Streetwise Professor

November 15, 2023

Gary Gensler: From Igor to Frankenstein

Filed under: Clearing,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 4:53 pm

Gary Gensler has been a menace to the market system for as long as he has been in government. Those of you who have followed this blog for a long time know that I relentlessly criticized him during his tenure as CFTC chairman. He apparently took notice, because he banned me from the CFTC building. I also consider it extremely likely that he was the moving force behind the 2013 NYT supposed hit piece on me–for which I should probably thank him, because on net that has turned out to be a major positive.

Gary Gensler. (Though this is how I like to think of him.)

At CFTC, Gensler was merely an Igor implementing the Frankendodd creation of his congressional masters. As head of the SEC, however, Gensler has become a full-fledged Dr. Frankenstein, stitching together regulatory monsters that threaten to stalk the landscape leaving economic devastation in their path.

I have already written several times about the SEC’s misguided Treasury clearing mandate. But that is only one of Gensler’s Monsters. There are many others.

Perhaps the most monstrous is the SEC’s proposed rule on climate-related disclosures. This would mandate that public companies disclose their carbon emissions–and those of their suppliers. This is at best vast speculative endeavor, and and worst an impossibility. It’s main concrete effect will be to provide a pretext for lawsuits against companies targeted by activists who will allege that the companies’ calculations were wrong, or were lies because alternative internal calculations came up with numbers that differed from those reported in their 10Ks.

The regulation would also require companies to make fulsome disclosures of their climate risks. Another speculative endeavor that cannot produce any meaningful or useful information. It requires each company to characterize the interaction between one complex system–climate–and another complex system–the economy–to predict the adverse consequences of this interaction for it, a small part of the economic system allegedly impacted by climate. Prognostications about climate are themselves wildly uncertain–indeed, arguably the biggest risk is model risk. Predicting how climate will impact economic outcomes at the company level under myriad possible climate scenarios is a mug’s game.

And indeed, it is even worse than that. For there is another element to the problem–government policy. This introduces an element of reflexivity that is particularly devilish. Government policy will respond to climate and economic outcomes as well as interest group pressure, and will affect economic outcomes (though whether these policies will actually affect climate outcomes is dubious). This is arguably by far the biggest risk that companies face.

Meaning that if the regulation comes into force, I recommend the following boilerplate disclosure for all companies: “We face the risk that some government agency will adopt a boneheaded policy that will dramatically raise our cost of doing business or eliminate the markets we service.”

This will also be a boon to lawyers. “Company X failed to disclose the risk associated with [insert climate scenario here] described in [poorly executed paper published in obscure journal].”

I could go on. But in Congressional testimony John Cochrane did a lot of the heavy lifting for me, so I direct you there.

And I ask: how will this information improve the allocation of capital? It is more likely that this will just add noise that impedes efficient capital allocation, rather than actionable information that improves it. The hive mind of investors is likely far more adept at evaluating the effects of the climate-economics-policy nexus than the managers of corporations.

I further note that this obligation’s burdens are greater for small companies than big ones. Meaning that it will likely lead to exit and consolidation, and greater concentration. Which other parts of this administration–notably Lina Khan’s FTC–think is a great evil. Ironic, that. Ironic, but not humorously so.

Moving right along, the trendy Gary has targeted the New Thing, Artificial Intelligence. In public statements Gensler has made the at least somewhat plausible argument that interactions between very similar AIs can produce destabilizing positive feedback mechanisms. But the SEC’s proposed AI regulation instead focuses on potential agency problems:

Today’s predictive data analytics models provide an increasing ability to make predictions about each of us as individuals. This raises possibilities that conflicts may arise to the extent that advisers or brokers are optimizing to place their interests ahead of their investors’ interests. When offering advice or recommendations, firms are obligated to eliminate or otherwise address any conflicts of interest and not put their own interests ahead of their investors’ interests. I believe that, if adopted, these rules would help protect investors from conflicts of interest — and require that, regardless of the technology used, firms meet their obligations not to place their own interests ahead of investors’ interests.”

The SEC remedy for this litany of horrors?

But under the guise of minimizing conflicts of interest, the SEC now proposes requiring advisers and broker-dealers to write new internal procedures and to log all uses of technologies relating to predictive data analytics for agency review. If left unchallenged, the new rules would hamper the American financial industry’s world-beating innovation.

The definition of what must be disclosed is comprehensive:

“an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes in an investor interaction.” 

This would basically encompass EVERY analytical function performed by covered entities, including e.g., quant traders’ algorithms, portfolio optimizers, and on and on and on. Basically any use of statistical methods is implicated (note the reference to “correlation matrix”).

Perhaps the “investor interaction” language will limit this to principle-agent applications (as bad as that would be), but it is so broad that it is highly likely that the SEC will interpret it to cover, say, an HFT firms algorithms to predict and analyze order flows. That involves “an investor interaction.”

This all brings to mind previous regulatory initiatives to require disclosure of all trading algorithms–something that was mercifully killed.

And what will the SEC do with this information? This would represent a massive amount of highly technical information that the SEC would not have the capacity or expertise to analyze proactively, and information that would metastasize inexorably. Hell, even storing the information would be a challenge.

Again, like the climate reg, this seems all pain no gain. This disclosure would entail massive cost. And for what? To find an agency violation needle in a massive informational haystack? Agency violations (such as trading ahead) that could not be detected using existing methods?

But that’s not all!

Gensler also looks askance at exchange volume discounts. Why? Because NO FAIR:

“Currently, the playing field upon which broker-dealers compete is unlevel,” said SEC Chair Gary Gensler. “Through volume-based transaction pricing, mid-sized and smaller broker-dealers effectively pay higher fees than larger brokers to trade on most exchanges. We have heard from a number of market participants that volume-based transaction pricing along with related market practices raise concerns about competition in the markets. I am pleased to support this proposal because it will elicit important public feedback on how the Commission can best promote competition amongst equity market participants.”

Volume discounts are obviously pervasive throughout the economy in the US and indeed the world. So why should these be somehow so nefarious in stock trading as to require their elimination?

Let’s apply some economics–which alas is an alien concept to Gensler. There are two basic reasons for volume discounts.

One is that it is cheaper to service bigger customers. In which case volume discounts are efficient, and banning them would be unambiguously bad.

Another is that it is a form of price discrimination. For example, big intermediaries may find it easier/cheaper to shift business between exchanges than smaller intermediaries, in which case their demand for the services of a particular exchange would be more elastic than the demand of the smaller firms. Exchanges would then rationally charge lower prices to the more elastic demanders.

The welfare effects of this type of price discrimination are ambiguous, making the case for banning it–even if it can be established that the volume discounts are demand-elasticity-driven discrimination vs. cost-based discrimination–ambiguous as well.

With respect to “concerns about competition,” well, elasticity-based discrimination requires that inter-exchange competition not be perfect in the textbook sense. But if that is what is driving the volume discounts, outlawing them treats a symptom of market power rather than market power itself, and how “imperfectly competing” exchanges will price when they can’t price discriminate is very much an open question–and exactly why the welfare effects of price discrimination are ambiguous.

Gensler seems to be channeling discredited Robinson-Patman like logic that protected the high cost against competition from the low cost. That is anti-competitive, not pro-competitive.

These are only some of the monsters the Frankensteinian Gensler is assembling in his DC laboratory. I could go on, but you get the idea.

There is hope, however. Whereas Gensler’s CFTC actions were largely rooted directly in very specific statutory directives, his work as Dr. Frankenstein is based on extremely expansive interpretations of the SEC’s statutory authority dating back to the 1930s. Such expansive interpretations–not just by the SEC, but many other agencies–are currently being challenged in the courts, including cases pending before the Supreme Court.

It is possible therefore, and indeed to be fervently hoped, that the Supreme Court will hand down decisions that demote Gensler back to Igor implementing very specific Congressional mandates, and end his career as regulatory Frankenstein.

And the benefits of such decisions would extend beyond reining in the SEC, for as bad as it is that agency is probably not the worst offender–the EPA probably is, but the competition for this dubious honor is intense. The administrative state–the American Mandarinate, as I like to think about it–needs to be culled. And with extreme prejudice, and as soon as possible.

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November 7, 2023

The Basis For the Treasury Basis Trade: Leverage Laundering?

Filed under: Clearing,Derivatives,Economics,Regulation — cpirrong @ 3:11 pm

The Treasury basis trade continues to be in the news, with one of the biggest basis traders–Citadel’s Ken Griffin–complaining that the SEC should regulate hedge fund basis trading, but should instead make sure that banks aren’t supplying too much leverage to . . . well, hedge funds mostly. This seems like a raising rival’s costs gambit. No doubt restrictions on leverage would hit Griffin’s competitors harder, whereas SEC regulation might have a more even impact.

Regardless, one question that hasn’t been asked in all the to-ing and fro-ing about Treasury basis trades is why they exist at all, let alone why they get so big. This graph (courtesy of FTAlphaville, based on CFTC data) provides a major clue:

Note the mirror image between leveraged funds (mainly hedged funds) and asset managers (ostensibly non-leveraged funds–the reason for the “ostensibly” will become clear shortly).

To the extent that hedge funds’ short positioning reflects basis trades, the graph suggests the following. Hedge funds take a leveraged market neutral position, buying bonds, funding them via repo, and selling futures. Futures are in zero net supply: the graph shows that the longs on the other side of the hedge funds’ futures short are asset managers.

Most asset managers do not, and in some cases even cannot, take leverage directly. So for example they are constrained in their ability to just buy Treasuries with borrowed money (e.g., via repo). But the basis trade allows them to lever up via futures. So in some sense, the basis trade is just an additional link in a chain of intermediation. Laundering leverage, if you will.

(A more complete picture might add swap dealers to the picture. Some managed money, such as leveraged ETFs, enter into swaps with dealer banks. The dealer banks in turn can hedge by taking offsetting futures positions.)

The hedge funds expect to earn a small margin on the trade–on average, though there is risk. The market is pretty competitive, so to a first approximation that margin (the difference between the actual futures price and the theoretical futures price derived from bond prices, bond vols and correlations, and repo rates) equals hedge funds’ marginal cost of supplying this intermediation. The asset managers on the long side of the futures trade are willing to pay “too high” a futures price (relative to bond prices) because this is a cheaper way of achieving a leverage target than via the available alternatives.

The March 2020 experience shows that the basis trade can be a fragile one that creates some systemic risk: this is why regulators are concerned about basis trades now, to Ken Griffin’s chagrin. Providing this leverage intermediation/laundering creates tail risks for the hedge funds that do so. This raises the question of whether there are regulatory constraints that inefficiently constrain the ability of asset managers to take leverage more directly, rather than via a longer dealer (or money market) to hedge fund to asset manager chain. If so, such constraints could give rise to unnecessary (systemic) risks.

If regulators are concerned about the systemic risks in basis trades, they should take a systemic approach–and understand more fully why basis trades exist in the first place, and why they have periodically become so large. Looking at individual links in the chain (hedge funds, or by Griffin’s lights, banks) can be misleading because it begs the question of why the chain exists in the first place. The link that is driving the process is likely the one that has escaped discussion so far–the asset managers at the end of the chain. Why do they want leverage and why is the basis trade the most cost effective way of supplying a lot of it? Could it be the most cost effective because other, more directly intermediated sources of leverage are unduly expensive because of regulatory or institutional constraints? Definitely worth regulators’ attention.

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November 3, 2023

Treasury Clearing Mandates: Rearranging the Market Structure Furniture on the Deck of SS Treasury Titanic Is Pointless

Filed under: Clearing,CoronaCrisis,Economics,Exchanges,Politics,Regulation — cpirrong @ 3:29 pm

The market for United States Treasury securities (notes and bonds) has been a source of concern for some years, dating back to the Treasury “flash” event of 15 October 2014, but especially in the aftermath of the “dash for cash” during the March 2020 Covid scare. The relentless selloff of Treasuries in the past year plus has contributed to the angst.

This has led the SEC to propose various changes to the structure of the Treasury market. The most important of these is mandated central clearing of most Treasury cash trades and repos. Well, since Gigi is back in the clearing saddle, I guess I have to mount up too.

The main justifications of the mandate come from Darrell Duffie and various collaborators at the New York Fed (notably Michael Fleming). The IMF has also produced an analysis outlining justifications of the mandating of clearing.

Just as with the Frankendodd clearing mandates, the case for Treasury clearing is very weak.

The basic argument is that Treasury market liquidity has eroded, and that clearing will enhance market liquidity. The supposed main cause of the decline in liquidity is that primary dealers face balance sheet constraints that limit their ability to intermediate the Treasury market.

In the Duffie paper and the Duffie, Fleming et al paper he cites, the main evidence of the deleterious effects of balance sheet constraints comes from the “dash for cash” in March 2020. Summarizing a variety of measures of market liquidity using principal components analysis, they show that liquidity usually varies inversely with market volatility, but liquidity declined far more than predicted by volatility alone in 2020. This was due, it is claimed, to the fact that dealers were not able to increase their holdings of Treasuries due to balance sheet constraints. Their ability to make markets was therefore constrained.

There is a big problem with this analysis. Dealers ended up holding far more Treasuries because Covidmania caused a sharp drop in the demand to hold Treasuries by hedge funds and others–they wanted to substitute cash for Treasuries. Part of the demand drop was accommodated by a price decline, but evidently dealers’ demands did not drop as much as the demands of non-dealers: thus, there was a major portfolio adjustment, with hedge funds etc. reducing their holdings and dealers absorbing as much of these sales as their balance sheets allowed.

Thus, this was a structural change in demand that led to major portfolio adjustments. Yes, the portfolio adjustments were accompanied by a decline in conventional measures of liquidity (bid-ask spreads, depth, etc.) but this decline in liquidity was a consequence of the underlying shock, and clearing of cash Treasuries or repos would have had little, if any, impact on this decline. Even if clearing increased dealers’ balance sheet capacity (something I discuss further below), given the underlying Covid-driven (and Covid policy-driven) demand shock it is highly likely that this incremental capacity would have been fully utilized as well and liquidity would have been about as bad.

This extraordinary shock that led to strained dealer intermediation capacity is different than the types of shocks that dealers typically intermediate. The role of Treasury liquidity suppliers–be they dealers or prop trading firms–is the same as the role of liquidity suppliers in any other market, be it stocks or currencies or commodities: to utilize inventory adjustments (balance sheet) to absorb temporary, temporally uncorrelated, and largely cross-sectionally uncorrelated investor (buy side) demand shocks. The dash for cash was a long-lasting shock highly correlated across major investors in Treasuries. It was a systematic shock that led to a long lasting adjustment in dealer portfolios, whereas market makers absorb idiosyncratic shocks that do not require long lasting adjustments to dealer portfolios.

That is, the kind of portfolio adjustments that occurred in response to Covid were fundamentally different in nature from the kind of portfolio adjustments that firms undertake to make markets. A long term transfer of risk rather than a short term transfer.

Therefore, using the dash for cash as the basis for policies intended to improve Treasury market liquidity is fundamentally misguided.

Be that as it may, it provides the underlying logic advanced for clearing mandates: improving liquidity requires increasing dealer balance sheet capacity, and clearing can supposedly do that.

How can clearing improve balance sheet capacity? The mandate defenders offer that hardy perennial as a justification: netting. For both cash Treasuries and repos, the argument goes, netting out offsetting exposures reduces the amount of capital and cash that dealers require to intermediate. For cash transactions, Duffie, Fleming et al estimate that netting would reduce daily settlement volumes substantially (70 percent in March 2020 according to their figures). This, and other factors, allegedly result in freeing up of dealer balance sheet capacity.

This analysis begs an important question: since dealers would internalize the benefits of more economical use of balance sheets that would result from clearing, why is it necessary to mandate it? Why don’t dealers and other market participants voluntarily utilize clearing more extensively in order to economize on the use of a scarce resource–balance sheet? After all, historically voluntary adoption of clearing in the stock market (e.g., NYSE clearing and CBOT clearing in the 19th century) was specifically intended to reduce settlement volumes by netting. In the case of the CBOT, the clearinghouse netted payment obligations but did not mutualize credit risk on derivatives transactions or impose margins (which were negotiated bilaterally).

The alleged failure of profit-motivated entities to reduce cost (from inefficient use of balance sheets) suggest that this does not come for free: at the margin there must be some cost for clearing that is greater than the putative benefit. That is, profit maximizers will balance marginal private benefits and marginal private costs. The benefits of netting from clearing are private, and thus the current degree of penetration in clearing likely reflects an efficient balancing of these marginal benefits and costs. The advocates of a mandate surely have not shown otherwise.

I further note that, as I wrote repeatedly during the Frankendodd era, netting redistributes default risk rather than reduces it. It is by no means clear that the distribution of default risk under central clearing/netting is more efficient than that under bilateral clearing.

Put differently, the advocates of clearing (both cash and repo) have not identified a “market failure”, e.g., a benefit from clearing that market participants do not internalize. Such a failure is a necessary (but not sufficient) condition for regulatory intervention such as a clearing mandate.

With respect to repo clearing, another supposed benefit is the disparity of margins (“haircuts”) in the repo market. Haircuts for some counterparties are low, but for others they are higher. Central clearing would impose uniform, value-at-risk (“VaR”)-based margins.

The operative theory behind central clearing is that the “loser pays”, namely the resources (margin, default fund contribution) posted by a counterparty is sufficient to cover any losses in the event of that counterparty’s default. Ideally, counterparty credit risk in central clearing is zero, though in reality some always remains.

Well, this begs another question: is the optimal amount of counterparty credit risk/default risk zero (or close to zero) in all transactions? Relatedly, is it optimal not to permit the pricing of counterparty credit risk, where the price varies by the creditworthiness of counterparties, with high credit quality entities paying smaller haircuts than lower quality credits? Central clearing makes pricing independent of creditworthiness, whereas bilateral arrangements that advocates of clearing dislike allow pricing of credit risk that reflects assessments of creditworthiness of counterparties.

Since credit risk mitigants (including margins/haircuts) are costly, and since market participants trade-off the costs and benefits of credit risk and its mitigants, allowing choice and competition on this dimension has strong justifications. Certainly the advocates of mandatory Treasury clearing have not identified a “failure” in this market that justifies regulatory intervention in the form of clearing mandates.

Put differently, clearing mandates force market participants to a corner solution–clear everything, and impose margins that make counterparty credit risk de minimis. The existing state of the market, where market participants can choose to clear with a CCP or not, reveals that they strongly do not prefer the corner solution. Furthermore, the advocates of clearing have failed to identify any market failure that implies that the interior solution/equilibrium is inefficient and can be improved by mandating the corner solution.

And the advocates have yet again failed to recognize the trade-off inherent in clearing: that is, the trade-off between counterparty credit risk and liquidity risk. This despite the fact that the reality of this trade-off has been made abundantly clear (no pun intended) repeatedly in the past–and including in particular the Treasury market basis trade turmoil during the dash for cash.

The real issue in Treasury markets right now, and the real threat to their stability, is the massive deficits in the United States, and the resultant increase in Treasury security issuance and Treasury securities outstanding. It is deficits and issuance that are driving the massive increase in the size of Treasury markets, and the consequent strains on the ability of dealers and others to intermediate the swollen market.

This is a challenge that no rearranging the market structure furniture on the deck of SS Treasury Titanic will fix. Furthermore, the economic case for mandating clearing of Treasury cash and repo transactions is laughably weak even if one overlooks that fact that clearing does not get at the real problem. But it appears that Gigi (cheered on by the Fed) will mandate a corner solution that makes the market less efficient, not more.

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October 16, 2023

Alfred E. Goldman

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — cpirrong @ 12:52 pm

In March, 2020 the Federal Reserve injected massive amounts of liquidity into the markets in response to a blow-up in Treasury basis trades. I wrote about it here.

In recent weeks, the Fed, the BIS, and the BoE have raised red flags about the renaissance of this trade and the resulting potential for systemic risk a la 2020. Not all are convinced. Goldman Sachs in particular is in Alfred E. Neuman mode: What? Me worry?

FT Alphaville quotes Goldman’s rates strategy team as follows:

We do not think the trade poses a major risk to Treasury markets in the near term . . . Leverage in the system is materially lower than it was in 2019/20 as a result of a series of [initial margin] increases (and price declines). The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.

This assessment is based on a fundamental error that I went on about ad nauseam in the post-Great Financial Crisis clearing debate, specifically, concluding that if leverage goes down in one part of the system it goes down systemically. Wrong. Wrong. Wrong.

Yes, the ostensible purpose of higher margins is to reduce leverage in the margined trades. But especially for the hedge funds and other sophisticated entities who engage in the Treasury basis trade at scale, they can substitute one form of leverage for another.

As a first approximation, a fund has a leverage target or a level of debt capacity, it can fund the higher margin in the less leveraged futures trade by increasing leverage elsewhere. The funds will typically evaluate leverage holistically, not on a trade-by-trade basis.

It is therefore fundamentally logically flawed to conclude that “leverage in the system” (which is in fact source of systemic risk) has declined because it has gone down in one piece of it.

If there are constraints on funds’ ability to offset mandated leverage reductions in one type of trade by increasing leverage elsewhere, that would increase the cost of engaging in that type of trade and would impact the scale of that trade. But what has alarmed the central bankers is exactly that the scale of the trade has increased and now exceeds its 2020 level:

Note that leveraged funds’ Treasury futures shorts are currently substantially larger now than in 2020. Thus, despite higher margins, the scale of the trade is subsantially larger–and it is the scale–and the concentration–of the trade that poses systemic risks.

This bigger scale could be because raising margins doesn’t really constrain the ability of funds to lever up to engage in basis trades. Or it could be that even though the higher margins raise the cost of the trade, the spread has widened sufficiently to offset, or more than offset the higher cost. For example, constraints on dealer balance sheets that impair liquidity in the cash market could depress cash prices relative to futures prices.

Goldman’s errors don’t end there. One thing that could spark a margin spiral is an increase in initial margins that induces mass liquidations that lead to changes in the basis that lead to large variation margin obligations–something that Goldman doesn’t mention.

Alfred E. chimes in again here: “The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.” That is, Goldman’s conclusion is essentially based on a very benign view on Treasury volatility.

There are myriad reasons to take a different view. The US’s acute fiscal situation and the accompanying periodic debt limit dramas. The constrained balance sheets of dealers that limit their ability to supply liquidity to the Treasury market. The prospect for an extremely chaotic election year. And geopolitics, with now two major disturbances ongoing (Ukraine and Israel/Gaza) with one continually on the boil in the background (China/Taiwan). And highly unsettled geopolitics with a feckless and befuddled administration at the tiller.

That is, it isn’t the level of margins that really matters. It is the possibility that margins may increase due to higher volatility. Goldman/Neuman isn’t worried. I think that’s unduly optimistic. Furthermore, an assessment of systemic risk must be based on the likelihood that Goldman’s don’t-worry-be-happy opinion is wrong.

And remind me: did Goldman predict the increase in Treasury volatility in 2019 or 2020? Stuff happens. Unknowns and unknowns and all that.

Furthermore, higher volatility->higher IM->liquidation of basis positions->margin spiral isn’t the only potential source of systemic risk. Other economic shocks can cause leveraged funds to slash positions and leverage, leading to liquidations of basis positions and the triggering of a margin cascade. That is, there is the possibility of fire sales.

These shocks can be systematic–a broad decline in stock or bond markets–or concentrated at a few funds, or even one, due to bad trades in other markets.

The 30 25 year anniversary last month of the LTCM collapse brings the latter to mind. Bad bets on convergence trades forced LTCM to liquidate and delever. Understandably, it attempted to unload its most liquid positions–including short Treasury futures. Treasuries had a massive rally on LTCM day that was not matched by a similar rally in the underlying, less risky Treasuries.

A squeeze–not unheard of in government debt futures markets–can also impose losses on basis trades, leading to liquidations that can exacerbate the price impact. Or a Treasury flash crash (in yields, and hence a flash spike in prices) like on 15 October 2014.

In sum, size does matter. Basis trades have become big again, and the factors that lead Goldman to parrot Alfred E. Neuman are hardly persuasive. From a systemic risk perspective, basis trades represent dry tinder that can explode into flame. Can does not mean will. But the possibility is there, and the effect if the right spark hits the tinder depends on the size of trade. The big scale and concentration of this trade thereby justify far more concern than Goldman expresses.

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May 30, 2023

I Sorta Agree With Jerome Powell and Gary Genlser on Something: Sign of the Impending Apocalypse?

Filed under: Clearing,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 1:00 pm

The Fed and the SEC have expressed concerns about Treasury “basis trades” wherein a firm purchases a cash Treasury security funded by repo-ing it out and sells Treasury futures. Their concern is somewhat justified. As mentioned in the linked article, and analyzed in detail in my paper in the Journal of Applied Corporate Finance (“Apocalypse Averted“) the spike in the cash-futures Treasury basis caused by COVID (or more accurately, the policy response to COVID) caused a liquidity crisis. The sharp basis change led to big margin calls (thereby creating a demand for liquidity) and also set off a feedback loop: the unwinding of positions exacerbated the basis shock, and thereby reinforced the liquidity shock.

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.

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May 9, 2023

Oh No Not This BS Again: The EU Looks to Regulate Commodity Trading Firms Like Banks

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Politics,Regulation — cpirrong @ 1:09 pm

In response to the liquidity crunch in the commodity trading sector (especially in energy trading) last year, the European Union is looking to regulate commodity traders more like banks:

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.

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January 12, 2023

Just Because It’s Not All Bad Doesn’t Mean It’s All Good, Man

Filed under: Clearing,Derivatives,Economics,Energy,Exchanges — cpirrong @ 12:02 pm

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.

Caps also interfere with clearing. There is a potential for large price movements when the cap no longer binds. Thus, in the EU gas situation, ICE Clear Europe has said that it will have to charge substantially higher initial margins (an estimated $33-47 billion more), and indeed, may choose to exit the EU.

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.

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November 28, 2022

I Remain DeFiant: DeFi Is Not the Answer (to Price Discovery) in Crypto

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.

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November 10, 2022

Another Blizzard in Crypto Winter, or, Tinker Bell Economics: To Call Crypto a “Trustless” System is a Joke

Filed under: Blockchain,Clearing,Cryptocurrency,Regulation — cpirrong @ 11:42 am

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.

Crucially, as part of its broker dealer/FCM operation, FTX engaged in margin lending to customers. Indeed, it permitted very high leverage:

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!

Also probably an illegal judgment call.

But it gets better! Alameda held large quantities of FTT, also apparently emergency funding provided by FTX. And it used billions of FTT as collateral for its trades and borrowing.

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.

In brief, crypto trading could be decentralized, but it isn’t. For reasons I wrote about years ago. (Also see here.)

Indeed, the issue is arguably even more acute in crypto markets, for a reason that SBF himself laid out in now infamous interview with Matt Levine on Odd Lots. Specifically, that token valuation relies on magic–belief, actually.

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.

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October 17, 2022

Clearing Is Not A Harmless Bunny: I Told You That I Told You That I Told You [ad infinitum] That I Told You So

Filed under: Clearing,Derivatives,Economics,Financial crisis,Regulation — cpirrong @ 10:54 am

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 the dangers 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.

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