Streetwise Professor

This week’s big derivatives story was about a public workshop at the CFTC on the issue of futurization.  I was one of the first people to comment on this issue, last year when ICE announced it was converting all of its energy swaps into energy futures.

That was Futurization 1.0. The conversion merely consisted of renaming “swaps” “futures”.  In all economic dimensions (contract specs, execution, clearing) the contracts remained identical.  But the renaming allowed some energy swap users to escape the dreaded Swap Dealer designation.

Futurization 1.1 was the CME’s conversion.  This illustrates some of the silly impacts of Frankendodd.  The CME has cleared energy swaps for going on 10 years now.  The parties would execute a swap, and submit the swap for clearing through an Exchange of Futures for Swaps (EFS) trade.  So the originally executed swap existed only until it was submitted for clearing, when it was replaced with economically equivalent futures contracts.  But no matter how short the swap’s life, the fact that it was born a swap meant that it counted towards the volume of swaps activity used to determine whether someone was a swap dealer.  So the process has now changed, and market participants use (mainly) block trades of futures to create the positions they want, thereby cutting out the interim swap step.

The transformation of the energy derivatives landscape, and the launch of swap futures by CME and Eris are now raising the question of whether futurization will spread beyond energy.

One motive to eschew swaps in favor of futures is unlikely to exist in interest rates, credit and other financial derivatives: the biggest market participants are likely to trade enough bespoke swaps for which there are no futures equivalents, meaning that they will be treated as swap dealers regardless: this reduces their incentive to substitute futures for swaps.

The main driver of futurization outside of energy will be CFTC regulatory treatment of futures and swaps.  Differential treatment will affect the economics of futures vis a vis swaps, and the prospect of such differential treatment was the center of controversy at the CFTC meeting, and in the larger debate in the industry.

The main sources of differential treatment are execution and margining.  Swaps will have to be executed subject to (allegedly) soon-to-be announced SEF rules, and are subject to immediate reporting.  Most market participants who will substitute futures for swaps will execute these deals via privately negotiated block trades subject to exchange rules.  Crucially, reporting of block futures trades is delayed 15 minutes, a concession to fears that immediate reporting would impair liquidity because block positioners (those supplying liquidity to the block futures market) could find it difficult to lay off their risk if the fact they had just done a big trade was announced immediately.  This would induce them to require larger price concessions for doing block trades.

Which raises the question: why the difference between the futures goose and the swaps gander?  Similar considerations obtain for swaps.

Thus, this rule difference is likely to favor futures executed via block trades as opposed to swaps executed via traditional means (but with immediate post-trade transparency) or via SEFs.  (Economically material differences between the rules governing block trades and SEF trades could also affect the relative costs of trading in these disparate ways, and hence affect the choice between them.)

Margining will be different for swaps and futures.  Futures will be margined assuming a one- or two-day liquidation period (i.e., margins will be based on something analogous to a one- or two-day value at risk).  However, swaps-even cleared swaps-will require a minimum liquidation period of 5 days for calculating initial margin.

This substantially higher margin for swaps results in a substantial economic disadvantage to these contracts compared to futures contracts that generate the exact same cash flows (in the absence of default).   This will likely be another factor pushing the market towards futures-which is a major reason for the fury of swaps dealers.

This differential treatment of economically equivalent contracts just because one is called a “swap” (BAD!) and the other is called a “future” (GOOD!) makes little-or no-economic sense-and reflects the swap-o-phobia that pervades DC, and which was an animating principle behind Frankendodd.

The reason to set margins based on a liquidation period reflects the purchase of IM: it is intended to cover potential losses on a defaulted position before that position can be liquidated by the clearinghouse (i.e., the position can be assumed by another solvent market participant).  The less liquid an instrument,  the longer it takes the CCP to work out of the position, the more it is exposed to potential adverse price moves and hence the more margin cover it needs.

This liquidation period depends on the economic characteristics of the contract, how widely it is traded in the marketplace, the identity, number and capitalization of the firms that trade it, and market conditions at the time of liquidation. All of these conditions should be pretty much the same for two contracts that specify the same contingent cash flows, one of which is called a swap and the other a future.  Consider say a 10 year vanilla IRS and economically equivalent futures contracts that offer the same contingent cash flows.  Abstracting from margining differences, these contracts have identical price risks, and should attract the same kinds of users.  Why should liquidity of one differ from the liquidity of the other in the event of the default of the holder of a big position?

And don’t tell me that futures are traded in light markets and swaps are traded in dark ones.  As already noted, futures traded as substitutes for swaps are and will be typically traded in blocks outside the limit order book.

More importantly: in the event of the default of a big FCM or dealer that should be the reason to be concerned, the CCP is going to try to get rid of the defaulted portfolio in big chunks through some sort of auction process.  The firm winning the auction will then trade out of the position, likely using the central market and block trades.

This isn’t much different than how a swap CCP will handle the default process.  Indeed, LCH obligates its members to assume portions of a defaulted portfolio, and one reason for having stringent CCP membership requirements is to ensure that the members have the capital and trading expertise to manage big pieces of defaulted portfolios.

We actually have a case study of futures and swap default management processes.  When Lehman defaulted, CME auctioned off its interest rate, equity, currency, commodity, and energy positions.  These trades were done at differentials from market prices, to reflect the risk that those taking over the positions would assume and have to work off.  A couple of the positions were under-margined: the firms taking over the positions required the CME to provide more funds than the Lehman margin it had against those positions.  As it turned out, the other positions were over-margined, and across all positions the over-margining exceeded the under-margining, meaning that the CME clearinghouse did not suffer any loss as the result of the default.  But this illustrates the possibility that futures can be under-margined, and that even the putatively more liquid futures contracts can require substantial price concessions to get someone to assume them.

LCH.Clearnet handled the default of the Lehman IRS positions. These totaled $9 trillion in notional-bigger than the Lehman futures positions at CME, and arguably far larger in terms of risk.  ($1 trillion in notional of a 10 year IRS poses substantially more risk than $1 trillion in notional of Eurodollar futures.)  90 percent of the position was hedged within a week.  According to LCH.Clearnet, the costs of trading out of the defaulted position were “well within” the Lehman margins it held.

It’s hard to see much of an economic difference between the CME and LCH experiences.  It doesn’t appear that it was materially more difficult to manage the default of “swaps” than it was “futures.”   The Lehman default does not provide any evidence that swap-o-phobia is anything but a mental illness.

Further, this case study illustrates that there is no reason to believe that absent government regulation, swaps will be under-margined and futures will not.  Indeed, had the Lehman positions been held at 5 separate CCPs, two of them would have been under margined.

Indeed, there are serious reasons to be concerned that government regulations of the margining of economically similar (and in some respects identical) contracts will create systemic risks, rather than mitigate them.

The margin regulations-with larger IM imposed on swaps than futures-are a form of price control, in this case default risk price control.  And we know that price controls work out swell, especially when applied by regulators in a two-sizes-fits-all fashion across all different kinds of instruments posing different risks and cleared by CCPs with potentially disparate financial strength.

Moreover, this price control will tend to induce activity to move towards futures CCPs.  Whereas in the absence of the margin differential clearing activity in, say, interest rate derivatives would be split between futures CCPs and swap CCPs, under the differential regulation, business will tend to tip to the futures CCPs-most notably, CME.  This will tend to lead to greater concentration of credit risk.

Wasn’t the whole point of Frankendodd to reduce concentration? Just asking.

The whole conceit that regulators can set risk prices is quite dangerous, and is likely to be a source of systemic risk because these prices are set on the basis of highly limited information in a politicized process, and because mistakes in setting risk prices (especially price differences between similar products) tend to lead to crowded trades and risk concentration that is highly destabilizing during crisis periods (cf. Basel II).

The case for setting different margins (default risk prices) on very similar-and in some cases identical-derivatives contracts is particularly weak.  It is the characteristics of the products and those who trade them that will drive liquidity and liquidation periods: products called “futures” that share the same economic characteristics as products called “swaps” will pose virtually the same challenges to liquidate in the event of a large default.  Given this, the economics suggest that imposing differential margins based on a name difference-rather than economic differences-can’t make things better, and could well make them worse.

But the Sorcerer’s Apprentices know better. So futures are likely to get an artificial advantage, and swaps an artificial burden. Such distortions are quite dangerous.  My conclusion? Futurize in haste, repent at leisure.

I’m sure you would never peg me as a green type, but I have decided to join the recycling movement!

I am doing so in response to the call by Barney Frank (the Frank of Frankendodd) to merge the SEC and the CFTC.  This idea has itself been recycled many times, dating back to the 1980s and the birth of stock index futures.

One of the recycling efforts was by Hank Paulson, in the spring of 2008, in his proposal to reform the financial markets.  A centerpiece of this proposal was the org chart shuffling.  What I said then holds true today, so I’ll conserve scarce resources (mainly my time), and merely recycle:

The biggest headline was that the recommendation for the merger of the SEC and the CFTC. This puts in me in mind of two quotes. The first is by Churchill: “A fanatic is one who can’t change his mind and won’t change the subject.” Whenever anything happens in the financial markets, the cry immediately goes up to merge the SEC and the CFTC. Many people are apparently fanatical, because they never change about their minds about the desirability of the merger, and the subject always seems to return to it.

The second quote is by somebody slightly–well, a lot actually–less famous; that would be me. In a 2001 Regulation Magazine piece on the Clinton regulatory legacy, I wrote that the SEC-CFTC combination was a solution in search of a problem.

I am always somewhat mystified by the substance of the arguments for the merger. The most commonly mentioned benefit is a harmonization of margins between stocks and stock index futures. What, it’s not possible to harmonize without going merging the two bodies? Moreover, given the myriad other more important issues facing the two agencies, this seems like a very thin reed on which to rest a major reshaping of the regulatory structure.

In reality, there is very little overlap between the regulatory responsibilities of the two agencies. What’s more, there are huge swathes of the trading landscape that fall outside the jurisdiction of either agency. So merger will hardly reduce that much duplicative or contradictory regulation, and will not fill any regulatory gaps. So what’s the point?

Indeed, there are many sources of potential danger in a merger. One, very underappreciated in my view, is that it sacrifices the advantages of specialization. There are issues unique to securities markets and derivatives markets. Specialized agencies can develop the expertise needed for each market space. Of course the staff at a merged agency could specialize, but major policy, rulemaking, and interpretive decisions are made at the commissioner level. Right now SEC commissioners, for example, need to deal with arcane issues of accounting, disclosure, securities intermediation, and securities trading practices in stock, option, and fixed income markets. This is an already daunting task. Adding new areas of responsibility involving different markets and different instruments with different issues will further tax the already limited expertise of the commissioners of the merged agency.

The inevitable outcome of this dilution of expertise and specialization will be to enhance the power of staff, and degrade the quality of commission decision making. Neither outcome is desirable.

Indeed, I would argue that the SEC is already underspecialized. The agency operates subject to three statutes, the Securities Act of 1933, the Exchange Act of 1934, which focus on primary and secondary markets for securities, respectively; and the Investment Company Act of 1940, which focuses on mutual funds and the like. The agency has responsibility over the issuers of securities, and the markets and intermediaries that trade securities. There is little overlap between these areas. Issues of disclosure and accounting can be conceptually and operationally distinguished from issues of market structure and organization.

A second area of concern is that a unified agency will provide a mechanism to reduce and distort competition between different sectors of the financial markets. There are many on Wall Street that would love to throttle the futures exchanges in order to reduce competition for the securities business. (The margin issue is a perfect example of this. The securities firms would love to force an increase in margins on futures to drive some business from the futures exchanges to the stock market.) The regulatory autonomy of the CFTC has largely precluded such an outcome. The SEC has indeed tried in the past to impede the development and introduction of futures products that compete closely with securities markets but has largely failed in these endeavors because it does not have the necessary authority or jurisdiction.

Now, of course, a merger would change agency politics. Under the current framework, the SEC is largely responsive to securities firms and exchanges, and the CFTC is responsive to the futures exchanges and the FCMs. A merged entity would be responsive to the interests of all of these parties. But that is not necessarily a good thing, as one very likely outcome is that the merged entity would implement regulations that would reduce competition between the varying constituencies.

A more sensible, but still problematic, regulatory reorganization would involve (1) stripping out the primary market, accounting, and disclosure responsibilities from the SEC and putting them in a separate agency focusing on these corporate finance issues, and (2) creating a separate agency responsible for trading and market structure issues in securities and derivatives markets. This second agency, call it the “Commission for Financial Trading and Markets” (“CFTM”) would focus on issues relating to manipulation; fraud; the financial adequacy of intermediaries (securities and derivatives brokerages); and facilitating competitive market structures in financial markets. Arguably the manipulation, fraud and competition responsibilities should give the CFTM some authority in the OTC markets.

This approach would be far preferable to mashing together two disparate agencies with very different histories and cultures in the hope that something beneficial will come out of the unnatural coupling. It would permit the development of some specialization, and many issues of fraud, manipulation, and market structure are common across securities and derivatives markets, so the specialization could be applied to a variety of related markets. This alternative is still problematic, however, because the CFTM could easily become a mechanism for stifling competition between different methods of allocating risks and discovering prices.

All that said, there is little likelihood that the merger (or the creation of a CFTM) will come to pass in any event. The idea has been around for decades, and has never even come close to implementation. This is no surprise. There are powerful political forces in the way. Most notably, the futures exchanges, their members, and the FCMs have fought the SEC’s loving embrace vociferously, and found vocal support in Congress. Moreover, whereas the SEC falls under the congressional banking committees (e.g., the Senate Banking Committee and the Securities, Insurance and Investment Subcomittee), the CFTC is under the ag committees. Neither is about to readily cede jurisdiction over a large, well-heeled, and generous industry.

What he, er I, said.

Expecting miracles from mashing together org charts is insane.  At best, it has no effect.  The more likely outcome is to make things worse.  (Want an example?  Look at the effects of the reorganization of the intelligence community post-911.)   The point about specialization is particularly apposite, IMO (naturally, since I brought it up!)  The five commissioners of the CFTC and the five commissioners of the SEC are already overwhelmed by their complex responsibilities, and can devote relatively little time to becoming expert in any one particular area.  Extending the scope of the commissioners’ responsibilities is supposed to make that problem better?

In the end, nothing is likely to happen.  This is a lame duck kerfuffle.  The people who will have skin in the game in the next Congress will want nothing to do with this, as has been the case for about the last 15 Congresses.

November saw a mini-drama involving the CME, CFTC, and DTCC about the issue of SDRs.  (Acronym overload!)  SDRs being Swap Data Repositories, a spawn of Frankendodd-arguably the only good thing in the Title VII litter.

CME had filed to become an SDR, and wanted to require anyone who cleared swaps through CME to report the trade to its SDR.  The CFTC didn’t like the idea of tying clearing and reporting, and held things up: it had stated that the choice of SDR should be up to the customer.  So CME sued.  DTCC-which has its own SDR and would benefit if some CME swap deals were reported to it-filed as an intervenor in the suit.

Lo and behold, the CFTC approved the CME application, including the provision that tied clearing and reporting.  CME dropped its suit, and DTCC is stomping its little feet:

“The Commission’s action late yesterday was an unexplained and an abrupt reversal of course,” the DTCC, which runs a rival swaps data repository, said in a statement.

“This action is inconsistent with the Commission’s previous actions, and will cause market participants to question the finality of any Commission rule or interpretation.”

Two comments.

First, issues of tying and vertical integration are cropping up all over in trading and exchanges.  I just presented a paper at a conference honoring Oliver Williamson that looks at vertical integration between execution and clearing and settlement.  But the issues are also present in things like data centers and reporting and likely will be present in any service exchanges offer.  Regulators are hostile to these sorts of arrangements.  The lesson of my paper is that there can be-and in my view, typically are-good, transactions cost economics-based reasons for these sorts of vertical arrangements.  Regulators should take a deep dive into TCE and learn something about the potential benefits of vertical restrictions or vertical integration rather than continuing to indulge in their reflexive hostility to it.  What’s the transaction at issue?  What are the potential contractual hazards?  Are the contracting and governance methods chosen to implement the transaction well-adapted to the contracting hazards?

IOW, as if (40 plus years after Coase made an observation on the subject) it is rather astounding that regulators look at every vertical restriction with a jaundiced eye.

Second, in some respects this is like Groundhog Day for me.  I’ve seen this before.  I came across a similar controversy in my failed attempt to create a predecessor to SDRs-an “energy data hub”-back in 2003.  It was obvious then, and is obvious now, that there are substantial scale and scope economies in creating and operating an SDR, and that an SDR is a natural, multi-product monopoly.  It is highly likely that the efficient form of organization would be an industry utility/cooperative, likely a non-profit.

But as I experienced in ’03, industry players see this as a great commercial opportunity, and there is intense competition to establish for-profit data hubs and regulators will not mandate the creation of a single hub or pick a winner.  Hence, it is likely that in the end, in each jurisdiction there will be one dominant hub that could be quite lucrative.  Hence the intense competition to be the winner in a winner-take-all contest.  This competition is typically dissipative.  Moreover, if multiple SDRs do survive (because, for instance, the firms play some sort of oligopoly pricing game), there will be excessive costs due to incomplete exploitation of scale and scope economies (i.e., fragmentation is costly).

Which all means that although mandatory reporting to a data hub/SDR is a good idea, as a result of political economy considerations it will be implemented in a highly inefficient way.

Go figure.

It is hard to overstate the importance of this report by Hal Scott and the Committee on Capital Markets Regulation, titled “Interconnectedness and Contagion.”  It evaluates the issue of systemic risk through the lens of the Lehman Brothers failure (and to a lesser degree, the AIG failure).

One way to summarize the report is “everything you knew about Lehman was wrong.”  Certainly, everything Gensler and Timmy! and Frank and Dodd and legislators and regulators around the world knew was wrong.

That conventional narrative is that Lehman’s failure brought the world financial system to its knees because it was so interconnected to the rest of the financial system.  That losses on exposures to Lehman-an most notably through derivatives exposures-threatened to propagate through an interconnected set of large financial institutions.   That the crisis was the result of a “daisy chain” or “domino” effect via what Scott refers to as “asset interconnectedness” (e.g., derivatives exposures) or “liability interconnectedness” (e.g., a big supplier of credit/liquidity fails, thereby forcing those dependent on it for credit or liquidity to fail).

Scott thoroughly debunks the interconnectedness narrative.  Instead, he shows persuasively that a contagion caused the crisis.  The Lehman shock dramatically shifted beliefs about whether large financial institutions would be bailed out, and also conveyed information about the severity of losses on real estate assets that were held not just by Lehman, but by a wide array of financial institutions.  This raised doubts about the solvency of all financial institutions, resulting in a run on their liabilities and a refusal to roll over these liabilities.  Given the dependence on short term credit, this run caused a major crisis.

In other words, it’s all about the funding mechanism.  It’s about liquidity.   It’s about runs.

Scott notes that the configuration of the financial network does affect its vulnerability to contagion, but that attempting to mitigate systemic risk through policies intended to affect the degree of interconnection is unlikely to reduce substantially the risk arising from contagion.

This is incredibly important because Frankendodd and EMIR and all of it is largely predicated on the belief that interconnection is the source of systemic risk.  But the diagnosis is wrong, meaning that the prescription is almost certainly wrong too.

Scott looks at CCP mandates in particular, and gives them 1.5 cheers.  I think that’s one or 1.5 too many, but it is gratifying to see that he does forthrightly downplay the potential benefits of CCPs as a means of preventing future crises.

The reason that I think he is not negative enough on this point is that he only looks at the first order impacts of CCPs, through their effect on derivatives netting, for instance.  He does devote some attention to the effects of CCP mandates on funding and liquidity, but more focused attention on the indirect effects of clearing and collateral mandates would, in my view, raise more serious concerns, especially in light of the primacy of funding/liquidity contagion channel in creating systemic risk.

Scott, citing Duffie’s work, claims that CCPs may reduce the incentive to run on big financial institutions.   I can see that in some scenarios, but I can also envision others in which a rigorous, highly-time sensitive, no-credit system like that will result from CCP and collateral mandates can lead to runs, either on the CCP, or on firms connected to the CCP.  That’s my take on what happened on Black Monday, 1987.

Clearing and collateral mandates will lead to a whole series of changes to the demand for liquidity, and the mechanisms for supplying it.  A cleared system is more tightly coupled; increases the likelihood in big shocks to liquidity demand; potentially ties up liquidity (especially under rigorous segregation regimes); and on and on.  Given the nature of cleared systems (and the imposition of rigorous daily variation margin based on mark-to-market for non-cleared derivatives), market users will make arrangements to secure contingent liquidity.  As a result, the entire financial network topology will change.  How it will change, and how these changes will affect systemic risk, are impossible to divine at present.  But it is certain that these changes will be profound and it is not difficult to imagine scenarios in which the new topology is as fragile in the face of large shocks as the old one.  Indeed, it’s not hard to imagine scenarios in which the new topology is more fragile than the old.

Clearing and collateral mandates should also be viewed as regulations of capital structures.  (“No credit extended through derivatives transactions” and “derivatives are at the top of the priority queue.”)  Capital structures will respond to this regulation, again in unpredictable ways, and in ways that affect the vulnerability of the system to contagion.

I am giving a talk on Monday at a joint Bundesbank-University of Frankfort conference about central banking.  My talk is about systemic risk and CCPs, and I will explore all of these themes.  The overarching theme is that you cannot view an intervention into the structure of financial markets, like a CCP mandate, in isolation.  You have to consider the endogenous responses throughout the system. The entire structure of financial contracts will change as the result of such a big intervention, and this structure will have its own special vulnerabilities.

When evaluating these vulnerabilities, one should pay special attention to liquidity issues, and liquidity contagion.  This was a theme of my JACF article “Clearing and Collateral Mandates? The New Liquidity Trap?”  Scott’s report adds special force to this contention that liquidity and contagion, rather than interconnection, should be the focus of any regulatory and legislative efforts.

It also suggests that much, and arguably virtually all, of the regulatory response to the 2008 Crisis was misdirected, and hence will either not reduce systemic risk, and may increase it.   Given the costs that these regulations impose, this is a sobering conclusion.

It finally suggests that it all comes down to central banks, as lenders of last resort.  If it is a liquidity problem (and in this Scott is closely aligned with Gary Gorton), the institutional means for supplying liquidity in times of crisis-which now means central banks-is of paramount importance.

Jon Corzine caused the demise of MF Global.

Poor management decisions by MF Global former CEO Jon Corzine triggered the brokerage firm’s collapse, while lax protections for customer funds contributed to the loss of an estimated $1.6 billion of customer money, congressional investigators have determined.

Evidence unearthed by the House Financial Services Subcommittee on Oversight puts the blame squarely on Corzine, the panel’s chairman, Rep. Randy Neugebauer, said in a preview of the report that will be released on Thursday.

“The responsibility for failing to maintain the systems and controls necessary to protect customer funds rests with Corzine,” the report says. “This failure represents a dereliction of his duty as MF Global’s chairman and CEO.”

Who knew?

Except anyone paying the slightest attention, I mean.  It has been beyond blindingly obvious since even before the implosion of the brokerage that Corzine was gambling for resurrection, and made the decisions that destroyed MF Global.  It was also clear that the firm was a managerial mess, a disaster waiting to happen.

But his “spokesman” says the failure was a collective one for which Corzine is not personally culpable:

A spokesman for Mr. Corzine said that “all of the firm’s significant business decisions…were subject to review, debate and approval” by MF Global’s board. “At all times, Mr. Corzine acted in good faith and did what he believed was necessary to turn around MF Global.”

Because boards are never, ever, ever the creatures of domineering, out of control CEOs.

The spokesman, Steven Goldberg, said that the panel didn’t find any evidence of “intentional wrongdoing” and that Mr. Corzine was working to turn around an already-failing business.

I see.  Taking huge risks-and running roughshod over risk controls to do so-is a turn-around strategy that only unintentionally results in mayhem.  His intentions were good, so everything’s just fine.  Big harm, no foul-because he didn’t mean it.

The fact that MF Global was “already failing” is precisely the motive for Corzine’s rashness.

The Neugebauer panel punts on the most important open question: who was directly responsible for the loss of customer money?  We all know that Corzine was the first mover who set of the chain of events that ultimately led to the looting of MFG’s not-so-segregated customer funds.  We knew that on Halloween, 2011.  But why, pray tell, we don’t know exactly who authorized this looting more than a year and two weeks after the firm’s collapse?

As I’ve written before, Edith O’Brien is essential to answering that question, but Edith O’Brien is silent because prosecutors refuse to grant immunity.

In the scheme of things, she doesn’t matter.  It is highly unlikely that she would have taken it upon herself to throw good customer money after bad Corzine bets.  And even if she did, letting her escape legal punishment would have no effect on the odds of a future recurrence of such a debacle.  It is more likely that someone else higher up in the firm made the call.  Given Corzine’s dominance, he is the most likely candidate for making that call.  Letting him skate would set a bad precedent that would encourage other CEOs to engage in such misconduct.  The balance of costs and benefits is clearly on the side of getting Ms. O’Brien’s testimony.

And indeed, this is Federal Financial Crime Prosecution 101: go for the big fish by catching and releasing the little ones.  The failure to follow this tried-and-true strategy is quite revealing, given the identity of the biggest fish: a made man in the Democratic Party, a former Senator and governor, and fund raiser for Obama.

Because of this pointed refusal to do something that would put Corzine at risk, the MF Global collapse remains the Immaculate Destruction, and the firm remains the Financial House Not Destroyed by Human Hands.  And the House Financial Services Subcommittee on Oversight does nothing to resolve that mystery.

Go to a conference where derivatives or Frankendodd are discussed, and you can’t escape without hearing somebody’s tongue trip over the word “extraterritoriality” (say it 5 times fast!) -the imposition of Frankendodd rules (such as swap dealer registration) on foreign firms.  Gensler has been quite aggressive in his interpretation of where the CFTC’s writ extends: in his mind, it basically extends everywhere that directly or indirectly could have an impact on US markets.  In an interconnected financial world, that doesn’t limit things much.

Foreign financial institutions (and other firms, such as pension funds and money managers) are less than thrilled.  To say the least.  Some smaller institutions have announced their intention to have no dealings with US firms that could put them in the monster’s grip.

Foreign regulators have also criticized US assertions of authority, both in writing and now in GiGi’s face:

Financial regulators from around the world have rounded on the main US swaps regulator over its attempts to extend new rules on derivatives overseas, warning of destabilising effects on the global financial system.

Supervisors from Japan, Europe and Hong Kong have previously criticised the Commodity Futures Trading Commission in written correspondence. On Wednesday, the regulators set out their concerns during a public meeting at the CFTC in Washington.

GiGi nodded, and then defended the CFTC’s actions.

Regulatory arbitrage is a concern, but unilateral assertions of US authority, and foreign pushback on those assertions, raise various concerns of their own.  In particular, they threaten to balkanize derivatives markets (and financial markets generally) as non-US firms limit their dealings with US entities.  This will reduce liquidity; tend to lead to concentrations of risk; and will impede the efficient allocation of risk.

Per usual, Gensler is appealing to a simplistic version of the financial crisis to justify his position, and not acknowledging the adverse consequences-most notably due to fragmentation-that will result from over-aggressive American initiatives.  Regulatory consistency across jurisdictions (which would mitigate regulatory arbitrage) ironically is undermined by the unilateral efforts of the US regulator to impose its will around the world.

This is particularly amazing given the CFTC’s less than glorious record at regulating a subset of US derivatives markets.  Hubris, anyone?  And unfounded hubris at that?

Speaking of regulatory hubris, David at Deus ex Macchiato is justifiably outraged at the assertion by an Irish regulator that global regulations of OTC markets had “the explicit policy objective” of reducing the size of these markets.  Because of course regulators know exactly how big OTC derivative markets should be and know with metaphysical certainty that the markets will reconfigure themselves to the regulatory fiat in ways that enhance stability.  Yes, these are the most complicated, interconnected markets in the world, so of course guys in Dublin and DC should know exactly how big they should be and exactly how they should be configured.  Because that always turns out just swell.

This is exactly what Hayek meant by “the fatal conceit.”  And I fearlessly predict that this very conceit will be the source of the next crisis.

Mere days after the collapse of MF Global, I was told by someone who would have reason to know that the key to unraveling the MF mystery was Edith O’Brien, the firm’s assistant treasurer.  A year later, Ms. O’Brien is still in limbo, refusing to testify without immunity from prosecution.

The likelihood that Ms. O’Brien would have conceived of and executed a massive fraud-the looting of MF Global customer segregated funds-is close to zero.  If there was a crime, it would have been conceived of and directed by someone far higher in the firm than Ms. O’Brien.

Prosecutors routinely give immunity to low-level employees in order to build a case against higher executives.  Prosecutors in the MF Global matter seem to be deviating from that routine.  This raises questions, the most notable of which is: are they departing from SOP because the individual who could be implicated is a well-known and highly connected Democratic politician, a former governor and senator, and bundler for Obama?

Maybe there’s a different explanation, but I’m hard pressed to think of one.

How dumb does Jon Corzine think we are?

The WSJ has this hanky puller on his struggles to move on from the wreckage of MF Global:

And the 65-year-old Mr. Corzine is struggling to figure out what comes next for himself, according to friends and former coworkers.

I can hardly type through the sobs.

Stand at LaSalle and Jackson or 10-30 S. Wacker and see how much sympathy you get, Jon.  I’d bring bodyguards.

But here’s where Corzine insults our collective intelligence:

Allegations from shareholders and bondholders that he hid problems or committed fraud at the brokerage firm make “no sense” because he had “no motive,” Mr. Corzine’s lawyers said in a court filing, citing his ownership of 441,960 shares in MF Global. The stake includes 50,000 shares bought shortly before the bankruptcy filing.

Uhm, equityholders in firms teetering on insolvency, or which are insolvent, have a huge incentive to hide problems or commit fraud or take huge risks.  It’s called gambling for resurrection.  Fraud or concealment permit the firm to survive-and maybe it will get lucky.  If things get worse-that hurts only the bondholders, who lose more when the firm loses even more value.  The stock was already worthless.  Ditto with taking on risk: if the insolvent firm’s bet turns bad, that just deepens the bondholders’ losses without hurting the equity holder, but if the bet turns out well the equity profits disproportionately.

Most frauds and concealment of losses are carried out by shareholders.  These are ways of stealing from bondholders.

The only thing that makes no sense is Corzine saying he had no motive.  And he expects us to believe that.

Corzine’s other defense is that MF Global’s failure was due in large part to its completely deficient accounting and control systems.  But that throws him into the Sarbanes-Oxley fire, for he signed off on the soundness of those systems.

Corzine is obviously ginning up the PR machine to try to build sympathy and lay the groundwork for a comeback.   Don’t do the world any favors, Jon.  You’ve done quite enough already.

Today is the 25th anniversary of Black Monday, the 1987 Crash.  This event had a profound effect on my professional trajectory.  I worked at an FCM at the CME-GNP Commodities-during the Crash.  The firm was owned and run by Brian Monieson, a former chairman of the Merc, and a board member at the time.  I walked into his office on the morning of the 20th, and he told me about how the CME clearinghouse had almost failed.  I had only a dim appreciation for clearing prior to that, but that sparked my interest in the subject.

Little known fact: I Granger Caused the Crash.  Throughout the late summer and fall of  ’87 I had been having issues with my direct boss, and soon after I defended my thesis in August I had received a good offer from one of my advisors, Dennis Carlton, to work at Lexecon.  I tried to work things out at GNP, but by mid-October it appeared hopeless.  I told Brian, and we had several phone calls on the 17th and 18th where he tried to convince me to stay.  I thought it over, and on the evening of the 18th decided that it wasn’t going to work.  So I walked into my boss’s office at 7AM on the 19th and slapped down my resignation letter on his desk.  Apparently the news leaked, and the rest is history 😛

The anniversary has spurred retrospectives from many quarters.  Many of these focus on the role of computers in the Crash, and how this was a harbinger of the supposed horrors the machines are inflicting on the markets today.  One good-well, representative-example of this is “Rage Against the Machine” in the FT:

It has been 25 years since Black Monday, when stock markets crashed around the globe and Wall Street woke up to the risks of computerised trading.

Yeah.  The computers were blamed then.  Suspect number one was “program trading”, a good deal of which was garden variety index arbitrage.  This is not a destabilizing strategy, and numerous postmortems absolved program trading as a cause or aggravator of the Crash.

Indeed, if technology was a problem, it wasn’t that computers were trading too fast: it was that printers were printing to slow.  Seriously.

At GNP we did a little index arb trading.  In the morning, it appeared that the arb was extremely profitable.  The price of the cash index (we were doing MMI) was way, way above where the futures were trading.  It looked like a great opportunity.  My colleague Matt who was in charge of this called down to the CBT floor before doing a trade, to see where the floor was trading.  Our floor clerk said (I don’t remember the numbers exactly): “Somebody is offering X over here.  Somebody else is offering X+20 over there.  Somebody else is offering X-20 over there.  I have no fucking idea what the price is.”  Matt didn’t make the trade.

Which was good, because the apparent opportunity was a mirage.  That’s where the slow printers come into play. Specialist posts on the NYSE had old fashioned daisy wheel printers.  Very, very slow.  They were overwhelmed by the order flow.  At 10AM the printers were spitting out orders that had been entered at 8 or earlier.  So the orders being executed on the NYSE were actually very stale, and the prices didn’t reflect current market conditions.  The futures didn’t have that problem.  So at 10 or 11 NYSE prices were reflecting orders submitted hours before, and the futures were reflecting current conditions.  Hence the futures were way below the cash, making it appear that there was a huge arbitrage opportunity.

The problem was that this induced more people to submit sell orders to the NYSE before they caught onto the fact that NYSE prices were not reflective of current conditions.  This exacerbated the backlog on the printers.

So it wasn’t fast technology that caused problems on 19 October ’87.  It was slow technology.

Program trading wasn’t an issue, really, but portfolio insurance was.  This is sometimes called “computerized trading” but it’s not, really.  Yeah, computers were used to calculate deltas, and these deltas were used to determine trading strategies.  You could have used an HP-12C (complete with Reverse Polish Notation!-and no, that’s not an ethnic joke) and the normal cdf table from Handbook of Tables For Mathematics (pp. 922-929 of the Fourth Edition) to do the same thing.

The problem with portfolio insurance was that, unlike index arbitrage and most market making strategies employed today in HFT, it was a positive feedback strategy, rather than a negative feedback strategy.  As prices fell, portfolio insurers had to sell more, which drove down prices further, which led them to sell more . . . until they pulled the plug on the strategies.  That is, unlike market making strategies which are buy low-sell high trades, portfolio insurance was buy low, sell lower.

The FT article uses the ’87 Crash as a springboard to make the usual litany of complaints about current market structure and computerized trading.

Some of the criticisms are defensible.  The current fragmentation of equity structure in the US is indeed the product of SEC RegNMS, which I characterized at the time of its introduction as implementing an “information and linkages” approach to market structure, in lieu of mandating a CLOB.  This socialization of order flow has some problems, particularly during times of market stress.  Links are vulnerable during times of stress.  Moreover, the proliferation of order types that has complicated trading dramatically is directly the result of this approach: many of the new order types are related to order routing, which is a much more complex task with many execution venues as opposed to one (as in futures markets where order flows are not socialized).

Other criticisms are less defensible.  The authors of the FT piece are apparently scared of the dark, as they warn of the dangers of dark pools.  These things are not new.   They just used to be called “third markets” or “block markets”.

The FT piece also warns that in the computerized world, liquidity can evaporate quickly.  They acknowledge that liquidity evaporated quickly in the old days-as it did on Black Monday-but suggest that can happen more quickly today.  Not really.  At all.  Locals could shut up or keep their hands in their pockets very quickly back on the floor if it looked like order flow was getting toxic.  And they were pretty quick at picking up on that.  Moreover, during the Crash clearing firms pulled their locals from the pits.  You would have thought that the pits would have been in a state of pandemonium on the 19th, but after the initial frenzy, they were actually spookily empty, as most locals and many brokers had been yanked from the floor by their clearing firms.

In brief, the functions of markets haven’t changed.  The technology for performing these functions has.  But the fundamental economics of performing the functions hasn’t.  Face-to-face and machine-to-machine markets have the exact same basic vulnerabilities.  Those who focus on the technology miss the economics.

The FT article, and others like this one in Bloomberg,  blame computerization and HFT, and the consequent alleged “loss of confidence” among investors, for the decline in equity volumes recently.  Color me skeptical.  Futures volumes have dropped too, despite a very different market structure, and a different composition in market users.

Historically, trading volume has ebbed and flowed.  It ebbed and flowed in the pre-computer era. It shouldn’t be any surprise that it ebbs and flows now.

If you are looking for the big lesson from the  1987 Crash that we should heed today, ignore all the BS about technology.  Look at clearing.  Look at the Brady Report and other post-Crash studies of what happened in clearing.  That’s what almost brought the markets down.  The operation of variation margining-which is usually a source of stability-threatened to bring the markets to a halt, with even more devastating consequences.

Then think of what will happen during the next big market move, given that the scope of clearing has been expanded substantially due to Frankendodd, and parallel efforts around the world.  Don’t worry about the technology of execution: worry about what happens after the trade, during clearing and settlement.  That’s where the truly systemic vulnerability lies.

There’s an old adage in the military: amateurs talk tactics, professionals talk logistics.  In the markets, the parallel is that most commentary focuses on execution, when much of the real important action happens out of sight, in clearing and settlement-the logistics of the financial markets.  That happened in post-Crash commentary, and it is being repeated today.  That’s a big mistake.  When looking for object lessons from Black Monday, don’t look at the computers and the execution of trades.  Look at what almost happened with disastrous consequences in clearing.  And worry deeply about how the system is vulnerable to a repeat in the future.  Arguably more vulnerable, given the dramatic growth in the size of the markets and the mandated reliance on clearing, and margining of non-cleared derivatives.

That’s the lesson I first began to grasp in Brian’s office early on 20 October.  And that experience has decisively shaped my criticism of efforts, like Frankendodd, intended to fix the markets.

This afternoon I attended the Working Group on Financial Markets at the Chicago Fed.  The scintillating topic was segregation models.  Really!  It was scintillating!  For a certain kind of geek, of which I am one.

It was scary, actually.

Segregation of customer money has been a subject of discussion post-Frankendodd, and I have written several posts on the subject.  Segregation has received even more discussion post-MF Global (AKA Corzine-gate, but since he’s a made man I guess he will skate).  The model that has been implemented for cleared swaps, and which (according to clearing maven John McPartland of the Chicago Fed) is likely to be adopted for cleared futures is LSOC-legally segregated, operationally commingled.

Back in the summer of 2011, I wrote that segregation could make the markets more fragile, because it would tend to reduce credit (mainly intraday credit) used to finance variation margin.  This is important, because the markets depend on using credit to fund margin payments.  If this credit freezes up, the markets will freeze up.  Indeed, a cleared system works on such tight deadlines that an interruption of credit can be catastrophic.  If margin calls aren’t met in a timely fashion, absent credit, margin payments don’t flow to those on the winning side of trades.  When this happens, the clearing system breaks down.  And in a Frankendodd world dependent on clearing, a breakdown in clearing means a meltdown in the markets.

Indeed, even delays of hours or even minutes in making margin payouts, or doubts that CCPs will make margin payments in a timely fashion, can be catastrophic.  Almost exactly 25 years ago, on 19 October, 1987, the mere rumor that the CME would not pay out variation margin led to a run on FCMs and the CME clearinghouse that almost brought the market to a crashing halt.

One of the speakers at today’s event, Barclays’ Kevin Murphy, noted that under segregated models FCMs don’t have a lien on  the collateral in customer accounts.  Which means they won’t extend credit to customers because there is no collateral backing the loans.  Murphy said that broker intraday credit is likely to be a thing of the past under greater segregation.

Think of the consequences on a day when markets move a lot.  Those on the winning side are expecting to receive variation margin payments.  Those on the losing side will be scrambling for cash to meet their VM obligations.  Where will they get it?  Not from their FCMs.  From their banks?  Uncertain-even if the customers arrange credit lines, banks can often find reasons to delay providing the credit, or not providing it at all.

This all means that there is a risk that VM owes will not be paid in time.  With no credit being extended, or the amount of credit being sharply constrained, there is a serious risk that VM pays will not be made on time.   If that happens, particularly during a period of market stress, all bets are off.  Almost literally.  People will fear that CCPs are insolvent, and there will be runs on them-people will liquidate positions to recover their margin money.

That would be very ugly indeed.  Again, a cleared system is very tightly coupled, more tightly coupled than OTC markets.  Tightly coupled systems are more prone to going non-linear, and failing catastrophically.  Segregation increases the tightness of the coupling.   Connect the dots.

Of course, markets don’t stand still.  People will recognize the need for contingent liquidity, and make arrangements for it.  But will those arrangements be as robust as the system we have now?  There is serious room for doubt.  If more robust alternatives are available, why weren’t they chosen before?  I know this argument is not dispositive, given the coordination issues involved, but there are strong incentives to adopt better systems.   We should be very leery of changes that implicitly assume that market participants with large amounts of money and risk in the game systematically choose wrong.

The whole move to clearing has been intended to wring credit risk from the derivatives markets.  But every move to reduce credit risk-including moves to greater segregation-almost always involve creating greater liquidity risk.

If given a choice between credit and liquidity risk, I would choose credit risk every time .

In other words, you have to pick your poison: credit risk or liquidity risk.  Yeah, credit risk may be like arsenic.  But liquidity risk is more like cyanide.

I know which one I would choose.