Streetwise Professor

April 23, 2010

Au Fin de Siecle

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 12:04 pm

I am sitting in the SF airport, on my way back to Houston after speaking at the ISDA Annual General Meeting.

Wikipedia states that “fin de siecle

refers to the end of the 19th century, in Europe, France and/or Paris. It has connotations of decadence, which are seen as typical for the last years of a culturally vibrant period (La Belle Époque at the turn of the 20th century), and of anticipative excitement about, or despair facing, impending change, or both, that is generally expected when a century or time period draws to a close.

There was definitely a fin de siecle feel to this ISDA event.  Decadent?  No, but certainly more extravagant that what I am used to.  Anticipative excitement?  Definitely not, but certainly anxiety, bordering on despair, about the impending change facing the OTC derivatives business.

Yesterday, of course, Obama gave a populist speech at Cooper Union in New York, in which he demanded that Wall Street submit meekly to the regulatory proposals racing through the Senate.  Deputy Secretary of the Treasury Neal Wolin carried this message to ISDA.  He gave a hostile, our-way-or-the-highway speech.  I haven’t seen Wolin speak before, so I have no benchmark to compare to, but not only was his speech very sharp-edged, but his body English also communicated a certain hostility.

The audience reaction was as tepid as any I’ve ever seen.  I would probably be exaggerating if I said half the audience gave any applause, and even those clapping were making only the most perfunctory effort.

Mark Brickell, formerly of J. P. Morgan, asked a very provocative question, and one that needed asking.  He asked Wolin whether by forcing things into clearinghouses, weren’t the new proposals creating the ultimate too big to fail institutions, and effectively committing the government to future bailouts?  Wolin’s answer was basically just a flat denial, and did not truly engage the real issue that lay at the heart of the question.

Wolin was also asked about the Lincoln bill’s no Federal assistance provision, which would be the Volcker bill on steroids, requiring not only banks to exit proprietary trading, but customer-facing derivatives market making activities too.  Consistent with other administration voices, Wolin neither endorsed or criticized the measure.  He said something like “there’s a lot in these bills.”  Thanks for that insight.

I was on an academic panel chaired by Chris Culp (Chicago), with David Mordecai (Chicago), and David Mengle (UCLA, which was Chicago West in those days).  Mengle gave a nice talk about close out netting and its essential role in the OTC trading model.  David Mordecai gave a conceptual talk about the broad lessons of the crisis, in which he drew on the insights of Ronald Coase (always a good choice).

I gave the 20 minute Cliffs’ Note version of my case against clearing mandates.  My talk was largely well received, though not by everybody.  One of the things I focused on during my talk was the experience of the 1987 Crash, in which the CME clearinghouse was in serious jeopardy.  Somebody from CME clearing came up afterwards, and was pretty outraged at what I said.  He told me I was “feeding the dealer frenzy.”  No, I am trying to counter the legislative and regulatory frenzy with some back-to-basics analysis of the economics of risk sharing.  He also denied that the CME clearinghouse was in trouble in ’87, which got me a little ticked.  I told him, hey, look, I was there, I lived it, and was told that very specifically by Brian Monieson, a CME board member, in the morning of 20 October, 1987; truth be told, when that was happening this gentleman was in grade school in India.  You can look at contemporary accounts, including the Brady report and the Bernanke article on clearing and settlement during the Crash, and learn the same thing.  You can also look at Tamarkin’s book The Merc.  I was told of the BOTCC problems on the 19th-20th by two well-respected FCMs.  This isn’t a secret.

In various conversations afterwards, many bankers asked me about the ’87 Crash.  For the most part, they were not aware of the history, and were quite interested in it.  (Thanks for making me feel old, guys.)  Several are involved in various clearing efforts today, and found this history quite thought provoking.  That’s a big reason why I make such a big deal out of this.  People are so focused on the last crisis, and preventing a recurrence; regulators and legislators are most guilty of this.  It is important to make people aware that the last crisis was not the first crisis.  That there’s more historical experiences that can inform our current deliberations than what transpired in September, 2008.  The Crash of ’87 is particularly valuable because it gives the lie to the widespread claims about the efficacy of clearing as a solution to systemic risk.

Went to the meeting knowing almost no one, walked away knowing quite a few people.

The reception/dinner last night was a very interesting, almost anthropological experience  Pretty much the sole subject of conversation was the pending legislation; that’s what gave things the fin de siecle feel.  Everyone knows big changes are coming; that a vibrant period is coming to a close; and that the future will be very different.  The only question is: how different?

I think that the prevailing sense is that yes, some regulatory changes are needed and desirable, but that the punitive-for-the-sake-of-being-punitive legislation will be extremely counterproductive.  There was also a sense of despair that their fate was in the hands of those not only with an animus and an agenda, but with only a limited understanding of the way the business really works, and the likely consequences of what is being proposed.

Substantively there was broad agreement that expanded clearing could provide benefits, but that pushing it too far could be a disaster.  (That’s basically my view.  My CME interlocutor might talk to some of his own members to learn that they share similar concerns.)  There was widespread amazement at the exchange trading requirements.  I made a brief comment about the inanity of the Lynch Amendment (which may also be introduced by Sherrod Brown in the Senate) which several people talked to me about; they, as I, cannot believe how anyone would expect that banks are expected to bear counterparty risk by capitalizing a clearinghouse and providing backstop funds without having a commensurate voice or control of the operations of the CCP.

One last note.  The reception last night was held at the Legion of Honor, a beautiful art museum, which has one of the biggest Rodin collections outside of France.  (It also hosts a Cartier exhibit, which reinforced the sense of extravagance.)  The Thinker dominates the entryway to the museum.  On my way out, I looked back at the sculpture.  The sky was crystal clear.  A brilliant half moon hung over The Thinker’s head.  Four stars, in a diamond shape, bracketed the moon.  Quite a sight.

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  1. Excellent insight to the current dynamics between the OTC community and Washington, and portrayal of the current debate on “reform”.

    Comment by Bill Hodgson — April 23, 2010 @ 12:32 pm

  2. I agree with you on most of your thoughts. My caveat would be that something should be done regarding prop trading. I don’t think it is sustainable in its present form. Prop trading didn’t cause the crisis, but allowed banks to really exploit leverage and public money to fuel the crisis.

    I would simply change the structure of the market-a Glass Steagall 2-but relevant to today’s marketplace. For example, wouldn’t the risk profiles of investment banks prop trading operations take a very different look if they had to be private companies rather than publicly traded?

    1987 is worth looking at. I was a cub clerk in the Euro Options pit and I have never seen sustained bedlam like that since. 4000 points lower on the S+P. I would suggest looking at the week before the actual crash on the 19th. Markets were incredibly volatile. Risk premiums increased tremendously. On October 20th, Bonds were up the limit, and eurodollars opened 350 points higher. (the average daily move for the eurodollar contract at that time was probably 4-7 points per day). On a standard deviation scale, this was a +/- 4 deviations from the mean, maybe more if you could calculate it.

    The CME clearinghouse is different today. At the time, we were a mutual organization. “Good to the last drop.” Other clearing members were required to cover a clearing member that went bust. Lehman would have been covered, the question would have been who had the money. It wasn’t clear that we were going to open that morning until around 7AM CST. Markets opened at 7:20 AM. (No 24 hour electronic trading then) CME clearing now has capital provisions, but also insurance policies that cover every position in the book. They are no longer “good to the last drop”. They also have technological advantages that make them more efficient. Most accounts are margined 2 times per day. They recognize volatility faster, and adjust margins using SPAN quicker.

    That being said, I would hate for a clearing house to become an AIG. Many of these OTC derivatives are very difficult to margin. Many might not be traded if they had to be margined. Certainly, there are plain vanilla derivatives that can be cleared. They ought to be cleared independently-with self regulatory clearing houses setting the margins-no govt involvement. There are enough clearing houses out there that can compete so pricing should be efficient.

    That being said, the bill pending before Congress today is one of the worst financial bills they will ever pass. Crippling to innovation. Codifying bad structure that will enhance, not detract from systemic risk in the future.

    Comment by Jeffrey Carter — April 24, 2010 @ 8:42 am

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