This article by Chris Whittal in International Financing Review does a good job at summarizing my beef with the BIS’s Macroeconomic Assessment Group on Derivatives. I appreciate Chris taking the time to speak with me and broadcasting my analysis to a broader audience.
A couple of people have expressed interest in my paper on clearing mandates and systemic risk. So here it is.
In a nutshell: the arguments that clearing (and non-cleared derivatives) collateral mandates will reduce systemic risk are fundamentally flawed. Ironically, this is because the analyses do not take a truly systemic approach.
My counterarguments will be familiar to those reading my posts on clearing over the past five years (!) but this piece lays them out in one place. One stop shopping, as it were. Or maybe one stop slashing. (One of my lawyer clients remarked to his partner yesterday that I wrote “slashing” blog posts. I said “Don’t leave out the burning!”)
A quick reprise on the BIS study purporting to show that Frankendodd and EMIR will increase economic growth by better than .1 percent per year.
A footnote in my earlier post questioned whether multilateral netting via single-category CCPs really reduced exposures substantially, if at all, compared to cross-product bilateral netting. The BIS study assumes-without any support that I can identify-that multilateral netting via CCPs is four times (!) as effective in reducing exposures as bilateral netting.
Again, I’m aware of no theoretical or empirical support for this number. The standard Duffie-Zhou theoretical analysis doesn’t reasonably support such a conclusion, and that is a purely theoretical exercise. Such a remarkable assertion should require some empirical support.
More importantly, this assumption begs a huge question: since derivatives counterparties internalize the benefits of netting (even when it imposes external costs on other claimants), if multilateral netting compresses exposures by so much, why weren’t banks falling over themselves years ago to move trades to CCPs, thereby reducing (shifting, actually) risk and freeing up capital? Why is it necessary to unleash Frankendodd to force dealer banks to pick up this money off the sidewalk? I thought they were greedy SOBs.
I see only two answers. First, that the netting economies really aren’t that large. Second, the dealer banks recognized that that increased netting merely transferred exposures to other creditors, who would adjust the prices of credit accordingly, making the (alleged) reduction in derivatives exposures not worth the cost of setting up and operating a CCP, posting collateral, etc.
Either way, there is no way to reconcile the BIS report’s claims that (a) netting of derivatives exposures is true net benefit, and (b) this net benefit can be achieved only as a result of regulation that forces dealer banks to clear to achieve multilateral netting economies. Indeed, to the extent that netting redistributes wealth from non-derivatives creditors to derivatives counterparties, dealer banks would have an excessive incentive to adopt clearing/multilateral netting.
In other words, the BIS report implicitly assumes that greedy bankers stupidly overlook oodles of money ready to be stuffed into their pockets.
Why do I get the impression that this was a put-up job intended to give the G20 something to crow about at the upcoming meeting in St. Petersburg?
John Kiff of the IMF tells me via Twitter (where he tweets as @kiffmeister) that the report recognizes some of the problems I identified in my post, namely that there are other sources of systemic risk than the counterparty risk channel that is the basis for the analysis. Yeah, that’s true, but I have looked through the report carefully, and can find no recognition whatsoever of the fact-and it is a fact-that collateral and netting have redistributive effects.
The BIS has released a report titled “Macroeconomic impact assessment of OTC derivatives regulatory reforms.” It concludes that the benefits of these reforms-including Frankendodd-will greatly exceed the costs, because (a) financial costs of a financial crisis are immense, and (b) the reforms will greatly reduce the probability of a financial crisis. Specifically:
In its report, the MAGD focuses on the effects of (i) mandatory central clearing of standardised OTC derivatives, (ii) margin requirements for non-centrally-cleared OTC derivatives and (iii) bank capital requirements for derivatives-related exposures. In its preferred scenario, the group found economic benefits worth 0.16% of GDP per year from avoiding financial crises. It also found economic costs of 0.04% of GDP per year from institutions passing on the expense of holding more capital and collateral to the broader economy. This results in net benefits of 0.12% of GDP per year. These are estimates of the long-run consequences of the reforms, which are expected to apply once they have been fully implemented and had their full economic effects.
Don’t believe it for a minute. The methodology of the analysis is irretrievably flawed. The net benefits are the free-est of lunches, because the report does not take into account the redistributive aspects of the collateralization and netting that results from clearing, capital, and uncleared derivatives collateral mandates. That is, it fails to recognize that the reduction in counterparty credit losses on derivatives that result from the “reforms” are accompanied by an increase in losses suffered by somebody else. It accounts for a transfer as a social gain.
In broad strokes, the BIS analysis goes as follows. Financial institutions are connected to one another by OTC derivatives trades. One way of measuring this interconnection is the CVA-the credit value adjustment on derivatives trades. The CVA is (roughly speaking) loss given default per dollar of exposure times credit exposure times the probability of default. If a given bank, B say, takes a hit of X to its balance sheet, due to a bad investment, or a rogue trader loss, or whatever, its probability of default goes up. This raises the CVA. This is immediately recognized as a mark-to-market loss, dollar for dollar, by its counterparties. These counterparties tend to be systemically important banks, and the loss makes them more leveraged. The greater leverage makes them riskier, and more subject to default. This raises their probability of default, which imposes CVA losses on their counterparties, and on and on. In this way, a shock to one bank propagates throughout the system, and feedback effects intensify the original effect. The end result is that major financial institutions become more leveraged, and the more leveraged the system, the more prone it is to a very costly crisis.
But Frankendodd lurches to the rescue! By collateralizing and increasing netting*, Frankendodd reforms reduce credit exposure in derivatives. Therefore, the CVA hit from a given rise in the probability of default is smaller. The leverage in the system doesn’t rise nearly as much when bank B takes the hit of X to its balance sheet. So a given shock has a substantially smaller impact on systemic leverage, and hence systemic risk. Yay!
Not so fast, people. Notice the flaw in the logic? Remember what started the cascading effect in the pre-Frankendodd world: an increase in the probability of default at B due to some adverse shock to its balance sheet. Collateral and clearing mandates reduce the exposure of derivatives counterparties to this shock. But a default doesn’t just affect derivatives counterparties: it hurts all of B’s creditors. Roughly speaking, the total cost incurred by B’s creditors as a result of an increase in the probability of default due to the loss of X is loss given default times total liabilities times the change in the probability of default. Given total liabilities, this does not change when derivatives are collateralized or netted more extensively. This, in turn, means that the decline in derivatives CVA that results from more derivatives collateral and netting is matched by an increase in losses suffered by other creditors. The “reforms” shift around the losses: they do not reduce them in aggregate.
That is, the “reforms” don’t reduce the losses that result from the balance sheet shock that raises B’s probability of default: they redistribute them. Note, moreover, that many of the same big financial institutions that benefit from the decline in derivatives CVA are hurt by the loss on B’s other liabilities, because these institutions are exposed to one another through a variety of claims, not just derivatives. Moreover, some of the others (non-bank creditors) that suffer from the redistribution may be systemically important too: money market funds that invest in the short term debt of financial institutions (including B) are one example. Repo is another example. Thus, the overall effect of Frankendodd and EMIR on systemic risk is quite equivocal. It shifts around losses, and there is no guarantee that the shift in losses improves the stability of the financial system.
But the BIS study does not treat the redistributive effects of the derivatives reforms. It treats them has a net gain. This is fundamentally, basically, and irredeemably wrong. Wrong, wrong, wrong. When evaluating systemic risk, it ignores the systemic redistribution of losses. As a result, it overestimates the gains of the regulatory changes.
To a first approximation, given the redistributive nature of their effects, the benefits of the reforms is zero. The BIS recognizes that they involve costs. Meaning that to a first approximation, Frankendodd and EMIR reduce wealth, rather than increase it.
But that’s just a first approximation. To understand fully the effects, you’d have to know how losses are redistributed, and the systemic importance of those who suffer bigger losses and of those who realize smaller ones. You’d also have to understand how financial contracts will change in response to the new set of creditor priorities inherent in the Frankendodd and EMIR rules. Financial contracts-capital structures, if you will-will change in response to the new rules. Claims will be repriced. There is going to be a new, different equilibrium structure of financial contracts. Maybe this new structure is less fragile. Maybe it is more so. I don’t know: the system is so complex that it will respond to this big shock in surprising ways. All I do know is that this where you need to look to figure out the effects of the so-called reforms on systemic risk, and this ain’t where the BIS looks. It counts benefits conferred on some subset of claimants, while ignoring the costs imposed on others (that are approximately equal in magnitude).
In other words, the BIS is hawking a free lunch, and as Friedman said, there ain’t no such thing.
The BIS study also has a particular model of systemic risk: the counterparty credit contagion model. B takes a hit, that spreads to C, D, and E, which then spreads to F, G, and H, and on and on, until most everyone drops dead like Aztecs fell to the smallpox. This is a common way of formalizing systemic risk, but reminds me of the story of the drunk looking for his keys under the lamppost because the light is better there, not because he lost them there. If you look at the history of financial crises, they almost never look like the systemic crises in these contagion models. An idiosyncratic shock at one institution doesn’t bring a house of cards crashing down. The collapses of individual institutions (Bear, Lehman) are symptoms of a deeper-and systemic-rot.
In sum, the BIS analysis is fundamentally flawed, and hence gives a wildly misleading estimate of the social benefits of the clearing and collateral mandates embedded in Frankendodd and EMIR and regulations adopted by other G20 nations. It is a sad, sad example of a reputable institution falling prey to free lunch fallacies.
It is particularly sad because it’s not as if this hasn’t been pointed out before. I raised the problem five years ago. So you may say-well, who are you anyways? Well, Harvard’s Mark Roe, one of the most accomplished bankruptcy scholars in the legal academy, has made the same point (and graciously cited my work). And, truth be told, it is a staple of the bankruptcy literature. And it’s also sad because I hear such “logic” over and over from regulators (e.g., scholars and policymakers at the Fed). They presume to identify systemic benefits based on analyses that look at only a portion of the system.
And speaking of sad. Could the BIS please spring for a typesetting program like LaTeX that prints readable equations? Please?
* It is by no means clear that moving more trades to clearing will reduce credit exposures in derivatives via netting, especially given the fragmentation of CCPs by product and jurisdiction. CCPs permit multilateral netting, but (a) bilateral trades can be compressed multilaterally, and (b) cross-product netting of exposures within dealer books can be larger than multilateral netting in single-category CCPs. But that’s really a secondary issue. The most important thing to remember is that the primary effect of netting is to redistribute default losses from derivatives counterparties to non-derivatives creditors.
The CME has seen increased volumes in its cash settled Brent contract in the aftermath of its launch of a program that pays rewards to those who trade the contract. This is a standard way to attract volume to a contract competing against an incumbent/dominant contract. Indeed, it’s probably the only way to do it.
Eurex tipped the Bund market away from LIFFE in 1998 after implementing a fee holiday, which LIFFE smugly refused to match, so confident was it of its liquidity advantage. But Eurex had enough organic order flow that it was fairly liquid already, and the fee cut made it cheaper to trade Eurex Bunds, as I document in my paper “Bund for Glory: Or, It’s a Long Way to Tip a Market” (which will be a chapter in a book I’m currently writing). The market tipped within a period of mere months.
Other exchanges didn’t repeat LIFFE’s near fatal mistake, and responded to fee cutting entrants by cutting their own fees to match. This is how CBOT saw off Eurex’s attempt to enter the US Treasury futures market in 2003, and how CME torpedoed EuronextLIFFE’s attempt to enter into the Eurodollar futures market a few years later.
Here’s the deal: incumbents have a huge liquidity advantage that entrants must overcome. How can this be done? The only way, really, is to cut fees, or actively reward volume to attract enough liquidity to compete with the incumbent. And the odds are still long, especially if the incumbent follows the CBOT script, and matches the reduced fees.
But if you want to encourage inter-exchange competition, you have to look favorably on entrants using strategies that reward volume as a way of building liquidity to make themselves into viable competitors.
This basic fact makes this FT article very disappointing. It criticizes the CME initiative, and only quotes those who are critical or dismissive of the endeavor. Yeah, it’s probably true that the only reason why those who participate in the incentive program trade is to collect the rewards. But their order flow can attract order flow from others: other traders see that there is two-way activity, and can be more confident that if they establish a position, it won’t be a Hotel California that they can check into, but can’t leave. Meaning that it’s BS to say, as one anonymous source to the story says, “there is no economic benefit to the trades whatsoever.” The economic benefit is that it can make the entrant a more viable competitor to the incumbent.
And quoting Bart Chilton. Please.
The quote that claims that spread trades-which dominate the activity in the CME Brent contract-“make no loss because they buy and sell at the same price” is just a crock. Yes, spread trades are lower risk, but calendar spreads do move.
The CME is engaging in a penetration pricing strategy. The only real strategy that permits competition against an incumbent. If you like competition, you should like a strategy that harnesses the greed of trading firms to generate liquidity and volume. Because, quite frankly, that’s the only way to compete.
But if you like monopoly, go ahead and denigrate what the CME is doing.
It would also be interesting to see how ICE built market share in its WTI cash settled contract that competes with the CME’s flagship oil contract. It is my recollection that ICE rebated fees for firms that brought volume to the ICE contract. (The structure of the ICE inducement, and Eurex’s in Bunds, were interesting. They basically made it a tournament, with rebates/bonus payment being limited to the top three-if memory serves- order flow providers. That provides a very high powered incentive while controlling the cost of the program.) If my recollection is correct, doesn’t that mean that sauce for the goose is sauce for the gander?
Competition in futures markets, where order flow is not socialized, is highly imperfect. Incumbents have huge advantages. Aggressive price competition-pentration pricing, specifically-is about the only way that an entrant can hope to dent the incumbent monopolist’s huge liquidity advantage, and even that is a highly dicey proposition. The FT story would have been much better had it recognized this reality rather than taking an all too critical view, and containing only quotes that were no doubt music to Jeff Sprecher’s ears.
It’s all so confusing. During the last spasm of Congressional criticism of the “financialization” of commodity trading, mainly during the Frankendodd “debates” over position limits, the target of criticism was evil speculators who trade commodities for purely financial reasons, and who have no involvement in the physical markets.
What concerns Brown and Senator Jeff Merkley, Democrat-Oregon, is that banks have numerous physical commodity holdings as well as the means to deliver those commodities, including oil tankers, transmission rights and pipelines, while they at the same time trade on energy prices in futures and swaps markets.
Big banks can buy “vast quantities” of commodities and pipelines, tankers and warehouses, said Merkley. This gives them “a huge amount of market information that’s very advantageous in trading” and gives them a “thumb on the scale in the terms of supply and demand and being able to have some influence over the price,” he said.
“If you’re simultaneously allowed to bet on the price and you’re allowed to have your thumb on the scale in reflecting the price it’s a huge conflict of interest,” he said.
“Financial institutions own fleets of oil tankers and can withhold delivery, while wagering on the price of oil or they can speculate on the price of energy while controlling supply,” Brown said.
This, the senators said, is a clear conflict of interest that is driving up commodity prices.
Make up your minds, people (which generously assumes you have them). Is the combination of physical and financial trading a good thing, or a bad thing?
As someone who has arguably written more about commodity market manipulation than anyone alive, I can say definitively that the most costly manipulative strategies-corners and squeezes-involve trading of “paper” (e.g., futures contracts) and the physical commodity. These strategies involve either taking excessive deliveries, or buying in excessive quantities in the physical market. Engaging in a market power manipulation requires some involvement in the physical market.
Historically, many of the biggest manipulations have been undertaken by hedgers.
And that’s the key point that escapes the Washington hand-wringers. On one of their wringing hands, they lament the involvement of non-hedgers in markets (let’s leave aside how you can have hedgers without speculators to take the other side of trades). On the other, they bemoan the fact that those involved in both the physical and financial commodity markets-who are often hedgers-can sometimes exploit market power to enhance profits. But if you believe that a primary function of commodity derivatives markets is to facilitate risk management by those involved in the producing, marketing, storing, and processing of commodities, you have to permit the physical traders to trade derivatives.
One of the consequences of that is that there will be manipulations by physical players. But severing physical and financial trading in order to prevent manipulation, which is what Brown and Merkley and others are suggesting, is crack-brained. It throws the hedging baby out with the manipulative bath.
And it is particularly crack-brained to focus on just one category of market participants, like banks. The potential for manipulation exists due to frictions in the physical market, and the ability of some market participants to trade both derivatives and the underlying commodities. Someone will step into the banks’ role if they are precluded from the market, and the potential for manipulation will remain. Taken to its logical conclusion, the Brown-Merkley “conflict of interest” standard would preclude any entity-not just banks-from trading both commodity derivatives and the underlying physicals.
So what’s the best way to attack manipulation? Not by destroying the ability of the markets to perform their vital risk transfer function. Instead, as I’ve argued for going on 20 years, the best way is to impose penalties after the fact for manipulative conduct. Thus, at least conceptually, I support FERC and CFTC enforcement efforts. The problem is that practically their efforts are often misdirected and intellectually confused.
Congress should economize on its limited comprehension of these issues by focusing on the key problems, rather than throw around vapid phrases like “conflict of interest” and recommend policies that undermine the ability of financial and physical commodity markets to function effectively. Better anti-manipulation laws predicated on a clear understanding of how manipulation works would be the place to start. And no, this does not involve the Xeroxing of 10(b)(5) of the Securities and Exchange Acts and inserting it into commodity trading laws, which has been Congress’s default response for about a decade. There is a complete mis-match between the fraud-based thrust of 10(b)(5) and the market power problems that sometimes arise in commodity markets. I’ve made recommendations over the years on the right regulatory/legislative approach that would target market power problems more precisely. This approach would permit the markets to exploit the synergies between paper and physical trading while at the same time improving the efficiency of these markets.
But instead, we get Congressional schizophrenia and meat cleaver approaches that would, if taken to their logical conclusion, destroy the markets in order to save them.
A further thought. Those who have the ability to trade the physical, and who have extensive information and developed logistical capabilities are usually the best positioned to break corners, and to mitigate the frictions that make corners possible. They also have the strongest incentive when they have a derivatives position that would be hurt by a manipulation.
I’ll post a link when I have a chance, but P.D. Armor’s breaking of the Leiter wheat corner in 1898 is a great example of this. There are many others.
The FT raises the alarm that hedging by US oil producers will undermine the shale oil boom:
As the US shale revolution transforms global trade in oil, it is also causing upheaval in the derivatives market – and making life harder for America’s shale producers.
The companies behind rising US crude production are selling more of their output in advance to guarantee revenues. That is putting downward pressure on future oil prices – making it harder for those companies to enter crucial hedging contracts.
. . . .
The principal reason for the downward drift in prices, say analysts and traders, is the hedging activities of shale oil producers themselves. As the volume of production in the hands of independent producers grows – EOG, a bellwether independent oil producer, doubled crude and condensate production between 2010 and 2012 – so does their hedging activity.
Um, no. This is a classic case of someone confusing correlation for causation. What’s driving down prices is the rise in output: the rise in output is also leading to more hedging activity. Yes, there will come a point where price comes down to a level that some producers will find it better to keep the oil in the ground. That’s the market in action.
There’s also this fascinating detail:
“There has always been a mismatch between producers and consumers in the futures market, but the increase in production by independents has made it worse,” says Jonathan Whitehead, global head of commodities markets at Société Générale.
Hmm. Buys and sells are equal in equilibrium. So just who balances that mismatch? Think. Think. Think.
Let me venture a wild guess: Speculators? So you mean that speculators are needed even more now than ever before? That without speculators hedging would be even more costly, and that would depress oil production?
Who knew?
No sooner than I had written a post that showed the potential comparative advantage that banks had in dealing in physical commodities did JP Morgan Chase announce that it was throwing in the towel, and exiting the business:
Wall Street’s biggest bank said an “internal review” had concluded it should pursue “strategic alternatives” for its physical commodities operations, which includes assets like its Henry Bath metals warehousing subsidiary and a vast global team trading everything from African crude to Canadian natural gas.
The firm will explore “a sale, spinoff or strategic partnership” for its physical arm, the statement said. It said the bank remained “fully committed” to its traditional financial commodity business, including trading derivatives and its activities in precious metals.
This decision was not the result of any single thing, but the cumulative result of many things. Greater capital requirements for banks. The maturation of commodity markets and the resulting flattening out of profits. The reputational risks of commodities dealing, with multiple regulators on the hunt for manipulation cases, and asking for big dollars to settle them. And, most recently, the political heat directed at banks’ commodity trading operations. Morgan’s commodity trading operation was big absolutely, but relatively not as big as Morgan Stanley’s or Goldman’s, and hence more readily expendable. Morgan decided to get out of the kitchen, rather than stand the heat. Especially since there is political pressure on all aspects on the banking business, and since navigating the post-Frankendodd, Volcker Rule world will be sufficiently challenging to the core businesses that commodities risks, political and reputational more than financial, just aren’t worth it.
Morgan Stanley has already mooted selling off its commodity arm. It will be interesting to see what Goldman decides to do, especially in light of the Metro melodrama. The European banks (notably Deutsche and Barclays) also have some thinking to do.
The exit or downsizing of bank commodity operations will redound to the benefit of the trading houses, and to private equity shops and perhaps hedge funds, including potentially some new entrants. I doubt it will make the commodities markets more competitive, and indeed, the opposite is more likely to be the case. This turns my minds to thoughts regarding the political economy of the pressure on the banks. The exit and downsizing also run contrary to the meme that banks have it all their way inside the Beltway.
The banks have done a terrible job of making their case. Perhaps it would be more accurate to say that they really haven’t made a case at all, likely as a result of hubris. They know they are doing God’s work (to steal from an old commodities guy, Lloyd Blankfein, who started his career at J Aron), but really need to work on their evangelism.
There is indeed a karmic aspect to this. Almost instant karma, in fact: following my musing about that by only a few days. I don’t say that with the least tinge of schadenfreude. Just stating the obvious.
I wonder what will happen to Blythe Masters, the head of Morgan’s commodity operation. I know her some. Most of our interactions were positive, until we butted heads over the report I wrote on commodity trading firms: in fact, she approached me to write the report because she’d liked what I’d written on the blog, and in comments to the CFTC.
I have a distinct recollection of sitting next to her at the JPM commodities conference in October, 2011, and watching the muscles in her jaw bulge as she ground her teeth furiously. She was obviously very tightly wound. If she was that intense before a relatively low-key conference presentation, I can only imagine how her jaw is working now. My guess is that she will stay at Morgan for a decent interval, and then land somewhere else. Like perhaps a private equity commodity trading shop.
Exit for economic reasons is part of the market process. Exit driven by political or regulatory pressure is problematic. Both factors are at work now, but unfortunately political and regulatory issues are predominating. The result will be less efficient, less competitive commodity markets. Which is exactly the opposite result that the politicians and regulators baying at banks and nipping at their heels claim to want. Unintended consequences yet again.
In its 2003 Physical Commodities Trading Order, the Fed permitted bank holding companies (not the depository institutions under the BHC umbrella) to purchase and sell physical commodities because they are “meaningfully connected to a financial activity such that it complements the financial activity.”
I mentioned one example of this the other day in the “Get Physical” post (and don’t worry: I won’t post any Madonna videos!), but want to go into more detail. The example is offtake agreements (and relatedly, tolling deals). In these arrangements, a bank (or other counterparty) agrees to supply inputs (e.g., crude to a refinery, gas to a power plant) and receives delivery of outputs (e.g., gasoline and heating oil, electricity).
Refineries, power plants, and the like typically need to pay for the inputs they process before they receive payment for their outputs. This creates a need for working capital to finance the timing gap between cash outflows and inflows.
Providing funding for working capital is clearly a traditional banking activity. One way to do this is for the bank to provide a loan or credit facility, and leave the refiner or power plant to acquire inputs and market outputs, and bear and perhaps manage the price and operational risks associated with those activities.
This exposes the bank providing the funds to risk: adverse movements in prices could put the refiner or generator into financial distress, and perhaps cause a default. The bank could require the borrower to hedge, but there is a moral hazard: if it doesn’t, or doesn’t do it effectively, the lender bears risk. The bank can monitor, but this is costly, and often imperfect.
The moral hazard problem can be eliminated by passing the risk on to the lender. An uptake agreement or tolling deal does this. These types of deal implicitly provide funding to bride the outflow-inflow gap, and pass the price risks back to the lender. The lender can manage these risks, and the agency cost in this arrangement is lower: there’s no moral hazard, and no need to monitor. Thus, bundling price risk management and funding can reduce the cost of funding working capital needs. This is presumably more valuable for lower credit quality refiners and generators.
There are other potential benefits. The lender may have a comparative advantage in managing risk due to specialization and expertise in this function: banks and commodity trading firms have a comparative advantage in risk management. Moreover, they may able to be able to manage risk more cheaply because they run large books: there are economies of scope in risk management. For instance, a lender doing an uptake deal with a refinery is short crude and long products, but it might have a long crude position based on a trade it executed with producer, and might have a short products position as the result of a swap with an airline or heating oil dealer. These natural hedges reduce the amount of trading necessary to manage the risks.
Moreover, trading firms specialize in marketing and logistics, and there are scale economies and scope economies in these activities. It may be cheaper for a big trading shop to provide marketing and logistical services, thereby eliminating the need for the refiner or the power plant to pay the overhead associated with such activities.
Thus, there are strong complementarities that make it beneficial to bundle financing, logistical, and marketing activities for some firms that process commodities. Who should provide these bundles? Banks have comparative advantages in funding and risk management, and can develop and staff physical trading operations. Commodity trading firms are typically more expensive suppliers of financing, but they have strong competencies in marketing and logistics. So both banks and commodity traders are reasonable suppliers of the bundled services, and thus reasonable counterparties in offtake and tolling deals.
What would be the effect of banning some market participants, like banks, from these activities? Econ 101 gives the answer. If these entities currently supply the bundled service-as is the case today-elminating them from the market will shift up the supply curve for this service, and in equilibrium it will be more costly. Meaning that refiners and power plants will incur higher costs that will be passed upstream (lower prices for inputs) and downstream (higher prices for outputs). To the extent that restricting participation gives (or enhances) the market power of those who remain in the market, these effects will be exacerbated.
What if some market participants-such as banks-get a subsidy of some sort that allows them to offer these services below cost? That is a source of inefficiency, to be sure: too much of the service is provided in equilibrium, and the beneficiaries of the subsidy have an excessively large market share. But it does not follow that banning the subsidized from the market is the right policy response. It’s usually better to eliminate the subsidy, especially in the case of something like a too big to fail subsidy, which has pervasive and perverse effects in all the markets in which the subsidized banks operate.
Evaluating the regulation of bank participation in any market, including the commodity markets, should proceed along similar lines. The concept of complementarity is the right way to consider these issues, and that principle can be analyzed in particular instances using basic economic analysis. The survival principle also suggests that if a firm gets market share in a particular business, it is because it is providing that service at lower cost, or delivering higher quality. If the lower cost is an artifact of some sort of subsidy, eliminate the subsidy, especially when it is a pervasive on that cuts across myriad lines of business. Populist venting about banks, especially venting based on some cramped understanding of what banking is and predicated on some belief that the involvement of financial institutions in commodity markets is somehow unnatural, is counterproductive. It is also likely really a mask for some political economy agenda, an effort to benefit one group of firms by handicapping-or eliminating-others.
Earlier in the year I wrote about the obscure, but very important, regulation of futures commissions merchants that essentially requires them to hold enough of their own money to cover shortfalls in customer margin accounts. This “residual interest” rule has caused a wholesale freakout among FCMs and market participants, and for good reason, as I pointed out in that post. The rule would not have prevented an MF Global or Peregrine situation-those involved fraud and/or numerous rule violations. Moreover, the rule puts further strains on the funding liquidity of the futures markets. There are already new strains aplenty, and liquidity shortages are a major source of systemic risk. A rule ostensibly designed to protects customers puts the entire system at greater risk.
The near universal opposition of the industry is leaving the CFTC unmoved. But the CFTC’s response is purely legalistic, and does not even attempt to address the fundamental economic issues:
But on Thursday, at an open meeting of the Agricultural Advisory Committee to the CFTC, regulators were unmoved by the criticism.
The proposed rules, said Ananda Radhakrishnan, director of the CFTC’s division of clearing and risk, merely clarify what the law already says: funds from one customer must not be used to pay for the position or deficit of another customer
“Nobody’s been able to make the argument, with all due respect, that what we are suggesting is not what the law says it is,” Radhakrishnan said. “The arguments we’ve heard … (are) that it’s going to be expensive, the earth is going to fall and so on and so forth. But nobody has done, to my view, a legal analysis saying, ‘your analysis is wrong.'”
Translation: “The law may well be an ass, but we’re rolling with it.”
I have some sympathy, because Congress has handed the CFTC many legislative directives that are at odds with economic common sense, and which are actually contrary to the purposes of the legislation (notably, the reduction of systemic risk). But where there’s a will, there’s a way. I get the sense that the CFTC is just hiding behind the legalisms in order to force through a proposal that it-and most likely Gensler-wants. If it had the will, it could likely find a way to adhere to the law as written but substantially mitigate the negative impacts of the regulation on liquidity, costs, and systemic risk. The failure to do so, and the appeal to the “Congress made me do it” defense (seen so clearly in the position limits regulation, and repeated in its appeal briefs) strongly suggests that the CFTC doesn’t have a strong economic justification for its regulation, can’t rebut the arguments of the critics, and is playing legal rope-a-dope in order to force through one of Gensler’s (and perhaps the staff’s) bright ideas/obsessions.
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