Streetwise Professor

There are reports that the CFTC will vote on the SEF rule next week.  The rule had been in limbo for months due to Gensler’s insistence that the rule require those requesting a quote solicit them from five potential counterparties.  Gensler has apparently relented because he could not get the new Democratic commissioner, Mark Wetjen, to join with Chilton and Gensler to vote out the 5 RFQ rule.

The compromise will require users to solicit two quotes for the next two years, and then three thereafter.

Whatever.

On the 1 year anniversary of the DFA, I named the SEF mandate as The Worst of Frankendodd. I haven’t changed my mind on that, though the competition is fierce.  And the RFQ requirement is the Worst of the Worst.  It is defended as a way of  improving competition.

This is at best paternalistic.  It presumes that those who want to enter into swaps don’t know their own interests.  Perhaps Gensler thinks that the buy side suffers from some sort of Stockholm Syndrome after years of captivity to the dealer banks.

In reality, buy side firms-most of whom are extremely experienced and sophisticated-are making trade-offs between competition and information leakage.  They are trying to minimize cost of execution, and have the information and incentive to do that.  Note too that they are required to do this for every trade, regardless of instrument, size, and other factors that may influence the trade-off.  But nope, one size fits all. They should be allowed to make that trade-off themselves, without any guidance from Gary.

RFQ5?  How about RFQ0?

Here’s an analogy.  How would you like it if the government told you how many stores you had to visit before making a purchase?  You know, to make sure that you get the best price.  Call it the CS5 rule.  You have to comparison shop at five stores before making a purchase.  On everything.   Of course, when deciding on whether to shop at one store or five, you trade-off the potential savings (which will depend on the value of the purchase, the good you are shopping for, and other factors) from shopping around more, against the cost (which will vary with the value of your time, how hurried you are, your income, the price of gas, where you live, etc.)  But none of that matters under the CS5 rule.  Want to buy a quart of milk?  Shop at five stores.  For your own good.

Yeah.  It’s that bad.  CS2 would be bad, but not that bad.

Once the SEF rule goes into effect it will be interesting to see how the structure of the industry involves.  There will be a land rush of new SEFs.  I predict there will be a shakeout, and there may well be only a single dominant SEF for each major instrument.  The SEF rule does not, as I understand it, require a SEF to send an order to another SEF offering a better quote.  Which means that the network effects of liquidity will tend to cause trading activity to “tip” to a single SEF for products big enough to support order book trading.

But the whole SEF landscape will also be shaped by the margin rules, the Bloomberg suit over those rules, block trading rules, and on and on.  The rule is not the beginning of the end, it is barely the end of the beginning.

The most recent controversy over HFT stems from this WSJ story about the CME.  In a nutshell, computerized traders receive confirmations of their trades before information about those trades is disseminated to the market at large.  As in a few milliseconds before.  But in an electronic world, a few milliseconds can be decisive.

One example of a particularly informative trade is when an away-from-the-market limit order is executed.  This means that a market order of sufficient size to blow through the quote size at the inside market was submitted.  Given that orders and communicate information, and that the bigger the order, the more informative it is, knowing before anybody else that such an order has been executed can provide valuable information.

The implications of this depend on how the information is used.  A trader (or, more accurately, a bot) that gets this information can use it to take liquidity aggressively.  For instance, it can use information gleaned from a big, price-moving crude oil buy to submit an aggressive order in heating oil or RBOB, thereby picking off resting limit orders that cannot adjust to the new information.  Or, as the WSJ article suggests, the bot can use the information derived from the NYMEX CL trade to take liquidity from ICE Brent or NYMEX lookalike futures.

This kind of trading exacerbates information asymmetries, and all else equal, increases spreads, reduces depth, and increases trading costs for the uninformed.

But the “all else equal” part of the statement doesn’t necessarily hold.  This presumes that the amount of capital devoted to HFT is constant.  But that’s not true in the long run.  If these sorts of advantages generate profits, that will attract more capital into HFT.  Moreover, note that the strategy just outlined involves placing limit orders, and then reacting when those limit orders are executed.  Competition to get the information advantage will lead to more aggressive quotes, and quotes in bigger size.  In the long run equilibrium, this competition will dissipate the rents from the information advantage.

Therefore, if there is any reason to reduce this speed advantage (either by slowing down some traders or speeding up the dissemination of trade execution information to the market at large), it is to prevent the investment of excessive capital into HFT.  The effect on spreads and depth in equilibrium is ambiguous.

Moreover, there are other possible uses of the information advantage that are clearly socially beneficial.  An HFT market maker-who is likely making markets in a variety of contracts-can utilize the information to revise limit orders either in the market in which the execution occurred, or in other markets, especially those that are closely related (again, consider the CL/HO or CL/RB example).  Using the speed/information advantage in this way reduces the HFT market maker’s vulnerability to getting picked off, and makes it willing to supply liquidity more aggressively.  This tends to reduce trading costs, and does not lead to the rent seeking that in the long run equilibrium tends to result in an inefficiently large HFT presence.

We also need some perspective here.  I consider it beyond hilarious that the WSJ has a video embedded in the online version of the story that has many images from the floor.  (And these days, one of the floor’s main functions is to provide visuals for stories on trading-especially the trader’s-head-in-his-hands shot on days when the market falls a lot.  Pictures of servers aren’t nearly so dramatic.)

Why hilarious?  Well, the floor was the epitome of time and space advantages to a select few.  A select few who paid for the privilege.  I remember distinctly a trader telling me: “Why do I spend $500,000 on a seat? Because I get to see the price before anybody else.”

Exactly.  The floor was the meat version of colocation.  Or the carbon based life form version, if you like.  Those on the floor could see the execution prices, and bids and offers, and order flows, that those off the floor could not.  They profited accordingly.  Which is why the marginal guy on the floor-the least efficient trader-was willing to pay hundreds of thousands of dollars in some cases to get on the floor.

In 2002 or so I wrote a paper titled “Upstairs, Downstairs” (still a working paper) which showed that floor traders earned a rent as a result of their time and space advantage: upstairs traders could not supply liquidity as effectively as floor traders due to their information disadvantage, and this meant that floor traders faced limited competition in supplying liquidity.  Moreover, exchange limits on membership meant that entry could not dissipate these rents.  But by reducing the time disparities between liquidity suppliers advantage, electronic trading increased liquidity supply: upstairs traders were no longer operating under a time and space handicap.  Trading costs and rents decline. And that decline in rents is precisely why floor traders fought electronic trading so fiercely for years.

So yes, in today’s electronic markets some traders have a speed advantage.  But this disparity is nothing when compared to that which existed in the floor days.

Which is why I can’t really get all that spun up over the WSJ story, or most of the other stories about how unfair markets are.  Everything is relative.  No, the playing field isn’t perfectly level today, and along the lines of yesterday’s post, it may be in the interest of the CME to take measures to make it more level.  They say that they are.  But arguably the field is more  level than it has ever been.  It’s certainly far more level than in the heyday of the trading floors.  Don’t get nostalgic for the days when market makers were meat, not machines.  The table was tilted in their favor, bigtime.  Much more than today.

HSBC’s Gary Dunn said something at the ISDA AGM that I think is very important:

Dunn pointed out the risk characteristics of a CCP are very similar to that of collateralised debt obligations, the tranched credit products that were prevalent in the run-up to the 2008 financial crisis.

In the CCPs default waterfall, the initial margin payments from clients and default fund contributions from clearing members are comparable to the equity or first loss and mezzanine tranches of a CDO. In other words, these are the first sources of funds that get eaten into to cover any losses.

According to Dunn, the super senior tranche (which in the case of CDOs tended to attract Triple A ratings, but often subsequently sustained losses during the credit crisis) is the additional steps the clearing house might take when all other funds are exhausted, whether it is haircutting, asking for more capitalisation from clearing members of possibly even a government bailout.

“If you start modelling the risks of a CCP as a CDO, you realise the correlation risks in a CCP aren’t at the moment fully appreciated, very much like they weren’t when we had CDOs and CDO squareds,” said Dunn.

“The probability of a CCP failing is still relatively low, but there is a reasonable probability that people or banks lose money even if a CCP doesn’t fail,” he added.

I can hear you saying: “Where have I read that before?”  Or: “When have you said that before?”  In January, 2011, now that you ask 😛

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

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

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

This is a big deal. Wrong way risk is particularly poisonous, and a source of systemic risk in systemically important institutions like big CCPs. Policymakers have been largely oblivious to this very important problem.  I’ve been on about it for over two years, but we see how that matters.  Maybe if people like Gary Dunn start raising the alarm this issue will get the attention it deserves.

But, of course, Anat Admati, etc., will dismiss this as self-interested scaremongering by banks, and will criticize me as being some sort of tool (which she has, by the way).

I understand perfectly that such self-interested scaremongering occurs.  But I also understand that sometimes there is a wolf.  This is one of those times.

There are all sorts of proposals out there to rein in HFT.  The Europeans in particular-and in particular, particular, the Germans-want to do so.

I’ve long argued that there is good HFT and bad HFT, and that trading platforms have an incentive and the information to adjust fee structures and trading protocols in order to mitigate the latter.  For example, some exchanges have cracked down on excessive cancellations or the entering and canceling of orders far away from the current inside market.

Today’s FT reports another example, and a rather dramatic one.  One of the biggest FX trading platforms, EBS, is jettisoning the venerable time priority (“first come-first served) system with continuous trading.  Instead, it will collect orders that arrive during a period lasting a few milliseconds, and then execute them in a batch.  Instead of a continuous market, it appears to be a high speed sequence of call markets.  This eliminates the advantage of getting your quote in a millisecond sooner than someone else.  Perhaps it will also deter forms of gaming, such as strategies that (allegedly) attempt to create and exploit latency.

Will it work?  Who knows?  But that’s the point.  Markets facilitate the process of discovery.  Market participants compete to find solutions to problems.  EBS has identified a problem, and are trying to fix it using a fairly innovative change to the matching process.  If they’re right that some kinds of HFT are detrimental to market performance (and thereby reduces the demand for to trade on the platform), and their replacement of continuous trading with high speed calls impedes this detrimental HFT without impeding the good kind, they’ll make money.  And others will likely imitate, or take the basic idea and try to improve on it.

Or maybe it won’t work as planned. In which case they can try something else, or lose business to a platform that devises a better protocol.  The point is that a trading platform identified a problem with HFT, and is doing something about it, on its own.

All of this is far superior to top-down, one-size-fits-all government mandated “solutions” that are driven by political economy considerations first, efficiency considerations second . . . or third . . . or Nth.  Trading platforms may not internalize all the costs and benefits of better trading rules and fee structures, but their information and incentives are far better than regulators or legislatures.  Between competition among HFT firms, and the efforts of trading platforms to optimize the demand for their services, it’s likely that HFT’s rough edges will be smoothed out.  And if trading platforms don’t adopt such measures, you have to doubt seriously whether there’s a problem in the first place.  Because if there is a problem, they’d be the ones in the best position to know, and the best position to fix it.

Pre-Crisis, there was very little academic writing on clearing.  Post-Crisis, with questions about the role of derivatives in creating systemic risk, and the mandating of clearing of derivatives as a means of mitigating this problem, this is changing.  This is a good thing, but unfortunately, this burgeoning academic literature is at risk of irrelevance, and worse, of being misleading, because the theoretical models of clearing are nothing like clearing as it actually is.  These models tend to focus on the mutualization of risk within CCPs.  That’s important, but as I’ll discuss in more detail below, mutualization is not the most important feature of CCPs.  Collateralization is.

I’ll just talk about a couple of papers in detail, Adam Zawadowski’s Entangled Financial Systems in the most recent RFS, and Clearing, Counterparty Risk, and Aggregate Risk by Biais, Heider, and Hoerova.

These papers have some important insights, and I don’t want to seem overly critical.  I just want to persuade scholars that the focus of these papers, and many others, is misdirected, and to suggest where they should direct their attention.

“Entangled Financial Systems” presents a model of the periodic collapse of the financial system through the channel of inter-bank derivatives exposures.  The paper is rough sledding, in part because it tackles a complicated issue, and in part because the exposition and especially the proofs are hardly paragons of clarity: I have my doubts about some of the proofs.  That said, the story is a plausible one.  Banks use fragile capital structures (short maturity debt to fund long-lived assets) to solve an agency problem.  They use derivatives to manage risk in order to protect non-pledgeable income.  Banks are at risk of blowing up due to an idiosyncratic, exogenous shock: perhaps an operational risk, like a rogue trader.  If a bank blows up, its counterparties don’t get paid in full on their derivatives.  If these counterparties don’t insure against this risk, they may fail, and so on, with the result being a daisy chain of failures.  Thus, one idiosyncratic failure can lead to the collapse of the entire system.

In the model, the original risk of a blowup is idiosyncratic and insurable.  But in equilibrium, banks don’t buy insurance against a counterparty failing because they don’t internalize the impact of their failure on their other counterparties.  Thus, there is a “market failure”: the system blows up periodically because it is privately efficient but socially inefficient not to buy counterparty insurance.

One crucial issue with the paper is that most things are, laudably, endogenized, but one crucial thing is not: each bank can trade with only two counterparties located adjacently on a circle.  The choice of counterparties is exogenously specified. This concentration of counterparty exposure is crucial in making the system vulnerable to collapse.

Zawadowski recognizes that greater diversification of exposures across counterparties reduces the fragility of the system.  Although the externality may induce insufficient diversification across counterparties (because the systemic benefits of this aren’t internalized), market participants in reality have a variety of reasons to spread their trades across many counterparties.  Meaning that real financial systems may be less fragile than in the model, with its exogenously imposed concentration of exposures.

I’m also skeptical that an idiosyncratic risk at a single institution can bring down the entire financial system.  Look at some of the rogue trader losses-Kerviel at SocGen, Adoboli at UBS.  These guys cost their banks billions-but even such huge losses didn’t lead to a financial system meltdown via any channel, including a derivatives channel.  Instead, the 2007-2008 Crisis was related to a systemic shock-a decline in US real estate prices-that hit multiple financial institutions and investors.  It’s hard to identify an actual episode where the channel analyzed in the model-an idiosyncratic shock at a single financial institution-led to a financial meltdown.  The idiosyncratic nature of the risk is important: that’s what makes the risk insurable.  The paper therefore has little to say about non-insurable risks.

Where does clearing come in?  In the paper, clearing is a form of counterparty insurance.  Mandating clearing internalizes the externality.

There are several problems here.  The first is that in the model, counterparty insurance is supplied by a continuum of investors who can diversify away the risk.  A CCP in theory can also diversify the idiosyncratic risk by mutualizing it.  But note that CCPs are voluntary cooperative arrangements among financial institutions.  If there is a gain from collective action-internalizing the externality through cooperation-why don’t financial institutions voluntarily cooperate to form CCPs?   (Though in the context of the model, sharing the risk among financial institutions is more costly than passing the risk to investors.  Still, there is a collective benefit from cooperation among the financial institutions.)  Such cooperation increases joint wealth: why don’t market participants cooperate to internalize the externality?  What stands in the way of consummating such mutually beneficial bargains?   Moreover, why does it happen in some markets, not in others?

But the mutualization issue generally is the bigger problem, and the root of my qualms about the developing literature on CCPs.  Most of the models, including the Biais et al paper, formalize CCPs as a mutual risk sharing/insurance mechanism.  (Hell, I’ve done that myself.)

But mutualization is only one of the functions of CCPs As We Know Them.  Indeed, I am increasingly leaning to the view that it is the most problematic of their functions.

CCPs operate on the “defaulter pays” principle.  That is, real world CCPs attempt to choose margins (collateral) and default fund contributions so that they almost always cover a defaulter’s losses, and that non-defaulters’ default fund contributions are seldom used to make good a defaulter’s losses.  That is, default funds are tapped-and risk mutualized-only in rare, and arguably extreme, situations.

Put differently, only tail risk is mutualized in real world CCPs, and the primary function of CCPs is to set margins so that default losses are NOT mutualized, except in extreme circumstances.  CCPs are like monoline insurance of supersenior positions well down on the default waterfall.

In the context of the _ paper, this is particularly problematic, as he shows that collateralization is an inefficient way to address the externality problem.  It ties up valuable resources that could be used to fund positive NPV projects.   This is just one problem with collateral: the “initial margin problem”, if you will.  There’s also the variation margin problem that I’ve written about over the years.

I consider the tail-risk mutualization aspect of CCPs highly problematic because of the wrong way risk problem.  Like super-senior tranches of a CDO, losses hit the default fund during systemic episodes when those exposed to the default fund (the members of the CCP) are under stress.

This all means that the academic literature, which is modeling CCPs as mutual insurers, has two big problems.

The first problem is one of positive economics.  Existing models are not able to predict (a) why clearinghouses form, and (b) why they are primarily mechanisms to net and collateralize exposures, and only mutualize extreme risks.  They do not predict why market participants sometimes cooperate to implement a “defaulter pays” model, and sometimes don’t-and why they have never implemented a fully mutualized insurance scheme.

We need models that help us understand why market participants sometimes cooperate to implement a defaulter pays mechanism, supplemented by mutualization of the extreme risks; why they sometimes don’t; and why they never fully mutualize.  That is, we need to understand why so few risks are mutualized, even when market participants choose to form CCPs.

With all due modesty, I think the answers will will be found in my original analysis from the 90s: that the usual bugbears of insurance-adverse selection and moral hazard-make it uneconomically costly to mutualize risk, and that these problems also make centralized/delegated setting of collateral levels more costly than bilateral arrangements for doing so, depending on the characteristics of the traded instruments and those trading them.

The second problem is one of normative economics and policy prescriptions derived from models.  Policy recommendations based on models of CCPs that are flatly contrary to the way CCPs really operate are highly misleading, and dangerous.  Eliding from a model that says “mutualization of risk is socially efficient but privately unprofitable” to prescribing a policy of mandating CCPs is deeply flawed, when in practice CCPs won’t mutualize risk as in the models, but will instead implement a defaulter pays model.  (NB: of late regulators are telling CCPs that their main source of concern is that CCPs will set margins too low.  That is, regulators want to make sure that CCPs really make defaulters pay.  So in practice, mandated CCPs will mutualize only extreme risks, and collateralize the rest.  Nothing like what’s in the models.)   It’s a sort of bait-and-switch.

Prudent normative policy recommendations need to be based on a model with good positive content. We need to understand much better why market participants eschew implementing the defaulter pay model before mandating it.  For that’s what clearing mandates do: they impose the implementation of defaulter pays, NOT the implementation of the kinds of mutualization in many formal models of clearing.   Given the costliness of collateral (IM-not to mention the destabilizing effects of VM), it is particularly misleading to advocate policy measures that will lead to increased collateralization based on models in which collateral plays no role whatsoever.  Again-a bait-and-switch.

In sum, I’m pleased that many talented scholars are turning their attention to clearing. Especially when they cite me 😛 But it will be a shame if these scholars go on a wild goose chase, and construct models of CCPs that are completely disjoint from real world CCPs.  This goes double when they make policy prescriptions based on their models.

We need to understand the costs and benefits of defaulter pays, with the mutualization of only extreme risks.  For that’s what CCPs are really about.  We need models that are based on an understanding of collective action issues-because non-mandated CCPs are institutions that arise from collective action.  Only when we understand these issues should we have much confidence about making policy recommendations.

I was invited to participate in a panel on clearing at ISDA’s Annual General Meeting in Singapore, but unfortunately I had to decline on account of my teaching obligations.  I therefore have to nod (vigorously0 in agreement from afar, because much of the discussion there has focused on the unintended consequences of the clearing and collateral mandates.  Consequences that I have been warning about for over four years.

One of the things that infuriated me about the advocacy for clearing (and yeah, I’m looking at you GiGi) was the claim that clearing would reduce the interconnectedness of the financial system.  I said this was patently false.  Clearing mandates would reconfigure the topology of the network of connections among financial institutions, but they would remain interconnected.  I noted that: CCPs would be vital interconnecting nodes in this new network: failure of these nodes would be catastrophic: and perhaps most importantly, CCPs could be vectors of contagion precisely during periods of financial stress.  I pointed out very early on that CCPs were repositories of wrong way risk because losses would hit default funds precisely during periods of extreme financial stress, and via that channel would bring that stress right back to the balance sheets of the banks with exposure to the default funds.  You know, when they were least able to stand the shock.  The CCP circuit connecting banks would be closed precisely when they were least able to stand the shock.

In retrospect, I seem like a Pollyanna.  Compared to people like HSBC’s Gary Dunn, anyways (Risk link-requires a subscription).  Gary went all Jeremiah at the AGM, warning of an apocalypse emanating from the clearing system.  Actually, his word was “Armageddon”:

Mandatory clearing of over-the-counter derivatives could jeopardise policy-makers’ hopes of a no-bailout financial system, according to Gary Dunn, senior manager for regulatory and risk analytics at HSBC.

Speaking at the annual general meeting of the International Swaps and Derivatives Association in Singapore today, Dunn sketched out an “Armageddon scenario” resulting from the fact that the same group of international banks are all members of the majority of central counterparties (CCPs) – so, a big bank default would simultaneously hit all CCPs of which it is a member.

“What happens when one bank defaults across six CCPs? The remaining members will have to pick up the bill. Given that they are almost certainly members of the other CCPs, this will result in a default contribution bill so large it could potentially lead to their failure also,” he said.

Given the key role CCPs will play in the future financial system, Dunn argued this would ultimately result in a taxpayer bailout amounting to trillions of dollars. In his Armageddon scenario, that bailout would be preceded by the complete liquidation of CCP initial margin stocks – much of which would likely be held in the form of government debt.

“The wrong-way risk in the current CCP system is so large it could potentially lead to a sovereign default,” he said. [Emphasis added.]

Interconnections between SIFIs via clearinghouses, with the fragility of these connections perhaps exacerbated by the fragmentation of CCPs (due to fragmentation along jurisdictional lines, perhaps).  Where have you seen that before?  Hint: Not in a Gensler speech.

The clearing panel also fretted abou the possibility that in its attempt to eliminate TBTF, the G-20 has just created new TBTF institutions.  Too big, and too interconnected:

Central counterparty clearers stand to be the next “too-big-to-fail” institutions and could pose an acute threat to the financial system if regulators stall on plans to manage the potential failure of a clearing entity.

At the annual general meeting of the International Swaps and Derivatives Association in Singapore today, a group of panelists highlighted the lack of clarity over resolution for failed CCPs as a significant concern for the G20 objectives of eliminating systemic risk.

“There are still no resolution plans for CCPs and it is murkier now that clearing houses have moved away from the utility model,” said Athanassios Diplas, senior adviser to the ISDA board, speaking at the event earlier today.

The G20 objectives agreed in 2009 deem that no financial institution should be considered too big to fail and that taxpayers should not bear the costs of resolution for any institution that does fail

While regulators have been busy penning rules to deal with the problem of too-big-to-fail banks, concerns are shifting to clearing houses, and the increased concentration of risk held in them as the Dodd-Frank Act in the US and the European Market Infrastructure Regulation push an increasing number of standardised over-the-counter swaps through central counterparties.

“We’re getting very close to solving too big to fail globally for banks, but I worry that this risk could move to CCPs. I’m not convinced that we have made CCPs deeply resolvable yet – we have to do that to address systemic risk issue in a thorough way,” Wilson Ervin, vice-chairman of the group executive office at Credit Suisse told IFR.

All of which was perfectly foreseeable in 2009 when the G-20 blessed clearing as the silver bullet solution.  Foreseeable-and foreseen by some.

And the late start on addressing this issue before CCP mandates went into effect has left the world financial system in highly exposed:

While the Financial Stability Board addressed basic principals for clearing house resolution in June 2012, the issue remains on the back burner with many regulators as they continue to get to grips with a workable bank resolution regime

CCPs are the solution.  So in their wisdom governments decided to load risk onto them.  But dealing with the failure of these government-mandated SIFIs “remains on the back burner.”

Great.  That will turn out well.

Fools rush in where angels fear to tread.  Governments have rushed into prescribing the Clearinghouse Cure, but have relegated addressing the very dangerous potential side-effect of that cure “to the back burner.”

But we’re not done!  The panel also fretted about the potentially destabilizing effects of increasing collateral and margins-both initial and variation margin (can’t find a link to this Mary Childs story: I think it is only available on Bloomberg terminals):

The numbers are large enough to be very worrisome,” Athanassios Diplas, principal at Diplas Advisors LLC and a senior adviser to the ISDA board, said on the panel. “I don’t

think anyone has trillions lying around the couch cushions.” Regulators should be careful in setting the collateral requirements given that margin calls contributed to the escalation of the financial crisis in 2008, according to Kim Taylor, president of CME Group Inc.’s clearinghouse.

Spiraling Losses

“Margin calls triggered liquidation of assets for positions, which triggered mark to market losses for other parties. It contributed to the spiral, and I think there’s the  potential for threshold-based margin” to help avoid a repeat, she said on the panel.

Margin calls exacerbating a crisis.  Whoever heard of such a thing?  Only anyone who has studied past financial panics and market crashes.  But Gensler and Timmy! and so many others assured us that collateral is only good: the more collateral the better.  Just another item on the bill of goods they sold the world-and for which we may have to pay dearly later.

Scary addendum.  At a recent Chicago Fed conference, I told someone from a major central bank that although the initial margin issue was important, it worried me that central banks and regulators seemed to be ignoring how variation margin could destabilize the system, especially with an expansion of clearing, which creates a very tightly coupled system of margin payments that must operate on a very tight and rigid time schedule.  He told me that there wasn’t as much concern about variation margin because it netted out to zero.

Seriously.  I kid you not.   It’s as stupid as the Krugman “we owe national debt to ourselves” mantra.  The payers have to find the liquidity to make the payment to the receivers.  In stress situations, they have to find a lot of liquidity precisely when liquidity dries up.  In response, they do things that impose additional stress on the system, and can break it.  Money is not transferred instantaneously and frictionlessly between those who owe and those who receive.  Those frictions-and just the timing required to recycle the payments-can cause the system to freeze up during periods of stress.

The “what, me worry?” approach to variation margin is very worrisome indeed.

But don’t worry!  Regulators will ensure that CCPs don’t engage in a race to the bottom when setting margins:

Britain’s new regulator for market operators warned clearers of tougher policing of fees to stamp out cut-throat competition that risks undermining financial stability.

. . . .

“We are not in the business of preventing competition but what’s important is the terms of that competition,” Britain’s new clearing supervisor, Edwin Schooling Latter, told Reuters in an interview.

The Bank of England became the regulator for clearing houses this month and Schooling Latter said in his first media interview he will not tolerate “a race to the bottom” such as clearers allowing banks to post too low margins against trades.

Margins refer to traders of derivatives posting government bonds or other high quality collateral to help cover any losses and the level of margins is determined by the clearing house.

“We want a world where the clearing houses compete on the quality of their risk management and not on how low their margins are,” Schooling Latter said.

Because regulators, of course, are so skilled at pricing risks.  They did such a bang-up job of it when setting capital requirements under Basel.  And by “bang-up” I mean like a train wreck.

The Sorcerer’s Apprentice metaphor seems more apt by the day.  Regulators and legislators have cast the spell to bring massive CCPs to life, but cannot control the consequences-which can be dangerous indeed.  They intended to solve one problem, but they have created others, and are scrambling to deal with them.

I’ve been asked for my take on the Senate report/hearings on the London Whale.  I’m responding more out of a sense of duty, rather than any actual enthusiasm for the subject.

There are two issues that need to be distinguished, IMO: the operational aspects of JPM’s CIO, and the economic substance of the transactions that cost the bank billions.

The operational aspect is indeed appalling.  The reliance on a spreadsheet with manual inputs to quantify the risks of the CIO is truly appalling.  Division, multiplication-whatever!   The failure to take into account market liquidity, and the ability to get out of a huge position in the event that circumstances changed.

The battle over marks-hardly surprising.  It has always been so, and will continue to be so long after we have all shuffled off this mortal coil.

With respect to the economic substance, I don’t have much to add beyond what I said last summer, or beyond what the wickedly sardonic Rhymes With Cars and Girls has written over the past days.  I encourage you to read Crimson Reach’s posts.

In a nutshell, Crimson ridicules the presumption that banks can invest in ways that are immune to the risk of loss, and mocks the Shocked! Shocked! response when losses are actually realized.  Relatedly, he eviscerates the attempts to distinguish between “hedges” and “speculative” trades.

These distinctions are indeed Talmudic.  Any investor-including banks-makes risk-return trade-offs.  With respect to banks particularly, they are in the business of taking credit risk.   There are myriad ways of taking on credit risk.  Making loans.  Buying or shorting corporate debt.  Buying or selling CDS .  What really matters is the risk of the overall portfolio.  There are many ways to achieve the same risk profile.  And since banks inevitably take on risk, there are many ways to lose money.  And believe me, banks have found them all.  Sovereign debt (remember the LatAm debt crisis, anyone?), mortgages, corporate debt, consumer lending.

What JPM described as a “hedge” was really a trading strategy was not a mechanical offset of an existing position.  It was designed to perform (relatively) well in a particular state of the world, i.e., another financial crisis.  In that sense, it was taking a view on the potential damage associated with that state of the world, and the likelihood of that state.  That state didn’t occur, and the position performed badly.

Like I said, there are myriad ways to invest or trade based on that view, and there’s virtually no way to prevent banks from investing or trading based on their views on risk.  That’s what banks do.  Deal with it.

These views will often be wrong.  Which is why banks frequently lose a lot of money.  When they share the same views, and hence trade/invest the same way, they will lose money at the same time: that’s when we have a systemic risk problem.  Again: LatAm sovereign debt in the ’80s; mortgages in the ’00s.  The blessing of the JPM case was that it was pretty much alone in its strategy.

Insofar as the atmospherics are concerned, I am sure that any forensic examination of any of these loss-making episodes would reveal the same kinds of behavior documented in the Senate report.  The same duplicity.  The same attempts to avoid blame.  The same attempts to defer recognition of losses.  The same arguments and backbiting.

The biggest problem with JPM was that, well, it was big.  If you look at many major financial debacles, a common feature is that big institutions make bets that are so big that they become price makers rather than price takers.  When the bets go wrong, and they want to get out, or to reduce exposure, size becomes a liability, rather than an advantage.  Size creates positive feedbacks, and in financial markets, positive feedbacks have very negative effects.  The holder of a big position suffers losses, and tries to reduce exposure: they are so big that these attempts move prices against them, thereby exacerbating the losses.

That’s what happened to LTCM.  That’s what happened to JPM’s CIO.  The difference was that JPM had the capital to survive: LTCM didn’t.  Another good thing.

Carl Levin is using the Whale Trade to dragoon the regulators into implementing the Volcker Rule, which is intended to prevent banks from “trading”, and to limit their activities to “lending” instead.  Again color me unimpressed.  Banks have proved since time immemorial that they can lose vast sums lending, thank you very much.  One of the virtues of trading is that the discipline of mark-to-market forces realization of losses sooner: it’s harder to conceal losses on the trading book than the banking book.  (I understand the complexities here.  Especially when banks are subject to capital requirements, realizing losses can force banks to shrink balance sheets in ways that generate fire sales and positive feedbacks.)  Yeah, the traders at CIO tried to finesse/manipulate the marks to defer recognition of the losses.  But they wouldn’t have even had to resort to chicanery had these losses been on the banking book: in a (perhaps perverse) way, the frantic attempts to jigger the marks demonstrate the ruthless disciplinary effects of marking to market.

In brief, drawing distinctions between “hedging” and “speculating” or between “trading” and “lending” or “investing” or “market making” is typically futile.  Banks can f*ck up-or make lots of money-doing any of these things. And have.  Rather than attempting to micromanage the activities of banks, it’s better to focus on making sure they have the incentives to take risks prudently, and have the capital to absorb the inevitable losses.

Which is why, as far as I am concerned, the would-be Ahab Carl Levin set out to kill a great whale, and brought home a minnow.

Just because I find the expropriation of Russian deposits in Cyprus wrong doesn’t mean that I’ve gone soft on Russia.  To the contrary, my criticism of Russia and my criticism of the Cypriot confiscation grow from the same roots: a belief in the rule of law, and a deep dislike for the natural state.

A couple of stories along those lines.  First, a Russian court permitted a Russian firm, Agroterminal, to walk away from an interest rate swap it had entered with the Italian bank Unicredit:

The court’s ruling was based on a clause in the swap documentation that says a party can unilaterally terminate if there are no outstanding obligations at that point. Agroterminal had made one of the swap’s quarterly payments to UniCredit Bank and terminated immediately afterwards, arguing that as the new quarterly payment had not been calculated, there was no outstanding obligation.

Put differently, per the Russian court’s interpretation, the party to a swap has the ability to walk away at any time between payment dates.  Yeah, the market will totally work under that interpretation.  It turns the swap into an option: each party has the choice to walk away when the swap is underwater immediately after each calculation date. Since the swap will be underwater to one of the parties, this means that the swap is a non-starter.  Not a forward starting swap: a non-starting swap.

The lawyers quoted in the Risk piece attribute the court’s decision to ignorance and naivete.  Actually, what is naive is that interpretation.  Maybe the court was playing dumb, but it is pretty clear that Agroterminal had the home court advantage-literally.  That is, the court was just favoring a Russian firm at the expense of a damn furrin’ bank.  The decision is transparently silly: if one would take it literally, any floating rate claim (e.g., a floating rate bond) would be unenforceable between payment dates.  The Russian court was looking for some fig leaf to justify stiffing the Italians, and it found it.  Go figure.

The second story: Putin’s judo buddy Arkady Rotenberg has made billions on contracts for the Sochi Olympics:

Those contracts, which number at least 21, include a share of an $8.3 billion transport link between Sochi and ski resorts in the neighboring Caucasus Mountains, a $2.1 billion highway along Sochi’s Black Sea coast, a $387 million media center, and a $133 million stretch of venue-linking tarmac that will double as Russia’s first Formula One track.

Wow.  I keep kicking myself  for not taking up judo (but wouldn’t kicking be Karate-related? Whatever).  Arkady is not just the best producer of steel pipe for gas pipelines, he’s also the best builder of transportation systems, highways, media centers, and Formula One tracks.  His personal connection with Putin is no doubt totally coincidental: can he help it if he  has such varied talents?

These two stories illustrate different aspects of the Russian natural state.  The elites get fed. Kormlenie lives.   Sometimes courts do the feeding.  Sometimes the government feeds its friends, through contracts or restrictions on competition.  But the natural state rewards the connected.

And this is Russia’s curse.  This is why it is on the hamster wheel from hell.

The clearing and reporting requirements of Frankendodd have barely gone into effect, and the unintended consequences are already beginning to pile up.  Who coulda seen that coming, eh?

Even I couldn’t have made up the bestest of them.  Namely, as a result of the SEC’s bizarre portfolio margining rule, ICE has said that it will not clear single-name CDS.  You know, the weapons of financial mass destruction that were supposed to be the reason for needing a clearing mandate in the first place.  So ICE won’t clear the poster children for the clearing mandate.  Like I say: you cannot make up this stuff.

From Risk:

Ice Clear Credit has shelved plans to clear single-name credit default swaps (CDSs) for clients of its member firms, as a result of a new Securities and Exchange Commission (SEC) policy on portfolio margining. Under the terms of that policy, circulated late on March 8 – the last working day before the start of mandatory clearing for CDX index trades in the US – clients would be able to benefit from risk offsets between cleared index and single-name contracts, but the vast majority would be charged twice the margin calculated by a central counterparty (CCP).

The move sparked a furious response from some buy-side firms and has now dissuaded Ice’s CDS clearing house from offering the service at all.

“Last Friday, the SEC issued a temporary approval requiring broker-dealer futures commission merchants (FCMs) to charge two times the initial margin requirement of the CCPs. This was unfortunate, so we made a decision, based upon that unexpected development – news of which we received very late in the day on Friday – and based upon input from many clients, that it would be better not to offer single-name clearing under those conditions than to make single names available,” Peter Barsoom, chief operating officer of Ice Clear Credit, told attendees at the Futures Industry Association (FIA) annual conference in Florida last week.

The SEC policy gives temporary approval for an FCM to allow cross-margining if it collects 150% of the margin required by a CCP, but only if the client has “virtually no credit risk”. For all other clients, 200% must be collected on positions held in the portfolio margin account, which participants say would apply to most buy-side firms.

Portfolio margining across asset classes is theoretically beneficial, but practically dicey due to the instability of correlations, which often result in positions being undermargined during conditions of market stress.  And yes, individual name CDS and indices can diverge, again particularly during periods of financial stress.  But a portfolio consisting of a position in an index and offsetting positions in single names (especially names in the index) is less risky than either leg on its own.  This means that it is possible to improve capital efficiency while holding risk level constant by giving margining offsets for portfolio benefits.  But noooooooooooo.  In its infinite wisdom, SEC has decided to punitively margin these portfolios.  This reduces substantially the benefits of clearing individual name CDS, so ICE says to hell with it.

Again, the irony is almost too much.  The risks of single-name CDS were constantly invoked to justify the clearing mandate.  Those arguments were largely bogus, but regardless, due to regulations adopted to implement the mandate, single-name CDS will not be cleared for the foreseeable future.  Yay!

This is yet another example of the perverse effects of regulatory setting of margin levels.  I’ve been saying this so much I’m blue in the face: you could call me the smurfwiseprofessor.   For the zillionth time: regulatory margin setting is a form of price control, risk price control specifically.  Price controls never work.  Worse than that, price controls always lead to distortions.  First with futurization and now with portfolio margining, we are seeing these distortions appearing, big time.  And they’ll likely only get worse, when margins on non-cleared swaps are finalized.

Regulators have neither the information or incentives to set these prices right.  They bewail regulatory arbitrage, but their attempts at price control are the destined to set off a regulatory arbitrage land rush.

Sheesh.

But it gets better!  Even the seemingly banal task of reporting swap trades is overwhelming the CFTC.  According to Scott O’Malia, they cannot find a London Whale in a phone booth:

Dodd-Frank Act derivatives rules are failing to give regulators a full picture of the swaps market and wouldn’t help them detect a loss similar to JPMorgan Chase & Co. (JPM)’s London Whale trades, according to Commodity Futures Trading Commission member Scott O’Malia.

Swap-trade data the agency has been receiving since the end of last year from repositories including the Depository Trust and Clearing Corp. is inadequate to identify large positions and have overwhelmed government computer systems, O’Malia said in a speech prepared for a Securities Industry and Financial Markets Association conference in Phoenix.

The data “is not usable in its current form,” said O’Malia, 45, one of the agency’s five commissioners. “The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.”

. . . .

Different swap dealers and trading counter-parties are using their own reporting formats because the government failed to specify standards, O’Malia said.

“It means that for each category of swap identified by the 70-plus reporting swap dealers, those swaps will be reported in 70-plus different data formats because each swap dealer has its own proprietary data format it uses in its internal systems,” he said. “The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?”

The CFTC’s computer systems are failing to handle the incoming data. “None of our computer programs load this data without crashing,” O’Malia said.

This should be no surprise.  The issues with CFTC computers particularly.  The GAO issued reports in the ’80s ripping the agency for its IT dysfunctions.

Frankendodd has barely come to life, and it is already wreaking havoc.  I am sure there are more good times to come!

And I am totally, totally sure that Obamacare will work just as well.  No prospect for unintended consequences there!

Sorry about the silence, folks.  I was in Geneva doing my annual teaching in the University of Geneva’s Masters program in International Trading, Commodity Finance, and Shipping.  It is a very unique program, and a joy to teach in.  I also spoke at the annual Trading Forum sponsored by the Geneva Trading and Shipping Association (which also sponsors the Masters program).  I spoke about Frankendodd, which is somewhat ironic given that Mary Shelley wrote Frankenstein on the shores of Lac Leman a few miles from Geneva.

Some quick catch up.

First, Bloomberg is threatening to sue the CFTC for discriminating in favor of futures and against swaps.  Bloomberg plans to launch a SEF, and (rightly) believes that the discrimination regarding the margin requirements will seriously impair the prospects for its success.

At the annual FIA gathering in Boca, Gary Gensler doubled down in his support for the discrimination (a Risk Magazine link, so a subscription is required):

“Under clearing rules finalised in 2011, swaps executed on a designated contract market or a Sef have the same margin requirement – one day for energy, metals and agriculture, which is where we as a market have been for years. Interest rate swaps have been cleared for nearly 10 years on LCH.Clearnet. They have used a practice for many years around five-day minimum margining,” Gensler told Risk, after his prepared remarks yesterday at the Futures Industry Association annual conference in Florida.

How’s that for an answer lacking any intellectual content or analysis?  LCH’s done it that way in interest rates for many years, so everybody should do that for everything going forward.

Got it.  Why think when you can merely defer to precedent, regardless of how relevant that precedent is?

Someone is thinking, and echoes my analysis of the inanity of treating economically equivalent instruments differently just because one is called a “future” (good!) and the other a “swap” (bad! bad! bad!):

“If there are two products that are equally standardised, that take the same time to liquidate, that have the same risk, volatility and liquidity characteristics, then both of them should be subject to the same margin requirement. Collateral should be determined on the characteristics of the product in question, not the wrapper,” said Sunil Hirani, chief executive of fledgling interest rate swap and futures exchange TrueEx, speaking on the sidelines of the conference.

“If a contract takes five days to liquidate then it should be subject to five-day value-at-risk, and a one-day liquidation product should be subject to one-day VAR. If a futures contract has worse risk, liquidity and time-to-liquidation characteristics than a swap, but then receives a more favourable margin treatment because it’s in a futures wrapper, that is an injustice,” he added.

My only quibble is that it’s not an injustice, it’s a recipe for regulatory arbitrage and potentially for systemic risk.

Speaking of SEFs, Scott O’Malia told Risk that progress on writing the SEF rules-which had been expected any day-is slow.  Tiresomely, this also bears the fingerprints of Gensler’s meddling hand:

Nonetheless, at a panel discussion on Sefs held earlier in the day, O’Malia recited the Dodd-Frank definition of a Sef and observed pointedly that “the word five does not appear anywhere in there” – an allusion to the controversial proposal that any request for quote (RFQ) via a Sef must go to a minimum of five dealers.

“[CFTC chairman] Gary Gensler’s original position was that he did not want Sefs to include RFQ capability at all,” says one chief executive of a trading platform that plans to register as a Sef. “His initial hope was to restrict all these new venues to a central limit order book model, but when it became clear that an order book would only work for the most liquid swap contracts, he conceded the need to permit RFQ as an execution method, but included the stipulation that quotes must be sought from a minimum of five market-makers.”

And some dealers claim this is now the major impasse, with Gensler said to be refusing to drop the so-called RFQ5 provision from the final language or bring it into line with corresponding Securities and Exchange Commission rules for securities-based Sefs, which state that an RFQ can be sent to a single dealer.

So again, Gensler wants to dictate market structure: every SEF has to have a CLOB foot.  One size fits all.  No appreciation whatsoever for the fact that there is a diversity of market participants and interests that may well be served by a diversity of execution mechanisms.  No appreciation for the fact that the supposed beneficiaries of Gensler’s would-be fiat might actually know their own interests better than he does.  No appreciation for the fact that the discovery process of competition can result in the creation of a set of SEFs that best matches the diverse needs of market users, and that this competition may spur innovation that would result in the creation of an as yet undreamed of trading mechanism that meets market users’ needs far better than a CLOB.

Keeping this Gary Knows Best attitude in mind, be afraid, be very afraid when you read this story of about the next potential target of CFTC inquiries: price setting mechanisms. Taking inspiration from the Li(e)bor issue, the Commission is now (informally) discussing the possibility of investigating other benchmarks, notably the London gold and silver fixes:

“The idea that pervasive manipulation, or attempted manipulation [of interest rates], is so widespread should make us all query the veracity of the other key marks,” said CFTC Commissioner Bart Chilton at a Feb. 26 roundtable in Washington on financial benchmarks. “What about energy, swaps, the gold and silver fixes in London and the whole litany of ‘bors’?” he said, referring to Libor, Euribor and other benchmarks.

What’s rather disturbing is the linking of the gold and silver fixes and “bors”.  These things are very different.  The main problem with Li(e)bor, etc., is that they are not set on the basis of transactions: on this I agree with Gensler, having been making this point in an interest rate and commodity context for going onto 20 years.  (In my 1992 book Grain Futures Markets: An Economic Appraisal, I criticized proposals for cash settled grain contracts due to the lack of cash transactions on which to base an index.)

In contrast, the LBMA fixes are centralized auction mechanisms (Note to Gar: nearly a CLOB!)  Indeed, they are textbook examples of a Walrasian auction.  An initial price is mooted, and the participants indicate the amount they want to purchase or sell at that price: the quantity announced by each participating bank includes customer bids and offers, so buying and selling interest reflects more than just the proprietary trades of the fixing banks.  If at the initial price there are more buys (sells) than sells (buys), the price is increased (decreased), and each fixing participant again indicates its trading interest at the new price.  The process continues until buys equal sells, i.e., until the market clears.

Crucially, participants in the auction who are buyers (sellers) at the clearing price take (make) delivery of metal in an amount equal to their bid (offer) quantity at that price.  That is, the clearing price results in actual trades.  This is miles different than Li(e)bor.

This is not to say that a Walrasian auction cannot be manipulated: for instance, a company with a large long derivatives position that has a payoff tied to the fixing price might want to put in large buy orders in the fix to drive up the clearing price in order to impact favorably the payoff of the derivative.  Here the relevant issue would be the impact of orders on the clearing price.  That’s a totally different issue than in Li(e)bor, but I’m quite concerned that CFTC views all benchmarks as indistinguishable pieces in a mass.

And Gensler’s analysis-free treatment of futurization and SEFs only fuels those concerns. Good policy needs to be predicated on good analysis, not the prejudices and suspicion of the policymaker.  Gary Says So ain’t good enough, even for government work.  But too often that’s what we are getting.  We’ve seen it with futurization and SEFs, which raises legitimate concerns that the same will occur with benchmarks.  The confabulation of LBMA fixes with ‘bors only heightens those concerns.

A side note (added later): The suggestion that the CFTC can examine the London fixes betrays incredible hubris.  How could the US CFTC possibly have any jurisdiction over a UK entity-the LBMA-or the conduct of banks, only one of which (HSBC USA) is a US entity?  Especially given that as far as I am aware there is no CFTC regulated derivatives contract tied to the London gold or silver fixes.  But Gensler is all about extraterritoriality, so don’t put it past him to try.  I hope he tries, actually.  The Brits will go totally ballistic if he does.  Perhaps that’s exactly what’s needed to constrain GiGi’s imperial ambitions.

One other thing.  I didn’t mention anything about clearing, but Gensler’s analysis-free approach has been particularly prominent there.  To say that his “analysis” of clearing over the past 4 years has epitomized a comic book approach to the issue is an insult to the intellectual rigor of comic books.