Streetwise Professor

September 30, 2010

Mr. Magoo Goes to Washington

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 7:02 pm

Jeremy Grant has an article titled “Concerns mount over clearing reforms” in today’s FT.   (Who knew?!)

It’s a good piece (and not just because he is kind enough to include a rather long quote from me).  Jeremy does a good job explaining the fundamental tensions inherent in the clearing mandates between risk bearing efficiencies, systemic risks, and competition.

The most succinct, and spot on, quote in the article is from the OCC’s Susan Milligan: “How this all plays out nobody yet knows.”

Least of all its creators, Dodd and Frank, and those in charge of implementing it, notably Gensler’s CFTC.  Hell, even Dodd admitted exactly as much.

We are witnessing not one, but multiple Mr. Magoos, driving merrily along leaving destruction and chaos in their wakes.   And it’s not just derivatives, but health care, banking, manufacturing, you name it.  I repeat: I sure hope Bismarck was right.

September 29, 2010

Lloyd Blankfein Channels SWP

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:22 pm

In this post-crisis (or is it continuing crisis?) world, Lloyd Blankfein and Goldman Sachs (a/k/a “The Giant Squid”) may not be considered the most savory company to keep, but that’s where I find myself today.  That’s because Goldman CEO Blankfein is also raising the alarm about the systemic risks posed by a vast expansion of derivatives clearing:

Lloyd BlankfeinGoldman Sachs Group Inc.’s chairman and chief executive officer, said using clearinghouses increase risks in an “extreme” crisis.

“I agree that clearinghouses make things less risky for the regular crisis, but in an extreme crisis that could affect the clearinghouse itself” and it’s “dramatically more risky,” Blankfein said at a finance and regulation conference in Brussels today. “We have to make sure that something that we do to reduce the risk in a once-in-a-20-year storm doesn’t increase the risk in a once-in-a-50-year storm.”

That may be an unintended consequence of the current regulatory push, Blankfein said, adding that clearinghouses themselves will need to be regulated and have capabilities to analyse the risk of financial instruments they clear.

“Otherwise, the clearinghouse becomes the biggest systemic risk in the world,” he said.

I’ve made the point often before, so I won’t belabor it now.* Needless to say, I agree.

Blankfein makes an interesting distinction here: “regular crisis” vs. “extreme crisis.”  I can hear it now: “Don’t worry!  This is only a mere regular crisis!”  That makes me feel so much better!

Welcome to the party, Lloyd.  You’re paying, right?

* I will recommence the belaboring process soon, though.  I am currently doing some research for an extended post on the Hunt silver episode, and what it tells us about the efficacy–and risks–in cleared, exchange traded markets.

Dear Dad: Send Money. And Power.

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:05 pm

No, this is not a letter/email from a poor–and megalomaniacal–college student.  It is a (slightly) snarky characterization of recent statements coming from the CFTC.

First, the money.  From Reuters (here’s a link to a related story: can’t find this story which was emailed to me):

The U.S. futures regulator could be forced to rein in tough new plans to tighten oversight of the $615 trillion over-the-counter derivatives market if it does not get promised new funding, two of the agency’s commissioners said on Tuesday.

If the Commodity Futures Trading Commission is denied the extra funding requested for fiscal 2011 it will have a hard time hiring staff needed to implement Wall Street reforms, said Jill Sommers  and Bart Chilton, commissioners with the CFTC.

“If we do not have the resources, we shouldn’t have ambitions that go beyond those resources,” Sommers, a Republican commissioner, told Reuters.

In a separate interview, Chilton, a Democratic commissioner, said the agency would be “in real trouble” if it went six months without a boost, and said he worries the CFTC could be in a lurch for the whole year.

“We would … have to pick and choose parts of the bill to implement — and that would mean things would not get done on time, as Congress as suggested,” Chilton said.

There is no doubt that CFTC needs a substantial boost in money and people in order to meet the Frank-n-Dodd requirements.  But given the daunting tasks, some devastating problems are inevitable.  CFTC cannot rely on existing self-regulatory organizations to to much of its heavy lifting in the markets it is now responsible for.  Moreover, dramatically scaling up the size of an organization inevitably creates problems as inexperienced people are brought in and experienced people are pushed beyond their capabilities and competence.  There will be problems.  Even train wrecks.  Plural.

The CFTC reminds me of the dog that finally caught the car, and asks: “Now what do I do with it?”

Second, the power.  Two pieces to this, just today.  The first is Gary Gensler’s floating the suggestion that the CFTC should have authority to set position limits just for energy, ags, or metals, but CDS as well:

Commodity Futures Trading Commission Chairman Gary Gensler said it’s “important” to have limits on trading positions in credit-default swaps as well as for commodities derivatives.

Regulators should have the authority to set position limits both on credit-default swaps and physical commodities derivatives, Gensler told a conference on financial rules in Brussels today. Limits “allow us to better protect against abusive practices.”

“We’ve been setting position limits in agricultural commodities and energy commodities for decades so we can learn from that,” Gensler said in an interview. Details of limits for credit-default swaps “are yet to come.”

Position limits are a bad idea to start with.  And apropos the money part of the post: Yeah.  More things on its plate in markets which it has no experience in regulating.  Just what the CFTC needs.

But this isn’t the only contemplated exercise of power in today’s news.  The CFTC is also considering mandating limitations on financial institution ownership of CCPs, along the lines of the Lynch Amendment that was one of the body parts left out when Frank-n-Dodd was stitched together:

The Commodity Futures Trading Commission is considering limiting banks and investors to owning no more than 20 percent of swaps clearinghouses, exchanges and trading systems, three people familiar with the matter said.

The CFTC, which will present its first proposed rules Oct. 1 for the $615 trillion over-the-counter derivatives market, may not grant exemptions for existing holdings, said the people, who declined to be identified because the talks haven’t been made public. Groups made up of bank holding companies, non-bank financial firms, major swaps users or dealers may not own more than 40 percent of clearinghouses, the people said.

Companies that may have to change their ownership structure include London’s LCH.Clearnet Ltd., the world’s largest interest-rate swap clearinghouse; Tradeweb Markets LLC, a derivatives trading platform; and NYSE Euronext, whose U.S. futures exchange is partly owned by banks.

Kevin McPartland is justifiably flabbergasted:

“What is an LCH.Clearnet going to do, that’s almost completely dealer-owned?” said Kevin McPartland, a senior analyst with Tabb Group in New York. “I can’t see how they’d expect that kind of massive divestiture of these clearinghouses that control trillions of notional” in swaps trades, he said.

Ah, but Kevin, you just haven’t fully grasped Gensler’s grandiosity (see above CDS position limit power grab).  The sorcerer’s apprentices are run amok, my friend.

The “theory” underlying this limitation is that it is necessary to combat conflicts of interest, whereby bank owners of CCPs might decide to eschew clearing of certain products that they profitably trade OTC.  Note that this problem could be avoided by ensuring that collateral and capital on cleared and non-cleared deals is chosen properly.  (Not that I am convinced that regulators can do that, but they think they can, and if they can, micromanaging the governance of CCPs is unnecessary.  And if they can’t: why the hell were they given this responsibility?)

In my view, this is a secondary or tertiary or whatever comes after tertiary consideration.  The key issue is aligning the incentives of those who govern CCPs and those who bear the risks.  Failure to do so will lead to a series of serious problems. The most important is that the CCP will have difficult attracting the capital necessary for it to provide its guarantee function because those that can most efficiently supply the capital will not do so if they are not given control rights commensurate to the risks that they are expected to take on.  If the idea behind mandating CCPs is to ensure the existence of sufficient capital to absorb big default losses, this is extremely counterproductive, to say the least.  And just think of the governance and management headaches that are inevitable when there is such a misalignment of incentives.

Historically CCPs have been dominated by financial institutions–banks, often–that are the residual risk bearers.  The ubiquity and survival of this model suggests strongly that it offers some substantial economic benefits.  Restrictions on CCP ownership and control will undermine this model, and likely make it impractical.  So what will take its place?  And if the substitute is so great, why didn’t market participants adopt it already?

It is hard to know what is more astounding about this idea: its presumptuousness, or the superficiality and incompleteness of the “analysis” supporting it.

Money.  Power.  Methinks there will be many more installments of this melodrama in the months to come.

September 28, 2010

Read the Woodward Article: Just Don’t Believe the Headline

Filed under: History,Military,Politics — The Professor @ 3:54 pm

Although I found the initial leaks of parts of the Woodward book on Obama and Afghanistan intriguing, I held off saying anything until the installments actually ran.  Today the first one is available, so here it goes.

The theme of the first installment, accurately conveyed by the headline, is that the military thwarted Obama by refusing to provide options other than those (or that) it considered militarily prudent.

This is a crock.

It would be more accurate to say: the military refused to provide Obama with the option he preferred–and which the military knew he preferred.  That option being, of course, a plan for a rapid withdrawal from Afghanistan.  Rapid withdrawal being something between an immediate cut and run leaving behind a token force of trainers, and an only slightly lighter version of the plan currently in force.

This refusal frustrated Obama no end, because the military’s obstinacy deprived him of the political cover he desired.  The Pentagon and the uniformed military weren’t about to recommend something they did not believe in.  They said, in effect: if you want to gut the mission in Afghanistan, you take the responsibility, and don’t hide behind us.

The most important figure in this was SecDef Gates, who Obama feared would resign if he chose the trainers-only option.  Obama could not stand such a high profile defection.  It would give the lie to all of his high sounding campaign rhetoric about Afghanistan being a war of necessity.

So Obama chose a course that was as close to his (and Rahm Emmanuel’s and Joe Biden’s) preference for effective abandonment of the Afghan campaign but which was still politically viable.

This demonstrates that the whole idea that Obama was at a loss to craft a policy without recommendations from the Pentagon is in fact a crock.  The article makes it clear that faced with the military’s opposition, Obama dictated his own plan.  Which is his right, as Commander-in-Chief.  But spare me the crocodile tears about the military leaving Obama adrift without strategic advice.  They gave it.  He didn’t like it.  He chose his own option all by his lonesome, thank you very much.  He was capable of doing so all along.

This is all pretty transparent, so one wonders why Gates went along even with the plan Obama eventually dictated, despite its transparently fatal defects.  The only thing that comes to mind is that Gates thought that by keeping the door open, and getting a commitment for more troops albeit with a limited timeline, there was a chance that it Obama would have to renege on his commitment to begin withdrawals almost as soon as the deployment would be completed.

This is a false hope, for it is clear that Obama is viscerally opposed to a continued commitment to Afghanistan.  In this he is one with his political base, and he has no intention of crossing them on this.  Indeed, as Obama’s political fortunes slip, he is even less able to anger those few allies he has left.

Although the military is portrayed as the heavy in this, I would take the opposite view.  They presented what they believe to be their best advice.  That’s their job.  It’s Obama’s to accept it, or not.

It should be noted, moreover, that the current brass is not a bunch of Jack D. Ripper-esque warmongers.  For the most part, they are deeply concerned about the stress on the Army and Marines in particular, and would be anxious to reduce commitments to the extent they believe prudent.  They also realize that Afghanistan is a logistical nightmare.  The fact that they were  pretty unified on the approach needed in Afghanistan despite their concerns over the stresses an increased commitment would impose on the force speaks volumes.

The Woodward piece talks about the specter of Viet Nam hanging over the deliberations.  Here’s a Viet Nam analogy that escapes Woodward’s mention–and the attention of most (and arguably all) who have raised this analogy.   Colonel H. R. McMaster’s book on the Joint Chiefs during Viet Nam shows powerfully that (a) the Joint Chiefs disagreed vehemently with McNamara’s and Johnson’s approach to the war in 1964, (b) McNamara basically isolated them, and (c) the Joint Chiefs acquiesced in this despite their deep misgivings.  McMaster believes that in acquiescing so, the Chiefs were derelict in their duty.  He believes that they should have resigned rather than give their tacit consent to a policy that they did not approve.

There is too little in what has appeared in Woodward’s piece and elsewhere to judge whether the uniformed military and SecDef Gates have been similarly derelict in their duty.  But their consistent opposition to presenting Obama with the option he craved but which revolted them suggests that they were more stalwart than their 1964-65 predecessors were.

I have said before that I am ambivalent about whether it is better to go large or go home in Afghanistan.  I am not ambivalent about the cold-blooded political course Obama has chosen.  His course has no chance of achieving anything there: the hard deadline is arguably the worst of all worlds.  It condemns many Americans–and allies, and Afghans–to death, without any prospect of achieving anything remotely resembling a military victory, even of the most limited variety.  I would much prefer that Obama do what he really wants to do, rather than follow a course that will have all of the same downsides, but which will get more people killed.

One last thing.  It is clear from reading Woodward’s first installment that Obama and Petraeus were bitter antagonists during these debates, and that Patraeus was particularly adamant in his opposition to Obama’s preferred course.  This makes sense, given their previous interactions, which no doubt left bad blood.  (And Patraeus would have every reason to hold a grudge against Obama and those pushing for the cut-and-run option, given the way they had slandered him during the Surge.)

This makes all the more remarkable Obama’s selection of Patraeus to take command in Afghanistan–and Patraeus’s decision to accept it.  The calculations, on both sides, regarding the offer and the acceptance cannot be even partly understood based on what is in the public record.  But it is evident that there is deep tension and suspicion in this relationship, and it is highly likely that there was a heavy dose of cynical gamesmanship by both.  That is the history I would really like to learn.  I wonder if and when we will.

Unintended, But Foreseen

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 9:57 am

In today’s FT:

LCH.Clearnet, Europe’s largest independent clearing house, and the London Stock Exchange have been rebuffed by one of their biggest rivals, Deutsche Börse group, in an attempt to break into trading and clearing of off-exchange equity derivatives.

The moves are a sign that the commercial interests of some exchanges and clearing houses could undermine efforts by global regulators to enact sweeping reforms of the vast over-the-counter derivatives markets.

. . . .

One US-based clearing industry expert said: “It is an interesting conflict where you have regulators saying you have to clear and you have to have competition in clearing but there are monopoly providers out there thwarting that. This is going to create a problem for that vision.”

This is from a piece that just came out (link to follow when available) in the Journal of Applied Corporate Finance (written in July):

First, the extensive scale and scope economies associated with clearing make it likely that the clearing industry will be highly oligopolistic, and that strategic considerations will influence decisively the way that the industry develops. Moreover, scope economies across trade execution and clearing (Pirrong, 2010b) will also affect the strategic and efficiency forces that will shape industry structure.  Strategic considerations will almost certainly drive a wedge between what is optimal for the individual decision makers, and what is optimal for the economy. [Emphasis added.]

From my Cato piece (written in May):

Moreover, the evolution of market structure in response to a mandate is difficult to predict. Given the scale and scope economies, it is unlikely that the market for CCPs will be competitive. In the presence of such indivisibilities and network effects, competitive processes do not necessarily result in the evolution of an efficient market structure. Furthermore, the distributional effects of the formation of CCPs, private information about these effects, and the ability of market participants to influence the regulatory process in order to achieve distributive gains makes it likely that the process of coordination and cooperation needed to create and structure CCPs will be plagued with inefficiencies.

So color me surprised.  Not.  There will be many more articles like that in today’s FT.  Bet on it.

September 26, 2010

Well, At Least This Time It Didn’t Blow Up

Filed under: Military,Politics,Russia — The Professor @ 2:09 pm

There has apparently been another failure of the Russian Bulava SLBM–or, perhaps more accurately, a scrub before another failure.  The Russian SSBN Dmitri Donskoi returned from the Russian missile test firing range without having fired a Bulava:

On September 10, Aleksandr Emelianenkov reported that the Dmitri Donskoi, a Typhoon-class SSBN adapted for test launching the Bulava, had sailed from Severodvinsk to the missile launch area where the Russian navy tests its ballistic missiles in the White Sea and then had returned to port without executing the anticipated 13th test launch of an RSM-56 Bulava SLBM. The SSBN returned to base with no explanation and so the anticipated test of Bulava on September 9-11 was postponed without setting a new launch date. Serdyukov on his return to Moscow from Paris, and before his departure to Washington for talks with Secretary of Defense Robert Gates, only commented that the no launch was imminent and said: “Most likely, this will happen in September and definitely not at the beginning of the month.” Emelianenkov, noting the series of failures that has plagued the Bulava, stated that insiders within the Russian military-industrial complex had asserted that everything was ready for the test launch and there were high hopes of success.

Who knows?  Maybe they tried to launch, but it fizzled in the tube.  Or maybe, the pre-launch diagnostics identified a problem.  But it sure didn’t go right.

Rolling heads lend credence to the theory that this was yet another episode in a litany of failures:

Shortly afterwards the Russian press reported a major shake-up in the leadership of Bulava development. Its long-time leader, Yuri Solomonov, the chief engineer in charge of the development of the solid-fueled Topol M upon which the Bulava was based, was removed from the Bulava project but left in charge of land-based Topol M development. By order of Anatoliy Perminov, head of Roskosmos, (Federal Space Agency) Aleksandr Sukhodolsky, the former design director at the Moscow Institute of Thermal Technology, will assume direction of the Bulava project. Solomonov sold the defense ministry and navy on the idea that the adaptation of the Topol M to sea-based launching would be a relatively simple technical problem. However, in the last six years out of twelve test firings only five were officially listed as successes. Unnamed sources close to the project say that actually only one test led to a warhead impact in the test area.

Contrast this serial charlie foxtrot with the truly delusional announcements regarding Russian military spending plans for the next decade:

Deputy Prime Minister, Sergei Ivanov, told journalists that a new 10-year government rearmament program will allocate some 22 trillion rubles ($710 billion) to produce and develop new weapons. According to Ivanov, the defense ministry will receive 19 trillion rubles ($613 billion) while the other Russian military services will receive 3 trillion rubles ($97 billion); 20 percent of the total being spent on research and development and the rest on the procurement of weapons (RIA Novosti, September 22).

To put these numbers in perspective.  Total German defense spending is about $41 billion/year.  French: about $64 billion.  UK: $58 billion.  China (officially–i.e., not to be believed): $100 billion.  Current Russian expenditure: about $60 billion, or 3.5 percent of GDP.

So, Russia is supposedly planning a delta in spending approximately equal to current spending, and bigger than total French, UK, and German spending.  Since procurement currently accounts for about a quarter of the Russian defense budget, this translates into a four-fold increase in procurement spend.

Why do I say delusional?  Let me count the ways.

First, as the Bulava fiasco shows, the quality of the Russian defense manufacturing is somewhere between dodgy and awful.  They can’t produce stuff now.  So they’re supposed to design and produce four times as much stuff in the next ten years?

Second, even Medvedev recognizes that the defense industrial base is a disaster:

This week President Dmitry Medvedev chaired a special session of the Commission of Modernization and Technological Development of the Russian Economy, attended by ministers, administration officials, defense industry chiefs and several prominent Russian billionaire oligarchs.  The purpose of the meeting was to discuss the state of arms production and call for radical improvements. The proceedings at a military electronics and avionics factory near Moscow were secret, but in his public opening remarks, Medvedev scolded the defense industry for its backwardness, its inability to “innovate” and produce modern equipment to rearm the Russian military. “The situation is quite bad, quite heavy,” announced Medvedev, “In many instances the Russian defense industry is unable to significantly increase production of high-tech equipment despite greater financing.” According to Medvedev, “we lag behind industrial developed nations” while continuing to develop slightly modernized versions of Soviet-era weaponry instead of making something new.

To translate: our defense manufacturing sucks.  So let’s quadruple spending!

Makes sense to me!

Third, Russia’s biggest military problem, believe it or not, isn’t hardware, it’s software–the people.  The experiment to professionalize the army was a colossal flop, and has been shelved.  The conscription system is broken, and will get only more so as the consequences of the demographic catastrophe of the 1990s and early-2000s for the size of the recruit pool begin to be felt.

But fixing the software problem is probably impossible.  It’s a heck of a lot easier to spend money on hardware–and a lot more lucrative for the spenders, if you know what I mean.

To summarize: no industrial base to build all these new weapons; no trained manpower to use them. I’m sure everything will work out just swell.

In his increasingly lame fashion, Medvedev is attempting to sell the military modernization as an integral part of his drive to modernize the Russian economy, with huge technology spillovers from the military to the civilian sectors:

Medvedev promised more defense spending and announced that defense industry innovation will not only modernize the armed forces, but also promote “the development of the entire economy.” Medvedev recalled the Soviet experience during the Cold War when the “innovative defense complex” determined the development of the material base of the Russian economy. The defense industry must become “a generator of innovation” and modernization. Medvedev proposed forming a Russian equivalent of the US  Defense Advanced Research Projects Agency (DARPA), first established in 1958 as a response to the Soviet launching of Sputnik in 1957 (, September 22).

After the meeting, Defense Minister, Anatoliy Serdyukov, told journalists some “75 percent of military technologies may be used in the civilian economy.” According to Serdyukov, technologies developed to produce new fighter jets, bombers, ballistic missiles and rockets may be used “in the civilian sector,” but the drain of ideas and specialists abroad is hampering development (Interfax, September 22).

This is utterly fantastical.  The vaunted spillovers have seldom been realized in western economies, and are less likely to be realized in Russia given the security establishment’s Gollum-like obsessive possessiveness when it comes to information and technology.

[Bonus laugh: look at the picture of Medvedev in uniform in the EDM piece.  He makes Dukakis in a tank look like Sergeant Stryker. And he has a penchant for getting photographed in uniform, and holding weapons in ways that make him look far more dangerous to himself than anyone downrange.  I bet Putin encourages Medvedev to make a fool of himself in this way.]

Russia has indicated that it will, for the first time, make large arms purchases overseas–including in the US–to meet its ambitious (i.e., insane) rearmament goals.  There are several things striking about this.

First, it is a pretty stunning admission of the implosion and obsolescence of Russia’s indigenous capacity.

Second, the kinds of equipment it is looking for reveals its self-identified weaknesses, most notably UAVs and communications gear.

Third, the Obama administration is probably just dumb enough to sell, all to preserve the reset fantasy.  But it should ask: against whom would Russia want to use these weapons? Is it in the American interest to enhance the combat power of Russia?  The question answers itself.

Moreover, beware the Russian negotiating tactics, as revealed by the ongoing Mistral saga with France.  They do a deal, in which France says that it will just sell a hull and the rights to build additional hulls in Russia, but no technology transfer.  Then Russia says it expects to get the technology too, and puts pressure on the French by opening a tender for bids for helo carriers; South Korea’s Daewoo has expressed interest in bidding.   The French are now between a rock and a hard place.

This is just an application of the tried-and-true divide-and-conquer/disaggregation strategy so often employed in energy.  Russia will play this game again and again in the weapons arena too.

Given that the Russians are quite open that their intention is to do to the West what the Chinese have done to them for years: buy weapons and then duplicate, not to say steal, the technology, this is a mug’s game.  Which is to say, anticipate the Russian’s putting this plan into overdrive while Obama is in office.

September 25, 2010

VaR and Margins

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 10:28 pm

Value at risk, VaR, is the most common means of measuring risk.  It provides useful information: it quantifies the magnitude of loss that can be incurred on a portfolio with a given probability.  But it is dangerously incomplete: it does not tell you how much you can expect to lose, conditional on the VaR boundary being breached.  VaR, in short, doesn’t tell you how bad bad can be.

This is relevant in the clearing debate.  CCPs choose margin levels in order to ensure that the probability that price moves will wipe out margin balances is sufficiently small.  This is exactly equivalent to calculating a VaR.

And hence, it is subject to the same problems as VaR.  This means that when evaluating the financial capacity of a CCP to withstand a large price shock that not only is the margin level (the VaR equivalent) that is important: the potential loss conditional on margins being blown through is important too.  If the loss conditional on margins being breached is X, but a CCP only has resources of X/2, during a crash (or a spike) that breaches margin levels–an event that will occur with positive probability–then on average the CCP will default.

This is not a purely hypothetical situation.  This important paper by David Bates and Roger Craine shows that in the days following the 1987 Crash, the loss on outstanding S&P500 futures positions conditional on breach of margin was huge, likely far beyond the financial resources available to the CME clearinghouse.

This raises the questions: do CCPs take this information into account when determining their financial resources?; will new CCPs do so; and importantly, do they have the incentive to do so?

This last question is crucial. Financial institutions have problematic incentives to take proper consideration of tail risk.  Indeed, that is arguably one of the major reasons for financial crises.  So why should CCPs, which are coalitions of self-same financial institutions, take into account the tail risks that they ignore independently?  Particularly inasmuch as collectives typically have weaker incentives (due, for instance, to free rider problems).

This is yet another, crucial issue, that has not received adequate attention amidst the paeans to clearing in the run up to and the days since the passage and Dodd-Frank; the same can be said of Europe too.

VaR was the subject of much criticism prior to the crisis: that criticism has only intensified since.  And for good reason.  That should be kept in mind when one hears assurances that CCP margins will prevent derivatives from being the source of a future financial crisis, because margin setting is in essence a VaR exercise.

Clearing Up a (Minor) Disagreement

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:05 pm

Jeff Carter at Points and Figures wrote a nice post on my Cato clearing piece, for which I am appreciative. He is pretty much in agreement with me that mandates are a bad idea.  He is concerned with the command-and-control mindset inherent in Frank-n-Dodd, and supports the development of voluntary “Coasean” approaches.  Hear, hear.

Jeff does take issue with my characterization of the way that CCPs work today:

That meant that if you blew up, and caused major losses you could not afford, the rest of the clearinghouse members would have to pony up cash to cover the loss. If the loss were big enough to blow through all the cash that all the members had, the clearing house would go bankrupt. There hasn’t been a bankrupt clearing operation in the modern day, since 1900, history of trading that I know of.

Exchange clearinghouses are no longer mutually held, and have not been since the last major exchange went public in 2003. Instead, the clearing house takes out an insurance policy to cover potential problems. It also has lines of credit with several different bankers. This simple fact doesn’t change our agreement that government mandated clearing is a poor solution, but it does change the calculus of analysis a little.

I take issue with his taking issue.  Yes, exchanges are demutualized, but counterparty risk is still mutualized.  Take the CME, for instance.  This CME document, in the sections labeled “Default by a Clearing Member” and “Summary of Resources Backing Clearing” beginning on p. 11 demonstrates that the losses of default are borne by other clearing members.  First the CME dips into the guarantee fund–which the clearing members fund.  Then the CME can assess the clearing members.  (The CME also commits up to $100 million of its own capital.)  The assessments are limited to 275 percent of each CM’s original contribution.  The total from the CME contribution, the guarantee fund, and the assessment comes to about $7.5 billion.  The costs of default by a clearing member are thus shared among–mutualized by–other clearing members.

Jeff mentions insurance, but there is no third party insurance that pays in the event of a default at the major exchanges.  (There is no mention of insurance in the CME document.)

Jeff also mentions credit lines, and indeed CCPs have lines with major banks.  In the aftermath of Black Monday, 1987, exchange CCPs realized that they needed a more reliable source of liquidity.  On Black Monday, major banks (the clearing banks) balked at funding big CM margin calls; this is where Fed pressure and liquidity injection was important.  To avoid this problem going forward, the CCPs obtained lines of credit that they could call on to obtain liquidity, just as Jeff says.

It is important to note that these credit lines are just that.  If a CCP draws on the line, it–or more accurately, its members–still owes the bank the money.  The lending bank incurs a loss attributable to a CM default only if the CCP itself becomes insolvent.  That is, the credit line is a source of liquidity: it is not in the first instance a means of sharing the default risk with the bank.  Only if the CCP becomes insolvent do the lending banks suffer any default losses.

The CME document linked above makes that clear.  It calls the credit lines a “Temporary Liquidity Facility.”  It’s a source of liquidity to be used in extremis: it’s not a form of insurance.

There’s an irony, here, of course, and one that gives the lie to many of the claims in support of clearing.  Clearing mandate advocates, notably Gensler, talk about clearing reducing financial interconnectedness, and reducing the potential for contagion.  But clearing in times of stress demands ready access to liquidity.  This inevitably requires a connection between the clearing and banking systems.  It can’t be avoided.  If a clearinghouse runs into a big problem, and draws the credit line, it is possible that the CCP will not be able to pay it back.  In the event, the CCP problem would become a banking problem, and the lending banks would bear some of the default loss.  (Of course, to the extent that banks are clearing members, they will bear default losses too.)

The credit lines also expose the CCPs to bank credit.  If the bank extending the line is itself in financial difficulty, which may well be the case during the kind of crisis that would necessitate the CCP to call on its line, the clearinghouse may not actually obtain the needed liquidity.  So the contagion can work both ways.  From the CCP to the bank, or the bank to the CCP.

Again, the point is that clearing changes the topology of the network of connections among financial institutions: it doesn’t eliminate these interconnections.  One way or another, derivatives default losses are ultimately borne by major financial institutions, clearing or no.  No two ways about it.

September 24, 2010

A CEO as Head of the NEC?: The Gung Ho Principle in Action

Filed under: Economics,Politics — The Professor @ 7:08 pm

There is talk that the Obama administration is contemplating naming a corporate executive to replace Larry Summers as director of the National Economic Council.  The one name that has been floating around is Anne Mulcahy, former CEO of Xerox.

The politics of this are risible–as many on the left have already argued.  It is a clunky, inartful attempt to quell private sector misgivings (I am being charitable) about the Obama administration.

Uhm, it’s not the people that is the problem, it’s the policy.  And it’s the big policies, be it health care and taxes and spending, the ones that Obama has already made clear he is loath to change, that are the problem.  With major changes in those policies, you could have Karl Marx in the job and it wouldn’t matter.

But there’s another, more basic problem, that relates to yesterday’s “Gung Ho” post.  Specifically, it has a great risk of falling into the trap of thinking that the economy is like a big firm, and can be “managed” accordingly.


Corporate executives, including CEOs, interface with the market, sure.  But a vast amount of their time and expertise is involved in matters of organization, governance, personnel, etc.  It’s mostly about understanding organizations–and indeed, a particular organization in a particular industry–than understanding the interactions of myriad organizations in disparate industries.  It doesn’t really require all that deep of an understanding of decentralized coordination through trade and the price system, or spontaneous orders.  Much of the expertise of a particular CEO is not that useful in understanding the broader economy.*  Moreover, it is reasonable to believe that a firm is a unitary thing with a well-defined objective (profit maximization): most of the job of management is to determine and implement strategies and tactics to achieve that objective.  In that context, gung ho makes sense.  In contrast, the broader economy is not a unitary thing with a defined objective.  It is a collection of diverse individuals all striving towards their own ends, all acting on their own unique, idiosyncratic information.

Furthermore, the interests of large, incumbent, corporations are often at odds with the broader interests of producers and consumers in the economy.  Big incumbent corporations aren’t all that enthusiastic about creative destruction.  Their managers are often quite comfortable with laws and regulations that suppress competition, and protectionism.  They often take the “what’s good for GM is good for America” approach–which is exactly wrong.

So, with the rare exception, I am rather skeptical about the desirability of having a corporate type in a major economic policy position.  So, perhaps it isn’t surprising that Obama would think it’s a good idea.

*Hayek made a useful distinction here, but his terminology would be particularly confusing to most in this context because that nomenclature is contrary to the conventional use of the word “economy.”  In Hayekian terms, CEOs are indeed masters of economy.  This article by Norman Barry puts the Hayek definition of “economy” nicely:

An economy is a social practice defined in terms of the pursuit of a ‘unitary hierarchy of ends,’ where knowledge of how to achieve these ends is given. A single firm (or a household) is an economy and may be evaluated with the methods of an engineering type of science for its success in achieving prescribed goals, or common purposes.

In contrast, a catallaxy is:

a network of many firms and households and has no specific purpose of its own: it is that which results naturally from the interaction of firms and households through the exchange process: “the order of the market rests not on common purposes but on reciprocity; that is, on the reconciliation of different purposes for the mutual benefit of the participants.”

So, what is conventionally referred to as “the economy” is in Hayekian terms a catallaxy, and the policy big picture should be predicated on an understanding of catallaxy, not economy in the Hayekian sense.  (Now you see the confusion.)

From a Hayekian perspective, therefore, a CEO-type is completely mismatched with a big policy job.  CEOs are experts at Hayekian “economy,” not catallaxy

Too Bad: An Update

Filed under: Commodities,Economics,Politics — The Professor @ 6:27 pm

Gensler doesn’t want Summers’s job: he wants Geithner’s.  It is likely that Geithner is on very thin ice–the next to go, probably after the Fall elections.  Gensler may have a good shot at achieving his dream.

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