Streetwise Professor

As I’ve written repeatedly in the past years, the mandated move to central clearing will increase substantially demands for liquidity to fund variation margin payments, especially during periods of high volatility and high market stress.  By definition, variation margin payments total zero–every dollar paid is received by somebody else–thus they don’t affect aggregate liquidity, but economic frictions preclude the development of a perfect pooling mechanism.  As a result, market participants will need to pre-plan how to fund their margin payments.

Not surprisingly, banks are crafting funding mechanisms for their buy-side clients (“end users”).  FTAlphaville quotes from a Risk story by Matt Cameron which describes some of the solutions dealer banks are peddling to their clients [emphasis provided by FTA]:

Clearing members say they have a solution. Most buy-side firms will have to access clearing services through these members – typically the large banks – due to strict membership criteria set by the CCPs. These clearing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities – essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP. Given the frequency of margin calls – there could be several per day in volatile markets – some also plan to extend credit lines, where they would meet intra-day margin calls, with the customer settling up in one go at the end of the day or start of the next.

It sounds a perfect solution, but the numbers involved are huge, raising the question of whether there is enough capacity and appetite among dealers to offer this service to the entire universe of end-users. According to research published by Morgan Stanley and Oliver Wyman on February 16, as much as 40–50% of the total annual traded volume of OTC contracts could be cleared by 2012/13 … creating an additional collateral requirement of between $2 trillion and $2.5 trillion … Most dealers say they would only have capacity to extend credit lines and provide collateral transformation services on a fraction of that.

Diving into the Risk article reveals more details–troubling ones.  It notes that unlike dealers, whose books are typically close to matched, end users are likely to have one-way positions with commensurately greater exposure to margin calls.  Which just provides just another reminder that clearing would not have been a panacea for AIG, which had huge directional positions, and was brought down by the need to fund margin calls–and would have been brought down by the need to fund margin calls in a cleared environment.  Indeed, the expansion of clearing threatens to increase the population of potential AIGs.

The article also emphasizes that the contingent funding obligations on banks could be huge, and are likely to be huge precisely when funding market conditions are stressed.  The various solutions proposed by the banks rely very heavily on repo markets, and in particular repo markets for lower quality, less-liquid instruments.  In essence, banks will repo out lower quality assets and use the cash to fund margin calls.  But repo markets for lower quality assets are the ones that are the most problematic during periods of market stress.  Note that haircuts on everything but high quality sovereign paper increased dramatically when the financial crisis took hold.  Companies that depended on the repo market for funding found this source cut off.  The shadow banking system was built on repo, and runs on the repo market are what cratered that system.  The death knell for Lehman was the decision by JP Morgan and BNY Mellon–the clearing banks–to refuse to take low quality assets to collateralize tri-party repo.

So just why exactly is it a good idea to create a system that increases reliance on a fragile funding source?  This creates exactly the kind of feedback mechanism that generates crises.  Adverse shocks lead to price changes that result in big margin calls.  These shocks also impair liquidity of the funding markets that participants rely on to obtain the cash they need to pay the margin calls.  That’s how things spiral from bad to worse to worser yet.

And there are knock-on effects in the asset markets:

“We reserve the right not to fund clients on a unilateral basis.  If we fall short and can’t fund the variation margin call, we will demand the cash from the client.  If the client doesn’t have the cash, it will have to liquidate the assets it does have or we will be forced to close them out . . .” says one dealer.

Great.  This is a perfect example of how individually rational behavior by banks can exacerbate market stress.  The collateral liquidations and  derivatives liquidations will both cause prices to move–generating more margin calls and reducing the value of the collateral available to secure funding of those calls.  Positive feedback again.  And since by design a lot of the collateral that is liquidated will be lower quality stuff traded in illiquid markets the price impacts will be large–and this will make it more difficult for others to use these assets to fund their positions, thereby creating a serious negative externality.

These problems are endemic in financial markets, including uncleared OTC derivatives markets.  But clearing makes the mechanism more rigid and time sensitive.  It increases the tightness of the coupling in the financial markets, and that makes them more vulnerable to chaotic breakdown and cascading failure.

Cameron’s article discusses other alternatives.  One is that CCPs accept lower-quality collateral. But this merely passes the hot potato.  CCPs are simply conduits that transfer margin monies from the losers to the winners.  The winners won’t necessarily accept the collateral that the losers provide, or will place a lower value on it.  Much of the collateral will be hard to value, during periods of market stress particularly.  And if there is a delivery option on collateral, how do you even price collateralized derivatives trades?: the price of the collateralized trade depends on the value of the collateral, which adds an additional risk to the trade.

So if the CCP can’t just pass collateral along from loser to winner because the collateral isn’t fungible like cash, then the CCP has to fund the cash payments to the winners collateralized by the non-cash instruments posted by the losers.  That puts the CCP in the position of a bank, and raises the question: just who is going to lend against that collateral?

Moreover, this undermines one of the main potential benefits of clearing: fungibility of trades across counterparties.  Different counterparties may have different funding capabilities.  Some may have  access to high quality collateral, some may rely more heavily on low quality collateral.  In an OTC market, those counterparties would trade derivatives at different prices reflecting their differing risks and the quality of the collateral that backs the trade.  But in a cleared market in which all trades are fungible–with offsetting positions netted out, meaning that they are treated as perfect substitutes–this pricing mechanism doesn’t work.  Economically important differences are not priced, which distorts incentives.  This will tend to work to the advantage of low-quality counterparties and to the disadvantage of high-quality ones.

In other words, if the collateral really isn’t fungible–like cash is–how can the trades backed by this collateral be fungible?

One of the risks of clearing is that it treats the unequal equally.  Widening the range of collateral that CCPs must accept only exacerbates that risk.

It also puts CCPs in a delicate position–exactly the position that JP Morgan and BNY Mellon found themselves with Lehman.  A firm is in trouble, and is offering to post dodgy paper as collateral.  If the CCP refuses, the firm is likely to default.  That could jeopardize the CCP.  Even if the CCP can absorb the default, it is at risk of being accused by the defaulter’s bankruptcy administrator of violating the bankruptcy laws–which is the situation Morgan and BNY found themselves in post-Lehman.

So maybe the CCP will decide to play European Central Bank for a day–or a week, or a month–and pretend that junk collateral is as good as gold or cash, thereby gambling on the resurrection of the troubled firm.  That just increases the risk of the financial system–and may subject the CCP to a run by firms that are worried about the quality of the collateral it has taken on.

Contrary to the airy promises of their evangelists, clearing mandates therefore do not fundamentally alter the economic problem that must be addressed: how to fund variation margins in periods of market stress.  Indeed, in my view mandates actually exacerbate the problem because they increase the rigidity and time-sensitivity of the system, require the clearing of more instruments less suitable to accurate valuation in short time frames, and reduce the ability to price risk in a discriminating way (because unequal entities and instruments are treated as interchangeable).  What’s more, the mandates tie up vast amounts of high quality collateral in initial margin payments, forcing greater reliance on lower-quality collateral to keep the system running.  And yet more–depending on the scope of the mandates, buy-side entities that pose no real default risks (e.g., pension funds) but do pose potentially serious funding and liquidity risks will be forced to clear.  Since funding and liquidity risks are the Achilles heel of the clearing system, it is absolutely insane to increase funding needs.

No matter how many times you turn over this problem, I think you will conclude that clearing mandates will substantially increase the necessity of central banks to provide liquidity, and lend against dodgy collateral.  Whether the central banks provide cash to CCPs collateralized by non-cash collateral paid by customers, or provide cash to dealer banks collateralized by low-quality collateral, or provide the cash to end-users similarly backed by low-quality collateral (although this alternative is least likely), to fund the vast margin payments during periods of stress they will be lending a lot to somebody.

Savor the irony.  The rallying cry for clearing mandates was “No More Bailouts,” “bailouts” in this instance meaning central bank loans to troubled financial institutions, intended in part to prevent a meltdown in derivatives markets.  But clearing mandates will only increase the demands on central banks to provide extraordinary funding to keep the derivatives markets going.  The parable of the Indian village that brought in cats to rid itself of mice, dogs to rid itself of the cats, elephants to rid itself of the dogs, and then in the end mice to rid itself of the rampaging elephants is apt indeed.

In the Risk article, Matt Cameron notes that seven out of eight regulators he contacted about the story refused comment: “Most said not enough analysis had been conducted.”  Read that again: “Not enough analysis had been conducted.”  Pardon my French, but Jesus H. Christ, wouldn’t you want to do that analysis before embarking on this titanic reengineering of the largest, most complex financial markets the world has ever seen?  “Not enough analysis had been conducted.”  Really?  Really?

But I know it’s true–and you do too.  And that’s the tragedy of it all.

I sometimes try to think of a rational reason for undertaking this huge experiment on a live patient.  In my more cynical moments–pretty much all my moments are cynical, but some more than others–I wonder if this is just a part of the movement to “financial repression”, defined by Reinhart and Rogoff as follows:

Banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payment system. Governments force local residents to save in banks by giving them few, if any, other options.

They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form of taxation. Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation.

Clearing mandates, mandates that non-cleared transactions be collateralized, limits on rehypothecation, segregation rules and on and are “other devices” that increase the demand for government paper.  And just coincidentally, I’m sure, we’re living in an age where governments are desperate for buyers.

Maybe the dots don’t connect.  But maybe they do.  But I guess financial repression is better than financial insanity, which is the only other explanation that comes to mind.

Cold comfort, that.

The more I learn about  the implementation costs and burdens of Frank-n-Dodd, the more monstrous the thing appears.  These burdens will be immense, and affect virtually every company that touches derivatives, regardless of the extent of their involvement.  IT.  Compliance.  Reporting.  And on and on and on.

But Frank-n-Dodd’s chief evangelist, Gary Gensler, has often said not to worry.  The greater transparency created by the law, via the mandating of swap execution facilities and clearing, will drive down execution costs for derivatives.  The savings will offset the burdens of the regulation.  Transparency will make the market more competitive, to the benefit of end users.

Gensler repeated this mantra in an interview in the WSJ:

I think that the core of Dodd-Frank is to bring the benefits of transparency and risk reduction to this marketplace, which has existed for 150 years.Right now, when you enter into bilateral swap transactions, probably most of you have a handful, at most 10, counterparties that you go to. And it might be three or four. And they’re the largest financial institutions.

And I think that openness and competition will come into this marketplace because of transparency, and because for most of the market, it will have to be centrally cleared.

But later he becomes extremely equivocal about these benefits:

MR. FINK:Offstage you mentioned profits of $30 billion that Wall Street makes on derivatives. You figure that would decline to $27 billion?

MR. GENSLER: No, I don’t know what it will decline to. It might go up. What we know is that the derivatives marketplace today is concentrated among large financial institutions.

Dodd-Frank modestly shifts the needle on information because Congress thought that markets are safer and more efficient with that transparency. After the transaction, you will be able to get real-time reporting of transactions in various ways. That’s the new law, called post-trade transparency. Some portion of the market also will have some pretrade transparency, where buyers and sellers meet in platforms.

Those two forms of transparency will modestly shift some of the information advantage. When you do that, you democratize the markets a bit more. The smaller banks might compete for business with some of the larger banks, and so forth.

“[Dealer profits] might go up.”  “Modestly shifts the needle on information.”  “Modestly shift some of the information advantage.”  “Democratize the markets a bit more.”  “The smaller banks might compete for business with some of the larger banks.”  Hardly stirring stuff there.  Pretty limp justification of the competitive benefits of Frank-n-Dodd.  Not exactly the kind of thing that suggests these transparency benefits will offset all of the other massive costs arising from the law.

The title to the WSJ article is “Keep on Hedging.”  Gensler is apparently taking that advice to heart, as he is quite strikingly hedging his advocacy of the cost-reducing effects of improved transparency.

And even these benefits are likely oversold, and perhaps chimerical.  Here’s just a list of some of the reasons to doubt that Dodd-Frank will actually increase competition in a way that reduces end user transaction costs, let alone by enough to overcome the huge regulatory overhead the law creates:

• Post-trade transparency–especially real time post-trade transparency, which the Commission is advocating–need not improve liquidity.  Indeed, it can have the opposite effect.  Liquidity suppliers will be reluctant to trade in size when their trades are exposed immediately after they are made.  This will widen spreads and reduce depth.
• It is not plausible that end users are at a substantial information disadvantage for vanilla products traded in volume, such as vanilla interest rate swaps in major currencies.  They have access to quotes from multiple sources, and can compare quotes for OTC trades to contemporaneous prices for closely related exchange traded products, like Eurodollar futures (for interest rate swaps) or NYMEX futures (for NYMEX lookalike swaps–go figure).
• Spreads on vanilla OTC products are very small.  Margins on these products are razor thin.
• It is well known that institutional traders in many markets prefer to trade on dark markets rather than transparent ones.  This is because their execution costs are lower on these markets.  And “dark market” is a misleading term: as I’ve noted before, there are different kinds of transparency.  Exchange trading, or SEF trading, has pre-trade and post-trade price transparency, but counterparty opacity: the prices are lit, but the counterparties are in the dark.  OTC dealings, or dealings in dark markets, or dealings in block markets, have less price transparency, but more counterparty transparency.  The latter works to the benefit of those who are known to be unlikely to be trading for information-driven reasons.  Forcing trading onto anonymous platforms, especially order driven platforms, raises the trading costs of the verifiably uninformed, which includes many hedgers and end users.  It is categorically false to say that price transparency and counterparty opacity–exchange trading–lowers the trading costs of all liquidity demanders.  Some are made worse off: that’s why they choose to trade off exchange.
• This helps explain why many, many end users oppose the various mandates.  It raises their costs.  They aren’t stupid.  They aren’t victims of battered spouse syndrome.  When they oppose the mandates, they are talking their books.
• Gensler talks like 10 big counterparties is a small number.  Not too many other industries with 10 major competitors.
• And if you believe those 10 firms are colluding, or would like to collude, tacitly on spreads, forcing them to trade through markets with pre-trade transparency is a great way to facilitate such collusion.  Collusion is harder to sustain when buyers and seller strike deals in private.  The colluders can chisel on the agreement through secret price cuts without being caught.  Harder to do when prices are posted publicly: you can see when cheating occurs.  When cheating can be detected, it can be punished, meaning that price transparency can facilitate collusion.  Cf. NASDAQ antitrust case, Stigler’s seminal articles on collusion, the fact that the Justice Department looks with deep suspicion at price sharing arrangements, the fact that public auctions are more susceptible to collusion, etc.
• Order driven markets are prone to tipping to a single dominant platform, which can exercise market power and charge supercompetitive prices.  Surely Genlser is aware that virtually every single futures and futures option contract in the US is dominated by a single exchange.  Mandating exchange-like, order driven markets for vanilla OTC derivatives is likely to result in the same tipping process, and with the charging of supercompetitive trading fees by the winner-takes-all platforms.
• It is almost certain that any benefits arising from compressed spreads–to the extent that they exist, which the foregoing suggests may well not happen–will be distributed very differently from the cost burdens of Dodd-Frank.  As I noted earlier, any firm that is at all involved in derivatives will have to incur substantial costs to comply with the law.  These include IT expenses associated with record keeping, reporting (including the reporting of trades and positions to data repositories), regulatory compliance, oversight, etc.  With regards to regulatory compliance, to achieve any relief from position limits it will be necessary to show that every transaction is a hedge, as opposed to showing that trades are “normally” used to offset price risks.  Similar record keeping burdens will be necessary to demonstrate whether a company is a swap dealer or major swap market participant or not.  It will be necessary to perform all these tasks, and invest in the people and IT overhead needed to perform them, if you trade modest amounts of derivatives or large amounts.  Those who trade smallish amounts will not generate sufficient benefits in terms of lower trading costs–even if those costs materialize, which I doubt–to offset the regulatory overhead.  Some will choose to stay away from derivatives altogether–which may be easier said than done.

In brief: (a) even Gensler is much more guarded in his predictions about the cost-reducing effects of transparency, and (b) for many market participants, transparency and mandated exchange-like trading will actually increase their trading costs.  What’s more, the regulatory burden–you know, the costs that the CFTC adamantly refuses to estimate despite the requirement that it perform a cost-benefit analysis of its rules–is very likely to be crushing: you talk to people in industry, and you realize that they are afraid.  Very afraid.

So remind me again why all this stuff that isn’t remotely related to systemic risk is a good idea.  And only non-masochists may answer, please.

Content warning!: this is a post about clearing minutia.  But believe it or not, there are a select few who actually like that kind of thing–so this one’s for you!

I was thinking more about the segregation issue, and particularly the credit and systemic risk issue.  I think I got the essence of the conclusion right, but was not completely happy with the supporting analysis, so I gave it some more thought and came up with something that I think is a more robust.

The issue is whether segregation or futures-style omnibus accounts lead to more market fragility during times of stress.  My original intuition, and my newer analysis says that segregation is more fragile in times of stress; that is, a CCP is more likely to fail with segregation than with omnibus accounts.  The basic reason is that segregation is more dependent on discretionary credit during times of stress; this dependence is a source of fragility.

The potential problem has its origins in the timing of cash flows in a CCP setup.  CCPs make margin calls on brokers (FCMs) that the FCMs have to meet in a short time period, on both house and customer accounts.  Often the FCM has to make payment on the customer account before the customers have made their variation margin payments; to meet the CCP deadline, therefore, credit has to be extended to these customers.  The FCM’s bank may make the payment to the CCP even though there are insufficient funds in the FCM’s account at the bank to cover the payment.  That is, banks for FCMs often extend credit to the FCMs to permit timely payment of margin calls to the CCP.

With omnibus accounts, the payment that the FCM owes on its customer account is the net payment owed to the CCP by all its customers on all their positions cleared through that CCP.  This means that the maximum amount of credit that is needed to ensure that the bank makes the margin payment to the CCP on behalf of the FCM is this net payment owed.

With segregation, it won’t be possible to net customer payments against one another.  This increases the amount of credit banks have to extend to ensure prompt payment of variation margin to CCPs.  And that is where the vulnerability arises.

A very stylized example demonstrates the point.  It is unrealistic in many ways but the elements of unrealism don’t overturn the basic result.  Assume an FCM has zero capital.  It has 10 customers, 5 who have to pay variation margin of 1000 apiece, and 5 who should receive 900 in variation margins apiece.  Thus, the net amount owed on this FCM’s customer account is 500=5x(1000-900).

Assume that the margin payment is due immediately, but none of the customers who owe have posted the necessary cash. With some probability all will stump up the necessary cash in the future, but with some probability none will.  In the latter event, there is a total loss of 5000 that is borne by others in the market: just who bears it depends on the type of account (0mnibus or segregated).

With omnibus accounts, the FCM owes the CCP 500.  If the FCM’s bank lends the FCM the 500, it can meet the margin call and there is no default to the CCP.  If all the customers who owe pay, the FCM can repay the bank, and the bank and the FCMs other customers get paid all they are owed.  However, if the customers who owe don’t pay, the FCM defaults on its loan to the bank for 500, and also cannot pay its customers who are owed money the 5×900=4500 that is due them.

Note that in this example, the risk that the customers who owe variation margin payments will default is borne by the bank and the other FCM customers.  That’s the “fellow-customer” risk in this setup.

Now consider the situation with segregation.  Here, it is not possible to net customer pays and receives.  Thus, it is necessary to provide 5×1000=5000 in credit to the FCM, or the FCM’s customers, to make it possible to meet the CCP deadline.  If the customers end up paying what they owe, everything is the same as with co-mingling.  If they don’t, however, the bank loses 5000–if it decides to extend the credit.

The total credit loss in the two alternatives is the same–5000–but the distribution is different.  The bank is on the hook for 100 percent with segregation, but only 10 percent under omnibus accounts–again assuming that it extends credit in each case.

That is a crucial difference, because the bank has the discretion to extend credit: that is, it is not a given that the bank extends credit.  It can say no.  If it says no, the FCM goes into default on its obligation to the CCP, and the CCP is on the hook for the loss in the event the customers who owe default.   This loss falls on the CCP’s capital, or on its default fund.  This could conceivably threaten the CCP.

Clearly, the bank is more likely to say “no” to a request to borrow 5000 than a request to borrow 500.  Note particularly this situation is likely to arise when the market is under stress.  That’s when big price moves occur that can raise doubts about the ability of customers to meet their margin calls, and when excess margins held at the FCM are going to be blown through.  It’s also when banks are likely to be more averse to taking on credit risk.

With omnibus accounts, there is credit extended, but much of it is not discretionary.  In the example, the FCM’s in-the-money customers provide 4500 of credit.  They have committed to do so by being customers of the FCM, and being on the winning side of their trades.  In effect, customers provide irrevocable letters of credit to other customers–and in return, receive irrevocable LCs from those customers.  These are not traditional LCs because their payoffs are conditional on market prices (and in a more realistic example, on the financial condition of the FCM).  But in essence, if you are a customer of an FCM under an omnibus system, you commit to provide credit to other customers under some circumstances, and in return receive a commitment from other customers to grant credit to you under other circumstances.

That lack of discretion is crucial in preventing a market breakdown.  “Freezing” of credit markets during times of market stress essentially means that lenders choose not to lend.  The more that you rely on the discretion of lenders, the more vulnerable you are to a market freeze.

During the Crash of 1987, the reluctance of banks to lend to FCMs was what threatened the major CCPs. Consider that in the context of the example.  In the example, under segregation, the bank is less likely to extend credit, making an FCM default more likely.  Moreover, since there is no sharing of risk among customers, with segregation the CCP is on the hook for a bigger loss: 5000.  With omnibus accounts, it loses only 500.  CCP failure is obviously more likely when it has to bear a 5000 loss than one a tenth as large.  Thus, with segregation, there is a larger probability that the CCP will absorb a loss, and conditional on a loss occurring, that loss is bigger.  This means a greater likelihood of CCP failure–or the need for greater CCP capital.

In brief, the clearing system is more likely to break down during periods of market stress, the greater the reliance on discretionary credit to meet variation margin calls.  This reliance is greater with segregation, than with futures-style omnibus accounts.  The latter reduces reliance on discretionary credit by the use of (implicit) commitments among FCM customers to lend to each other.  That makes the system more robust.

There is considerable symmetry in the commitments that FCM customers make, but that symmetry is not complete.  Some customers are more creditworthy than others.  They essentially subsidize the less creditworthy customers (unless, as I discuss below, commissions or other terms offset this effect).  Moreover, tail risks that create default risks are not symmetric.  Customers who are long stock index futures, for instance, are likely to experience big margin calls than those who are short because crashes are more likely than spikes.  Customers who are short CDS are more likely to experience big margin calls than those who are long because of jump to default risk.

Even though the exchange of commitments is not necessarily of equal value (i.e., a given customer may provide a commitment that is more valuable than the commitment he receives from the other customers due to these sources of asymmetry), there is an exchange of value.  Moreover, more creditworthy customers should be able to negotiate better commissions to reflect the benefits they are providing to other customers–which helps the FCM attract the business of these other traders.  The ability to negotiate commissions and other terms of agreements between customers and FCMs (e.g., margins) reduces the scope for cross subsidies between customers.  This limits the distributive consequences of omnibus accounts.

These credit issues are likely to arise only in rare circumstances, but those are exactly the circumstances in which a market breakdown and CCP failure would occur.  A liquidity crunch occurs when due to heightened risk and asymmetric information, lenders choose not to lend.  This is most likely to occur during periods of market stress–which is exactly when big margin calls increase the demand for liquidity/credit.  That is, stressed conditions reduce the supply of credit and increase its demand.  It is desirable to reduce reliance on discretionary credit in these circumstances.  Omnibus accounts do just that.  They are a liquidity pooling mechanism by which customers implicitly commit to extend credit to one another.  This commitment reduces the need to rely on discretionary extensions of credit by banks in order to raise the cash necessary to make payments to CCPs.  This, in turn, reduces the likelihood of a CCP collapse.

This analysis strongly suggests that the systemic risks of segregation are far greater than the CFTC acknowledges.  Indeed, in its NOPR on OTC derivatives segregation, the agency argues that segregation reduces systemic risks.  Its analysis fails completely, however, to consider the implications of segregation on the demand for credit during times of market stress.  The foregoing analysis implies that segregation leads to higher demands for liquidity and credit precisely under the conditions in which liquidity and credit are likely to be in short supply.  That, in turn, means that the possibility of market breakdown or CCP failure is greater with segregation.

Market participants will adjust on other margins, of course.  CCPs will presumably require greater margins and greater default fund contributions with segregation: these are also essentially precommitments of resources that substitute for the precommited resources lost under segregation.  They are also costly, and it is nigh on to impossible to know whether these costs are larger or smaller than the costs inherent in a system based on omnibus accounts.

But apropos my earlier post, CCPs, exchanges, FCMs, and their customers have strong incentives to adopt the system that minimizes these costs.  They have skin in the game, and a bigger pie to split when the choose the lowest-cost mechanism.  They also have better information to evaluate these costs than any regulator.  No, their incentives aren’t perfect.  Their information isn’t perfect either.  But perfect isn’t an option, so those aren’t meaningful objections to relying on competition and contract to determine the choice of institutions, rather than regulatory fiat.

Apparently not having enough on its plate, the CFTC has seen fit to vote out a NOPR on collateral segregation for cleared swaps.  The Commission decided to jettison the omnibus customer account model used successfully for donkey years in futures markets, and to require OTC CCPs to segregate collateral in their books and records, while permitting comingling of customer moneys in one account.  This legal segregation/operational comingling of customer collateral is intended to protect customers against “fellow-customer risk,” i.e., the risk that  the margins of non-defaulting customers of a futures commission merchant (FCM) that (a) has defaulted, and (b) has customers in default will be used to meet shortfalls in the defaulting customers’ accounts.

I wrote about this last year in a post titled “Alfred E. Newman Chooses an FCM: the Moral Hazard of Segregation.”  I argued that it is necessary to understand why futures exchanges would choose–and stick with–the omnibus model that exposes customers to the risk of each others’ default.  The most likely answer is that it provides customers with an incentive to monitor their FCMs.  FCMs that are undercapitalized, or which do not manage risk properly, pose a greater risk customers.  By giving customers skin in the game, they have an incentive to monitor the FCM’s capitalization and the adequacy of its risk management.  With segregation, customers can play Alfred E. Newman: “What?  Me worry?”  They have zero, zip, nada incentive to monitor their FCM.  Their money is safe even with an undercapitalized, or even crooked, broker.  This lack of customer monitoring leads to the survival of riskier FCMs, thereby increasing the risk in the system.

The CME and ICE Trust made a similar argument in letters to the CFTC.  Their letters apparently, uhm, cut no ice with a majority of the commissioners.  The CFTC evaluated the argument and rejected it.  In a nutshell, the Commission bought into the argument advanced by big money managers and pension funds that they don’t have the information to monitor FCMs.

This assertion has problems on many levels.  Yes, customer information about the safety and soundness of FCMs is imperfect.  They can’t evaluate that risk perfectly.  But they can see things like whether the FCM is overcapitalized, and by how much.  They can get some kind of idea as to what kind of customers the FCM serves.  They can observe first hand how the FCM manages the risk of that particular customer: does the FCM insist on prompt payment of margins?  Does it collect and evaluate information on the customer’s creditworthiness?  To the extent that a customer perceives that an FCM is slacking off with him, he can infer that’s a more general problem.  So they can–and do–observe signals on FCM safety and soundness.

And note that there is monitoring by multiple customers.  Each one might observe a noisy signal of FCM creditworthiness, but collectively they may get a relatively precise signal.  The literatures on global games and bank runs suggests that there are mechanisms whereby customers who decide whether to patronize an FCM based on a noisy signal of its riskiness can provide effective monitoring.

A sketch of a model would go something like this.  Customers observe a noisy signal on FCM riskiness.  They know other customers are observing noisy signals.  Each customer adopts a cut-off rule that says “I leave if I get a signal that the riskiness of the FCM rises above a certain level.”  In equilibrium, when enough customers get a bad signal, they run.  Sometimes that’s inefficient because they are fooled by bad draws of the signal.  But with enough customers, that’s relatively unlikely.  Instead, runs tend to occur when the FCM is in fact risky.  The prospect of being destroyed in a run gives an FCM an incentive to control its risk.

Things appear to work this way in practice.  Runs on FCMs often precede revelations that there is something seriously remiss.  There was a run on Refco before it imploded.  Ditto Lehman:

Some argue that the futility of relying on risk mutualisation in the default waterfall was illustrated by the fact that Lehman’s omnibus customer account dropped by roughly 75 percent during the week prior to its default. However, others say this proves the current system works.

“It shows market participants have the incentive to monitor the financial health of their FCM. Moving to an LSOC regime may well undermine this incentive,” said Taylor at the CME.

Exactly, Kim.

There is also empirical evidence that monitoring of relatively opaque financial institutions does occur when there is an incentive to do so.  In the 19th century, notes of different banks sold at varying discounts to reflect creditworthiness, and market participants would often run on banks that were perceived to be unduly risky.  Evidence presented by Calomiris and Gorton and others shows that these runs were not Diamond-Dybvig “sunspot” runs, but reflected bad fundamentals.  Rates in the Fed Fund market depend on the creditworthiness of the borrower.  Similarly, prices on CDS depend on creditworthiness of the counterparties.

As I noted earlier, big money managers and pension funds were pushing for segregation–indeed, greater segregation than the CFTC actually settled on.  Their protestations of their inability to monitor should be taken with a grain of salt–and would be quite alarming if true.  No, I think that the main motive is that they do in fact incur costs to monitor FCMs, but that other customers effectively free ride of their monitoring.  Segregation allows them to play Alfred E. Newman, and not worry about their FCMs risk–and thus not have to incur the costs of monitoring.

If the foregoing analysis is correct–and the CFTC’s arguments certainly don’t convince me otherwise–the proposal will increase total risk in the system, and shift costs from one kind of customer (the money managers and FCMs) to other customers.  This will come in the form of higher initial margins and higher default fund contributions because the inability to mutualize risk among customers requires shifting that risk elsewhere.  It will also come in the form of greater–and perhaps much greater–operational costs.  But note that these will all hit the big money managers and pension funds less than smaller entities.  They typically have lower funding costs (and hence are less impacted by the margin increases) and since many of the increased operational expenses are fixed costs, they have a bigger impact on the smaller firms.

Note too there are other possible regulatory responses that can reduce monitoring costs without interfering with incentives to monitor by fiddling with segregation.  In particular, improving FCM disclosures would help.  These could include providing customers with statistics on the fellow-customer risk they face, based, for instance, on stress tests.  CCPs perform such evaluations to estimate the risk they take on from FCMs and their customers, and properly protected and presented, such information would allow customers to make discriminating choices among FCMs based on risks and rewards.

There are other problems with the proposal.  In particular, given the concern about systemic risk in clearing, the proposal is particularly troubling.  CCPs mark-to-market on a daily or twice-daily or greater basis.  Thus, once or twice a day it is necessary for FCMs to meet variatio margin calls on both customer and house accounts.  Frequently the FCM needs to meet the call before the customer has provided the funds.  So in meeting the call, the FCM extends credit to the customer.  Moreover, settlement banks typically extend credit to the FCM to meet the variation margin payment.  In the omnibus system, banks view the credit as being collateralized by the omnibus account.  This is well diversified, usually, across customers and across products in the customer accounts.

Moving to segregation basically makes this credit mechanism unworkable, or at least far more costly than under the omnibus system.

This credit mechanism is extremely important.  Indeed, the possibility of its breakdown during times of market stress is one of the things that poses threat to the viability of a clearing system.  The near failure of this credit mechanism on 20 October, 1987 is what threatened the collapse of the major Chicago CCPs.

So what replaces it? It’s not immediately obvious how credit could be extended to meet variation margin payments in a segregated system in the way it is in an omnibus system.  With segregation, a bank extending credit to an FCM doesn’t have recourse to the entire portfolio of customer funds.  Individual accounts pose more risk, and are more difficult for the bank to evaluate.  It is also more operationally difficult to evaluate creditworthiness and to extend credit on hundreds of single accounts rather than a single omnibus account. So it will be much more costly to use credit to meet the metronomic variation margin calls.

But margin calls will still need to be met, and fast.  With credit being far more costly, FCMs will have to hold more liquid assets, and will likely require customers to post higher margins in order to have the cash necessary to meet the calls: in effect, segregation increases–perhaps dramatically–the precautionary demand for liquid assets. Moreover, during periods of market stress, even these additional holdings of liquid assets may not be enough to meet margin calls.  Riddle me this, Gary: What happens then, when they can’t be financed by credit?

This represents a major change in the operation of the market.  Given that it was possible for CCPs to operate in the past, but chose not to, it is reasonable to conclude they did not do so because it is more expensive than the omnibus system.

There’s also a monitoring angle here too.  Banks that extend credit to FCMs monitor them.  They are not going to extend credit to FCMs that are undercapitalized, or which do not manage properly the risk in the customer accounts.  So the omnibus system gives settlement banks an incentive to monitor FCMs.  Go to segregation, and that bank incentive to monitor vanishes.

There is a broader issue here.  Why does the CFTC perceive that it is necessary to impose a particular mechanism on market participants?  What is the market failure here?

The choice of segregation mechanism, and the specification of the default waterfall more generally, involves complicated trade-offs and incentive effects.  Yes, fellow-customer risk is a bummer, but we don’t live in Nirvana: we can’t make it disappear.  To reduce fellow-customer risk you either have to push the risk elsewhere or pay real costs to reduce it.

Exchanges and CCPs internalize many of the costs and benefits of those trade-offs and incentives.  If they choose an costlier mechanism, or one that allocates risk inefficiently, or one that provides bad incentives to control risk, the demand for their services declines.  They see lower volumes and lower prices as a result.

Now this may not work perfectly to achieve a first best outcome in the omniscient social planner sense.  But exchanges and CCPs (and integrated exchanges that operate CCPs) tend to have better information and stronger incentives than any regulator.  Absent some convincing demonstration that there is some major externality or other problem that leads them to choose badly, there is no basis to prescribe just how they should operate their businesses.

But no.  The CFTC just can’t seem to leave well enough alone.  It has again arrogated to itself the authority to impose a system on the marketplace, without making any showing whatsoever that competition and private contract lead to inefficient outcomes that can be improved by regulatory fiat.  This is especially perverse in this particular instance given that the likely outcome of the dictat is to increase risk–and indeed systemic risk.  All in the name of implementing an act ostensibly implemented to reduce risk.

How much irony can we take?

Timmy!, the addressee in a WaPo love letter (h/t R) isn’t feeling the love from outside the 202.  Timmy! lectured—or should I say hectored—the world on derivatives, saying, for all intents and purposes, our way or the highway.

To say this went over like the proverbial, uhm, lead balloon would be the understatement of the year.  The Singapore Monetary Authority and the Hong Kong Monetary authority took umbrage at Geithner’s implication that they were lax regulators.  The CEO of the Futures and Options Association, Anthony Belchambers, was quite biting in his reply:

US Secretary Geithner’s comments do not appear to take any account of the fact that the SEC, arguably, was an equally tragic failure – and by a regulatory authority that was notably “heavy touch” but also in some areas “no touch”!

Ouch!  Can you say “Bernie Madoff”?  I knew you could.

Martin Wheatley, who is leaving his position as the head regulator in Hong Kong to take up the leadership of the UK’s Consumer Protection and Markets Authority (eat your heart out, Elizabeth Warren!) was equally scathing.  More so, actually:

US Treasury secretary Tim Geithner was talking “nonsense” when he warned that the world must follow America’s lead on financial regulation, according to a senior European regulator and outgoing head of Hong Kong’s market watchdog.

“To suggest that the US sets a gold standard that other markets should follow is nonsense,” said Mr Wheatley, speaking on the last day of his six-year stint as head of Hong Kong’s Securities and Futures Commission.

That’s gonna leave a mark.

I guess this is what they call smart financial diplomacy.  It’s having about the same effect as the administration’s “smart diplomacy” more generally.  Which is not a good thing.  International coordination on derivatives and other aspects of financial regulation, but US browbeating will not facilitate this coordination.  The opposite effect is more likely, and all of the WaPo puff pieces in the world won’t make any difference.

Reading the BIS paper I just posted about brought to mind an issue that I think is of paramount importance, but which has been almost completely overlooked.  Like many other analyses of the effects of clearing mandates and rules relating to derivatives, the focus has been on providing mechanisms to reduce the likelihood of default on derivatives positions.  The idea is that losses on derivatives positions can be a channel of contagion between important financial institutions.  So to address this problem, legislators and regulators want to raise collateral requirements and other requirements to ensure that non-defaulting derivatives counterparties receive all that they are owed when a firm defaults.

But focusing on derivatives alone is dangerous.  All of the measures intended to increase the safety of derivatives markets–increasing collateralization, multi-lateral netting, etc.–privileges derivatives and derivatives counterparties.  But that privileging comes at the expense of other claimants of a bankrupt firm.  Let’s say that without greater collateralization and netting, derivatives counterparties would have lost X, but with the greater collateralization and netting, they lose 0.  Sounds great: there is no possibility of derivatives losses cascading from firm to firm.  But not so fast: what means, to a first approximation* is that now somebody else loses X more than they did under the previous rules.  In other words, the loss of X has been shifted from the derivatives counterparties to somebody else. There can still be contagion—just via a different channel.

There is something of a debate about the priority of derivatives in bankruptcy.  Mark Roe has questioned this priority privileging.  I’m in London for a conference at the LSE, and one of the conference papers, by Patrick Bolton and Martin Oehmke, also questions privileging derivatives.  I’m not sold on the specific Roe-Boton-Oehmke arguments because I think they don’t see the whole picture, but I do think it is a very important issue.

It is a particularly important issue in the context of the ongoing regulatory debate because all of the rules intended to reduce the likelihood of derivatives defaults effectively increase the priority of derivatives.  Which means that they reduce the priority of other claimants.  That’s not obviously a good thing.  But since the regulators and legislators have failed to look at the problem holistically, instead focusing on derivatives in isolation without seriously questioning how the changes in derivatives rules will primarily shift risk rather than reduce it, whether it is a good thing or not has escaped attention completely.

A couple of analogies come to mind.  One is target fixation.  Many fighter pilots become so focused on the target they are chasing that they fail to see the guy that just jumped their six and is about to shoot them down.  Being fixated on the derivatives target, regulators and legislators are unaware that they are shifting risks elsewhere—risks that may very well jump them of the future while they are still fixated on derivatives.

Another is levees.  Building up a levee around a particular city protects that city, yes, but the rising water has to go somewhere.  So raising the levees in one place makes the flooding problem worse somewhere else.  Legislators and regulators seem obsessed with raising the levees around Derivatives City, without regard as to how this will affect where the water goes and who gets flooded–Commercial Paper Town and Moneymarketville, for instance.  It could well be the case that keeping Derivatives City high and dry results in even more devastating flooding in other, less privileged precincts.

The Corps of Engineers has created many problems in the past with its attempts to control the Mississippi and Missouri Rivers through its efforts to control floods: there is a very real risk that a (metaphorical) Corps of Financial Engineers will also create havoc despite its intention to do good.

There are of course differences.  A river system is more mechanical than a financial system.  But that actually makes the situation more fraught in financial markets.  Market participants will respond to the privileging of one class of claim—such as derivatives—by adjusting their behavior, by adjusting what they trade, their capital structures, etc.

But maybe it’s not that different.  The design of the levee system will affect where people build and how they build.  Designing the levee system properly requires just that—a systemic approach, not an approach focused on just one part of the system, but its entirety; and an approach that takes into account how people will respond to the design of the levee system.  Unfortunately, that’s not the way that it’s being done in the derivatives markets.  The history of the Mississippi River valley suggests that’s not an encouraging thing.

* As I discuss below, this privileging will affect decisions people make, and thus the amount of risk.  That means the problem is even more complex than what I consider here.  But that only makes the derivatives-centric focus of regulators and legislators even more dangerous.

Yes, there definitely is an echo.  The BIS has released a paper that, er, echoes several SWP themes.  Most notably, the paper by Daniel Heller and Nicholas Vause notes that variation margin calls can lead to substantial demands on market liquidity.  In high volatility environments, the liquidity needed to fund variation margins would represent over 28 percent of G14 dealer cash and cash equivalents on one day out of 200 for interest rate swaps alone.  CDS margin calls could also result in a substantial cash drain on dealers.

It should also be remembered that these kinds of events are likely to be associated with (either caused by, or causing) tightness in funding markets.   It should also be noted that the BIS just looks at dealer variation margin payments.  In stressed market conditions, however, other market participants—including hedge funds, broker-dealers, and depending on the kinds of regulations that are adopted, certain derivatives end users—will also be subject to big margin calls.  This places further demands on liquidity.   These hedge funds and others would be looking to banks—including notably the big dealers—for funding.  This could lead to major liquidity shortages, and as the BIS notes, central banks are likely to need to inject liquidity either to banks or CCPs in order to mitigate these shortages.  [The zero sum nature of these margin calls raises some interesting issues.  I am currently noodling through some models based on the Holmstrom-Tirole setup to work through these issues.]

It would not be correct to suggest or imply that this is a problem associated with clearing alone.  Many OTC derivatives trades—including trades between dealers—are marked to market daily, and require variation margin payments.  Thus, big price moves would create funding demands to meet margin calls even in the absence of central clearing.  However, note that the increase in initial margins that clearing mandates, and margining mandates for non-cleared derivatives, will increase funding and liquidity needs beyond the level that would be required without these mandates.  Add to this Basel III liquidity requirements, and the heightened potential for liquidity crunches in the new environment are clearly manifest.

The BIS paper also quantifies the potential burden that variation margin payments could place on CCP default funds in the event of a default by one or more clearing members.  It concludes:

With a probability of one in 10,000, non-margin resources at risk from the failure of one particular dealer, two particular dealers or any dealer with sufficiently adversely affected portfolios would respectively be 20%, 37% and  42% of total initial margins for IRS, and 36%, 46% and 65% of total initial  margins for CDS. If prevailing levels of volatility were high, these figures would  equate to $21 billion, $39 billion and $44 billion for IRS, and $13 billion,  $16 billion and $23 billion for CDS.

These are big numbers, and indicate the kinds of resources that CCPs must have on tap to deal with defaults.

Note especially that these resources are likely to be contributed by major banks—which means that major defaults will impact non-defaulting bank balance sheets, contrary to the facile claims that clearing would put a firewall between derivatives defaults and major banks.  It also has implications for the appropriate capital charges for default fund exposures.

The BIS report quantifies roughly the economies of scope that result from clearing (another common theme here), and argues that these economies will permit more economical use of capital.  Left unstated is an important point that I’ve emphasized—but which is too often ignored.  Specifically, if clearing improves capital efficiency, it will reduce the marginal cost of trading derivatives, which will lead to an increasing scale of derivatives trading—and hence greater total counterparty risk.  Even if one assumes that CCPs allocate a given amount of counterparty risk more efficiently than is the case in the bilateral markets (an arguable assumption), it is not evident that this improvement in the allocation of risk would more than offset the effect of an increase in the total amount of risk to be allocated.  This issue deserves far more attention than it has received—which is not a hard statement to make, given that it has received almost no attention whatsoever.

The BIS report also discusses procyclicality of margins—another echo.  This is an extremely important—and extremely vexing—matter.  It is one about which CCPs are quite sensitive.  I don’t have any easy answers, except to say that (a) it is a real issue that deserves attention, (b) it is by no means obvious that CCPs have the appropriate information or incentive to take into account the knock-on effect of margin changes, and that (c) mechanical, value-at-risk driven approaches like those proposed by CFTC, SEC, and the Fed are the worst way to set margins.

Today’s WSJ carries an article related to procylicality in which I am quoted.  The issue is getting attention, and is not going away.  It is not going away in part because it is a very knotty problem.  So I am certain that the echoes will continue for some time to come.

The deputy governor, financial services of the Bank of England, Paul Taylor, gave a speech warning of the dangers inherent in clearinghouses. All of his major points were raised in my ISDA discussion paper (and which I’ve been flogging in my research and here on SWP for going on 3 years now).  Most notably, he highlighted the dangers of procyclical margins, and the very real possibility of a CCP failure and the devastating consequences such a failure would have. Been there, said that.

Such realism is good to hear, but as I said when Bernanke echoed similar concerns, it would have been a damn sight better had people like Mr. Tucker piped up before the clearing mandate train left the station with Congressional and Parliamentary Casey Joneses at the throttle.

But here’s the truly ironic part.  As I did in my ISDA piece, Tucker grapples with how to resolve a failed CCP:

Two strategies come to mind, which I am airing for debate. The first would be ‘recapitalising’ the CCP so that it can carry on.  The second would be to aim to bring off a more or less smooth unwinding of the CCP’s book of transactions.

On the former route, in the banking sphere the basic strategy is to develop regimes for bondholders to share in the losses after the equity is wiped out; a distressed bank gets ‘recapitalised’ in some way through a reconstruction of its liabilities.  But CCPs do not issue debt, so there is not obviously an economic equivalent of recapitalisation by way of haircutting the debt claims of bondholders.  Recapitalisation would seem to entail an injection of new outside capital.   That should not come from the public sector.  So the only options are the surviving clearing members themselves or a new ‘owner’.  On the face of it, the clearing members would have to be involved, as surely the stricken CCP’s default fund would also need replenishing in order for it to continue.

If the default fund were to be replenished by its surviving clearing members, that could in principle be sorted outat the time or it could be pre programmed.  In practice, making it up at the time must be dangerous.  A pre-programmed allocation of losses would be akin to the old “Down To The Last Drop” rule that used to be employed by a Chicago clearing house [the CME], under which surviving clearing members ultimately had collectively to absorb all losses: mutualisation.  (It was dropped because, as banks became futures-exchange clearing members, bank supervisors didn’t like the unlimited exposure of CMs who were banks.  An example of unjoined-up thinking.) [That’s not the way I heard it explained by those involved in the decisions.] [Emphasis added.]

Breathe deep the irony.  Remember that the primary justification advanced for mandating CCPs was to create a firewall that would limit the exposure of major financial institutions to counterparty losses arising from derivative defaults.  That is, the concern was that the failure of one large financial institution would cause it to default on derivatives trades, imposing losses on other large financial institutions, potentially resulting in their failure.  CCPs were supposed to contain default risks and prevent the from spreading, contagion-like, through the financial system.  But Mr. Tucker argues that for clearing mandates to work, it is necessary to breach the firewall and make big financial institutions the residual claimants of counterparty risk.

Mr. Tucker has just revealed the dirty little secret.  Well not a secret exactly; I’ve been pointing this out for years, notably in my posts on AIG.  Specifically, clearing does not make risks go away.  (No, Gary, there is no magic box.)  It just shifts risk around.  It has to go somewhere.*  Collateralization, by moving derivatives counterparties to the front of the creditor line, shifts risks to other creditors (who may well be large financial institutions, in part).  If collateralization is insufficient, the risks go to the other members of the clearinghouse–which means, it goes to other financial institutions.  Put differently, it vectors the risk right back to the same financial institutions that clearing was intended to protect.

Following the inexorable logic of the situation, namely, that the risk has to go somewhere, Tucker looks for where the risk can go.  Can’t go to bondholders, because a CCP doesn’t have any.  So it must go to clearing members–large financial institutions.**  Which means we’re right back where we started.

Which is another echo.  Several times I’ve predicted that clearing mandates would likely spur a process similar to that in the apocryphal story of the Indian village infested by mice, that brought in cats to eliminate the mice, that brought in dogs to deal with the proliferation of cats, that brought in elephants to drive out the hordes of dogs . . . and then brought back the mice to rid themselves of the rampaging elephants.  Clearing mandates were predicated on the chimerical belief that it was possible to make risk go away, when in fact, its primary effect is to shift risk around.  Which raises the question of where it has to go.  The BOE’s Mr. Tucker has apparently concluded, quite logically, that ultimately it has to rest with large financial institutions where it was in the first place.

In other words, bring back the mice.

* As I’ve noted repeatedly, clearing also affects incentives and therefore can affect the level of risk in the system.  There are a variety of reasons why CCPs may lead to an increase in total risk exposure, mainly by creating moral hazard, and increasing capital efficiency through netting.

** An important caveat here.  The nature of clearing members is not exogenous, and independent of the sharing rule.  Imposing good to the last drop is likely to make big banks reluctant to be clearing members with effectively unlimited exposure to other members.  Instead, GTTLD would likely lead to the creation of affiliates with limited capitalization.  By not recognizing this likelihood, Mr. Tucker is guilty of some “unjoined-up thinking” of his own.

Update.  Whoops.  In my hurry, wrote “Taylor” instead of Tucker.  Thanks MDC.

LCH.Clearnet has announced that three exchanges have expressed an interest in buying the heretofore independent CCP.  Why does stuff like this happen on my vacation?  I’ll just make a brief comment, and leave more for later.

Jeremy Grant posits that LCH is in play because of cross margining efficiencies.  This conjecture is understandable, but fundamentally flawed.  Yes, there are definitely cross margining efficiencies.  More generally, there are economies of scope due to diversification effects that make it less costly to consolidate clearing for multiple asset classes in a single CCP.  But this does not explain why exchanges would want to vertically integrate clearing and execution.  Ownership is not necessary to exploit scope economies.  Indeed, the two things are often in tension–and are in this instance.

Scope economies do not explain integration.  Indeed, things cut the other way.  To the extent that there are more scope economies in clearing than execution (which is quite plausible), in the absence of transactions costs the most efficient way to organize the business would be to form a single clearinghouse, with which multiple execution exchanges would contract to obtain clearing services.  In fact, one of the costs of integration is that it often entails the sacrifice of scope economies in clearing.

Put differently, scope economies do not explain the pattern of ownership: the relevant question is why do exchanges find it optimal to own their own clearing facilities, rather than obtaining clearing services by contract.  That would be the way to optimize cross margining, netting, and diversification economies.   Such economies would be exploited maximally by having, say, LCH, clear just about everything, and sell its clearing services to myriad exchanges that offer execution services in different product classes.  But that’s not the way the market is moving.

Thus, the fact that many exchanges are already integrated, and why more exchanges are seeking to integrate, must arise from some other economic force than scope economies.  The most plausible explanation–and one that I advanced more than 5 years ago–is transactions costs.  Due to double marginalization problems and the transactions costs that arise when complementary activities are supplied by single firms (or by a small number of firms that do not compete vigorously), it is often efficient to integrate these complementary activities.  That is a basic lesson of Williamsonian Transactions Cost Economics (TCE).

In my view, that’s why exchanges like CME and DB have integrated, and why other exchanges have or are in the process of doing the same thing.  This drives regulators and legislators nuts: they see such integration as a nefarious scheme to leverage monopoly.  That’s bad economics–and it’s been known to be bad economics for going on 50 years.  Instead, it is all about transactions cost economization.  Regulators can try and fight it, and they will.  If they succeed in their quest, however, they will only succeed at raising costs and reducing efficiency.

Insofar as the potential LCH deals with exchanges are concerned, SwapClear is presumably a major target in any deal, but also a major obstacle.  I can’t see the banks that dominate SwapClear going along with a merger of LCH into NYSE-EuroNext or NASDAQ or LSE.  Or if that happens, I would expect them to leave SwapClear and set up their own CCP, perhaps through ICE Trust or through a new, freestanding interest rate swap and repo CCP.  (Going through ICETrust would exploit scale economies, so that would be a likely approach.)

I have more to say on this, and probably will.  But it’s been a long day in the sun, so it will just have to wait.

Really?:

Lawmakers in the Parliament voted that clearinghouses should have to hold capital of at least 10 million euros ($14.1 million) to absorb possible losses.

Yeah. That will prevent the next financial crisis.