Streetwise Professor

So today, 12 October, 2012, is the day when many Frankendodd rules go into effect.  Swap dealer registration for instance: but not position limits!

Yes.  848 pages of legislation (or 2319 pages, depending on how you count)-where commas matter-that spawned thousands of pages of rules (over 9k as of July, and where commas will also matter) that will spawn thousands more pages of interpretations, no action letters, legal rulings, etc.  All in an attempt to re-engineer a devilishly complex, interconnected financial system.  A system that will not stand still, but which will change in response to the law and the regulations, thereby producing myriad unintended consequences.

I’m sure it will turn out just swell.  Timmy! and GiGi and their successors have everything under control.  They’re from the government and there to help you!  Trust them on this!  Don’t you worry your pretty little head over it.

JK.  In reality, Mickey Mouse (how appropriate) gives you a better idea of how things are likely to turn out.

I fearlessly predict that the next financial crisis will follow directly from Frankendodd. It is a monster, which like Frankenstein’s, will escape its master’s control and wreak havoc. Mark my words.

The always thoughtful and considerate David at Deus ex Macchiato responds to my post on ring-fencing.  He concurs in part, and dissents in part.  Or he claims to dissent, but I think we’re more in agreement than he lets on.

His disagreement relates to my claim that entities outside the ring-fence could be too big to fail, and are reliant on fragile funding and hence vulnerable to destabilizing runs.  He basically argues that there are regulatory/supervisory responses to this, e.g., collateralization of OTC derivatives trades, higher capital charges on firms outside the fence looking in, rules intended to reduce the risk of runs on money market funds.

In essence, my interpretation is that David is arguing that it is possible to increase the stability of the shadow banking system through such supervisory/regulatory changes.  I wish I were so sanguine.

But it does provide a good way to frame the trade-off that is involved.  Ring-fencing increases reliance on wholesale funding and shadow banking by preventing the funding of certain activities with stickier deposits.

That’s what makes me concerned.  I think these wholesale/shadow banking funding structures are a source of vulnerability.  That’s basically the interpretation that Gary Gorton gives in his forthcoming book.

Given that, I think we should be very, very concerned about “reforms” that increase reliance on wholesale/shadow bank funding.  As David notes, this must be accompanied by other changes that address the fragility of these funding mechanisms.  I am much more skeptical than David, apparently, that such changes are likely to occur.  And this is the source of my concern about ring-fencing.  Especially about ring-fencing that is not bundled with measures that reduce the fragility of the wholesale/shadow bank funding mechanism.  That’s why ring-fencing alone is particularly worrisome. My priorities would be the reverse: focus on shadow banking and wholesale funding first.

But like I said, I think David is more aligned with me than he lets on.  For he says:

After all, as SWP points out, it wasn’t the universal banks who were most vulnerable: having deposit funding reduced their liquidity risk during the crisis. So perhaps there are systemic benefits to having casino and retail banking mixed? Surely that is something that we should settle before ring fencing.

Abso-effing-lutely.  That’s exactly what we need to settle first: that’s what I meant about “my priorities would be the reverse.”  That’s exactly why the fetishization of ring-fencing as a solution, or at the very least the first step in a solution, is highly dangerous.

To put it differently.   We need a back-to-basics rethink on what activities should be funded by insured deposits or some other form of guarantee; which should rely on wholesale mechanisms; and what can be done (short of some sort of insurance mechanism) to make the wholesale/shadow bank system more stable.  Is there a compelling economic reason why only traditional commercial banking activities should have access to insured funding?  This seems as much of a historical artifact as anything else, something that grew out of the banking system as it was in the 1930s.

Before lunging ahead with structural reforms that seem rooted more in nostalgia than economics, it is imperative that we think a lot more seriously about the right match between funding and the activities that are being funded, and what system of insurance or guarantees can improve the functionality of this match.  After all, during the crisis there was a massive ad hoc extension of guarantees to a wide variety of shadow banking and wholesale funding activities.  Wouldn’t it be better to think about that in advance, instead of making it up as we go along?

And again, that’s what worries me about the focus on ring-fencing.  It punts on this extremely vital issue; potentially force-feeds the shadow banking system; and puts us at risk of more ad hoc bailouts of this system in the future.  Which is precisely why I believe that it is naive-foolish, actually-to believe that ring-fencing protects taxpayers.  It could well put them at greater risk.

So on this big point, I think we agree, David: “Surely that is something that we should settle before ring fencing.”

Gas prices in California are topping $5/gallon, and politicians are in a frenzy, making claims of manipulation.  Diane Feinstein is taking the lead:

Feinstein, in a letter to the Federal Trade Commission (FTC), called for the agency to implement broad monitoring of oil-trading markets and investigate possible “collusion.”

“Publicly available data appears to confirm that market fundamentals are not to blame for rising gas prices in California,” she wrote, citing state data that showed gasoline production last week was almost as high as a year ago and that gasoline and blending components were equal to this time last year.

The California senator cited Reuters’ Friday report on the “short squeeze,” in which traders said refiner Tesoro Corp had to scramble to buy fuel from other companies to meet commitments.

While traders told Reuters that no single party appeared to be withholding supply intentionally and that there was no suggestion anyone conspired to drive up prices, Feinstein wrote: “An FTC investigation is likely the only way to determine whether this reported squeeze took place.”

Look.  I’ve seen this movie many times before.  There is a localized spike in gasoline prices.  Politicians start screaming “We must do something about this at once! Immediately! Immediately! Harrumph! Harrumph!”  The FTC scurries to do an investigation, and finds that fundamentals explain the spike.

They also find something I’ve included in my classes for 10+ years: that Federal environmental policy is directly culpable.  The key here is that these spikes tend to be localized.  Why? Because due to EPA regulations, there are highly localized formulas for gasoline.  Which means that when there is a supply disruption in a particular locale that requires a specific gasoline blend, supplies can’t be shipped in from other markets because the refineries serving those markets produce a different blend.

This happens in the Chicago area with some frequency.

You may think that the environmental benefits of customized gasoline blends are sufficiently great to justify the occasional-and inevitable-price spikes that such a system produces.  If so, you should STHU about the price spikes. But then you wouldn’t be a politician, who wants it all ways all the time.

This story brings up another pet peeve of mine.  (Yes, there are many.  I know.)  Specifically, the promiscuous and imprecise use of terms related to manipulation.

Feinstein seized on a statement in a Reuters report that Tesoro had been the victim of a “short squeeze.”  Now, this term can refer to a a manipulation, in which the holder of a large long forward position-a position larger than the quantity that can be delivered at the competitive price-demands excessive deliveries of the commodity, driving up the price, and liquidating some of its long position at the supercompetitive price.  The demand for excessive deliveries is an exercise of market power.  The firm demanding delivery is deliberately squeezing the shorts.

This term is also commonly used to refer to a situation where a firm or firm is short, and has to cover under tight supply conditions, but where nobody exercises market power. Here the short is squeezed by tight but competitive market conditions.

Note that the same term is used to refer to two very different situations: one in which somebody exercises market power, and one in which nobody does.

I strongly suspect that Tesoro was caught in the second kind of squeeze.  One way to determine this is to see if Tesoro bought back contracts.  If it delivered on 100 percent of its contractual obligations, one of the longs to whom it had sold couldn’t have exercised market power: that requires the liquidation of some contracts at the supercompetitive price.

But use of ambiguous terms that can have diametrically opposed implications fuels political fires from the likes of Feinstein.  (Scary thought.  She’s the smarter and more honorable of the two senators from CA.)

So my prediction. Much harrumphing for as long as prices stay high in CA. The FTC will dutifully investigate. It will conclude that the spike was produced by an adverse supply shock that could not be ameliorated by increasing supply from other markets. The politicians will greet this report with stony silence. But the harrumphing will begin anew with the next spike.

But you’ll never get a harrumph from this guy. Not until there is credible evidence of manipulation.

The Bank of Canada has decided that Canadian entities can meet their G-20 clearing obligations by clearing with international CCPs like LCH or CME.

The alternative-which was seriously considered, until fairly recently-was to require the formation of a domestic Canadian CCP through which Canadian financial institutions would be required to clear.  The Bank of Canada was leaning towards a “Canadian solution” because it believed that it could monitor such an institution more effectively, that a domestic CCP would insulate Canada from global financial shocks, and that it would be easier to provide C$ liquidity support to a domestic entity.

I co-authored a study for the Canadian Market Infrastructure Committee (CMIC) which argued that (a) these benefits were illusory because there would be C$ swaps traded by non-Canadian entities and non-Canadian entities would likely be important members of a Canadian CCP due to scale and scope economies, and (b) mandating clearing via a domestic CCP would dramatically increase collateral and liquidity costs of trading C$ swaps due to the fragmentation of netting sets (among other reasons).  As a result, I/CMIC recommended that Canadian banks, investment funds, and insurers be permitted to meet their G-20 obligations with an international clearer that could margin more efficiently.

It’s good to see that BoC acknowledged the force of these arguments, despite its initial preference for a domestic CCP.  Reason sometimes prevails.

I’m less enamored with BoC Deputy Director Timothy Lane’s argument that commodity trading firms (e.g., Cargill, Glencore, Vitol, Trafigura, Dreyfus) are systemically important.  Much more on that subject soon-it consumed much of my summer.  Hopefully he’s open to persuasion on this issue, as he was on the necessity of mandating the use of a domestic CCP for Canadian IRS.  But it would be gratuitous of me to make too much of a bother of the global commodity trading firm (“GCTF”) matter now.  So I say kudos to Mr. Lane, and the BoC, for setting priors aside; evaluating the arguments and evidence; and coming to the right choice (IMO) with respect to clearing of C$ swaps.

I had a chance to read Judge Wilkins’s decision in the position limits litigation on a flight over to London, where I am speaking on the impact of financial regulation, at a conference put on by Lloyds Bank.

There is virtually no economics in the opinion-it is a highly technical analysis of issues related to administrative procedure, statutory interpretation, and the like.  The perfect thing to read while trying to get sleepy as part of my jet lag management strategy.

How technical?  The placement of commas technical.

There are essentially two parts to the decision.  The first relates to § 6a(a)(1) of Frankendodd.  This part is straightforward.  Judge Wilkins ruled that it was unambiguous that the CFTC had to make a finding of the necessity of position limits.  It didn’t.  Back to the drawing board, GiGi.

The second part relates to sections 6a(a)(2), (a)(3) and (a)(5).  Here you have to get into the weeds.  These Judge Wilkins found to be ambiguous.  The ambiguity relates to the words “as appropriate,” as in:

Section 6a(a)(2)(A):

In accordance with the standards set forth in paragraph (1) of this subsection . . . the Commission shall by rule, regulation, or order establish limits on the amount of positions, as appropriate, other than bona fide hedge positions, that may be held by any person . . .

Section 6a(a)(3):

In establishing the limits required in paragraph (2), the Commission, as appropriate, shall set limits –

(A)on the number of positions that may be held by any person for the spot month, each other month, and the aggregate number of positions that may be held by any person for all months; and . . .  [Emphasis added.]

What Judge Wilkins could not determine unambiguously was whether “as appropriate” referred to the setting of limits at all, or the specific quantity of the limits.  The plaintiffs (ISDA and SIFMA) argued that the CFTC had to determine whether it was appropriate to set limits at all.  The CFTC argued that it had to set some limits, and Congress directed it to set the specific quantities appropriately.

This is where the commas come in.  I won’t bore you with the details, but if you are planning any intercontinental travel, I direct your attention to pp. 29-30 of the ruling.  You don’t have to thank me for easing your jet lag.

This matter of ambiguity turns out to be mightily important under the Chevron doctrine which determines whether a court need show deference to an agency’s decision.  And here the CFTC (and yes, I’m looking at you, Gary) is hoist on its own petard.

For the CFTC claimed that the language in the statute is NOT ambiguous.  Citing the Peter Pan (!) case, the Judge ruled that by claiming that the ambiguous wasn’t, the CFTC wasn’t owed any deference, and that there is precedent in his Circuit to vacate and remand the rule:

It is well-settled in this Circuit that “deference to an agency’s interpretation of a statute is not appropriate when the agency wrongly believes that interpretation is compelled by Congress.” Peter Pan, 471 F.3d at 1352, 1354 (internal quotation marks and citations omitted) (vacating and remanding agency decision because agency “premised its construction on the plain language of the statute, which it treated as unambiguous, and because we find that the statutory language is in fact ambiguous . . . .”).

Whoops.  By adamantly asserting that there was no ambiguity in the relevant sections of Frankendodd that the judge did find ambiguous, the CFTC lost any claim to deference.

Where do things go from here?  Probably a ping pong game, with the rule bouncing back between the agency and the courts.

Presumably the CFTC will stitch up some justification for a necessity finding, and go into a long disquisition to meet step two of the Chevron test:

“[I]t is incumbent upon the agency not to rest simply on its parsing of the statutory language. It must bring its experience and expertise to bear in light of competing interests at stake” to resolve the ambiguities in the statute.

I don’t know whether a justification of a necessity finding that is based on bad economics or bad (or no) empirical evidence is vulnerable to legal challenge.  I suspect it would be difficult for the plaintiffs to get the rule overturned because of a weak justification for the necessity finding.  I also suspect that CFTC will be able to pass the Chevron tests if it does recognize the ambiguity-which makes me wonder why they didn’t so recognize it at the outset.

My guess, therefore, is that the CFTC can, after yet more hearings, and comments, and time, correct what Judge Wilkins found wanting.  But that doesn’t mean that it’s out of the woods yet.  Not by a long shot.  For the plaintiffs made four additional challenges of the rule.  The judge did not feel it necessary to rule on these additional charges because he found sufficient grounds in the first to remand the rule back to the agency.

Notable among the additional grounds for challenging the rule is “Insufficient Evaluation of Costs and Benefits under 7 U.S.C. § 19(a).”  Will the CFTC stand pat on its existing cost-benefit analysis, which gives the word “perfunctory” new meaning?  Or will it feel obliged to gin up something better, given that the court was obviously not impressed with some of its other legal reasoning, and given that the SEC has lost a major case due to its failure to do a proper cost-benefit analysis?

The other challenges relate more to the specifics of the rules.

In brief, they have not yet begun to litigate (apologies to John Paul Jones).  The position limit rule has a long, long way to go before it becomes a reality.

This also raises the question of whether other Frankendodd-spawned rules will be challenged.  I’m guessing yes.  And there will be much rejoicing-among lawyers, anyways.

It is a good thing when bad rules are stopped.  The ongoing uncertainty pending definitive legal resolution is more problematic, however.  But that’s our reality, and will be for some time, on position limits, and other aspects of Frankendodd.

The title of my 2010 Regulation piece on CFTC position limits characterized the agency’s attitude as: “No Theory? No Evidence? No Problem!”  I had a problem with that attitude.  So did a couple of industry groups, ISDA and SIFMA, and they sued seeking to block imposition of the limits.  And Federal District Court Judge Robert Wilkens has a problem with it too.  He vacated the rule and remanded it to the agency for reconsideration, and granted the plaintiffs’ summary judgment motion against the rule.

The decision turned on whether the CFTC had to find that position limits were necessary to prevent and diminish excessive speculation.  The agency said no: it had no discretion, that Congress had mandated that it impose limits.  The plaintiffs said yes: the plain language of the statute requires the CFTC to make a finding that limits are necessary because speculation is excessive and is causing unwarranted fluctuations in prices.

The agency further argued that imposition of limits were mandatory, whereas plaintiffs pointed to statutory language saying that Congress had granted the authority to impose limits “as appropriate.”

The judge was quite firm in his findings regarding necessity:

The precise question, therefore, is whether the language of Section 6a(a)(1) clearly and unambiguously requires the Commission to make a finding of necessity prior to imposing position limits. The answer is yes.

But the plaintiffs’ victory was not so clearcut as has been portrayed in the initial reporting on the decision.  The judge noted that the two sides had unambiguous, but diametrically opposed interpretations of the statute.  The judge disagreed with both, finding the statute ambiguous:

In sum, although each party believes the statute is clear and unambiguous, their respective “plain readings” compel different results. Ultimately, however, this Court need not choose between the competing interpretations. As explained below, Section 6a is ambiguous as to the precise question at issue: whether the CFTC is required to find that position limits are necessary and appropriate prior to imposing them. Because the Position Limits Rule is based on the CFTC’s erroneous conclusion that the CEA is unambiguous on this issue, the Court “may neither defer to the agency’s construction nor endorse plaintiffs’ construction.” See Humane Soc’y of U.S. v. Kempthorne, 579 F. Supp. 2d 7, 15 (D.D.C. 2008). Instead, the Court must remand this rule to the agency.

As a result, he chose not to choose between the parties’ diametric interpretations.  So the rule will go back to the Commission.  Presumably it will make a finding of necessity based on some attempt to stitch together some empirical evidence on the adverse impact of speculation.  Presumably the plaintiffs will find this evidence unpersuasive (with good reason) and challenge the Commission’s finding, thereby setting up a further round of litigation.  The results of this litigation would presumably depend on what is a satisfactory basis for a finding of necessity by the Commission.  This seems to me to be a potentially far more contentious issue in which the courts may be more likely to defer to the agency’s discretion and judgment.

This decision does not address another challenge to the limits: that the CFTC failed to perform an adequate cost-benefit analysis as required by statute.  That’s another big issue that would require a more discriminating critique of the substance of the Commission’s analysis by the courts.

So this decision is not the end of position limits.  It is probably the end of the beginning, at best.

The concrete results in the short and medium term are beneficial, however.  A bad rule that has no firm grounding in good economic thinking or empirical evidence, and which would impose substantial costs on markets and market participants, will not go into effect next week as planned.  The Commission will be forced to confront these economic and empirical issues, and defend its judgments on these grounds: “Congress made me do it” will not suffice.

No doubt this process will be time consuming.  It will certainly extend well past the election, and depending on the outcome of the election the matter may become moot.  A Republican CFTC is much less likely to pursue position limits with the Javert-like intensity of a Gensler-led agency.  But even under a Democratic administration, the CFTC’s will to pursue position limits will be sorely tested.  It now faces a greater burden of providing some theory, and providing some evidence, or else it will continue to experience big problems in court.

A good day, a good result, but not a final one.  The position limit wars will continue, but the battlefield looks far different today than it did when Frankendodd lurched out of the castle on The Hill, and when the CFTC did what it perceived to be the monster’s bidding.

The BofE’s Andrew Haldane is getting a lot of attention-and rightfully so-for his critique of complex financial regulation, most notably Basel Faulty.  Yes, there is a lot to criticize in complex financial regulation-and lord knows, I’ve indulged-but it’s essential to emphasize that simplicity is no panacea.  Indeed, complex regulations evolve precisely from the deficiencies of simpler ones.

That is, you have to ask: Why did the rules become complex?  Was complexity valued for complexity’s sake? Or did complexity develop/evolve because of the recognized defects of simpler structure?

Most likely.  Rules become more complex in an attempt to respond to attempts to exploit simpler rules.  There is a regulatory dialectic.  The regulators and the regulated interact in a way that leads to spiraling complexity.

Take bank capital requirements.  Simple capital requirements specify, say, capital equals a certain percentage of assets.  This is fine if assets are identically risky, or the regulated have no ability to tilt their portfolios towards risky assets.

But that’s exactly what happened in the old, simple world with simple capital requirements.  Banks looked for riskier assets in order to expropriate their depositors, lenders, and deposit insurers.  With capital requirements insensitive to risk, banks had a tremendous incentive to make their assets as risky as possible.

There are two responses to this.  One is to limit the nature of the assets banks can hold.  The other is to make capital requirements depend on the riskiness of assets.

Both are great in theory, devilish hard in practice.  Risk-based capital requirements (or limitations on the assets that banks can hold) demand that regulators have the ability to make discriminating evaluations of the relative riskiness of assets.  Even more crucially, they demand that regulators know at least as much as those they are regulating.

Neither condition is likely to hold in practice.  And again, there is a regulatory dialectic, as banks sniff out-or create-assets that are “underpriced” from a capital requirements perspective.  That is, they identify-or create-assets with risk prices implicit in capital charges that do not reflect true risks, and which satisfy the restrictions on the nature of assets that banks can hold.  (Think of AAA ABS of various types.  They’re AAA!  What could go wrong?)  Thus, portfolios end up being riskier than regulators had anticipated.

So they adjust the capital requirements.  But as in any regime of price controls-and capital requirements are essentially risk price controls-the regulators don’t have the necessary information to set the prices properly, meaning that some risks are always underpriced.  The capital requirements become more complex, setting off a new round of attempts to identify the underpriced and overpriced risks.

What starts simple becomes progressively more complex.  Regulations and capital requirements end up being bizarrely baroque not because people like it that way, but because the less baroque rules were exploited.

Put differently: complexity is endogenous, and almost inevitable.  Simple sounds nice, but simple is easy to exploit, and complexity blooms in order to counter this exploitation.

Haldane argues that during the last crisis institutions subject to simple rules were less likely to fail than those subject to more complex ones.  This is superficially plausible, but again, remember that the rules are endogenous, complexity is endogenous.  There was no experiment, natural or otherwise, that randomly assigned some institutions to simple rules and others to more complex ones.  The rules and the institutions co-evolved, endogenously.  I would bet that there was some other constraint on the complexity of the firms subject to the simple rules that made it unduly costly for them to outwit the simple rules.  They stayed simple as a result, so the rules could stay simple too.

Maybe Haldane is right.  Maybe there is a simple but robust way of regulating financial institutions.  But I have my doubts.  Complexity results from the failures of the simple.

Haldane is stating, in an ironically more complex way, the old Indian story of the village beset by mice that brought in cats to rid itself of the rats, then brought in dogs to rid itself of the infestation of cats, then brought in elephants to drive out the resulting packs of dogs-and responded by bringing back the mice to scare away the elephants.  Seeing the effects of complexity (elephants) the simpler problems (mice) don’t look so bad.

But don’t be deceived.  If Haldane were to get his way, the cycle would begin again.  This is the fallen condition of homo economicus.

Meaning “High Frequency Blogging.”  Some quick takes on things that caught my eye.

1. Echoing my looking back, looking forward point (made in July) re Libor, lawyers are very nervous that changes in the rate setting mechanism will call existing contracts-with outstanding amounts in the mere hundreds of trillions-into question.  Yeah, it’s broken, but be damned careful how you fix it-especially if you expect those “fixes” to be retroactive, and affect existing contracts.  Unless you want to subsidize corporate litigators and wreak widespread economic havoc.
2. OTC derivatives rules may be delayed due to “squabbling” among international regulators.  What a shock.  I mean, Carnac the Magnificent couldn’t have seen that coming.
3. The White House is backing off on its claims that the Mohammed video is the sole cause of the assaults on US diplomatic facilities throughout the Middle East.  On 9/11/12.  Jay Carney has a new explanation: an absence of gun control.  Seriously.  When asked about the attack on the US Consulate in Benghazi in which US ambassador Stevens was killed, Carney said: There is an abundance of weapons, including heavy weapons, and there are certainly groups that carry those weapons and look to take advantage of those circumstances—as there are around the region and the world.”  So, on 9/11, some heavily armed dudes were just walking around and decided: “Hey.  Let’s attack something.  Eenie, meenie, meiny, mo [NOT referring to Mohammed, mind you]-The American Consulate!”  Totally random.  Totally.  Not anti-US.  Not at all.
4. The Taliban attack on a US airbase in Afghanistan that destroyed six USMC AV-6 Harriers was a total clusterf*ck.  But O didn’t let that interrupt Jay-Z, Letterman, etc.  Priorities.  Have to have priorities, dontcha know.
5. This piece on China’s Solyndra Economy echoes several points I made in my earlier post recommending that we lose any competition with China on green energy technology.
6. The very excellent Michael Pettis rightly points out dangers for commodities emanating from China’s fraught economic condition.  Like me, Michael is somewhat amazed that people who would decry central planning and heavy handed government efforts to direct the allocation of capital in the US or Europe are in awe of Chinese genius in using central planning and heavy handed government efforts to direct the allocation of capital in China.  This will not end well.  Yeah, I’ve been saying that for a while, but I am convinced that in a few years (if not sooner) China will wish to have Japan’s problems.
7. Finally, to that point, consider the fact that large quantities of inventories of steel in China-allegedly in China, I should say-don’t exist.  And if it happens in steel, it can happen in copper or soybeans or whatever, and likely does.  Phony warehouse receipts have been used to collateralize billions of loans-or the same warehouse receipts have been used to collateralize billions in loans.  Either way, China’s shadow banking system-which depends heavily on loans collateralized by commodities inventory-arguably is far more shadow than bank.  Remember that even modest slowdowns in economic activity can unravel fraud schemes in a hurry.  Such a slowdown is happening in China right now, and it is extremely likely that numerous such frauds will be revealed.  Given the dependence of China on shadow banking, the consequences of this could be seismic.  What say you, Tooltime Tom Friedman?

And on that happy note, I am pulling the kill switch on this HFB experiment.

The regulatory and trading world is all up in arms over the big price drop in WTI, Brent, HO and RBOB on Monday. Fat finger? Runaway algo? Round up the usual suspects!

I say none of the above, especially in light of yesterday’s  story that Saudi Arabia is going to increase oil output.

The price pattern is not typical of a liquidity event, such as arises from a trading or algo error.  In such an event, the price usually retraces quickly to its pre-error level.  That is, price impacts are almost purely transitory if it is understood that the order was an error, or simply a demand for liquidity.  Indeed, a paper by Bayuksahin, Haigh and Harris documents that prices of trades subsequently identified by the exchange as errors reverse well before the official announcement: the market participants figure it out on their own.

Here, the price fell dramatically, then only partially recovered.  Thus, there was a persistent/permanent component to the price move.  This combination of temporary and persistent price impacts means that market participants viewed that there was some likelihood that the order/orders was/were submitted by somebody with private information. (The fact that the move occurred on all major energy markets simultaneously supports that view, although with algorithmic trading one cannot be as confident: one can be more confident it wasn’t 4 or 5 fat human fingers.)

Put that together with yesterday’s Saudi announcement (into which they were probably dragooned by a threat from the IEA and the administration to tap the SPR) and the most likely explanation is that the announcement was leaked, or that the individual or individuals behind the decision decided to make a little money on their information and control.  Which they did, because prices traded off more after the story was released publicly.

Therefore, IMO Monday’s event was an oil leak: somebody spilled the news of the Saudi decision, and that triggered a big trade that pushed down prices.

Not a tech issue.  Just old fashioned front running of an announcement.

Bloomberg’s Brad Keoun has out a long piece today highlighting the risks of collateral transformation, a development driven by Frankendodd’s clearing and collateral mandates:

Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.

Keoun quotes Darrell Duffie and Anat Admati raising concerns about the systemic risk that collateral transformation creates.  And bully for them, because they’re right.  As I pointed out in this post from July, 2011, and in several others in the months since (as well as in a paper in the J. Applied Corporate Finance.)  Anat argues that clearing and collateral mandates are resulting in the shifting of risk, rather than its reduction as promised by Frank ‘N Dodd and Gigi and Timmy!:

The banks’ new lending business “smells like trouble,” said Anat Admati, a finance and economics professor at Stanford who studies markets and trading and advises bank regulators on systemically important firms.

“The point of the initiatives on derivatives was that derivatives can hide a lot of risk,” Admati said. “Now they’re going to just shuffle the risk around.”

I wrote that mandates would result in a substitution of new forms of credit exposure and leverage for the credit exposures and leverage eliminated from derivatives via collateral in this July, 2010 Cato Policy Analysis (see especially p. 25).

So although these consequences were unintended, they were foreseeable and foreseen.

But even though these developments have been in train for months, and although they are pregnant with systemic significance, regulators are ignorant of the potential risks.  In the most shocking but not really part of his piece, Keoun writes:

U.S. regulators implementing the rules haven’t said how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment. [Emphasis added.]

But Congress and the regulators pinky swore that Frankendodd would make the system safer!  Trust us on this, they said.  We know what we’re doing!

Uhm, I don’t even think they slept in a Holiday Inn Express before taking on the wholesale reshaping of the vast derivatives markets.

Gensler and Geithner are particularly culpable here, because both pronounced repeatedly that Frankendodd, and specifically its collateral and clearing mandates, would reduce the interconnectivity of major financial institutions.

Not exactly.  Out with the old, in with the new: new interconnections, and arguably more fragile ones, are being forged to replace the old ones.  Again, predictable and predicted.

And they continue to assure the world that Frankendodd has made the world safer-even though the analysis necessary to support that claim has not even been done.

Think about it.  It is widely recognized that shadow banking, including quite specifically repo, was a major source of systemic risk that contributed to the severity of the financial crisis.  Collateral and clearing mandates have essentially resulted in the development of a new form of shadow banking.

This is an improvement?  Maybe it is.  But inasmuch as key regulators haven’t even acknowledged the development, and haven’t analyzed its systemic consequences, their pronouncements are not credible.

And make no mistake: this will not be the last big unintended consequence of Frankendodd that will tend to undermine the intent of the act.  And take fair warning: regulators are likely to be well behind the curve in understanding and reacting to these consequences.  Meaning that, to paraphrase Anat Admati, the systemic risk hasn’t gone away, it’s just been shuffled around.  That includes, mind you, the systemic risk resulting from the regulations and the regulators.