This is just an example of the inherent systemic risk created by margining, collateralization, and leverage. The issue is not a particular trade per se–it is an inherent feature of a large swathe of trades and instruments. What made the basis trade a big issue in March 2020 was its magnitude. And per the article, it has become big again.
This is not a surprise. Treasuries are a big market, and leveraging a small arb pickup is what hedge funds and other speculators do. It is a picking-up-nickels-in-front-of-a-steamroller kind of trade. It’s usually modestly profitable, but when it goes bad, it goes really bad.
All that said, the article is full of typical harum-scarum. It says the trade is “opaque and risky.” I just discussed the risks, and its not particularly opaque. That is, the “shadowy” of the title is an exaggeration. It has been a well-known part of the Treasury market since Treasury futures were born. Hell, there’s a book about it: first edition in 1989.
Although GiGi is not wrong that basis trades can pose a systemic risk, he too engages in harum-scarum, and flogs his usual nostrums–which ironically could make the situation worse:
“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.
Zero margin? Really? Is there anyone–especially a hedge fund–that can repo Treasuries with zero haircut? (A haircut–borrowing say $99 on $100 in collateral is effectively margin). And how exactly do you trade Treasury futures without a margin?
As for nostrums, “The SEC has been seeking to push more hedge-fund Treasury trades into central clearinghouses.” Er, that would exacerbate the problem, not mitigate it.
Recall that it was the increase in margins and variation margins on Treasury futures, and the increased haircuts on Treasuries, that generated the liquidity shock that the Fed addressed by a massive increase in liquidity supply–the overhang of which lasted beyond the immediate crisis and laid the groundwork for both the inflationary surge and the problems at banks like SVB.
Central clearing of cash Treasuries layers on another potential source of liquidity demand–and liquidity demand shocks. That increases the potential for systemic shocks, rather than reduces it.
In other words, even after all these years, GiGi hasn’t grasped the systemic risks inherent in clearing, and still sees it as a systemic risk panacea.
In other words, even though I agree with Gensler (and the Fed) that basis trades are a source of systemic risk that warrant watching, I disagree enough with GiGi on this issue that the apocalypse that could result from our complete agreement on anything will be averted–without the intervention of the Fed.
For decades, Europe’s commodity traders have avoided being regulated on par with other financial firms. A new proposal currently working its way through the European Union legislative system could change that.
To close “loopholes,” dontcha know:
The loophole allows industrial companies like utilities and food processors — but also commodity trading houses — to take derivative positions without the scrutiny facing investment firms. Designed to reduce the burden of managing price risk, it also means that traders aren’t subject to rules on setting aside capital or limiting positions the same way banks and hedge funds are.
2022 certainly saw unprecedented liquidity pressures in the commodity trading sector, as firms that had sold derivatives (especially on gas and power) to hedge their exposures from supplying the European market saw huge margin calls that greatly strained credit lines and led a coalition of traders to request ECB support (which the ECB declined).
The crucial part of the previous paragraph is “to hedge.” The danger of restricting or increasing the cost of such activities through regulation of the type that is apparently under consideration is that it will constrain hedging activities, thereby (a) making these firms more vulnerable to solvency, as opposed to liquidity problems, and (b) raising the costs of commodity intermediation.
Note that the companies that received state support that are mentioned in the article are not commodity traders qua commodity traders, e.g., Vitol or Trafigura or Gunvor. They are energy suppliers who were structurally short gas and did not hedge, and hence were facing serious solvency issues when gas prices exploded in late-2021 (before the Russian invasion) and winter and spring 2022 (when the invasion occurred). That is, firms that didn’t hedge were the ones that faced insolvency and received state support. (Curiously, Uniper is missing from the list of companies in the Bloomberg article, although Fortum Oyj was collateral damage from Uniper’s collapse.)
The relevant issue in determining whether commodity trading firms should be regulated like banks or hedge funds is not whether the traders can go bust: they can. It is whether (a) they are financially fragile like banks, and (b) whether they are systemically important.
These are exactly the same issue I addressed in my Trafigura white papers in 2013 and especially 2014. To summarize, commodity trading firms engage in completely different transformations than banks and many hedge funds. Commodity traders transform commodities in space, time, and form: banks engage in liquidity and maturity transformations. The difference is crucial.
Liquidity and maturity transformations are inherently fragile–they are the reasons that bank runs occur, as the recent failures of SVB, First Republic, and Signature Bank remind us. That is, the balance sheets of banks are fragile because they finance long term, illiquid assets with liquid short term liabilities.
Commodity traders’ balance sheets are completely different. The “pure” asset light traders especially: they fund short term (“self-liquidating”) relatively liquid assets (commodity inventories) with short term relatively liquid liabilities. Further, hedging is a crucial ingredient in this structure: banks are willing to finance the inventories because the price risks can be hedged.
This is not to say that commodity traders cannot fail–they can. But they do not face the same kinds of fragility (vulnerability to runs) that entities that engage in maturity and liquidity transformations do. It is this fragility that provides the rationale for bank capital requirements and limitations on the scope of their activities. This rationale is lacking for commodity trading firms. They are intermediaries, but not all intermediaries are alike.
Further, as I also pointed out almost a decade ago, major financial firms dwarf even the largest commodity trading firms. Even a Trafigura, say, is not remotely as large or systemically important as, say, Credit Suisse. Yes, a bankruptcy of a big trader would inflict losses on its lenders, but these losses would tend to be spread widely throughout the global banking sector given that most loans and credit lines to commodity traders are widely syndicated. And the potential for these kinds of losses are exactly reason that banks hold capital and that it is prudent to impose capital requirements on banks.
As I noted in the 2014 study, virtually the entire merchant energy sector in the United States imploded in 2002-3. Lenders ate losses, but the broader economic effect was minimal, the assets of the failed firms continued to operate, and the lights stayed on.
In sum, analogizing commodity traders to banks is seriously intellectually flawed, and what’s good or justified for one is not necessarily for the other because of the huge differences between them.
Pace Bloomberg, the events of 2021-2022 did not “expose” some new, unknown risk. The liquidity risk inherent in hedging has long been known, and I analyzed it in the white papers. Indeed, it’s been a focus of my research for years, and is the underlying reason for my criticism of clearing and collateral mandates–including those embraced enthusiastically by the EU.
Thus, a more constructive approach for Europe would be not to apply mindlessly regulatory restrictions found in banking to commodity firms, but to investigate ways to facilitate liquidity supply to commodity traders under extreme situations. Direct access of commodity traders to central bank funding is inadvisable, but central bank facilitation of bank supply of margin funding to commodity traders during such extraordinary circumstances worthy of investigation.
Recall that the Federal Reserve’s response to a funding crisis originating in the Treasury futures markets was instrumental in containing the systemic risks arising from COVID in March 2020 (as described in my Journal of Applied Corporate Finance article, “Apocalypse Averted“). The Fed’s actions were extemporized (just as they were during the 1987 Crash). The EU and ECB would do well to use that experience, and that of 2021-2022, to devise contingency arrangements in advance of future shocks. That would be a more constructive approach to the risks inherent in commodity risk management than to impose regulations that could impede risk management.
It is important to note that making hedging costlier instead of making it cheaper increases the risk of extreme price disruptions. Constraining risk management means that commodity traders will supply less intermediation especially during high risk periods. This will swell margins and make commodity supply less elastic, both of which will tend to exaggerate price movements during periods of stress.
I always wonder about the political economy of such regulatory proposals. Yes, no doubt regulatory reflex is a driver: “We have to do something. Let’s take something off the shelf and make it fit!” But my experience in 2012-2014 also motivates a more cynical take.
The genesis of the Trafigura white papers was an abortive white paper I wrote for the Global Financial Markets Association, a banking industry group. The GFMA approached me to investigate the systemic riskiness of commodity trading firms, and I came up with the wrong answer, so they spiked the study. Somehow or another Trafigura got wind of this, and that was the genesis of the influential (if I do say so myself) papers I wrote for the firm.
The point being that in 2012 the banks were pushing to regulate commodity trading firms with capital requirements and the like in order to raise the costs of competitors, and were looking for intellectual cover for that endeavor–cover I did not provide after a deep dive into the commodity trading sector.
Hence, I wonder if this reprise of the ideas that were largely shelved in the mid-2010s is an example of “let no crisis go to waste,” i.e., whether there are interests in Europe pressing to regulate commodity firms for shall we say less than public spirited reasons.
The proposals are apparently very protean at this stage. But it will be interesting to see where they progress from here. And I’ll weigh in accordingly.
A coda to my previous post. The EU natural gas price regulation avoids many of the faults of price controls, largely as a result of its narrow focus on a single market: TTF natural gas futures. That said, the fact that it potentially applies to one market means that there are still potentially negative consequences.
These negative consequences are not so much to the allocation of natural gas per se, but to the allocation of natural gas price risk. Futures markets are first and foremost markets for risk, and the price regulation has the potential to interfere with their operation.
In particular, the prospect of being locked into a futures position when the price cap binds will make market participants less likely to establish positions in the first place: traders dread being stuck in a Roach Motel, or Hotel California (you can check out but you can never leave). Thus, less risk will be hedged/transferred, and the market will become less liquid. Relatedly, price caps can lead to perverse dynamics when the price approaches the cap as market participants look to exit positions to avoid being locked in. This can lead to enhanced volatility which can perversely cause the triggering of the cap.
These negative effects are greater, the closer prices are to the cap. Europe’s good luck with weather this winter has provided a relatively large gap between the market price and the cap, so the negative impacts are relatively unlikely to be realized. But that’s a matter of luck rather than a matter of economic principle.
Risk transfer is a vital economic function that generates substantial economic value. The cost of interfering with this mechanism is material, and should not be ignored when evaluating the EU policy. That policy avoids many of the standard problems with price caps, but its narrow focus to the futures market means that it has the potential to create economic costs not typically considered in evaluations of price controls. Meaning that not even Saul Goodman would come to its defense.
The meltdown of FTX continues to spark controversy and commentary. A recent theme in this commentary is that the FTX disaster represents a failure of centralization that decentralized finance–DeFI–could correct. Examples include contributions by the very smart and knowledgeable Campbell Harvey of Duke, and an OpEd in today’s WSJ.
I agree that the failure of FTX demonstrates that the crypto business as it is, as opposed to how it is often portrayed, is highly centralized. But the FTX implosion does not demonstrate that centralization of crypto trading per se is fundamentally flawed: FTX is an example of centralization done the worst way, without any of the institutional and regulatory safeguards employed by exchanges like CME, Eurex, and ICE.
Indeed, for reasons I have laid out going back to 2018 at the latest, the crypto market was centralized for fundamental economic reasons, and it makes sense that centralization done right will prevail in crypto going forward.
The competitor for centralization advocated by Harvey and the WSJ OpEd and many others is “DeFi”–decentralized finance. This utilizes the nature of blockchain technology and smart contracts to facilitate crypto trading without centralized intermediaries like exchanges.
One of the exemplars of the DeFi argument is “automated market making” (“AMM”) of crypto. This article provides details, but the basic contours are easily described. Market participants contribute crypto to pools consisting of pairs of assets. For example, a pool may consist of Ether (ETH) and the stablecoin Tether (USDT). The relative price of the assets in the pool is determined by a formula, e.g., XETH*XUSDT=K, where K is a constant, XETH is the amount of ETH in the pool and XUSDT is the amount of Tether. If I contribute 1 unit of ETH to the pool, I am given K units of USDT, so the relative price of ETH (in terms of Tether) is K: the price of Tether (in terms of Ether) is 1/K.
Fine. But does this mechanism provide price discovery? Not directly, and not in the same way a centralized exchange like CME does for something like corn futures. DeFi/AMM essentially relies on an arbitrage mechanism to keep prices aligned across exchanges (like, FTX once up an time and Binance now) and other DeFi AMMs. If the price of Ether on one platform is K but the price on another is say .95K, I buy ETH on the latter platform and sell Ether on the former platform. (Just like Sam and Caroline supposedly did on Almeda!) This tends to drive prices across platforms towards equality.
But where does the price discovery take place? To what price do all the platforms converge? This mechanism equalizes prices across platforms, but in traditional financial markets (TradFi, for the consagneti!) price discovery tends to be a natural monopoly, or at least has strong natural monopoly tendencies. For example, it the days prior to RegNMS, virtually all price discovery in NYSE stocks occurred on the NYSE, even though it accounted only for about 75-80 percent of volume. Satellite markets used NYSE prices to set their own prices. (In the RegNMS market, the interconnected exchanges are the locus of price discovery.)
Why is this?: the centripetal forces of trading with private information. Something that Admati-Pfleiderer analyzed 30+ years ago, and I have shown in my research. Basically, informed traders profit most by trading where most uninformed traders trade, and the uninformed mitigate their losses to the informed by trading in the same place. These factors reinforce one another, leading to a consolidation of informed trading in a single market, and the consolidation of uninformed trading on the same market except to the extent that the uninformed can segment themselves by trading on platforms with mechanisms that make it costly for the informed to exploit their information, such as trade-at-settlement, dark pools, and block trading. (What constitutes “informed” in crypto is a whole other subject for another time.)
It is likely that the same mechanism is at work in crypto. Although trading consolidation is not as pronounced there as it is in other asset classes, crypto has become very concentrated, with Binance capturing around 75-80 percent of trading even before the FTX bankruptcy.
So theory and some evidence suggests that price discovery takes place on exchanges, and that DeFi platforms are satellite markets that rely on arbitrage directly or indirectly with exchanges to determine price. (This raises the question of whether the AMM mechanism is sufficiently costly for informed traders to insure that their users are effectively noise traders.)
The implication of this is that DeFi is not a close substitute for centralized trading of crypto. (I note that DeFi trading of stocks and currencies is essentially parasitical on price discovery performed elsewhere.) So just because SBF centralized crypto trading in the worst way doesn’t mean that decentralization is the answer–or will prevail in equilibrium as anything more than an ancillary trading mechanism suited for a specific clientele, and not be the primary locus of price discovery.
The future of crypto will therefore almost certainly involve a high degree of centralization–performed by adults, operating in a rigorous legal environment, unlike SBF/FTX. That’s where price discovery will occur. In my opinion, DeFi will play an ancillary role, just as off-exchange venues do today in equities, and did prior to RegNMS.
One last remark. One thing that many in the financial markets deplore is the fragmentation of trading in equities. It is allegedly highly inefficient. Dark pools, etc., have been heavily criticized.
Fragmentation and decentralization is also a criticism leveled against OTC derivatives markets–here it has been fingered as a source of systemic risk, and this criticism resulted in things like OTC clearing mandates and swap execution facility mandates.
It’s fair to say, therefore, that in financial market conventional wisdom, decentralization=bad.
But now, a failure of a particular centralized entity is leading people to tout the virtues of decentralization. Talk about strange new respect!
All of these criticisms are largely misguided. As I’ve written extensively in the past, fragmentation in TradFi is a way of accommodating the diverse needs of diverse market participants. And just because some hopped up pervs found that running a centralized “exchange” was actually a great way to steal money from those blinded by their BS doesn’t mean that centralization is inherently unfitted for crypto because decentralized mechanisms also exist.
If crypto trading is to survive, well-operated centralized platforms will play an outsized role, supplemented by decentralized ones. Crypto is not so unique that the economic forces that have shaped market structure in stocks and derivatives will not operate there.
So don’t overgeneralize from a likely (and hopefully!) extreme case driven by the madness of woke crowds.
Another blizzard hit the winter-bound crypto industry, with the evisceration of crypto wonder boy Sam Bankman-Fried’s (SBF to crypto kiddies) FTX and its associated hedge fund Alameda Capital. (Which should be renamed Alameda No Capital.) The coup coup de grâce was delivered by SBF’s former frenemy (now full fledged enemy), Binance’s Changpeng Zhao (CZ, ditto). But it is now evident that FTX was a Rube Goldberg monstrosity and all CZ did was remove–call into question, really–one piece of the contraption which led to its failure.
The events bring out in sharp detail many crucial aspects of the crypto landscape. (I won’t say “ecosystem”–a nauseating word.).
One is crypto market structure. FTX (and Binance for that matter) are commonly referred to as “exchanges,” giving rise to thoughts of the CME or NYSE. But they are much more than that. FTX (and other crypto “exchanges”) are in fact highly integrated financial institutions that combine the functions of trade execution platform (an exchange qua exchange), a broker dealer/FCM, clearinghouse, and custodian. And in FTX’s case, it also was affiliated with a massive crypto-focused hedge fund, the aforementioned Alameda.
FTX offers high leverage products and tokens. The exchange currently offers 20x maximum leverage, down from its previous 101x leverage products. This is still one of the highest maximum leverage a crypto exchange offers when compared to FTX’s other competitors. Leveraged long and short tokens for BTC, ETH, MATIC, and others are also offered by the exchange; for example, the ETHBULL token allows investors to trade a 3x long position in Ethereum.
FTX also engaged in the equivalent of securities lending: it lent out the BTC, etc., that customers held in their accounts there.
These are traditional broker dealer functions, and historically they are functions that have led to the collapse of such firms–more on that below.
FTX supersized the risks of these activities through one of its funding mechanisms, the FTT token. Ostensibly the benefits of owning FTT were reduced trading fees on the exchange, “airdrops” (a distribution of “free” tokens to those holding sufficient quantities on account with FTX, a promise to return a certain fraction of trading revenues to token holders by repurchasing (“burning”), and some limited governance/voting rights. The burning also served the function of limiting supply. (I plan to write a separate post on the economics of valuation of these tokens, though I do touch on some issues below.)
So FTT is (or should I say “was”?) stock-not-stock. Not a listed security, but an instrument that paid dividends in various forms.
FTT was in some ways the snowman here. For one thing, FTX allowed customers to post margin in FTT.
Huh, whut?
Risky collateral is always problematic. (Look at the reluctance of counterparties to accept anything but cash as collateral even from pension funds as in the UK.) Allowing posting of your own liability as collateral is more than problematic–it is insane. Very Enron-y!
Why? A subject I’ve written on a lot in the past: wrong way risk.
If for any reason FTT goes down, the value of collateral posted by customers goes down. Which means that your assets (loans to customers) go down in value.
A doom machine, in other words.
The integrated structure of FTX exacerbated this risk, and bigly. If customers start to get nervous about its viability, they start to pull the assets (BTC, ETH, etc.) they have on account there. Which is a problem if you’ve lent them out! (Recall that AIG’s biggest problem wasn’t CDS, but securities lending.)
And this has happened, with customers attempting to pull billions from the firm, and FTX therefore being forced to stop withdrawals.
And things can get even worse. The travails of a big broker dealer can impact prices, not just of its liabilities like FTT but of assets generally (stocks and bonds in a traditional market, crypto here) and given the posting of risky assets of collateral that can make the collateral shortfalls even worse. Fire sale effects are one reason for these price movements. In the case of crypto, the failure of a major crypto firm calls into question the viability of the asset class generally, with some of them being affected particularly acutely.
The integrated structure of crypto firms is also a problem. Customer assets are held in omnibus accounts, not segregated ones. Yeah yeah crypto firms say your assets on account are yours, but that’s true in a bookkeeping sense only. They are held in a pool. This structure incentivizes customers to run when the firm looks shaky. Which can turn looks into reality. That’s what has happened to FTX.
The connection with a hedge fund trading crypto is also a big problem. (The blow up of hedge funds operated by big banks was a harbinger of the GFC in August, 2008, recall.). And it is increasingly apparent that this was a major issue with FTX that interacted with the factors mentioned above. FTX evidently lent large amounts–$16 billion!–of customer assets to Alameda Research. Apparently to prop it up after huge losses in the first blizzards of Crypto Winter. (In retrospect, SBF’s buying binge earlier this year looks like gambling for resurrection.)
SBF described this as “a poor judgment call.”
You don’t say! I hear that’s what Napoleon said while trudging back from Russia in November 1812. Probably Custer’s last words, but we’ll never know!
And this was the string that CZ pulled that caused the whole thing to unravel. When he announced that he had learned of Alameda’s large FTT position, and that as a result he was selling FTT the doom machine kicked into operation, and at hyper speed: doom occurred within days.
Looking at this in the immediate aftermath, my thought was that FTX was basically MF Global with an exchange operation. A financially fragile broker dealer combined with an exchange.
And the analogy was even closer than I knew: FTX’s using customer assets to “fund risky bets” revealed this morning is also exactly what MF Global did. Except that Corzine was a piker by comparison. He filched almost exactly only 1/10th of what FTX did ($1.6 billion vs. $16 billion). (Maybe SBF should take comfort from the fact that Corzine walks free–though I don’t recommend that he walk free at LaSalle and Jackson or Wacker and Adams). (I further note that SBF is a huge Democrat donor. Like Corzine, his political connections may save him from the pokey, though by all appearances he should spend a very long stretch there.)
In sum, FTX’s implosion is just a crypto-flavored example of the collapse of an intermediary the likes of which has been seen multiple times over the (literally) centuries. As I’ve written before, there is nothing new under the financial sun.
The episode also throws a harsh light on the supposed novelty of crypto. Remember, the crypto narrative is that crypto is decentralized, and does not rely on trusted institutions: it is trustless in other words.
Wrong! As I’ve written before, economic forces lead to centralization and intermediation in crypto markets, just as in traditional financial markets. Market participants utilize the services of firms like FTX and Binance, and have to trust that those firms are acting prudently. If that trust is lost, disaster ensues.
That is, tokens are valuable if people believe they are valuable–that is, if they have trust in their value. Furthermore, there is a sort of information cascade logic that can create market value: if people see that a token sells at a positive price–especially if it sells at a very large positive price–and they observe that supposedly smart people hold it, they conclude it must have some intrinsic value. So they pile in, increasing the value, validating beliefs, and extending the information cascade.
But this is Tinker Bell economics. If people stop believing, Tinker Bell dies.
And when someone very influential like CZ says “I don’t believe” death is rapid: the information cascade stops, then reverses. Especially given how FTT was the keystone of the FTX arch.
In brief, crypto theory is completely different than crypto reality. Crypto markets share all major features with the demonized traditional “trust-based” financial system. To the extent they differ, they are even more based on trust, given the ubiquity of Token Tinker Bell Economics.
I have long called myself “the Clearing Cassandra” for my repeated and unheeded warnings about the dangers of letting the Trojan Horse of clearing (and the margining of uncleared trades) into the financial citadel. Specifically, clearing/margining can create financial shocks (and indeed financial crises) rather than preventing them (which is the supposed justification for mandating them).
We have seen several examples of this in the past several years, including the COVID (lockdown) shock of March 2020 (a subject of a JACF article of mine) and the recent energy market tremors. The most recent example, and in many ways the most telling one, is the recent instability in the UK that led the Bank of England to intervene to prevent a full-on crisis. The tumult fed a spike in UK government yields and contributed to a plunge in the Pound.
The instability was centered on UK pension funds engaged in a strategy called Liability Directed Investment (LDI)–which should now be renamed Liquidity Danger Investment. In a nutshell, in LDI defined benefit pension funds hedge the interest rate risk in their liabilities through interest rate swaps that are cleared or otherwise margined daily on a mark-to-market basis, rather than investing in fixed income securities that generate cash flows that match the liabilities. The funds hold non-fixed income assets (sometimes referred to as “growth assets”) in lieu of fixed income. (I discuss the whys of that portfolio strategy below.)
On a MTM basis, the funds are hedged: a rise in interest rates causes a decline in the present value of the liabilities, which matches a decline in the value of the swaps. Even if there is a duration match, however, there is not a liquidity match. A rise in interest rates generates no cash inflow on the liabilities (even though they have declined in value), but the clearing/margining of the swaps leads to a variation margin outflow: the funds have to stump up cash to meet VM obligations.
And this has happened in a big way due to interest rate increases driven by central bank tightening and the deteriorating fiscal situation in the UK (which has been exacerbated substantially by the energy situation, and the British government’s commitment to absorb a large fraction of energy costs). This led to big margin calls . . . which the funds did not have cash to cover. So, cue a fire sale: the funds dumped their most liquid assets–UK government gilts–which overwhelmed the risk bearing capacity/liquidity of that market, leading to a further spurt in interest rates . . . which led to more VM obligations. Etc., etc., etc.
In other words, a classic liquidity spiral.
The BofE intervened by buying gilts in massive amounts. This helped stem the spiral, though the problem was so acute that the BofE had to extend its purchases beyond the period it initially announced.
So yet again, central bank intervention was necessary to provide liquidity to put out fires created by margining.
FFS. When will people who should know better figure this out? How many times is it necessary to hit the mule upside the head with a 2×4?
I just returned from France, and while walking by the Banque de France I thought of a conference held there in the fall of 2013 at which I spoke: the conference was co-sponsored by the BdF, BofE, and ECB. It was intended to be a celebration of the passage and implementation of various post-Crisis regulations, clearing mandates most prominent among them.
I did my buzz kill Clearing Cassandra routine, in which I warned very specifically of the liquidity spiral dangers inherent in clearing as a source of financial instability. I got pretty much the same response as the Trojan Cassandra–a blow off, in other words. Indeed, I quite evidently got under some skins. The next speaker was Benoît Cœuré, a member of the ECB governing council. The first half of his talk was a very intemperate–and futile–attempt at rebuttal. Which I took as a compliment.
Alas, events have repeatedly rebutted Cœuré and Gensler and all the other myriad clearing cheerleaders.
The LDI episode has validated other arguments that I made starting in late-2008. Most notably, clearing was touted as a “no credit” system because the clearinghouse does not extend any credit to counterparties: variation margin/mark-to-market is the mechanism that limits CCP credit exposure. Since one (faulty) narrative of the Crisis was that it was the result of credit extended to derivatives counterparties, clearing was repeatedly touted as a way of reducing systemic risk.
Not so fast! I said. Such a view is profoundly unsystemic because it neglects the fact that market participants can substitute other forms of credit for the credit they no longer get via derivatives trades. And indeed, in the recent LDI episode exemplifies a very specific warning I made over a decade ago: those subject to clearing or margining mandates would borrow on the repo market to fund margin obligations, including both initial margin and variation margin.
And indeed the UK funds did exactly that. This actually increased the connectedness of the financial system (contrary to the triumphant assertions of Gensler and others), and this connectedness via the repo channel was another factor that drove the BofE to intervene.
My beard is not quite this long (though it’s getting there) but this is pretty much spot on:
Clearing is Not a Harmless Bunny
Again: Clearing converts credit risk into liquidity risk. And all financial crises are liquidity crises.
Maybe someday people will figure this out. Hopefully before I snuff it.
And the idiocy of this is especially great with respect to the UK pension funds because they posed relatively little credit risk in the first place. So there was not a substitution of one risk (liquidity risk) for another (credit risk). There was an addition of a new risk with little if any reduction of any other risk.
The LDI strategies were right way risks. Interest rate movements that cause swaps to lose value also increase the value of the funds (by reducing the PV of their liabilities). The funds were not–and are not-leveraged plays on interest rate risk. So the prospects of defaults on derivatives that could be mitigated by clearing were minimal.
Here I have to part ways with someone I usually agree with, John Cochrane, who characterizes the episode as another example of thedangers of leverage. He cites to a BofE document about the LDI episode that indeed mentions leverage, but the story it tells is not the classic lever-up-and-lose-more-when-the-market-moves-against-you one that John suggests. Instead, in figure in the BofE piece that John includes in one of his posts, the increase in interest rates actually makes the pension fund better off in present value terms–even including its LDI-related positions–because its assets go down less in value than its liabilities do. In that sense, the LDI positions are an interest rate hedge. But there is a mismatch in the liquidity impacts.*. It is this liquidity mismatch that causes the problem.
The BofE piece also suggests that the underlying issue here is pension fund underfunding. In essence, the pension funds needed to jack up returns to close their funding gap. So instead of investing in fixed income assets with cash flows that mirrored those of its pension liabilities, the funds invested in higher returning assets like equities. Just investing in fixed income would have locked in the funding gap: investing in equities increased the odds of becoming fully funded. But just investing in equities alone would have subjected the funds to substantial interest rate risk. So the LDI strategies were intended to immunize them against this risk.
Thus, the original sin was the underfunding. LDI was/is not a way of adding interest rate risk through leverage to raise expected returns to close the gap (gambling on interest rate risk for resurrection). Instead it was a way of managing interest rate risk to permit raising returns to close the gap by changing portfolio composition. (No doubt regulators were cool with this because it reduced the probability that pension fund bailouts would be needed, or at least kicked that can down the road, a la US S&L regulators in the 1980s.)
No, the real story here is not the oft-told tale of highly leveraged intermediaries coming to grief when their speculations turn out wrong. Instead, it is a story of how mechanisms intended to limit leverage directly lead to indirect increases in debt and more importantly to increases in liquidity risks. In that way, margining increases systemic risk, rather than reducing it as advertised.
*The BofE document describes an LDI mechanism that is somewhat different than using swaps to manage interest rate risk. Instead, it describes a mechanism whereby positions in gilts are partially funded by repo borrowing. The borrowing is necessary to create a position large enough to create enough duration to match the duration of a fund’s liabilities. But a swap is economically equivalent to a position in the underlying funded by borrowing, so the difference is more apparent than real. Moreover, the liquidity implications of the interest rate hedging mechanism in the BofE document are quite similar to those of a swap.
Gary Gensler has long lusted to get his regulatory hooks into cryptocurrency. To do so as head of the SEC, he has to find a way to transform crypto (e.g., Bitcoin, Ether, various tokens) into securities, as defined under laws dating from the 1930s. Although Gensler has stated that crypto regulation is a long way off–presumably because it is no mean feat to jam an innovation of the 2010s into a regulatory framework of the 1930s–he thinks that he may have found a way to get at the second largest crypto, Ether.
Gensler pictured here:
Sorry! Sorry! Understandable mistake! Here’s his actual image:
Crypto Regulation. Excellent!
Ether just switched from a “proof of work” model–the model employed by Bitcoin–to a “proof of stake” model. Gensler recently said that Ether may therefore qualify as a security under the Howey test, established in a 1946 Supreme Court decision–handed down when computers filled large rooms, had no memory, and caused the lights to dim in entire cities when they were powered up.
Per Gensler:
Securities and Exchange Commission Chairman Gary Gensler said Thursday that cryptocurrencies and intermediaries that allow holders to “stake” their coins might pass a key test used by courts to determine whether an asset is a security. Known as the Howey test, it examines whether investors expect to earn a return from the work of third parties.
“From the coin’s perspective…that’s another indicia that under the Howey test, the investing public is anticipating profits based on the efforts of others,” Mr. Gensler told reporters after a congressional hearing. He said he wasn’t referring to any specific cryptocurrency.
To call that a stretch is an understatement. A huge one. Because the function of proof of stake is entirely different than the function of a security.
Proof of work and proof of stake are alternative ways of operating an anonymous, trustless crypto currency. As I’ve written in several pieces here and elsewhere, eliminating the need for trusted institutions to guarantee transactions does not come for free. Those tempted to defraud must incur a cost if they do in order to be deterred. A performance bond sacrificed on non-performance or deceit is a common way to do that. Proofs of stake and work both are effectively performance bonds. With proof of work, a “miner” incurs a cost (electricity, computing resources) to get the right to add blocks to the blockchain: if a majority of other miners don’t concur with the proposal, the block is not validated, the proposing miner gets no reward, and sacrifices the expenditure required to make the proposal. Proof of stake is a more traditional sort of bond: you lose your stake if your proposal is rejected.
A security is something totally different, and serves a completely different function. (NB. I favor the “functional model of regulation” proposed by Merton many years ago. Regulation should be based on function, not institution.). The function of a security is to raise capital with a marketable instrument that can be bought and sold by third parties at mutually agreed upon prices.
So with a lot of squinting, you can say that both securities and staking mechanism involve “the efforts of others,” but to effect completely different purposes and functions. The fundamental difference in function/purpose means that even if they have something in common, they are totally different and the regulatory framework for one is totally inappropriate to the regulation of the other.
This illustrates an issue that I often come across in my work on commodities, securities, and antitrust litigation: the common confusion of sufficient and necessary conditions. Arguably profiting from the efforts of others could be a necessary condition to be considered a security. It is not, however, a sufficient condition–as Gensler is essentially advocating.
But what’s logic when there’s a regulatory empire to build, right?
I’m also at a loss to explain how Gensler could think that proof of stake involves the “efforts” (i.e., work) of others, but proof of, you know, work doesn’t.
Gensler’s “logic” would probably even embarrass Sir Bedevere:
“What also floats in water?” “A security!”
Gensler might have more of a leg to stand on when it comes to tokens. But with Bitcoin, Ether, and other similar things, hammering the crypto peg into the securities law hole is idiotic.
But never let logic stand in the way of Gary’s pursuit of his precious:
Clearing of course has always been a mania of Gary’s. His deep affection for me no doubt dates from my extensive writing on his Ahab-like pursuit of clearing mandates in derivatives more than a decade ago. Clearing is Gensler’s hammer, and he sees in every financial problem a nail to be driven.
The problem at issue here is the periodic episodes of large price moves and illiquidity in the Treasury market in recent years, most notably in March 2020 (the subject of a JACF article by me).
Clearing is a mechanism to mitigate counterparty credit risk. There is no evidence, nor reasonable basis to believe, that counterparty credit risk precipitated these episodes, or that these episodes (whatever their cause) raised the risk of a chain reaction via a counterparty credit risk channel in cash Treasuries.
Moreover, as I have said ad nauseum, clearing and the associated margining mechanism is a major potential source of financial instability.
Indeed, as I point out in the JACF article, clearing and margin in Treasury futures and other fixed income securities markets is what threatened to turn the price (and basis) movement sparked by Covid (and policy responses to Covid) into a systemic event that required Fed intervention to prevent.
I note that as I discussed at the time, margining also contributed greatly to the instability surrounding the GameStop fiasco.
Meaning that in the name of promoting financial market stability Gensler and the SEC (the vote on the proposal was unanimous) are in fact expanding the use of the very mechanism that exacerbated the problem they are allegedly addressing.
Like the Bourbons, Gensler has learned nothing, and forgotten nothing. He has not forgotten his misbegotten notions of the consequences of clearing, and hasn’t learned what the real consequences are.
As Gideon John Tucker said famously 156 years ago: “No man’s life, liberty or property are safe while the Legislature is in session.” Nor are they when Gary Gensler heads a regulatory agency.
HC Group were kind enough to include me in their HC Insider podcast. Paul Chapman and I discussed systemic risk issues in commodity markets, which is a hot topic these days given the tumult in commodities since last fall. Central banks and regulators are paying closer attention to commodities now than they ever have.
Here’s a link to the Podcast. As you can see from the categories, we covered a lot of ground. Hope you find it informative.
This raises an issue that I have written about for going on 15 years–the “tight coupling” of the clearing mechanism, and the acute destabilizing potential thereof. Tightly coupled systems are subject to”normal accidents” (also known as systemic collapses–shitshows): in a tightly coupled system, everything must operate in a tight sequence, and the failure of one piece of the system can cause the collapse of the entire system.
If ICE had acted in a mechanical fashion, and declared a default, the default of a large member could have caused the failure of ICE clearing, which would have had serious consequences for the entire financial system, especially in its COVID-induced febrile state. But ICE had people in the loop, which loosened the coupling and prevented a “normal accident” (i.e., the failure of ICE clearing and perhaps the financial system).
I have a sneaking suspicion that the exact same thing happened with LME during the nickel cluster almost exactly two years after the ICE situation. It is evident that LME uncoupled the entire system–by shutting down trading altogether, apparently suspending some margin calls, and even tearing up trades.
Put differently, it’s a good thing that important elements of the financial system have ways of loosening the coupling when by-the-book (or by-the algorithm) operation would lead to its destruction.
The ICE event was apparently a “technical issue.” Well that’s exactly the point–failures of technology can lead to the collapse of tightly coupled systems. And these failures are ubiquitous: remember the failures of FedWire on 19 October, 1987, which caused huge problems. (Well, you’re probably not old enough to remember. That’s why you need me.)
This issue came up during the FTX roundtable precisely because FTX (and its fanboyz) tout its algorithmic, no-man-in-the-loop operation as its innovation, and its virtue. But that gets it exactly backwards: it is its greatest vulnerability, and its greatest threat to the financial markets more generally. We should be thankful ICE had adults, not algos, in charge.
The mechanical means of addressing margin shortfalls on a real time frequency increases the tight coupling on the exchange, and is tailor made to create destabilizing positive feedback loops: prices move a lot leading to margin shortfalls in real time that trigger real time trades that accentuate the price movement. It is like seeding the market with huge numbers of stop orders, which are inherently destabilizing. Further, they can create incentives to manipulate. Anyone who can get some idea of where the stops are can “gun the stops” and trigger big price moves.
In the face of the agricultural industry complaints, Bankman-Fried gave ground. While maintaining his position that automated liquidations could prevent bad situations from growing worse, he said the FTX approach was better suited to “digitally settled” contracts — such as those for crypto — than to trades where physical collateral such as wheat or corn is used
Sorry, Sam, but digital settlement vs. physical settlement matters fuck all. (And “physical collateral”? Wut?) And you are deluded if you believe that “automated liquidations” generally prevent bad situations from growing worse. If you think that, you don’t get it, and are a positive threat to the financial markets.
The LME restarted trading of nickel. Well, sort of. In the first five sessions prices were limit down, and trading stopped as soon as the limits were hit. The LME deemed two subsequent sessions “disrupted” and declared the trades in these sessions “null and void.”
In other words: more mulligans after the trade cancellations that followed the spike to $100K/tonne prices. The LME should change its name to the London Mulligan Exchange. Which is not a good look.
Departing LME CEO Matthew Chamberlain tried to shift blame last week, claiming that the problem was that the exchange did not have visibility into risk due to the fact that approximately 80 percent of Tsingshan’s nickel position was in the form of OTC trades with big banks, such as JP Morgan. This is weak excuse. It is highly likely that the banks hedged their Tsingshan exposure on the LME, so the exchange saw the positions, but just didn’t know for sure exactly who was behind them. But the LME has known for months (years actually) that Tsingshan was the elephant in the nickel ring, and that the banks who were short the LME were almost certainly hedging an OTC exposure. The LME should have been able to add two and two.
The price increases today and in the previous session suggest that the short covering is ongoing, and that the “I’m going to hang on to my position” rhetoric from Tsingshan, and the insinuations that the banks were allowing it to extend and pretend, are therefore not correct. It (and perhaps other shorts) are trying to reduce positions. Continued gyrations are therefore likely, and a default that would make recent “disruptions” look like child’s play is not out of the question. The fear of this is likely what is causing the LME to take actions (voiding trades) that only further blacken its already dusky reputation. To a fox caught in a trap, chewing off a leg is the best option.
