Streetwise Professor

According to Matt Leising and Justin Blum at Bloomberg, the Justice Department investigation of the CDS markets includes clearing:

A U.S. antitrust probe of the credit-default swaps market includes efforts to guarantee contracts through clearinghouses, according to a Justice Department spokeswoman.

“The Antitrust Division is investigating the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,”  Laura Sweeney, a Justice Department spokeswoman in Washington, said today in an e-mail.

Just what would the anticompetitive practices in CDS clearing be?  Here are some theories the DOJ might be considering and investigating:

• If a subset of big dealers form a clearinghouse, and exclude other market participants from membership, they could reduce competition.  That is, as I’ve shown in my academic work, a cooperative organization that is subject to strong scale and/or scope economies can serve to cartelize an industry.  A smaller than optimal set of members creates a CCP.  It is just big enough such that no other organization can achieve the scale or scope to compete with it, but smaller than optimal, thereby ensuring that its members can charge supercompetitive prices.  What’s more, through the pricing of its services, and the rules for sharing revenue, the members can coordinate pricing, and in some cases, achieve a monopoly pricing outcome.
• The DOJ may actually be more interested in the resistance of the CDS dealers to clearing.  Here the idea would be that the CDS market currently behaves like an oligopoly that is very profitable.  The dealers don’t have to worry that much about competitive entry, because there are few other firms that have the scale to compete effectively.  Clearing would make it easier for other firms to enter in competition with the big dealers, as these competitors would essentially be able to take advantage of the clearinghouse’s scale.  This would undermine a competitive advantage of the big dealers–so if they kneecap or slow walk clearing, they could protect their oligopoly.  Similar arguments would apply to anticompetitive practices in trading.
• The big banks are impeding competition by refusing to deal with potential competitor clearinghouses, such as the CME’s or the just euthanized NYSE-EuronextLIFFE venture.

I don’t know which, if any, of these theories is in DOJ’s mind.  But the antitrust scrutiny of the entire gamut of OTC trading practices is quite interesting, and bears close watching going forward.

Administration officials, most notably Geithner and Gensler, Congressional leaders, and European regulators have touted central counterparties/clearinghouses as a way of dramatically reducing systemic risk.  They have portrayed the CCP as nearly free of the risk of default.  

Apparently the Federal Reserve takes a different view.  (H/T Matt Leising, who made me aware of the issue and reports on it in today’s Bloomberg.)  Evidently responding to the glowing praises of clearinghouses emanating from Geithner et al, on behalf of the members of ICE Trust the law firm of Cleary, Gottlieb, Steen and Hamilton wrote the Fed a letter requesting that

a zero percent risk weight  under the risk-based measure of the Board’s Capital Adequacy Guidelines for state  member banks and bank holding companies (“Risk-Based Capital Rules”) be  assigned to (1) the counterparty credit risk charge on credit default swap (“CDS”)  transactions with ICE Trust, and (2) funds placed with ICE Trust as part of ICE  Trust’s guarantee fund (“GF Contributions”) or as additional margin (“Margin”).” That is, the Cleary lawyer asked the Fed to consider the ICE Trust clearinghouse to be effectively free of default risk, thereby eliminating the necessity of any bank or securities firm with an exposure to the clearinghouse to hold any capital against that exposure.

The Fed demurred, however:

Based on all the facts of record, including the information provided in your  request and other supervisory information, the Board believes that it would be  appropriate to allow current participants in ICE Trust (and their top-tier bank  holding companies) to apply a 20 percent risk weight under the Risk-Based Capital  Rules to claims on ICE Trust, including counterparty credit risk of the CDS  exposures cleared through ICE Trust and claims in the form of Margin and  GF Contributions, for the first-quarter reporting period of 2009 and for subsequent  reporting periods. A 20 percent risk weight for such claims on ICE Trust is  appropriate because the risks ICE Trust poses to counterparties are not materially  different than those posed by other U.S. depository institutions, as well as by banks  in countries that are members of the Organisation for Economic Co-operation and  Development (“OECD banks”). Claims on OECD banks are also risk weighted at  20 percent.

That is, from the Fed’s perspective, ICE Trust is just another bank. Note the key sentence: “the risks ICE Trust poses to counterparties are not materially different than those posed by other U.S. depository institutions.” Thus, an OTC counterparty must hold as much capital against a CDS position cleared through ICE as a CDS deal done with Goldman Sachs–or even BofA or Citi. So much for the magical powers of a clearinghouse to make counterparty risk disappear.

Interestingly, the Fed letter notes that the capital weight required for derivatives traded on exchanges like the the CME that adjust margins daily is zero.  

This decision is very difficult to square with the official boosterism of clearing emanating from the administration, the Hill, and the EC.  It has always seemed to me that the Fed was much more diffident about the efficacy of clearing than Treasury, and this letter makes that difference in enthusiasm quite plain.

There is another interesting angle to this.  In his recent testimony Geithner made it plain that he intended to impose more onerous capital requirements on OTC deals that were not cleared than cleared deals.  The Fed letter essentially puts cleared and non-cleared deals on a level playing field.  So does this mean that other changes are in store, such as raising the capital requirement to above 20 percent on bank-to-bank OTC derivative exposures?  If so, will other inter-bank exposure capital weights be changed, or will there be a differential between OTC derivative risk weights and other inter-bank exposure weights?  Or will the Fed decision be modified subsequently?   Whatever changes are to come, this appears to represent a major disconnect between the Fed–which announced its decision on 5 June–and Treasury, which as recently as last week stated its intention to treat cleared and non-cleared exposures differently.  

Moreover, the Fed’s action gives the lie to Treasury and Congressional and EC boosterism of clearing.  It is a salutary reminder that clearing does not make counterparty risk go away.  Perhaps the Fed’s equation of the risk of ICE Trust and Citi, for instance, is wrong.  But by making it quite plain that the counterparty risk of ICE Trust is north of zero, its decision will hopefully lead to a more productive and informative discussion of the real risks of clearing vs. bilateral dealing.   It’s about time.

In his testimony in a joint hearing of the House Financial Services and Agriculture Committees last week, Treasury Secretary Timothy Geithner stated:

We also will require that regulators carefully police any attempts by market participants to use spurious customization to avoid central clearing and exchanges.

Just how is this “careful policing” supposed to work?  Will those who want to enter into customized transactions have to get pre-approval?  This seems inherently unworkable, due to fact that transactions are frequently time sensitive.  Alternatively, will parties have the ability to enter into transactions without prior restraint, but face the risk that a regulator will subsequently challenge, and disallow the transaction?

Under either alternative, what are the criteria that will be used to separate the unspurious sheep from the spurious goats?  Given the myriad possible reasons for entering into a particular transaction, and designing it in a particular way, it seems nigh on to impossible to identify ex ante a set of criteria that can be employed.  Hence regulators will have incredible discretionary powers.  Presumably there will be legal challenges to regulator decisions, meaning that there will be more than a few court cases arising out of these “policing” efforts.  

The closest analogy that comes to mind is the IRS, which rules on the permissibility and legality of various financial transactions that have tax implications.  We all know the byzantine and costly process associated with such powers.  In essence, the CFTC and/or SEC would have to be empowered to make similar judgments of the commercial rationale for particular transactions, and evaluate the trade-offs that market participants make.  For instance, is a particular transactions structure designed to reduce basis risk, or to escape the clearing requirement?  What will be the standard applied to such evaluations?  Who will have the burden of proof?  

Given the myriad arcane and complex commercial rationales that may exist for entering into derivatives transactions, especially customized ones, it stretches credulity to the breaking point to believe that the SEC or the CFTC have the expertise, not to say the incentive, to make the right call.  There will be many false positives and false negatives.  What’s more, the transactions costs of such a system are likely to be large, just as is the case with the tax code.  Much money will be spent in court trying to reverse the false positives and false negatives.  

Am I done?  Hardly.  Let’s consider the regime in which done deals are subsequent to regulatory challenge ex post.  What happens if a particular transaction is found to be “spurious”?  The deal will be in the money to one party or the other.  How is it to be unwound?  Is it just terminated, costing the in the money party the value of the contract, and allowing the loser to skate?  Is there some termination process whereby the contract is valued?  But if the deal is customized, who does the valuation?  Another source of litigation.  Just what we need.  

Relatedly, there is the possibility that the underwater party to a contract can opportunistically utilize the requirement that a deal not be “spuriously” customized to attempt to escape the onerous obligation to perform.  In the old days, transactors who entered into futures contracts tried to argue that (a) they entered into the futures as a speculative wager, and (b) wagers are uneforceable in court, to escape losing trades.  I foresee such attempts as inevitable if “spurious” customization is banned.  Thus, such a ban will undermine the reliability of contracts and create legal risks.  This is hardly a desirable public policy outcome.

All in all, attempts to distinguish spurious from non-spurious customized transactions, and the Talmudic inquiries necessary to do so, will be extremely onerous.  Moreover, the existence of such a distinction creates substantial legal risk, and the prospect for protracted and expensive litigation.  But perhaps for Geithner et al, these are features, not bugs: regulatory burdens that will serve the larger purpose of suffocating the OTC market.  

And all this begs the question:  Why would anyone want to create a “spuriously” customized contract?  One can understand why one would want to structure a deal solely to reduce tax payments, hence the arms race between the IRS and financial engineers.  It is far harder to understand why someone would want to customize something to escape the obligation of having it cleared, or traded on an exchange.  It is easy to understand why someone would want to customize a deal to achieve specific risk management objectives that cannot be attained using standardized and cleared contracts.  But what’s so bad about clearing that people would want to go to the lengths of designing a customized, illiquid instrument solely to avoid it?  And if the private “bad” of clearing is so big, where’s the public “good” that offsets it?  

This puzzle as to why consenting adults would choose to customize to avoid clearing and exchange or exchange-like clearing is just part of a larger puzzle: if the OTC market is so terrible, why do informed parties utilize it, and why has it grown relative to the exchange traded sector to such an extent that OTC volume and open interest now dwarf exchange volume and open interest?  The entire thrust of the Geithner-Obama policy implicitly assumes the existence of what would have to be the greatest market failure in the history of man, a market failure that has led to trillions and trillions of dollars of transactions that are suboptimal in the way that they are designed, traded, cleared, or settled, or all of the above.   So just what is the market failure?  So far, the administration and its cheerleaders in the media have failed miserably to identify it, let alone to show that its cost is sufficiently massive to justify a vast re-engineering of the financial markets.  Repeating “AIG AIG AIG” over and over again like financial Hare Krishnas doesn’t cut it.

FT’s Energy Source blog kindly links to my piece on oil speculation.  Kate Mackenzie notes my argument on why commercial traders who perceive that they have an information advantage, and who speculate on that information, may support constraints on non-commercial speculators who compete with them.  (Ironically, we have houseguests named “Kate” and “Mackenzie” visiting this weekend.)

There’s another reason why some hedgers may want to crack down on speculation: some hedgers earn a risk premium rather than pay it, and competition from speculators reduces the profit that these hedgers earn.  When there is some segmentation between a particular commodity market (e.g., oil) and the broader financial markets, due for instance to a fixed participation cost like the cost of becoming informed, idiosyncratic risk affects risk premia.  This, in turn, can affect who benefits and loses from greater speculative participation.

The original Keynesian “normal backwardation” story assumes complete segmentation, in which case net hedging pressure–whether short hedging volumes exceed long hedging pressure at an unbiased price–determines the sign of the bias in the futures price (whether the future is above or below the expected spot price at expiration), and the amount of speculative risk bearing capacity determines the magnitude of the bias.  For instance, if short hedging pressure predominates (as Keynes believed) the futures price will be biased downwards (will be less than the expected spot price), meaning that short hedging is costly but long hedgers make a speculative profit; as the downward biased futures prices drift upwards on average to converge with the spot price at expiration, long hedgers profit on their long futures positions.  The bias is a profit for long hedgers, and a cost incurred by short hedgers.  This bias attracts speculators, who bid up the futures price until the expected profit arising from the bias balances the cost of the risk that they incur.  The greater the speculative risk bearing capacity, the lower the bias–and the lower the trading profit of the long hedgers.

This means that entry of speculators helps some hedgers–short hedgers–but HURTS others–long hedgers.  The bidding up of the futures price benefits hedgers who sell futures, and hurts hedgers that buy futures.  Thus, in a Keynesian world, long hedgers oppose speculators.  This means that hedgers will not uniformly support speculation.  Indeed, some market participants should actively support measures to constrain speculation.  

In a world where each commodity futures market is perfectly and frictionlessly integrated with the broader financial market, risk premia are determined solely by the systematic component of the commodity price’s risk.  

In a world between the frictionless world and the Keynesian one, both systematic and idiosyncratic risks affect risk premia, as was shown by Hirshleifer in the late-80s.  In this world, some hedgers will also prefer to crack down on speculation.  For instance, when short hedging predominates, long hedgers prefer to constrain speculation.  That’s because, like in the Keynesian world, they are effectively selling price insurance to the short hedgers, and receive a profit from doing so.  They don’t like the entry of speculators who compete away some of these profits.  

This can also explain why some hedgers would support measures that weaken the linkage between the broader financial market and a particular commodity market.  This weakening allows idiosyncratic risk to affect risk premia, and some hedgers in the market capture this risk premium as a profit even though those on the other side of the market pay it as a cost.  What’s more, the magnitude of this idiosyncratic risk premium depends on the ease of entry by speculators into the futures market.  

This analysis can explain some of the hostility to passive long index investors.  These investors are typically portfolio investors, and their participation in commodity markets helps to strengthen connections between commodity markets and the stock and bond markets.  Moreover, they compete with long hedgers in serving the risk management demands of short hedgers.  In so doing, they compete away some of the profit that long hedgers can earn in a market where short hedging predominates.  

Of course, this story implies that hedgers will not speak with one voice: based on these factors alone, one group of hedgers (e.g., short hedgers in the Keynesian story) will support speculation, while another group (long hedgers in the Keynesian theory) will oppose it.  (If long hedging predominates, the roles will be reversed.)  But combined with the other factors outlined in my earlier post–and perhaps others as well–this means that commercial traders who use futures markets as hedging tools can take very different views on the benefits of speculation.  

This is an old, old, old story in any analysis of regulation.  Although speculation improves the allocation of risk, and leads to overall improvements in welfare, it also has distributive effects.  Due to its effects on competition over information rents, or raising rivals costs considerations, or competition over risk premia, the entry of speculators can redistribute wealth at the same time that it increases (risk adjusted) wealth overall.  

This means that you should be very, very, very . . . skeptical about the protestations of some commercial firms about the evils of speculation.  They don’t necessarily have the interests of the market at large at heart.  Indeed, they almost certainly place their own interests foremost.  What’s more, it is inevitable that for some significant number of commercial firms these interests are contrary to market efficiency.  In derivatives markets, as in virtually every other, some firms can benefit from restrictions on entry or other impediments to competition.  Derivatives regulation, including regulation of speculation, is like other forms of regulation a rent seeking contest in which interested parties attempt to secure rents through the political process.  Sadly, it’s often those with the best lobbyists who win–not those with the strongest economic case.

Almost exactly a year ago, I testified before the House Ag Committee and wrote an oped for the WSJ on the effect–or lack thereof–of speculation on oil prices.  The issue was high on the political agenda at the time, as oil prices hit $147/bbl, and gas prices were above $4/gal.  The collapse in prices during the financial crisis put the issue on the backburner, but it is back with a vengeance.  To loud Congressional hosannahs, the CFTC has announced its intent to impose a far reaching regime of position limits on energy and other commodities “in finite supply“–pray tell, what traded commodities are in infinite supply?

So, I guess I have to roll that rock up the hill, yet again.  (I have posts on the subject of “excess speculation” and position limits from 2006, 2007, 2008, and 2009.)  

At the risk of becoming even more of a repetitive bore than usual, I’ll restate my objections to the intellectual basis to these policy initiatives, and the policy initiatives themselves.  Before doing so, it is worthwhile to define “excessive speculation,” something those that hurl around the phrase with abandon almost never do.  I define “excessive” speculation as that which drives prices away from the competitive price consistent with available information.  That is, excessive speculation distorts prices.  Now, my objections:

• The mechanism by which speculators allegedly distort prices is almost never specified, and when it is, it makes no sense.  Advocates of the “excessive speculation” hypothesis routinely say that speculators inject artificial demand into the market.  Given that most speculators almost never actually take delivery, and thus offset their positions as they become prompt, they are not influencing either supply or demand for the physical commodity.  This is a point that has been recognized since at least 1902 in a report authored by the US Industrial Commission, which included several Congressmen and Senators.  Which I guess goes to show that Congressional IQ exhibits an inverse Flynn Effect.  
• This is especially the case for commodity index traders, who almost all trade cash settled instruments, and hence can in no way influence supply or demand.
• That is, none of the boatloads of money allegedly flowing into commodity funds actually goes into, you know, actual commodities.  Some of the money in commodity-linked investments is purely notional (e.g., in commodity swaps, or index swaps).  Some goes into T-bills (in the form of margin, or in fully collateralized commodity trades).  
• The evidence of a distorting speculative effect is laughable.  Distortions in prices should lead to distortions in quantities, e.g., in commodity stocks.  No reliable evidence of such an effect exists.  Indeed, I have looked at one commodity–copper–in close detail as part of a chapter of my upcoming book on commodity price modeling.  People were screaming about a speculative bubble in copper last year at the same time as the (louder) screams about a speculative bubble in oil.  But copper stocks (and the stocks of other industrial metals) were drawn down sharply at the same time prices were spiking: this is exactly what one would expect to observe with a positive demand shock.  Indeed, I am working on calibrating a rational expectations theory of storage model to copper data, and this model can explain the twists and turns of prices and stocks during the extreme events of the last several years.  That is, speculative irrationality is not required to explain the movements in copper prices AND inventories over the 1997-2009 period.  (I’ll post more on this when I finish a couple more parts of the analysis next week, hopefully.)
• Some of the “evidence,” logically ungrounded as it is, doesn’t even support the assertion of a speculative effect.  For instance, a common piece of “evidence” is that prices rose right along with measures of long speculative interest in the oil markets.  (This was a Michael Masters favorite).  Set aside the correlation-causation post hoc/propter hoc problems, and the potential for spurious regression problems whenever one examines the relation between two highly autocorrelated series.  Just look at the graph in this WSJ story:

Sure, prices and long non-commercial positions were both trending up in 2005-2008 (not that that means a damn thing).  But look at what happens in late-08 and early-09.  Prices and long spec positions are mirror images: prices were plunging when long interest was rising, and then, just as long spec interest peaked and began to fall, prices ceased their fall and moved strongly upwards.  How can you possibly explain this if the market dances to the speculators’ tune?  The speculative Pied Piper story says that these measures should move up and down together, not in opposite directions.  Now, this Masters style analysis is B.S., but those who used it to rationalize their assertions of a speculative effect are hoist on their own petard: they vouched for the validity of non-commercial long open interest as a measure of the “excess” demand for oil caused by speculation, but the most recent experience is decidedly inconsistent with that story.  Not that that they have even paused for thought, but continue to flog the same story.  

• Not to mention that numerous analyses, relying primarily on Granger causality, have failed to find any reliable connection between changes in speculative positions and price changes.  Or the analysis (by the CFTC!) showing that commercial traders tend to be market leaders and speculators are followers.

The calls for government regulation have gone international, and gone beyond calls for mere position limits.  Gordon Brown and Nicholas Sarkozy penned a WSJ editorial advocating widespread governmental “supervision” (Euphemism alert!) of the energy markets (including cooperation with OPEC):

For two years the price of oil has been dangerously volatile, seemingly defying the accepted rules of economics. First it rose by more than $80 a barrel, then fell rapidly by more than $100 before doubling to its current level of around $70. In that time, however, there has been no serious interruption of supply.

The oil market is complex, but such erratic price movement is cause for alarm. The surge in prices last year gravely damaged the global economy and contributed to the downturn. The risk now is that a new period of instability could undermine confidence just as we are pushing for recovery.

Where does one even begin the ridicule (beyond noting the point that whenever French and British politicians agree, it must be a really bad idea)?  Regarding volatility.  Uhm, the past two years have been among the most volatile in the memory of most living people–you have to go back to the 1930s to find anything remotely similar.  In 2007-FH2008, Chinese (and Asian growth generally) greatly spurred demand for commodities.  Note that in addition to commodity prices, shipping charter prices skyrocketed, even though the price of something perishable like transportation on a ship can hardly be distorted by speculative buying, because it has to be consumed and hence is impossible to hoard.  That was followed by a financial collapse and economic recession of severities unseen since aforementioned 1930s.  Look at every measure of uncertainty, notably such things as the VIX volatility index.  These things have been at dizzying heights since last August (and had begun their rise even earlier, in 2007).  What would be weird is if oil prices (and commodity prices generally) HADN’T been volatile during this period.  

Regarding “serious interruption of supply.”  Uhm, Gordo, Nicky–there’s this concept called “demand.”  Believe it or not, it’s one of the “accepted rules of economics.”  Don’t take my word for it.  It’s in all the textbooks.  Price evolution in the recent period is clearly demand driven, not supply driven.  Prices spiked when demand spiked.  Prices plummeted when demand cratered.  

And there have been supply shocks.  Nigeria is an ongoing source of supply shocks, and during the price spike last summer losses of sweet Nigerian crudes in the face of very high demand for distillates (driven in part by European regulations regarding clean diesel) led to big spreads between benchmark sweet crudes like WTI and Brent and sourer crudes.  What’s more, OPEC output cuts (especially by Saudi Arabia) played a key role in the firming of prices following the price collapse in October-January.

I should also note that recent research by Lutz Kilian (nicely summarized in his JEL piece) shows that movements in oil prices hew more closely to movements in proxies for demand than measures of supply.  James Hamilton disputes Kilian’s contention that supply shocks are unimportant, but Kilian does demonstrate that demand is clearly an important price driver.  (I also have some reservations about some of Kilian’s analysis, most importantly his conclusion that changes in demand for precautionary inventories is also an important driver of prices.  I don’t disagree with the logic, having written several posts and an academic paper–which will also be another chapter in the book–showing rigorously how that can work in practice.  My problem is that Kilian does not measure factors that could affect precautionary inventories directly, but instead attributes oil price movements not explained by supply or demand measures to an “oil market specific” factor which he asserts is related to the precautionary inventory effect.  I am currently working on developing some more direct measures that would influence precautionary inventory holdings.  I have a good handle on measuring demand side risks that could influence such holdings, but measuring supply side risks is far more difficult.)

In recent months, the oil market and world equity markets have exhibited unprecedented positive correlation (something I called attention to in October-November).  Oil and equities swooned together; they rallied together March-June; and have been selling off together in the last couple of weeks.  This reflects the dominant role of demand in commodity prices at present.  Both equities and commodities are responding to rapidly evolving views in a highly uncertain situation about the likelihood and strength of economic recovery.  They are also responding to government policies, notably aggressive quantitative easing strategies that raise the specter of inflation.  

Now, you could argue that this is speculative.  And indeed it is.  Both equity market and commodity market participants are speculating on the future course of the world economy.  But is it destablizing speculation?  

What’s more, to the extent that energy prices (and commodity prices) are reflecting information/perceptions/sentiment about the future course of economic recovery, and are reflecting the same information/perceptions/sentiment as equity markets and bond markets, why would anyone think that position limits on commodity derivatives would break this linkage?  Once embedded in equity prices, information/perceptions/sentiment about future economic growth become public information that will be embedded in prices even if speculators are forced to trade less.  

The arguments against position limits as a policy are well known.  Speculators absorb risk from hedgers, and supply liquidity.  They therefore impair ability of the markets to serve their essential risk shifting function.  They therefore increase the costs of managing risk, and impose harm on hedgers.

This makes a mockery of the distinction that politicians and regulators draw between the “good hedgers” with price exposures inherent in their businesses that need to be managed, and “bad speculators” who have no underlying exposure to manage, but are taking on risk like gamblers in a casino.  But there is a symbiotic relationship between hedging and speculation.  To whom do hedgers transfer the risk if not to speculators?  And if there are no speculators, how is it possible to hedge risks?; after all, hedging doesn’t make risk magically disappear, it just transfers it to somebody willing to hold it–a speculator.  Thus, politicians and regulators who invariably say that they just want to protect “legitimate” commercial participants from the predations of evil speculators are more full of it than usual.

That said, there is an apparent puzzle: many of the most ardent critics of speculation are physical market participants.  But it’s not necessarily a puzzle, for the same reason that nobody should be amazed that Walmart supports Obama’s health care plan: many firms benefit from regulations that make markets less efficient.

In the commodities case, here are a couple of examples.

It is well known that some commercial market participants are informed traders who make money on the basis of their information.  A Cargill, for instance, has an extensive information network that allows it to trade profitably.  (I sat at the trading desk of Continental Grain some years back, and observed that the traders had access to information around the world about weather conditions and grain flows due to their physical presence in numerous markets.  This gave them an information edge.)  Such firms don’t hedge mechanically.  They trade futures and other derivatives strategically to optimize a risk-return trade-off.  Their information advantage allows them to time the placement and unwinding of their hedges so as to make money.  

Competition from informed speculators tends to erode the competitive/information advantage that informed commercial firms have.  Hamstringing such competition could provide a greater benefit to such firms than would result from the loss of liquidity from speculators.  

As another example, a reduction in market liquidity resulting from speculative position limits almost certainly has disparate impacts on commercial firms.  Some firms, due to capital structure, operational leverage, real options, or other reasons, get more benefit out of hedging than other firms in the same industry.  A regulation that reduces market liquidity raises everybody’s costs, but the first type of firm’s costs go up more than the second type of firm’s.  Thus, the second type of firm may actually support regulations that make hedging costlier or less effective because it raises their rivals costs more than its own costs go up.  

So, the support of some commercial firms for restrictions on speculation is not necessarily a puzzle.  In my view, it more likely reflects an opportunistic use of the regulatory process to distort competition in a way that profits some firms.  This is a ubiquitous phenomenon, observed in many industries and many regulations: why should derivatives trading be any different?  

Well, that’s all I have to say for now, though I doubt this will be last word on the subject, hardy perennial that it is.  Like Sisyphus, I am resigned to the unending task of rolling the rock of enlightened reason up the slope of benighted ignorance, only to see it slip back down again:)

A trader at British oil brokerage PVM Oil Associates has been identified as a rogue trader who entered buy orders for 9mm barrels of Brent crude futures on ICE Futures in London during the illiquid early morning hours, causing a spike in the price of oil–and costing PVM $10 million.  To me, the most interesting aspect of this is the potential for can’t-change-their-mind-won’t-change-the-subject fanaticism of American legislators railing against the “London loophole”:

Unauthorised trading in oil futures in London and the corridors of power in the US Congress may not seem to have much in common.

But London’s markets have become easy targets for US lawmakers eager to show that loose practices on foreign energy markets are hurting US consumers.

Traders, so the theory goes, are carrying out nearly half the world’s global crude oil futures trades on ICE Futures Europe under the eyes of the Financial Services Authority.

The  PVM case  could re-ignite such concerns, just as US politicians are again railing against “excessive speculation” in energy and commodity markets.

This week Bart Chilton, a commissioner at the US futures watchdog, the Commodity Futures Trading Commission, said it was looking for signs of excessive speculation in commodity markets, with specific attention on oil prices.

Last month senator Carl Levin, a Michigan Democrat who has long campaigned for  tighter regulation of energy markets, said the US futures markets regulator needed to enforce strict position limits to curb speculation that last year caused record  wheat prices  that could not be explained by the dynamics of supply and demand.

A year ago, Mr Levin became convinced that improper trading of oil futures was taking place in the UK’s financial centre without sufficiently tight supervision by regulators.

A version of the West Texas Intermediate crude oil contract is traded in London on ICE Futures Europe, and regulated by the FSA. It is similar to the WTI contract traded on the New York Mercantile Exchange, regulated by the US futures watchdog, the CFTC.

Dubbing this the “London Loophole”, Mr Levin forced the CFTC to forge closer ties with the FSA, including a system by which the FSA would report irregular market activity much more quickly to the US.

Yet it does not seem to have worked as intended in the PVM case. CFTC officials claimed they were kept in the dark for several hours in spite of last year’s agreement for closer co-operation.

The FSA said on Friday: “We work very closely with the CFTC to ensure fair and orderly markets. The way we oversee the commodity markets is adequate for the UK regime.”

If there was any delay, regulatory experts say that could easily have been due to the time it took for FSA officials to get a clear picture of what had taken place at PVM, not a break-down in communications with the CFTC.

“The last thing they want to do is start rumours if they don’t know all the facts,” said one.

For the record: rogue trading is an international problem. A few choice examples: Singapore’s China Aviation Oil (2004, $550 million); France/Germany, SocGen’s Jerome Kervial, (2007-2008, $6.5 billion) (yes, with a “b”); Japan/Singapore, MItsui Oil Asia (2006, $81 million).  

Oh, and the United States.  We don’t know whether the 22 September, 2008 spike in the oil price–which dwarfed the recent spike apparently caused by the PVM trader–was due to a rogue trader, but it is highly suspect nonetheless.

And who can forget the MF Global trader in Memphis who lost $141.5 million in a day on Minneapolis wheat?  

I could go on.  

Where does rogue trading occur?  Well, where trading occurs.  There is a lot of trading in London, so it is inevitable that some rogue trading will occur there.  When assessing the adequacy, or not, of regulatory oversight in a market, it would be worthwhile to control for the magnitude of trading activity.  On that score, Singapore looks like a more dodgy place (with the infamous Nick Leeson/Barings episode in addition to the two cases listed above).  So, actions relating to the London Loophole (a vastly overrated financial bogey man in any event) are unlikely to have any effect on the frequency of rogue trading.  

It is primarily a problem of internal controls, but there is no system of controls that is capable of eliminating rogue trading altogether.  (Moreover, as with anything, there is a trade off, and it would be inefficient to invest in controls sufficient to eliminate such trading.)   And the US is hardly immune to the problem.  So although regulatory jingoism may feel good, it can happen here.  And it does.

The Senate Permanent Subcommittee on Investigations released a report on “Excessive Speculation in the Wheat Market.”  The report blames index funds in particular for driving up wheat prices, and particularly for driving a wedge between wheat futures prices and the price of cash wheat, both prior to and at contract expiration.  

The methodology of the report should be tiresomely familiar by now.  It notes concurrent events–(a) increased volume of trading by long-only index investors, and (b) higher prices and lack of convergence–and asserts (a) caused (b).  To be fair, the report does make comparisons between Chicago wheat and Kansas City wheat, which have experienced different degrees of index participation (measured by fraction of open interest) and convergence problems, but this analysis is weak because it does not attempt to determine whether other differences between the contracts might also be responsible for the differences in behavior.  (A bit more on this below.)    

However, the report largely ignores the rigorous empirical evidence that has examined the relations between index fund trading and price changes, and found no reliable evidence of such a connection.  Moreover, there are numerous commodities embedded in the indices, and the following the logic of the hypothesis, increasing index activity should affect price levels and cash-futures relations in all of these markets.  The report does not undertake a rigorous cross-sectional or time series of the cross-section analysis of the relation between index participation and the basis or convergence.

There are also serious logical problems with the analysis.  The main issue relates to the convergence of deliverable cash and futures prices as a contract moves to expiration.  It is very difficult indeed to see how index funds could possibly be implicated for this phenomenon.  Index funds roll from the expiring contract to the first-deferred contract before expiration. They therefore cannot have a direct impact on the expiring futures price at expiration.  Indeed, during the roll, long-only funds are selling the expiring futures, which per the crude story embedded in the report should cause that futures price to decline relative to the cash price.  In brief, I cannot think of any reasonable argument explaining how index funds can prevent convergence when they are out of the market altogether when the absence of convergence has occurred.  

Relatedly, the report repeatedly states that the index funds are creating demand for wheat (and other commodities).  Uhm, no, actually.  They don’t take delivery, and don’t consume the physical wheat or hold it off the market.  For every contract they buy, they also sell, so they don’t create any demand.  Moreover, although unexpected flows of buy orders can cause price reactions even if the orders are submitted by the uninformed (because other market participants don’t know exactly who is submitting the orders and there is a positive probability that the buy is from an informed trader), index activity is pretty well understood, and unlikely to result in the market being systematically surprised as would be required to support the report’s conclusion.  

The analysis also begs the question of why smart money hasn’t piled in to offset the purported effect of the dumb index money.  After all, in the scheme of things, the Chicago wheat futures market isn’t that large.  If the investment of the index funds was sufficient to drive up prices, not that much investment would be required to have an offsetting effect.  During the time that the basis and convergence anomalies were most pronounced, the world was awash in liquidity and capital desperate for returns.  Not only was money piling into indices, it was also going into hedge funds and managed futures funds whose whole business is to identify mispricings and jump on them.  That is, if this was an era of “excessive speculation” as the report laments, why didn’t other evil speculators trade ruthlessly against the dumb money?  

All this said, the absence of convergence during the period studied (most pronounced in wheat, but also present in corn and soybeans) is a puzzle.  It would seem to present a fabulous opportunity for operators of delivery facilities (e.g., Cargill, ADM and The Andersons) to make huge money buying cash, selling expiring futures, and delivering, and continuing to do that until convergence was achieved.

In a competitive market, the spread between expiring futures and cash prices should equal the marginal cost of making delivery.  This should be true, regardless of whether index funds are inflating the entire price structure or not.  What could explain such an extremely high shadow cost of delivery?  

One difference between Chicago and Kansas City is that the former’s contracts use a shipping receipt delivery mechanism which is effectively a call option on delivery elevator capacity, whereas the latter’s is a traditional in-store warehouse receipt delivery mechanism.   The report doesn’t mention this difference, which in theory could have an effect on futures-cash spreads (as I outlined in posts last summer).  However, it is difficult to believe that this option-based story is sufficient to explain the very large futures-cash spreads at expiration.  

Where convergence is concerned, the first focus of inquiry should be the behavior of delivery elevators and their operators.  It needs to be asked: “Why don’t you deliver more when the expiring future is so far above the cash?”  It is an extremely serious failing of the report that it does not ask this question.  Interestingly, the names “ADM,” “Cargill,” and “The Andersons” appear only once in the report–and then only to state factually that they operate delivery facilities.  It is beyond belief that any serious study of the convergence issue would not attempt to dig into this real mystery of why operators of delivery facilities do not pick up the money that appears to be there in large amounts for the taking.  This is not an accusation of any wrongdoing–perhaps there is an explanation, and the apparent large sums of money to be had are chimerical because there is some cost that the delivery facility operators incur that is not obvious to me and other observers of this phenomenon.  But it should be the primary focus of any examination of convergence.  In the Senate report, this issue doesn’t even rise to the level of afterthought: it isn’t thought about at all.

The flagrant failure to engage the primary puzzle suggests that this was not a serious endeavor to understand an admittedly anomalous regularity in the wheat market.  Instead, it suggests that the Subcommittee and its chairman, Levin, had predetermined agenda: Speculation bad!  Index speculation bad!  The report goes nowhere close to proving that point.  Indeed, its watery-thin empirics, shaky logic, and failure to ask the most basic question prove only that one shouldn’t look to legislative reports for a serious discussion of serious issues.  They are polemics, not science.

The European Commission has just released a Commission Staff Working Paper  on “Ensuring efficient, safe, and sound derivatives markets.”  Not surprisingly, it comes out in favor of extending central clearing, especially to credit default swaps.  It must be said that the EC’s paper is far superior to the product of the US Treasury Department (a low bar, to be sure).  That said, I believe that many of the arguments and conclusions are fundamentally wrong.  The paper does the best job I have seen in making the case for extending clearing, but in so doing has unintentionally pointed out the flaws in that case.  Indeed, the basis for many of the paper’s conclusions actually supports the exact opposite of what the paper recommends.

At a high level, the failings of the paper are: (1) it identifies alleged benefits of central clearing, virtually all of which are private benefits, but completely begs the question “if these (private) benefits are as large as the EC says, why haven’t private parties adopted central counterparties (CCPs) more widely?”; (2) relatedly, it does not provide any explanation of why the market share of products purportedly traded on inefficient market structures has increased in recent years; (3) it fails to take into account the endogeneity of market structure, or explain how these structures arose and why–or why not–they are inefficient; and (4) although it clearly identifies the unique risks associated with CDS, it draws the exact wrong conclusion about how default risks from CDS should be borne–bilaterally or through a CCP.

The paper’s main case for CCP clearing (set out in section 2.4.2 and 2.4.2.2) focuses on netting, and the benefits associated therewith including “more efficient use of collateral” and “operational efficiencies.”  But these are benefits captured by the members of a CCP, and provide no rationale for mandating the adoption of clearing.  There’s no externality related to these issues that needs internalizing.  Relatedly, the paper asserts that a CCP is “considered a zero risk counterparty” and hence frees regulatory capital.  Really?  Clearinghouses can fail.  Cf. Hong Kong, 1987, and the near failures in Chicago at the same time, and the near failure on COMEX on “Silver Tuesday” 1981.  If regulators really treat it this way, a CCP would be a source of regulatory arbitrage, again meaning that market participants would have a strong–too strong, in fact–incentive to adopt it.  

With respect to risk sharing and collateral, the paper mistakenly claims that all collateral can be used to cover the costs of a default.  This is obviously wrong–as the box on SwapClear default management process in section 3.2.5.1 shows.  

The paper fails to mention that netting is not necessarily a social benefit, and can facilitate redistribution from one group of firms to another.  This redistribution can also give excessive incentive to form a clearinghouse.  

The paper also fails to recognize that more rigid collateral mechanisms can reduce the utility of a market as a hedging mechanism, and forcing adoption of these mechanisms can actually increase risks some firms face by precluding otherwise mutually beneficial hedging trades.

The paper touts that a CCP “an institution whose sole focus is risk  reduction.” But the world involves trade-offs, and an organization with a “sole focus” is not able to make such trade-offs. If the CCP prices risk appropriately, and therefore charges the right amount of collateral, then other market participants will make the appropriate decisions. But as I’ve argued extensively here, in my Regulation Magazine piece, and in working papers and presentations, for many transactions the clearinghouse is at an informational disadvantage relative to dealers in appraising risk–in which case it is less likely to price risk appropriately.

Moreover, the paper does not consider the incentives that the CCP faces. Yes, it has one job, but how strong are its incentives to do that job? A CCP is typically subject to low-powered incentives (e.g., non-profit form), which is understandable since it is an agent, and an agent of multiple principals; whereas a dealer bears many of the costs of poor counterparty risk management, as an agent the CCP does not. Moreover, although the CCP is touted as a solution to systemic risk, if systemic risk gives rise to externalities that affect those beyond its membership, this benefit is overstated: the CCP does not internalize all relevant externalities and therefore takes too few measures to address systemic risk.

The clear logical implication of the EC paper is: “If clearing is so great, somebody should have done it by now.”  Like virtually all advocates of the idea, the EC paper does not raise, let alone answer, that objection.  To do so, the EC must identify the market failure, and show how its proposed solution would ameliorate it. It has not done so.  It has not even recognized the necessity of doing so.  

The paper also asserts that clearing can “solve[] disruptive information problems” by improving information on positions.  But this can be achieved without the mutualization of risk that clearing entails.  

The paper sets out in great detail the dramatic growth in OTC trading, and the limited penetration of clearing, even in relatively standardized sectors.  Again, given the asserted benefits of clearing and other changes to OTC market structure, this calls for an explanation that is completely absent from the paper.  There must be something else going on here sufficient to overcome the supposed advantages of a CCP.

The paper does provide a very nice description of the variations in structure across different OTC products.  Note that these structures arise endogenously.  This raises the questions: (1) why do different products (e.g., interest rate swaps and CDS) have different structures? and (2) are these structures inefficient?  The endogenous variation suggests that there are fundamental differences across products and participants, and that different structures have evolved to accommodate these differences.  The paper sets out no serious argument or evidence that these variations are accidental, or inefficient.  As a result, it provides no basis for recommendations on how to change market structure via regulation.  

This failure to grapple with endogeneity–the causes of variations in market structure across products–leads to silly inferences, such as: “CCPs have proven to be resilient even under stressed market conditions . . . and showed their ability to ensure normal market function in the case of failure of a major market player” (2.4.2.1).  Yes . . . but this does not imply that similar results would obtain if all products were cleared.  The products that are cleared, and which worked successfully, have attributes that differ from the attributes of products that are not cleared–a point that the paper makes very forcefully.  Therefore one cannot conclude that requiring clearing of other products would work as well.  It could also be stated that other non-cleared products, e.g., CDS, also worked successfully in the face of the failure of a major dealer.

This issue of the differences across products is essential, and one that the paper raises repeatedly before drawing the wrong conclusion.  For instance, in the Executive Summary, and elsewhere, the paper says that CDS are different because of their “binary and discontinuous pay-out structure, concentrated dealer market structure, difficulty in valuing the rights and obligations contained in the contract, especially for the less liquid single name part of the market, lack of solid risk management measures and disproportionate dimension of the derivatives market with respect to the underlying market.”  I agree, completely.  

But I disagree with the conclusion drawn from these differences: “CDS have particular risks . . . all of which are difficult to mitigate . . . . For all these reasons, CCP clearing is desirable.”  But all of these features pose major informational challenges to clearing, and in my view, make it sensible to share risks bilaterally; the conclusion therefore does not follow from the stated premise.   Similarly, the paper points out the valuation difficulties involved in setting collateral from some products, due to the difficulties of valuation.  Again, agreed.  But the relevant question is who can do this better, bilateral parties or a CCP.  For some products, a CCP can do just fine, but for other products, it is quite likely that dealers can do a better job.  

These very considerations are why many operators of clearinghouses–who at first blush would seem to have an interest in a clearing mandate–have come out almost universally against such a requirement.  Note, this is not allegedly self-interested dealers talking: it is the clearing operators.  They recognize the unique risks of clearing some products, notably CDS, and believe that these risks make some products inappropriate for clearing.  That’s been the gravamen of my argument all along, but the paper completely overlooks this point–even though the clearing operators expressed their reservations very publicly weeks before the paper was released.  

Relatedly, in section 2.4.1.4 the paper identifies as a “Potential weakness of bilateral clearing” to be the fact that it relies on “each party’s internal ‘risk engine’ . . . . These risk engines are essential parts of a bank’s comparative advantage and while the broad contours may be similar each bank has a slightly different approach to risk assessment.  Overall, the crisis has highlighted the difficulty of designing models that adequately measure market risk.”  True, again.  But the relevant–unasked–question is: in this imperfect world, who can design the better model?  (Not perfect, but better.)  Due to the very “comparative advantage” aspect the paper identifies, dealers and other big traders have stronger incentives and better information to build better models than a CCP.  (A point I first made back in the 1990s.)  Moreover, an argument can be made that diversification in models is beneficial as a way of reducing the market’s exposure to model risk, whereas a clearinghouse chooses one model, and exposes the market in a big way to its (inevitable) limitations.  

In sum, in my view the paper presents a very thorough and accurate overview of the various OTC markets and products, and the unique characteristics of these products.  It then either ignores the implications of these differences altogether when making its recommendations, or makes recommendations that do not follow from its factual analysis.  Indeed, its recommendations are often the opposite of what a thorough consideration of the implications of these differences would imply.  

That is, the paper is very effective at pointing out the wide variation in the informational and risk characteristics of the various products traded in the OTC market.  It also effectively characterizes the wide variation in trading structures.  But it fails altogether at connecting these two inherently interconnected things.  Moreover, it focuses on the private benefits of its favored “solution” (clearing), even though this cannot be the appropriate basis for its policy recommendation.  There must be some sort of externality or other market failure that results in the adoption of inefficient institutional arrangements, but the paper fails altogether to identify what this externality or other market failure.

In brief, whereas the Treasury Department earns an F+ (and I am a generous grader), the EC merits a gentleman’s C.  It at least provides a factual basis for a considered analysis of the trade-offs entailed with different market structures.  I disagree with the conclusions it draws from its facts, but it’s a start, and a big improvement over Treasury’s arguendo ad AIG.

A couple of interesting stories about investment and Russia: one about investment in Russia, the other about Russia as an investor.

The investment in Russia story involves Putin’s invitation to Shell to participate in the Sakhalin III and IV projects.  Shell, if you recall, was browbeaten into giving up a stake in the Sakhalin II project at a bargain basement price to Gazprom.  The new offer (along with deals with German Eon and French Total) is widely considered a symptom of Russian desperation for cash as a result of the financial crisis, and its technological backwardness, combined with the desperation of the supermajors to replenish reserves.  

To me, reserves or no, it is the height of folly for Shell to rush back in.  Russia has proven time and again that it has myriad ways to separate oil majors foreign and domestic from their oil investments.  Environmental regulations, taxes, labor law, you name it.  Although some have suggested that Shell will only invest if it receives “international bank guarantees”  I don’t find this credible.  What bank would take this risk?  How could you write a contract that would specify the relevant contingencies, given the imagination of the Russians in finding ways of exerting pressure to extort wealth?

Russia may be desperate.  Today.  They were desperate in the late-90s when they entered the PSAs with Exxon and Shell and others.  They took the terms offered, then undid some of the deals when prices turned around and they felt that they didn’t need the supermajors’ money.  

Indeed, Russia used the fact that it agreed to the PSAs due to its economic exigencies to justify its subsequent attacks on Shell and others; it had been taken advantage of, Russia whined, and was taking back what had been taken from it due to its weakness.  

It is eminently predictable that it will do the same again when the market turns around at some future date. Indeed, if Shell and others rush back in now, it will reassure Putin and future Russian leaders that they pay no price for expropriation.  Steal from them today, and they’ll be back tomorrow.  

So, it appears that Shell is ready to play Charlie Brown yet again.  Good luck with that.

The other story relates to GM’s second thoughts about selling Opel to Magna, Sberbank, and Russian automaker GAZ.  GM is seeking other potential buyers, and demanding Sberbank pay 14 times more than it originally offered (perhaps reflecting a perception that the economy has firmed and the value of Opel is higher as a result).  

Another sticking point is concern about technology:

However, the Magna talks have run into difficulty over access to the Detroit group’s global technology, which Magna wants to secure on behalf of Russian partners. If the sale proceeds, Magna and Sberbank plan to build Opel-based cars in Russia with Gaz, billionaire Oleg Deripaska’s car company.

This is wise.  Property rights in Russia are weak, and this is especially the case with respect to intellectual property.  It will be very difficult for Opel and GM from keeping GAZ from circumventing any contractual protections on its IP.  

In short, whether you are thinking of investing in Russia, or having Russians invest in you . . . be VERY careful.

Finally had a chance to look over the much anticipated Treasury White Paper on “reforming” financial regulation.   It’s a long document, addressing many issues with which I am not that conversant, so I will focus my attention on the Paper’s recommendations for OTC derivatives.

The Paper begins its analysis with an extended discussion of what it asserts was a “lax regulatory regime for OTC derivatives–and, in particular, for credit default swaps” (p. 44):

In the years prior to the crisis, many institutions and investors had substantial positions in CDS–particlarly CDS that were tied to asset backed securites (ABS), complex instruments whose risk characteristics proved to be poorly understood even by the most sophisticated market participants.   At the same time, excessive risk taking by AIG and certain monoline insurance companies that provided protection against the decelines in the value of such ABS, as well as poor counterparty risk management by many banks, saddled our financial system with an enormous–and largely unrecognized–level of risk.   When the value of the ABS fell, the danger became clear. . . . Lacking authority to regulate the OTC derivatives amrket, regulators were unable to identify or mitigate the enormous systemic threat that had developed (pp. 44-45).

Based on this rather tendentious reading of the history of highly non-standardized, illiquid instruments, and on this reading alone, the Treasury makes the following policy recommendation:

To contain systemic risks, the Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).

This has to be one of the most collossal non-sequiturs on record.   Highly non-standardized financial derivatives allegedly led to a systemic crisis–so we should mandate clearing for standardized products.   As an exercise in logic, by comparison to this the “Burn the Witch” scene in Monty Python in the Holy Grail is a model of precise reasoning.

Thus, as has been true all along, the case for clearing of standardized OTC derivatives levitates, with no evident means of logical or empirical support.   This could be a great Vegas magic act.

In retailing, this is known as the “bait-and-switch.”   Regulators often punish stores that engange in such conduct.   Here, we’re out of luck–because the regulators are the ones perpetrating the bait-and-switch.

A coherent case for mandating clearing would require a demonstration that OTC derivatives suitable for clearing pose a systemic threat, at least illustrated by anecdotes analogous to the now tired arguendo ad AIG.   (The absence of any such anecdotes is very, very telling–not to mention that argument-by-anecdote is a very de minimus standard because “data” is not the plural of “anecdote.”)   What’s more, the argument would require a rigorous comparative analysis of the systemic risks posed by alternative mechanisms–bilateral and centrally cleared.   Instead, we are repeatedly entertained by next part of the magic act: assertions that clearing makes these risks disappear!

Even the arguendo ad AIG has its defects.   To wit:

• If “the most sophisticated market participants” failed to recognize the risk characteristics of the CDS on ABS, how possibly could one expect a CCP to do any better?   Yet another magic trick: the CCP as deus ex machina, that magically appears to solve all of the difficulties that had stumped the most sophisticated.   Indeed, if anything, the CCP is likely to be a less sophisticated evaluator of risks.   So wouldn’t forcing things onto clearinghouses potentially make things worse?
• “Excessive risk taking by AIG and the monolines . . . saddled our financial system with an enormous . . . level of risk.”   This betrays a serious misunderstanding of the role of derivatives.   As I argued in It’s a Wonderful Life, AIG Edition, AIG et al took on existing risks associated with existing ABS.   If AIG et al hadn’t taken on the risk, it would have remained somewhere else in the financial system.   And it’s almost certain that it would have remained with Goldman, SocGen, DB, etc.   So, if the decline in ABS prices was so big to threaten the existence of those firms unless AIG paid off on its CDS, their existence would have been even more threatned without AIG’s equity absorbing a portion of the loss.   The bailout would have been bigger, not smaller.   The only substantive difference is that it would have gone to these firms directly, rather than being laundered through AIG.
• More generally, this points to a continuing defect with the Treasury analysis, and most other analyses of regulatory changes: the equilibrium responses to these changes.   It is clear that Treasury, and Washignton generally, now views OTC derivatives as the financial equivalent of Satan, and wants to crack down on them.   Let’s say this happens, and OTC derivatives shrink, or even disappear.   How will market participants respond?   Will there be less hedging because an instrument that revealed preference suggests is superior to available alternatives is constrained?   If so, will the system become more susceptible to disruption, not less?   By focusing on the seen, and failing to inquire at all about the endogenous, equilibrium effects of changes in regulation that are largely unseen, regulators are likely to make things worse, not better.
• As I’ve noted before, “standardization” is a red herring in many respects.   Standardized instruments may be unsuitable for clearing due to serious information problems.

Other policy recommendations also float in the air, untethered by logic or evidence.   For instance, the White Paper asserts in a decidedly conclusory way that “[m]arket efficiency and price transparency should be improved in derivatives markets by requiring the clearing of standardized products . . . and by moving the standardized part of these markets onto regulated exchanges and regulated transparent electronic execution systems . . . . Furthermore, regulated financial institutions should be encouraged to make greater use of regulated exchange traded derivatives.”

Note the implicit assumption that incumbent arrangements are inefficient, and result in an inefficient level of price transparency.   Why should inefficient market arrangements persist?   Surely, they can.   And if they do, it should be possible to present argument and evidence demonstrating this.   No luck if you are looking for anything about that in the White Paper, or virtually any government discussion of this issue.

Another lighter-than-air argument relates to “market integrity”: “Market integrity concerns should be addressed by making whatever amendments to the CEA and the securities laws that are necessary to ensure that the CFTC and the SEC . . . have clear, unimpeded authority to police and prevent fraud, market manipulation, and other market abuses involving all OTC derivatives” (p. 46).   What the necessary laws might be, the Paper doesn’t bother to say: I guess that’s the mind reading portion of the act.   Again, you would think that if there are demonstrable gaps in the existing authorities to punish manipulation, etc., it would be possible to cite chapter and verse to support the claim.   No such citations here.

I can only hope–and I am sure that it is just that–that the level of analysis is superior in the remainder of the White Paper.   All I can say is that the case laid out regarding the dangers of OTC derivatives, and the improvements that would result from the policy recommendations, is completely lacking.   Completely.   Like I said above, the policy recommendations regarding OTC derivatives levitate, unsupported by any serious analysis or evidence.   Out of such sloppy group-think legislative and regulatory disasters are made.   So get ready for an explosion when the spark of reality ignites the gas holding aloft this regulatory Hindenberg.