Streetwise Professor

The debate over the Russian spy scandal is still rolling along at my first post on the subject.  I don’t have a lot more to say, because there hasn’t been a great deal of new information.  In the absence of new facts, this story has followed the trajectory of many spy stories.  It has largely degenerated into a babble of Holmes-and-Moriarty-on-the-train-style arguments, most flogging a particular pet cause, i.e., to exculpate Russia or to damn it.  My favorite of these is that the Russians deliberately set up a ring of bumblers to distract the FBI from its real, and capable, deep cover illegals.  Not disprovable, so not worth any time arguing about.

I just want to draw attention to one article written by America’s premier scholars on Soviet espionage during the Cold War, Harvey Klehr and John Earl Haynes.  They make the good point that one should not read to much into the fact that this ring had yet to make any serious attempts at espionage, if public reports are to be believed.  But as Klehr and Haynes argue, operations of this sort are not intended to generate intelligence immediately.  Instead, they are long term investments intended to create the capability–the option–to secure intelligence in the future when its value is particularly high:

There has already been speculation that despite years of residence in the United States, none of the accused had been able to gather and transmit any classified information. Since none has been charged with espionage, it is plausible that their actual value to Russia until their arrests had been minimal.  The charges they do face, money laundering and failure to register as foreign agents, carry substantial penalties, but apart from a message from Moscow suggesting that their major task was to get close to policy makers, there is little indication of what their masters wanted them to do.   That has led a number of commentators to dismiss this gaggle of agents as a bad example of a bureaucracy so addled that it spent large amounts of money to construct a spy ring whose tasks could have been met by anyone with access to the Internet.

This dismissive response misses the point.  Russian intelligence, the SVR, made a very expensive, long-term investment by inserting these “illegals,” as agents without diplomatic cover are known, into the United States with instructions to spend several years constructing new identities and burrowing deeply into American society.  The pay back in terms of espionage tasks performed (either procurement of information or, more likely, recruitment of sources with access to sensitive information and servicing those sources) would come only after five, ten, or more years of slow development.

If one takes this seriously, the most surprising thing is the fact that there seems to have been extensive contact between the plants and their Russian contacts prior to the time that they were activated for serious spying.  (The contacts are still here, by the way: at least they have not been publicly kicked out of the country, as is pro forma in such episodes.  Why?)  Often, illegals are left with only infrequent contact for extended periods until they are activated.  Perhaps this reflects a deep-seated fear in the SVR that the good life in America would be too attractive, and that these individuals would be very reluctant to perform on call at some distant date.  Hence, keeping them busy and engaged on seemingly menial tasks was deemed essential to ensure that they stayed in the SVR’s orbit and control.

Like everything else, just a guess.  But I think the question is an interesting one.

About this time of day, 147 years ago, 15,000 Confederate soldiers topped the gentle rise of Seminary Ridge and began trudging towards the Emmitsburg Road, and beyond it, a low stone wall just below the crest of Cemetery Ridge.  When it ended, the Confederate force reeled back, blasted and torn.  A few stalwart men had penetrated a point in the Union line where the 71st Pennsylvania had broken, but the breach was soon sealed by a horde of running, shouting–and shooting–Federals from Pennsylvania, New York, Ohio, Minnesota, Massachusetts, Maine, and Vermont.

If you’ve stood on the ground, you wonder what Robert E. Lee could have possibly been thinking.  Advancing a mile without cover against a line of veteran troops on an elevation, with cover, and with ample artillery.  To me, it was the culmination of a little more than a year of remarkable achievements by the Army of Northern Virginia that had hurled its opponent from the very gates of Richmond onto the soil of Pennsylvania, winning engagement after engagement.  Hubris born of a year of amazing victories had convinced him that his men could accomplish anything.

But not all of his men were convinced.  His chief subordinate, James (“Old Pete”) Longstreet surely was not.  He resisted launching the assault, his opposition verging on insubordination.  And it is not as if Longstreet was a timid man who routinely opposed the offensive.  In fact, he was the architect of three of the greatest, most successful assaults of the Civil War: at Second Manassas, Chickamauga, and the Wilderness.  But he was a realist, and he foresaw what awaited his division, and the two of A. P. Hill’s Corps, that were to make the assault over that ground, against that enemy.

Lee realized it too, but too late: “It is all my fault” he said, as the broken ranks that had stepped off so confidently an hour or so before streamed back torn and bloodied, and so many fewer than before.

Faulkner wrote a famous elegy to the (mis-named*) Pickett’s Charge:

For every Southern boy fourteen years old, not once but whenever he wants it, there is the instant when it’s still not yet two o’clock on that July afternoon in 1863, the brigades are in position behind the rail fence, the guns are laid and ready in the woods and the furled flags are already loosened to break out and Pickett himself with his long oiled ringlets and his hat in one hand probably and his sword in the other looking up the hill waiting for Longstreet to give the word and it’s all in the balance, it hasn’t happened yet, it hasn’t even begun yet, it not only hasn’t begun yet but there is still time for it not to begin against that position and those circumstances which made more men than Garnett and Kemper and Armistead and Wilcox look grave yet it’s going to begin, we all know that, we have come too far with too much at stake and that moment doesn’t need even a fourteen-year-old boy to think This time. Maybe this time with all this much to lose and all this much to gain: Pennsylvania, Maryland, the world, the golden dome of Washington itself to crown with desperate and unbelievable victory the desperate gamble, the cast made two years ago….

Faulkner’s description was not accurate when he wrote it. Not every Southern boy imagined himself in the shade of the trees on Seminary Ridge in the early afternoon of 3 July, 1863: maybe every white Southern boy–a revealing lacuna.  But even with that modification, Faulkner’s characterization of the youthful Southern imagination is now an anachronism.  Well into the 20th century, the Civil War–pardon me, the War of Northern Aggression–was deeply imbued in the consciousness of most white Southerners.  Now, even in the deepest recesses of the erstwhile Confederate states, thoughts of the war hardly enter the minds of 14 year old boys.  Yes, interest in the War is more intense in the South than in the remainder of the country, but that isn’t saying much.  Today, Southern 14 year olds are far less distinct from their Northern peers than was the case when Faulkner wrote.

And yes, there are a large number of people with an abiding intellectual interest in the War, some going so far as to want to relive the lives of Confederate soldiers to the extent possible in the modern world (as described in Confederates in the Attic).  But the very intensity and novelty of these aficionados demonstrates how things have changed: whereas during Faulkner’s day a deep, mystic, and romanticized connection with the Civil War was ubiquitous in the South, today any connection is limited to a very few, often quite eccentric, individuals.

Which is for the good.  I am an ardent historical preservationist who believes that the past can be instructive and should be preserved.  But preserving an idealized, romanticized view of a culture that enslaved millions was destructive.  As much as I am in awe of the bravery and martial skill of the soldiers of the Confederacy, I have no fondness for the Lost Cause, which is really a fondness for a profoundly unjust social system, the remnants of which persisted for far too long after the War.  So I am grateful that, in 2010, the Southern boy for whom it is “still not yet two o’clock on that July afternoon in 1863” is the exception, rather than the rule.

* Pickett’s Division represented only one of three that made the assault.  Two divisions from A. P. Hill’s Corps, Pettigrew’s and Trimble’s, also participated.  (I saw a plaque honoring Pettigrew at the University of North Carolina, Chapel Hill, during a visit in April; he entered the school as a 15 year old.)  Trimble was horribly wounded and captured.  Pettigrew was mortally wounded on the retreat from Gettysburg.  A. P. Hill was physically incapacitated during most of the battle, most likely from the effects of syphilis, and was shot in the last days of the War, during Grant’s final assault on Petersburg.  Pickett’s survival (in a charge that felled every one of his brigade commanders–Garnett and Kemper and Armistead–and all but one regimental commander) and the Virginia-centric bent of post-war historiography ensured the connection between his name and the charge.

Today is the 147th anniversary of the second day of the largest battle of the American Civil War–and the largest battle ever fought in the Western Hemisphere.  During a few short hours (the major Confederate assault did not begin until mid-afternoon, and the battle ended around dark), the two sides suffered collectively tens of thousands of casualties in  swirling, intense, and confusing combat concentrated in a few acres of rolling Pennsylvania countryside.

July 2d was the day of Devil’s Den, Little Round Top, the Wheatfield, the Peach Orchard, Culp’s Hill and Cemetery Hill.  It was also the source of intense controversy that rages to this day.  Lee-Longstreet.  Meade-Sickles.  My bookshelf groans under the weight of books on the battle, and the controversies.

I have often expressed my admiration for Russia’s Finance Minister, Alexi Kudrin.  My respect has only increased after reading this broadside:

Russian Finance Minister Alexei Kudrin’s proposal to raise the retirement age is an attack on the United Russia party that Prime Minister Vladimir Putin chairs, a senior party official said.

“Kudrin, with fatal insistence, is advocating increasing the pension age,” said Andrei Isayev, the party’s first deputy secretary of the presidium, according to comments posted on the United Russia website today. “He is making an active play against the party, causing the electorate’s outrage.”

Against the party!  Heaven forfend!  That sounds right out of the 1930s–or 1984.

Kommersant adds additional detail, emphasizing that Isayev leveled the most devastating charge against Kudrin: he’s a liberal:

Isayev called the finance minister “liberals’ informal leader” trying to engineer “a decrease of the ruling party’s  support in elections” through knowingly unpopular initiatives that  would make voters indignant. “Since United Russia said more than once that it would vote against any increase of the retirement age… it is clear that Kudrin’s proposal is but an attempt to put a spoke in the party’s wheels.” Warming up to the subject, Isayev said that the latest political season revealed an alarming trend, namely that the opposition was now criticizing both the ruling party and its leader Vladimir Putin. “Considering how closely Putin and United Russia are associated in the eyes of voters, our opponents hope to boost their own political clout at the cost of United Russia leader’s,” said Isayev.

Interesting how Isayev is accusing a senior minister in the government, who serves at Putin’s pleasure, of being an “opponent” and de facto member of the opposition.  Further interesting that Isayev considers it “an alarming trend” that the opposition would have the temerity to criticize United Russia–and Putin.  Uhm, what are oppositions supposed to do?  Oh, I forgot: there’s not supposed to be an opposition.

The hysterical nature of Isayev’s screed suggests either a Sovietesque intolerance for dissent, or nervousness about the party’s political prospects, or both.

In fact, Kudrin is an ultimate realist who deals primarily in facts rather than dogma, especially party dogma.  His proposals are based on a sober appraisal of objective forces.

Russian macroeconomic policy has been quite reasonable under Kudrin’s stewardship.  He has always been a voice of sanity during both boom and bust.  Which is probably why Putin keeps him around despite the fact that he crimps the style of the siloviki and nouveau apparatchiks like Isayev.

And Kudrin is not a member of the “what, me worry?” school of Russian demographics (the charter member of which is a frequent commentor:) :

The number of working adults will equal that of pensioners by 2030, Kudrin said. There are 128 working adults for every 100 pensioners in the country today, he told the St. Petersburg International Economic Forum last month. Russia’s demographic problem is “worse than in other countries,” he said.

Indeed, demographic concerns underlay his proposal.  In contrast, political short-termism of the rankest sort motivates the histrionics of Isayev.

Kudrin’s grounding in reality, and his focus on the long term is why I admire him.  His ability to do that under what have to be difficult political circumstances is all the more admirable.

Which is why that I wish that the SVR would hatch diabolical plot to plant Kudrin as an “illegal” in the US, with the ultimate aim of infiltrating him into the deepest recesses of American economic policy structures.

Frank-N-Dodd mandates that all cleared swaps trade on either a contract market (i.e., an exchange) or a “swap execution facility.”  There’s been a lot of uncertainty about just what a swap execution facility (“SEF”) is, but the bill provides enough clues to get a pretty good idea.

The short answer: a lot like an exchange.  A whole lot.

Some key points:

• An SEF must permit multiple participants to trade by accepting bids and offers made by multiple participants.  This means that an SEF must be a “many-to-many” execution platform.  A “many-to-one” platform, such as an electronic system in which a bank or broker-dealer posts bids and offers that customers can execute against wouldn’t qualify.
• They must permit “impartial access,” although that term is not defined.  But it suggests a mechanism in which no one can be excluded.  (Here the link to clearing is important.  If anybody is allowed to enter bids and offers that others can execute against, they must be effectively equivalent as potential counterparties.  Clearing standardizes–homogenizes–credit risk across counterparties.)
• The bill specifies that the goal of the section on SEFs is to promote pre-trade transparency.
• SEFs must establish and enforce rules to deter trade abuses.  They must have the capacity to investigate to detect rule violations.
• Relatedly, they must collect information that can be used to establish whether rule violations have occurred.
• They must permit trading only in non-manipulable swaps.
• They must monitor trading to ensure that rules are adhered to.  In particular, they must engage in real time monitoring of trading, and have systems to permit accurate and comprehensive trade reconstructions.
• SEFs must monitor trading in swaps markets to prevent manipulation.
• The bill states that SEFs “shall” impose position or accountability limits.
• SEFs are required to adopt rules to provide for the exercise of emergency authority.
• They are to make public “timely” information on price and trading volume and other trading data, as prescribed by the CFTC or the SEC (for security-based swaps). That is, they must offer “timely” post-trade transparency, but just what constitutes “timely” is an open question.  (Yet another thing on regulators’ plates.)

If you compare this list to the obligations imposed on contract markets (i.e., futures exchanges), you’ll see that SEFs are subject to almost all of the same obligations as contract markets.

In essence, SEFs must be a many-to-many execution platform that is also self-regulating entity that polices for trade practice violations and manipulation.  The combination of many-to-many with “impartial access” and extensive pre-trade and post-trade transparency effectively requires the creation of a public exchange; the mandated link between clearing and SEF execution is also very (futures) exchange-like.

It seems unlikely that “dark pool” like structures would meet these requirements; these are often not many-to-many, frequently don’t permit the making or executing against bids/offers (e.g., crossing networks), and offer limited pre- and post-trade transparency (hence the “dark” in “dark market”).  Traditional dealer-client execution wouldn’t cut it either: that’s not many-to-many.  Moreover, the real time trade monitoring and the ability to engage in accurate and comprehensive trade reconstructions seems to be an insuperable obstacle for voice brokers, meaning that effectively the bill requires the creation of electronic exchanges.

This suggests that (a) market participants will have a very limited choice of methods for executing transactions in swaps, and (b) these choices are far different than market participants have opted for currently.  Congress, in its infinite wisdom, is forcing pretty close to a one-size-fits-all trade execution system on the market.

The lack of diversity in execution methods compatible with the SEF mandate contrasts sharply with the incredible diversity of market participants.  It is well known that these diverse participants would like to have access to a variety of execution methods compatible with their particular needs.  For instance, those wanting to trade in very large quantities often prefer–and often strongly prefer–not to trade on many-to-many exchange-type markets because of information leakage, price impact, front running, etc.  The incredible array of execution platforms in equity markets testifies to this, as does the variety of derivatives execution methods, which range from order driven exchange markets to voice brokered markets to electronic dealing systems to telephone markets.

What is the rationale for restricting choice in execution?  The only hint of a justification is the desire for greater transparency.  But it is well known that  transparency has costs as well as benefits.  Mandating a high level of pre- and post-trade transparency just begs the question of why market participants would systematically choose the wrong level of transparency (i.e., a level that does not maximize the difference between costs and benefits), and why even if some market participants might profit from a sub-optimal level of transparency, competitive forces don’t prevail in overcoming the self-interest of a subset of participants.  Moreover, transparency isn’t the only thing that matters to market participants.  Other aspects of execution affect their costs and benefits as well.  A myopic focus on transparency alone ignores these other relevant dimensions.

The clash between the diversity of market participants and the my-way-or-the-highway SEF rules will result in chronic conflict in coming years.  There will be a demand, and likely a very strong demand, for the creation of alternative execution mechanisms to accommodate diverse trader needs.  There will be conflicts with regulators, and litigation, over whether these alternative mechanisms fall afoul of the SEF requirements.  There will be lobbying for exemptions, exceptions, and new laws permitting the creation of new kinds of facilities.

In 2005, I wrote that there was a 30 years war over securities market structure that was effectively started by the Securities Act Amendments’ mandate of a National Market System in 1975: that is now on its way to becoming a hundred years war (with the fallout from the Flash Crash just being the catalyst for another intense battle in that war).  The SEF mandate will spark a long running battle in derivatives market structure as well.  This is not the end of battles over derivatives market structure: this is the beginning.

The SEF rule is a Procrustean bed: an “arbitrary standard to which exact conformity is forced,” “a scheme or pattern into which someone or something is arbitrarily forced.”  Just why such conformity is optimal in a market with a wide range of buyers and sellers of different sizes, different trading objectives, different demands for immediacy and liquidity, etc., is hard to comprehend.  I understand that the nature of trading markets makes it that they are unlikely to be highly competitive (and I’ve written about that extensively in my academic work), and that as a result some inefficiencies (notably market power) can persist.  But competitive forces do exist, and especially given modern electronic trading technologies, it is possible for these competitive forces to respond to, and accommodate, diverse transacting preferences.

But rather than let market forces work, albeit imperfectly, Congress would rather play Procrustes, forcing traders large and small onto the same type of trading platform.

Where’s Theseus when you need him?

Patrick Pearson is head of market infrastructure for the EC’s financial market regulator.  He apparently hasn’t read the memo declaring that clearing mandates will usher in the era of the Big Rock Candy Mountain:

Central clearing  . . . is a concept so dear to regulators [sic] hearts that it has become something of a mantra — particularly since the demise of Lehman Brothers and the counterparty risks that were brutally revealed by that event.  So when Patrick Pearson . . . stood up to address an ABS conference in London on June 15 his words took some in the audience by surprise.  “Clearing houses don’t reduce counterparty risk,” he stated.  “They simply redistribute it.  Central counterparties (CCPs) can act as a channel for risk.  Their failure s far more dangerous than the failure of one single counterparty.”

. . . .

“If we shift massive amounts of OTC derivatives onto an exchange–are they safe enough to manage the risk? . . . . We don’t know.  There are 13 clearing houses in Europe.  If one defaulted there would likely be multiple defaults of clearing houses across the region.  Just imagine how the markets would react.”

Hallelujah.  How long have I been waiting for a regulator or legislator recognize those basic facts.

The author of this piece, Louise Bowman, recognizes that Pearson has gone off the happy talk reservation and committed the dire sin of telling the truth:

Hang on!  The market has long worked on the assumption that central counterparty clearing will be mandated in Europe — it is just a matter of when . . . . The question is therefore what the highly eloquent Pearson was trying to say.  In addition to questioning whether central clearing reduces counterparty risk he suggested that exchange trading of OTC derivatives might not be adopted in Europe–something that has also been seen as almost inevitable given the regulators’ drive for transparency in this market.

It is encouraging that not everyone in a position of regulatory responsibility has drunk deep the Klearing KoolAid.  It will be interesting to see how things develop in Europe.  It will be especially interesting to see whether an extended debate over clearing and exchange trading mandates lead to rather testy interactions between US and European officials, as alas, KoolAid seems to be the only thing served on Capitol Hill, Pennsylvania Avenue, and 21st St.

Pearson is, so far, pretty much a voice in the wilderness.  One hopes, however, that he catalyzes a more constructive debate on these issues.  There is a growing group of clearing skeptics among academics and practitioners.  Pearson’s outspokeness raises the possibility that the skeptics’ arguments might actually receive a serious hearing at least somewhere it matters.

My daughter, Renee, is a member of the Young Leaders Program at the Heritage Foundation for this summer.  She is working on Heritage’s Index of Economic Freedom.  She just authored her first post on Heritage’s “The Foundry” blog.  An excerpt:

Seven of the eight economies ranked most free in the Index of Economic Freedom were once British colonies or trade posts. It’s no coincidence. Political institutions developed by the British such as representative democracy and rule of law provide a vital base for economic freedom.

Yet the U.K. no longer has the distinction of being ranked in the top ten freest economies. Its economic freedom score has fallen significantly in recent years due to expensive welfare programs that have eroded economic freedom and slowed growth.

As they say, read the whole thing.  That’s an order!

Renee will be presenting a paper on the parallels between commodity regulation in the 1930s and today at the Von Mises Institute Conference in Italy in October.

Congratulations, Renee.  Keep up the good work.