Streetwise Professor

I’ve been writing for some time that Frank-N-Dodd will open a battle over derivatives market structure.  This battle will be waged in the markets, and in the political and regulatory arenas.  In particular, clearing mandates will lead to a protracted conflict.  The nature of the clearing business, with its strong scale and scope economies and the myriad competitive implications of alternative configurations of the clearing business will make this battle particularly intense.  And the stakes will be particularly high given the importance of clearing in the new financial architecture.

In an article forthcoming in the Journal of Applied Corporate Finance, I put it this way (link to follow when it’s available):

It is well known that the effects of central clearing on the costs of bearing counterparty risk and on systemic risk depend crucially on the equilibrium configuration of the clearing industry.  For instance, netting benefits are maximized when clearing is concentrated into a small number of multi-product clearinghouses—and arguably into a single CCP.  But the failure of an immense CCP would have disastrous consequences for the stability of the financial system, and could set off a daisy chain of failures of other CCPs, with further damaging effects.  Moreover, the scale and scope of CCPs are almost certain to affect incentives, governance costs, and the effectiveness and accuracy of risk pricing.  So it is by no means obvious what is the structure of the clearing market that optimally trades off these competing considerations.

It is equally unknown what clearing market structure will evolve, and how close this structure will come to approximating the ideal structure.  In this regard, it is essential to keep in mind two facts.

First, the extensive scale and scope economies associated with clearing make it likely that the clearing industry will be highly oligopolistic, and that strategic considerations will influence decisively the way that the industry develops.   Moreover, scope economies across trade execution and clearing (Pirrong, 2010b) will also affect the strategic and efficiency forces that will shape industry structure.  Strategic considerations will almost certainly drive a wedge between what is optimal for the individual decision makers, and what is optimal for the economy.  This is particularly true inasmuch as there is no market mechanism evident that would induce CCPs to internalize the systemic externalities associated with their failure.

Relatedly, governance and organizational form will matter.  For instance, for profit and not-for-profit mutual CCPs are likely to act differently.  Which choice is preferable?  What will determine CCP choices of organizational form?  CCPs are effectively cooperatives: how will collective action problems affect their incentives  and actions?  What regulations are required to address the governance problems that might arise under each form?  These are not easy questions to answer, but those answers will have an important effect on how clearing works in practice.

Second, industry evolution will inevitably be a highly politicized process.  Dodd-Frank gives regulators enormous discretionary authority over the operation of CCPs.  Interested parties will influence the regulatory process for their private benefit.  Political tradeoffs, rather than efficiency considerations, also threaten to cause serious divergences between the structure that evolves in practice, and the one that would optimize the relevant economic tradeoffs.  The effects of politics are particularly pronounced in this context because finance is a truly international industry, and hence jurisdictional issues and competition between jurisdictions will play a decisive role in determining the industry’s ultimate configuration.  For instance, governments in major financial centers (e.g., the US, London, the EU, and individual countries in the EU, Japan, Singapore, and Hong Kong) have all expressed a strong interest in domiciling CCPs, for both economic and political reasons.  But accommodating these interests would fragment clearing, reducing netting benefits and raising serious concerns about coordination during a crisis.  Moreover, regulatory competition between jurisdictions to favor their local CCPs could compromise financial market stability.

I’ve written elsewhere–long before the crisis, in fact–that there is a fundamental tension in clearing organization.  Risk control and moral hazard considerations provide a strong rationale to limit participation in CCPs, and/or to impose substantial capital requirements on participants.  But limiting membership to CCPs can also be a way of cartelizing the industry: given the strong scale and scope economies, a CCP that has fewer than optimal members can still be large enough to make it impossible for any other competing CCP to achieve the scale economies to compete with it.

What’s the right trade off?  Barney?  Chris?  Gary?

The politicized process is underway.  Bloomberg’s Matt Leising (article not online, it appears) and the WSJ describe how the battle lines began to form at a recent CFTC-SEC public workshop.  The competition-risk trade-off is a main axis of conflict.  First Matt Leising, describing the arguments of those who favor opening up CCPs to encourage competition:

Financial firms should be allowed to become members of over-the-counter derivatives clearinghouses even if they don’t meet current minimum capital requirements, according to an industry group. The Commodity Futures Trading Commission and Securities and Exchange Commission should allow smaller firms that don’t meet clearinghouse guidelines to become members, said Jason Kastner, vice chairman of the Swaps and Derivatives Markets Association.

Kastner spoke at a roundtable discussion today on OTC derivatives clearing at CFTC headquarters in Washington. Clearinghouse operators Intercontinental Exchange Inc., CM Group Inc. and LCH.Clearnet Ltd. in the $615 trillion privately negotiated derivatives markets enforce capital requirements and trading rules intended to bolster the ability of their organizations to withstand losses. Those requirements prevent all but the world’s largest banks, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Barclays Plc, from sending trades to the clearinghouses, the SDMA told the Federal Reserve in June.

“It’s not just about capital,” Kastner said today, referring to rules such as Intercontinental’s that members of its credit-default swaps clearinghouse have a minimum net worth of $5 billion. Regulators should create and enforce rules so that smaller firms can become members so “that it’s somehow proportional.”

But then Matt notes that some argue that Dodd-Frank is about reducing systemic risk, and has nothing to do with competition:

The main purpose of the financial-reform law, named after its principal authors, Connecticut Senator Christopher Dodd and Massachusetts Representative Barney Frank, was to make the financial system stronger by increasing risk-management standards, said Jonathan Short, a senior vice president at Intercontinental.

“It all sounds great on paper to say ‘let a thousand flowers bloom,’” he said. “I’ve never heard the Dodd-Frank Act
described as something that was done to promote competition among firms.”

[It should be noted that Dodd-Frank does include provisions encouraging competition and enjoining CCPs not to violate anti-trust rules.  How to reconcile that with the injunctions to reduce systemic risk?  Who knows?  Not Dodd and Frank’s problem.  They just wave their wands and presume the broomsticks will take care of it.]

This all makes some people nervous:

Ananda Radhakrishnan, director of the CFTC’s Division of Clearing & Intermediary Oversight, said he would hesitate before telling clearinghouses to lower their capital standards for members.

“As someone in charge of clearing, I’m reluctant to tell someone ‘you should lower the level of capital,’” he said. [In charge of clearing?  Think much of yourself, Al Haig Radhakrishnan?]

The WSJ article notes that people have picked up on the tension inherent in the issue:

James Hill, a global credit-derivatives officer at Morgan Stanley, warned that if companies without proper risk management expertise were allowed into the clearinghouses, “they will become the next “too big to fail,” and we don’t want to do that.”

After J.P. Morgan Chase & Co. managing director Jeremy Barnum said regulators would have to weigh “very complicated tensions” in determining how to write the rules, Mr. Kastner shot back that “it’s not credible to say it’s complicated.”

Not credible, indeed.

So, barely weeks after the passage of Dodd-Frank, we are seeing the sausage making process begin.  Efficiency and rent seeking and competitive considerations are all going into the hopper.  Who the hell knows what will come out the other end?  The potential for a colossal mistake–or mistakes–is great.  And these mistakes will be systemic in the effect.  For as I also say in the JACF piece:

This change is fraught with potential unintended consequences.  It is predicated on a belief that market participants systematically chose the wrong ways to trade derivatives and allocate the default risks inherent in them, but there strong reasons to believe that in fact many of the institutions adopted prior to the crisis had a strong economic rationale.  This means that forcing the implementation of a particular market infrastructure via legislative fiat runs the serious risk of reducing the efficiency of the financial markets.  In particular, although it is intended to reduce systemic risk, the mandating of expanded clearing carries its own systemic risks.  Moreover, the future evolution of market structure is highly uncertain, especially given the cost characteristics of clearing and the fact that this evolution will occur in a highly regulated environment in which political—and rent seeking—influences will play an important role.  Very bad evolutionary paths are certainly possible.  In brief, the effects of Dodd-Frank on the efficiency and stability of the financial markets are highly uncertain at best, and highly unfavorable outcomes wholly unintended by the authors are quite possible, and indeed, likely.

One final thought about systemic risk.  It is worth remembering that the imposition of a single, one-size-fits-all infrastructure is inherently systemic in its effects.  Any flaw or failure in that standard structure will have systemic consequences.  A mandate that is ill-adapted to the fundamental economic conditions in the derivatives markets creates a systemic risk because (a) ill-adaption makes failure more likely, and (b) the sweeping breadth of the mandate means that the effects of such a failure will be system wide in scope.

But have no worries, Gary Gensler tells us: “U.S. regulators won’t succumb to Wall Street efforts to weaken financial-market oversight as they implement the biggest rules overhaul since the Great Depression.”

Just how is this supposed to happen?  Yes, interested parties–and not just the big banks–have an incentive to shape the rules to benefit them.  But interested parties also have the best information and the greatest knowledge.  Are Genlser and the other regulators to shut their eyes and ears to what industry participants tell them?  That would mean ignoring the good advice, as well as the bad, self-interested kind.  If not, how are they to distinguish between the good and the bad?  Mistakes are inevitable.

This information problem is inherent in regulation, especially when involving something as incredibly complex, dynamic, reflexive/responsive, and interconnected as the financial markets.  Painting this as a morality play between the good government types (the “Goo goos” in Boston Mayor James Curley’s trenchant phrase) and the malign self-interested banks is insultingly simplistic.

Congress and Obama have given regulatory agencies the authority to lead the industry, but no map to show them where to go.  The blunder potential is huge.  The cacaphony  of voices, reflecting differences in information, interest, and motivation, will make it difficult to avoid such blunders.  Last week’s meeting gives just an inkling of the conflicts to come.

But I’m sure it will all turn out well.  It always does, doesn’t it?

You don’t have to answer that.

There was a kerfuffle earlier this week when the CFTC said that Exchange of Futures for Futures transactions–EFFs–were legal, despite the CME’s claim that they were banned wash trades.  There has been some breathless commentary that this is a grave competitive threat to CME, and raises the specter of “fungibility,” meaning that clearing and execution would effectively be unbundled.  A trade could be traded on one exchange, and then cleared elsewhere.  This would, supposedly, increase the competition that the CME would face.

I rolled this rock up the hill too many times pre-crisis, when fungibility was a headline issue before it was overshadowed by the crisis and its effects.   For instance, this was a big issue in the DOJ’s infamous passive-aggressive letter in the winter of ’08.

So, let me say it yet again.  As the Chicago School of Antitrust Economics pointed out long ago, if clearing is the source of the CME’s market power (as the advocates of fungibility claim), the CME could maximize the profits it earns by charging the appropriate price for clearing services.  It would have no incentive to tie execution and clearing.  Indeed, it would have an incentive to encourage competition in execution in order to maximize the derived demand for its (monopoly) clearing services.

So, the argument that tying execution and clearing is anti-competitive is fundamentally flawed.  There is another purpose for it.

I should also note that even with fungibility, the CME competitor ELX will face daunting obstacles in challenging CME in execution.  That’s because clearing is not the only source of scale economies in providing trading services.  Due to the effects of liquidity, there are huge scale economies in execution as well.  Price impact costs are far smaller in bigger, more liquid markets.

Indeed, it is the existence of large scale economies in clearing and execution which, in my view, drive the integration/bundling of the two services.  Integrating back-to-back monopolies economizes on transactions costs.

But integration does not require bundling of the services.  So why does CME insist on doing so?  (I.E. why do you have to trade on the CME to clear on the CME?)  The most likely explanation is that it wants control over access to the clearinghouse for risk management and control reasons.  The CME wants control over whose risk it takes and whose risk it guarantees.  EFFs could call that into question.  But if that’s the case, the CME would be advised to make it straight up, rather than relying on the wash trade argument.

I called this a kerfuffle because I don’t think EFFs will catapult ELX into contention in head-to-head competition with CME.  The CME’s liquidity advantages are too great.  This will get ELX some headlines, but not much business.

Update (1145 CT, 8/19/10). Last night, after posting this, I read something from the CME that was sent to me before I’d written the post.  It makes the “clearinghouse control” argument “straight up.”  Responding to a Consultative Paper issued by Center of European Securities Regulators, CME CEO Craig Donohue wrote:

[F]ungibility (i.e., one contract could be substituted for another contract) is not necessary or desirable.  Fungibility for OTC derivatives contracts across multiple exchanges or trading venues serves only to provide linkages, or interoperability, among various clearing houses providing clearing services for the exchanges or trading venues listing such contracts.  Interoperability among clearinghouses increases systemic risk to each clearing house and the financial system as a whole.  Indeed, when one side of a matched trade is transferred, the original clearing house automatically becomes exposed to the risk of the other clearing house.  As transfers build and links between clearing houses increase, the ability to contain a single failure decreases and the risk throughout the system increases.

So, CME is making the risk control argument in a straightforward way.

This is a good response to Bill’s question in his comment.  The key issue is one-sided transfers.  Before an EFF, trader A’s counterparty is the CCP of the original exchange (CCP1).  CCP1 has an offsetting position with A’s original trading party, B say.  If A executes an EFF with an exchange using CCP2, since both CCP1 and CCP2 have to have zero net positions, and the EFF doesn’t change CCP1’s position with B, the chain of contracts is now:  A has a position with CCP1; CCP1 has an offsetting exposure with CCP2; and CCP2 has its original exposure with B.  Thus, giving A the unilateral right to EFF into CCP1 allows him to create an inter-CCP exposure without CCP1’s consent.  CCP1 may not want to be exposed to CCP2, for both risk and operational reasons.  From a systemic risk perspective, too, this creates the dread interconnections that clearing is intended (by the ignorant, admittedly) to eliminate.

Hope that helps, Bill and BwO.

As an aside, the Donohue letter does go on to say that the CME endorses “open access” to CCPs.  The distinction is that open access as the CME uses the term means that end users can choose their clearinghouse when doing a cleared OTC deal, and if they enter into offsetting trades with different dealers, direct the trade to the original CCP in order to liquidate a position.

In response to BwO’s comment.  The argument in a nutshell is that monopoly leveraging is generally unprofitable.  Assume that product M is monopolized, and product C is competitive.  Can the monopolist increase profits by requiring that anybody who buys M also buy C from it?  Except under special conditions, the answer is no.  This is because consumers may not like the monopolist’s variety of C.  They are willing to pay less for the M+C bundle provided by the monopolist than they are for a bundle of M and their preferred variety of C.  This means that bundling reduces the demand for M, reducing the price that the monopolist can charge.  The demand for his product–and his profit–is greatest when he lets customers choose their preferred variety of C, and he charges the monopoly price corresponding to this higher demand curve.  (A similar argument holds with respect to the case where the M monopolist is not the low cost producer of C).

So, except under highly unusual circumstances (which I discuss next) it is absolutely NOT the case that “tying is anti-competitive bundling that parlays one monopoly into another monopoly.”  This has been widely understood in economics and anti-trust since the 1960s.  So yes I can argue that, and it has been argued since Bork, Posner, Director and others first addressed the issue, and virtually every model on the subject implies this result except if you build in some special (and usually contrived) conditions.  Even Whinston, who made his name on these alternative models, admits that there aren’t good practical examples of the factors he identifies leading to the anti-competitive result.

There are some counterexamples in the literature.  Hart and Tirole (1990) have one.  Whinston (1990) has several.  None of these models is remotely applicable to the case of clearing.

Carlton and Waldman (2002) have a very nice model specifically designed to address the Microsoft bundling issue in a two period model.  The key assumptions in their model is that the tied products are durable goods, and that any entrant cannot produce the monopoly product in the first period, but can produce the competitive one.  They show that under some conditions–not all–anti-competitive bundling might work here.  Neither of these assumptions is relevant in the clearing/execution context: these are not durable goods, and simultaneous entry by an integrated competitor is possible.  Nor is their assumption that one good is competitive and produced subject to constant returns to scale: in trading, both clearing and execution are subject to strong scale economies.  In this working paper I modify the Carlton-Waldman model, and show that in conditions that are most plausible in the clearing/execution setting, anti-competitive bundling is not likely to be a profit increasing strategy for the clearing monopolist.  That paper discusses the literature in some detail, and examines other transactions-cost based reasons for integration of clearing and execution.

Thanks for the comments.

In a semi-follow up to yesterday’s post on trading mechanisms, today I’m going to explore post-trade price transparency.

One example that has been brought up repeatedly in the context of increasing transparency in the OTC derivatives markets is the introduction of TRACE in the corporate bond market.  TRACE mandated the disclosure of all corporate bond trades, including information on price and trade size.  Currently, the information has to be reported within 15 minutes of the trade.

It has been argued that TRACE improved the efficiency of the corporate bond market, and reduced trading costs and dealer profits.  This supposedly occurred because the opacity of the market pre-TRACE gave the dealers market power that they could exploit to their benefit.

The empirical basis for these pro-TRACE claims is a couple of studies.  One compared round-trip trading costs pre- and post-TRACE, and found that post-TRACE costs were smaller.  Another exploited the fact that TRACE was phased in over time, and ran cross-sectional regressions that compared trading costs for bonds that were TRACE-eligible and those that weren’t, while controlling for other observable factors.  This study also found that TRACE lowered costs.

I am always a little leery about these kinds of studies.  They implicitly assume that the characteristics of the transactions in the TRACE and non-TRACE samples are the same, or can be controlled for based on observable variables.  I’m not quite so sure, especially given some of the other things that transpired post-TRACE–as I’ll discuss now.  (In social sciences, you always have to worry about endogeneity problems.  They’re devilishly hard to control for; natural experiments or good instrumental variables are hard to come by.)

Most notably, there is anecdotal evidence that post-TRACE, corporate bond dealers dramatically reduced the size of their trading teams, and reduced their inventory holdings.  They effectively transitioned from dealers to brokers.  The reduction in inventory means that they reduced their capital commitments to this business.

Now this is hard to square with a story that TRACE reduced dealer market power, which in turn reduced trading costs.  Typically, firms exercise market power by restricting output and capacity.  Thus, something that increases competition should lead to an expansion of output and capacity.   The opposite happened, apparently.

You can tell a kind of monopolistic competition story.  Dealers had market power due to opacity, but competed away the rents by overinvesting in capacity, or in “quality” by investing excessively in inventory that allowed them to accommodate customer needs more readily.  But even in a monopolistic competition story, increasing competition (by reducing customer search costs, for instance, through better disclosure) makes individual firm demand curves more elastic, meaning that those firms that continue to operate should increase output and operate closer to their minimum average cost point.  That’s hard to square with what happened post-TRACE.

It should also be noted that the theoretical foundation for the contention that improved disclosure reduces profitability by increasing competition is weak.  Madhavan (RFS, 1996) has a sequential trading model in which dealers can choose not to disclose trades, but are in competition with one another.  In equilibrium, dealers don’t disclose a trade that occurs today because the order flow is informative, and the information they get when they do a trade allows them to trade more profitably in the future; a dealer that trades today has a competitive advantage over other dealers in trading in the future.  But in equilibrium, dealers don’t earn any profits.  This is because they compete aggressively to attract order flow today.  Some trades are “loss leaders” that they use to attract order flow that increases the profitability of future trades.  Thus, lack of disclosure is not necessarily profitable for dealers because competition for market power dissipates rents.

There are other post-TRACE developments that are hard to square with the Gary Gensler & apple pie story.  (The details can be found in a JEP paper by Bessembinder and Maxwell.)  Notably, if you believe that trading costs really fell, this should have benefited corporate issuers.  Ultimately, investors are willing to pay less for bonds, the greater the costs of trading them later.  If trading costs fell, publicly traded bonds should have become a relatively more attractive form of finance for corporations.  But in fact, post-TRACE, firms relied much more on privately placed bonds; corporate bond issuance fell; and CLOs (collateralized loan obligations–securities backed by bank loans) grew dramatically.  So, corporations relied much less heavily on instruments that should have become relatively cheaper to issue if trading costs really fell as a result of TRACE, and relied more on stuff that couldn’t be traded at all (private placements) or traded in dealer markets (the CLOs)!  This is inconsistent with the view that transparency reduced corporate bond trading costs dramatically, and rather implies the opposite.  (Of course, a lot of other stuff was going on during this period, so it’s a stretch to lay all this on TRACE, but still, it is facially not supportive of the claim that TRACE reduced trading costs.)  (This also raises the question: if the dealer structure without disclosure was so inefficient, why didn’t issuers use their leverage to mandate disclosure, e.g., by conditioning participation in underwriting syndicates to firms that committed to disclose trade information?)

Why might trading costs have gone up?  Anecdotally, it became harder to trade in size post-TRACE as dealers weren’t willing to take on big positions once they had to disclose that they had done so.  That is, dealers were at risk of being front run once they took on big positions from a customer/counterparty.  So they offered less liquidity, making it more expensive for the insurance companies and pension funds that dominate the market to trade.  This would explain why they reduced their head counts, cut back on inventory, and essentially shifted from dealing to broking.

This all suggests that the effect of TRACE was to lower the transactions costs for some (primarily small retail traders), increase trading costs for others (mainly big investors), and change the composition of trades (in favor of trades that were easy to broker).  Put differently, TRACE made “wholesale” trades more expensive–pricing some out of the market altogether.  Not an unalloyed benefit, and arguably quite the reverse.  If the corporate bond market is primarily a wholesale market, the effects of transparency could have been detrimental on net, even if some benefitted.)

This isn’t dispositive, but it should give pause.  In particular, when evaluating the effect of a market structure change, or of a mandated change in transparency, you need to look beyond simple before and after or cross sectional price comparisons, as these may be incomplete and misleading.  Moreover, you need to look at things other than price.  If a policy change results in exit of firms and reductions in the size of firms, and substitution away from the product affected by the change, you have to seriously question whether the change increased competition.  Usually you’d expect reductions in barriers to competition to lead to entry, increased output, and substitution towards the product that became more competitive.   When the exact opposite happens, you better have a really good story–which I haven’t seen anybody advance–or you better seriously entertain the hypothesis that the supposedly pro-competitive change had the exact opposite effect.

So, rather than being the feel good story of the summer, upon closer examination TRACE appears to be an ambiguous tale at best, and more likely a highly cautionary one.  And those who constantly prattle about the wonders of transparency–and you know whom I speaking of–should be pressed to address all of the dimensions of the TRACE experience.   Because it is quite plausible that interventions into wholesale markets, including mandates to make trading more “exchange like” with more pre- and post-trade transparency, can increase the costs that customers in those markets pay.

I’ve written a lot about clearing mandates, but less on the Dodd-Frank Act’s attempts to alter the way derivatives trades are executed.  In part, this reflects the incredible uncertainty about just what a “swap execution facility” must be and do.

But, it is pretty evident that there is deep suspicion about bilateral OTC market dealings, both in Congress and especially among regulators.  CFTC Chairman Gary Gensler in particular has criticized bilateral trading mechanisms.  He, and many others, want to move the vast bulk of trading activity to exchange-like systems.  The standard argument is that the opaque OTC markets work to the advantage of dealers and to the disadvantage of customers.  The greater pre- and post-trade transparency in auction-based, order driven exchange markets, the story goes, will undermine the information advantage that dealers have in OTC markets, thereby eroding their profits.

As was routine in the clearing debate, this begs crucial questions.  Most importantly, why would customers choose to trade in opaque dealer markets?  Why can’t exchanges win in competition for customers with OTC dealers, if the former offer a better deal?

There is a tremendous diversity of trading mechanisms across products, and within products.  In products where exchanges compete with dealer markets, dealer market shares vary widely.  The dealer share is virtually 100 percent in FX and FX derivatives.   It is large–on the order of 80 percent–in linear interest rate derivatives.  It is closer to 50 percent in interest rate options and equity derivatives.  In the cash equity markets, a lot of trading took place on anonymous exchanges, but a good deal once took place in non-anonymous upstairs markets.  Nowadays, the upstairs markets are less important, but dark pools serve similar functions, notably facilitating large trades.  Cash Treasuries were long dealer markets, and still are to a large degree, although electronic markets have made in-roads.

There is also time series variation.  Biais and Green have an interesting paper that documents how the municipal and corporate bond markets migrated from exchange trading (on the NYSE) to a bilateral dealer market.

The simplistic “dealers scalp their poor customers” story doesn’t explain this cross sectional and time series variation in the market shares of “wholesale” dealer markets.  There must be something else going on.

What many of these off-exchange markets have in common is that they screen out informed trading.  Dark markets and third markets utilize screening technologies, or trading mechanisms that are unattractive to informed traders (e.g., crossing networks).  Others, like the upstairs markets, block markets, and OTC derivative and bond markets (govvies, corporate, and munis) rely on reputation, and are not anonymous.  Dealers reduce their risk of dealing with counterparties with private information by knowing who they trade with.  They are “opaque” in the sense that there is little pre- or post-trade transparency.  But they are far less opaque than exchange markets–especially electronic markets–in the crucial dimension of the observability of the identity of the counterparties.

The empirical evidence shows pretty conclusively that big traders incur much smaller trading costs by trading in these venues.  Which is pretty obvious: the big traders aren’t stupid, and are going to trade where they get the best prices.  The Biais-Green piece is interesting in this regard.  The market moved from exchange to OTC when insurance companies and pension funds began to dominate bond trading.

So, the claim that customers are victimized in dealer markets is hard to square with the evidence.  Big customers often benefit by trading in markets that are opaque in some dimensions, but transparent in others.  Dealer-based “wholesale” markets favor a particular kind of customer, and those customers choose to trade there.  They aren’t victims.

I am also less than persuaded that OTC market customers are all that ignorant about values.  For instance, a customer buying or selling an OTC interest rate swap can look to the Eurodollar futures market and to the Treasury futures as a source of information on the yield curve that they can utilize to evaluate the bids and offers of OTC dealers.  It’s even easier in the energy markets, to compare a dealers bid and offer on a NYMEX lookalike product with the real McCoy trading on the screen.  Moreover, those who are trading OTC have the opportunity to trade these close substitutes in highly liquid exchange markets–but they don’t.  Presumably because it is cheaper to trade off exchange than on, even though they are allegedly trading with rapacious dealers who keep them in the dark.

And this raises an issue that has been the focus of debates about “fragmentation” between exchange and dealer markets in the past, but which has strangely disappeared from sight in the current debate.  Once upon a time, a major objection to off-exchange trading was that “free rides” off of exchange price discovery, and worsens liquidity on the exchange market.  In essence, those who can verifiably demonstrate they are not privately informed can get lower trading costs by trading off exchange, thereby leaving those who cannot demonstrate that they are uninformed more vulnerable to trading against the informed, and incurring higher trading costs as a result.  That is, off exchange venues like block markets and dealer markets “skim the cream.”

This can’t be the case in some markets.  In corporates and munis, for instance, there’s no market to free ride off of, for all intents and purposes.

Even in markets where cream skimming and free riding are possible, it is not clear that the net effect of this is welfare reducing.  If the exchange market is perfectly competitive–and this is a huge if, and a huge implicit assumption in most of the literature on fragmentation and cream skimming–then the externality associated with price discovery means that off-exchange trading is welfare reducing.  But exchange markets are not necessarily perfectly competitive.  As I’ve shown in my academic work, exchanges exercise market power, through entry limits (e.g., limits on the number of exchange members), organizing member cartels, and super-marginal cost pricing.  They can do so because the “tippiness” of anonymous markets tends to make price discovery a natural monopoly.

If exchanges exercise market power, we aren’t in a first best world anymore, and therefore what would normally be considered a market failure–like an externality–can actually improve welfare.  I show this explicitly in a couple of papers, one published in the JLEO, and in a working paper titled “Third Markets and the Second Best.”  In these models, competition from off-exchange markets reduces exchange market power, leading to lower total execution costs (and higher aggregate surplus).

But even if this happens, off-exchange trading has distributive effects.  Those who can avail themselves of the off-exchange opportunities gain, those who can’t, don’t.  But the gains of the former are bigger than the losses of the latter.  These distributive effects are the reason, though, for the intense controversy over market structure.

This means that forcing trading onto exchanges can reduce competition and increase total trading costs.  Ironically, the biggest losers in this would be those who are ostensibly being helped: those who voluntarily choose to trade in dealer markets, like the OTC derivatives markets.

Some who fret about the persistence of opaque bilateral markets attribute their persistence to the “tippiness” of financial markets.  For instance, Biais and Green argue that muni and corporate bond markets have remained OTC because it is hard to tip order flow away from established markets.

I find this argument unpersuasive for two reasons.

First, and most importantly, tipping occurs in anonymous markets, as a consequence of informed trading.  The uninformed like to cluster in a single market because that minimizes their losses to the informed.  But the whole thing about many wholesale markets is that they allow the uninformed to avoid losing to the informed through another mechanism–transparency about trader identity and type.  Markets fragment between price discovery natural monopolies (where informed and uninformed trading take place) and other markets where less price discovery occurs because these trading mechanisms screen out many of the informed, making the uninformed who trade there better off.

Second, the tipping argument may be plausibly persuasive in corporates or munis, but not in many OTC derivative markets.  For instance, there are extremely liquid markets for Eurodollar and energy futures.  Traders who choose to trade OTC could avail themselves of this liquidity–but they don’t.  Again, because it is cheaper to trade someplace else.  Put differently, tipping may be able to explain something like munis where there’s only one market (though I doubt that): it cannot explain the side-by-side survival of two big markets, like Eurodollars and interest rate swaps.

In brief, there is a diversity of trading mechanisms because there is a diversity in trader types.  Forcing trading onto a one-size-fits-all platform will inevitably have distributive effects, and will almost certainly have efficiency effects too.   These efficiency effects are likely to be adverse, because anonymous trading venues where trades with private information can buy and sell tend to have market power.  Reducing competition from non-anonymous trading venues, like OTC dealer markets enhances the market power of the anonymous markets, and their owners can profit accordingly.  Moreover, in profiting, they price their services in a way that creates deadweight market power losses.

We should never expect financial markets to approximate even remotely perfectly competitive markets.  But fragmented markets in which some traders participate in face-to-face dealer markets can be better than having everybody trade on “transparent” exchanges.   This is because usual descriptions of transparency focus on price transparency, and that’s not all that matters.  Markets that offer the most price transparency often offer the least counterparty transparency.

Gary Genlser has repeatedly used the analogy of going to the store and buying an apple at a posted price to argue that everybody should want to trade on markets with pre-trade transparency.  But there is diversity even in apple markets: wholesale and retail markets are different, and offer different degrees of transparency.  The same can be said with even greater force in financial markets.

Which is why I conclude that if Gensler and those of like mind get their way, and succeed in forcing–yes, it would be by force–more trading onto anonymous, exchange-type markets, trading costs will rise and welfare will fall.  And the biggest losers will those who are the alleged victims of the lack of price transparency in OTC markets.  They will be losers because that lower price transparency is more than offset by other advantages of trading in non-anonymous markets.

I finally had a chance to do some preliminary analysis of cocoa data.  My initial findings are that price movements and price-stock relationships during July, 2010 were consistent with manipulation, and unlikely to have resulted from chance in a competitive market.

In brief, I executed the kind of event study described in my 2004 American Law and Economics article on manipulation, which examined the Ferruzzi soybean case.  For a January, 2000-June, 2010 control period, I regressed the change in the log of the July London cocoa price against the change in the logs of (a) the September London cocoa price, (b) the November London cocoa price, and (c) the July ICE New York cocoa price.  (I used the settlement prices for London, and the opening price from New York).  For each year, the data included in the sample runs from 1 March to the last trading day of the July contract.

Given the coefficients from the regression, I then forecast what the log change in the July price would have been for each day in the month of July, and take the difference between the actual log change and that forecast.  I then cumulated these residuals over the month of July, and calculated t-statistics using conventional methods.

The basic result is that the July, 2010 price rose about 6 percent more than one would have predicted, given the movements in the September, November, and July ICE prices.  The t-stat on this cumulative residual is as high as 2.95, which is statistically significant at all conventional levels.  (The p-value is about .1 percent.)  This rise in the relative price of July cocoa is exactly what you would expect to observe during a corner, and given the typical co-movements of all these prices, are highly unlikely to have occurred by chance in a competitive market.

Moreover, the July-September spread was the highest observed–by far–when the contract went off the board, then at any time dating back to 2000.  July was 235 GBP over September when the contract went off the board.  Prior to this year, the biggest back was under 100 GBP/ton.

Stocks rose rapidly in July at the same time that spreads were blowing out.  In a competitive market, you would expect stocks to plummet when spreads moved into a strong backwardation.

The spreads-stocks relation exhibits the typical “supply of storage” (or Working) curve shape, although it is somewhat noisy; backwardation is larger, the smaller are stocks.  By 12 July, 2010,  the stocks were very large for the amount of backwardation in the market.  Or put differently, given the level of stocks, backwardation was unusually large.  This is especially true if one adjusts for the strong downward time trend in stocks observed 2002-mid-2010.  After adjusting for the time trend in stocks, the spread usually associated with the level of stocks observed in mid-July 2010 was a contango of about 20 GBP–nowhere near a backwardation of 250 GBP.

Thus, the market exhibited all the indicia of market power manipulation during July, 2010.  There is no plausible competitive explanation.

The data cast the Sergeant Schultz “I see NUTHINK!” attitude of LIFFE, and the FT’s slobbering coverage of Tony Ward, in a very, very bad light.  The data support a manipulation claim quite strongly; LIFFE’s denials and the FT’s breathless Tiger Beat-esque coverage are very hard to square with this data.   One would have hoped that they would have taken at least a cursory–and skeptical look–at what transpired in the market before declaring that nothing is amiss.  One would have hoped in vain.

Jeremy Grant is going to town with stories and video interviews on the implications of clearing mandate on his FT TradingRoom site.  One that particularly caught my attention was this interview with Guy Sears.  They discussed the implications of clearing mandates on pension funds.  Sears says (about the 5:55 mark):

It’s about the governance and who carries the risk in this model.  Clearinghouses work by seeing an instrument and worrying about the risks of failure in an instrument.  How far away has it got from its original price?  What’s the market risk in the instrument?  At the end of the day, of course, what really matters is whether the guy holding the instrument is good for his money.  We would say that the pension schemes and savings pools are good for their money.  Making them provide margin to pay for everyone else’s risk is asking them to take part in socializing risks they really should have to pay for because they aren’t risky.

Sears makes a point that I’ve emphasized from early on that has largely been overlooked.  Specifically, two factors interact to determine the risk of default: instrument risk and balance sheet risk.  CCPs price instrument and generally don’t price balance sheet risk, except in the crudest and most problematic of ways.*

As Sears says, balance sheet risk–the risk that “the guy holding the instrument is good for his money”–is crucial.  Not pricing it leads to distortions in the allocation of trading activity across market participants.  It also means that those who use clearing do not pay a price for adding balance sheet risk, which distorts their risk taking decisions.

Sears effectively objects to charging pension funds the same price for risk as a hedge fund pays.  This is a fair objection.  It harms pension funds directly, but it can also distort trading activity, causing hedge funds to trade derivatives relatively more than they should, and pension funds relatively less.  Does this reduce systemic risk?  That seems difficult to argue.

Moreover, different entities have different ways of effectively undoing the effects of clearing.  High and frequently adjusted margins on cleared products mean, essentially, that market users are not in a credit relationship with the CCP, in the same way that they can be in a bilateral dealing.  But this means that mandating clearing frees up credit capacity that can be used to undo, in whole or in part, the debt-reducing effects of clearing.  Some entities, notably pension funds, have less ability to leverage up (and indeed, given their high creditworthiness, are not really in that much of a credit position relative to their counterparties in any event).  This means that a clearing requirement would hit pension funds particularly hard, and unjustifiably.

Pension funds will respond by (a) reducing their usage of derivatives, and (b) reducing their investments in higher return assets in order to accumulate the cash needed to post margins on the derivatives they do trade.  Response (a) means that these funds will incur higher transactions costs to achieve their investment and liability management objectives, and will bear more risks.  Response (b) means that pensions will be less remunerative.

The Frank-n-Dodd bill exempts retirement funds from the clearing mandate to the extent that they utilize derivatives for risk management/hedging purposes.  It is ambiguous whether this exemption would, for instance, cover a fund’s use of an equity derivative or commodity derivative contract to achieve an investment objective.  But the recognition that retirement funds might deserve different treatment is one good thing I can say about Dodd-Frank.  (Although it’s not evident whether this exemption was the result of a fluke moment of lucidity, or the lobbying power of pension funds–including public and union funds.  The latter would be rich indeed.)

But Sears’s main point holds.  Balance sheet risks are an important determinant of counterparty risks.  CCPs don’t price this risk.  This lack of risk pricing is costly.

* CCPs often impose capital requirements, but these are generally multiples of margins.  Since margins don’t vary with balance sheet risk, these capital requirements don’t either.  Moreover, CCPs sometimes condition margins on credit ratings.  Given the crudity of these ratings, and the perverse feedback that results from ratings change-induced increases in margin, this is a coarse and potentially destabilizing way of pricing balance sheet risk.

Not long ago I wrote a post about commodity forward curves, focusing on the confusion between “backwardation” as the term is used in the market, and as misused by Keynes, to the confusion of many.  The basic point was that  Keynesian “normal backwardation” stories cannot explain directly observable forward curves.  Normal backwardation is about risk premia–differences between futures prices and expected spot prices–and these risk premia are not observable directly.

For an asset that is always in positive supply, there can be backwardation in the Keynesian sense but the forward curve will always be at full carry.  Arbitrage considerations drive the forward curve, and risk preferences of the marginal speculator affect both spot and futures prices, without affecting the spot-futures spread.  In essence, if the futures price is downward biased, the spot price will be less than the present value of the expected spot price; this price depression causes an appreciation in the spot price that rewards someone holding the asset for the risk, and this upwards drift over and above the risk free rate is exactly the same as the upward drift in the futures price.  Changes in risk preferences affect both spot and futures prices in the same way by the same amount, leaving spreads unchanged.

But commodities are not always in positive net supply.  There are sometimes stockouts.  Indeed, stockouts must occur in an efficient equilibrium, as if not, some units of the commodity would be produced but never consumed, which would be wasteful.

If risk preferences are to affect the forward curve, then, it must be through their effect on stockholding.  I have investigated this using a dynamic structural storage model of the kind that I examine in detail in my forthcoming book.

The technical details in a nutshell:  I utilize a simple model in which there is one random, mean reverting demand shock; that is, the demand shock follows an O-U process.  Production costs are subject to decreasing returns.   I solve the dynamic programming problem giving the optimal storage rule using the standard machinery.

To take risk preferences into account, I take a trick from contingent claim pricing theory.  If the marginal speculator is risk neutral, the forward price is the expected spot price, where expectations are taken with respect to the true (physical) probability measure.  If the demand shock risk is priced, however, due to risk aversion, the forward price is the expected spot price, where the expectations are taken with respect to an equivalent measure.  The demand shock process in the equivalent measure has a “drift” that differs from that of the process under the physical measure.  A negative drift adjustment means that the forward price is downward biased (Keynesian backwardation).  A positive drift adjustment means that the forward price is upward biased.

I solve the dynamic program for the storage problem under three values of the drift: zero, as under the assumed physical measure, plus 5 percent and minus 5 percent.

The results are interesting, and intuitive (I think, anyways).  The drift–and hence risk preferences–have a first order effect on inventories.  With downward bias, inventories are lower than under the physical measure.  Intuitively, downward bias makes it costly to hedge inventories, so inventories are smaller.

I’ve studied the performance of these model economies using long simulations.  Interestingly, even though inventories are smaller in the downward biased economy, the effects on prices are relatively small.  Plots of the spot prices (based on the same sequence of simulated shocks) from the two economies are almost on top of one another, and the average difference in prices across the simulations is about 1 percent.  There is a slight difference in price volatility (about a 5 percent difference).  Volatility is higher in the downward biased economy as demand shock-buffering inventories are smaller in that economy.  Importantly, prices are highly correlated across the two economies.  Demand shocks are the main drivers of price movements in both economies, and for an identical set of demand shocks, price movements are highly correlated.

Spot-forward spreads are affected somewhat.  (I simulate a spot-3 month spread).  Backwardations are more pronounced, and more frequent, in the downward bias economy.  This is because stockouts are more likely in this economy due to the smaller stockholdings.  But overall, the differences in calendar spreads between the two economies are not large (although they are larger than the price differences); the time series plot of the simulated spread for the downward biased economy is a slight displacement of the simulated spread for the risk neutral economy.  Backwardations peak at about the same times in each simulation, and contangoes/full carry periods exhibit large overlaps (though not complete overlaps, because there are times that the downward biased economy exhibits departures from full carry when the risk neutral economy does not).

One key result is that almost never in the simulations does a substantial backwardation exist in the downward biased economy while the risk neutral economy is at full carry.

Results for the upward biased economy are symmetric.  Inventories are larger, price volatility smaller, and prices about the same in the upward biased economy as in the risk neutral one.  Spreads tend to be closer to full carry, and backwardations are not as extreme, although the timing of backwardations is highly coincident in the two economies.

This has implications for the speculation debate.  Changes in market structure that lead to increased integration between a commodity market and the broader financial markets can, in theory, have an impact on the behavior of the commodity market.  In general, if you believe that a commodity market that is, as in the Keynesian treatment, isolated from the broader financial market exhibits “normal backwardation”, then the entry of diversified speculators that results in a dissipation of downward bias will have some effect on prices and spreads, and potentially a big effect on inventories.

The effect on prices and spreads is likely to be very hard to detect.  Even with a relatively big bias like that I assumed in the simulations, the effects on prices and spreads are not large.  Scholars have had a very hard time detecting any risk premium/bias in forward prices going back to the seminal contribution of Telser in 1960.  Certainly, there are no reliable estimates of bias as large as I assumed in my simulations.  This suggests that any effects of increased speculation on price bias/risk premia would be too small to have any effect on prices and spreads that could be identified reliably.

So, I am skeptical that any “financialization” of commodities that has occurred in recent years has had an effect on price levels or forward curves that can be distinguished against the normal noise in prices and spreads.

It should be noted, moreover, that integration of the commodity markets into the broader financial markets leads to consistent pricing of risks across markets.  Indeed, arguably differences in risk prices is a major driver of flows of capital.  If, for instance, a commodity market (say, oil) is not perfectly integrated in the financial system, so the price of oil price risk is higher than the price justified by risk premia on other investment opportunities in the economy, investors have an incentive to take on more oil price risk in order to capture its too high price. This will reduce the bias.

Integrating fragmented markets and equalizing price differences is typically efficiency enhancing.  It leads to a more efficient allocation of risk.  That’s a big part of what capital markets should be about.

In the commodity case, if the isolated commodity market exhibits downward biased forward prices, the entry of speculative capital that reduces this bias makes hedging cheaper, and encourages the holding of larger buffer stocks.  This reduces price volatility.

Phil Verleger has argued that this process has occurred in the energy markets.  That due to greater financialization, inventories are larger.  He points to the specific case of heating oil, and argues that recent stock buildups encouraged by more speculative activity in the market have helped prevent big price spikes during cold snaps.

These conclusions are also diametrically opposed to the scare stories that are repeatedly told about the effects of the entry of financial players into the commodity markets.  People telling those stories–and you know who they are–assume that the good old days when commodities and finance didn’t mix (which was never completely the case) were some sort of golden age, and that the entry of financial players has upset the operation of the market.

The simple model I’ve set out here implies that such entry may indeed change the market, but in a salutary way by leading to a more efficient allocation of risk.  The effects on price levels and spreads are likely small, and certainly not  immense, as the commodity Cassandras have asserted.  The effects on inventories are likely larger, but this effect is salutary, and tends to reduce price disruptions in the market.

The basic moral of the story: be very skeptical about claims that changes in the degree of financial participation in commodity markets have first order effects on prices and spreads.  Don’t try to explain changes in the shape of forward curves based on changes in speculative activity in the markets.  Intertemporal optimization–adjustment of inventories–in response to fundamental shocks is the most important driver of forward curves, and changes in financial participation likely have second or third order effects on prices and spreads.

Today’s FT runs another cringe-worthy PDA with Anthony Ward of Armajaro.  It is as probing and hard hitting as anything you would expect to read in, say, TigerBeat.  Its tone runs the gamut from credulous to worshipful.

I found the last two paragraphs particularly entertaining:

He is said to argue now as he did in 2002, that all he has done is go to the futures market “to buy cocoa in the most efficient and low-risk way possible”. The trade is likely to bring a stream of profits to Armajaro, particularly if the new Ivorian crop, due in October, disappoints.

Even if prices decline, Mr Ward is unlikely to suffer. A competitor who knows him well has no doubt he will have hedged his position. One admiring executive says: “No one knows the cocoa market better than Anthony.”

Paragraph 1: He’s long cocoa, so if prices rise due to a disappointing crop he reaps a stream of profits.

Paragraph 2: He’s hedged, so if prices fall, he doesn’t lose.  That is, he isn’t long cocoa.

If both of those things are true, he would indeed be a great trader: prices rise he wins, prices fall, he doesn’t lose.  He’s long the upside but not the downside.

How does that work, exactly? I mean, these diametrically opposed statements are in adjacent sentences.  Didn’t an editor think that such a feat was unlikely, or at least sufficiently intriguing to demand further investigation, explanation, and reconciliation?

There is, of course, a way that it could work: Armajaro could be long cocoa puts.  But this seems highly unlikely, as the traded put market is small relative to the deliveries that Ward has taken.  At the very least, though, the tension between the last two paragraphs should have spurred the report to do some actual, you know, investigation and reporting, to see whether the put story has any factual basis, and if so to provide some background on the cost of the puts and its effect on the profitability of the strategy.  And if it doesn’t (as is likely the case), to state forthrightly that Armajaro’s position is a risky one subject to a risk of losses symmetric to the prospect of gains.

But instead the reader gets a breathless fan mag portrayal of the hero who is able to do things that are impossible, or at least so unlikely as to demand further explanation.

This is all bad enough, but nothing compared to the apparent failure to ask any aggressive questions to test the reasonableness of Ward’s denial of squeezing or cornering the market.   If the questions were asked, but not answered, that should have been made plain, or the piece shouldn’t have run at all.  But that would ruin a nice piece of hagiography.

Mr. Ward’s evident hold over the FT is very curious.  An enterprising competitor could do worse than trying to figure out why–after, of course, doing some serious reporting on what has transpired in the cocoa market in recent weeks.

Dripping with condescension, Timmy! blew off the concerns of, oh, I don’t know, just about everyone in every kind of business about the effects of the regulatory avalanche that the administration and Congress have unleashed.  No sign here of that deep empathy that is supposedly he hallmark of Obama appointees (h/t R):

“Businesses always want their taxes lower and always want to live with low regulation,” Geithner said. “There is nothing remarkable, or particularly interesting frankly, that we’re in the midst of another debate, which you hear in almost any administration, with people looking for ways to help affect the outcome on the basic path of regulation and taxes.”

. . . .

But when asked a third time by The [Daily Caller] to address the [Business Roundtable] memo, Geithner said it was “a long, diffuse list of familiar concerns, again reflecting nothing remarkable … in the fact that business would like to operate with fewer restrictions.”

Translation: “The concerns expressed from coast-to-coast by businesses large and small, in virtually every industry, are not legitimate.  They are just petty, grubby attempts to achieve favorable regulatory treatment and reduced taxes.  Those who advance these concerns are self-interested and mercenary, and beneath the contempt of a high minded Olympian such as I.  Let them eat regulation.”

Astoundingly, Geithner dismisses any idea that the financial deform and health care bills are creating spending-suppressing uncertainty:

Geithner contested the idea that the health and financial regulation bills have made it more difficult for businesses to plan for the future.

“The basic framework is set. And that should help again give people a lot of clarity about what the basic rules they’re going to operate under is [sic],” he said. “But of course there’s a lot of rule-writing design, and there should be. A lot of the existing set of rules, muck of rules, were not any good. And so you want people to go back and revise and reform.”

Anyone who could say this is either a mendacious liar or a clueless clown.  (And yes “both” is making a strong run for the money.)  In the financial bill alone, there are at least 243 rules touching on every aspect of banking, securities, and derivatives markets that remain to be written: the true total is probably higher.  Nobody knows what those rules will be.  Nobody knows how those rules will interact.  Nobody knows how businesses and households are going to respond to this blizzard of new ukases.

A lot of clarity my [insert body part of choice here]. “Revise and reform” suggests an incremental process to fix known problems.  In contrast, what we face in the coming years is anything but incremental, but is instead a wholesale re-engineering of the entire financial sector.  And the same is true of the health care legislation.

Let’s just take one slice of one piece of legislation: the derivatives title of Frank-n-Dodd.  What has to be cleared?  No idea.  What will margin requirements be?  Who knows?  What capital requirements will regulators impose?  Oh, probably somewhere between zero and 100 percent.  Who will be exempted from the clearing requirements?  I’ll get back to you on that.  How will derivatives be traded (e.g., WTF is a “swaps execution facility”)?  I haven’t the foggiest idea.  What will energy position limits be?  Ditto.  And on and on and on.

Then, once you’ve finally learned what the rules will actually be, now try to figure out how market participants will respond to them.  What will happen to credit?  Prices?  Entry and exit?  Liquidity?

I talk to quite a few people in finance and energy on a regular basis.  A big part of the reason that I talk to them is that they’re trying to figure out what the hell is in the bills, how regulators are going to respond, and what the implications are for their businesses, and they figure that maybe I have some insights onto that.  And my answer is: I only wish I knew.

“A lot of clarity.”  All that people are clear about is that NOTHING is clear.  As a result, the pucker factor is quite high.

In typical administration fashion, Geithner admits that there is uncertainty out there, but this has nothing to do with anything the administration or Congress has done.  It’s just a psychological phenomenon, a sort of financial post traumatic stress syndrome dating to 2008–conveniently before Obama and Geithner arrived to save us peons:

“The big uncertainty that the world is still in … is that people, again, scarred by the trauma induced by the crisis are still looking to see how strong is growth going to be,” he said.

No, Timmy!  The big uncertainty is that, letting “no crisis go to waste,” the administration and Congress have played the Sorcerer’s Apprentice, and cast spells touching on every aspect of the economy, the effects of which by their own admission they have not the slightest understanding.  (Cf. Nancy Pelosi: “And we will find out what is in the Bill, as soon as it passes,” and Chris Dodd: “We don’t know ultimately how well the ideas we’ve incorporated here will achieve the results we desire” and “No one will know until this is actually in place how it works.”  Yeah, just screams “clarity,” doesn’t it?)  If the people who wrote this stuff have no idea, how are the rest of us poor slobs supposed to figure it out?

In fact, if it sticks with the attitude Geithner expressed, the administration is signing its own death warrant.  Call it a capital strike, going Galt, what have you.  With this barrage of regulations; pea soup fog of uncertainty; and higher spending and taxes as far as the eye can see, investment and consumer spending and employment growth will remain moribund, at best, with devastating political consequences.  And in 2010 or 2012, if things do indeed play out this way, the incantation “Bush did it” won’t work any electoral magic.  Sadly, by then the damage that the nation will have suffered will be immense.

I have a  couple of recent publications that may be of interest to some of you.

A couple of folks have expressed interest in my recent Energy Law Journal paper on manipulation.  Here it is: my policy recommendations are at the end.

Cato just released a Policy Analysis I did on clearing mandates. The link is here: you can download the paper from that page.