Streetwise Professor

May 9, 2010

Lost at Sea

Filed under: Military,Politics,Russia — The Professor @ 5:40 pm

It seems that the riddle-mystery-enigma aspect of Russia is no more pronounced than at sea.  The Russian Navy recaptured a tanker, the Moscow University, that had been seized by Somali pirates.  So far, so good.  But whither the pirates?

At first, Medvedev talked tough:

Russian President Dmitry Medvedev had hinted Thursday at tough punishment for the pirates, saying “perhaps we should get back to the idea of establishing an international court and other legal tools” to prosecute pirates. “Until then, we’ll have to do what our forefathers did when they met the pirates,” he said.

Then a Navy spokesman said the pirates had been released back to their small craft and sent home, adding “why should we feed some pirates?”

It was all too much for Mikhail Voitenko, the editor of an online journal who gained notoriety for his calling BS on the Russian government’s statements about the Arctic Sea mystery.  Voitenko claims that the pirates were killed:

Mikhail Voitenko, editor of the Russian online Marine Bulletin, said the release strained credulity and instead sparked suspicion the pirates had all been killed

“There is no more stupid version than the one that has been proposed to us — that there was no sense in dealing with the pirates and that in Russia there are no suitable laws for convicting them,” he wrote.

“If the pirates really were let go, it should have been done in the presence of journalists. If the pirates were killed, a heroic version would have to be thought up,” Voitenko said.

Speaking of the Arctic Sea, what ever happened with that? Was there a serious investigation?  What WAS the cargo?  Who did seize it?  What happened to them?  The ship became a modern day version of the Flying Dutchman.  Which is not unusual when it comes to Russia.

Did Biden Have Travel Insurance?

Filed under: Politics,Russia — The Professor @ 8:41 am

Vladimir Putin personally vetoed the participation of Joe Biden and Prince Charles at this year’s celebration of the 65th anniversary of the Allied victory over Nazi Germany:

Russia invited Gordon Brown and other heads of state to attend the Kremlin’s celebrations on Sunday – the biggest ever. But with the prime minister unable to attend because of the general election, the Foreign Office suggested Prince Charles instead.

Last week, however, the prince was quietly stood down after Putin made it clear that he did not want him there – apparently in a sign of his continuing annoyance with the UK over its failure to extradite Boris Berezovsky, the Kremlin critic and former oligarch, to Russia.

Putin, Russia’s prime minister, also snubbed Biden, who had planned to go to Moscow and has been left kicking his heels in Brussels. Biden is close to Mikheil Saakashvili, Georgia’s president. During the 2008 Russian-Georgia war Putin famously threatened Saakashvili, pledging to “hang him by the balls”.

Yes, Berezovsky and Saakashvili might have had a little to do with it, but probably not much.  It also reflects, quite likely, Putin’s inveterate hatred of the US and the UK.  It also reflects, IMO, a continuing unwillingness of Russia to want to share the credit for vanquishing Hitler.  Although US, French, and British troops will participate in the Red Square parade for the first time, Russia is incredibly invested in a narrative of WWII in which the US and UK were bit players.  This narrative is an essential element in the meta narrative that justifies the legitimacy of the current Russian state.  A public snub of the US and UK  would be a powerful reminder of Russia’s belief that those nations were not essential to the ultimate outcome of the war.  (I also recall some kerfuffle over the 65th Anniversary of D-Day.  I can’t find a story, but I recall some Russian pique over that, in particular over Obama’s or Brown’s slighting of Russia’s role in the war.  Anybody else remember that?  So there might be an element of payback here.)

The US administration is supposedly ticked:

The White House is privately furious at the snub. Barack Obama told Russia’s president, Dmitry Medvedev, he was unable to attend but had confidently offered Biden as his replacement. [What, tee time get in the way?  Did he find the idea of being associated with “victory” awkward?]

Hey, maybe Barry should just phone his BFF Dmitri and get this all straightened out so Joe doesn’t have to reprise The Terminal in Brussels.

As if.

This is a small thing in substance, but one which is quite revealing.  It speaks volumes about Putin’s pettiness, pique, and power.  It reveals that the putative head of state is hardly even a figurehead.  It demonstrates that the vaunted “reset” is becoming a joke; if you can’t even fake symbolic bonhomie, how can you achieve real progress on substantive issues?  Will this administration get a clue?

May 7, 2010

Louis A. Gates?

Filed under: Military,Politics — The Professor @ 5:13 pm

Secretary of Defense Robert Gates has fired a shot across the bows of the US Navy.   He cast doubts on the Navy’s mission, and whether its procurement plans were consistent with what should be its mission or were a relic of the past.  He even hinted at reducing the number of carriers in the fleet.  This has touched off quite a firestorm in the Navy blogosphere, like this piece.

I hope to comment on the substance of Gates’s remarks, and the responses thereto later.  I just have time now to mention a historical parallel.  Truman’s Defense Secretary, Louis A. Johnson, believed that the Navy and the Marine Corps were anachronisms in the nuclear age, and desiring to cut defense expenditures overall, Johnson imposed brutal cuts on the USN and USMC, including the elimination of the first supercarrier, the USS United States, then on the ways.

This touched off the “Revolt of the Admirals” and vicious internecine fighting between the Navy and the newly-established US Air Force.  The Navy survived most of the feared cuts.

The Korean War broke out soon afterwards, and the dreadful first days of the war revealed that Johnson’s budget measures had ravaged the military, the Army as well as the Navy.  (In fairness, Johnson was faithfully implementing Truman’s policy.)  American forces were woefully unprepared.  The first Army units deployed from Japan were ill-equipped, poorly trained, and soft from garrison duty.  They paid a horrific price in the face of the NoKo onslaught.  Ironically, the 1st Marine Division staved off disaster.

Not saying that history will repeat itself, but the Johnson parallel popped into mind reading Gates’s remarks and the reaction to them.  It will be very interesting to see where things go from here.


Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 12:09 pm

NASDAQ has decided to cancel–bust–trades made between 2:40 and 3:00 PM ET if they were at prices more than 60 percent away from the market price prior to 2:40.

Very bad idea.

The orders executed at these prices were almost certainly stop orders.  Old fashioned stop orders.  The kind that have been destabilizing for years, not some newfangled HFT thing.  When stops are hit, they reinforce the price movement that triggered them.

Busting these trades therefore encourages the use of a particularly destabilizing type of order.  If the idea is to reduce the amount of positive feedback in the system, this will have the exact opposite effect.

There is still no definitive understanding of what triggered the selloff.  The P&G story seems bogus–the slide started before that.  Yes, algorithmic trading or program trading of some sort was probably involved.  Let’s try to think of the most likely trigger.

A big index futures sale that really moved the futures price would have triggered sell orders in stocks generally, first in the index component stocks, then in other stocks (as correlation or pair algorithms kicked in). The main effect of algorithms would have been to speed the transmission of the initial shock.  The question is: what would have caused a big index futures trade?  An error?  (CME says its system worked fine, and Citi denies it was involved in any erroneous trade, as had been rumored.)

There are no answers right now, but the methodology for providing the answers should be pretty straightforward, and ironically, the very accurate time sequencing and record keeping made possible by electronic trading will greatly ease the process of implementing that methodology.   Look which markets moved first.  Look at the orders that were associated with those moves.  Then trace the effects from there.  Knowing where the event started, the basics of algo trading strategies makes it straightforward to hypothesize how the shock wave should have traveled.  One can then test those hypotheses to see whether in fact these strategies accelerated the decline.

There are also reports that many HFT traders withdrew from the market when things got crazy.  This isn’t surprising, really.  That’s what market makers do.  (Remember the stories of NASDAQ market makers not answering their phones–or making markets–during the ’87 Crash.  Or clearing firms yanking their locals off the floor on that day.)  This is very consistent with the Greenwald-Stein story of how a big volume shock can lead to higher execution risk which causes a decline in liquidity which in turn makes the market more volatile.  That is another feature inherent in continuous markets, human or automated.  HFT firms that make markets won’t behave that differently than human market makers.  They’ve just embodied the logic in the market makers’ heads into computer code.

Another thing that is consistent with the Greenwald-Stein story is the report that the NYSE liquidity circuit breakers exacerbated problems.  Greenwald-Stein recommended that in the event of a major disruption, the market transition from continuous trading to an auction market.  That’s what NYSE did.  But this apparently resulted in orders being redirected to other execution venues.  The circuit breaker deprived the market of NYSE liquidity for a time, and the wave of orders stressed liquidity in other venues.  But one of the points that was made clear in the aftermath of the ’87 Crash is that circuit breakers have to be coordinated.  Tripping a circuit breaker in one market but not the other can make things worse, not better.

One thing that is not really consistent with G-S is the rapid rise in prices after the plummeting fall.  Indeed, the rise is in some ways more remarkable than the fall.  It is almost vertical, with the Dow moving up more than 4 percent in less than 15 minutes, with most of that distance covered in about 10.  This suggests that value buyers jumped on the opportunity, and drove up prices.  In G-S, the execution risk keeps the value buyers away.

Thus, another important question is: who were these value buyers?  Mightn’t they have been algo/HFT traders?  If so, it is imperative than any rule changes or regulations implemented in response to this event do not cripple those using negative feedback strategies.

I am probably asking for too much there, as the tendency to lump traders into big categories is very strong, and the ability and willingness to make careful distinctions virtually absent.

And it is highly likely that stop order traders who almost certainly exacerbated the price decline will not receive proper scrutiny, and indeed are likely to be pitied as victims; busting trades is consistent with that narrative.  That would be a real pity, and would betray a failure to understand what kinds of orders and trading strategies are destabilizing.  Stop orders should be taxed, if anything, and those using them don’t deserve pity–or mulligans.

May 6, 2010

Clearing and Capital Structure

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 8:26 pm

One of the arguments in favor of mandated clearing is that (a) CCPs require initial margin to collateralize trades, and (b) many OTC deals do not.  Requiring collateralization, the argument goes, reduces the default risk associated with derivatives.

Even assuming this argument is correct, it does not imply that clearing reduces the risk of failure of a financial firm, or the risk that its failure will have destabilizing spillover effects.  This is because the argument fails to address the equilibrium responses of affected firms.

In essence, collateralization reduces the credit/leverage in a derivatives transaction.  But if firms are forced to reduce leverage in one set of transactions, they can increase it in others.  Indeed, you’d expect this to happen.  If a firm has a given debt capacity, or a given target leverage, it will almost certainly respond to a mandated reduction of leverage in one set of transactions by using the debt capacity/target leverage freed up in this way by increasing leverage elsewhere.  For instance, it could borrow the initial margin amount.  (This is done, to some degree already for cleared transactions.)  A reasonable approximation of the first order net effect of mandated collateralization of some deals is that the firm’s leverage will not change much.  Yes, all else equal more collateral means less leverage, but all else is not equal.

Of course, the firm can’t be made better off by the imposition of a constraint.  Revealed preference implies that the firm is at most indifferent to forced changes to its capital structure, but likely prefers the freely chosen allocation of debt/credit capacity between derivatives transactions and other deals.  For instance, it may be cheaper to obtain credit/leverage through derivatives than through an on balance sheet loan.  (That’s the essence of my argument as to why end users may object to being forced to clear.)  But it is almost certain that firms subject to the clearing mandate will adjust their capital structures in ways that mitigate the impact of the mandate on their overall leverage and counterparty risk.  This is likely especially true for large financial firms that have many substitute funding sources.

Nor is it obvious that the form of the leverage will change all that much.  Even if you believe that the leverage implicit in derivatives trades, when combined with bankruptcy rules, encourages counterparties to run, it is likely that reducing that kind of leverage will encourage substitution into a form of debt that is similarly vulnerable to runs.  Runs are damaging to firms.  That’s why they can be a disciplining device.  By choosing its capital structure, a firm chooses a probability of a run.  This choice must be considered maximizing in some respect.  If you force a reduction of the use of one kind of credit that is vulnerable to runs, firms are likely to substitute towards another form that results in a probability of a run that is close to the original, maximizing choice.

This means that increasing derivatives collateralization will not substantially reduce the likelihood a firm will become bankrupt, or vulnerable to a destructive run.  Its main effect will be to redistribute the losses consequent to such a bankruptcy.  Derivatives counterparties may suffer smaller losses (due to multilateral netting and its effect on priority, and to lower leverage in derivatives deals due to greater collateral), but other counterparties will suffer commensurately greater losses.  As I’ve argued before, a priori one cannot conclude that this reallocation of default losses is more efficient than the one that results from the voluntary contracting decisions of the agents.  (Also note that the derivatives counterparties would often be the counterparties to the offsetting leverage increasing transactions.)

Put differently, the first order effect of clearing, whether through netting or increased collateralization is to change priority, not the amount  of leverage (and hence the risk of bankruptcy/default/run).  Its primary effect is redistributive.  It is not evident, moreover, that this effect is socially beneficial.  If there are externalities due to credit (arising from systemic risk, for instance), why should a credit exposure implicit in a derivatives transaction create a more harmful externality than a credit exposure inherent in some other transaction?

The amount of leverage, rather than the contractual means by which firms add leverage, is arguably the fundamental underlying concern.  Attempting to control leverage at the capillaries by regulating some transactions is pointless: leverage needs to be regulated at the heart.

This means that the most important steps should be to eliminate subsidies to leverage, whether through the tax code or subsidies to debt implicit in TBTF/bailouts.  The next most important measure is capital requirements and liquidity requirements, although I am much more dubious of their efficacy as they are, in essence, price controls set by (relatively) ignorant third parties which can be gamed by the much more knowledgeable parties that are supposed to be constrained by them.  Set the prices wrong and the cure can be worse than the disease; given the information imbalances, the prices are almost certainly wrong.  (The financial crisis, and the contribution of the Basel rules to it, provide a cautionary tale.)

This is another example, as if another was needed, as to how superficial analyses of the effects of clearing mandates create a false sense of security, and thereby encourage complacency.  They don’t fix a problem: they just move it around.  The cat won’t sit on a hot stove again, but in its obsession to avoid the stove it risks stepping in the rat trap.

There’s Computer Trading and There’s Computer Trading

Filed under: Economics,Exchanges — The Professor @ 6:26 pm

One story circulating to explain today’s selloff is a large, mistaken order entry by Citi.  Certainly not outside the realm of possibility.  It’s happened before.  There’s the famous story of the MATIF trader who swung around in his chair to speak to a colleague, and unwittingly rested his elbow on the “Sell 100” key on his trading keyboard, triggering a deluge of sell orders that caused the market to tank before he realized his mistake and started buying furiously.  Or the case of the guy who thought he was in the training mode of the Eurex system, when in fact he was in the live trading mode; he was goofing around, submitting big orders into the “simulated” market that were in fact going into the real market and causing the price to go crazy.  As I recall, this cost his employer (a German bank) $150 million.  Or the error in Japan where somebody submitted an order at a price that was off by several orders of magnitude.

So yes, stuff like this can happen in computerized markets, although systems are being made more robust to these kind of errors.  More robust, not completely so.

And, perhaps, once the original mistaken order went in, and affected prices of Dow stocks, that triggered other programs that caused additional selling.

But I am highly confident that the near immediate snap back was also computer driven, as other algos’ signals indicated that the new prices were too low and submitted buy orders.

The post mortem will be interesting.

The terms “program trading” and “computerized trading” are used so much it’s worthwhile distinguishing the problematic kinds from the beneficial ones.

Computerized trading was widely believed to have exacerbated the 1987 Crash.  The order execution then wasn’t computerized, but portfolio insurance strategies made order submissions contingent on price movements according to a computer algorithm, so the trading was computerized in some relevant sense.

This is the kind of automated trading that is problematic because it can create destabilizing positive feedback effects.  Synthesizing index puts as portfolio insurance through a dynamic trading strategy means that big price declines triggered more sell orders that arguably exacerbated the price declines which caused additional sales, and so on.  Option hedging strategies (e.g., dealers use dynamic hedges to manage the risk of options they’ve traded with customers) can have the same effect.

Stop orders (which probably contributed to what transpired today) can have a similar effect; price declines (rises) trigger sell (buy) orders that can exacerbate price moves.  These kinds of orders are as old as the market.

Margin-driven trades can do the same: those suffering losses on a price decline (increase) sell (buy) and who cannot come up with the necessary margin sell (buy) to close positions–again, as old as the market.

Some computerized trading–and I would argue that most algo trading–is very different.  It is a negative feedback strategy.  That’s what market makers do: they sell into purchases and buy into sales.  Much algo trading is effectively automated market making.  It is, in effect, the realization of what the great Fisher Black imagined in 1971, when he wrote an article in the Financial Analyst’s Journal titled “Towards a Fully Automated  Stock Exchange.”  Black envisioned a fully automated specialist that made markets, and thereby stabilized prices.  Computerized/algo market making programs based on negative feedback would have bought on today’s decline as Black described.  The rapid snap-back is perfectly consistent with that.

Moral of the story: ignore categorical condemnations of computerized or quantitative trading in the aftermath of today’s events.  There’s good, bad, and ugly.  Be careful, and try to distinguish them.

The Biggest Losers

Filed under: Economics,Financial crisis,Politics — The Professor @ 4:48 pm

Freddie Mac has just gone back to the Federal trough for $10.6 billion.  And it and Fannie will be back for more–lots more–in the months and years to come.

The F&F losses are the biggest suffered by any firms as the result of the real estate crash, dwarfing AIG’s losses, for instance.

The that fact that F&F’s losses indicates were bigger than anybody’s demonstrates, quite clearly, that it’s exposures were probably the biggest as well.  Although many, including many liberal-leaning economists, defend the firms from charges that they were culpable for the real estate bubble and subsequent crash, their outsized losses indicate that they were certainly a major contributor, if not the sole cause.

They need to be put out of their misery.  Razed, and the ground sown with salt.  The entire model must be so discredited that no one ever even dreams of resurrecting it.  It is the most classic example of how implicit guarantees reduce funding costs and permit leveraging up to massive size while taking on massive risks.

But Congress appears to have little appetite for putting the Biggest Losers on a path to extinction.  There is a Republican bill floating around that would have that effect, but its prospects are dim at present.  Outrageously, the Dodd bill, like the Frank bill before it, do absolutely nothing to rein in their Frankensteins.  (Or would that be Frankendodds?)

Given what happened in the market today, “Biggest Losers” has other meaning too.

First, the market crash and rebound.  Too early to tell yet, although initial reporting suggests that huge moves in P&G and Accenture, perhaps due to mistaken trades or mistaken quotes or mistaken prints, touched off a panic; the market was already as jumpy as a cat on coke given the European tumult, and this was sufficient to set off a collapse.  No doubt that computerized trading contributed to the precipitous drop, but I would also surmise that the near immediate rebound (which brought us back to a mere 4 percent loss on the day, up from 9 percent) was computer driven too.  I am sure that the quant signals indicated that the market was mispriced and this triggered a flood of automated buy orders.  We’ll see how this plays out.

Second, Greece.  I personally think the Europeans are crazy to bail out the Greeks.  It will not address the long term problems that Greece, and the other PIIGs face.  Indeed, given asynchronous performance required–the Greeks get the money today, and have to promise to go on a really, really strict diet tomorrow–is a recipe for a repeat performance in months or years.  Yes, I understand that a Greek default or restructuring would impose serious hurt on French and German banks, but it is better for the governments of those countries to deal with that fallout directly rather than taking actions that will at best delay the reckoning, and make it worse when it comes.

Insofar as the Euro is concerned–another Big Loser in the short run and the long.  It is down to around $1.26 right now.  (It’s an ill wind that blows nobody good: I’m short the Euro because I’m traveling to Euroland next month.)  But the entire Greek fiasco, and the looming threat of similar problems in Italy, Spain, and Portugal, put the long run viability of the entire project in jeopardy.  I don’t think it is salvageable, or worth saving.


Filed under: Uncategorized — The Professor @ 2:29 pm

That last post was the 1000th one here on SWP.  Makes me tired just thinking about it.  When I got to post #990 or so, I started to wonder whether #1000 would be on Russia or clearing, the subjects I’ve written most about.  Luck of the draw made clearing the winner.  But more Russia stuff will come soon, I am sure.

The other milestone occurred yesterday, with comment #5000.  Ironically, although Russian posts probably generate 80+ percent of the comments on SWP, the 5000th comment was on financial regulation.  The comment was submitted by a relative newcomer, gcoaster.  My old offer stands: a free SWP t-shirt (with the CBOT building picture that is the post backdrop on the front) for milestone commentors.  So, if you’re interested, gcoaster, send me an email with your information and I’ll send you the shirt.  Though I understand if you want to remain anonymous.  rkka, who submitted comments 3000 and 4000 has declined to reveal his secret identity so he can claim his prize.

A Second Voice in the Wilderness

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 2:24 pm

Harvard’s Mark Roe has an oped in today’s WSJ where he opines that clearing is NOT the “magic bullet” for systemic risk.  I definitely agree with that conclusion, as readers of SWP certainly know.

Several of Mark’s arguments echo the ones I’ve been making for the past two years.  First, they can create a moral hazard, and there is room to doubt that they have the requisite information to price counterparty risk properly:

The clearinghouse reduces our incentives to worry about counterparty risk. Your business might collapse before you need to pay up, but that’s not my problem because the clearinghouse pays me anyway. The clearinghouse weakens private market discipline. [That’s the moral hazard point.]

Still, if the clearinghouse is as good or better at checking up on your creditworthiness as I am, all will be well. But one has to wonder how good a clearinghouse will be, or can be. [That’s the information point.]

Second, they can create a systemic risk:

Moreover, if trillions of dollars of derivatives trading goes through a clearinghouse, we will have created another institution that’s too big to fail. Regulators worried that an interconnected Bear or AIG could drag down the economy. Imagine what an interconnected clearinghouse’s failure could do.

AIG needed $85 billion in government cash to avoid defaulting on its debts, including its derivatives obligations. Could one clearinghouse meet even a fraction of that call without backup from the U.S.? True, we could have many clearinghouses, each not too big to fail—but then maybe each would be too small to do enough good.

The Senate bill would allow a clearinghouse to grab new collateral out from failing derivatives-trading banks to cover old, but suddenly toxic, debts the banks owe to the clearinghouse. This could harm other creditors and cause the firm to suffer a run. Nevertheless, to protect itself in a declining market, a clearinghouse would have to make those big collateral calls. That’s good if it protects the clearinghouse. But it’s bad if it starts a run on a weakened but important bank.

. . . .

Clearinghouses can help manage some systemic risk if they’re run right. If not, they can become the Fannie and Freddie of the next financial meltdown.

Third, by allowing multi-lateral netting, clearing gives derivatives counterparties priority over other creditors, a point I first made back in ’08.  This is systemically ambiguous.  There is no guarantee that the derivatives counterparties are more systemically important, or more vulnerable to contagion, than other claimants.  For instance, reducing the payoffs that the buyers of a big intermediary’s short term paper obtain in the event of a bankruptcy by reshuffling priority imposes bigger losses on these creditors.  In the Lehman case, these creditors included money market funds who had bought Lehman commercial paper; the threat of a run on the money market funds led the Fed to guarantee them.

Where Mark and I part company is on bankruptcy treatment of derivatives.  He believes that all aspects of the bankruptcy code that give priority to derivatives counterparties should be eliminated.  Although I (see above) concur that changing priorities can be problematic, I also believe that treating derivatives exactly the same as other debts is problematic too.  Indeed, I think that there is a good argument for several of the safe harbor provisions.

I’ve been planning to write an extended post on this issue, and still hope to, so I’ll just summarize here.  First, the bankruptcy rules allow derivatives counterparties to seize collateral, whereas other creditors are stayed, meaning they cannot do so.  The reason this makes sense is that whereas in traditional debt the amount of exposure is limited to the face amount of the borrowing (plus interest owed), the exposure is potentially unlimited in derivatives.  Derivatives traders use collateral to limit their exposure; staying them would expose them to unlimited risk.

Second, the rules allow termination and close out netting of defaulted derivatives positions.  Without such termination and netting, (a) a defaulter’s counterparties would be locked into positions that generate unhedgeable risk, and (b) could expose such counterparties who have winning and losing positions with the defaulters to having to pay the bankrupt’s estate on the losing positions and not getting much back on the winning ones.  This is particularly problematic in a dealer model in which dealers tend to run matched books (or close to it).  With termination and close out netting, their exposure is related to their net positions.  Without it, it could be as large as their gross positions, which are a multiple of their net.  The dealer market maker model would not be sustainable under these conditions.   No doubt there would be various work arounds, but these are likely to be very costly and impede greatly the ability of the market to serve its risk transfer functions.

So Mark and I would agree that dictating CCPs is a bad idea; we would disagree on the advisability of wholesale changes in the treatment of derivatives in bankruptcy.

I know that Mark also shares my concern about the psychology that underlies the fixation on clearing mandates as the panacea to systemic risk.  There is a palpable obsession with “solving” the systemic risk problem.  Clearing has been seized on as this solution.  Groupthink has taken over, and there is virtually no questioning or critical analysis of clearing as it is, as opposed to clearing as people wish it to be. There is this rather unsettling similarity to a cult; it is like clearing is the space ship that will take the believers to a better place.  Or to a belief that there is a magic pill or painless diet that will cause one to lose weight and keep it off.  The thought is comforting.  It’s easy.  This makes people unwilling to ask uncomfortable questions.

This desire to “solve” systemic risk in one step is especially troubling because it bears the seeds of the next crisis.  The thing that is most likely to breed complacency is a belief that a problem has been solved.  As Mark, and I and others, have argued, clearing is not a foolproof solution, but has its own risks.  Overlooking those risks is a very dangerous thing.

May 5, 2010

Clearing Currencies

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:03 pm

The European Commission is pushing for foreign currency derivatives to be cleared.  This is also a bone of contention here in the US.

It is interesting that those advocating clearing, and also exchange trading, have not attempted to explain the very pronounced cross sectional variation in trading and clearing practices across markets, and the time trends in particular markets.  Virtually all FX derivatives trading is OTC (with currency futures being the hair at the end of the tail of the dog).  The large bulk of linear interest rate derivative trading is OTC (even though the Eurodollar futures and similar markets are immense, they are dwarfed by the even more immense OTC interest rate swaps).  Equity derivatives and interest rate option trading is more evenly split between OTC and exchange.  Moreover, whereas in recent years a good portion of interest rate swap business has migrated to clearing naturally (accounting for about 50 percent of the interbank business), no OTC FX business is cleared.  A decent amount of OTC equity business is cleared.  A considerable part of OTC energy trading in the US is cleared–and was trending in that direction starting from about 2003 without anybody from the government telling market participants to do it.

The lack of clearing in OTC FX is pretty interesting, inasmuch as counterparty risk on an FX swap of a given amount and tenor is greater than that of a corresponding interest rate swap because principal is at risk in the former, but not the latter.  If clearing is such an economical way of allocating counterparty risk, why is it almost completely absent for products in which that risk is pronounced?  Similarly, due to the jump-to-default feature in CDS, these products pose large counterparty risks, but they weren’t cleared either until the dealers came under pressure to do so.  So, the instruments that arguably pose the greatest counterparty risks were not cleared voluntarily.

It would be nice of those who have the Olympian insight to dictate how markets should be structured could explain how they are structured.  If the European Commission is right, then the participants in the FX derivatives market are wrong.  Why?  And why should FX market participants choose a different mix of execution and counterparty risk allocation methods than participants in interest rate swaps and equity and energy derivatives?  Especially since there’s more than a little overlap between the participants in these various markets.

This is an interesting economic puzzle, the solution to which might, just might, be somewhat illuminating.  It might just shed some light on the economic trade-offs involved in clearing.  Just a guess.  But in the haste to prescribe–to dictate–market structure, our legislative and regulatory betters couldn’t be bothered to understand.  They just know.  So everybody should just shut up and get with the program.

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