Streetwise Professor

Izabella Kaminska writes very interesting posts at FTAlphaville.  She finds unusual things in the markets, including the commodity markets, and writes about them intelligently and provocatively.  I have to take issue, however, with one of her more recent efforts.

She takes as her inspiration an article by the improbably named (to an American ear, anyways) Hilda Ochoa-Billembourg.  Izabella’s takeaway from HOB (you didn’t think I was going to type that again, did you?) is that the Achilles heel of QE2–which, remember, was specifically designed to produce some inflation–was that it did not produce the right kind of inflation (something which Bernanke adamantly, and not too plausibly, denies):

If you work with the premise that QE2 led to what has been described as ‘bad inflation’ — inflation being exported into commodity and emerging market securities rather than domestic ones — you could argue the Fed has always had an interest in sterilising that inflation effect.

What to do then?  Have the Fed intervene in the commodities markets by selling longer-dated futures, of course!  Kaminska suggests that the Fed–or some Government Body To Be Named Later–did this, although her argument here is highly circumstantial and, uhm, speculative.  Now that deflation fears are reviving given the European tumult and the palpably slowing US economy, she suggests that it could be just the right time for the Fed or GBTBNL to buy commodity futures.

Or not.  I have problems with the argument from start to finish.  It is predicated on the view that speculators are driving the curve (although Kaminska admits that it doesn’t affect spot prices)–a highly dubious proposition.  It presumes a sort of disconnect between the Treasury market and the energy (and other commodity) futures markets (“One might even say that the market has shifted from expressing inflationary views via the Treasury market to the oil market.”  If so, there’s money to be made!) Although she recognizes–blessedly–that speculators affect the risk premium embedded in futures prices, she confounds a risk premium with an inflation expectation effect (which should be impounded in the interest rate terms structure in any event).  Most notably, she makes the all-too-common mistake of confusing Keynesian contango/backwardation–which is a difference between a spot price and an unobserved expected future spot price–and contango/backwardation of the observed curve, which is the difference between traded prices.  (An expected spot price is not traded.)    The risk premium can change without having any impact on the shape of the futures curve; the effect of the risk premium–and hence hedging/speculative balance–on the futures curve is indirect, operating through the effect of the risk premium on inventory decisions: roughly speaking, more Keynesian backwardation (hedgers pay speculators a greater risk premium) leads to less inventory which tends to reduce the contango/increase the backwardation in the curve.  But detecting this effect is hard even in a simulated market, let alone in a real one.  Her story also depends on an implausible relation between speculation and the Brent-WTI spread.

But put all that aside.  Assume it’s all correct.  Do we really want the Fed, or any other GBTBNL, monkeying around with still more relative prices?  Really?

Several times I’ve recounted the story of the great economist Sherwin Rosen, who in 1982 startled an 830 AM section of his Econ301 class at Chicago by shouting: “And that’s the problem with inflation.  It FUCKS UP RELATIVE PRICES.”  Well, of late the Fed apparently thinks that effing up relative prices is its job.  Heretofore, its efforts (unless Izabella is right that the Fed has been active in commodity markets as well) have focused on the yield curve and inflation expectations: twisting this rate relative to that–or is it torquing?

How is that working out for us?  Trivial growth in the H1 2011.  And how about that last jobs report!  Or should I say, that no jobs report?

We really don’t need it attempting to affect–to f*ck up–the relative prices of commodities or anything else.  Indeed, the now common diagnosis of the failure of QE2 (which you might have read here first, well before its end) is that the Fed’s intervention screwed up relative prices: forcing down the dollar, which induced other countries to intervene to prevent undue appreciation of their currencies, thereby sparking inflation in emerging markets, which has led to yet further policy responses; forcing up commodity prices, which put a drag on developed economies.  So we should now believe that there will not be any unintended consequences on other relative prices from an attempt to intervene into the commodity markets?  Really?

The probability that the Fed could somehow tweak relative prices just right this time based on a theory that would do Professor Irwin Corey proud, and which could use a good trip to the barber for a shave with Occam’s razor, is vanishingly small.  The probability that it would wreak yet additional havoc through such an intervention approaches one.

The problems are almost beyond numbering.  There is the knowledge problem: how could the Fed possibly know what the “right” relative prices are?  There is the implementation problem: how could the Fed actually achieve the relative prices it wants to, if by some miracle it could divine what they should be?  There is the strategic/expectations problem: how could the Fed succeed given that it would not be acting on automotons, but on live, thinking, reactive, strategic actors who respond to the Fed in ways that are hard to predict?

No, as Sherwin might say if he were still alive: the Fed has f*cked up relative prices enough, thank you.

So Ben, et al: Stop before you do even more damage, and inject more uncertainty into an economy that is already reeling from it.  We need no more Sorcerer’s Apprentice interventions.  Don’t just do something, stand there.  Become what you were intended to be–a lender of last resort to address liquidity problems and banking crises–and stop trying to be some grandiose central planner that manipulates price signals to achieve some “aggregate” outcome.  It hasn’t worked up to now, and it won’t work any better if you double down.  Do more by doing less.  Go away and leave us alone.

In brief, we may need to revise Reagan’s statement of the ten scariest words in the English language: now, it should be “I’m from the Fed, and I’m here to help you.”  With help like this . . .

One of the leading crude oil futures contracts–CME Group’s WTI–has been the subject of a drumbeat of criticism for months due to the divergence of WTI prices in Cushing from prices at the Gulf, and from the price of the other main oil benchmark–Brent.  But whereas WTI’s problem is one of logistics that is in the process of being addressed, Brent’s issues are more fundamental ones related to adequate supply, and less amenable to correction.

Indeed, WTI’s “problem” is actually the kind an exchange would like to have.  The divergence between WTI prices in the Midcontinent and waterborne crude prices reflects a surge of production in Canada and North Dakota.  Pipelines are currently lacking to ship this crude to the Gulf of Mexico, and Midcon refineries are running close to full capacity, meaning that the additional supply is backing up in Cushing and depressing prices.

But the yawning gap between the Cushing price at prices at the Gulf is sending a signal that more transportation capacity is needed, and the market is responding with alacrity.  If only the regulators were similarly speedy.

Three companies are at various stages of planning new capacity to ship oil from the Midcontinent to the Gulf.  A fourth is looking to redirect flows from Cushing to Houston.  The addition to capacity would total 1.4 mm bbl/day if all were completed.  Since that’s more capacity than is needed, not all the projects will go to completion.  But regardless, over the medium term it is likely that new pipelines will break the bottleneck and crush the differentials between WTI and LLS, MARS, and Brent.

The main obstacles that the WTI contracts face are enviros and Coasean challenges.  Environmentalists have been trying to put every regulatory roadblock possible in the way of one of the pipeline projects–TransCanada’s Keystone XL. This would bring oil produced from oilsands from Alberta through Oklahoma and on to Texas.  The project cleared one roadblock last week, when the State Department (which has to approve due to the international nature of the pipeline) released an eight volume (!) study finding that the pipeline poses no significant environmental impacts.  The pipeline’s opponents are vowing to redouble their efforts, and the issue is now wrapped up in presidential election year politics.

The Coasean challenge is that reversal of the Seaway pipeline currently flowing from the Gulf to the Midcontinent would cost one of the owners–ConocoPhillips–money by raising input costs for its Midcontinent refineries.  Even though there are more than enough gains on the table to compensate CP for any losses arising from a rise in the price of Midcon crude, so far no one has been able to craft a deal whereby the winners (primarily Canadian and US producers) can make it worth CP’s while to agree to the reversal.

But these problems are all surmountable.  WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

Brent’s problems are more fundamental, because they arise from declining supply.  Even as paper volumes continue to rise, physical volumes available for delivery are falling inexorably.  The Brent complex had faced this problem before, and confronted it by adding Forties, Oseberg, and Ekofisk to the eligible stream.  But BFOE production has declined from 1.6 mm bbl/d in 2006 to barely more than half that today.  And the decline continues apace.  This makes the contract vulnerable to squeezes of a kind that were chronic in the 1990s and early 2000s, and which spurred Platts to add the three other grades to the benchmark.

There are, moreover, few additional North Sea oil stream that can be added to the benchmark this time.  So over the medium term Platts is considering adding other low sulphur crudes produced outside the North Sea to the contract.

The Brent problem is analogous to that faced by the Chicago Board of Trade grain and soybean contracts in the early-1990s.  Volumes of corn, wheat, and soybeans shipped into Chicago and Toledo–the delivery points–were falling, though not due to declining production, but due to changing trade patterns.  Deliverable supplies in Chicago and Toledo were not reliably sufficient to ensure the pricing integrity of the contract.  The Ferruzzi soybean squeeze in July, 1989 brought matters to a head and forced a reluctant CBT to act.

The CBT’s initial response was to tinker with the contract, adding St. Louis as a delivery point at a modest premium to Chicago.  Within a few short years, however, all delivery warehouses in Chicago proper had closed, and the exchange had to adopt a substantially different delivery mechanism (which I helped design–more on this below).

One approach available to Platts would be to create what I called an “economic par” contract in a report (subsequently a book–such a deal!) on the CBT contracts that I wrote in the aftermath of the Ferruzzi episode.  In an economic par contract, differentials for delivery of different grades (or at different locations) are set approximately equal to the cash market differentials.  For instance, if Brent was made the par grade, and another type of crude that typically sells for a $2 discount to Brent were made eligible for delivery against the contract, the deliverer would receive $2 less for delivering that grade than delivering Brent.

The advantages of this type of system are (a) it allows a dramatic expansion of deliverable supply, thereby easing technical/squeeze pressures on the contract, and (b) it can improve hedging effectiveness/reduce basis risk.  In essence (as pointed out in the book), options pricing theory implies that with economic par terms the futures price becomes like a weighted average of the prices of the deliverable grades.  This reduces the idiosyncratic component of futures price fluctuations, making the contract a better hedge for a variety of users.  (Cash settlement based on a variety of crude streams would produce a similar outcome.)  In the present instance, an economic par contract would be a poorer hedge for Brent cargoes, but a better hedge for other kinds of oil (e.g., Urals).

Since cash market differentials can vary over time, it is advisable to adjust the contract premia and discounts periodically.  (The failure to do so with Treasury Bond futures in the 1990s caused some problems with the contract that were eventually fixed by the change from an 8 percent par coupon to a 6 percent.)  Such changes can actually make the contract a better hedge by keeping the weights in the average more stable over time, thereby reducing the likelihood that the idiosyncratic risk of a particular deliverable grade exerts disproportionate influence on contract pricing.

Accomplishing such a substantial remake of a contract is, however, a difficult thing.  Contract changes have different effects on different players, and each will try to lobby for changes that suit its interests.  The case of Chicago grains is illustrative.  As the decline in Chicago and Toledo continued apace, and the tinkering that followed the Ferruzzi squeeze proved inadequate, the CBT formed a committee to come up with a new contract design.  The committee had representatives from virtually every affected party.  Since the interests of these parties were so divergent, the process became rancorous and political, and the committee could not come to agreement on the kinds of changes that would have been necessary to fix the problem.  Eventually, in late-1996 the CFTC said enough, and ordered the exchange to change the contract stat.

Realizing that the traditional committee method that gave everybody a voice would not meet the demands of an impatient CFTC, the exchange created a small task force (0f which I was an outside member) of more independent participants, and which pointedly excluded the big incumbent players (mainly Cargill, Continental, ADM, and The Andersons).  This Grain Delivery Task Force came up with a radical new design (based on delivery via shipping receipts into barges on the Illinois River) in less than 6 months.  The new design was approved by the membership and the CFTC over the following months.

Suffice it to say that the kind of consultative process that Platts envisions in revising the Brent contract will almost certainly bog down in the kind of rent seeking self-interested behavior that stymied fundamental changes in the CBT grain contracts.  (In one of the early go ’rounds on this, in 199o–which spawned my report/book–one of the members of the committee set up to revise the contract was so outraged by my recommendations for bigger changes that we almost came to blows.  The representatives from ADM and Cargill took him outside to cool down.  I had similar experience, though more civil, during discussions of revising the canola contract in Winnipeg a few years later.  Considering that the Brent market is so much bigger and the dollars at play in 2011 are so much bigger than two decades ago, the potential for pyrotechnics is all the greater now. )

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

So Brent boosters, enjoy your laugh while it lasts.  It won’t last long, and remember, he who laughs last laughs best.

I was incorrect to blame the leak of confidential CFTC trade information on the agency itself.  I jumped to a conclusion, and that was wrong.

The malfeasor has been revealed.  It is US Senator Bernie Sanders (Socialist–really–VT):

Oil trading data that exposed the extensive positions speculators held in the run-up to record high prices in 2008 were intentionally leaked by a U.S. senator, sparking broader concern about industry confidentiality as Congress moves on Wall Street reform.

Senator Bernie Sanders, a staunch critic of oil speculators, leaked the information to a major newspaper in a move that has unsettled both regulators and Wall Street alike.

In a June 16 e-mail reviewed by Reuters, a senior policy adviser to Sanders discusses how his office received private data with the names and positions of traders and forwarded it exclusively to a Wall Street Journal reporter.

The e-mail, which also attaches two files with the data, was sent to Public Citizen’s Tyson Slocum asking him to review it and speak with the newspaper about his observations.

In a statement from Sanders provided to Reuters, Sanders said he felt the data needed to be publicly aired.

“The CFTC has kept this information hidden from the American public for nearly three years,” he said. “This is an outrage. The American people have a right to know exactly who caused gas prices to skyrocket in 2008 and who is causing them to spike today.”

No, Senator, the outrage is that you violated confidentiality to engage in political grandstanding.  Moreover, you provide no evidence to support your assertion that the firms and individuals whose identity you revealed “caused gas prices to skyrocket.”  None.

There you have it, ladies and gentlemen.  The Senator from Vermont, providing additional proof, as if any was needed of Mark Twain’s dictum that “America is a nation without a distinct criminal class…with the possible exception of Congress.”

Today’s WSJ has an article that lists the positions of several market participants in the oil futures market on 30 June, 2008, shortly before prices hit their all-time high  This information was leaked by somebody in the CFTC.  A CFTC spokesman “said the agency couldn’t comment because the list contains confidential information.”

You don’t say.  [I cleaned that up.]  Apparently somebody in CFTC didn’t get the memo.

This is egregious.  Truly egregious.  This is highly confidential information.  Its disclosure was clearly intended to advance some political agenda.

Let me hazard a guess what is driving that agenda: next month the CFTC is likely to move on its energy position limits proposal.  The disclosures about the positions held by financial players will no doubt help shape the battlefield for that fight.

I cannot emphasize enough what an abuse this is.

And it will hinder the CFTC going forward.  The agency often relies on voluntary cooperation by market participants to supply data that helps it understand what is going on in the market, or to help develop policies.  Is there any doubt that companies receiving such requests will now think twice about cooperating?

And don’t you feel so much better that under Frank-n-Dodd that the CFTC will have access to far more data from far more markets?

I just shake my head.   And speaking of heads, somebody’s should roll over this.  Maybe several somebody’s heads.

I was quoted in this WSJ/Dow Jones article about why sovereign CDS are not being cleared.  I think that legal risk has something to do with it.  But upon further consideration, I think the problem with sovereign CDS is far deeper than that.

The problem is not exclusively with clearing vs. bank intermediated-bilateral.  The problem is with wrong way risk which makes it very dangerous to have a bank as the counterparty selling protection in a sovereign CDS.  Clearing sovereign CDS through a bank-dominated CCP means that banks are the ultimate counterparty, and if the protection seller defaults there is a possibility that banks will be on the hook to pay out on the defaulted contracts precisely when they are in financial distress.

The recent crisis in Europe demonstrates that with current monetary arrangements, the default of any sovereign name of any size can trigger a financial crisis that threatens banks.  Note that bank CDS spreads tend to blow out whenever one of the PIIGS looks shaky. I don’t have the data at hand, but I would wager there is a very high correlation between Greek, or Portugese, or Spanish, or Italian CDS spreads and bank CDS spreads.  Which means that there is a substantially elevated risk that a bank or bank-backstopped counterparty (i.e., a CCP) won’t be there if a sovereign defaults.

There are structural reasons for correlation.  Banks tend to hold large amounts of sov debt in their portfolios.  A surge in sovereign default risk tends to lead to funding problems for banks–especially those with large sovereign exposures.  Thus, sovereign debt crises are associated with substantially elevated risk of bank failure.

This is actually a firmer basis for governments and regulators to be skeptical about–and perhaps even hostile to– sovereign CDS than their usual kill-the-messenger bleats about evil speculators.  Sovereign CDS are potentially beset with wrong way risk, and they pose a real systemic threat to banks if the banks sell protection: in contrast, banks buying protection makes good sense as a hedge if the counterparty is likely to be able to perform in a sovereign debt crisis.  The risk is right-way when banks are protection buyers.

The issue with clearing sovereign CDS is that clearing makes banks contingent protection sellers, and the contingency kicks in right when banks are least able to afford it.  But even a bank running a balanced book would still pose problems because if a counterparty from whom it bought protection defaults, it would be obligated to dip into its capital to pay off the parties to whom it had sold protection, and again precisely when it is least able to afford it.

This suggests that there are acute systematic risks inherent in sovereign CDS under both bilateral and cleared approaches.  Since we have seen that the potential default of any European sovereign name, even those of middling size, can precipitate financial panic, sovereign CDS are arguably the most problematic derivatives out there from a counterparty risk/systemic risk perspective.  They are likely beneficial as long as banks are not major protection sellers under any contingency.  That’s impossible to achieve with clearing, and likely very difficult to achieve in a bilateral market.

What this suggests to me is that (a) it is unwise in the extreme to clear sovereign CDS, and (b) banks should be subject to a hefty capital charge on their gross sales of sovereign protection.  Gross, not net, because the gross drives their contingent exposure.  Low capital charges on a positive net position in protection purchases would be defensible as that risk is right way and net protection purchases gives banks an incentive to lay off sovereign debt risk on those who can bear it at a lower cost than they can.

Looking at the issue of sovereign debt risk more broadly, this analysis again raises serious alarms about the wisdom of mandating or incentivizing banks to hold large sovereign debt positions, where the incentivizing comes in the form of liquidity requirements that must be met by sovereign debt holdings and favorable capital charges, and the mandating comes in the form of margin and clearing requirements.  But the financial repression pressures driven by the pressing need of governments to get somebody to hold their bonds is driving us in that direction.

Which suggests to me that the systemic risk of the future–and the systemic risk from hell–is the prospect for chronic fiscal crises around the world.

And on that cheery note . . . back to work.

Exchanges are in the business of facilitating the discovery of prices.  The whole rationale for exchanges is that discovering more accurate prices encourages the efficient allocation of scarce resources.  That’s the value that they produce for society.

Which is why it peculiar, to say the least, that exchanges consistently don’t use prices to allocate a scarce resource at the heart of their businesses: communications capacity.  The recent volume surge caused by the intense volatility over the past week has taxed this capacity heavily, as this FT article shows.  Four major exchanges faced technical problems due to an avalanche of message traffic, most notably Borsa Milano.

To the extent that exchanges react to message traffic surges, they do so through non-price allocation methods, such as “throttling.”

As I have been discussing since the very first SWP post, exchange bandwidth is a scarce resource.  There can be intense spikes in bandwidth usage.  Some market participants exploit the fact that this capacity is not priced to engage in trading strategies that may be parasitical, predatory, and destablizing.  Even non-opportunistic use of exchange bandwidth can cause serious technical problems, including problems so severe that exchanges must shut down.   There is every indication that there are periodic tragedies of the commons on exchanges.

Pricing capacity, including peak-load pricing, is the obvious way to eliminate tragedies of the commons and abusive uses of system capacity.  You’d think that idea would come naturally to those in the business of pricing everything from stocks to bonds to soybeans.  But despite recurrent, and arguably increasingly serious, problems, exchanges uniformly shrink from this solution.

It was a puzzle to me five plus years ago.  It puzzles me still.

Betting the Business has a recent post that is a paean to central clearing.  I have some major problems with it.

The problems start with the title: “Central clearing lowers end-user costs.”  That short, unqualified, declaration begs major questions.  Most importantly: If clearing is more efficient, why did cleared markets lose market share to the putatively less efficient alternative, bilateral uncleared OTC trades?

I’m not suggesting that such inefficient outcomes are possible, but I take it as a rebuttable presumption that competitive processes tend to result in the displacement of the inefficient by the efficient.  So I’d like to see a convincing story at least, backed by some anecdotes at least, that would represent a plausible rebuttal.  That’s a low bar: it would be preferable, of course, to have a rigorous model supported by empirical evidence.  But I’ve yet to see anyone clear even that low bar: indeed, very few have tried.  To be honest, BTB don’t in this piece.

And by “convincing,” I don’t mean stories that rely on bankers’ Svengali-like hold on their customers, or customers suffering from some variant of battered spouse syndrome.  These stories are facially implausible, and indeed, counterfactual during the period during which OTC derivatives markets grew dramatically, the 1980s and 1990s.  This was a period in which banks were suffering “disintermediation”: they were losing business and customers to capital markets that customers found more efficient sources of capital.  So, the Svengali thing wasn’t working so good when it came to traditional loan business.  Ironically, many of the big loan customers that banks lost simultaneously began trading OTC derivatives with them.  Also ironically, one of the major reasons that the CDS market began was that banks were losing their traditional loan business.  JP Morgan in particular made a strategic decision to develop CDS business aggressively because it was facing more intense competition from capital markets in making traditional loans.  Which all means that customers–especially big ones–have the ability to adopt more efficient ways of financing and managing risk.

My other big problem with the BTB piece relates to netting:

Central clearing, if managed appropriately, helps to reduce the volume of credit risk by cancelling out many offsetting positions, disappearing some credit risk and leaving us with a smaller, residual credit risk from derivatives trading. One of the problems with OTC markets is that brokers wanting to closely guard their clients don’t have an incentive to cancel out offsetting exposures to counterparties. Critics of the clearing system keep overlooking the fact that risk can in fact disappear. The derivatives market system, depending upon how it is structured and operated, can have more or less total credit risk.

The notion that multilateral netting necessarily reduces risk is incorrect regardless of whether one focuses on credit risks in derivatives alone, or takes the proper perspective of looking at credit risk in toto.

With respect to credit risk in derivatives taken in isolation, clearing some products and not clearing others–which is inevitable given the unsuitability of some products for clearing, and indeed, the refusal of CCPs to clear them–may exploit some scale economies from multilateral netting in a particular product, but can destroy cross-product scope economies.  For instance, clearing a credit index but not all the names in the index destroys the scope economies that a bank can realize by holding positions with customers in both the index and the components.  Or if an interest rate swap is cleared but an interest rate swaption is not, netting economies across these products are lost.  These are simple examples, but they could be multiplied ad infinitum.

Indeed, these cross-product netting opportunities are one very plausible explanation as to why clearing lost ground to bilateral markets dominated by dealers.  Dealers trading multiple products can exploit cross-product netting economies and thereby offer their customers lower costs.

What’s more, when we consider clearing-as-it-will-be-in-this-messy-world, as opposed to the Platonic ideal of clearing, even within a single product clearing mandates may reduce netting economies.  Jurisdictionalism is likely to result in the creation of multiple CCPs for a given product type.  For instance, it is likely that regulators in the US and Europe insist that CCPs for particular products be established in their jurisdictions, and that financial institutions subject to their jurisdiction will use these “home” CCPs.  That creates operational headaches and reduces the netting benefits of clearing.

A proper, systemic approach also demonstrates that the disappearance of risk, like a magician’s trick, is often an illusion that works because the audience’s eyes are fixed in one place, and therefore they miss where the real action is.  As I pointed out several years ago, taking derivatives positions and the capital structures of market participants as given, netting redistributes risk from derivatives counterparties to other holders of liabilities on these derivatives market participants.  Yes, multilateral netting (and bilateral netting supported by collateral, rights of offset, etc., for OTC deals under bankruptcy laws) reduces the credit risk in derivatives trades, but the risk doesn’t disappear down the magician-CCP’s hat: it is reallocated to those who have lent money to the firms that hold positions in the netted derivatives.  Netting puts derivatives counterparties closer to the front of the line of creditors in bankruptcy.

Now the issue of the proper priority of derivatives is a sticky one, and I don’t claim to have the answer.  Giving derivatives counterparties priority tends to reduce their incentive to run, but it can increase the incentive of other creditors to run.  And in equilibrium, capital structures will depend on priority rules.  So it may be the case that clearing reduces the risk of runs on derivatives dealers by their derivatives counterparties, but increases the risk of runs by their repo counterparties, or the buyers of their corporate paper. It’s unclear how that cuts.  (No pun intended.)

Though I don’t have the answer as to the optimal priority rules, I do realize that netting does affect priority–and that this means that statements about netting “making risk disappear” are not generally true, and are typically wrong, because these statements are based on only a portion of the total risks.  The risk no more disappears due to a change of priorities achieved through netting than the rabbit really disappears into the magician’s hat.

It should be noted, moreover, that this issue of netting and priority has long been understood in other contexts, notably in payment systems.  Work in the 1990s and early 2000s (by Charlie Kahn, among others) emphasizes that netting systems and real time gross settlement have different affect the priority of payment system participants relative to other creditors of those systems.

There are some other problems with the BTB analysis, but I’ll just mention them in passing.  They say:

Margins are paid by those who use the system. In the OTC markets, banks either correctly price risk, or trade with clients by granting these subsidies from the taxpayer, or from wealth transfers by their bond holders. Clearing and margining is a potent dissuader of free riding on the system by negligent brokers, and also helps to mitigate agency conflicts between bonus motivated bankers and the bank’s stakeholders, which, we have learned, includes the taxpayers/citizens of each country.

I can’t say that I fully track that paragraph, but I will say that I am struck by the free riding analysis.  It suggests a sort of transubstantiation, where bankers are agency-conflicted, or perversely incentivized due to too big to fail subsidies when acting individually, but somehow become less conflicted and better incentivized when they act collectively through a CCP (and most CCPs will be bank dominated).  It’s not obvious how that works.  Indeed, collective action problems and multi-task/multi-principal agency problems usually result in weaker, not stronger incentives.

In this regard, it should also be noted that the homogenization of credit risk in a CCP creates problems.  CCPs make all trades by all members fungible, even if those members bring differing amounts of credit risk to the system.  This tends to reallocate trading activity away from the more creditworthy to the less creditworthy.

I also consider this unrealistic:

And to protect the public, it is necessary for regulators to see and be able to manage the true volume of credit supporting derivatives trading. Clearing is part of making that possible.

Given the fungibility of credit, you will never unambiguously know how much credit is used to support derivatives trades, even in a cleared system.

I have other issues (I can just imagine you exclaiming: “I’ll say!”), but I’ll leave it at that.  Suffice it to say that there are major holes in this clearing paean, and that it certainly does not provide a firm basis for mandating the adoption of central clearing.

Zero Hedge provides a reminder of the approaching automatic triggering of an increased haircut on Spanish and Italian government bonds in RepoClear.  Earlier this year LCH indicated that it would increase margins on Irish bonds when the spread hit 450 bp, and Italian and Spanish debt is reaching that level.

This is the kind of action that is individually rational for a clearer to take, but which can be destabilizing, pace my earlier posts on the hike in silver margins earlier in the year.

The haircut spiral plays a central role in a recent paper by BOE Financial Stability Executive Director Andrew Haldane and two co-authors.  The paper is nicely done, and the use of numerical methods to study the highly non-linear dynamics of complicated financial networks is the right way to go.

I am not persuaded that the paper focuses on the real sources of financial crises, however.  The reason is directly related to my post earlier in the week on clearing and systematic risk.  Haldane et al study how an idiosyncratic shock to the bank-specific haircut of a particular bank can propagate through a complex, densely connected network.  In some cases, such a shock can lead to a systemic crisis resulting from a cascade of banks deciding to hoard liquidity.  Not surprisingly, they find that the likelihood and intensity of such a contagion depends on the connectedness of the network, the skewness of the sizes of firms in the network, and the size and connectedness of the bank hit by the shock.

But I remained unconvinced as an empirical matter that major financial crises, at least in recent years, have developed in this fashion.  For this story to work, a single bank–and in the Haldane et al results, that bank would likely have to be a very big, highly connected one–is hit by an idiosyncratic shock that results in it having to pay higher haircuts on its secured lending.  In the real world, this could happen as the result of a rogue trader risk or some other major operational failing.

Perhaps the canonical example of such an episode would be the Kervial debacle at SocGen.  But even though that occurred when the markets were already stressed (in January, 2008), it didn’t lead to contagion.  I would be interested to hear of other examples, but I can’t think of any that have led to the cascade of failures like that that plays the central role in the Haldane et al analysis.

Instead, the major financial crises, most notably that of 2007-2008, the one that may be impending,  1998, etc., have been marked by an adverse shock hitting virtually all major financial institutions due to the similarity of their balance sheets.  European banks today are on the brink because they are all–all–heavily exposed to Eurozone government debt, and in particular to PIIGS debt.  This is a system-wide shock–a systematic shock, not a diversifiable, idiosyncratic one that is magnified through the web of interconnections among banks.  Such interconnections, margin spirals, liquidity hoarding, and so is a real possibility and could exacerbate the effects of the shock, but the point is that what is going on now, and what went on in 2007-2008, and what went on in 1998 is very different than the mechanism studied in the Haldane et al paper.

Perhaps many of the recommendations that Haldane and his coauthors make based on their analysis of the propagation of an idiosyncratic shock carry over to the case of a common shock hitting virtually all banks.  For instance, bigger liquidity cushions might be stabilizing in this situation as they are in the Haldane et al setup.

But maybe not.  Especially when one considers that for a variety of reasons–financial repression among them–sovereign debt is, and likely will remain a major component of any liquidity buffer.

That doesn’t work so well when the collapse of the creditworthiness of the governments issuing the debt is the root of the crisis, as is the case today.

I recommend the Haldane paper, but I think that it,  and many other papers that are based on tracing out the implications of idiosyncratic shocks to individual banks in a dense network, aim well wide of the mark.  I would like to see empirical work–hell, a case study, or even an anecdote–showing this mechanism working in practice.  If it is instead the case, as I am highly confident that it is, that financial crises are typically the result of an economy-wide, non-idiosyncratic, shock, the mechanism will be different and the policy implications will almost certainly be different.

A conjecture: in such a world, the greatest crisis accelerant is the similarity of balance sheets across major financial institutions.  To some degree, this cannot be avoided.  But there is no doubt in my mind that uniform regulations–and the Basel standards and other coordinated risk-based capital requirements–encourage even greater similarities in balance sheets.  This is a real danger, and if my conjecture is correct, many of the efforts currently underway to harmonize capital and liquidity requirements could make crises more rather than less likely . Basel Faulty and all that

The self-interested role of governments in cramming down more of their burgeoning debt will only exacerbate this problem, as regulators have an incentive to tilt capital and liquidity requirements in favor of holding government debt.  As dodgy as that debt is these days, it’s hard to imagine a better way to create the next crisis.

Central counterparties work on the principle of mutualization.  CCP default funds are a mechanism for mutualizing–sharing–counterparty loss risk, where the CCP-insurer has some protection in the form of a “deductible” that consists of the defaulter’s margin plus default fund contribution.

Insurance works when risks are diversifiable.  So, to the extent that the risks of default exhibit relatively little correlation across clearing members (CMs), mutualization through a CCP can improve the allocation of risk: through diversification, the variability of the average default loss across all CCP members is smaller than the variability of any CM’s default loss profile.

It should be noted that these diversification effects work in OTC markets too: market participants who deal with multiple counterparties diversify exposure to counterparty losses.  Moreover, in OTC markets, it is often possible to hedge counterparty risk through the CDS market.  [Which raises a question: how do you hedge CCP credit risk?  It is highly unlikely that CDS will be traded on CCPs.  Perhaps using a portfolio of CDS on CMs?  But who clears those CDS?  Sounds like the wrong way risk from hell.]

CCPs have been sold as a means of reducing systemic risk.  The basic story is that in bilateral OTC markets, the failure of one entity can cause the failure of other entities in falling-domino-like fashion.  In this telling, a CCP reduces interconnectivity of the financial market, and thereby reduces the likelihood of that the failure of one firm–even a big one–will cause the failure of others.  Put differently,  in this view default/counterparty risk is insurable because it is diversifiable, and therefore mutualization can improve the allocation of risk.

But is the domino-model really a good description of systemic risk?  Is the system really threatened by the isolated, idiosyncratic failure of one firm, even a big one?

Here’s an alternative story, in which a big, system-wide shock hitting many institutions simultaneously is the source of systemic crisis.  Some examples: Black Monday in 1987, the Asian and Russian crises in 1998, and the subprime meltdown of 2007-2008.

In such episodes, there are large price moves across asset classes.  These price moves often blow through margins–and by a lot.  During the subprime crisis, for instance, even well-before the Lehman episode, some prices moved by huge amounts.  In August, 2007–more than a year before Fannie-Freddie, Lehman, and AIG–David Viniar of Goldman lamented that there had been several 25 standard deviation moves in multiple markets.  In a “normal” (Gaussian) world, 25 sd moves don’t occur.  Period.  People don’t set margins based on the possibility of 25 sigma moves.  So when such moves occur–and they occur in the real, non-normal world–margins get blown through.  Meaning that if someone defaults, they’re well into the default fund, and the protection of the “deductible” is gone.

Moreover, such earth-shaking episodes are typically associated with adverse shocks to bank (CM) balance sheets.  What’s more, such events raise serious doubts about the solvency of banks/CMs: adverse selection problems can run rampant, causing markets to freeze.  This tends to cause funding and liquidity to dry up.  Due to actual insolvency, and illiquidity driven by widespread fears of potential insolvency, those facing big margin calls may face substantial difficulty in meeting them.   Thus, they are more likely to default.  This is what happened to AIG and Lehman.

Since the shock hits all financial institutions simultaneously, and since the shock is big, this risk of default is not idiosyncratic; it is highly correlated across firms.  Given such a shock, if one firm defaults, others are at elevated risk of default too.

If defaults that breach margins occur, the surviving CMs who contribute to the default fund must absorb the loss, and take a hit to their capitals.  But this hit occurs exactly when capital is very valuable/costly for them.  That is, hits to the default fund are likely to come at the absolute worst times–during adverse moves in the overall market.

It is possible that a CCP’s default exposure in such a circumstance could crater the clearinghouse.  But even if the CCP survives, its surviving members suffer a loss (via to their exposure to the default fund) when they can afford it least.

This has some interesting implications.  In particular, it means that the systematic risk of default fund capital is very high, which in turn means that default fund capital is extremely expensive.  The default fund is like a deep out of the money short put on the market.  Such puts are essentially bets on systematic risk, and hence are very expensive.

The expense of such capital means that CMs are likely to want to minimize the amount they post.  They have every incentive to try to construct risk measures that make CCPs look safe, with very low risk of default, in order to reduce their exposure to the default fund.

Think that this can’t be done?  Think again: that was essentially the entire game in CDOs.  As Coval-Jurek-Stafford show in an AER paper, “super senior” CDOs were claims that had low probabilities of default, but that defaults would occur precisely during periods of crisis–analogous to the foregoing characterization of the risk profile of default funds.  C-J-S present empirical evidence that these CDOs–which were AAA rated–were grossly underpriced, meaning that those who were buying these securities didn’t fully appreciate how heavily they loaded on systematic risk because analysis–and ratings–were framed almost exclusively in terms of unconditional default probabilities, and the rating agencies and many investors and regulators ignored the fact that defaults would occur when the value of capital was very high.  I can see the same thing happening with CCPs–who will reflect the interests of their members–focusing on default probabilities to justify their capitalization to regulators.

Another interesting implication is for what instruments should be cleared.  Instruments that have big losses during big systematic shocks–those that load heavily on systematic risk–are exceptionally dangerous for CCPs.  This means that clearing things like senior or supersenior tranches (or derivatives on them) is exceptionally dangerous.

This has a corollary: anybody that uses AIG to justify clearing mandates doesn’t know what the hell they’re talking about.  AIG’s positions in derivatives on supersenior tranches were, as C-J-S show, systematic risk time bombs.  Clearing those things would dramatically increase the systematic risk of default funds, because they would expose default funds to losses precisely during systemic crises.

Some people know this.  Jon Gregory, for instance.  When discussing “market coverage of a CCP”, he states:

Finally, CDO tranches (especially supersenior) would be expected to have serious correlation [i.e., systematic risk] impact since in a scenario where there are losses on these tranches it is likely that many CCP counterparties [and CMs] are in a distressed state.

The above analysis is to some degree subjective but one general point–probably beyond argument–is that the most important trades products to be traded through CCPs are arguably the most risky from the point of view of the stability of the CCP.  There has been much recent interest to trade all CDS index products and single-name products through CCPs. . . . The general point is that the products that market participants will most want and need to trade through a CCP will be the precise products that are most difficult to handle in this way (pp. 381-382).

In sum, the belief that CCPs can reduce systemic risk is predicated on a particular narrative of  the likely source of a future crisis.  This view is that the failure of a single institution, arising from some shock idiosyncratic to it (a bad trading decision, an operational risk such as a rogue trader) can lead to the failures of other institutions via a contagion mechanism.

But, in my view, that isn’t an accurate characterization of the actual crises that have occurred over the years.  These have been associated with broad-based shocks that hit large numbers of institutions simultaneously.  Again: Black Monday, Asia/Russia, subprime.

There have been multiple examples of large, one-off collapses of highly interconnected and leveraged institutions that have not resulted in a cascade of failures that led to a systemic crisis.  To name several off the top of my head: MG (1992), Barings (1995), Amaranth (2006). For a while, it looked like the Hunt collapse in 1980 could have broader, systemic consequences, but that fear evaporated rather quickly.

The contrast between the effects of the collapse of Amaranth in 2006 and the crisis surrounding the problems of LTCM in 1998 is particularly instructive.  Amaranth was actually bigger than LTCM (though it should be noted that the markets were bigger too), and had large OTC positions.  The difference was that Amaranth’s collapse was not caused by a systematic shock, whereas LTCM’s was.  LTCM engaged in strategies that blew up because of major shocks arising in Asia and Russia.  It was thus on the verge of failure precisely when liquidity had dried up, and its (big bank) counterparties were in bad financial shape because of the crisis.

The Amaranth collapse was effectively a diversifiable risk, and potentially clearing improved the allocation of that risk (many of Amaranth’s positions were cleared).  But the bilateral markets could have likely handled it quite well too.  In contrast, LTCM’s risk was not diversifiable.  Clearing would have still passed the risk of its failure onto stressed financial institutions, and likely resulted in some similar emergency measure to mitigate the impact of its huge losses.  (I’ve long argued that the same would have been the case with AIG.)

Along these lines, FTAlphaville has a very interesting post describing some forthcoming research which shows that incorporating “common jumps” into models of index option prices go a long way towards explaining the volatility skew, and reconciling the skews of index components and the skew of the index:

According to a technical paper published on Risk.net by Alex Langnau, global head of analytics at Allianz Investment Management and Daniel Cangemi, head of FICC trading at EFG Financial Products, Wall Street’s next top (risk) model is actually a copula that attempts to explicitly link correlation skew to systemic risk so as to improve tail risk management of large portfolios.

The basic premise lies in the idea that the downside risk of a portfolio of assets is generally substantially higher than the downside risk of its components — because assets tend to correlate more strongly in times of crisis.

. . . .

As the authors conclude this could become extremely useful for trying to figure out the additional risk attached to asset portfolios:

We have presented a generalisation of the Merton jump option formula to multi-assets as well as diffusive skews and found that common jumps are an appropriate and intuitive way to define copulas that describe the systemic risk of a portfolio.

Financial institutions should start treating systemic risk as market data across asset classes and start to mark, risk-manage and price these effects in a systematic way.

This suggests that these common jumps are of first order importance.  And these common jumps aren’t diversifiable.  What I argue above is that the major risk that CCPs face arises from such system-wide, common shocks.  And in the event, mutualization is all but irrelevant.  Except, perhaps, to the extent that CMs attempt to limit their exposure to this risk via the default fund by undercapitalizing CCPs, thereby threatening the ability of these vital–and soon to be even more vital–pieces of market infrastructure to survive a systematic shock.  In which case, mutualization makes things worse because if some CCPs don’t survive, the knock-on effects from the original shock will be even more catastrophic.

In some respects, the issues I’ve discussed here reflect an older literature on bank runs.  One view of bank runs is that they are idiosyncratic in origin (i.e., a bad shock–perhaps even a sunspot–hits a single bank, leading to a run), but have systemic effects due the interconnectedness of the financial system.  In this view, widespread panics spread like a wildfire from a single, isolated spark.

An alternative view, associated most strongly with the work of Calomiris and Gorton, is that runs occur when depositors receive adverse information about the aggregate economy, which raises concerns about the viability of all banks.  In this view, panics involving runs at many financial institutions reflects the fact that all banks are exposed to a common risk.

The Calomiris-Gorton view, and the evidence they amassed to support it is persuasive.  In more recent times, major periods of crisis have been associated with a common shock hitting many financial institutions, rather than from the contagion of an idiosyncratic shock to one big institution laying low otherwise healthy institutions.  In these types of events, mutualization of risk isn’t of much help, and can actually make things worse.  Meaning that clearing mandates were sold largely on the basis of a misleading portrayal of, or misunderstanding of, the real dynamics of financial crises.

One takeaway from this is that there should be a very hard look at CCP capitalization, and at measuring the cost of default fund capital.  The exposure that default funds face to systematic risk affects the cost of capital–and hence the cost of clearing.  That cost should be taken into consideration when deciding the scope of clearing mandates–that is, when deciding what should be cleared.   For the analysis suggests that clearing can be very expensive, and that a major source of cost has been largely overlooked.  Forcing too much to be cleared can create costs with no corresponding benefit.

John Lothian has an interview with Deutsche Boerse’s Head of Media Relations, Frank Herkenhoff.  Compare:

John Lothian: The vertical integration of your clearing house is continuously criticized by your competitors…

Frank Herkenhoff: Vertical integration between trading and clearing generates significant user benefits. Vertical integration allows maximum innovation in trading and clearing services, by aligning incentives at the trading and clearing level, as well as promoting systemic stability. Vertical integration is efficient as it reduces double marginalization and transaction costs. NYX had already initiated the move to vertical integration, independent of this transaction. The integrated business model has proven to be efficient and secure and has consequently become a role model for the industry over the past years.

And contrast:

The execution, clearing, and settlement of financial transactions are all subject to substantial scale and scope economies which make each of these complementary functions a natural monopoly.  Integration of trade, execution, and settlement in an exchange improves efficiency by economizing on transactions costs.  When scope economies in clearing are more extensive than those in execution, integration is more costly, and efficient organization involves a trade-off of scope economies and transactions costs.  A properly organized clearing cooperative can eliminate double marginalization problems and exploit scope economies, but can result in opportunism and underinvestment.  Moreover, a clearing cooperative may exercise market power.  Vertical integration and tying can foreclose entry, but foreclosure can be efficient because market power rents attract excessive entry.  Integration of trading and post-trade services is the modal form of organization in financial markets, which is consistent with the hypothesis that transactional efficiencies explain organizational arrangements in these markets.

This is the abstract from a paper about vertical integration in clearing that I wrote in 2006, and then updated in 2007: similar material will be in the monograph I’m working on now.

If you have way too much time on your hands, and delve into the paper, you’ll see that I discuss explicitly how the alignment of incentives between execution and clearing facilitates innovation, and improves coordination of responses to systemic shocks.  I go into great detail about double marginalization.  The parallels between Herkenhoff’s last sentence (integration is the role model) and the last sentence of my abstract (integration is the modal form of organization) are also pretty obvious. So Herkenhoff hits basically all the points I made in my paper.

Coincidence?