Streetwise Professor

I am somewhat used to getting material from SWP ripped off.  The Economist did it a couple of times early on in the history of this blog, and other less eminent writers/bloggers have done it subsequently.  But seldom have I seen such a total expropriation-of Russian Yukos-like proportions-as this piece by Jennifer Rubin at the WaPo.  The title and main metaphor of the piece.  The substance of the analysis.  Blatant and shameless.

I give away what I write here.  (Some may say that’s a fair price.)  I am more than pleased when people quote what I write.  Indeed, that’s the primary compensation for the time and effort that I devote: I write so that my ideas, such as they are, get discussed and disseminated and yes, criticized.  The ethical expectation is that credit be given.  It doesn’t cost a thing.  Except, perhaps, for those who are so insecure and desperate to be thought of as creative and perhaps under pressure to produce new content day after day that they take from others without attribution.

There’s a right way to do this.  Felix Salmon and I have had disagreements, in public via our respective blogs.  But he gives a respectful hearing to what I say, attributes it plainly (with links), and characterizes it fairly.  John Kemp (also of Reuters) is another example.

And then there’s the Jennifer Rubin way.

According to sources quoted by the WaPo, that is.  That’s appalling.

Not that the administration is telling us.  Indeed, it’s blaming you, silly website user person.  You had the termity to hit the back button when the f*cking website didn’t respond the way you’d expected, you know, like the way www.amazon.com or even freaking www.pets.com perform.

No, they’re telling us the website is feeling better! It doesn’t want to go on the cart!

Oh, if only we had one boon worker with a truncheon to put it out if its misery. And put us out of the misery it’s inflicted on us.

The administration is declaring victory in the battle to fix Healtcare.gov.  I declare BS.

Note the metric of success: the administration claims 100K people have “selected plans.”  Never mind that this is 1/8th of the target by 12/1.  The question, framed in futures-speak, is: How many out-trades?

An out-trade is where a buy is not matched by a sell.  Since the backend that communicates information from users to insurers isn’t fixed-and some parts aren’t even built yet-and since there are also bottlenecks in communications between the government and insurers and users regarding eligibility for and amount of subsidies, the number of actual matched buys-and-sells is a fraction of the 100K.  How big a fraction?  Don’t look to the administration for answers.

No, don’t look to them, because they are in full obfuscation mode.  They are engaging in a Potemkin Village strategy.  They are pointing to the newly spruced up facade of the Healthcare.gov system-the user interface, which is now less crappy than it used to be (a very low standard, indeed)-and saying: “See! Look! It is fixed!  Isn’t it beautiful?  The procession can now move on!”  The hidden message: “Pay no attention to the fact that behind the somewhat improved facade, your personal information necessary actually to match you with an insurer so you can actually buy the policy may well be screwed up, or not get to the insurer, or just disappear into the ether.”

Out-trades are messy, costly, and risky: the biggest problem is that you don’t know your risk position because you don’t know whether you have a trade or not.

It is reasonable to surmise, based on what insurers are saying, that the number of out-trades is substantial, and is only likely to increase both absolutely but also as a fraction of applications, as more traffic moves to the site.

The web interface is not the deal.  That is just the facade of PotemkinVillage.gov.  Behind it is nothing, or ramshackle construction.  Sort of like this village in Siberia that adopted the Potemkin strategy in anticipation of a visit by Putin.

And that’s not the worst of it.  Behind that, assuming everything gets working, is a set of horrid, expensive policies.

The Brent-WTI spread reached a record level last week, defying predictions that the gap would continue to close.  But this isn’t the retro spread of the last couple of years.

When Brent-WTI was at its earlier record wides, the spread between Brent and Gulf Coast crude prices (e.g., LLS) was not that anomalous.  Instead, WTI was at a huge discount to LLS. This reflected a bottleneck in getting crude from the Midcontinent to the Gulf.

Now that bottleneck is largely eliminated: LLS is only at a $4 premium to WTI, which is pretty close to marginal transportation costs.  The current price structure is that the LLS-WTI spread has normalized, but the LLS-Brent spread has cratered.

So where’s the bottleneck now?  Part of it is legal: it is impossible to export crude from the US, except in a limited way to Canada.  It is possible to export products, and US refined product exports are at all time highs, nearly 3 times larger than the level of only 8 years ago.  (Interestingly, US product exports started their upward trend in 2005, well before the splurge in US oil production.)  However, refinery capacity is insufficient to close the gap, and there are logistical constraints that limit the amount of products that can be shipped out.   Some simple distillation units are being built to refine crude into products (including fuel oil) that can be exported.

Meanwhile, production issues in Libya and Nigeria are supporting Brent prices.

If the differential persists, it will be interesting to see whether there is pressure to eliminate, or at least relax, the constraints on exports of US crude.  I would presume that even if pressure begins to build, there will be a political battle in the US that will likely long delay any such relaxation or elimination.  So in the meantime this will be a boon for domestic refiners, and a roller coaster ride for traders.  The political, infrastructure, and refining bottlenecks that separate Brent and WTI will not close anytime soon, and the supply shocks on either side of the divide will cause prices to move with considerable independence.  A continued spike in US production will weigh on US prices, but can’t be communicated efficiently to Brent prices because of the bottlenecks; similarly, another shock to Nigerian or Libyan production will primarily move Brent.

In some ways, the world oil market, which is conventionally considered a “world” market due to the relative ease of shipping the stuff around the world, is becoming more like the natural gas market, with regional markets separated due to various bottlenecks, and the prices in these markets driven by idiosyncratic supply and demand shocks in those regional markets.  The adjustments necessary to ease the bottlenecks in crude are likely cheaper than those in gas, but they won’t take place overnight.  And until they do, Brent-WTI will remain a major speculative play.

There ware widespread protests in Ukraine, especially western Ukraine (Kiev and Lvov).  The police responded violently to protests in Kiev yesterday.  Today, Yanukovich’s chief of staff and the ambassador to Canada resigned.  The police seem to be less aggressive today.

This is a manifestation of the widespread anger at Yanukovich’s decision to spurn the Association Agreement with the EU, and his kowtowing to Russia.  The bow is getting only deeper, as the PM Azarov just announced that Yanukovich was on his way to Moscow to negotiate a roadmap with Putin.  Yanukovich pretends that he can blaze an independent path, but if he really believes this, he is delusional.  He chose Russia, and is going to Putin to receive terms, not negotiate them.

The events in western Ukraine echo the Orange Revolution of almost exactly 9 years ago, in which Yakunovich was ousted as president.  That episode shook Putin to his core, and intensified his already extreme paranoia about western designs to overthrow him.  Putin’s relentless campaign against the opposition in Russia was in large part the product of events in Kiev in 2004.

Given that, I would have thought that Yanukovich and Putin would have potentially anticipated, and acted to undermine and preempt, a repeat in response to the Ukrainian government’s abandonment of the deal with the EU.  That’s why when there were some protests in the immediate aftermath of the vote halting preparations for approving the agreement that I was skeptical that the movement would grow sufficiently to threaten the government.  Now I am not quite so sure.

This bears watching.  In particular, it bears watching to see whether Putin and Russia will intervene more directly if it seems that Yakunovich loses his nerve.

The United States, and the other countries in the 5+1 group, have reached some sort of agreement with Iran which trades a relaxation in sanctions for some temporary limitations on Iran’s nuclear program.  Most of the discussion has focused on the specifics of this deal, but that is short sighted.  All parties admit that this is just an interim step along the path towards a more permanent settlement.  We need to look forward and try to anticipate where that path will lead.  It is unlikely to lead anywhere good, from an American perspective, and likely to be highly favorable to Iran.

The dynamic will favor Iran because it is easy for them to delay or evade any substantive cutbacks in their efforts to obtain nuclear weapons, and because it will be difficult for Obama to resist Iranian demands.  Look at the protracted and frustrating and largely futile attempt to stop the North Korean nuclear program: Obama’s personal investment in the Iran initiative will make the US even more likely to make concessions in order to keep the process alive.

Other news illustrates exactly how this process works.  The Russians have repeatedly violated the Intermediate Range Nuclear Forces Agreement but the administration has refused to make these violations public because . . . well, you have to read it to believe it:

Inside the meeting, Kerry expressed anger and frustration about the Russian cheating and warned that if the violations became widely known, future efforts to convince the Senate to ratify arms control treaties would be harmed.

In other words, we can’t possibly acknowledge treaty violations because that would impede our ratification of treaties  . . . that would be violated. Treaty-making becomes an end unto itself, rather than a means of securing American interests.  That mindset gives anyone we are negotiating with a tremendous advantage: they know they can play us for patsies because we are so obsessed with the process, rather than the results.

And Iran is pressing its advantage.  It claims that the agreement recognizes its right to enrich uranium, which the administration denies: in response Iran released a statement calling the administration a liar.  Moreover, it announced that it is commencing talks with international oil companies, thereby signaling its belief-expectation, actually, or demand, actually actually-that sanctions will be lifted.

And why not?  They know Obama has entered the bazaar, and can’t get out.  It would be a humiliating setback for Obama to admit that his initiative has failed, and knowing that, the Iranians will keep upping the price for a deal.  They further know that Obama’s domestic political weakness, courtesy of Obamacare, makes him all the more dependent on claiming a major foreign policy achievement.  Obama’s approval rating is around 40 percent.  This represents rock bottom for him: these 40 percent would support him even if he mandated adoption of Swift’s A Modest Proposal by executive order.  Admitting failure would help cement his loss of power and influence.

The costs of this are already large, and will only grow over time.  In the short run, the biggest cost will be endured by Syrians, who have been consigned to the tender mercies of Assad and the jihadis: Obama cannot simultaneously pursue an agreement with Iran and confront Iran’s major ally in the region.  This casts Obama’s decisions regarding Syria in August and September into a whole new light.  Following through on his threat to attack Iran’s client Assad would have seriously complicated, and likely derailed, a deal with the Iranians.  Although political considerations and his incautious off-teleprompter “red line” remark forced him to make noises about attacking, he was desperate to find a reason not to, which the Russians graciously offered.

And no doubt the Russians were aware of his predicament, and the Iranian angle to that.  The Saudis found out about the US-Iran talks, and tipped off the Israelis.  It is inconceivable that the Russians weren’t aware as well, given all the potential sources of information.  No wonder they found it so easy to give Obama a deal he couldn’t, and wouldn’t, refuse, even though it made him look craven and feckless.

Viewed in retrospect, the administrations actions during the weeks leading up to the CW deal with Syria look all the more bizarre and discreditable.

The longer run consequences will be even more malign.  Iran, already an aggressive power with dreams of hegemony in the Middle East will be emboldened, and will have more resources to fund their ambitions.  And again, they know that Obama will be reluctant to push back, lest he admit that his initiative was ill-conceived.  In response, other powers in the region, notably Saudi Arabia, will take a more independent and aggressive posture, knowing their interests are no longer aligned with those of the US at least as long as Obama is president: Saudi Arabia may well go nuclear by placing a carry-out order with Pakistan.  Feeling threatened and abandoned, the risk of an aggressive Israeli response is also greater.   Iran’s Lebanese client, Hezbollah, will be strengthened, raising the odds of conflict in Lebanon and between Hezbollah and Israel. The diversion of Israeli resources to counter a more powerful Hezbollah will encourage attacks by Hamas.

This makes the administration’s response to those criticizing the rapprochement all the more disgusting.  Carney and some Congressional Democrats (like Nelson of Florida) have claimed that refusing the deal and increasing sanctions on Iran would actually be a “march to war.”  This is truly a false choice: particularly outrageous coming from a president who always accuses his political opponents of advancing false choices.  An emboldened, richer Iran increases rather than reduces the odds of conflict in the region.

Doubts about the prudence-and even sanity-of Obama’s initiative are only deepened by one of the justifications given for it: namely that it is a response to the strengthening of moderate elements in Iran, and will bolster the moderates’ strength going forward.  Unbelievable.  We’ve heard about “Iranian moderates” since 1979, and numerous previous US attempts to deal with chimerical Iranian moderates have ended in American tears, for the Iranians play American delusions about moderates like a violin.  Just ask Robert McFarlane.  Many defenders of Obama on Twitter harken to Reagan’s Arms for Hostages debacle, claiming “at least Obama isn’t selling weapons to the mullahs.”  This is a defense?  Fool me once, shame on you.  Fool me twice, shame on me.  The Reagan experience should be a stern warning of how treacherous the Iranians can be.  They responded to payments for releasing hostages by taking more hostages.  That should make one all the more reluctant to deal with the mullahs today.

Obama is also disregarding Iran’s long running and relentless terrorist  campaign against the US.  The attacks on the US embassy and Marine barracks in Beirut and on the American Air Force personnel in Khobar Towers are only the most egregious examples.

Khobar Towers is of particular interest.  After an extended investigation, US intelligence concluded the Iranians were behind the attack.  This was extremely awkward for the Clinton administration, because at the time it was in the midst of an attempt to open relations with the . . . wait for it . . . “moderate” Iranian president Khatami.  Clinton sent a secret letter to the Khatami demanding that Iran punish those responsible, which the then reigning Mr. Moderate dismissed with the back of his hand. Either the moderates aren’t really moderates, or the moderates don’t call the shots.  Either way, same result: basing strategies on the influence of Iranian moderates is as delusional as making plans dependent on the intervention of magical unicorns.

In sum, Obama has entered into an agreement that will not be honored, will subject him and the US to increasing demands that he cannot refuse, will strengthen and embolden a sworn enemy of the United States, will destabilize the region and increase the risks of conflict, and betrays and confuses our allies.

Given that this endeavor is inimical to American interests, reputation, and prestige (both of which affect our ability to advance our interests) one wonders about the motivation.  Folly or blunder based on a desire to achieve a legacy or a fundamental misunderstanding of reality are actually the least frightening alternatives.  The more sinister possibility is that Obama is acting on a view of American interests and proper place in the world that is at odds with the mixed idealist-realist view that has shaped US policy since at least WWII.   I usually adhere to the maxim not to attribute something to malice which can be explained by stupidity, but it gets harder to do that every day.

I’ve been hammering on the theme of the systemic risks of central clearing-especially mandated central clearing-for around five years.  And now those concerns are being expressed with greater frequency.  Fed Governor Jerome Powell gave a speech focusing on the most straightforward source of systemic risk in mandated clearing: the concentration of risk in the clearinghouse, which becomes a single point of failure whose collapse could jeopardize the broader financial system.   Bernanke made a similar argument a couple of years back.

Some articles from the last several days highlight more subtle, but in my view more important, concerns.  This Reuters piece mentions several things I’ve focused on over the years: the strains that clearing can put on the liquidity of individual firms, and the system at large; margin pro-cyclicality;  and crucially, the fact that self-preserving actions taken by CCPs may have destabilizing effects elsewhere in the financial system.

This last point demonstrates a danger in the Powell approach which focuses on making CCPs invulnerable, which I’ve referred to as the levee effect.  Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a CCP can redistribute shocks elsewhere in the system in a highly destabilizing way.  CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects.  Indeed, greater reliance on CCPs increases the tightness of the coupling of the financial system, which can be highly problematic under stressed conditions.  Liquidity and funding are the primary channels by which CCP decisions will have external effects on the broader financial markets.

These considerations are related to a broader point, which is that CCPs are merely parts, albeit important ones, of a broader financial system, and they must be evaluated in the context of the entire system.  An article in the International Financing Review by Christopher Whittall provides another illustration of this, again related to liquidity.  He notes that Basel III’s leverage ratio clashes with the tremendous thirst of CCPs for liquidity:

“The move towards central clearing creates a focus on how to fund margin requirements, which should dictate an increase in repo activity from banks. The problem is repo becomes very unappealing for banks under the leverage ratio.”

So sayeth the head of fixed income at a major bank.  CCPs create tremendous funding needs, and particularly contingent funding needs that are especially large in stressed conditions when liquidity is hard to come by.  These needs are hard enough to address in the absence of a leverage ratio, but as the fixed income guy notes, this is an even bigger problem when it is present.  As he says: “Viewed as a whole, we can start to start to see how these different regulations don’t quite hang together from a macro-prudential perspective.”

Exactly.  Illustrating another theme: Regulatory responses to the crisis have tended to focus on the individual pieces with too little attention paid to how regulations of one piece affect the other pieces.  The interaction between the leverage ratio and clearing mandates is a particularly worrisome example.  In any complex system, it is the interaction between interconnected pieces of the system that can lead to abrupt collapses.  Making each piece of the system more robust doesn’t necessarily make the system more robust.  Indeed, the opposite can be true.

Yes, I’ve been a Cassandra on these issues.  So in some sense, it’s good to see that the concerns that prompted my prophesies are now getting more widespread attention.  But methinks that the post-crisis regulatory juggernaut is impossible to reverse, and that although some of the problems in clearing and the interactions between clearing and other aspects of financial regulation can be ameliorated, the basic sources of systemic risk inherent in the new financial and regulatory structure will persist.

Ukraine has shocked many Europeans and dismayed many Ukrainians, by announcing that it will suspend preparations to enter into an Association Agreement with the EU.  Russia was violently opposed to such an agreement that would have moved Ukraine away from Russia and towards Europe.  Hence, this is viewed as another “diplomatic” triumph for Putin.

It’s not really that shocking, or that much of a triumph.  If you think of the correlation of forces (to use the Soviet military term), it decidedly favored the Russians. There is geographic proximity.  There is the fact that the Ukrainian economy is a basket case, and extremely vulnerable to Russian pressure-pressure which Putin had been exerting for months, and would only have intensified had Ukraine gone along with the Europeans.  There is the fact that the Ukrainian political and economic elite has a lot to lose if Europe insists on reforms that open up the economy and increased transparency.  There is the fact that Old Europe was decidedly lukewarm about the prospect of drawing closer to a corrupt, dysfunctional, and bankrupt country that could become another money sink.  Europe also insisted on the freeing of Ukrainian President Yakunovich’s arch rival and predecessor, Yulia Tymoshenko, which could be extremely perilous for Yakunovich.  Countries on the front line with Russia-notably the Poles and Baltic States, but also the Swedes, who are seeing repeated Russian aerial intrusions and other indications of Russian aggressiveness-were pushing this, but they aren’t the main forces in the EU. In contrast to tepid European interest, Ukraine is a near obsession with Putin.

And then there is money and corruption.  Days before the Ukrainians hit the brakes, Yakunovich traveled to Russia.  There were conflicting reports about whether he even met with Putin, and if he did, where, and what was discussed in the meetings (if they occurred).  Also, in the midst of one of the repeated standoffs between Gazprom and the Ukrainians over gas, it was announced that Gazprom would sell gas at a large discount to Ukrainian oligarch Firtash.  Firtash had been the intermediary in shady gas deals between Russia and Ukraine in the past, but had been cut out by Tymoshenko. Now he’s back, and will deliver gas to Ukraine.  Since Firtash is an ally of Yakunovich, the opposition immediately charged that this was a corrupt bargain that will put money into Yakunovich’s pocket, and bankroll his reelection campaign.  Putin, in other words, could make deals that the Europeans could not hope to match.

Putin, in other words, had all the cards.  Only overweening European self-regard about the obvious superiority of their system could have deluded them into believing that the odds were on their side.

Putin, of course, couldn’t resist chewing the scenery, joining Lavrov in accusing the Europeans of blackmailing Ukraine.   Of course Putin was the one really doing the blackmailing-and the bribing.  He had the sticks.  He had the carrots.  He used them both, and thereby cajoled the Ukrainian ass to turn its back on the EU.

Sovok players.  Sovok tactics.  Sovok results.  Is this really surprising?

The Wall Street Journal’s story about Syria’s 21 August chemical weapons attack details the regime’s ruthlessness and American fecklessness.  It also makes it plain that The Russians lied repeatedly on Assad’s behalf in the aftermath.  For the Russians (and the Iranians) were aware of it almost immediately, and called Assad on it*:

Calls came in to the presidential palace from Syrian allies Russia and Iran, as well as from Hezbollah, the Lebanese militant group whose fighters were inadvertently caught up in the gassing, according to previously undisclosed intelligence gathered by U.S., European and Middle Eastern spy agencies. The callers told the Syrians that the attack was a blunder that could have profound international repercussions, U.S. officials say.

But recall the weeks after this.  Lavrov and other officials repeatedly denied that the regime was behind the attacks.  They supported Assad’s claim that the attack was launched by the rebels.  They cynically and shamelessly denied what they knew to be true and asserted what they knew to be false in order to protect their client.

Further recall that the Russians played this situation flawlessly, and achieved their aim: no American attack on Assad, Assad is in place and the tide is turning in his favor, and if anything the US is now a de facto supporter of the regime as its continued existence is necessary to carry out the elimination of its CW.   All of this done with the assistance of Obama and Kerry, the only question being whether this assistance was witting, unwitting, or just dimwitted.

And the Russians know it.  Indeed, they are pinching themselves over how easy it all was:

President Bashar al-Assad has tightened his hold on power. His regime has denied using chemical weapons, blaming the attacks on the rebels. In exchange for giving up his chemical arsenal, he avoided an American military intervention and likely will get even more support from Russia and Iran. Mr. Assad has pressed ahead with his offensive using conventional arms. U.S. intercepts show a Russian official later boasting to a Syrian counterpart about how easy it had been to get the U.S. to back off strike plans, officials briefed on the intelligence say.

The story is based on accounts of US intelligence intercepts provided by government officials.  And that is interesting in itself.

Unlike many intelligence leaks (e.g., the Osama raid, Stuxnet, the junk bomber) these are not calculated to make Obama and the administration look good, to portray them as aggressively and cleverly attacking America’s enemies.  To the contrary, they are uniformly damning.  Not just the revelation that the Russians think that Obama was (and is) an easily played chump.  But the revelations that the US had observed previous CW attacks.  That they observed the build up to this one, but didn’t react because they thought it was just going to be another “minor” attack like the earlier ones: apparently none of these met the Obama “whole bunch” test.  The revelations that the US was slow in responding in part because the intercepts had not been translated.

Which raises the question: who is leaking this damning information, and why? Is this the Intelligence Community’s payback for Obama throwing them under the bus over Snowden (which I noted and predicted in the aftermath of the Merkel cellphone kerfuffle)?  Or the consequence of the internecine battles over foreign policy in this administration?

Regardless, it is a uniformly depressing story.   But it can teach some lessons.  The most obvious of these is that the Russians will say anything to advance their interests, even if that something is 180 degrees from the facts.  Keep that in mind in events involving Syria in the future.  And also keep it in mind when you read anything the Russians say about Iran.

And keep in mind this administrations fecklessness and cluelessness when evaluating any deal it reaches with Iran.  Combine this with the fact that the Russians will run interference for Iran, just as they did with Syria, and the overwhelming odds are that no deal is far better than any deal Obama is likely to strike.

*Which means, OMG, we’re spying on foreign leaders! Heaven forfend. What will the NSA do next?

Matt Leising had a nice article a few days back about the CFTC’s rule that does not treat US Treasury securities as “qualifying” liquid resources for CCPs.  Instead, under new regulation 33-33 they must obtain “prearranged and highly reliable funding.” Based on Fed rules, this means that a CCP must get  committed line of credit from banks.   This imposes a substantial cost on CCPs, because under new Basel III rules, committed lines impose a large capital charge on the issuing banks.  For purposes of calculating capital, the banks have to assume that the lines are fully drawn.  This capital cost will be passed onto CCPs.

It is ironic that outgoing (resisting the great urge to snark) Chairman Gary Gensler repeatedly argued that one of the main benefits of the Frankendodd clearing mandate is that it would reduce the interconnectedness of the financial markets, especially interconnectedness through derivatives contracts.  Now he has pushed through a regulation that mandates an interconnection among major financial institutions via a derivatives channel: the lines connect derivatives CCPs to major banks.   I have long pointed out that Gensler’s claim that clearing would reduce interconnectedness was grossly exaggerated, and arguably deceptive.  Instead, I pointed out that the mandate would reconfigure-and is reconfiguring-the topology of the network of connections between financial firms.  What the CFTC has done is dictate what that form of interconnection will be.  This particular dictate is extremely problematic.

A CCP needs access to liquidity in the event of a default of a clearing member.  The CCP needs to pay obligations to the winning side of the market, in cash, in a very tight time window.  Failing to make these variation margin payments could impose financial distress on those expecting the cash inflow, and more disturbingly, call into question the solvency of the clearinghouse.  This could spark a run in which parties try to close positions in order to reduce exposure to the CCP.  Given that this is likely to occur in highly unsettled market conditions, such fire sales (and purchases) will inevitably inject substantial additional volatility into price that can exacerbate pressures on the clearing mechanism.

A CCP holding Treasuries posted as IM by the defaulting CM can sell them to raise the cash.  Alternatively, it could repo them out.  During most periods of financial turbulence-and financial crisis-which is likely to be either the cause or effect of the default of one or more large CMs, there is a “flight to quality” and Treasury security prices rise and there is a rush to buy them by investors seeking a safe haven.  Moreover, under such circumstances the Fed will perform its lender of last resort function, and readily accept Treasuries as collateral: even if CCPs could not access the Fed directly*, they could access it indirectly.   Thus, in “normal” crises, Treasuries should be highly liquid, and a ready source of cash that can be used to meet variation margin obligations.

Put differently, from a liquidity perspective, Treasuries are a negative beta asset: they become more liquid when overall market liquidity declines-or verges on collapse.  This is a highly desirable attribute.  Another way to characterize it is that from a liquidity perspective, Treasuries have right way risk.

Bank lines are very different.  Banks become stressed during crisis situations, and face a higher risk of being unable to perform on credit lines under these circumstances.  (Indeed, what if the defaulter is one of the suppliers of a committed line?) Banks fighting for survival but which can perform might try to evade this performance during stressed market conditions, which in a tightly coupled system (and clearing is a source of tight coupling) can be extremely disruptive: a few minutes delay in performing could cause a huge problem.  And if the banks do perform, doing so poses the substantial risk of increasing their risk of financial distress.  That is, committed lines are positive beta from a liquidity perspective: that is, they pose wrong way risks.   If drawn upon, these lines can be an interconnection that is a source of contagion from a derivatives default to systemically important banks, precisely at the time that they are least able to withstand the shock.

In the event, a CCP that does collect Treasuries as IM can likely use these right way assets to raise the cash need to meet its obligations, and can avoid drawing down on its committed line.  But that would mean that the committed line is superfluous, and imposes unnecessary costs on the CCP, and hence on the users of the clearing system.

I also conjecture that having met its liquidity requirements with a committed line, pursuant to the CFTC reg, CCPs would  have a weaker incentive to take Treasuries as collateral, and a stronger incentive to permit the posting of lower quality assets (or incentivizing such posting by reducing haircuts assessed to such collateral) for IM. This would mitigate the cost impact to users that results from the CCP having to secure the committed line, and pay for it (the cost being passed onto the users), thereby reducing the loss of trading/clearing volume and the associated revenues.  This would increase the odds that the line will be drawn on (because the lower quality assets pose a substantial risk of becoming illiquid during a crisis situation-they embed wrong way risk too).  I’ll have to think this through more, because the situation is somewhat complex: it depends on the pricing of the line, which will depend on the likelihood it will be drawn against, and the market conditions at the time it is.  This will depend in part on the quality of collateral that the CCP collects.  I’m not sure of what the equilibrium outcome will be, but I suspect that mandating the obtaining of lines will undermine incentives to demand the posting of high quality collateral.  If it does, this is a bad outcome that increases wrong way and systemic risks.  If it doesn’t, then the cost of the lines is superfluous and a burden on clearing and derivatives trading.

There is one scenario in which Treasuries would not be good collateral: if the financial crisis (and default of a CM or CMs) was the result of a fiscal crisis in the US, or a default (real or technical)  of the kind feared during the last (but the last, most likely) debt ceiling standoff.  But that’s an Armageddon scenario in which banks are likely to be highly stressed and unable to perform, or in which they would incur exceptional and arguably existential costs if they did.  Put differently, there’s likely no good source of liquidity in this scenario, and the CFTC rule will hardly make a difference.

In sum, it is highly unlikely that bank lines are a better source of liquidity, especially under crisis situations, than Treasuries.  Indeed, they are plausibly worse, and actually create an interconnection that can transmit a shock to the derivatives market (and the CCP that clears it) to systemically important banks: this is the exact opposite of what clearing was supposed to achieve. The cost of the lines, which is likely to be substantial, particularly given their necessary size, is a deadweight burden on the markets: all pain, no gain.

Other than that, the rule is great.  And a fitting parting shot from Gensler.

* Frankendodd makes it difficult for US CCPs to obtain Fed liquidity support.  This is a serious mistake that could come back to haunt us in some future crisis.  To work effectively, the LOLR must be able to direct liquidity to where it’s needed,  quickly and efficiently.  CCPs could be a major source of liquidity demand in future crises, which makes isolating them from the Fed highly dangerous, and the invitation to an ad hoc response in some future crisis.