Streetwise Professor

The Bank of Canada has decided that Canadian entities can meet their G-20 clearing obligations by clearing with international CCPs like LCH or CME.

The alternative-which was seriously considered, until fairly recently-was to require the formation of a domestic Canadian CCP through which Canadian financial institutions would be required to clear.  The Bank of Canada was leaning towards a “Canadian solution” because it believed that it could monitor such an institution more effectively, that a domestic CCP would insulate Canada from global financial shocks, and that it would be easier to provide C$ liquidity support to a domestic entity.

I co-authored a study for the Canadian Market Infrastructure Committee (CMIC) which argued that (a) these benefits were illusory because there would be C$ swaps traded by non-Canadian entities and non-Canadian entities would likely be important members of a Canadian CCP due to scale and scope economies, and (b) mandating clearing via a domestic CCP would dramatically increase collateral and liquidity costs of trading C$ swaps due to the fragmentation of netting sets (among other reasons).  As a result, I/CMIC recommended that Canadian banks, investment funds, and insurers be permitted to meet their G-20 obligations with an international clearer that could margin more efficiently.

It’s good to see that BoC acknowledged the force of these arguments, despite its initial preference for a domestic CCP.  Reason sometimes prevails.

I’m less enamored with BoC Deputy Director Timothy Lane’s argument that commodity trading firms (e.g., Cargill, Glencore, Vitol, Trafigura, Dreyfus) are systemically important.  Much more on that subject soon-it consumed much of my summer.  Hopefully he’s open to persuasion on this issue, as he was on the necessity of mandating the use of a domestic CCP for Canadian IRS.  But it would be gratuitous of me to make too much of a bother of the global commodity trading firm (“GCTF”) matter now.  So I say kudos to Mr. Lane, and the BoC, for setting priors aside; evaluating the arguments and evidence; and coming to the right choice (IMO) with respect to clearing of C$ swaps.

Bloomberg’s Brad Keoun has out a long piece today highlighting the risks of collateral transformation, a development driven by Frankendodd’s clearing and collateral mandates:

Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.

Keoun quotes Darrell Duffie and Anat Admati raising concerns about the systemic risk that collateral transformation creates.  And bully for them, because they’re right.  As I pointed out in this post from July, 2011, and in several others in the months since (as well as in a paper in the J. Applied Corporate Finance.)  Anat argues that clearing and collateral mandates are resulting in the shifting of risk, rather than its reduction as promised by Frank ‘N Dodd and Gigi and Timmy!:

The banks’ new lending business “smells like trouble,” said Anat Admati, a finance and economics professor at Stanford who studies markets and trading and advises bank regulators on systemically important firms.

“The point of the initiatives on derivatives was that derivatives can hide a lot of risk,” Admati said. “Now they’re going to just shuffle the risk around.”

I wrote that mandates would result in a substitution of new forms of credit exposure and leverage for the credit exposures and leverage eliminated from derivatives via collateral in this July, 2010 Cato Policy Analysis (see especially p. 25).

So although these consequences were unintended, they were foreseeable and foreseen.

But even though these developments have been in train for months, and although they are pregnant with systemic significance, regulators are ignorant of the potential risks.  In the most shocking but not really part of his piece, Keoun writes:

U.S. regulators implementing the rules haven’t said how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment. [Emphasis added.]

But Congress and the regulators pinky swore that Frankendodd would make the system safer!  Trust us on this, they said.  We know what we’re doing!

Uhm, I don’t even think they slept in a Holiday Inn Express before taking on the wholesale reshaping of the vast derivatives markets.

Gensler and Geithner are particularly culpable here, because both pronounced repeatedly that Frankendodd, and specifically its collateral and clearing mandates, would reduce the interconnectivity of major financial institutions.

Not exactly.  Out with the old, in with the new: new interconnections, and arguably more fragile ones, are being forged to replace the old ones.  Again, predictable and predicted.

And they continue to assure the world that Frankendodd has made the world safer-even though the analysis necessary to support that claim has not even been done.

Think about it.  It is widely recognized that shadow banking, including quite specifically repo, was a major source of systemic risk that contributed to the severity of the financial crisis.  Collateral and clearing mandates have essentially resulted in the development of a new form of shadow banking.

This is an improvement?  Maybe it is.  But inasmuch as key regulators haven’t even acknowledged the development, and haven’t analyzed its systemic consequences, their pronouncements are not credible.

And make no mistake: this will not be the last big unintended consequence of Frankendodd that will tend to undermine the intent of the act.  And take fair warning: regulators are likely to be well behind the curve in understanding and reacting to these consequences.  Meaning that, to paraphrase Anat Admati, the systemic risk hasn’t gone away, it’s just been shuffled around.  That includes, mind you, the systemic risk resulting from the regulations and the regulators.

Maybe that’s a disturbing mental image, but the title is more than apt given Gensler’s recent NYT oped, “Libor, Naked and Exposed.”  As is his wont, demonstrated repeatedly on Frankendodd-related issues such as clearing and SEF mandates, Gensler presents a misleading and distorted analysis to advance some regulatory or political agenda.

Gensler questions the integrity of Libor.  This is certainly understandable in the light of the deluge of revelations in the past couple of months.  But the “evidence” that Gensler uses to justify his skepticism is completely off point, and certainly grossly overstates the impact of any manipulation on this important benchmark rate.

The first comparison Gensler makes is between Libor and Euribor.  He notes that dollar Euribor is about double dollar Libor.  But what Gensler omits to say is that this is an apples to horse apples comparison, given the major differences between the banks in the Libor and Euribor panels.  The former includes major banks (crucially, TBTF banks that benefit from the implicit and explicit support of governments and central banks), and most notably major US banks with ready access to dollar funding.  The latter includes something of a dog’s breakfast of foreign banks.  It has two Spanish and one Portuguese cajas and five German landesbanken, for crissakes.  And Dexia! The Euribor panel banks are all weaker, and don’t benefit from the same safety net as the banks in the Libor panel.  Moreover, since the beginning of the crisis, foreign banks have much greater difficulty in securing dollar funding than US banks.  Even big European banks (such as French giants like Paribas)  have faced acute dollar funding problems.  This is one reason why they have been deleveraging, and selling off dollar assets.  The Euribor banks almost certainly have even worse problems.

This issue of fragmentation of funding markets also bears on Gensler’s second piece of evidence: the divergence between Libor and the dollar rate implicit in FX swap prices. Gensler treats the violation of the interest rate parity relation as an indicia of manipulation.

But again, this reflects the acute problems European banks have faced in securing dollar funding.  They can borrow in Euros, but have to swap it into dollars to fund their dollar assets.  They are willing to, and the market is making them, pay a premium to execute this transaction.

Gensler claims “this divergence between theory and practice has yet to be adequately explained.”  Really?  It is well-understood.  Don’t believe me?  How about some economists from the New York Fed?  They investigated this issue in detail in 2009, and concluded that the divergence in the basis between the FX swap implied USD rate and USD Libor was caused by the dislocations associated with the financial crisis.

Indeed, Gensler’s oped implicitly recognizes this: he notes that implied and Libor rates have not been aligned “since 2008.”  Hmm.  What happened in 2008?  Think, think, think.  A financial crisis maybe?  Could that be it?  I’m thinkin’.

One key piece of evidence that FRBNY economists  Coffey, Hrung, Nguyen, and Sakar present is that the basis blowout was not limited to Libor.  It was also present when they used the New York Funding Rate produced by ICAP.  It was also present when they used Eurodollar deposit rates.

Look, anybody who has followed this knows that basis relationships that had been steady as a rock for years went haywire starting in August, 2007.  (Happy Anniversary!)  The CDS-cash bond basis went haywire.  Interest rate spreads (e.g., OIS-Libor) went haywire.  Spreads between borrowing rates across banks have become much more dispersed and become much more volatile.  (This relates directly to the Euribor-Libor comparison: banks are much more heterogeneous now than in, say, 2006, making comparisons between averages across different groups of banks much less meaningful now than then.)

This pertains to another piece of evidence: the lack of comovement between bank CDS spreads and their Libor submissions.  This could be informative, particularly in normal times, but it is problematic during crisis times.  CDS spreads and yields on the underlying cash bonds diverged dramatically, and often exhibited little comovement, during the period of the crisis.  CDS spreads were being driven by liquidity and risk aversion issues.  If the CDS-cash bond basis became much more volatile, it’s not at all surprising that the CDS-Libor spread also became much more variable, given that CDS and cash bonds have closer kinship than CDS and unsecured short term borrowings.

Noticing a pattern here? Basis relationships of every sort became much more volatile during the crisis period, and hence are far less reliable evidence of manipulation in Libor than would have been the case more than 5 years ago.  In essence, Gensler is trying to tell time with a broken watch.

Recall that Gensler mentions “the divergence between theory and practice.”  Anybody who has been paying attention understands why that’s true.  The theory is predicated on an assumption of frictionless financial markets.  Financial markets where capital and liquidity constraints are not binding, thereby permitting arbitrageurs to eliminate swiftly divergences in prices across related markets.  That was a reasonable approximation of reality in say, July, 2007: certainly in July, 2005.  It is completely unreasonable post-August, 2007.

Or as the FRBNY economists put it:

The widening of the basis illustrates the breakdown in arbitrage relationships that has afflicted many markets during the financial crisis. For example, eurodollar interest rates in New York and London diverged during the crisis-as did yields on corporate bonds and credit default swaps, which are closely related securities.  The element common to all of these phenomena was increased funding costs, which impeded arbitrageurs from shrinking the basis between these types of securities.  In addition, counterparty credit risk became prominent, and previously risk-free arbitrage trades suddenly became risky . . . funding constraints and counterparty risk explain the rise in the basis and the relative importance of each factor changed as the crisis evolved. [Emphasis added].

Since then, the coefficient of financial friction has reached record levels.  Capital and liquidity and funding constraints are binding everywhere, and binding hard.  In particular funding markets-and Libor is a measure of a funding costs for some banks-have been dysfunctional for 5 years.  Severely dysfunctional.  Most of the European banking system relies on the ECB for funding.  Markets across regions that were once highly integrated are now fragmented as never before.

This is particularly important for dollars.  Having access to dollar funding via deposits and access to the Fed (like major US banks) is completely different than having to raise dollars through wholesale markets, like most European banks that have been hit hard by the flight of US money market funds and other sources of dollar liquidity.  This is what drives things like the Euribor-Libor differential, and the swap-Libor basis.

Hell, there is fragmentation of funding even within currency areas, in particular, the Eurozone.  European subsidiaries are attempting to fund their local lending with local deposits, especially in countries where conversion risk (i.e., the risk that a country will leave the Euro) is acute.  For instance, Italian subsidiaries of French banks are funding their loans to Italian businesses with local deposits, rather than money from the parent banks.

In other words, Gensler is relying on a textbook model that presumes a frictionless world.  That ain’t our world, today.  The textbook needs to be thrown out.  But Gensler uses it as his bible.

There are two explanations of this, both quite frightening.

The first is that he really doesn’t understand this.  That he doesn’t understand that the financial system has suffered cataclysmic shocks and doesn’t work the way it used to.   It would inspire confidence, wouldn’t it, that an individual playing a crucial role in reshaping that financial system through the promulgation of rules under Frankendodd doesn’t understand why things are working-or not working-the way they are?

The second is that he is a fan of the band Say Anything.  That he knows that his “evidence” has nothing to do with Libor manipulation, but he is saying it to advance some regulatory or political agenda.

I’m betting on the second alternative, because Gensler is a serial offender in this: look back at my posts from 2009 and 2010 and you will see numerous times where I called BS on the former Goldman managing director for making ludicrous statements about financial markets-all of which were calculated to justify Frankendodd and a massive expansion of Federal regulation of derivatives markets.

Regardless of the reason, one thing is clear: Gensler’s misleading analysis lies naked and exposed. This is not to say that Libor was not manipulated.  It is to say that what Gensler hypes is not evidence of the existence of manipulation, or the magnitude of its effect.

It is unfortunate that he penned such a distorted oped, given that his agency provided a very rational proposal to reform the Libor fixing process in its Barclay’s settlement order.   Gensler should limit himself to promoting that proposal, rather than writing pieces that sow confusion and promote misunderstanding about a highly contentious issue that could have huge and costly impacts on banks-and hence on the world financial system, stressed as it already is.  That is not constructive.  It is irresponsible and dangerous.

ICE has created something of a kerfuffle by its announcement that it will convert its cleared energy swaps contracts to futures.  Despite a lot of breathless reporting, there is less here than meets the eye.

ICE has merely relabeled its cleared energy swaps as futures in order to avoid burdening its customers with the costs that Frankendodd imposes on swaps.  Futures and swaps are subject to different regulatory regimes.  Firms with sufficiently large swap positions are considered swap dealers under Frankendodd, and must meet a variety of requirements that those not blessed with this designation can avoid: holders of equivalent futures positions need not meet the same requirements.  Swaps trades also involve additional reporting obligations not imposed on futures trades.

So what ICE will do effective in January is change the name of its contracts, thereby reducing the regulatory burden on its customers, without changing their economic substance one iota.  Note that these are cleared swaps, so the change doesn’t create a new clearing obligation on those trading them.  The central counterparty for the futures will be the same as for the swaps: ICE Clear Europe. The contracts will have identical settlement terms.  They will have identical cash flows.  They will trade on the exact same ICE platform.  The economic substance of every aspect of the old “swap” transaction and the new “futures” transaction remains the same, from execution to clearing to settlement.  Nothing changes but the name.

And the regulatory burden.

Which points out the potential for absurd outcomes under Frankendodd.  The CFTC has labored mightily to craft definitions of a swap and swap dealers and major swap market participants.  Where one falls under these definitions matters a lot.  Firms will endeavor to take measures that minimize the regulatory burden they face. ICE is basically picking the low hanging fruit, and taking note of Congress’s morbid obsession with “OTC swaps” and idealization of futures by magically transforming the former into the latter, and thereby making life easier-and cheaper-for its clients.

The incentive to label or structure transactions to achieve the same economic outcome at lower regulatory cost will be quite strong in the Frankendodd era.  This will initiate a regulatory dialectic in which regulators will attempt to adjust regulations in order to limit such attempts to escape regulatory burdens by relabeling or restructuring; the regulated will adjust to the adjustments; the regulators will adjust some more; and on and on.*

The lawyers will rejoice.

Much of the reporting on the ICE move has been pretty far off base, such as this from the WSJ:

Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations.

ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more-opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets.

Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations.

ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more-opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets.

. . . .

Many energy producers and users generally have preferred swaps contracts because each contract can be written up individually and to a company’s own specifications. That has enabled them to be more targeted in their hedging. Futures contracts, by contrast, are generally standard contracts covering the price of a specific energy grade to be delivered at a certain time.

Pretty much none of that is true.  All of it suggests a change in the way these instruments are designed, traded, and cleared, none of which is in fact changing. The contracts are already standardized, traded on an electronic platform, and cleared.  This is not a movement of bespoke, uncleared, bilateral contracts onto an exchange.

Look.  It’s long been known that the economic substance of swaps and futures are effectively identical, especially when the former are cleared.  Changing the label-hell, call them bananas-doesn’t change the economics.  If the CFTC had even less burdensome regulations for bananas, ICE would launch ICE Bananas.

Which illustrates that Frankendodd is quite often and in many ways truly bananas.

* Relabeling of derivatives contracts was employed in the 19th century to avoid legal restrictions.  When Illinois banned options trading, traders bought and sold the same things, but started calling them privileges.

The Bulava-esque trajectory of the “bailout” of the Spanish banks would be hilarious if it weren’t so tragic.  But it was predictably tragic.

The Euros pulled one of their characteristic delay and pray moves.  (Though, being thoroughly pomo, I doubt praying had much to do with it.)  In essence, they funded-maybe, because the details of the funding and the identify of the funder(s) are Players to Be Named Later-the movement of Spanish bank liabilities onto the balance sheet of the Spanish government.  This boosted the debt-to-GDP ratio of Spain to the severe pain range: uhm, bringing the SPVs on balance sheet doesn’t make the entity stronger; quite the contrary.  A level that is likely unsustainable given the dire economic straits the country finds itself in, with GDP contracting and unemployment at Great Depression heights.  Moreover, the move has affected the game between the EU and the other debtor nations, who see that Spain extracted a deal that compares favorably, in terms of “conditions” to theirs.  Thus, Ireland may want a renegotiation of its deal, and the Greeks may conclude that telling the Troika to eff off might be the best course.  Moreover, it gave those holding bonds not just in Spain but in other precarious countries-notably Italy-serious concerns that they might be subordinated.

Furthermore, by absorbing a big chunk of EFSF/ESM resources, the Spanish bailout raised serious questions about their ability to assist other countries, with Italy again at the top of the list.  This further increases the angst of bondholders. (A warning to CCPs that have resources to absorb the default of N members, but no means to recapitalize.  When the N-2d or N-1st default occurs, there is likely to be a run on the CCP, making its ultimate demise almost inevitable.)

Hence, after an initial burst of foolish EUphoria, Spanish bond yields spiked, as did those on Italian debt.

Well played!  Well played! Bravo!

No, Europe’s real choices, as opposed to its finger-in-the-dike stopgaps, are exactly the same as they were last year, and the year before that.  Amputation or gangrene.  Socialization of debt or dissolution of the Eurozone as it currently exists.

But Europe refuses to grasp those nettles.  Truth be told, moreover, it seems impossible that they can negotiate the arrangement necessary to make socialization palatable to those who are likely to be net contributors-notably, the Germans. Germany obviously does not want to be Europe’s ATM, and reasonably demands mechanisms that limit its exposure.  Furthermore, it is highly unlikely that the electorates of other nations are willing to surrender sovereignty, or undertake the structural reforms* necessary to make them competitive and put them on a reasonable growth trajectory.

Indeed, look at the delusional policies that France is pursuing.  Lowering the retirement age.  Looking to make it virtually impossible to layoff or fire anybody-which will mean that it it will be financially insane to hire anybody in the first place.  In the name of growth!  These policies are popular-not only did Hollande win, but the Socialists won an outright majority in the just-finished parliamentary elections.

Good luck with that!  Be careful what you ask for!

Everyone is importuning Merkel and Germany to save them.  Particularly annoying are the gratuitous proddings of Timmy! and Obama.  Timmy!’s post-bailout-that-wasn’t-a-bailout remarks were particularly grating.  Sayeth Timmy!: the bailout represents”concrete steps on the path to financial union, which is vital to the resilience of the euro area.”

Read that again.  Geithner, whom the (relatively) solvent Euros loath, is telling Europe that financial union is the way to go.  What chutzpah.

Germany realizes that such a financial marriage in haste will permit it plenty of time to repent its error at its leisure.  But there isn’t time to negotiate a solid pre-nup before the whole thing goes up the spout.  And I doubt there is a pre-nup that all parties are willing to sign, or would adhere to if they did.

The core of this game is empty, it seems to me. Which means that it is a matter of time before the whole thing collapses.  And that time is drawing nigh.

* Structural reform-supply-side measures, if you will-are essential to supporting long run growth.  But commentators insist on either misunderstanding this, or grossly mischaracterizing it.

For instance, consider the recent Roubini-Ferguson oped on Europe:

Structural reforms that boost productivity growth should be accelerated. And economic growth needs to be jump-started. The policies to achieve this include further monetary easing by the ECB, a weaker euro, some fiscal stimulus in the core, more bottleneck-reducing and supply-stimulating infrastructure spending in the periphery (preferably with some kind of “golden rule” for public investment), and wage increases above productivity in the core to boost income and consumption.

Uhm, none of those are structural measures.  They are all variants on Keynesian nostrums.

But that is nothing compared to the truly aggravating Martin Wolf:

Moreover, “structural reform” is a woolly term. If by this Mr Schuknecht means that falling prices, induced by ultra-high unemployment, debt deflation and sovereign and banking insolvencies, will ultimately restore competitiveness, he is correct, provided the country is able to stick with such policies, for a very long period indeed (probably a decade, or even far longer). This is what is required if a country with a large private sector debt overhang and a sizable structural current account deficit is to eliminate its fiscal deficit, regain competitiveness and restore growth, particularly in a currency union whose core country has a structural current account surplus and low inflation. The question is whether democratic politics (or the eurozone) will survive the experience. I doubt it.

Way to bash a straw man there, Marty! You know that’s not what German FinMin official Ludger Schuknecht meant by the term, and for you to insinuate otherwise is truly low.  Schuknecht is referring to the kinds of labor market and other reforms that transformed Germany from the sick man of Europe to the prosperous nation whose pocket everyone wants to tap.  If you want to discuss structural measures, at least do it fairly.  John Stuart Mill you ain’t. (Mill was/is legendary for his even-handed characterizations of his opponents’ views.)

With these clueless or deeply misleading analyses from esteemed purveyors of opinion, structural reforms don’t stand a chance.  Especially in delusional countries like France, which are hell-bent on implementing structural deforms.

After all that, isn’t a little musical entertainment in order? I think it is!

Global regulators are lumbering towards announcing proposals on the margining of non-cleared swaps, though they will miss the original G-20 deadlines:

Global regulators said on Wednesday they will issue proposals in coming weeks on rules to encourage banks to put derivative trades through a central clearing house, but they won’t be ready for the G20 summit in June.

. . . .

The FSB said it will issue a consultation paper on setting globally agreed margin rules for trades that are cleared directly between two parties rather than through a central clearing house.

“Momentum on OTC derivatives has accelerated in recent months,” FSB Chairman Mark Carney said at a news conference in Hong Kong.

The FSB is expected to push for a minimum margin that banks must post on derivatives trades that aren’t processed through a central clearing house. The aim is to provide an incentive for trades to be centrally cleared, or at least ensure there is a lower risk of an uncleared trade running into difficulties.

Here we go again.  Regulators believe they know how to determine the risks of transactions, and price those risks.

This of course worked out so well with Basel II, which deemed that mortgage loans and mortgage backed securities and sovereign debt were low risk and provided incentives for financial institutions to invest in them.

How’s that working out?

The clearing proposals in particular are frightening for at least two reasons.  First, they are predicated on the view that clearing necessarily mitigates systemic risk, a highly misguided view as I’ve pointed out here for years. Second, and relatedly, the very policy of attempting to encourage the movement of transactions to CCPs will tend to increase the riskiness of CCPs by leading them to clear products that are not well-suited to clearing, thereby increasing the riskiness of CCPs.  And because these CCPs are systemically important, this creates systemic risks.

It is also interesting to note that this one regulatory effort my be undermined by another one.  The New! Improved! Basel Rules will set capital requirements for exposures to CCPs.  The prevailing belief is that this will result in low risk weights (2 percent) on exposures to CCPs.  But an analysis by JP Morgan suggests that actual risk weights are likely to be far higher:

New capital rules outlined under Basel III are designed to incentivise the use of a CCP by levying a relatively small 2% risk weight against a bank’s exposure to a clearing house. This charge is much lower than the punitive charges proposed against traditional bilateral non-cleared trades and is designed to make clearing more financially attractive.

However, in-depth research by JP Morgan analyst Kian Abouhossein and his European banks team has cast doubt on this presumption. Taking a hypothetical clearing house that is only 45% funded against its theoretical capital requirements, they argue that the move towards central clearing could in fact prove far more costly under the new rules than initially thought.

This is because the new Basel III rules are expected to require a higher risk weight for exposure to central counterparties that may be regarded as underfunded; the rules will also levy a higher charge depending on whether the ultimate counterparties to the trade are clearing members, or clients of clearing members. Banks that clear trades on behalf of clients will also be required to take credit valuation adjustment charges against those clients which represent a measure of potential loss in the event that client counterparty goes bust.

In summary, JP Morgan finds therefore that the proposed floor 2% risk weight can only be attained under specific circumstances. In reality, the bank argues, the real risk weighting could shoot up dramatically.

So on the one hand, global regulators are trying to encourage the movement of trades to CCPs, but other global regulators are devising rules that will (unintentionally) make CCP exposures extremely expensive.

I am sure this process of setting prices for counterparty risk will turn out just swell, and lead to an efficient allocation of  these risks.

All these various efforts to regulate margins and capital weighting for counterparty exposures are a species of centralized price control.  All such schemes are doomed to failure.  Doomed.  The regulators lack the information to determine the right prices, and are in fact at an information disadvantage relative to private actors, so these schemes inevitably result in substantial losses arising from adverse selection problems.  Moreover, it is grimly ironic that these schemes are touted as a means of reducing systemic risk, when in fact they are far more likely to create systemic risks.  As I’ve noted repeatedly (and as others, such as Roberta Romano have also pointed out), these regulated pricing schemes tend to encourage everyone to load up on the same risks, and it is these correlated risk exposures that create systemic risk.

These global Sorcerer’s Apprentices believe that they are preventing the next crisis.  It is more likely that they are casting the spell that will bring it about.

On the anniversary of the passage of Frankendodd, I named the swaps execution facility mandate as the Worst of Frankendodd.  There was intense competition for the honor, to be sure, but I stand by that conclusion.

Gary Gensler sortied into enemy territory at the ISDA AGM in Chicago to do his best to defend the worst.  My verdict (based on press coverage): #Fail.

Interestingly, although Gensler used to focus (wrongheadedly) on the supposed competitive benefits of a SEF mandate, in Chicago he tried to portray it as a bulwark against systemic risk:

“Transparency to the public lowers the risk [for] clearinghouses,” he told the conference.

“Clearinghouses can only survive if they have reliable pricing feeds on a daily basis to mark to market their positions, and also have reliable, liquid markets in default scenarios,” Gensler said.

“There is far less risk in a clearinghouse if you have both pre-trade transparency and post-trade transparency.”

Dealers have criticised the move to electronic execution of OTC derivatives, complaining the large size and small volume of trades means such rules are inappropriate for the market.

This is clearly-no pun intended-incorrect, particularly when viewed in the context of Gensler’s desire for extensive pre-trade transparency and near real time reporting of trades.

CCPs will obtain the prices of deals cleared through them, that they can use to determine marks on a periodic basis.  Moreover, they have access to information from member firms that will permit marking deals to market.

Pre-trade transparency is particularly irrelevant in this context.

And Gensler is positively delusional if he thinks that the pre- and post-trade transparency is going to ensure “reliable and liquid markets” in default scenarios-especially if those scenarios involve the default of a systemically important clearing member.   Note that even for normally listed, exchange traded products CME used an auction procedure, rather than normal trading protocols, to handle the Lehman default.  Also note that LCH was able to handle the Lehman IRS portfolio default in a pretty effective and orderly way even without mandated centralized trading.

Gensler appears to believe that OTC derivatives markets, even for cleared products, will be like exchange trade futures.  Hardly.  One size does not fit all.  The nature of the transactions, the transactors, and the products is very different.  That’s why there are different markets and different market structures: the different structures are discriminating ways of accommodating the diversity of trades and traders. Market structures are endogenous, and reflect the characteristics of trades and traders, a point that is lost on Gensler and all too many others.

Indeed, the biggest problem that CCPs will not be obtaining price information on fairly active products, even if those products trade without pre-trade or post-trade transparency: even without SEFs, it will be relatively easy to mark 10 year USD IRS or active credit indices to market.  The problem will be obtaining information on the value of the products that don’t trade.  Gensler apparently believes in the Field of Dreams Theory: if you build a SEF, the trades-and bids and offers-will come, for everything.

No, actually.  Many products traded OTC do not trade frequently.  That’s a major reason why a dealer market structure rather than a centralized auction market structure, predominates there.  Moreover, the life cycle of trading activity in OTC and listed products is quite different.  Exchange traded products start out illiquid, and if they become liquid at all, become progressively more liquid as their maturity/time to expiry declines.  With OTC products, the cycle is the reverse.  Five year and 10 year swaps are quite active and liquid, and a lot of deals are done.  Those deals live on, and the 10 year swap becomes a 9 year swap and then an 8 year swap, and so on, and these products are far less liquid than the benchmark maturities.  You can have all the SEFs in the world, and 3.35 year swaps ain’t going to be trading, and won’t even be bid or offered.  Meaning that it SEFs will matter exactly bupkus for such products.

What’s more, mandated pre- and post-trade disclosure has costs  (mainly in the form of lower liquidity as disclosure of trades and price information raises risks to liquidity suppliers, inducing them to supply less), and these costs will vary by product.  Again, one-size-fits-all is misguided in the extreme.  Gensler dismisses these costs, and pays even less attention to the heterogeneity of products and transactions.

ISDA has pretty much acquiesced to most of the clearing-related rules, but is still fighting hard against the SEF mandate:

A theme of the ISDA conference, which includes large dealers as well as users of derivatives, is that while central clearing reduces systemic risk, regulators should not impose new rules on how derivatives trade, because it could disrupt those established markets and reduce trading volumes.

“Listed and over-the-counter markets are completely different, and it’s important that lawmakers and regulators keep this in mind,” said [ISDA Chairman and Morgan Stanley’s head of Global OTC Clearing Stephen] O’Connor,

He added that the industry was open to more public reporting, but with restrictions such as not revealing the size of very large trades or delaying trade reporting. “We’re not anti-public reporting,” he said.

I agree with O’Connor, but you might say “but he’s biased and protecting the dealers’ gravy train.”  Fine.  But interestingly, a supposed beneficiary of what Gensler wants so badly, isn’t sold on the idea:

Michael Davie, head of LCH.Clearnet’s SwapClear platform, agreed that regulators, clearers and market participants must know what is going on, but public reporting isn’t essential.

As I’ve argued ad nauseum, regulators will know what is going (in terms of positions and trades) due to swap data repositories.  As Davie says, public trade reporting-particularly in near real time-isn’t important for CCPs to do what they need to do.  And as I state above, public reporting of trades won’t help CCPs at all if there are no trades.

No, Gary.  SEF mandates are still the Worst of Dodd-Frank.  And slathering on the systemic risk lipstick won’t make that pig any more attractive.

A quick comment about the ISDA AGM.  A perusal of the press coverage is fascinating.  Virtually every issue-every damn one-that is the subject of intense debate at the AGM was raised here on SWP, or in my academic writing years ago.  Going back to 2008-2009, and sometimes to the late-90s (obviously pre-SWP, but not pre-Pirrong clearing research).  That old Cassandra feeling is particularly powerful right now.  I was invited to participate in the meetings, but had to decline due to another commitment, which alas did not materialize due to the vagaries of court scheduling.  (No! I am not on trial!  Sorry to disappoint some of you.) It would have been a fascinating experience.

John Parsons and Antonio Mello at Betting the Business argue that the dominance of OTC derivatives is not indicative of their efficiency, but instead resulted from the banks underpricing credit risk:

The logic that OTC markets are superior only works on the premise that banks are competing with exchanges on a level playing field. But prior to the financial crisis of 2007-2008 (and until the effort to reform finance is successfully completed), the playing field has been not level: banks have enjoyed some significant privileges. Key among them was the failure of some banks and regulators to properly price the credit risk embedded in derivatives.

This is a very strong statement, and one which John and Antonio do not provide persuasive evidence.  Their evidence is a post at FTAlphaville by David Murphy, which details the history of credit value adjustments (CVA), and a BIS report.  David notes that although in the early days of OTC markets, banks did not charge for the credit embedded in derivatives, they eventually did so.  Parsons-Mello argue, based on the BIS report, that regulators lagged these developments, and did not impose adequate capital charges on OTC derivatives exposures, particularly on CVA exposures which were larger than actual default losses.

There is some empirical evidence that speaks to this issue.  Papers dating back to the 1990s demonstrated that interest rate swap prices vary with counterparty credit risk, although the effect was small primarily because netting and the fact that principal is not at risk in an IRS made the credit exposures relatively small.  Counterparty credit risk in CDS is much larger.  Recent work by Gandhi, Longstaff, and Arora found small pricing effects in intedealer CDS trades, that became larger in the aftermath of the 2008 Crisis.  They conclude that the small effect reflects the fact that most interdealer traders were collateralized, though by variation margin rather than independent amounts (the OTC equivalent to initial margin).  The use of collateralization to reduce credit exposure is inconsistent with the hypothesis that credit risk embedded in derivatives is underpriced.

No doubt Parsons-Mello would interpret the evidence differently than Gandhi et al.

Collateralization is one way to control credit exposure.  Credit limits are another.  Reducing credit limits of firms that suffer adverse shocks to creditworthiness would tend to reduce the impact of such shocks on pricing.  Since credit exposure can be managed on a variety of margins-pricing, collateralization, credit limits-just looking price effects is not sufficient to determine whether credit risks embedded in derivatives are overpriced or underpriced.

The Mello-Parsons argument depends crucially on inconsistent capital treatment across equivalent categories of risk.  It is also somewhat in tension with an argument that they have made before that collateralization mandates do not raise the costs of trading OTC derivatives.  As they have pointed out before (as have I), credit that is embedded in a derivatives trade can be unbundled into a default free (collateralized) derivative and an unsecured credit line.  If capital charges are set consistently across equivalent risks, regulations that reduce credit exposure in a derivatives trade (e.g., a collateral or clearing mandate) can and will be offset by a substitution of an equivalent form of credit, leading to little or no change in overall exposure, just a change in its composition.

There is no reason to believe that regulators set capital charges consistently.  I think that John and Antonio are arguing that they should.  I would suggest that this is an impossibility.  This has been a theme of mine in several posts relating to Basel rules (you can find more related posts by typing “Basel” into the search bar).  The capital charges are inevitably make crude distinctions between different sources of risk.  Banks who understand the true risks far better optimize their activities to take advantage of disparities between their more informed estimates of actual risk and the regulatory risk charges.  Moreover, they tend to do so in a way that is highly correlated across banks because they all face the distorted capital cost structure.  Maybe making derivatives-related capital charges more sensitive to counterparty credit risk will reduce the subsidy of risk arising in derivatives books and the risk exposure there will fall commensurately; but the resulting structure of capital charges are likely to subsidize another risk, leading banks to pile into that activity.

In other words, risk based capital charges are an extremely blunt tool. They are a form of regulated pricing, and like virtually all regulated price structures, lead to acute distortions.  I am skeptical that they are a reliable means of reducing systemic risk.  Indeed, by inducing correlated risk taking across financial institutions, they can actually exacerbate that risk. (Mello-Parsons do recognize the difficulties of setting the capital charges: I think the difficulties are so acute as to make it virtually impossible to get anywhere near right, and very easy to make big mistakes.)

Assessing a CVA-based capital charge also creates the very serious risk of inducing vicious cyles/feedback loops, especially during times of crisis.  CVA charges are based on CDS prices, and CDS prices vary not just with expected default rates and losses, but also embed risk premia and liquidity adjustments that depend on market frictions and market-wide conditions.  Put differently, CDS prices reflect default rates and losses in the equivalent measure, and the market chooses the measure.  During crisis periods in particular, as liquidity dries up and risk limits (e.g., VaR limits) bind, expected default losses in the equivalent measure rise relative to expected default losses in the physical measure, meaning that CDS spreads widen absolutely and relative to what the spreads implied by expected default losses.

With CVA-based capital charges, such widening in CDS spreads will lead to higher CVAs and more variability in CVAs, which depending on how the CVA charge is implemented, could lead to higher capital charges, or to actions intended to reduce capital charges.  Increases in capital charges raise the costs associated with outstanding positions and new deals, thereby leading to reductions in positions, increases in collateral postings, or both.  These will tend to exacerbate market stresses, as firms dump positions to reduce exposures (and CVA) and sell assets to raise cash to meet collateral calls, which will lead to additional price movements that can affect CVAs, and on and on.

Put another way, it binds regulatory capital very tightly to conditions in the CDS market.  The more concerned you are about the functioning of that market, especially during times of stress, the more concerned you should be about hardwiring regulatory capital requirements to the CDS market.

That is, like any market-price based mechanism for setting collateral or capital charges (think of VaR), a CVA-based mechanism is highly likely to be procyclical, and perhaps severely so.  This makes it a major potential source of systemic risk.

In sum, I do not discount the possibility that capital requirements led to an underpricing of credit risk in OTC derivatives, and hence caused these markets to be larger than they should have been, or would have been given requirements that discriminated accurately among different risks in banks’ books.  The evidence one way or the other is rather thin.  I am highly skeptical, however, of the ability of regulators to address this problem without creating others equally severe, given the information advantages that banks have and their ability to optimize their risk taking subject to the (distorted) structure of capital requirements.

Moreover, I am downright frightened of basing derivatives capital requirements on CVA, or any market-price based measure.  It is individually rational for banks to price using CVA, but tying capital charges to this measure will almost certainly lead to procyclical capital charges that are highly correlated across major financial institutions.  That is a very bad-and very scary-idea.

I therefore do not dismiss the Mello-Parsons diagnosis, though I am not completely sold.  I am particularly concerned that any “cure” could be worse than the disease.

Posner & Weyl are continuing to flog their idea of an FDA for financial products.

I wrote about this really, really bad idea in February.  Given the swooning over the Posner-Weyl proposal, that post needs to be re-released.  So here it is.

I don’t need to change a word.  The FDA idea is a very bad one and the metaphor is completely inapposite.  Posner and Weyl are repeating their argument, and so my rebuttal needs no change.

It is good to see that not everyone is swooning.  This blog at The Economist rips into the proposal.  Great!

But gee, the points in the Economist post seem familiar.  Very familiar.  Every damn one.  To the points I made two months ago.

Purely coincidental, I’m sure.

Recognition is dawning that clearing mandates-the supposed silver bullet for making the derivatives market safe-are not the panacea that their advocates claimed.  Recently, major regulators in the US and the UK have warned about the dangers of concentrating so much risk in CCPs.  The recognition is spreading to the press too, as illustrated by this article in The Economist:

The source of all this angst is the clearing-house, a mundane bit of financial-market plumbing that sits between buyers and sellers in transactions. And the reason why people are fretting is that G20 policymakers have seized upon clearing as the solution to some big problems in the over-the-counter derivatives market.

. . . .

That feeds worries about the other effect of lots more clearing: a new concentration of risk. Moving derivatives trades to clearing-houses mitigates the effect of a default of a clearing member (Lehman Brothers’ cleared trades were handled smoothly in 2008, for example). But it makes the impact of a clearing-house itself going down much worse. They may lack the heft of big banks, but few financial institutions are more interconnected. Failures are rare but they do happen: Hong Kong’s futures clearing-house ran out of resources in 1987, for example, and it took a government bail-out and the closure of the main stockmarket for things to get back to normal.

This should not be a surprise-after all, it’s not like what happened in Hong Kong-or in Chicago-in 1987 was a big secret.  And it’s not as if nobody, ahem, has been raising this point for going on four years now.

And that italicized part is just too rich.  Didn’t Timmy! and GiGi constantly-and I mean constantly-tell us that clearing eliminated interconnections in the financial system? Yes they did! I guess that explanation is now seen to be the BS it always was.  I’ve been calling BS on that for about three years.  I’m waiting for the dynamic duo to admit they were either ignorant, or liars.  There is no third alternative.

The aforementioned regulators are demanding that CCPs be made immune from failure.  The Economist agrees:

The more systemic they become, the more tightly clearing-houses should be regulated. That means more clarity over their collateral and margining policies. It means agreeing on plans for recapitalising a failing entity without tapping the taxpayer. And it means getting clearing-houses to hold more equity: LCH.Clearnet had just €333m ($463m) of capital in 2011, compared with collateral and cash under management that averaged €73 billion. Clearing can achieve many things. Solving the too-big-to-fail problem is not one of them.

Sigh. On the one hand, it is good to see growing awareness of the systemic vulnerabilities that CCPs create.  On the other, it is distressing that regulators and commentators seem to have target fixation and can focus on only one thing at a time.  Put differently, they fail to consider how the financial system will adjust to attempts to make one part of the system safer.

I’ve also written about this ad nauseum.  The point is that raising margins, or increasing the size of default funds, or changing margin calculations, or tightening up restrictions on eligible collateral, or other measures to improve the safety of CCPs will induce reactions and adjustments elsewhere in the financial system, and these adjustments have systemic implications.

For instance, requiring more collateral is likely to lead to the growth of systemically-fragile collateral transformation services and other shadow banking mechanisms to secure collateral to post for CCP margins.  Expanding CCP member commitments to default funds increases their exposure to wrong way risks, and is an important source of interconnection in the financial markets.

I return to the 1987 Chicago experience.  Yes, the big exchange CCPs were under stress, but a major source of stress in the financial system as a whole was due to the extraordinary need for liquidity to meet margin calls-the very mechanism that is put in place to protect CCPs against default.  Sometimes “safety” equipment can be downright dangerous.

I return to a metaphor I’ve used before: that of flood controls.  Building up levees to protect one location can increase the risk of a catastrophic flood elsewhere in a river system.  It is good that more regulators and market observers recognize that CCPs are a source of systemic risk, but the levee-building reflex is worrisome in the extreme.  It suggests an inability to think about the financial system as a whole, a system that reacts to changes imposed on one part of it.  These responses are not necessarily salutary, and can be downright frightening.

The responses need to be anticipated, to the extent possible.  But it is often difficult to do that with accuracy.  Which means that it is necessary to proceed cautiously when making the levee around CCPs higher and higher.  There will be responses to this process, and it is likely best to proceed cautiously and incrementally, seeing what the responses are to the gradual changes, and then adjusting accordingly.  Wholesale changes made in a hurry focused monomaniacally on one part of the system are a recipe for an major disaster elsewhere in the system.

I say again: to understand how policy changes affect systemic risk you need to think of the financial system as an organic whole, a system that responds often unpredictably to changes imposed on one part of it.  Although it is encouraging to see that the magical thinking about clearinghouses is being replaced by sober concern, it is far less encouraging that the concern is leading to policies focused on individual institutions that do not pay adequate attention to how the system will respond.

In other words: Don’t build financial levees without giving very deep study how other financial currents will react to the levees during flood times.