Streetwise Professor

Ambrose Evans-Pritchard has a fascinating article in today’s Telegraph. It is fascinating on many levels.

For one, it helps explain why European banks have been battered even worse than American ones. European banks invested in made-in-America subprime (which suggests that Americans are not uniquely culpable for that problem), but they also plunged far greater sums into emerging market investments, all of which are plummeting in value. The travails of European banks, and the prospects of worse to come, also helps explain the dramatic weakening of the Euro, the pound, and the Swiss franc.

Although US subprime has attracted most of the attention, because it cratered first, it is clearly not the only source of toxicity in bank balance sheets. It is becoming increasingly evident that low interest rates, attributable in part to the Asian savings glut and partially to liberal US monetary policy (less so European directly, but in an open economy Europeans didn’t have complete control over their interest rates) that encouraged yield shopping in a big way, and yield shopping means “add risk” in any language.

For another, the article also has some interesting tidbits about Russia. To wit:

Russia too is in the eye of the storm, despite its energy wealth – or because of it. The cost of insuring Russian sovereign debt through credit default swaps (CDS) surged to 1,200 basis points last week, higher than Iceland’s debt before Götterdammerung struck Reykjavik.

The markets no longer believe that the spending structure of the Russian state is viable as oil threatens to plunge below $60 a barrel. The foreign debt of the oligarchs ($530bn) has surpassed the country’s foreign reserves. Some $47bn has to be repaid over the next two months.

As Michel pointed out in a comment to another post, the heavy indebtedness of the oligarchs presents the Russian government with several unpalatable choices (though DR does not find them as bad.) Bailing the oligarchs out of their foreign denominated debt would put a large dent in, and perhaps exhaust, the massive reserves that Russia has so assiduously accumulated in the past several years. Since most of the debt is collateralized by shares in companies, many of which are Russian (though, again per DR, some are in the US and Europe), oligarchic default would transfer large ownership positions in “strategic” Russian businesses to despised foreigners. Or, the Russian government could expropriate the oligarchs/nationalize their businesses, and hang the Western lenders out to dry. By so doing, they would keep their “crown jewels” out of the hands of foreigners (and, conveniently, in the control of the siloviki in the government), but (a) this would turn Russia into a pariah that would have acute problems accessing capital markets in the future, and (b) destroy value by concentrating even more control over enterprises in state hands, which distorts incentives and encourages rent seeking.

My guess is that in the short to medium term, the government will try to buy time and dole out financial support to the oligarchs in the hope that things will turn around. Only if the country’s reserves are depleted too rapidly, or the reserves fall to an uncomfortably low level, will the government contemplate something more extreme. And if it comes to that, I would wager that Russia would choose “pariah” over ceding substantial stakes in “strategic” businesses–even minority stakes–to foreigners. The latter option is too much at odds with the entire rationale for Putinism, and would drive the nationalist elements in Russia around the bend, thereby jeopardizing Putin’s domestic support. Given the choice between stickin’ it to The Man (i.e., foreigners) and living without foreign capital (who needs those bloodsucking bastards anyways?), and being labeled a traitor to the motherland, I think it’s pretty clear which way Putin would jump. But maybe he’ll get lucky, things will turn around, the price of oil will recover (along with the world economy) and Putin will never have to make that hard choice. That’s why buying time and spending the reserves makes sense in the near term.

But, suffice it to say, that the worm has truly turned in the last three months. During that short time, Russia has gone from globe straddling giant (in its own mind, anyways) to a gambler looking to survive by drawing an inside straight. Not that things are rosy in the USA, but as bad as things are here, I’d rather play our hand than Putin’s.

According to this Interfax report, Vladimir Putin has provided assurances that investment in Russia’s energy sector is risk free!:

Investment in Russian oil, gas sector risk-free, Putin tells Shell CEO
Interfax

Moscow, 20 October: Russian Prime Minister Vladimir Putin has assured Shell chief executive Jeroen van der Veer that investment in the Russian oil and gas industry carries no risks.

“These concerns can be lifted,” Putin said, commenting on the Shell CEO’s view that Russia had to guarantee good payback terms when foreign companies developed Russian deposits.

“In Jackpot, you can win or lose, and more often than not you lose. But if we draw up a system in which we can fully repay the spending on exploration and not refuse to reimburse you for developing these deposits, then there will be no losses, and there’ll be an opportunity to win big,” Putin said, commenting on the Shell CEO’s remarks.

“We intend to continue to improve regulatory standards in the sphere of natural resources,” the prime minister said.

For his part, Russian First Deputy Prime Minister Igor Shuvalov explained the gist of the discussion between Putin and Van der Veer: “Jackpot carries high investment risks. Our head of government stressed that investment carries no risks.”

I feel so much better now!

I mean really, how is one to interpret to such Orwellian statements? Is it that Putin has an extremely sadistic sense of humor and he just wanted to torment Van der Veer, one his previous victims (Sakhalin II)? Or, perhaps, making such outlandish assertions and then standing back and to observe that nobody contradicts him validates his sense of absolute power. Or maybe, just maybe, he has stared into an (economic) void, and has come to the realization that the vision that the world was at his (and Russia’s feet) when oil was $140+/bbl was chimerical; that his previous cockiness was nothing but a case of the Cocaine Blues; and that Russia desperately needs the likes of Shell and other foreign investors.

Even if the last conjecture is right, hopefully Shell and BP and others will think “once burned, twice–no thrice–shy.” For if Vlad has turned on a dime once, he can do it again. And once somebody has put their money in assets–like oil wells–that cannot be picked up and moved out of Russia, he will have no compunction at expropriating yet again. And he will do so exactly at the moment when the investments are most valuable.

So, Mr. Van der Veer, and your fellow energy CEOs: Don’t be a sucker.

My most recent clearing post explored the possibility that the formation of a clearinghouse for OTC derivatives is efficient, but that distributive considerations and collective action problems have heretofore prevented its formation. In this post, I consider the possibility that the costs of formation of an OTC clearinghouse (for CDSs, for instance) exceed the benefits.

A central counterparty (CCP) is a default risk sharing mechanism. In a typical CCP setup, a group of intermediaries who trade on their own account and as agents for customers share default risk among themselves. If a customer defaults, the intermediary through whom that customer clears bears the loss. The risk sharing mechanism kicks in only if the one of the CCP member firms defaults.

Two factors drive the default risk that the CCP members share. The first is the riskiness of the instruments that are cleared. The second is the riskiness of the balance sheets of the member firms. A default occurs only if (a) a member firm incurs a loss on its position(s), and (b) this loss exceeds the value of the other assets (net of liabilities) that the firm can draw upon (e.g., sell) to cover this loss. Thus, the members of a CCP take on an option-like exposure, where the option is a complex one with a payoff that depends on multiple factors, namely, the prices of the instruments cleared and the values of the other assets and liabilities in each member’s portfolio.

Recent events (though not in the context of a CCP) indicate that both sources of risk are important in determining the likelihood of default. Lehman and Bear Stearns defaulted on their derivative obligations not because of losses incurred on these derivatives, but because of losses incurred on other investments (primarily mortgage securities). In contrast, AIG collapsed because the huge losses on derivative positions overwhelmed the capital on its otherwise healthy balance sheet.

To operate effectively, any risk sharing mechanism must price risks appropriately. Mispricing of risks provides perverse incentives. If the default risk posed by a particular member of a CCP is underpriced, that member will trade excessively, thereby imposing excessively large risks of loss on the other members.

It should be noted that in practice CCPs typically do not charge different members different fees to reflect differential risks. That is, there is no “experience rating” of clearing fees. Instead, CCPs price risk indirectly by choosing collateral (margin) levels and capital requirements. Since the CCP is effectively a risk sharing mechanism, where the risks are not priced directly and “premiums” do not flow from one member to another, a CCP ideally sets collateral and capital levels so that the expected default cost is the same across all members. By doing so, there are no wealth transfers across members. Failure to do so leads to a transfer of wealth from one set of members to another.

Even though CCPs do not price default risk through insurance premia, as a convenient shorthand I will refer to the pricing of default risk by the CCP, with the understanding that this pricing is indirect through the setting of collateral.

Information asymmetries challenge any risk pricing/insurance mechanism. If the insured (i.e., a clearing member) has better information about his risks than the insurer (i.e., the CCP), he will trade too much and hold positions that are too big when his information indicates that the insurance is underpriced, and trade too little and hold positions that are too small when his information indicates that the insurance is overpriced. Asymmetric information problems usually result in incomplete insurance of risks. In the extreme, information asymmetries and the associated adverse selection and moral hazard problems can make risk sharing inefficient altogether.

In the context of a CCP, asymmetric information about the instruments traded and the balance sheets of the dealer firms that trade them–and who would be the members of a CCP–impedes the sharing of default risk. The severity of these information problems can vary by instrument, and by the nature of the firms that intermediate the trading of these instruments. An examination of CDSs in particular, and more exotic derivatives in general, strongly suggests that asymmetric information about both risks is likely to be acute. This tends to reduce the net benefit of introducing a CCP for these products, and may make this net “benefit” negative, especially when the costs of establishing and operating a CCP are considered.

First consider the issues relating to the risks of a particular type of instrument. To price risk, a CCP uses information on (a) the risk-return characteristics of this instrument, and (b) the current price/value of the instrument. Given the current value of the instrument, and holding the (true economic) capital of a member firm constant, the likelihood of default depends on the probability distribution of returns on the instrument and the size of the position. Therefore, margin setting/risk pricing depends on information regarding the price behavior of the instrument. Moreover, information about the current price of the instrument is important. A CCP uses an estimate of market price to adjust collateral. Using an incorrect price leads to an incorrect estimate of the gain or loss on a position, and therefore to an incorrect determination of the risk exposure, and relatedly, the collateral level.

For homogeneous, linear, traditional instruments traded in liquid, transparent markets, a CCP is likely to have information on these variables that is nearly as good as, and perhaps better than, that in possession of its members. For an actively traded instrument (e.g., S&P 500 futures), transactions are numerous and observed, so positions can be marked to current value with no difficulty. Moreover, extensive historical data is readily available to calibrate risk models, and “rocket science” modeling is not necessary to estimate these risks. Thus, for such instruments, centralized clearing is unlikely to face severe adverse selection problems, and risks can be priced correctly. One would expect to observe central clearing for such instruments–and one does.

Things are quite different for exotic instruments. These instruments are traded less frequently, and so current market price information is harder to come by. Indeed, at times, there may be no transactions, so it is necessary to “mark-to-model” rather than “mark-to-market.” Moreover, sophisticated modeling is necessary to quantify and understand the risks of these instruments.

This pricing complexity is likely to be an important issue for credit derivatives, especially on individual names. The products are relatively new. Often they are not traded in high volumes in liquid transparent markets. Marking to market is not a trivial exercise as a result. Moreover, understanding the risks of these things is difficult. This is particularly true for portfolios of these instruments, due to the potential for default dependence between different instruments (i.e., the unconditional risk of default of a single instrument is not sufficient to determine the risk posed by a CCP member with positions in multiple instruments; you need to know about the correlations across instruments, and these dependencies are especially tricky to model and calibrate with credit products).

Big dealer firms specialize in developing models designed to quantify and characterize these risks. Moreover, these dealers expend resources to develop the data to calibrate and test these models. They have strong incentives to develop good models, as with better models they can manage their own risks better, and perhaps generate higher trading profits. Therefore, it is highly, highly likely that for a product like CDSs, dealer firms that engage in proprietary trading of these instruments will have better models and better information than a CCP.

To reiterate something I’ve said in previous posts, this is not to say that these models are great in some absolute sense. The key issue in risk sharing is asymmetry, which depends on the relative quality of information. If a CCP member has a better model than the CCP, there is an information asymmetry problem, even if the former’s model is, well, pretty bad. As I’ve said before, the one eyed man is king in the land of the blind.

(For an illustration at the problems associated with third party’s attempts to evaluate the risks of heterogeneous, complicated, non-linear derivatives, consider the rating agencies’ disastrous experience with CDOs, and monoline insurers.)

Thus, in my view, it is almost certainly the case that for exotic derivatives, and for CDSs in particular, dealer firms that make markets in these products have much better information about their values and risks than would a CCP. This creates the potential for adverse selection, which reduces the benefit of default risk sharing through a CCP.

It should also be noted that big dealer firms that (a) are the primary intermediaries in exotic derivatives and CDS products, and (b) would be the members of any OTC derivatives clearinghouse, are very complex financial firms with relatively opaque balance sheets. They are in the business of providing information intensive intermediation, through their loans, investments, and trading. As a result of this information intensity, it is challenging for third parties to appraise their balance sheets, and quantify the risks associated with those balance sheets. It is certainly the case that the intermediaries (banks and investment banks and in some cases insurance companies) have better information than third parties about the value of the assets and liabilities on their balance sheets, and the risks of those assets and liabilities–including the correlations between those asset and liability values and the values of derivatives positions on its books.

This means that if a CCP’s members are complex dealer firms engaged in information intensive intermediation, the potential for asymmetric information about balance sheet values is acute.

Put these two things together, and it is evident that the formation of a CCP to clear exotic products, including credit derivatives, and which has big financial institutions with complex balance sheets who supply information intensive intermediation, faces far more daunting challenges than a CCP clearing “vanilla” products and which has simpler firms has members. The pricing of risk is almost certainly far more difficult, and more importantly, the potential for information asymmetries is far greater. Thus, adverse selection problems would almost certainly be far more acute if the big dealer firms formed a CCP to share default risks for credit derivatives and other exotic products.

This suggests caution is in order in moving towards a CCP structure in CDS products in particular. Myriad regulators, market participants, commentators, and legislators have seized on central clearing as the panacea for these products. There has been little–if any–recognition in the public debate of the special challenges that these kinds of products and the institutions that trade them would impose on a central clearing mechanism. Thus, it is quite possible that a CCP has not been adopted for these products is not due to the selfishness of dealers who fear that clearing would increase competition for them, but instead reflects a sober appraisal of the greater costs of sharing default risks for these products.

A couple of other points are worth noting. First, traditional CCPs typically do not vary risk pricing (i.e., collateral levels) to reflect the balance sheet risks specific to each member firm. CCPs typically set collateral levels based on the risks of the instruments held in each member’s portfolio of cleared products, and two members with the same portfolio would post the same collateral even if their balance sheet risks are quite different. CCPs do impose some constraints on balance sheets, but normally through capital requirements that are simply a function of collateral levels. For instance, the CME clearinghouse sets minimum member capital equal to a multiple of the member’s margin level. Importantly, it does not vary capital requirements or collateral levels based on assessments of the balance sheet risks of member firms. Thus, in most CCPs balance sheet risks are not priced.

This may not be a big problem when CCP members are relatively simple–and relatively homogeneous–firms with relatively simple and transparent balance sheets. Many futures commission merchants and securities firms that are clearing members fit this characterization. Some are subsidiaries of complex, broad-based intermediaries, but from the perspective of the clearinghouse, the relative simple balance sheets of the actual member firms are what matters.

If big banks and investment banks continue to dominate intermediation of CDS and exotic derivatives, the members of any clearinghouse for these products will inevitably be firms with complex, opaque balance sheets, for which asymmetric information is likely to be quite acute. Simply adopting futures and options CCP practices will not be adequate for this business. Moreover, I have serious concerns that the difficulties in assessing and pricing balance sheet risk will seriously impair the effectiveness of a CCP for credit derivatives.

The second point is that it is incorrect to say that default risks are not shared among dealers in a bilateral OTC structure. Dealers trade with dealers. I daresay that big dealer firms had the biggest exposures to Lehman, Bear, and AIG. Inter-dealer trade means that default risks are shared among the dealers who would be the members of a clearinghouse even in a formally bilateral market.

This has an important implication. Specifically, the choice between a “bilateral” and “centrally cleared” market structure is a choice between different ways of sharing default risks among dealers (and between dealers and customers); it is NOT a choice between interdealer sharing and no interdealer sharing.

Thus, it is imperative to analyze the comparative costs and benefits of these alternative sharing mechanisms. This is a multi-faceted problem, but I will focus on one issue, one that I think is of primary importance.

In a CCP structure, the CCP is responsible for evaluating the balance sheet and product specific risks of each member firm. That is, there is a centralized risk evaluation and risk pricing mechanism. In contrast, in a “bilateral” market, each dealer firm makes individualized assessments of the product specific and balance sheet risks posed by each counterparty. Moreover, since dealers trade with one another, each dealer assesses and monitors the counterparty risks of each of the other dealers.

Centralized monitoring has one clear benefit–there is no duplicative monitoring. Each dealer is evaluated once. In contrast, in a bilateral market, each dealer assesses and monitors every other dealer, meaning that for N dealers there are 2 to the power N monitoring costs incurred.

However, decentralized monitoring likely has a substantial benefit when complex financial institutions trading complex products are involved. These firms interact with one another in many markets, and have various sources of hard and soft information about the balance sheet risks of its counterparties. This information is almost certainly superior to what a clearinghouse is likely to collect. Moreover, since due to the complexity of the balance sheets of the big dealer firms, any individual firm’s assessment of the balance sheet risks of another is likely quite noisy. Multiple signals should be more precise than a single one. Therefore, monitoring by multiple counterparties generates information that is likely to be collectively far more precise than the information collected by any one. If this information can be aggregated in some way, multiple counterparty risk assessments in a bilateral market can be far more efficient than a single risk assessment by a CCP. (The mechanism for aggregation is a complicated subject in itself. Dealers will make inferences from the actions of others. If dealer A cuts back on trading with B, or decides not to trade with B altogether, dealers C, D, etc., will make inferences about A’s information regarding B’s performance risk. One issue that deserves study is whether this aggregation method encourages information cascades that can lead to inefficient outcomes.)

Furthermore, dealers in bilateral markets can–and do–charge counterparty-specific prices for balance sheet risk. Specifically, they require different counterparties to post different amounts of collateral, where variations in collateral levels across counterparties reflect both product-specific risks and the particular balance sheet risks of each counterparty.

(Member-specific collateral levels in a CCP setting would also put tremendous stress on the governance of a clearinghouse. Each member would have an incentive to influence the CCP to impose higher collateral requirements on competitors. Heterogeneity puts stress on collective/cooperative bodies such as clearinghouses. Even though institutional mechanisms such as the non-profit form can mitigate heterogeneity-driven rent seeking in such organizations, it cannot eliminate it, and these rent seeking costs are typically greater when members are heterogeneous.)

This analysis raises the question of whether it is efficient to bundle the trading of these instruments with the supply of information intensive intermediation. Big banks and investment banks with opaque balance sheets (due to the information intensity of their various financing and trading activities) pose greater balance sheet risks than would simple, “vanilla” intermediaries that specialize in trading these derivatives and eschew other activities.

But we don’t see such simple, vanilla, boutique intermediaries. I think that for a variety of reasons this makes sense, as there are likely scope economies between trading things like CDSs and offering other forms of financial intermediation. After all, banks specialize in evaluating credit risk, and the resources and skills used to do this in lending and underwriting can be put to use in valuing and assessing the risk of derivatives, and most particularly, credit derivatives. Moreover, there are scope economies in modeling and risk evaluation. Thus, I think a strong case can be made that bundling of intermediation of complex derivatives (and especially credit derivatives) with the supply of other information intensive financial intermediation activities is efficient.

In sum, before charging ahead with a CCP for credit derivatives and other exotic products, it is worthwhile to step back and ask why this hasn’t happened before now. Sure, it may reflect inefficient strategic behavior by dealers and collective action problems. But it may be the result of high costs of centralized risk sharing for complex products traded by firms who supply information intensive intermediation, and therefore have somewhat inscrutable balance sheets and balance sheet risks.

I have serious reservations about the efficiency of a CDS clearinghouse consisting of big banks/investment banks. Balance sheet risks are a big deal when such firms are involved, and traditional CCPs have not priced these risks (or have priced them in a very, very crude way.) Moreover, the risks of the instruments themselves will be difficult for a CCP to quantify. Indeed, sometimes it will be difficult for the CCP just to determine the market value of these instruments. (Which is why firms like Markit are included in CDS CCP proposals.) Given the instruments, and the firms trading them that would be in a clearinghouse, risk pricing will be extremely difficult, and beset by asymmetric information problems. To me, it is by no means clear that centralized assessment, pricing and sharing of position and balance sheet risks is more efficient than decentralized, “bilateral” assessment, pricing and sharing of these risks.

This argument may seem somewhat Panglossian–to some it may appear that I am suggesting that we live in the best possible world, and intervention to change performance risk sharing mechanisms is therefore unwarranted. I would disagree with that characterization. Suffice it to say that starting from the basics of risk sharing economics, and analyzing the specifics of credit derivatives and other exotic products, a strong argument can be made that a bilateral OTC market structure is efficient relative to alternative structures, including a CCP-based system. To put things in legal terms, I should think that the burden of proof should lie on those who implicitly or explicitly assert that the existing market structure is inefficient compared to a realistic alternative.

And I will close by noting that some practitioners with skin in the game share reservations similar to those I have expressed here. This Bloomberg article by Matt Leising quotes “electronic trading pioneer” Thomas Peterffy’s objections to the CME’s proposal to clear CDS products. Long time Chicago broker Chris Hehmeyer (CEO of FCM Penson GHCO) is also “balking at” this initiative. Peterffy “doubts that the exchange will be able to determine CDS pricing because they trade infrequently.” Although neither Peterffy nor Hehmeyer (or David Rutter, also quoted in the article) mention the very different balance sheet risk posed by big CDS dealers, I wouldn’t be surprised if that’s a concern as well. Though they aren’t quoted as saying so, these gentlemen have to realize that when the big dealers clear CDS products, the other members of the clearinghouse–firms like theirs–not only bear the risks associated with the CDSs, but also the risks associated with subprime, or CDOs, or whatever happens to be floating the banks’ boats at the moment. This cannot be a comforting thought.

So, before we rush in to create a CDS clearinghouse, it behooves us to examine carefully the risks of doing so. Not all instruments and not all intermediaries are created equal. Some are well-suited for the sharing of default risk through a central clearing mechanism. Others are more problematic. Credit derivatives are among the most problematic of all. Creating a central counterparty without a full assessment of the unique challenges that these products pose is itself a risk–a risk of a train wreck somewhere down the line when the mispricing of default insurance encourages excessive risk taking, and a member (or members) of the clearinghouse defaults. Conditional on the probability of default, a central counterparty is probably the efficient way to bear risk. But if the CCP prices risk wrong, it could increase the probability of default and actually create more problems than it solves.

Do I know this will happen for certain? No, I don’t. But I do think there is considerable basis to conclude that it is a serious possibility. So before venturing down the CDS CCP road, it would be advisable to (a) give this issue serious attention, and (b) design the CCP to mitigate these problems.

Today’s musical selection is Queen’s I Go Crazy. (Some may dispute the verb, or the tense thereof.) What is making me go crazy? The continuing stream of conclusory assertions that someway, somehow, OTC derivatives are at the root of the current financial crisis, and that some past opportunity to regulate these monsters was missed, thereby paving the way for our current difficulties.

This WaPo article is a classic in the genre. Inasmuch as I am quoted in it, perhaps I seem an ingrate to criticize, but criticize I must–although it is better than most. In this narrative, ardent free marketers and patriarchial figures Alan Greenspan, Arthur Levitt, Robert Rubin, and Larry Summers crush the Quixotic crusade of valiant CFTC chair Brooksley Borne to regulate OTC derivatives. If fair Brooksley’s advice had been taken, the article suggests, what went wrong wouldn’t have gone wrong.

That is, to say the least, a very debatable proposition. One thing worth noting is that the focus at the time was interest rate swaps, instruments that have played no role in the collapse of any financial institution. Credit derivatives were in their infancy at the time discussed in the article. Indeed, they were barely a gleam in their inventors’ eyes.

More importantly, although Born warned of the systemic risk posed by OTC derivatives, discussion of how any specific regulation she proposed would have affected current events is completely absent. Nor was Born herself particularly specific at the time.

The article discusses clearing, but importantly misses a key point. The Commodity Exchange Act (CEA) requires contracts for future delivery to be traded on a designated contract market, i.e., and exchange regulated by the government. The concern at the time was that the legal status of OTC swaps ambiguous given this language. Were swaps futures? If they were, any swap not traded on an exchange would potentially be legally unenforceable. This was a major, major concern. In response to this, during this time period the CFTC proposed a set of criteria to distinguish futures–that had to be traded on exchanges–from non-futures, that were exempt from the contract market provision of the CEA. One of the criteria that would have made something a future was centralized clearing. That is, a centrally cleared product was more likely to be considered a future than one that was not centrally cleared.

Thus, if anything, CFTC policy ideas at the time militated AGAINST moving to central clearing of OTC instruments. In essence, the Born-era CFTC approach tied the means of execution (on an exchange) to the means of sharing credit risk (central clearing.) The Commodity Futures Modernization Act (CFMA) essentially avoided this pernicious bundling constraint, and thereby made it more likely that OTC clearing would develop.

There is no reason to force all trading into a particular model, e.g., to force all transactions to occur on exchanges. Many important markets are dealer markets–the Treasury market being a prime example. A CEA-type link between trading mechanism (on exchange) and performance risk sharing mechanism (clearing) creates an unnecessary constraint that raises costs. It requires a one size fits all approach despite the fact that a diversity of trading and risk sharing mechanisms satisfying heterogeneous and diverse needs is likely to be efficient.

The article also denigrates the elimination from the CFMA of a provision calling for federal oversight of a clearinghouse. But, as the article notes, the OTC clearing idea “sat dormant.” If it wasn’t adopted with less onerous regulations, is it reasonable to conclude the industry would have started one if more strict regulations were in place?

The reasons for the dormancy of OTC clearing are important to understand, and not completely understood. I have a slew of clearing-related posts coming, so I will defer fuller discussion until then. For now, suffice it to say that Brooksley Born’s defeat at the hands of the patriarchy had nothing to do with it. As I already noted, the Born ultimatum approach would have actually impeded the development of clearing. It should also be noted that the article’s narrative is contradictory; the article specifically states that Treasury pushed for the idea of an OTC clearinghouse even though Treasury Secretary Rubin is portrayed as one of Born’s antagonists.

Moreover, the article states that the failure of AIG was attributable to its large losses in credit derivatives, and implies that if credit derivatives had been better regulated then (a) AIG’s failure might have been avoided, and (b) the financial crisis would have not been as bad as it is. The latter proposition is the important one, and the basis for it is completely lacking in the article, and in most discussions of the issue.

Ultimately, AIG’s failure is attributable to the fact that it insured against losses on mortgage securities, and these mortgage securities plummeted in value. It is exactly analogous to an insurance company that insured against earthquakes, only to be bankrupted when a trembler of unprecedented power occurred.

That is, in the first instance AIG’s losses on credit derivatives were a symptom of, rather than a cause of, the financial tremors. And as I have written before, it is plausible that (a) AIG was the efficient bearer of this risk, and (b) as a result, the same tremor would have wreaked even greater havoc on less-well capitalized institutions had they not purchased insurance from AIG. No insurance company should be so well capitalized that the probability of default is zero. Thus, the fact that an insurance company failed does NOT imply that constraints on its issuance of insurance would have been welfare improving. In fact, the opposite conclusion is far more likely to be true; constraining or eliminating even incomplete insurance would have almost certainly been inefficient.

To make OTC credit derivatives the villain of the piece requires a more complex argument. One would have to argue that the existence of insurance for mortgage derivatives contributed to the proliferation of subprime debt, and tranched securities created atop it, and to the housing bubble. For these mortgage/real estate factors are at the root of the current difficulties. This causal link is inherently indirect, and very hard (and perhaps impossible) to prove. Moreover, any contribution of credit derivatives is almost certainly of second or third order as compared to the direct causes–loose monetary policy, political encouragement and subsidization (via Freddie and Fannie) of subprime lending, agency problems, rating agency failures, etc.–that fed the housing bubble and the proliferation of subprime debt.

I again reiterate that one needs to be specific as to the content of regulations before passing judgment on their likely effects. In particular, it is very difficult to demonstrate how most regulatory proposals, which frequently focus on various fraud, disclosure, trading mechanism, and manipulation-related issues, mitigate systemic risks.

Furthermore, I would suggest that any attempts to regulate instruments per se are almost inevitably doomed to failure. Regulate one instrument, and in a trice financial engineers will figure out a workaround. This is almost certainly a wealth-reducing arms race. (Were I speaking completely self-interestedly, I would advocate such regulatory efforts, for it would increase the derived demand for my services.) A functional regulatory approach is preferable under these circumstances, but the basic distinction between functional regulation and regulation of particular instruments has been completely overlooked in most of the public debate.

In sum, I go crazy because the public treatment of regulatory issues surrounding derivatives is largely built on myths, incomplete history, and a failure to understand the basic vulnerabilities of any regulatory system. A Reuter’s article aptly states that credit derivatives are “vilified as a major contributor to the current financial crisis.” This is true, but the argument behind the vilification is largely–and arguably completely–nothing but an assertion, repeated over and over again, with little supporting argument and less supporting evidence. This is the perfect hothouse environment in which to grow bad policies and bad regulations that will have serious, adverse unintended consequences down the line.

What is needed is a sober appraisal of the costs and benefits of specific financial innovations, and proposals to regulate their use and development. What we have instead is knee-jerk reactions based on bad analysis. Virtually everyone is calling for more regulation, details to follow. Having seen how regulation often works, I reply: Be damned careful what you ask for.

The Economist has two articles that cleave very closely to various SWP posts that predate their publication.

This one discusses the “collateral damage” of the SEC short-sale ban on the convertible bond market, and particularly its effect on banks. The 9 October article says that the effect on convertibles was “a typical example of the unintended consequences of meddling with the markets in response to populist pressures.” Gee, but that seems very, very similar to what I wrote on 27 September in “Unintended–But Totally Predictable–Consequences.” Specific use of the term “Collateral damage”? Check. Specific use of the term “Unintended consequences”? Check. Analysis of the damaging effect on convertibles market and on banks? Check. Criticism of stupid pandering policy? Check. Very pronounced similarities here, undoubtedly.

This one makes several arguments regarding commodity speculation that I have flogged repeatedly on SWP and in my Congressional testimony and WSJ piece. Here, the similarities aren’t quite as close, but the focus on looking for distortions in stocks and the lack of a direct channel by which fund money can affect physical commodity prices reprises two themes that I have emphasized repeatedly.

But, then again, maybe both things are so obvious that it’s no surprise that the Economist advanced the same arguments. But, especially with the short sale ban post, the similarities in argument and language make me lean towards rejecting the null hypothesis of “coincidence.”

Any thoughts, readers?

More from Matt Leising at Bloomberg on yesterday’s oil squeeze:

“This sharp move reflected extreme tightness in the prompt physical market as participants that were short oil scrambled to find physical oil before expiration,” wrote the analysts, led by Jeffrey Currie. Record oil prices have made refiners rely on stocks of existing supply, the analysts wrote, creating “critically low” inventory levels.

Vulnerable to Spikes

“This tight inventory situation has left the oil market with very little cushion and therefore extremely vulnerable to price spikes,” the note said.

Trading was light on Nymex yesterday. About 41,000 crude contracts for October delivery changed hands, 85 percent less than the 15-day moving average volume of 280,000 contracts, according to Bloomberg data.

The traders who sold contracts short might have been betting on price declines due to less-than-expected damage to oil rigs and production from Hurricane Ike as it crossed the Gulf of Mexico.

“Ike did more damage than originally thought,” said Rick Mueller, director of oil markets at Energy Security Analysis Inc. in Wakefield, Massachusetts.

The most recent storm in the Gulf made landfall in Texas on Sept. 13, cutting off power and damaging some refineries. U.S. energy producers resumed output for about 23 percent of oil and 34 percent of natural-gas production in the Gulf after the storms, the Minerals Management Service said yesterday in a statement on its Web site.

This suggests that deliverable supplies were low due to Ike. Low deliverable supplies make the market more vulnerable to a squeeze. Put differently, somebody with a 10 million barrel futures position may not be able to squeeze the market profitably when deliverable supplies are 9 million, but may be able to do so when they are only 5 million or 4 million. Thus, Ike’s disruptions raised the likelihood of a squeeze.

One should not go the next step–as people often do–of concluding that Ike “caused” the price disruptions in the October contract. Just as a forest fire requires BOTH dry tinder AND a spark, a squeeze requires low deliverable supplies AND the affirmative action of a large long (or longs). A large long must demand excessive deliveries. The low deliverable supply only means that the long can get the same price effect–and a bigger profit–by demanding fewer deliveries and liquidating more contracts at an artificially high price. Put differently, the cost of manipulation is burying the corpse of deliveries. With low deliverable supplies, the corpse is small, and the manipulation is easier to carry out. To mix metaphors, and extend the forest fire example, the low deliverable supply is the dry timber, but the uneconomic demands for delivery by a large long or longs is the spark that is necessary for the fire to occur. Low deliverable supply is a precondition that makes the market vulnerable to a squeeze. But somebody has to do the squeezing. Smaller players can squeeze when deliverable supplies are small.

Since the FTC Report on the Grain Trade in 1920-1921, it has been common to label events like those of yesterday as “natural squeezes” because “natural” market conditions made the squeeze possible. The “natural” terminology has been used to excuse the opportunistic exercise of market power by those who exploit these conditions to distort prices. This “reasoning” is wrong, and highly injurious to the market. It essentially gives longs a manipulation option. Hold a large long position to expiration. If something happens to reduce deliverable supply–squeeze away, and make money. If nothing happens, just liquidate at the competitive price. When they come after you for squeezing, just say “Hey, it was a natural squeeze. And natural is good, right? That’s what they tell me at Whole Foods!” It’s worked. And it has undermined market efficiency. Regardless of whether exogenous events made a squeeze more profitable, a necessary condition for the squeeze to occur is for somebody to exercise market power opportunistically. These people should not be allowed to skate.

As commentor Scott Irwin noted, due to the fact the squeeze took place in a very short period of time, it is unlikely that it will have acute deadweight costs, although large amounts of money will change hands as a result. (The fact that the main price action took place in the last half-hour of trading that is used to determine settlement prices–and the final prices on swaps tied to NYMEX CL–suggests that somebody was long swaps as well as futures, and earned profits from the price distortion on a cash settled OTC swap position.)

The main deadweight cost is the effect that the episode will have on the speculation debate. People are already seizing on this as evidence that market manipulation is a serious problem that needs to be addressed by more draconian restrictions on market participants. My take is very different. The contrast between what happened on 9/22 and what happened in the last half of 2007 and the first 8 months or so of 2008 shows that the big price surge in oil that peaked in July was almost certainly NOT the result of manipulation.

Yesterday’s events bear all the hallmarks of a squeeze. It waddled like a squeeze, it quacked like a squeeze, it flew like a squeeze, and it swam like a squeeze, so . . . I would have a hard time arguing that what happened in the October CL price was normal and competitive.

So what yesterday shows is, yeah, manipulation can happen. What happened on 9/22 bears all the hallmarks of a manipulation—and look how different that was from what transpired over the first 7 or so months of 2008. The 9/22 event was intense, but limited to a very short period of time in a single market. It affected one price that moved a lot relative to other prices (e.g., the November price, the prices of heating oil and gasoline). It happened as the contract moved to expiration/delivery. That’s what happens during a squeeze, a manipulation.

In contrast, the runup in oil prices over 2007-July, 2008 was long, sustained, occurred in all markets, was not concentrated around contract expirations, and did not result in one price getting way out of line with all other prices.

Thus, in my view, by contrast, the squeeze of 9/22 shows that what happened in 2007 and the first 7 months of 2008 was NOT manipulative.

The events also showed that when a squeeze happens—people notice. Regulators notice. The subpoenas went out within hours of the event. People will sweat. People will pay. That’s the way to deal with it. By focusing on people who engage in demonstrable wrongdoing, and punishing them severely—not by clamping down on all speculative activity, virtually all of which is quite legitimate. Cut out the cancer—don’t shoot the patient in the head—a surefire cure, but not a very constructive one.

This episode also brings to mind a historical parallel. In May, 1921, the Senate was holding hearings on the regulation of futures trading. A representative of the Chicago Board of Trade, Julius Barnes, testified that there was no need to regulate futures trading because the exchange had the incentive and ability to prevent manipulation. The very moment he was speaking, a large grain trader named Field executed a huge squeeze of the expiring May wheat future. The price of May wheat rose $.17/bu–almost 10 percent–on the last day of trading, and the price of cash wheat fell $.20/bu the day after the contract expired. This spike and crash is symptomatic of a squeeze.

An exasperated Barnes wrote to his business partner: “nothing has embarrassed, in recent years, like the gyrations in Chicago May–the very day we were arguing before the Senate Committee that the governors of these exchanges were making some progress themselves in eliminating manipulation.” A month later, a chastened representative of the CBT, L.F. Gates, testified before the Senate that “The trade recognizes the manipulator as the enemy of the whole organization. We dislike him as much as any of you gentlemen do, and if we could find any way of shitting him out absolutely, we would do it. Maybe you can help us on some of these problems.” In other words, the CBT almost begged for regulation. The Congress obliged, passing the Futures Trading Act, the first major Federal regulation of the futures markets, and the progenitor of the Commodity Exchange Act that governs the markets to this day.

Thus, the actions of a squeezer–Mr. Field–on one day dramatically changed the political landscape, and forced a previously recalcitrant CBT to submit to Federal regulation. Sadly, whoever squeezed the October crude contract on 22 September, 2008 may have a similar legacy. Even though the October CL squeeze in no way validates the wild accusations leveled against oil speculators for causing the price runup to $147 in July, it may well become the “I rest my case” Perry Mason moment that will be used to justify wide ranging restrictions on energy trading. Restrictions that will do little if anything to prevent events like those that occurred on Monday; that will not prevent prices from rising to $147 or higher when fundamentals justify it; and that will impair the efficient operation of the market as a price discovery and risk management tool.

Thanks, buddy, WTF you are.

It is apparent that the decisive factor that drove the Treasury to intervene with AIG is the insurer’s immense position in credit derivatives, notably credit derivatives tied to various mortgage securities. Whereas it seems that in the case of Lehman’s slow motion implosion, market participants had the opportunity to move positions and thereby limit the potential for a cascade of knock-on defaults on derivatives arising from a Lehman default, AIG’s much more rapid plunge permitted no such luxury. Fearing that AIG defaults would trigger defaults or bankruptcies by its counterparties (either because they held offsetting positions with others, or because the loss of the insurance contracts would blow holes in balance sheets large enough to force bankruptcy), the government decided to step in and effectively guarantee AIG’s performance on all its obligations.

The wreck of AIG hard on the heels of the collapse of Lehman hard on the heels of the disappearance of Bear has led to repeated calls for the establishment of a clearinghouse–a central counterparty (“CCP”)–for OTC derivatives, including credit derivatives. In this post I will attempt to discuss some of the issues this possibility raise. Bottom line: a CCP could help a lot, but it is not a panacea. Moreover, the benefits of a CCP depend crucially on the answer to the question: Why hasn’t the market already created a CCP?

What does a CCP do? It insures default/performance risk by mutualization, i.e., sharing of these risks across market participants. Note that in the days (or should I say day) before the AIG collapse, the Treasury essentially tried to create such a mutualization mechanism on the fly when it attempted to coax/coerce banks into lending to AIG. Not surprisingly, this effort failed, and in the event, the government stepped in as the ultimate insurer–meaning that taxpayers are essentially bearing the risk.

One way a CCP would have definitely helped is through the netting of offsetting exposures. In the OTC market, as currently constituted, when A sells a contract to B who sells to C who sells to D, (a) B and C have no market risk exposure (because they have offsetting positions), but (b) there are four sources of performance risk; default by A, B, C, or D is a possibility. For instance, B could suffer a loss on another position that impaired its ability to perform on its contract with either A or C. With clearing, or with some sort of mandatory netting (“ringout”) arrangement, B and C would be taken out of the chain of contracts, and only A and D would pose and face performance risk. B and C could blowup and neither A nor D would care.

In brief, central clearing reduces overall credit and performance risk by reducing the overall magnitude of performance risk exposure. Without netting, performance risk is roughly related to gross positions in the market, whereas with netting, performance risk is reduced to the net exposure.

The CCP also centralizes position information, making it easier for somebody (e.g., the Fed, Treasury) to figure out market exposures. I can only imagine the nightmare that regulators lived trying to figure out who traded how much with whom, and then assembling the jigsaw puzzle to visualize the potential for systemic problems. This is especially true given the dodgy nature of documentation in the credit derivatives market. Although participants have supposedly made progress cleaning up back office problems, these problems haven’t disappeared. This would represent another benefit of a CCP–it would force a rationalization of the confirmation process.

Now let’s figure out how things would have worked out in the AIG case had a CCP been in place. I presume that AIG had a big net position (as otherwise it wouldn’t have been facing multi-billion mark-to-market losses.) So, to the extent its positions weren’t fully collateralized (and I return to the collateral issue below), AIG would have failed to the clearinghouse. These losses would have been covered, to the extent possible, by funds precommited by CCP members in the form of a default fund or its equivalent. In addition, most CCPs have credit lines with banks. If the default fund was inadequate to cover the value of the AIG’s defaulted positions, the CCP would have been able to call on these credit lines, which would have become liabilities of the remaining, solvent members of the CCP. Through this mechanism, or through the CCP’s ability to require members to make additional capital contributions, the losses would have been shared by the other CCP members. A member’s share would be, to a first approximation, an increasing function of the size of the participant and its positions.

Thus, the effects of the CCP would be to diffuse the risk of a single default among all of the members of the CCP. It is likely–though I doubt it can be proven mathematically–that this would reduce the likelihood of the default causing a cascade of knock on defaults. Under the current, non-cleared system, the exposure to an AIG default is related to the direct and indirect gross exposures of each trader in the market to AIG. A firm with a big direct, or even indirect, exposure to AIG, would suffer a big loss from the latter’s default. That big loser would be more likely to be unable to perform on its other obligations than an otherwise identical firm with a smaller gross exposure to AIG. Under a CCP, there would be less dispersion across firms in the exposure to AIG. Thus, under most circumstances it appears less likely that one firm would experience a disproportionate loss from an AIG default.

Here’s a simple example that may capture some of what I am trying to convey. A and B are sellers of CDO insurance. C and D are buyers. C and D have portfolios of CDOs that they have financed with debt and equity. To normalize things, let’s assume that each insurance buyer’s debt is 90 and equity is 10. To make it simple, to emphasize the concentration effect, assume that C buys only from A, and D buys from B. A defaults. This occurs when B has suffered a big loss on his CDO position–let’s say that the CDOs have fallen in value to 50, and instead of paying the 50 it owes, A only pays 20. B no longer has insurance over its entire position. It now a CDO worth 50, and a payment of 20 from A–it thus can only pay 70 of its debt of 90. It defaults on the loan. There is a knockon effect.

Now lets say that the default of 30 is shared among B, C, and D in equal proportions. (NB: In reality, sharing rules are much more complicated.) Let’s say too that B is sufficiently capitalized to be able to cover its insurance obligation and its 1/3 share of the 30 default. Here, C and D receive (on net) 40 of the 50 that they are owed, leaving them with assets of 90 and liabilities of 90. They don’t default. Under the CCP, B and D bear some of the loss that C bears alone with no clearing. This reduces the probability that C will default.

Now, of course exposures are endogenous. In my example, C is a fool for having put all his eggs in one basket. Therefore, you would expect traders to consciously attempt to trade with more counterparties and limit their concentration in the absence of a CCP. Nonetheless, various considerations related to asymmetric information–something I will discuss more below–may in fact induce concentration.

It should also be noted that clearing economizes on collateral. Collateral is related to gross positions in the absence of clearing; with clearing they are related to net positions. This can reduce demands for liquidity during periods of systemic stress. Firms will face smaller collateral calls, and thus have less need for credit or to liquidate assets during periods of market stress.

So if clearing is so great, why hasn’t it happened already? On the answer to that question turns the policy recommendation.

One reason is that there is a coordination or externality problem that means that although it is collectively rational to form a CCP, it is individually irrational, or that the costs of coordinating the creation of a risk sharing arrangement are too high.

For instance, I have argued that some market participants (especially big, highly creditworthy players–like AIG before its collapse’-) may oppose the formation of a clearinghouse because a CCP levels the credit playing field. The biggest, most creditworthy firms have a competitive advantage in a non-cleared OTC market, and a CCP might undermine this advantage. The big guys may therefore not want to participate. And if they don’t play, the clearinghouse will never get off the ground.

Moreover, to the extent that a systemic event caused by a chain of defaults has costs that affect parties other than the intermediaries–a plausible hypothesis–the contracting parties do not internalize all of the costs of their decisions. They therefore do not fully internalize the benefits of the formation of a CCP–and hence may not agree to its creation.

These arguments suggest that the mandatory creation of a CCP would be welfare improving.

There are arguments, however, that suggest that there are substantial costs to the formation of a CCP. In particular, asymmetric information makes it costly to share risks. To the extent that participants in a CCP have private information about their own creditworthiness and the riskiness of the positions they clear, moral hazard and adverse selection problems will occur. These are real costs of risk sharing. The greater these costs, the smaller the benefit of forming a risk sharing arrangement.

As I have argued in a working paper, these costs are greater, the more difficult it is to value the instruments being cleared. Valuation is relatively easy in instruments that are standardized and traded on transparent markets with nearly continuously available, competitively determined prices. Valuation is much more difficult for idiosyncratic instruments that are infrequently traded, and/or which are traded in opaque markets.

The former conditions describe centralized exchange markets for liquid instruments, like T-bond futures. The latter, alas, describes many OTC derivatives, especially credit derivatives, and especially credit derivatives on CDO structures. Hence, it may well be the case that the reluctance to move to a CCP system for more complex instruments is due to the fact that the costs of sharing default risk are higher for these instruments.

Of course, these explanations–coordination/externality vs. high cost–are not mutually exclusive. If I had to make a gut call, I would say that the coordination/externality problems are sufficiently acute that some regulatory effort may be warranted to require the formation of a CCP system. At the same time, any such regulation should take into account the moral hazard and adverse selection problems that are inherent in more complicated instruments, and therefore recognize that risks cannot be shared as extensively for such instruments as is the case for vanilla products traded in transparent markets. This regulation should also recognize that pricing information, transparency, and valuation expertise are required to mitigate the costs of risk sharing for more complex instruments. Therefore, the creation of a clearinghouse might also require measures to improve price transparency and share valuation expertise. This raises other possible sources of resistance. Individual traders profit from private information on prices, and hence are reluctant to share this information. Thus, formation of clearing may require the mandating of disclosure of transaction pricing information. Good luck with that.

In brief, the AIG mess would probably haven’t been as messy if a CCP had been in place. Moreover, it is possible that the absence of a CCP is due to a market failure. However, it should also be recognized that clearing of the kind of stuff that got AIG into trouble ain’t easy–it ain’t like clearing T-notes or even OTC vanilla swaps. It is almost certainly the case that it is uneconomic to share performance risks as widely and extensively in more exotic credit and mortgage products as is the case for vanilla, exchange traded stuff.

I should note that this post was written more hastily than I usually like, but I feel that the issue is sufficiently important and timely to justify a more hurried take. If, upon further consideration, I decide that this analysis is incomplete or incorrect, I’ll make the necessary changes.

AP has an interesting article that complements my earlier analysis:

A debilitating dispute at Anglo-Russian joint venture TNK-BP, in large part resolved, has also stoked concerns. The company reassigned 148 technical specialists from the country earlier this year amid visa difficulties and litigation.

In July, chief operating officer Tim Summers said the Russian shareholders’ desire to cut capital expenditure by $900 million in 2008 could wipe up to 1 million tons to 5 million tons from the company’s output over the next 12 months.

Further evidence that the Russian partners in BP-TNK are highly desirous of getting cash out now.

The article also points out that the nearly confiscatory tax regime also depresses the incentive to invest.

During the aftermath of Hurricane Katrina, General Russel Honore castigated a reporter for being “stuck on stupid.”

For some reason, that phrase has come to mind repeatedly in the past hours. Perhaps it is due to the fact that I am sitting on the 9th floor of the Hilton in College Station, Texas, watching the rains and winds of Hurricane Ike. But more likely, it is that I am passing the time reading several of the latest “studies” purporting to lay the blame for the runup of commodity prices (especially energy prices) in 2007-2008 at the feet of speculators, and more particularly, commodity index traders.

The most widely disseminated of these is the Masters-White “Accidental Hunt Brothers” piece. Another is “The Commodities Market Bubble: Money Manager Capitalism and the Financialization of Commodity Markets” by University of Missouri-KC professor L. Randall Wray.

In a nutshell–same old, same old BS.

I could go on and on deconstructing this bilge, but even though the opportunity cost of my time is only slightly above zero, being marooned as I am, it is still positive. So I will limit myself to hitting the low-lights.

The most fundamental problem with these papers is their failure to identify any channel whereby side-bets on commodity price outcomes affect the supply and demand for physical commodities. Masters and White are particularly slippery in this regard, equating in a conclusory way the purchase of physical oil by China to the purchase of forward and futures contracts in similar notional quantities by index funds, and then asserting that the side bets contribute just as much to demand as the Chinese purchases of physical oil, and hence are just as responsible for any price increases. Similarly, Masters-White state that index traders are holding “stockpiles” of oil. Uhm, no, they don’t. They hold contractual claims on oil that they liquidate without converting them into actual, bona fide stockpiles of physical oil. The Masters-White argument is akin to saying that the bettors at race tracks own the outcomes of horse races. No, they own betting tickets–contingent claims that have payoffs that depend on the outcome of a horse race. Absent some other mechanism (e.g., bribing the jockeys), these contingent claims don’t influence the outcome of the race.

Put differently, moneys invested in indices don’t actually flow into the market for the physical commodities. Nobody uses these dollars to buy oil or corn. Instead, these funds are used to place collateralized bets on future movements in prices. The actual money invested in these strategies (if the index investor follows a fully collateralized strategy) is used to buy T-bills in dollar amounts equal to the notional value of the commodity index. The actual moolah doesn’t flow into the commodity markets, the way that it does when Sinopec or PetroChina buys a supertanker of Arabian crude.

Masters-White and Wray also fail to address the fact that index investors liquidate their positions before they become claims on physical commodities, and hence they are typically sellers at the time that spot prices are determined.

In terms of “evidence” these authors merely point to the fact that index fund investments have risen at the same time that commodity prices have risen. They do not appear to separate out the effect of increases in the amount of commodity index fund assets that was caused by the effect of rising prices on the value of existing positions from the increases attributable to the flows of new moneys into the funds. There is no effort to carry out rigorous statistical tests (e.g., cointegration tests, Granger Causality tests) to establish causation or an equilibrium relation. (It is possible that the visual relationship between two strongly trending series like an oil price and the size of index positions could be a spurious one. The authors of these studies make no attempt to explore this possibility.)

Masters-White make a big deal of the fact that all commodities in the various indices have gone up, and say that this would be extremely unlikely unless the index investment was driving all of them. But commodities not in funds, such as MGE wheat, iron ore, minor metals, have been skyrocketing in price too.

This line of reasoning does suggest one potentially rigorous test of the hypothesis. Namely, if the increasing importance of index money is injecting a common element into prices of all index commodities, overwhelming individual commodity-specific fundamentals, one should observe increasing correlations across commodities in indices, and stable or declining correlations between indexed and non-indexed commodities. This effect should be especially pronounced in high frequency data (daily, or intra-day) because the index investments are by construction made simultaneously or nearly simultaneously across commodities in the indices. Of course, Masters-White-Wray don’t even come close to identifying, let alone testing, such a refutable hypothesis.

In terms of “theory,” Masters-White and Wray put great stock in the cost-of-carry relationship between spot prices and futures prices, asserting that by buying futures, index investors drive up futures prices, which equal spot prices plus carrying costs, thereby forcing spot prices up too. But, for instance, in copper and oil, the price rises in 2007-2008 occurred simultaneously with movements from contango into backwardation.

Masters-White assert that order flow moves prices, so the predominately long order flow of index funds therefore must move prices up. There are two fundamental problems with this “reasoning.” First, when index funds roll, their order flow is on the sell side–so why don’t they move nearby prices down when they roll?

Second, and more importantly, they are very confused on the relationship between order flow and price discovery. Although Masters-White are correct that orders in futures markets are anonymous, they draw the wrong conclusion from this. The impact of any particular individual, anonymous order on prices depends on the average information content across orders. Holding the intensity of informed trading constant, increasing the intensity of index trading reduces the average informativeness of order flow. Thus, more orders are entered, but their individual impact is smaller, leading to little or no net impact on prices. (Index trades are likely to be deemed uninformative on average for reasons identified by current colleague Praveen Kumar and fellow Chicago GSB PhD classmate Duane Seppi. It is unlikely that a particular trader has private information on all components of an index, and if he has private index on any individual components, it is more effective to trade on that information in the markets for the individual components. This is why markets for index products, e.g., SP500 futures, are typically much more liquid than the markets for the individual components.) Moreover, informed traders adjust the intensity of their trading in response to changes in uninformed order flow, and generally trade to offset the effect of uninformed orders on prices. Thus, even if “dumb money” moves prices away from where they “should be,” this is an opportunity for smart money to trade against that, thereby forcing prices back towards the level justified by fundamentals.

Masters-White also make a big deal out of the fact that many market participants quote spot prices basis a futures to conclude that futures prices are driving spot prices, and hence noise injected into futures prices by index trading must therefore contaminate spot prices. In other words, futures prices are the dog, spot prices are the tail.

This is to confuse mechanics with substance. The key point is still that when it comes to determining futures prices as the market moves to expiry, participants recognize that if they hold positions to term they must make or take delivery of physical product. Thus, futures prices at expiration reflect supply and demand fundamentals in the physical market. I will not take delivery of something at a price if I do not believe that I can sell it at that price or better. I cannot sell it at that price or better unless there is physical demand for the product at that price. Thus, even though it is common to price some physical trades basis a futures price, that basis is determined in the market. Moreover, it adjusts to reflect physical supply and demand fundamentals, just as the delivery mechanism connects fundamentals to futures prices.

Put differently, basis pricing does not mean that spot prices do not reflect physical market realities. The best illustration of this (discussed in a SWP post over the summer) is the heavy/sour crude basis, which widened dramatically over the summer. This reflected the high demand for low sulfur diesel, the low yield of such fuel from heavy crude, and disruptions in the markets for sweet crude (driven primarily by problems in Nigeria.) (All of these are nuances that Masters et al, and Michael Greenberger, miss completely–even though they are salient factors in understanding the summer’s market dynamics.) Physical crude traders did not mindlessly pass on increases in WTI prices to the prices of heavy crudes. Differentials adjusted to reflect physical market supply and demand realities.

This gets back to the fundamental problem with all these analyses, one that is highlighted by Masters’ and White’s choice of a title for their opus–“Accidental Hunt Brothers.” I have said it a zillion times, but maybe the zillionth-and-first repetition will make it sink into heretofore impervious skulls: PRICES SERVE TO ALLOCATE REAL RESOURCES. IF PRICES ARE SUBSTANTIALLY DISTORTED, THAT MUST MANIFEST ITSELF IN PRONOUNCED DISTORTIONS IN THE ALLOCATION OF REAL RESOURCES. In the case of the real Hunt brothers, to keep prices high, they had to accumulate huge quantities of physical silver–real physical inventories, not phantom paper inventories. When the government propped up the price of wheat and milk, it had to buy and hold (or destroy) huge quantities of physical wheat and milk. As another example, when a manipulation takes place, the manipulation causes manifest distortions in commodity flows. For instance, in 1910 famous (or infamous) speculator James A. Patten (benefactor of the Patten Gymnasium at Northwestern University as well as the Chicago Art Institute) cornered the New York cotton market. Prices became so distorted that English spinners shipped cotton back to the US to take advantage of the price distortions–the economic equivalent of water flowing up hill.

If speculators are distorting prices, that necessarily causes distortions in stocks or flows of physical commodities. If index investors, or other speculators, were Hunt brothers, accidental or otherwise, they would necessarily find themselves in the same circumstances–paying for, holding, and financing large positions in physical commodities. Positions so large–if the price distortions are as large as asserted–that could not escape notice. Neither Masters-White, Wray, nor any of the other critics of index investment have provided any evidence of such distortions. Indeed, they haven’t even tried to do so.

To his (mild) credit, Wray recognizes the problem, anyways. He notes that Krugman has argued that speculative distortion should lead to accumulations of large and growing inventories in the hands of speculators. He attempts to avoid confronting this implication by stating that Krugman’s argument presumes perfect competition, and that commodity markets are not perfectly competitive, therefore Krugman’s argument doesn’t hold.

It is Wray’s argument that doesn’t hold. Perfect competition is not the essential linchpin of the analysis. Even if there is some market power on the producer side of the market, sellers will respond to higher prices by increasing output. Similarly, consumers will respond by reducing consumption. If somebody–a speculator–injects additional demand for the real commodity into the market, and drives prices up, producers will increase output and consumers will reduce consumption. This is sustainable only if the speculators willing to pay the (putatively) artificially high price put their money where their mouths are, and hold inventories of the commodity. (Wray tries to finesse the analysis by stating that maybe large oil producers are keeping oil in the ground rather than producing it. Maybe. But that is something that cannot be laid at the feet of the speculators. Moreover, it is hard to reconcile with the movement of the market into backwardation.)

Wray makes some other basic economic errors. For instance, he notes: “Americans have responded to rising gasoline prices in the manner economists expect, with consumption falling sufficiently to offset China’s increased use of crude oil—yet crude prices barely responded.” Catch the freshman mistake? If the reduction of consumption is an equilibrium response to higher prices, you wouldn’t expect the drop in consumption to cause a fall in prices. The reduction in consumption is a movement along a demand curve, and absent any shift of the demand curve, holding all else equal, the price should not fall. Wray’s is essentially a yo yo theory of prices. Rising prices cause falling consumption cause falling prices cause rising consumption cause rising prices . . . Maybe Wray should get rich by inventing a perpetual motion machine.

In brief, there is nothing new here. Indeed, these papers–trumpeted to the skies by Senators Lieberman, Cantwell, and others–are just a repetition of the same blarney that’s been flying about for months now. Can we please get unstuck from stupid, and start having an intelligent debate on these issues, one that reflects at least a modicum of comprehension of basic economics? Alas, I seriously doubt it.

In one of my earliest SWP posts, Whither NYMEX?, I pondered the future of NYMEX. Somewhat later (and in an interview on CNBC) I predicted that NYMEX would wind up in the hands of the CME. That prediction has come to pass with yesterday’s vote by the NYMEX membership to accept the CME’s merger offer. The weeks leading up to the vote saw the chest-puffing bluffing that one can expect from canny experienced traders trying to extract the most from a trade as possible, but the CME management did not budge after raising its offer to the holders of trading rights, and in the end the trading rights members meekly accepted the CME bid.

This outcome was almost inevitable given the lack of any competing bid for NYMEX. This distinguished the NYMEX bid from the CME’s bid for the CBT, where ICE made the Chicago Boys sweat. The lack of a competing bid was in no way surprising, given (a) the contract between CME and NYMEX to trade the latter’s contracts on GLOBEX, and (b) the clearly superior synergies between CME and NYMEX as compared to NYMEX and anybody else. ICE was not a player in this game because of antitrust obstacles that would have been acute particularly in the hothouse environment surrounding energy prices and the criticism that the USDOJ has faced. NYSE-Euronext wasn’t a good fit at all, and wouldn’t have offered nearly the same economies in clearing. NYMEX was also not viable as a standalone in the long run, especially given its weak technological position, doubts about its management, and Byzantine internal politics (factors discussed in Whither NYMEX.) So, when push came to shove, the members had no better option than to accept the CME’s bid.

So, now the question becomes: Whither CME? The decline in the company’s stock price has been pretty stunning, but its fundamentals are still strong. It has, however, effectively completed one phase of its strategy–and of the industry’s evolution: the consolidation of the US futures trading industry on a first rate execution and clearing platform. It can expect continued growth in revenues from growing trading volumes, especially when the credit crisis runs its course. But that organic development is not going to be sufficient to generate the profit growth capitalized even in the company’s currently lower stock price. CME will need to develop a whole new product line. The most likely candidate is OTC clearing. The acquisition of NYMEX is a step in that direction given the New York exchange’s nice OTC energy clearing business. But the big prize is clearing of OTC financial derivatives, notably credit derivatives. That is an immense market, and cracking it faces numerous challenges.

Clearing works best with homogeneous products traded in transparent markets with accurate and reliable pricing. (I have a working paper that argues that traditional impediments to risk shifting–moral hazard and adverse selection–are most acute when products are customized and heterogeneous, require specialized valuation expertise, and when there is not reliable pricing information.) These conditions are not yet met in OTC credit derivatives.

Moreover, CME will face competition in this business. The big banks are not willing to give up this lucrative business without a fight, and even if the CDS market moves to centralized clearing, the big banks have already established a clearing entity in combination with The Clearing House Formerly Known as BOTCC to vie for this business.

CME’s management will spend some time on the integration of its new acquisition, but this should be a relatively straightforward process given that NYMEX contracts already trade on GLOBEX and that there is considerable overlap between clearing memberships on the two exchanges. Once that task is complete, Donahue’s and Duffy’s real work begins–to revolutionize the management of derivatives performance risk by integrating OTC and exchange clearing.