Streetwise Professor

There is little new to report on the multi-billion JPM loss.  The big question is what position JPM has remaining, what it plans to do with it.  The bank probably has the staying power to hold on for awhile, and can avoid dumping it on the market a la Amaranth/Brian Hunter or LTCM.  But as Jamie Dimon admitted yesterday, this will expose the bank to considerable volatility going forward.

The exact transaction/transactions at issue is/are unknown, so it is impossible to make a definitive evaluation.  What is known does permit some conclusions, however.

The first is that whatever the position is, it is big.  And size is often a liability.  The bigger the position, the bigger a liability it becomes.  Market judo uses your size against you.  For if things don’t go your way, it is hard to exit a big position, and even attempting to do so can exacerbate your losses.

Reading this, I didn’t know whether to laugh or cry (h/t R):

Senior traders and dealers described Iksil as a “bright guy”, who was faithfully executing strategies demanded by the bank’s risk management model but who may have simply misjudged the amount of liquidity in the markets.

How many traders could have this as their epitaph: “He Simply Misjudged the Amount of Liquidity in the Markets”?

You can just imagine the Wily Coyote moment. You try to get out of a position and find out you have just run over the cliff and there is nothing to catch your fall, as liquidity disappears from beneath your feet just when you need it.

A couple of other points.

First, there is a lot of pixels being strewn about as to whether the Morgan trade was a prop trade or a hedge, and how this relates to the Volcker Rule.  Well, that’s a big part of the problem.  There is no hard and fast line.  As Holbrook Working pointed out long ago, what is conventionally called hedging is really speculation on the basis.  And if your basis position is big enough, and the basis is volatile enough, you can lose a lot of money.

The first member of the billion dollar club-Metallgesellschaft-was allegedly hedging.  It wasn’t doing basis trades, per se, but had a huge calendar spread position. Ditto Amaranth. LTCM’s “convergence trades” (that became divergence trades) were essentially basis trades that could be characterized as hedges.

It’s all about size and capital and correlation and volatility.  The right (or should I say wrong) combination of those factors-and particular a good dose of sh*t happens-can create a lot of risk, and result in big losses.

This is why much of the discussion of the Volcker Rule is quite beside the point.

Second, there is the question of when things went pear shaped, and when Jamie Dimon knew they were going pear shaped. He was very contrite about, and critical of, the trade yesterday.  He vigorously defended it in April.  If he got the bad news sometime between the defense and the criticism it’s one thing.  If he defended the trade in April knowing that it was already losing, or was substantially riskier than he let on, and that the firm was looking for the exits, it’s quite another.

If it was the latter, you can imagine his dilemma. If he failed to defend the trade vigorously, it would have no doubt resulted in a self-fulfilling disaster, as everyone would have anticipated the impending unloading of the position and traded against it.  But if in defending the trade he made misleading or knowingly inaccurate statements, he would face serious legal problems.

Again, right now there are only questions.  But no doubt there will be intense scrutiny that will lead to many uncomfortable political and legal moments for Dimon, and for JP Morgan as a whole.

JP Morgan just announced a huge-$800 million $2 billion!-mark-to-market loss in the synthetic credit portfolio run out of its Chief Investment Office.  Bruno Iksil-“The Whale”-is almost certainly wearing the collar for this bloodbath (uhm, I think that’s a mixture of 3 metaphors-whatev).

Some immediate reactions.

1. Whales get harpooned.  No matter how big you are, the markets are bigger.
2. Traders can move prices by putting on big enough trades.  It’s not moving prices that is the trick: it is profitably closing big positions after you moved the price.  There has to be some asymmetry.  If your buying drives up prices, your selling to exit a position is almost certain to drive them down-and indeed, drive them down more due to market frictions.
3. That is, to be profitable, Whale Trades require an exit strategy.  Corners have an exit strategy-but even these are not foolproof, as many cornerers have found to their dismay.  Some other manipulative strategies, such as moving a price that affects the payoff to a related derivative, also have an exit strategy.  But just flexing, just moving a price by trading in huge size, is vanity and usually results in losses because there is no exit strategy. Like the Duke of York, you can march up the price hill by buying a lot, but you end up marching down the hill again when you try to sell.
4. Banks can kiss any weakening of the Volcker Rule adios! Indeed, the rule is likely to be tightened considerably.  I’m sure Jamie Dimon is getting lots of love from his fellow CEOs.  Lots.
5. Speaking of Dimon, I wonder if he can kiss his job good bye.

On the anniversary of the passage of Frankendodd, I named the swaps execution facility mandate as the Worst of Frankendodd.  There was intense competition for the honor, to be sure, but I stand by that conclusion.

Gary Gensler sortied into enemy territory at the ISDA AGM in Chicago to do his best to defend the worst.  My verdict (based on press coverage): #Fail.

Interestingly, although Gensler used to focus (wrongheadedly) on the supposed competitive benefits of a SEF mandate, in Chicago he tried to portray it as a bulwark against systemic risk:

“Transparency to the public lowers the risk [for] clearinghouses,” he told the conference.

“Clearinghouses can only survive if they have reliable pricing feeds on a daily basis to mark to market their positions, and also have reliable, liquid markets in default scenarios,” Gensler said.

“There is far less risk in a clearinghouse if you have both pre-trade transparency and post-trade transparency.”

Dealers have criticised the move to electronic execution of OTC derivatives, complaining the large size and small volume of trades means such rules are inappropriate for the market.

This is clearly-no pun intended-incorrect, particularly when viewed in the context of Gensler’s desire for extensive pre-trade transparency and near real time reporting of trades.

CCPs will obtain the prices of deals cleared through them, that they can use to determine marks on a periodic basis.  Moreover, they have access to information from member firms that will permit marking deals to market.

Pre-trade transparency is particularly irrelevant in this context.

And Gensler is positively delusional if he thinks that the pre- and post-trade transparency is going to ensure “reliable and liquid markets” in default scenarios-especially if those scenarios involve the default of a systemically important clearing member.   Note that even for normally listed, exchange traded products CME used an auction procedure, rather than normal trading protocols, to handle the Lehman default.  Also note that LCH was able to handle the Lehman IRS portfolio default in a pretty effective and orderly way even without mandated centralized trading.

Gensler appears to believe that OTC derivatives markets, even for cleared products, will be like exchange trade futures.  Hardly.  One size does not fit all.  The nature of the transactions, the transactors, and the products is very different.  That’s why there are different markets and different market structures: the different structures are discriminating ways of accommodating the diversity of trades and traders. Market structures are endogenous, and reflect the characteristics of trades and traders, a point that is lost on Gensler and all too many others.

Indeed, the biggest problem that CCPs will not be obtaining price information on fairly active products, even if those products trade without pre-trade or post-trade transparency: even without SEFs, it will be relatively easy to mark 10 year USD IRS or active credit indices to market.  The problem will be obtaining information on the value of the products that don’t trade.  Gensler apparently believes in the Field of Dreams Theory: if you build a SEF, the trades-and bids and offers-will come, for everything.

No, actually.  Many products traded OTC do not trade frequently.  That’s a major reason why a dealer market structure rather than a centralized auction market structure, predominates there.  Moreover, the life cycle of trading activity in OTC and listed products is quite different.  Exchange traded products start out illiquid, and if they become liquid at all, become progressively more liquid as their maturity/time to expiry declines.  With OTC products, the cycle is the reverse.  Five year and 10 year swaps are quite active and liquid, and a lot of deals are done.  Those deals live on, and the 10 year swap becomes a 9 year swap and then an 8 year swap, and so on, and these products are far less liquid than the benchmark maturities.  You can have all the SEFs in the world, and 3.35 year swaps ain’t going to be trading, and won’t even be bid or offered.  Meaning that it SEFs will matter exactly bupkus for such products.

What’s more, mandated pre- and post-trade disclosure has costs  (mainly in the form of lower liquidity as disclosure of trades and price information raises risks to liquidity suppliers, inducing them to supply less), and these costs will vary by product.  Again, one-size-fits-all is misguided in the extreme.  Gensler dismisses these costs, and pays even less attention to the heterogeneity of products and transactions.

ISDA has pretty much acquiesced to most of the clearing-related rules, but is still fighting hard against the SEF mandate:

A theme of the ISDA conference, which includes large dealers as well as users of derivatives, is that while central clearing reduces systemic risk, regulators should not impose new rules on how derivatives trade, because it could disrupt those established markets and reduce trading volumes.

“Listed and over-the-counter markets are completely different, and it’s important that lawmakers and regulators keep this in mind,” said [ISDA Chairman and Morgan Stanley’s head of Global OTC Clearing Stephen] O’Connor,

He added that the industry was open to more public reporting, but with restrictions such as not revealing the size of very large trades or delaying trade reporting. “We’re not anti-public reporting,” he said.

I agree with O’Connor, but you might say “but he’s biased and protecting the dealers’ gravy train.”  Fine.  But interestingly, a supposed beneficiary of what Gensler wants so badly, isn’t sold on the idea:

Michael Davie, head of LCH.Clearnet’s SwapClear platform, agreed that regulators, clearers and market participants must know what is going on, but public reporting isn’t essential.

As I’ve argued ad nauseum, regulators will know what is going (in terms of positions and trades) due to swap data repositories.  As Davie says, public trade reporting-particularly in near real time-isn’t important for CCPs to do what they need to do.  And as I state above, public reporting of trades won’t help CCPs at all if there are no trades.

No, Gary.  SEF mandates are still the Worst of Dodd-Frank.  And slathering on the systemic risk lipstick won’t make that pig any more attractive.

A quick comment about the ISDA AGM.  A perusal of the press coverage is fascinating.  Virtually every issue-every damn one-that is the subject of intense debate at the AGM was raised here on SWP, or in my academic writing years ago.  Going back to 2008-2009, and sometimes to the late-90s (obviously pre-SWP, but not pre-Pirrong clearing research).  That old Cassandra feeling is particularly powerful right now.  I was invited to participate in the meetings, but had to decline due to another commitment, which alas did not materialize due to the vagaries of court scheduling.  (No! I am not on trial!  Sorry to disappoint some of you.) It would have been a fascinating experience.

John Parsons and Antonio Mello at Betting the Business argue that the dominance of OTC derivatives is not indicative of their efficiency, but instead resulted from the banks underpricing credit risk:

The logic that OTC markets are superior only works on the premise that banks are competing with exchanges on a level playing field. But prior to the financial crisis of 2007-2008 (and until the effort to reform finance is successfully completed), the playing field has been not level: banks have enjoyed some significant privileges. Key among them was the failure of some banks and regulators to properly price the credit risk embedded in derivatives.

This is a very strong statement, and one which John and Antonio do not provide persuasive evidence.  Their evidence is a post at FTAlphaville by David Murphy, which details the history of credit value adjustments (CVA), and a BIS report.  David notes that although in the early days of OTC markets, banks did not charge for the credit embedded in derivatives, they eventually did so.  Parsons-Mello argue, based on the BIS report, that regulators lagged these developments, and did not impose adequate capital charges on OTC derivatives exposures, particularly on CVA exposures which were larger than actual default losses.

There is some empirical evidence that speaks to this issue.  Papers dating back to the 1990s demonstrated that interest rate swap prices vary with counterparty credit risk, although the effect was small primarily because netting and the fact that principal is not at risk in an IRS made the credit exposures relatively small.  Counterparty credit risk in CDS is much larger.  Recent work by Gandhi, Longstaff, and Arora found small pricing effects in intedealer CDS trades, that became larger in the aftermath of the 2008 Crisis.  They conclude that the small effect reflects the fact that most interdealer traders were collateralized, though by variation margin rather than independent amounts (the OTC equivalent to initial margin).  The use of collateralization to reduce credit exposure is inconsistent with the hypothesis that credit risk embedded in derivatives is underpriced.

No doubt Parsons-Mello would interpret the evidence differently than Gandhi et al.

Collateralization is one way to control credit exposure.  Credit limits are another.  Reducing credit limits of firms that suffer adverse shocks to creditworthiness would tend to reduce the impact of such shocks on pricing.  Since credit exposure can be managed on a variety of margins-pricing, collateralization, credit limits-just looking price effects is not sufficient to determine whether credit risks embedded in derivatives are overpriced or underpriced.

The Mello-Parsons argument depends crucially on inconsistent capital treatment across equivalent categories of risk.  It is also somewhat in tension with an argument that they have made before that collateralization mandates do not raise the costs of trading OTC derivatives.  As they have pointed out before (as have I), credit that is embedded in a derivatives trade can be unbundled into a default free (collateralized) derivative and an unsecured credit line.  If capital charges are set consistently across equivalent risks, regulations that reduce credit exposure in a derivatives trade (e.g., a collateral or clearing mandate) can and will be offset by a substitution of an equivalent form of credit, leading to little or no change in overall exposure, just a change in its composition.

There is no reason to believe that regulators set capital charges consistently.  I think that John and Antonio are arguing that they should.  I would suggest that this is an impossibility.  This has been a theme of mine in several posts relating to Basel rules (you can find more related posts by typing “Basel” into the search bar).  The capital charges are inevitably make crude distinctions between different sources of risk.  Banks who understand the true risks far better optimize their activities to take advantage of disparities between their more informed estimates of actual risk and the regulatory risk charges.  Moreover, they tend to do so in a way that is highly correlated across banks because they all face the distorted capital cost structure.  Maybe making derivatives-related capital charges more sensitive to counterparty credit risk will reduce the subsidy of risk arising in derivatives books and the risk exposure there will fall commensurately; but the resulting structure of capital charges are likely to subsidize another risk, leading banks to pile into that activity.

In other words, risk based capital charges are an extremely blunt tool. They are a form of regulated pricing, and like virtually all regulated price structures, lead to acute distortions.  I am skeptical that they are a reliable means of reducing systemic risk.  Indeed, by inducing correlated risk taking across financial institutions, they can actually exacerbate that risk. (Mello-Parsons do recognize the difficulties of setting the capital charges: I think the difficulties are so acute as to make it virtually impossible to get anywhere near right, and very easy to make big mistakes.)

Assessing a CVA-based capital charge also creates the very serious risk of inducing vicious cyles/feedback loops, especially during times of crisis.  CVA charges are based on CDS prices, and CDS prices vary not just with expected default rates and losses, but also embed risk premia and liquidity adjustments that depend on market frictions and market-wide conditions.  Put differently, CDS prices reflect default rates and losses in the equivalent measure, and the market chooses the measure.  During crisis periods in particular, as liquidity dries up and risk limits (e.g., VaR limits) bind, expected default losses in the equivalent measure rise relative to expected default losses in the physical measure, meaning that CDS spreads widen absolutely and relative to what the spreads implied by expected default losses.

With CVA-based capital charges, such widening in CDS spreads will lead to higher CVAs and more variability in CVAs, which depending on how the CVA charge is implemented, could lead to higher capital charges, or to actions intended to reduce capital charges.  Increases in capital charges raise the costs associated with outstanding positions and new deals, thereby leading to reductions in positions, increases in collateral postings, or both.  These will tend to exacerbate market stresses, as firms dump positions to reduce exposures (and CVA) and sell assets to raise cash to meet collateral calls, which will lead to additional price movements that can affect CVAs, and on and on.

Put another way, it binds regulatory capital very tightly to conditions in the CDS market.  The more concerned you are about the functioning of that market, especially during times of stress, the more concerned you should be about hardwiring regulatory capital requirements to the CDS market.

That is, like any market-price based mechanism for setting collateral or capital charges (think of VaR), a CVA-based mechanism is highly likely to be procyclical, and perhaps severely so.  This makes it a major potential source of systemic risk.

In sum, I do not discount the possibility that capital requirements led to an underpricing of credit risk in OTC derivatives, and hence caused these markets to be larger than they should have been, or would have been given requirements that discriminated accurately among different risks in banks’ books.  The evidence one way or the other is rather thin.  I am highly skeptical, however, of the ability of regulators to address this problem without creating others equally severe, given the information advantages that banks have and their ability to optimize their risk taking subject to the (distorted) structure of capital requirements.

Moreover, I am downright frightened of basing derivatives capital requirements on CVA, or any market-price based measure.  It is individually rational for banks to price using CVA, but tying capital charges to this measure will almost certainly lead to procyclical capital charges that are highly correlated across major financial institutions.  That is a very bad-and very scary-idea.

I therefore do not dismiss the Mello-Parsons diagnosis, though I am not completely sold.  I am particularly concerned that any “cure” could be worse than the disease.

For years Russia and Gazprom have pooh-poohed the shale gas revolution.  No longer.  Putin has raised the alarm:

Russian President-elect Vladimir Putin urged energy producers from the world’s biggest natural- gas exporter to “rise to the challenge” of a changing market as the U.S. increases output of shale gas.

U.S. shale gas production may “seriously” restructure supply and demand in the global hydrocarbons market, Putin said today in an address to the Russian lower house of parliament.

The impact of shale is being felt immediately in pricing, with customers demanding concessions on Gazprom’s oil-linked pricing mechanism.  The divergence between oil and gas prices has exploded, and now tops 52 (WTI to Henry Hub) and 60 (Brent to Henry Hub): historically, the ratio has been around 10.  Although the disparity is not nearly so large in Europe, oil-linked gas prices have diverged substantially from spot prices there as well.

In defense of the oil peg, Gazprom’s Alexander Medvedev keeps blowing the same gas:

Mr Medvedev insists that the oil link is here to stay. “[Because] the liquidity of the gas market is so low, spot pricing can’t give the right price signals, to suppliers or customers,” he says. “We want predictable prices for the consumer.”

To repeat: liquidity is endogenous, and liquidity feeds to liquidity.  A move to a market-based pricing mechanism would lead to a spiral of liquidity, just as occurred in the US following deregulation in the early-1990s.

And please, oil prices that diverge radically from gas prices are giving better price signals? Really?

Finally, since when are oil prices predictable?  Yes, historically they are less volatile than gas prices, but that’s irrelevant.  Volatility per se is neither good nor bad. Prices that don’t adjust to reflect supply and demand conditions for the particular commodity are sending bad signals. If supply and demand are volatile, or there are rigidities and bottlenecks that make it difficult to adjust output in respond to shocks, then prices have to be volatile to send the right signals.  A price that is perfectly predictable is likely sending the wrong signal at all times but on a set of measure zero.

No, if prices are volatile, than customers who don’t like the risk should have the opportunity to hedge that risk via derivatives markets.  That’s exactly what happened in the US markets.  But that would involve speculators who take on that risk, and we can’t have THAT now, can we?

The pricing mechanism is really just a means to an end, from Gazprom’s perspective, the end being high prices.  You can bet the company would jettison the link in a second if the divergence was working the other way.  But the availability of low cost supplies will undermine that end, as Putin publicly recognizes.  The biggest potential obstacle to those supplies hitting the market is environmental restrictions on tracking.  Hence the widespread suspicions that Gazprom bankrolls anti-fracking campaigns and organizations, particularly in Europe.  (Good luck with that in China!)

Gazprom is one of the world’s least efficient companies. It can survive due to a relative lack of competition.  Vigorous competition from new supplies will dramatically erode its profitability-and with that comes damage to the budget of the Russian state, not to mention the personal budgets of all those myriad officials who feed at the Gazprom trough.

The day can’t come soon enough.

The Commodity Futures Modernization Act has been demonized as a major contributor to the financial crisis-unfairly in my view. This view is ahistorical, and fails to understand what led up to its passage.  In brief, the evolution of derivatives markets, and particularly the growth of the swaps market in the 1980s and 1990s created legal and economic challenges that the Commodity Exchange Act, dating from 1922 with a major modification in 1936, was completely unable to handle.  The CEA was passed at a time where “off exchange” transactions meant $10 bets at bucket shops, not huge deals between major banks and corporations.  The categories of market participants and the kinds of derivatives traded that Congress had in mind when drafting this legislation were vastly different from those developed during the wave of financial innovation that began in earnest in the early-1970s. As a result, by the mid-1980s, and certainly by the 1990s, the regulatory framework in place was completely ill-adapted to market conditions.

In particular, the exchange trading requirement of the CEA constrained the ability of market participants to undertake mutually beneficial transactions.  Those entering into perfectly sensible OTC deals risked running afoul of the requirement, which put their transactions at considerable legal risk.  The CFTC responded to this situation by issuing a variety of interpretative statements and no action letters and exemptions that were intended to give relief to these transactions.  Soon a confusing thicket of ambiguous and often contradictory rulings, exemptions, no action letters and interpretations grew up around OTC derivatives trades. The legal, logical, and linguistic contortions became increasingly absurd.  Although these permitted certain transactions to go forward, they did not address the very serious risk that someone could challenge whole categories of OTC trades and instruments in court, and that a judge would find them in violation of the CEA.

This was the genesis of the CFMA.  The “modernization” was intended to create a legal framework that reflected modern market reality, and which gave legal certainty to economically beneficial transactions.  It was an effort to clear the thicket, to replace an often absurd and contradictory set of ad hoc improvisations with a coherent structure.

The fundamental problem that CFMA was intended to address was that legal and legislative categories did not correspond to market reality.  The CFTC reacted by crafting ad hoc fixes.  But in the face of rapid innovation, the bolting of one ad hoc fix onto another created a vast Rube Goldberg contraption that was an accident waiting to happen.

Move forward 10 years from CFMA to Frankendodd.  Frankendodd creates numerous categories of instruments and market participants-swap, securities swap, swap dealer, major swap market participant, and on and on. It then delegates to multiple regulators the task of establishing detailed criteria describing these categories. Frankendodd itself weighs in at 2400+ pages, and the myriad regulations thereunder will run to many thousands of additional pages.

And that will just be the beginning.  The proliferation of categories that do not correspond to market realities today, let alone market realities in the future that develop in response to fundamental economic changes, financial innovations, and the regulations themselves, will lead to serious contradictions between what makes commercial and policy sense, and the letter of the law and the regulations.  The regulators will inevitably respond today the way they did in the 1980s and 1990s-with ad hoc responses intended to address the specific transactions and transactors at issue, with only passing regard for the coherence of the overall set of rulings and interpretations.  A Talmudic mind will be required to sort through it all.

Lawyers will rejoice and prosper-hence the rejoicing-because the most important design consideration for a transaction or a new structure will be how it can be jiggered to satisfy the regulations and interpretations, rather than the most efficient way to achieve a particular economic objective.  And even then there will be considerable uncertainty given the inevitable contradictions in the regulations, interpretations, judicial rulings, and on and on.

In due course, the whole edifice will become utterly unworkable and incoherent, and create a real systemic risk-a risk arising from the serious legal uncertainty that is inevitable.  And the problems arising out of Frankendodd will be all the worse than those arising out of CEA because it is more sweeping, the markets are more complicated and international, and the categories and distinctions and requirements it creates are vastly more numerous.

The ink on some regulations arising out of Frankendodd is barely dry, and this regulatory dialectic is already beginning.  The regulators are already making ad hoc adjustments.  From the FT:

US regulators are exploring ways to give large foreign banks and overseas subsidiaries of US lenders a reprieve from stringent new derivatives rules, potentially alleviating one of the biggest concerns facing global financial institutions.

The US Commodity Futures Trading Commission is looking to grant a temporary exemption to swap dealers that may fall under the jurisdiction of foreign financial authorities from complying with a host of post-financial crisis regulations governing derivatives transactions, people familiar with the matter said.

If you think this exception is the exception, you have another thing coming.  This is just the beginning of the dialectic.  Moreover, the international nature of the derivatives industry, and the creation of laws, rules, and regulations in different jurisdictions around the world will just accelerate it.

Within a period of a few years, derivatives regulations will be another absurd Rube Goldberg contraption.  And in its inimitable fashion, Congress (and the EU-if it still exists) will feel compelled to pass The Derivatives Modernization Act of 2020 (to choose a realistic round number).  Mark my words.

The CFTC had to play Goldilocks and decide the level of OTC swaps activity required to make a firm a swap dealer and thereby subject to the collateral and capital requirements and other obligations entailed in such a designation.  Earlier proposals ($100 million, then $3 billion) were commonly deemed too small.  Industry proposals were deemed to be too big.  The Commission decided on $8 billion, with the possibility of reverting to $3 billion depending on the results of forthcoming data collection and analysis by the Commission.

The usual suspects-like “Better Markets”-claim that the limit is far too big, and represents a huge loophole.  Genlser (no Goldilocks, if you know what I mean) fired back, claiming that the limit was actually quite small, compared to the immense size ($300 trillion notional) in the US swaps market.

These kinds of debates are frustrating in any event, because cutoffs like this economize on information, but are inherently arbitrary.  They focus on the easily measured, rather than the economically significant.  They reduce multi-dimensional problems to a single dimension, which inevitably leads to distortions.  In particular, they provide incentives to devise transactions and structure business to circumvent the rule.

The real questions that should be asked in determining the criteria for swap dealer designation are: What is the market failure that this regulation is intended to address? and What criteria will mitigate that market failure in a cost-effective way?

The whole justification for Frankendodd is that derivatives pose a systemic risk.  Systemic risk, properly understood, involves some sort of externality.  One potential externality is that a default by one large derivatives trading firm can lead to a daisy chain of defaults.  Another is that default costs are passed onto taxpayers in the form of bailouts.  Swap dealer designation, and the consequent regulation of their activities, are supposedly intended to address these externality problems.

Viewed from this perspective, $8 billion in notional amount seems like a very small number.  Based on BIS numbers, market values are about 3 percent of notional amounts.  Applying this to an $8 billion notional gives a market value of $240 million.  The financial system can withstand such a default, and even several such defaults.  Yes, counterparty risk also depends on gross amounts, but even an $8 billion loss is not catastrophic, especially inasmuch as any such loss would be spread over a number of counterparties.

To put things in perspective, look at the notional holdings of firms whose collapse or threatened collapse arguably posed a systemic threat.  LTCM’s derivatives book was $1.25 trillion-in 1998.  That’s 2 orders of magnitude bigger than the $8 billion figure being imposed 14 years later, when the markets are substantially larger.  Lehman’s was about $35 trillion-over 4000 times the  $8 billion threshold.  Bear Stearns: $13.5 trillion, about 1700 times the $8 billion. AIG’s notional was down to $1.6 trillion-200 times the threshold-at the time of its default.   And note that Lehman and AIG failed nearly simultaneously.

I am unaware of any default by a firm with $8 billion notional that created a systemic risk.

So I am in the too small camp.  I don’t know exactly what the number is, but there should be a pretty close correspondence between firms that are deemed to be systemically important and those that are subject to the requirements imposed on swap dealers.

Yes, the default of a firm with $8 or $10 billion in notional would presumably be painful for its counterparties.  But absent any knock-on effects, any externalities, that loss is internalized by the contracting parties.  This does not require any regulation to protect them.  Let them protect themselves, contract as they will, and live with the consequences.

I should also note that swap dealer regulation, which is effectively microprudential in focus, and which attempts to regulate only a part of firms’ capital structure, will not have the desired effects on systemic risk even if it is applied only to systemically important firms.  As I’ve noted repeatedly, firms can contract around this restriction, and will substitute different forms of leverage-and potentially riskier and more fragile forms of leverage-for the leverage squeezed out of derivatives transactions through collateral requirements.

In sum, all this to-ing and fro-ing over the swap dealer rules has resulted in a regulation that is far more inclusive than necessary to achieve its ostensible purpose of reducing systemic risk.  Moreover, the whole idea is fundamentally flawed for a reason I’ve written about often: it is virtually impossible to reduce the risk in the financial system by regulation of the pieces.

Yesterday Obama delivered another of his it-must-have-been-some-other-body-it-wasn’t-me (h/t Chuck Berry) speeches on energy.  And, true to form, he delivered another clarion call to round up the usual suspects: evil speculators, whom he confabulates with manipulators .  (And I am being generous, because confabulation is inadvertent, whereas I Obama’s slander is almost certainly deliberate):

That’s what’s happening right now.  It’s those global trends that are affecting gas prices.  So even as we’re tackling issues of supply and demand, even as we’re looking at the long-term in terms of how we can structurally make ourselves less reliant on foreign oil, we still need to work extra hard to protect consumers from factors that should not affect the price of a barrel of oil.

That includes doing everything we can to ensure that an irresponsible few aren’t able to hurt consumers by illegally manipulating or rigging the energy markets for their own gain.  We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher — only to flip the oil for a quick profit.  We can’t afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick.  That’s not the way the market should work.  And for anyone who thinks this cannot happen, just think back to how Enron traders manipulated the price of electricity to reap huge profits at everybody else’s expense.

. . . .

That includes doing everything we can to ensure that an irresponsible few aren’t able to hurt consumers by illegally manipulating or rigging the energy markets for their own gain.  We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher — only to flip the oil for a quick profit.  We can’t afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick.  That’s not the way the market should work.  And for anyone who thinks this cannot happen, just think back to how Enron traders manipulated the price of electricity to reap huge profits at everybody else’s expense.

He used the word “manipulate” or “manipulation” 11 times in his relatively brief remarks.  In typically dishonest fashion, he isn’t responding to specific, credible evidence of manipulation; he provides no evidence that manipulation is rampant or is at all responsible for current price levels.  Hell, he can’t even come up with a current example, having to reach back more than a decade to Enron (itself a dubious example).  He merely insinuates and implies.  But the average listener or reader will conclude from his remarks that manipulation is causing their pain at the pump.  Rather than encouraging a sober and realistic appraisal of the role of speculative trading in energy, he is feeding suspicions and encouraging a witch hunt.

Moreover, note the repeated and casual identification of manipulation and speculation.  This is itself a manipulative use of language.  Manipulation is not even a proper subset of speculation: hedgers can be some of the most dangerous manipulators.  It further encourages the popular suspicion that financial trading in commodity markets is inherently dishonest and crooked.

Insofar as concrete steps are concerned, he is demanding substantial increases in resources for the CFTC to oversee the energy markets and a substantial hike in the criminal and civil penalties for manipulation.  With respect to oversight, I’ve said more times that I should have to that the undetected manipulation is the unsuccessful manipulation.  If manipulation distorts prices, that distortion will be manifest.  Moreover, those harmed by the manipulation have every incentive to bring the manipulation to the attention of the regulators.  The idea that manipulation is rife and is having huge impacts on prices, but it is necessary to surveil the markets intrusively using “modern tools” to find it is an oxymoron.  Which means that greater penalties imposed ex post are defensible.

It doesn’t inspire confidence that Obama justifies the greater CFTC resources by quoting another of GiGi’s inane metaphors.

The other major concrete step is to give the CFTC authority over margins for energy derivatives.  This is another hardy perennial: similar proposals were made with respect to stock index futures in the aftermath of the 1987 Crash.

Obama’s justification for this is risible: “Congress should give the agency responsible for overseeing oil markets new authority to protect against volatility and excess speculation by making sure that traders can post appropriate margins, which simply means that they actually have the money to make good on their trades.”  So which is it? Are margins to ensure contract performance, or are they to reduce volatility and excess speculation?  If the former, there is zero evidence that CME Group or ICE or OTC market participants aren’t charging margins that are sufficiently high to control efficiently counterparty risk.  If the latter, there is (a) no evidence that there is excess speculation in energy, or that it is elevating volatility, and (b) no evidence that tweaking margins will have any impact on volatility.  Indeed, hiking margins can raise volatility by reducing the amount of speculative capital available to absorb fluctuations in hedging demand.

In sum, the parts of Obama’s markets aimed at speculator-manipulators are intellectually confused, empirically baseless, and deeply irresponsible because they encourage a witch hunt atmosphere by slandering (by slimy insinuations) legitimate market actors as criminal manipulators.

Well played.  Because of all the practice, no doubt.

A few other things stand out.  First, he repeats the “we use more than 20 percent of the world’s oil and we only have 2 percent of the world’s proven oil reserves” mantra.  Hell, even he admits he says this repeatedly: “But as I’ve said repeatedly.”  Repetition of a dubious factoid does not make the conclusion it is intended to support true. Indeed, that’s a staple of the Big Lie.

Second, he continues to take credit for increased US oil output when in fact he and his administration don’t have a damn thing to do with it, except that it could have been higher yet without some of their counterproductive policies.

Third, take a look at this remark: “We’ve added enough new oil and gas pipeline to circle the Earth and then some.”  To which my first response is:  What do you mean “we” kimosabe? Again, a guy who has never done anything that would risk getting a callous taking credit for the actions of those that actually put hands to shovel and made some truly shovel ready projects realities.  Moreover, it raises the question: if building so much pipeline capacity is such a great thing, why is he doing everything in his power to stall or stop Keystone?  Is that uniquely damaging? (To the environment, I mean, not to the fortunes of Buffett’s BNSF.)

A rule of thumb to keep in mind.  Whenever Obama talks about energy generally, and speculation specifically, it is safe to conclude you are being manipulated: that’s not at all speculative.

* Title suggested by R.

University of Maryland law professor Michael Greenberger is quoted often in the financial press on derivatives related matters. I have no idea why. He is a complete buffoon on these issues.

Perhaps it is his stint at the CFTC makes reporters think he’s credible. All the worse for the CFTC.

Personal anecdote. He and I were on the same panel when I testified on oil speculation before the House Ag Committee in July, 2008. He said something typically inane; I think it was about increases in Saudi oil output not driving prices down. I jumped on him, saying that he had overlooked the fact that Saudi crude was heavy and sour, and the market was short light, sweet crude. He was flustered, and responded by stammering “I’m not an economist” to which I responded: “That’s the first thing you’ve ever said that I agree with.”

And the last.

But Greenberger has crossed the line from buffoonery to mendacity with this interview:

Greenberger makes very serious allegations: criminal conspiracy to manipulate the prices of multiple commodities.

He says speculators are “working together.” “There is doubtless criminal conduct here.” He compares speculators to bank robbers and burglars. He asserts that the (alleged) huge profits of commodity speculators are due to their criminal conduct, and would not exist if prosecutors did their jobs; instead, they have “blindfolded themselves, stuffed their ears, held their noses” and let criminal conduct proceed uninvestigated, and of course unpunished.

He even gives this a political spin, saying that since higher gas prices are the only thing that can result in Obama’s defeat, the conspiracy could lead to the Republicans taking the White House, and racking up big gains in the House and the Senate.

Which obviously begs the question: then why wouldn’t an Obama DOJ be falling all over itself to investigate? An Obama CFTC? An Obama SEC? I mean, this part of the interview alone marks Greenberger as completely unhinged, as it makes no sense that a hyper-politicized administration would refuse to investigate rampant criminality that threatens its re-election.

Greenberger’s evidence for his lurid claims about a criminal conspiracy to manipulate prices?-zip. Really. Zip. His claim that speculators are driving up prices by trading futures is without solid empirical foundation, but is common enough. But to allege criminal conduct, and a vast conspiracy among major financial institutions, goes far beyond the pale. He says he won’t name names. Why not? If he has the evidence, why shouldn’t he? Truth is an absolute defense in libel and slander.

And recall what Judge Easterbrook wrote over 25 years ago: an undetected manipulation is an unsuccessful manipulation. If there is such a vast and successful effort to manipulate prices, the evidence would be there for all to see.

If Greenberger can back up what he says about criminal conduct, and a criminal conspiracy, he should do so. Now. Stat. If he can’t, he shouldn’t be making such lurid claims. It is beyond irresponsible. It is mendacious.

Recognition is dawning that clearing mandates-the supposed silver bullet for making the derivatives market safe-are not the panacea that their advocates claimed.  Recently, major regulators in the US and the UK have warned about the dangers of concentrating so much risk in CCPs.  The recognition is spreading to the press too, as illustrated by this article in The Economist:

The source of all this angst is the clearing-house, a mundane bit of financial-market plumbing that sits between buyers and sellers in transactions. And the reason why people are fretting is that G20 policymakers have seized upon clearing as the solution to some big problems in the over-the-counter derivatives market.

. . . .

That feeds worries about the other effect of lots more clearing: a new concentration of risk. Moving derivatives trades to clearing-houses mitigates the effect of a default of a clearing member (Lehman Brothers’ cleared trades were handled smoothly in 2008, for example). But it makes the impact of a clearing-house itself going down much worse. They may lack the heft of big banks, but few financial institutions are more interconnected. Failures are rare but they do happen: Hong Kong’s futures clearing-house ran out of resources in 1987, for example, and it took a government bail-out and the closure of the main stockmarket for things to get back to normal.

This should not be a surprise-after all, it’s not like what happened in Hong Kong-or in Chicago-in 1987 was a big secret.  And it’s not as if nobody, ahem, has been raising this point for going on four years now.

And that italicized part is just too rich.  Didn’t Timmy! and GiGi constantly-and I mean constantly-tell us that clearing eliminated interconnections in the financial system? Yes they did! I guess that explanation is now seen to be the BS it always was.  I’ve been calling BS on that for about three years.  I’m waiting for the dynamic duo to admit they were either ignorant, or liars.  There is no third alternative.

The aforementioned regulators are demanding that CCPs be made immune from failure.  The Economist agrees:

The more systemic they become, the more tightly clearing-houses should be regulated. That means more clarity over their collateral and margining policies. It means agreeing on plans for recapitalising a failing entity without tapping the taxpayer. And it means getting clearing-houses to hold more equity: LCH.Clearnet had just €333m ($463m) of capital in 2011, compared with collateral and cash under management that averaged €73 billion. Clearing can achieve many things. Solving the too-big-to-fail problem is not one of them.

Sigh. On the one hand, it is good to see growing awareness of the systemic vulnerabilities that CCPs create.  On the other, it is distressing that regulators and commentators seem to have target fixation and can focus on only one thing at a time.  Put differently, they fail to consider how the financial system will adjust to attempts to make one part of the system safer.

I’ve also written about this ad nauseum.  The point is that raising margins, or increasing the size of default funds, or changing margin calculations, or tightening up restrictions on eligible collateral, or other measures to improve the safety of CCPs will induce reactions and adjustments elsewhere in the financial system, and these adjustments have systemic implications.

For instance, requiring more collateral is likely to lead to the growth of systemically-fragile collateral transformation services and other shadow banking mechanisms to secure collateral to post for CCP margins.  Expanding CCP member commitments to default funds increases their exposure to wrong way risks, and is an important source of interconnection in the financial markets.

I return to the 1987 Chicago experience.  Yes, the big exchange CCPs were under stress, but a major source of stress in the financial system as a whole was due to the extraordinary need for liquidity to meet margin calls-the very mechanism that is put in place to protect CCPs against default.  Sometimes “safety” equipment can be downright dangerous.

I return to a metaphor I’ve used before: that of flood controls.  Building up levees to protect one location can increase the risk of a catastrophic flood elsewhere in a river system.  It is good that more regulators and market observers recognize that CCPs are a source of systemic risk, but the levee-building reflex is worrisome in the extreme.  It suggests an inability to think about the financial system as a whole, a system that reacts to changes imposed on one part of it.  These responses are not necessarily salutary, and can be downright frightening.

The responses need to be anticipated, to the extent possible.  But it is often difficult to do that with accuracy.  Which means that it is necessary to proceed cautiously when making the levee around CCPs higher and higher.  There will be responses to this process, and it is likely best to proceed cautiously and incrementally, seeing what the responses are to the gradual changes, and then adjusting accordingly.  Wholesale changes made in a hurry focused monomaniacally on one part of the system are a recipe for an major disaster elsewhere in the system.

I say again: to understand how policy changes affect systemic risk you need to think of the financial system as an organic whole, a system that responds often unpredictably to changes imposed on one part of it.  Although it is encouraging to see that the magical thinking about clearinghouses is being replaced by sober concern, it is far less encouraging that the concern is leading to policies focused on individual institutions that do not pay adequate attention to how the system will respond.

In other words: Don’t build financial levees without giving very deep study how other financial currents will react to the levees during flood times.