Streetwise Professor

Retiring Congressman Barney Frank, the Frank of Frankendodd, felt compelled to share some parting wisdom on whether in the aftermath of MF Global it was appropriate for the CME to exercise self-regulatory powers:

“I have no doubt about the CME’s integrity, but nobody should be in the position of having a dual role,” Rep. Frank said. “We should make sure [a conflict of interest] doesn’t arise, that the temptation isn’t there, that people are not unconsciously influenced

. . . .

Rep. Frank pointed to the separation of the Nasdaq Stock Market, now owned by Nasdaq OMX Group Inc., from the National Association of Securities Dealers.

That process began in 2000 and saw the NASD become a full-time regulatory body now known as the Financial Industry Regulatory Authority, or Finra. Part of the rationale of that move was to separate the regulatory function from a for-profit exchange operation.

“I think it would be better if they did what NASD did,” Rep. Frank said.

He said that.  He really did.  He held up Finra–the Finra that couldn’t find Madoff and Stanford with a map and both hands–as the model to emulate.  Seriously.

Of course the Finra (or government regulation) models are superior because the people who work for them are saintly, and never subject to temptation.  They are never subconsciously influenced.  They are Spock-like creatures, incapable of being captured, influenced, or duped.

And they have the best information and the strongest incentives.

Sure they do.

As I said in my weekend post, perfection is not an option here.  A serious analysis of incentives and information is required.  And of course, as I said in that post, Barney Frank doesn’t provide any serious analysis.  His is the epitome of Beltway superficiality: he invokes “conflict of interest” as if that is the only relevant consideration, and cites some example that is ridiculous on its face.

And he doesn’t get called on it.

Would somebody please–please–ask the man a serious question in response to such bleatings?  Would somebody please  challenge him on the Finra lunacy?

* Because doors are expensive.  Note: click on the link only if you have a strong stomach.

Donkey years ago, when major exchanges were beginning the process of transforming from not-for-profit member owned firms to for-profit investor owned ones, there was a considerable amount of discussion over whether it was appropriate for for-profit exchanges to exercise regulatory functions.  The concern was that they would be subject to conflicts of interest that would undermine their incentive to regulate fraud and manipulation on their marketplaces.

I wrote a paper on the subject at the time, but shelved it in large part because these fears dissipated rather rapidly.  In the aftermath of the MFer debacle, however, they have returned with a vengeance.  Barney Frank just opined that the CME should not be a self-regulatory organization.  Yeah, I know, it’s Barney Frank (and aren’t you leaving Barney, so why not shut up?), but he’s not alone in his call.  Indeed, I get the sense that this is the emerging conventional wisdom.

So perhaps it’s time to revisit and revise that paper–thankfully Word is backward compatible!

I’ll use this post to summarize some of the arguments in that paper, and apply them to the MF/CME situation.

The main conclusion of the paper is that in comparing alternatives–self-regulating non-profit, member owned exchanges and self-regulating investor owned ones, the latter probably have stronger incentives to regulate most forms of bad conduct.

I divided the kinds of misconduct potentially subject to exchange oversight into two categories: misbehavior by agents (such as brokers cheating their customers), and market manipulation.  Based on my extensive analysis of self-regulation of manipulation, I concluded that neither type of exchange can be expected to self-regulate manipulation well.

With respect to agency problems, I concluded that for-profit exchanges are actually likely have a stronger incentive.  Member owned exchanges have more of a potential conflict of interest because the agents are among the exchange owners: some owners benefit directly from the (bad) conduct at issue.  Moreover, there is a collective action problem: perhaps one broker’s misconduct harms the others, by damaging the reputation of the exchange, but this is a public bad from the perspective of other broker-owners and free rider problems undermine the incentive of the brokers to act against it.

If you want a great example of that, look at the conduct on the floors in Chicago that was uncovered in the 1989 FBI sting.

With a for-profit exchange, however, inefficiently lax oversight of agents reduces the derived demand for the exchanges services, reducing its profits.  Put differently, for profit businesses are harmed when the suppliers of complementary services engage in misconduct that harms customers: brokers and exchanges provide complementary services, and misconduct by the former harms customers and reduces the demand for the latter’s services and hence its profits.  This gives the latter–the exchanges–a high powered incentive to police the supplier of (complementary) brokerage services.  Making them self-regulatory organizations permits them to engage in such policing and act on this incentive.

Against this it is sometimes argued that exchanges are likely to go easy on big brokerage firms that are their big customers.  But the ultimate customer is vitally important here too.  It is in the exchange’s interest that these ultimate customers are served by the most efficient, highest quality agents.  Higher cost/lower quality agents translates into lower derived demand for the exchange’s services.  Customers served by a broker that poses undue risks to its clients can go to another broker if the exchange cracks down  on the malfeasor.  The crackdown doesn’t reduce the exchange’s derived demand: it increases it, even if the broker is large.  Indeed, the risk posed by a bad broker to the exchange is all the greater, the bigger that broker is.  Which all means that there are fundamental problems with viewing the brokerage firms like MF as the exchange’s customers.

My argument depends crucially on there being a mechanism by which the self-regulating exchange incurs a cost when it engages in too little oversight.  The most likely mechanism is a reputational one, in which revelation of broker misconduct not caught by the exchange leads demanders of trading services to revise downward their estimate of the quality of the product they are getting (i.e., they conclude that they are at greater risk of being cheated by brokers), trade less (or are only willing to pay lower prices for exchange services), and thereby reduce exchange profits.

In the case of the CME and MF, this mechanism is clearly at work.  In the price of CME stock has fallen about $21/share since immediately prior to the MF blowup.  This represents a decline of market capitalization of $1.4 billion–approximately the same magnitude as the the missing money.  The work in the 1980s of Peltzman & Jarrell shows that it is quite common for product quality problems (that result in recalls) causing losses in market cap to the firm whose products are recalled that are far larger than the cost of the recall itself.  Bad quality outcomes have costly reputational effects.  This provides an incentive to avoid bad quality outcomes.

My paper drew from the property rights literature, which showed how the power of incentives could affect the incentives to supply quality.  That literature shows that a high power incentive system (like for-profit organization) could lead to a less efficient supply of quality than a low power incentive system (like non-profit organization) when quality was non-contractible or non-observable, and other mechanisms (like reputation) don’t cause a for-profit entity to internalize the effects of providing inefficiently low quality.  I concluded that this non-contractibility/non-observability issue was not relevant for the agency problems and other problems (such as informed trading).  Thus, I concluded that for-profit exchanges were likely to be better self-regulators of agent misconduct than non-profit ones.

The MF case doesn’t change my opinion on that.

But that is not necessarily the alternative being advanced by Frank et al. They presumably want to transfer all regulatory authority to the government.  To agencies like the CFTC and the SEC–which also had regulatory oversight responsibilities over MF, and didn’t stop the blowup and the possibly illegal appropriation or transfer of customer money.  Agencies that are subject to very low power incentives (except maybe for ass covering).  The CME is being pilloried for failing to stop the transfer of money that apparently began immediately after its auditors left MF: the SEC didn’t catch Allen Stanford or Bernie Madoff from stealing huge sums over periods of years–years–despite numerous warnings.

So I’m sure that yeah, handing over all regulatory responsibility to the CFTC and SEC will ensure nothing like MF ever happens again. And I also believe, as Christmas approaches, that Santa Claus is going to bring me a new Ferrari.

Actually, to extend Samuel Johnson’s aphorism, such recommendations are like 5th marriages: a triumph of idiocy over experience.

The facts in the MF case are still murky.  The collapse of a brokerage firm is not all that exceptional.  The potential theft of a billion plus in customer seg funds is very exceptional.  The issue is whether the CME could have stopped this theft.  Quite clearly such an action cannot be stopped by any ordinary and routine auditing.  Indeed, the money disappeared immediately after the last audit.  So preventing the theft would have required some extraordinary action, such as taking over control MF’s customer funds, transferring accounts, etc., earlier.  Given the truly exceptional nature of what MF apparently did, any assertion that CME should have done that reeks of hindsight bias: a common theme of the post-event commentary by industry people is that MF did the unthinkable, so it is pretty unrealistic to expect anyone to take actions to prevent the impossible (or unthinkably unlikely).

Self-regulation is imperfect.  Government regulation is imperfect.  Under either system, stuff happens.  Choosing which of these systems is, as Churchill said of democracy, the worst except for all the others that have been tried from time to time, requires a careful comparative analysis that focuses on incentives and information.  I’ve done that type of analysis in the past, and concluded that there is no single answer.  Exchanges do a lousy job at policing manipulation, and that function is best left to ex post legal enforcement–including private enforcement via civil lawsuit.  Exchanges–especially for-profit exchanges–do better at policing bad agents like brokers.  Not a perfect job, but their information and incentives are stronger in this case than in the case of manipulation.

The MF case shows that there is a market feedback mechanism at work that imposes costs on exchanges when people and firms they regulate do bad things.  Self-regulation harnesses that feedback mechanism, and it would be foolish to discard it on a whim based on an incompletely understood single instance like MF.  That’s doubly true given that the proposed alternative–complete reliance on government regulators–has more than its share of examples of proven failure, with Madoff and Stanford again being only the most prominent examples.

Remember.  Perfection is never an option.  Getting the right institutions in place requires a careful comparative analysis of the alternatives.  I can guarantee you Barney Frank hasn’t done that.  Nor have most people who are bold in their opinions on the matter. I’ve carried out such an analysis some years ago, and don’t claim to have the answer, but I know enough to say that (a) the situation is not so cut and dry and Barney et al make it, and (b) there is a colorable case that exchange self-regulation of certain forms of conduct is like what Churchill said about democracy.

And also remember that data is not plural of anecdote, and that anecdote and analysis are not synonyms.  Right now people are making strong recommendations on the basis of a single anecdote, and doing so before it is understood in any detail.  So I will withhold judgment, and when I make it I will endeavor to do so informed by the MF example, but also by a more complete comparative analysis of the incentives and information under the alternatives.

Coverage of MFer John Corzine’s House testimony yesterday has focused on his repeated denial of any intent to dip into customer seg funds.  That’s walking a thin legal line, and it’s unclear that lack of intent would be sufficient to evade time in the pokey.  That part of his testimony seemed weasely, at best.

But this piece suggests idiocy:

Why did you bet the survival of the firm on European sovereign debt?

“We looked at the ratings, but they were not the only consideration. We looked at what counterparties would charge for initial margin. We would look at how individual securities were looked at by regulatory authorities around the globe – what they were able to use as collateral. We look at prices in markets to determine whether people thought the default or restructuring risk was being priced into it.

“There were many considerations along with the ongoing dialog that, which after the fact clearly can be second guessed, that the European community was going to take a much more forceful steps to avoid bankruptcy or insolvency.”

Looked at initial margins?  What about the risk of variation margin or the equivalent?  What about the risk of ratings trigger-induced increases in haircuts?

Initial margin isn’t what killed the trade.  It was increases in margin–additional collateral calls based on adverse movements in the price of the European debt, and perhaps collateral calls based on the downgrade–that sunk the company.

In other words, what killed the firm was its inability to fund the trade over its life in the face of adverse price moves.  Note that nowhere in Corzine’s answer does he mention mark-to-market risk, funding risk, haircut risk, variation margin risk, or anything related.  Given the firm’s leverage and the leverage in the trade, that oversight is beyond idiotic.  The main risk of a trade like that to a firm like MF was that prices would move against it and it wouldn’t have the resources to fund the additional collateral calls.

That’s exactly what happened–and per Corzine’s answer, that risk played no role in his decision to make the trade.  None.  That is just beyond belief.

Could he really have overlooked that risk?  Or was he just weaseling again, leaving out the crucial risk of the trade from his account, in the hope nobody would notice?

The Bank of England’s most recent Financial Stability Report includes an extended discussion of the various systemic risks posed by CCPs.  For SWP readers, the analysis will be familiar.  It focuses on the margin mechanism as a channel of contagion, procyclicality, and wrong way risk.  It emphasizes the risks arising from the pivotal role of sovereign debt in the clearing system.  Adverse shocks to sovereign debt prices can initiate the destabilizing margin cycle.  Moreover, given the correlation between the financial condition of CCP members and sov debt prices, sovereigns are a source of wrong way risk in teh system

Recognizing the very real possibility for a CCP failure, the BoE recommends the implementation of a resolution regime for CCPs to ensure that the market can continue to operate even if a CCP exhausts its financial resources.  I recommended this in  my ISDA white paper.

So I concur wholeheartedly with this BoE analysis.  But as was the case with Bernanke’s warnings about the systemic risks of CCPs, I ask: where the hell was the BoE  when everyone was drinking the clearing KoolAid?  Some of this realism would have been much more constructive before Frankendodd, the G-20 clearing commitments, and other moves to mandate clearing around the world.   Right now, the BoE, the Fed, and more than a few financial journalists remind me of someone who stood on the platform waving goodbye to a departing train, but are now running down the track screaming that its brakes are defective.

So regulators are no scrambling to figure out how to buttress the much expanded clearing system against its inherent vulnerabilities.  Would that as much thought and effort had been expended to identify, anticipate, and mitigate these vulnerabilities before regulation and legislation imposed such heavy reliance on CCPs.

Clearing was mandated in haste.  Unfortunately, given the current tumult in world financial markets, we may not have the luxury of mitigating the risks of these mandates at leisure.

A while back–summer of 2010, if memory serves–I predicted that any CFTC position limit rule would be the subject of legal challenge.  My prediction was that someone would argue that the CFTC did not have the statutory authority to promulgate position limits because it had not made a finding that there was indeed excessive speculation that made it necessary to impose limits.  Subsequently, a DC Appeals Court decision that overturned an SEC regulation due to a failure to carry out an adequate cost-benefit analysis, made it clear that  this would be a major vulnerability for a variety of CFTC rulemakings, position limits among them. The day after the post-Dodd-Frank position limit rule was passed, speaking at a JP Morgan commodity conference, I said a suit challenging the rule would be “coming soon to a courthouse near you.”

Well, soon means about 6 weeks.  Today ISDA and SIFMA filed suit in DC contesting the position limit rule.   These organizations allege that the CFTC:

— Erred in concluding that the Dodd-Frank Act required it to establish position limits without first determining whether they were even necessary;

— Failed to present a reasoned analysis or consider all evidence in setting position limits;

— Failed to conduct an adequate cost-benefit analysis as required by law;

— Conducted a flawed rulemaking process that prevented commenters from meaningfully participating.

I imagine that others–such as the CME and maybe ICE–will follow suit, as it were.  I also expect that other rules will also wind up in court.  The position limit rule is probably the most vulnerable because of the statutory language about excessive speculation, but all of the rules the CFTC has passed are on extremely shaky on cost-benefit analysis grounds.

Frankendodd is under some pressure in Congress, but given the Democratic control of the Senate and the White House, nothing is going to happen on that front.  Instead, pieces of it will be chipped away in court.  Position limits could well be the first chip off the block.  Which is as it should be.

My new book, Commodity Price Dynamics: A Structural Approach (Cambridge UP) is now available.  Only 3 left in stock at Amazon!  Order Soon!  Sorry–no Kindle version.

From the book description:

Commodities have become an important component of many investors’ portfolios and the focus of much political controversy over the past decade. This book utilizes structural models to provide a better understanding of how commodities’ prices behave and what drives them. It exploits differences across commodities and examines a variety of predictions of the models to identify where they work and where they fail. The findings of the analysis are useful to scholars, traders, and policy makers who want to better understand often puzzling – and extreme – movements in the prices of commodities from aluminum to oil to soybeans to zinc.

I’d quote from the blurbs, but I’m just too darned modest.

In all seriousness, the book represents the culmination of years of my professional research.  I’m currently working on some extensions that apply the techniques utilized in the book to some current policy issues, such as the effects of speculation and commodity pricing anomalies, such as the huge basis observed for wheat in particular (and corn and soybeans too) in the mid-to-late ’00s.

I think the structural approach is quite useful in understanding how commodity prices behave, and crucially, how commodity derivatives should be priced. That’s where the book differs from earlier explorations of the structural approach, like the book of Williams and Wright from the early 1990s.

Moreover, I believe that the structural approach is useful in demonstrating that price behaviors that are commonly considered to be irrational, and driven by excessive speculation or noise trading, are in fact perfectly consistent with rational expectations-based models.

Also, I try to resist the quite common tendency to fall in love with the models one works on. One of the main contributions is to show where the structural model for storable commodities fails miserably, and to suggest extensions that may correct these failures. As I say in the introduction, I try to break the models and learn from the pieces.

For my next book, I’m changing gears, and working on a subject that has been covered in myriad SWP posts. It will be titled “Market Macrostructure” and will also be a Cambridge imprint. The first half of the book will analyze the organization of the execution of financial transactions, focusing on issues like liquidity network effects and dark pools. The second half-will examine the organization of post-trade services, most notably clearing. I’m sure that you are all shocked by that.

There are many misconceptions about the CME’s responsibilities in the MF Global situation, and the implications of this situation for the CME’s longstanding claims that no customer has lost money as a result of a clearing member default.  These misconceptions are epitomized by this Sun Times article:

CME owns the Chicago Mercantile Exchange, Chicago Board of Trade and the New York Mercantile Exchange, where much MF Global business took place. It legally clears, or guarantees, the trading on its markets and often boasts that no customer has ever lost money because a trading firm failed.

That more than 100-year record may be in jeopardy with MF Global, one of the largest brokerages on the Chicago and New York commodity markets. Former New Jersey governor and Goldman Sachs Group Inc. chairman Jon Corzine led the firm but made a disastrous investment in European debt.

The claim is true, and regardless of what happens with MF it will remain true.  The clearing guarantee is not in play here.

If clearing firm A defaults, customers of clearing firms B, C, etc., will get paid as long as the clearinghouse is solvent.  That has always been the case in the past, and it is true now.

It is possible that customers can lose money under the omnibus account system employed in the US, if there is a default on A’s customer account, and A cannot cover it, then A’s customers bear some of the losses.  As an example of this, the London customers of Griffin trading lost money when that firm went bust in 1999: no US customer customer lost.  (Customers of a COMEX member, Volume Investors, did lose when that firm went under).

There was no default in either MF Global’s house or customer accounts, so the clearinghouse guarantee never came into play.  So the Sun Times account–like many others–is fundamentally misleading.

Moreover, 60 percent of customer margin associated with open positions was transferred to other clearing members.  Most of the missing money in question, from what has been reported, was customer money on deposit at MF Global but not margin associated with open positions.  (That is the case with two MF customers I know personally.)  The CME clearinghouse guarantee has nothing to do with that money.

CME has raised the amount that it is willing to commit to cover any shortfalls from the bankruptcy trustee’s distribution of cash to customers.  This is not the CME’s legal obligation, but is, as I said in an FT article a couple of weeks ago, an indication of the importance of this situation to CME’s reputation.

CME will be subject to scrutiny primarily for its role as the MFer’s Designated Self-Regulatory Organization (and hence responsible for auditing it) prior to the firm’s rapid implosion.  Moreover, as Jeff Carter (a one-time CME floor trader and board member) writes, CME has not done itself any favors with its handling of the “public perception of the crisis.” (Though I have also heard that CFTC is attempting to control what the exchanges–CME and ICE–are saying.  As well it might, as it will also come under considerable scrutiny.)

A big question in my mind is why Corzine isn’t getting the Madoff treatment from the Feds and the media.  He has been called to testify in front of a House committee.  I wonder if he’ll invoke the amendment that comes right after the one about unreasonable searches and seizures.  But it is amazing to me how little critical coverage he has received.  Especially given the bad press that rich bankers are getting these days.

Oh, I forgot.  He’s a progressive Dem in good standing.  What was I thinking?  My bad.

So there are two major things wrong with coverage of the MFer’s tale.  The first is that the role of the CME’s guarantee to its customers is being misrepresented with some regularity–including by the home field rag.  The second is that the most likely culprit–and certainly the person ultimately responsible for the firm’s collapse, and anything that occurred as the firm crashed and burned–is all but invisible.

Back in the summer I argued that sovereign CDS are acutely vulnerable to wrong way risk.  Indeed, the problem is so severe as to call into doubt the viability of these instruments.  From today’s Dow Jones News Wires:

But some market participants said that, if risk aversion from Europe spirals out of control and credit markets freeze, a large firm could fail to meet its obligations in a credit-default swap, setting off a chain reaction that threatens to destabilize the global banking system.

They are urging closer scrutiny of banks’ gross sovereign CDS positions and of the interconnectedness of the banking system.

“When there is a high degree of correlation between the underlying risk and that of the hedge counterparty [in this case, the sovereign and a bank selling CDS], can you rely on a payment from your protection seller?” asked Joyce Frost, partner at Riverside Risk Advisors LLC, a derivatives consultancy.

The correlation may be so strong, she said, that if Italy, for example, continues to deteriorate, the protection purchased from a highly correlated European bank may not be worth as much as originally thought. The value of that hedged position would be worth less than if the CDS were written by an uncorrelated counterparty–a U.S. or Canadian dealer, for example.

This is a phenomenon market experts call “wrong-way risk.”

Katy Burne goes on to argue that “[t]he lack of sovereign CDS clearing makes individual institutions more vulnerable to a messy default.”  This is fundamentally incorrect.  Clearing does not make wrong way risk go away because banks are CCP members, and would be on the hook in the event that a big loss on sovereign CDS caused a bank/clearing member to default.  In particular, the senior tranche of a CDO-like nature of CCP default funds makes them acutely vulnerable to wrong way risk.

Wrong way risk is intrinsic to sovereign CDS.  If big sovereigns are at risk of defaults that would cause payouts on CDS–heck, if even sovereigns that seem small in the scheme of things, like Greece, are in trouble–banks are likely to be in trouble.  The correlation is a fundamental feature of the instrument.  Whether banks are the ultimate counterparties in bilateral trades or via CCPs is immaterial: the problem is there.

The latest estimates of the shortfall in MF Global customer accounts have doubled, to $1.2 billion:

The trustee overseeing the wind-down of MF Global Holdings Ltd.’s brokerage said more than $1.2 billion in customer funds could be missing from the failed firm, more than double the original estimate of missing cash.That estimate of missing funds represents funds that should have been segregated in stand-alone customer accounts by MF Global in accordance with regulations, the trustee said.

Apparently the issue is that MF held about $600 million of its own capital in customer seg accounts to cover potential customer defaults (which as a clearing broker it is on the hook for).  Add that $600 million to the $600 million original shortfall estimate (which apparently was made without taking into account the MF Global capital held in the accounts), and you get to the $1.2 billion figure.

Already ugly.  Getting uglier.

When financial/trading firms implode, they do so with incredible speed. A lot of money sloshes in and out of them every day, and in the desperation and chaos of the implosion controls break down–and are sometimes deliberately broken down.  In the scramble for cash to meet incompatible demands from importuning creditors and clients, a lot of money can go out the door.  This isn’t like the collapse of a manufacturing firm with assets like machines and buildings that are hard to turn into cash quickly, and which keeps little cash on hand.  Firms like MF have mainly liquid assets, and handle large quantities of cash and liquid assets for others.  Thus, there is a much greater risk of illicit transfers in collapse of this type of firm than in others.

Interestingly, this is one reason why financial firms have fragile capital structures.  If they didn’t, it would be quite easy for managers to misappropriate assets.  Capital structure fragility and the associated potential for runs are a disciplinary device: customers and funders who suspect misappropriation can run, and destroy the firm in a trice.

But this disciplinary device is imperfect, as are all such devices.  Sometimes managers misbehave, and these firms implode quickly as customers and funders flee. We are witnessing exactly that with MF Global.