Streetwise Professor

Gazprom’s customers are continuing their fight against its pricing practices.  Apparently never having heard of Marshall Field (“the customer is always right”), Gazprom is blaming the buyers for their stupidity and mistakes:

OAO Gazprom said it isn’t responsible for its customers’ “strategic mistakes,” signaling Russia’s gas-export monopoly may not compromise in a pricing dispute with European utilities.

“In 2010, strategic mistakes were made in assessing the market outlook, with hopes for very cheap gas and further collapse of spot prices,” Sergei Komlev, head of pricing and contract formation at Gazprom’s export division, said in an interview at his Moscow office. Buyers are seeking “one-off help, given the difficult situation they found themselves” in.

. . . .

“Some of our partners expected they’d be able to sell gas to their clients cheaply by mixing Russian and spot gas, which turned out to be wrong,” Komlev said. “The first thing our clients have to do is admit the mistake they have made during the sales campaign of 2010. The general market obsession with low spot prices has proved to be a wrong strategy.”

This is so much gibberish.  Gazprom’s customers’ problem is that its prices are linked to oil prices (gasoil and fuel oil prices, actually, on a lagged basis), and oil prices have diverged from world gas prices.  Yes, perhaps the increase in spot prices has hit European customers, but these prices are still well below the oil-based Gazprom price.  For instance, the gas price at the TTF hub in the Netherlands is about $350/mcm, and has hovered around that level since December of last year (The price quoted in Bloomberg is per MWh, which can be converted to a price per MCM).  In contrast, the German Border Price for Russian gas is about $450 (it was $400+ last month).

Gazprom’s sweetheart spokesman Komlev (check out the video–and note the liar’s look down and to the left when answering the question about whether Russian gas prices are too high) has this to say:

“A deep connection between oil and gas prices has remained and even grown stronger.”

The gap between spot and contract prices isn’t as “gigantic” as it was in the past two years and will narrow closer to winter because of seasonal demand, Komlev said.

The only thing deep is the manure Komlev is spreading.  Well, that and his homey from ING Financial:

“The problem with the spot market is that it is not liquid enough and spot prices are highly volatile,” Igor Kurinnyy, an oil and gas analyst at ING Financial Markets in London, said by e-mail. “The oil link in Gazprom’s price formulas will stay in place for the time being.”

Insofar as a “deep connection” is concerned, the data clearly say otherwise.  Gas and oil prices have diverged.  And if there’s such a deep connection, then it should be a matter of indifference to Gazprom as to whether it prices off of oil or off of spot prices.

I guess not.

As for liquidity, (a) liquidity is increasing, (b) liquidity would increase substantially if Russian gas were priced off of spot, and (c) there are numerous markets in the US where large quantities of contract gas are priced off of spot prices with modest levels of liquidity.

Gazprom’s testiness over its pricing mechanism reflects the fact that it is increasingly under siege, and not just from European utilities.   Gazprom has played divide-and-conquer for years.  It has repeatedly tried to scare the Europeans by threatening to sell gas to the Chinese.  But that’s no longer working.  The Chinese are bargaining hard, and have lined up large quantities of gas from Central Asia.  So in order to try to put pressure on the Chinese by convincing them that they’ll send gas elsewhere, the Russians are reaching out to one of the charter members of their Coalition of the Losers, North Korea (other members–Venezuela, Syria, Libya–whoops, scratch that one), with a truly risible proposal to build a pipeline through North Korea to sell gas to South Korea.  Like the South Koreans are going to put themselves at the mercy of Kim Jong Il and the nutocracy to the north.  And like the Chinese need the gas.  I’m sure they’re rolling on the floors in Beijing.

So it can’t play the Chinese against the Europeans.  It can’t play the Koreans against the Chinese. The threat from the spot market is growing with gas supplies around the world. So Gazprom is left to treat its European customers like Otter treated Flounder:

Time and the markets are not on its side. It can insult now, but more options are becoming available, which will put increasing pressure on the oil-linked pricing mechanism. Which means that the company will have to come up with somebody a helluva lot slicker than Komlev to make their case in the future–because it will have no case.

I was incorrect to blame the leak of confidential CFTC trade information on the agency itself.  I jumped to a conclusion, and that was wrong.

The malfeasor has been revealed.  It is US Senator Bernie Sanders (Socialist–really–VT):

Oil trading data that exposed the extensive positions speculators held in the run-up to record high prices in 2008 were intentionally leaked by a U.S. senator, sparking broader concern about industry confidentiality as Congress moves on Wall Street reform.

Senator Bernie Sanders, a staunch critic of oil speculators, leaked the information to a major newspaper in a move that has unsettled both regulators and Wall Street alike.

In a June 16 e-mail reviewed by Reuters, a senior policy adviser to Sanders discusses how his office received private data with the names and positions of traders and forwarded it exclusively to a Wall Street Journal reporter.

The e-mail, which also attaches two files with the data, was sent to Public Citizen’s Tyson Slocum asking him to review it and speak with the newspaper about his observations.

In a statement from Sanders provided to Reuters, Sanders said he felt the data needed to be publicly aired.

“The CFTC has kept this information hidden from the American public for nearly three years,” he said. “This is an outrage. The American people have a right to know exactly who caused gas prices to skyrocket in 2008 and who is causing them to spike today.”

No, Senator, the outrage is that you violated confidentiality to engage in political grandstanding.  Moreover, you provide no evidence to support your assertion that the firms and individuals whose identity you revealed “caused gas prices to skyrocket.”  None.

There you have it, ladies and gentlemen.  The Senator from Vermont, providing additional proof, as if any was needed of Mark Twain’s dictum that “America is a nation without a distinct criminal class…with the possible exception of Congress.”

Today’s WSJ has an article that lists the positions of several market participants in the oil futures market on 30 June, 2008, shortly before prices hit their all-time high  This information was leaked by somebody in the CFTC.  A CFTC spokesman “said the agency couldn’t comment because the list contains confidential information.”

You don’t say.  [I cleaned that up.]  Apparently somebody in CFTC didn’t get the memo.

This is egregious.  Truly egregious.  This is highly confidential information.  Its disclosure was clearly intended to advance some political agenda.

Let me hazard a guess what is driving that agenda: next month the CFTC is likely to move on its energy position limits proposal.  The disclosures about the positions held by financial players will no doubt help shape the battlefield for that fight.

I cannot emphasize enough what an abuse this is.

And it will hinder the CFTC going forward.  The agency often relies on voluntary cooperation by market participants to supply data that helps it understand what is going on in the market, or to help develop policies.  Is there any doubt that companies receiving such requests will now think twice about cooperating?

And don’t you feel so much better that under Frank-n-Dodd that the CFTC will have access to far more data from far more markets?

I just shake my head.   And speaking of heads, somebody’s should roll over this.  Maybe several somebody’s heads.

Betting the Business has a recent post that is a paean to central clearing.  I have some major problems with it.

The problems start with the title: “Central clearing lowers end-user costs.”  That short, unqualified, declaration begs major questions.  Most importantly: If clearing is more efficient, why did cleared markets lose market share to the putatively less efficient alternative, bilateral uncleared OTC trades?

I’m not suggesting that such inefficient outcomes are possible, but I take it as a rebuttable presumption that competitive processes tend to result in the displacement of the inefficient by the efficient.  So I’d like to see a convincing story at least, backed by some anecdotes at least, that would represent a plausible rebuttal.  That’s a low bar: it would be preferable, of course, to have a rigorous model supported by empirical evidence.  But I’ve yet to see anyone clear even that low bar: indeed, very few have tried.  To be honest, BTB don’t in this piece.

And by “convincing,” I don’t mean stories that rely on bankers’ Svengali-like hold on their customers, or customers suffering from some variant of battered spouse syndrome.  These stories are facially implausible, and indeed, counterfactual during the period during which OTC derivatives markets grew dramatically, the 1980s and 1990s.  This was a period in which banks were suffering “disintermediation”: they were losing business and customers to capital markets that customers found more efficient sources of capital.  So, the Svengali thing wasn’t working so good when it came to traditional loan business.  Ironically, many of the big loan customers that banks lost simultaneously began trading OTC derivatives with them.  Also ironically, one of the major reasons that the CDS market began was that banks were losing their traditional loan business.  JP Morgan in particular made a strategic decision to develop CDS business aggressively because it was facing more intense competition from capital markets in making traditional loans.  Which all means that customers–especially big ones–have the ability to adopt more efficient ways of financing and managing risk.

My other big problem with the BTB piece relates to netting:

Central clearing, if managed appropriately, helps to reduce the volume of credit risk by cancelling out many offsetting positions, disappearing some credit risk and leaving us with a smaller, residual credit risk from derivatives trading. One of the problems with OTC markets is that brokers wanting to closely guard their clients don’t have an incentive to cancel out offsetting exposures to counterparties. Critics of the clearing system keep overlooking the fact that risk can in fact disappear. The derivatives market system, depending upon how it is structured and operated, can have more or less total credit risk.

The notion that multilateral netting necessarily reduces risk is incorrect regardless of whether one focuses on credit risks in derivatives alone, or takes the proper perspective of looking at credit risk in toto.

With respect to credit risk in derivatives taken in isolation, clearing some products and not clearing others–which is inevitable given the unsuitability of some products for clearing, and indeed, the refusal of CCPs to clear them–may exploit some scale economies from multilateral netting in a particular product, but can destroy cross-product scope economies.  For instance, clearing a credit index but not all the names in the index destroys the scope economies that a bank can realize by holding positions with customers in both the index and the components.  Or if an interest rate swap is cleared but an interest rate swaption is not, netting economies across these products are lost.  These are simple examples, but they could be multiplied ad infinitum.

Indeed, these cross-product netting opportunities are one very plausible explanation as to why clearing lost ground to bilateral markets dominated by dealers.  Dealers trading multiple products can exploit cross-product netting economies and thereby offer their customers lower costs.

What’s more, when we consider clearing-as-it-will-be-in-this-messy-world, as opposed to the Platonic ideal of clearing, even within a single product clearing mandates may reduce netting economies.  Jurisdictionalism is likely to result in the creation of multiple CCPs for a given product type.  For instance, it is likely that regulators in the US and Europe insist that CCPs for particular products be established in their jurisdictions, and that financial institutions subject to their jurisdiction will use these “home” CCPs.  That creates operational headaches and reduces the netting benefits of clearing.

A proper, systemic approach also demonstrates that the disappearance of risk, like a magician’s trick, is often an illusion that works because the audience’s eyes are fixed in one place, and therefore they miss where the real action is.  As I pointed out several years ago, taking derivatives positions and the capital structures of market participants as given, netting redistributes risk from derivatives counterparties to other holders of liabilities on these derivatives market participants.  Yes, multilateral netting (and bilateral netting supported by collateral, rights of offset, etc., for OTC deals under bankruptcy laws) reduces the credit risk in derivatives trades, but the risk doesn’t disappear down the magician-CCP’s hat: it is reallocated to those who have lent money to the firms that hold positions in the netted derivatives.  Netting puts derivatives counterparties closer to the front of the line of creditors in bankruptcy.

Now the issue of the proper priority of derivatives is a sticky one, and I don’t claim to have the answer.  Giving derivatives counterparties priority tends to reduce their incentive to run, but it can increase the incentive of other creditors to run.  And in equilibrium, capital structures will depend on priority rules.  So it may be the case that clearing reduces the risk of runs on derivatives dealers by their derivatives counterparties, but increases the risk of runs by their repo counterparties, or the buyers of their corporate paper. It’s unclear how that cuts.  (No pun intended.)

Though I don’t have the answer as to the optimal priority rules, I do realize that netting does affect priority–and that this means that statements about netting “making risk disappear” are not generally true, and are typically wrong, because these statements are based on only a portion of the total risks.  The risk no more disappears due to a change of priorities achieved through netting than the rabbit really disappears into the magician’s hat.

It should be noted, moreover, that this issue of netting and priority has long been understood in other contexts, notably in payment systems.  Work in the 1990s and early 2000s (by Charlie Kahn, among others) emphasizes that netting systems and real time gross settlement have different affect the priority of payment system participants relative to other creditors of those systems.

There are some other problems with the BTB analysis, but I’ll just mention them in passing.  They say:

Margins are paid by those who use the system. In the OTC markets, banks either correctly price risk, or trade with clients by granting these subsidies from the taxpayer, or from wealth transfers by their bond holders. Clearing and margining is a potent dissuader of free riding on the system by negligent brokers, and also helps to mitigate agency conflicts between bonus motivated bankers and the bank’s stakeholders, which, we have learned, includes the taxpayers/citizens of each country.

I can’t say that I fully track that paragraph, but I will say that I am struck by the free riding analysis.  It suggests a sort of transubstantiation, where bankers are agency-conflicted, or perversely incentivized due to too big to fail subsidies when acting individually, but somehow become less conflicted and better incentivized when they act collectively through a CCP (and most CCPs will be bank dominated).  It’s not obvious how that works.  Indeed, collective action problems and multi-task/multi-principal agency problems usually result in weaker, not stronger incentives.

In this regard, it should also be noted that the homogenization of credit risk in a CCP creates problems.  CCPs make all trades by all members fungible, even if those members bring differing amounts of credit risk to the system.  This tends to reallocate trading activity away from the more creditworthy to the less creditworthy.

I also consider this unrealistic:

And to protect the public, it is necessary for regulators to see and be able to manage the true volume of credit supporting derivatives trading. Clearing is part of making that possible.

Given the fungibility of credit, you will never unambiguously know how much credit is used to support derivatives trades, even in a cleared system.

I have other issues (I can just imagine you exclaiming: “I’ll say!”), but I’ll leave it at that.  Suffice it to say that there are major holes in this clearing paean, and that it certainly does not provide a firm basis for mandating the adoption of central clearing.

The Exchange Formerly Known as the Chicago Mercantile Exchange–now dubbed the CME Group–has announced that the tax situation in its current corporate home of Illinois is “untenable“:

“Our tax situation is untenable,” [CEO Craig] Donohue told Reuters, noting that CME is taxed more heavily than any of its global competitors. The company is talking with at least three states — Texas, Florida and Tennessee — about relocating some of its business to take advantage of lower tax rates there, Donohue said.

Did he say Texas?  Well, come on down!  Plenty of room!  Might I suggest Houston?

I am a native Chicagoan, and a latter-day Texan. As someone who still identifies with Chicago, and who is deeply proud of the city’s history, I am truly saddened by the circumstances that led to the CME thinking seriously about pulling up stakes.  It is the company that arguably has the deepest, longest, and most emotional tie with the city.  Their destinies and identities have been linked for almost 160 years, if you include the CBT, and nearly 100 just looking at CME alone.  The exchanges have long been iconic symbols of the city.  When derivatives exchanges began to spring up around the world beginning in the 1980s, they all looked to emulate Chicago.   The futures exchanges were the city’s unique and enduring contribution to the world of finance.

But, as they say in Texas, bidness is bidness.  Illinois has become an unbelievably hostile environment for business.  As Walter Russell Mead has blogged about regularly, the Blue State model is broken beyond repair.  And Illinois is about the bluest and brokenest state in the country–in many senses of the word “broke.”  “The City That Works”–Chicago’s old-time motto–is no longer operative.  The state is well into the fiscal death spiral: bloated spending leading to high taxes that drives out business and people.  The writing was on the wall before the last election, but the new governor and the legislature refused to make fundamental changes in the way the state spends and operates, deciding instead just to ratchet up taxes.  When businesses and people can move, that never works.  Never.

So the mystic chords of memory only go so far, and the CME owes it to its shareholders to make a rational decision.  And a rational decision means start humming “Southbound.”  The tax environment is better, and the regulatory environment is too.  In Texas specifically, tort reform has made a big difference in the business environment.

And unlike Boeing (also a Chicago company, as of recently), CME Group won’t have to worry about the NLRB if–or should I say when?–it decides to move.

Like the bumper stickers say, I wasn’t born in Texas, but I got there as soon as I could.  And damned glad I did, for a variety of reasons.  Paradoxically, it is in many ways more like the US of a long time ago, but its future is a lot brighter than that of virtually any other “progressive” place in the US–including progressive Illinois and Chicago.

Though actually that’s not really a paradox, IMO.

Betting the Business (i.e., John Parsons and Antonio Mello) notes that the Coalition of Derivatives End Users has backed off its more extreme claims about the effects of clearing and margin mandates.  John and Antonio have been correct to point out that Frank-n-Dodd requirements may just result in the credit implicitly bundled in derivatives deals being unbundled, by the extension of a loan or a credit line.  (This is something that I also pointed out in my Cato piece last year).  But they have not explicitly addressed an implication that I pointed out, and specifically asked them to analyze.  Specifically, if margin requirements merely result in making implicit credit explicit, how do these requirements affect the aggregate amount of credit in the system?   This is the crucial question because the amount of leverage in the system is the first-order driver of systemic risk.

The End User Coalition’s letter makes this point:

Margin lending facilities offered by banks (and especially if offered by [Swap Dealers] or [Major Swap Participants] [as will almost surely be the case], would merely re-allocate and re-label risk, but not materially reduce it.  What was formerly a derivatives exposure risk would be converted to a lending facility risk.  A counterparty default from a derivatives obligation would have the same impact on a bank as a default on a margin lending facility obligation.  In other words, changing the form of the risk does not eliminate the risk (p. 10).  [Emphasis in original.]

. . . .

Some have suggested that end-users that traditionally pledge non-cash collateral cold continue their operations by using a secured financing facility.  Like the margin lending facility discussed earlier in Section II.B.3., a secured financing facility does little or nothing to remove risks from the system.  Instead, it simply changes the name of the risk from derivatives exposure to financing facility exposure (pp. 11-12).

Exactly.  And exactly as I’ve pointed out for well over a year.

Revealed preference suggests that implicit and explicit credit are not perfect substitutes.  Indeed, the End User Coalition letter points out (on p. 12) why a secured lending facility may be an imperfect substitute for using non-cash collateral in a derivatives deal.   Thus, the imposition of the constraint will be costly for firms, and will lead to less hedging.

But the Parsons-Mello main point–and the important implication–remains unchanged: substitutions of one form of credit for another will limit, and perhaps sharply so, the effects of margin and clearing and capital mandates on the amount of leverage in the system.  Since leverage is the source of systemic risk–what’s the point?

I also think that P-M are too dismissive of contentions that the regulations as written will result in deadweight losses.  This is because the amount of margin required can be so large as to require firms to alter drastically their capital structures, and such alterations are costly and can result in some of the inefficiencies the Coalition laments.  As the Coalition letter points out, for non-cleared swaps, the margin requirement is quite onerous: the margin must be sufficient to cover 99 percent of 10 day price moves.  That’s a lot.  This will likely require firms to (a) hold far larger amounts of their assets in liquid instruments, and hence less in more productive assets, (b) reduce their derivatives usage, or (c) most likely, both.

Margins and liquidity are costly.  That’s why firms strive to manage liquidity tightly, and are quite sensitive to margin: the amount of collateral and the form in which it must be held are definitely not matters of indifference to them.  A big margin requirement, and a requirement that the margin be posted in liquid assets, will definitely be a binding constraint, and its shadow price will be non-trivial. I don’t know what it is, but I know it’s not zero–primarily because firms optimize with respect to margin costs.

All this means that, at best, the margin requirement and capital requirement rules on end users will merely lead to a relabeling of credit and will not alter the economic substance of end user’s balance sheets.  (Similar arguments hold for financial institutions too.)  At worst, the constraints will result in costly changes to these balance sheets: excessive holding of liquid assets (can you say financial repression?), deficient investments in higher returning illiquid assets (i.e., the productive assets that enhance productivity), and too little hedging.  I read M-P to mean that the margin requirements on end users will merely lead to a relabeling, and that the requirements will not alter balance sheets.  I think that is far too sanguine.

And for what, exactly?  Under the best circumstances (i.e., no change in the economic substance of balance sheets), systemic risk doesn’t change a whit.  Under the worst circumstances, capital is misallocted, risks are misallocated, and there is no reduction in systemic risk (because end users do not contribute to it in a material way).  So, in the best of outcomes: no gain and no pain; in the worse ones, all pain and no gain.

Such a deal.

One final quibble with Betting the Business.  They state:

But of course an implicit credit line embedded in the bid-ask spread has great advantages to dealer banks. It is hidden, bundled with the derivative contract sold and therefore difficult to figure out by client end-users, who never really know how much they are paying for the amount of credit extended. Welcome to the opaque world of OTC markets.

Who cares how the cost components of a derivatives deal break out?  The end user cares only about the all-in cost, and the bid or offer is sufficient for end users to figure that out.  They can solicit quotes from multiple dealers and choose the most favorable one.  They can compare the quotes to the prices of related, exchange traded instruments to evaluate the reasonableness of the prices they are quoted.

Do you really care how the cost of a gallon of gasoline breaks down between the price of the crude, refining margins, transportation, retailing margin, etc?  No: you care about what it costs you to fill up.  If one station quotes $4.60 and another $4.65 for gasoline of equivalent quality, do you care why?  Or, to use the famous example of a pencil: do you really care about what each step of the process of putting a pencil in your hands cost?  No: you care about the price of the pencil.

That’s the information economizing role of prices at work.  It works in OTC markets as it does in pencils and gasoline.

Back in the late-90s and early-00s I often remarked that it was interesting how exchanges had drawn so little anti-trust scrutiny, despite the fact that may were effectively monopolies.  I also predicted that they would get more scrutiny when they became for-profit, and more like conventional firms.

That prediction is being borne out today, and how.  Exchanges, particularly merging exchanges, are the subject of considerable attention from anti-trust authorities.  ICE CEO Jeffrey Sprecher–who ironically had hoped that anti-trust objections to the CME-CBT deal would open the door for an ICE-CBT merger–has seen the writing on the wall:

Exchanges will have to “rethink their global strategies” because of unexpectedly strong scrutiny of proposed bourse tie-ups from antitrust regulators, according to IntercontinentalExchange (ICE), one of the world’s biggest exchanges.

A string of proposed mergers has come unstuck in recent months, either through nationalist opposition in the home market of exchanges perceived as the targets of takeovers, or as antitrust authorities have moved to stymie combinations amid concerns they could reduce competition.

. . . .

Jeff Sprecher, ICE chief executive, said: “There’s been a marked change in the way regulators look at exchanges generally. The good news is that they are looking to exchanges to provide more transparency to prevent another meltdown.

“The bad news is that they want to ensure a lot more exchanges to ensure competition. So the impediments are now higher than they were a few years ago and I think it’s going to cause everyone to rethink their global strategies,” he told the Financial Times.

A major sticking point for anti-trust regulators has been vertical integration between execution and clearing.  The USDOJ Anti-trust Division’s Parthian shot at the CME from early-08 is one example of this.  Battles currently going on in Europe are another.

But the vertical silo wars have now gone beyond execution and clearing to encompass other vertical restrictions, including exclusive arrangements for use of data centers.  Last week, Swedish competition authorities raided the country’s stock exchange as part of an investigation of its deal with Verizon over exclusive access to a data center.

This area is fraught with potential for policy error, because as Sam Peltzman notes in his chapter on Aaron Director in Cohen and Wright’s Pioneers of Law and Economics, and as Posner notes in his Antitrust Law, anti-trust policy over vertical restrictions and vertical integration has long been a mess.

The brief against integration, particularly between execution and clearing venues, is that clearing is a natural monopoly, and that the operator of a clearing monopoly can thwart competition in execution by creating a vertical silo, and providing clearing services exclusively to its integrated execution arm. That is, that the clearing monopolist can leverage his market power into execution, which would otherwise be competitive.

As Peltzman notes, and as Director argued well over a half-century ago, this fear of leveraging one monopoly into two is commonsensical–and more often than not, wrong.   The essence of the Chicago critique is that the monopolist (in this case, the operator of the clearing service) can extract all of the monopoly rent by choosing the monopoly price for his product.  Keeping out potentially more efficient suppliers of complementary services (e.g., execution, which is highly complementary to clearing) just reduces the profit the monopolist could extract.  The monopolist wants complements sold for the lowest price possible, in order to push out the demand curve for the monopoly good as far as possible.  Thus, keeping out a more efficient supplier of the complementary good, or reducing competition in the sale of the complementary good, is counterproductive.

Chicagoans starting with Director explained vertical restrictions as a form of price discrimination (which has ambiguous welfare consequences) or as a means of addressing free rider problems (as in Telser’s model of resale price maintenance) or as a way to eliminate double-marginalization problems.  Transaction costs economists devised other efficiency-related explanations for vertical integration.

But the suspicion of vertical integration and ties and exclusive dealing and other vertical restraints lives on.  Hence the fighting over silos in the exchange space.

Post-Chicago, there have been several attempts to produce models which lead to anti-Chicago implications, i.e., to show that monopoly leveraging is possible.  In this post I will discuss those models, and show that they don’t apply to the facts of the exchange case.  In a future post, I will discuss the efficiency rationales for integration and exclusivity.

The most prominent post-Chicago leveraging model is by Whinston.  In his model, there is a monopoly good M.  Some customers want to consume that good along with another good C that could be produced by competitive firms.  But some customers don’t want to buy M.  They wish to consume C alone.

In Whinston’s model, the M monopolist may want to tie or vertically integrate into C (and not sell to other producers of C) if entry into C production requires payment of a fixed cost.  By tying/integrating, those who want to buy M have to buy C from the M producer too.  Thus, potential entrants into the C market can sell only to those who want to buy C alone.  If there are too few of those customers, or fixed costs are too high, it will be unprofitable to enter into the production of C.  Then the monopolist can sell C to the stand-alone customers at a monopoly price.

This model clearly doesn’t fit the facts in the clearing-execution case.  Those products are highly complementary.  Indeed, they are consumed in nearly fixed proportions–if you want to trade, you need to clear, and if you clear, you need to trade.  The whole point of the Whinston model is about monopolization of a product some customers do not find complementary to M. The monopolist uses his power over the customers who have strong complementarity to gain a monopoly over customers who do not experience any complementarity with M.   This is clearly at odds with the assertions of those who assert that clearing monopolies use their power to achieve execution monopolies, because those assertions rely heavily on the notion that clearing is an essential service–i.e., highly complementary to execution, and a service that all traders consume.  That’s completely at odds with the Whinston story, so it is of no help to the anti-silo crowd.

Carlton and Waldman have an interesting model that embeds complementarity, but arrives at similar conclusions to Whinston’s model.  But whereas Whinston argues that ties/integration can be used to extend a monopoly to a non-complementary good, Carlton-Waldman devise a model in which a monopolist ties a complementary good to protect his M monopoly.

C-W present a two-period model.  A firm has a monopoly over M.  It is guaranteed this monopoly for 1 period, but in the second period, a competitor can enter.  The M monopolist can also produce a good C, and a firm that can enter the M market in the second period can produce C in the first period.

In one model, the rival incurs a fixed cost to enter the C market.  By tying the complementary good in the first period, the M monopolist deprives the entrant of any sales in the first period.  The profits from producing C and M in the second period may not be sufficient to cover entry costs, meaning that with the tie entry may not occur in either market, thereby preserving the M monopoly.  In contrast, without a tie, the entrant can produce C in the first period, and make a profit that contributes towards covering fixed costs: he can make a profit because his C good is superior to that of the monopoly producer of M.  The profit from entering C production in the first period may cover fixed costs of entering the C market.  Then, in the second period, it may be profitable to enter the M market as well.  In this case, tying protects the M monopoly.

In the second model, there is customer lock in due to network effects.  By tying in the first period, the monopolist of M locks in a lot of consumers of C, and deprives the entrant of any sales in the first period.  The customer lock-in reduces the profitability of entry into M and C production in the second period, likely by enough to make such entry unprofitable.  Again, the tie protects the M monopoly.

These models work best to explain ties in highly technologically dynamic industries where monopolies are likely to be short-lived in any event.  That doesn’t seem to fit the exchange-clearing case.  Moreover, there is no legal or economic bar on entry into clearing and execution simultaneously: the necessity of sequential entry is the key driver of the C-W results.  Indeed, integrated exchanges have entered in competition with incumbents, and execution platforms have secured clearing services by contract, so simultaneous entry has occurred.

A third type of model relies on contracting externalities to explain how exclusive dealing and integration can impair competition.  One example of this is a model by Hart and Moore.  In H-M, an upstream monopolist can sell to multiple downstream retailers.  In the exchange case, the upstream firm would be the clearing monopoly, and the retailers execution venues.

In the H-M model, the upstream monopolist negotiates with the downstream firms individually and secretly.  Moreover, they negotiate over output–the quantity sold: this is a key assumption.  H-M show that under these conditions, the monopolist cannot credibly commit to sell the monopoly output Q_m.  For instance, if he sells .5Q_m to one firm, he has an incentive to sell more than .5Q_m to the other: he cannot credibly commit to selling .5Q_m to the second firm once he has sold that amount to the first firm.  Thus, total output exceeds the monopoly output and the monopolist’s profit is smaller.  Indeed, he can only achieve the Cournot duopoly profit.  If he sells to N retailers, he can get only the N-firm Cournot profit.

By integrating, or selling to only a single retailer, the monopolist effectively commits to the monopoly output.  This may come at a cost.  For example, there may be diseconomies of scale in retailing, or retailers may be differentiated and service different customer clienteles.  But the gains from eliminating the commitment problem may exceed the costs arising from diseconomies of scale or underproduction of variety/customization.

The monopolist obviously has incentives to avoid the commitment problem that drives the exclusionary result.  For instance, he could charge the monopoly price, post that price publicly, and let the downstream firms buy as much as they want–which would be .5Q_m.  This would require the avoidance of secret price discounts.  Reputation may ensure this in a repeated game.  The retailers could monitor competitors’ sales to see if the monopolist were cheating.

Moreover, this doesn’t seem to match up well with the mechanics of the exchange case.  “Output” is not the choice variable; prices are.  And trading volumes are readily observable, making it possible to detect whether a clearing monopolist were offering secret price cuts.

A similar model is one in which a downstream monopolist buys from two upstream suppliers who compete in an input market in which the supply curve for the input slopes up.  Similar commitment problems preclude achievement of the monopsony outcome in the input market.  This model has the same choice variable problem as the H-M model, and what’s more, it is difficult to imagine what the relevant input with the upward-sloping supply would be.  Computer programmers?  Servers?  Again, it doesn’t fit the exchange case well at all.

Another model of anti-competitive integration is by Ordover, Saloner, and Salop.  In that model, two downstream firms D1 and D2 compete, as do two upstream firms U1 and U2.  If D1 and U1 integrate, and the integrated firm refuses to sell to D2, D2 now has to buy an input from a monopoly supplier U1.  D2 pays a higher price for the input, which makes it a less formidable competitor for the integrated firm, which therefore becomes more profitable.

This model is quite fragile.  What’s more, an example in a related paper by Riordan and Salop makes it hard for me to take the theory seriously.  Their example of how this could work is that the purchase of Autolite–a spark plug maker–by Ford could raise the price of spark plugs to GM and Chrysler, thereby allowing Ford to raise the price of cars.  Really.  They couldn’t come up with a better example.  (Posner snarkily dismisses the applicability of this theory by pointing out the complete absence of credible examples.)

Moreover, it doesn’t fit at all the arguments of the anti-silo advocates.  Their premise is that clearing is a natural monopoly.  But the OSS model depends crucially on integration reducing competition upstream (i.e., in clearing).  That can’t happen if clearing is already a monopoly.  OSS is not a theory of monopoly leveraging.

In brief, there are a variety of rather special models that arrive at anti-Chicago conclusions, and which suggest that vertical restrictions and vertical integration can be anti-competitive.  None of these models, however, fit the facts of securities or derivatives trading.  Moreover, many are completely at odds with the arguments made by those who claim that integration between clearing and execution is monopoly leveraging.

Which means that the anti-silo forces are on very shaky intellectual ground.  There is no existing, rigorous, logically consistent theory that is (a) consistent with the facts of the exchange case, and (b) rationalizes their conclusion that integration is anti-competitive monopoly leveraging.

In his industrial Organization text, Tirole warns:

Few topics in industrial organization are as controversial as market foreclosure.  . . . Though market foreclosure is a “hot” issue among those concerned with anti-trust proceedings and with regulation, economists still have a very incomplete understanding of its motivation and effects.  Nor can they always explain successfully why a particular tool is employed to achieve foreclosure.  (Tirole, The Theory of Industrial Organization, p. 193).

True, that.  And given that Tirole is hardly a wild-eyed libertarian, those convinced that vertical silos in exchanges are anti-competitive foreclosure should take his words as cautionary.

Posner once upon a time was more of a libertarian than Tirole, but his words are also worth considering:

The general prohibition in section 2 of the Sherman Act against monopolizing is adequate to deal with the rare case in which a firm imposes a tie-in with the purpose or likely effect of monopolizing the market for the tied (or for that matte the tying) product.  A special tie-in doctrine, inevitably with a life of its own, is unnecessary and inappropriate.  (Antitrust Law, 2d. Ed., p. 207). [Emphasis added.]

Whinston recognizes that many of the models of vertical exclusion are quite special cases, limited primarily to “triangular” situations (i.e., two upstream firms and one downstream, or two downstream firms and one upstream).  Thus, like Tirole, he cautions against drawing strong conclusions on the basis of special models.

In his “Should Antitrust Be Modernized” (J. Econ. Perspectives, 2007), Dennis Carlton cautions that rules intended to identify anti-competitive exclusive acts “could potentially challenge a wide array of core competitive behaviors” and hence become “dangerous” (p. 170).   Peltzman, in the chapter on Director I alluded to earlier, takes a more benign view of the effects of errors in precluding certain types of vertical restrictions.  Sam explains courts’ hostility to vertical restrictions by a monopolist to the belief that it is unlikely that outlawing such restrictions is unlikely to have a serious detrimental impact on competition, that any benefits of the restriction are likely to be indirect, and that courts typically discount any such indirect effects.  Transaction costs economics suggest that these benefits may be large, however, so such discounting is problematic at best.

In sum, the existing models that demonstrate that vertical restrictions can leverage monopoly don’t fit the facts of the clearing-execution case and are so highly stylized that even their developers caution against taking them too seriously in practical situation.  Moreover, thoughtful analysts of anti-trust discount their applicability.

Based on this, antitrust authorities–and those who criticize integration between clearing and execution, or between exchanges and data centers, for that matter–should be much more circumspect in their attacks on silos: the cases in which integration or vertical restrictions are anti-competitive are the exception, rather than the rule.  This circumspection should be all the greater because there are compelling efficiency rationales for vertical integration and other vertical restrictions involving clearing and execution.  I’ve laid out some of those rationales in working papers, and will devote a future post to the subject.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Cold comfort, that.

David at Deus ex Machiatto responded to my response to his post on HFT.  A brief surrebuttal, if I may.

First, regarding CLOBs.  I wrote in the Regulation piece “Thirty Years War” that I linked to in my reply that the SEC had a choice between mandating a CLOB, and an “information and linkages” approach, and chose the latter.  Its implementation of the information-and-links approach was flawed, however, because they didn’t go all the way: the limitation to top-of-book protection is the most obvious flaw.

Moreover, a linkage-based approach is problematic during periods of market stress.  Any tightly coupled system is prone to failure.  David mentions that a CLOB has a single off switch, but that coordinating a shut-down of  multiple linked markets is more difficult.  That’s definitely true.  Failures of linkages–which are prone to happen during periods of high traffic and high volatility–can propagate through a linked system in unpredictable, chaotic, and destructive ways.  All this argues for a CLOB.

But, linkages are inevitable even if all trading in a particular instrument (e.g., a particular stock) takes place on a single CLOB.  In equities, for instance, cash and futures and options and futures markets should be interrelated and interactive, but cannot be run through a single CLOB.  Thus, linkages between such markets are inevitable, these linkages can break, and this tightly coupled system is prone to destructive feedbacks during periods of market stress.  Now with the proliferation of cross-market/asset strategies, linkages are pervasive and there cannot be a true single off switch.

But this is not an artifact of computerization of the markets and HFT.  It was a problem in the Crash of ’87, for instance.  The years immediately following saw a lot of chin pulling about how to coordinate among interrelated markets.

With respect to dark markets, darkness is a mechanism for segmenting privately informed traders and those who are trading for reasons other than private information.  In the old days, with block markets, non-anonymity (counterparty transparency), reputation (“no bagging the street”), and repeat dealing were the mechanisms for doing this.  Similarly, payment for retail order flow and ex post evaluation of trading performance of various sources of order flow was a segmenting mechanism.  As long as you have some people that are trading for reasons other than private information, you will have mechanisms to help them signal their lack of information.  If you force dark markets to light up, you will see the evolution of a mechanism that performs the same functions.  As surely as the light follows the darkness.  Or something.

David and I will agree to disagree about forcing limits on order exposure.  My argument against a say 1 second minimum exposure time is based on the fact that quotes are like free options.  Forcibly extending time-in-force increases the cost of that option to the quoter.  This is especially the case during periods when order flow is toxic–as was clearly the case during the hours leading up to the Flash Crash–that cost can become appreciable.  Many quoters will decide not to quote or radically reduce size.

In other words, the supposed cure is likely to actually exacerbate the problem of liquidity supplier flight which was at the root of the Flash Crash.  Making something more expensive is not the way to get more of it.  Minimum exposure rules would raise dramatically liquidity supply costs during periods when order flow is toxic, so you will get even less liquidity then.

Remember on exchange floors the rule is that a quote is good only “as long as the breath is warm.”  That’s because locals wanted to limit the value of the options they were extending.

There’s no free lunch here.  If you impose a constraint, and the constraint binds–there is a cost associated with that.  Somebody is going to pay it.

The “warm breath” metaphor reminds me that many of the things you see in HFT have close analogies to floor trading.  Sharply limited quote exposure times is one.  Colocation gives HFT traders a time-and-space advantage like that that floor traders possessed.  Even flash trading has its parallels: it is just another time-space advantage for a subset of traders who specialize in liquidity supply.  (Though to the extent that flash trading is used primarily to exploit the lack of full book protection the analogy breaks down.)

I’m sure we haven’t reached the end of this discussion, but that’s all for now.  As the title of my Regulation piece suggested, these battles over market structure and trading rules have gone on a long, long time, and will continue for as long as asset and derivatives markets exist.

Free Exchange, one of the blogs at the Economist writes up one of my takedowns of the SPR release.