Streetwise Professor

The CFTC voted out two rules today, one on position limits, the other on clearing.  I’ve beaten both issues to a bloody pulp over the last couple of years, so I don’t have too much to add.  Just a couple of high level comments.

Bottom line: Both rules are highly ill-advised.

Regarding position limits, some of the most inane provisions of the original proposal are gone, notably the “class” limits that constrained netting across the futures and OTC swaps.  This was a hidden constraint on market making by dealers, and made no economic sense.  Fortunately it is gone.  Also gone–for the most part–is the conditional spot month limit that treated cash-settled and delivery-settled contracts differently.  This made zero economic sense too, and it is also gone.  The one exception is that there are different limits for cash- and delivery-settled contracts for Henry Hub nat gas.  This makes zero economic sense too, and is a blatant political compromise by the Commission intended to throw a bone to ICE that lost on the conditional limit issue generally.  Laws, sausages–and CFTC rules.

My comment letter on position limits criticized both stricken provisions.  But other provisions I inveighed against, particularly those that constrain ETFs like USO and US Nat Gas funds, remain.

The partisan rancor on this issue came through loud and clear at the meeting, as this piece by Jeremy Grant makes clear.  Jill Sommers and Scott O’Malia were very outspoken:

“We went beyond the statute” by doing things like narrowing the bona fide hedge exemption, Sommers told Reuters. “Those are the things that people can use for a legal challenge.

O’Malia said: “over-reached in interpreting its statutory mandate to set position limits.”  O’Malia also emphasized the lack of empirical evidence of a need for limits, echoing my “No Theory? No Evidence? No Problem!” refrain.

As I was quoted saying in the Reuters piece, this statutory overreaching will be the basis for a legal challenge.  Not just on the hedge exemption issue, but on the more fundamental issue of whether it is necessary for the Commission to find that “excessive speculation” has indeed caused “unwarranted” fluctuations in prices, i.e., the “no evidence” point.  I would not be surprised if the cost-benefit analysis, such as it is, is not challenged as well.

The disappointing guy was Dunn, who blasted the idea of position limits, but voted for them anyways.  Not exactly a profile in courage or conviction by a retiring commissioner.

The other rule would require CCPs to admit firms with a minimum of $50 million in capital.  I think this is a terrible idea.  I understand that CCPs could potentially use excessively onerous admission requirements to reduce competition: hell, I’ve been making that point for well over a decade.  But I also understand that undercapitalized members, and members who cannot contribute constructively to the auctioning of a defaulter’s position, can undermine the effectiveness and even the safety of the clearinghouse.

There is a tension between encouraging competition, and making CCPs secure: Gensler and the majority focused on competition, and I think that is a major mistake, particularly given the fact that the clearing mandate in Dodd-Frank is intended to reduce systemic risk. Micromanaging CCP operations is a horrible, horrible idea.

Grounds for challenge?  Maybe.

No surprises here, really. Gensler is hell-bent on ramrodding through his agenda.  And that’s probably the best way to phrase it: the agenda is pretty bent, and will create some regulatory hell.

This long Zero Hedge post recapitulates William Buiter’s analysis of the leveraged EFSF “bazooka.”  It is a very detailed exposition of why this mechanism is not credible.  As Buiter lays out, it is not credible primarily because it is laden with wrong way risk.  Good object lesson in what can go wrong with a CCP, by the way.

Last Friday I was part of a group of 8 economists who made presentations to the Board of Governors of the Federal Reserve.  Once or twice a year the Board invites academics to discuss a policy-relevant economic issue.  The subject of Friday’s session was Network Economics, and Alistair Milne and I spoke about network issues in clearing and trading.

The Parthian shot in my presentation was that it was essential not to ignore the unintended effects of derivatives regulation.  In particular, clearing mandates, capital and collateral rules, and the like are all intended to reduce the amount of leverage in the financial system.  But even if you require extensive collateral against derivatives trades, market participants can offset the reduction in leverage inherent in derivatives trades by using the freed up debt capacity to add leverage in other forms.  What goes out through the front door can return through the back door.  This can be particularly dangerous if you think you’ve solved the problem when Mr. Leverage walks out the front and ignore that he’s snuck back in.

Put differently, it is very hard to reduce leverage in the system as a whole by regulating just a piece of firms’ capital structure.

Another example.  Reducing derivatives counterparty credit risk through clearing and netting and collateralization works by increasing the priority of derivatives in bankruptcy.  But if you move derivatives towards the head of the line, somebody else ends up further back.  Like unsecured creditors, including money market funds who buy short term bank debt.  They can be systemically important, too, meaning that the regulations have primarily shifted the locus of systemic risk, and not really reduced it.

Focusing on the collateral issue, the numbers here are huge.  Tabb Group estimates that interest rate derivative collateral alone will total $1.4 trillion.  Credit, equity, and commodity derivatives-related collateral will likely add hundreds of billions to the total: although these markets are smaller, they are riskier, requiring more collateral per dollar of notional.

So where is all this collateral going to come from?  I’ve written about collateral management services, by which banks will effectively lend cash that can be used for margins, with the loans collateralized by assets that CCPs will not accept directly.  In other words, Mr. Leverage is  a Back Door Man.

CME Group’s Craig Donohue talked about the need for such services:

“There will be a need and a value for the collateral transformation services,” Donohue, chief executive officer of CME said today during a panel discussion at the Futures Industry Association annual conference in Chicago.

The types of accepted collateral may need to be expanded as thousands of new users seek to back trades. While cash and government securities will always be the least costly way to pay for margin, some who want to pledge “three chickens and an old Ford” will find it more expensive to have non-standard collateral transformed into acceptable form, said Jeffrey Sprecher, chief executive officer of Atlanta-based Intercontinental Exchange Inc.

The demand has created a “cottage industry” of firms and units within banks that will charge a fee to hold securities or other assets for investors in return for acceptable margin, said Richard Prager, managing director and head of global trading for BlackRock Inc. (BLK)

Cottage industry.  Somehow this brings to mind all the stories about shadow banking system in China that mushroomed after the government tried to crack down on bank lending.

And CCPs are looking to expand the assets they are willing to take as collateral.  This exposes the CCPs to higher risks, including valuation risks.  As an example, LCH.Clearnet (which has already begun accepting gold) is going to accept some corporate debt as collateral (no link yet, but it’s from a Matt Leising Bloomberg story that Matt emailed to me):

LCH.Clearnet Ltd., the biggest interest-rate swap clearinghouse, is considering accepting corporate bonds for the first time to meet an anticipated surge in demand for a broader array of collateral in the $601 trillion over-the-counter derivatives market.

“We want to be able to have more clients come to clearing,” Floyd Converse, head of U.S. sales and marketing for London-based LCH.Clearnet, said in an interview in Chicago this week at the Futures  Industry Association annual conference.  The world’s biggest swaps clearinghouses are expanding the
types of securities they accept as regulations force thousands of new users in the U.S. and Europe to use clearing. Among them, CME Group Inc., the world’s largest futures exchange, is broadening the variety of company debt it accepts as margin for its customers.

(Quick thoughts off the top.  “Investment grade” doesn’t really give the warm and fuzzies, does it?  Will corporate debt be accepted as collateral against CDS trades?  I know LCH.Clearnet doesn’t clear CDS, but there is a reason to wonder whether competitive pressure would lead to such an outcome.  Wouldn’t this expose a CCP to substantial credit correlation risk, which is devilishly difficult to quantify and manage?)

And it is becoming far more widely accepted that CCPs will require central bank liquidity during periods of extreme systemic stress.

All of these stories suggest that mandates are first and foremost just leading to a reshuffling of leverage and risk.  There is room for deep skepticism that this reshuffling will reduce systemic risks.

Indeed, if Gary Gorton is right, and shadow banking was first and foremost a mechanism designed to create informationally insensitive debt that could be posted as collateral, the potential increase in demand for collateral could catalyze a similar process.  This process is systemically risky because it increases fragility and creates substantial tail risks, as this new Gorton paper discusses.

There is also reason to doubt that this is a good use of capital, and could lead to lower growth.  Just what we need.  The cost-benefit trade-off appears particularly unfavorable with respect to collateral posting by long-only buy side investors (e.g., pension funds) and “end users” who do not pose substantial systemic risks.

So, do Ben et al get it?  My sense is that they do, although Bernanke was pretty inscrutable through the entire morning.

One person who obviously doesn’t get it, or is pretending that he doesn’t (which would be even more disturbing) is Gary Gensler.  October is sprinkled with major conferences, and Gensler has been doing the rounds.  Despite all of the advances in understanding of the complexity of the issues involved, Gensler continues to peddle his cartoonish morality play:

“While the crisis had many causes, it is evident that swaps played a central role,” Mr Gensler said. “Swaps added leverage to the financial system with more risk being backed by less capital.

“They contributed, particularly through credit default swaps, to the bubble in the housing market. They contributed to a system where large financial institutions were thought to be not only too big to fail, but too interconnected to fail. Swaps – developed to help manage and lower risk for end-users – also concentrated and heightened risk in the financial system and to the public.”

No recognition of the ability of firms to substitute swap-based leverage with other types of leverage, and their willingness to do so.  No acknowledgement of how mandates re-order priorities in bankruptcy, and the implications thereof.    No appreciation for the potentially destabilizing effects of rigid variation margin mechanisms, and the pro-cyclicality of these mechanisms.   And yeah, Gary: clearing mandates don’t concentrate risk and create their own interconnections.

Gensler is also still pushing the transparency nostrum.  He links the crisis of ’08 to the opacity of the swaps market.  Well, lack of pricing information was arguably an important problem with AIG in particular, his proposed cure–the SEF mandate–will have no effect on this.  The problem with the instruments that AIG bought wasn’t that they weren’t traded on transparent markets: it was that they weren’t traded.  Markets are not the Field of Frickin’ Dreams: If you build it, there’s no guarantee anybody will come.  Comparisons of markets for illiquid products to exchange traded futures are superficial and silly.

In sum, Gensler continues to say foolish things.  Is he a fool, or does he just believe his audience is?  He batters straw men.  He sticks to a cartoonish narrative of the events of 2008.  He pushes nostrums.  He ignores deep complexities, and the huge potential for unintended consequences of the policies he advocates.

Nonetheless, he is not shy about telling others what to do. @OTCderivatives tweets that Gensler said the CFTC should be “top dog” in IOSCO because of the size of US markets.   In London, he chided the Europeans for not including exchange traded derivatives in Emir:

It is critical, though, that those swaps traded on regulated exchanges also are subject to the clearing requirement to bring the benefits of clearing to swaps, regardless of where they are traded – on exchange or off exchange.

This will no doubt thrill the Germans, because an expansion of the Emir remit would also force open access to exchange CCPs.

But given that the Germans have been quite adept at slapping Timmy! around, I doubt that a mere agency head will give them much trouble.

[Interesting aside.  Risk Magazine’s Laurie Carver tweeted that Gensler blew him off to allow “other less aggressive journalists ask him comfy things.”   Go figure.]

To sum up.  Dodd-Frank has set off a very complex dynamic of unintended consequences, many of which will undermine the intent of the law.  One of the figures primarily responsible for implementation of Dodd-Frank has a very simplistic view of the world that ignores these complexities.  What could go wrong?

No, it’s not all Kudrin all the time here at SWP.  I know there are those of you looking for your clearing fix.

A brief thought about an unintended destination on the Road to SEFdom–a vertical silo.

Long time readers will know that my transactions cost economics-based analysis predicts that dominant execution venues will vertically integrate into of post-trade services, including clearing and settlement.  Many dominant markets are already “silos” and others are moving in that direction.  The days of an execution venue obtaining post-trade services from a “horizontal” CCP or settlement provider (like LCH.Clearnet) are numbered except when regulation (like RegNMS) socializes order flow.

Horizontal, independent clearers (or settlement providers) can survive in an OTC market, where there is no centralized execution venue.  Vertical integration economizes on transactions costs and double-marginalization costs when there are back-to-back monopolies (and near monopolies).  No execution venue, no back-to-back monopoly problem.

That’s where the SEF mandate comes in.  By forcing exchange-like execution of swap transactions, there is a very real possibility that a dominant execution venue will emerge–and that the resulting frictions in the dealings between that venue and its clearer will lead to a merger between them (or some sort of long-term, exclusive contract.)

Whether this outcome occurs depends on the rules for SEFs.  There is likely to be a proliferation of SEFs early on, but rules for SEFs will determine whether a handful or one survive for a particular instrument class.  If SEF regulations (a) require them to operate auctions (rather than, say, RFQs), and (b) do not impose obligations on SEFs to direct orders to other SEFs offering better prices, then network effects will lead to tipping to a single venue.  Conversely, if there are SEF order handling rules analogous to RegNMS, multiple SEFs may survive.  Under the first alternative, integration is likely to occur.  Under the second, the likely outcome is for multiple SEFs to be served by one horizontal CCP.

SEF rules are still up in the air, and I have not seen any discussion of inter-SEF obligations–or lack thereof.  In contrast to SEC, CFTC has no tradition of even contemplating, let alone imposing, order handling rules.  The issue has never really come up.  I think the presumption in the agency is there will be rigorous competition among SEFs, but that conclusion depends crucially on SEF rules.  In particular, rules relating to the way SEFs compete.  If SEFs are required to operate auction-like mechanisms, and are under no obligation to direct orders to markets displaying better prices, markets will tip to a single SEF.  This will lead to integration.  If regulators impose order handling obligations, multiple SEFs will survive, and integration is far less likely.

Has anybody thought this through?  Are order handling rules even on the table?

I am in London for the ISDA Annual Europe Conference, where like in the NY version, I moderated a panel on clearing.  Yesterday’s panel was very informative and interactive, and made for some good copy.  As in NY, it was only possible to scratch the surface, but that in itself is revealing because it tells you just how many knotty issues are still unresolved.  Another thing that came through loud and clear was how interconnected these issues are.

The most entertaining debate centered around interoperability.  The looming fragmentation among CCPs has regulators around the world trying to mitigate the cost and risk increasing consequences of fragmentation by pushing for CCPs to interoperate.  The three major clearers represented on the panel–Michael Davie from LCH.Clearnet, Paul Swann from ICE Clear Europe, and Kim Taylor from CME Clearing–were all pretty negative on the idea, with Michael and Paul being adamantly opposed, and Kim only slightly more accepting of the idea.  Michael wins the quip of the day award for his characterization of the idea: “It’s crackers.”

Jurisdictional fragmentation was foreseeable months ago: I discussed the problem in some detail in my 2010 Cato and Journal of Applied Corporate Finance pieces, and again more recently in my ISDA study.  It is on the front page now, with the face-off between the UK and the ECB over the latter’s insistence that any clearer of Euro-denominated derivatives be domiciled in the Eurozone, with access to the European Central Bank.

There is some economic sense to the ECB’s position, but there is also economic sense to having global CCPs that can maximally exploit economies of scale and scope arising from netting and capital efficiency.  But this just illustrates the ill-thought out nature of clearing mandates.  Global banks can access central bank liquidity in a variety of currencies and net efficiently and collateralize efficiently across multiple currencies.  Forcing clearing eliminates some netting and capital efficiencies (but can potentially improve others), but creates thorny issues about access to central bank liquidity that makes global CCPs problematic.

The Canadians are now grappling with the very difficult tradeoff between efficiencies that come from global CCP scope, and the potential systemic fragility that could arise from concentrating so much risk in a single entity.  A Bank of Canada official, Tim Lane, warned:

In carrying out the G20 mandate requiring all OTC derivatives to be centrally cleared, it is essential to ensure that we do not unduly concentrate risk in a relatively small number of institutions that are direct clearing members of global CCPs,” he said.

These were the very institutions that spread and amplified contagion through the global financial system in 2008, Mr Lane told the annual Sibos settlement and payments conference.

Quite a puzzle, no?  Who could have possibly anticipated this?  (You don’t need to answer that.)

And the COO of the DTCC has warned about the difficulties and dangers of clearing CDS.

“We may be creating a much higher level of risk,’’ he said, by requiring swaps to be turned into standardized products, traded on electronic exchanges and where risks are covered by a central counterparty, backing up the two sides of a trade.

He noted, for instance, that a central counterparty failed during the Asian financial crisis of the ‘90s.

Again, who knew?  Again: no need to answer.

Lawrence Sweet, a senior VP at FRBNY replied:

Risk management procedures must be strong and the new systems “sufficiently robust” to guard against failure of central counterparties or firms involved in the trades.

And, he said, those swap contracts that are too complicated or risky to be put into centrally cleared, electronic markets should not be. The question is “how much can we put in there in a safe way,’’ he said.

And the answer is?!?!  [Crickets.]  Stating a set of desiderata without providing a reasonable strategy for getting there is gratuitous, at best, and reminiscent of the Steve Martin “How to Make a Million Dollars Without Paying Taxes” routine.

Why stop now?  From the FT, Jeremy Grant’s article from yesterday (2 SWP bonus quotes) is summarized by the FIA’s news brief as follows: “Complications arise as regulators detail clearing rules.”   I am so shocked that I am speechless.

Witness what the Sorcerer’s Apprentices have wrought.  Perhaps to some clearing mandates sounded like a good idea at the time, but it’s pretty evident that those very same some hadn’t fully thought through the issue.  Everybody is now dealing with the implications of the mandates on the fly, and are learning that the “solution” is just another package of problems.  Gazing across the fence from OTC World into Clearing Land, the grass in the latter seemed so, so much greener.  Now, having jumped, the jumpers are finding plenty of weeds, and plenty of nettles.

This week marks the beginning of a whirlwind couple of months in which I give talks or participate in conferences on either clearing or Frank-n-Dodd (there of course being a big overlap there).  Tuesday I moderated a panel at the ISDA Annual New York Conference, and yesterday I participated in a panel on Frank-n-Dodd at a Futures Industry Association event in New York.

First, the FIA event.  What came through loud and clear was the widespread belief that the SEF mandate in Frank-n-Dodd is wholly wrongheaded.  The consensus is that it is an attempt to jam a one-size-fits-all model on an inherently heterogeneous and non-standardized business–the business of executing OTC derivatives transactions.  That heterogeneity reflects the inherent heterogeneity of particular transactions, and the firms that want to execute them.  The market has evolved to accommodate heterogeneity, and the SEF mandate will impose uniformity.  Everybody better fit a 42-regular sportcoat, because that is what Frank-n-Dodd is going to force everybody to wear.

Of course there are dissidents from the consensus: most prominently those who do, or want to, operate SEFs.  Big surprise.  The NYT recently ran an article describing the efforts of these firms to influence policy.  The point you should take away from that article is that the idea of SEFS is not new, that SEFs have tried to gain traction in the market for some time (they are not “Johnny-come-latelys” in the words of one exec quoted in the article), but they have not made a big dent in the marketplace.

The failure to this point of SEFs to transform execution in the swap market, the way electronic trading did for listed derivatives, is a crucial fact.  It is not dispositive proof that the SEF mandate is misguided, but it does raise serious questions about it.  Before remaking the world, it is a pretty good idea to understand why the world is the way it is and why it isn’t the way you want to remake it.  Competition is never perfect, but competitive forces usually work inexorably towards the adoption of more efficient practices.  The rebuttable presumption should be that competition has pretty much gotten it right, and that policy prescriptions that are wildly at odds with existing practice are likely based on ignorance.  Those advocating a wholesale re-engineering of the results of market processes should be required to advance a coherent justification, based on rigorous logic and empirical evidence.

This the SEFocrats have not done.  Not even close.  And no, invoking the magic word “transparency” or advancing theories that presume that half the market is suffering from something akin to battered spouse syndrome don’t cut it.

The SEF rules are a particularly prominent example of the deficiency in cost-benefit analysis in CFTC rulemaking.  I have it on good authority that some analysis will soon be forthcoming that demonstrates that the cost of these rules will be immense.  As for benefits, the six members of the FIA panel couldn’t name one–even when pressed to do so.  We, collectively, couldn’t even come up with a “well you don’t sweat too much for a fat girl” compliment.  (If you don’t like that remark, direct your complaints to Ty Cobb:  I stole it from him.)  So, insofar as cost-benefit analysis is concerned–you should be able to do the math pretty easily.

The title for the post, by the way, is a joint product.  Tom LaSalla of CME Group coined “SEFdom” to describe what Frank-n-Dodd will soon bring on us.  I added the Hayekian allusion.  (Go figure.) I think the comparison is apt.

Insofar as the ISDA panel on clearing is concerned, I walked away from it thinking what I do after hearing any informed discussions of this subject: that it is the most devilishly complex issue you can possibly imagine.  It is one of the world’s biggest onions, and neither I nor anyone who has spent considerable time and effort thinking about it or actually doing it has gotten through even a small fraction of its layers.  The number of serious issues, their complexity, and their interconnectedness, is hard to exaggerate.

Which further demonstrates the frivolity of legislators and regulators around the world,who seized upon it as a panacea and imposed it without due consideration of these complexities.  The idea was hatched out of superficial understanding by panicked people who then proceeded to let others deal with the brain-twisting realities.

One hopes (though I do not expect) that regulators will be sufficiently patient and flexible to permit people who actually know something accommodate these complexities, and make the hard trade-offs that are necessarily involved.  New ideas on ways to perform the same functions as CCPs are still being developed: ISDA chief Conrad Volstad mooted a promising approach that would achieve the purposes of the clearing mandate, but at far lower cost.  These approaches deserve analysis and development before another one-size-fits-all approach is locked in.

I don’t like clearing mandates, but think that clearing has its virtues if it is done right, and in a way that reflects its comparative benefits and costs.  In this way it differs from the SEF mandate, which is why I gave the latter my Worst of Frank-n-Dodd Anniversary Award.  But rigid and superficial conceptions about how the mandate should work (and you know whom I am talking about) raise the very serious possibility that the potential benefits of clearing will be swamped by the unintended costs of imposing it where it is inappropriate, or in a way that is not adapted to its strengths and weaknesses.

In this week’s edition of Energy Metro Desk, John Sodergreen wrote: “Normally, Pirrong is a ‘take no prisoners’
sort of economist.”  He was referring to my apparently serene response to the Singleton paper on energy speculation.

Rest assured, all, that I am not mellowing in my old age.  My response to Singleton qua Singleton was serene primarily because the results are capable of many interpretations, many of which are quite compatible to my views.  Further rest assured that I am my scathing self when it comes to the efforts to misinterpret and overinterpret Singleton’s results.  It is being waved about as the smoking gun proving that speculation distorts prices.  This is completely wrong, and reflects either the ignorance or agenda–or more likely, both–of anyone making the claim.

Remember what Puddin’ Head Wilson said: “We should be careful to get out of an experience only the wisdom that is in it — and stop there.”  People are getting far too much “wisdom” out of Singleton than there is in it. Singleton’s results are perfectly consistent with a favorable or benign effect of speculation.

But there is nothing more likely to get me to break out the black flag than an epistle from Bart Chilton, and yesterday he did not disappoint.  The NY Times’ Dealbook had this gem from our ol’ buddy Bart:

It’s a familiar cry from Wall Street executives and Congressional Republicans: New regulations will dampen profits and crimp an already-feeble job market.

But some federal regulators, now charged with writing dozens of new rules for Wall Street, beg to differ. Bart Chilton, a Democratic member of the Commodity Futures Trading Commission, argues that a regulatory shake-up would actually spawn a wave of hiring on Wall Street and in Washington.

“The possibilities for economic growth and competition here are mind-boggling,” Mr. Chilton said on Friday during a speech at the University of Maryland.

The debate centers on the controversial Dodd-Frank Act, which overhauled financial regulations after Wall Street nearly collapsed during the financial crisis. The law, among other things, transformed the $600 trillion derivatives markets, a lightly regulated industry at the center of the mess.

. . . .

“I have no doubt that these new regulations, instituting new types of clearing, trading and reporting platforms, will foster a landslide of hiring in the financial sector,” Mr. Chilton said.

In particular, Mr. Chilton forecast growing demand for technology experts. “All of this new trading activity, with new regulatory oversight requirements, will mean the development of new technologies, both in the private and public sectors,” he said.

The mind boggles.  Chilton, like all too many regulators and legislators, confuses costs and benefits.  This is the broken window fallacy on crack.  Said regulators and legislators should be required to have Bastiat’s discussion of the seen and the unseen flashed before their eyes repeatedly, Clockwork Orange-like, until the idea sinks in.  Short of that, I am at a loss at how to educate them on this profound–yet simple–concept.

Yes, we can see all the accountants and lawyers beavering away on Sarbanes-Oxley-related work.  But what about all the other–and actually productive–things those people could be doing if Congress in its infinite wisdom and overweening arrogance hadn’t seen fit to create an artificial demand for their services, that distracted them from doing something that is actually socially productive?  What about the companies that are smaller, and the companies that don’t exist, because of the burdens of this and other counterproductive regulation?

Frank-n-Dodd is Sarbanes-Oxley raised to a power far greater than one.  Yes, there will be lawyers and compliance people working in their tens of thousands to ensure adherence to its mind-numbing dictates.  Yes, the idiotic SEF requirement will result in a splurge in spending on technology, and there will be much rejoicing among programmers and IT people.  To the bean counting regulator or legislator this is good.  To the more perceptive, it is a crime.

Riddle me this, Bart: If this technology were actually valuable, why do you and your ilk have to force its creation?  You, in particular have been critical of the dizzying pace of technological development in the trading space.  So you know this is obviously a technologically dynamic industry where there is intense competition to create new products and services and methods of delivering them, not some tradition-bound backwater.  If the kind of technology Frank-n-Dodd is going to bring into existence were actually delivering value to market participants, you can be damned sure that somebody would have figured that out.  Many somebodies, in fact, who would be competing like hell to bring it to market faster and better than anyone else.

And further: please tell me what actually beneficial inventions will not be created, or will be delayed, because their would-be inventors are instead (rationally) responding to some inane government mandate?  You can’t, and I can’t.  But they exist.  Just because you can’t see them, doesn’t mean they aren’t there

And please: tell me how you distinguish a cost from a benefit.

Sadly, the inability to tell cost from benefit is rife in the 202 area code.  The disease is probably most acute at EPA, which blessed us with this gem of economic analysis:

In fact, the EPA has even suggested that new regulations can have a positive impact on job growth. “In periods of high unemployment, an increase in labor demand due to regulation may have a stimulative effect that results in a net increase in overall employment,” the agency wrote in February.

This is the kind of moronism we are dealing with, people.  And the rot is spreading.  Including to the CFTC, apparently.

When you read or hear this or that macroeconomic theory about why the recovery–such as it is–has been so weak, and why the economy totters on the brink of another recession, put it in its proper perspective.  Yes, macro factors are important.  But so too is the massive regulatory millstone hanging around our collective necks.  People who think costs are benefits are running amok.  And sad to say, they are just getting warmed up.

We need to fight these people.

* The Degüello was a bugle call dating from the Moorish Wars of the Reconquista in Spain. Literally, it means “throat slashing” and was played to signal “no quarter–take no prisoners.” Santa Ana’s army played it before the final charge at the Alamo.

This article by George Priest about the incoherence of the USDOJ Antitrust Division’s attack on the ATT-TMobile merger is worth a read.

The key fact that Priest focuses on is the response of Sprint’s stock price to the announcement of the Division’s attempt to block the merger.  If the merger really would reduce competition, Sprint’s stock price should have fallen.  The fact that Sprint’s price in fact rose is strong evidence that the merger would have increased competition in the wireless market.

The key analytical point in the article is this:

Much of the Justice Department’s failing on this issue derives from its failure to understand that network industries must be evaluated differently from more traditional, manufacturing industries. The market share guidelines upon which the Justice Department relies to oppose this acquisition may make sense in the context of manufacturing industries. But they make no sense in the context of networks in which there are great benefits from large networks with large market shares.

This was the mistake the Justice Department made in the Microsoft case almost a decade ago. It wanted to break up Microsoft, supposedly to create greater competition among Web browsers. The courts prevented the effort, and to good effect.

The rise of Google, Facebook and the competition from smartphones that resemble computers have shown that the focus then on browser competition misunderstood the rapidly changing nature of network competition. The Obama administration is making the same mistake with its opposition to AT&T’s acquisition of T-Mobile.

This is exactly right.  And it helps explain the intellectual confusion at DOJ and in the European Commission on all matters relating to financial exchanges and financial markets.  Financial trading is a network industry, and the same failure to understand the implications of network economics for market structure that has muddled antitrust enforcement in telecomms and software is leading to a similar muddle in antitrust analysis of financial markets.

Back in June, at a nice lunch with several LCH.Clearnet executives in The City, I was asked my opinion on the company’s future.  Recent news, notably the offers for the company by Markit and LSE, have brought that conversation to mind.

My answer was that I thought that the trend towards vertical integration by exchanges was inexorable, and that there were good economic reasons for this (which I have discussed for years here on SWP).  As a result, I didn’t/don’t consider the model of an independent firm clearing for multiple execution venues/exchanges to be viable.  Especially with Frank-n-Dodd and Emir, but likely even without that impetus, there definitely will be increasing opportunities for clearing OTC derivatives.  (Although I cautioned that if the ambitions of regulators and legislators to make OTC trading exchange-like were successful, the same kind of dynamic now playing out in listed derivatives could occur in swaps.)  So SwapClear is clearly a viable business (similarly, RepoClear).  But major dealer firms would demand considerable influence over, and perhaps control over, the clearing entity.  Any such entity would either be, or closely resemble, a member cooperative.

My prediction was that (a) the exchange clearing business of LCH.Clearnet would either go away, or be absorbed into an exchange or exchanges, and (b) the swap clearing business would be largely in the orbit of the big dealer banks, although how that would be achieved organizationally remains to be seen.

The LSE offer is clearly intended to obtain the in-house clearing capability that LSE has lacked for decades (in part due to its own missteps in the 1970s and 1980s).  But LSE has no comparative advantage in operating the OTC clearing business, and the dealer banks have no interest in having LSE control it.

In contrast, the OTC derivatives business is a much closer fit with Markit, given the overlap between the membership of OTCDerivNet (which governs SwapClear) and the ownership of Markit, and the synergy between Markit’s OTC valuation, processing, and data business and OTC clearing.  But Markit really has no need for LCH.Clearnet’s listed clearing business.

So the sensible outcome would be to split the baby, with LSE taking over its own clearing by acquiring part of LCH.Clearnet, and Markit taking the OTC-related business.  That end state seems much more sensible than either LSE or Markit swallowing all of the big London-Paris clearer.  How that end state is reached–how the baby actually gets split–will be quite interesting to watch.  I am sure there will be much drama in the coming months.

There are news reports providing some glimpses into draft regulations regarding the regulation of derivatives and securities markets in Europe.  It looks like it is taking some of the worst of Frank-n-Dodd, and adding some dumb flourishes of its own.

Insofar as the worst of Frank-n-Dodd is concerned, despite initial indications to the contrary, it looks like the proposal is going to incorporate something like a SEF requirement.  You might recall that on The Monster’s first birthday, I named the SEF requirement as its worst feature.  Well, the Euros (don’t they have bigger problems right now? Just asking.) don’t look to be avoiding the US’s mistake:

Widely traded derivatives would have to be transacted on an electronic platform to improve transparency and safety, draft European Union rules showed on Monday.

The bloc is overhauling its markets in financial instruments directive (MiFID) to catch up with technological advances, apply lessons from the financial crisis and deal with problems such as price fragmentation raised by the original rules.

“The main aim of the proposal is to ensure that all organised trading is conducted on regulated venues and is fully transparent,” the draft, seen by Reuters, said.

More specifically, world leaders agreed in 2009 that derivatives, largely traded bilaterally between banks in an opaque $600 trillion sector, should be traded electronically.

This will give supervisors the full picture of who is affected when a counterparty gets into trouble, which they lacked when Lehman Brothers bank collapsed three years ago.

“The proposed revision will shift trading of the suitably developed derivatives to such platforms,” a draft of the MiFID reform, now circulating widely in Brussels, said.

“This obligation will be imposed on both financial and non financial counterparties,” the draft added.

Another unfortunate imitation is the adoption of restrictions on commodity speculation, including position limits:

The European Securities and Markets Authority should have the power to impose position limits on traders in crisis situations when “the stability of the whole or part of the financial system” is threatened or “delivery arrangements for physical commodities” could break down, the document says.

The Euro flourishes are clearing-related, although here I have to say that the reporting is not too clear.  As I’ve written in the past, European regulators are obsessed with the vertical integration of execution and clearing–the silo issue.  Various reports (including the two linked above) and this one suggest that the regulators will force CCPs to be open access.  The reporting also states that integrated exchanges will have to share data streams, including calculations of indexes that are the basis for traded products.

Insofar as open access is concerned, the FT article quotes language stating that CCPs will be required to accept trades for clearing “on a non-discriminatory and transparent basis, regardless of the trading venue on which the transaction is executed.”

The idea here is to facilitate competition between CCPs, apparently.  But it is fraught with difficulties.

For one, there is the question of why a dominant CCP, including one that is integrated with an execution venue, would turn away business.  Even if it is a monopoly, it could sell clearing services at the monopoly price.  If, as the anti-silo crowd commonly argues, the execution of transactions is potentially highly competitive, absent some cost, the monopoly CCP would maximize profits by selling its services at the monopoly price.  It wouldn’t be necessary to mandate open access.  The CCP would gladly offer access–for a price.

It is therefore necessary to understand why an integrated CCP wouldn’t sell clearing services to others on an open access basis.

One possible reason is that the dominant CCP believes that open access rules will eventually result in the regulation of the prices it can charge for its services.

I think a more important reason relates to a fundamental misunderstanding  among the Europeans of the way competition is likely to work.  There are two possibilities.

One possibility is that there remains a single clearer–given the cost conditions in clearing, that’s not unlikely, although it seems that the Europeans think that they are constructing rules that will reduce the likelihood of this outcome.  Note that particularly now, financial trading is highly technological.  There will thus be the necessity of coordinating technologies and changes in systems between the execution venues and the clearer.  This can be very difficult to achieve across firm boundaries; this is one of the factors that I identified as justifying integration well over 5 years ago.  It should also be noted that this is precisely the reason given for many recent exchange decisions to integrate into clearing; the LSE is the most recent and prominent example of this.

The other possibility is that there are multiple CCPs offering to clear a particular instrument.  There are myriad challenges to this, but I’ll focus on just one.  In particular, assume a transaction in a particular instrument is cleared at CCP A and CCP B.  A trade is executed on venue X.  If the parties to the trade can choose independently where to clear, the buyer may submit the trade to A and the seller to B.  In this case, A and B must be interoperable.  Interoperability is extremely challenging.  It is likely to increase collateral costs (as A and B are going to require collateral from each other).  Moreover, A and B may find it difficult to negotiate an interoperability arrangement because of (a) competitive pressures (the model the Europeans seem to have in mind involves a unique balance of competition and cooperation), and (b) distrust of each other’s risk management, arising from the difficulties of monitoring.  Moreover, the technology/system coordination issues are now multiplied, as X has to coordinate with both A and B.  And if there are multiple execution venues (Y and Z, say) as the Euros presumably hope and expect, these difficulties are multiplied accordingly.

Having an exclusive arrangement with an execution venue avoids this problem.  Those trading on X could be required to clear on A, for instance.  But that just raises the same kinds of problems as if there is only a single clearer.

In brief, it is hard to see how robust competition between CCPs is possible.  Once that is admitted, the whole basis of the regulation collapses.

The whole evolution of the exchange space–most notably in Europe–in the past 5 years is exactly contrary to the thrust of the proposed regulation.  And maybe that’s the point: the Euroregulators are clearly bugged by this trend.  But maybe they should try to understand it first; it’s pretty evident that they don’t now.

Case in point: LCH.Clearnet’s difficulties–its loss of exchange clearing business (EuronextLIFFE, ICE, and almost certainly LSE)–suggests that integration is not primarily driven by anticompetitive impulses.  Instead, in my view it reflects the difficulties of coordinating complementary activities across firm boundaries in a highly technologically dynamic industry.*  At the very least, the Euros should consider that possibility, and take it seriously, before attempting to micromanage the structure of a dynamic industry with strong network characteristics.

Instead, it seems that the regulations are based on an intellectual framework that would be suspect in any industry (as I’ve written about before), and which does not seem to take into account that unique characteristics of financial trading: network effects, scale  and scope economies, technological dynamism, and information asymmetries with respect to performance risk.

So, if the European endeavor is truly the son of Frank-n-Dodd, it may well be the ugly bastard child.  It has the defects of F-n-D, and adds some more–as if more were needed.

Perhaps this is Brussels’ negotiating position.  There is considerable opposition (particularly in Germany–go figure) to some of these initiatives, and maybe the EU is proposing a more radical change in the knowledge that it will have to be watered down.   One can only hope that it drowns.

* I spoke at an FIA panel that touched on this issue in March, 2007.  I made the coordination point.  Charlie Carey, then head of the CBT (which had already agreed to sell out to the CME–this was the day before ICE made its surprise offer) was sitting next to me.  After I made this point, he handed me a note that said that was an extremely important, but insufficiently appreciated, fact.