Streetwise Professor

January 14, 2011

Battle of the Tools

Filed under: Politics,Russia — The Professor @ 10:43 am

If you had asked me to choose between the egregious (soon to be ex-) White House Press Secretary Robert Gibbs and a reporter from ITAR-TASS, I would probably have responded “Is death an option?”  But yesterday, a face off occurred between Gibbs and I-T correspondent Andrei Sitov, and Gibbs actually came off well–although given the circumstances, it would have been hard not to.

Sitov snottily asked the usually snotty Gibbs:

This is America, the democracy, the freedom of speech, the freedom of assembly, the freedom to petition your government, and many people outside would also say — and the quote-unquote freedom of a deranged mind to react in a violent way is also American. How do you respond to that?

To which Gibbs creditably responded:

“No, no,” Gibbs said, his voice growing firmer and more direct. “I would disagree vehemently with that. …There is nothing in the values of our country, there’s nothing on the many laws on our books, that would provide for somebody to impugn and impede on the very freedoms that you began with by exercising the actions that that individual took on that day.

“That is not American. … Violence is never, ever acceptable. We had people that died. We have people whose lives will be changed forever, because of the deranged actions of a madman. Those are not American. Those are not in keeping with the important bedrock values by which this country was founded and by which its citizens live each and every day of their lives in hopes of something better for those that are here.”

Apparently unsatisfied, Sitov was heard bitching later:

Sitov said he had heard of Russians who reacted to the shooting by saying, “and these people lecture us.””If you want to stop this,” Sitov told Politico, “you have to be willing to restrict some freedoms.”

You can watch for yourself:

Sitov’s questioning goes beyond chutzpah. Apparently he never heard Jesus’s injunction “first take the plank out of your own eye, and then you will see clearly to remove the speck from your brother’s eye.” For it’s not as if mass killings, including mass public shootings are a rarity in Russia. Remember the police chief in Moscow who strode through a supermarket shooting people? How about the shooting in the open air market in Samara Or about the murder of 12 people in Krasnodar? I could go on.

Just look at murder rates more generally.  Between 2000 and 2009, Russia’s murder rate varied between 15 and 28, in contrast to the US’s 5-5.7.

Sitov asserts a trade-off between murder, or mass killing, and freedom.  He insinuates that Russia has chosen order and safety, whereas the US has chosen freedom and vulnerability to the predations of the deranged.  He flatly states that restrictions on freedom are necessary to achieve safety.

Well, look at your own country, dude.  You have neither freedom nor safety.  Great job!

As a general proposition, what Sitov says is readily debunked.  I have at hand the country rankings for the most recent Index of Economic Freedom (which my daughter helped to compile last summer).  The top six countries: Hong Kong, Singapore, Australia, New Zealand, Switzerland, Canada.  Their murder rates are all near the bottom: .5, .38, 1.2, 2.0, 1.0 and 1.81, respectively.

You might object that Singapore and Hong Kong are not particularly free politically.  Fine.  The Economist’s Democracy Index top six: Norway, Iceland, Denmark, Sweden, New Zealand, Australia.  Murder rates, in order: .6, .31, 1.0, 1.25, 2, 1.2.  All well in the lower end of the table.

In brief: the data decisively reject Sitov’s hypothesis of a positive association between freedom and murder/public safety.  Indeed, if anything there is a negative correlation.  (Which actually makes some sense.)   Not that he’s likely to care.

The determinants of violence are many and complex–as are the determinants of economic success.  There is likely a strong social and cultural component, as the presence of many Scandinavian countries among both the low murder rate and high freedom rankings attest.  And, if you transplant Scandinavians to the US–as happened in droves in the 19th century, as my family tree (dad’s side) attests–they don’t commit murder here either.  (Which brings to mind Milton Friedman’s retort to a Swedish economist who told him “in Sweden we have no poverty”: “That’s interesting, because in America among Scandinavians, we have no poverty either.”)  Celts–e.g., a few branches on mom’s side of the tree–a very different story, both on poverty and violence.

Sitov was engaging in all too common Russian ploy: attempting to rationalize Russian repression of social, political, and economic freedom by claiming some (entirely chimerical) benefit, in this instance, lower rates of violence.  This is an absolute crock.  Russia has both little freedom and high violence.  (Russian repression is also justified as a means of ensuring greater social solidarity and harmony–also a crock.)

Perhaps it’s no surprise that Sitov is a tool.  But to be a bigger tool than Robert Gibbs–that’s quite an accomplishment.

January 13, 2011

Evidence. What a Concept.

Filed under: Uncategorized — The Professor @ 9:06 pm

Today the CFTC voted out its position limit proposal for public comment.  Even though the vote was 4-1 (with Jill Sommers the lone nay), the ultimate fate of the initiative is still in doubt.  Indeed, its fate is even cloudier that previously thought.  That’s because of the most newsworthy aspect of today’s meeting: Commissioner Michael Dunn expressed skepticism about the need for limits.

This is newsworthy because (a) Dunn is a Democrat who is widely viewed as a swing vote on the Commission, but more importantly (b) is (as Reuters correspondents  Roberta Rampton and Sarah Lynch put it) a “circumspect senior commissioner who rarely airs his personal views in public.”

Dunn has a very, very solid basis for his skepticism.  Indeed, he echoed a theme I have hammered on for a long time: the lack of any evidence that speculation has actually distorted prices:

An important swing vote on the five-member Commodity Futures Trading Commission expressed skepticism about whether curbs on their trades would prevent a large run-up in prices.
. . . .

“To date, CFTC staff has been unable to find any reliable economic analysis to support either the contention that excessive speculation is affecting the markets we regulate or that position limits will prevent excessive

“The test then is for the CFTC staff to determine whether position limits are appropriate. With such a lack of concrete evidence, my fear is that, at best, position limits are a cure for a disease that does not exist or at worst,
a placebo for one that does.”
. . . .

“If there is more than anecdotal evidence that there is excessive speculation distorting the prices in our markets, we need to see it. If there is statistical or economic analysis that shows that excessive speculation exists and that position limits will lower the price that we pay for gas, milk and steak … we need to see it.”

“Only after all these questions have been answered will I be able to determine whether or not position limits are appropriate.”

Nothing to criticize (a shocker, I’m sure): Nothing much to add.  I have pointed out repeatedly that the theoretical and empirical basis for the proposition that speculation has distorted prices is lacking (as suggested by the title of my piece on limits in Regulation: “No Theory? No Evidence? No Problem!“) So it’s encouraging to see Commissioner Dunn see that the lack of evidence is indeed a problem. It’s particularly encouraging to see him do so on a day when a group of eight senators put out an evidence-free statement demanding that the commission act to impose limits.

If actual, you know, evidence and data demonstrating the distortive effects of speculation asserted by the senators is required for position limits to move forward, they ain’t moving forward.

And speaking of not moving forward (yet, anyways), the rule limiting ownership and regulating governance of contract markets, SEFs, and clearinghouses was not put to a vote today, as had been anticipated.  There are apparently deep divisions within the commission, with some thinking what’s currently on offer goes too far, and others, not far enough.  These restrictions could have even more pernicious effects than position limits, so I can only hope that they too do not advance.

Reinforcing Failure

Filed under: Economics,Politics,Russia — The Professor @ 10:49 am

According to Stratfor, Vladimir Putin has announced plans to create 200,000 new jobs in monogorods (h/t R):

Russia plans to create more than 200,000 jobs in single-industry towns by 2015, Russian Prime Minister Vladimir Putin said, RIA Novosti* reported Jan. 12. The additional jobs would reduce the average level of registered unemployment in those towns from the current figure of 4.5 percent to 2 percent in 2015, Putin said. Moscow is developing comprehensive investment plans to modernize single-industry towns, including building industrial parks and infrastructure for small and high-tech business, Putin added.

Note the assertion that unemployment in the towns is supposedly 4.5 percent.  That’s pretty low, by any standard, including recent Russian standards.  If the economic situation in the monogorods is so acute to justify a massive investment program, the real unemployment rate can’t be 4.5 percent.   This number is likely analogous to the United States U3 unemployment statistic, which counts only people working or actively looking for work.  In depressed market conditions, other measures, like U6 which includes discouraged workers who have stopped looking for work, marginally attached workers, and part time workers who would like to work full time.  It would be interesting to know what the Russian analog to U6 would be, and in particular what the analog to U6 would be in monogorods.  It is likely that there are hosts of people who realize that looking for work is an exercise in futility.

There is a larger issue here, though.  That is the wisdom of injecting large amounts of money into the monogorods.  These single-industry towns were mainly Soviet creations, the results of misguided, not to say bizarre, social and economic engineering projects.  They are isolated.  Their workforces are often relatively old with out-of-date skills.  The costs of transportation to and from these places is often extreme.  The technology of the industrial plant is more suited for museum display than actual use.  In many cases, the industries themselves are dead or dying (or killing).

All this means that the prospects for rejuvenating these industries, and the associated towns, are bleak.  Even overlooking the fact that in Russia a healthy fraction of the money directed to these towns will never reach the ostensibly intended beneficiaries, there is no reason to believe that modern day central investment planning will be any more sensible than Soviet-era planning.  Moreover, the fundamental obstacles–geographic isolation, poor infrastructure and the associated high transportation costs, lack of scale, lack of a skilled workforce–that have condemned these cities to their current desperate straits will depress the returns on the capital the state directs to them: after all, if the potential returns were high, why wouldn’t private capital have flowed there?  (Perhaps you could argue that the hostile climate for private investment is a deterrent.  If so, that’s hardly an endorsement for the current system.)

All industrialized nations, including the US and UK, have faced wrenching problems in their industrial belts.  Just go to Detroit or Upstate New York or Birmingham or myriad other places in what were once the industrial heartlands of these countries to witness some of the problems.  Labor mobility and economic dynamism have mitigated these problems in western countries.  (Mitigated, not eliminated.)  In the US, workers have moved from the Rust Belt to the Sun Belt, and from manufacturing jobs to employment in services.  For many, the transition has been difficult, to say the least.

Government policies to encourage investment in declining areas has been notably unsuccessful.  There are no easy policy answers to the problem of declining industries.

Russia’s difficulties make those of America’s Detroits pale in comparison.  The monogorods are more isolated.  Capital and especially labor are far less mobile in Russia.  In the US, people could move from relatively expensive areas to relatively inexpensive ones (usually with better weather, to boot).  In Russia, in contrast, the more economically vibrant areas, especially Moscow, are extremely expensive.  The Russian economy is less dynamic and flexible.  All of these factors make it more difficult for labor markets to facilitate the transition of workers in monogorod towns to jobs in other locations, or to jobs in their current cities but in other industries/occupations.

Monogorods are a potential political problem, as the pen throwing dust-up in Pulkovo in 2009 demonstrated.  The rigidities in the Russian economic system mean that the monogorod problem is not going to take care of itself anytime soon.  That rigidity, plus the fact that many monogorods might as well be on the back side of the moon, mean that even grandiose state plans are doomed to failure.  But politically, Putin has to try.  Reinforcing Soviet era failure appears to him to be preferable to surrender.

* I wasn’t able to find the story on RIA Novosti’s English language web site.

The Bluth Company Goes to Russia

Filed under: Politics,Russia — The Professor @ 9:57 am

During the Winter Break, my daughter Renee and I have been watching Arrested Development on Netflix.  In an episode we watched the other night, in an effort to attract publicity and restore the tattered reputation of the Bluth Company, (somewhat) sensible Bluth brother Michael proposes to build a new demonstration home in two months, and then hold a ribbon cutting ceremony like those his father regularly performed before his incarceration.  Completely insensible Bluth brother Job, elevated to company president as a result of the legal mess that has now ensnared Michael, agrees with the idea–but demands that the house be built in two weeks.  Unable to find a construction crew willing to do the job, Michael puts his misfit relatives to work, and they miraculously complete the dwelling in the allotted time.

When the day of the ceremony arrives, the house is girded by a bright red ribbon tied in a bow.  From the outside, the house looks perfect.  Always the tacky showman, Job descends from a helicopter with a giant pair of scissors to cut the ribbon.  But as soon as the ribbon parts, to their dismay the Bluths find that the ribbon has been holding the house together, and watch as the four sides of seemingly well-built house fall crashing to the ground.

Something not too different has happened in Russia.  In the aftermath of the summer’s forest fires, to burnish the reputation of his government which had been tarnished by its blundering response to the disaster, Vladimir Putin said that the state would replace houses lost in the fire, and ordered a crash effort to build them before winter set in.  The results, however, were Bluth-esque:

While the houses appeared beautiful and modern at first glance, it has now become clear that they are entirely unfit to live in. According to a report by Moskovsky Komsomolets, their newly-relocated residents are suffering from intolerable cold and other consequences of shoddy construction.

One such resident, Anna Yegorovna, explained that her new home in the village of Beloomut was all but falling apart. Seams in the ceiling were never sealed, baseboards are detaching from the walls, floors are lumpy, windowsills are warped, and wind blows through the house with ease. To top it off, the basement is brimming with water.

Officials dismiss the complaints:

“The demands residents are making are too great – to heat the house from the outside, to change the flooring. But the deadlines were all the same – have the houses at a preliminary stage of completion by October 20, and be well enough to pass the housing inspection by November 1,” [a regional official] told Channel Five. “Well, of course, they didn’t do it in time.”

Who is this “they”?  And who set the deadlines?  Could it be Vladimir “Job Bluth” Putin?  Yes it was.

No, he didn’t descend from a helicopter to cut a ribbon or hand the homes’ occupants the keys, but he is known to be a tacky showman who has pulled just about every other stunt in the book, and in this instance, his peremptory order to complete the homes before the snow flew was as realistic as Job Bluth’s two week deadline, and the results were equally predictable.

January 12, 2011

The Antitrust Division Lays an Egg. Again.

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 5:43 pm

The US Department of Justice’s Antitrust Division hardly covered itself in glory the last time it weighed in on derivatives market structure when it criticized vertical integration of trading systems and clearinghouses in 2007 (if memory serves), in the aftermath of its (apparently grudging) approval of the CME-NYMEX merger. I excoriated that “analysis” on SWP, and I have been told that the posts I wrote made the rounds on Capitol Hill, causing (in the words of somebody in a position to know) one senator’s “head to explode” in anger (at the DOJ, not me) when he read them.

Well, the Antitrust Division is at it again. They submitted a comment letter in response to the CFTC’s proposed rulemaking on conflicts of interest at exchanges, SEFs, and clearinghouses. It is slightly better than the Parthian shot fired at the CME in 2007, but that is praise only in the “you don’t sweat much for a fat girl” variety, for the economic analysis in the comment is weak on the issues it discusses, and completely ignores salient economic considerations.

In brief, the DOJ recommends that the CFTC adopt a tougher rule that imposes “an aggregate ownership cap on major derivative dealers” because it fears that the absence of such a cap would “[preserve] the opportunity for these powerful entities to achieve majority ownership in DCMs/SEFs” thereby jeopardizing competition.

The Department argues that “limiting aggregate ownership and imposing stringent governance requirements . . . may prevent the emergence of a dominant trading platform controlled by major dealers to the detriment of other market participants.”

Let’s unpack that particular set of claims.  Is it the “emergence of a dominant trading platform” that bothers the DOJ, or the fact that it might be “controlled by major dealers”?   It is quite possible–and indeed, I would claim likely–that the nature of liquidity (specifically, its network aspects) strongly–strongly–favors the “emergence of dominant trading platforms.”   If market power is the concern, who controls the dominant platform is of secondary or tertiary importance, at best.  Does the DOJ believe that multiple platforms that compete aggressively are likely to emerge if dealers are precluded from controlling them?  What is the basis in economics for this claim?  I’m not aware of any.  I would argue that the tendency for a single entity to emerge is driven by liquidity, and technological scale and scope effects (e.g., the ability to trade multiple instruments on a single platform).

There is, in fact, a stark example of this phenomenon staring the DOJ in the face: the very same CME that exercised the DOJ so mightily in 2007.  The CME is not dealer dominated, but it has emerged as the dominant exchange in the US in the past decade.

This means that the Division’s belief “that an aggregate ownership cap on Enumerated Entities may facilitate competition by encouraging the creation of new DCMs/SEFs” is seriously misguided.  What is going to drive market structure is the economics of liquidity (which could, in fact, be affected by CFTC SEF regulations, with exchange-like limit order book systems more susceptible to natural monopoly) and the economics of scale and scope driven by technology.

The Division anticipates this argument by saying that “[i]t could be argued that economies of scale in trading are so pronounced that derivatives markets will best be served by a single trading platform.”  It then rejects this by saying “[t]his claim would seem to be inconsistent with developments in other financial markets–for example, cash equities–where multiple trading platforms have flourished.”

Two responses.  First, that claim is not inconsistent with developments in most derivatives markets in the US and overseas, which are the markets of interest.  Those markets are almost universally dominated by a single large exchange.  (With respect to options, (a) index options are still dominated by single exchanges, and (b) in the US, for options on individual stocks, order handling rules effectively socialize order flows in a way that eliminates tipping that creates a dominant exchange).

Second, in equity markets, many of the trading platforms (e.g., dark pools) are means by which demonstrably uninformed traders reduce trading costs.  As I’ve written before, it is price discovery that is the natural monopoly: dark pools and other mechanisms (e.g., internalization) that don’t contribute to price discovery aren’t subject to network effect driven economies of scale.  Moreover, those mechanisms have not, heretofore, developed in derivatives markets, likely because the information intensity of trading is not as acute.  Moreover, Reg NMS in US equities essentially socialized order flows and created a network of interconnected platforms, where the interconnection is mandated and regulated; prior to RegNMS, a single exchange dominated equity trading in the US, and single exchanges dominate equity trading in most other markets (that lack a RegNMS-type rule).  Without a similar regulation in derivatives trading, the tipping tendency will prevail, leading to the dominance of one or a small number of platforms, ownership restrictions or no.

The kind of “competition for monopoly” story that DOJ tells (p. 6) is a more reasonable one, but ownership and governance restrictions are not going to affect one whit whether such competition occurs.  Regardless of who owns a dominant exchange, there is a lot of money to be made displacing it, giving an incentive for somebody–anybody–to attempt to displace it.  All that takes is money and technology, which is pretty widely available.

I also consider it ironic in the extreme that DOJ holds up BrokerTec as an example of an entity that spurred technological innovation through a competition for the CBT’s monopoly on Treasury futures.  It’s ironic because BrokerTec was a dealer initiative.  Similarly, the most recent competitor for the CME (which is not dealer owned or dominated) is a dealer dominated ELX, and CME’s strongest competitor in energy is the dealer-dominated ICE.  And dealer dominated Turquoise has tried to oust non-dealer dominated LSE in British equities.  So, if anything, dealer ownership limits would have hamstrung these competitors to dominant exchanges.

The focus on control of a dominant entity by dealers seems to reflect politics, rather than economics.  The Antitrust Division’s concern should be about competition and market power generally, not about who collects market power rents. It has definitely not made the case–nor do I think it is possible to make the case–that restrictions on ownerhsip will have a material effect the magnitude of market power rents.

That said, (a) I’m not advocating intrusive regulation of competition in derivatives trading, and (b) I’m not advocating RegNMS-like rules for derivatives.  I’m just saying that if your desire is to create multiple competitive platforms, something like RegNMS is necessary, and governance and ownership restrictions are superfluous at best, and counterproductive at worst.

The DOJ’s discussion of joint ventures (p. 6) suggests they just don’t understand the economics of exchanges and financial trading.  They are concerned about a joint venture between dealers that admits too many members!  The concern should be quite the opposite.  As shown in my 2002 JLEO paper, exchanges can exercise market power by (a) admitting enough members that allow them to achieve scale economies that make them immune to competitive entry, but (b) which have fewer members than optimal.  This is a consequence of the liquidity network effect.  DOJ should be concerned about limits on membership, not that membership is too inclusive.  The analogy between exchanges and airline alliances is completely off point.

With respect to clearing, the DOJ’s concern that restricting access to CCPs could serve to reduce competition is well-grounded; indeed, that’s exactly the kind of point I just made in the previous paragraph.  I made that argument long before they did.  But what is missing from its analysis is any consideration of the effects on ownership and governance regulations on (a) the willingness of institutions to commit the capital necessary to ensure that CCPs have the financial wherewithal to absorb large defaults, thereby mitigating systemic risk, and (b) CCP decisions on margins and capital levels that also impact their financial soundness and ability to withstand large price, volatility and liquidity shocks.  As I’ve argued over and over, it is difficult to balance these considerations.  But given that the whole purpose of clearing mandates is to reduce systemic risk, you’d think that these considerations should predominate.  What’s more, it’s just inexcusable to ignore the financial safety/systemic risk issue altogether.  Trade offs are hard, but ignoring them is unpardonable.

Indeed, the DOJ treats this issue dismissively: “[t]hese actions against potential new clearing members could be explained away, for example, by expressing risk management-related concerns.”  Yeah, sure, somebody is likely to make that argument, and it deserves consideration rather than dismissal because these concerns are of first-order importance.  Not that you’d learn that from reading the DOJ comment.

This is a very important issue, one that deserves careful, honest, and balanced analysis, none of which the DOJ provides.

With respect to governance recommendations, the DOJ comment is similarly incomplete and superficial.  It focuses on conflicts of interest, but says nothing about ensuring that ownership structures align the incentives of those bearing the risk and those making the decisions.  Misalignment would court disaster.  To overlook this issue completely is quite disgraceful.

All in all, this is a fundamentally flawed analysis of the economics of derivatives trading and clearing, competition in those markets, and the benefits of restrictions on ownership and governance.  Despite its crowing about its expertise in these markets, DOJ exhibits glaring deficiencies in its understanding of the economics of competition in trading and in clearing.  As a result, if the CFTC has any sense, it will dismiss DOJ’s recommendations out of hand.

Yeah.  I know.

The CFTC Does Net Neutrality? Or, The Blob Grows Some More

Filed under: Uncategorized — The Professor @ 2:15 pm

The CFTC’s Proposed Rule on Core Principles for Designated Contract Markets (DCMs) contains something that has escaped comment (but not the sharp eyes of Jerry, who brought it to my attention).

Specifically, it states:

A DCM can satisfy the requirement that membership and participation criteria are impartial, transparent, and non-discriminatory by establishing clear and impartial guidelines and procedures for granting access  to its facilities and publishing such guidelines and procedures on its Web site. Such requirements may  establish different categories of market participants, but may not discriminate within a particular category. Fee structures may differ among categories if such fee structures are reasonably related to the cost of providing access or services to a particular category. For example, if a certain category requires greater information technology or administrative expenses on the part of the DCM, then a DCM may recoup those costs in establishing fees for that category of member or market participant (p. 80579, emphasis added).

So, it appears the CFTC is adopting its own version of net neutrality for DCMs (exchanges, in everyday, non-legalese parlance).  Specifically, it is asserting regulatory authority over the pricing of exchange services.  Just like the FCC’s net neutrality rule (as proposed) would regulate the terms on which the operators of internet services can offer and price access to their systems, the CFTC’s access principle (Core Principle Two) imposes constraints on the terms on which operators of exchanges can offer access to their trading facilities.

The principle is that (a) within a category of users, all must be offered access on the same terms at the same prices, and (b) across categories, access fees can differ on a cost basis.

On an intellectual level, this demonstrates yet again a point I’ve harped about for years: financial markets, especially electronic ones, raise many of the same issues that have been staples of analysis, argument, and regulation for years in what are traditionally considered network industries, such as telecoms and electricity transmission.  (A point that will be one of the themes in my next book, tentatively titled Market Macrostructure: The Organization of Securities and Derivatives Markets.)   Financial regulators are just waking up to that fact, but unfortunately all too often it appears that they are reinventing the wheel, and not taking advantage of all the work that has been done on network industry pricing and regulation.

On a practical level, this is yet another troubling example of the expansion of the CFTC’s authority.  It is becoming the new regulatory Blob*.  Its capacity and competence are already challenged by its existing responsibilities.  Dodd-Frank added massive new ones, and here the agency is claiming even more.

The experience in network industries is that regulating access prices is beset by conceptual difficulties, impeded by the lack of data to quantify cost differences, and mired in politics and rent seeking.  Some regulatory agencies, notably the FCC and FERC, have developed vast apparatuses to deal with these complications.  In contrast, CFTC has no real experience in this area.  It is miles away from its normal bailiwick.  There is no reason whatsoever to believe that it has the competence to regulate the pricing of access services.  Yes, it allows cost based differences, but pray tell what expertise does the agency have to measure these cost differences?  And with the proliferation of SEFs, which will almost certainly be subject to similar constraints at some future date, just think of all the disputes that could arise.

Even beyond the issue of competence and resources, the proposed rule poses conceptual difficulties.  Any system of categorizing users will result in heterogeneity within categories.  Due to this heterogeneity, some customers within a category will be costlier to serve than others in the same category.  The proposed rule would suppress any price differences across entities in a particular category.  Which will mean that those subject to the regulation will attempt to create more, narrower categories.  Which will mean that these decisions will likely be subject to legal challenge.

On the other hand, lawyers will be happy.

One other quick comment on the Core Principles rulemaking.  To show that a derivatives contract that can be settled by delivery is not subject to manipulation, the Commission requires a DCM to ensure the deliverable supply for the contract is adequate.  This makes sense as a means of reducing the frequency of market power manipulation.  In contrast, the criteria that the Commission uses to determine whether cash-settled contracts are subject to manipulation does not impose any requirements relating to deliverable supply.

You might say: of course not!  Because there’s no delivery, you don’t need to worry about a delivery squeeze.  But you’d be wrong.  As I show in my 2000 JOB piece on manipulation of cash-settled derivatives contracts, one can manipulate a cash-settled derivatives contract by buying or selling large quantities of the physical in the cash market.  Indeed, the very same factors that determine the susceptibility of a delivery settled contract to a squeeze or corner determine the susceptibility of a cash-settled contract on that commodity to manipulation by buying or selling large quantities of the physical commodities used to determine the settlement price.  Thus, the size of the cash market, deliverable supply if you will, is relevant for these contracts as well.

Appendix C of the Proposed Rule does mention the “size and liquidity of the cash market” and “the volume of cash
market transactions and/or the number of participants contacted in determining the cash-settlement price” but these don’t get at the kind of manipulation I discuss in the JOB piece.  Particularly, the volume of cash market transactions doesn’t correspond even remotely to the relevant measure of the size of the deliverable supply.  I would also note that whereas CFTC goes into great detail prescribing what DCOs must do to document that the deliverable supply for a delivery-settled contract is adequate, it imposes no comparable requirement for cash-settled ones.

Instead, the appendix focuses on manipulations that could arise from false reports, or settlement indices based on a small number of cash market transactions.  These are relevant to the susceptibility of a cash-settled contract to one kind of manipulation, but are irrelevant to determining its susceptibility to market power manipulation, where the market power is exercised in the cash market.

A small point, perhaps.  But given that manipulation is an offense that has been under the CFTC’s jurisdiction, or that of its predecessor agencies since 1922, and which has in fact been its primary responsibility since that date, it does raise questions about the agency’s qualifications to regulate new, arcane, and inherently complex areas, such as the pricing of access.

Beware the Blob.

* Steve McQueen is one of my favorites.  A hero to sinewy blond guys everywhere.  I also like this:

January 10, 2011

Wrongway Peachfuzz Returns to Wall Street?

The scariest kind of counterparty risk is “wrong way” risk.  This kind of risk occurs when there is a dependence between the size of the exposure (i.e., the amount that can be lost in the event of a default) and the probability of the counterparty’s default.  In particular, wrong way exists when the exposure is large when the probability of a counterparty default is large.

A canonical example of wrong way risk is a firm that writes a put on its own stock.  If the firm goes bankrupt, and its stock becomes worthless, it defaults.  When it defaults the exposure is as large as it can be: the strike price of the put.  In contrast, a firm that writes calls on its own stock has “right way” risk.  If the firm does badly, and indeed goes bankrupt, default losses on the call are zero because the call is out of the money.

Central counterparties–clearinghouses–are touted specifically as ways of mitigating counterparty risk.  Post-Financial Crisis, they have been particularly advanced as a means to reduce systemic risk by reducing counterparty risk absorbed by big financial institutions.  This raises interesting questions: Do CCPs have a wrong way risk problem?  If so, what implications does this have for the performance of CCPs during systemic crises?

The answers in brief: yes, they may well have a wrong way risk problem, and that means that it is dangerous to rely on them as a means of reducing the likelihood and severity of truly systemic crises.

As I noted before, the defining feature of wrong-way risk is a dependence between default probability and the size of exposure.  This is often characterized as a “correlation” between default risk and exposure.  But as I’ll discuss below, “correlation” is too limiting a concept.  Correlation implies dependency, but dependency does not imply correlation.

The magnitude of wrong way risk depends on the nature of transactions and counterparties involved.  In particular, out-of-the-money options exposures, very senior tranches of structures, and highly rated counterparties are most vulnerable to wrong way risk.  (For a good book on this subject, see Jon Gregory’s descriptively titled Counterparty Credit Risk.)

Moneyness matters because a deep out of the money option generates an exposure only if the underlying price moves a lot.  But if the underlying price and the creditworthiness of the option writer tend to move in the same direction, a big movement in the underlying that puts the option in the money also tends to be associated with a dramatic erosion in the creditworthiness of the writer. Thus exposure and default risk peak simultaneously.

The seniority of a tranched structure matters for a similar reason.  There will be losses on a senior (or supersenior) tranche only in the event of an extreme adverse shock hitting near simultaneously many of the credits underlying the structure.  If this same adverse shock puts the writer of protection on the tranche into financial difficulties, the writer is most likely to default at the same time that it is supposed to payoff on the protection it sold.  Think monolines, or AIG.

The credit quality of the counterparty matters because a high quality counterparty is likely to default on a contract only if it suffers a severe adverse shock to its balance sheet.  With the right kind–or should I say wrong kind?–of dependence between the exposure and the counterparty’s balance sheet, this big adverse shock leads to a big move in the value of the contract.  Thus, exposure is big precisely when the counterparty is highly likely to default.

Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts.  Default funds are analogous to protection written on supersenior tranches.  The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices.  Indeed, margins are usually set to absorb 95-99 percent of market moves.  Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin.  If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.

This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances.  Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.

So it seems that CCPs are potentially vulnerable to wrong way risk.  They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem.  Which raises the question: are the dangerous dependencies likely to be present?  That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?

Given that we are talking about tail events, it’s difficult to assess that question analytically and empirically.  But there are reasons to believe that these dependencies are in fact lurking.

A big financial shock that is sufficient to cause movements in derivatives prices big enough to breach margin levels, and/or which damages a CCP member’s balance sheet (or multiple members’ balance sheets) severely enough to force it (them) into default is likely to be associated with severe financial difficulties at other CCP member firms.  For instance, during the financial crisis all banks were cratering simultaneously and prices were moving dramatically; their stock prices all plunged together and their CDS spreads all spiked togehter.  They were all exposed to the same big underlying risk–in the event, real estate prices.  When those prices went south, all financial institutions were in distress, most of them in severe distress.  The financial tumult also resulted in big moves in stock prices, interest rates, credit prices, and commodity prices–all of which could have and did create widening exposures on derivatives trades.  Indeed, since CCPs have zero net positions, a big move in any price is going to create a big exposure for the CCP.

And it’s not just price movements that matter.  Financial and economic shocks are also associated with big changes in volatilities that affect exposures on non-linear positions (notably options or contracts with embedded options). Moreover, big volatility makes it more likely that exposure values and creditworthiness will move substantially.

Perhaps even more crucially, big financial and economic shocks tend to result in correlations in prices shooting towards one and minus one.  This has both direct and indirect effects.  The direct effect is to move–often by a lot–the mark-to-market values on correlation-sensitive positions (e.g., CDOs, multi-product options).  The indirect effect is perhaps even more pernicious, as it is exactly these high correlations between the value of assets on financial institutions’ balance sheets and the values of derivatives exposures that generate acute wrong way risks.  That is, the effects of stressed–crisis–financial conditions on correlation creates the very form of dependency that gives rise to wrong-way risk.

Liquidity effects of crises can also create dependencies.  Liquidity tends to decline during crises, which tends to increase volatilities, thereby exaggerating movements in exposures and creditworthiness.  It also makes it more difficult to manage the risk on exposures, and to trade out of positions in order to reduce exposures.  (The common liquidity shock may be one reason why correlations tend to risk towards one in absolute value during crises.)

These dependencies can be especially exaggerated for certain kinds of products and CCPs.  Consider, for instance, a CCP that clears CDS, a substantial portion of which are written on financial names, and which has financial firms for members.  Exposures tend to spike for such a CCP at the very same time its members are suffering dramatic declines in creditworthiness.  Not good.

Thus, in crisis periods, dependencies between the value of the backers of CCPs–the member firms (often banks)–and the exposures that CCPs are effectively writing protection against are highly likely to be of the wrong way variety.

This means that CCPs offer dubious protection against systemic risk.  A huge economic shock, like that suffered in 2007-2008 creates dependencies that give rise to wrong way risks.  They also give rise to big changes in exposures.  The structures of CCPs have features that are particularly vulnerable to these dependencies.

Even if a CCP does not fail during a crisis, the wrong way risk problem means that the financial institutions that backstop it will have to make payouts at precisely the times that they are under strain.  That is, CCPs load risk onto big financial institutions precisely during crises that are already stressing them.

This is not to say that CCPs cannot share garden variety default risks more efficiently than bilateral arrangements.  But that’s not what the advocates of CCPs hyped when arguing for clearing mandates.  No, these advocates repeatedly and specifically held them up as an antidote for crisis, as a bulwark against systemic risk.

The foregoing analysis of wrong way risk implies, however, that CCPs themselves are most vulnerable to default precisely at the time that their advocates look to them to be the breaks that contain financial firestorms.  Consequently, any sense of security against financial contagion that they provide is very likely a tenuous one, and arguably a false one.  Such complacency is particularly worrisome as it can undermine the urgency to find more effective and reliable measures to reduce the vulnerability of the financial system.

I am not saying that CCPs are as defective in concept as monoline insurers, or as AIG was.  (Jon Gregory argued back in 2008, and argues again in his book, that the monolines and AIG were fundamentally, fatally and irredeemably flawed.)  I am just pointing out that they share key features with those casualties of the last crisis, and as a result, may well be casualties in the next one.

It should also be noted that the Basel III capital requirements for CCPs that I discussed in an earlier post do not capture this risk in any meaningful way.  They cannot provide, therefore, an incentive to reduce it in any meaningful way.

In a classic Rocky and Bullwinkle episode, Captain Peter “Wrongway” Peachfuzz sailed his ship up Wall Street. Let’s hope that’s not a metaphor for the effect of mandated clearing.  But you should be concerned that clearing concentrates wrong way risk, and that this guy becomes the poster child for Frank-n-Dodd and its clearing mandates:

The Fixer is In

Filed under: Economics,Politics — The Professor @ 12:07 pm

The Washington punditocracy is in something of a rapture over Obama’s appointment of Bill Daley–of the Chicago Daleys, natch–to be his chief of staff.  This stream of hosannas is a perfect illustration of the fact that said punditocracy is as a rule clueless.

Argument I in the Obama+Daley paean is that Daley is a pragmatist that will help an Obama pivot to the center. But it should be noted that Daley’s predecessor, Rahm Emanuel thought that Obama’s 2010 political course was dangerously unbalanced.  Emanuel was apparently leaking furiously in the summer and fall of last year about his attempts to push the administration towards the center.  Fat lot of good that did, proving that a more politically astute, less ideological chief of staff is not a sufficient condition to keep this administration from veering too hard left.  It also shows that the signaling value of the chief of staff is limited at best.

Argument II is that Daley’s long experience in business, including stints as an executive or director at J.P. Morgan, Bank One,SBC, Fannie Mae, Boeing and Merck will help the administration repair its damaged and dysfunctional relationship with business.  This argument is even more clueless than the first.

All of the businesses that Daley is or was involved in are heavily, heavily politicized.  Those kind of companies are willing to pay big to have political heavyweights like Daley around because of their connections.  Such individuals are, to put it impolitely but accurately, fixers.  Daley was in business not because he is an entrepreneur or an innovator, or because he has a preference for the private sector; he was in business because he was a politician with valuable political connections who could help these firms negotiate their relationship with the government, and make some rain for himself and his political cronies.

Even to the extent that Daley has some understanding of, and empathy for, the operations of the private sector (instead of being someone who is merely trading on his political connections), his experience has been  exclusively with corporate behemoths, and again, all corporate behemoths in highly regulated and politicized industries.  He may well be able to negotiate accommodations with such firms, but that’s hardly good news to the larger economy–and especially to the vast array of smaller businesses that are vital to economic growth.

The Daley types, and the corporations and corporate executives that they deal with, are agents of corporatism.  And as Adam Smith pointed out long ago, and as Milton Friedman argued repeatedly, the interests of individual corporations are not well aligned with those of consumers, workers, or suppliers of capital.   Corporatism is not your friend, or mine.

In particular, someone with Daley’s experience and connections is ill-suited to understand or represent the interests of smaller businesses and entrepreneurs that are the biggest potential casualties of the legislative and regulatory onslaught that Obama has unleashed.  Those are the individuals and firms that, for instance, are most likely to be devastated by Obamacare.  The Daleys of the world will be great at negotiating deals that mitigate the impact of mandates for big corporation, but the smaller fish will not merit their/his attention.  Jamie Dimon may be quite pleased with the results, but that’s not going to help the economy grow.

All pretty ironic coming from a president that rages regularly at the Citizens United decision for giving undue influence to large corporations.

It’s not really surprising that political pundits confuse corporations with the broader economy and corporatism with free market policies.  Immersed in the political waters, their understanding of markets and wealth creation is extremely limited.  So it is par for the course for them to confuse a pol that helps businesses fix their problems with someone who actually understands how economies work and wealth is created.

And it is also imperative to remind ourselves of what the commentariat has almost uniformly ignored: the miasmatic political swamp that gave birth to Daley, and which nourishes him and his family and his political allies to this day.  You can see the results of Daleyism in Illinois, and they aren’t pretty.  Why would anybody expect the results at the national level to be any better?

Too bad Mike Royko isn’t around to teach the commentariat some Chicago home truths.

Hypothesis Testing

Filed under: Politics — The Professor @ 10:05 am

Not risking cutting themselves with Occam’s Razor, the mainstream media and leftish commentariat (but I repeat myself) is fixated on pushing the convoluted hypothesis that Sarah Palin, the Tea Party, Rush Limbaugh, yadda yadda, drove a clearly deranged individual to shoot AZ Rep. Giffords and murder six people.

All right, let’s take that as a hypothesis, and generalize it a bit.  The more generalized hypothesis is that language and rhetoric that describes or depicts or advocates violence, no matter how metaphorically, routinely leads otherwise normal people to commit heinous, violent acts.

Let’s now consider some implications of that hypothesis:

  • Rap lyrics that extol cop killing and rape are directly responsible for the murders of policemen and rapes.
  • Video games that graphically depict wholesale slaughter cause those who play them to commit violent acts.
  • Death metal music is a direct cause of violent crime, including the Columbine massacre.

Indeed, given that the language and images that supposedly triggered the AZ killer were (a) disseminated far less widely and for a far shorter period than violent metal or rap, or video games, and (b) were far less graphic and suggestive than any of these, it would be reasonable to hypothesize that rap, etc., should be tied directly to an immense body count.

I’d love to hear from Krugman, et al, a serious discussion of this hypothesis and whether the evidence supports it.  Because if the data rejects the more general hypothesis, it is ludicrous in the extreme to assert that the more limited Sarah Palin Did It hypothesis is valid.

As for me, I’m sticking with Occam’s Razor, the simplest explanation: Crazy people do crazy things.  And trying to rationalize crazy is nuts.

January 9, 2011

Political Points

Filed under: Commodities,Derivatives,Economics,Exchanges,History,Politics — The Professor @ 10:21 am

My post on the “points” system under which the CFTC would monitor positions, and then intervene on a discretionary basis when any position breached pre-set levels (“points”) brought to mind a story about the famous–or notorious, depending on your perspective–speculator, Arthur Cutten. Cutten engaged in massive speculations in wheat during the 1920s.  In 1925, he made the largest income tax payment up to that time in the history of northern Illinois–over $500,000.  Importantly, as a result of his market activities, Cutten attracted the attention–and the ire–of the government.

The Grain Futures Act of 1922 required large speculators to report their positions to the government.  Speculation continued apace despite this requirement, and the authorities were impatient to do something to stop it.  Calvin Coolidge’s Secretary of Agriculture, W.M. Jardine, demanded that the Chicago Board of Trade do something to stop the “gambling” in grain. In response, the CBT created the Business Conduct Committee.

Even in the aftermath of the creation of the BCC, Cutten continued his speculations.  Cutten bought millions of bushels of May, 1926 wheat.  The Grain Futures Administration, the division of the Department of Agriculture responsible for enforcing the GFA, “suggested to the Board of Trade that Cutten’s holdings were too large for one person” (Ferris, The Grain Traders, p. 180).  The BCC swung into action and called in Cutten for a little chat.

When Cutten arrived for the meeting May wheat was selling at $1.65/bu.  (He had bought at around $1.50/bu).  His arrival at LaSalle and Jackson* was observed, and traders soon discerned its import: wheat began selling off as he ascended in the elevator to the conference room where the BCC was meeting.

The BCC told Cutten: “the Grain Futures Administration has made the complaint that you are carrying too much open stuff.”  Cutten resisted selling, but the committee persisted.  Finally, one of the committee members put his arm around Cutten, and told him: “You ought to sell some wheat for the sake of the Board of Trade.  You know, this committee is the device we settled upon to keep the government from taking fuller control of trading in futures.  They get the figures and watch the accounts from day to day.”

Cutten still resisted: “Why should I sell before I’m ready?”  The committee member responded: “For the sake of the Board of Trade.”

Cutten finally relented.  Prices fell further.  He later lamented that the elevator ride to the BCC meeting had cost him a million dollars.

The mechanism that forced Cutten to sell looks remarkably similar to that proposed under the point system.  The government monitored large positions, and exerted pressure on a particular trader–in this case, through the CBT–and that trader eventually capitulated.

What is worrisome about this story is that the intervention that forced Cutten to sell occurred in an overtly politicized environment.  The Secretary of Agriculture, in step with a long line of Senators and Representatives viewed commodity speculation as a social ill.  Jardine had demagogued the issue repeatedly: he had dragooned the CBT into creating not only the BCC, but to mandate clearing of all grain transactions as well.  A speculator who had gained considerable notoriety for his previous operations in the market was targeted for pressure.  At least insofar as the public record is concerned, there is no evidence that the GFA or its handmaiden BCC undertook any serious inquiry to determine whether the speculator’s actions had or threatened to distort prices.  Similarly, there is no evidence that less intrusive measures were considered or proposed: to mitigate concerns about a corner, for instance, the BCC could have limited Cutten’s ability to take deliveries of wheat in quantities necessary to effectuate a squeeze.

Thus, one reasonable interpretation of the events of 1926 is that the GFA–the great-grandfather of the CFTC–intervened in the market for political purposes, rather than on the basis of a well-reasoned and empirically supported concern that the market had in fact been distorted by the actions of a particular individual.

Having watched closely–and up close–the fevered battles over commodity speculation in the past several years, I have no confidence that the same thing wouldn’t happen under the points system.  In fact,  I would put that more strongly: I have every confidence that the same thing will happen again.   Discretionary authority is subject to political pressure, not to mention the whims of regulators.  Consequently, it is inevitable that such authority will be abused.

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