Streetwise Professor

The CFTC and SEC have released their swap definitions. Among other things, the CFTC rule excludes commodity forward contracts from the swap definition.

The CFTC proposed rule is 300 pages long.  Do you believe that such a massive attempt at definition will not have ambiguities and uncertainties that will require clarification?  Do you believe that market participants will not try to write contracts to take advantage of exclusions and exemptions, and that these attempts will not result in litigation?  Do you believe that a rulemaking that is far broader in its application than pre-CFMA laws and regulations  will not result in the growth of a thicket of decisions, interpretive letters, no action letters, etc., that will be more confusing and more contradictory than that which developed prior to 2000 (before the passage of the CFMA) to clarify the distinction between “futures” that had to be traded on exchanges and commodity forward contracts that didn’t?

If so, have a nice dream.  Reality will be waiting for you when you wake up.

The Commission also voted out a proposal for a hybrid margin segregation mechanism, where customer funds would be segregated operationally (i.e., held in a single account), but would not be at risk to a the default of another customer.

This is a victory for BlackRock and other big money managers who lobbied hard for it.  And yes, they are winners.  But make no mistake, the main effect of this rule is redistributive, meaning that there are losers.  And to the extent that it affects efficiency, the effect is negative because mandatory segregation encourages moral hazard: clearing member customers now have zero incentive to monitor their clearing members.

The distributive effect arises from the fact that removing customers from default risk mutualization means that default losses are just shifted elsewhere, e.g., CCP equity or the CCP’s default fund.  Alternatively, CCPs may choose to up margins to reduce default fund exposure to customer defaults.

The costs of default don’t go away.  They are mainly shifted around.  Low default risk firms (e.g., BlackRock, pension funds) will no longer be at risk and will benefit.  But somebody else will pay.

A much preferable approach would be to establish omnibus segregation as a default standard, but permit clearing members and their clients contract for individually segregated accounts .  This would permit those who value segregation more highly than it costs clearing members to segregate to negotiate mutually beneficial arrangements with clearing firms.  Such contracts would reflect information available only to the contracting parties, but which regulators could not know when setting a one-size-fits-all standard.

This would internalize (i.e., price) many of the costs of segregation which  under the CFTC proposal would be shifted to default fund participants (i.e., other clearing members) and from some customers (the BlackRocks of the world) to others.

For instance, if a large money manager and a clearing member negotiate a segregation arrangement, this would shift risk to the member’s other customers, and to the CCP default fund. The shift in risk to other customers would tend to reduce their demand for the member’s services, leading this firm to internalize some, and perhaps all, of the effects of this risk transfer.

However, the risk transferred to the default fund would not necessarily be priced.  This problem could be addressed by allowing the CCP to set default fund contributions based on segregation, with members with larger sums in segregated accounts being required to make a larger default fund contribution.

I don’t understand the mania for one-size-fits-all rules when private contracting can result in efficient outcomes that take into account individual differences.  Derivatives market participants are by and large quite sophisticated, and capable of trading off the costs and benefits of alternative arrangements, including alternative segregation arrangements.  Permitting individualized negotiation which prices these costs and benefits–which differ among market participants–is the most efficient and effective way of ensuring they optimize that trade off, and do so in ways that reflect differences among them.  Let CCP members who participate in the default fund come up with methods that internalize the potential spillover between segregation and the default fund.

One size fits all rules create a tremendous incentive for affected parties to influence the rulemaking process for their benefit.  BlackRock, Pimco, some big pension funds, etc., seem to have done that in this instance.  They’ve secured a rule that protects them from some risks–by shifting those risks to others, not by reducing them (in fact the overall risk likely has increased due to moral hazard).  The outcome is affected by the costs and benefits of exercising influence, not by the economic costs and benefits of alternative segregation mechanisms.

This is another example–as if we needed more–of a prescriptive regulation dictating an allocation of resources that is perfectly amenable to private contracting.  And one where there are no obvious barriers to private contracting, and where as a result such contracting would lead to an allocation that balances efficiently costs and benefits.

Today’s FT carried an interesting article about a Glencore trade in wheat and corn.  FT is a royal PITA to quote from, so I’ll just recapitulate.  In brief, as the Russian drought was beginning, Glencore received early reports from “Russian farm assets” of rapidly deteriorating growing conditions in Russia.  It bought wheat and corn, and profited handsomely from the trade.  It claims that such proprietary trades are exceptional for the firm.

More controversially, on 3 August, 2010 Yury Oganev, Glencore’s Russian grain division chief, publicly advocated a ban on Russian exports (a position not endorsed by Glencore).  Two days later Russia indeed banned exports.  Glencore claims that its export business wasn’t helped by the ban, but note the dog that isn’t barking:  the company does not make any statements about whether profits from the wheat and corn trade more than offset the loss to the export business.

Several things bear noting here.

First, this is a classic example of how information is generated and used in commodity markets.  Market participants with physical assets collect information on supply and demand fundamentals, and use that information in their trading.  It is trading on private information, and it tends to contribute to price discovery–as well as generate profits for those with the information advantage.  Such private information tends to reduce market liquidity and impose costs on the (relatively) uninformed, but that’s part of the inherent trade-off between price informativeness and liquidity.

Second, this shows why trading firms with physical assets can have advantages.  Ownership of these assets helps produce valuable information on fundamentals.

Third, this is “speculation,” but it illustrates how such speculation can actually improve the allocation of resources.  Glencore had an early warning of an impending shortage.  It traded on that information, thereby causing prices to reflect it.  This provided a signal that other market participants could use  to take actions to mitigate the effects of the drought.  In particular, market participants who base their consumption and storage decisions on market prices would tend to adjust those decisions in response to the price changes.  The magnitude, or value, of those adjustments is impossible to quantify, but are conceivably large.  In particular, delayed reaction to the drought information would likely have resulted in greater consumption prior to the information becoming public, which in turn would have led to a bigger price spike when it became widely known.

Fourth, the actions of Oganev are far less admirable, in particular if he made the public call for an export ban after the trade was put on.  I believe that the Russian government had reasons of its own–not “good” reasons from an economic efficiency perspective, but political reasons–to impose an export ban.  Hence, I think that Oganev’s plea probably didn’t affect the Russian government in any way.  But it is unethical for a firm with a position to advocate wasteful policies that would tend to favor that position, and an export ban would have done just that.  Advocating wealth-destroying policies is hardly laudable either, position or no.

Commodity trading and processing firms are notoriously opaque–precisely because they make money on the information they generate in their operations, and have every incentive to hold that information very tightly.  This story provides a very revealing glimpse at what goes on in those firms.  It is a particularly interesting example of the synergy between the operation of physical assets and trading operations.

Oh, yeah.

The WSJ seized on Ben Bernanke’s “Puddin’head Wilson” speech about the need to be especially vigilant about the risks inherent in huge CCPs, including those engendered or expanded by Frank-n-Dodd mandates (h/t Carl E and Mark B):

One by one, financial regulators who supported the Dodd-Frank law in 2010 are beginning to deny paternity, especially for the bouncing bundle of new derivatives rules. Perhaps they now realize the law created more systemic risk than it eliminated. Witness Federal Reserve Chairman Ben Bernanke speaking in Atlanta recently and warning about the consequences of forcing much of the derivatives market into central clearinghouses.

Mr. Bernanke specifically warned of this “concentration of substantial financial and operational risk in a small number of organizations, a development with potentially important systemic implications.” He went on to say that “strong risk management at these organizations as well as effective prudential oversight is essential.”

It sure is, and the federal regulators who failed to oversee the big banks will now have to oversee both the banks and the new entities housing their derivatives trades. As we’ve noted before, clearinghouses have succeeded in managing risk and enabling efficient markets in many areas of trading over many years. They are especially useful when they develop organically to meet a market need. [Emphasis added.]

Uhm, where have I heard the phrase about CCPs “develop[ing] organically to meet a market need”?  Sounds verrryyy familiar.

Perhaps the WSJ is too aggressive in stating affirmatively that Frank-n-Dood “created more systemic risk than it eliminated.”  But it would not be aggressive at all to state that (a) that is a very real risk, (b) that risk depends in large part on the decisions that regulators make going forward, and (c) that risk received virtually zero attention from legislators and policymakers at Treasury (a very guilty party), the CFTC (similarly guilty), the Fed, or Congress.

The WSJ is on very firm ground in excoriating those who have now found their voices on CCP risks, but who remained conspicuously silent when weighing in on the issue could have slowed down the stampede to clearing:

Add it all up and you have a disturbing number of financial eminences suddenly rushing to get clearinghouse warnings into the public record. Do they know something that the taxpayer doesn’t? It’s hard to tell, because even as the Beltway crowd scrambles to draft clearinghouse warning memos for posterity—and for their posteriors—regulators are also promoting “independent director” rules that will discourage people with knowledge and experience from overseeing these institutions. This is the last thing regulators should be doing if they now understand the risks.

When we started warning against forcing this market into clearinghouses in 2008, the regulators who agreed could have held meetings inside a phone booth, if we still had phone booths. Last May, our story about Senator Chris Dodd’s effort to give clearinghouses access to the Fed’s discount window—and therefore to a taxpayer rescue—attracted scarcely more support. Dodd-Frank was the law of the land by July, with taxpayers officially backing Wall Street derivatives trading for the first time.

Now taxpayers get to watch regulators who did nothing to stop this policy, when their opposition might have made a difference, suddenly offering insightful critiques when it doesn’t.

I share the WSJ’s anger and dismay at the Johnny-come-latelies who now sound alarms.  NOW they tell us.  I wonder if it’s not just CYA, as the Journal would have it, but also another way to assert power and authority, and to expand bureaucratic turf.

The Economics of Contempt is, er, contemptuous of the WSJ stand:

The WSJ says that it’s “not aware of any governments that have ever asked clearinghouses to manage risks as complicated as those mandated by Dodd-Frank.”

That’s funny, because we still don’t know what financial instruments will be subject to Dodd-Frank’s clearing requirement yet! So how does the WSJ know how complicated the risks that clearinghouses will be asked to manage are? They don’t. The CFTC and the SEC don’t even know yet. The WSJ is just making things up.

This is like the people who make the fairly simple and widely-understood point that clearinghouses don’t work well for illiquid or bespoke instruments, and then claim that because of this, Dodd-Frank’s clearing requirement was a bad idea. They apparently don’t have the patience to wait to see which instruments the CFTC and the SEC decide have to be cleared — they want to demagogue the clearing requirement, and they want to demagogue it now, dammit!

FWIW, EOC is a pretty strong Dodd-Frank booster.

IMO, EOC is far too contemptuous of the Journal piece.  Yes, many of the implementation details of Frank-n-Dodd remain to be determined, notable among them just what products will be cleared, and more importantly the process by which that decision will be made.  Yet it is abundantly clear that the intent of the authors of Frank-n-Dodd, the Treasury, and Gensler in particular at the CFTC is to push as many derivatives as possible onto CCPs.  This can be done directly through mandating that particular products be cleared, or indirectly, by imposing punitive margin and capital requirements on non-cleared trades.  We don’t know exactly what they will do, but we know what they want to do–they’ve told us over and over again.  The WSJ editorial is quite fair in speaking to the risks that CCPs could pose if these people get their way.

But even if EOC is right, then we have two alternatives: either clearing mandates and much of Frank-n-Dodd was sound and fury, signifying nothing, or it runs the kinds of risks that the WSJ and, uhm, others identify.  And the sound and fury is not without its costs.  It has created huge uncertainty, and led to the commitment of innumerable resources to trying to understand, shape, plan for, etc., the regulatory changes.

Regardless, the WSJ is spot on in calling out those currently speaking out on their failure to do so when it mattered.

But that’s water over the dam now.  What’s needed is for these newly vocal regulators to put their supposedly new revelations into practice.  Two very practical issues on which they can do so are taking a duly humble approach to the process of determining what gets cleared and what doesn’t (the issue that EOC focuses on), and on CCP membership and governance standards.

Not that I’m holding my breath.

I was interviewed for about 10 minutes for a Fox News story on energy prices and Obama’s anti-speculation rant: about 3 seconds made it on air.

It is becoming clear that Obama’s criticism of speculators was not a one-off. Instead, it is part of a broader campaign to demonize them. Today’s installment of the Two Minutes’ Hate came courtesy of the Justice Department (so tempted to use quotes around that). Eric Holder announced the formation of an Oil and Gas Price Fraud Working Group consisting of Department of Justice, the National Association of Attorneys General, the Commodity Futures Trading Commission, the Federal Trade Commission, the Department of the Treasury, the Federal Reserve Board, the Securities and Exchange Commission, as well as the Departments of Agriculture and Energy.  The Group’s charge is:

In March 2011, President Obama asked the Attorney General to work with federal and state agencies to monitor oil and gas markets for potential wrongdoing.   In response to the President’s call for action, Department of Justice leadership consulted with federal agencies and state attorneys general and discussed pending inquiries in some states, the most effective legal tools and areas that require additional exploration.   As a result of this examination and to further the central mission of the Financial Fraud Enforcement Task Force, the Attorney General formed the Oil and Gas Price Fraud Working Group.

The Oil and Gas Price Fraud Working Group will explore whether there is any evidence of manipulation of oil and gas prices, collusion, fraud, or misrepresentations at the retail or wholesale levels that violates state or federal laws and harms consumers or the federal government as a purchaser of oil and gas.   The Working Group will also evaluate developments in commodities markets and examine investor practices, supply and demand factors and the role of speculators and index traders in oil futures markets.

Here’s the Reuters feed on Obama’s announcement:

* ( RTR ) 04/21 02:30PM OBAMA SAYS HAS ASKED ATTORNEY GENERAL TO CREATE TEAM TO “ROOT OUT” FRAUD, MANIPULATION IN OIL MARKETS THAT COULD HIT GAS PRICES
* ( RTR ) 04/21 02:31PM OBAMA, IN PREPARED REMARKS, SAYS TEAM’S FOCUS WILL INCLUDE OIL MARKET TRADERS AND SPECULATORS
* ( RTR ) 04/21 02:31PM OBAMA SAYS WILL MAKE SURE THAT NO ONE IN OIL MARKET IS TAKING ADVANTAGE OF THE AMERICAN PEOPLE FOR THEIR OWN SHORT-TERM GAIN

Here’s some additional reporting on Obama’s remarks today:

“The attorney general’s putting together a team whose job it will be to root out any cases of fraud or manipulation in the oil markets that might affect gas prices – and that includes the role of traders and speculators,” President Obama said at a town hall meeting in Nevada on Thursday. “We are going to make sure that no one is taking advantage of American consumers for their own short-term gain.”

That same article quotes Northwestern polisci professor Laurel Harbridge, giving the enabling professoriate’s take on this gambit:

Laurel Harbridge says the formation of the investigative group is a way for the president to take control of the situation without taking more extreme steps.

“Doing something that suggests that there’s at least the possibility that gas prices are high because of manipulation or something like that kind of turns the high gas prices into something that he’s combating and he’s against rather than either a problem that can’t be dealt with or something that’s due to domestic policy decisions,” Harbridge said.

In other words, it’s an opportunistic effort to scapegoat others on the basis of zero evidence in order to distract attention from the real issues–but that’s cool!

Here’s a non-enabling professor’s take:

Craig Pirrong, a finance professor at the University of Houston who specializes in commodity prices, says the task force is hardly needed, since the agencies already have the tools to monitor for fraud and take action. [Yeah.  It’s like their day job.]

“This is a transparently political fishing expedition that insinuates that fraud or manipulation is distorting oil prices without providing even the flimsiest factual basis for such a suspicion,” Pirrong said. “This is part of a broad effort by the administration to deflect criticism with regard to gasoline prices.”

Actually, the “fishing expedition” characterization is probably optimistic.  Especially given Obama’s assertion of ownership of the issue, and his personal identification with the claim that speculators are distorting prices, there is a high likelihood that fishing expedition will give way to witch hunt.  Remember when Obama told bankers “[m]y administration is the only thing standing between you and the pitchforks”?   It is becoming increasingly clear that Obama won’t be standing between oil “speculators” and the pitchforks this time.  Indeed, he’s taking leadership of the mob.

What determines commodity prices is a complex issue.  Injecting superheated political rhetoric won’t improve our understanding, and in fact will inevitably have the exact opposite consequence.  This, combined with the implicit threat of legal investigations and perhaps legal action (“nice little market you have here–wouldn’t want anything to happen do it”) will have no positive consequences, and likely many negative ones.

It’s already ugly out there.  But it just got a whole lot uglier.

It would be nice if this witch hunt was as funny as this one:

I wouldn’t speculate on it, though.

I haven’t written much about clearing lately, and I just know some people are going through withdrawal as a result, so a quick post to feed your jones.

The ISDA Annual General Meeting was in Prague last week.  Clearing was on everybody’s mind.  There were numerous discussions that echoed things I’ve said on SWP and in my academic writing over the past 2.5 years or so.

One example: the head of UniCredit Group’s commercial and investment banking expressed concerns that CCPs will be  undercapitalized.  He compared them to, yes, monoline insurers:

Mustier said the “thin capitalisation” of CCPs – which will end up clearing hundreds of trillions of dollars notional in standardised derivatives – could be compared with monoline insurance companies that underwrite securitisations. Before the crisis, individuals who questioned the ability of monoline insurance companies to underwrite large amounts of securitisations using little capital were told small levels of capital were appropriate because the underlying deals had high credit ratings and the risks had been modelled, said Mustier – although he emphasised CCPs have other lines of defence, which makes the monoline comparison an unfair one.

“I don’t want to make a comparison between clearing houses and other very leveraged financial institutions of the past such as monoline insurance, for instance, where we had roughly the same ratios, because in clearing houses we have something that is fundamentally different, which is the initial deposits that financial participants provide when they open up a trade, and the margin calls, which should mitigate the risks of clearing the position,” said Mustier. “But, nevertheless, clearing houses are very thinly capitalised even if their structure should protect them.”

On the one hand I agree with Mr. Mustier–there is a danger CCPs will be undercapitalized. On the other hand, I think the comparison with monolines is a very fair one. Indeed, this is the gravamen of my post on wrong way risk in CCPs. As Jon Gregory has pointed out, monoline insurers were subject to wrong way risk because they were insuring very senior claims. They insured AAA tranches, and the junior tranches provided a cushion that made it very unlikely that the monolines would have to pay off. Armageddon had to happen for the monolines to pay off on what they insured. But Armageddon did happen, they had to pay off, and they had far too little capital to deal with it.

The initial margins that Mustier refers too, along with the default fund contribution of a defaulting CCP member, are exactly like the junior tranches of the securities that monolines insured.  Those funds will get blown through only in Armageddon, and it is quite possible that in such a situation, CCP capital will prove inadequate.  And even if it is sufficient, under those circumstances the member firms–primarily banks–are going to absorb huge hits.  Which kind of defeats the whole purpose of CCPs–to insulate big financial institutions from risk during crises.  Actually, there’s no “kind of” about it.

The dangers of fragmentation of CCPs resulting from the desire of each major jurisdiction to have its own clearinghouses was another theme of the AGM:

“We must not fragment the clearing house and exchange environment. A fragmented approach will lead to weaker institutions, and greater risk.”

But while Rohner urged closer co-ordination of regulatory reform, he warned it is not a sure thing: “Governments may be unable or unwilling to achieve the necessary level of co-operation, which could lead policymakers to resort to ring-fencing or other limitations on structures or geographic reach to protect the home market or taxpayer. This could fragment the OTC derivatives market.”

And yet another SWP theme is that low entry requirements for CCP membership are extremely problematic.  Cue Athanassios Diplas of Deutsche Bank and Tom Benison of JPM:

Regulators are pushing for CCPs to lower their barriers to entry, letting weaker firms into clearing’s inner circle – but these firms could be overwhelmed in a crisis, the larger banks argued.

“Let’s say you’re a clearing member with $75 million in capital, and your cost of entry to a CCP is $25 million for the guarantee fund – and you join two CCPs. But those CCPs also have the right to call on you for an additional $25 million if they run out of money,” said Athanassios Diplas, global head of counterparty portfolio management at Deutsche Bank, at a press briefing. “They can’t both get it, they don’t know about each other – and the assessment will come at the worst point in time – the day after the Lehman Brothers collapse, for example.”

Tom Benison, managing director for credit trading at JP Morgan, echoed the point. “If one CCP has to make a call for more funds, it’s likely to mean we’re really far out in the tail when it happens – which means every CCP is really far out in the tail. So how many CCPs are calling for funds?”

Benison’s point is a variation on the wrong-way risk point I’ve made before: CCPs are going to call on member capital during extreme circumstances–the Armageddon scenarios.  That’s precisely when those entities may themselves be facing dire circumstances, meaning that the capital might well not be there  when you need it.

Now, you may just write me off as a running dog of the big banks.  All I can say is that I’ve been making these arguments in my spare time for a long time–in some cases, before the crisis and before clearing mandates were even thought of and before anybody was really thinking about clearing period. And regardless, if the argument is faulty–have at it.

In my view, the concerns expressed at the ISDA AGM are real ones.  Ones that didn’t even enter the heads of  the Sorcerer’s Apprentices who conjured clearing mandates to life.  But they are ones that market participants and regulators are going to have to deal with going forward.  And the very scary thing is that we’ll only find out in the next financial Armageddon time whether they’ve got it right.  Which, given the very unsettled situation around the world, could happen sooner than we’d like.

For some reason, the Clash come to mind:

PS. Hopefully quite soon a more authoritative and complete discussion of these issues that I’ve just completed (the draft, anyways) will be released. As they say: Watch this space!

CFTC Commissioner Bart Chilton has been touting research that he claims supports his view that speculation has distorted prices, thereby necessitating position limits.   I’ve read each one.  My conclusion: if this is the best he can come up with, the case for position limits is weaker than I thought.  And that’s saying something.

The citations fall into a couple of categories: superficial quasi-academic studies, and quotations from various figures, including some well-known economists, who have done absolutely no serious research on the subject.

Here are my quick takes on each one.

Since Chilton has had three years to trawl the earth to find work that would support his idee fixe, it is rather amazing that this is the best he can come up with. It’s rather sad, actually, that he believes that he is looking at the problem in a “more sophisticated way.” Although Chilton says that based on his literature review, “[i]t’s simply not the case that ‘there is no evidence that financial investors affect commodity prices,'” that’s not true. What I wrote in Regulation last summer, and what I’ve repeated numerous times on this blog remains true. As yet there is no serious theory, and certainly no serious evidence that speculators have distorted commodity prices.

On Monday, Fed Chairman Ben Bernanke gave a speech on clearinghouses to the Atlanta Fed’s annual conference.  Ironically, Bernanke echoed the theme of my talk at that conference in May, 2009: central counterparties (CCPs, i.e., clearinghouses) could fail, and are a potential source of systemic risk:

Overall, the historical record shows that clearinghouse arrangements have generally withstood even severe crises. This solid performance reflects good planning and sound institutional structures but also some degree of good luck, as crises have also revealed important vulnerabilities, vulnerabilities which prompted subsequent reforms by both the private and public sectors. Clearly, if we do not want to put all our trust in continued good fortune, we will have to continue to be proactive in identifying and remedying weaknesses in these critical infrastructures.

. . . .

Clearinghouses around the world generally performed well in the highly stressed financial environment of the recent crisis. However, we should not take for granted that we will be as lucky in the future. Past crises, including the financial panic of 1907 and the 1987 stock market crash, led to significant reforms and improvements in clearing and settlement that paid off in subsequent periods of financial stress. Given the growing interdependencies among clearinghouses, along with the new mandates for central clearing, now is a good time to reflect on the lessons of the recent crisis and consider whether further improvements are possible. For more than a century, financial stability has depended on the resilience under stress of clearinghouses and other parts of the financial infrastructure.

As we rely even more heavily on these institutions in the United States and around the world, we must do all that we can to ensure their resilience, even as our financial system continues to evolve rapidly and in ways that we cannot fully predict. In short, I think Pudd’nhead Wilson would agree that that is one important basket.

Bernanke discusses some historical episodes in which CCPs teetered on the brink, notably the Panic of 1907 and the Crash of 1987.  He notes, quite rightly, that the expanded role of clearing under Dodd-Frank (and likely in Europe under EMIR) means that CCPs are even more systemically important, and that it is therefore essential to ensure their safety and soundness.

Although Bernanke has taken up a theme that I’ve been flogging for going on 2.5 years now, please don’t get the impression that he got the idea from me.  Bernanke wrote an important paper on clearing and the Crash (RFS, 1990) that was instrumental in helping me understand the “plumbing” of the market and where it can go wrong.  I lived through the Crash, and witnessed first-hand of the near implosion of the clearing system in Chicago, but Bernanke’s article helped me understand some of the issues on a deeper level.   Indeed, I think that one salutary effect of my speaking and writing on the subject has been to make more people in industry and government aware of what Bernanke wrote 20+ years ago.  Credit where credit is due.

I agree with what Bernanke says in this speech, but I think it’s essential to go further.  Bernanke focuses on the potential for CCP failure, and how that can be prevented.  That’s no doubt important, but that’s not the only systemic risk arising from clearing mandates.

Most importantly, the imposition of these mandates will alter the entire financial system.  They will alter the way firms contract, how they borrow, their capital structures, etc.  These changes will have systemic effects and affect the way the system operates in a crisis.

Moreover, I am concerned that a focus on protecting CCPs can lead to the adoption of policies that are destabilizing.  For instance, conventional means of strengthening CCPs can increase their vulnerability to wrong way risk.

As another example, CCP margining can have destabilizing effects.  Although the regulatory tendency to protect CCPs may lead them to agitate for more collateral, and tighter collateralization mechanisms, this can have destabilizing effects during a crisis.  Similarly, having immense amounts of liquid assets tied up in collateral at CCPs can make the system more vulnerable to liquidity shocks.  Put differently, it increases the burden on central banks to respond to liquidity shocks.

Consider the following scenario.  There is a spike in the demand for liquidity.  Vast amounts of liquid assets are tied up in derivatives collateral at CCPs.  One likely response to the liquidity shock is to liquidate derivatives positions to free up the liquid assets–“dead liquidity”–held at CCPs.  This can lead to big price movements that can be destabilizing.  Central banks may need to be especially aggressive in supplying liquidity to avoid these problems.  Perhaps this would require extending credit to CCPs, or to their members, in a way that would effectively permit rehypothecation of margin monies to the Fed.

Again, clearing mandates are a major change to the financial system.  There will be far reaching effects on all aspects of financial contracting.  Most of these are unpredictable and will be dynamic.  But regulators have to be aware of those ripple effects, and understand that those effects will depend on how CCPs operate and how they are regulated.  A microprudential focus on CCPs (which is the default tendency of financial regulators) could have perverse macroprudential effects.

I’m sure Bernanke is aware of that, but a conventional reading of this “watch that basket” speech could lead regulators to focus on the microprudential, and overlook the potentially perverse unintended macro implications of that focus.

I liked Bernanke’s historical discussion.  The Panic of 1907 case is particularly interesting, and I will discuss it in some detail in my forthcoming book.  One thing that is of particular interest, that Bernanke does not discuss, has implications for one current regulatory debate.

Specifically, as shown by Elmer Wicker in his book Banking Panics in the Gilded Age, the New York Clearing Association often failed to deal effectively with panics by mutualizing risk because of heterogeneities among its membership.  Although mutualizing risk would have mitigated adverse selection problems (because there was less uncertainty about the condition of the banking system as a whole than individual banks), it also would have transferred wealth from the healthy banks to the unhealthy ones.  The disagreements among heterogeneous banks undermined coordinated action during several crises–including especially the Panic of 1907.

That is worth keeping in mind today when evaluating proposed rules regarding CCP membership policies.  Encouraging open access through low capital requirements, or aggregate ownership restrictions, as proposed by the CFTC, will lead to more heterogeneous memberships at CCPs.  This will have many perverse consequences, including the real potential for the same kind of problems that undermined the effectiveness of the NYCH in the Gilded Age.

I’m pleased that Bernanke brought this episode into the public eye.  I’m also pleased that he has brought the potential vulnerabilities of the clearing system into the public debate.  His speech is a welcome antidote to the superficial happy talk of Geithner and Gensler and the cheerleaders for Frank-n-Dodd.  Without a sober recognition of the vulnerabilities that a greater reliance on clearing can create, the cure may actually kill us in the next crisis.

And now on two fronts, as it were.

The battle over the “vertical silo” (i.e., vertically integrated in econspeak as opposed to bizspeak) approach to execution and clearing remains under assault in Europe:

European Union states want to extend a draft law curbing risk in privately negotiated derivatives to the whole sector, which could ultimately dent profitability of the world’s first mega bourse merger.

. . . .

But banks say the merged group should be opened up to clearing competition. Extending the law’s scope to regulating listed as well as OTC derivatives would achieve this goal.

It would make it easier for users to clear listed contracts transacted on Deutsche Boerse or Euronext’s LIFFE derivatives platform elsewhere and not be locked into the group’s clearers.

“The inclination among OTC derivatives fans like us is ‘why differentiate between one derivative and another?’,” said David Clark, chairman of the Wholesale Markets Brokers’ Association.

“The big deal in all this is the competition element with Deutsche Boerse. This move to extend the scope of the draft law has got politics written all over it,” Clark said.  [Politics?  Whoda thunk?]

. . . .

Exchanges sense integrated business models are under threat.

“Some are trying to weaken vertical structures by creating clearing links with other structures. That creates systemic risk and shifts focus away from the real issue of dealing with OTC derivatives,” an exchanges industry official said on condition of anonymity due to the sensitivity of the issue.

The battle between the “verticalists” and “horizontalists” in clearing is a decade old and has never resolved, with the same two countries pitted against each other today as back then.

“Verticalists” and “horizontalists”?  Sounds like something out of Swift.  Count me as a verticalist–or more accurately, a marketalist.  That is, that this is something best left to market processes rather than legislation and regulation.

Now a battle on vertical integration is evidently brewing in the US too.  At least in the eyes of some market analysts, ICE’s CEO Jeffrey Sprecher is worried that a horizontalist, non-marketalist US Department of Justice may condition acceptance of a NASDAQ-ICE-NYSE-EuronextLIFFE merger on opening up of the derivatives clearinghouse (from Bloomberg: no link yet):

IntercontinentalExchange Inc. may drop out of its joint bid for  NYSE Euronext if the U.S. Department of Justice raises concerns about the deal’s combined futures business, Sanford C. Bernstein & Co.’s Brad Hintz said.  ICE, the second-largest U.S. futures market, and Nasdaq OMX Group Inc. made an unsolicited offer for NYSE Euronext last week, valued at $11.3 billion, countering Deutsche Boerse AG’s February offer for $9.53 billion. In the proposal, Atlanta-based ICE would take NYSE’s Liffe futures-trading markets, expanding in Europe. New York-based Nasdaq OMX would take NYSE Euronext’s listings, equity and options units.

ICE and CME Group Inc., the world’s largest futures market, own their own clearinghouses, which may create barriers to entry and be anti-competitive, the U.S. Department of Justice said in 2008. Equity and options exchanges –such as those owned by NYSE Euronext and Nasdaq OMX–use centralized  clearinghouses like OCC that aren’t owned by any one market.

“The most important issue facing these competing offers is the possibility that the ICE/NYSE Liffe merger will resurrect DOJ concerns with vertical integration of futures execution and clearing,” Hintz, an analyst at Sanford C. Bernstein in New York, wrote in a e-mailed note today. “If this issue arises ICE will likely drop out of the bidding and the Deutsche Boerse deal moves  forward.”

Yes, be afraid.  Be very afraid.  I have the sense that the DOJ’s Antitrust Division is itching to attack vertical integration in derivatives, the economics be damned.

* This perhaps corny (perhaps?) title was inspired by my recollection that today is the 149th anniversary of the first day of the Battle of Shiloh.  Two of my great-grandmother’s brothers fought in the battle: Eli and John, who served in the 46th Ohio Volunteer Infantry.

Eli was something of what is called a “Jonah” in the Navy–a hardluck guy.  He was captured at Shiloh, and held in a prison camp in Montgomery, AL for a couple of months.  Exchanged, he returned to Ohio.  He claimed he was unable to return to his regiment because of dysentery contracted during his imprisonment.  His military record includes a note from his family doctor, believe it or not.

His efforts to stay home were unavailing, and he was ordered to report to his unit.  He returned to the 46th shortly before the Battle of Chattanooga.  He proceeded to lose his belt and cartridge box, for which he was dunned $10 pay.  He was then assigned duty as a wagon driver–probably not an endorsement of his soldierly qualities.

Maybe he straightened out, or the need for infantrymen was pressing, for he was in the ranks again for the Atlanta Campaign.  Unfortunately for him.  He was shot in the left arm close to the shoulder joint at the Battle of Dallas, GA, 28 May, 1864.  The surgical record indicates that the regimental doctor performed a resection of his left arm, removing the bone from the shoulder to the elbow.  This surgery was required because the ball struck too close to the joint to amputate.

My great-grandmother told my grandfather that “Uncle Eli had a dead arm.”  His arm dangled uselessly at his side, and my great-grandmother remembers him using his right hand to lift up his left to rest it on the dinner table.

John, on the other hand, served without incident or injury from October, 1861 to the muster out of the regiment in July, 1865.  Pretty amazing, given that the regiment fought at Shiloh, the Siege of Vicksburg, Chattanooga (the storming of Tunnel Hill, the bloodiest part of the battle), the Atlanta Campaign (including the Battle of Atlanta on 22 July, 1864), the March to the Sea, and the Battle of Bentonville.  One lucky brother, one unlucky.

Back when position limits were first being debated at the CFTC in the summer of 2008, here on SWP I questioned whether the Commission had the statutory authority to impose limits in the absence of a finding that “excessive speculation” had caused unwarranted fluctuations in commodity prices.  According to John Kemp of Reuters and Commodities Today, that argument has been raised by numerous commentors on the CFTC position limit NOPR:

The last day of the two-month consultation on Monday witnessed a volley of carefully coordinated submissions from Goldman Sachs, Barclays Capital, Morgan Stanley, the International Swaps and Derivatives Association (ISDA) and a host of others, all urging the CFTC to withdraw the proposed rulemaking.

Many of the objections build upon the criticisms set out at length by the Futures Industry Association (FIA) at the end of last week. The responses help lay the legal paper trail that will be cited when the rule is eventually challenged in the courts.

The gulf between the commission and the industry is so broad it is unbridgeable. A legal challenge to the CFTC’s authority to impose position limits appears inevitable. The only question now is who will bring it. None of the big banks, oil companies or institutional investors is likely to want to court controversy by acting as plaintiff.

But the rule could be challenged by an industry association on behalf of its members (there is safety in numbers) or by any individual firm willing to stand up and accuse the CFTC of over-reaching.

. . . .

But more fundamentally, most objectors argue the CFTC has no rationale and no legal authority to impose position limits at all, notwithstanding passage of the Dodd Frank Act in July 2010 (PL 111-203).

The FIA continues to argue the commission has no authority to impose limits unless it can come up with objective evidence that speculation has actually burdened interstate commerce and position limits are necessary to cure the problem.

BTW, I wasn’t coordinating with anybody.  I think I was the first, and certainly among the first, to raise this issue.

I’m not a lawyer, and especially not an expert on statutory interpretation.  Regardless of whether the law requires the CFTC to act only after making a credible finding that speculation has in fact distorted markets, however, I believe that would be the prudent course.  Given the real potential for harm inherent in the regulation, it should be adopted only if that harm is balanced by some benefit.  Insofar as harm is concerned, if the regulations are binding, that means definitively that they impose costs on market users.  So what is the benefit?  Is it too much to ask the Commission to demonstrate that they are intervening to fix a real problem?

As I noted in my comment to the Commission, it gave a very limited justification for its limits.  What’s more, the limits as proposed were far more expansive than required to fix the problem that the Commission identified.  Thus, in my opinion, the proposed limits are unduly burdensome.  There are far more efficient ways to mitigate the specific problem that the Commission has identified.

On a related note, Kemp omits any discussion of another mandate in Dodd-Frank, namely, that the Commission determine the costs and benefits of its proposed regulations.  Gensler has attempted to stonewall implementation of this black-and-white statutory language.  Although he hides behind statutory language when he does not want to defend substantively his actions (“Don’t look at me!  Congress made me do it!”) he blithely ignores that which he finds inconvenient.  (Yet another soul looking for free options–politicians and regulators are particularly prone to this sort of opportunism.)

This suggests another legal and substantive attack on any position limit rule: even if a finding of “excessive speculation” is not required, the Commission should provide a cost-benefit justification for position limits.  It has not done so.

With good reason.  For if it even tries, the results will be laughable.  The argument I raised in my comment letter would imply that the NOPR would not pass the cost-benefit test, and that it wouldn’t even be close.

But Gensler seems intent on pushing forward.  If he succeeds (which is not assured, as indicated by the Commission’s cancellation of today’s meeting) the (bad) joke will be on the markets–and the millions who depend on them.

So, I presume the industry will see Gensler and the agency in court.  I hope the plaintiffs (whoever they are) make both the statutory authority and cost-benefit analysis arguments.  That would be very interesting.