Streetwise Professor

All you clearing and market infrastructure aficionados must read Bill Hodgson’s piece on collateral transformation at DerivSource.  He points out quite accurately the new sources of fragility and vulnerability to stress that will arise from collateral transformation services that are being offered to finance CCP margins in the aftermath of clearing mandates.

The bitter irony here is that many derivatives end users (real money investment funds, industrial hedgers) did not pose any real systemic risk under bilateral structures.  But forcing them to clear drives them to utilize funding mechanisms that are systemically risky.  As one big corporate end user told me: clearing mandates have transformed credit risks into liquidity risks: I can manage the first, but the second scares me.

I continue to gape in amazement that the sorcerer’s apprentices that created these mandates did not think to step two.  They did not step back and ask: “Gee, we’re imposing a major change on the structure of financial markets.  How will market participants respond?”  This is especially unbelievable since a big component of the narrative of the financial crisis is that it was the result of excessive financial engineering.  What, did FrankenDodd, Timmy!, GiGi, the G-20, the EC, etc., think that the big changes that they imposed would not lead to a new burst of financial engineering?  Are they really that clueless?

I think I know the answer.  I think you do too.

Markets do not stand still.  Market participants will adjust contracts in response to regulations and laws motivated by beliefs that the existing system of contracts is flawed.  A useful first approximation is that these contractual adjustments will try to reproduce the economic substance of the banned or restricted contracts.  However, many of the work-arounds necessarily utilize less efficient–and often more fragile–ways to achieve that substance.  Which means that vulnerabilities have largely been relocated, rather than eliminated, and in many cases the new vulnerabilities are more dangerous than the old.

Read Bill’s piece to get an excellent illustration of this dynamic at work.  And then remember that the biggest systemic risk is government, and in particular, ill-considered government policies.  And that’s especially true when static-minded legislators and regulators attempt to impose their vision on a dynamic, strategic, reacting, self-ordering system.

There is an increasing drumbeat of stories warning about the systemic risks posed by CCPs.  This FTAlphaville article discusses several dangers I’ve discussed repeatedly, including the stresses put on liquidity, the concentration of risk resulting from the reconfiguration of the topology of the financial network that results from central clearing, and wrong way risks.  Several articles, including this one, report on the BOE’s Deputy Governor Paul Tucker warning about the lack of plans for resolving insolvent clearinghouses–a fear echoed by the ECB’s Peter Praet. Risk has a long article about various CCP risks; particularly interesting is the discussion of the contingent liability that clearing members face in the event of a “forced allocation” of a defaulting member’s portfolio.  The Risk article also reprises an SWP theme about the stupidity of limiting clearing member ownership and control of CCPs.

And the beat goes on.  Although not about clearing directly, this story on the downgrading of MF Global does have implications for clearing, given the CFTC’s decision to require admission of firms with as little as $50 million in capital to CCPs.  And speaking of the CFTC, its recently adopted clearinghouse rule requires CCPs to have enough capital to cover the failure of its single largest member, not the two largest: as I noted in my ISDA white paper, not only should a CCP have enough capital to cover two big defaults, it should have plan to replenish capital after even a single failure.  Although the CFTC may revisit the requirement later, pending negotiations with the Financial Stability Oversight Council, a failure of a single member–not even the largest one–of a CCP will likely require the services of Kevin Bacon do deal with the resulting run:

Needless to say, none of these stories are a surprise to me. I’ve been warning that CCPs could be Trojan Horses packed with systemic risk for a long time, to no avail. I hope that, unlike Cassandra, my warnings are mistaken. But it is becoming abundantly plain that these concerns are becoming far more widespread. It would have been better had that happened before politicians, regulators, and central bankers fallen victim to groupthink and seized on clearing as a “solution” before they had closely analyzed the problem in all its complexity. But the G-20 put its imprimatur on clearing, and the groupthinkers are not about to admit a mistake and start all over. So market participants and regulators are having to deal with the realities of a framework that poses dangers that may be different than, but just as threatening, as those clearing was intended to address.

By the sounds of this speech by deputy chairman Alexander Medvedev, Gazprom is indeed feeling that its beloved oil-linked pricing mechanism is under siege.  Medvedev’s tone is very defensive, and his arguments risible.  How risible?  Let’s deconstruct.

Fail #1:

“Oil-indexed , long-term contracts that ensure the basic supply volumes from Russia, Qatar, Norway and Algeria… are exactly the mechanism that protects all the parties, since the gas market is not like, for example, the fish market, where you can catch, sell, and make a profit in one day,” Medvedev said.

Well.  Oil isn’t like fish: don’t catch, sell, and profit in a day on oil.  But there are vibrant spot and term markets for oil: oil prices aren’t linked to anything else, but fluctuate minute-to-minute with market forces.  And gas isn’t like fish either, but there is a vibrant spot and term gas market in North America.  So it’s obviously nothing inherent in gas as a commodity that precludes the development of a vigorous spot market, or necessitates oil-linked pricing.

Jeez, apparently Medvedev has been consulting with Gensler about inane market analogies.  Gensler: apples.  Medvedev: fish.  Both: lame.

Fail #2:

“Two-and-half years of abominably low spot prices in Europe have created the illusion that gas has lost its link to oil once and for all. This is not true.

So gas has decoupled from gas in the short run.  Even if they recouple in the future, gas is always coupled with gas.  A gas-based pricing mechanism can never become decoupled from gas, but gas and oil can become decoupled.  So the movement away from oil-linkages towards reliance on robust gas pricing mechanisms reduces the risk of decoupling and more efficient pricing.

Fail #3:

Spot-price trading is incapable of giving correct price signals to the market due to the small volumes and low liquidity.

Trading volume is endogenous.  Liquidity feeds liquidity.  As the US experience shows, liquid and deep cash and derivatives markets can develop very quickly given the right structural conditions: movement away from oil-linked mechanisms would accelerate this process dramatically.  What’s more, the Dutch gas hub is already pretty liquid, as is the UK’s National Balancing Point.  They certainly give better pricing signals than oil.  They will only give more accurate signals as market liquidity develops–which it will quite rapidly if oil-linked pricing and contracts fade away. Moreover, prices that don’t reflect fundamentals spur transactions that tend to eliminate inaccuracies.

Fail #4:

“US prices are so low they do not cover operating costs and in our opinion this situation will not last long. The situation there will return to normal and will make the US market attractive again.”

A lot of smart people are betting otherwise.

And here’s some whine to go with all that fail:

Medvedev also hit out at Europe’s efforts to reduce Gazprom’s dominance. “Natural gas has become a hostage of geopolitics in which there is an artificial demonisation of Gazprom,” he said. “Sometimes it seems that if even the export of bananas or coal were the largest source of budget revenues for Russia, it is in this area that political games would be played. We do not believe that there is an energy security problem in the EU.”

All at once now: awwwwwwwwww.  Boo-frickin’-hoo.  Poor, poor, persecuted Russia.  Poor, poor, misunderstood Gazprom.

Amazing.  Gazprom is a grotesquely inefficient state protected monopoly with a reputation for thuggishness, corruption, and opacity.  Gazprom isn’t demonized: it is justifiably reviled.  100 percent natural ingredients: nothing artificial about it.

Again, it warms the cockles of my heart to hear Gazprom attempt to defend an archaic pricing mechanism.  The defensiveness means they are feeling the heat: the silliness of their arguments makes it plain that the economics are inexorably consigning oil-linked contracts to oblivion.  The fundamentals of the gas market are changing as dramatically as the contracting practice: indeed, these fundamental changes will drive the move to new pricing mechanisms.

Medvedev knows that Gazprom is a Soviet relic that will face daunting difficulties in a more competitive environment in which gas fundamentals, not oil fundamentals, drive prices.  Gazprom is attempting to fight market forces, but in the end, market forces will win–with bleak consequences for Gazprom, and the parasitical class that feeds off it.

I have only had time to skim press coverage of the new Mifid & Mifir promulgated by the European Commission, but on my initial read, that appears to be a fair description.  All of the bad ingredients of Frankendodd made worse, with some special Euro accents of a decidedly dirigiste flavor.  The same deep suspicion of markets, the same cartoonish view of why market structures have evolved as they have, the same conceit of knowledge and control, the same breezy disregard for unintended consequences.

Sorcerer’s apprentices run amok, again.  Led by a French apprentice no less.

After July 21, 2010, who woulda thunk that regulatory arbitrage would have thrown business in the US’s direction?  If Mifid and Mifir go through anything like what Barnier et al propose, that could well happen.

There has been a lot of hyperventilating over this Bloomberg story about the transfer of derivatives positions from Merrill Lynch to Bank of America.  Much of the commentary, most notably by Felix Salmon, has expressed outrage at dumping risk on the deposit insurance fund.

The Bloomberg story focuses on the fact that FDIC and the Fed are at odds over the transfer. This tells you a lot, and what it should tell you is not comforting.  Both sides are talking their book, and what the Fed is saying reveals its concerns about stresses in the market, and particularly on dealer firms.

FDIC is obviously and justifiably concerned about the contingent liability it assumes as a result of the transfer.  Presumably the Fed is not oblivious to this.  So why would it favor the transfer?

I think it speaks volumes about the Fed’s concerns over the condition of dealer firms.  In the current environment, the most worrisome ones would be Merrill, Morgan Stanley, and perhaps to a lesser degree Goldman.  All of these have seen their credit spreads widen recently.  Concerns about creditworthiness of these firms can lead to runs.

I don’t think that runs on derivatives per se are the issue: yes, counterparties can seek to novate, or find other ways to get cash out of their dealers with whom they have in-the-money positions (although that’s not as much of an issue with standard interdealer CSAs in which no credit is extended.)  But counterparties, customers, and lenders of/to dealer firms who are concerned about the derivatives exposure of a dealer of questionable creditworthiness have an incentive to reduce their exposure to the dodgy firm.

This, ironically, illustrates the systemic danger associated bankruptcy rules that give derivatives trades priority: it gives ostensibly junior claimants who can pull their money an incentive to get out first. You can’t evaluate the systemic risks of derivatives without considering capital structure more generally.

And there are reports that big non-dealer counterparties are getting nervous about dealer creditworthiness.  Novation inquiries are increasing as dealer credit spreads have gapped.

[Black humor moment in linked article:

“We’ve not experienced clients moving away from us. On the contrary, we’ve seen more clients come to us as a result of our strong positioning in the equity derivatives markets,” said a source close to one French bank.

Sure.  Remember that the French have claimed their banks have “no toxic assets.”  Which presumably explains why Sarkozy is running around like his head is on fire and his a** is catching it (h/t Charlie Daniels) trying to get the Germans to recapitalize French banks.]

Thus, my interpretation of the Fed’s action is this.  It sees the conditions are ripe for a customer and funder run on Merrill.  It wants to reduce the risk that customers and lenders perceive.  The less risk in ML, the lower the likelihood that customers and lenders will get the urge to go for a jog–or a sprint.  Reducing ML’s derivative exposure reduces its risk, and makes a destabilizing run less likely.  Not that BAC is in great shape, but it is less vulnerable to what the Fed fears than Merrill is, and less vulnerable to a depositor run precisely because of deposit insurance.

So that’s the real story here, IMO: the Fed’s encouragement of the move of ML’s derivatives to BAC reveals its nervousness about the vulnerability of ML, and some dealer firms generally, to a run.  From its perspective, moving the derivatives risk to BAC is the least bad option. If you believe that runs are an inefficient equilibrium outcome–and that is a reasonable belief–doing something to reduce the likelihood of a jump to that equilibrium makes sense.  And that’s what the Fed appears to be doing.

And no, that shouldn’t give you the warm and fuzzies.

I’m in New York.  No, I’m not joining OWS down in Zuccotti Park.  Quite the opposite.  I was speaking at event sponsored by the object of their ire, at the JP Morgan Chase Commodity Forum.

I spoke about Dodd-Frank and commodity trading.  I did my shtick, and it went over pretty well: I was surprised that “Frank-n-Dodd” was something most hadn’t heard before.  The audience found the phrase amusing, and more than a few people remarked on the phrase afterwards.

Substantively, the most interesting thing I heard was said by Morgan’s head of commodities, Blythe Masters.  She noted that F-n-D imposed huge compliance and administrative burdens.  Huge.  Moreover, these are fixed costs.  So Frank-n-Dodd increases economies of scale in banking, which will favor the big over the small, and encourage the big to get bigger and the small to go away.

In other words, something ostensibly intended to address too big to fail will encourage big banks to get bigger through regulation-induced scale economies. The effect will be the exact opposite of the intent.

The road to hell is paved with good intentions.  Frank-n-Dodd just well may be the world’s largest paving company.

The CFTC voted out two rules today, one on position limits, the other on clearing.  I’ve beaten both issues to a bloody pulp over the last couple of years, so I don’t have too much to add.  Just a couple of high level comments.

Bottom line: Both rules are highly ill-advised.

Regarding position limits, some of the most inane provisions of the original proposal are gone, notably the “class” limits that constrained netting across the futures and OTC swaps.  This was a hidden constraint on market making by dealers, and made no economic sense.  Fortunately it is gone.  Also gone–for the most part–is the conditional spot month limit that treated cash-settled and delivery-settled contracts differently.  This made zero economic sense too, and it is also gone.  The one exception is that there are different limits for cash- and delivery-settled contracts for Henry Hub nat gas.  This makes zero economic sense too, and is a blatant political compromise by the Commission intended to throw a bone to ICE that lost on the conditional limit issue generally.  Laws, sausages–and CFTC rules.

My comment letter on position limits criticized both stricken provisions.  But other provisions I inveighed against, particularly those that constrain ETFs like USO and US Nat Gas funds, remain.

The partisan rancor on this issue came through loud and clear at the meeting, as this piece by Jeremy Grant makes clear.  Jill Sommers and Scott O’Malia were very outspoken:

“We went beyond the statute” by doing things like narrowing the bona fide hedge exemption, Sommers told Reuters. “Those are the things that people can use for a legal challenge.

O’Malia said: “over-reached in interpreting its statutory mandate to set position limits.”  O’Malia also emphasized the lack of empirical evidence of a need for limits, echoing my “No Theory? No Evidence? No Problem!” refrain.

As I was quoted saying in the Reuters piece, this statutory overreaching will be the basis for a legal challenge.  Not just on the hedge exemption issue, but on the more fundamental issue of whether it is necessary for the Commission to find that “excessive speculation” has indeed caused “unwarranted” fluctuations in prices, i.e., the “no evidence” point.  I would not be surprised if the cost-benefit analysis, such as it is, is not challenged as well.

The disappointing guy was Dunn, who blasted the idea of position limits, but voted for them anyways.  Not exactly a profile in courage or conviction by a retiring commissioner.

The other rule would require CCPs to admit firms with a minimum of $50 million in capital.  I think this is a terrible idea.  I understand that CCPs could potentially use excessively onerous admission requirements to reduce competition: hell, I’ve been making that point for well over a decade.  But I also understand that undercapitalized members, and members who cannot contribute constructively to the auctioning of a defaulter’s position, can undermine the effectiveness and even the safety of the clearinghouse.

There is a tension between encouraging competition, and making CCPs secure: Gensler and the majority focused on competition, and I think that is a major mistake, particularly given the fact that the clearing mandate in Dodd-Frank is intended to reduce systemic risk. Micromanaging CCP operations is a horrible, horrible idea.

Grounds for challenge?  Maybe.

No surprises here, really. Gensler is hell-bent on ramrodding through his agenda.  And that’s probably the best way to phrase it: the agenda is pretty bent, and will create some regulatory hell.

Last Friday I was part of a group of 8 economists who made presentations to the Board of Governors of the Federal Reserve.  Once or twice a year the Board invites academics to discuss a policy-relevant economic issue.  The subject of Friday’s session was Network Economics, and Alistair Milne and I spoke about network issues in clearing and trading.

The Parthian shot in my presentation was that it was essential not to ignore the unintended effects of derivatives regulation.  In particular, clearing mandates, capital and collateral rules, and the like are all intended to reduce the amount of leverage in the financial system.  But even if you require extensive collateral against derivatives trades, market participants can offset the reduction in leverage inherent in derivatives trades by using the freed up debt capacity to add leverage in other forms.  What goes out through the front door can return through the back door.  This can be particularly dangerous if you think you’ve solved the problem when Mr. Leverage walks out the front and ignore that he’s snuck back in.

Put differently, it is very hard to reduce leverage in the system as a whole by regulating just a piece of firms’ capital structure.

Another example.  Reducing derivatives counterparty credit risk through clearing and netting and collateralization works by increasing the priority of derivatives in bankruptcy.  But if you move derivatives towards the head of the line, somebody else ends up further back.  Like unsecured creditors, including money market funds who buy short term bank debt.  They can be systemically important, too, meaning that the regulations have primarily shifted the locus of systemic risk, and not really reduced it.

Focusing on the collateral issue, the numbers here are huge.  Tabb Group estimates that interest rate derivative collateral alone will total $1.4 trillion.  Credit, equity, and commodity derivatives-related collateral will likely add hundreds of billions to the total: although these markets are smaller, they are riskier, requiring more collateral per dollar of notional.

So where is all this collateral going to come from?  I’ve written about collateral management services, by which banks will effectively lend cash that can be used for margins, with the loans collateralized by assets that CCPs will not accept directly.  In other words, Mr. Leverage is  a Back Door Man.

CME Group’s Craig Donohue talked about the need for such services:

“There will be a need and a value for the collateral transformation services,” Donohue, chief executive officer of CME said today during a panel discussion at the Futures Industry Association annual conference in Chicago.

The types of accepted collateral may need to be expanded as thousands of new users seek to back trades. While cash and government securities will always be the least costly way to pay for margin, some who want to pledge “three chickens and an old Ford” will find it more expensive to have non-standard collateral transformed into acceptable form, said Jeffrey Sprecher, chief executive officer of Atlanta-based Intercontinental Exchange Inc.

The demand has created a “cottage industry” of firms and units within banks that will charge a fee to hold securities or other assets for investors in return for acceptable margin, said Richard Prager, managing director and head of global trading for BlackRock Inc. (BLK)

Cottage industry.  Somehow this brings to mind all the stories about shadow banking system in China that mushroomed after the government tried to crack down on bank lending.

And CCPs are looking to expand the assets they are willing to take as collateral.  This exposes the CCPs to higher risks, including valuation risks.  As an example, LCH.Clearnet (which has already begun accepting gold) is going to accept some corporate debt as collateral (no link yet, but it’s from a Matt Leising Bloomberg story that Matt emailed to me):

LCH.Clearnet Ltd., the biggest interest-rate swap clearinghouse, is considering accepting corporate bonds for the first time to meet an anticipated surge in demand for a broader array of collateral in the $601 trillion over-the-counter derivatives market.

“We want to be able to have more clients come to clearing,” Floyd Converse, head of U.S. sales and marketing for London-based LCH.Clearnet, said in an interview in Chicago this week at the Futures  Industry Association annual conference.  The world’s biggest swaps clearinghouses are expanding the
types of securities they accept as regulations force thousands of new users in the U.S. and Europe to use clearing. Among them, CME Group Inc., the world’s largest futures exchange, is broadening the variety of company debt it accepts as margin for its customers.

(Quick thoughts off the top.  “Investment grade” doesn’t really give the warm and fuzzies, does it?  Will corporate debt be accepted as collateral against CDS trades?  I know LCH.Clearnet doesn’t clear CDS, but there is a reason to wonder whether competitive pressure would lead to such an outcome.  Wouldn’t this expose a CCP to substantial credit correlation risk, which is devilishly difficult to quantify and manage?)

And it is becoming far more widely accepted that CCPs will require central bank liquidity during periods of extreme systemic stress.

All of these stories suggest that mandates are first and foremost just leading to a reshuffling of leverage and risk.  There is room for deep skepticism that this reshuffling will reduce systemic risks.

Indeed, if Gary Gorton is right, and shadow banking was first and foremost a mechanism designed to create informationally insensitive debt that could be posted as collateral, the potential increase in demand for collateral could catalyze a similar process.  This process is systemically risky because it increases fragility and creates substantial tail risks, as this new Gorton paper discusses.

There is also reason to doubt that this is a good use of capital, and could lead to lower growth.  Just what we need.  The cost-benefit trade-off appears particularly unfavorable with respect to collateral posting by long-only buy side investors (e.g., pension funds) and “end users” who do not pose substantial systemic risks.

So, do Ben et al get it?  My sense is that they do, although Bernanke was pretty inscrutable through the entire morning.

One person who obviously doesn’t get it, or is pretending that he doesn’t (which would be even more disturbing) is Gary Gensler.  October is sprinkled with major conferences, and Gensler has been doing the rounds.  Despite all of the advances in understanding of the complexity of the issues involved, Gensler continues to peddle his cartoonish morality play:

“While the crisis had many causes, it is evident that swaps played a central role,” Mr Gensler said. “Swaps added leverage to the financial system with more risk being backed by less capital.

“They contributed, particularly through credit default swaps, to the bubble in the housing market. They contributed to a system where large financial institutions were thought to be not only too big to fail, but too interconnected to fail. Swaps – developed to help manage and lower risk for end-users – also concentrated and heightened risk in the financial system and to the public.”

No recognition of the ability of firms to substitute swap-based leverage with other types of leverage, and their willingness to do so.  No acknowledgement of how mandates re-order priorities in bankruptcy, and the implications thereof.    No appreciation for the potentially destabilizing effects of rigid variation margin mechanisms, and the pro-cyclicality of these mechanisms.   And yeah, Gary: clearing mandates don’t concentrate risk and create their own interconnections.

Gensler is also still pushing the transparency nostrum.  He links the crisis of ’08 to the opacity of the swaps market.  Well, lack of pricing information was arguably an important problem with AIG in particular, his proposed cure–the SEF mandate–will have no effect on this.  The problem with the instruments that AIG bought wasn’t that they weren’t traded on transparent markets: it was that they weren’t traded.  Markets are not the Field of Frickin’ Dreams: If you build it, there’s no guarantee anybody will come.  Comparisons of markets for illiquid products to exchange traded futures are superficial and silly.

In sum, Gensler continues to say foolish things.  Is he a fool, or does he just believe his audience is?  He batters straw men.  He sticks to a cartoonish narrative of the events of 2008.  He pushes nostrums.  He ignores deep complexities, and the huge potential for unintended consequences of the policies he advocates.

Nonetheless, he is not shy about telling others what to do. @OTCderivatives tweets that Gensler said the CFTC should be “top dog” in IOSCO because of the size of US markets.   In London, he chided the Europeans for not including exchange traded derivatives in Emir:

It is critical, though, that those swaps traded on regulated exchanges also are subject to the clearing requirement to bring the benefits of clearing to swaps, regardless of where they are traded – on exchange or off exchange.

This will no doubt thrill the Germans, because an expansion of the Emir remit would also force open access to exchange CCPs.

But given that the Germans have been quite adept at slapping Timmy! around, I doubt that a mere agency head will give them much trouble.

[Interesting aside.  Risk Magazine’s Laurie Carver tweeted that Gensler blew him off to allow “other less aggressive journalists ask him comfy things.”   Go figure.]

To sum up.  Dodd-Frank has set off a very complex dynamic of unintended consequences, many of which will undermine the intent of the law.  One of the figures primarily responsible for implementation of Dodd-Frank has a very simplistic view of the world that ignores these complexities.  What could go wrong?

No, it’s not all Kudrin all the time here at SWP.  I know there are those of you looking for your clearing fix.

A brief thought about an unintended destination on the Road to SEFdom–a vertical silo.

Long time readers will know that my transactions cost economics-based analysis predicts that dominant execution venues will vertically integrate into of post-trade services, including clearing and settlement.  Many dominant markets are already “silos” and others are moving in that direction.  The days of an execution venue obtaining post-trade services from a “horizontal” CCP or settlement provider (like LCH.Clearnet) are numbered except when regulation (like RegNMS) socializes order flow.

Horizontal, independent clearers (or settlement providers) can survive in an OTC market, where there is no centralized execution venue.  Vertical integration economizes on transactions costs and double-marginalization costs when there are back-to-back monopolies (and near monopolies).  No execution venue, no back-to-back monopoly problem.

That’s where the SEF mandate comes in.  By forcing exchange-like execution of swap transactions, there is a very real possibility that a dominant execution venue will emerge–and that the resulting frictions in the dealings between that venue and its clearer will lead to a merger between them (or some sort of long-term, exclusive contract.)

Whether this outcome occurs depends on the rules for SEFs.  There is likely to be a proliferation of SEFs early on, but rules for SEFs will determine whether a handful or one survive for a particular instrument class.  If SEF regulations (a) require them to operate auctions (rather than, say, RFQs), and (b) do not impose obligations on SEFs to direct orders to other SEFs offering better prices, then network effects will lead to tipping to a single venue.  Conversely, if there are SEF order handling rules analogous to RegNMS, multiple SEFs may survive.  Under the first alternative, integration is likely to occur.  Under the second, the likely outcome is for multiple SEFs to be served by one horizontal CCP.

SEF rules are still up in the air, and I have not seen any discussion of inter-SEF obligations–or lack thereof.  In contrast to SEC, CFTC has no tradition of even contemplating, let alone imposing, order handling rules.  The issue has never really come up.  I think the presumption in the agency is there will be rigorous competition among SEFs, but that conclusion depends crucially on SEF rules.  In particular, rules relating to the way SEFs compete.  If SEFs are required to operate auction-like mechanisms, and are under no obligation to direct orders to markets displaying better prices, markets will tip to a single SEF.  This will lead to integration.  If regulators impose order handling obligations, multiple SEFs will survive, and integration is far less likely.

Has anybody thought this through?  Are order handling rules even on the table?

James Hamilton and Jing Wu have a new paper on speculation and oil futures pricing (h/t Brian Goff).  The paper is very carefully done and very impressive econometrically.  It presents some provocative results, but IMO the radical simplifying assumptions James and Jing used in order to come up with something that they could estimate cast serious doubts on the results.  I am also sure that the results will be overinterpreted and misinterpreted to advance political agendas, and regret that the authors provide the hook in a few careless statements that should have been heavily qualified, but weren’t.

Here are my initial detailed comments:

1. The paper focuses on risk premia.  Hallelujah!  The price of risk is what speculators are most likely to affect, because most speculative transactions involve a transfer of risk, rather than the commodity.  A very basic point, but one which is all too frequently overlooked.
2. The most provocative result in the paper is a huge discontinuity of their estimate of the risk premium in oil futures  between the pre-2005 period and 2005-2011 (see Fig. 5).  This discontinuity is an artifact of HW’s splitting of the sample.  They motivate the choice of splitting date by observing that the growth in crude oil futures open interest increased dramatically beginning in 2004.  It would be preferable to do some testing for structural breaks and estimate accordingly.
3. More generally, I am very suspicious of such a sharp discontinuity.  I think it is highly likely that it is symptomatic of other changes going on in the market, and the limitations of their model.  (More on the latter below).
4. The model is not complete, even on its own terms.  Although it discusses the role of speculators (“arbitrageurs” in HW) in absorbing risk from hedgers, hedgers are not formally modeled.  This is a huge hole.  Moreover, “investors”–such as those who trade via index funds–are modeled extremely mechanically.  Yes, once they are in the market, index traders tend to trade mechanically, but the allocation of speculative capital between index funds and other investment opportunities is not as mechanical a process as the paper assumes.  Indeed, in the model the index-fund investors’ trading does not depend at all on risk-return tradeoffs.  They are just automatons that flow in and out of the market based on some autoregressive process. This is extremely problematic: index investor capital allocation decisions are presumably the result of an optimization process that reflects their investment opportunity set and the pricing of risk across these opportunities.  (Again, more on this below).
5. Relatedly, since hedgers are not in the model, there is no effect of index investors shocks on hedger behavior.
6. The model of fundamentals is extremely cramped and limiting.  I am no big fan of affine models generally, but even overlooking that, it is definitely the case that more than one (latent) fundamental factor drives spot oil prices.  Thus, the model becomes a two-factor model, with one (fundamental) factor driving the spot price and the “risk neutral” forward curve and the other (index-investor buying) affecting the shape of the forward curve.
7. One cannot generate interesting forward curve dynamics using a one-factor fundamental model.  One cannot generate interesting and realistic inventory-price relations using a one factor model.  As I show in my forthcoming book, at least two fundamental factors are needed to generate reasonable dynamics.  Furthermore, as I also show in the book, the homoskedastic error structure for the fundamentals variable assumed in the HW paper cannot generate price and inventory behavior observed in the real world.
8. Thus, the fundamentals model is almost certainly seriously mis-specified.  I can understand the modeling choice, but it has consequences.  It is my sense that this mis-specification is so severe that it casts serious doubts on the results.
9. In a frictionless world, risk premia for a particular factor are determined by the covariation between that factor and the pricing kernel.  In markets with frictions (as in the Hirshleifer models of the late-80s, early-90s), idiosyncratic risk of the factor may impact risk premia, in addition to the effect of systematic risk (driven by the covariation).  HW is a single market model: the oil market is all there is, and only factors within the oil market affect risk premia.  This is in essence an old-school Keynesian model of the risk premium.  Again, this is highly problematic.  In particular, since the whole movement of financial investors into commodities strengthens the linkage between broader financial markets and commodity markets, ignoring systematic risk (and hence inter-market covariation) is a serious deficiency.
10. It is a stylized fact that correlations between commodity returns and returns on broad equity indices and FX have changed substantially in recent years.  Although some have asserted a connection between index trading and this change in correlation structures, you can tell fundamentals-based stories as well.  For instance, if supply shocks were dominant in pre-2005, but demand shocks (e.g., the growth of China, the financial crisis) were dominant since, one would tend to observe the oil-S&P correlation to change from negative to positive.  As long as you are not in a Keynesian world with each commodity and investment an island with risk borne only by those living on that island, this change in correlations would lead to a change in risk premia.  The change in sign in the risk premium at the end of the sample corresponds to the financial crisis and associated major recession.  During this time demand shocks were clearly driving oil prices, and the correlation between the S&P and crude prices was very high and positive.  Thus, there was more systematic risk 2007 and later, and this would be expected to affect risk premia, but the model precludes this.
11. The omission of systematic risk in a model of risk premia is a serious, and IMO disabling, limitation.  It is particularly odd to ignore this in a paper that examines “financialization” of a commodity market, since financialization involves financial investors adding commodities to broadly diversified portfolios in order to optimize some risk-return trade-off.
12. These issues all affect how one interprets the HW findings.  What if risk premia did in fact change?  This could well reflect more accurate risk pricing due to the integration of commodities into investor opportunity sets.  Risks are going to be priced differently–and more efficiently–if there is more trade between islands.  A reduction in frictions, and an increase in the connections between markets, should lead to better risk pricing.  So finding a change in risk pricing could represent a very salutary development.
13. Indeed, tying some of these threads together, doesn’t “financialization” reflect a normal economic process of equilibrating prices between segmented markets?  Here, the prices are the prices of risk, and the movement of resources (risk) is more abstract than the movement of physical oil between Cushing and the Gulf.  In the latter example, profit seeking traders will drive the difference in prices in the two markets to the cost of transportation between them.  In the case of risk premia, any innovations (which could well include index investing) that reduces the costs of moving resources (risk bearing capacity) between prices will affect the prices in those markets, and tend to equalize them.  Since in the broader financial markets, oil and other commodities are small relative to the broader capital markets, it should be expected that the risk prices of commodities should account for the bulk of the change toward equalization.  It should also be welcomed.
14. To summarize a bit, the crucial questions include: what risks are priced?  Who participates in the market that determines these prices?  and, What are the investment opportunities available to these participants?  I think on every question, the HW paper is on very, very shaky ground.  The one-dimension model of fundamentals is far too restrictive, and the dynamics are far too simplistic.  Crucial players–hedgers–are left out, and others are treated mechanically.  In a paper that attempts to determine the effect of the movement of well-diversified financial investors into commodities, the Keynesian islands approach is inadequate: these investors have extensive investment opportunities that affect their behavior–and the pricing of risk that is the whole subject of the paper.  Mechanical treatment of one group of agents can make sense in some models, as in noise trader microstructure models.  Mechanical treatment of investors actively and aggressively looking for superior risk-return performance is a serious shortcoming in a model of the pricing of this trade-off.
15. I sympathize with James and Jing.   The impressive empirical cleverness required to estimate even this radically simplified model demonstrates just how challenging is the task of understanding the pricing of commodity risk.  I could readily believe that it could be impossible to estimate a richer model that includes fundamentals subject multiple, potentially heteroskedastic shocks, and three classes of optimizing investors with diverse investment opportunities. But the very complexity of the problem should make people very reluctant to make strong statements about the effects of “financialization” on price behavior.
16. In summary, I believe Hamilton-Wu are eminently correct to focus on risk premia as the variable that could be affected by the entry of a new class of market participant, but the daunting nature of that task is evident.  The radical simplification (again, understandable as a practical matter) needed to permit estimation, which involves abstraction from virtually all of the important economic issues makes their conclusions and results highly dubious as a basis for policy.  But there are plenty of fools out there (and let’s be clear, I do not include the authors in that category) who will no doubt rush in where prudent and thoughtful angels fear to tread.
17. For this reason, I wish they would have abstained from statements likely the valediction in their paper: “We suggest that increased participation by financial investors in oil futures markets may have been a factor in changing the nature of risk premia in crude oil futures contracts.”  This kind of suggestion only encourages the fools.  Every link of the chain of reasoning supporting this suggestion is flimsy.  Most importantly, the suggestion rests on a structural break which corresponds roughly with a period of time during which more financial investors participated in commodity markets.  But many other things changed during the same period.  Indeed, Hamilton himself has repeatedly pointed out that this period was one in which there was a virtual cessation in the growth of oil output.  That’s a pretty important fundamental.  Moreover, this was a period in which emerging markets, notably China, began to impact commodity markets dramatically.  Furthermore, most of the period (say 2007-2011), was one of financial an economic upheaval not observed since the 1930s.  That’s a pretty big change too.  Why put all the focus on index investing?  The model certainly doesn’t support that, because (a) all of these other factors are omitted altogether, and (b) even the model of index investing is crude and mechanical.
18. That is, to attribute the change in risk premia estimated from a clearly mis-specified model to a single change among many that occurred during the period of change is highly, yes, speculative, and an extremely tenuous piece of post hoc ergo propter hoc reasoning.

I do not want to close on a negative note.  I admire that Hamilton and Wu have focused on the right issue and have brought impressive econometric skills to the problem.  Improving our understanding of these issues would best be achieved by following the direction James and Jing have pioneered, by incorporating some of the features discussed above.  It will be a hard road, but worth taking.  Hamilton-Wu is a helpful first step along that road, and I hope that people understand it is only that, and that much hard slogging remains.

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A few technical asides:

1. The use of NYMEX data in which time to expiration changes presents some complications to the estimation and interpretation.  It would be worthwhile to look at LME metals data (e.g., copper) because (a) it has also been claimed that financial investors have affected metals pricing, and (b) LME trades constant-maturity contracts that are easier to handle empirically.
2. If the focus is on index investors, who by definition trade in multiple commodities in a mechanical way, it seems that cross-sectional evidence would be quite informative.  For instance, did risk premia change in a way similar to that claimed for oil in other markets that are also part of commodity indices?