouses, and had this effect.  Do we really want lawyers (or judges) trying to figure out whether such indirect assistance is legal when the financial system is on the brink?  Or will the fear of such a constraint lead to the kind of backroom dealing and cover-ups that occurred during and after the AIG bailout?  (And which, by the way, may get Timmy! in the legal crosshairs of the TARP Inspector General.)

Has anybody in the Senate even thought about this?

You know, when you play chess, or plan military strategies, you have to think several steps ahead.  You have to play “what if?”  I believe, with almost metaphysical certainty, that nobody who will be voting on this has done so.  More often, they are looking back, and learning false lessons about the past, or ignoring potentially informative experiences, or just engaging in pointless political posing and posturing.  Which bodes very ill for the next future, and the next crisis–when, and not if, it occurs.

Which is just one reason why Congress is the biggest systemic risk.

The Ukraine-Russia gas-lease deal is hugely controversial within Ukraine.  The passage of the bill in the Rada was accompanied by civil disobedience, not to say near riot.  It is also somewhat controversial in Russia.  Putin has claimed that it will be extremely expensive for his country, but that it is necessary to cement ties between the two countries.

Independent commentary is broadly split.  Alexander Golts argues that Yanukovich took Medvedev and Putin to the cleaners:

The Duke of Wellington used to say some victories are worse than defeat. I suspect that President Dmitry Medvedev’s “brilliant diplomatic victory” in Kharkiv on behalf of Russia’s Black Sea Fleet will in reality create very serious problems for Russia in the future.

. . . .

Mindful of how they got burned by Bakiyev and Lukashenko, Medvedev and Putin decided not to fall in the same trap with Yanukovych. But this is exactly what happened. With the lower gas prices to take effect immediately, Ukraine can now save roughly $4 billion annually, whereas the lease extension will only take effect only after the current agreement expires in 2017.

At the same time, Ukrainian opposition parties have made it clear that once they come to power, they will annul the agreement.

. . . .

Yanukovych has already made the Kremlin a hostage to his hold on power — and he has been in office for only two months. Now Moscow has a deeply vested interest in seeing that Yanukovych or another member of the Party of the Regions remains in power right up through 2042. And the $4 billion per year in gas discounts that Russia has already promised Ukraine could turn out to small potatoes compared with the sums Yanukovych could demand from Russia in the years ahead, knowing that he has the upper hand in the relationship.

Conversely, Stephen Blank (whom I consider the most trenchant American commentor on Russia), believes this is a major coup for Russia:

However, in numerous ways this short-term deal represents a defeat for Ukraine and a massive victory for Russia. Kyiv loses because the BSF and its accompanying socio-political-economic-cultural infrastructure enable Russia to keep the Crimea, and thus Ukraine, in a permanent condition of de facto circumscribed and limited sovereignty. Moscow will retain all its points of leverage over Kyiv and gain more because the deal allows Russia to build two nuclear reactors in Ukraine and preserve its nuclear monopoly there (as an alternative to gas). Apart from this limitation on Ukraine’s effective sovereignty, Moscow also reinforces its tangible leverage over Kyiv by restoring its dependence on Russian subsidies and preserving Ukraine’s non-transparent gas economy. Third, it prevents Ukrainian democratization and market reforms. Fourth, it thereby inhibits Kyiv’s moves towards the IMF, and ultimately the EU. Fifth, given the lease’s duration of 25 years, with an option to renew for another five years, this deal all but ensures that future Ukrainian governments will be stuck with a minority controlled by Moscow in the Crimea, and will find it very difficult to move westwards towards the EU or NATO until 2042, if not later.

This deal also has profound implications for Ukrainian and European gas supplies. Russia is intensifying its work with Ukraine on the aforementioned consortium to restructure its gas network (RIA Novosti, April 22). Nonetheless, with Ukraine firmly dependent on Russia, Moscow will gain more leverage upon it because it is pushing hard for South Stream, which will essentially bypass Ukraine as regards supplying Central and Southeastern Europe. If South Stream proceeds, as Moscow hopes, it will isolate Ukraine from Europe even more.

The fundamental difference between Golts’s analysis and Blank’s is that Golts believes that the deal isn’t worth the paper it was written on, whereas Blank’s opinion is predicated on the assumption that Ukraine and Russia will adhere to the agreement.

In my initial take on the deal, I raised repeatedly the issue of performance on the agreement.  Consequently, I am very sympathetic to Golts’s take (although, unlike him, I view it as a potential feature rather than a definite bug).  There is a serious asynchronicity in performance under the deal.  Ukraine’s obligations don’t kick in until 2017, but Russia’s take effect immediately.  And with the uncertainty about what will happen in the gas markets in the coming years, with all the pipeline projects and shale gas and LNG, getting immediate price relief while retaining the option to act opportunistically in the future makes good sense for Ukraine.

It is also quite reasonable to conclude that Ukraine really didn’t give up anything.  Fast forward to 2017, and the expiration of the existing lease.  Can you imagine the potential for conflict?  Do you really think Russia would pick up and leave, willingly and meekly?  Don’t you think that there would be brinksmanship, blackmail, threats, bribery, political chicanery?  I would say that it was doubtful, at best, that Russia would leave, and if it did, it would only be after a period of substantial tension and uncertainty.

Most of the things Blank mentions would have remained with or without the deal.  Russia would have retained leverage over Ukraine (due to energy, and other things) without the deal.  Ukraine’s move west was pretty much a dead letter anyways, all the more because of Obama’s cosmic indifference to it, and his self-deluding man crush on Medvedev.

You also have to consider the alternatives.  Blank mentions three:

It had three alternatives: the first, which it pursued, was to offer Moscow a share in a consortium alongside Ukraine and the EU, to manage the reorganization of the Ukrainian gas distribution network. Moscow turned this down, not wanting to be part of a consortium in regard to reforming the Ukrainian gas network, because it would not have a controlling share and, equally importantly, opportunities for corruption in the current status quo constitute the foundation of much of Russia’s gas wealth and leverage upon Ukraine and other East European states. If there is to be a consortium, Moscow wants it to be one that it controls.

Kyiv’s second alternative was to bite the bullet and institute reforms within its gas economy (Kyiv Post, April 15). Yet, that course alienates President Yanukovych’s power base, which depends on cheap gas and non-transparent deals.

The third alternative is the deal that was struck.

Given that Ukraine is a deeply divided, and even more than typically dysfunctional ex-Sov polity, Blank’s second alternative (reform) is, no pun intended, a pipe dream.  Yes, it would be nice, but ain’t gonna happen.

Blank’s scorn of the Europeans is well merited.  They are hopeless when it comes to a robust, united stance on Russia.  Moreover, with the fissioning fiscal situation (Greece today, Portugal tomorrow, then maybe Spain, and Italy), Europe will be even more distracted, and less interested in getting involved in messy intrigues in the FSU.  Combine that with the don’t-give-a-damn attitude of the US, Russia will have little foreign opposition in its efforts to restore its suzerainty over its former dominions.  If the US doesn’t take the lead, nobody will.

The biggest risk to Russia in the deal is that Ukraine reneges–although, given that possession is nine points of the law, even absent a deal getting Russia out of Crimea would be dicey at best.

The biggest risk to Ukraine is that Russia reneges.  Indeed, I think that is almost inevitable.  This deal does not change the bilateral monopoly situation that characterizes the Russian and Ukrainian gas systems.  And any likely changes in the near term, e.g., the completion of South Stream, will enhance Moscow’s bargaining power.  There is little on the horizon that would enhance Kiev’s.  Russia will find many excuses to jack the price in the future, when it suits it.

So, my view is that this is just an interlude in the ongoing battle of bilateral opportunism between two fundamentally corrupt and unprincipled states.  Remember the old Soviet joke: “We pretend to work and they pretend to pay us”?  Well, I’d characterize this deal as “We pretend to give them a price break, and they pretend to extend our lease.”  All this deal does is create more promises to be broken.  And broken they will be.

To the post-ISDA reception party at The Supperclub, sponsored by ICAP, that is.  And I didn’t.

Actually, Mama had nothing to do with it.  I am a Poor Richard, early to bed, early to rise kind of guy; healthy (yes), wealthy (well, comfortable), and wise (Streetwise, anyways 🙂 ).  That, plus the 2 hour time difference meant that the party began well after my normal, CT bedtime.  So, while the daring ones were headed to the Supperclub, I headed back to the hotel for some shuteye.

The linked article says suggests that the fin de siecle decadence which I had not seen was not entirely absent.  (This definitely NOT work friendly article suggests that even more strongly.)

All which provides further reason, as if further reason was needed, why I became a professor, rather than a banker.

Update:  A reliable eyewitness tells me that the NYT story was more than a little exaggerated for effect.  The back room was empty, the dominatrix flix were nowhere to be seen, and in the main, it was just “a bunch of geeks dancing.”  And probably talking about Greeks.

According to this morning’s press reports, Dodd and Lincoln have agreed to bolt together their bills.  The Lincoln bill passed by the Senate Ag Committee would become the derivatives title of the Dodd financial “reform” legislation.  Crucially, according to these reports, the no Federal assistance/derivatives dealer spinoff/Volker plan on steroids will become part of the Senate bill.

Perhaps maintaining the spinoff is simply a negotiating ploy.  Republicans are likely to filibuster the bill, because it is not bipartisan.  Negotiations are ongoing.  One common negotiating ploy is to include outrageous clauses, that one can generously sacrifice during negotiations.

But maybe it isn’t.  Maybe Dodd and Lincoln believe in this insanity.  And it is insanity.

I’ve mentioned some of its scary features.  But I haven’t mentioned all of the frightening implications.  Derivatives markets are intended to provide risk bearing capacity and liquidity.  To do so, those making markets must combine trading talent, valuation expertise, and risk capital.  One of the reasons that dealers came to dominate OTC markets is that they were able to offer this combination.  Crucially, their balance sheets provided the risk capital that made traders more willing to deal with them than other  potential counterparties.  Dealers assemble networks of positions backed by their capital.  There are economies of scale and scope.  Prevent financial institutions from backing derivative deals with their balance sheets, and it will be impossible to exploit these economies.

It is interesting to recall that many financial institutions set up bankruptcy remote, separately capitalized, AAA derivatives trading subsidiaries.  But market participants preferred to trade with banks directly, thereby having recourse to the banks’ balance sheets.  That is, the market once upon a time had a choice to trade on something like that contemplated in the Lincoln bill, and consciously chose not to.

The spinoff clause is therefore likely to impair the liquidity and risk bearing capacity of the derivative markets.  (Perhaps, from the perspective of Lincoln and those of like “minds”, this is a feature, not a bug.)  Moreover, it is likely to result in more counterparty risk, as less-well capitalized intermediaries replace the banks.

I’ve focused on the derivatives aspects of the Senate bills, but there’s plenty more to hate in the Dodd bill.  Let me comment just briefly on the resolution aspects.

The $50 billion dollar “bailout fund” has drawn the most attention, and the most fire, but it’s small beer compared to other things in the bill.

Most importantly, as I’ve noted repeatedly, the fundamental source of too big to fail is the inability of the government to commit not to bail out creditors of a failing or failed institution.  Increasing the discretion of authorities responsible for resolution reduces ability to commit.

And the Dodd bill does just that.  It gives the FDIC and the Treasury and the Fed tremendous discretionary authority to make creditors whole on the taxpayers’ dime.  This discretionary authority is almost completely free from any Congressional check.  Moreover, this authority has effectively unlimited access to the public purse.

To sum up:  instead of constraining regulators’ ability to bail out creditors of big financial institutions, the bill expands their discretion; instead of increasing the credibility of commitments not to bail out by limiting access to government funds, the bill undermines credibility by giving the Fed and the executive branch virtually completely discretionary authority to pay as much as they want to the creditors of large financial institutions.

Sure, the bill also mandates greater prudential oversight, but this is unlikely to be sufficient, as a litany of past failures of such oversight should make plain.  That is tapping on the break, while the measures I just described are flooring the gas pedal.

I know it’s tiresome to hear it yet again, but it bears repeating: the source of TBTF is the implicit subsidy to creditors that exists when the government cannot pre-commit credibly not to bail them out.  The Dodd bill basically says in flashing neon:  We Will Bail Out Creditors!!!  Regulatory discretion plus unconstrained access to the Treasury is a recipe for systemic risk.

If, heaven forfend, the Dodd bill passes, keep an eye on the difference in the funding costs of big financial institutions and small ones.  If my analysis is correct, that difference–which is already substantial–will remain wide, and likely grow.

There is of course a conceptual link between the derivatives and bailout provisions.  Big derivatives dealers will take on too much risk, to the extent that they are subsidized via the TBTF features of the bill currently slouching towards passage.  But the right way to address that problem is not to hive off derivatives trading from the banks that get the implicit subsidy.  If they can’t take advantage of the subsidy via derivatives trading, they’ll just take advantage of it some other way.  Believe me, there are an infinite number of ways that smart bankers can exploit the subsidy to the fullest; close off one way, they’ll find another.  The better way to go is to take measures to reduce, and substantially so, the TBTF subsidy.  This the Dodd bill does not do: in fact, it does the opposite.

Sergei Guriev and Ekaterina Zhuravskaya of Moscow’s New Economic School have produced an excellent paper comparing Russia with South Korea.  The starting point of their analysis is the superficial similarity between South Korean economic growth performance in the 1980s-1990s, and Russia’s performance in the 1990s and 2000s (i.e., lagged about 11 years).  This similarity is sometimes touted as evidence that Russia is the next South Korea development miracle.

Not so fast, there, say Sergei and Katia.  There are huge differences between South Korea and Russia.  Notably, virtually 50 percent the latter’s growth is (per calculations by Guriev and Tysvinski cited in the paper)  is attributable to natural resources (notably oil), whereas none of Korea’s is.

More importantly, the authors emphasize that when evaluating future prospects for growth, it is necessary to take account of the staggering institutional gap between Russia and Korea.  By all measures, both contemporary, and comparing Russia today to South Korea in the late-1990s, Russia’s institutions are extremely weak relative to Korea’s, and this weakness is inimical to growth.  Sergei and Katia argue that, without a substantial improvement in Russia’s political and economic institutions, notably its protection of property rights, Russia has no chance at being a Eurasian Tiger.  No chance.

And here’s where their analysis is particularly pessimistic.  They emphasize the interaction between the resource rents that have accounted for huge share of Russia’s growth, and the prospect for developing growth-supporting, modernization-supporting institutions; specifically, they note that the resource curse undermines the development of robust market-supporting institutions.  They further note that, consistent with the predictions of a good portion of the resource curse literature, the energy and resource boom in Russia has led the elites to take measures to reinforce the status quo in order to protect their access to resource rents.  That is, the resource boom has coincided with a weakening of institutions, and the still-birth of any modernization efforts.  (The reinforcement of the power vertical and the erosion of federalism are the main examples they discuss.)

None of this should be a shock to SWP readers.  Guriev and Zhuravskaya are advancing arguments and evidence that I’ve been making for the past four years.

For those giddy with the success of a bond sale, or the nascent signs of a Russian economic recovery on the back of strong oil prices, the Guriev-Zhuravskaya analysis should be a bracing corrective.   The long term prospects for Russia’s development as anything other than a resource appendage, at the mercy of the economic prospects of the rest of the world (which determine the demand for the country’s resources), depend crucially on the development of strong institutions that constrain kleptocracy, corruption, expropriation, and rent seeking.  But, ironically, the dynamics of a resource-oriented polity are inimical to the development of those strong institutions.

This implies, as G-Z state,

that Russia’s long-term prospets are rather bleak. . . . Russia is very likely to embark on a slow-growth trajectory.  Even in the best-case scenario, it will not catch up with the advanced economies in the foreseeable future, and in the worst case, Russia will follow the fate of the Soviet Union.

Put differently, in SWP-ese: Russia: In economic purgatory for the foreseeable future.

Talk about cultural vertigo.  Thursday night: reception with derivatives dealers in the Legion of Honor in San Francisco.  Friday night: A Texas A&M ritual “ring dunk” and Bar-B-Q in College Station.  Hard to imagine two more different social occasions, but both were very enjoyable in their very different ways.

And here’s an interesting contrast in perspectives on the same issue from those different parts of the country.  In San Francisco, CDOs were of course a not uncommon subject of conversation and comment.  In College Station, I was talking with my daughter Renee’s best friend’s father, Roy, a cattle rancher from Elmendorf, Texas.  The subject turned to real estate.  Roy mentioned a housing development near San Antonio that was largely vacant: the banks that financed the houses, “didn’t keep any skin in the game, but sent all the money up north.” That’s going to be my new catch phrase for structured finance: “Sending all the money up north.”  Too true.

It is, as the Talking Heads sang, The Big Country, and a source of endless fascination to explore it.  It is especially fascinating to have such a juxtaposition of experiences.

Three stories about Russia caught my eye.

Story number one: Playing the Sorcerer’s Apprentice comes with its own particular risks.  Not long after Putin played the cat with the canary over the Russian role in the overthrow of the Bakiyev government in Kyrgyzstan, Russia is now anxious since that country is at risk of spinning out of control.

Russia has already made noises about protecting militarily Russians in the Central Asian country.  Given that (a) Russia has already announced a policy that it reserves the right to protect Russians abroad, and (b) “protection of Russian citizens” was a pretext for the invasion and de facto annexation of Abkhazia and South Ossetia, this could be a prelude to a Russian military intervention in Kyrgyzstan.  But I doubt this is an appealing option to the Kremlin–or to the Russian White House (which is what probably matters).  Military engagement in Kyrgyzstan would be a far different kettle of fish from the invasion of Georgia, since (a) Kyrgyzstan is not continguous to Russia, and hence would present some serious logistical issues, and (b) intervening in a civil war in a backwards, Muslim country would bring back bad memories, and the prospect of a thankless and pointless task with no readily identifiable end game.

So, driven by its obsessive desire to hamper US and NATO operations in Afghanistan, and to deny the US any presence in Central Asia, Russia has contributed to the creation of a mess that it will present it with few appealing options.  (Not to mention that hampering US/NATO operations is completely contrary to its continued whinging about the NATO failure to eradicate, or even target, Afghan opium production.)

Be careful what you ask for: words to live by.

Story number two: Ukraine and Russia have apparently concluded a deal whereby Ukraine will extend the Russian lease on the Sevastapol naval base in exchange for discounted prices on gas.  Before commenting further, I should say that using “concluded” and “a deal” in any sentence involving either Russia or Ukraine, and especially involving Russia AND Ukraine, is quite dangerous.  No deal is ever really concluded when these jokers are involved.

In some respects, this is good news (again, to the extent that the deal is real, and not just the forum for ex post opportunism by one side, the other, or both in the months and years to come).  First, it provides Russia relief on gas prices without Ukraine conceding any control over its gas infrastructure to Russia.  (Though this means that that infrastructure could become a flash point in some future dispute.)  Second, it reduces the prospect for conflict in 2017, which would have been almost inevitable if Ukraine had attempted to force out the Russian Black Seas Fleet.   Third, it may also reduce tensions with Georgia (reduce, but not eliminate) because if forced from Sevastapol, Russia was considering building a naval base in Abkhazia, which would have created numerous problems in the region.  It is also probably a net economic winner for Russia, as it saves itself the cost of building a new base for its (shambolic) fleet.

Story number three: Gazprom earned the world’s largest profit in 2009, but was a distant 30th in market capitalization.  Little needs to be said of this: it is yet another testament to how aggressively the market discounts the future prospects of Russian companies, and for good reason.

In some respects, the debate over clearing has been at cross purposes.  Those who advocate clearing, including many in the banking community, often focus on the chaotic events that accompany the default of a large OTC counterparty, such as Lehman or LTCM; advocates of clearing argue that a central counterparty can mitigate the disruptions associated with a large failure.  Those, like me, who are skeptical of mandates (but who are not averse to clearing if freely chosen by market participants, as has occurred in energy, freight forwards, and many interest rate swaps) focus on the incentive and information effects that affect behavior prior to a default.

I confess to being less than clear about the distinction, and therefore think it’s worthwhile to address these issues in more detail.

In essence, the distinction is between ex ante and ex post.  I have focused on the ex ante incentives, whereas others have focused on ex post issues.  Both are important.  (This parallels distinctions that transactions cost economists sometimes draw between agency theory and property rights models, which focus,  on ex ante incentives, and Williamsonian governance theories, which focus on the ex post management of contractual relationships.)

Of course, the ex ante and ex post issues are not unrelated.  Ex ante incentives affect the positions and risks that are undertaken, and hence affect the likelihood of a major default.  Resolution mechanisms affect the cost of dealing with default.  The expected cost of clearing vs. bilateral mechanisms for allocating counterparty risk is, roughly, given by the probability of a major default (which depends on the ex ante incentives) times the cost of such a default (which depends on the ex post resolution mechanism).  It is not evident a priori whether this product is larger under a cleared or uncleared system, hence the grounds for legitimate debate over the merits of clearing.

There is a colorable case that the combination of multilateral netting and the existence of a central counterparty that can coordinate the transfer and replacement of defaulted positions can reduce the cost conditional on a default occurring.  Multilateral netting reduces the magnitude of the positions that need replacing.  This reduces the stress on market liquidity resulting from a default.  Moreover, clearing facilitates the transfer of customer positions to solvent clearing members, thereby avoiding the necessity of replacing these positions via market transactions, further reducing said stress.  Moreover, the information that a CCP possesses about total positions, and its ability to coordinate the hedging/replacement of the defaulted risks can reduce uncertainty and mitigate price impact.  (Although it should be noted that the experience of the CME with the Lehman problem, as documented by the Valukas report, and as suggested by what I have learned from informed sources that the LCH unwind of the Lehman positions was not as breezy as LCH has suggested demonstrate that this is at best a relative statement.)

Some research that grew out of the ’87 Crash sheds light on this last issue.  An interesting paper by Greenwald and Stein (JOB, 1988) shows that normal, continuous trading mechanisms can exhibit poor performance during periods of market stress caused by a large shock to the volume of transactions (especially when this shock is accompanied by an increase in fundamental uncertainty).  In essence, there are execution price risks under these circumstances that create negative externalities.  Potential replacement counterparties are reluctant to trade in these circumstances because of the extreme uncertainty about execution prices during periods of large volume shocks.  This tends to reduce liquidity, which tends to exacerbate the execution price risk.

This means that the uncoordinated replacement of large numbers of defaulted positions by a large number of firms through the use of ordinary, continuous market mechanisms (whether OTC or exchange) can lead to substantial price changes that are not fundamentally driven, but are microstructural in origin.  This can have further knock-on effects, as these (distorted) market prices affect collateral/margin calls, can induce asset fire sales, etc.

Thus, a plausible characterization of a key trade-off between bilateral and cleared structures is: (a) counterparty risks are more efficiently priced and shared in a bilateral setting, and hence moral hazards and adverse selection problems are less acute in that setting; (b) further, hub-and-spoke clearing networks create concentrated points of failure that are more problematic than more distributed (but still concentrated) bilateral networks; but (c) a cleared system reduces replacement cost risks/price impacts conditional on default.

Which raises the question: is it possible to obtain the information benefits associated with bilateral arrangements for some transactions, while mitigating the price impact of an uncoordinated replacement of defaulted positions? Can we have our cake and eat it too?

Put differently, clearing is a bundle of functions including inter alia: (1) the pricing of counterparty risks; (2) the mutualization of losses not covered by collateral; and (3) the management of risk associated with defaulted positions, and the replacement of these positions.  I argue that for many transactions and transactors, bilateral mechanisms are superior for (1) and (2); I recognize that CCPs may do (3) better.  Is there any way to get the benefits of (3), without incurring the disadvantages that CCPs arguably face with (1) and (2)?

I think that this could be possible.  In essence, it would involve pre-commitment to a suspension of normal, continuous trading activities in the event of a default by a large market participant (a dealer, such as Lehman, or a big hedge fund, such as LTCM), and its replacement with an auction-type mechanism.  (This is the essence of the Greenwald-Stein recommendation for “circuit breakers” that replace continuous trading with a call auction.  The key difference is that the Greenwald-Stein circuit breakers are price-contingent, which has some problematic features, whereas what I am proposing is default-contingent.)

ISDA implemented a “Big Bang” auction protocol to facilitate the settlement of CDS positions in the event of the default in a named credit.  Although as I predicted in my post on this subject some years back, this protocol has not eliminated all problems with pricing the debt of defaulted credits (as shown in a recent Markit Magazine article), it has greatly smoothed the process of handling CDS-triggering credit events.  Perhaps something similar could be designed and implemented to deal with a big derivatives default.

ISDA could of course play a central role in shepherding the creation of such a mechanism.  Similarly, regulators, notably the NY Fed, could also play a constructive role, perhaps in both the design and implementation.  I am pretty sure that ISDA would be quite willing to engage in such a cooperative endeavor.

The process would of course be facilitated by the development of robust trade repositories that permit rapid determination of the positions that are defaulted against.  I have supported the creation of such repositories (see my Regulation magazine piece) from the outset.

Just thinking out loud, here are some ideas of a potential structure.

First, a compression round whereby multilateral exposures are netted.  (This would have implications for bankruptcy priorities and bankruptcy law; these implications would have to be weighed carefully and addressed).

Second, an auction round for replacement of positions.  This auction round would follow a disclosure, based on the information in the trade repository, of all the positions, to the potential bidders.

The auction round raises several issues that need to be considered.  Who would be allowed to participate?  Permitting anyone to participate could just be a jump from the frying pan into the fire if some of the winning participants are themselves in dodgy financial condition.  (This is a dilemma that CME faced in its Lehman auction, and likely explains why it limited participation in the auction of Lehman positions).

Another issue is that the number of positions to replaced can be immense, and highly heterogeneous, with many non-standardized contracts.  Perhaps one way to deal with the latter would be to auction off shares of portfolios, e.g., USD interest rate (swap, swaption, etc.) positions; FX positions; equity derivatives; and so on.  This would mitigate cherry picking/adverse selection problems and simplify the bidding.  It would, however, mean the splitting of some individual contracts among multiple counterparties.  (It should be noted, though, that many of the positions would not be cleared or even clearable in any event, so this issue is not eliminated by a clearing mandate.)

Yet another issue is that those assuming positions would be taking on counterparty risk.  Thus, the repository would have to disclose the counterparties to the defaulted contracts to the potential bidders.

So, I realize that there are many thorny operational issues that must be addressed to implement this proposal.  But some would exist under a clearing mandate because not everything would be cleared in any event.  I further realize that FRBNY and the dealer community tried to do some of this on the fly in the “Lehman weekend,” and in LTCM years before.  The Lehman attempt foundered (as Theo Lubke of FRBNY, and several bankers I spoke to, indicated at the ISDA AGM).  But perhaps this is not surprising as extemporizing on the fly in those conditions faces faint chances of success, particularly given the lack of information available to the participants; a pre-planned mechanism that can rely on more complete information is almost certain to work better.  I would also note that in a cleared market something like this will have to be in place in any event.

The logic behind my approach is pretty straightforward.  Whenever things are bundled, the immediate question should be: can efficiency be enhanced by unbundling them?  (A lot of what goes on in finance involves unbundling things and allocating the pieces in a value-enhancing way.)  Sometimes you can’t: so be it.  But sometimes you can.

Clearinghouses bundle counterparty risk pricing, counterparty risk management (including the collateralization mechanism), mutualization, position information collection, and default resolution.  There is no logic that says that those functions have to be bundled.  Repositories can collect and aggregate information, perhaps more effectively than CCPs (because they can incorporate information on non-cleared positions, and information on positions held across CCPs).  CCPs are not always the best at counterparty risk pricing and collateralization mechanics.  Mutualization can have some extremely problematic features.  So why not an approach that unbundles, and allows specialization in these various functions?

Once repositories are created, the development of a robust, coordinated defaulted contract resolution/replacement mechanism would go a long way to improving the efficiency of the OTC derivatives market while permitting it to continue to do what it does best.  This would be an easier process (though not a simple one) than what will be set in motion by the vast expansion of CCPs as contemplated in the pending legislation.  CCPs will have to develop resolution procedures in any event.  Moreover, it is desirable to develop procedures to deal with contracts that are not cleared (which will be the most challenging ones in any event).  But force-fed CCPs will also have to grapple with challenging pricing, risk management, risk sharing, and governance issues as well.  And if there are multiple CCPs, there will have to be some coordination of the resolution procedures.  (If there isn’t there will be trouble.)  So, a mandated and extensive expansion of CCPs will have to solve many more problems than just the resolution mechanism.  So why not just focus on that?

I am sitting in the SF airport, on my way back to Houston after speaking at the ISDA Annual General Meeting.

Wikipedia states that “fin de siecle”

refers to the end of the 19th century, in Europe, France and/or Paris. It has connotations of decadence, which are seen as typical for the last years of a culturally vibrant period (La Belle Époque at the turn of the 20th century), and of anticipative excitement about, or despair facing, impending change, or both, that is generally expected when a century or time period draws to a close.

There was definitely a fin de siecle feel to this ISDA event.  Decadent?  No, but certainly more extravagant that what I am used to.  Anticipative excitement?  Definitely not, but certainly anxiety, bordering on despair, about the impending change facing the OTC derivatives business.

Yesterday, of course, Obama gave a populist speech at Cooper Union in New York, in which he demanded that Wall Street submit meekly to the regulatory proposals racing through the Senate.  Deputy Secretary of the Treasury Neal Wolin carried this message to ISDA.  He gave a hostile, our-way-or-the-highway speech.  I haven’t seen Wolin speak before, so I have no benchmark to compare to, but not only was his speech very sharp-edged, but his body English also communicated a certain hostility.

The audience reaction was as tepid as any I’ve ever seen.  I would probably be exaggerating if I said half the audience gave any applause, and even those clapping were making only the most perfunctory effort.

Mark Brickell, formerly of J. P. Morgan, asked a very provocative question, and one that needed asking.  He asked Wolin whether by forcing things into clearinghouses, weren’t the new proposals creating the ultimate too big to fail institutions, and effectively committing the government to future bailouts?  Wolin’s answer was basically just a flat denial, and did not truly engage the real issue that lay at the heart of the question.

Wolin was also asked about the Lincoln bill’s no Federal assistance provision, which would be the Volcker bill on steroids, requiring not only banks to exit proprietary trading, but customer-facing derivatives market making activities too.  Consistent with other administration voices, Wolin neither endorsed or criticized the measure.  He said something like “there’s a lot in these bills.”  Thanks for that insight.

I was on an academic panel chaired by Chris Culp (Chicago), with David Mordecai (Chicago), and David Mengle (UCLA, which was Chicago West in those days).  Mengle gave a nice talk about close out netting and its essential role in the OTC trading model.  David Mordecai gave a conceptual talk about the broad lessons of the crisis, in which he drew on the insights of Ronald Coase (always a good choice).

I gave the 20 minute Cliffs’ Note version of my case against clearing mandates.  My talk was largely well received, though not by everybody.  One of the things I focused on during my talk was the experience of the 1987 Crash, in which the CME clearinghouse was in serious jeopardy.  Somebody from CME clearing came up afterwards, and was pretty outraged at what I said.  He told me I was “feeding the dealer frenzy.”  No, I am trying to counter the legislative and regulatory frenzy with some back-to-basics analysis of the economics of risk sharing.  He also denied that the CME clearinghouse was in trouble in ’87, which got me a little ticked.  I told him, hey, look, I was there, I lived it, and was told that very specifically by Brian Monieson, a CME board member, in the morning of 20 October, 1987; truth be told, when that was happening this gentleman was in grade school in India.  You can look at contemporary accounts, including the Brady report and the Bernanke article on clearing and settlement during the Crash, and learn the same thing.  You can also look at Tamarkin’s book The Merc.  I was told of the BOTCC problems on the 19th-20th by two well-respected FCMs.  This isn’t a secret.

In various conversations afterwards, many bankers asked me about the ’87 Crash.  For the most part, they were not aware of the history, and were quite interested in it.  (Thanks for making me feel old, guys.)  Several are involved in various clearing efforts today, and found this history quite thought provoking.  That’s a big reason why I make such a big deal out of this.  People are so focused on the last crisis, and preventing a recurrence; regulators and legislators are most guilty of this.  It is important to make people aware that the last crisis was not the first crisis.  That there’s more historical experiences that can inform our current deliberations than what transpired in September, 2008.  The Crash of ’87 is particularly valuable because it gives the lie to the widespread claims about the efficacy of clearing as a solution to systemic risk.

Went to the meeting knowing almost no one, walked away knowing quite a few people.

The reception/dinner last night was a very interesting, almost anthropological experience  Pretty much the sole subject of conversation was the pending legislation; that’s what gave things the fin de siecle feel.  Everyone knows big changes are coming; that a vibrant period is coming to a close; and that the future will be very different.  The only question is: how different?

I think that the prevailing sense is that yes, some regulatory changes are needed and desirable, but that the punitive-for-the-sake-of-being-punitive legislation will be extremely counterproductive.  There was also a sense of despair that their fate was in the hands of those not only with an animus and an agenda, but with only a limited understanding of the way the business really works, and the likely consequences of what is being proposed.

Substantively there was broad agreement that expanded clearing could provide benefits, but that pushing it too far could be a disaster.  (That’s basically my view.  My CME interlocutor might talk to some of his own members to learn that they share similar concerns.)  There was widespread amazement at the exchange trading requirements.  I made a brief comment about the inanity of the Lynch Amendment (which may also be introduced by Sherrod Brown in the Senate) which several people talked to me about; they, as I, cannot believe how anyone would expect that banks are expected to bear counterparty risk by capitalizing a clearinghouse and providing backstop funds without having a commensurate voice or control of the operations of the CCP.

One last note.  The reception last night was held at the Legion of Honor, a beautiful art museum, which has one of the biggest Rodin collections outside of France.  (It also hosts a Cartier exhibit, which reinforced the sense of extravagance.)  The Thinker dominates the entryway to the museum.  On my way out, I looked back at the sculpture.  The sky was crystal clear.  A brilliant half moon hung over The Thinker’s head.  Four stars, in a diamond shape, bracketed the moon.  Quite a sight.