Streetwise Professor

I am in London for the ISDA Annual Europe Conference, where like in the NY version, I moderated a panel on clearing.  Yesterday’s panel was very informative and interactive, and made for some good copy.  As in NY, it was only possible to scratch the surface, but that in itself is revealing because it tells you just how many knotty issues are still unresolved.  Another thing that came through loud and clear was how interconnected these issues are.

The most entertaining debate centered around interoperability.  The looming fragmentation among CCPs has regulators around the world trying to mitigate the cost and risk increasing consequences of fragmentation by pushing for CCPs to interoperate.  The three major clearers represented on the panel–Michael Davie from LCH.Clearnet, Paul Swann from ICE Clear Europe, and Kim Taylor from CME Clearing–were all pretty negative on the idea, with Michael and Paul being adamantly opposed, and Kim only slightly more accepting of the idea.  Michael wins the quip of the day award for his characterization of the idea: “It’s crackers.”

Jurisdictional fragmentation was foreseeable months ago: I discussed the problem in some detail in my 2010 Cato and Journal of Applied Corporate Finance pieces, and again more recently in my ISDA study.  It is on the front page now, with the face-off between the UK and the ECB over the latter’s insistence that any clearer of Euro-denominated derivatives be domiciled in the Eurozone, with access to the European Central Bank.

There is some economic sense to the ECB’s position, but there is also economic sense to having global CCPs that can maximally exploit economies of scale and scope arising from netting and capital efficiency.  But this just illustrates the ill-thought out nature of clearing mandates.  Global banks can access central bank liquidity in a variety of currencies and net efficiently and collateralize efficiently across multiple currencies.  Forcing clearing eliminates some netting and capital efficiencies (but can potentially improve others), but creates thorny issues about access to central bank liquidity that makes global CCPs problematic.

The Canadians are now grappling with the very difficult tradeoff between efficiencies that come from global CCP scope, and the potential systemic fragility that could arise from concentrating so much risk in a single entity.  A Bank of Canada official, Tim Lane, warned:

In carrying out the G20 mandate requiring all OTC derivatives to be centrally cleared, it is essential to ensure that we do not unduly concentrate risk in a relatively small number of institutions that are direct clearing members of global CCPs,” he said.

These were the very institutions that spread and amplified contagion through the global financial system in 2008, Mr Lane told the annual Sibos settlement and payments conference.

Quite a puzzle, no?  Who could have possibly anticipated this?  (You don’t need to answer that.)

And the COO of the DTCC has warned about the difficulties and dangers of clearing CDS.

“We may be creating a much higher level of risk,’’ he said, by requiring swaps to be turned into standardized products, traded on electronic exchanges and where risks are covered by a central counterparty, backing up the two sides of a trade.

He noted, for instance, that a central counterparty failed during the Asian financial crisis of the ‘90s.

Again, who knew?  Again: no need to answer.

Lawrence Sweet, a senior VP at FRBNY replied:

Risk management procedures must be strong and the new systems “sufficiently robust” to guard against failure of central counterparties or firms involved in the trades.

And, he said, those swap contracts that are too complicated or risky to be put into centrally cleared, electronic markets should not be. The question is “how much can we put in there in a safe way,’’ he said.

And the answer is?!?!  [Crickets.]  Stating a set of desiderata without providing a reasonable strategy for getting there is gratuitous, at best, and reminiscent of the Steve Martin “How to Make a Million Dollars Without Paying Taxes” routine.

Why stop now?  From the FT, Jeremy Grant’s article from yesterday (2 SWP bonus quotes) is summarized by the FIA’s news brief as follows: “Complications arise as regulators detail clearing rules.”   I am so shocked that I am speechless.

Witness what the Sorcerer’s Apprentices have wrought.  Perhaps to some clearing mandates sounded like a good idea at the time, but it’s pretty evident that those very same some hadn’t fully thought through the issue.  Everybody is now dealing with the implications of the mandates on the fly, and are learning that the “solution” is just another package of problems.  Gazing across the fence from OTC World into Clearing Land, the grass in the latter seemed so, so much greener.  Now, having jumped, the jumpers are finding plenty of weeds, and plenty of nettles.

Javier Blas at FT was a standup guy about the sentence in his article on the Singleton that made it sound like I had criticized the CFTC for not inviting those taking contrary views to the August confab about speculation and the Singleton paper.  In response to my venting (who? me?), the sentence has been corrected in the online version to make it clear that I did not make any such claim, and the version online now contains this text:

“This article has been corrected since original publication to reflect that only Philip K.Verleger has criticised the CFTC’s move to invite academics, mainly with one point of view.”

I appreciate the rapid and gracious response.

Interesting to note that Ken Singleton and I are commonly being used to personify contending sides in the commodity speculation debate.  One example is this piece from the FT on Wednesday.

Before going into substance, I need to set the record straight.  Javier Blas is flatly incorrect to say that I criticized “the CFTC’s decision to invite academics who mainly defended only one point of view.”  Flatly incorrect.  I have never said that either publicly or privately, and I defy Mr. Blas to prove otherwise.

Indeed, I was invited, so I know the statement to be untrue and I would not make it becuase (a) I just wouldn’t, and (b) I’m not so foolish as to make a statement that could easily be proven wrong.   I decided not to attend the event for a variety of reasons, most of them personal.

So, a retraction and correction is warranted (though I’m not holding my breath).

Now that’s out of the way, let me revisit one more time why the Singleton paper is being grossly misinterpreted, though not by Ken (at least in ear/eyeshot of me).

To recapitulate, Singleton finds that a measure of index fund participation helps predict future returns on oil futures positions.   This measure has serious, serious problems, as Scott Irwin and Dwight Sanders have shown.  Singleton has acknowledged some of the problems.  But that still leaves a puzzle, as why would a very noisy measure of speculative participation have predictive power?  But I’ll leave that puzzle aside and take as given that speculation leads prices.

The question is: why?  Does this mean that speculation has distorted prices?

In a rather stinging response to Singleton, the IEA does a nice job of summarizing my views as to why it does not necessarily support this conclusion, and could support the exact opposite one:

Finally, as suggested by the University of Houston’s Craig Pirrong in his blog, suppose that Professor Singleton’s findings do indicate that excess returns on crude oil futures are predictable, conditional on measures of speculative activity. Nonetheless, such a predictability of returns would not imply that speculation has distorted prices. Rather, predictability is the result of market frictions that might create hedging demand, leading to an increase in the risk premium. Professor Pirrong suggests that, in such circumstances, speculative positions can predict changes in futures prices. To prevent the predictability  of returns, it might be advisable to reduce constraints on the flow of speculative investment to  commodity markets, rather than limiting them.

(The entire IEA piece is worth reading.)

Singleton advances another argument–and it is only that, because his evidence cannot distinguish his explanation from that just advanced–based on various behavioral finance/learning stories.  There are indeed asset pricing models in which investor learning can lead to self-reinforcing price movements.  The key phrase here is “asset pricing models.”  The key question is whether such asset pricing models are applicable to commodities.

I am highly, highly skeptical.  Assume for sake of argument that speculative activity in a commodity derivatives market has distorted the price of the commodity; convergence implies that if nearby futures prices are indeed distorted, physical prices have to be distorted too.

Millions–and in some cases billions–of individual consumers, and myriad producers, face these prices.  If these producers and consumers are not playing the same learning game that is going on in the futures market, the price distortion will affect their production and consumption decisions.  All else equal, if speculators cause the price to be too high, consumption will be depressed, and production will increased.  This will lead to an accumulation of inventories.  If the price distortion is large, the inventory accumulation is likely to be large.

Now, there are circumstances in which it may be difficult to detect empirically the inventory accumulation.  If supply and demand are extremely–extremely–inelastic, large price moves may result in small inventory changes that are hard to detect in the noisy stock data that are available for some commodities.  Moreover, all else may not be equal.  As Singleton (perhaps cleverly) notes, my research shows that a decline in fundamental uncertainty could lead to a decline in inventory that masks the speculation-induced change.  (Although more plausibly, higher fundamental volatility leads to greater speculation, which would lead to an increase in inventory that could be blamed on speculative price distortions.)

But there are historical episodes–like the Hunts in silver and government price-support programs–in which price distortions have been associated with huge accumulations of inventory.  Those claiming speculative distortion need to provide a credible explanation whenever an alleged price bubble is not accompanied by a rise in inventories.  It can happen, but it’s unlikely–so show me how.

So, for the Singleton story to work, it has to be the case that consumers and producers–or at least a big chunk of them–are playing the same learning game as the investors.  I find this wildly implausible, particularly for consumers.  Would consumers really buy more gasoline today–gasoline which they are going to consume, not store in anticipation of profiting from price appreciation–for speculative reasons because prices have been trending up?  Really? (Perhaps you could argue that they would engage in intertemporal substitution, but this also stretches credulity.)  It might be somewhat more plausible that suppliers would not produce more today in response to a speculative price bubble in anticipation that they can sell at a higher price in the future.

These stories–and they are just that–are not logically impossible, but they are just implausible, to me anyways.  The consumer side is particularly implausible.  To emphasize: most consumers of gasoline or copper or corn or whatever cannot store the commodity, and hence cannot earn a speculative profit.  Thus, they should respond parametrically to prices, and respond to higher prices by reducing consumption.  The decline in consumption in markets (like the US) where consumers are subject to price changes (because there are no price controls or subsidies) during the oil price spike of 2008 supports this view.  So price distortions should lead to inventory accumulation.

This is an excellent illustration of why commodities are a good place to test theories of speculative distortion.  The speculators may play their games in the financial markets, but if they affect prices, consumers and producers who don’t play the game alter their behavior.  Looking for evidence of behavioral changes–consumption and production changes–is a great way to detect price distortions.  That is not possible in asset markets.  Consumers and producers are canaries in the coal mine.

Which all means that to persuade, Singleton, and those who are using his paper to say Eureka!, need to provide a plausible explanation of how learning/behavioral finance effects change the behavior of producers and consumers in ways that what would mean that price distortions do not lead to noticeable changes in quantities like inventory.  That is, he points to models of asset markets in which there are no consumers; to make a realistic and testable model, you would need to include producers and consumers as well–not just demand for a stock of assets, but flow demand and supply.

One last thing.   The Singleton paper has “boom and bust” in the title, and many behavioral finance/learning models predict boom and bust patterns in speculative prices.  There was a boom and bust in oil prices and other commodity prices–but the bust in 2008 was not plausibly the kind of speculative bubble bursting that occurs in the models.  It was definitely driven by a huge collapse in demand resulting from the financial crisis.  Thus the “bust” part of the price movements should not be used as evidence in favor of the theory.  Instead, it fits far better a fundamentals-based story.  As I told many reporters as prices peaked in summer 2008, when they asked what would bring down prices: be careful what you ask for.  A major recession would be the most likely cause of a big price decline.  That’s what happened–not the bursting of a speculative bubble.

Relatedly.  Prices that positively cannot be driven by asset pricing bubbles–because they are are definitively not assets–boom and bust.  During the same period that oil prices were booming and then busting, shipping rates were doing the same thing.  Space on a ship is not an asset.  It is not storable; you use it or lose it.  You can speculate on the price of the ship, but the price of the services of the ship cannot be subject to asset pricing bubbles–because these services are not an asset.  The spike and thudding collapse of shipping rates in 2007-early 2009 is indicative of a rise and fall in the demand for commodities (which are transported by ship), and cannot be explained by speculative distortion induced by learning, etc. Put differently, booms and busts occur in markets in which asset price bubbles are impossible.

To summarize.  1. Singleton’s results are perfectly consistent with rational pricing, no speculative distortions, and financial market frictions.  2.  The conditions that would reconcile the kind of learning/behavioral finance model that would be necessary to explain the lack of inventory accumulation are highly implausible.  If somebody wants to tell a more convincing story about commodity price bubbles, it is necessary to do more than just genuflect to models devised to explain things like the dot-com bubble.   You have to create a model that includes flow demand and supply, and derive testable implications of investor/speculator learning or irrationality for quantities produced, consumed, and stored.   Only then will it even be remotely possible to determine the real implications of these learning models for commodities.

I have a warm spot in my heart for German Finance Minister Wolfgang Schaeuble, because of his periodic slapdowns of Timmy!  (I think there is another slapdown-ready opportunity arising, given Timmy!’s–and Obama’s–recent penchant for giving the Euros gratuitous advice on dealing with their existential crisis.)

But he said a couple of things recently that give me pause.  First (h/t R) is this speech:

German Finance Minister Wolfgang Schaeuble said that while markets are the most efficient means of creating wealth in an economy, they can also be irrational and therefore need regulation.

“Markets are the best means of finding solutions, but they’re not always rational” and can destroy themselves, Schaeuble said today in a speech in Berlin. “That’s why they need rules and bounds.”

It is the job of the government to create an order that promotes, rather than hinders, moral behavior, Schaeuble also said at an event organized by the Catholic Academy in Berlin.

On an abstract level, that’s not really objectionable, because only some anarchists deny the need for market rules.  (Anarchocapitalists believe that rules shouldn’t be imposed, but created by cooperation and consent.)  The questions are: What rules are the right ones?  Where should the bounds be set?  Who decides?  How?

In this speech, Schaeuble gave an example of how he answers these questions, and those answers suggest that his pro-market rhetoric is boilerplate camouflaging another statist control freak:

German Finance Minister Wolfgang Schaeuble on Wednesday called for regulating all innovative financial products and urged banning so-called over-the-counter trade.

“We must apply the rules of transparency to all market participants–hedge funds and private equity funds,” Schaeuble said at an event sponsored by the Konrad Adenauer Foundation and the Catholic Academy ahead of a planned state visit to Germany by Pope Benedict XVI.

“We should ban OTC trade where possible, because we don’t have transparency (in these markets). And then we should try to regulate all innovative financial products. We cannot achieve everything through regulation, but we can try to tighten the rules.”

Another slave to the god of transparency.   Like that will solve everything.  And apparently a market in which consenting adults make mutually advantageous transactions about which they don’t reveal everything is far worse than no market at all.

I would further note that there is no perfectly transparent market.  Futures and stock exchanges have a great deal of pre-trade and post-trade price transparency, but the identity of traders is concealed: the markets are anonymous, and the buyer does not know the identity of the seller.  Thus, even on exchanges not everything is transparent.  OTC, the buyer typically knows the seller, but there is less pre- and post-trade transparency.  There are trade-offs involved, and different mechanisms have developed to permit market participants to choose which kinds of transparency rules work best for them.  The side-by-side existence of exchanges and OTC markets gives choices that can accommodate differences in the costs and benefits of alternative forms and levels of transparency across market participants.

And if transparency is such an unalloyed good in markets, Herr Schaeuble, does the same principle hold for governments?  Is Germany’s government a paragon of transparency?  Do you conduct all of your discussions and decisions in the full public glare?  Does your government have secrets?  Does Europe’s?  Is this a good thing?

We all know the answers to those questions.  It would be quite illuminating to hear why secrecy–very incomplete transparency–is acceptable and even necessary for governments that wield vast coercive powers, but some modicum of secrecy is completely unacceptable for private actors who cannot coerce anybody.

Schaueble’s remarks, and the place where he delivered them, suggest a typical European conservative mindset that is ambivalent, at best, towards markets and individual choice.  Hayek’s essay “Why I Am Not a Conservative” provides an illuminating analysis of this mindset.

So please confine yourself to putting the (verbal) boot into Timmy!, Wolfie.  There are enough control freaks about, thank you.

This week marks the beginning of a whirlwind couple of months in which I give talks or participate in conferences on either clearing or Frank-n-Dodd (there of course being a big overlap there).  Tuesday I moderated a panel at the ISDA Annual New York Conference, and yesterday I participated in a panel on Frank-n-Dodd at a Futures Industry Association event in New York.

First, the FIA event.  What came through loud and clear was the widespread belief that the SEF mandate in Frank-n-Dodd is wholly wrongheaded.  The consensus is that it is an attempt to jam a one-size-fits-all model on an inherently heterogeneous and non-standardized business–the business of executing OTC derivatives transactions.  That heterogeneity reflects the inherent heterogeneity of particular transactions, and the firms that want to execute them.  The market has evolved to accommodate heterogeneity, and the SEF mandate will impose uniformity.  Everybody better fit a 42-regular sportcoat, because that is what Frank-n-Dodd is going to force everybody to wear.

Of course there are dissidents from the consensus: most prominently those who do, or want to, operate SEFs.  Big surprise.  The NYT recently ran an article describing the efforts of these firms to influence policy.  The point you should take away from that article is that the idea of SEFS is not new, that SEFs have tried to gain traction in the market for some time (they are not “Johnny-come-latelys” in the words of one exec quoted in the article), but they have not made a big dent in the marketplace.

The failure to this point of SEFs to transform execution in the swap market, the way electronic trading did for listed derivatives, is a crucial fact.  It is not dispositive proof that the SEF mandate is misguided, but it does raise serious questions about it.  Before remaking the world, it is a pretty good idea to understand why the world is the way it is and why it isn’t the way you want to remake it.  Competition is never perfect, but competitive forces usually work inexorably towards the adoption of more efficient practices.  The rebuttable presumption should be that competition has pretty much gotten it right, and that policy prescriptions that are wildly at odds with existing practice are likely based on ignorance.  Those advocating a wholesale re-engineering of the results of market processes should be required to advance a coherent justification, based on rigorous logic and empirical evidence.

This the SEFocrats have not done.  Not even close.  And no, invoking the magic word “transparency” or advancing theories that presume that half the market is suffering from something akin to battered spouse syndrome don’t cut it.

The SEF rules are a particularly prominent example of the deficiency in cost-benefit analysis in CFTC rulemaking.  I have it on good authority that some analysis will soon be forthcoming that demonstrates that the cost of these rules will be immense.  As for benefits, the six members of the FIA panel couldn’t name one–even when pressed to do so.  We, collectively, couldn’t even come up with a “well you don’t sweat too much for a fat girl” compliment.  (If you don’t like that remark, direct your complaints to Ty Cobb:  I stole it from him.)  So, insofar as cost-benefit analysis is concerned–you should be able to do the math pretty easily.

The title for the post, by the way, is a joint product.  Tom LaSalla of CME Group coined “SEFdom” to describe what Frank-n-Dodd will soon bring on us.  I added the Hayekian allusion.  (Go figure.) I think the comparison is apt.

Insofar as the ISDA panel on clearing is concerned, I walked away from it thinking what I do after hearing any informed discussions of this subject: that it is the most devilishly complex issue you can possibly imagine.  It is one of the world’s biggest onions, and neither I nor anyone who has spent considerable time and effort thinking about it or actually doing it has gotten through even a small fraction of its layers.  The number of serious issues, their complexity, and their interconnectedness, is hard to exaggerate.

Which further demonstrates the frivolity of legislators and regulators around the world,who seized upon it as a panacea and imposed it without due consideration of these complexities.  The idea was hatched out of superficial understanding by panicked people who then proceeded to let others deal with the brain-twisting realities.

One hopes (though I do not expect) that regulators will be sufficiently patient and flexible to permit people who actually know something accommodate these complexities, and make the hard trade-offs that are necessarily involved.  New ideas on ways to perform the same functions as CCPs are still being developed: ISDA chief Conrad Volstad mooted a promising approach that would achieve the purposes of the clearing mandate, but at far lower cost.  These approaches deserve analysis and development before another one-size-fits-all approach is locked in.

I don’t like clearing mandates, but think that clearing has its virtues if it is done right, and in a way that reflects its comparative benefits and costs.  In this way it differs from the SEF mandate, which is why I gave the latter my Worst of Frank-n-Dodd Anniversary Award.  But rigid and superficial conceptions about how the mandate should work (and you know whom I am talking about) raise the very serious possibility that the potential benefits of clearing will be swamped by the unintended costs of imposing it where it is inappropriate, or in a way that is not adapted to its strengths and weaknesses.

In this week’s edition of Energy Metro Desk, John Sodergreen wrote: “Normally, Pirrong is a ‘take no prisoners’
sort of economist.”  He was referring to my apparently serene response to the Singleton paper on energy speculation.

Rest assured, all, that I am not mellowing in my old age.  My response to Singleton qua Singleton was serene primarily because the results are capable of many interpretations, many of which are quite compatible to my views.  Further rest assured that I am my scathing self when it comes to the efforts to misinterpret and overinterpret Singleton’s results.  It is being waved about as the smoking gun proving that speculation distorts prices.  This is completely wrong, and reflects either the ignorance or agenda–or more likely, both–of anyone making the claim.

Remember what Puddin’ Head Wilson said: “We should be careful to get out of an experience only the wisdom that is in it — and stop there.”  People are getting far too much “wisdom” out of Singleton than there is in it. Singleton’s results are perfectly consistent with a favorable or benign effect of speculation.

But there is nothing more likely to get me to break out the black flag than an epistle from Bart Chilton, and yesterday he did not disappoint.  The NY Times’ Dealbook had this gem from our ol’ buddy Bart:

It’s a familiar cry from Wall Street executives and Congressional Republicans: New regulations will dampen profits and crimp an already-feeble job market.

But some federal regulators, now charged with writing dozens of new rules for Wall Street, beg to differ. Bart Chilton, a Democratic member of the Commodity Futures Trading Commission, argues that a regulatory shake-up would actually spawn a wave of hiring on Wall Street and in Washington.

“The possibilities for economic growth and competition here are mind-boggling,” Mr. Chilton said on Friday during a speech at the University of Maryland.

The debate centers on the controversial Dodd-Frank Act, which overhauled financial regulations after Wall Street nearly collapsed during the financial crisis. The law, among other things, transformed the $600 trillion derivatives markets, a lightly regulated industry at the center of the mess.

. . . .

“I have no doubt that these new regulations, instituting new types of clearing, trading and reporting platforms, will foster a landslide of hiring in the financial sector,” Mr. Chilton said.

In particular, Mr. Chilton forecast growing demand for technology experts. “All of this new trading activity, with new regulatory oversight requirements, will mean the development of new technologies, both in the private and public sectors,” he said.

The mind boggles.  Chilton, like all too many regulators and legislators, confuses costs and benefits.  This is the broken window fallacy on crack.  Said regulators and legislators should be required to have Bastiat’s discussion of the seen and the unseen flashed before their eyes repeatedly, Clockwork Orange-like, until the idea sinks in.  Short of that, I am at a loss at how to educate them on this profound–yet simple–concept.

Yes, we can see all the accountants and lawyers beavering away on Sarbanes-Oxley-related work.  But what about all the other–and actually productive–things those people could be doing if Congress in its infinite wisdom and overweening arrogance hadn’t seen fit to create an artificial demand for their services, that distracted them from doing something that is actually socially productive?  What about the companies that are smaller, and the companies that don’t exist, because of the burdens of this and other counterproductive regulation?

Frank-n-Dodd is Sarbanes-Oxley raised to a power far greater than one.  Yes, there will be lawyers and compliance people working in their tens of thousands to ensure adherence to its mind-numbing dictates.  Yes, the idiotic SEF requirement will result in a splurge in spending on technology, and there will be much rejoicing among programmers and IT people.  To the bean counting regulator or legislator this is good.  To the more perceptive, it is a crime.

Riddle me this, Bart: If this technology were actually valuable, why do you and your ilk have to force its creation?  You, in particular have been critical of the dizzying pace of technological development in the trading space.  So you know this is obviously a technologically dynamic industry where there is intense competition to create new products and services and methods of delivering them, not some tradition-bound backwater.  If the kind of technology Frank-n-Dodd is going to bring into existence were actually delivering value to market participants, you can be damned sure that somebody would have figured that out.  Many somebodies, in fact, who would be competing like hell to bring it to market faster and better than anyone else.

And further: please tell me what actually beneficial inventions will not be created, or will be delayed, because their would-be inventors are instead (rationally) responding to some inane government mandate?  You can’t, and I can’t.  But they exist.  Just because you can’t see them, doesn’t mean they aren’t there

And please: tell me how you distinguish a cost from a benefit.

Sadly, the inability to tell cost from benefit is rife in the 202 area code.  The disease is probably most acute at EPA, which blessed us with this gem of economic analysis:

In fact, the EPA has even suggested that new regulations can have a positive impact on job growth. “In periods of high unemployment, an increase in labor demand due to regulation may have a stimulative effect that results in a net increase in overall employment,” the agency wrote in February.

This is the kind of moronism we are dealing with, people.  And the rot is spreading.  Including to the CFTC, apparently.

When you read or hear this or that macroeconomic theory about why the recovery–such as it is–has been so weak, and why the economy totters on the brink of another recession, put it in its proper perspective.  Yes, macro factors are important.  But so too is the massive regulatory millstone hanging around our collective necks.  People who think costs are benefits are running amok.  And sad to say, they are just getting warmed up.

We need to fight these people.

* The Degüello was a bugle call dating from the Moorish Wars of the Reconquista in Spain. Literally, it means “throat slashing” and was played to signal “no quarter–take no prisoners.” Santa Ana’s army played it before the final charge at the Alamo.

Gillian Tett has apparently discovered (via JP Morgan) that commodity production costs are a fundamental.  Who knew?

This article by George Priest about the incoherence of the USDOJ Antitrust Division’s attack on the ATT-TMobile merger is worth a read.

The key fact that Priest focuses on is the response of Sprint’s stock price to the announcement of the Division’s attempt to block the merger.  If the merger really would reduce competition, Sprint’s stock price should have fallen.  The fact that Sprint’s price in fact rose is strong evidence that the merger would have increased competition in the wireless market.

The key analytical point in the article is this:

Much of the Justice Department’s failing on this issue derives from its failure to understand that network industries must be evaluated differently from more traditional, manufacturing industries. The market share guidelines upon which the Justice Department relies to oppose this acquisition may make sense in the context of manufacturing industries. But they make no sense in the context of networks in which there are great benefits from large networks with large market shares.

This was the mistake the Justice Department made in the Microsoft case almost a decade ago. It wanted to break up Microsoft, supposedly to create greater competition among Web browsers. The courts prevented the effort, and to good effect.

The rise of Google, Facebook and the competition from smartphones that resemble computers have shown that the focus then on browser competition misunderstood the rapidly changing nature of network competition. The Obama administration is making the same mistake with its opposition to AT&T’s acquisition of T-Mobile.

This is exactly right.  And it helps explain the intellectual confusion at DOJ and in the European Commission on all matters relating to financial exchanges and financial markets.  Financial trading is a network industry, and the same failure to understand the implications of network economics for market structure that has muddled antitrust enforcement in telecomms and software is leading to a similar muddle in antitrust analysis of financial markets.

Back in June, at a nice lunch with several LCH.Clearnet executives in The City, I was asked my opinion on the company’s future.  Recent news, notably the offers for the company by Markit and LSE, have brought that conversation to mind.

My answer was that I thought that the trend towards vertical integration by exchanges was inexorable, and that there were good economic reasons for this (which I have discussed for years here on SWP).  As a result, I didn’t/don’t consider the model of an independent firm clearing for multiple execution venues/exchanges to be viable.  Especially with Frank-n-Dodd and Emir, but likely even without that impetus, there definitely will be increasing opportunities for clearing OTC derivatives.  (Although I cautioned that if the ambitions of regulators and legislators to make OTC trading exchange-like were successful, the same kind of dynamic now playing out in listed derivatives could occur in swaps.)  So SwapClear is clearly a viable business (similarly, RepoClear).  But major dealer firms would demand considerable influence over, and perhaps control over, the clearing entity.  Any such entity would either be, or closely resemble, a member cooperative.

My prediction was that (a) the exchange clearing business of LCH.Clearnet would either go away, or be absorbed into an exchange or exchanges, and (b) the swap clearing business would be largely in the orbit of the big dealer banks, although how that would be achieved organizationally remains to be seen.

The LSE offer is clearly intended to obtain the in-house clearing capability that LSE has lacked for decades (in part due to its own missteps in the 1970s and 1980s).  But LSE has no comparative advantage in operating the OTC clearing business, and the dealer banks have no interest in having LSE control it.

In contrast, the OTC derivatives business is a much closer fit with Markit, given the overlap between the membership of OTCDerivNet (which governs SwapClear) and the ownership of Markit, and the synergy between Markit’s OTC valuation, processing, and data business and OTC clearing.  But Markit really has no need for LCH.Clearnet’s listed clearing business.

So the sensible outcome would be to split the baby, with LSE taking over its own clearing by acquiring part of LCH.Clearnet, and Markit taking the OTC-related business.  That end state seems much more sensible than either LSE or Markit swallowing all of the big London-Paris clearer.  How that end state is reached–how the baby actually gets split–will be quite interesting to watch.  I am sure there will be much drama in the coming months.

There are news reports providing some glimpses into draft regulations regarding the regulation of derivatives and securities markets in Europe.  It looks like it is taking some of the worst of Frank-n-Dodd, and adding some dumb flourishes of its own.

Insofar as the worst of Frank-n-Dodd is concerned, despite initial indications to the contrary, it looks like the proposal is going to incorporate something like a SEF requirement.  You might recall that on The Monster’s first birthday, I named the SEF requirement as its worst feature.  Well, the Euros (don’t they have bigger problems right now? Just asking.) don’t look to be avoiding the US’s mistake:

Widely traded derivatives would have to be transacted on an electronic platform to improve transparency and safety, draft European Union rules showed on Monday.

The bloc is overhauling its markets in financial instruments directive (MiFID) to catch up with technological advances, apply lessons from the financial crisis and deal with problems such as price fragmentation raised by the original rules.

“The main aim of the proposal is to ensure that all organised trading is conducted on regulated venues and is fully transparent,” the draft, seen by Reuters, said.

More specifically, world leaders agreed in 2009 that derivatives, largely traded bilaterally between banks in an opaque $600 trillion sector, should be traded electronically.

This will give supervisors the full picture of who is affected when a counterparty gets into trouble, which they lacked when Lehman Brothers bank collapsed three years ago.

“The proposed revision will shift trading of the suitably developed derivatives to such platforms,” a draft of the MiFID reform, now circulating widely in Brussels, said.

“This obligation will be imposed on both financial and non financial counterparties,” the draft added.

Another unfortunate imitation is the adoption of restrictions on commodity speculation, including position limits:

The European Securities and Markets Authority should have the power to impose position limits on traders in crisis situations when “the stability of the whole or part of the financial system” is threatened or “delivery arrangements for physical commodities” could break down, the document says.

The Euro flourishes are clearing-related, although here I have to say that the reporting is not too clear.  As I’ve written in the past, European regulators are obsessed with the vertical integration of execution and clearing–the silo issue.  Various reports (including the two linked above) and this one suggest that the regulators will force CCPs to be open access.  The reporting also states that integrated exchanges will have to share data streams, including calculations of indexes that are the basis for traded products.

Insofar as open access is concerned, the FT article quotes language stating that CCPs will be required to accept trades for clearing “on a non-discriminatory and transparent basis, regardless of the trading venue on which the transaction is executed.”

The idea here is to facilitate competition between CCPs, apparently.  But it is fraught with difficulties.

For one, there is the question of why a dominant CCP, including one that is integrated with an execution venue, would turn away business.  Even if it is a monopoly, it could sell clearing services at the monopoly price.  If, as the anti-silo crowd commonly argues, the execution of transactions is potentially highly competitive, absent some cost, the monopoly CCP would maximize profits by selling its services at the monopoly price.  It wouldn’t be necessary to mandate open access.  The CCP would gladly offer access–for a price.

It is therefore necessary to understand why an integrated CCP wouldn’t sell clearing services to others on an open access basis.

One possible reason is that the dominant CCP believes that open access rules will eventually result in the regulation of the prices it can charge for its services.

I think a more important reason relates to a fundamental misunderstanding  among the Europeans of the way competition is likely to work.  There are two possibilities.

One possibility is that there remains a single clearer–given the cost conditions in clearing, that’s not unlikely, although it seems that the Europeans think that they are constructing rules that will reduce the likelihood of this outcome.  Note that particularly now, financial trading is highly technological.  There will thus be the necessity of coordinating technologies and changes in systems between the execution venues and the clearer.  This can be very difficult to achieve across firm boundaries; this is one of the factors that I identified as justifying integration well over 5 years ago.  It should also be noted that this is precisely the reason given for many recent exchange decisions to integrate into clearing; the LSE is the most recent and prominent example of this.

The other possibility is that there are multiple CCPs offering to clear a particular instrument.  There are myriad challenges to this, but I’ll focus on just one.  In particular, assume a transaction in a particular instrument is cleared at CCP A and CCP B.  A trade is executed on venue X.  If the parties to the trade can choose independently where to clear, the buyer may submit the trade to A and the seller to B.  In this case, A and B must be interoperable.  Interoperability is extremely challenging.  It is likely to increase collateral costs (as A and B are going to require collateral from each other).  Moreover, A and B may find it difficult to negotiate an interoperability arrangement because of (a) competitive pressures (the model the Europeans seem to have in mind involves a unique balance of competition and cooperation), and (b) distrust of each other’s risk management, arising from the difficulties of monitoring.  Moreover, the technology/system coordination issues are now multiplied, as X has to coordinate with both A and B.  And if there are multiple execution venues (Y and Z, say) as the Euros presumably hope and expect, these difficulties are multiplied accordingly.

Having an exclusive arrangement with an execution venue avoids this problem.  Those trading on X could be required to clear on A, for instance.  But that just raises the same kinds of problems as if there is only a single clearer.

In brief, it is hard to see how robust competition between CCPs is possible.  Once that is admitted, the whole basis of the regulation collapses.

The whole evolution of the exchange space–most notably in Europe–in the past 5 years is exactly contrary to the thrust of the proposed regulation.  And maybe that’s the point: the Euroregulators are clearly bugged by this trend.  But maybe they should try to understand it first; it’s pretty evident that they don’t now.

Case in point: LCH.Clearnet’s difficulties–its loss of exchange clearing business (EuronextLIFFE, ICE, and almost certainly LSE)–suggests that integration is not primarily driven by anticompetitive impulses.  Instead, in my view it reflects the difficulties of coordinating complementary activities across firm boundaries in a highly technologically dynamic industry.*  At the very least, the Euros should consider that possibility, and take it seriously, before attempting to micromanage the structure of a dynamic industry with strong network characteristics.

Instead, it seems that the regulations are based on an intellectual framework that would be suspect in any industry (as I’ve written about before), and which does not seem to take into account that unique characteristics of financial trading: network effects, scale  and scope economies, technological dynamism, and information asymmetries with respect to performance risk.

So, if the European endeavor is truly the son of Frank-n-Dodd, it may well be the ugly bastard child.  It has the defects of F-n-D, and adds some more–as if more were needed.

Perhaps this is Brussels’ negotiating position.  There is considerable opposition (particularly in Germany–go figure) to some of these initiatives, and maybe the EU is proposing a more radical change in the knowledge that it will have to be watered down.   One can only hope that it drowns.

* I spoke at an FIA panel that touched on this issue in March, 2007.  I made the coordination point.  Charlie Carey, then head of the CBT (which had already agreed to sell out to the CME–this was the day before ICE made its surprise offer) was sitting next to me.  After I made this point, he handed me a note that said that was an extremely important, but insufficiently appreciated, fact.