Streetwise Professor

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

My post on the “points” system under which the CFTC would monitor positions, and then intervene on a discretionary basis when any position breached pre-set levels (“points”) brought to mind a story about the famous–or notorious, depending on your perspective–speculator, Arthur Cutten. Cutten engaged in massive speculations in wheat during the 1920s.  In 1925, he made the largest income tax payment up to that time in the history of northern Illinois–over $500,000.  Importantly, as a result of his market activities, Cutten attracted the attention–and the ire–of the government.

The Grain Futures Act of 1922 required large speculators to report their positions to the government.  Speculation continued apace despite this requirement, and the authorities were impatient to do something to stop it.  Calvin Coolidge’s Secretary of Agriculture, W.M. Jardine, demanded that the Chicago Board of Trade do something to stop the “gambling” in grain. In response, the CBT created the Business Conduct Committee.

Even in the aftermath of the creation of the BCC, Cutten continued his speculations.  Cutten bought millions of bushels of May, 1926 wheat.  The Grain Futures Administration, the division of the Department of Agriculture responsible for enforcing the GFA, “suggested to the Board of Trade that Cutten’s holdings were too large for one person” (Ferris, The Grain Traders, p. 180).  The BCC swung into action and called in Cutten for a little chat.

When Cutten arrived for the meeting May wheat was selling at $1.65/bu.  (He had bought at around $1.50/bu).  His arrival at LaSalle and Jackson* was observed, and traders soon discerned its import: wheat began selling off as he ascended in the elevator to the conference room where the BCC was meeting.

The BCC told Cutten: “the Grain Futures Administration has made the complaint that you are carrying too much open stuff.”  Cutten resisted selling, but the committee persisted.  Finally, one of the committee members put his arm around Cutten, and told him: “You ought to sell some wheat for the sake of the Board of Trade.  You know, this committee is the device we settled upon to keep the government from taking fuller control of trading in futures.  They get the figures and watch the accounts from day to day.”

Cutten still resisted: “Why should I sell before I’m ready?”  The committee member responded: “For the sake of the Board of Trade.”

Cutten finally relented.  Prices fell further.  He later lamented that the elevator ride to the BCC meeting had cost him a million dollars.

The mechanism that forced Cutten to sell looks remarkably similar to that proposed under the point system.  The government monitored large positions, and exerted pressure on a particular trader–in this case, through the CBT–and that trader eventually capitulated.

What is worrisome about this story is that the intervention that forced Cutten to sell occurred in an overtly politicized environment.  The Secretary of Agriculture, in step with a long line of Senators and Representatives viewed commodity speculation as a social ill.  Jardine had demagogued the issue repeatedly: he had dragooned the CBT into creating not only the BCC, but to mandate clearing of all grain transactions as well.  A speculator who had gained considerable notoriety for his previous operations in the market was targeted for pressure.  At least insofar as the public record is concerned, there is no evidence that the GFA or its handmaiden BCC undertook any serious inquiry to determine whether the speculator’s actions had or threatened to distort prices.  Similarly, there is no evidence that less intrusive measures were considered or proposed: to mitigate concerns about a corner, for instance, the BCC could have limited Cutten’s ability to take deliveries of wheat in quantities necessary to effectuate a squeeze.

Thus, one reasonable interpretation of the events of 1926 is that the GFA–the great-grandfather of the CFTC–intervened in the market for political purposes, rather than on the basis of a well-reasoned and empirically supported concern that the market had in fact been distorted by the actions of a particular individual.

Having watched closely–and up close–the fevered battles over commodity speculation in the past several years, I have no confidence that the same thing wouldn’t happen under the points system.  In fact,  I would put that more strongly: I have every confidence that the same thing will happen again.   Discretionary authority is subject to political pressure, not to mention the whims of regulators.  Consequently, it is inevitable that such authority will be abused.

Bart Chilton has come out in support of a position “point” plan that would permit the CFTC to monitor trader positions, investigate positions larger than pre-set “points,” and vote to require traders to reduce any such positions.  As a result, it appears that this interim plan will go forward.

In some respects, this is better than hard limits, but many issues remain.  The proposal gives the Commission considerable discretion, and discretion can be misused and abused.

Here are several open questions.

First, what conditions would permit the ordering of a position reduction?  Must there be some showing of a market disruption?  In the language of the CEA, must the Commission show that the position in question represents “excessive” speculation?  How would that be defined, and what criteria would be used to evaluate whether it has occurred?  Must the Commission show that the position has caused “unwarranted” price fluctuations?  Or must the Commission merely show that the position has the potential to cause such unwarranted flucutations?  (“Bart doesn’t like it” shouldn’t be sufficient to justify a required reduction.)  If not, what is the statutory basis for the authority?

Second, what evidentiary burden must the CFTC meet to support any order to reduce a position?  That is, what evidence must the CFTC produce to support a finding that the position has caused a disruption/unwarranted price fluctuation (or has the potential to do so)?

Third, what recourse does the affected trader have to an order to reduce his position?  Can he appeal the decision?  To whom?  Can the trader get injunctive relief?

With respect to this third question, there’s an interesting case from 1979:

On Thursday, March 15, 1979, the Commission, pursuant to this section, issued an order to the Board of Trade of the City of Chicago (Board of Trade) to suspend all trading in the March 1979 Wheat Futures Contract (Contract) for the following day, Friday, March 16, 1979. The order stated that the Commission had reason to believe that an emergency within the meaning of Section 8a(9) of the Act existed with respect to the Contract in that significant transportation and warehouse facility shortages had caused a major market disturbance which prevented the market from accurately reflecting the forces of supply and demand. The order additionally specified that the Commission had reason to believe that there existed a threatened manipulation or corner in wheat as a consequence of this market disturbance and as a result of the combined long open positions maintained in the Contract by a small number of speculative traders.

. . . .

The Board of Trade complied with the Commission’s order, and all trade in the Contract was suspended on Friday, March 16. Throughout that day Board of Trade officials and the Commission communicated with each other concerning further trading in the Contract. On that Friday afternoon the President of the Board of Trade advised the Commission that under its own rules it had declared an emergency in the Contract and that trading would be limited to “liquidation only (except new sales for delivery only).”2 In response to the Commission’s inquiry concerning what reasons the Board of Trade intended to announce for issuing the order, the President of the Board of Trade stated that the true reason was the shortened trading period remaining due to the one day suspension of trading ordered by the Commission.3 After the Commission notified the Board of Trade President that such a reason was unacceptable, the Board of Trade issued its order which stated that “various factors” led to the conclusion that trading in the Contract should be limited to liquidation only.

That same evening the Commission issued a supplemental order. The supplemental order recited that the Commission continued to believe that an emergency existed with respect to the Contract, and that further action was appropriate. The Commission ordered the Board of Trade to:

(1) immediately terminate all trading in the Contract on March 19, 20, and 21, 1979, the three remaining trading days in the Contract;

(2) permit deliveries of wheat to be made in fulfillment of current open positions in the Contract through the last day permitted for delivery under the rules of the Chicago Board of Trade at the settlement price for the Contract in effect at the close of trading in the Contract on March 15, 1979; and

(3) settle all positions in the Contract remaining open as of the close of business on March 30, 1979, at the settlement price for the Contract in effect at the close of trading in the Contract on March 15, 1979.” (App. 5a)

On the next day, Saturday, March 17, the Board of Trade instituted this action in the district court seeking review of the Commission’s March 16 supplemental order. The complaint asserted that the Commission’s order was arbitrary, capricious, an abuse of discretion, not in accordance with law, and in excess of the Commission’s statutory authority because no emergency existed within the meaning of Section 8a(9) of the Act. The Board of Trade’s complaint sought an injunction restraining the Commission from enforcing its March 16 supplemental orde

Could a trader ordered to reduce a position initiate a similar action?

In my opinion, there is a legitimate reason for emergency authority (although I have argued frequently that ex post deterrence is superior to a market intervention) in cases of manipulation.  Given the inherent vagaries of the idea of “excessive speculation,” however, I have serious concerns about giving the Commission discretion to intervene selectively in order to force individual traders to reduce positions when manipulation is not suspected.  Any such authority should be constrained.  The Commission should be required to set out a coherent rationale for any such intervention; provide evidence that but for such intervention the existence of said position would cause prices to diverge substantially from the competitive level justified by fundamentals; offer the target of such action the opportunity to present contrary evidence; and permit review by a court.

Absent such protections, the market would be at risk to arbitrary actions based on flaky theories that have not been subjected to serious empirical test.  This would create an unnecessary regulatory risk.  Moreover, political economy factors could further distort the exercise of this discretion, as some traders (or other interested parties) may attempt to influence the Commission to take action against market rivals, or to bail out traders caught on the wrong side of the market.  Given the political and popular frenzy that sometimes accompanies big price movements, such perverse outcomes are well within the realm of possibility.  Indeed, I argued in my 1995 JLE piece on self-regulation that fear of such opportunistic intervention was a major reason why exchanges in the past failed to pass rules permitting the exchange to force traders to liquidate or take other actions that would potentially influence market prices.  I think these exchanges were on to something.  The CFTC should ponder that.

In October, 2007, I wrote a post titled “Cocaine Blues” in which I noted the association between oil prices, and Soviet/Russian aggressiveness/obstreperousness/cussedness/hey-ma-look-at-me-top-of-the-worldness.

Anne Applebaum just noticed the connection:

Why the change of tone? Why now? Many complex theories have been hatched to explain it. This being Russia, none can be proved. But perhaps the explanation is very simple: Oil is once again above $90 a barrel – and the price is rising. And if that’s the reason, it’s nothing new. In fact, if one were to plot the rise and fall of Soviet and Russian foreign and domestic reforms over the past 40 years on a graph, it would match the fall and rise of the international oil price (for which domestic crude oil prices are a reasonable proxy) with astonishing precision.

To see what I mean, begin at the beginning: In the 1970s, oil prices began to rise significantly, along with the then-Soviet Union’s resistance to change. The previous decade (with oil prices at $2 or $3 a barrel, not adjusted for inflation) had been one of flux and experimentation. But after OPEC pushed prices up in the 1970s, oil revenue poured in – and the Soviet Union entered a period of internal “stagnation” and external aggression. Soviet leader Leonid Brezhnev invested heavily in the military, halted internal reforms and in 1979 (when oil was at $25 a barrel) – invaded Afghanistan.

Brezhnev was eventually followed by Yuri Andropov, who had the good fortune to run the Soviet Union when oil prices were still high (at his death, in 1984, they averaged $28 a barrel). Andropov could thus afford both an internal crackdown on dissidents and a continued tense relationship with the West. But Andropov was followed by Mikhail Gorbachev, who took over just as prices plunged. In 1986 (with oil down to $14 a barrel), he launched his reform programs, perestroika and glasnost. By 1989 (when oil was still only at $18) he allowed the Berlin Wall to fall, freed Central Europe and ended the Cold War.

Prices fluctuated, but they did not really rise again in the 1990s (plunging as low as $11 in 1998), the years when Boris Yeltsin was still trying to be best friends with Bill Clinton, the Russian media were relatively free and there was still talk, at least, of major economic reforms. But in 1999 (when oil prices rose to $16 a barrel), Yeltsin’s prime minister, Vladimir Putin, launched the second Chechen war, the West bombed Belgrade, and the mood in Russia turned distinctly anti-Western once again.

The fortunate Putin took over as president in 2000, at the start of a long and seemingly inexorable rise in oil prices. Indeed, Gorbachev’s calls for internal reform were long forgotten by 2003 (when oil prices were creeping up to $27 a barrel). The days when Yeltsin pushed for Russia to join Western institutions were a distant memory by 2008, when Russia invaded Georgia (and oil was at $91 a barrel).

The new Russian president, Dmitry Medvedev, did try to sound nicer in 2009 (when oil prices averaged about $53 a barrel), leaving Putin, now the prime minister again, grumbling in the background. Medvedev locked a draconian treason law, invited democracy activists to the Kremlin, denounced the Belarusan dictator and even seemed to some to have liberalized Russian television just a bit.

But now it is 2011, Putin is very much in the foreground, and Khodorkovsky has just been sentenced by a kangaroo court. As I write these words, oil is at $92.25 a barrel.

Is this analysis too simplistic? Sure it is. But I haven’t yet heard a better explanation.

That’s because there isn’t one.

And as Sergei Guriev and Aleh Tsyvinski note in their “Challenges Facing the Russian Economy after the Crisis” (in the volume Russia After the Global Economic Crisis, Aslund, Guriev, and Kuchins (eds.)), this is a big problem for Russia’s future:

Russia’s internal problems relate to the “resource curse.”  If oil prices remain high, Russia will probably delay much-needed economic reforms.

. . . .

But in Russia it is especially problematic [to improve economic and political institutions] as the ruling elite is not interested in building such institutions.  The “resource curse” provides and explanation.

Guriev and Tsyvinski argue that higher oil prices are antithetical to the political reforms that Russia requires to become a truly modern, innovative, entrepreneurial economy and more humane polity.  To which I would add they are also antithetical to the development of a more neighborly, less revisionist Russian foreign policy.

There’s another interesting implication of the rising oil price that hasn’t drawn attention, at least that I’ve seen.  In particular, it will intensify conflict between Gazprom and its customers.  Gazprom has historically sold gas under contracts with prices tied to the price of oil.  But oil and gas prices have diverged in recent years (for a variety of fundamentals-based reasons).  As a result, Gazprom’s big European customers want to change the contract terms and pricing, but Gazprom does not–and that’s an understatement.  The increase in oil prices has increased the divergence, putting Gazprom’s gas prices even more out of line with cash market values.  Which will only crank up the tension between Gazprom and its customers.  And since there is nothing that happens to Gazprom that doesn’t have a political angle, this will result in some political tensions as well.  (EG, how will BFFs Berlusconi and Putin deal with the issue?)

In a nutshell: higher oil prices will stymie domestic reform in Russia and fuel external tensions.  A fun time will be had by all, because Putin et al can’t lay off that whiskey, and let that cocaine be.

A couple of days back the WSJ ran a rather long article about the demise of the pork bellies contract at the CME. The story has an interesting historical angle, because about 50 years ago the bellies saved the Merc from its own demise.  In the 1950s, onions were the exchange’s lifeblood–its only really active contract–and onion trading was banned in 1958.  The Merc leadership seized on pork bellies as a replacement, and the contract was introduced in 1961.  It soon became a success, and likely saved CME from oblivion.  Given that the CME is now the world’s dominant futures exchange, and has been among the most innovative exchanges since the 1970s, the onion-pork belly saga is one of those contingent events that influenced the way the history of a major industry evolved.

It’s nice that the WSJ spilled some ink on the subject, but the economics in the article is something of a muddle.  Or, perhaps, to be charitable to the writers, they are channeling some muddle thinking.

To wit, the article states that in the absence of an actively traded pork belly contract, market participants have no reliable information about prices:

For independent bacon processors, the decline of the pork-belly futures contract has meant that belly prices are becoming a mystery. The amount they pay for spot bellies is now based on a daily price quoted by the Agriculture Department, which collects it from producers on a voluntary basis.

So what’s the proposed solution?  Cash settlement:

The CME and industry executives are trying to rejuvenate the pork-belly future. The exchange is looking at modifying some of the contract’s specifications, such as allowing traders to settle in cash instead of actual slabs of meat. Currently sellers, if holding a contract through expiration, must deliver 40,000 pounds of inspected frozen pork bellies with a producer certificate within 15 days, and a buyer must take possession. Another exchange idea: to trade fresh pork bellies instead of frozen ones.

“We are keen to change things as soon as we can,” said Tim Andriesen, managing director of commodity products at CME.

. . . .

Changing the contract from physical settlement to cash settlement could help. Financial traders have largely shunned the contract because it requires buyers to take possession of massive quantities of meat.

“For a contract to be successful, you have to have fund participation” from hedge funds and commodity funds, said Dan Norcini, an independent livestock trader in Idaho who has been trading commodities for more than 20 years. “There’re not enough volumes for them to move in and move out.” Mr. Norcini stopped trading pork bellies about three years ago.

So, because of the lack of active futures trading there’s no good information about cash market prices, so the contract should be changed to cash settlement to rejuvenate futures trading.  How does that work, exactly?  The circularity is dizzying.

Whenever a contract exhibits problems, regardless of the cause, it is too often the case that the knee-jerk response is to call for cash settlement.  (As another example, consider calls for cash settlement to fix perceived problems in wheat convergence.)  Usually this response is completely irrelevant to the contract’s real problem.

Cash settlement works if there is an independent, reliable, relatively unmanipulable source of cash market prices that can be used to set a futures price at expiration.  The markets for which these conditions prevail is very, very small.  Cash settlement works in equities for contracts like the S&P500/eMini because there is an active, transparent cash market for stocks.  It works pretty well for live hogs because the USDA collects data on the price paid for every animal bought by processors.

Beyond those examples, cash settlement is problematic, or in many cases, actually counterproductive.  In the late-90s/early-00s, cash settlement in natural gas indexes was rife with misreporting and fraud.  In 2008 I wrote a few posts about reports that banks were putting the lie in LIBOR.

Virtually no commodity market has enough active, transparent cash markets to support cash settlement.  In grains and soybeans, cash prices reported by the USDA are bids and offers from country elevators, barge loading terminals, and processors.  These aren’t bona fide cash transactions, and if these prices were used as the basis for futures settlement prices the temptation for the kind of monkey business that went on in nat gas in the Enron days would corrupt the grain business too.

Frequently the developments that create problems for a particular delivery-settled contract would create problems for cash settlement too.  For instance, the decline in terminal grain markets–most notably Chicago–created problems for the Chicago-based delivery system for corn, wheat, and soybeans in the 1970s and 1980s.  But the decline in terminal grain markets also meant that there were no longer vibrant centralized cash grain markets that could have been used to settle futures contracts.

In commodities in particular, the facts that futures markets are the locus of price discovery, and that market participants rely heavily on futures prices to set cash prices means that cash settlement is often problematic due to the circularity problem I mentioned earlier.

I would also note that, contrary to conventional wisdom, cash settled contracts are not necessarily less vulnerable to market power manipulation that delivery settled ones.  As I showed in a 2000 JOB paper, it is always possible to design a delivery settled contract that is less vulnerable to long market power manipulation than any given cash settled contract, but this delivery settled contract is more vulnerable to short market power manipulation.

Furthermore, the assertion that delivery creates headaches that financial players want to avoid should not be taken seriously.  Financial players trade vast amounts of delivery-settled contracts in a wide variety of commodities from aluminum to corn to crude to wheat to zinc.  (Indeed, isn’t that what keeps Bart Chilton up nights?)  They can–and do–liquidate/roll their positions before they need to make or take delivery.  (Which is why Bart should sleep better.)  The folks active in the delivery market are those who have the expertise and infrastructure to handle the physical commodity.  And ironically, some financial players are realizing that it can be quite profitable to develop that expertise and invest in that infrastructure for some commodities.

Finally, it should be recognized that delivery settlement has a compelling advantage.  At delivery, people have to put their money where their mouths are.  If they think futures prices at expiration deviate from cash market values, they can make or take delivery to take advantage of that perceived disparity.  Delivery is a bona fide transaction: an exchange of the thing for money.  Prices are intended to measure the terms of such transactions, and delivery–or the mere potential for delivery–ensures that happens.  In contrast, with a few exceptions, with cash settlement it is often very, very difficult to collect data from such bona fide transactions, or to execute the trades necessary to exploit perceived divergences between cash values and futures prices (with stocks again being an exception).

It’s long been known that most futures contracts fail because underlying conditions prevent their viability.  Frequently, these underlying conditions relate to industry structure (with vertical integration, for instance, being inimical to futures trading) and marketing practices.  These conditions can evolve over time, making once thriving contracts no longer viable.  That’s what’s happening in bellies, and cash settlement is not a magic formula that will change that.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

No doubt when you were quaffing down a warm cup of hot chocolate on Christmas, you were thinking to yourself: “I wonder how that cocoa corner played out.”  Well, maybe not.

But anyways, wonder no more.  In mid-December, Armajaro, the British hedge fund run by Tony Ward, delivered the bulk of the 110,000 tons of cocoa tendered against the expiring contract.

The deliveries occurred at a price of about 2000 BP/tonne; Armajaro took deliveries at prices of around 2700 BP/tonne. On deliveries of about 240,000 tons, that corresponds to a loss of 168 million BP, or about $260 million.

That, boys and girls, is what they call “burying the corpse.”*

Armajaro’s losses on the deliveries it took might actually exceed this outsized sum if they made any deliveries or cash sales at spot prices prior to December.  Prices were below 1800 BP/tonne in November; only tragic political turmoil in the Ivory Coast has buoyed prices of late.  But even chaos in the most important cocoa producer (something not anticipated in July) has not been enough to drive prices back to the inflated levels seen in July.

In his recent article on the cocoa market, FT commodities editor Javiar Blas duly notes that Armajaro delivered a huge quantity of cocoa.  But he lets pass in deafening silence the fact that this large delivery completely undercuts his previous “reporting” on Armajaro’s actions.  In this case, “reporting” meaning “credulously repeating Tony Ward’s fantastical cover story.”  A cover story, I might add, which was transparently fantastical when it was first spun in July–as I pointed out then.  You might remember the bologna about expectations of a bad crop (which would in no way make it rational to take huge deliveries in the face of a steep backwardation) and pre-sales of the deliveries (which would have, in fact, enhanced the profitability of a manipulative strategy, and the existence of which, in any event, is belied by December’s deliveries). Self-evident and self-serving tripe then, and now.

Blas writes:

In any case, investors will do well not to focus on Armajaro’s selling, but on the buying side. If big physical players turn to the exchange for supplies over the short term, it could be a signal that the cocoa market is heating up again.

Yeah, if I were him I wouldn’t want anybody focusing on Armajaro’s selling either.  Sorry, but “move on, nothing to see here” doesn’t quite cut it.

Armajaro’s escapade sparked considerable popular pique .  I had quite a few people contact me to register their outrage at Ward’s machinations.  Someone started an anti-Armajaro Facebook group, and a couple of British artists also tried to publicize the shenanigans.

The exchange and the British regulators–not so much.  And the FT–definitely not so much at all.  Quite the contrary.  It’s sad commentary when some ordinary folks on Facebook have better BS detectors than those operating the market, those supposedly overseeing it, and those who get paid to report on it.

* And no, Mr. Nissen, I didn’t coin that phrase.  But I wish I had.

Today’s post on SEFs led to a nice email exchange with Alex Yavorsky of Moody’s Investor Services.  It got me thinking about an aspect of transparency that has gone unremarked, to my knowledge.

In the mom-and-apple-pie treatment of transparency so beloved by Gary Gensler, Ken Griffin, the NYT, and others, improved transparency unambiguously increases competition.  With regards to OTC derivatives, the story is that lack of pre-trade transparency makes it necessary for customers to shop around for quotes.  Search costs can create market power: firms can charge higher prices because customers realize that even if they think the price is too high, they have to incur search costs to find a better deal, so they pay up in order to avoid the search costs.

There are models of monopolistic competition (e.g., some theory by Stiglitz from the ’80s, if memory serves) that generate this kind of result.  In these models, free entry generates zero profit but prices exceed the perfectly competitive price.  Transparency that reduces search costs reduces market power and moves prices closer to the competitive equilibrium.

But transparency doesn’t always work that way.  Indeed, greater price transparency can lead to less competitive outcomes.  In particular, transparency can facilitate collusion, and opacity can make it more difficult to collude.

The basic problem with collusion is the prisoners’ dilemma: each individual member of a cartel has an incentive to undercut the collusive price.   In order to deter this kind of conduct, colluders employ punishment strategies, cutting prices in response to a defection.  If a potential defector realizes that he cannot profit from his defection because others will respond immediately and slash prices, he can be deterred from cutting prices the first place.

But for these strategies to work, it must be necessary to detect defections.  Price transparency makes it possible to detect violations of the collusive agreement.  Forcing everybody to post prices publicly is a great way to support collusion: if everybody–including your supposed competitors–can see your price, they can see if you are defecting from a price setting agreement.  In contrast, if buyers and sellers can negotiate prices in private, it is much harder to detect defections.   Secret price cuts strike at the vitals of any collusive agreement.

The inane NYT article on OTC derivatives mentions, in a typically clueless way, the NASDAQ dealer collusion on spreads.  This actually illustrates the role that price transparency can play in facilitating collusion.  NASDAQ dealers posted their quotes on the NASDAQ system.  Any dealer who defected from the agreement to avoid odd-eighth quotes was immediately detected, and this spurred a variety of forms of retaliation–some revealed in rather entertaining fashion on recordings of traders’ phone lines.  Such collusion would have been much, much harder to sustain in the absence of an “automatic quotation” system that made price quotes transparent.

A fully transparent CLOB could–not necessarily would have, but could–result in the same outcome.  It would be a great way of coordinating pricing activities among OTC dealers.  In contrast, the supposedly scary dark OTC markets as they operate presently are very adverse to collusion.  Secret price cuts are quite easy in this environment.  (Moreover, since at present there are other terms of OTC deals, such as credit and collateral terms, that can be varied, it is possible to undercut a putative collusive agreement even while adhering to price terms by giving easy credit and collateral terms.  The increased standardization of deal terms as a result of the clearing mandate also would tend to make collusion easier.)

In the end, what made the NASDAQ market competitive was opening up access to the market.  Prior to the SEC’s order handling rules (put in place in 1997), dealers were under no obligation to submit customer limit orders to the NASDAQ system.  This limited the competition dealers faced in supplying liquidity.  The order handling rules required dealers to incorporate customer limit orders into their quote streams.  This led to the entry of new liquidity suppliers that dramatically narrowed spreads and reduced market maker profits.  It also encouraged the technological revolution–HFTs and algo trading–that has revolutionized liquidity supply.

What this suggests is that a transparent system without open entry is vulnerable to collusion, but that a transparent system with open entry and access can be extremely competitive.  Although we probably won’t find out given that the CFTC rule (as proposed) does not mandate a CLOB, it is interesting to conjecture how a swaps CLOB would work.  Would it be like the pre-order handling rule NASDAQ, or the post-rule NASDAQ?

That would depend on a couple of things.  One, it would depend on whether the swaps market is amenable to competitive liquidity supply from HFTs or algos the way that the equity market is, or the futures market is becoming.  Two, if it is, it would depend on whether the rules are conducive to entry of such liquidity suppliers and/or competition among platforms leads the CLOB operators to permit such access.

Differences  between the characteristics of swap transactions (size and frequency, most notably) makes me skeptical that equity-like or futures-like liquidity supply would be competitive in this market.  These are products for which big dealers may have a strong advantage in liquidity supply.

Insofar as the second issue is concerned, given the nature of CLOBs and the liquidity network effect, one CLOB would be likely to survive, or at least be extremely dominant.  The operator of this CLOB would have market power, which it can exercise by limiting entry (e.g., a CLOB operated by a group of dealers) or supercompetitive pricing.

This means that the CLOB rule would almost certainly have soon resulted in a battle royale over the terms and pricing of access to the CLOB.  This is seen again and again and again in network industries.  It has happened in the securities industry.  It has happened in the telephone industry.  It is happening as I write in the internet–today the FCC passed a net neutrality rule.

Suffice it to say that the implications of transparency and a CLOB would have been far, far more complex than the simplistic narrative advanced by Gensler et al.  It is by no means clear that mandated CLOBs and transparency would increase competition.  That result depends on a complex interaction between the products (which influences the economics of liquidity supply) and the rules governing the pricing of and access to CLOBs.

As an aside, it’s long been a pet peeve of mine that scholarly and policy debates on financial markets have largely ignored the extensive literature on competition and regulation in other network industries.  (I’ve just begun Spulber’s and Yoo’s book on network economics: it looks very good and its discussion of net neutrality echoes some of the arguments I’ve made regarding competition in OTC markets.)  My next book will be about financial market structure, and one of the themes of the book will be the close analogies between the policy issues in traditional network industries and in the financial markets.

In my post on the CFTC’s action (on SEFs) and non-action (on position limits), I erred in my characterization of the SEF rule as passed by the Commission on a 4-1 vote on the 16th of this month.  The rule that had been considered but not voted on at the 9 December meeting would have imposed an essentially CLOB-like model for the execution of swaps.  The initial reporting that I saw on the rule passed on the meeting on the 16th suggested that that rule had similar provisions.  I have heard from several folks who have told me that the rule as passed was actually much less prescriptive and restrictive than the one that had been mooted earlier.  I stand corrected.*

And a good thing too.  The new rule, described here, actually gives market users a choice.

Choice.  Wow.  What a concept.

Specifically, “required transactions” (trades that must be cleared, are not block trades, and which are available for trading) must be executed on either an order book or a request for quote (RFQ) facility.  RFQ facilities must disseminate quotes to at least 5 market participants, all of whom can respond to the quote request.  Alternatively, and RFQ system can be a trading system that displays streaming firm and indicative quotes on a trading screen and operates by:

Transmitting a request for quote to no less than five market participants, based upon an indicative streaming quote, taking into account any resting bids or offers that have been communicated to the requester along with any responsive quotes.

Thus, under the rule, CLOB trading is not mandated, and it is permissible for those making markets to disseminate indicative rather than firm quotes.  The rule does not impose one-size-fits-all-futures-like trading protocols on swaps dealing.

That’s a good thing.  There are a diversity of market participants, and a diversity of execution venues can evolve under the rule to satisfy their diverse needs.  (Again, note the substantial variety of trading mechanisms in the equity market, both within countries and across countries.  Why not for derivatives too?)

This is viewed as a victory for banks.  Maybe banks will benefit, but that’s no reason to lament the result: this is not a zero sum game.  The whole idea behind competition is that it facilitates the consummation of more mutually beneficial transactions than alternative arrangements.  It is perfectly possible for both banks and customers/end users to be better off under the rule than under the more restrictive proposal that was fortunately kicked to the curb. Indeed, that’s what I expect.

That’s also why I find commentary like this mystifying:

The revised rule proposal, passed by the CFTC in a 4-to-1 vote on Dec. 16, allows banks to show negotiable prices on a request-for-quote, or RFQ, system that can be limited to a select number of trading partners. This more flexible model will limit competition among swap-execution facilities and allow volumes to grow, New York-based [Alexander] Yavorsky [of Moody’s Investor Services] said in a report today. [Emphasis added.]

Huh?  How can more flexibility–more choice–limit competition among SEFs?  And if competition is reduced (leading, presumably, to higher costs) why would volumes grow?

No.  It works the other way.  The rule as implemented lays the groundwork for competition between systems with varying attributes; it permits competition on the basis of design and features, and the evolution of systems targeted at particular classes of users.

Systems that offer less value than others won’t survive in this competitive environment.  Moreover, I expect a variety of systems–some pure CLOBs, some RFQ systems that essentially facilitate negotiation among swap buyers and sellers–to survive.  I expect several types of systems to survive because this will permit a better match between the characteristics of trading systems and the characteristics of those using them.  Given the diverse characteristics of market users, one size doesn’t fit all.  And now, thanks to this more flexible and pro-competition rule, these diverse users won’t have to make do with that one size that wouldn’t fit anybody very well.

Gary Gensler was doing his best Procrustes impersonation, desiring to force everybody into the same execution bed, regardless of their actual characteristics.  Instead, under the new rule, some will avoid the uncomfortable stretching that would have resulted under Gensler’s preferred rules; others will get to keep their legs.

I understand that the rule was the subject of extended negotiation among the commissioners.  That process definitely improved the end result.  Hopefully a similar process will occur with position limits, although there are apparently still some perverse vestiges of features like the crowding-out provision in the position limit rule that is on the table.  (Perhaps more on that later.)

*It would be very helpful if approved rules were available far more quickly on the CFTC website and in the Federal Register.  There is about a week lag, which makes it very difficult to know with certainty exactly what is in these rules.

What are positions limits supposed to do, exactly, and how? Here I want to focus on all month limits, not spot month limits.  Spot month limits can constrain market power manipulations.  I think there are better ways to do that, but at least there is a reasonable goal, and a reasonable connection between means and objectives.  Can the same be said for all month limits?  I am extremely skeptical, especially limits of the kind currently under consideration by the CFTC.

Here’s what the CFTC website says:

To protect futures markets from excessive speculation that can cause unreasonable or unwarranted price fluctuations, the Commodity Exchange Act (CEA) authorizes the Commission to impose limits on the size of speculative positions in futures markets.

I’ll take as given the theoretical correctness and empirical relevance of the highly dubious but positive assertion that “excessive speculation that can cause unreasonable or unwarranted price fluctuations,” and focus on the ability of position limits to address this problem.  I’ll focus particularly on the kind of position limits the CFTC is currently considering, which set limits as a fraction of open interest.

It’s first important to note that all limits that have been in force and have been proposed since 1936 have or would have limited the permissible size of the position any individual entity can hold, not the size of speculative positions in aggregate in futures markets.  That’s problematic when one considers several of the most widely cited examples of speculative bubbles in history.  (Again, not endorsing that any or all of these are truly speculative bubbles.  Just seeing if, under the assumption that they were, speculative position limits of the kind implemented and mooted in futures markets would have had the slightest impact.)

A list of such speculative bubbles might include tulips in 17th century Holland, the Mississippi Bubble in 1719,  stocks in the 1920s, the internet boom, and US real estate in the 2000s.  In historical recountings of these episodes, each was characterized by widespread participation by small traders, e.g., housewives speculating on RCA in the 1920s, or individuals putting their 401(k)s in internet high-fliers in the 1990s.  If they were manias, they were popular–or populist–ones.

Limiting the size of the position that any individual could have held would not have constrained seriously the overall amount of speculation in these episodes, because the aggregate speculation was driven by a large number of small positions.  When speculation is excessive because of an excessive number of small or medium-sized deluded traders plunge in the market, and predominately on the same side, limiting the size of any individual position will not constrain this form of excess.

In modern derivatives markets, much speculation takes place through funds or ETFs that aggregate the monies of large numbers of individual speculators into large pools.  If a popular speculative mania leads to an influx of money into these pools, and if there are sufficient economies of scale in managing these pools, then limits on the size of individual positions under the control of one entity could effectively tax speculation, although in a very indirect way.  If the constraint is binding on these pools, it would mean that they are not able to exploit fully their economies of scale.  This would mean that they incur higher costs than in the absence of the constraint.  This would raise the cost of speculation by small investors, which would tend to reduce the amount of speculation they undertake.  How much would depend on (a) the difference between the cost of operating a pool at efficient scale, and the (higher) cost of operating at a scale imposed by the limit, and (b) the elasticity of speculation with respect to transactions costs.

I don’t know for certain what (a) and (b) are.  (I do know that I haven’t seen anyone even point these out to be relevant factors in evaluating position limits.)  My intuition is that they are small, meaning that speculative limits would not appreciably constrain the mass speculative frenzy species of excessive speculation (if it indeed exists or is empirically important).

Moreover, it is not obvious that position limits of the type currently under consideration by the CFTC would even uniformly achieve this objective.  The currently contemplated limits would set maximum position size as a percentage of open interest.  So permissible individual position sizes in big markets (e.g., crude oil) would therefore be larger than permissible individual position sizes in smaller markets (e.g., wheat).  But scale economies relate to absolute size, not percentages of total market size.  And as Adam Smith put it, economies of scale are limited by the extent of the market. This means that the difference between cost at efficient scale and cost at aggregate outputs that differ from integer multiples of the efficient firm scale is declining with market size.  Thus, the kind of constraint under consideration would have a much smaller effect on the amount of speculation in big markets than in small markets, regardless of the elasticity of speculation with respect to transaction cost.  (The analysis is trickier when there is considerable heterogeneity among the cost curves of different pool operators.  Economies of scope–operating pools in different markets–are also relevant.  Index investing raises additional complications.)

This all means that speculative position limits are not well suited to addressing the popular speculative wave species of excessive speculation, especially in large markets (like the energy markets).  This is especially true of position limits based on percentages of open interest.

Given that many of the conventional and political attacks on commodity speculation in the 2000s were–and continue to be–based on variations on the popular mania explanation, imposition of speculative limits will leave their supporters disappointed, for two reasons.  First, because these attacks are dubious theoretically and empirically.  Second, because even if such speculative waves sometimes cause unwarranted price fluctuations, limits on the positions any individual entity can hold will have little, if any effect, on the size, strength, or price impact of these waves.

This means that any defense of position limits must be predicated on a belief that a position, or a handful of large positions, that are large relative to the overall market, can cause unwarranted price fluctuations.

There are examples of this historically, of course.  The Hunts come to mind immediately.

Putting aside manipulation for a moment (and it is hard to see what type of manipulation all month limits would stop), when one trader takes a disproportionately large position, it means that he has a far different view of the future course of prices than other traders.  He’s taking all the action (or a disproportionately large amount of the action) on one side of the market because at the current price, his view on where prices are going is the opposite of consensus opinion (or perhaps because there’s a big imbalance among hedgers).  This is contrarian speculation.  If the contrarian speculator is right–he makes a lot of money.  If he’s wrong–he loses a lot of money.

One justification for constraining this type of trading is a belief that such traders are more likely to be wrong than right.  They are unduly confident in their own abilities to forecast prices, or unduly convinced of the superiority of their information.  Their trading on these false beliefs does drive prices away from where they should be, and when reality intrudes, prices snap back.  Those movements could be characterized as unreasonable or unwarranted price fluctuations.

This is a rather peculiar theory because it presumes a positive correlation between the irrationality of the investor, and the amount of money he has to invest.  How did the dumb become so rich?  Not that it is impossible, just that you’d expect the correlation to go in the other direction (albeit smaller than one in absolute value).

The market is, of course, a stern disciplinarian that punishes such irrational plungers; fools and their money are soon parted.  The Hunts, for example, were poster children for the old joke: “Want to make a small fortune trading commodities?  Start with a large fortune.”  Ditto Amaranth.  Given the potential costs of position limits in constraining legitimate speculation, is it really necessary for the government to try to prevent what the market ruthlessly helps to deter?

It should also be noted that there is a tension between this justification for position limits and the anti-speculative wave justification.  Contrarians by definition take views at odds with the conventional wisdom.  If the conventional wisdom is irrational and not based on fundamentals–as the popular mania critique of speculation believes–we want contrarians to lean against the wind.  Since they are by definition at odds with the views of most others, they will take positions that are disproportionately large on one side of the market. This is the theme of The Big Short, which describes how a handful of traders bet against the real estate bubble.  If such bubbles exist, we want people to lean against it.

Position limits, and those based on concentration in particular, will constrain just that kind of contrarian trading.  So if you worry about bubbles driven by mass speculation, (a) position limits will do little to constrain it, and (b) will make it harder for those not suffering from the popular delusion to trade in ways that limits the price distortions resulting from it. This is a perverse, unintended consequence of limits on large trader positions.

If big speculators are right on average, or right more than they are wrong, limits that constrain their trading will not reduce deviations between actual prices and what prices “should” be, and could in fact increase the frequency and magnitude of these disparities.  So this justification for position limits depends crucially on a view of the correctness of big speculators.  This is something everybody has a speculative opinion on, ironically–but little or no evidence to back it up.

Another justification for limiting the size of an individual trader is that if he is wrong, the failure that results when reality intrudes could have knock-on effects.  The failure of the Hunts, for instance, did have some systemic consequences (as I wrote about some months ago).

But position limits are ill-adapted to addressing this kind of problem.  The real problem is the failure of a really big, leveraged player.  Some players are big, but not leveraged.  If they lose, they have the wherewithal to make good their losses, limiting any systemic consequences resulting from knock-on failures.  If prices move against a big ETF (like USO, for instance), it’s painful for the fund holders, but their positions are effectively fully collateralized, so their losses do not create counterparty default losses that could put others into distress.  Position limits constrain leveraged and unleveraged players alike. (It would be interesting to understand whether the imposition of limits could actually affect the relative importance of leveraged players in the market.  If so, limits could have unintended, adverse consequences.)

Relatedly, with respect to this problem, the metric of big is not big relative to the size of the specific market in which the speculator participates.  It is big relative to the broader financial system.

Consider a couple of polar cases.  For a small market, let’s say Minneapolis wheat, someone could accumulate a position that is huge relative to open interest, without accumulating position that is large relative to the financial system in any way.  During the peak of the price spikes in 2008, the maximum value of the open interest in July Minneapolis wheat was about $650 million.  In the scheme of things, this is chicken feed, even if one person had held the entire position, let alone 10 or 12.5 percent.

Now consider a big market, like crude oil.  At the peak in July, 2008, the value of NYMEX open interest was on the order of $200 billion–nearly 3 orders of magnitude bigger than for MW.  Somebody with 12.5 percent of this market (the upper bound under previous CFTC proposals) would have had a notional position value of about $25 billion–that’s serious money, which, if the position holder is leveraged, could lead to some knock-on problems if it went south. (Of course, $25 billion is an upper bound on the loss a long could suffer.  For both longs and shorts, the uncollateralized credit exposure is far smaller.  Perhaps sufficiently small that even such a large position is not systemically risky even if held by a leveraged player.)

Note that under the new proposals, where OTC markets are included, the disparity would become even more extreme.  The OTC positions tied to CL are large, absolutely and relative to the NYMEX open interest, as compared to OTC positions tied to MW absolutely and relative to MGE open interest.  (How much larger, nobody really knows at present.  That’s one reason why some commissioners are reluctant to act until they know more about the size of the OTC market.)

So under this theory of the systemic risk associated from the failure of a big speculator, you might conclude that a limit would be sensible for crude but not for Minneapolis wheat.   But the commodity position limits will be imposed on markets of all sizes.

In this regard, it is interesting to note that press reports state that the limits the CFTC is considering would hit far more agricultural traders than energy and metals traders.  Given that the latter markets are a lot bigger than the former, and hence would pose a far greater systemic risk, this means that the proposed limits are very poorly adapted to addressing any putative systemic risk posed by “large” speculators.

One last thing.  In October, I had a discussion (disclosed on the CFTC website) with the CFTC position limits team.  I basically argued that in designing such limits, it was imperative that the limits be designed based on a diagnosis of the problem to be solved.  This led to a discussion of potential problems associated with large positions.  A lot of the scenarios that were discussed revolved around how traders with big positions might exploit microstructural frictions to make money.

Yeah, maybe.  But I am skeptical that somebody is going to accumulate a huge position, with all of the capital required and risk entailed, to play liquidity games for ticks.  Moreover, many of the big players that some critics of speculation are obsessed with, e.g., the “massive passives” (ETFs and index funds) that keep Bart Chilton up nights, most certainly do not play these games.  They pretty much trade in a mechanical fashion, rolling on a schedule, and investing and liquidating based on customer money inflows and outflows.   So again, there seems to be a huge disconnect between  the paranoia about massive passives, and the types of behavior that some at the CFTC look to prevent using position limits.

There’s a common pattern to all this.  Come up with a scenario in which speculation distorts prices.  Then evaluate how position limits of the type currently under consideration would operate under this scenario.  And then conclude that these position limits would either not address the purported problem, or could actually be counterproductive and make the purported problem worse.

Given that speculative limits also interfere with the legitimate uses of derivatives markets, the very real possibility that they have virtually no offsetting benefit makes this a very bad policy choice.

Supporters of a specific position limit proposal should be required to provide a reasonable justification for that specific proposal.  This justification should first spell out in detail exactly a scenario or scenarios under which speculation distorts prices.  It should then show how–exactly–their proposed limit will reduce the likelihood of these scenarios.

I’ve gone through several alternatives above, and argued that there is a complete mismatch between the diagnosis and the prescription; position limits appear to me to be the financial equivalent of leeches or faith healing.  But maybe my imagination is unduly limited.  Maybe there are other stories/scenarios that I haven’t considered.  I’d be glad to entertain them–but I would also have to be convinced how a specific position limit proposal would improve market performance under these scenarios.

Of course, I also believe that those advancing these scenarios should provide rigorous theoretical justifications and empirical evidence to demonstrate that their scenarios are real possibilities.  But I’m pretty confident that supporters of limits will be unable to meet even the weaker burden of showing how position limits cure what they identify as ailing the market, no matter how implausible, not to say crack-brained, that diagnosis is.  And until someone proves otherwise, position limits will remain a solution in search of a problem.

* My daughter Renee gave a paper on the political economy of regulation of speculation, focusing on position limits, at the Instituto Bruno Leoni Mises Seminar 2010 in Sestre Levanti, Italy last October.  Her paper compared the drive for position limits in the 1930s to that in the late-2000s.  The audio of her presentation is available online.  Her paper has been accepted for publication in the Journal of Economic Affairs.