Streetwise Professor

I’ve written frequently about the problematic evolution of financial market structure under a clearing mandate.  One concern is the proliferation of CCPs.  One potential reason for this proliferation is that exchanges will want to control their own CCPs.

Long before before the crisis, I wrote about this vertical integration issue, in detail.  I dismissed worries that vertical integration is anti-competitive.  But I did note a fundamental tension.  Large, multi-product (and hence likely multi-exchange) CCPs have advantages from a risk-bearing perspective (although perhaps not from a systemic risk perspective).  But vertical integration likely economizes on transactions costs.  Thus, “siloed” CCPs can make sense even if it does not optimize risk bearing.  But the trade-off is a real one, and hard to evaluate.

I know some, notably the Bank of England, are worried about silos because they are concerned that they inflate the costs of managing counterparty risk.  But transactions costs are real costs too.

Apropos all this, today the FT has an article about how LSE is putting together its own CCP. It has cleared through LCH, but for strategic reasons thinks it necessary to control its clearing.  Given that LSE was once held out as the exemplar of how exchanges didn’t need to control their clearing, this is big news.  It also puts an exclamation point to my arguments that the evolution of the clearing business is not going to be driven purely to reduce systemic risks.  Clearing decisions are going to be made by for profit firms with their own particular agendas.  This means that the evolution of the market is likely to be quite complicated, and lead to results that the clearing mandate evangelists have not contemplated.  The implications of this structure for systemic risk are by no means obvious.

And a story in WSJ Europe raises yellow flags, and perhaps red ones, about the EU’s clearing mandate plans.  Read it. It will all sound very familiar to regular SWP readers.  Like in the US, however, it is unfortunate that people are coming to grips with the complexities of clearing mandates–and the potential dangers–only after they are a fait accompli.

Tyler Cowen wrote a post about my Cato clearing piece, for which I am grateful.  Tyler was tepid in his appraisal: and I am tepid of my appraisal of his appraisal.

On a minor point, he says I say “not necessarily” too often.  Well, I am primarily responding to arguments that say or assume things to be necessary when they are not.  Moreover, even when things are not necessarily true, they may be true, and it would be overstatement to say otherwise.  I tried to be precise in my evaluations, and neither overstate nor understate the case.

More substantively, Tyler makes the two arguments that are least likely to persuade me: arguendo ad AIG, and “look, the CME did just fine during the crisis.”  Regarding the former, I think that (a) Tyler is guilty of hindsight bias, assuming that CCPs would have seen AIG’s positions to be exceptionally risky when nobody else did; (b) this is a red herring, as AIG positions would never have been cleared; and (c) the AIG case is far more complicated, as I argued extensively on SWP many moons ago.  With regard to the latter: (a) things at CME were dicier that he lets on, something else I’ve written about, and (b) this argument is fraught with selection bias, as CME cleared the stuff that was easiest to be cleared.  Even Tyler admits that clearing CDS with their jump to default risk would be very difficult; this is true of other instruments currently traded OTC too.

My biggest objection is that Tyler really doesn’t come to grips with any of the substantive arguments in the paper, including inter alia those relating to: (a) the question of how a putatively and seriously inefficient market structure could not just survive  but thrive and grow relative to the putatively more efficient alternative; (b) the information regarding default risk and the incentives of CCPs vis a vis dealers; (c) relatedly, moral hazard and adverse selection issues; (d) the differences in costs that hedgers will bear due to cash management costs, etc., (e) the potential loss of netting economies in clearing due to fragmentation; (f) relatedly, the possibility that the industry will evolve inefficiently due to the effects of strong scope and scale economies, jurisdictional issues, and the use of clearing for strategic purposes by exchanges; (g) the ability of affected firms to alter their financial contracting (capital structures) to undo most if not all of the leverage-reducing that is purportedly one of the benefits of CCPs and more restrictive collateralization; and (h) most importantly, the potential for systemic risk arising from CCPs.  I could go on, but these are the biggies.

Tyler does, in a way, address (h), but unpersuasively, IMO.  For instance, he says: “it seems to me that clearinghouses would have had a strong profit incentive to monitor or limit the kind of risk-taking which led to the A.I.G. debacle.”  Even overlooking the AIG reference, this is problematic.  There are two cases.

The first is that CCPs are mutual organizations or effectively mutual organizations, dominated by large financial intermediaries.  In that case, the CCPs would effectively inherit the incentives of these intermediaries, which Tyler apparently thinks are inadequate to induce them to police risks efficiently.  In addition, there would be all the problems associated with moral hazard, cooperative governance, and agency problems associated with multiple principals.  (Ironically, Tyler effectively concedes this point in one of his older posts that he links to where he expresses reservations about ICE Trust.)

The second case is that CCPs are for profit firms, collecting fees, potentially in competition with one another, and taking on tail risk.  Indeed, the entire business of a CCP is taking on tail risk.  But we know that pricing that risk is hard, and that moreover, shareholder incentives often lead financial institutions to underprice that risk, or to take on too much of it (which amounts to the same thing).

So Tyler, in effect, is reduced to arguing that CCPs are easier to regulate: “The key point is that a clearinghouse can more easily be forced to carry heavy capitalization and said capitalization, unlike with a current bank, cannot so easily be undone by off-balance sheet transactions or hidden leverage.  The clearinghouse has different incentives and is much easier to regulate and therefore we should put some more trust in them.”

Somehow, putting more trust in regulators is hardly calculated to build confidence.  The point that CCPs are likely to have simpler capital structures that make it harder to take on hidden leverage is a good one, but in many respects the portfolio of risks a CCP takes on is very complicated and difficult for a regulator to appraise properly.  Again, it is all tail risk, and in a mandated environment, said risk will involve more complicated, less liquid, more difficult to evaluate instruments, and crucially, will also depend on the balance sheet risks posed by the firms it clears.  These firms can take on hidden leverage, off-balance sheet transactions, etc., so regulators have to look through the CCP back to the same institutions that allegedly are the problem in the incumbent structure.

Furthermore, as I argue above, CCP incentives are far more problematic than Tyler lets on.  Moreover, CCPs, whether for-profit firms or mutuals, have the incentive to influence regulators in the same way banks do.  Putting all this together, I don’t think it is quite as easy as Tyler does to determine the right level of CCP capital or to monitor its operations.

I’ve written many times that I do not know for sure what the optimal organization of counterparty risk allocation and pricing mechanisms is.  Nobody does.  I have often emphasized that I intend to raise issues and arguments that are grounded in good economics but which have gone unraised and unanswered in the conventional paeans to clearing.  If advocates of clearing have a good case, they could meet these arguments head on, which they have not done so far.

After reading Tyler’s piece, I have to say that most of the substantive arguments I’ve raised still remain unengaged.  So skeptical I remain.  I appreciate Tyler’s taking the time to take my piece seriously, and am encouraged that he recognizes the need for a comparative approach., but would respectfully suggest that he should take a harder look at the real problems that CCPs must confront.  I think if he does that, he’ll have more concerns about clearing mandates than he has expressed heretofore.

The FT ran a rather bizarre editorial on end user exemptions from clearing mandates.  As seems to be the wont of clearing advocates of late, it is strident, but hardly persuasive.

Here’s the core of the argument:

But the fact that reform might impose higher costs on non-financials is precisely the reason for sticking to it. Costly margin requirements indicate that the derivatives companies purchase not only insure them against adverse market movements but can require them to make substantial payments should market conditions move against them. If OTC derivatives are cheaper than taking out insurance, this suggests that the systemic risks of the OTC market and the banks that dominate it are being borne by taxpayers. Ending this subsidy would force corporations to bear the fair economic cost of their actions.

This is apparently the S&M theory of public policy: unless a policy inflicts pain, it is ineffective.  The more costly a policy is, the better it must be!

Here’s my most charitable characterization of the argument:  Due to Too Big to Fail, banks subsidize their customers.  In particular, they subsidize them by taking on default risk and not charging for it.  Therefore, it is necessary to impose costs on these customers in the form of collateral requirements in order to eliminate the subsidy.

Here is one testable implication of this theory: in the absence of TBTF subsidies, all deals will be fully collateralized.

This implication is refuted by experience.  For instance, prior to the formation of the Chicago Board of Trade Clearing Corporation (under government pressure), margining was discretionary.  Exchange rules permitted parties to demand margin: it did not require it.  Routinely brokerages extended credit to their customers and to other brokerages that they traded, and did not require the posting of initial margins, and only required posting of variation margins when a pre-established  credit limit was breached.  These brokers were not the beneficiaries of any TBTF subsidy.  So, credit exposure via incomplete collateralization existed even in the absence of a TBTF subsidy.

Moreover, this theory doesn’t explain why the credit terms extended by OTC dealers vary by customer and deal.  Such variation in credit terms means that dealers are evaluating credit and charging for it based on the nature of the customer and the trade.  Of course, it is possible that these terms are too generous overall (due to TBTF) but the behavior of dealers belies the simplistic story that the FT spins, to the effect that dealers don’t care about credit risk in doing derivatives deals, and hence it is necessary to deny them the discretion to choose their own credit terms.

Furthermore, the FT editorial, like much of the pro-clearing discussion, implicitly assumes that everything else will remain the same after the imposition of a clearing mandate; collateralization will reduce counterparty risk in derivatives trades, and other credit risks will remain unchanged, so overall banks will face fewer default risks.  This is certainly incorrect, and market participants will respond to a mandate by taking actions that undo much of its effect.

For instance, the mandate that all deals be collateralized effectively tells dealers: Thou shall not extend credit through derivatives transactions.  But there are multiple ways that dealers can extend their customers credit.  In particular, if precluded from extending unsecured credit through a derivatives trade, they can substitute other forms of unsecured credit for that they would have offered their customers via derivatives.  Now, revealed preference implies that this is not the preferred arrangement, as otherwise end users and dealers would have chosen it in the first place.  But the use of other forms of credit to finance, effectively, margin/collateral will almost certainly be a second best response to the mandate.  Thus, collateral requirements will do far less to reduce the amount of credit and leverage in the system than their advocates believe.

Moreover, and perhaps more importantly, if TBTF subsidies are the Original Sin, merely foreclosing one way to exploit these subsidies will have little effect on the riskiness of banks.  So if dealers are foreclosed from exploiting TBTF subsidies in their derivatives business, they have every incentive to find other ways to do so.  And they are sure to be creative.

That is, TBTF subsidies are like water.  They will find some outlet.  Dam up one outlet, and the water will find its level through some other channel.  So maybe OTC derivatives won’t be the source of the next crisis (just as they weren’t the source of the last crisis), but if TBTF continues to exist, risk taking will be continued to be subsidized, some excessive risks will be undertaken somewhere, and inevitably, this will cause problems down the road.

But whatever the next crisis, we may be able take comfort that derivatives will not have caused it.  Very cold comfort.

There will be other unintended consequences.  Even though dealers and other intermediaries are likely to try to design financing methods and provide services that reduce the operational and financial burden of end user collateral requirements, again by revealed preference, these alternatives are more burdensome to end users than the incumbent system.  As a result, some end users will decide not to hedge; others will hedge less.  Others will adopt different capital structures that are less efficient.  As a result, more end users will suffer financial distress, and others will incur costs in the form of less efficient investment policies, etc.  These are real costs.  And they can result in defaults–just not on derivatives trades.  Are we really better off when a firm that eschews hedging because of the higher burden inherent in collateralization defaults on its debt to a bank when the risk it would have hedged comes to pass?

If TBTF is the real problem, it is counterproductive to try to address it through micromanaging the ways that financial institutions  attempt to exploit the TBTF subsidy.  Deal with the real problem–the subsidy–rather than attempt to anticipate and foreclose every possible way that clever bankers can attempt to milk this subsidy.  Deal with TBTF upstream, not downstream.

Like a child’s security blanket, clearing and collateral mandates give some a sense of warmth and security.  And a false sense of security, as it turns out, because they do not eliminate or even reduce substantially the true source of danger in financial markets.

On Friday I attended a conference on OTC clearing sponsored by the Chicago Fed.  The conference was excellent, and organizers Ed Nosal and Robert Steigerwald of the Fed, and Darrell Duffie of Stanford, did an excellent job of assembling a stellar group of speakers.  I had the privilege of moderating (Me?  A moderator?) one of the panels.

The speakers represented all of the major constituencies; sell side/dealers, buy side, end users, exchanges, CCPs, regulators.  Perhaps not surprisingly, there was little consensus on important issues relating to governance, organization, capital requirements, collateral, the number or size of CCPs, or any of the important matters that still remain to be decided.  It is evident that the coming months and years will be fraught with uncertainty as the industry gropes towards equilibrium in the Brave New World of Dodd-Frank.

The lunchtime speaker was Citadel founder Kenneth Griffin.  Griffin gave a paean to central clearing, and to Dodd-Frank more generally.  Clearing is cheaper operationally and administratively.  It reduces risk.  It economizes on capital.  It is the cure for all that ails the financial markets.

So if it is so wonderful, what stands in the way of its adoption?  Per Griffin: a small, self-interested cabal of dealers who reap billions and billions of profits at the expense of end users, and who will lose their ill-gotten gains in a cleared world.

This narrative is a familiar one, the stock theme of the advocates of central clearing.  And as I’ve said on numerous occasions, this story begs far more questions than it answers.  Most importantly, if the efficiencies of clearing are so manifest, and the market power losses so large, why don’t basic competitive forces undermine dealer dominance?  An inefficient business, with high monopoly markups on top of that, is a juicy target for entry by more efficient suppliers.  You would expect such a business to suffer erosion in market share; quite rapid erosion, in fact.  But the reverse has happened to dealers in recent years, as OTC markets have grown absolutely and relatively.

Maybe competition doesn’t work, or works differently, in OTC derivatives markets.  If so, it would be nice to have a convincing model, backed by empirical evidence, to explain such an anomalous outcome, so different from the received understanding in economics, and from the experience in many other industries.  Needless to say, Griffin didn’t provide either model or evidence.

He didn’t help himself by quoting OCC data about concentration in US OTC markets.  This is akin to the drunk looking for his wallet under the lamppost.  The OCC data are readily available and easy to use, but they are incomplete because they only cover US banks.  More comprehensive surveys indicate that there are currently 10 or 11 major international dealer firms; there were 14 prior to the crisis.  I’d be interested to hear Mr. Griffin identify other industries with 10-14 major competitors, and argue that they are similarly uncompetitive.

Moreover, it is well known that concentration figures can be very misleading measures of competitiveness.  They do not measure the effects of potential competition.  Moreover, concentration ratios are endogenous.  As Demsetz showed long ago, industries can become concentrated and profitable as efficient producers gain market share at the expense of less efficient rivals.

It’s not just me, folks.  After Griffin’s talk, I chatted with an economist, a former colleague with a very responsible non-academic policy and research-oriented job who was unpersuaded by Griffin’s jeremiad.   This individual said: “He ignores the IO [industrial organization] questions.”  Exactly.  Why is the industry organized this way?  Why doesn’t competition erode market power and market power rents?  Why don’t putatively more efficient organizations and institutions (clearing, in Griffin’s view) displace less efficient ones?  Why do the inefficient survive?

He brought up energy, in which clearing has made strong inroads in the past 8 years, to bolster his point.  The problem is that the case of energy suggests quite the opposite.  Clearing grew in energy naturally, organically, without a push from Dodd, or Frank, or the Fed or anybody else.  If this can happen in energy, and this is efficient, why can’t it happen in other sectors of the OTC market?

Inquiring minds, open to persuasion, want to know.  Griffin didn’t deliver.  What he did deliver was a sermon, complete with saints and devils.

Moreover, the Citadel commander’s argument presumes that end users–who, as he properly notes, must be the ultimate source of any dealer market power profits–are the victims of some sort of battered spouse syndrome.  For end users are among the most vociferous opponents of clearing mandates.  FMC Treasurer Thomas Deas was quote outspoken on this score at the session immediately prior to Griffin’s speech.  Why are end users the most ardent defenders of a system that is supposedly rigged against them, and robs them blind?

Griffin also failed to analyze seriously the trade-offs of alternative ways of allocating and pricing counterparty risk.  No suggestion of any comprehension of issues relating to the information and incentives to price and manage counterparty risk.  No mention of moral hazard or adverse selection.  No discussion of how the industry will evolve and how this will affect the ability of clearing to realize its full potential.  Most importantly, no mention of the potential systemic risks in clearing–a point mentioned prominently in the opening remarks at the conference delivered by Chicago Fed President Charles Evans.

He did acknowledge objections to clearing mandates–but in an incomplete way, and in caricature.

If the substance was, to me, unpersuasive, the delivery and tone were off-putting in the extreme.  “Supercilious” hardly does it justice.

The serious people who spoke on all sides of the clearing issue during the conference proper raised many interesting arguments and issues.  They made it plain that the way forward will be complex, and that it is by no means evident that the way mapped out by Frank-n-Dodd will improve the efficiency, stability, and safety of the financial markets.  Griffin’s talk was, in contrast,unserious, one-sided, and ultimately unconstructive.  Manichean sermons, delivered in sneering and belligerent tones, are like that.

I saw the headline of this Matt Leising article, “Lehman Derivatives Records a Mess,” and reflexively thought it would be about its OTC trades (of which there were, if memory serves, over 900,000 if memory serves).

I was wrong.  It was about its exchange traded–and cleared–positions:

Barclays PLC had no idea how big Lehman Brothers Holdings Inc.’s futures-and-options trading business was when it considered taking over the defunct bank’s derivatives trades at exchanges in 2008, a Barclays executive said.

“Lehman’s books were in such a mess that I don’t think they knew where they were,” Elizabeth James, a director of Barclays’s futures business, testified today in U.S. Bankruptcy Court in Manhattan. James worked on Barclays’s purchase of Lehman’s brokerage during the 2008 financial crisis.

She said she received an e-mail from former Barclays trading executive Stephen King saying Lehman had “absolutely no idea” if it had sold $2 billion more options than it had bought, or whether it owned $4 billion more than it had sold.

. . . .

Transferring margin together with trading positions “is normal practice in the ETD business,” she told U.S. Bankruptcy Judge James Peck, referring to Lehman’s exchange-traded derivatives. “You’d be crazy if you didn’t.”

She said Lehman’s lack of records initially prevented her from performing “due diligence” to discover what Lehman’s and its customers’ positions were, where Lehman kept its bank accounts, and who its brokers were.

James said she had seen a tabulation of Lehman’s positions at the Options Clearing Corp. showing that the daily margin requirements for its trades had varied by as much as $1 billion within a few days in September 2008.

Moral of the story: moving more trading to exchanges, exchange-like systems, and clearing will not necessarily lead to greater clarity about the positions that big entities like Lehman hold.  One of the arguments for clearing has been that it will improve regulatory transparency, and help regulators figure out where the risk is and who is exposed to whom.  Even overlooking the basic fact that it is possible to have centralized trade reporting without mutualizing credit risk through clearing, the Lehman story shows that this alleged advantage has been vastly oversold.

Big complicated firms have big, complicated, and dynamic positions that are hard to keep track of, regardless of where and how they are traded.  There is a long, long, long way to go before even approaching the ideal of “mapping” risk in the financial system.  More centralized collection of information is a necessary, but by no means sufficient, condition to achieve this goal.

The Lehman story should be a cautionary tale to all those who naively believe that waving a legislative wand and casting a spell that drives trading to exchanges will magically eliminate all of the huge operational difficulties associated with measuring and managing risk.

I’ve been writing for some time that Frank-N-Dodd will open a battle over derivatives market structure.  This battle will be waged in the markets, and in the political and regulatory arenas.  In particular, clearing mandates will lead to a protracted conflict.  The nature of the clearing business, with its strong scale and scope economies and the myriad competitive implications of alternative configurations of the clearing business will make this battle particularly intense.  And the stakes will be particularly high given the importance of clearing in the new financial architecture.

In an article forthcoming in the Journal of Applied Corporate Finance, I put it this way (link to follow when it’s available):

It is well known that the effects of central clearing on the costs of bearing counterparty risk and on systemic risk depend crucially on the equilibrium configuration of the clearing industry.  For instance, netting benefits are maximized when clearing is concentrated into a small number of multi-product clearinghouses—and arguably into a single CCP.  But the failure of an immense CCP would have disastrous consequences for the stability of the financial system, and could set off a daisy chain of failures of other CCPs, with further damaging effects.  Moreover, the scale and scope of CCPs are almost certain to affect incentives, governance costs, and the effectiveness and accuracy of risk pricing.  So it is by no means obvious what is the structure of the clearing market that optimally trades off these competing considerations.

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.

Relatedly, governance and organizational form will matter.  For instance, for profit and not-for-profit mutual CCPs are likely to act differently.  Which choice is preferable?  What will determine CCP choices of organizational form?  CCPs are effectively cooperatives: how will collective action problems affect their incentives  and actions?  What regulations are required to address the governance problems that might arise under each form?  These are not easy questions to answer, but those answers will have an important effect on how clearing works in practice.

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.

I’ve written elsewhere–long before the crisis, in fact–that there is a fundamental tension in clearing organization.  Risk control and moral hazard considerations provide a strong rationale to limit participation in CCPs, and/or to impose substantial capital requirements on participants.  But limiting membership to CCPs can also be a way of cartelizing the industry: given the strong scale and scope economies, a CCP that has fewer than optimal members can still be large enough to make it impossible for any other competing CCP to achieve the scale economies to compete with it.

What’s the right trade off?  Barney?  Chris?  Gary?

The politicized process is underway.  Bloomberg’s Matt Leising (article not online, it appears) and the WSJ describe how the battle lines began to form at a recent CFTC-SEC public workshop.  The competition-risk trade-off is a main axis of conflict.  First Matt Leising, describing the arguments of those who favor opening up CCPs to encourage competition:

Financial firms should be allowed to become members of over-the-counter derivatives clearinghouses even if they don’t meet current minimum capital requirements, according to an industry group. The Commodity Futures Trading Commission and Securities and Exchange Commission should allow smaller firms that don’t meet clearinghouse guidelines to become members, said Jason Kastner, vice chairman of the Swaps and Derivatives Markets Association.

Kastner spoke at a roundtable discussion today on OTC derivatives clearing at CFTC headquarters in Washington. Clearinghouse operators Intercontinental Exchange Inc., CM Group Inc. and LCH.Clearnet Ltd. in the $615 trillion privately negotiated derivatives markets enforce capital requirements and trading rules intended to bolster the ability of their organizations to withstand losses. Those requirements prevent all but the world’s largest banks, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Barclays Plc, from sending trades to the clearinghouses, the SDMA told the Federal Reserve in June.

“It’s not just about capital,” Kastner said today, referring to rules such as Intercontinental’s that members of its credit-default swaps clearinghouse have a minimum net worth of $5 billion. Regulators should create and enforce rules so that smaller firms can become members so “that it’s somehow proportional.”

But then Matt notes that some argue that Dodd-Frank is about reducing systemic risk, and has nothing to do with competition:

The main purpose of the financial-reform law, named after its principal authors, Connecticut Senator Christopher Dodd and Massachusetts Representative Barney Frank, was to make the financial system stronger by increasing risk-management standards, said Jonathan Short, a senior vice president at Intercontinental.

“It all sounds great on paper to say ‘let a thousand flowers bloom,’” he said. “I’ve never heard the Dodd-Frank Act
described as something that was done to promote competition among firms.”

[It should be noted that Dodd-Frank does include provisions encouraging competition and enjoining CCPs not to violate anti-trust rules.  How to reconcile that with the injunctions to reduce systemic risk?  Who knows?  Not Dodd and Frank’s problem.  They just wave their wands and presume the broomsticks will take care of it.]

This all makes some people nervous:

Ananda Radhakrishnan, director of the CFTC’s Division of Clearing & Intermediary Oversight, said he would hesitate before telling clearinghouses to lower their capital standards for members.

“As someone in charge of clearing, I’m reluctant to tell someone ‘you should lower the level of capital,’” he said. [In charge of clearing?  Think much of yourself, Al Haig Radhakrishnan?]

The WSJ article notes that people have picked up on the tension inherent in the issue:

James Hill, a global credit-derivatives officer at Morgan Stanley, warned that if companies without proper risk management expertise were allowed into the clearinghouses, “they will become the next “too big to fail,” and we don’t want to do that.”

After J.P. Morgan Chase & Co. managing director Jeremy Barnum said regulators would have to weigh “very complicated tensions” in determining how to write the rules, Mr. Kastner shot back that “it’s not credible to say it’s complicated.”

Not credible, indeed.

So, barely weeks after the passage of Dodd-Frank, we are seeing the sausage making process begin.  Efficiency and rent seeking and competitive considerations are all going into the hopper.  Who the hell knows what will come out the other end?  The potential for a colossal mistake–or mistakes–is great.  And these mistakes will be systemic in the effect.  For as I also say in the JACF piece:

This change is fraught with potential unintended consequences.  It is predicated on a belief that market participants systematically chose the wrong ways to trade derivatives and allocate the default risks inherent in them, but there strong reasons to believe that in fact many of the institutions adopted prior to the crisis had a strong economic rationale.  This means that forcing the implementation of a particular market infrastructure via legislative fiat runs the serious risk of reducing the efficiency of the financial markets.  In particular, although it is intended to reduce systemic risk, the mandating of expanded clearing carries its own systemic risks.  Moreover, the future evolution of market structure is highly uncertain, especially given the cost characteristics of clearing and the fact that this evolution will occur in a highly regulated environment in which political—and rent seeking—influences will play an important role.  Very bad evolutionary paths are certainly possible.  In brief, the effects of Dodd-Frank on the efficiency and stability of the financial markets are highly uncertain at best, and highly unfavorable outcomes wholly unintended by the authors are quite possible, and indeed, likely.

One final thought about systemic risk.  It is worth remembering that the imposition of a single, one-size-fits-all infrastructure is inherently systemic in its effects.  Any flaw or failure in that standard structure will have systemic consequences.  A mandate that is ill-adapted to the fundamental economic conditions in the derivatives markets creates a systemic risk because (a) ill-adaption makes failure more likely, and (b) the sweeping breadth of the mandate means that the effects of such a failure will be system wide in scope.

But have no worries, Gary Gensler tells us: “U.S. regulators won’t succumb to Wall Street efforts to weaken financial-market oversight as they implement the biggest rules overhaul since the Great Depression.”

Just how is this supposed to happen?  Yes, interested parties–and not just the big banks–have an incentive to shape the rules to benefit them.  But interested parties also have the best information and the greatest knowledge.  Are Genlser and the other regulators to shut their eyes and ears to what industry participants tell them?  That would mean ignoring the good advice, as well as the bad, self-interested kind.  If not, how are they to distinguish between the good and the bad?  Mistakes are inevitable.

This information problem is inherent in regulation, especially when involving something as incredibly complex, dynamic, reflexive/responsive, and interconnected as the financial markets.  Painting this as a morality play between the good government types (the “Goo goos” in Boston Mayor James Curley’s trenchant phrase) and the malign self-interested banks is insultingly simplistic.

Congress and Obama have given regulatory agencies the authority to lead the industry, but no map to show them where to go.  The blunder potential is huge.  The cacaphony  of voices, reflecting differences in information, interest, and motivation, will make it difficult to avoid such blunders.  Last week’s meeting gives just an inkling of the conflicts to come.

But I’m sure it will all turn out well.  It always does, doesn’t it?

You don’t have to answer that.

Jeremy Grant is going to town with stories and video interviews on the implications of clearing mandate on his FT TradingRoom site.  One that particularly caught my attention was this interview with Guy Sears.  They discussed the implications of clearing mandates on pension funds.  Sears says (about the 5:55 mark):

It’s about the governance and who carries the risk in this model.  Clearinghouses work by seeing an instrument and worrying about the risks of failure in an instrument.  How far away has it got from its original price?  What’s the market risk in the instrument?  At the end of the day, of course, what really matters is whether the guy holding the instrument is good for his money.  We would say that the pension schemes and savings pools are good for their money.  Making them provide margin to pay for everyone else’s risk is asking them to take part in socializing risks they really should have to pay for because they aren’t risky.

Sears makes a point that I’ve emphasized from early on that has largely been overlooked.  Specifically, two factors interact to determine the risk of default: instrument risk and balance sheet risk.  CCPs price instrument and generally don’t price balance sheet risk, except in the crudest and most problematic of ways.*

As Sears says, balance sheet risk–the risk that “the guy holding the instrument is good for his money”–is crucial.  Not pricing it leads to distortions in the allocation of trading activity across market participants.  It also means that those who use clearing do not pay a price for adding balance sheet risk, which distorts their risk taking decisions.

Sears effectively objects to charging pension funds the same price for risk as a hedge fund pays.  This is a fair objection.  It harms pension funds directly, but it can also distort trading activity, causing hedge funds to trade derivatives relatively more than they should, and pension funds relatively less.  Does this reduce systemic risk?  That seems difficult to argue.

Moreover, different entities have different ways of effectively undoing the effects of clearing.  High and frequently adjusted margins on cleared products mean, essentially, that market users are not in a credit relationship with the CCP, in the same way that they can be in a bilateral dealing.  But this means that mandating clearing frees up credit capacity that can be used to undo, in whole or in part, the debt-reducing effects of clearing.  Some entities, notably pension funds, have less ability to leverage up (and indeed, given their high creditworthiness, are not really in that much of a credit position relative to their counterparties in any event).  This means that a clearing requirement would hit pension funds particularly hard, and unjustifiably.

Pension funds will respond by (a) reducing their usage of derivatives, and (b) reducing their investments in higher return assets in order to accumulate the cash needed to post margins on the derivatives they do trade.  Response (a) means that these funds will incur higher transactions costs to achieve their investment and liability management objectives, and will bear more risks.  Response (b) means that pensions will be less remunerative.

The Frank-n-Dodd bill exempts retirement funds from the clearing mandate to the extent that they utilize derivatives for risk management/hedging purposes.  It is ambiguous whether this exemption would, for instance, cover a fund’s use of an equity derivative or commodity derivative contract to achieve an investment objective.  But the recognition that retirement funds might deserve different treatment is one good thing I can say about Dodd-Frank.  (Although it’s not evident whether this exemption was the result of a fluke moment of lucidity, or the lobbying power of pension funds–including public and union funds.  The latter would be rich indeed.)

But Sears’s main point holds.  Balance sheet risks are an important determinant of counterparty risks.  CCPs don’t price this risk.  This lack of risk pricing is costly.

* CCPs often impose capital requirements, but these are generally multiples of margins.  Since margins don’t vary with balance sheet risk, these capital requirements don’t either.  Moreover, CCPs sometimes condition margins on credit ratings.  Given the crudity of these ratings, and the perverse feedback that results from ratings change-induced increases in margin, this is a coarse and potentially destabilizing way of pricing balance sheet risk.

Commentor Matt asked my views about the clearing portion of the Squam Lake Report on Fixing the Financial Crisis, which was written by a group of distinguished finance academics.  Since I know that the rest of you were waiting with bated breath but were just to shy to ask, here it goes.

In a nutshell: superficial, question begging, and at times contradictory.

The superficiality is perhaps understandable, because the report was intended to be a high-level overview understandable by policy makers and the public.  But it does undermine the persuasiveness of the report.  Indeed, it makes it potentially dangerous if policy makers aren’t fully aware of the limitations of the analysis.

The Report identifies “two important advantages of clearinghouses” (p. 113): netting and “by standing between counterparties and requiring each of them to post appropriate collateral, a well-capitalized clearinghouse prevents counterparty defaults from propagating.”

Many problems here.  First, as the Report itself acknowledges (pp. 116-117), although clearing has the potential to exploit more completely netting economies, if CCPs are fragmented, adoption of clearing can actually result in a loss of netting economies.

Second, netting benefits are largely private, and if counterparty risk is costly and collateral is a costly way to mitigate it (propositions that the Report accepts), why don’t market participants organize their transactions and create institutions to exploit efficiently these netting economies?  Indeed, mightn’t the growth of large dealers and the failure to implement clearing more comprehensively be the best way to exploit netting economies across the full range of derivatives products (and other scope economies between derivatives and non-derivatives businesses)?  The survivorship principle would suggest so.  These are important, but begged, questions that bear directly on the relative merits of cleared and bilateral markets.

Third, the Report veers into Steve Martinesque How to Make a Million Dollars Without Paying Taxes territory in assuming that CCPs will (or enjoining them to) choose “appropriate” collateral and are “well-capitalized.”  Define “appropriate.”  Define “well-capitalized.”  What are the informational requirements to make these determinations?  Who has the information?  Do the CCPs?  Will regulators?  What are the incentives of CCPs (and their members) to choose “appropriate” margins and be “well-capitalized”?  How do those incentives compare to those in place in a bilateral OTC market?  If negative externalities from default propagation among systemically important financial institutions are a flaw in the existing financial infrastructure, why would one expect a CCP whose residual risk bearers are systemically important financial institutions to choose margin levels and capitalization to internalize that externality?  More begged questions.

Fourth, the statement that CCPs “prevent counterparty defaults from propagating” is not necessarily correct.  Clearinghouses can fail, and lead to the propagation of defaults.  Indeed, one of the self-contradictory parts of the Report acknowledges this: “even a well-capitalized clearinghouse can fail.  The failure of a clearinghouse for all OTC derivatives is likely to have enormous systemic consequences” (p. 117).  Once you recognize this, you need to take seriously the issue of whether CCPs are more or less vulnerable to this propagation than bilateral structures.  The Report fails to address this crucial issue.

The Report is similarly schizophrenic on AIG.  In the chapter on clearing, it states that clearing would not have been sufficient to prevent “the AIG catastrophe” (p. 114).  But in its conclusions, it states “[f]inally, by giving AIG an incentive to use and clear standardized CDS contracts, our recommendations would have reduced AIG’s systemic importance” (p. 149).  Well, which is it?

The former judgment is correct; the latter, not.  Even based on the limited and rather one-sided characterization of the virtues of clearing, it is plain that clearing would not have made much of a difference in the AIG case.  Netting wouldn’t have made a damn bit of difference, because AIG wasn’t a dealer with a lot of offsetting positions.  It had a huge net position on one side of the market.  The same financial firms that would have been harmed by an AIG failure in September, 2008 would have been on the hook in an alternative world where the AIG deals had been cleared, either as members of the CCP, or as counterparties with large net positions that would have been owed money by the CCP, or likely both.  “Appropriate collateral” probably wouldn’t have made a whit of difference either.  The conventional wisdom at the time was that the instruments AIG traded were of very low risk, and hence it is highly likely that original margin amounts wouldn’t have been so large as to dissuade AIG from taking big positions.  Indeed, AIG’s creditworthiness and the low perceived risks of the positions led its counterparties to enter into big trades without demanding independent amounts; if a CCP had demanded cash collateral up-front, AIG could have used that creditworthiness and low perceived risk to borrow to fund the margin.  Moreover, the Report fails to analyze the full implications of a reduction in AIG’s positions resulting from clearing, or higher capital requirements, or whatever.  Since the AIG trades essentially transferred risks, how would hampering AIG’s ability to take on that risk have affected the amount of that risk in the financial system and the efficiency of the distribution of that risk?  The answers to those questions aren’t obvious, nor are they self-evidently that a reduction in AIG’s positions would have mitigated the effect of a real estate price collapse on the financial system.

The Report repeatedly assumes away crucial problems of implementation of its recommendations.  For instance, it recommends “appropriate differences between capital requirements that are cleared and not cleared.”  Again: What is appropriate?  What information do you need to make that determination?  Who has the information?  Do they have the incentive to use it?  Can such price controls–and that’s what they are–be gamed by parties better informed than those who set them?  Could the systemic consequence of such gaming be worse than the disease that the capital requirement differentials are designed to cure?

Relatedly, it recommends that due to the systemic importance of CCPs, regulators require “appropriate collateral” (there’s that “A” word again); “strong operational controls”; and “sufficient capital.”  All of the questions raised in the previous paragraph are begged on these issues as well.

The authors of the Report mimic Goldilocks on the issue of the structure of the clearing sector (pp. 116-117).  Too many CCPs are bad, because this fragmentation can impede exploitation of netting economies.  Too few CCPs are bad, because that makes the financial system too vulnerable to the failure of one of these behemoths.  So how many is just right, Goldilocks?  And how are we going to get there?

The answer:

[r]egulators and lawmakers should not intentionally or unintentionally promote the proliferation of redundant or specialized clearinghouses.  The proliferation of clearinghouses would create unnecessary systemic risk by eliminating opportunities to reduce counterparty risk (p. 117).

Thanks a lot.

Indeed, the evolution of this industry going forward will determine the effects of clearing mandates, or other measures to favor clearing.  For far more reasons than the Report mentions, it is quite possible that the industry will evolve in a way that worsens the stability of the financial system.  And there are strong reasons to believe that the industry will not necessarily evolve in a salutary way.

First, the pervasive scale and scope economies mean that the industry is unlikely to evolve in an efficient, competitive fashion, or that the resulting structure will be systemically more robust.  These economies tend to favor consolidation into a relatively small number of systemically vital, and vulnerable, CCPs.  Moreover, this structure can impede competition (a point that the Report acknowledges).

Second, the Report’s rather naive injunction to regulators and lawmakers aside, jurisdictional considerations will tend to induce fragmentation.  Every major jurisdiction wants a piece of the clearing pie, for economic reasons, and for reasons of political control.  It is also likely that governance and control issues will also lead some market participants to favor specialized  (by product or geographically) CCPs (over which they can exert influence) over broader ones.

Third, political economy considerations completely ignored in the Report–but not in the real world–will also affect the evolution of the infrastructure.  Market participants will attempt to influence legislators and regulators on capital levels, margin levels, operational risk controls, the numbers of CCPs, etc.  We are already seeing industry pressure regarding membership requirements for CCPs–an issue that has both competitive and systemic risk implications.

Just who knows what kind of structure will evolve from these cross-currents of economic and political forces (with the politics rooted, of course, in economics and rents)?  I don’t know for sure, but am deeply concerned that the political economy dynamics will seriously distort the process in a way that reduces the efficiency of the market during normal times, but doesn’t reduce–and may increase–its vulnerability to crises in abnormal ones.  The Olympian, and superficial, analysis of the Report doesn’t come to grips–at all–with these weighty matters.

In brief, the clearing chapter (and related material) in the Squam Lake Report is too incomplete, and sometimes flawed on those issues that it does address, to provide actionable policy guidance.  And since that’s the purpose of the Report, it it is unsuccessful on its own terms.