Streetwise Professor

On Monday, Fed Chairman Ben Bernanke gave a speech on clearinghouses to the Atlanta Fed’s annual conference.  Ironically, Bernanke echoed the theme of my talk at that conference in May, 2009: central counterparties (CCPs, i.e., clearinghouses) could fail, and are a potential source of systemic risk:

Overall, the historical record shows that clearinghouse arrangements have generally withstood even severe crises. This solid performance reflects good planning and sound institutional structures but also some degree of good luck, as crises have also revealed important vulnerabilities, vulnerabilities which prompted subsequent reforms by both the private and public sectors. Clearly, if we do not want to put all our trust in continued good fortune, we will have to continue to be proactive in identifying and remedying weaknesses in these critical infrastructures.

. . . .

Clearinghouses around the world generally performed well in the highly stressed financial environment of the recent crisis. However, we should not take for granted that we will be as lucky in the future. Past crises, including the financial panic of 1907 and the 1987 stock market crash, led to significant reforms and improvements in clearing and settlement that paid off in subsequent periods of financial stress. Given the growing interdependencies among clearinghouses, along with the new mandates for central clearing, now is a good time to reflect on the lessons of the recent crisis and consider whether further improvements are possible. For more than a century, financial stability has depended on the resilience under stress of clearinghouses and other parts of the financial infrastructure.

As we rely even more heavily on these institutions in the United States and around the world, we must do all that we can to ensure their resilience, even as our financial system continues to evolve rapidly and in ways that we cannot fully predict. In short, I think Pudd’nhead Wilson would agree that that is one important basket.

Bernanke discusses some historical episodes in which CCPs teetered on the brink, notably the Panic of 1907 and the Crash of 1987.  He notes, quite rightly, that the expanded role of clearing under Dodd-Frank (and likely in Europe under EMIR) means that CCPs are even more systemically important, and that it is therefore essential to ensure their safety and soundness.

Although Bernanke has taken up a theme that I’ve been flogging for going on 2.5 years now, please don’t get the impression that he got the idea from me.  Bernanke wrote an important paper on clearing and the Crash (RFS, 1990) that was instrumental in helping me understand the “plumbing” of the market and where it can go wrong.  I lived through the Crash, and witnessed first-hand of the near implosion of the clearing system in Chicago, but Bernanke’s article helped me understand some of the issues on a deeper level.   Indeed, I think that one salutary effect of my speaking and writing on the subject has been to make more people in industry and government aware of what Bernanke wrote 20+ years ago.  Credit where credit is due.

I agree with what Bernanke says in this speech, but I think it’s essential to go further.  Bernanke focuses on the potential for CCP failure, and how that can be prevented.  That’s no doubt important, but that’s not the only systemic risk arising from clearing mandates.

Most importantly, the imposition of these mandates will alter the entire financial system.  They will alter the way firms contract, how they borrow, their capital structures, etc.  These changes will have systemic effects and affect the way the system operates in a crisis.

Moreover, I am concerned that a focus on protecting CCPs can lead to the adoption of policies that are destabilizing.  For instance, conventional means of strengthening CCPs can increase their vulnerability to wrong way risk.

As another example, CCP margining can have destabilizing effects.  Although the regulatory tendency to protect CCPs may lead them to agitate for more collateral, and tighter collateralization mechanisms, this can have destabilizing effects during a crisis.  Similarly, having immense amounts of liquid assets tied up in collateral at CCPs can make the system more vulnerable to liquidity shocks.  Put differently, it increases the burden on central banks to respond to liquidity shocks.

Consider the following scenario.  There is a spike in the demand for liquidity.  Vast amounts of liquid assets are tied up in derivatives collateral at CCPs.  One likely response to the liquidity shock is to liquidate derivatives positions to free up the liquid assets–“dead liquidity”–held at CCPs.  This can lead to big price movements that can be destabilizing.  Central banks may need to be especially aggressive in supplying liquidity to avoid these problems.  Perhaps this would require extending credit to CCPs, or to their members, in a way that would effectively permit rehypothecation of margin monies to the Fed.

Again, clearing mandates are a major change to the financial system.  There will be far reaching effects on all aspects of financial contracting.  Most of these are unpredictable and will be dynamic.  But regulators have to be aware of those ripple effects, and understand that those effects will depend on how CCPs operate and how they are regulated.  A microprudential focus on CCPs (which is the default tendency of financial regulators) could have perverse macroprudential effects.

I’m sure Bernanke is aware of that, but a conventional reading of this “watch that basket” speech could lead regulators to focus on the microprudential, and overlook the potentially perverse unintended macro implications of that focus.

I liked Bernanke’s historical discussion.  The Panic of 1907 case is particularly interesting, and I will discuss it in some detail in my forthcoming book.  One thing that is of particular interest, that Bernanke does not discuss, has implications for one current regulatory debate.

Specifically, as shown by Elmer Wicker in his book Banking Panics in the Gilded Age, the New York Clearing Association often failed to deal effectively with panics by mutualizing risk because of heterogeneities among its membership.  Although mutualizing risk would have mitigated adverse selection problems (because there was less uncertainty about the condition of the banking system as a whole than individual banks), it also would have transferred wealth from the healthy banks to the unhealthy ones.  The disagreements among heterogeneous banks undermined coordinated action during several crises–including especially the Panic of 1907.

That is worth keeping in mind today when evaluating proposed rules regarding CCP membership policies.  Encouraging open access through low capital requirements, or aggregate ownership restrictions, as proposed by the CFTC, will lead to more heterogeneous memberships at CCPs.  This will have many perverse consequences, including the real potential for the same kind of problems that undermined the effectiveness of the NYCH in the Gilded Age.

I’m pleased that Bernanke brought this episode into the public eye.  I’m also pleased that he has brought the potential vulnerabilities of the clearing system into the public debate.  His speech is a welcome antidote to the superficial happy talk of Geithner and Gensler and the cheerleaders for Frank-n-Dodd.  Without a sober recognition of the vulnerabilities that a greater reliance on clearing can create, the cure may actually kill us in the next crisis.

And now on two fronts, as it were.

The battle over the “vertical silo” (i.e., vertically integrated in econspeak as opposed to bizspeak) approach to execution and clearing remains under assault in Europe:

European Union states want to extend a draft law curbing risk in privately negotiated derivatives to the whole sector, which could ultimately dent profitability of the world’s first mega bourse merger.

. . . .

But banks say the merged group should be opened up to clearing competition. Extending the law’s scope to regulating listed as well as OTC derivatives would achieve this goal.

It would make it easier for users to clear listed contracts transacted on Deutsche Boerse or Euronext’s LIFFE derivatives platform elsewhere and not be locked into the group’s clearers.

“The inclination among OTC derivatives fans like us is ‘why differentiate between one derivative and another?’,” said David Clark, chairman of the Wholesale Markets Brokers’ Association.

“The big deal in all this is the competition element with Deutsche Boerse. This move to extend the scope of the draft law has got politics written all over it,” Clark said.  [Politics?  Whoda thunk?]

. . . .

Exchanges sense integrated business models are under threat.

“Some are trying to weaken vertical structures by creating clearing links with other structures. That creates systemic risk and shifts focus away from the real issue of dealing with OTC derivatives,” an exchanges industry official said on condition of anonymity due to the sensitivity of the issue.

The battle between the “verticalists” and “horizontalists” in clearing is a decade old and has never resolved, with the same two countries pitted against each other today as back then.

“Verticalists” and “horizontalists”?  Sounds like something out of Swift.  Count me as a verticalist–or more accurately, a marketalist.  That is, that this is something best left to market processes rather than legislation and regulation.

Now a battle on vertical integration is evidently brewing in the US too.  At least in the eyes of some market analysts, ICE’s CEO Jeffrey Sprecher is worried that a horizontalist, non-marketalist US Department of Justice may condition acceptance of a NASDAQ-ICE-NYSE-EuronextLIFFE merger on opening up of the derivatives clearinghouse (from Bloomberg: no link yet):

IntercontinentalExchange Inc. may drop out of its joint bid for  NYSE Euronext if the U.S. Department of Justice raises concerns about the deal’s combined futures business, Sanford C. Bernstein & Co.’s Brad Hintz said.  ICE, the second-largest U.S. futures market, and Nasdaq OMX Group Inc. made an unsolicited offer for NYSE Euronext last week, valued at $11.3 billion, countering Deutsche Boerse AG’s February offer for $9.53 billion. In the proposal, Atlanta-based ICE would take NYSE’s Liffe futures-trading markets, expanding in Europe. New York-based Nasdaq OMX would take NYSE Euronext’s listings, equity and options units.

ICE and CME Group Inc., the world’s largest futures market, own their own clearinghouses, which may create barriers to entry and be anti-competitive, the U.S. Department of Justice said in 2008. Equity and options exchanges –such as those owned by NYSE Euronext and Nasdaq OMX–use centralized  clearinghouses like OCC that aren’t owned by any one market.

“The most important issue facing these competing offers is the possibility that the ICE/NYSE Liffe merger will resurrect DOJ concerns with vertical integration of futures execution and clearing,” Hintz, an analyst at Sanford C. Bernstein in New York, wrote in a e-mailed note today. “If this issue arises ICE will likely drop out of the bidding and the Deutsche Boerse deal moves  forward.”

Yes, be afraid.  Be very afraid.  I have the sense that the DOJ’s Antitrust Division is itching to attack vertical integration in derivatives, the economics be damned.

* This perhaps corny (perhaps?) title was inspired by my recollection that today is the 149th anniversary of the first day of the Battle of Shiloh.  Two of my great-grandmother’s brothers fought in the battle: Eli and John, who served in the 46th Ohio Volunteer Infantry.

Eli was something of what is called a “Jonah” in the Navy–a hardluck guy.  He was captured at Shiloh, and held in a prison camp in Montgomery, AL for a couple of months.  Exchanged, he returned to Ohio.  He claimed he was unable to return to his regiment because of dysentery contracted during his imprisonment.  His military record includes a note from his family doctor, believe it or not.

His efforts to stay home were unavailing, and he was ordered to report to his unit.  He returned to the 46th shortly before the Battle of Chattanooga.  He proceeded to lose his belt and cartridge box, for which he was dunned $10 pay.  He was then assigned duty as a wagon driver–probably not an endorsement of his soldierly qualities.

Maybe he straightened out, or the need for infantrymen was pressing, for he was in the ranks again for the Atlanta Campaign.  Unfortunately for him.  He was shot in the left arm close to the shoulder joint at the Battle of Dallas, GA, 28 May, 1864.  The surgical record indicates that the regimental doctor performed a resection of his left arm, removing the bone from the shoulder to the elbow.  This surgery was required because the ball struck too close to the joint to amputate.

My great-grandmother told my grandfather that “Uncle Eli had a dead arm.”  His arm dangled uselessly at his side, and my great-grandmother remembers him using his right hand to lift up his left to rest it on the dinner table.

John, on the other hand, served without incident or injury from October, 1861 to the muster out of the regiment in July, 1865.  Pretty amazing, given that the regiment fought at Shiloh, the Siege of Vicksburg, Chattanooga (the storming of Tunnel Hill, the bloodiest part of the battle), the Atlanta Campaign (including the Battle of Atlanta on 22 July, 1864), the March to the Sea, and the Battle of Bentonville.  One lucky brother, one unlucky.

Immediately following the announcement of the proposed NYSE-EuronextLIFFE-Deutsche Borse deal, I stated that the main risk to the transaction would be that European antitrust regulators who are not keen, to say the least, on the vertical integration of exchanges and clearinghouses (the “silo” model).  A close watcher of these developments, Anthony Belchambers of the Futures and Options Association, believes this risk is quite real:

European regulators could push merger partners NYSE Euronext (NYX) and Deutsche Boerse AG (DB1.XE) to spin off part of their derivatives clearing business, according to a senior industry lobbyist.

Fusing NYSE Euronext’s London-based Liffe unit with the German company’s Eurex business would create a dominant force in European-listed derivatives, and antitrust officials may target the profitable clearing segment as part of any approval, said Anthony Belchambers, chief executive of the Futures and Options Association, which represents banks and brokers in the region.

“Clearly they’re going to be looking very closely at this,” Belchambers said of the regulators’ stance. He was speaking in an interview on the sidelines of an industry conference organized by the Futures Industry Association, the FOA’s U.S. counterpart.

Deutsche Boerse has in the past successfully fought efforts by some European lawmakers to force the separation of its clearing business, and analysts said a renewed push could effectively sink the planned NYSE Euronext deal.

Belchambers said regulators are likely to focus on exchanges’ control of clearing trades in futures and options contracts listed on their markets, a framework that has enabled market operators like Eurex and Liffe to fend off competitors in fixed-income and stock-index contracts.

This would be a deal killer, most likely; the main attraction of the deal is the potential to exploit clearing efficiencies and profits, and DB considers integrated clearing an essential part of its business model.  I would think that DB would rather stand pat with its current business than merge and amputate its clearing operations.

Given that, will European regulators push it and impose conditions that make the deal unpalatable, especially for DB?  And if they do, will that leave the door open for NASDAQ (perhaps in conjunction with ICE)?  Absent a deal killer, or the serious prospect of a deal killer, I don’t see NASDAQ or NASDAQ + ICE as a serious threat to break up the proposed merger, especially since NASDAQ+NYSE would pose antitrust issues here in the US.

In what will hopefully be the continuation of a spirited and thoughtful exchange of views on OTC derivatives markets, John Parsons and Antonio Mello at Betting the Business respond to my response to their response to my post on Gensler’s beliefs about the efficacy of central counterparties.  Or something like that.

We agree on some key issues, namely, (a) the amount of margin is not the measure of the total amount of credit firms use up when moving from bilateral to cleared trades, and (b) systemic risk is the crucial issue when evaluating the effects of clearing mandates.

I think we also disagree on some issues.

Netting, for one.  MP state:

The reliance on bilateral arrangements meant that exposures that offset one another at the system level were not offset. Individual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures. A major objective of the reform is to encourage the canceling of offsetting exposures and reducing systemic risk by substituting standardized instruments and clearing, among other things, where possible.

As I’ve written repeatedly before, multilateral netting primarily effects priority; netting effectively places derivatives counterparties in front of other creditors in the event that a firm goes bankrupt.  The systemic consequences of this are ambiguous: yes, derivatives counterparties may be systemically important, but other creditors may be too, meaning that it is not obvious whether this reordering of priorities improves stability.

Insofar as the other claims are concerned, I am somewhat puzzled by the statement that “[i]ndividual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures.”  With respect to bilateral offsetting exposures, presumably market makers relied on set-offs in bankruptcy.  With respect to multilateral exposures, market participants internalized any improvements in capital efficiency from netting (or compression).  They also internalized any benefits that resulted from lower risk of replacing defaulted positions with counterparty A that were offset by non-defaulted trades with B, C, D, etc.  Crucially, they recognized that capturing some netting efficiencies multilaterally could undermine some bilateral netting for deals that could not be compressed or cleared because of the nature of these contracts or their liquidity; they internalized these various netting efficiencies.  They internalized the benefits of customization.  They would have internalized the transfer of wealth arising from the shift in priorities inherent in multilateral netting.  Thus, they could trade-off these various effects and internalize the resulting costs and benefits.  Maybe some costs and benefits were not internalized, so it is literally true that the incentives were not sufficient to lead to a completely efficient outcome, but I don’t consider insufficient netting to be the first order problem.  Indeed, to the extent that netting transfers wealth, there can be too much netting.

I’d also note, as was recognized when the CBT was considering whether to adopt clearing in the early-20th century, that by improving the efficiency of capital utilization (by freeing up credit committed to offsetting positions with different counterparties), netting can also lead to increases in the size of net positions and net risk exposures. (This was also an objection to clearing that was raised vociferously in the aftermath of Black Friday in 1869.)  This can increase systemic risks.

MP also criticize the opacity of OTC markets, and suggest that clearing would make things more transparent:

It lacked transparency. Neither the end-users nor the public authorities had adequate information about the market. This lack of information has handicapped end-users in getting good prices. The lack of transparency has hampered competition. The lack of transparency promoted unsound accounting. Opacity perverted incentives. It distorted compensations. We could go on… It also handicapped the authorities in supervising the marketplace. A major objective of the reform is creating transparency, which will then make it possible to improve the functioning of the market.

Transparency is used in different ways here.  It is used to refer to price transparency and position transparency.  There is another type of transparency–counterparty transparency–that MP don’t discuss but which is relevant to the issues they raise.

With respect to position transparency, this is a bad argument in favor of clearing.  It is possible to achieve such transparency via reporting to repositories without the problematic risk sharing and risk pricing aspects of central clearing.  Indeed, a single trade repository is required because (a) there will be multiple clearinghouses, and (b) some products will not be cleared.  If it’s position visibility that you want (especially to regulators), that should be achieved via reporting to a single repository, not by having multiple CCPs.

With respect to price transparency, I think that MP overstate the lack of competition and price information, especially for the more liquid products that are likely to be traded most actively on SEFs.  Most end users I’ve heard discuss the subject state that they have been able to get good price quotes from multiple dealers.  ISDA recently ran an experiment which found that spreads for liquid products are extremely tight–in the .5bp-1bp range.  Moreover, with respect to many standardized OTC products, end users can compare the bids and offers they get to the prices of exchange traded instruments (e.g., Eurodollar futures, crude oil futures) to determine the quality of a dealer’s quotes.  End users also have the ability to utilize those products–to the extent they don’t, that means that the bundle of services provided by the dealer is more valuable to end users than the different bundle available on exchanges.

Moreover, as I’ve written before, trading in a non-anonymous way by soliciting quotes from dealers can actually be cheaper for end users than trading in an anonymous exchange or exchange-like (i.e., SEF) environment with pre-trade transparency.  The verifiably uninformed are typically going to get better prices in non-anonymous settings than in anonymous ones, where spreads are widened and depths reduced in order to protect quoters against being picked off by the informed.

All of this is not to say that OTC bilateral markets were perfect.  Too big to fail provided perverse incentives.  Uncoordinated replacement and hedging of defaulted positions exacerbates price moves.  But clearing presents its own difficulties, so just inventorying the defects of bilateral markets is not sufficient to prove the superiority of clearing.  You have the Churchill democracy issue: something can be the worst thing ever, except for all alternatives that have been tried from time to time.  Moreover, I don’t consider the defects that MP identify to be nearly as problematic as they do.

Thus, it still comes down to a comparative analysis which must make comparisons along numerous dimensions; some of these comparisons may cut one way (e.g., favoring centralized clearing), others may cut the opposite way (favoring bilateral mechanisms).  Moreover, when discussing policy it is important to recognize that clearing bundles many services–risk pricing, risk sharing, netting/compression, default risk management, position reporting–that may be better provided separately.

I still think that a crucial issue that relates to one of my areas of agreement with MP–that firms subject to a clearing mandate will substitute one form of credit for another–deserves further analysis.  I hope that they respond more fully to my analysis of the implications of the degree of substitutibility of different forms of credit.  In my view, that will have very important implications for the effects of clearing mandates.

John Parsons and Antonio Mello have a series of posts taking aim at the notion that requiring end users to post collateral on derivatives trades will impose a large burden on them that will cause them to reduce real investment.  Their basic point is that OTC derivatives trades often embed an unsecured credit line, and that firms that are forced to post collateral can fund it with an explicit borrowing transaction and/or credit line. This ability to substitute one form of credit for another should dampen the impact of clearing and collateral mandates on corporate end users.

I agree with the essential point.  It was one of the reasons why I long ago opined that requiring AIG to post collateral (initial margin/independent amount) likely would not have materially caused them to reduce their positions in CDS because they would have been able to borrow–and would have wanted to borrow–to fund that collateral.  Less debt in one portion of the balance sheet would have made it possible to borrow more in other ways.  I discussed that point more generally in my Cato Policy Analysis piece.

I further agree with Parsons’ and Mello’s conclusion that this means that looking at the total collateral that end users will be required to post is a misleading measure of the financial burden that collateral, clearing, and capital requirements will impose on end users.

That analysis is as fine as it goes, but it’s worthwhile to push it further–much further.  In particular, to push it to examine the effects on systemic risk, which Parsons-Mello also (rightly) identify as the key driver of the ultimate impact for good or ill of clearing mandates.

There are a couple of cases.  In the first case, firms have access to perfect substitutes for the unsecured credit embedded in many OTC derivatives trades.  In the second, there are not perfect substitutes.  (It seems to me that M-P believe there are pretty close substitutes–feel free to correct me if I’m wrong, guys).

In the first case, clearing mandates and required collateralization will have no appreciable effects.  Firms will just substitute an economically identical form of financing/credit for the proscribed bundled credit.  New labels will be slapped on old bottles.

But that means that the systemic effects of the mandates will be minimal–and perhaps non-existent.  That’s because the mandates will not affect the quantity, character, and crucially, fragility of the capital structures of either end users or financial intermediaries.  The same banks will end up extending the same amount of credit of the same risk characteristics to the same counterparties. It will just go by a different name.

In the second case, where there are not perfect substitutes, things are much more complicated.  Firms will adjust on many margins.  They will substitute different kinds of financial claims (debt and equity) for the proscribed financing embedded in derivatives: the systemic effects of this are very difficult to know.  Firms will engage in less risk management, most likely: again, the systemic effects, and efficiency effects more broadly considered, are hard to predict.  And yes, firms will likely reduce the scale of investment as limited pledgeable capital will be diverted from supporting real investments into liquid assets to support derivatives positions.

It is interesting to note that corporate end users–manufacturers, airlines, energy companies, and the like–have been the most outspoken critics of clearing mandates and margin requirements, while financial firms have been relatively mute on the subject.  This is particularly interesting given that to address end user concerns, CFTC Chairman Gensler has emphasized that financial firms are the main targets of the mandates and margins.

To me, this makes sense in light of the foregoing analysis.  Banks and other financial institutions likely can substitute other forms of unsecured credit for credit bundled in derivatives trades more readily than can end users.  Banks engage in massive amounts of unsecured credit transactions (e.g., interbank funding) with other banks with which they trade derivatives and extend and receive embedded credit.  (Many interbank trades are not collateralized.)  A mandate that says “thou shall not extend unsecured credit via derivatives trades” is unlikely to be hugely burdensome on the banks, because they will just increase other unsecured  financing to substitute for the decreased credit embedded in derivatives trades.  It is plausible that end users have fewer such options.

Why might end users have poorer substitutes?  Here are some conjectures.

For one, the mandates may reduce the set of firms from which end users may obtain credit.  Consider a firm that is looking to hedge natural gas prices.  It can do a swap with Goldman, sure, but it it can also do a trade–and get credit from–BP, or Cargill, or myriad other firms.  With the mandate, the firm won’t be able to get credit from those counterparties.  It may still trade with them, but it would have to finance the necessary collateral either out of its own resources or by borrowing from a bank.

This creates many potential difficulties.  For instance, due to concentration limits and other factors, any given creditor may incur increasing marginal costs to extend financing to a given borrower.  This means that it is often more efficient to get a given total amount of credit from multiple sources, rather than just one.  Reducing the number of potential suppliers of credit can therefore raise the costs of credit.

Moreover, narrowing the sources of potential credit may expose end users to greater opportunism.  It is well understood that banks obtain information about the firms that they finance which gives them an advantage over other potential sources of credit.  They can exploit this information advantage opportunistically.  Firms seeking credit can limit their vulnerability to such holdups by dealing with multiple creditors.  Margin and clearing mandates that force end users to get credit to support derivatives positions through banks may therefore increase their vulnerability to holdup–thereby inflating the cost of trading derivatives.

I also wonder whether the credit embedded in derivatives trades is likely to represent a more robust commitment to extend finance in the future than other forms of unsecured lending.  This is more conjectural, but I find it a plausible conjecture.  If the suppliers of other forms of credit can more readily renege on commitments to supply liquidity to support a derivatives position, the liquidity and funding risks are greater in a clearing/margin mandate world.

These are just thoughts off the top as to how bundled and unbundled credit can differ.  I suspect that there must be some difference, at least for end users, based on revealed preference grounds.  This essentially turns the Parsons-Mello point on its head.  If the form of credit associated with a derivatives position is a matter of indifference, why do we see a decided preference among many users for non-collateralized trades that bundle credit from the counterparty?  Why are end users so vociferous in their opposition (granting that some of their vociferous arguments don’t really hold water)?

But these are the kinds of questions that have to be addressed to understand fully how clearing and collateral mandates are going to work.  And these are the kinds of questions that the advocates of the mandates haven’t even acknowledged, let alone answered.

There’s another issue here that deserves special attention.  Clearing and margin mandates must be met by the posting of high quality, liquid collateral such as cash and Treasury securities.  Where is the increased supply of these instruments going to come from?  (Manmohan Singh at IMF has written about this issue.)

Here I think that the Holmstrom-Tirole distinction between “inside” and “outside” liquidity is important.  They distinguish between liquidity supplied within the corporate sector (“inside liquidity”) and liquidity supplied by households, or through the government (via taxing the household sector) (“outside liquidity”).  My thoughts here are very preliminary–this is really thinking out loud–but I sense that the effects of clearing mandates on inside and outside liquidity is actually the crucial issue, and one that deserves probing analysis by knowledgeable people.

One plausible conjecture is that much of the liquidity that currently supports derivatives trading is inside liquidity, and that mandates, by requiring posting of collateral in the form of cash and high quality securities, will increase the demand for outside liquidity.  Some of this may be supplied by the corporate sector as they adjust investment policies to favor more liquid assets.  But a good portion will have to come from the household sector or the government sector.

This is unsettling.  It is unsettling in part because it means that the efficiency of derivatives markets will be intertwined even more closely with fiscal and monetary policies that affect the supply and demand for outside liquidity.  It is also unsettling because as Gary Gorton, Bengt Holmstrom, and Jean Tirole (and others) have argued, one impetus for securitization–including subprime securitization–was the need for high quality collateral, i.e., it was a response to demand for liquidity from the corporate/financial sectors. To the extent that clearing and margin mandates make the corporate and financial sectors more dependent on outside liquidity, it would tend to drive a similar dynamic.

Moreover, when systemic risk is considered, correlated/aggregate/macro shocks are the most difficult to address through the design of liquidity supply mechanisms.  If we are worried about the financial system’s vulnerability to aggregate shocks–more generally, shocks that can’t be diversified away within the corporate sector–we have to think seriously about legislative and regulatory changes that may affect the reliance of the corporate/financial sector on outside liquidity.

In sum, I think it is worthwhile to think long and hard about some of the indirect effects of clearing mandates–especially their effects on capital structure and the demand for liquidity, particularly specific forms of liquidity.

To try to close the circle here, Mello and Parsons analyze a crucial issue: the effects of clearing mandates on capital structure.  In a Modigliani-Miller world, this wouldn’t matter, and that might be their point.  But if capital structure is relevant, legislatively mandated changes in the way companies finance themselves and the way credit is extended and used will have real effects.  What’s more, some of these effects may be systemic.  After all, research on systemic risk focuses on the ways that imperfections in financial markets can lead maximizing firms to choose capital structures that lead to inefficient, and often destabilizing, responses to economy-wide shocks.   Therefore, to understand the systemic effects of major policy changes like mandatory clearing and collateralization of derivatives trades, we need to understand how these policies will affect financial contracting generally.  I don’t think we understand even remotely what those effects will be.  I am far from convinced that those effects will be salutary, or even benign.  But that’s the kind of thing academics and policy makers should be focusing on.

John Parsons of MIT takes issue with my post arguing that CFTC Chairman engages in magical thinking on clearing.  John claims that my criticism is based on a (non-existent) “conservation of risk” principle.  I respectfully disagree.  I am criticizing the arguments that Gensler has in fact advanced, whereas John is generously attributing to him arguments as to how changing rules (including clearing rules) can reduce risk that I have not seen Gensler make.

In contrast, I have written extensively that clearing affects both the allocation of risk for given economic decisions, and the amount of risk through its effects on myriad decision margins; I do so explicitly in “Do You Believe in Magic?”  From the very beginning of my writing on clearing mandates, dating back to late-2008 when the issue became a salient one, I have made that point repeatedly.  Indeed, my analysis of AIG–Exhibit A-to-Z in many pro-clearing mandate arguments–has emphasized this point.  See here, here,  and here, and my piece in the Journal of Applied Corporate Finance; I also raised it in an exchange with Jeffrey Gordon of Columbia Law School in my presentation on clearing that you can view here.  This working paper, written in the fall of 2008, details a variety of ways in which clearing (via its effects on margining, netting, monitoring, and risk sharing) affects both the amount of risk exposures and the allocation of these exposures.  I could go on and cite additional papers and presentations: suffice it to say, most of what I have written about clearing focuses on how clearing affects incentives and information, as compared to bilateral mechanisms, and how these changes affect the amount of risk in the system and the way that risk is allocated.  That’s far more than a start, I think it’s fair to say.

John states that the effects of clearing on the amount of risk in the system is “the very heart of the original argument behind clearing which Gensler is making.”  I’d like to see exactly what argument John is referring to.  I’ve read a lot of what Gensler has said and written in the last three years, and I haven’t even seen that issue even at the peripheries of his arguments.  Typically Gensler argues that shifting the risk to the clearinghouse eliminates interconnections and eliminates counterparty risk because the CCP stands behind trades, or because CCPs will require collateral that make sure that firms will have the resources to pay for their derivatives losses.  That’s it.  Nothing related to how clearing will affect incentives or information in a way that reduces the amount of risk in the system.

Consequently, I think the magic box metaphor is a very apt characterization of what he has been pushing since 2008.  Or, since it’s Sunday, it’s fair to say that he is promising a miracle that is sort of the inverse of the loaves and fishes: rather than taking meager fare and feeding multitudes, he is claiming that clearing will take risk from multitudes and make it meager.  There is certainly nothing as nuanced in what Gensler has said publicly as what John is attributing to him.

John closes by saying:

Let’s have a good discussion about which rules of the game produce the lowest total social risk and the greatest social payoff from the operation of the OTC derivatives market. It’s a tough problem to tackle. Oversimplification will not do.

Welcome to the party!  Seriously.  Compare that to what I wrote at the end of the piece in Regulation, “The Clearinghouse Cure,” published in 2008 (linked above):

The nature of this analysis is inherently qualitative. It is difficult for anyone, be they academics, market participants, or regulators, to determine definitively whether a clearinghouse would improve the  efficiency of the CDS market. I certainly do not claim to possess such definitive knowledge. It is troubling, however, that basic considerations relating to the economics of risk sharing and information have been almost completely absent in the public discourse over CDS clearinghouses. It is also troubling that the  potential pitfalls have not been fully aired. Nor has there been an extensive comparative analysis of alternative risk-sharing mechanisms. Therefore, at the very least, this article aims to raise the quality of the debate by identifying crucial issues that have been largely ignored until now, and to challenge a consensus that threatens to engineer a fundamental transformation of the financial markets without proper regard for fundamental economic issues. Moreover, the considerations identified herein should be kept in mind when designing a CDS clearinghouse to ensure that information problems do not make this prescription worse than the disease it is intended to cure.

I’ve been calling for a good serious discussion around these issues for arguably longer than anyone, and have written extensively about many of the “hard problems.”  There is indeed an oversimplification problem in this debate–and that’s precisely why I’ve been so hard on Gensler (and Geithner): because they’ve been the ones oversimplifying repeatedly and consistently, and as a result, we run the very serious danger of adopting arrangements that do not generate the greatest social payoff.  If I seem combative making that point (Combative? Moi? Nobody’s ever accused me of that before!) it’s primarily a response to the repeated oversimplification by the advocates of clearing mandates.

I know I can have a constructive discussion with John Parsons, even though it is highly likely that we would disagree on crucial issues.  But it would be a real discussion about real issues, and based on my extensive reading on the entire regulatory and legislative discussion leading up to Dodd-Frank and clearing mandates, that’s precisely what’s been missing in the 202 area code.

Gary has a magic box, called a “clearinghouse.”  You put counterparty risk in the box, and it disappears!:

One of the central goals of Dodd-Frank is to redirect much of the OTC derivatives market through exchanges, electronic trading platforms and central clearinghouses that stand behind dealings in derivative contracts.

“What that means to the American public is it’s less likely that the taxpayers stand behind that transaction,” [Gary Gensler] said.

“Instead the clearinghouse stands behind it, and I think that’s what Congress recognized. Moving as much of this into clearinghouses lowers interconnectedness, but also says a clearinghouse stands there, not the taxpayer.”

Uhm, but what stands behind the clearinghouse?  Where does that risk go?  Well, financial institutions—including many major banks—actually stand behind clearinghouses.   Meaning that if counterparty losses are big enough, the banks bear a big chunk of the loss (so things are still interconnected).  Or, if the banks limit the amount of loss they are willing to bear, the clearinghouse can fail.  Who wears the loss in that event?

Gensler might argue that collateralization in clearinghouses makes it highly unlikely the banks will bear any loss, and even less likely that the clearinghouse will fail.  Let’s say that collateralization is indeed extremely robust, so that the risk of clearinghouse failure is vanishingly small.  Does that mean that everything is great?

Well no, really. The risk still hasn’t disappeared.  Given the positions that firms take*, collateralization (and netting, another commonly touted benefit of clearing) affects the distribution of losses arising from the bankruptcy of a derivatives trading firm, not the total amount of the losses.  If collateralization is so robust that derivatives counterparties always get paid, that means that the entire loss arising from a bankruptcy falls on the firm’s other creditors.  So the magician may point to the magic derivatives clearinghouse box and say: “See!  No losses!  They disappeared!”  But they are somewhere, behind the curtain, borne by somebody else; collateralization changes the priority of claims, not their magnitude.**  Most likely, the loss is shifted to unsecured creditors—who may include banks backed by taxpayers, or owners of money market mutual funds who may run if it looks like their funds will break the buck, which can also lead to a Federal bailout (like what happened in September, 2008).

There’s also the issue of where the collateral comes from.  Some of it may come in the form of loans extended by banks that used to extend credit via derivatives trades; like in a real-world magic trick, the credit didn’t disappear, it was just shifted somewhere else.  Some collateral may come from firms foregoing higher yielding, but less liquid investments: this is a real cost as too many resources are tied up in liquid assets and too little invested in more productive projects.

There are other things going on behind the curtain.  Rather than enter into expensive collateral derivatives trades, firms may decide to hedge less, forcing their claimants (including lenders, employees, suppliers, and shareholders) to bear more risk.  Again, the risk doesn’t disappear–it leaves through a trapdoor and winds up someplace else.

And collateral can have perverse effects in a crisis.  The pressure of collateral calls can force firms to liquidate positions, exacerbating price moves.  Or firms may engage in fire sales of other assets to meet the calls, causing price shocks to spill over from the derivatives market to other markets.  How’s that for an interconnection?

Gary also has a magic transparency trick, a visibility cloak if you will.  Exactly the opposite of Harry Potter’s invisibility cloak, it makes the invisible visible:

“I also think transparency helps,” he said, looking back to the widespread uncertainty during the crisis of the value of assets on the books of giants such as American International Group.

“The law now says they have to be valued daily and valuations have to be shared between the counter-parties and if they run a clearinghouse, the clearinghouse has to share it with the public.”

Indeed, this cloak is so magical it can make visible things that don’t even exist.   For, in situations like AIG, the problem was that the values of the assets were uncertain because there were no trades: these things weren’t marked to market, they were marked to a guess—or to a self-serving price that was hard to challenge because there were no real prices to compare it to.   Many of the contracts that Gensler would like to see cleared trade little, if at all—and no trades, no prices.  It is a magical cloak indeed that can make prices and valuations visible when there are no trades to produce actual prices.

Magical thinking about clearing, counterparty risk, and transparency is extremely dangerous.  It creates very real risks.  Those who believe that things like clearing and transparency are magical solutions, and who do not grapple with the complex realities and difficult trade-offs are all too likely to impose rules and regulations that make things worse, not better.  Sad to say, I think that’s happening in spades, both here in the US and in Europe–and that’s not a card trick.  The consequences are pretty sobering to contemplate.

* The amount of margin will affect the sizes of positions and the structure of positions that firms take.  Netting will also affect positions, because (a) netting can actually economize on collateral, and (b) the amount of collateral savings can depend on how extensive cross-margining and portfolio margining are.  It is difficult to know what the net effect of clearing mandates will be on the trades that firms make, and the composition of the firms that make them.  I mention one possible effect below–some hedgers may exit the market, or hedge less.  Indeed, the potential effects are so extensive it is difficult even to list them.  Making it costlier to shift risks via derivatives transactions affects not just risk management decisions, but capital structure decisions (hedging really being just a capital structure choice), investment decisions (the amount and composition of investment), management compensation decisions, and on and on.  All I want to emphasize in the main discussion is that one major effect of collateralization is to affect claim priority, given the total aggregate size of claims against a bankrupt firm.  It secures some claims–which reduces the priority of other claims.

**Same caveat.

. . . of SWP discussing clearing, here’s a video (approx. 90 minutes) of my talk on the subject at the Law and Economics Workshop at Columbia Law School from December of last year.  You need to supply your own NoDoz.

There are a lot of jokes about economists that go something like: “An economist and a physicist are on the top floor of a skyscraper.  Someone runs in screaming: ‘The building is on fire. The stairways are all blocked.’  The physicist immediately panics, then looks at the economist, who is amazingly calm.  The physicist says: ‘How can you be so calm?  We’re all gonna die.’  The economist smiles wanly and says: ‘No we’re not.  First, assume a 100-story ladder.'”

That genre of joke came to mind when reading this:

Clearing houses for derivatives can help reduce risk to the financial system, Federal Reserve Governor Daniel Tarullo said in written remarks prepared for House Financial Services Committee testimony tomorrow.

“If properly designed, managed, and overseen, central counterparties offer an important tool for managing counterparty credit risk, and thus they can reduce risk to market participants and to the financial system,” Tarullo said.

Translation: “First, assume a properly designed, managed and overseen central counterparty.”

Yes, if we assume all those things are true, our assumed world is wonderful indeed.

But as I’ve written for the past two-and-a-half years (and I think I can honestly say “you read it here first!”), all that is easier assumed than done.

Reading an article by Samuel G. Hanson, Anil K. Kashyap and Jeremy C. Stein in the most recent issue of the Journal of Economic Perspectives helped crystalize a thought that is implicit in what I’ve written, but which I have not made as explicit as I should.

Specifically: Historically clearinghouses have been microprudential institutions, with the responsibility of ensuring that a particular set of claimants get paid what they are owed due to the default of a single trader or firm, just as bank regulation has been microprudential in its focus on ensuring that depositors get paid in the aftermath of the failure of an individual bank.  But Dodd-Frank and all of the other initiatives around the world give CCPs huge macroprudential responsibilities.

As Hanson et al show, there can be substantial tensions between microprudential and macroprudential regulation: some things that are prudent microprudentially are very dangerous from a macro/market-wide/systemic perspective.   I do not believe that Frank-n-Dodd, Geithner, Gensler, the EC, you name it were or are fully cognizant of the difference.  And therein lies the danger.

Here’s the most obvious example.  CCPs utilize margins–collateral–to control counterparty exposure.   That’s sensible microprudentially.   But as I argued beginning in 2008, and as Brunnermeir and Pedersen formalized in 2009, collateralization and rigid mark to market can be systemically destabilizing.  I referred to this as the “collateral death spiral.”  Prices change a lot, imposing big MTM losses on some parties, who liquidate their positions, exacerbating the price moves, which leads to more liquidations.  This positive feedback mechanism is what creates serious systemic risks.

Brunnermeir and Pedersen emphasize that a purely mark-to-market system that bases margin calls only on price moves, and makes no effort to distinguish between fundamentals-based price moves and those that result from mispricings or liquidity effects are the most systemically dangerous.  And that’s exactly how CCPs work.  They are ruthlessly mechanical. If you talk to people in the futures business, that is a feature, not a bug.  I can’t count the number of times I’ve heard about the virtues of the “discipline of a rigorous daily mark-to-market system.”  Microprudentially–agreed.  Macroprudentially–not true, and more than that, dangerously misleading.

So, there is a fundamental disconnect between Timmy!’s and GG”s paeans to rigid collateralization and mark-to-market and their assertion that mandatory clearing will eliminate the prospect that derivatives will be a source of systemic risk.  Indeed, evaluated properly, the reverse is more likely to be true.  In times of market stress, rigid collateralization can be a doomsday machine.

That is a reality that can’t be assumed away–but has been.   And don’t count on that ladder saving our collective rear ends when–when, not if–the next financial firestorm occurs.

The big news in Exchangeworld is the likely merger of NYSE-Euronext and Deutsche Borse.

This reflects in some sense a return to financial normalcy in the aftermath of the crisis.  The years leading up to the crisis saw a plethora of exchange mergers and combinations, but the pace of consolidation slowed noticeably in 2008-2010.  Now it is picking up again.

Both NYSE-Euronext and DB operate cash equity and derivatives exchanges.  The former operates NYSE, of course, and also European equity markets in the Netherlands, Portugal, France, and elsewhere, and the LIFFE derivatives exchange in London.  The latter operates the German stock market, a US-based options market ISE (a purchase in the pre-crisis boom which turned out to be a rather bad deal for DB) and the Eurex derivatives exchange which trades equity options and a wide range of financial futures.  DB is highly vertically integrated; most importantly, it operates its own execution and clearing platforms in both equities and derivatives.  LIFFE historically outsourced its derivatives clearing to LCH.Clearnet, but is also vertically integrating into clearing (although it still contracts with LCH for some clearing services).

Cost savings are the major driver of this merger.  There are substantial scale and scope economies in execution systems.  In derivatives, moreover, there are substantial scale and scope economies in clearing.  In particular, margining and netting efficiencies reduce customer capital costs.

The competitive effects are likely to be relatively small, even though that has been a focus of a lot of the commentary.  Cash equities are already ruthlessly competitive, especially in the United States: RegNMS socialized order flow, eliminating any tipping effects, as demonstrated by the precipitous decline in NYSE market share from the mid-80s to the mid-20s in the years following RegNMS.

With respect to derivatives, the LIFFE and Eurex do not compete head to head in any major product.  Cross-product competition is relatively tame in futures.  And just as with the CME-CBT merger, putting LIFFE short term interest rate futures and UK government bond futures and Eurex European bond products on the same platform would facilitate spreading trades and enhance liquidity and reduce trading costs and execution risks for customers.

Nor do LIFFE and Eurex compete head-to-head with any CME product.  Thus, the direct competitive effect of the merger on CME is also likely to be relatively mild.  By reducing trading and clearing costs, a LIFFE-Eurex combination may attract some business from CME product groups to its product groups, but again, these inter-product class cross elasticities do not appear to be large.  Order flow has not been socialized by regulatory fiat in derivatives on either side of the Atlantic, meaning that the order flow network effect is still in place.  This means that LIFFE and Eurex could not credibly compete against CME on its home turf (each had conspicuous failures trying): it also means that a combined LIFFE-Eurex will face daunting obstacles in trying to do so.  Indeed, I doubt they will seriously try; twice burned, thrice shy would be a reasonable motto.

Consistent with this, CME Group’s stock price has been up close to 2 percent since the news of the potential tie up became public.

The biggest uncertainty surrounding the deal involves European antitrust approval.  As noted above, the merging exchanges are not direct competitors in any major product.  In the US, in the mergers of CME and CBT and CME and NYMEX, that fact was decisive in avoiding  Justice Department challenges.  It should be in Europe too, but I’m not as familiar with European antitrust thinking or precedents so I’m not sure they’ll see it the same way.

The most interesting question involves clearing.  European policymakers have been critical of vertical integration in clearing.  (The USDOJ is too, but only disclosed its (economically nonsensical) objections after the CME-NYMEX merger closed.)  They deem vertical integration as anticompetitive, and have failed to consider seriously the efficiencies that integration can generate (a subject I’ve written a lot about on SWP and my academic research).

Given this skepticism, the Euro antitrust folks may view this merger as an opportunity to open up access to clearing at Deutsche Borse and LIFFE.  That is, I could see them conditioning approval of the merger on the parties’ agreement to open up access to their clearing services.  It will be interesting to see whether they attempt to do so: I estimate that there is a non-trivial probability of this happening.  If they try, it would likely be a deal killer.  DB in particular has been adamant that integration is an essential part of its model and strategy, and LIFFE has adopted that view as well.  A deal becomes much less attractive–and, in my opinion, unattractive–if it requires a fundamental transformation of the exchanges’ business models.

The news of the potential deal has sparked considerable speculation about other tie-ups.  One commonly heard belief is that CBOE is the odd-man out, and that it should tie up with CME.  Other than the fact that both have “Chicago” in their names, these entities don’t have a lot in common, or a lot to gain by combining. In particular, there are no benefits on the clearing side. There are no economies on the regulatory/compliance side.  There are not really big advantages on the system side either.  So, other than savings on letterhead and some management salaries, there is nothing to be gained by merging.

It is likely that many more possible combinations will be mooted and discussed in the coming days.  I’ll be among those discussing them, but that will have to wait.  For teaching calls.  It’s rough work, but somebody has to do it.