Streetwise Professor

June 9, 2021

GiGi’s Back!: plus ça change, plus c’est la même chose

Filed under: Clearing,Economics,Exchanges,HFT,Regulation — cpirrong @ 2:45 pm

One of the few compensations I get from a Biden administration is that I have an opportunity to kick around Gary Gensler–“GiGi” to those in the know–again. Apparently feeling his way in his first few months as Chairman of the SEC, Gensler has been relatively quiet, but today he unburdened himself with deep thoughts about stock market structure. If you didn’t notice, “deep” was sarcasm. His opinions are actually trite and shallow, and betray a failure to ask penetrating questions. Plus ça change, plus c’est la même chose.

Not that he doesn’t have questions. About payment for order flow (“PFOF”) for instance:

Payment for order flow raises a number of important questions. Do broker-dealers have inherent conflicts of interest? If so, are customers getting best execution in the context of that conflict? Are broker-dealers incentivized to encourage customers to trade more frequently than is in those customers’ best interest?

But he misses the big question: why is payment for order flow such a big deal in the first place?

Relatedly, Gensler expresses concern about what traders do in the dark:

First, as evidenced in January, nearly half of the trading interest in the equity market either is in dark pools or is internalized by wholesalers. Dark pools and wholesalers are not reflected in the NBBO. Moreover, the NBBO is also only as good as the market itself. Thus, under the segmentation of the current market, nearly half of trading along with a significant portion of retail market orders happens away from the lit markets. I believe this may affect the width of the bid-ask spread.

Which begs the question: why is “nearly half of the trading interest in the equity market either is in dark pools or is internalized by wholesalers”?

Until you answer these big questions, studying the ancillary ones like his regarding PFOF an NBBO is a waste of time.

The economics are actually very straightforward. In competitive markets, customers who impose different costs on suppliers will pay different prices. This is “price discrimination” of a sort, but not price discrimination based on an exploitation of market power and differences in customer demand elasticities: it is price differentiation based on differences is cost.

Retail order flow is cheaper to intermediate than institutional order flow. Some institutional order flow is cheaper to intermediate than other such flows. Competitive pressures will find ways to ensure flows that are cheaper to intermediate pay lower prices. PFOF, dark pools, etc., are all means of segmenting order flow based on cost.

Trying to restrict cost-based price differences by banning or restricting certain practices will lead clever intermediaries to find other ways to differentiate based on cost. This has always been so, since time immemorial.

In essence, Gensler and many other critics of US market structure want to impose uniform pricing that doesn’t reflect cost differences. This would be, in essence, a massive scheme of cross subsidies. Ironically, the retail traders for whom Gensler exhibits such touching concern would actually be the losers here.

Cross subsidy schemes are inherently unstable. There are tremendous competitive pressures to circumvent them. As the history of virtually every regulated sector (e.g., transportation, communications) has demonstrated for decades, and even centuries.

From a positive political economy perspective, the appeal of such cross subsidy schemes to regulators is great. As Sam Peltzman pointed out in his amazing 1976 JLE piece “Toward a More General Theory of Regulation,” regulators systematically attempt to suppress cost-based price differences in order to redistribute rents to gain political support. The main impetus for deregulation is innovation that exploits gains from trade from circumventing cross subsidy schemes–deregulation in banking (Regulation Q) and telecoms are great examples of this.

So who would the beneficiaries of this cross-subsidization scheme be? Two major SEC constituencies–exchanges, and large institutional traders.

In other words, all this chin pulling about PFOF and dark markets is politics as usual. Furthermore, it is politics as usual in the cynical sense that the supposed beneficiaries of regulatory concern (retail traders) are the ones who will be shtupped.

Gensler also expressed dismay at the concentration in the PFOF market: yeah, he’s looking at you, Kenneth. Getting the frequency?

Although Gensler’s systemic risk concern might have some justification, he still fails to ask the foundational question: why is it concentrated? He doesn’t ask, so he doesn’t answer, instead saying: “Market concentration can deter healthy competition and limit innovation.”

Well, concentration can also be the result of healthy competition and innovation (h/t the great Harold Demsetz). Until we understand the existing concentration we can’t understand whether it’s a bug or feature, and hence what the appropriate policy response is.

Gensler implicitly analogizes say Citadel to Facebook or Google, which harvest customer data and can exploit network effects which drives concentration. The analogy seems very strained here. Retail order flow is cheap to service because it is uninformed. Citadel (or other purchasers of order flow) isn’t learning something about consumers that it can use to target ads at them or the like. The main thing it is learning is what sources of order flow are uninformed, and which are informed–so it can avoid paying to service the latter.

Again, before plunging ahead, it’s best to understand what are the potential agglomeration economies of servicing order flow.

Gensler returns to one of his favorite subjects–clearing–at the end of his talk. He advocates reducing settlement time from T+2: “I believe shortening the standard settlement cycle could reduce costs and risks in our markets.”

This is a conventional–and superficial–view that suggests that when it comes to clearing, Gensler is like the Bourbons: he’s learned nothing, and forgotten nothing.

As I wrote at the peak of the GameStop frenzy (which may repeat with AMC or some other meme stock), shortening the settlement cycle involves serious trade-offs. Moreover, it is by no means clear that it would reduce costs or reduce risks. The main impact would be to shift costs, and transform risks in ways that are not necessarily beneficial. Again, shortening the settlement cycle involves a substitution of liquidity risk for credit risk–just as central clearing does generally, a point which Gensler was clueless about in 2010 and is evidently equally clueless about a decade later.

So GiGi hasn’t really changed. He is sill offering nostrums based on superficial diagnoses. He fails to ask the most fundamental questions–the Chesterton’s Fence questions. That is, understand why things are they way they are before proposing to change them.

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February 22, 2021

GameStop: Round Up the Usual Suspects

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — cpirrong @ 7:52 pm

Shuttling between FUBARs, it’s back to GameStop!

Last week there were House hearings regarding the GameStock saga. As is usual with these things, they were more a melange of rampant narcissism and political posing and outright stupidity than a source of information. Everyone had an opportunity to identify and then flog their favorite villains and push their favorite “solutions.” All in all, very few constructive observations or remedies came out of the exercise. I’m sure you’re shocked.

Here are a few of the main issues that came up.

Shortening the securities settlement cycle. The proximate cause of Robinhood’s distress was a huge margin call. Market participants post margins to mitigate the credit risk inherent in a two day settlement cycle. Therefore, to reduce margins and big margin calls, let’s reduce the settlement cycle! Problem solved!

No, problem moved. Going to T+0 settlement would require buyers to stump up the cash and sellers to secure the stock on the same day of the transaction. Almost certainly, this wouldn’t result in a reduction of credit in the system, but just cause buyers to borrow money to meet their payment obligations. Presumably the lenders would not extend credit on an unsecured basis, but would require collateral with haircuts, where the haircuts will vary with risk: bigger haircuts would require the buyers to put up more of their own cash.

I would predict that to a first approximation the amount of credit risk and the amount of cash buyers would have to stump up would be pretty much the same as in the current system. That is, market participants would try to replicate the economic substance of the way the market works now, but use different contracting arrangements to obtain this result.

I note that when the payments system went to real time gross settlement to reduce the credit risk participants faced through the netting mechanism with daily settlement, central banks stepped in to offer credit to keep the system working.

It’s also interesting to note that what DTCC did with GameStop is essentially move to T+0 settlement by requiring buyers to post margin equal to the purchase price:

Robinhood made “optimistic assumptions,” Admati said, and on Jan. 28, Tenev woke up at 3:30 a.m. and faced a public crisis. With a demand from a clearinghouse to deposit money as a safety measure hedging against risky trades, he had to get $1 billion from investors. Normally, Robinhood only has to put up $2 for every $100 to vouch for their clients, but now, the whole $100 was required. Thus, trading had to be slowed down until the money could be collected.

That is, T+0 settlement is more liquidity/cash intensive. As a result, a movement to such a system would lead to different credit arrangements to provide the liquidity.

As always, you have to look at how market participants will respond to proposed changes. If you require them to pay cash sooner by changing the settlement cycle, you have to ask: where is the cash going to come from? The likely answer: the credit extended through the clearing system will be replaced with some other form of credit. And this form is not necessarily preferable to the current form.

Payment for order flow (“PFOF”). There is widespread suspicion of payment for order flow. Since Robinhood is a major seller of order flow, and since Citadel is a major buyer, there have been allegations that this practice is implicated in the fiasco:

Reddit users questioned whether Citadel used its power as the largest market maker in the U.S. equities market to pressure Robinhood to limit trading for the benefit of other hedge funds. The theory, which both Robinhood and Citadel criticized as a conspiracy, is that Citadel Securities gave deference to short sellers over retail investors to help short sellers stop the bleeding. The market maker also drew scrutiny because Citadel, the hedge fund, together with its partners, invested $2 billion into Melvin Capital Management, which had taken a short position in GameStop.

To summarize the argument, Citadel buys order flow from Robinhood, Citadel wanted to help out its hedge fund bros, something, something, something, so PFOF is to blame. Association masquerading as causation at its worst.

PFOF exists because when some types of customers are cheaper to service than others, competitive forces will lead to the design of contracting and pricing mechanisms under which the low cost customers pay lower prices than the high cost customers.

In stock trading, uninformed traders (and going out on a limb here, but I’m guessing many Robinhood clients are uninformed!) are cheaper to intermediate than better informed traders. Specifically, market makers incur lower adverse selection costs in dealing with the uninformed. PFOF effectively charges lower spreads for executing uninformed orders.

This makes order flow on lit exchange markets more “toxic” (i.e., it has a higher proportion of informed order flow because some of the uninformed flow has been siphoned off), so spreads on those markets go up.

And I think this is what really drives the hostility to PFOF. The smarter order flow that has to trade on lit markets doesn’t like the two tiered pricing structure. They would prefer order flow be forced onto lit markets (by restricting PFOF). This would cause the uninformed order flow to cross subsidize the more informed order flow.

The segmentation of order flow may make prices on lit markets less informative. Although the default response among finance academics is to argue that more informative is better, this is not generally correct. The social benefit of more accurate prices (e.g., does that lead to better investment decisions) have not been quantified. Moreover, informed trading (except perhaps, ironically, for true insider trading) involves the use of real resources (on research, and the like). Much of the profit of informed trading is a transfer from the uninformed, and to the extent it is, it is a form of rent seeking. So the social ills of less informative prices arising from the segmentation of order flow are not clearcut: less investment into information may actually be a social benefit.

There is a question of how much of the benefit of PFOF gets passed on to retail traders, and how much the broker pockets. Given the competitiveness of the brokerage market–especially due to the entry of the likes of Robinhood–it is likely a large portion gets passed on to the ultimate customer.

In sum, don’t pose as a defender of the little guy when attacking PFOF. They are the beneficiaries. Those attacking PFOF are actually doing the bidding of large sophisticated and likely better informed investors.

HFT. This one I really don’t get. There is HFT in the stock market. Something bad happened in the stock market. Therefore, HFT caused the bad thing to happen.

The Underpants Gnomes would be proud. I have not seen a remotely plausible causal chain linking HFT to Robinhood’s travails, or the sequence of events that led up to them.

But politicians gonna politician, so we can’t expect high order logical thinking. The disturbing thing is that the high order illogical thinking might actually result in policy changes.

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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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January 29, 2021

GameStop-ped Up Robinhood’s Plumbing

The vertigo inducing story of GameStop ramped it up to 11 yesterday, with a furore over Robinhood’s restriction of trading in GME to liquidation only, and the news that it had sold out of its customers’ positions without the customers’ permission. These actions are widely perceived as an anti-populist capitulation to Big Finance.

Well, they are in a way–but NOT the way that is being widely portrayed. What is going on is an illustration of the old adage that clearing and settlement in securities markets (like the derivatives markets) is like the plumbing–you take it for granted until the toilet backs up.

You can piece together that Robinhood was dealing with a plumbing problem from a couple of stories. Most notably, it drew down on credit lines and tapped some of its big executing firms (e.g., Citadel) for cash. Why would it need cash? Because it needs to post margin to the Depositary Trust Clearing Corporation (DTCC) on its open positions. Other firms are in similar situations, and directly or indirectly GME positions give rise to margin obligations to the DTCC.

The rise in price alone increased margin requirements because given volatility, the higher the price of a stock, the larger the dollar amount of potential loss (e.g., the VaR) that can occur prior to settlement. This alone jacks up margins. Moreover, the increase in GME volatility, and various adders to margin requirements–most notably for gap risk and portfolio concentration–ramp up margins even more. So the action in GME has led to a big increase in margin requirements, and a commensurate need for cash. Robinhood, as the primary venue for GME buyers, had/has a particularly severe position concentration/gap problem. Hence Robinhood’s scramble for liquidity.

Given these circumstances, liquidity was obviously a constraint for Robinhood. Given this constraint, it could not handle additional positions, especially in GME or other names that create particularly acute margin/liquidity demands. It was already hitting a hard constraint. The only practical way that Robinhood (and perhaps other retail brokers, like TDAmeritrade) could respond in the short run was trading for liquidation only, i.e., allow customers to sell their existing GME positions, and not add to them.

By the way, trading for liquidation is a tool in the emergency action toolbook that futures exchanges have used from time-to-time to deal with similar situation.

To extend the plumbing analogy, Robinhood couldn’t add any new houses to its development because the sewer system couldn’t handle the load.

I remember some guy saying that clearing turns credit risk into liquidity risk. (Who was that guy? Pretty observant!) For that’s exactly what we are seeing here. In times of market dislocation in particular, clearing, which is intended to mitigate credit risk, creates big increases in demand for liquidity. Those increases can cause numerous knock on effects, including dislocations in markets totally unrelated to the original source of the dislocation, and financial distress at intermediaries. We are seeing both today.

It is particularly rich to see the outrage at Robinhood and other intermediaries expressed today by those who were ardent advocates of clearing as the key to restoring and preserving financial stability in the aftermath of the Financial Crisis. Er, I hate to say I told you so, but I told you so. It’s baked into the way clearing works, and in particular the way that clearing works in stressed market conditions. It doesn’t eliminate those stresses, but transfers them elsewhere in the financial system. Surprise!

The sick irony is that clearing was advocated as a means to tame big financial institutions, the banks in particular, and reduce the risks that they can impose on the financial system. So yes, in a very real sense in the GME drama we are seeing the system operate to protect Big Finance–but it’s doing so in exactly the way many of those screaming loudest today demanded 10 years ago. Exactly.

Another illustration of one of my adages to live by: be very careful what you ask for.

Margins are almost certainly behind Robinhood’s liquidating some customer accounts. If those accounts become undermargined, Robinhood (and indeed any broker) has the right to liquidate positions. It’s not even in the fine print. It’s on the website:

If you get a margin call, you need to bring your portfolio value (minus any cryptocurrency positions) back up to your minimum margin maintenance requirement, or you risk Robinhood having to liquidate your position(s) to bring your portfolio value (minus any cryptocurrency positions) back above your margin maintenance requirement.

Another Upside Down World aspect of the outrage we are seeing is the stirring defenses of speculation (some kinds of speculation by some people, anyways) by those in politics and on opinion pages who usually decry speculation as a great evil. Those who once bewailed bubbles now cheer for them. It’s also interesting to see the demonization of short sellers–whom those with average memories will remember were lionized (e.g., “The Big Short”) for blowing the whistle on the housing boom and the bank-created and -marketed derivative products that it spawned.

There are a lot of economic issues to sort through in the midst of the GME frenzy. There will be in the aftermath. Unfortunately, and perhaps not surprisingly given the times, virtually everything in the debate has been framed in political terms. Politics is all about distributive effects–helping my friends and hurting my enemies. It’s hard, but as an economist I try to focus on the efficiency effects first, and lay out the distributive consequences of various actions that improve efficiency.

What are the costs and benefits of short selling? Should the legal and regulatory system take a totally hands off approach even when prices are manifestly distorted? What are the costs and benefits of various responses to such manifest price distortions? What are the potential unintended consequences of various policy responses (clearing being a great example)? These are hard questions to answer, and answering them is even harder in the midst of a white-hot us vs. them political debate. And I can say with metaphysical certainty that 99 percent of the opinions I have seen expressed about these issues in recent days are steeped in ignorance and fueled by emotion.

There are definitely major problems–efficiency problems–with Big Finance and the regulation thereof. Ironically, many of these efficiency problems are the result of previous attempts to “solve” perceived problems. But that does not imply that every action taken to epater les banquiers (or frapper les financiers) will result in efficiency gains, or even benefit those (often with justification) aggrieved at the bankers. I thus fear that the policy response to GameStop will make things worse, not better.

It’s not as if this is new territory. I am reminded of 19th century farmers’ discontent with banks, railroads, and futures trading. There was a lot of merit in some of these criticisms, but all too often the proposed policies were directed at chimerical wrongs, and missed altogether the real problems. The post-1929 Crash/Great Depression regulatory surge was similarly flawed.

And alas, I think that we are doomed to repeat this learning the wrong lessons in the aftermath of GameStop and the attendant plumbing problems. Virtually everything I see in the public debate today reinforces that conviction.

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October 22, 2020

VOLT Redux

Filed under: Clearing,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 6:44 pm

The very first substantive post on this blog, almost 15 years ago, was about a failure of the electronic trading system at the Tokyo Stock Exchange.

Whoops, they did it again!

Apparently believing that misery loves company, Euronext has also experienced failures.

Euronext’s problems seem quite more frightening, because they involve the out-trade from hell: reversing the polarity on transactions:

“It has been identified that some of the 19/10 trades sent yesterday to the CCPs (central counterparty clearing house) had the wrong buy/sell direction”, Euronext said.

Thought you were long? Hahahahahaha. You’re short, sucker!

I hate it when that happens! (Yes, Euronext reversed the trades after it realized the problem.)

The lessons of my “Value of Lost Trade” (“VOLT”) piece still hold. It is inefficiently costly to drive the probability of a failure to zero. Whether exchanges have the efficient probability of failure (or really, the efficient vector of failure probabilities, because there are multiply types of failure) depends on the value of foregone trades when a system is down (or the cost of other types of errors, such as reversing trade direction).

Meaning that system failures will continue to occur, and long after this blog fades away.

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April 21, 2020

WTI-WTF? Part II (of How Many???)

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Regulation — cpirrong @ 2:23 pm

Just another day at the Globex, folks. May WTI up a mere $49.88 on its last trading day at the time I write this paragraph, a while before the close. (Sorry, can’t calculate a percentage change . . . because the base number is negative!) That’s just sick. But at least it’s positive! ($12.25. No, $9.96. No . . .) (This reminds me of a story from Black Monday. My firm did a little index arb. We called the floor to get a price quote on the 19th. Our floor guy said “On this part of the pit it’s X. Over there it’s X+50. Over there it’s X-20. I have no fucking idea what the fucking price is.”)

But June has been crushed–down $7.35 (about 35 percent). Now the May-June spread is a mere $.83 contango. That makes as little sense as yesterday’s settling galactic contango (galactango!) of $57.06. (Note that June-July is trading at at $7.71 and July-August at $2.65.

I’m guessing that dynamic circuit breakers are impeding price movements, meaning that the prices we see are not necessarily market clearing prices at that instant.

A few follow-ons to yesterday’s post.

First, the modeling of the dynamics of a contract as it approaches expiration when the delivery supply/demand curve is inelastic, and some traders might have positions large enough to exploit those conditions to exercise market power, is extremely complicated. The only examples I am aware of are Cooper and Donaldson in the JFQA almost 30 years ago, and my paper in the Journal of Alternative Investments almost a decade ago.

Futures markets are (shockingly!) forward looking. Expectations and beliefs matter. There are coordination problems. If I believe everyone else on my side of the market is going to liquidate prior to expiration, I realize that the party on the other side of the contract will have no market power at expiration. So I should defer liquidating–which if everyone reasons the same way could lead to everyone getting caught in a long or sort manipulation at expiration. Or, if I believe everyone is going to stick it out to the end, I should get out earlier (which if everybody else does the same results in a stampede for the exits.)

In these situations, anything can happen, and the process of coordinating expectations and actions is likely to be chaotic. Cooper-Donaldson and Pirrong lay out some plausible stories (based on particular specifications of beliefs and the trading mechanism), but they are not the only stories. They mainly serve to highlight how game theoretic considerations can lead to very complex outcomes in situations with market power and inelasticity.

One thing that is sure is that these game theoretic considerations don’t matter much if the elasticities of delivery supply and demand are large. Then no individual can distort prices very much by delivering too much or taking delivery of too much. Then the coordination and expectations problems aren’t so relevant. However, when delivery supply or demand curves are very steep–as is the case in Cushing now due to the storage constraint–they become extremely relevant.

Perhaps one analogy is getting out of a theater. When there are many exits, there won’t be queues to get out and little chance of tragedy even if someone yells “fire.” If there is only one exit, however, hurried attempts of everyone to leave at once can lead to catastrophe. Moreover, perverse crowd dynamics occur in such situations. That’s where we were yesterday.

About 90 percent of open interest liquidated yesterday. That is why today is returning to some semblance of normality–the exit isn’t so crowded (because so many got trampled yesterday). But that begs the question of why the panicked rush yesterday? That’s where the game theoretic “anything could happen” answer is about the best we can do.

About that storage constraint. My post yesterday focused on someone with a large short futures position raising the specter of excessive deliveries by not liquidating that position, thereby triggering a cascade of descending offers until the short graciously accepted at a highly profitable price.

But there is another market power play possible here. A firm controlling storage could crash prices (and spreads) by withholding that capacity from the market. The most recent data from the EIA indicates about 55 mm bbl of oil storage at Cushing. That’s about 80 percent of nameplate capacity (also per EIA.). Due to operational constraints (e.g., need working space to move barrels in and out; can’t mix different grades in the same tank) that’s probably effectively full. Therefore, someone with ownership of a modest amount of space could withhold it drive up the spread. If that party had on a bull spread position . . .

Third, we are into Round Up the Usual Suspects mode:

And first in line is the US Oil ETF. There has been a lot of idiotic commentary about this. They were forced to take delivery! (Er, delivery notices aren’t possible before trading ends.) They were forced to dump huge numbers of contracts yesterday! (Er, they publish a regular roll schedule, and were out of the May a week before yesterday’s holocaust. They also report positions daily, and as of yesterday were 100 pct in the June.)

Not to say that USO can be implicated in hinky things going on in the June right now, but as for May–that dog don’t hunt.

Fourth–WTF, June WTI? Well, my best explanation is that the carnage in the May served to concentrate minds regarding June. No doubt risk managers, or risk systems, forced some longs out as the measured and perceived risk for June shot up yesterday. Others just decided that discretion was the better part of valor. The extremely unsettled positions no doubt impaired liquidity (i.e., just as some wanted to get out, others were constrained by risk limits formal or informal from getting in), leading to big price movements in response to these flows. If that’s a correct diagnosis, we should see something of a bounceback, but perhaps not too much given the perception (and reality) of an extremely asymmetric risk profile, with going into expiry short being a lot more dangerous than going into it long. (This is why expectations about future conditions at delivery can impact prices well before delivery.)

Fifth, on a personal note, in an illustration of the adage that the apple doesn’t fall far from the tree (and also of Merton’s Law of Multiples) my elder daughter Renee completely independently of me used “WTI WTF” in her daily market commentary yesterday. I’m so proud! She also raised the possibility of negative prices some time ago. Good call!

And I finish this just in time to bring you the final results. CLK goes off the board settling at $10.01, up a mere $47.64. CLM settles at $11.57, down -$8.86. The closing KM20 spread, $1.56.

Someday we’ll look back on this and . . . . Well, we’ll look back on it, anyways.

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March 24, 2020

It Really Does Pain Me to Say I Told You So About Clearing, But . . .

In the aftermath of the last crisis, I played the role of Clearing Cassandra, warning that in the next crisis, supersizing of derivatives clearing would create systemic risks not because clearinghouses would fail, but because of the consequences of what they would do to survive: hike initial margins and collect huge variation margin payments that would suck liquidity out of the system at the same time liquidity supply contracted. This, in turn, would lead to asset fire sales, that would distort asset prices which would lead to further knock-on effects.

I wrote a lot about this 2008-2012, but here is a convenient link. Key quote from the abstract:

The author also believes that the larger collateral mandates and frequent marking‐to‐market will make the financial system more vulnerable since margin requirements tend to be “pro‐cyclical.” And more rigid collateralization mechanisms can restrict the supply of funding liquidity, and lead to spikes in funding liquidity demand that can reduce the liquidity of traded instruments and generate destabilizing feedback loops. 

Well, the next crisis is here, and these (conditional) predictions are being borne out. In spades.

Here’s what I wrote a few days ago as a contribution to the Regulatory Fundamentals Group newsletter:

In the aftermath of the last crisis of 2008-2009, G20 nations decided to mandate clearing of standardized OTC derivatives transactions.  The current coronavirus crisis is the first since those reforms were implemented (via Dodd-Frank in the US, for example), and this therefore gives the first opportunity to evaluate the performance of the supersized clearing ecosystem in “wartime” conditions.  


So far, despite the extreme price movements across the entire derivatives universe–equities, fixed income, currencies, and commodities (especially oil)–there have been no indications that clearinghouses have faced either financial or operational disruption.  No clearing members have defaulted, and as of now, there have been no serious concerns than any are on the verge of default. 

That said, there are two major reasons for concern.


First, the unprecedented volatility and uncertainty show no signs of dissipating, and as long as it continues, major financial institutions–including clearing firms–are at risk.  The present crisis did not originate in the banking/shadow banking sector (as the previous one did), but it is now demonstrably affecting it.  There are strong indicators of stress in the financial system, such as the blowouts in FRA-OIS spreads and dollar swap rates (both harbingers of the last crisis).  Central banks have intervened aggressively, but these worrying signs have eased only slightly.  

Second, as I wrote repeatedly during the debate over clearing mandates in the post-2008 crisis period, the most insidious systemic risk that supersized clearing creates is not the potential for the failure of a clearinghouse (triggered by the failure of one or more clearing members).  Instead, the biggest clearing-related systemic risk is that the very measures that clearinghouses take to ensure their integrity–specifically, frequent variation margining/marking-to-market–lead to large increases in the demand for liquidity precisely during circumstances when liquidity is evaporating.  Margin payments during the past several weeks have hit unprecedented–and indeed, previously unimaginable–levels.  The need to fund these payments has inevitably increased the demand for liquidity, and contributed to the extraordinary demand for liquidity and the concomitant indicators stressed liquidity conditions (e.g., the spreads and extraordinary central bank actions mentioned earlier).  It is impossible to quantify this impact at present, but it is plausibly large.  

In sum, the post-2008 Crisis clearing system is operating as designed during the 2020 Crisis, but it is unclear whether that is a feature, or a bug.  

It is becoming more clear: Bug, and the bugs are breeding. There have been multiple stories over the last couple of days of margin calls on hedging positions causing fire sales, with attendant price dislocations in markets like for mortgages. Like here, here, and here. I guarantee there are more than have been reported, and there will be still more. Indeed, I bet if you look at any pricing anomaly, it has been created by, or exacerbated by, margin calls. (Look at the muni market, for instance.)

But those in charge still don’t get it. CFTC chairman Heath Tarbert delivers happy talk in the WSJ, claiming that everything is hunky dory because all them margins bein’ paid! and as a result, derivatives markets are functioning, CCPs aren’t failing, etc.

This is exactly the kind of non-systemic thinking about systemic risk that I railed about a decade ago. Mr. Tarbert has a siloed view: he is assigned some authority over a subset of the financial system, sees that it is working fine, and concludes that rules regarding that subset are beneficial for the system as a whole.

Wrong. Wrong. Wrong. Wrong. WRONG.

You have to look at the system as a whole, and how the pieces of the system interact.

In the post-last-crisis period I wrote about the “Levee Effect”, namely, that measures designed to protect one part of the financial system would flood others, with ambiguous (at best) systemic consequences. The cascading margins and the effects of those margin calls are exactly what I warned about (to the accompaniment a collective shrug by those who mattered, which is why we are where we are).

What we are seeing is unintended consequences–unintended, but not unforeseeable.

Speaking of unintended consequences, perhaps one good effect of September’s repo market seizure was that it awoke the Fed to its actual job–providing liquidity in times of stress. The facilities put in place in the aftermath of the September SNAFU are being expanded–by orders of magnitude–to deal with the current spike in liquidity demand (including the part of the spike due to margin issues). Thank God the Fed didn’t have to think this up on the fly.

It also appears that either (a) the restrictions on the Fed imposed by Frankendodd are not operative now, or (b) the Fed is saying IDGAF so sue me and blowing through them. Either way, such liquidity seizure are what the Fed was created to address.

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March 13, 2020

Wuhan Virus and the Markets–WTF?

What a helluva few weeks it’s been, eh boys and girls? By way of post mortem (hopefully?) rather than prediction, here’s my take.

Under “normal” circumstances, two factors drive asset valuations: expectations of cash flows, and the rate at which investors discount those cash flows. COVID-19–Wuhan Virus, to call it by its proper name–has has profound influence on both.

WV has caused a major aggregate supply shock, and an aggregate demand shock, and these amplify one another. The aggregate supply shock stems from shutdown of productive capacity due to social distancing. And people who aren’t working aren’t earning and aren’t spending, hence the aggregate demand shock.

These developments obviously reduce the income streams from assets (e.g., corporate profits). That’s a negative for stocks.

As an aside, these factors defy traditional policy prescriptions. Monetary and fiscal policy are focused on addressing aggregate demand deficiencies, i.e., trying to move demand-deficient economies (where demand deficiencies arise from price rigidity and nominal shocks) back to the production possibilities frontier. Supply shocks shrink the PPF. Pushing the PPF back to its normal state in current circumstances is a function of public health policy, and even that is likely to be problematic given the huge uncertainties (that I discuss below) and the dubious competence of government authorities (which I discussed last week).

The pandemic nature of WV also makes it the systematic shock par excellence. It hits everyone and every asset class, and cannot be diversified away. A big increase in systematic risk results in a big increase in risk premia, meaning that the already depressed expected cash flows on risky assets get discounted at a higher rate, leading to lower valuations.

A lot higher rate, evidently. Why? Most likely because of the extreme uncertainty about the virus. Data on how infectious it is, how many people have been infected, the fatality rate, how it will be affected by warmer weather, etc., are extremely unreliable. In other words, we know almost nothing about the salient considerations.

This is in part due to lack of testing, and to inherent defects in the testing: those who get tested are disproportionately likely to be symptomatic, exposed, or hypochondriacal, leading to extreme sample selection biases. The tests are apparently unreliable, with high rates of false positives and false negatives. The RNA tests cannot detect past infections. It is in part due to the novelty of the virus. Is it like influenza, and will hence burn out when temperatures warm? Or not?

Another major source of uncertainty is due to the fact that the initial outbreak in China was covered up by the evil CCP regime. (Which now, in an Orwellian twistedness that only totalitarian regimes can muster, is boasting that it will save the world. And which is blaming the United States for its own abject failures. Which is why I insist on calling it the Wuhan Virus–so go ahead, call me a racist. IDGAF.) Thus, data from Ground Zero is lacking, or wildly unreliable. (Ground One–Iran–is equally duplicitous, and equally malign.)

This huge uncertainty regarding a major systematic factor leads to even greater discount rates–and hence to lower stock prices.

And then there is the truly disturbing factor. These textbook causal channels (lower expected cash flows, higher discount rates) have in turn caused changes in asset prices that force portfolio adjustments that move us into the realm of positive feedback mechanisms (which usually have negative effects!) and non-linearities. This represents a shift from “normal” times to decidedly abnormal ones.

When some investors engage in leveraged trading strategies, big price moves can force them to unwind/liquidate these strategies because they can no longer fund their large losses. These unwinds move asset prices yet more (as those who placed a lower valuation on these assets must absorb them from the levered, high-value owners who are forced to sell them). Which can force further unwinds, in perhaps completely unrelated assets.

Not knowing the extent or nature of these trading strategies, or the degree of leverage, it is virtually impossible to understand how these effects may cascade through the markets.

The most evident indicators of these stresses are in the funding markets. And we are seeing such stresses. The FRA-OIS spread (known in a previous incarnation–e.g., 2008–as the LIBOR-OIS spread) has blown out. Dollar swap rates are blowing out. The most vanilla of spreads–the basis net of carry between Treasury futures and the cheapest-to-deliver Treasury–have blown out. Further, the Fed has pumped in huge amounts liquidity into the system, and these alarming spread movements have not reversed. (One shudders to think they would have been worse absent such intervention.)

One thing to keep an eye on is derivatives clearing. As I warned repeatedly during the drive to mandate clearing, the true test of this mechanism is during periods of market disruption when large price moves trigger large margin calls.

Heretofore the clearing system seems to have operated without disruption. I note, however, that the strains in the funding markets likely reflect in part the need for liquidity to make margin calls. Big margin calls that must be met in near real-time contribute to stresses in the funding markets. Clearinghouses themselves may survive, but at the cost of imposing huge costs elsewhere in the financial system. (In my earlier writing on the systemic impacts of clearing mandates, I referred to this as the Levee Effect.)

The totally unnecessary side-show in the oil markets, where Putin and Mohammed bin Salman are waging an insane grudge match, is only contributing to these margin call-related strains. (Noticing a theme here? Authoritarian governments obsessed with control and “stability” have a preternatural disposition to creating chaos.)

Perhaps the only saving grace now, as opposed to 2008, is that the shock did not arise originally from the credit and liquidity supply sector, i.e., banks and shadow banks. But the credit/liquidity supply sector is clearly under strain, and if parts of it break under that strain yet another round of extremely disruptive knock-on effects will occur. Fortunately, this is one area where central banks can palliate, if not eliminate, the strains. (I say can, because being run by humans, there is no guarantee they will.)

Viruses operate according to their own imperatives, and the imperatives of one virus can differ dramatically from those of others. Pandemic shocks are inherently systematic risks, and the nature of the current risk is only dimly understood because we do not understand the imperatives of this particular virus. Indeed, it might be fair to put it in the category of Knightian Uncertainty, rather than risk. The shock is big enough to trigger non-linear feedbacks, which are themselves virtually impossible to predict.

In other words. We’ve been on a helluva ride. We’re in for a helluva right. Strap it tight, folks.

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September 20, 2019

Back to the Fed Future, or You Had One Job

In the Gilded Age, American financial crises (“panics,” in the lexicon of the day) tended to occur in the fall. Agriculture played a predominant role in the economy, and marketing of the new crop in the fall led to a spike in the demand for cash and credit. In that era, however, the supply of cash and credit was not particularly elastic, and these demand spikes sometimes turned into panics when supply did not (or could not) respond accordingly.

The entire point of the Fed, which was created in the aftermath of one of these fall panics (the Panic of 1907, which occurred in October), was to make currency supply more elastic and thereby reduce the potential for panics. In essence, the Fed had one job: lender of last resort to ensure a match of supply and demand for currency/credit, when the latter was quite volatile.

This week’s repospasm is redolent of those bygone days. Now, the spikes in demand for liquidity are not driven by the crop cycle, but by the tax and corporate reporting cycles. But they recur, and several have occurred in the autumn, or on the cusp thereof (this being the last week of summer).

One of my mantras in teaching about commodities is that spreads price bottlenecks. Bottlenecks can occur in the financial markets too. The periodic spikes in repo rates–not just this week, but in December, and March–relative to other short term rates scream “bottleneck.” Many candidates have been offered, but regardless of the ultimate source of the clog in the plumbing, the evidence from the repo market is that there are indeed clogs, and they recur periodically.

The Fed’s rather belated and stumbling response suggests that it is not fully prepared to respond to these bottlenecks, despite the fact that their regularity suggests that the clogs are chronic. As the saying goes, “you had one job . . . ” and the Fed fell down on this one.

And maybe the problem is that the Fed no longer just has one job, and it has shunted the job that was the reason for its creation to the back of the priority list. Nowadays, the Fed has statutory obligations to control employment and inflation, and views its main job as managing aggregate demand, rather than tending to the financial system’s plumbing.

This is concerning, as dislocations in short-term funding markets can destabilize the system. These markets are systemically important, and failure to ensure their smooth operation can result in crises–panics–that undermine the ability of the Fed to perform its prioritized macroeconomic management task.

One of the salutary developments post-crisis has been the reduced reliance of banks and investment banks on flighty short-term funding. The repo markets are far smaller than they were pre-2008, and the unsecured interbank market has all but disappeared (representing only about .3 percent of bank assets, as compared to around 6 percent in 2006). But this is not to say that these markets are unimportant, or that bottlenecks in these markets cannot have systemic consequences. For the want of a nail . . . .

Moreover, the post-crisis restructuring of the financial system and financial regulation has created new potential sources of liquidity shocks, namely a supersizing of potential demands for liquidity to pay variation margin. When you have a market shock (e.g., the oil price shock) occurring simultaneously with the other sources of increased demand for liquidity, the bottlenecks can have very perverse consequences. We should be thankful that the shock wasn’t a Big One, like October, 1987.

Hopefully this week’s tumult will rejuvenate the Fed’s focus on mitigating bottlenecks in funding markets. Maybe the Fed doesn’t have just one job now, but this is an important job and is one that it should be able to do in a fairly routine fashion. After all, that job is what it was created to perform. So perform it.

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September 17, 2019

Funding Market Tremors: Today May Not Have Been “The Big One,” But It Was Bad Enough

The primary reason for my deep skepticism about the wisdom of clearing mandates was liquidity risk. As I said repeatedly, in order to reduce counterparty risk, clearing necessarily increased liquidity risk through the variation margining mechanism. Further, it was–and is–my opinion that liquidity risk is a far graver systemic concern that counterparty risk.

A major liquidity event has occurred in the last couple of days: rates in the repurchase market–the major source of short term funding for vast amounts of trading activity–shot up to levels (around 5 percent) nearly double the Fed’s target ceiling for that rate. Some trades took place at far higher rates than that (e.g., 9.25 percent).

Market participants have advanced several explanations, including big cash demands due to corporate tax payments coming due. Izabella Kaminska at FTAlphavile offered this provocative alternative, which resonates with my clearing story: the large price movements in oil and fixed income markets in the aftermath of the attack on the Saudi resulted in large margin calls in futures and cleared OTC markets that increased stresses on the funding markets.

To which one might say: I sure as hell hope that’s not it, because although there was a lot of price action yesterday, it wasn’t The Big One. (The fact that Fred Sanford’s palpitations occurred because he couldn’t get his hands on cash makes that bit particularly apropos!)

I did some quick back-of-the-envelope calculations. WTI and Brent variation margin flows (futures and options) were on the order of $35 billion. Treasuries on CME maybe $10 billion. S&P futures, about $1 billion. About $2 billion on Eurodollar futures.

The Eurodollar numbers can help give a rough idea of margin flows on cleared interest rate swaps. Eurodollar futures open interest is about $12 trillion. Cleared OTC notional volume (not just USD, but all IRS) is around $80 trillion. But $1mm in notional of a 5 year swap is equivalent to 20 Eurodollar futures with notional amount of $20 trillion. So, as a rough estimate, variation margin flows in the cleared IRS market are on the order of 100x for Eurodollars. That represents a non-trivial $200 billion.

Yes, there are potentials for offsets, so these numbers are not additive. For example, a firm might have offsetting positions in EDF and cleared IRS. Or be short oil and long Treasuries. But variation margin flows on the order of $300 billion are not unrealistic. And since market moves were relatively large yesterday, that represents an increment over the typical day.

So we are talking real money, which could certainly contribute to an increased demand for liquidity. But again, yesterday was not remotely a truly epic day that one could readily imagine happening.

A couple of points deserve emphasis. The first is that perhaps it was coincidence or bad luck, but the big variation margin flows coincided with other sources of increased demand for liquidity. But hey, stuff happens, and sometimes stuff happens all at once. The system has to be able to withstand such simultaneous stuff.

The second is related, and very concerning. The spikes in rates observed periodically in the repo market (not just here, but notoriously in China) suggest that this market can go non-linear. Thus, even if the increased funding needs caused by the post Abqaiq fallout wasn’t The Big One, in a non-linear market, even modest increases in funding needs can have huge impacts on funding costs.

This highlights another concern: inter-market feedback. A shock in one market (e.g., crude) puts stress on the funding market that leads to spikes in repo rates. But these spikes can feedback into prices in other markets. For example, if the inability to fund positions causes fire sales that cause big price moves that cause big variation margin flows which put further stress on the funding markets.

Yeah. This is what I was talking about.

Today’s events nicely illustrate another concern I raised years ago. Clearing/margining make markets more tightly coupled: the need to meet margin calls within hours increases the potential stress on the funding markets. As I tell my classes, unlike in the pre-Frankendodd days, there is no “fuck you” option when your counterparty calls for margin. You don’t pay, you are in default.

This tight coupling makes the market more vulnerable to operational failings. On Black Monday, 1987, for example, the FedWire went down a couple of times and this contributed to the chaos and the potential for catastrophic failure.

And guess what? There was a (Fed-related!) operational problem today. The NY Fed announced that it would hold a repo operation to supply $75 billion of liquidity . . . then had to cancel it due to “technical difficulties.”

I hate it when that happens! But that’s exactly the point: It happens. And the corollary is: when it happens, it happens at the worst time.

The WSJ article also contains other sobering information. Specifically, post-crisis regulatory “reforms” have made the funding markets more rigid/less-flexible and supple. This would tend to exacerbate non-linearities in the market.

We’re from the government and we’re here to help you! The law of unintended (but predictable) consequences strikes again.

Hopefully things will normalize quickly. But the events of the last two days should be a serious wake-up call. The funding markets going non-linear is the biggest systemic risk. By far. And to the extent that regulatory changes–such as mandated clearing–have increased the potential for demand surges in those markets, and have reduced the ability of those markets to respond to those surges, in their attempt to reduce systemic risks, they have increased them.

I have often been asked what would cause the next financial crisis. My answer has always been: the regulations intended to prevent a recurrence of the last one. Today may be a case in point.

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