Streetwise Professor

February 1, 2021

Battle of the Borgs

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 6:39 pm

One metaphor that might shed some light on how seemingly small events can have cascading–and destructive–effects in financial markets is to think of the financial system as consisting of borgs programmed to ensure their survival at all costs.

One type of borg is the clearinghouses/CCP borg. The threat to them is the default of their counterparties. They use margins to protect against these defaults (thereby creating a loser pays/no credit system). When volatility increases, or gap risk increases, or counterparty concentration risk increases–or all three increase–the CCP Borg responds to this greater risk of credit loss by raising margins–sometimes by a lot–in order to protect itself.

This puts other borgs (e.g., Hedge Fund Borgs) under threat. They try to borrow money to pay the CCP Borg’s margin demands. Or they sell liquid assets to raise the cash.

These actions can move prices more–including the prices of things that are totally different from what caused the CCP Borg to raise margins on. This can cause increases in volatility that triggers reactions by other Managed Money Borgs. For example, these Borgs may utilize a Value-at-Risk system to detect threats, and which is programmed to cause the MM Borg to reduce positions (i.e., try to buy and sell stuff) in order to reduce VaR, which can move prices further, triggering more volatility. Moreover, the simultaneous buying and selling of a lot of various things by myriad parties can affect correlations between prices of these various things. And correlation is an input into the borgs’ model, so this can lead to more borg buying and selling.

All of these price changes and volatility changes can impact other borgs. For example, increases in volatilities and correlations in many assets that results from Managed Money Borgs’ buying and selling will feed back to the CCP Borgs, whose self-defense models are likely to require them to increase their margins on many more instruments than they increased margins on in the first place.

This is how seemingly random, isolated shocks like retail trader bros piling into heavily shorted, but seemingly trivial, stocks can spill over into the broader financial system. Borgs programmed to survive, acting in self-defense, take actions that benefit themselves but have detrimental effects on other borgs, who act in self-defense, which can have detrimental effects on other borgs, and . . . you get the picture.

This is a quintessential example of “normal accidents” in a complex system with tightly coupled components. Other examples include reactor failures and plane crashes.

I note–again, reprising a theme of the Frankendodd Years of this blog–that clearing and margins are a major reason for tight coupling, and hence greater risk of normal accidents.

I note further that it is precisely the self-preservation instincts of the borgs that makes it utterly foolish and clueless to say that creating stronger borgs with more powerful tools of self-preservation, and which interact with other borgs, will reduce systemic risk. This is foolish and clueless precisely because it is profoundly unsystemic thinking because it views the borgs in isolation and ignores how the borgs all interact in a tightly coupled system. Making borgs stronger can actually make things worse when their self-preservation programs kick in, and the self-preservation of one borg causes it to attack other borgs.

Why do teenagers in slasher flicks always go down into the dark basement after five of their friends have been horribly mutilated? Well, that makes about as much sense as a lot of financial regulators have in the past decades. Despite literally centuries of bad historical experiences, they have continued to try to make stronger, mutually interacting, borgs. Like Becky’s trip down the dark basement stairs, it never ends up well.

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  1. It’s because there is no tolerance for failure. People get hurt, politicians get blamed. Bankruptcy (and possibly creative destruction which might be the cause of the volatility or bankruptcy) isn’t acceptable. Because we believe in central planning we must be able to fix it.

    Comment by Jeffrey Carter — February 1, 2021 @ 7:40 pm

  2. Craig- well stated. I’m afraid of dark basements but more afraid of the lack of technology advances in clearing.
    Why can we trade in milliseconds yet clear Futures or Equities in T+1 or T+2.
    Time for a change – or a light in the basement. .

    Comment by Joe Raia — February 1, 2021 @ 7:48 pm

  3. In this case, can’t the borg be tamed through better plumbing? I remember going from T+5 settlement to T+3 in 1995. It took two decades to go to T+2. Now, the banks don’t want to pay for the systems (or lose the float) to go to T+0, but given the complexity of the system and potential costs of failure, isn’t it time to go to T+0?

    I’m sure there will be unintended consequences, but I didn’t see much trouble in moving to T+2.

    Comment by Highgamma — February 1, 2021 @ 8:27 pm

  4. Reminds me of the Titanic, initially deemed to big to fail but in reality it was to big that it failed. Centralizing and systemizing risks increase stability momentarily in exchange for higher costs of failure. Perhaps to high of a cost to bear.

    Comment by Adrian P — February 2, 2021 @ 11:35 am

  5. @Joe Raia – instant clearing might solve some existing problems but I could also imagine it would introduce a bunch of new problems.

    For example, it would require all participants to dedicate enough cash to cover their peak positions during a session. This would likely increase costs for market makers, probably resulting in worse spreads for everyone else.

    Comment by derrizanile — February 4, 2021 @ 2:48 am

  6. Re shortening the settlement cycle, including “instantaneous clearing” (which means instantaneous settlement, really)–that actually tends to exacerbate the liquidity shocks that occur due to events like $GME. I wrote a post about Real Time Gross Settlement almost exactly 5 years ago.. As I note in the post, it doesn’t reduce risk, but just reallocates it. Moreover, it can lead to extreme liquidity needs and to work in the payments system requires central banks to provide intraday credit. As a practical matter, CBs can deal with banks directly, so it is somewhat straightforward to set up that mechanism in an RTGS payments system. However, CBs could not deal with brokers directly. So the liquidity supply/intraday credit mechanism–that would be necessary to go to a very short settlement cycle–would be more complex, with more linkages (brokers to banks to central banks, presumably). The more linkages, the more potential for breakdowns.

    Even without more complex linkages, shortening the settlement cycle increases the tightness of the coupling in the system. This by itself increases the risk of a “normal accident,” i.e., a systemic failure. An operational fault somewhere in the system can jeopardize the stability of the whole, and the more tightly coupled the system, the greater that risk.

    Comment by cpirrong — February 5, 2021 @ 10:09 am

  7. A bit late to this party, I suppose, but we do have a real-world example of instantaneous clearing: blockchain-based atomic swaps, where the publication of a single cryptographic secret enables both sides of the swap. This is instantaneous in the blockchain sense anyhow, meaning “on the same block”, since the security models here have no concept of time outside of the distributed consensus on the ordering of blocks. It does eliminate default risk, pretty much a necessity since the whole point of these systems is to eliminate the need for trusted parties. Liquidity issues come up quite often, where you go to the likes of SideShift to swap, say, Litecoin for ETH, and get a message saying, sorry, fresh out of ETH, try back later.

    Comment by M. Rad. — February 7, 2021 @ 9:08 pm

  8. Thanks, I read your earlier post and think I understand the argument, but I’m left with questions. By the way, I highly value your opinion in these matters.

    First, is T+2 better than T+1 (or T+3) for that matter? How do we determine the right amount of credit to supply to clearinghouse participants via the settlement system? (I can see your arguments as an argument against T+0 but not T+1.)

    Second, while I think that you answered this, why is it good to provide credit through the settlement system (especially via a clearinghouse)? It seems that would lead to a lack of monitoring and other inefficiencies?

    Third, Robinhood’s CEO mentioned that the margin system at the DTC is “opaque”. He claims to not have the ability to plan for large margin calls. Is there an economic reasoning behind this or is it just the clearinghouse being a “borg”?

    Thanks for any insight that you can provide.

    Comment by Highgamma — February 9, 2021 @ 3:26 pm

  9. >>it never ends up well.<<…
    …Except for the guy with the chain saw.

    Comment by Richard Whitney — February 10, 2021 @ 7:15 am

  10. @Highgamma. I’m going to write a post on T+x. Again, it’s a tradeoff. The shorter you make the settlement cycle, the less direct credit risk, but the greater the need for liquidity to support it (and hence the greater the liquidity risk). And liquidity risk is basically indirect credit risk.

    Re your second question. You’ve hit on the key issue. As I wrote about clearing some years ago (to a collective yawn from policymakers), the amount of credit is unlikely to change if you change the settlement cycle. The form of credit is likely to change. Whom the brokers are borrowing from, in particular, will change. The systemic risk impacts of this are not obviously beneficial. It’s just rearranging the chairs. An example of the seen vs. unseen.

    Re Robinhood’s somewhat hapless CEO. Clearinghouses are notoriously vague about their margin models, in large part to avoid gaming. Yes, we know the basics (e.g., 99.5 pct VaR) but (a) how that is calculated (esp. the parameter inputs) is not transparent, and (b) there are all sorts of fudge factors and discretion that allow the borgs to borg. From what I understand, DTCC basically went to T+0 settlement and demand that RH post 100 pct margin. I doubt that was considered to be a likely outcome, and it is surely the case that the circumstances in which it would be imposed were not known to market participants.

    Comment by cpirrong — February 13, 2021 @ 6:36 pm

  11. Thanks for your response. I look forward to the T+x post.

    Comment by Highgamma — February 18, 2021 @ 5:36 pm

  12. @Highgamma. You’ll have to wait a bit. Weather intervened directly (no power!) and indirectly (by diverting my attention to the TX power issue). But I’ll get to it!

    Comment by cpirrong — February 19, 2021 @ 12:18 pm

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