Streetwise Professor

Value at risk, VaR, is the most common means of measuring risk.  It provides useful information: it quantifies the magnitude of loss that can be incurred on a portfolio with a given probability.  But it is dangerously incomplete: it does not tell you how much you can expect to lose, conditional on the VaR boundary being breached.  VaR, in short, doesn’t tell you how bad bad can be.

This is relevant in the clearing debate.  CCPs choose margin levels in order to ensure that the probability that price moves will wipe out margin balances is sufficiently small.  This is exactly equivalent to calculating a VaR.

And hence, it is subject to the same problems as VaR.  This means that when evaluating the financial capacity of a CCP to withstand a large price shock that not only is the margin level (the VaR equivalent) that is important: the potential loss conditional on margins being blown through is important too.  If the loss conditional on margins being breached is X, but a CCP only has resources of X/2, during a crash (or a spike) that breaches margin levels–an event that will occur with positive probability–then on average the CCP will default.

This is not a purely hypothetical situation.  This important paper by David Bates and Roger Craine shows that in the days following the 1987 Crash, the loss on outstanding S&P500 futures positions conditional on breach of margin was huge, likely far beyond the financial resources available to the CME clearinghouse.

This raises the questions: do CCPs take this information into account when determining their financial resources?; will new CCPs do so; and importantly, do they have the incentive to do so?

This last question is crucial. Financial institutions have problematic incentives to take proper consideration of tail risk.  Indeed, that is arguably one of the major reasons for financial crises.  So why should CCPs, which are coalitions of self-same financial institutions, take into account the tail risks that they ignore independently?  Particularly inasmuch as collectives typically have weaker incentives (due, for instance, to free rider problems).

This is yet another, crucial issue, that has not received adequate attention amidst the paeans to clearing in the run up to and the days since the passage and Dodd-Frank; the same can be said of Europe too.

VaR was the subject of much criticism prior to the crisis: that criticism has only intensified since.  And for good reason.  That should be kept in mind when one hears assurances that CCP margins will prevent derivatives from being the source of a future financial crisis, because margin setting is in essence a VaR exercise.

Jeff Carter at Points and Figures wrote a nice post on my Cato clearing piece, for which I am appreciative. He is pretty much in agreement with me that mandates are a bad idea.  He is concerned with the command-and-control mindset inherent in Frank-n-Dodd, and supports the development of voluntary “Coasean” approaches.  Hear, hear.

Jeff does take issue with my characterization of the way that CCPs work today:

That meant that if you blew up, and caused major losses you could not afford, the rest of the clearinghouse members would have to pony up cash to cover the loss. If the loss were big enough to blow through all the cash that all the members had, the clearing house would go bankrupt. There hasn’t been a bankrupt clearing operation in the modern day, since 1900, history of trading that I know of.

Exchange clearinghouses are no longer mutually held, and have not been since the last major exchange went public in 2003. Instead, the clearing house takes out an insurance policy to cover potential problems. It also has lines of credit with several different bankers. This simple fact doesn’t change our agreement that government mandated clearing is a poor solution, but it does change the calculus of analysis a little.

I take issue with his taking issue.  Yes, exchanges are demutualized, but counterparty risk is still mutualized.  Take the CME, for instance.  This CME document, in the sections labeled “Default by a Clearing Member” and “Summary of Resources Backing Clearing” beginning on p. 11 demonstrates that the losses of default are borne by other clearing members.  First the CME dips into the guarantee fund–which the clearing members fund.  Then the CME can assess the clearing members.  (The CME also commits up to $100 million of its own capital.)  The assessments are limited to 275 percent of each CM’s original contribution.  The total from the CME contribution, the guarantee fund, and the assessment comes to about $7.5 billion.  The costs of default by a clearing member are thus shared among–mutualized by–other clearing members.

Jeff mentions insurance, but there is no third party insurance that pays in the event of a default at the major exchanges.  (There is no mention of insurance in the CME document.)

Jeff also mentions credit lines, and indeed CCPs have lines with major banks.  In the aftermath of Black Monday, 1987, exchange CCPs realized that they needed a more reliable source of liquidity.  On Black Monday, major banks (the clearing banks) balked at funding big CM margin calls; this is where Fed pressure and liquidity injection was important.  To avoid this problem going forward, the CCPs obtained lines of credit that they could call on to obtain liquidity, just as Jeff says.

It is important to note that these credit lines are just that.  If a CCP draws on the line, it–or more accurately, its members–still owes the bank the money.  The lending bank incurs a loss attributable to a CM default only if the CCP itself becomes insolvent.  That is, the credit line is a source of liquidity: it is not in the first instance a means of sharing the default risk with the bank.  Only if the CCP becomes insolvent do the lending banks suffer any default losses.

The CME document linked above makes that clear.  It calls the credit lines a “Temporary Liquidity Facility.”  It’s a source of liquidity to be used in extremis: it’s not a form of insurance.

There’s an irony, here, of course, and one that gives the lie to many of the claims in support of clearing.  Clearing mandate advocates, notably Gensler, talk about clearing reducing financial interconnectedness, and reducing the potential for contagion.  But clearing in times of stress demands ready access to liquidity.  This inevitably requires a connection between the clearing and banking systems.  It can’t be avoided.  If a clearinghouse runs into a big problem, and draws the credit line, it is possible that the CCP will not be able to pay it back.  In the event, the CCP problem would become a banking problem, and the lending banks would bear some of the default loss.  (Of course, to the extent that banks are clearing members, they will bear default losses too.)

The credit lines also expose the CCPs to bank credit.  If the bank extending the line is itself in financial difficulty, which may well be the case during the kind of crisis that would necessitate the CCP to call on its line, the clearinghouse may not actually obtain the needed liquidity.  So the contagion can work both ways.  From the CCP to the bank, or the bank to the CCP.

Again, the point is that clearing changes the topology of the network of connections among financial institutions: it doesn’t eliminate these interconnections.  One way or another, derivatives default losses are ultimately borne by major financial institutions, clearing or no.  No two ways about it.

Damn.

I’ve written frequently about the problematic evolution of financial market structure under a clearing mandate.  One concern is the proliferation of CCPs.  One potential reason for this proliferation is that exchanges will want to control their own CCPs.

Long before before the crisis, I wrote about this vertical integration issue, in detail.  I dismissed worries that vertical integration is anti-competitive.  But I did note a fundamental tension.  Large, multi-product (and hence likely multi-exchange) CCPs have advantages from a risk-bearing perspective (although perhaps not from a systemic risk perspective).  But vertical integration likely economizes on transactions costs.  Thus, “siloed” CCPs can make sense even if it does not optimize risk bearing.  But the trade-off is a real one, and hard to evaluate.

I know some, notably the Bank of England, are worried about silos because they are concerned that they inflate the costs of managing counterparty risk.  But transactions costs are real costs too.

Apropos all this, today the FT has an article about how LSE is putting together its own CCP. It has cleared through LCH, but for strategic reasons thinks it necessary to control its clearing.  Given that LSE was once held out as the exemplar of how exchanges didn’t need to control their clearing, this is big news.  It also puts an exclamation point to my arguments that the evolution of the clearing business is not going to be driven purely to reduce systemic risks.  Clearing decisions are going to be made by for profit firms with their own particular agendas.  This means that the evolution of the market is likely to be quite complicated, and lead to results that the clearing mandate evangelists have not contemplated.  The implications of this structure for systemic risk are by no means obvious.

And a story in WSJ Europe raises yellow flags, and perhaps red ones, about the EU’s clearing mandate plans.  Read it. It will all sound very familiar to regular SWP readers.  Like in the US, however, it is unfortunate that people are coming to grips with the complexities of clearing mandates–and the potential dangers–only after they are a fait accompli.

Tyler Cowen wrote a post about my Cato clearing piece, for which I am grateful.  Tyler was tepid in his appraisal: and I am tepid of my appraisal of his appraisal.

On a minor point, he says I say “not necessarily” too often.  Well, I am primarily responding to arguments that say or assume things to be necessary when they are not.  Moreover, even when things are not necessarily true, they may be true, and it would be overstatement to say otherwise.  I tried to be precise in my evaluations, and neither overstate nor understate the case.

More substantively, Tyler makes the two arguments that are least likely to persuade me: arguendo ad AIG, and “look, the CME did just fine during the crisis.”  Regarding the former, I think that (a) Tyler is guilty of hindsight bias, assuming that CCPs would have seen AIG’s positions to be exceptionally risky when nobody else did; (b) this is a red herring, as AIG positions would never have been cleared; and (c) the AIG case is far more complicated, as I argued extensively on SWP many moons ago.  With regard to the latter: (a) things at CME were dicier that he lets on, something else I’ve written about, and (b) this argument is fraught with selection bias, as CME cleared the stuff that was easiest to be cleared.  Even Tyler admits that clearing CDS with their jump to default risk would be very difficult; this is true of other instruments currently traded OTC too.

My biggest objection is that Tyler really doesn’t come to grips with any of the substantive arguments in the paper, including inter alia those relating to: (a) the question of how a putatively and seriously inefficient market structure could not just survive  but thrive and grow relative to the putatively more efficient alternative; (b) the information regarding default risk and the incentives of CCPs vis a vis dealers; (c) relatedly, moral hazard and adverse selection issues; (d) the differences in costs that hedgers will bear due to cash management costs, etc., (e) the potential loss of netting economies in clearing due to fragmentation; (f) relatedly, the possibility that the industry will evolve inefficiently due to the effects of strong scope and scale economies, jurisdictional issues, and the use of clearing for strategic purposes by exchanges; (g) the ability of affected firms to alter their financial contracting (capital structures) to undo most if not all of the leverage-reducing that is purportedly one of the benefits of CCPs and more restrictive collateralization; and (h) most importantly, the potential for systemic risk arising from CCPs.  I could go on, but these are the biggies.

Tyler does, in a way, address (h), but unpersuasively, IMO.  For instance, he says: “it seems to me that clearinghouses would have had a strong profit incentive to monitor or limit the kind of risk-taking which led to the A.I.G. debacle.”  Even overlooking the AIG reference, this is problematic.  There are two cases.

The first is that CCPs are mutual organizations or effectively mutual organizations, dominated by large financial intermediaries.  In that case, the CCPs would effectively inherit the incentives of these intermediaries, which Tyler apparently thinks are inadequate to induce them to police risks efficiently.  In addition, there would be all the problems associated with moral hazard, cooperative governance, and agency problems associated with multiple principals.  (Ironically, Tyler effectively concedes this point in one of his older posts that he links to where he expresses reservations about ICE Trust.)

The second case is that CCPs are for profit firms, collecting fees, potentially in competition with one another, and taking on tail risk.  Indeed, the entire business of a CCP is taking on tail risk.  But we know that pricing that risk is hard, and that moreover, shareholder incentives often lead financial institutions to underprice that risk, or to take on too much of it (which amounts to the same thing).

So Tyler, in effect, is reduced to arguing that CCPs are easier to regulate: “The key point is that a clearinghouse can more easily be forced to carry heavy capitalization and said capitalization, unlike with a current bank, cannot so easily be undone by off-balance sheet transactions or hidden leverage.  The clearinghouse has different incentives and is much easier to regulate and therefore we should put some more trust in them.”

Somehow, putting more trust in regulators is hardly calculated to build confidence.  The point that CCPs are likely to have simpler capital structures that make it harder to take on hidden leverage is a good one, but in many respects the portfolio of risks a CCP takes on is very complicated and difficult for a regulator to appraise properly.  Again, it is all tail risk, and in a mandated environment, said risk will involve more complicated, less liquid, more difficult to evaluate instruments, and crucially, will also depend on the balance sheet risks posed by the firms it clears.  These firms can take on hidden leverage, off-balance sheet transactions, etc., so regulators have to look through the CCP back to the same institutions that allegedly are the problem in the incumbent structure.

Furthermore, as I argue above, CCP incentives are far more problematic than Tyler lets on.  Moreover, CCPs, whether for-profit firms or mutuals, have the incentive to influence regulators in the same way banks do.  Putting all this together, I don’t think it is quite as easy as Tyler does to determine the right level of CCP capital or to monitor its operations.

I’ve written many times that I do not know for sure what the optimal organization of counterparty risk allocation and pricing mechanisms is.  Nobody does.  I have often emphasized that I intend to raise issues and arguments that are grounded in good economics but which have gone unraised and unanswered in the conventional paeans to clearing.  If advocates of clearing have a good case, they could meet these arguments head on, which they have not done so far.

After reading Tyler’s piece, I have to say that most of the substantive arguments I’ve raised still remain unengaged.  So skeptical I remain.  I appreciate Tyler’s taking the time to take my piece seriously, and am encouraged that he recognizes the need for a comparative approach., but would respectfully suggest that he should take a harder look at the real problems that CCPs must confront.  I think if he does that, he’ll have more concerns about clearing mandates than he has expressed heretofore.

Felix Salmon is a big fan of Basel III, but admits to concerns about the perpetuation of the Basel II risk weightings after reading this by Noah Millman in the Economist:

More important, the new regulatory scheme could fail in several ways. The most serious failure in Basel III is that it doesn’t address the principal contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights. One of the key components of Basel II was to increase the amount of capital banks had to hold against riskier assets. Extremely low-risk assets, meanwhile, could be held with very little or even no capital. Risk, moreover, was calculated primarily by reference to the rating assigned by one of the recognised ratings agencies. The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitisation was a way to “manufacture” apparently risk-free assets out of risky pools. What brought banks like Citigroup and Bank of America to their knees wasn’t direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.

Since it did not change this risk-weighting, Basel III effectively doubles down on Basel II.

Martin Wolf at the FT echoes these concerns, even more forcefully:

These new ratios are also very much the children of Basel II, the previous regulatory regime: they rely on what should by now be discredited risk-weightings – one of the points Martin Hellwig of Germany’s Max Planck Institute makes in a superb recent paper on the intellectual bankruptcy of current approaches to regulation of capital. We might think of the new requirements as a “capital inadequacy ratio”.

The Hellwig paper is worth a read.

Needless to say, I agree with these concerns about Basel III.  It’s better than Basel II because it has higher capital levels (even though Wolf thinks they are grossly inadequate), but it shares the fundamental flaw: the attempt to price risks, which is doomed to failure because those setting the prices are going to have less information than those responding to them, who can moreover design their portfolios and design securities and financial instruments to exploit mispricing of risks.

I wrote about this several times, most recently in Basel Faulty.

Yes, there is a bigger cushion in Basel III, and the liquidity requirement is an improvement.  But Basel III perpetuates the most problematic feature of Basel II.  In particular, I think it bears repeating that since the mispricing will distort the incentives of all covered entities, it tends to lead them to trade the same way, which is lethal in response to a systemic shock.

It is nice to see that this is becoming increasingly recognized, but it is discouraging that the message does not appear to be coming through loud and clear–or even garbled–where it matters, in Basel.

The FT ran a rather bizarre editorial on end user exemptions from clearing mandates.  As seems to be the wont of clearing advocates of late, it is strident, but hardly persuasive.

Here’s the core of the argument:

But the fact that reform might impose higher costs on non-financials is precisely the reason for sticking to it. Costly margin requirements indicate that the derivatives companies purchase not only insure them against adverse market movements but can require them to make substantial payments should market conditions move against them. If OTC derivatives are cheaper than taking out insurance, this suggests that the systemic risks of the OTC market and the banks that dominate it are being borne by taxpayers. Ending this subsidy would force corporations to bear the fair economic cost of their actions.

This is apparently the S&M theory of public policy: unless a policy inflicts pain, it is ineffective.  The more costly a policy is, the better it must be!

Here’s my most charitable characterization of the argument:  Due to Too Big to Fail, banks subsidize their customers.  In particular, they subsidize them by taking on default risk and not charging for it.  Therefore, it is necessary to impose costs on these customers in the form of collateral requirements in order to eliminate the subsidy.

Here is one testable implication of this theory: in the absence of TBTF subsidies, all deals will be fully collateralized.

This implication is refuted by experience.  For instance, prior to the formation of the Chicago Board of Trade Clearing Corporation (under government pressure), margining was discretionary.  Exchange rules permitted parties to demand margin: it did not require it.  Routinely brokerages extended credit to their customers and to other brokerages that they traded, and did not require the posting of initial margins, and only required posting of variation margins when a pre-established  credit limit was breached.  These brokers were not the beneficiaries of any TBTF subsidy.  So, credit exposure via incomplete collateralization existed even in the absence of a TBTF subsidy.

Moreover, this theory doesn’t explain why the credit terms extended by OTC dealers vary by customer and deal.  Such variation in credit terms means that dealers are evaluating credit and charging for it based on the nature of the customer and the trade.  Of course, it is possible that these terms are too generous overall (due to TBTF) but the behavior of dealers belies the simplistic story that the FT spins, to the effect that dealers don’t care about credit risk in doing derivatives deals, and hence it is necessary to deny them the discretion to choose their own credit terms.

Furthermore, the FT editorial, like much of the pro-clearing discussion, implicitly assumes that everything else will remain the same after the imposition of a clearing mandate; collateralization will reduce counterparty risk in derivatives trades, and other credit risks will remain unchanged, so overall banks will face fewer default risks.  This is certainly incorrect, and market participants will respond to a mandate by taking actions that undo much of its effect.

For instance, the mandate that all deals be collateralized effectively tells dealers: Thou shall not extend credit through derivatives transactions.  But there are multiple ways that dealers can extend their customers credit.  In particular, if precluded from extending unsecured credit through a derivatives trade, they can substitute other forms of unsecured credit for that they would have offered their customers via derivatives.  Now, revealed preference implies that this is not the preferred arrangement, as otherwise end users and dealers would have chosen it in the first place.  But the use of other forms of credit to finance, effectively, margin/collateral will almost certainly be a second best response to the mandate.  Thus, collateral requirements will do far less to reduce the amount of credit and leverage in the system than their advocates believe.

Moreover, and perhaps more importantly, if TBTF subsidies are the Original Sin, merely foreclosing one way to exploit these subsidies will have little effect on the riskiness of banks.  So if dealers are foreclosed from exploiting TBTF subsidies in their derivatives business, they have every incentive to find other ways to do so.  And they are sure to be creative.

That is, TBTF subsidies are like water.  They will find some outlet.  Dam up one outlet, and the water will find its level through some other channel.  So maybe OTC derivatives won’t be the source of the next crisis (just as they weren’t the source of the last crisis), but if TBTF continues to exist, risk taking will be continued to be subsidized, some excessive risks will be undertaken somewhere, and inevitably, this will cause problems down the road.

But whatever the next crisis, we may be able take comfort that derivatives will not have caused it.  Very cold comfort.

There will be other unintended consequences.  Even though dealers and other intermediaries are likely to try to design financing methods and provide services that reduce the operational and financial burden of end user collateral requirements, again by revealed preference, these alternatives are more burdensome to end users than the incumbent system.  As a result, some end users will decide not to hedge; others will hedge less.  Others will adopt different capital structures that are less efficient.  As a result, more end users will suffer financial distress, and others will incur costs in the form of less efficient investment policies, etc.  These are real costs.  And they can result in defaults–just not on derivatives trades.  Are we really better off when a firm that eschews hedging because of the higher burden inherent in collateralization defaults on its debt to a bank when the risk it would have hedged comes to pass?

If TBTF is the real problem, it is counterproductive to try to address it through micromanaging the ways that financial institutions  attempt to exploit the TBTF subsidy.  Deal with the real problem–the subsidy–rather than attempt to anticipate and foreclose every possible way that clever bankers can attempt to milk this subsidy.  Deal with TBTF upstream, not downstream.

Like a child’s security blanket, clearing and collateral mandates give some a sense of warmth and security.  And a false sense of security, as it turns out, because they do not eliminate or even reduce substantially the true source of danger in financial markets.

On Friday I attended a conference on OTC clearing sponsored by the Chicago Fed.  The conference was excellent, and organizers Ed Nosal and Robert Steigerwald of the Fed, and Darrell Duffie of Stanford, did an excellent job of assembling a stellar group of speakers.  I had the privilege of moderating (Me?  A moderator?) one of the panels.

The speakers represented all of the major constituencies; sell side/dealers, buy side, end users, exchanges, CCPs, regulators.  Perhaps not surprisingly, there was little consensus on important issues relating to governance, organization, capital requirements, collateral, the number or size of CCPs, or any of the important matters that still remain to be decided.  It is evident that the coming months and years will be fraught with uncertainty as the industry gropes towards equilibrium in the Brave New World of Dodd-Frank.

The lunchtime speaker was Citadel founder Kenneth Griffin.  Griffin gave a paean to central clearing, and to Dodd-Frank more generally.  Clearing is cheaper operationally and administratively.  It reduces risk.  It economizes on capital.  It is the cure for all that ails the financial markets.

So if it is so wonderful, what stands in the way of its adoption?  Per Griffin: a small, self-interested cabal of dealers who reap billions and billions of profits at the expense of end users, and who will lose their ill-gotten gains in a cleared world.

This narrative is a familiar one, the stock theme of the advocates of central clearing.  And as I’ve said on numerous occasions, this story begs far more questions than it answers.  Most importantly, if the efficiencies of clearing are so manifest, and the market power losses so large, why don’t basic competitive forces undermine dealer dominance?  An inefficient business, with high monopoly markups on top of that, is a juicy target for entry by more efficient suppliers.  You would expect such a business to suffer erosion in market share; quite rapid erosion, in fact.  But the reverse has happened to dealers in recent years, as OTC markets have grown absolutely and relatively.

Maybe competition doesn’t work, or works differently, in OTC derivatives markets.  If so, it would be nice to have a convincing model, backed by empirical evidence, to explain such an anomalous outcome, so different from the received understanding in economics, and from the experience in many other industries.  Needless to say, Griffin didn’t provide either model or evidence.

He didn’t help himself by quoting OCC data about concentration in US OTC markets.  This is akin to the drunk looking for his wallet under the lamppost.  The OCC data are readily available and easy to use, but they are incomplete because they only cover US banks.  More comprehensive surveys indicate that there are currently 10 or 11 major international dealer firms; there were 14 prior to the crisis.  I’d be interested to hear Mr. Griffin identify other industries with 10-14 major competitors, and argue that they are similarly uncompetitive.

Moreover, it is well known that concentration figures can be very misleading measures of competitiveness.  They do not measure the effects of potential competition.  Moreover, concentration ratios are endogenous.  As Demsetz showed long ago, industries can become concentrated and profitable as efficient producers gain market share at the expense of less efficient rivals.

It’s not just me, folks.  After Griffin’s talk, I chatted with an economist, a former colleague with a very responsible non-academic policy and research-oriented job who was unpersuaded by Griffin’s jeremiad.   This individual said: “He ignores the IO [industrial organization] questions.”  Exactly.  Why is the industry organized this way?  Why doesn’t competition erode market power and market power rents?  Why don’t putatively more efficient organizations and institutions (clearing, in Griffin’s view) displace less efficient ones?  Why do the inefficient survive?

He brought up energy, in which clearing has made strong inroads in the past 8 years, to bolster his point.  The problem is that the case of energy suggests quite the opposite.  Clearing grew in energy naturally, organically, without a push from Dodd, or Frank, or the Fed or anybody else.  If this can happen in energy, and this is efficient, why can’t it happen in other sectors of the OTC market?

Inquiring minds, open to persuasion, want to know.  Griffin didn’t deliver.  What he did deliver was a sermon, complete with saints and devils.

Moreover, the Citadel commander’s argument presumes that end users–who, as he properly notes, must be the ultimate source of any dealer market power profits–are the victims of some sort of battered spouse syndrome.  For end users are among the most vociferous opponents of clearing mandates.  FMC Treasurer Thomas Deas was quote outspoken on this score at the session immediately prior to Griffin’s speech.  Why are end users the most ardent defenders of a system that is supposedly rigged against them, and robs them blind?

Griffin also failed to analyze seriously the trade-offs of alternative ways of allocating and pricing counterparty risk.  No suggestion of any comprehension of issues relating to the information and incentives to price and manage counterparty risk.  No mention of moral hazard or adverse selection.  No discussion of how the industry will evolve and how this will affect the ability of clearing to realize its full potential.  Most importantly, no mention of the potential systemic risks in clearing–a point mentioned prominently in the opening remarks at the conference delivered by Chicago Fed President Charles Evans.

He did acknowledge objections to clearing mandates–but in an incomplete way, and in caricature.

If the substance was, to me, unpersuasive, the delivery and tone were off-putting in the extreme.  “Supercilious” hardly does it justice.

The serious people who spoke on all sides of the clearing issue during the conference proper raised many interesting arguments and issues.  They made it plain that the way forward will be complex, and that it is by no means evident that the way mapped out by Frank-n-Dodd will improve the efficiency, stability, and safety of the financial markets.  Griffin’s talk was, in contrast,unserious, one-sided, and ultimately unconstructive.  Manichean sermons, delivered in sneering and belligerent tones, are like that.

I saw the headline of this Matt Leising article, “Lehman Derivatives Records a Mess,” and reflexively thought it would be about its OTC trades (of which there were, if memory serves, over 900,000 if memory serves).

I was wrong.  It was about its exchange traded–and cleared–positions:

Barclays PLC had no idea how big Lehman Brothers Holdings Inc.’s futures-and-options trading business was when it considered taking over the defunct bank’s derivatives trades at exchanges in 2008, a Barclays executive said.

“Lehman’s books were in such a mess that I don’t think they knew where they were,” Elizabeth James, a director of Barclays’s futures business, testified today in U.S. Bankruptcy Court in Manhattan. James worked on Barclays’s purchase of Lehman’s brokerage during the 2008 financial crisis.

She said she received an e-mail from former Barclays trading executive Stephen King saying Lehman had “absolutely no idea” if it had sold $2 billion more options than it had bought, or whether it owned $4 billion more than it had sold.

. . . .

Transferring margin together with trading positions “is normal practice in the ETD business,” she told U.S. Bankruptcy Judge James Peck, referring to Lehman’s exchange-traded derivatives. “You’d be crazy if you didn’t.”

She said Lehman’s lack of records initially prevented her from performing “due diligence” to discover what Lehman’s and its customers’ positions were, where Lehman kept its bank accounts, and who its brokers were.

James said she had seen a tabulation of Lehman’s positions at the Options Clearing Corp. showing that the daily margin requirements for its trades had varied by as much as $1 billion within a few days in September 2008.

Moral of the story: moving more trading to exchanges, exchange-like systems, and clearing will not necessarily lead to greater clarity about the positions that big entities like Lehman hold.  One of the arguments for clearing has been that it will improve regulatory transparency, and help regulators figure out where the risk is and who is exposed to whom.  Even overlooking the basic fact that it is possible to have centralized trade reporting without mutualizing credit risk through clearing, the Lehman story shows that this alleged advantage has been vastly oversold.

Big complicated firms have big, complicated, and dynamic positions that are hard to keep track of, regardless of where and how they are traded.  There is a long, long, long way to go before even approaching the ideal of “mapping” risk in the financial system.  More centralized collection of information is a necessary, but by no means sufficient, condition to achieve this goal.

The Lehman story should be a cautionary tale to all those who naively believe that waving a legislative wand and casting a spell that drives trading to exchanges will magically eliminate all of the huge operational difficulties associated with measuring and managing risk.

Back in the Dark Ages, I wrote my PhD thesis on the ocean shipping industry.  Specifically, I applied core theory to explain the diversity of organization across different sectors of the shipping business, with collusion in the liner (container) business, and competition in the bulk sector.  Not long after going into academia, I realized that the core theory thing was a dead end professionally, so I remade myself into a derivatives scholar.

Well, reading the Economist this week, I had a peanut butter-chocolate Reese’s moment: the magazine ran an article about derivatives on container shipping rates:

Clarksons, the world’s biggest shipbroker, which pioneered derivatives for dry-bulk cargoes like iron ore and coal in the early 1990s, made its first container-derivative trade in January this year. Since then two other London-based brokers, ICAP and Freight Investor Services, have also started to offer derivatives settled against the Shanghai Containerised freight index, which is based on per-box rates on the world’s busiest container routes. Alex Gray of Clarksons admits that the market is tiny at the moment. But he reckons that container derivatives may be worth 5-10% of the physical market by the end of 2011.

One interesting sidelight in the article:

Half the container fleet runs like a bus network with regular sailings at set times. With these ships, prices are set under long-term contracts. But the spot market, where vessels are chartered for specific trips or time periods, is very unpredictable, particularly since regulators put a stop two years ago to an arrangement between shipping lines (the top 15 of which control 80% of the market) to manage overcapacity by co-operating on routes and rates.

If this is an accurate description of the business, it’s changed a lot since I studied it in any detail.  The most interesting feature is the statement about regulators.  My thesis argued that the cost and demand structures in liner shipping (cost indivisibilities and highly divisible demand) made competition unstable, and that collusion (shipping conferences–“an arrangement between shipping lines . . . to manage overcapacity by co-operating on routes and rates”) was an efficient response.  If collusion is no longer permitted, then some alternative, e.g., more long term contracting, should develop.  (I also showed that long term contracts can mitigate the inefficiencies that exist with spot contracting.)

Anyways, it’s interesting to see the convergence of the two seemingly divergent issues that have defined my professional career.  Maybe it’s time to take another look at the shipping business.  (Don’t worry: I’ll still have time for you, Gary and Bart.)