Streetwise Professor

The US Department of Justice’s Antitrust Division hardly covered itself in glory the last time it weighed in on derivatives market structure when it criticized vertical integration of trading systems and clearinghouses in 2007 (if memory serves), in the aftermath of its (apparently grudging) approval of the CME-NYMEX merger. I excoriated that “analysis” on SWP, and I have been told that the posts I wrote made the rounds on Capitol Hill, causing (in the words of somebody in a position to know) one senator’s “head to explode” in anger (at the DOJ, not me) when he read them.

Well, the Antitrust Division is at it again. They submitted a comment letter in response to the CFTC’s proposed rulemaking on conflicts of interest at exchanges, SEFs, and clearinghouses. It is slightly better than the Parthian shot fired at the CME in 2007, but that is praise only in the “you don’t sweat much for a fat girl” variety, for the economic analysis in the comment is weak on the issues it discusses, and completely ignores salient economic considerations.

In brief, the DOJ recommends that the CFTC adopt a tougher rule that imposes “an aggregate ownership cap on major derivative dealers” because it fears that the absence of such a cap would “[preserve] the opportunity for these powerful entities to achieve majority ownership in DCMs/SEFs” thereby jeopardizing competition.

The Department argues that “limiting aggregate ownership and imposing stringent governance requirements . . . may prevent the emergence of a dominant trading platform controlled by major dealers to the detriment of other market participants.”

Let’s unpack that particular set of claims.  Is it the “emergence of a dominant trading platform” that bothers the DOJ, or the fact that it might be “controlled by major dealers”?   It is quite possible–and indeed, I would claim likely–that the nature of liquidity (specifically, its network aspects) strongly–strongly–favors the “emergence of dominant trading platforms.”   If market power is the concern, who controls the dominant platform is of secondary or tertiary importance, at best.  Does the DOJ believe that multiple platforms that compete aggressively are likely to emerge if dealers are precluded from controlling them?  What is the basis in economics for this claim?  I’m not aware of any.  I would argue that the tendency for a single entity to emerge is driven by liquidity, and technological scale and scope effects (e.g., the ability to trade multiple instruments on a single platform).

There is, in fact, a stark example of this phenomenon staring the DOJ in the face: the very same CME that exercised the DOJ so mightily in 2007.  The CME is not dealer dominated, but it has emerged as the dominant exchange in the US in the past decade.

This means that the Division’s belief “that an aggregate ownership cap on Enumerated Entities may facilitate competition by encouraging the creation of new DCMs/SEFs” is seriously misguided.  What is going to drive market structure is the economics of liquidity (which could, in fact, be affected by CFTC SEF regulations, with exchange-like limit order book systems more susceptible to natural monopoly) and the economics of scale and scope driven by technology.

The Division anticipates this argument by saying that “[i]t could be argued that economies of scale in trading are so pronounced that derivatives markets will best be served by a single trading platform.”  It then rejects this by saying “[t]his claim would seem to be inconsistent with developments in other financial markets–for example, cash equities–where multiple trading platforms have flourished.”

Two responses.  First, that claim is not inconsistent with developments in most derivatives markets in the US and overseas, which are the markets of interest.  Those markets are almost universally dominated by a single large exchange.  (With respect to options, (a) index options are still dominated by single exchanges, and (b) in the US, for options on individual stocks, order handling rules effectively socialize order flows in a way that eliminates tipping that creates a dominant exchange).

Second, in equity markets, many of the trading platforms (e.g., dark pools) are means by which demonstrably uninformed traders reduce trading costs.  As I’ve written before, it is price discovery that is the natural monopoly: dark pools and other mechanisms (e.g., internalization) that don’t contribute to price discovery aren’t subject to network effect driven economies of scale.  Moreover, those mechanisms have not, heretofore, developed in derivatives markets, likely because the information intensity of trading is not as acute.  Moreover, Reg NMS in US equities essentially socialized order flows and created a network of interconnected platforms, where the interconnection is mandated and regulated; prior to RegNMS, a single exchange dominated equity trading in the US, and single exchanges dominate equity trading in most other markets (that lack a RegNMS-type rule).  Without a similar regulation in derivatives trading, the tipping tendency will prevail, leading to the dominance of one or a small number of platforms, ownership restrictions or no.

The kind of “competition for monopoly” story that DOJ tells (p. 6) is a more reasonable one, but ownership and governance restrictions are not going to affect one whit whether such competition occurs.  Regardless of who owns a dominant exchange, there is a lot of money to be made displacing it, giving an incentive for somebody–anybody–to attempt to displace it.  All that takes is money and technology, which is pretty widely available.

I also consider it ironic in the extreme that DOJ holds up BrokerTec as an example of an entity that spurred technological innovation through a competition for the CBT’s monopoly on Treasury futures.  It’s ironic because BrokerTec was a dealer initiative.  Similarly, the most recent competitor for the CME (which is not dealer owned or dominated) is a dealer dominated ELX, and CME’s strongest competitor in energy is the dealer-dominated ICE.  And dealer dominated Turquoise has tried to oust non-dealer dominated LSE in British equities.  So, if anything, dealer ownership limits would have hamstrung these competitors to dominant exchanges.

The focus on control of a dominant entity by dealers seems to reflect politics, rather than economics.  The Antitrust Division’s concern should be about competition and market power generally, not about who collects market power rents. It has definitely not made the case–nor do I think it is possible to make the case–that restrictions on ownerhsip will have a material effect the magnitude of market power rents.

That said, (a) I’m not advocating intrusive regulation of competition in derivatives trading, and (b) I’m not advocating RegNMS-like rules for derivatives.  I’m just saying that if your desire is to create multiple competitive platforms, something like RegNMS is necessary, and governance and ownership restrictions are superfluous at best, and counterproductive at worst.

The DOJ’s discussion of joint ventures (p. 6) suggests they just don’t understand the economics of exchanges and financial trading.  They are concerned about a joint venture between dealers that admits too many members!  The concern should be quite the opposite.  As shown in my 2002 JLEO paper, exchanges can exercise market power by (a) admitting enough members that allow them to achieve scale economies that make them immune to competitive entry, but (b) which have fewer members than optimal.  This is a consequence of the liquidity network effect.  DOJ should be concerned about limits on membership, not that membership is too inclusive.  The analogy between exchanges and airline alliances is completely off point.

With respect to clearing, the DOJ’s concern that restricting access to CCPs could serve to reduce competition is well-grounded; indeed, that’s exactly the kind of point I just made in the previous paragraph.  I made that argument long before they did.  But what is missing from its analysis is any consideration of the effects on ownership and governance regulations on (a) the willingness of institutions to commit the capital necessary to ensure that CCPs have the financial wherewithal to absorb large defaults, thereby mitigating systemic risk, and (b) CCP decisions on margins and capital levels that also impact their financial soundness and ability to withstand large price, volatility and liquidity shocks.  As I’ve argued over and over, it is difficult to balance these considerations.  But given that the whole purpose of clearing mandates is to reduce systemic risk, you’d think that these considerations should predominate.  What’s more, it’s just inexcusable to ignore the financial safety/systemic risk issue altogether.  Trade offs are hard, but ignoring them is unpardonable.

Indeed, the DOJ treats this issue dismissively: “[t]hese actions against potential new clearing members could be explained away, for example, by expressing risk management-related concerns.”  Yeah, sure, somebody is likely to make that argument, and it deserves consideration rather than dismissal because these concerns are of first-order importance.  Not that you’d learn that from reading the DOJ comment.

This is a very important issue, one that deserves careful, honest, and balanced analysis, none of which the DOJ provides.

With respect to governance recommendations, the DOJ comment is similarly incomplete and superficial.  It focuses on conflicts of interest, but says nothing about ensuring that ownership structures align the incentives of those bearing the risk and those making the decisions.  Misalignment would court disaster.  To overlook this issue completely is quite disgraceful.

All in all, this is a fundamentally flawed analysis of the economics of derivatives trading and clearing, competition in those markets, and the benefits of restrictions on ownership and governance.  Despite its crowing about its expertise in these markets, DOJ exhibits glaring deficiencies in its understanding of the economics of competition in trading and in clearing.  As a result, if the CFTC has any sense, it will dismiss DOJ’s recommendations out of hand.

Yeah.  I know.

The scariest kind of counterparty risk is “wrong way” risk.  This kind of risk occurs when there is a dependence between the size of the exposure (i.e., the amount that can be lost in the event of a default) and the probability of the counterparty’s default.  In particular, wrong way exists when the exposure is large when the probability of a counterparty default is large.

A canonical example of wrong way risk is a firm that writes a put on its own stock.  If the firm goes bankrupt, and its stock becomes worthless, it defaults.  When it defaults the exposure is as large as it can be: the strike price of the put.  In contrast, a firm that writes calls on its own stock has “right way” risk.  If the firm does badly, and indeed goes bankrupt, default losses on the call are zero because the call is out of the money.

Central counterparties–clearinghouses–are touted specifically as ways of mitigating counterparty risk.  Post-Financial Crisis, they have been particularly advanced as a means to reduce systemic risk by reducing counterparty risk absorbed by big financial institutions.  This raises interesting questions: Do CCPs have a wrong way risk problem?  If so, what implications does this have for the performance of CCPs during systemic crises?

The answers in brief: yes, they may well have a wrong way risk problem, and that means that it is dangerous to rely on them as a means of reducing the likelihood and severity of truly systemic crises.

As I noted before, the defining feature of wrong-way risk is a dependence between default probability and the size of exposure.  This is often characterized as a “correlation” between default risk and exposure.  But as I’ll discuss below, “correlation” is too limiting a concept.  Correlation implies dependency, but dependency does not imply correlation.

The magnitude of wrong way risk depends on the nature of transactions and counterparties involved.  In particular, out-of-the-money options exposures, very senior tranches of structures, and highly rated counterparties are most vulnerable to wrong way risk.  (For a good book on this subject, see Jon Gregory’s descriptively titled Counterparty Credit Risk.)

Moneyness matters because a deep out of the money option generates an exposure only if the underlying price moves a lot.  But if the underlying price and the creditworthiness of the option writer tend to move in the same direction, a big movement in the underlying that puts the option in the money also tends to be associated with a dramatic erosion in the creditworthiness of the writer. Thus exposure and default risk peak simultaneously.

The seniority of a tranched structure matters for a similar reason.  There will be losses on a senior (or supersenior) tranche only in the event of an extreme adverse shock hitting near simultaneously many of the credits underlying the structure.  If this same adverse shock puts the writer of protection on the tranche into financial difficulties, the writer is most likely to default at the same time that it is supposed to payoff on the protection it sold.  Think monolines, or AIG.

The credit quality of the counterparty matters because a high quality counterparty is likely to default on a contract only if it suffers a severe adverse shock to its balance sheet.  With the right kind–or should I say wrong kind?–of dependence between the exposure and the counterparty’s balance sheet, this big adverse shock leads to a big move in the value of the contract.  Thus, exposure is big precisely when the counterparty is highly likely to default.

Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts.  Default funds are analogous to protection written on supersenior tranches.  The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices.  Indeed, margins are usually set to absorb 95-99 percent of market moves.  Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin.  If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.

This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances.  Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.

So it seems that CCPs are potentially vulnerable to wrong way risk.  They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem.  Which raises the question: are the dangerous dependencies likely to be present?  That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?

Given that we are talking about tail events, it’s difficult to assess that question analytically and empirically.  But there are reasons to believe that these dependencies are in fact lurking.

A big financial shock that is sufficient to cause movements in derivatives prices big enough to breach margin levels, and/or which damages a CCP member’s balance sheet (or multiple members’ balance sheets) severely enough to force it (them) into default is likely to be associated with severe financial difficulties at other CCP member firms.  For instance, during the financial crisis all banks were cratering simultaneously and prices were moving dramatically; their stock prices all plunged together and their CDS spreads all spiked togehter.  They were all exposed to the same big underlying risk–in the event, real estate prices.  When those prices went south, all financial institutions were in distress, most of them in severe distress.  The financial tumult also resulted in big moves in stock prices, interest rates, credit prices, and commodity prices–all of which could have and did create widening exposures on derivatives trades.  Indeed, since CCPs have zero net positions, a big move in any price is going to create a big exposure for the CCP.

And it’s not just price movements that matter.  Financial and economic shocks are also associated with big changes in volatilities that affect exposures on non-linear positions (notably options or contracts with embedded options). Moreover, big volatility makes it more likely that exposure values and creditworthiness will move substantially.

Perhaps even more crucially, big financial and economic shocks tend to result in correlations in prices shooting towards one and minus one.  This has both direct and indirect effects.  The direct effect is to move–often by a lot–the mark-to-market values on correlation-sensitive positions (e.g., CDOs, multi-product options).  The indirect effect is perhaps even more pernicious, as it is exactly these high correlations between the value of assets on financial institutions’ balance sheets and the values of derivatives exposures that generate acute wrong way risks.  That is, the effects of stressed–crisis–financial conditions on correlation creates the very form of dependency that gives rise to wrong-way risk.

Liquidity effects of crises can also create dependencies.  Liquidity tends to decline during crises, which tends to increase volatilities, thereby exaggerating movements in exposures and creditworthiness.  It also makes it more difficult to manage the risk on exposures, and to trade out of positions in order to reduce exposures.  (The common liquidity shock may be one reason why correlations tend to risk towards one in absolute value during crises.)

These dependencies can be especially exaggerated for certain kinds of products and CCPs.  Consider, for instance, a CCP that clears CDS, a substantial portion of which are written on financial names, and which has financial firms for members.  Exposures tend to spike for such a CCP at the very same time its members are suffering dramatic declines in creditworthiness.  Not good.

Thus, in crisis periods, dependencies between the value of the backers of CCPs–the member firms (often banks)–and the exposures that CCPs are effectively writing protection against are highly likely to be of the wrong way variety.

This means that CCPs offer dubious protection against systemic risk.  A huge economic shock, like that suffered in 2007-2008 creates dependencies that give rise to wrong way risks.  They also give rise to big changes in exposures.  The structures of CCPs have features that are particularly vulnerable to these dependencies.

Even if a CCP does not fail during a crisis, the wrong way risk problem means that the financial institutions that backstop it will have to make payouts at precisely the times that they are under strain.  That is, CCPs load risk onto big financial institutions precisely during crises that are already stressing them.

This is not to say that CCPs cannot share garden variety default risks more efficiently than bilateral arrangements.  But that’s not what the advocates of CCPs hyped when arguing for clearing mandates.  No, these advocates repeatedly and specifically held them up as an antidote for crisis, as a bulwark against systemic risk.

The foregoing analysis of wrong way risk implies, however, that CCPs themselves are most vulnerable to default precisely at the time that their advocates look to them to be the breaks that contain financial firestorms.  Consequently, any sense of security against financial contagion that they provide is very likely a tenuous one, and arguably a false one.  Such complacency is particularly worrisome as it can undermine the urgency to find more effective and reliable measures to reduce the vulnerability of the financial system.

I am not saying that CCPs are as defective in concept as monoline insurers, or as AIG was.  (Jon Gregory argued back in 2008, and argues again in his book, that the monolines and AIG were fundamentally, fatally and irredeemably flawed.)  I am just pointing out that they share key features with those casualties of the last crisis, and as a result, may well be casualties in the next one.

It should also be noted that the Basel III capital requirements for CCPs that I discussed in an earlier post do not capture this risk in any meaningful way.  They cannot provide, therefore, an incentive to reduce it in any meaningful way.

In a classic Rocky and Bullwinkle episode, Captain Peter “Wrongway” Peachfuzz sailed his ship up Wall Street. Let’s hope that’s not a metaphor for the effect of mandated clearing.  But you should be concerned that clearing concentrates wrong way risk, and that this guy becomes the poster child for Frank-n-Dodd and its clearing mandates:

Yesterday was the 5th anniversary of Streetwise Professor.  Time do fly.

I’ll try to keep the navel gazing to a minimum, but I think a few comments are warranted.

The blog, and most notably its reception, have exceeded all the expectations I had when I started it.  I originally envisioned it as a place to think out loud on relatively arcane issues related to financial markets and market structure, and thought that if a few readers stopped by from time-to-time, that would be nice.  It has played that think-out-loud role, but it has attracted many more readers than I had ever anticipated.  Not a huge number by blog standards, but given the rather arcane and arguably eccentric content, a surprising number.

I think a couple of things are responsible.  The first is the wholly unplanned foray into writing about Russia.  That subject generates by far the most comments, and certainly the most heated and passionate ones.  Given the fact that there would be no readily apparent reason for me to write about Russia, it has also resulted in some rather puzzled inquiries from friends and acquaintances, who have offered some rather entertaining hypotheses to explain it.

There is an explanation, convoluted, but an explanation nonetheless.  Several interests serendipitously converged on the subject of Russia.  I attended the Naval Academy in the Cold War, which generated an initial interest in Russia.  I took a year long Russian Civilization sequence at the University of Chicago after I transferred from Navy, taking classes from major scholars Arcadius Kahan and Richard Hellie (both now passed, sadly), which fed that interest.  The interest went into hibernation as I launched into my profession, but as my career developed, I became deeply involved in energy issues (an unexpected departure in its own way with its own story), and also became very interested in institutional economics issues, including property rights economics and political economy.  Russia represented a fascinating case study regarding energy and institutions, and that’s what started me down the path of Russian commentary.  After that, my tendency towards serial intellectual obsessions (which started with Civil War history as a kid) took over, and led me to read and write more; one damn thing led to another, and reading about one thing led to related issues and on and on.  Conditioned response played a role too: I naturally wrote more about the subjects that generated the most feedback.

The second major factor explaining SWP’s unanticipated trajectory was the financial crisis.  As a result of the crisis, aracana that I’d written and researched about for years–financial market structure and clearing, most notably–to the collective indifference of a big swathe of the economics/finance academy all of sudden became extremely topical.

It’s funny, actually.  In October, 2008, (note the timing) I received a rejection letter from a journal for a paper I’d written about the economics of clearing and OTC markets and which had been under review since mid-2007.  The letter said that the topic was of insufficiently general interest to warrant publication.  (It took 18 months to figure that out?)  Well, virtually all of the issues discussed in that paper were soon at the center of debates over financial reform and clearing mandates.  If the journal had actually published it in a timely manner, the editor would have looked prescient.  Instead . . .

But the blog gave me the opportunity to write about topical things in a timely way without having to deal with editorial gatekeepers (whose value added is not necessarily positive).  Although I know a number of who come here to read about Russia, or broader financial issues, groan when they see another clearing post or market structure post, these have served their role as first drafts for some serious academic work, and moreover, have had some influence in business and policy circles.  I’ve been gobsmacked on more than one occasion when some pretty prominent people have mentioned a specific blog post–by title–that had influenced their thinking.  I’ve also had the pleasure of hearing, sometimes directly, sometimes through back channels, that I’ve ticked off a few people.  Given who said people are, I consider it an honor.  I’ve been warned that if I want to have more influence, I need to be more politic.  (The other day somebody at a major financial institution told me that I risked being burned for heresy.)  Well, that cuts against my personal (Jacksonian) grain, and what’s more, being “politic” usually involves pulling punches and leaving important things that need to be said unsaid.  So, that’s not likely to happen.

Where will things go from here?  Who knows?  The moral of the story so far is that the trajectory of SWP is highly contingent on developments in finance, regulation, and yes, Russia, and those are all extremely dynamic.  The subject matter will probably stay in the same general ballparks–financial markets, especially their regulation; Russia; energy; climate issues from time to time–but the specifics will depend on how the world turns.  And the past five years have shown that the world does turn in highly bizarre directions.

I appreciate all of you that have come to visit SWP over the past five years.  It is truly gratifying, and completely unexpected.  It’s been an interesting and rewarding five years, and I look forward to engaging with you all in the years to come.  Thanks, and Happy New Year.

Just before Christmas, the Basel Committee on Banking Supervision released its “Consultative Document on Capitalisation of bank exposures to central counterparties.”  In plain English, it sets out principles on how to determine the amount of capital banks must put aside to protect against the risk of a clearinghouse default, or the risk that the margins a clearinghouse collects are inadequate to cover the loss of a defaulting trader or traders.

A couple of days back I commented on the token 2 percent capital charge against trade exposures.  Here I’ll take up the more complicated issue of the capital charges for the banks that are clearinghouse members that must stump up funds to cover the loss (over margin) arising from the default of any other member firm.

In a nutshell: the rules illustrate the fundamental problems with Basel in all its incarnations.

The proposal sets different levels of capital charges, depending on whether the amount of funds precommitted to the clearinghouse (its own resources, or its own monies plus any monies invested by member firms) are larger or smaller than the CCP’s “hypothetical capital.”  If the CCP’s own resources (e.g., contributed capital, retained earnings) exceed the hypothetical capital, the amount of capital a bank  exposed to the default by another member must hold is 1.6 percent of its default fund contribution.  If the hypothetical capital exceeds the CCP’s own resources, but is less than the sum of those resources and precommitted default fund contributions, the capital charge is proportional to 1.6 percent of the difference between the total prefunding and hypothetical capital plus 100 percent of the difference between the hypothetical capital and the CCP’s own resources; this is effectively a 100 percent capital charge on the marginal dollar in the default fund.  When the hypothetical capital exceeds the sum of the CCP’s resources and its members’ prefunded contributions to the default fund, the capital charge is proportional to the sum of 100 percent of the members’ prefunded contribution to the default fund and 1.92 percent of the difference between hypothetical capital and the total prefunded contributions. (These calculations assume that the CCP meets to-be-released CPSS-IOSCO standards.  The capital charge for non-complying CCPs is based on a risk weight of 1250 percent.)

Using the “waterfall” analogy, the capital charge on default fund contributions is 1.6 percent if the first element of the waterfall–the CCP’s own financial resources–exceeds hypothetical capital.  If the hypothetical capital exceeds the resources in the first element of the waterfall, the capital charge depends on how much of a call the hypothetical exposure represents on the banks’ default fund contributions.  If the hypothetical capital exceeds the resources in the second element of the waterfall, the capital charge depends on how much of a call the hypothetical exposure represents on the bank’s obligation to commit additional funds in the event of an exhaustion of the CCP’s resources and default fund contributions.

The key variable here is the hypothetical capital.  This is calculated using the “Current Exposure Method,” which is defined here.  The current exposure is the sum of the mark-to-market value of a position (net of collateral) and “amount for potential future credit exposure calculated on the basis of the total notional principal amount.”  This notional principal-based amount depends on the instrument in question, with the exposure of interest rate derivatives being a small proportion (0 to 1.5 percent, depending on maturity) of notional, and at the other extreme, commodity exposure ranging between 10 and 15 percent of notional, again depending on maturity.  Hypothetical capital for a given notional amount held by a particular clearing member times the weight is equal to that product, multiplied by 1.6 percent (a 20 percent risk weight times an 8 percent capital ratio).

Given that CCPs mark positions to market frequently, and require posting of initial margin, the mark-to-market portion of the hypothetical capital is/will be zero, or quite close to it.  This means that hypothetical capital for CCPs will be, almost always, a multiple of notional amount.

However, notional amount is a poor–very poor–proxy for the risk of underlying positions.  The default risk posed by a given notional amount can vary substantially even within the five categories set out in the Basel rules.  For instance, different currencies have different risks, and those risks differ than the risks in gold; different equity products (e.g., different indices) have different risks; and different commodities can have substantially different risks (compare, for instance, natural gas or electricity with oil or corn).  But the rules treat everything within a given type-maturity bucket as equally risky.  Moreover, the weights across categories are highly dubious.  Is three month silver seven times riskier than three month gold?  Is three month oil ten times riskier than three month gold?

Furthermore, the risk posed to a CCP’s capital and the capital of its members also depends on the riskiness of individual clearing members (via their balance sheets).  The hypothetical capital calculation does not take this into account, although in a footnote (note 21) the document does suggest the possibility that the risk weight in the hypothetical capital calculation can be adjusted to reflect for the rating of CCP members: the document says bank supervisors “may increase the risk weight . . . if . . . the clearing members of the CCP are not highly rated.”  As written, this seems like a blanket adjustment based on the collective rating strength of the members, rather than an adjustment that reflects differences in ratings among members.  And I shall pass over without comment the reliance on ratings as a measure of credit quality.

Lastly, the hypothetical capital merely sums these (imperfect) exposure amounts across the members of a CCP.  This does not reflect the correlation of exposures across members; arguably the 20 percent risk weight is a correlation adjustment, but a very rough one that does not vary in a discriminating fashion with the way that individual exposures contribute to a CCP’s total exposure.  (As one example: a CCP clearing credit derivatives on financial institutions has a very different structure of exposures, and interrelationships between them, than a CCP clearing commodity products.)

In sum, capital charges depend on hypothetical capital, and hypothetical capital does not vary in an economically sensible way with the risks that CCP exposures pose to member banks.

Given the substantial increase in capital requirements for CCP members of clearinghouses with resources less than hypothetical capital, the rules will provide a strong incentive to make CCP capital (retained earnings plus contributed capital) somewhat greater than this hypothetical capital.  But given that this hypothetical capital is only tenuously related to CCP risk (for the reasons discussed above), this provides little assurance that CCP capital is adequate to absorb the actual potential default losses.

This further means that the capital charge of a member bank attributable to its participation in a default fund bears little association with the true risk to the bank’s capital arising from its CCP membership.  A bank that is a member of a CCP that has capital in excess of hypothetical capital may still be very much at risk to suffer losses via its default fund contributions, and its commitment to replenish default funds.  Its capital charge will not reflect this exposure, however.  This will permit banks to take higher exposures to other risks.  This, in turn, will have perverse feedback effects because the true exposure of members to each other depends crucially on the riskiness of member balance sheets.  Capital charges that do not reflect true CCP exposure risk frees up capital that can be used to take on other risks that inflate the riskiness of the CCP.

As I’ve noted, and as Deus Ex Macchiato emphasizes, based on a directive from the G-20, the new capital regime is intended in part to shove derivatives risks from bilateral deals to central clearing.  That’s troublesome given that, if my analysis is correct, the CCP capital requirements don’t adequately reflect actual risks.  It is by no means clear that the new rules won’t actually reduce the amount of capital held against derivatives risks.  And remember, blather about CCPs reducing interconnectedness aside, this risk taken off of balance sheets by shifting bilateral exposures to CCPs goes right back to CCP member banks via their capital and default fund contributions.  It would be nice to have some confidence that this risk recycling actually results in an increase in the capitalization of derivatives risks.  If it doesn’t, the supposed systemic risk-reducing benefits of clearing will prove chimerical–or worse. It could indeed lead to an increase in the scale of derivatives trading, and the amount of derivatives risk that banks bear.

It’s also worthwhile to contemplate the implications of these proposed rules for incentives on various decision margins.  For instance, with marking to market and some initial margining, capital charges will not vary with initial margin levels.  Thus, even though reducing initial margins would increase the exposure of CCP capital and member default fund obligations (prefunded and contingent), a CCP could reduce initial margins without increasing the capital charges its members incur for their CCP exposures.  Given that members may benefit from lower initial margins (margins are costly, and lower margins may lead to greater trading activity and higher revenues for member banks), this would tend to provide an incentive to reduce initial margins.

Against this, one could make a couple of arguments.  One is that the CCP members will recognize that reducing margins reduces the buffers protecting the other stages of the waterfall and thereby raises their risks.  This will lead them to resist such efforts.

But if you believe that bank self-interest is sufficient to ensure that they choose the right level of collateralization, you should also believe that capital rules are altogether superfluous.  After all, the ostensible rationale for these rules is that financial institutions don’t internalize the costs of the risks that they bear, and hence when left to their own devices will take on risks that are outsized relative to their capitals.  So if you believe that capital requirements are essential due to some mispricing of risk, you also have to believe that undermargining is a serious concern if capital requirements do not properly account for the relation between collateral levels and the amount of risk that CCP members bear.

You could also argue that regulation of margins directly, via CPSS-IOSCO standards and prudential regulation of CCPs, will overcome this problem.  Given the complexities of margin, the information advantage that CCP members have over prudential regulators, and the vulnerability of prudential regulators to capture and pressure, this is a very thin reed to lean on.

One last thing.  Beating me to the punch, David at DEM compares the default fund to the mezzanine tranche of a CDO.  He further notes that “mezz tranches in Basel are punitively treated.”  He interprets the Basel proposal thusly:

The Committee tentatively proposes to use this idea, and figure out whether the CCP’s first line of defence – margin – is enough to cover the capital that would be required for its portfolio of exposures. If it is, then default fund contributions aren’t that risky; if not, then they are acting in part like capital (i.e. margin is too low), and thus they should be treated as pretty risky.

The idea is a reasonable one. But the details are delicate. I haven’t run any numbers yet, and for once I’m excited about seeing how they come out. Will the major CCPs turn out to have enough margin based on the Basel methodology?

My analysis above suggests that the answer to this question is no.  That in reality, the proposal will have no bearing on whether CCP margins are accurate or adequate.  Or put differently, capital charges will depend tenuously–very tenuously, at best–with the adequacy of margins.

And taking the CDO analogy further, we know that there is a good reason to treat mezzanine exposures punitively.  They are very risky–tail risky.  In particular, as the whole subprime fiasco demonstrated, mezz tranche risk is systematic risk: they perform very badly precisely in those states of the world in which returns on financial assets generally are low.  They are like short, out of the money puts on the market portfolio.  Put differently, default funds take a hit precisely in those states of the world in which banks in general are likely to be in bad shape. (And as puts, these exposures have embedded leverage.)

I fail to see how the proposed CCP capital rules really take this systematic tail risk into account.  If you believe that some other market or regulatory failure makes capital requirements necessary, banks by themselves won’t take the systematic tail risk into account voluntarily.  So if the capital requirements don’t get them to internalize that risk, they’ll take on too much of it.

Which means that the new rules will not induce the proper scaling of derivatives trading activity.  The markets will be too big.

In sum, IMO the Basel proposal does not give incentives to (a) choose margins appropriately, (b) control the risks on bank balance sheets (which feedback to CCP risks), (c) rightsize the derivatives markets, or (d) allocate trading activity efficiently across firms and products.  All of which is worrisome, and reinforces my concern that clearing mandates have, at best, exchanged new risks for old, with no confidence that the exchange ratio is one-for-one.

The Basel Committee on Banking Regulation has rolled out Grandson of Basel I, its response to the financial crisis.  One thing that interests me is Basel III’s treatment of exposures to central counterparties.  In two words: very generously:

To address the systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets, the Committee is supporting the efforts of the Committee on Payments and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) to establish strong standards for financial market infrastructures, including central counterparties. The capitalisation of bank exposures to central counterparties (CCPs) will be based in part on the compliance of the CCP with such standards, and will be finalised after a consultative process in 2011. A bank’s collateral and mark-to-market exposures to CCPs meeting these enhanced principles will be subject to a low risk weight, proposed at 2%; and default fund exposures to CCPs will be subject to risk-sensitive capital requirements. These criteria, together with strengthened capital requirements for bilateral OTC derivative exposures, will create strong incentives for banks to move exposures to such CCPs.

Two percent of eight percent is a little more than nothing.  It means a financial institution must hold 16 cents in capital against $100 in exposure to a CCP.

This is actually higher than the current system.  Under Federal Reserve rules, for instance, exposures to CCPs receive a zero risk weight.

This move by the Basel Committee is of a piece with legislative and regulatory efforts around the globe to drive derivatives from bilateral arrangements to cleared ones, under the belief that the former are inherently more systemically risky than the latter.  But the danger is thinking about one risk being inherently greater than another.  Indeed, it is this very kind of categorical thinking that has made previous Basel rules the incubators of crisis.

In earlier incarnations of Basel, government debt was considered very safe–so no risk weight.  Mortgage debt was considered very safe–so a relatively small risk weight.  Agency debt was considered inherently safe relative to corporate debt–so again, a small risk weight relative to the 100 percent applied to corporate debt. Ditto interbank exposures.

Thus, in an effort to make banks “safe”, the Basel rules incentivized banks to invest in government debt, mortgages and better yet, AAA mortgage CDOs, and agency debt, and to engage in massive interbank lending.  And what happened?  These supposedly categorically safe instruments were the sources of the ongoing systemic turmoil.

Now, the Gnomes of Basel are telling the world that cleared derivatives are categorically, inherently safer than bilateral derivatives.  As a result, they are trying to structure the incentive system to drive derivatives onto CCPs.

Based on their track record: be afraid.  Be very afraid.

The problem with Basel generally is that its architects don’t seem to take into account the incentives their rules create.  Historically governments, agencies, mortgages, etc., have been relatively safe.  So give them a favorable treatment.  But this gives financial institutions subject to the rules and who also are driven by perverse incentives to add risk arising from government guarantees (implicit and explicit) the motivation to construct portfolios and design instruments and make lending decisions that are “safe” according to Basel, but which are in fact far riskier than the capital charges reflect.  Moreover, even if a particular category of investment is relatively safe by some measure, if everybody is given an incentive to hold it, when something goes wrong in that category the systemic effects of the problem are far worse than if institutions weren’t facing a common incentive system that encouraged them to engage in correlated trades.

The same dynamic is going on with CCPs.  CCPs went through the recent crisis relatively unscathed.  So Basel is relying on that historical fact to justify the expansion of CCPs, and is implementing incentives to encourage that growth.  But this means that the new CCPs will not be your grandfather’s CCPs.  They will be different–and far riskier.  The incentive system will encourage the shifting of more risk, and more exotic and difficult to measure and manage risks onto CCPs.

Thinking cynically (and believe me, it comes easily), given that it appears that banks have won major victories in the Basel process, I can readily imagine the following train of thought going through bankers’ heads.  Mandates in the US and EU are going to force greater use of clearing.  How can we make this work for us?  Well, if we essentially have to hold no capital against cleared derivatives exposures (yes, I know about margin, CCP capital requirements etc.), maybe the mandate won’t be so bad–and indeed, it might free up some capital and allow us to put on even bigger positions.

I am not alone in my skepticism about Basel III generally.  London Banker has it about right:

And yet, have you heard any regulator take responsibility for regulatory failures yet? I haven’t. In fact, I’ve seen no historic analysis of capital requirements, deregulation of credit markets, securitisation, derivatives, demutualisation, or any of the other regulatory policy innovations which should reasonably be matters for review in assessing the causes of the current crisis.

As the bankers and regulators do not seem keen to be reflective about their own policies and conduct, it’s hard to imagine that they can craft constructive reforms to make the system safer or more efficient in future.

I’ve downloaded the draft Basel Accord III, released this week, for leisure reading. Sadly, I’m trending to the view that all harmonised regulation is likely to end in disaster [welcome to the club!] as it precludes independent judgement and sensible challenge to orthodoxy. Once something has been agreed by a big enough committee, it becomes impossible to question whether it makes sense. Ultimately the unintended consequences of incentives and distortions mean it won’t make sense, but by then it’s far too late to change course and break from the herd.

I also agree pretty much with Falkenblog in his appraisal of the supposed innovation of Basel III–leverage limits, A/K/A non-risk based capital requirements:

The key is that drinker engage in moderation only when they realize hangovers are not worth any temporary high. Unless they believe that in their hearts, they will get around your regulations the same way college kids–who generally are below the 21 year old drinking age–tend to get around restrictions promoting their sobriety. Any top-down rule to prevent excess will simply waste time because you can hide the leverage at the other end, say be investing in assets that are leverage, or who have suppliers who implicitly leverage them (as in the dot-com bubble). Such rules might even make things worse by giving people a false sense of security if nothing bad happens for 10 years, as often is the case.

I used to be head of ‘economic risk capital allocations’ for a bank, and we had very low risk for mortgages. I left before the madness started, but I can see how it morphed because it would be easy for the business line managers pushing product to point to historical losses in mortgages and say they are basically riskless (eg, the Stiglitz and Orzag analysis). Now, some smart people (eg, Greg Lipmann, Andy Redleaf, Peter Schiff, among many others) saw the past data were not relevant once you start lending to people with no money down, or people with no documents, and that depending on collateral prices rising basically was a game of musical chairs. But within large organizations like banks and GSEs these people were demoted, as happened to David A. Andrukonis, the risk manager at Fannie Mae who was fired for getting in the way of Bill Syron’s $38MM windfall. A big idea that is plausible and has many beneficiaries is very hard to resist in real time, and such ideas don’t end via argument, but rather conspicuous failure.

So, define risk–not its correlates like leverage, but actual risk–first. Make sure it isn’t backward-looking, looking at the past couple of crises, but by say anticipating the next bubble in muni debt or education. Unless you can convince people that such risks are real, any leverage rule will be made irrelevant via the creativity of people designing contracts taking into account the letter of the law. That’s really hard, you might say, and we have to do something now. Doing something is not better, unless you are pandering to the mob is a primary objective. If risk management were merely following some simple asset-to-liabilities test, someone would have figured that out by now.

I particularly like the part that says: “Make sure it isn’t backward-looking, looking at the past couple of crises, but by say anticipating the next bubble in muni debt or education.”  That echoes my concern about the CCP exposure weights, which seem to be symptomatic of more of the same, backward-looking, last crisis thinking, rather than looking forward and trying to anticipate how these rules, in combination with clearing mandates, will change the magnitudes of risks and where they reside.  Incentivizing the offloading of risk to CCPs increases the likelihood that they will be the source of the next crisis.

I’d also note that the whole reason for moving to risk-based capital requirements, imperfect as they are, is that simple asset-to-liabilities rules (which is what the leverage ratio is) didn’t price risk at the margin, and hence encouraged excessive risk taking.

It is particularly curious that Tyler Cowen, a (perhaps lukewarm) supporter of leverage limits, and to whom Falkenblog was responding, didn’t heed the recent post of his fellow Marginal Revolution co-blogger Alex Tabbarok, who emphasized the importance of understanding the relevant decision margin:

Lesson two of economics is think on the margin. Lesson nineteen, which we don’t always get to in Econ 101, is to remember that there are many margins.

Basel in all its generations has always mispriced risks at the margin, and the vaunted leverage ratio doesn’t price risk on any margin.  So I’m sure that will work out swell.

One of the sob stories in yesterday’s NYT piece is that the incumbent dealers froze out Bank of New York Mellon from membership in ICE Trust, a CCP for CDS.  The CEO of BNY Mellon Clearing is quoted as saying “We are not a nobody.”

Which raises the question: given BNY Mellon’s non-nobodiness status, if OTC derivatives trading is so obscenely profitable, why didn’t that bank–and others–endeavor to get a bigger piece of those profits and increase the scope of its business in competition with the major dealers?  What was the entry barrier that prevented that?  I’m not saying there wasn’t one, just that nobody has come up with a credible answer as to what it is.

To put things in perspective, BNYM is 7th among US banks (that’s just US banks) in overall derivatives positions.  It is dwarfed by the big 5.  In terms of overall notional, in billions, per OCC data, the rankings are JPM ($75253); BAC  ($48520); Citi ($45991); Goldman ($42087); HSBC ($3683); Wells Fargo ($3612); BNY Mellon ($1457).  In terms of CDS, which is really what is relevant in any discussion of ICE Trust, the numbers are (in the same order): $5355; $4694; $2397; $499; $759; $126; $.7.  Yes, $.7 for BNY.  And even this comparison is misleading, because it covers only (a) US banks, (b) not all of the US derivatives dealers do all their business through a bank; and (c) there are other firms in CDS that rank above BNY Mellon, including: PNC, Suntrust, US Bank NA, Keybank, Fifth Third, RBS Citizens, Morgan Stanley Bank, Deutsche Bank Americas, and Huntington Bank.

That disparity speaks volumes.  As I’ve said before on SWP and elsewhere, and as has been noted in other contexts in the economic literature, cooperative organizations work better and can be governed more efficiently when the members are homogeneous.  BNY Mellon is a very different animal than the members of ICE Trust.  Moreover, is it really credible that the major dealers were so afraid of competition from the bank with the 17th largest CDS book among US banks, with an outstanding position that was rounding error as compared to the other ICE Trust members, that anti-competitive exclusion was the true motive for keeping out Bank of New York Mellon?

Note to Louise Story:  Data is our friend.  Further note to Louise Story (forwarded from George Stigler’s ghost): the plural of “anecdote” is not “data.”

Next thought.  As I suggested in yesterday’s post, there is a tension between the dominant narratives involving OTC derivatives.  The one narrative is that there is an evil cabal of bankers that exercise market power and keep prices (spreads) at supercompetitive levels: this would suppress output.  In this narrative, regulators should take measures that increase competition–and thereby increase output.  The other narrative is that OTC derivatives markets are too big, thereby posing a systemic risk, and that output should shrink.

This sounds like Alice in Wonderland.  One pill makes you too big.  The other pill makes you too small.  Which is it?  Are the markets too big or too small?  Which pill did they take?

If you really think that the OTC derivatives markets are too big because of systemic risks, on second best grounds you should favor reducing competition, and enhancing market power.   You should rejoice that a dealer cabal restricts output.  (You should rejoice on other grounds too: high profits lead to higher capital–to the extent it isn’t paid out in bonuses and dividends–and hence less systemic risk.)

So: pick your poison (or your pill, as you like).

(Further apologies to George Stigler, who said that “Well, there are always second best considerations” is an economics conversation stopper.  Not that I think the above will stop this particular conversation.)

Next item: thanks to Felix Salmon, my sometimes foil/sparring partner, for his extended coverage of SWP in his story on the Story story.  To satisfy your curiosity, Felix: no, she didn’t.

Today’s NYT carries a breathless–and endless–expose on OTC derivatives clearing.  All of the issues it discusses have been discussed, at length, here on SWP.  I almost hesitate to say anything more, because it’s tedious to repeat myself because it’s tedious to repeat myself.  But the fact that stale arguments continue to dominate the conventional wisdom–as now officially endorsed by the New York Times–means that I must venture once more into the breach.

In a nutshell, the article repeats a familiar narrative about the OTC derivatives market.  You might call it the What’s the Frequency Kenneth Griffin Narrative.  (Indeed, Citadel and Griffin are cited throughout the article.)  An oligopoly, not to say cabal (though the NYT comes close to doing so, by referring to “a secretive elite”), of large banks operating in an opaque market earns outrageous profits.  It is now attempting to perpetuate its oligopoly through control of clearinghouses, ironically mandated by the Dodd-Frank Act.

Let’s focus on the clearing aspect for a moment.  First of all, as I’ve said repeatedly, there is definitely a double edged sword involved in clearing.  On the one hand, limiting access to clearing is a great way to exercise market power.  On the other hand, too liberal access to clearing can create systemic risks, and make the governance and management of clearinghouses far more complex and far less efficient (by increasing the heterogeneity of the membership).

Indeed, I gave a talk on clearing before the Columbia Program in the Law and Economics of Capital Markets Regulation on Thursday where I made this very point.   The audience (which consisted of a very distinguished group of law and finance scholars) was generally sympathetic to clearing, I think, and as a result there were a lot of skeptical questions.  One was right along the lines of the NYT article, suggesting that dealers were an oligopoly and that clearing would increase competition.  I responded that in fact, clearing could be a great way of cartelizing an oligopoly.  However, trying to mitigate this problem through regulating CCP admissions criteria could undermine the goal of reducing systemic risk.  As I put it in the slides for my talk, this was one of many Morton’s Forks in Dodd-Frank. (I’ll post a link to the slides and the video from my talk when they are available–probably just in time for Christmas!)

The NYT article describes the efforts of the dealer banks to exert control over CCP risk committees.  Well, duh.  It’s their capital at risk.  Which presents another problem here.  To reduce systemic risk, CCPs have to have a lot of capital backing trades.  That capital doesn’t fall from the sky.  Where is it going to come from?  Since clearing has begun, major market intermediaries have provided the capital.  And since it is their capital at risk, they have demanded and exercised control over the risks that they are taking on.  It’s not that complicated.

Attempts to regulate governance in ways that reduce the control that group X exerts means that you will simultaneously reduce the amount of capital that group X is going to supply.  So you need to get capital from someone else.  And if you don’t the CCP will be undercapitalized and then there are problems; indeed, in the event, CCPs will be the source of the very systemic risk legislators and regulators hoped that they would banish.

In other words, there are trade-offs here that are quite thorny, but the NYT–and too many other people who should know better–ignore altogether because they get in the way of a good morality play.  It is particularly ironic, and annoying, that many of those who were baying for clearing mandates are now just waking up to those trade-offs.

There are other issues in this article regarding clearing that need to be addressed.  One is ICE Trust.  The author of the piece, Louise Story, talks about the formation of the ICE Trust, which involved the combination of a dealer-run initiative Formerly Known as the Board of Trade Clearing Corporation and ICE.  As originally envisioned, and as currently operating, ICE Trust was an inter-dealer clearing system.  So who other than the dealers would you expect to dominate it?

In her attempts to make ICE Trust appear as sinister as possible, Story descends into self-parody:

The banks also refused to allow the deal with ICE to close until the clearinghouse’s rulebook was established, with provisions in the banks’ favor. Key among those were the membership rules, which required members to hold large amounts of capital in derivatives units, a condition that was prohibitive even for some large banks like the Bank of New York.

I read that to Mrs. SWP, who laughed out loud.  Mrs. SWP is an art major, but she is endowed with common sense.  Her response (post-laugh): “Like they were going to join an organization before they knew what the rules were?  And they were going to join an organization with rules that hurt them?”

More substantively, the quote makes the capital requirements seem like–and only like–a means for exclusion.  Yes, they can play that role, as I’ve written ad nauseum for years.  But high requirements can also be a crucial way of ensuring the safety of the institution, and reduced heterogeneity in the financial condition of members can make the difference between an effective organization and a dysfunctional one.

In other words, the NYT is printed in black and white, but the issues involve are anything but black and white.  Until people get real in grappling with the trade-offs, we are doomed to pointless arguments and counterproductive policies.

The other big issue in the article relates to transparency and trading, and its effect on profits.

The story begins with this tale:

This fall, many of Mr. Singer’s customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price higher.

But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives.

“At the end of the day, I don’t know if I got a fair price, or what they’re charging me,” Mr. Singer said.

It proceeds:

And the profits on most derivatives are masked. In most cases, buyers are told only what they have to pay for the derivative contract, say $25 million. That amount is more than the seller gets, but how much more — $5,000, $25,000 or $50,000 more — is unknown. That’s because the seller also is told only the amount he will receive. The difference between the two is the bank’s fee and profit. So, the bigger the difference, the better for the bank — and the worse for the customers.

It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it. Moreover, only the real estate agent — and neither buyer nor seller — would have easy access to the prices paid recently for other homes on the same block.

Ask yourself: for what product that you buy do you know the markup or the seller’s profit?  Answer: probably none.  You rely on competition, comparison shopping, etc., to discipline sellers and ensure that you get a good price.  Presumably that, and soliciting multiple offers, are exactly what Mr. Singer does when buying the physical oil he sells (the markups on which and profits made by the seller he almost certainly does not know either).  (By the way, do Mr. Singer’s customers know his costs and markups?  Just asking.)

The usual retort is that the OTC derivatives market is an oligopoly and that a lack of price transparency limits competition.  By structural measures, OTC dealing is less concentrated than most industries.  With respect to transparency, many large market participants (end users) repeatedly stress that they have access to multiple bids and offers, and are perfectly capable of shopping for good deals.

Moreover, and this cannot be stressed enough, for many products–including Mr. Singer’s heating oil–there are exchange traded markets with great transparency pre- and post-trade.  Mr. Singer and others can utilize that information to evaluate the price offers being made by the dealers on OTC trades.  Moreover, they can trade on those markets if they are so convinced that the OTC dealers are hosing them. So why don’t they?

I am also annoyed that people, including Ms. Story, accept uncritically the proposition that OTC dealing is obscenely profitable.  Maybe it is–I would definitely like to see a more definitive study on this that goes beyond the mere quoting of revenue numbers from OTC trading and how it compares to overall bank revenues.

Indeed, there’s a fundamental tension between various criticisms of OTC derivatives markets.  On the one hand, they are supposedly extremely profitable.  On the other, they supposedly pose huge risks for the banks that are the major dealers.

Think that there could be a connection?  The counterparty risks that dealers face are a contingent liability.  If OTC derivatives dealing is indeed highly risky, as is often asserted, this contingent liability could be quite large.  Which means that in a competitive market prices–notably spreads between dealer bids and offers–must be wide enough to compensate for that risk.

This further means that looking at profits in “normal” times can be misleading.  These “profits” are in part, and arguably in large part, compensation for risk.  And given the nature of risk in these markets, where things can go along swimmingly for a long time and then go non-linear, the losses for which these “profits” are compensation can be extremely concentrated in time; the contingent liability becomes a real one, and particularly a real big one, relatively infrequently. So you can look at profits over years that look fat and say that they are supercompetitive.  But they can disappear in a trice.

This is arguably analogous to the equity premium puzzle.  That puzzle states that the returns to investing in stock appear to be very high given the risks.  That conclusion is dependent on how you measure the risk, and the compensation required (based on preferences) for these risks.  Legions of finance academics and practitioners have wrestled with those issues for decades now, and there has been no definitive resolution of the puzzle.  Very little–and arguably no–comparable research has been undertaken to study the risk-return trade-off in derivatives dealing.  That problem is, moreover, arguably far more complex than the equity premium puzzle.  It is a tail risk problem, and evaluating tail risks and the appropriate compensation for them is hard.  (Tail risk could be the source of some of the equity premium too.)  With free entry and exit, to a first approximation you would estimate that the prices charged compensate for risk.  You should certainly be very reluctant to draw strong conclusions to the contrary without a much deeper analysis than has been done until now.

(This is also analogous to a peso problem.)

Until the risks of OTC derivatives dealing, and the costs of those risks, are measured far more accurately than has been the case heretofore (and the analysis usually doesn’t go much beyond the kind of stuff that’s in the NYT article), I would be chary indeed about arguing that OTC dealers make supercompetitive profits.

And I would be especially careful about arguing about the huge risks of OTC dealing out of one side of my mouth, and the huge profits of OTC dealing out of the other.

This gets at the main problem with all of these jeremiads against OTC derivatives markets.  OTC dealing is supposedly hugely profitable.  Customers are supposedly exploited.  But OTC derivatives markets expanded dramatically absolutely and relative to the transparent, anonymous exchange markets that offer products that are close substitutes on many dimensions.

Huge profitability and supercompetitive prices should have encouraged entry by other potential OTC counterparties; the entry of new trading mechanisms (including, potentially, exchange-like mechanisms with clearing as well); and the movement of trading to existing futures and options exchanges.  But the reverse happened.

In other words, criticisms like Mr. Singer’s, and Kenneth Griffen’s, and Louise Story’s remind me of what Yogi Berra said about Ruggeri’s (a restaurant on The Hill in St. Louis): “Nobody goes there anymore. It’s too crowded.”   The OTC markets are big and crowded with customers.  If they’re such a bad deal for these customers, why is that true?  Why hasn’t entry, or the movement of customers to available substitutes, constrained market power and prevented exploitation of customers?  Not to say that such an outcome is inconceivable, just that Louise Story, Kenneth Griffin, and the cast of thousands who criticize OTC derivatives markets haven’t come close to answering these questions.

I long for the day when there will be serious consideration of these issues, rather than superficial black hat-white hat narratives.  There are so many thorny, thorny issues involved in derivatives market structure.  The trade-offs are not easy.  Let’s stop pretending that they are.  And most importantly, let’s stop legislating and regulating like they are.

In my recent piece on clearing in the Journal of Applied Corporate Finance, I wrote:

It is equally unknown what clearing market structure will evolve, and how close this structure will come to approximating the ideal structure.  In this regard, it is essential to keep in mind two facts.

First, the extensive scale and scope economies associated with clearing make it likely that the clearing industry will be highly oligopolistic, and that strategic considerations will influence decisively the way that the industry develops.   Moreover, scope economies across trade execution and clearing (Pirrong, 2010b) will also affect the strategic and efficiency forces that will shape industry structure.  Strategic considerations will almost certainly drive a wedge between what is optimal for the individual decision makers, and what is optimal for the economy.  This is particularly true inasmuch as there is no market mechanism evident that would induce CCPs to internalize the systemic externalities associated with their failure.

. . . .

Second, industry evolution will inevitably be a highly politicized process.  Dodd-Frank gives regulators enormous discretionary authority over the operation of CCPs.  Interested parties will influence the regulatory process for their private benefit.  Political tradeoffs, rather than efficiency considerations, also threaten to cause serious divergences between the structure that evolves in practice, and the one that would optimize the relevant economic tradeoffs.  The effects of politics are particularly pronounced in this context because finance is a truly international industry, and hence jurisdictional issues and competition between jurisdictions will play a decisive role in determining the industry’s ultimate configuration.  For instance, governments in major financial centers (e.g., the US, London, the EU, and individual countries in the EU, Japan, Singapore, and Hong Kong) have all expressed a strong interest in domiciling CCPs, for both economic and political reasons.  But accommodating these interests would fragment clearing, reducing netting benefits and raising serious concerns about coordination during a crisis.  Moreover, regulatory competition between jurisdictions to favor their local CCPs could compromise financial market stability.

There is another mandate in Frank-n-Dodd, this one for reporting all swaps transactions to trade respositories.  The scale and scope economy issues, and the jurisdictional and political issues are also present for repositories, and a recent article in eFinancial News demonstrates that the problems in the likely evolution of clearing market structure that I identified above, with the associated inefficiencies, are coming to pass with the repositories:

However, repositories are not a cure all. While the concept of a trade repository is not controversial, there are issues to address. Most notably, the sudden explosion of repository providers is leading to fragmentation, a problem familiar in other areas of the market, such as the clearing landscape.

Market participants are concerned that fragmentation would undermine the purpose of repositories to provide a single integrated view of derivative risk. The DTCC’s Douglas said: “The problem with trade repositories is that if everyone wants to build their own, how can regulators be sure that they are seeing the whole picture?”

l;”>The market has also raised concerns that multiple repositories may lead to double-reporting, while others highlight the implicit problem of dividing repositories along asset-class lines.

Richard Metcalfe, head of global policy at the International Swaps and Derivatives Association, which supports repositories in principle, warns that this approach does not show the trade data in its fullest context. He said: “You are looking at derivatives in isolation from positions that dealers might be hedging or adding to.”

This problem may be partially addressed by developing interconnectivity between the different trade repository providers. Interconnectivity would help build a full regulatory picture but would still afford dealers a choice of reporting venue, according to Philip Brown, head of client relations for Europe and the Americas at Clearstream.

. . . .

“>But the legislation is not yet finalised and the industry will have to move fast before the proliferation of repositories in both US and Europe renders the task of standardisation slow, tedious, and painful.

Metcalfe said: “I think the key issue is can we ensure that supervisors work together internationally to ensure that the information can be aggregated.”

It’s easier to create repositories than CCPs.  That’s why the process of creating them is further along than for CCPs.  But you can expect that all of these problems will occur in spades as development of clearinghouses proceeds in the coming months and years.

It’s also important to remember that repositories just consolidate data, not risk, so the consequences of getting it wrong are not as severe, by far, with repositories as compared to CCPs.  Fragmentation seriously impairs the allocation of risk, by reducing netting possibilities, reducing diversification, and limiting cross margining.  It also will create the potential for serious coordination problems in the event of a crisis; poor coordination across CCPs could greatly exacerbate the effects of a crisis.

Which all means that when you see the difficulties already becoming manifest in trade repositories, you should be very concerned about the effects of a clearing mandate.  Frank-n-Dodd, and what the EC is doing, can mandate clearing, but they can’t mandate market structure.  That is going to evolve in a messy way, driven by the nature of indivisibilities and politics–as the repository experience is showing.  And a messy evolution in clearing is a very sobering prospect, given that our legislative and regulatory betters have decided it wise to put all our eggs in that basket.

This was unintended, but not unpredictable.  At least it shouldn’t have been.  But one hopes that even for the dreamers and the slow learners, that what is happening in trade repositories is a cautionary tale that will open their eyes to what is likely to transpire in clearing.

Frank-n-Dodd mandated clearing.  The CFTC is now promulgating a raft of rules regulating the clearing process.  One of these rules limits the ability of clearinghouses to determine to whom they offer clearing services, and how:

The Commodity Futures Trading Commission approved a proposed rule to force the world’s largest banks to offer swaps clearing services to smaller firms, a change that would promote competition in the $615 trillion market.

. . . .

“Swaps dealers or major swaps participants are prohibited from interfering with or attempting to influence decisions related to the provision of clearing or the acceptance of clearing customers,” according to the proposed rule. The potential regulation now enters a 60-day public comment period before any final CFTC vote.

I’ll defer comment now on this particular rule because it hasn’t been posted on the CFTC website yet, and want to read the full rule rather than going on just the news report.  But this does relate to a general issue that I’ve been thinking about lately: CCP governance.  So I’ll provide some general analytical observations on this subject that are likely to be relevant as the CFTC and SEC proceed on clearing issues.

I’ll focus on CCP membership and its implications for the way CCPs are run.  In particular, in addition to controversy about who should be allowed to open clearing accounts and who should have a say in who can do so, there is also controversy about who should be able to become a CCP member, and CCPs’ ability to set membership standards and to exclude some firms from membership.  This issue came up at the roundtable I participated in on 22 October.  There is a group of smaller banks and brokerage firms that are pressing to become CCP members, and to limit the ability of CCPs to set standards that could result in their exclusion.  This is likely to be a big issue going forward.

As I’ve written for years, there are difficult trade-offs here.  On the one hand, there is the issue of market power.  I’ve shown–in work going back into the 1990s–that when there are substantial scale economies, as is the case in clearing, it is possible for a CCP–even if it is member-owned, and a not-for-profit–to exercise market power by limiting membership.  That is, a suboptimally small “club” of intermediaries can get together and form a CCP, without fear of competition from another CCP due to the scale economies.

On the other hand, allowing open access can jeopardize the financial security of the CCP.  I want to focus on this issue.

A key point here is heterogeneity.  CCPs with heterogeneous members, in particular firms that vary in their financial strength, risk management capabilities, etc., face difficulties that CCPs with more homogeneous members do not.  These difficulties, in fact, can undermine the ostensible public purpose behind mandating CCPs: reducing systemic risk.

CCPs are firms that have to be governed and managed.  It is well known that heterogeneity increases the costs of governing cooperative organizations.  Henry Hansmann’s The Ownership of Enterprise provides numerous examples of this.  Conflicts between members are more likely, the more heterogeneous they are.  In particular, some members can attempt to use the organization to transfer rents from other members.  In my 2000 JLE paper “A Theory of Financial Exchange Organization” I explain a lot of the supposedly inefficient and cumbersome governance mechanisms in futures and stock exchanges as a rational way of mitigating rent seeking among the heterogeneous members of these exchanges.

Let’s take the case of a CCP in particular.  A CCP mutualizes risk, and therefore creates potential moral hazard problems.  The CCP can mitigate these problems by imposing capital requirements, and crucially, by choosing margin/collateral policies.

When CCP members are heterogeneous, in particular, when some are better capitalized than others, or when some incur higher costs to post collateral than others, the members will disagree on what the appropriate margins should be.  The better capitalized firms and those who incur lower costs to post collateral will prefer higher margins.  The more poorly capitalized firms and those who incur higher collateral cots will prefer low margins.

The well capitalized firms are concerned that since clearing makes the cleared products fungible, customers don’t care who they trade with.  Since risks are shared, every member is effectively a perfect substitute from the perspective of customers.  Thus, clearing tends to make it easier for less-well capitalized firms to get business.  But since default risk is mutualized, this reallocation of trading activity towards the less-well capitalized firms tends to force the better-capitalized firms to suffer more default losses.  One way (albeit, imperfect) to control this problem is to raise the costs that the less-well capitalized firms incur (relative to the costs of the better-capitalized ones).  Since collateral is typically costlier for the lower-cap firms, this can be done by charging relatively high margins.

Thus, I would expect that more highly capitalized firms would prefer higher margins than the less highly capitalized firms.  (Similar arguments can be made relating to other risk control policies that CCPs might adopt.)  The more heterogeneous the membership, the more acute the conflict between the members.

The CCP governance mechanism has to have some way of dealing with these conflicts, and making decisions.  Some decisions are going to be made by voting.  With one-member, one-vote kinds of systems, the median member will drive the outcome.  A CCP with a few big members and a larger number of small members may therefore tend to choose policies that favor the smaller members.  This is not likely to be optimal from a systemic risk perspective, and is also likely to result in larger members doing things to limit their exposure.  This in turn limits the risk sharing benefits that a CCP can offer.

Other kinds of voting rules can mitigate these problems, e.g., rules that are based on size or capitalization in some way, with bigger/better-capitalized members having more votes.  But smaller members are unlikely to be satisfied with merely belonging to a CCP but having to defer to the bigger members on key policy issues.  Hence if they pressure regulators and Congress to craft regulations that require CCPs to admit them, they are also likely to pressure regulators and Congress to craft regulations of CCP voting rules that give them some influence over CCP decisions.

Other decisions will be implemented by CCP management.  But CCP managers will be accountable to the members, and subject to influence by them.  Here again, voting rules will matter.  Moreover, Peltzman-Becker pressure group considerations suggest that managers, like politicians, will adopt policies that balance support among the various constituencies.  Median-voter type considerations again exist.  This means that CCPs with more heterogeneous members are likely to adopt policies that appeal to the median member.

In brief, when trying to determine the riskiness of CCPs, you have to consider how they are governed and managed.  Moreover, you have to recognize that governance and management depend on the composition of the membership.  And in particular, that CCPs with more heterogeneous members will behave differently than CCPs with more homogeneous ones.

One concern that is oft-expressed is that there will be a “race to the bottom,” with CCPs competing on margin and thereby compromising safety and creating systemic risks.  Given the economies of scale and scope in clearing, I doubt that the competition between CCPs will end up being all that intense, although there may be an initially period of intense competition that results in the market tipping to one or two dominant CCPs.

This analysis of CCP governance suggests another concern, and one that I think is more of a real worry.  Namely, that member heterogeneity can lead CCPs to adopt policies that benefit the median member, but which are not optimal from a systemic risk perspective.   Clearing inherently faces a moral hazard problem.  This moral hazard problem can create systemic risk.  Member heterogeneity makes it more difficult to control this moral hazard problem.  Internal pressures from riskier members–who can essentially pass their risks and the associated costs on to less risky ones–can lead CCPs to choose margin and other risk control policies that are not systemically optimal.  Internal pressures to reduce margins, rather than a race to the bottom between competing CCPs, is something to be concerned about.

One other historical note that illuminates another important cost of heterogeneity.  In Banking Panics of the Gilded Age, Elmus Wicker shows that with one notable exception (the Panic of 1873), the New York Clearinghouse was unsuccessful in dealing with financial panics and contagion.   (NYCH was a bank clearinghouse, not a derivatives clearinghouse, but there are important similarities.  Most importantly, NYCH had the ability to mutualize some risks.)  Wicker argues that conflicts between heterogeneous members were the main impediment in dealing with panics.  Although mutualization of risks would have mitigated panic (because the banks collectively were more likely to be solvent than any individual bank), mutualization transferred wealth from the stronger banks to the weaker ones.  The inability to overcome this distributive conflict stymied the ability of the NYCH to respond to crises in an effective way.   Thus, not only can heterogeneity increase the likelihood of a problem at a CCP (due to its effect on the severity of moral hazard problems), it can reduce the effectiveness of a CCP in dealing with a crisis situation.

This means that regulators should be extremely careful when crafting rules for CCP membership and voting policies.  Yes, there are legitimate grounds for concern that CCPs will use membership policies to exercise market power.  But there are also grounds for concern that forcing CCPs to admit more firms will lead to more heterogeneity, and that this can raise governance costs and jeopardize the financial safety of CCPs.  Similarly, regulation of governance and voting procedures to give more power to smaller members can also raise governance costs and jeopardize safety.  Inasmuch as the ostensible purpose of CCPs is to improve the stability of the financial system, it would be perversely ironic if political pressures induced regulators to adopt rules on CCP membership and governance that created systemic risks.  Tread carefully, people.

The next brawl on the Frank-n-Dodd fight card is over segregation of customer funds in the clearing model.  From the FT:

The “risk” that is in the spotlight centres on how customer assets, such as margins required to cover potential losses on derivatives trades, are held.

Under the current futures model, “futures clearing merchants” (FCMs), which handle cleared derivatives hold these assets in pooled accounts. If one of the FCMs’ customers defaults, and causes the FCM to go under too, then the clearing house can tap into this pooled account – also called an “omnibus” account – to cover any losses that are not met by margin payments or the clearing house’s default fund.

For investors these accounts are an important safety net. And they want the pooled accounts to be replaced by a system of separate, or segregated, accounts. Then, if another investor defaults, their assets are safe.

“It is an extreme event, but it is not impossible,” said Richard Prager at BlackRock at the meeting organised by the CFTC.

. . . .

If regulators opt for segregated accounts, clearing houses won’t be able to tap into these in the event of a default. Instead, clearers say the current system of using omnibus accounts gives them an extra shield. The removal of this shield would mean they would have to find funds elsewhere, potentially driving up clearing costs for users.

Kim Taylor from CME Clearinghouse said the removal of omnibus accounts could require a 60 to 100 per cent rise in the default fund, the capital put up by the backers of clearing houses. Such a rise in capital costs could lead banks to “think twice” about being in the clearing business, she said.

Point number 1 (which everybody saying anything about clearing should repeat until they internalize it): a primary effect of any priority rule–and the difference between segregation vs. omnibus accounts is first and foremost a difference in who is in what loss position in default–is to shift risk around.  Under the omnibus model, the customers of an FCM are at risk to its other customers and the FCM itself.  If some customers default, and the FCM does not have the resources to cover this, under the omnibus system the clearinghouse can seize the entire customer margin held in the omnibus account to make whole those at other FCMs (including the other FCMs themselves) who are owed money.  This means that non-defaulting customer funds at the defaulting FCM can be used to cover the losses of the defaulting customers at that FCM (though not the losses on the FCM house account).  Under segregation, this can’t happen.  But that doesn’t mean the losses go away: they are borne by the other clearinghouse members who don’t default.  These firms are obligated to pay up to make those owed money whole.

In other words, with an omnibus account system, customer default losses are shared among FCM customers and members of the CCP.  Under segregation, they are shared only among members of the CCP.  The rule shifts losses around.

Note that this is somewhat ironic if the policy objective of a CCP mandate is to reduce the counterparty risk losses suffered by the large, systemically important financial institutions that are among the members of CCPs.  Segregation rules force said firms to bear larger default costs than omnibus rules: losses are shifted in their direction.  (And compared to bilateral markets, it can also be the case that large systemically important financial institutions will bear larger default losses under clearing than without it.)

In other words, just looking at the risk piece, the choice between segregation and omnibus is a choice between different sharing rules.  Default losses are actually spread more widely under the omnibus system, as non-defaulting customers are in a potential loss position.

But whenever you look at insurance arrangements, you have to consider the incentive effects, and most notably, the potential for moral hazard.  The crucial thing to understand here is that the segregation system is more vulnerable to moral hazard than the omnibus system.

This is true for at least a couple of reasons.

First, customer incentives to monitor FCMs are stronger with omnibus accounts.  A customer realizes that if the FCM doesn’t monitor its customers appropriately, or lets them assume excessively risky positions, he is at risk of loss from the FCM’s carelessness.  He therefore has an incentive to choose an FCM carefully, and to monitor that FCM, and potentially move to another FCM (“exit”)  or raise hell with his current one (“voice”) if he finds that FCM is slacking in watching its customers.

Second, under segregation, customers don’t care about the riskiness of the FCM’s trading or financing.  Remember a customer is in a loss position under an omnibus system when (a) there is a default in some customer accounts, and (b) the FCM can’t cover this loss.  Condition (b) is more likely to occur, the riskier the FCM’s own trading, financing, etc.  Therefore, a customer is more likely shy away from a high flying FCM that trades aggressively, or levers up to the max, or chooses fragile forms of leverage when under an omnibus system.  Under segregation, the customer channels Alfred E. Newman: “What, me worry?”  He will choose an FCM only on the basis of commissions, services, the quality of the Christmas party and golf outings, etc.  This means that under segregation, customer accounts will be at riskier FCMs, on average, than under omnibus accounts.

More moral hazard means that default losses will be greater on average under segregation.  And since non-defaulting CCP members are on the hook for the entire default loss with segregation, this means that CCP members have more capital at risk under segregation than with an omnibus system.  That’s why Kim Taylor concludes: “Such a rise in capital costs could lead banks to ‘think twice’ about being in the clearing business, she said.”  A bigger share of a bigger amount translates into a lot more capital.

Given this, it’s no surprise that the omnibus account system has had survival value.  It is a way of controlling moral hazard.  It reduces the insurance benefits of clearing (from the customers’ perspective), but it reduces the costs of providing this insurance.  As is the case with virtually every insurance system, including the most prosaic automobile policy, you need something like a deductible to mitigate moral hazard. Insurance is almost never complete due to the perverse effects of moral hazard. Omnibus accounts play the role of mitigating some moral hazards in clearing.

I would hope that regulators ask why the omnibus system evolved, survived, and dominated before prescribing the sharing rule that CCPs adopt.  (I’ve told one regulator exactly that.)  The survival principle tells you something.  Before changing what is, ask why it is.  Believe it or not, there is very likely to be a good reason for it.  And with omnibus accounts, that reason is control of risk.

I have to quote just one more thing from the FT article:

But the issue highlights the complexities – and costs – of reforms.

Well, no sh*t.  Some people (sounds of throat clearing) have been saying that for literally years.  If only the Sorcerers’ Apprentices had appreciated that before passing Frank-n-Dodd.