Streetwise Professor

As usual, Deus Ex Macchiato is worth reading:

One difficult criticism for those of us who believe that strong financial regulation is necessary – even if we don’t believe that the current structure is heading in the right direction – is that of rent seeking. The issue is that the stronger regulatory power is, the more it can be exploited. For me, the clearing provisions in Dodd Frank are a great example of this. The clearinghouses have been handed juicy profits by regulatory fiat.

Read the rest.  That’s an order.

Gretchen Morgenson is getting good reviews for her book Reckless Endangerment, which unlike most of the financial crisis genre casts considerable blame on Fannie and Freddie.  So bravo for that.

But sometimes she can be so clueless.  I mean really: how can she not understand the difference between credit default swaps (“complex swap deals it had struck with its trading partners”) and repo?  She goes on and on comparing MF Global to AIG, claiming both were brought down by CDS.  Then she goes into a riff on CDS written on Greece, and credit linked notes, and ISDA, and blah blah blah.

Gretchen: secured lending–repo–brought down MFG.  You could have written something interesting about the repo market, how it works, how it is a fragile form of financing that can bring down firms.  That would have been informative and useful.  But to flog the CDS horse when CDS aren’t even involved.  Sheesh.

To put it in NavSlang: the MFers really screwed the pooch.  $600+ million in customer funds are missing.  That represents about 11 percent of the segregated customer funds.  It will be fun and games for customers to recover their money.  Matt Leising reports that customers may wait years to recover if MF Global is sued, as is almost inevitable.

New emerging details suggest that right after waving goodbye to CME auditors last week, MF started dipping into the customer kitty.  ICE states that there was no segregation breach.  Perhaps ICE was going to audit this week.

Not surprisingly, the CME and CFTC are coming under considerable criticism for the MF collapse.  One suggestion in this article by Greg Meyer is that the CME Group is lax in its oversight because MF was one of its biggest sources of order flow, thereby presenting the exchange with a conflict of interest.

I disagree with this interpretation.  I’ve written a lot about self-regulation over the years, and the theme of that research is that self-regulation is well-suited for some things because incentives are strong and well-aligned, and ill-suited in others for which incentives are weak or poorly-aligned.  Market manipulation is the main example of the latter.  (I have an article in the JLE from 1995 that examines this in detail.)  Especially for a for-profit investor owned exchange, incentives for broker oversight are stronger.  Having a broker go bust, especially as ugly as MF went bust, is not good for business because it casts doubt on the reliability of FCMs generally.   Lower confidence in the reliability of brokers and the safety of customer funds reduces the demand to trade.  Yes, MF accounted for a decent amount of order flow, but there is vigorous competition to serve that flow, and it is in CME Group’s interest that it be served by reliable and trustworthy FCMs.  There is no upside for CME from lax enforcement here, and a whole lot of downside–which it is experiencing now.

There is no such thing as perfect, error free, real time auditing.  Moreover, regulators had been pressuring MF Global for some time, so it’s not like the firm completely escaped scrutiny.  The issue is that when firms like this go down, it tends to happen very rapidly.  They are inherently fragile.  Once the run begins, it tends to end rather quickly.  In MF’s case, it lost funding when haircuts on its repo’d Eurodebt went up because of (a) the decline in market value of the debt, and (b) its rating downgrade–which was in fact in large part a response to regulatory action.  The end came in a matter of days.

Another theme is that there was a breakdown in controls at MF Global.  Uhm, controls are intended primarily to keep underlings–like the Delta One trader at UBS–in line: they aren’t designed to, and are unlikely to, stop a determined CEO from taking on excessive risk.  That’s especially true when the CEO is somebody like Corzine.  (Who is, by the way, a disgrace to my alma mater.)  It’s the board that has to keep the CEO in line, and all too often the board is like the CEO’s petting zoo.  That appears to be the case here.

One last thing.  I noted that the collapse of MF makes the CFTC look foolish not because of its failure to oversee the firm, but because of its adoption of a rule regarding clearinghouse membership that MF lobbied for very hard.   (The NY Fed also doesn’t look too swift for approving MF as a primary dealer.)  Another big supporter of the $50 million capital rule adopted by the CFTC was Jefferies Group.  Jefferies was downgraded by a non-big 3 rating agency (Egan-Jones).  The company’s stock fell about 15 percent on the news; it has since recovered on positive comments from Meredith Whitney on CNBC.  This bears watching, and again highlights the tension between the goal of making CCPs safe and allowing easy access to CCPs.

*Obscure Supersuckers reference.  A h/t to the first to decode it.

Gillian Tett of the Financial Times is shocked! shocked! to learn that Frankendodd: (a) has dramatically increased the complexity of financial markets; (b) creates myriad opportunities for regulatory arbitrage; and (c) gives advantages to big, sophisticated, politically juiced players that can decode, game, and influence the regulatory process most effectively.

Yeah.  I can sympathize.  It’s not like anybody could have seen that coming.  Nosiree.

Starting with my earliest post-crisis writings on clearing, I have pointed out repeatedly that the supposed virtues of clearing–netting and greater collateralization–look far different when you examine the nexus of financial contracts as a whole, rather than focusing on derivatives alone.  A primary effect of netting and greater collateralization  is to increase the seniority of derivatives in bankruptcy.  But if you increase the seniority of one claim, the seniority of other claims is reduced.  Sure, you can make derivatives more secure, but at a cost of making other claims less secure.

The systemic implications of this are ambiguous.  The implicit presumption seems to be that derivatives are somehow uniquely threatening to the stability of the financial system.  I say “implicit” because the clearing pom-pom squad has never discussed explicitly the distributive aspects of reshuffling priority via regulation, so I don’t even know if they are even aware of it.

But it is not hard to imagine scenarios in which giving derivatives even greater advantages in bankruptcy (due to safe-harbor provisions they already have a lot) can cause a systemic problem, but through another channel.  For instance, derivatives counterparties of a firm teetering on the brink of failure may rest easy given their priority status, especially if the CCP is considered safe.  But other claimants may not be so serene.  For instance, consider money market mutual funds  that invest in the paper of the dodgy firm.  Realizing that they will be totally hammered in bankruptcy, the investors in the money market fund may run.  That would not be pretty.

It’s even more complicated than that, because given the new seniority rules, there is likely to be widespread alterations in capital structures of derivatives market participants, and repricing of those claims.  Who knows how that is going to play out, and what new fragilities will be baked into the new structures?

This point is finally dawning on people.  One person who caught on long ago is Harvard’s Mark Roe.  Today, he published an oped that makes the point clearly and forcefully. It is definitely worth a read.

Money quotes:

Equally problematic is the fact that, while the clearinghouse and its participants can net wins and losses to reduce risk for those inside the clearinghouse, the clearinghouse does not assuredly eliminate the basic risk facing the entire financial system. Often, it merely transfers that risk to creditors outside the clearinghouse.

. . . .

Whether the clearinghouse reduces systemic risk depends on the relative systemic importance of those inside and those outside the clearinghouse – AIG versus Citibank in this basic example – not on the clearinghouse’s capacity to reduce risk among its members. In this example, if Citibank is precarious and is as systemically vital as AIG, the clearinghouse has obscured that it has saved AIG only by transferring risk from the clearinghouse to Citibank, which then fails.

Much recent regulatory activity has focused on enabling, enhancing, and requiring clearinghouses for these kinds of financing arrangements. Yes, clearinghouses offer many benefits, including greater transparency, better pricing, and better regulatory focus, and we should try to make them viable. But regulators world have overestimated their overall benefit. Too much of what is justified as reducing systemic risk is really just offloading risk onto others.

Exactly.

Reading Mark’s piece  brought to mind Bernanke’s quoting of Puddin’ Head Wilson in his discussion of CCPs.  Bernanke said if you are going to put all your eggs in one basket, keep a very close eye on that basket.

One of my problems with the whole CCP debate is that too often the tendency is to treat derivatives as the only eggs that matter.  But if you pay attention only to the basket with the derivatives eggs, you will not pay attention to other ones that are as valuable, or moreso.

To change metaphors, target fixation all too often leads one to miss the bogey that just jumped your six, with fatal results.  The obsessive focus on derivatives, and clearing, is a form of target fixation.  It risks diverting attention from other potentially mortal dangers. You need to have a system-wide perspective to truly understand systemic risk.

Mark is generally negative on giving derivatives any priority.  He has written things very critical of safe harbors.  He and I have discussed this, and have agreed to disagree: I can see reasons for differentiating the treatment of derivatives from other claims.  But the important point is to understand that this is an issue, and one that has to be examined from a system-wide perspective, because seniority rules shift risk around.

Mark gets that, and makes serious arguments about what the right rules should be.  Unfortunately, all too many of those who make the decisions and the rules don’t appear to get it.

Like Tim Worstall, I am puzzled at all of the machinations in Europe to avoid a hard Greek default in order to avoid triggering CDS.  Apparently the concern is that payoffs on CDS would potentially jeopardize the financial health of banks that sold protection, leading to contagion.

Greek CDS represents about 1 percent of debt outstanding, with a notional amount outstanding of about $4 billion.

Look.  If European banks collectively cannot handle a $4 billion payout (which would be the maximum, assuming zero recovery), then their problems are even worse than feared.

To worry about the $4 billion CDS, rather than the $471 billion in outstanding Greek government debt, is beyond bizarre.  This suggests some weird sort of obsession among the Euros about derivatives, and CDS in particular.  You don’t have to look far for more evidence of this obsession.

And remember, CDS are zero sum.  Ever dollar paid by one party is received by the counterparty.

Moreover, many of the CDS contracts will have been entered by banks looking to hedge exposure to Greek sovereign debt, and private Greek debt.   Restructuring Greek debt in a way that leads to substantial writedowns but does not trigger CDS screws the hedgers worst: they suffer losses on their bonds, and their hedges do them no good whatsoever.

Punish the hedgers.  Wow.  That’s a really constructive policy.

And there are long-term consequences.  In particular, the effective abrogation of Greek sovereign CDS contracts will raise questions about the reliability of other outstanding sov CDS.  Many hedges are looking far shakier now, for if the Euros do backflips to avoid triggering Greek CDS payouts, just think of what they would do for Italy or Spain.  Since it is the most risk averse banks that would have decided to hedge, and since risk aversion depends in large part on the bank’s financial condition, this hurts the most risk averse (and likely weakest) banks most.  Less hedging will be done going forward, but risks will be transferred regardless–through the cash markets.  CDS prices will become less reliable (probably a feature rather than a bug to the Eurocrats).

Ironically, this creates a new speculative trade–a trade on the basis between CDS and the bonds–in which the parties effectively speculate on the political risk inherent in CDS.

There will be knock-on effects too.  If private contracts can be circumvented for political reasons in the case of sovereign CDS, the risk that other derivative contracts can be effectively nullified increases too.  The risk is probably greatest for other CDS–notably European bank CDS–but it exists for other types of derivatives too.  All because once you admit the principle that “payouts on derivatives contracts can spread contagion”, you can’t limit its application–or the risk that the principle will be applied–only to Greek CDS.  Just this once.  Pinky swear.

Looking at the whole European fiasco brings to mind Churchill’s quote about the United States always doing the right thing, after trying everything else first.  The Euros try about everything, but they don’t look like they are going to the right thing.  The exact opposite in fact.

All you clearing and market infrastructure aficionados must read Bill Hodgson’s piece on collateral transformation at DerivSource.  He points out quite accurately the new sources of fragility and vulnerability to stress that will arise from collateral transformation services that are being offered to finance CCP margins in the aftermath of clearing mandates.

The bitter irony here is that many derivatives end users (real money investment funds, industrial hedgers) did not pose any real systemic risk under bilateral structures.  But forcing them to clear drives them to utilize funding mechanisms that are systemically risky.  As one big corporate end user told me: clearing mandates have transformed credit risks into liquidity risks: I can manage the first, but the second scares me.

I continue to gape in amazement that the sorcerer’s apprentices that created these mandates did not think to step two.  They did not step back and ask: “Gee, we’re imposing a major change on the structure of financial markets.  How will market participants respond?”  This is especially unbelievable since a big component of the narrative of the financial crisis is that it was the result of excessive financial engineering.  What, did FrankenDodd, Timmy!, GiGi, the G-20, the EC, etc., think that the big changes that they imposed would not lead to a new burst of financial engineering?  Are they really that clueless?

I think I know the answer.  I think you do too.

Markets do not stand still.  Market participants will adjust contracts in response to regulations and laws motivated by beliefs that the existing system of contracts is flawed.  A useful first approximation is that these contractual adjustments will try to reproduce the economic substance of the banned or restricted contracts.  However, many of the work-arounds necessarily utilize less efficient–and often more fragile–ways to achieve that substance.  Which means that vulnerabilities have largely been relocated, rather than eliminated, and in many cases the new vulnerabilities are more dangerous than the old.

Read Bill’s piece to get an excellent illustration of this dynamic at work.  And then remember that the biggest systemic risk is government, and in particular, ill-considered government policies.  And that’s especially true when static-minded legislators and regulators attempt to impose their vision on a dynamic, strategic, reacting, self-ordering system.

There is an increasing drumbeat of stories warning about the systemic risks posed by CCPs.  This FTAlphaville article discusses several dangers I’ve discussed repeatedly, including the stresses put on liquidity, the concentration of risk resulting from the reconfiguration of the topology of the financial network that results from central clearing, and wrong way risks.  Several articles, including this one, report on the BOE’s Deputy Governor Paul Tucker warning about the lack of plans for resolving insolvent clearinghouses–a fear echoed by the ECB’s Peter Praet. Risk has a long article about various CCP risks; particularly interesting is the discussion of the contingent liability that clearing members face in the event of a “forced allocation” of a defaulting member’s portfolio.  The Risk article also reprises an SWP theme about the stupidity of limiting clearing member ownership and control of CCPs.

And the beat goes on.  Although not about clearing directly, this story on the downgrading of MF Global does have implications for clearing, given the CFTC’s decision to require admission of firms with as little as $50 million in capital to CCPs.  And speaking of the CFTC, its recently adopted clearinghouse rule requires CCPs to have enough capital to cover the failure of its single largest member, not the two largest: as I noted in my ISDA white paper, not only should a CCP have enough capital to cover two big defaults, it should have plan to replenish capital after even a single failure.  Although the CFTC may revisit the requirement later, pending negotiations with the Financial Stability Oversight Council, a failure of a single member–not even the largest one–of a CCP will likely require the services of Kevin Bacon do deal with the resulting run:

Needless to say, none of these stories are a surprise to me. I’ve been warning that CCPs could be Trojan Horses packed with systemic risk for a long time, to no avail. I hope that, unlike Cassandra, my warnings are mistaken. But it is becoming abundantly plain that these concerns are becoming far more widespread. It would have been better had that happened before politicians, regulators, and central bankers fallen victim to groupthink and seized on clearing as a “solution” before they had closely analyzed the problem in all its complexity. But the G-20 put its imprimatur on clearing, and the groupthinkers are not about to admit a mistake and start all over. So market participants and regulators are having to deal with the realities of a framework that poses dangers that may be different than, but just as threatening, as those clearing was intended to address.

I have only had time to skim press coverage of the new Mifid & Mifir promulgated by the European Commission, but on my initial read, that appears to be a fair description.  All of the bad ingredients of Frankendodd made worse, with some special Euro accents of a decidedly dirigiste flavor.  The same deep suspicion of markets, the same cartoonish view of why market structures have evolved as they have, the same conceit of knowledge and control, the same breezy disregard for unintended consequences.

Sorcerer’s apprentices run amok, again.  Led by a French apprentice no less.

After July 21, 2010, who woulda thunk that regulatory arbitrage would have thrown business in the US’s direction?  If Mifid and Mifir go through anything like what Barnier et al propose, that could well happen.

I’m in New York.  No, I’m not joining OWS down in Zuccotti Park.  Quite the opposite.  I was speaking at event sponsored by the object of their ire, at the JP Morgan Chase Commodity Forum.

I spoke about Dodd-Frank and commodity trading.  I did my shtick, and it went over pretty well: I was surprised that “Frank-n-Dodd” was something most hadn’t heard before.  The audience found the phrase amusing, and more than a few people remarked on the phrase afterwards.

Substantively, the most interesting thing I heard was said by Morgan’s head of commodities, Blythe Masters.  She noted that F-n-D imposed huge compliance and administrative burdens.  Huge.  Moreover, these are fixed costs.  So Frank-n-Dodd increases economies of scale in banking, which will favor the big over the small, and encourage the big to get bigger and the small to go away.

In other words, something ostensibly intended to address too big to fail will encourage big banks to get bigger through regulation-induced scale economies. The effect will be the exact opposite of the intent.

The road to hell is paved with good intentions.  Frank-n-Dodd just well may be the world’s largest paving company.