Streetwise Professor

In a previous post I noted that whereas (to quote Oliver Wendell Holmes) FDR had a second rate intellect and a first rate personality, Obama rates a tie at best in the first category and  is out of the running altogether in the second.  In another, I compared Obama to Woodrow Wilson, with words that resonate today in light of the ongoing debt ceiling battle:

Like Wilson, Obama is a self-styled progressive who is deeply skeptical of the Founders’ creation.  Like Wilson, Obama is firmly convinced of his own rectitude and his moral superiority over his political foes.  As with Wilson, this makes Obama firmly opposed to compromise with these foes; he views compromise as betrayal of a fundamental belief, and as Wilson did, he views his opponents as morally defective.  Obama, like Wilson, is a Nobel Peace Price winner (although Wilson actually did something to merit it).

Today at Powerline, Reagan biographer Steven Hayward makes the same two comparisons in one paragraph:

Increasingly it is apparent that Obama is not the second-coming of FDR, as he hoped, but the second-coming of Woodrow Wilson (Jimmy Carter also fits for multiple reasons), chiefly his arrogance toward Congress and condescension of the American people.  I think it was Oliver Wendell Holmes who said of FDR that he had “a second-rate intellect, but a first-rate temperament.” With Obama, we were supposed to be getting both a first-rate intellect to go with a first-rate temperament, but it is increasingly obvious that Obama has neither.

In the end, Wilson’s self-righteousness, rigidity, arrogance, condescension, habitual demonization of his political foes, and academic detachment–not to say alienation–from ordinary Americans, resulted in a stunning political crack-up.

Obama is at risk of suffering a similar fate because he shares so much with Wilson.  But now is not the time, and the debt ceiling is not the issue.  Any cuts promised in a deal would prove chimerical, and as a result, a victory on getting Obama to agree to cuts would prove pyrrhic if it were to enhance Obama’s reelection chances–which it very well could.  So raise the ceiling, vote through cuts, watch the latter die in the Senate, and let the Republican presidential candidate have a principled argument about the issue next year, for what happens in November 2012 is what matters, not what transpires in July or August of 2011.

On several occasions I’ve opined that when push comes to shove, Vladimir Putin could not countenance joining the WTO and adhering to its rules that would restrict his ability to shuttle rents around to maintain the political equilibrium.  Here’s more evidence:

He said no trade-off is possible between Russia’s new car assembly rules and its membership in WTO. “Our position, can’t be changed,” Mr. Putin said.

The rules, which effectively trade off the low import duties on car components and the billions of investment in the Russian car industry are opposed by U.S. and EU.  To get the carrots, the car makers have to boost the capacity of their existing facilities or build new ones, and source components locally.

Russia’s trade partners consider the rules dangerous for the global car trade, as varying import duties on cars and parts — and linking the lower duties on parts to higher production capacities — would distort the global car trade and could end up artificially  stimulating the export of Russian-built cars.

. . . .

“It’s a red line we can’t cross,” Mr. Putin said, talking about the new car assembly rules on Friday. “We can’t trade-off the interests of our car makers.”

WTO presents a great example of the dissonance between Putin and Medvedev.   The latter routinely mentions his ambitions for Russia to join the WTO; the former routinely throws up roadblocks and raises doubts.  You can’t go to long with two sets of hands on the steering wheel: I’m betting Putin will eventually grab sole control–especially since Medvedev appears to be somewhat challenged in the driving department:

On the TV series NCIS, Ziva David is a Mossad agent seconded to the US agency.  She speaks excellent English, except she routinely mangles idiomatic expressions.

At least she has an excuse–she’s a foreigner.  What’s Obama’s?  (Don’t go there.)

Case in point.  Yesterday, in a dramatic flourish, he walked out of tense negotiations over the debt ceiling and said to Republican representative Eric Cantor, “Eric, don’t call my bluff.”

Huh?  Didn’t he really mean to say the exact opposite?  That is, warning Cantor to take him seriously, and not to make the mistake of thinking he’s bluffing?

Or maybe it’s a big Freudian slip, revealing that he is in fact bluffing, and is afraid Cantor will call it.  That would be kind of funny, actually.

Regardless, I would call.

Maybe we should seek the advice of our resident poker expert . . . you know who you are.

Strategy Page reports that Russia is planning to add something novel–military police (MPs):

Russia is forming a military police (MP) force. The first of the 20,000 MPs are to be in service by the end of the year, and their main goal will be to end violence, and especially hazing, in the ranks. This comes five years after deciding not to from [sic] a military police branch. Back then, the goal was the same, to reduce the violence and hazing in the ranks.

Let’s see.  The Russian military is beset by violence and corruption.  Russian police are utterly notorious for their violence and corruption.   Which strongly suggests that putting together “military” and “police” in Russia is not the greatest combination since peanut butter and chocolate, but is instead a match made in hell, and that this great experiment will not achieve its intended goal.  It will instead just create a new opportunity for shakedowns, corruption, and blackmail.  I just wonder how many months until this “innovation” is conceded to be just another failure.

Autocrats and would-be autocrats invariably attempt to project an image of unconstrained power and authority, in large part to overawe those lower in–but still relatively high up–in the hierarchy.  Putin is no exception to that rule.  Nor is he an exception to the rule that autocratic appearances are often deceiving, and that underneath the projected image of order powerful factions vie for rents and control.  Particularly in a sprawling country like Russia, and one with a sprawling bureaucracy, these internecine struggles are almost impossible for the one at the pinnacle of the vertical to control.  Projection of an image of unchallenged authority is often little more than an attempt to mitigate the consequences of the fact that the nominal ruler’s control is sharply circumscribed.

Pavel Baev argues that this is the case in Russia today, with Putin and Medvedev exercising only weak authority over siloviki and other bureaucrats:

Elections in Russia are not about selling a vision or swaying the electorate, they concern showing who is the boss – and demonstrating that the boss means business. In this crucial respect, the ongoing election campaign is a complete mess, and not because it is still unclear whether President Dmitry Medvedev will cling to his slim chance to stay for the second term, but because Prime Minister Vladimir Putin, who is seen by the whole country as the “real boss,” cannot assert control over the self-serving bureaucracy. Putin has been busy filling and dressing the ranks of the Popular Front, which is supposed to secure an electoral triumph of the discredited United Russia party, and is not responding to the embarrassing scandals that leak out of numerous cracks in the executive pyramid with increasing intensity (Nezavisimaya Gazeta, July 7).

Perhaps the highest resonance scandal spins around the defense ministry, which is loudly accused by industrial lobbyists of sabotaging the implementation of the armaments procurement program, first of all in the top priority area of strategic missiles (Kommersant, July 6; Moskovsky Komsomolets, July 8). Allegations of gross incompetence appear more convincing due to the resignation of several top brass, and Medvedev provides Serdyukov no defense perhaps assuming that a scapegoat would be needed closer to the elections (Ezhednevny Zhurnal, July 6). That might cool some tempers but will not resolve the core problem created by the plain fact that the stretched state budget in years of slow growth could not possibly sustain the over-ambitious rearmament program.

Several juicy scandals unfold simultaneously between the interior ministry and the state prosecution as the investigation of the protection racket involving illegal casinos in the Moscow region produces more compromising evidence (Vedomosti, July 7).  [Bootleggers and Baptists, again!]  Medvedev has launched a campaign to clean up the ranks of law enforcement but it has deteriorated into back-stabbing between various services and agencies and all attempts to put a lead on revealing these feuds to the public have only made the quarrels noisier (www.gazeta.ru, July 6). On the local level, the merger between police and organized crime has left many municipalities defenseless, and only in rare cases – such as the village of Sagra near Yekaterinburg – dare the inhabitants to take a stand against the violent gangs, much as in old Western movies (www.lenta.ru, Ekho Moskvy, July 7).

. . . .

Putin’s half-hearted efforts at tightening control are in fact as helpless as Medvedev’s attempts to assert his authority. Russia’s “national leader” can no more discipline the “power structures” than he can control Ramzan Kadyrov, whom he appointed to rule Chechnya – and who has turned it into a personal fiefdom prospering from the ransom paid by Moscow. It is the predatory behavior of the uncontrollable siloviki that increasingly compels successful Russians to consider emigration and drives the capital flight. This outflow of people and money may erode the support base for democratic opposition but it hardly prolongs the regime’s durability. Putin cannot allow the elections to expose the weakness of his grasp on power, or mobilize the self-serving repression apparatus – he can only rely on the lack of alternatives, which is never a lasting advantage.

But this is not new, not by a long shot.  Consider William C. Fuller’s Strategy and Power in Russia, 1600-1914.  Describing 18th century Russia, Fuller writes:

But their [sic] were other, less readily apparent limitations, or at least so some historians have contended.  Such scholars have argued that all of the lip service paid to the “unbounded power” of the autocracy actually masked the reality of an essentially feeble state.  The “all-powerful autocrat” in this view was a fictitious creation of mythmakers anxious to dupe people both at home and abroad into thinkng that the Russian state was much stronger than in fact it was.  Since autocrat-usurpers frequently owed their crowns, if not their lives, to the efforts of favorites and clans, the schemes and preferences of those courtiers represented a self-evident check on the monarchical will.  As one historian puts it, the power of the autocracy “was in fact very narrowly circumsribed,” for “the articulation of tsarist will depended upon the familial and personal patronage networks that dominated the court and the upper administration. . . . At the very least, any autocrat had to seek to balance all the various factions and “parties” against one another.

Clan politics and factional strife are often blamed for the lumbering inefficiency of the highest organs of administration in eighteenth-century Russia. (pp. 118-119).

And see if you can tell whether this is from Baev describing Russia circa 2011 or Fuller describing Russia circa 1750:

This same confusion of personal interest with the interests of the state is all supposed to to explain the extraordinary corruption of Russia’s governing class.

In fact it is Fuller, but it is a fitting description of current affairs.  Fuller continues:

Embezzlement, extortion, graft, the acceptance of foreign bribes–none of these practices was uncommon among the aristocratic elite.

In other words, Putin is facing problems inherent to autocratic systems, and is, within the constraints of a nominally democratic system, attempting to employ many of the same techniques to deal with them.  He cannot rely on the formal and traditional allegiance due a hereditary autocrat, so he is using media control to create a personality cult and an aura of unchallengeable authority and infallibility.  Like tsars and tsarinas before him, he is a really a balancer, not a true ruler.  He is limited in his ability to control his nominal agents.

These considerations may prove decisive in determining Putin’s decision regarding the presidency.  The tandem is vulnerable to attempts to play one of the two off against the other in the same way that Putin keeps the siloviki under control by pitting clans and factions against each other.  Hence the emphatic and almost ritualistic assertions that Putin and Medvedev are of one mind, despite evidence to the contrary.  The agency problems of a would-be autocracy are bad enough, without the potential for conflict and coordination problems at the top.    Thus, I would conclude that if Baev’s description is at all accurate, the duumvirate will pass into history with the next election.

But even if it does, the age-old disabilities of autocratic, personalized, a-institutional systems will continue to operate.  The hamster wheel has spun for centuries, and will continue to do so for the foreseeable future.

The Bank of England’s Andrew Haldane gave a speech on high frequency trading that highlighted its risks.  He cites evidence that various measures of persistence in stock prices have risen since 2005, and attributes this to the advent of HFT.  Maybe.  But many other things have changed in the same time period, so giving privileged status to HFT as the cause is quite a stretch.  Short of a natural or controlled experiment (e.g., randomly assigning stocks that can and cannot be traded using HFT), attributing broad changes in pricing behavior to any single factor is highly conjectural.

His argument rests on the assertion that market making is more fickle during times of stress due to HFT.  I would say that market making is more fickle during times of stress, full stop.  Liquidity has always dried up during crashes and crises, no matter what the technology.  The floors in Chicago were depopulated during the ’87 Crash.  Many locals–liquidity suppliers–who didn’t leave voluntarily were pulled off the floors by their clearing firms.  And many those that remained stood with their hands concealing their badges lest somebody try to win the outtrade lottery by claiming that he had made a profitable trade.  NASDAQ market makers didn’t answer their phones during the Crash, and many specialists evaded their affirmative obligations to make markets (so much for one of Haldane’s suggested fixes).  No HFT, but no liquidity and a crash all the same.

I wrote about a lot of the proposals that Haldane mooted in the immediate aftermath of the Flash Crash.  Market making obligations are hard to enforce, as Haldane notes.  The argument for them, as I laid out last year, is that they could affect the time pattern of liquidity supply.  Such constraints necessarily reduce the return on capital, which will lead to an exit of market making capacity.  This will raise costs in tranquil times, in the hope that the obligations imposed on market makers will lead a larger proportion of a smaller population of market makers to remain active during turbulent times, thereby improving liquidity during those times.  Given the strong incentives to evade the obligations during turbulent times, and the difficulties of specifying and enforcing what those obligations are due to the high dimensionality of the services that market makers perform, this is quite a gamble: in more technical economic jargon, market making behavior is not contractible.  There is no guarantee that the greater participation rate will more than offset the loss in capacity, leading to a more desirable allocation of liquidity supply between stable and turbulent times.

Haldane also plumped for minimum order times.  Despite David of Deus Ex Machiatto’s best efforts, I remain wholly unconvinced of the wisdom of this.  Ditto Eric Hunsader of Nanex’s very nice and thoughtful comment.  David presents a calculation of the option value, and hence the cost, of mandating a one-second quote-in-force rule.  The calibration technique is a natural one, but I am skeptical of its applicability.  The price of an option with a maturity of a month that David is using to calibrate is based on private and public information flows over a period of days, which is fundamentally different than the market makers’ pricing problem, which is driven by private information flows over very short time scales.  The whole point about market microstructure theory is that price behavior is fundamentally different at small time scales, so in my view it is unlikely that a one month option can be scaled down to value an option granted on a far shorter time scale.

But quibbles about calibration and scaling aside, this begs a huge question: if it is so cheap to grant options under all market conditions, why doesn’t competition ensure that said options are in fact supplied at their allegedly negligible cost (fractions of a basis point, per DEM)?  After all, competition–as a graph in Haldane’s presentation shows–has driven down spreads to very low levels in normal times.  The wholesale exit of market making capacity during turbulent times–in many cases, the refusal to trade at any price–indicates that it is very costly, and for some prohibitively costly, to grant options under these circumstances.  It is a cost problem, and this cost problem is endemic to financial trading, regardless of the technology.

It has long been known that situations of extreme adverse selection–a problem completely abstracted from in the option calibration problem, by the way–can lead to a breakdown of trading, or at the very least, a sharp reduction in trading activity.  When lemons risk becomes too great, markets freeze up or shut down.

An old paper by Glosten in the Journal of Business suggests that this is a rationale for having a designated market maker or specialist: in his model, a monopoly specialist market is less vulnerable to breakdown than a competitive one.  But that’s a different solution than mandating quoting by competitive market participants.  In the Glosten model, competitive markets are subject to breakdown under conditions of extreme information asymmetry.  That’s true regardless of the technology.

Glosten’s paper, I might add, was published in 1985, before HFT was a gleam in a geek’s eye.  There is indeed little new under the sun, and the focus on technological novelty obscures the enduring nature of the fundamental economic problems of liquidity supply.

Indeed, I believe it to be almost certain that imposing a restriction on quoting times will not improve liquidity, and will usually make it worse.  Imposing a constraint increases costs, and increasing costs invariably reduces supply.  A quoting time rule says: “If you quote, your quote must be in force for x seconds.”  The “if” is the key thing here: a market maker can avoid the constraint by not quoting at all, and if the cost of extending the x-second option becomes too large due to severe lemons problems, that’s exactly what he will do–or will program his machine to do.  Not exactly the best way to induce liquidity supply.

So a quoting-time rule alone is extremely counterproductive.  Hence Haldane’s musing about market making obligations–which are noncontractible and hence not effectively enforceable, and hence not much use either.

In other words, if you want to encourage liquidity supply in the worst way, imposing constraints is that way!

Going back to basics, if you think that there is a market failure (e.g., a periodically occurring severe lemons problem), a natural way to address that failure is to subsidize what is being undersupplied, not to tax it.  Just how to subsidize is not obvious, but one thought would be to widen tick sizes.

Another more productive approach would be to constrain the kinds of trading strategies that can be destabilizing, most notably stop orders.  The CME’s stop order logic clearly helped put the brakes on the Emini Flash Crash.  Extending that logic to other markets would be salutary.

This is an area where fragmentation and the associated difficulties of coordination across linked platforms raises difficulties not present in a CLOB, as David emphasized.  But that’s where regulators could play a constructive coordinating function.  Haldane and other regulators have discussed coordinated circuit breakers–a coordinated stop order logic would be an excellent place to start.

Free associating  somewhat (for that’s what blogs are for!), I can envision a way to make such limits forward looking, rather than backward looking.  The Easley-O’Hara-Prado order flow toxicity measure could help identify times in which market breakdowns are more likely, and this could be used to trigger constraints on stop orders.  All circuit breakers under consideration are conditional on price movements, which often involves shutting the barn door after the horse has bolted.  Something forward looking based on real time monitoring of quoting behavior and the adverse selection risk of order flow would be preferable.  This would put computing technologies to work reducing the risk of flash crashes.

I also think it is worthwhile to explore measures directed at parasitic types of trading.  In particular I am still convinced that pricing of exchange capacity–e.g., charging prices for submitting and canceling orders, where said prices vary with system usage–is a promising avenue to explore.

One final note.  During his talk, Haldane mentions the importance of “moving from analysing market microstructure to market macrostructure.” Hear! Hear!  That’s what I’ve been on about for the last 15 plus years.

I claim credit for coining the term “macrostructure” in this context: maybe somebody used it first, but if so I wasn’t aware of it in ’98 or ’99 when I started describing my research using that term.*  I have a paper in the JLEO from 2002 titled “Securities Market Macrostructure,” and the title of my next book will be “Financial Market Macrostructure.”  I actually had to fight the editorial board at Cambridge UP to get them to sign on to that title; they wanted a more plain-spoken title and thought that “macrostructure” was not commonly enough used in economics to fit the bill.  Glad I prevailed–and glad Mr. Haldane is popularizing the phrase.

As I use it, macrostructure modeling involves deriving the implications of microstructural forces for the organization of securities and derivatives markets–the number of exchanges; how trading is divided between exchanges and OTC markets; fragmentation of trading; how exchanges are organized and governed, etc.  My perhaps heterodox views on fragmentation, dark markets, etc., are firmly rooted in this way of analyzing market structure.  Maybe Mr. Haldane and others often disagree with those heterodox views, but it is encouraging to see that the idea of building an understanding of market structure and regulation on firm microstructure foundations is gaining acceptance.

* I’d be interested to hear from anyone who can provide an example of the term “macrostructure” used in this way (which I describe more fully in the text below) that pre-dates 1998 or so, when the word popped into my head.  I wouldn’t want to deny the actual innovator the props he or she deserves.

The looming debt limit deadline has spurred widespread speculation of some sort of grand bargain on taxes and spending.  I consider it likely that some deal will be announced and that the limit will be raised.  I consider it a near certainty that the bargain will be a farce.

Any such trade will involve the Republicans agreeing to tax increases, and Obama and the Senate Democrats making promises to reduce future spending, including perhaps entitlement spending.  The problem with any such deal is asynchronous performance.  Tax increases must be implemented by legislation, and remain in place until Congress explicitly votes to eliminate them (unless there is a provision for expiration written into the law).  In contrast, budgets are passed year to year–well, they are supposed to be, anyways–and it is virtually impossible to precommit future Congresses to adhere to promises to cut future spending.  Watch for any deal to have eye-popping spending cut numbers–all in out years.  Pie crust promises–easily made, even more easily broken.   As previous deals have shown, the tax increase parts get implemented, and the promised spending cuts fade into oblivion.

Even promises of changes to entitlement programs are usually evanescent.  The metronomic “doc fix” in Medicare is a classic example.

The only reason any of this matters is in their effects on  the 2012 election.  2011 and 2012 will be years that the locusts hath eaten–as were 2009 and 2010.  Years when we should have grasped the nettle of our debt and spending problems–but did not and will not.  The time we have to do so is shrinking, but a serious start in 2013 would give us a serious chance.  But if Obama is reelected, that will not happen.  2013-2016 would become locust years as well, because Obama is Obama, and because the last two years of a second term invariably dissolve into conflict, exhaustion and incoherence in which nothing of substance is accomplished.

A bargain would therefore likely be a bad thing.  It would not actually address the problem, but would perhaps create the perception that it has.  This would empower the incumbents who would bask in the false glow of pretend accomplishment.  And since the status quo embodied in the incumbents is fundamentally unsustainable, this would be a disaster of the first magnitude.

A fundamental change in the direction of government in the US is needed not just because spending is unsustainable.  The burden of debt is becoming unsustainable not only because spending is increasing, but because growth is anemic: debt burdens ease over time if growth outstrips the cost of servicing the debt.  But US economic performance in The Locust Years has been poor.  Yesterday’s dreary employment report makes it abundantly clear just how poor that performance has been.  In terms of employment, this “recovery”–such as it is–is the worst since the Great Depression.

And likely for the same reasons.  Hyperactive federal governments that heap massive regulatory burdens on the backs of businesses and households, and which generate vertigo-inducing uncertainty to boot.  Today, the looming specter of Obamacare and Frank-n-Dodd are huge drags.  But these are only the most visible things.  From the EPA to the NLRB to whatever government agency you can name, regulators are raising both costs and uncertainty.  Which is almost certainly why “Recovery Summers” are chimerical: why years that should have witnessed a sharp rebound in economic activity have instead been consumed by pests swarming out of the District of Columbia.

No, what happens between now and August 2 is important only in how it affects what happens in November, 2012.  Sadly, an Obama defeat then is not sufficient to ensure that the country can turn things around, but it is necessary.  Any dealing around the debt ceiling should be done with one objective in mind: ensuring that our future harvests do not fall to the sun-blotting clouds of spenders and regulators.

It looks like the travails of partly-Alfa Group owned Avianova are not payback for Alfa’s role in torpedoing the Rosneft-BP deal, but are instead just another example of corporate governance a la Russe:

On the surface, the story seems to have all the trappings of every Alfa conflict of yore. (Think BP vs Alfa-Access-Renova, or Telenor versus Alfa-subsidiary Altimo.) But what do these stories actually say about the Russian investment climate?

The two shareholders are preparing to face off at a board meeting in London next week to determine whether Avianova, Russia’s 13th biggest air carrier, should be run by Andrew Pyne, its holding company’s British chief executive, or Konstantin Teterin, a Russian airline executive hired to take his place.

As the FT has reported, Pyne, who has served as chief executive of Whitefish Aviation, Avianova’s holding company, for the past four years, was suddenly barred from entering the company’s Moscow offices last week after Teterin, an Aeroflot veteran, was appointed first deputy general director.

And speaking of Russian corporate governance, this is an absolute riot.  The new chairman of that paragon of efficiency and good management, Rosneft, shared this gem with the world:

“To make this decision [to give up a controlling stake in the company] the government should be guided by a certain calculus, not an abstract notion that the public sector is bad and the private sector is good,” said Nekipelov, who is also vice president of the Russian Academy of Sciences.

According to the privatization plan for Rosneft, which pumps nearly a quarter of the country’s oil, the state will first lower its stake from 75.16 percent to 51 percent and after 2015 sell off more shares to be left with minority ownership.

“Rosneft’s assets are huge. Its capitalization is around $90 billion. To allow some independent directors to manage such assets is a very exotic point of view,” Nekipelov said.

Let’s see.  ExxonMobil market cap: $405 billion.  Chevron: $214 billion.  Shell: $143 billion.  BP: $140 billion.  ConocoPhillips: $130 billion.  How exotic: they are all far bigger, they all have outside directors, they all are privately owned–and they are all far more efficient than Rosneft.  Note that Rosneft pants after all of them for joint ventures.  Rosneft dreams of playing in the same league.  But it never will when it thinks corporate accountability is “exotic”, and that it is an “abstract notion” that privatization can enhance the efficiency of a commercial enterprise.

Two stories.  Two points in the portrait of a dysfunctional “business” culture.

As I’ve written repeatedly in the past years, the mandated move to central clearing will increase substantially demands for liquidity to fund variation margin payments, especially during periods of high volatility and high market stress.  By definition, variation margin payments total zero–every dollar paid is received by somebody else–thus they don’t affect aggregate liquidity, but economic frictions preclude the development of a perfect pooling mechanism.  As a result, market participants will need to pre-plan how to fund their margin payments.

Not surprisingly, banks are crafting funding mechanisms for their buy-side clients (“end users”).  FTAlphaville quotes from a Risk story by Matt Cameron which describes some of the solutions dealer banks are peddling to their clients [emphasis provided by FTA]:

Clearing members say they have a solution. Most buy-side firms will have to access clearing services through these members – typically the large banks – due to strict membership criteria set by the CCPs. These clearing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities – essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP. Given the frequency of margin calls – there could be several per day in volatile markets – some also plan to extend credit lines, where they would meet intra-day margin calls, with the customer settling up in one go at the end of the day or start of the next.

It sounds a perfect solution, but the numbers involved are huge, raising the question of whether there is enough capacity and appetite among dealers to offer this service to the entire universe of end-users. According to research published by Morgan Stanley and Oliver Wyman on February 16, as much as 40–50% of the total annual traded volume of OTC contracts could be cleared by 2012/13 … creating an additional collateral requirement of between $2 trillion and $2.5 trillion … Most dealers say they would only have capacity to extend credit lines and provide collateral transformation services on a fraction of that.

Diving into the Risk article reveals more details–troubling ones.  It notes that unlike dealers, whose books are typically close to matched, end users are likely to have one-way positions with commensurately greater exposure to margin calls.  Which just provides just another reminder that clearing would not have been a panacea for AIG, which had huge directional positions, and was brought down by the need to fund margin calls–and would have been brought down by the need to fund margin calls in a cleared environment.  Indeed, the expansion of clearing threatens to increase the population of potential AIGs.

The article also emphasizes that the contingent funding obligations on banks could be huge, and are likely to be huge precisely when funding market conditions are stressed.  The various solutions proposed by the banks rely very heavily on repo markets, and in particular repo markets for lower quality, less-liquid instruments.  In essence, banks will repo out lower quality assets and use the cash to fund margin calls.  But repo markets for lower quality assets are the ones that are the most problematic during periods of market stress.  Note that haircuts on everything but high quality sovereign paper increased dramatically when the financial crisis took hold.  Companies that depended on the repo market for funding found this source cut off.  The shadow banking system was built on repo, and runs on the repo market are what cratered that system.  The death knell for Lehman was the decision by JP Morgan and BNY Mellon–the clearing banks–to refuse to take low quality assets to collateralize tri-party repo.

So just why exactly is it a good idea to create a system that increases reliance on a fragile funding source?  This creates exactly the kind of feedback mechanism that generates crises.  Adverse shocks lead to price changes that result in big margin calls.  These shocks also impair liquidity of the funding markets that participants rely on to obtain the cash they need to pay the margin calls.  That’s how things spiral from bad to worse to worser yet.

And there are knock-on effects in the asset markets:

“We reserve the right not to fund clients on a unilateral basis.  If we fall short and can’t fund the variation margin call, we will demand the cash from the client.  If the client doesn’t have the cash, it will have to liquidate the assets it does have or we will be forced to close them out . . .” says one dealer.

Great.  This is a perfect example of how individually rational behavior by banks can exacerbate market stress.  The collateral liquidations and  derivatives liquidations will both cause prices to move–generating more margin calls and reducing the value of the collateral available to secure funding of those calls.  Positive feedback again.  And since by design a lot of the collateral that is liquidated will be lower quality stuff traded in illiquid markets the price impacts will be large–and this will make it more difficult for others to use these assets to fund their positions, thereby creating a serious negative externality.

These problems are endemic in financial markets, including uncleared OTC derivatives markets.  But clearing makes the mechanism more rigid and time sensitive.  It increases the tightness of the coupling in the financial markets, and that makes them more vulnerable to chaotic breakdown and cascading failure.

Cameron’s article discusses other alternatives.  One is that CCPs accept lower-quality collateral. But this merely passes the hot potato.  CCPs are simply conduits that transfer margin monies from the losers to the winners.  The winners won’t necessarily accept the collateral that the losers provide, or will place a lower value on it.  Much of the collateral will be hard to value, during periods of market stress particularly.  And if there is a delivery option on collateral, how do you even price collateralized derivatives trades?: the price of the collateralized trade depends on the value of the collateral, which adds an additional risk to the trade.

So if the CCP can’t just pass collateral along from loser to winner because the collateral isn’t fungible like cash, then the CCP has to fund the cash payments to the winners collateralized by the non-cash instruments posted by the losers.  That puts the CCP in the position of a bank, and raises the question: just who is going to lend against that collateral?

Moreover, this undermines one of the main potential benefits of clearing: fungibility of trades across counterparties.  Different counterparties may have different funding capabilities.  Some may have  access to high quality collateral, some may rely more heavily on low quality collateral.  In an OTC market, those counterparties would trade derivatives at different prices reflecting their differing risks and the quality of the collateral that backs the trade.  But in a cleared market in which all trades are fungible–with offsetting positions netted out, meaning that they are treated as perfect substitutes–this pricing mechanism doesn’t work.  Economically important differences are not priced, which distorts incentives.  This will tend to work to the advantage of low-quality counterparties and to the disadvantage of high-quality ones.

In other words, if the collateral really isn’t fungible–like cash is–how can the trades backed by this collateral be fungible?

One of the risks of clearing is that it treats the unequal equally.  Widening the range of collateral that CCPs must accept only exacerbates that risk.

It also puts CCPs in a delicate position–exactly the position that JP Morgan and BNY Mellon found themselves with Lehman.  A firm is in trouble, and is offering to post dodgy paper as collateral.  If the CCP refuses, the firm is likely to default.  That could jeopardize the CCP.  Even if the CCP can absorb the default, it is at risk of being accused by the defaulter’s bankruptcy administrator of violating the bankruptcy laws–which is the situation Morgan and BNY found themselves in post-Lehman.

So maybe the CCP will decide to play European Central Bank for a day–or a week, or a month–and pretend that junk collateral is as good as gold or cash, thereby gambling on the resurrection of the troubled firm.  That just increases the risk of the financial system–and may subject the CCP to a run by firms that are worried about the quality of the collateral it has taken on.

Contrary to the airy promises of their evangelists, clearing mandates therefore do not fundamentally alter the economic problem that must be addressed: how to fund variation margins in periods of market stress.  Indeed, in my view mandates actually exacerbate the problem because they increase the rigidity and time-sensitivity of the system, require the clearing of more instruments less suitable to accurate valuation in short time frames, and reduce the ability to price risk in a discriminating way (because unequal entities and instruments are treated as interchangeable).  What’s more, the mandates tie up vast amounts of high quality collateral in initial margin payments, forcing greater reliance on lower-quality collateral to keep the system running.  And yet more–depending on the scope of the mandates, buy-side entities that pose no real default risks (e.g., pension funds) but do pose potentially serious funding and liquidity risks will be forced to clear.  Since funding and liquidity risks are the Achilles heel of the clearing system, it is absolutely insane to increase funding needs.

No matter how many times you turn over this problem, I think you will conclude that clearing mandates will substantially increase the necessity of central banks to provide liquidity, and lend against dodgy collateral.  Whether the central banks provide cash to CCPs collateralized by non-cash collateral paid by customers, or provide cash to dealer banks collateralized by low-quality collateral, or provide the cash to end-users similarly backed by low-quality collateral (although this alternative is least likely), to fund the vast margin payments during periods of stress they will be lending a lot to somebody.

Savor the irony.  The rallying cry for clearing mandates was “No More Bailouts,” “bailouts” in this instance meaning central bank loans to troubled financial institutions, intended in part to prevent a meltdown in derivatives markets.  But clearing mandates will only increase the demands on central banks to provide extraordinary funding to keep the derivatives markets going.  The parable of the Indian village that brought in cats to rid itself of mice, dogs to rid itself of the cats, elephants to rid itself of the dogs, and then in the end mice to rid itself of the rampaging elephants is apt indeed.

In the Risk article, Matt Cameron notes that seven out of eight regulators he contacted about the story refused comment: “Most said not enough analysis had been conducted.”  Read that again: “Not enough analysis had been conducted.”  Pardon my French, but Jesus H. Christ, wouldn’t you want to do that analysis before embarking on this titanic reengineering of the largest, most complex financial markets the world has ever seen?  “Not enough analysis had been conducted.”  Really?  Really?

But I know it’s true–and you do too.  And that’s the tragedy of it all.

I sometimes try to think of a rational reason for undertaking this huge experiment on a live patient.  In my more cynical moments–pretty much all my moments are cynical, but some more than others–I wonder if this is just a part of the movement to “financial repression”, defined by Reinhart and Rogoff as follows:

Banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payment system. Governments force local residents to save in banks by giving them few, if any, other options.

They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form of taxation. Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation.

Clearing mandates, mandates that non-cleared transactions be collateralized, limits on rehypothecation, segregation rules and on and are “other devices” that increase the demand for government paper.  And just coincidentally, I’m sure, we’re living in an age where governments are desperate for buyers.

Maybe the dots don’t connect.  But maybe they do.  But I guess financial repression is better than financial insanity, which is the only other explanation that comes to mind.

Cold comfort, that.

David at Deus ex Machiatto responded to my response to his post on HFT.  A brief surrebuttal, if I may.

First, regarding CLOBs.  I wrote in the Regulation piece “Thirty Years War” that I linked to in my reply that the SEC had a choice between mandating a CLOB, and an “information and linkages” approach, and chose the latter.  Its implementation of the information-and-links approach was flawed, however, because they didn’t go all the way: the limitation to top-of-book protection is the most obvious flaw.

Moreover, a linkage-based approach is problematic during periods of market stress.  Any tightly coupled system is prone to failure.  David mentions that a CLOB has a single off switch, but that coordinating a shut-down of  multiple linked markets is more difficult.  That’s definitely true.  Failures of linkages–which are prone to happen during periods of high traffic and high volatility–can propagate through a linked system in unpredictable, chaotic, and destructive ways.  All this argues for a CLOB.

But, linkages are inevitable even if all trading in a particular instrument (e.g., a particular stock) takes place on a single CLOB.  In equities, for instance, cash and futures and options and futures markets should be interrelated and interactive, but cannot be run through a single CLOB.  Thus, linkages between such markets are inevitable, these linkages can break, and this tightly coupled system is prone to destructive feedbacks during periods of market stress.  Now with the proliferation of cross-market/asset strategies, linkages are pervasive and there cannot be a true single off switch.

But this is not an artifact of computerization of the markets and HFT.  It was a problem in the Crash of ’87, for instance.  The years immediately following saw a lot of chin pulling about how to coordinate among interrelated markets.

With respect to dark markets, darkness is a mechanism for segmenting privately informed traders and those who are trading for reasons other than private information.  In the old days, with block markets, non-anonymity (counterparty transparency), reputation (“no bagging the street”), and repeat dealing were the mechanisms for doing this.  Similarly, payment for retail order flow and ex post evaluation of trading performance of various sources of order flow was a segmenting mechanism.  As long as you have some people that are trading for reasons other than private information, you will have mechanisms to help them signal their lack of information.  If you force dark markets to light up, you will see the evolution of a mechanism that performs the same functions.  As surely as the light follows the darkness.  Or something.

David and I will agree to disagree about forcing limits on order exposure.  My argument against a say 1 second minimum exposure time is based on the fact that quotes are like free options.  Forcibly extending time-in-force increases the cost of that option to the quoter.  This is especially the case during periods when order flow is toxic–as was clearly the case during the hours leading up to the Flash Crash–that cost can become appreciable.  Many quoters will decide not to quote or radically reduce size.

In other words, the supposed cure is likely to actually exacerbate the problem of liquidity supplier flight which was at the root of the Flash Crash.  Making something more expensive is not the way to get more of it.  Minimum exposure rules would raise dramatically liquidity supply costs during periods when order flow is toxic, so you will get even less liquidity then.

Remember on exchange floors the rule is that a quote is good only “as long as the breath is warm.”  That’s because locals wanted to limit the value of the options they were extending.

There’s no free lunch here.  If you impose a constraint, and the constraint binds–there is a cost associated with that.  Somebody is going to pay it.

The “warm breath” metaphor reminds me that many of the things you see in HFT have close analogies to floor trading.  Sharply limited quote exposure times is one.  Colocation gives HFT traders a time-and-space advantage like that that floor traders possessed.  Even flash trading has its parallels: it is just another time-space advantage for a subset of traders who specialize in liquidity supply.  (Though to the extent that flash trading is used primarily to exploit the lack of full book protection the analogy breaks down.)

I’m sure we haven’t reached the end of this discussion, but that’s all for now.  As the title of my Regulation piece suggested, these battles over market structure and trading rules have gone on a long, long time, and will continue for as long as asset and derivatives markets exist.