Streetwise Professor

January 29, 2008

Been There, Done That

Filed under: Derivatives,Economics,Energy,Exchanges — The Professor @ 10:00 am

The New York Times reports that the Treasury and the SEC are contemplating requiring banks to disclose publicly quotes and trades in derivatives, such as CDOs. Where have I heard that idea before? Oh yeah, I came up with it 5 years ago to address problems in the energy market.

Now, of course, I shouldn’t take entire credit for the idea, as Mike Prokopp at Amerex, Ed Bell, then of PA Consulting, and Bob Anderson at the CCRO, and some folks at Reuters were thinking along similar lines. But I think it is fair to say that I contributed as much, and perhaps more, to the development and evangelization of the concept as anybody.

In energy, the issue was that many traders falsely reported the prices at which they bought and sold natural gas to trade publications such as Gas Daily and Inside Ferc. The price reporting was purely on an “honor system,” and like everything, honor has its price–and that was a price many traders weren’t willing to pay. So the basic idea I developed was that of a “data hub.” In a nutshell, traders would report prices of actual transactions to a central repository, that would validate the submissions by matching buys against sells. The data would then be disseminated to the marketplace.

The concept is pretty straightforward, but in the energy space it attracted a lot of flak, some of which I am still picking out of my backside. Transparency is not everybody’s friend; traders feel that they give up valuable information by publicly disclosing their prices. Moreover, the price reporting incumbents–notably Platts–had a vested interest in maintaining the old system. FERC and CFTC said nice things about the idea, but the political pressure from some industry groups, individual energy firms, and Platts overwhelmed the arguments that an academic and a few industry mavericks put forth. As a result, neither regulatory agency was willing to mandate that firms report prices to a particular entity. Absent a mandate, the collective action problems of creating a viable data hub were daunting.

In May, 2004 the idea was all but dead. As a last gasp effort to revive it, my then assistant Jeff Graefe had the idea to organize a roundtable on the idea at UH. Bob Anderson, who had formed a non-profit company called Energy Data Hub (imagine that) was there, as were several representatives of energy firms. Bob was about to give up on the idea when Jim Allison from Conoco-Phillips gave the idea his strong endorsement, and suggested that the concept be extended.

The original concept behind the hub was to collect and disseminate data on simple energy products, like day ahead and month ahead gas. Allison said that it would be much more useful to collect and disseminate information on more complicated products, including longer dated swaps and options. This would help firms get better estimates of the values of their outstanding contracts, and hence allow them to manage risk and determine profitability much more effectively.

With Allison’s strong endorsement, Anderson plugged ahead with the Data Hub. It is now collecting data from several companies, and should go live later this year. Although I take pride in pioneering the concept, Bob deserves credit in persevering to make the concept a reality, and Jim deserves credit for the vision to see how the concept could be used to solve problems other than the false-reporting issue that had been the reason for its development.

It is ironic, in light of the NYT article, that at a lunch with Anderson before Christmas I mentioned that the hub concept could–and should–be extended beyond energy to deal with other opaque markets, such as credit derivatives. The idea is, as they say, scalable, and numerous segments of the derivatives marketplace could do with greater transparency.

I am not a big fan of government mandates, but theory and practical experience tell me that (a) a mandate is the only way this can be done quickly, and (b) a mandate is economically efficient. As I noted before, trading firms don’t like transparency. They operate on the motto “The One Eyed Man is King in the Land of the Blind.” A individual firm that sees some deal flow–but not all the deals–likely has something of an information advantage over other firms. If all prices are revealed to everybody, the informational playing field is level–and who can make any money when that happens? So many firms–especially the big hitters that see a big chunk of the deal flow–would rather have a relatively opaque market. Sure, they don’t know values as accurately as if all prices were disseminated publicly, but trading profitability only requires that you have better information than others. So the biggest, most influential firms have a vested interest in opposing greater transparency.

Moreover, there is a positive externality from disclosure of value information; it helps other firms manage their risk better and mark their books more accurately. Firm A doesn’t benefit if firm B can manage risk better. Though Firm A could manage risk and mark books better if it also received information from firms B, C, etc., no individual firm captures all the benefits of its disclosures. Moreover, investors in the stock of the trading firms (and investors in hedge funds trading in these opaque markets) would benefit from having more accurate valuation information. But firm A gets all the trading benefits of keeping the information to itself, but none of the benefit that disclosure confers on other firms who can use the information to manage risk and mark more accurately. Collectively firms would benefit from disclosure (as the trading part of it is close to a zero sum game but the risk management part is positive sum), but individual firms can’t capture the collective benefit through unilateral disclosure.

Thus, there is a collective action problem, similar to the common pool problem in the oil business. It is well known (as documented by Gary Libecap and Steve Wiggins) that operators of common pools typically do not resolve that problem efficiently. On a priori grounds I would predict that collective action problems would make it very difficult for individual firms to come to an efficient agreement regarding mutual disclosures of price information. Indeed, the resistance of the “front offices” (i.e., the traders) to the idea would likely overcome the influence of the “middle offices” (i.e., the risk managers) who would otherwise favor the concept. (Traders usually swing much more stick than the green eyeshade types.) My experience in the energy data hub was strongly consistent with this conjecture.

So, despite my usually libertarian/Chicago instincts, here is a situation where I believe a mandate to be warranted, and I support the Treasury/SEC initiative. It is clearly most needed in the credit derivatives market, and in the market for various structured products, but it is also defensible in other parts of the derivatives market as well.

Perhaps the SEC/Treasury action will also galvanize FERC and CFTC to revisit the issue in energy markets too. Although the Energy Data Hub lives, it is still fighting the collective action problem.

When the subprime stuff hit the fan, it was clear that the market could use better price information. It was equally clear that due to the conflicting interests and the collective action problem, market participants were unlikely to provide it absent a nudge from the feds. That nudge has come, and none too soon.

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