Streetwise Professor

In the aftermath of Knight’s HAL moment, Larry Tab wrote a very good and succinct piece on the implications of fragmentation in equity markets:

Most think about fragmentation in terms of trading venues. And yes, the U.S. equity market has a number of trading venues. There are 13 exchanges, about 50 dark pools and many internalizing brokers that can match buyers and sellers. To ensure the best match, sophisticated order routers need to examine many trading venues. And without being in two places at once, the more venues checked, the greater the chance buyers and sellers miss each other.

While checking many venues complicates execution, markets also can fragment in other ways, including price and time. The more price points, the more missed trades. This is especially true as liquidity providers spread orders across more price points and venues. As fractions turn to pennies, and pennies to sub-pennies, through dark pools and the NYSE Retail Liquidity Program (RLP), trading volume becomes fragmented from 16 price points per dollar to 100, or 1,000.

The same problem exists with time. The quicker the quote timeframe, the more messages I need to produce and analyze. If I am quoting across 13 exchanges and 20 dark pools, then I need to manage my quotes across 33 venues. If my quoting frequency changes from seconds to tenths to tens of milliseconds to milliseconds, then my quoting rate increases from 33 to 330, 3,300, 33,000 quotes per second. Multiply that across 5,000 stocks trading at pennies or possibly sub-pennies and think about the massive technology and message infrastructure needed to trade.

Moreover, this dense web of linkages between venues raises the potential for algo errors.  More trading venues means more changes in the way the venues operate and their technologies, which means more changes in algos, which raises the odds of a programming glitch.  For instance, the catalyst for the Knight implosion was the NYSE’s introduction of its RLP program.  Another example that I just read (but can’t find a link to right now) is an HFT firm that had an algo go haywire because it hadn’t been informed of a change in the software at one of the trading venues it connected to: fortunately, this firm had measures in place that turned off the program after it had lost only $5K.  There is likely an externality across venues: a change by venue A increases the odds that the change will trigger a perverse algo response that will have adverse effects on venues B, C, D, etc.

So fragmentation has costs.  This raises the questions: why does fragmentation exist?, and, do the benefits exceed the costs?

It should first be noted that equity markets have always been fragmented to some degree.  Back in the day, substantial volumes of NYSE stocks were executed by “Third Market” dealers (notably, Bernie Madoff!) and in block trades negotiated away from the floor.

This fragmentation was driven by informational considerations.  (Relatively) uninformed order flow that could signal ignorance by some means (order size in the case of retail trades executed by Third Market dealers, or reputation and non-anonymous dealing in the case of blocks) reduced trading costs by trading in off-exchange venues.  If they traded in the anonymous NYSE marketplace, they could not be distinguished from informed order flow, and paid execution costs that reflected the adverse selection risks faced by liquidity suppliers in such a marketplace: by trading in another venue that had methods of screening out informed traders (imperfectly, but to some extent), the uninformed avoided paying this adverse selection premium.

This type of fragmentation exists today: Dark Pools have evolved to perform the same functions as Third Markets and block markets.  Dark pools use a variety of methods to attempt to screen out informed and opportunistic traders.  And some HFT/algo strategies (arguably opportunistic) are attempts to circumvent these screening technologies.

The proliferation of non-Dark Pool trading venues-anonymous, non-screening trading platforms-is relatively novel.  Until the mid-00s, such venues did not exist.  Virtually all informed order flow, and a good chunk of uninformed order flow, in NYSE stocks was executed on the NYSE.  The exchange had a market share of 85+ percent up through around 2005.

Since then, NYSE market share has plunged to around 30 percent.  Some of that volume has been snagged by Dark Pools, but the bulk has been taken by other exchanges.

This reflects an explicit policy choice by Congress, and the SEC.  Since the mid-1970s, Congress has pushed for the creation of a National Market System of competing exchanges.  That effort was moribund until 2005, when the SEC implemented RegNMS that obligated electronic markets to direct orders to other markets displaying better prices.

This effectively socialized order flow.  In the pre-RegNMS days, market participants had an incentive to direct their orders to the market that they expected to have the best price.  This created a self-reinforcing feedback loop.  The biggest market (the NYSE) tended to have the best price, so traders sent their orders there, thereby reinforcing the NYSE’s advantage.  With the mandated routing of orders to other markets, the NYSE no longer had a lock on order flow.  Other venues could compete for it effectively.

This had already been seen in options, which had been subject to order routing mandates much earlier.

From the SEC’s (and Congress’s) perspective, this was a feature, not a bug.  The whole idea behind NMS was to create a more competitive marketplace not dominated by a single exchange.

It worked, but it has had unintended consequences.  The adverse consequences of fragmentation Larry Tabb discusses are among them.

This points out a fundamental dilemma in securities market design.  If order flow is not socialized by order routing mandates, the liquidity network effect tends to lead to the dominance of a single exchange that exercises market power.  We see this in futures around the world.  Although electronic trading has taken over futures trading, we don’t see fragmentation like in the equity markets, which means that fragmentation is not an inevitable consequence of the computerization of trading.  Part of that is due to the fact that information asymmetries are less severe in futures than individual equities (e.g., because there is less private information about an equity index than an individual stock), and so there is no “dark pool” type fragmentation.  But most of it is due to the fact that there is no socialization of order flow in futures.  Perhaps because it was, historically, a more obscure corner of the financial world than the stock market,  Congress never caught the itch to create a National Futures Market System.  But regardless of the reason, the order flow feedback effect, where order flow attracts order flow, has led to the dominance of a single exchange in virtually every major futures contract.

This points out a fundamental dilemma.  Due to the nature of liquidity, policy makers have to pick their poison.  They can eliminate fragmentation, at the cost of market power.  They can eliminate market power, but only by living with the adverse consequences of fragmentation.

Those are the choices.  Period.  The economics of liquidity can’t be legislated or regulated away.  All that policy makers can do is affect how those economics will manifest themselves.  Don’t like exchange monopolies (or near monopolies)?  Socialize order flow a la RegNMS-and live with the consequences of fragmentation like we see today.  Don’t like the consequences of fragmentation? Abstain from requiring exchanges to direct order flows to markets displaying better prices-and live with the market power that will result when trading tips to a single venue of price discovery.

Not an easy choice.  I don’t know what the more efficient alternative is.  But it would be refreshing if debates over market structure would acknowledge that there are no Goldilocks, “just right”, choices.  Instead, there is more of a lady and the tiger like dilemma. Bewail the evil consequences of fragmentation if you will, but be prepared to show how those consequences are less malign than the costs of market power.  And vice versa.

Obama has repeatedly said that the US cannot afford to lose to China in the solar panel industry.  Well, I am (not) pleased to report that the US is being very competitive in this race.  Very.

Surely you are saying to yourself: SWP has finally lost it.  Has he forgotten Solyndra? Abound Solar?  First Solar?

Of course I haven’t forgotten these testaments to industrial planning and the miraculous insights that Nobel Prize winners in physics bring to it.  It’s just that the vaunted Chinese have done just as badly.  The competition to lose the most is very fierce indeed:

As solar panel prices continue to march lower, Chinese solar companies are struggling with heavy debt loads, triggering expectations many will be forced to seek a new infusion of funds through takeovers or mergers.

Suntech Power Holdings (STP.N) could be liable for hundreds of millions in new payments after it disclosed a potential fraud by a partner, while peers such as LDK Solar (LDK.N), JA Solar Holdings Co (JASO.O), Trina Solar (TSL.N) and Yingli Green Energy Holding Co (YGE.N) are also feeling pressure.

With prices for solar panels barely covering the cost to build them, dozens of small Chinese solar companies are believed to have shut their doors, and equity investors have fled the sector, sending share prices of the U.S.-listed Chinese companies down more than 85 percent since early 2011.

Most of the Chinese solar companies will be able to stay open only if government lenders continue to keep lines of credit open despite forecasts of several more quarters of red ink.

More:

Since Jiangxi LDK Solar Hi-Tech Co. Ltd. settled in Xinyu, in southeastern China’s Jiangxi Province, the local government has gone out of its way to give it preferential treatment, making the company a focus of the local economy.

However, the manufacturer of solar modules, along with other similar Chinese firms, has encountered difficult times of late. In the past few years, these companies have built up large inventories even as demand has fallen off and profits all but disappeared. Naturally, LDK Solar ran up large debts.

All of this left the government with a choice: let the company fend for itself, or intervene, doubling down on its support. In fact, this wasn’t much of a choice, as the government has reflexively lent even more support to the troubled company, bringing into full view the relationship between government and business in China.

Governments at the city and provincial levels have taken steps to protect LDK Solar’s creditors and prevent the firm from filing bankruptcy. At the same time, the government has tried to find a white knight to buy the company, which employs thousands in Xinyu.

The situation in China’s solar industry and especially at LDK Solar shows the degree to which government becomes involved, for better or worse, in the market in China and how some companies become too big to fail.

Isn’t Chu a Chinese name?  Just wondering.

The Chinese and Americans join the Germans and Spanish in the solar bloodbath.  Billions have been thrown down this rathole.

Remind me again why we have to-HAVE TO-win this competition?  If the Chinese want to subsidize the production of solar panels, far be it from me to stop them.  Consumers around the world can benefit from China’s beneficence-and stupidity.  There is no reason for us to imitate it.

In the comments on an earlier post, pahoben and I exchanged views about the analogy between China circa 2012 and Japan circa 1990s.  I remember that in the 1990s, Smart People like Lester Thurow told us that America’s economic fate hinged on who “won” the flat panel display industry.  Really?  How’s that looking now?  And what is so wonderful about “winning” the competition to produce products that will inevitably become commoditized-as flat panels did?

Now we are being told by Smart People like Tooltime Tom Friedman and our very own POTUS that solar is the future, my boy.

How is that supposed to work, since everybody who tries to force feed this “business” loses money?

I’ve seen that movie repeatedly.  I know how it comes out.  Badly.

Profits are a signal that guide resources to their highest value use.  If subsidized companies can’t earn a profit, what does that tell you?

It tells me that this is a competition that we should gladly let some other sucker win.  But the Smart Set in the US seems hell bent on winning the Biggest Sucker competition.  Can’t we just be slacker losers instead?  It’s much cheaper.

John Cassidy’s book, When Markets Fail was incredibly annoying.  Coase obviously didn’t make a real dent on his consciousness.  How is that possible, in this day and age?

Cassidy writes for the New Yorker, and yesterday he turned his penetrating analytical abilities to criticize Romney by hyping government support for Olympic athletes:

In the past fifteen years, government spending on sports facilities and sports-training programs has steadily increased to a point where the British Olympic team now receives about a hundred and twenty-five million pounds (about two hundred million dollars) in annual funding. And guess what? The team’s performances have improved greatly. Four years ago in Beijing, the British team won nineteen golds and forty-seven medals over-all, putting them in fourth place behind China, the United States, and Russia. This year, Team G.B. leapfrogged Russia in golds.

“You do not get excellence on the cheap nor do you get all the virtuous outcomes that come from that without long term and predictable levels of funding,” Lord Coe, the great middle-distance runner who headed up the London Organizing Committee, said over the weekend. “That’s what we witnessed in Beijing, that’s what we witnessed here and if we want to maintain our position in Olympic sport then that’s what you will need to do.” Many of the British heroes from this year’s Games echoed Coe’s sentiments. “I was at Atlanta in 1996 when G.B. finished thirty-sixth in medal table,” said Ben Ainslie, a sailor who just won his fourth gold medal. “So to see where we are now in third place at London 2012 demonstrates just how successful this strategic investment has been.”

I haven’t seen Romney or Ryan asked about the financing of the Olympics. Their response would probably be that Team U.S.A. did splendidly without much government backing, and that’s true. The United States Olympic Committee, unlike its British counterpart, relies on individual donations and corporate sponsorship for funding. Such a system can produce great athletes, especially when it is combined with supportive parents and outstanding college programs. But government-financed initiatives can work, too: the British showed that.

In fact, the entire London Games was a testament to the productive role that governments can play.

Really?  Bad economics is seldom persuasive, and the above is chock-full of it.

To start with, straw man arguments are unpersuasive.  Nobody claims that additional government spending should not lead to improved performance.  So, it’s hardly a surprise that, all else equal, the UK’s medal tally increases if it spends tens of millions supporting Olympic athletes.

The questions are whether this is a good investment, and whether-as Cassidy clearly believes-that Britain’s subsidies should be imitated by other nations.

The answer to both questions is definitely No!  And you would think that a guy that finds a market failure lurking behind every blade of grass would understand that, for the logic is pretty straightforward.

Even without government subsidies, the superstar syndrome (eloquently analyzed by one of my intellectual idols, and thesis advisor, the lamentably late Sherwin Rosen) induces overinvestment in athletic achievement.  The big winners earn rents, and due to the nature of tournaments and the superstar system, virtually all of the rents go to the top performer in a few sports, e.g., Michael Phelps, Usain Bolt.  This induces competition to be the superstar.  This competition dissipates the rents.  The more popular the sport, the bigger the platform (e.g., the Olympics), the greater the endorsement potential, the more rents, and the greater the waste.  (This is actually an argument for old-style amateurism.)

Government subsidies only make things worse, and arguably far worse, because of the non-cooperative nature of the interaction.  Government X gets utility out of sports achievement.  It subsidizes sport.  But government Y also gets utility out of sports achievement.  Given the nature of sports competition, this sets up a very wasteful competition between X and Y.

This is most easily seen when the pools of talent and the effectiveness of the subsidized training in the two countries is equal.  (The argument can be extended to cases where there are asymmetries.)  Tournament competition is winner take all, and for the most part, the margin of victory doesn’t matter in determining the utility of winning.  This means that if X outspends Y by a dollar, X’s athletes win, and it gets 100 percent of the benefits of victory: 50 percent of expenditure generates 1oo percent of the gains.  This gives Y an incentive to see that dollar, and raise X a dollar.  The trivial increase in Y’s expenditure leads the gains of victory to shift entirely from X to Y.

But X won’t stand for that.  For a mere $2 more, it can get all of the benefits of victory.

Note the discontinuity.  A small change in expenditure leads to a discontinuous change in the fruits of victory, from 0 to 100 percent.

And so it goes.  In equilibrium, both sides overspend.  Indeed, all of the spending is overspending.  In equilibrium, X and Y spend the same positive amount, and the outcome is random, with each nation’s athletes having an even chance of winning.  If they had  spent nothing, the outcome would be random, with each nation’s athletes having an even chance of winning.  In other words, the outcomes (the probability that X’s or Y’s athletes win) doesn’t change if the countries subsidize: in that sense, the entire expenditures of X and Y are a pure waste.

You might argue that the absolute level of performance would improve, and that has some value.  Maybe.  But the main thing is who gets the gold, not the time they do it in (in track or swimming), or the distance they jump, or the height they clear, or the score (in shooting, say), or the dominance in the ring or on the mat.  In the Olympics, it is the medal count that countries tout-and which Cassidy emphasizes in his piece. So on that dimension-the dimension of the number of wins/medals-it is unambiguous that the subsidy is a waste.  Expenditures of resources affect nothing.  All pain, no gain.

Moreover, the waste tends to get worse, the larger the number of competing countries.

This isn’t rocket science.  It is non-cooperative game theory 101.  The problem is that when resources aren’t allocated by price, but are allocated in a winner take all race, there is wasteful competition for rents-as anyone who claims to be an expert about market failures (like Cassidy) should know.

In market settings, the Coasean logic operates: such waste will be mitigated by the incentive to craft efficiency enhancing arrangements (where efficiency takes transactions costs into account). With governments, not so much.  Or, to put it differently, the transactions costs incurred to reduce government waste are quite high.

The bottom line is pretty simple: government subsidization athletic performance is incredibly wasteful.  A government failure. But Cassidy lauds these subsidies.

That tells you all you need to know about how much attention you should pay to him.

Maybe that’s a disturbing mental image, but the title is more than apt given Gensler’s recent NYT oped, “Libor, Naked and Exposed.”  As is his wont, demonstrated repeatedly on Frankendodd-related issues such as clearing and SEF mandates, Gensler presents a misleading and distorted analysis to advance some regulatory or political agenda.

Gensler questions the integrity of Libor.  This is certainly understandable in the light of the deluge of revelations in the past couple of months.  But the “evidence” that Gensler uses to justify his skepticism is completely off point, and certainly grossly overstates the impact of any manipulation on this important benchmark rate.

The first comparison Gensler makes is between Libor and Euribor.  He notes that dollar Euribor is about double dollar Libor.  But what Gensler omits to say is that this is an apples to horse apples comparison, given the major differences between the banks in the Libor and Euribor panels.  The former includes major banks (crucially, TBTF banks that benefit from the implicit and explicit support of governments and central banks), and most notably major US banks with ready access to dollar funding.  The latter includes something of a dog’s breakfast of foreign banks.  It has two Spanish and one Portuguese cajas and five German landesbanken, for crissakes.  And Dexia! The Euribor panel banks are all weaker, and don’t benefit from the same safety net as the banks in the Libor panel.  Moreover, since the beginning of the crisis, foreign banks have much greater difficulty in securing dollar funding than US banks.  Even big European banks (such as French giants like Paribas)  have faced acute dollar funding problems.  This is one reason why they have been deleveraging, and selling off dollar assets.  The Euribor banks almost certainly have even worse problems.

This issue of fragmentation of funding markets also bears on Gensler’s second piece of evidence: the divergence between Libor and the dollar rate implicit in FX swap prices. Gensler treats the violation of the interest rate parity relation as an indicia of manipulation.

But again, this reflects the acute problems European banks have faced in securing dollar funding.  They can borrow in Euros, but have to swap it into dollars to fund their dollar assets.  They are willing to, and the market is making them, pay a premium to execute this transaction.

Gensler claims “this divergence between theory and practice has yet to be adequately explained.”  Really?  It is well-understood.  Don’t believe me?  How about some economists from the New York Fed?  They investigated this issue in detail in 2009, and concluded that the divergence in the basis between the FX swap implied USD rate and USD Libor was caused by the dislocations associated with the financial crisis.

Indeed, Gensler’s oped implicitly recognizes this: he notes that implied and Libor rates have not been aligned “since 2008.”  Hmm.  What happened in 2008?  Think, think, think.  A financial crisis maybe?  Could that be it?  I’m thinkin’.

One key piece of evidence that FRBNY economists  Coffey, Hrung, Nguyen, and Sakar present is that the basis blowout was not limited to Libor.  It was also present when they used the New York Funding Rate produced by ICAP.  It was also present when they used Eurodollar deposit rates.

Look, anybody who has followed this knows that basis relationships that had been steady as a rock for years went haywire starting in August, 2007.  (Happy Anniversary!)  The CDS-cash bond basis went haywire.  Interest rate spreads (e.g., OIS-Libor) went haywire.  Spreads between borrowing rates across banks have become much more dispersed and become much more volatile.  (This relates directly to the Euribor-Libor comparison: banks are much more heterogeneous now than in, say, 2006, making comparisons between averages across different groups of banks much less meaningful now than then.)

This pertains to another piece of evidence: the lack of comovement between bank CDS spreads and their Libor submissions.  This could be informative, particularly in normal times, but it is problematic during crisis times.  CDS spreads and yields on the underlying cash bonds diverged dramatically, and often exhibited little comovement, during the period of the crisis.  CDS spreads were being driven by liquidity and risk aversion issues.  If the CDS-cash bond basis became much more volatile, it’s not at all surprising that the CDS-Libor spread also became much more variable, given that CDS and cash bonds have closer kinship than CDS and unsecured short term borrowings.

Noticing a pattern here? Basis relationships of every sort became much more volatile during the crisis period, and hence are far less reliable evidence of manipulation in Libor than would have been the case more than 5 years ago.  In essence, Gensler is trying to tell time with a broken watch.

Recall that Gensler mentions “the divergence between theory and practice.”  Anybody who has been paying attention understands why that’s true.  The theory is predicated on an assumption of frictionless financial markets.  Financial markets where capital and liquidity constraints are not binding, thereby permitting arbitrageurs to eliminate swiftly divergences in prices across related markets.  That was a reasonable approximation of reality in say, July, 2007: certainly in July, 2005.  It is completely unreasonable post-August, 2007.

Or as the FRBNY economists put it:

The widening of the basis illustrates the breakdown in arbitrage relationships that has afflicted many markets during the financial crisis. For example, eurodollar interest rates in New York and London diverged during the crisis-as did yields on corporate bonds and credit default swaps, which are closely related securities.  The element common to all of these phenomena was increased funding costs, which impeded arbitrageurs from shrinking the basis between these types of securities.  In addition, counterparty credit risk became prominent, and previously risk-free arbitrage trades suddenly became risky . . . funding constraints and counterparty risk explain the rise in the basis and the relative importance of each factor changed as the crisis evolved. [Emphasis added].

Since then, the coefficient of financial friction has reached record levels.  Capital and liquidity and funding constraints are binding everywhere, and binding hard.  In particular funding markets-and Libor is a measure of a funding costs for some banks-have been dysfunctional for 5 years.  Severely dysfunctional.  Most of the European banking system relies on the ECB for funding.  Markets across regions that were once highly integrated are now fragmented as never before.

This is particularly important for dollars.  Having access to dollar funding via deposits and access to the Fed (like major US banks) is completely different than having to raise dollars through wholesale markets, like most European banks that have been hit hard by the flight of US money market funds and other sources of dollar liquidity.  This is what drives things like the Euribor-Libor differential, and the swap-Libor basis.

Hell, there is fragmentation of funding even within currency areas, in particular, the Eurozone.  European subsidiaries are attempting to fund their local lending with local deposits, especially in countries where conversion risk (i.e., the risk that a country will leave the Euro) is acute.  For instance, Italian subsidiaries of French banks are funding their loans to Italian businesses with local deposits, rather than money from the parent banks.

In other words, Gensler is relying on a textbook model that presumes a frictionless world.  That ain’t our world, today.  The textbook needs to be thrown out.  But Gensler uses it as his bible.

There are two explanations of this, both quite frightening.

The first is that he really doesn’t understand this.  That he doesn’t understand that the financial system has suffered cataclysmic shocks and doesn’t work the way it used to.   It would inspire confidence, wouldn’t it, that an individual playing a crucial role in reshaping that financial system through the promulgation of rules under Frankendodd doesn’t understand why things are working-or not working-the way they are?

The second is that he is a fan of the band Say Anything.  That he knows that his “evidence” has nothing to do with Libor manipulation, but he is saying it to advance some regulatory or political agenda.

I’m betting on the second alternative, because Gensler is a serial offender in this: look back at my posts from 2009 and 2010 and you will see numerous times where I called BS on the former Goldman managing director for making ludicrous statements about financial markets-all of which were calculated to justify Frankendodd and a massive expansion of Federal regulation of derivatives markets.

Regardless of the reason, one thing is clear: Gensler’s misleading analysis lies naked and exposed. This is not to say that Libor was not manipulated.  It is to say that what Gensler hypes is not evidence of the existence of manipulation, or the magnitude of its effect.

It is unfortunate that he penned such a distorted oped, given that his agency provided a very rational proposal to reform the Libor fixing process in its Barclay’s settlement order.   Gensler should limit himself to promoting that proposal, rather than writing pieces that sow confusion and promote misunderstanding about a highly contentious issue that could have huge and costly impacts on banks-and hence on the world financial system, stressed as it already is.  That is not constructive.  It is irresponsible and dangerous.

I have crossed pixels with Felix on occasion, most notably over the issue of “empty creditors,” in which I took the Coasean position.  But today, I largely agree with his take on the Knight Capital implosion:

We’re seeing the same thing with the fiasco at Knight Capital, where a highly-sophisticated high-frequency stock-trading shop lost an enormous amount of money in a very small amount of time, and small investors lost absolutely nothing. On the grounds that we can’t present this as news without somehow determining that it’s bad for the little guy, it took no time at all for grandees to weigh in explaining why this really was bad for the little guy after all, and/or demonstrates the need for strong new regulation, in order to protect, um, someone, or something. It’s never really spelled out.

Knight lost $440 million.  That really stinks for its shareholders, but its loss is a windfall for those on the other side of its Hal moment.   Every dollar lost by Knight is a dollar gained by someone who entered an away from the market limit order that Knight triggered, or arbitrageuers that took advantage of the price anomalies.  You might argue that the temporary distortions in prices for dozens of stocks is a source of welfare loss, but I defy you to identify a real decision (e.g., the amount of investment by an affected firm, or its capital structure) that was affected by the very short lived fluctuations.

The final score: Knight -$440 million.  Others who bought and sold the affected stocks: +$440 million.  Third parties (not counting those who get the vapors when the markets don’t work as neatly and tidily as they think they should): $0.  Net result: $0.

Not quite, though, because of the pour encourager les autres aspect of Knight’s travails: to me this episode is an example of Darwinian selection in action.  Those who don’t adequately check their code are driven from the market (or almost are-Knight was rescued from bankruptcy on very harsh terms by a group of brokers and dealers).  Indeed, the outcome here is likely to be more efficient than a purely Darwinian one: here others can learn from Knight’s tale (“there but the grace of a geek go I: I’d better be extra vigilant”) whereas that learning mechanism doesn’t operate under pure natural selection.

Although I sometimes agree with Felix Salmon, the same cannot be said of me and John Kemp, another Reuters writer.  The correlation between our views pushes -1.

That’s true today, with respect to Kemp’s analysis (if that’s the right word) of ICE’s decision to relabel swaps as futures.  Kemp presents this as a smashing victory for Frankendodd.  Now it may seem churlish of me to criticize, given that Kemp did give my blog post extended play in his piece: I am aware of Brendan Behan’s dictum that there is no such thing as bad publicity, except where your obit is concerned.  But duty calls.

Kemp spends inordinate space in a disquisition on the Talmudic distinctions under the Commodity Exchange Act between contracts for future delivery and commodity forward contracts.  All of which is completely irrelevant because the ICE contracts transubstantiated from swaps to futures are definitely not commodity forward contracts exempt from CEA exchange trading requirements.  Kemp quotes my statement that nothing of economic substance changes as a result of the relabeling-and doesn’t disagree.  But he cavils:

Pirrong has been critical of Dodd-Frank and much of the CFTC’s rule-making. In this instance, he appears to argue that the sole outcome will be another round of regulatory arbitrage. (“A swap by any other name” Aug 2)

Arguably, however, ICE’s decision to re-label its cleared swaps as futures suggests regulators have won this round of the battle, ensuring that all contracts with an economically equivalent purpose will be treated in the same way, rather than subject to an artificial distinction.

Note the attempt to cast doubt on my analysis by pointing out my (unapologetic) criticism of Frankendodd, and Igor’s (i.e., the CFTC’s) implementation thereof. (“Distrust the skeptic!”)

Sorry, but I’m finding it hard to see the great regulatory victory here.  Nothing of economic substance has changed: Kemp does not dispute this, and in fact agrees with it (though he doesn’t go far enough, because the transactions are equivalent in form and substance as well as purpose).  The “artificial distinction” he criticizes is in fact a creation of the regulation: it is the direct result of Frankendodd’s establishment of a separate regime for swaps.  By revealed preference, the regulatory regime that ICE has chosen to operate under is less burdensome that the swap regime created by Frankendodd.  Since the economic substance of the transactions at issue hasn’t changed, this implies that either the swap regime is inefficiently costly (at least for some transactions), or the futures regime is inefficiently lax but a mere relabeling permits ICE and others to take advantage of that laxity.

I guess you have to take your victories where you find them, but that’s pushing it.

I have long been a China bear, even before the financial crisis.  (Bearishness here means that I believe China has many structural weaknesses that make it highly unlikely it will achieve the  prodigies that China bulls predict.)  A major reason for this bearishness has been the Chinese financial system.  For years, bad loans have been buried. More recently, the combination of financial repression and the need to get bad loans off bank balance sheets have encouraged the development of a shadow banking system that makes the West’s look positively staid and stable by comparison.

This is illustrated quite graphically in an excellent special report on Reuters.  Do read the whole thing, but here are my takeaways.  First, as just noted, financial repression which depresses returns on bank accounts encourages savers to look for higher return-and higher risk-alternatives.  Second, shadow banking mechanisms such as “Wealth Management Products” are being used to fund very dodgy assets and get them off bank balance sheets.  Third, these shadow banking products involve maturity, credit, and liquidity transformation.  In many cases, the degree of transformation is extreme, with very short term liabilities (as little as a few weeks) used to fund long maturity, non-performing, extremely illiquid assets  Fourth, the degree of disclosure about these products is appalling.

In brief, there are all the ingredients of a run present there.  Indeed, if the Reuters characterization is correct (and I have heard the same or worse from those who have major skin in the game), this system is far more fragile than the web of ABCP, SPVs, liquidity puts, subprime MBS and CDOs and CDO squareds that collapsed in the US in 2007-2008.

Woefully uninformed investors have no ability to discriminate between good and bad trust companies, wealth management products, etc.  Bad news about a few, or a big one, quite likely would lead to a spike in suspicion about all of them: given the highly dubious quality of the underlying assets (resulting to a considerable degree to the malinvestment caused by the government’s stimulus efforts in 2008-2009), such bad news is quite likely to arrive.  This would spark a run on the entire shadow banking sector (because investors cannot discriminate given the near complete opacity), which given the extreme maturity mismatches and the illiquidity of the underlying assets would lead to a collapse in short order.  Some of this would blow back onto banks, threatening their solvency.  But even if banks walk away from related trust companies, etc., investors in the shadow banking products would be ruined.  This could have social ramifications that no doubt petrify the ruling Communist Party.  Even absent social disturbances caused by infuriated investors seeing their wealth evaporate, and the associated potential for a government crackdown, the decline in wealth would lead to a sharp reduction in consumption, slowing Chinese economic growth; putting a drag on the world economy (especially commodity producing countries); and exacerbating the already unprecedented imbalance between investment and consumption.

The heavy hand of the Chinese government has contributed mightily to this state of affairs.  Distortions of prices (notably interest rates) and misallocations of capital through a banking system that favors state owned enterprises and forces entrepreneurs who generate the real growth to rely on shadowy sources of capital, currency management, the focus on export and investment oriented growth, all exacerbated by the response to the 2008-2009 crisis have led to the development of a warped financial system that is extremely fragile.  More fragile, almost certainly, than the one that imploded in the US and Europe 4-5 years ago.

When will a collapse come?  The coordination game, multiple equilibrium nature of these things makes that very hard to predict.  A small change can lead to a jump to a run equilibrium.  The risk is there, just as a huge pile of dead underbrush in a forest poses the risk of a conflagration at any instant.  When the spark or the carelessly discarded cigarette or the lightning strike will set it off is impossible to predict.  But one must be very lucky indeed to avoid a big fire when the conditions are so favorable.

Last week Reuters reported that Obama had signed a secret finding authorizing the CIA to provide assistance to anti-Assad forces in Syria.  Uhm, the fact that it was splashed all over Reuters, and then in every news outlet worldwide, means it isn’t secret.

This part jumped out at me:

The White House is for now apparently stopping short of giving the rebels lethal weapons, even as some U.S. allies do just that.

. . . .

The State Department said on Wednesday the U.S. government had set aside a total of $25 million for “non-lethal” assistance to the Syrian opposition. A U.S. official said that was mostly for communications equipment, including encrypted radios.

Perhaps this is just a dodge, and the Saudis, Qataris, and others are going to provide weapons that will permit the rebels to combat more effectively the heavy weapons, artillery, and fixed and rotary wing aircraft that the Syrian military has in its arsenal while the US retains sort of plausible deniability.  But maybe this is just another example of Obama’s lead-from-behind, half-in, half-out approach to military matters, Afghanistan being another prime example.  Commit enough to generate significant casualties, but not enough to achieve any decisive or lasting result.

Unless the objective is to encourage a protracted and brutal civil war in Syria, such half measures are catastrophic, both as a matter of policy and as a matter of humanity.  Strengthening the rebels some, but not enough to overcome the government, will prolong the suffering, and also prolong the uncertainty in the region, which is the last thing it needs.

As Fisher (or was it Macauley?-sources disagree) said: moderation in war is imbecility.  As Napoleon said (no disagreement about attribution here): If you want to take Vienna-or Damascus-take Vienna-or Damascus.

But that’s probably the nub of the problem.  Obama doesn’t know what he wants, or if he knows, is unwilling to take any political risk to get it.  So he continues the cynical game of leaking information about his “secret” military aggressiveness, while failing to make hard decisions about what to do with Assad.  This moderate course is a recipe for stalemate-which will condemn thousands to death and injury.  We know by hard experience that we cannot dictate outcomes in that region, but we can influence them.  No outcome is likely to be all that desirable, but letting things go on their own without a more robust attempt to influence them seldom works out well in that part of the world.

ICE has created something of a kerfuffle by its announcement that it will convert its cleared energy swaps contracts to futures.  Despite a lot of breathless reporting, there is less here than meets the eye.

ICE has merely relabeled its cleared energy swaps as futures in order to avoid burdening its customers with the costs that Frankendodd imposes on swaps.  Futures and swaps are subject to different regulatory regimes.  Firms with sufficiently large swap positions are considered swap dealers under Frankendodd, and must meet a variety of requirements that those not blessed with this designation can avoid: holders of equivalent futures positions need not meet the same requirements.  Swaps trades also involve additional reporting obligations not imposed on futures trades.

So what ICE will do effective in January is change the name of its contracts, thereby reducing the regulatory burden on its customers, without changing their economic substance one iota.  Note that these are cleared swaps, so the change doesn’t create a new clearing obligation on those trading them.  The central counterparty for the futures will be the same as for the swaps: ICE Clear Europe. The contracts will have identical settlement terms.  They will have identical cash flows.  They will trade on the exact same ICE platform.  The economic substance of every aspect of the old “swap” transaction and the new “futures” transaction remains the same, from execution to clearing to settlement.  Nothing changes but the name.

And the regulatory burden.

Which points out the potential for absurd outcomes under Frankendodd.  The CFTC has labored mightily to craft definitions of a swap and swap dealers and major swap market participants.  Where one falls under these definitions matters a lot.  Firms will endeavor to take measures that minimize the regulatory burden they face. ICE is basically picking the low hanging fruit, and taking note of Congress’s morbid obsession with “OTC swaps” and idealization of futures by magically transforming the former into the latter, and thereby making life easier-and cheaper-for its clients.

The incentive to label or structure transactions to achieve the same economic outcome at lower regulatory cost will be quite strong in the Frankendodd era.  This will initiate a regulatory dialectic in which regulators will attempt to adjust regulations in order to limit such attempts to escape regulatory burdens by relabeling or restructuring; the regulated will adjust to the adjustments; the regulators will adjust some more; and on and on.*

The lawyers will rejoice.

Much of the reporting on the ICE move has been pretty far off base, such as this from the WSJ:

Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations.

ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more-opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets.

Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations.

ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more-opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets.

. . . .

Many energy producers and users generally have preferred swaps contracts because each contract can be written up individually and to a company’s own specifications. That has enabled them to be more targeted in their hedging. Futures contracts, by contrast, are generally standard contracts covering the price of a specific energy grade to be delivered at a certain time.

Pretty much none of that is true.  All of it suggests a change in the way these instruments are designed, traded, and cleared, none of which is in fact changing. The contracts are already standardized, traded on an electronic platform, and cleared.  This is not a movement of bespoke, uncleared, bilateral contracts onto an exchange.

Look.  It’s long been known that the economic substance of swaps and futures are effectively identical, especially when the former are cleared.  Changing the label-hell, call them bananas-doesn’t change the economics.  If the CFTC had even less burdensome regulations for bananas, ICE would launch ICE Bananas.

Which illustrates that Frankendodd is quite often and in many ways truly bananas.

* Relabeling of derivatives contracts was employed in the 19th century to avoid legal restrictions.  When Illinois banned options trading, traders bought and sold the same things, but started calling them privileges.