Streetwise Professor

The advocates of mandated OTC derivatives clearing insisted-insisted-that mandated clearing would simplify the market, and reduce dangerous interconnections between financial institutions.  The canonical illustration of this point was something like this, with the first diagram being the messy bilateral, pre-clearing mandate market, and the second being the neat and tidy clearing mandate market:

Uhm, not really. Not at all. These diagrams presume that the only interconnections between OTC derivatives users are via the derivatives markets themselves. In fact, derivatives users are connected via credit and liquidity support mechanisms as well, and the adoption of clearing which results in the unbundling of the credit and liquidity arrangements embedded in derivatives trades will lead to the forging of new connections that will make the post-mandate system as complicated and interconnected and fragile, and perhaps more complicated and interconnected and fragile, then it was before.

These interconnections are of different types.  Some are operational.  Consider this from an illuminating article in Wall Street & Technology:

A new swaps ecosystem needs to be established in order to enable central clearing. “You’re talking about a whole reinvention of the entire market,” says Henry Hunter, global head of product development at MarkitServ, a provider of middleware and online confirmation and affirmation services to the buy and sell sides in the derivatives space. “That’s a massive infrastructure change that is happening over a period of years.”

Wholesale reinventions always go well.  Always.  But it gets better:

“It’s a complicated mess,” says MarkitServ’s Hunter, who notes there could be as many as six different players involved in any trade — the client, the executing broker, an execution venue (i.e., the SEF), a CCP, a clearing member acting for the client, and possibly a clearing member acting for the dealer as well. “Managing that choreography can get complicated, so that’s where the middleware comes in.”

And the mess doesn’t stop there. Clearing brokers have the burden of modifying their electronic trading infrastructures and processing systems. According to Morgan Stanley’s Brock Arnason, executive director and global product manager for the Matrix platform, “The infrastructure that is required to support a clearing business is quite significant.” Clearing brokers must capture their clients’ voice and electronic trades and then run them through validation rules to determine clearing eligibility, he explains.

Think of all the operational linkages described in those short paragraphs.  Think of all the possible problems that can arise, particularly in stressed market conditions.  The financial system is a tightly coupled one as it is, and the rigid schedule on which clearing must work, to initiate trades, close them, and margin them, makes it all the more tightly coupled.  The choreography could very well go wrong, and is most likely to go wrong precisely at the most dangerous time.

In addition to the operational connections, there are financial connections, especially related to collateralization: I’ve written about this extensively on SWP, and in places like my recent J. Applied Corp. Fin. paper.  More from the WS&T article:

One of the most disruptive changes on the buy side under the new derivatives rules will be the need to manage margin calls from the clearinghouses on cleared swaps. “Some clients are going from never having to post initial margin to now always posting margin,” comments Morgan Stanley’s Swankoski. When clearing becomes mandatory, “All clients, big or small, are going to have to post initial margin on their cleared transactions.”

. . . .

To help buy-side firms complete this process, the clearing brokers are looking to provide collateral transformation services, according to Forkan. “They’re now building in services to ensure that organizations that post one type of asset can convert it into another type of asset,” he says. “That is a cost of clearing that the asset management community is going to have to bare. Given the huge investment that the banks have made in technology and infrastructure, they are keen to offer services that generate profit — it’s a large opportunity for the global banks to grab market share among the asset managers that need services.”

To reiterate, the advocates of clearing asserted that collateralization would reduce leverage in the system by preventing the bundling of credit in derivatives trades.  But as I’ve said repeatedly, this will just lead to the substitution of unbundled credit for the proscribed bundled leverage.  Collateral transformation is an example of this.  Moreover, this form of credit, when joined with the rigidity of the margining process for cleared transactions (and for non-cleared trades which Frankendodd requires to be marked-to-market on a daily basis), these new credit arrangements are likely to be more fragile than the bundled ones they replace.

In brief, there will continue to be a dense web of interconnections between market participants-the second diagram above is a very misleading of the post-Frankendodd world, which will continue to look like the first diagram.  Moreover, These interconnections are likely to be even more fragile.

And we’re not finished!  Another point that I’ve made for the past several years is also becoming increasingly recognized.  Namely, the breaking of netting sets will arguably lead to greater complexity, greater collateral demands, and potentially greater total risk exposures.

With respect to operational complexity:

Another big challenge for buy-side firms will be managing their existing bilateral OTC derivatives business alongside cleared swaps to gain a holistic picture of counterparty risk. Since not all trades will be required to be cleared, buy-side firms will have both a bilateral book of trades that they are still managing as well as daily collateral calls for the cleared book of swaps, says Omgeo’s Leveroni. “You will end up with a mixed clearing environment and operational complexity that you didn’t have before,” he cautions.

. . . .

“The buy side is going to struggle with having enough collateral to post for the book of business,” Leveroni says. “This is worrying a lot of people. You want to make sure you manage that collateral right, so you only send cash to the cleared call and you send the corporate bond to your bilateral call. You have to be smart in the collateral you send to each call. Those are the real risks to the buy side.”

With respect to increased needs for collateral, consider this from Matt Leising:

Derivatives users will face significant challenges to meet new collateral requirements as the trades are forced into clearinghouses, according to industry executives.

Investors have pledged about $200 billion to back futures trades around the world, Bill de Leon, a managing director at Pacific Investment Management Co., said today on a panel discussion at the Futures Industry Association annual conference in Boca Raton, Florida. That amount could be 10 times as large for the majority of trades in the $708 trillion over-the-counter derivatives market, he said.

“This is going to be one of the biggest challenges going forward,” said Jeffrey Jennings, the global head of listed derivatives at Credit Suisse AG. Exchanges such as CME Group Inc. (CME) are expanding the collateral they accept to allow corporate bonds to be pledged and are offering to reduce margin across assets like futures and interest-rate swaps. “That’s not going to be enough,” he said.

. . . .

Other plans by brokerages to offer to transform for their customers unacceptable margin into cash or U.S. Treasuries that are accepted by clearinghouses won’t solve the problem, and may add to risk during volatile times, said David Olsen, global head of OTC clearing for JPMorgan Chase & Co. (JPM)

“In my opinion, collateral transformation is really just a marketing term for repo,” he said. The collateral obtained from selling securities to garner cash or Treasuries in the repurchase market don’t fit many type of derivative users, such as pensions, that may have 30-year swaps they need to maintain, he said.

With respect to the fact that fragmentation of clearing across jurisdictions and instruments and the elimination of netting economies across cleared and non-cleared positions (a point I’ve made, as have Duffie-Zhu) consider this very readable paper by David Murphy.

It is not an exaggeration to say that every claim made by Frank, Dodd, Geithner, Gensler, and all the other clearing fanboys and fangirls around the world are extreme exaggerations at best, and often flatly wrong.  New vulnerabilities have been substituted for old.  New interconnections have supplanted those that prevailed in the bilateral world-and many of the new interconnections are more problematic.  Financing and liquidity and credit arrangements remain deeply meshed with derivatives transactions.  Mandated clearing eliminates some netting benefits, while creating others, and it is by no means clear that the mandates have reduced exposures.

The whole top down restructuring of the derivatives markets-which represent a complex, emergent order-does not lead to the replacement of a complex and sometimes chaotic system with a simple and ordered one.  It will result it a new complex system that will emerge in response to the new laws and regulations.  The regulations were motivated, in essence, by fears of the instabilities and non-linearities in the old order: but the new system will have its own instabilities and non-linearities. Indeed, I believe that a mandated, top-down attempt to impose a new order is likely to result in a less supple, more rigid, and less stable system than the (imperfect and sometimes unstable) one it is intended to supplant.

An analogy that comes to mind is the Corps of Engineers.  For decades the Corps has intended to impose order on a complex system of rivers.  The results have been less than happy.  The imposed order has too often proved illusory, and attempts to control the system have resulted in an increased likelihood of catastrophic floods and the destruction of valuable natural ecosystems. Attempts to control complex systems are usually futile, and tend to result in the replacement of more frequent small crises with a few mega-crises (this is a point also made by Taleb and Bookstaber).

In this regard it is always useful to remember Hayek’s warning about the illusion of control: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Chris and Barney and Timmy! and Gary think they know a lot more than they really do.  They see like a state (to use James Scott’s phrase), and as Scott shows, these attempts to re-engineer complex systems from above almost always end in grief.

But as the continued existence and persistence of the Corps of Engineers shows, the illusion of control and the faith that top-down re-engineering of complex systems can work is enduring.  The idea is hard to kill, and ironically, its failures often lead to demands for more and more and more control.  I expect, alas, that this will be the case in the derivatives markets.

Deus ex Machina has a typically succinct and excellent post on CCPs.  He argues that CCPs perform two functions, derivatives receivable insurer and central margin custodian, and there is no reason why these functions must be combined in a single entity.

Absolutely true. I have made this point several times, notably in this Cato policy review piece.

My only quibble with DEM is that CCPs perform more than the two functions.  In addition to those, it serves as a trade data repository, monitor of the creditworthiness of its members (which, admittedly, could be considered part of their derivatives receivable insurer function), and importantly, default manager.

But DEM’s (and my) fundamental point remains the same: what is the economic rationale for combining in all these functions in a single entity for all derivatives?  Maybe this bundle is optimal for some derivatives (e.g., highly liquid, mainly short maturity futures and options), but not for others.  But why is that the right bundle for all derivatives?  Is there a reason to believe that the market will necessarily settle on the wrong bundle, thereby requiring the mandating of the futures bundle for all derivatives trades?

Vital questions, IMO, but ones that have seldom been asked by people who merrily dictate market structure and contracting practices.  Or by academics for that matter.

DEM’s numbering of the functions of CCPs brings to mind a Monty Python sketch (but then again most things do):

The Economist just ran a long piece about the unintended, and largely unforeseen, consequences of collateral and clearing mandates.*  And they aren’t all good.  Anything but.

I say largely unforeseen because I’ve been jumping up and down about these consequences here on SWP, in some academic papers (including one to be published in the next issue of the  Journal of Applied Corporate Finance), and numerous presentations.  I have repeatedly emphasized that it was a fallacy that requiring more collateral would necessarily reduce the amount of leverage in the system, make the leverage in the system less fragile, or reduce interconnectedness among financial institutions. I have consistently argued that market participants would substitute alternative forms of leverage and utilize other financing techniques (e.g., collateral transformation and liquidity swaps) as fragile or more fragile than the leverage embedded in derivatives, and that these new forms of financing would just change the topology of the network of connections among firms in the financial markets, and that the new topology would be as or more complex than the pre-mandate topology.

It was always particularly maddening to see regulators and others present pictures of the OTC derivatives market with a spaghetti bowl of interconnections between market participants, and contrast it to a neat and tidy picture of a cleared market with a few neat lines connecting market participants with the CCP.  There was no consideration of how the necessity of funding collateral and making variation margin payments would lead to the creation of financing arrangements among firms that would resemble the spaghetti bowl picture.  No consideration of how the very complex financial system would adjust on the myriad margins available to it.

In some respects, I can make some allowances for the regulators and legislators who imposed this on the world.   Those allowances are mainly a function of low expectations.  I am less forgiving of the academic community.  Many people smarter than I whom I respect have bought into the neat and tidy picture, and have dismissed concerns that the various Frankendodd mandates (and their European cousins) will create a new set of problems that may be worse than the ones that were supposedly fixed.

I think that in large part, this failure to anticipate the real effects of mandates, and the blithe confidence in the efficacy of collateral in particular, reflects the standard partial equilibrium, ceteris paribus way that economists use to approach problems.  This method is very powerful, and I utilize it regularly, but it has its limits.  In particular, it blinds one to the systemic responses to big changes like Frankendodd, to the fact that market actors will respond to these shocks on many dimensions.  As I’ve said repeatedly, there has been a systematic failure to consider how the financial system as a whole would respond to massive interventions designed to reduce systemic risk.

This is a particularly hard problem to analyze mathematically and formally due to its inherent complexity.  The daunting nature of the task, and the fact that formal mathematical modeling is almost required by top tier journals, has, in my opinion, made it unattractive for academics to pursue these issues.  The constraints of the accepted toolset have led to the slighting of an extremely important and interesting issue.

But this is not to say that the problem is immune to analysis that can generate meaningful insights and falsifiable predictions.  Indeed, largely disdained non-formal (“literary”) approaches can do so-and have done so.  I started from a very simple premise, that there were fundamental economic considerations that had led market participants to choose financing arrangements and contracts with certain amounts of leverage and fragility.  Constraining the ability to use those sorts of financing arrangements would induce actors to substitute towards arrangements with similar properties.  Non-formal analysis also shed light on how these mechanisms would operate during periods of systemic stress.

Based on these non-formal approaches, I made predictions about how the markets would evolve under clearing and collateral mandates.  Those predictions can be tested by empirical observation (though again, more descriptive than formally econometric).  That’s as “scientific” (in the Friedman Methodology of Positive Economics sense) as the densest, or most elegant, mathematical model.

And as it turns out, in this instance, some of those predictions are being borne out.  In ways that make me appreciate Cassandra.

I think it is more important to focus on important problems and find the best tools for the job at hand, rather than let narrow conceptions about the appropriate tools define and the problems you work on.  The latter mindset has limited academic economists’ influence on big things like Frankendodd.

The one-eyed man is king in the land of the blind.  Non-formal methods provide sight-and insight-on issues to which formal methods are often quite blind.  Given the incentive structure in academia, however, I am skeptical that the lesson will be learned.

* Link fixed. H/T Phil R.

Coverage of MFer John Corzine’s House testimony yesterday has focused on his repeated denial of any intent to dip into customer seg funds.  That’s walking a thin legal line, and it’s unclear that lack of intent would be sufficient to evade time in the pokey.  That part of his testimony seemed weasely, at best.

But this piece suggests idiocy:

Why did you bet the survival of the firm on European sovereign debt?

“We looked at the ratings, but they were not the only consideration. We looked at what counterparties would charge for initial margin. We would look at how individual securities were looked at by regulatory authorities around the globe – what they were able to use as collateral. We look at prices in markets to determine whether people thought the default or restructuring risk was being priced into it.

“There were many considerations along with the ongoing dialog that, which after the fact clearly can be second guessed, that the European community was going to take a much more forceful steps to avoid bankruptcy or insolvency.”

Looked at initial margins?  What about the risk of variation margin or the equivalent?  What about the risk of ratings trigger-induced increases in haircuts?

Initial margin isn’t what killed the trade.  It was increases in margin–additional collateral calls based on adverse movements in the price of the European debt, and perhaps collateral calls based on the downgrade–that sunk the company.

In other words, what killed the firm was its inability to fund the trade over its life in the face of adverse price moves.  Note that nowhere in Corzine’s answer does he mention mark-to-market risk, funding risk, haircut risk, variation margin risk, or anything related.  Given the firm’s leverage and the leverage in the trade, that oversight is beyond idiotic.  The main risk of a trade like that to a firm like MF was that prices would move against it and it wouldn’t have the resources to fund the additional collateral calls.

That’s exactly what happened–and per Corzine’s answer, that risk played no role in his decision to make the trade.  None.  That is just beyond belief.

Could he really have overlooked that risk?  Or was he just weaseling again, leaving out the crucial risk of the trade from his account, in the hope nobody would notice?

The Bank of England’s most recent Financial Stability Report includes an extended discussion of the various systemic risks posed by CCPs.  For SWP readers, the analysis will be familiar.  It focuses on the margin mechanism as a channel of contagion, procyclicality, and wrong way risk.  It emphasizes the risks arising from the pivotal role of sovereign debt in the clearing system.  Adverse shocks to sovereign debt prices can initiate the destabilizing margin cycle.  Moreover, given the correlation between the financial condition of CCP members and sov debt prices, sovereigns are a source of wrong way risk in teh system

Recognizing the very real possibility for a CCP failure, the BoE recommends the implementation of a resolution regime for CCPs to ensure that the market can continue to operate even if a CCP exhausts its financial resources.  I recommended this in  my ISDA white paper.

So I concur wholeheartedly with this BoE analysis.  But as was the case with Bernanke’s warnings about the systemic risks of CCPs, I ask: where the hell was the BoE  when everyone was drinking the clearing KoolAid?  Some of this realism would have been much more constructive before Frankendodd, the G-20 clearing commitments, and other moves to mandate clearing around the world.   Right now, the BoE, the Fed, and more than a few financial journalists remind me of someone who stood on the platform waving goodbye to a departing train, but are now running down the track screaming that its brakes are defective.

So regulators are no scrambling to figure out how to buttress the much expanded clearing system against its inherent vulnerabilities.  Would that as much thought and effort had been expended to identify, anticipate, and mitigate these vulnerabilities before regulation and legislation imposed such heavy reliance on CCPs.

Clearing was mandated in haste.  Unfortunately, given the current tumult in world financial markets, we may not have the luxury of mitigating the risks of these mandates at leisure.

There are many misconceptions about the CME’s responsibilities in the MF Global situation, and the implications of this situation for the CME’s longstanding claims that no customer has lost money as a result of a clearing member default.  These misconceptions are epitomized by this Sun Times article:

CME owns the Chicago Mercantile Exchange, Chicago Board of Trade and the New York Mercantile Exchange, where much MF Global business took place. It legally clears, or guarantees, the trading on its markets and often boasts that no customer has ever lost money because a trading firm failed.

That more than 100-year record may be in jeopardy with MF Global, one of the largest brokerages on the Chicago and New York commodity markets. Former New Jersey governor and Goldman Sachs Group Inc. chairman Jon Corzine led the firm but made a disastrous investment in European debt.

The claim is true, and regardless of what happens with MF it will remain true.  The clearing guarantee is not in play here.

If clearing firm A defaults, customers of clearing firms B, C, etc., will get paid as long as the clearinghouse is solvent.  That has always been the case in the past, and it is true now.

It is possible that customers can lose money under the omnibus account system employed in the US, if there is a default on A’s customer account, and A cannot cover it, then A’s customers bear some of the losses.  As an example of this, the London customers of Griffin trading lost money when that firm went bust in 1999: no US customer customer lost.  (Customers of a COMEX member, Volume Investors, did lose when that firm went under).

There was no default in either MF Global’s house or customer accounts, so the clearinghouse guarantee never came into play.  So the Sun Times account–like many others–is fundamentally misleading.

Moreover, 60 percent of customer margin associated with open positions was transferred to other clearing members.  Most of the missing money in question, from what has been reported, was customer money on deposit at MF Global but not margin associated with open positions.  (That is the case with two MF customers I know personally.)  The CME clearinghouse guarantee has nothing to do with that money.

CME has raised the amount that it is willing to commit to cover any shortfalls from the bankruptcy trustee’s distribution of cash to customers.  This is not the CME’s legal obligation, but is, as I said in an FT article a couple of weeks ago, an indication of the importance of this situation to CME’s reputation.

CME will be subject to scrutiny primarily for its role as the MFer’s Designated Self-Regulatory Organization (and hence responsible for auditing it) prior to the firm’s rapid implosion.  Moreover, as Jeff Carter (a one-time CME floor trader and board member) writes, CME has not done itself any favors with its handling of the “public perception of the crisis.” (Though I have also heard that CFTC is attempting to control what the exchanges–CME and ICE–are saying.  As well it might, as it will also come under considerable scrutiny.)

A big question in my mind is why Corzine isn’t getting the Madoff treatment from the Feds and the media.  He has been called to testify in front of a House committee.  I wonder if he’ll invoke the amendment that comes right after the one about unreasonable searches and seizures.  But it is amazing to me how little critical coverage he has received.  Especially given the bad press that rich bankers are getting these days.

Oh, I forgot.  He’s a progressive Dem in good standing.  What was I thinking?  My bad.

So there are two major things wrong with coverage of the MFer’s tale.  The first is that the role of the CME’s guarantee to its customers is being misrepresented with some regularity–including by the home field rag.  The second is that the most likely culprit–and certainly the person ultimately responsible for the firm’s collapse, and anything that occurred as the firm crashed and burned–is all but invisible.

Back in the summer I argued that sovereign CDS are acutely vulnerable to wrong way risk.  Indeed, the problem is so severe as to call into doubt the viability of these instruments.  From today’s Dow Jones News Wires:

But some market participants said that, if risk aversion from Europe spirals out of control and credit markets freeze, a large firm could fail to meet its obligations in a credit-default swap, setting off a chain reaction that threatens to destabilize the global banking system.

They are urging closer scrutiny of banks’ gross sovereign CDS positions and of the interconnectedness of the banking system.

“When there is a high degree of correlation between the underlying risk and that of the hedge counterparty [in this case, the sovereign and a bank selling CDS], can you rely on a payment from your protection seller?” asked Joyce Frost, partner at Riverside Risk Advisors LLC, a derivatives consultancy.

The correlation may be so strong, she said, that if Italy, for example, continues to deteriorate, the protection purchased from a highly correlated European bank may not be worth as much as originally thought. The value of that hedged position would be worth less than if the CDS were written by an uncorrelated counterparty–a U.S. or Canadian dealer, for example.

This is a phenomenon market experts call “wrong-way risk.”

Katy Burne goes on to argue that “[t]he lack of sovereign CDS clearing makes individual institutions more vulnerable to a messy default.”  This is fundamentally incorrect.  Clearing does not make wrong way risk go away because banks are CCP members, and would be on the hook in the event that a big loss on sovereign CDS caused a bank/clearing member to default.  In particular, the senior tranche of a CDO-like nature of CCP default funds makes them acutely vulnerable to wrong way risk.

Wrong way risk is intrinsic to sovereign CDS.  If big sovereigns are at risk of defaults that would cause payouts on CDS–heck, if even sovereigns that seem small in the scheme of things, like Greece, are in trouble–banks are likely to be in trouble.  The correlation is a fundamental feature of the instrument.  Whether banks are the ultimate counterparties in bilateral trades or via CCPs is immaterial: the problem is there.

Ironically, in financial markets positive feedback loops are typically a very negative thing.  Self-reinforcing spirals in tightly coupled systems like the financial markets are usually downward spirals.

Margining and collateral mechanisms are the most important positive feedback mechanism in financial markets.  AIG and MF Global are two examples of how these mechanisms turn high flying financial firms into smoking holes in the ground.  They suffer losses, counterparties demand more collateral, that puts further stress on the firm, they lose customers, counterparties demand even more capital, and before you know it–impact with the ground at high speed.

Procyclicality of margin can work at the level of the market too.  We are seeing the first signs of that with respect to Italy today.  LCH.Clearnet SA (the French arm, and not RepoClear) raised margins on Italian government debt today.  This will tend to induce some sales of leveraged Italian bond positions, which will reduce prices further.  Similarly, increasing haircuts will tend to reduce liquidity, which will also tend to put downward pressure on prices.  Lower prices and lower liquidity put further pressure to raise haircuts.

So–lookout below!  The spiral has begun.  Keep eyes on RepoClear.  I imagine it will be under tremendous pressure to avoid jacking up repo margins.  And who knows, since the 450 basis point  margin raising trigger* is based on the spread over an average of German, French, and some other countries’ debt, maybe RepoClear won’t have to raise margins on Italian bonds because French yields are rising too, due in large part to French banks’ holding of $400 billion in Italian bonds.  The looking glass world of Europe . . . .

Another comment, following on the previous post.  There will be tremendous pressure on CCPs to accept riskier collateral in the clearing mandate world.  Sovereign debt has been a primary asset for margining purposes, and the assumption has been that this collateral is low risk.  But we now know that is a fiction.

Pressure to expand collateral pools, combined with the risk that said collateral can decline in value, and precipitously, creates another positive feedback mechanism.  Markdowns in collateral held at CCPs (or indirectly, via collateral transformation services) will induce fire sale liquidations of margined positions, or of other assets in order to raise cash to offset the decline in the value of collateral.

Geithner, Gensler and others have touted collateral as the elixir for all derivatives market ills.  No.  In some circumstances the elixir is really a deadly poison.  Positive feedback mechanisms destabilize financial markets, and collateral mechanisms are among the most important sources of positive feedback in these markets.  We are moving to a regime in which more collateral is being required, collateral mechanisms are being made more rigid and less flexible (e.g., reducing hypothecation) but the supply of safe collateral is contracting–or at least not growing commensurately with the demand.  This will be a major source of fragility in the system, and one that has been built into the system all in the name of making it more robust.  Another gift from the sorcerer’s apprentices.

* The term “trigger” is hardly comforting in this context.

Last week the Basel Committee released its revised proposal on capital requirements for exposures to CCPs.  It made a few tweaks to its earlier proposal, which had attracted considerable criticism.  The critics are not mollified, and some new criticisms have been directed at the new version.

I won’t deconstruct the new proposal in detail.  I’ll just focus on a few of the high level issues, all in the way of reiterating a broader point that I’ve raised previously.

One criticism of the new proposal is that it imposes punitive burdens on client clearing, and is therefore inconsistent with the stated goal of encouraging the movement of more derivatives transactions to CCPs.  Against this, it is claimed that the new rules facilitate portability of client accounts between clearing firms.  So, you won’t be able to find someone willing to clear for you in the first place, but you’ll be able to move your account easily.  Or something.

The allegedly punitive treatment of client clearing, combined with the capital and margin burdens placed on non-cleared trades, will tend to reduce end user hedging with derivatives.  This is clearly an undesirable outcome, and will induce end users to devise alternative means (and in particular, to adjust their capital structures) in order to achieve the same objectives as they currently do through derivatives.  These alternatives  are likely to be more costly than derivatives.  Moreover, they will still result in the creation of counterparty risk (or credit risk).  From a systemic perspective, it is not clear that the ultimate effect will be to reduce the amount of credit risk, or improve its allocation.

The new draft reduces slightly the capital charges for default fund contributions, but the treatment is still sufficiently tough to make it likely that CCPs will jack up margins to avoid incurring the high capital charges associated with exposures in excess of the CCPs “hypothetical capital.”  Maybe this is precisely the intent, because the idea that derivatives trades should be massively collateralized is a matter of faith among many regulators.  But demanding high collateral can lead to many adverse effects, including less hedging, the utilization of riskier assets to pay initial margins, the substitution of other forms of leverage, including fragile repo-based collateral transformation services, and the engineering of securities that can be used as collateral (either directly with a CCP or indirectly via a collateral transformation) but which are loaded with systematic tail risk.

The proposals retain the very crude distinctions between risk exposures.  Capital charges across exposures do not vary sufficiently to account for their different risk characteristics.

All of these issues point out the basic problem with Basel capital requirements.  These rules are essentially price controls.  They cannot–metaphysically–get the prices right.  The way the risks are priced via capital charges will affect resource and risk allocation decisions.  Those subject to the rules will have the information and incentive to figure out how to minimize their impact, and will tend to load up on risks that are underpriced and take too few of the overpriced risks.  Many of the endogenous responses to the capital charges will occur in unexpected ways and places, and the connection between these responses and the rules will often be highly indirect and difficult to identify.

But the big problem is that since everybody is facing the same distorted price signals, they will tend to make correlated mistakes.  This increases the vulnerability of the system.  That’s why Basel is faulty generally.  The CCP capital charges are just a particular example of that.  They are intended to reduce systemic risk, but they largely ignore how the system will respond to the rules, thereby creating new vulnerabilities.

Just step back and look at what is going on now in Europe.  One of the basic principles of Basel II was that sovereign debt was safe.  Another was that mortgages were safe.  Financial Crisis I exploded the latter belief.  Financial Crisis II is demolishing the former.  But the favorable capital charges accorded these investments encouraged the supply and demand for both.

If you haven’t noticed, this is not working out well.  The CCP capital charges will have far reaching effects on how much risk there is in the system, and where it resides. The necessary crudeness of the capital rules, their inability to price different risks in a discriminating way, and the endogenous behavioral responses that they induce not just in clearing but throughout the interconnected financial markets, will create new systematic errors and vulnerabilities that won’t work out to well either.

The conceit of these rules is that they are pricing systemic risk.  How is that even possible when those formulating rules do not–and realistically, cannot–consider fully the systemic responses to them?  Charging a price can make things worse if the price is wrong.  A financial Gosplan hardly inspires confidence, and methinks that’s exactly what Basel is.