Streetwise Professor

The issue of the systemic risks posed by a clearing mandate that expands the scale and scope of central counterparties has come to the fore of late.  Too late, perhaps, but even at this late date it is an advance.

The focus of this concern is now on whether CCPs will be too big to fail, and whether they should have access to the Fed’s liquidity provision facilities.

Now that the financial defo . . . I mean “reform” bill is on the verge of passage, with (a) a clearing mandate, and (b) a provision granting CCPs access to the Fed, as one of the people who raised the profile of this issue I should restate my views.

First, yes, the clearing mandate will make CCPs a much more integral part of the broader financial system; CCPs can fail; a failure would be catastrophic; and hence CCPs are likely too big to fail.

TBTF is pernicious.  So how to deal with it?  In this instance, by not mandating clearing and thereby creating new TBTF institutions.

But it looks like a clearing mandate is inevitable, so the question becomes: given that CCPs are crucial financial institutions whose failure threatens the stability of the financial system, should they have access to the Fed?

Here, my answer is a qualified yes.  The Fed has legitimate lender of last resort functions that involve the supply of liquidity to solvent institutions during times of liquidity crises.  CCPs can be prodigious consumers of liquidity, especially during times of market stress that induce big price movements that trigger big flows of margin money.  A solvent CCP could face a severe liquidity crunch in such circumstances, and access to Fed liquidity, either directly, or indirectly (a la 1987) can prevent this liquidity crunch from causing the failure of a CCP–which would have serious systemic consequences.  These consequences include the closure of markets, large moves in asset prices, and asset fire sales.  Thus, if one could trust the Fed to be a classical Bagehotian LOLR, lending to solvent institutions against good collateral, permitting CCP access to the Fed’s liquidity programs could improve the stability of the financial system.  This would make a disastrous meltdown of CCPs due to liquidity problems less likely.

But that “if one could trust the Fed” clause is why my answer is a qualified one.  The truth is that the Bernanke Fed has stretched and bent the Fed’s legitimate LOLR functions beyond recognition in a way that must have Bagehot spinning in his grave.  Many of its actions (e.g., AIG) can legitimately be seen as bailouts that exacerbate moral hazard problems going forward.  As a result, there is reason for legitimate concern that giving the Fed a new set of institutions to bail out is a very bad thing indeed.

But the problem is that although cutting off CCPs from the Fed altogether would preclude it from bailing them out, it would also preclude legitimate liquidity support.  It is difficult to say, here and now and in the abstract, whether this package deal is superior to the alternative–a risk of bailouts, but the ability to prevent future liquidity crises from blowing up CCPs.   As it stands, that is the choice.  It is a stark one, and not an easy one to make.

This illustrates a fundamental problem with a lot of the financial regulation debate.  The issues that are being debated are the consequence of underlying problems that remain unaddressed.  In the present instance, the underlying issues are (a) the role, power, and discretion of the Fed, and (b) clearing mandates that expand clearing, and expand it into more problematic and difficult areas.  Clearing mandates have been a given from almost the beginning.  The Fed’s role has been debated, but it has emerged from the process as powerful, or more powerful than before.  The failure to address these underlying issues is why we are confronted with the Hobson’s choice between risking CCP bailouts and being unable to respond to CCP liquidity crises.

The increasing angst over the Hobson’s choice should have led to a serious rethink of clearing mandates.  To spark such a rethink was one reason why I have hammered on this issue for some time.  But that hasn’t happened; since the whole rationale for clearing was to reduce systemic risk, to proceed apace with mandates even as it became evident that CCPs created their own systemic risks and then argue over how to deal with that consequence was irresponsible in the extreme.  It should have also led to a more searching evaluation of how to constrain the Fed to its legitimate Bagehotian LOLR role.  That hasn’t happened either.

Well, Congress has made its choices, and we’ll all have to live with them.  It’s summertime, but the living ain’t easy.

Can you say that any more?  Well, even if use of the word “retarded” is increasingly frowned upon, there are some special cases in which its use is so evocative, and hence so appropriate, that it should be blessed.

The compromise on the Lincoln amendment is one such case:

The bill also includes a provision, authored by Sen. Blanche Lincoln (D., Ark), which would limit the ability of federally insured banks to trade derivatives. This provision almost derailed the bill following vehement objections from New York Democrats. Ms. Lincoln worked out a deal in the early hours of Friday morning that would allow banks to trade interest-rate swaps, certain credit derivatives and others—in other words the kind of standard safeguards a bank would take to hedge its own risk.

Banks, however, would have to set up separately capitalized affiliates to trade derivatives in areas lawmakers perceived as riskier, including metals, energy swaps, and agriculture commodities, among other things.

Under any modern understanding of what “risk” means, this makes no sense.  Ever heard of diversification, or the fact that “risk” of a particular position is attributable to its contribution to the payoff distribution of the entire portfolio of risks, not anything inherent to the position itself?  (Meaning that even if energy prices are volatile, doing energy swaps may not be that risky in a portfolio context.)  Under any modern understanding of the economics of financial intermediation (in which information about counterparties is vital) this makes no sense either.  (Meaning that the costs of intermediation are lower if information obtained in trading one instrument with a counterparty can be used when dealing in other instruments.)  Under any modern understanding of counterparty risk, where maximizing netting opportunities can be quite valuable, this makes no sense; splitting up businesses in an arbitrary fashion like this reduces scope economies from netting and other things.  It also makes no sense even on its own terms, because yes, banks use interest rate and credit derivatives to manage their own risks, but from my understanding of the provision, banks will still be able to be dealers in these products, and the whole basis of Lincoln’s proposal (to the extent that it had one) is that dealing is a particularly risky activity.  Not that I am buying into that argument; I’m only pointing out that is that’s what you believe, this provision is contrary to that belief.

This is transparently a compromise to save the face of a senator in over her head, who made a wild legislative proposal to stave off a primary challenge.  The banks were willing to throw a couple of bones in order to save their biggest books; metals, energy, and ags are small potatoes compared to interest rates and credit.  Lincoln gets to do what senators do best–pose.  The banks largely escape major damage.

Even by sausage making standards, this is revolting.  It is good that the most egregious parts of the Lincoln proposal have been jettisoned.  It is bad news, however, for liquidity and hedging in the disfavored products, especially commodities.  This, along with the position limit measure in the bill, and the clearing mandate, will increase the costs of managing commodity price risks in particular.

All pain, no gain: the only thing that can be said is the pain could have been a lot worse.

He being Gary Gensler, and his story being that mandated clearing will improve the stability of the financial system by eliminating interconnectedness:

“Over-the-counter derivatives are meant to lower risk on our economy, and to some extent they do,” Mr. Gensler says. “But they have concentrated risk in a few big banks…through their interconnectedness.” He says forcing them onto clearinghouses would shift the risk from any single institution to the clearinghouse. It can more easily offset, for instance, bets that interest rates will rise with bets that they will fall. That would make it possible to allow a big financial firm that is floundering to fail, restoring market discipline.

Repeating the same BS over and over doesn’t turn it into gold.  Clearinghouses are interconnected.   And they will almost certainly be too big to fail–and they can fail, a point that Gensler has never acknowledge.  Even the New York Times sort of gets it (although I disagree with a lot of what they say in this editorial).  “Interconnection” is just about the worst argument to make in support of clearing mandates.

Gensler has company in Europe. Gertrude Tempell-Gugerel of the European Central Bank supports central clearing mandates, for equally inane reasons.  She starts out with a non sequitur (since Lehman and AIG failed, clearing must be better–wrong), and goes downhill from there:

Therefore central clearing has become part of the G20’s agenda and mandatory clearing is seen as a tool to address the risks in OTC derivatives trading. Should a counterparty involved in OTC trading go bankrupt under central clearing, it would not create the chain reaction that the default of Lehman Brothers triggered. A central counterparty (CCP) would allow an institution with offsetting positions to net their exposures and substantially reduce counterparty risk.

In addition, a CCP would need to comply with high risk management standards and require counterparties to post appropriate collateral. Moreover, mandatory reporting of contracts to trade repositories would significantly enhance information on OTC derivatives exposures, to the benefit of authorities and market participants alike.

No chain reaction is possible when there is a clearinghouse?  Really?  What is the color of the sky on the planet where that is true?  Netting already takes place to a considerable extent.  Indeed, clearing done badly can actually REDUCE the amount of netting, if clearing is fragmented by product and even within products (e.g., multiple competing interest rate swap or CDS CCPs). And for the billionth time (perhaps I exaggerate), netting like this is a private benefit: if the benefit is as great as Gert (and many other regulators) say, why haven’t private parties fallen all over themselves to exploit it?  Mightn’t there be some costs that more than offset this putative benefit?   “High risk management standards”–why not impose them on banks?  And what about the information disadvantage that CCPs are likely to suffer vis a vis dealer banks?  That goes unmentioned.  Collateral can be the trigger for a systemic crisis.  Moreover, Tempel-Gugerel overlooks the likely equilibrium responses to a clearing mandate.  Rather than extending credit implicitly in derivatives transactions (as is often the case now) big banks are likely to extend credit to their customers to permit them to post margins, leaving the overall amount of leverage in the system pretty much unchanged.  Since it’s leverage that is ultimately the source of systemic risk, this obsession with collateral is likely to provide a false sense of security.  The information benefits can be achieved by mandatory trade reporting to a repository (which I’ve advocated for well over 7 years) without requiring mutualized counterparty risk sharing, or centralized risk pricing (in the face of severe information disadvantages).

The advocates of clearing mandates have had almost two years to come up with credible arguments, and to attempt to rebut counter arguments.  They’ve done neither.  They keep recycling the same old BS, and don’t even acknowledge, let alone address, the myriad arguments that have been raised against clearing mandates.

Policies built on willful ignorance do not end well.

Matt Leising and Shannon Harrington report that smaller firms are accusing the big dealers of blocking access to clearinghouses:

Rules intended to lessen the risk of a systemwide failure are “working to restrict access to only the incumbent dealers,” the Swaps and Derivatives Market Association said in a statement sent today to Theo Lubke, senior vice president at the Federal Reserve Bank of New York. The group of more than 20 brokers including Jefferies & Co., Imperial Capital LLC and Newedge USA LLC formed in February to lobby Congress and regulators for access to derivatives clearing.

Intercontinental Exchange Inc., CME Group Inc. and other companies that operate clearinghouses for the $615 trillion privately negotiated derivatives markets enforce capital requirements and trading rules intended to bolster the ability of the clearinghouses to withstand losses. Those requirements, though, 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, according to the statement by the brokers group.

“The effort to protect clearing, however, is actually a proxy war to limit competition to the incumbent dealers’ $100 billion in profits for derivatives execution,” the brokers group said. Mike Hisler, a spokesman for the association, and Ray Zorovich, the group’s policy assistant, are listed as contacts on the statement. Hisler also is a partner at New York- based Hexagon Securities LLC, a member of the association.

This was only a matter of time.  I’ve written academic articles dating back well into the 1990s that in the presence of large scale economies in a particular service (e.g., trading), including scale economies arising from network effects, a suboptimally small coalition of suppliers can form a cooperative firm that offers this service (see, for instance, my 1999 J. of Financial Markets and 2002 J. of Law, Econ., and Org. articles).  The cooperative is smaller than optimal, but just big enough that no competing coalition can form because it cannot achieve the same scale economies.  Because it is suboptimally small, and faces no competition, the members of the dominant coalition/cooperative firm earn rents.

I applied this argument to clearing in the early-2000s, and again in a couple of papers done in 2007 and 2008.  So, what Matt and Shannon report is no surprise to me.  None whatsoever.  It was a direct implication of the work I’ve done for going on 15 years.

Indeed, when many asked me whether dealer opposition to clearing was motivated by their desire to limit competition, I would often reply that forming a clearinghouse that limited entry was perhaps the best way to cartelize the industry, and make even more profits.

But that’s not the end of the story.  I’ve also written that there are good economic reasons to limit entry into a clearinghouse.  In particular, rigorous financial requirements are necessary to ensure the safety and soundness of the CCP.  Moreover, I’ve also written that the transaction costs/organizational costs of operating a clearinghouse will be greater, the more heterogeneous the membership: this provides further justification for limiting membership to a relatively homogeneous group of firms.  Setting margin, capital levels, etc. is more difficult, and the process more rancorous, the more heterogeneous the membership.  (The effects of heterogeneity on governance was the focus of my 2000 JLE piece on exchange organization.)

In brief: just as is the case in virtually all trading services, market structure issues in clearing are extremely, extremely knotty because of the pervasive scale and scope economies.  The pronounced scope and scale economies create opportunities for the exercise of market power, most notably by the formation of cooperative firms that restrict entry and face no competition.  This is the way that exchanges earned rents for their members for years, and years, and years.  At the same, time, open entry is particularly problematic for CCPs given the effects of heterogeneity on governance costs, and the extreme importance of financial stability.

Battles over market structure in securities have been raging for decades, due in large part to similar considerations.  Ditto recently in futures markets.  (Note the battles that raged over the CME-CBT and CME-NYMEX mergers.)

Note that this battle over entry is going to create serious legislative and regulatory conflicts because, as I have pointed out ad nauseum (including in a forthcoming Policy Paper for Cato) there is a fundamental tension between enhancing competition and reducing systemic risk in CCPs.  Conventional political economy considerations are going to play out here.  The pressure of the SDMA and other firms will inevitably lead to regulatory interventions that will open up entry and access, and thereby threaten to compromise the financial soundness of CCPs.

The irony is almost too much to take.

There are no free lunches.  None.  Only very difficult trade-offs.

Is their any evidence that any legislator or regulator has given serious consideration to this problem?  Not that I’ve seen.  But now, with clearing mandates on the horizon, there will be years of knock down-drag out fights over CCP rules, membership requirements, etc.  At every turn, there will be a tension between the systemic risk issues and the competition issues.  The results will not be pretty: they will be driven by the political economy considerations that dominate all such issues.  Economic efficiency and the soundness of the financial system will take a back seat, a distant back seat, to rent seeking.  We know how that usually works out.

No regulator or legislator can say that s/he wasn’t warned.  They just weren’t paying attention, or thinking seriously about the subject.  Oh yes, they said: just mandate clearing and we can go live on the big rock candy mountain.  As if.

For some reason Mark 6:4 just popped into my head.

I think I’ve made the analogy before on SWP, but it bears repeating.  There’s an old story about the Indian village that is beset by mice, and brings in cats to get rid of them.  The village is soon overrun by the cats, so they bring in dogs to scare off the cats, but then the dogs become a plague, so they bring in the elephants . . . and then realize that mice weren’t such a bad problem after all, so they bring back the mice to scare off the elephants.  The moral: short sighted “solutions” to a problem adopted without consideration of all of the consequences can lead to worse problems than you started with.

The criticism of CCP membership problems is just a harbinger of things to come: after too long, the mice might look pretty good by comparison.

Last August, I wrote a post titled “Not Tall Enough to Regulate” in which I skewered CFTC Commissioner Bart Chilton.  He was very peeved.  He’s not going to be any happier about this post, because he hasn’t changed his mind, nor have I.

This weekend’s WSJ has a semi-fawning story on Chilton, focusing on his advocacy of position limits–and the endorsement thereof in the House and Senate bills currently in conference.  The article gives Chilton an opportunity to explain his position.  His utter failure to do so, which implicitly implicates the entire position limits initiative both at the CFTC and in Congress, speaks volumes about the intellectual bankruptcy of the pro-limits side.

Here’s what the article says (emphasis added):

The volatile summer of 2008, when $145-a-barrel oil led to $4-a-gallon prices at the pump, was the pivotal moment for the Midwesterner. Mr. Chilton says he largely ignores prices, but the surging cost of oil changed his mind. “I’ve seen nobody who can justify $147 [a barrel for crude oil]. It doesn’t mean the massive passives are the sole culprit. I think they’re having an impact. As regulators, it’s our job to be asking these questions,” he says. Mr. Chilton pushed the CFTC to propose position limits that would prevent traders from having a large concentration in energy contracts for four of the most highly traded commodities at the center of the global energy market.

“Position limits that are reasonable,” Mr. Chilton says, “would end the possibility of large concentrations in individual markets that could inordinately influence price.”

. . . .

In July 2008, the CFTC staff issued a report saying that financial traders weren’t driving oil prices higher. Mr. Chilton was infuriated and publicly called the report “deeply flawed.” Today, he charges the report was “political” and done to appease Republicans.

Mr. [Dr.] Harris says, “There was no political pressure from any party. We looked but we couldn’t find any smoking gun. There were a lot of people working hard to find out what was going on. We had dedicated economists and their reputation was more important than political pressure.”

Possibility.  Could.  I think.  A refusal to take seriously empirical evidence, or to critique it rigorously, and a complete failure to provide any of his own.  Ad hominem accusations of politicization when competent economists–which Chilton certainly is not–did not give the answer he wanted.  (This is particularly rich from a political lifer who owes his position to long service as a Senate staffer.)

This is the basis for major policy changes that could have serious effects on the market?

I have a piece on position limits coming out in Regulation titled “No Theory?  No Evidence?  No Problem!”  That’s Chilton (and to a large extent, Gensler, and most of the Senate) in a nutshell.  Any cogent–or even coherent–theory of how speculators are influencing prices?  No.  In particular, any cogent/coherent theory of how passive traders–buy and hold traders so beloved in securities markets–cause prices to increase 100 percent in a period of months?  Surely you jest.  Any empirical evidence to support the claims that speculation and/or passive traders have distorted prices?  See above slander of CFTC economists, along with the CFTC position limit NOPR, for illustrations of the “we don’t got to show you no steekin’ evidence” attitude of Chilton et al.  He just “thinks” it’s “possibly” true–that’s enough, dontcha know.

Here’s a guy who has never been in the markets, and who has never seriously studied markets (“he largely ignores prices”), declaring that prices are somehow wrong.  He wants to restrict the market in order protect against the theoretical possibility (and a theoretically ungrounded theoretical possibility at that), but does not give serious consideration to the far more realistic and likely deleterious effects of the limits on liquidity, hedging, and price discovery.  His justification for the “crowding out” provisions are particularly inane, and not based on any serious economics analysis.

As I point out in the Regulation piece, markets aggregate massive amounts of dispersed information, so it is impossible to explain–“justify”–exactly why prices are what they are.  If it were possible, we wouldn’t need markets to discover prices. That’s why debates over speculation never end: you can’t prove or disprove that the price was right.  Bob Barker doesn’t give you the answer just before going to commercial.

But we know that people spend tremendous time and resources to develop information about values–arguably too much time and resources–and that through trading decisions, this information is embedded in prices.  Moreover, since prices guide the allocation of resources, distortions in prices should result in distortions in quantities–something which (as I point out in the Regulation piece)  were not observed in the commodity price boom and bust.  Commodities are different than say, internet stocks: they are consumed and produced every minute of every day, and distortions in prices will distort those decisions–and such distortions are noticeable.  And if speculators are overpaying–they’ll end up owning the stuff.  None of that happened, and Chilton and others have failed even to acknowledge the issue, let alone confront it.

There should be a pretty high bar to overturn the operation of markets.  Any such action should be based on serious economic reasoning and sound empirical evidence.  And no, deep musings during guitar picking sessions or boat trips to restaurants don’t count.

Kudos to Jeremy Grant at FT’s Trading room, who published not one, not two, but three articles expressing serious reservations about clearing mandates.  One is by Sanjit Das, another by Shearman and Sterling attorney Barney Reynolds, and the third byReuben Lee.   Each echoes points I’ve been making over the last 20 months.

The Reynolds piece was interesting, though I don’t quite track his claim that end user clearing will result in said end users posting collateral to a clearing house, and to the dealer it trades through, to cover the dealer’s collateral costs.  But Reynolds does make a key point: namely, that the impacts of clearing on the normal day to day operations of the market should be taken into account, not just the systemic risk implications.   He says that clearing rules should be set “with a view to preserving commercial hedging activity, not merely with a view to protecting financial institutions from another black swan event.”

Since it is quite possible that CCPs are vulnerable to black swan events, systemic risk considerations are close to a push.  This means that the efficiency effects of clearing under normal market conditions should be given considerable weight, and as Reynolds argues, and as I argue, OTC bilateral dealings have clear advantages on this score.

But it doesn’t really matter, does it?  The clearing train has probably left the station, both in the US and Europe.  A clearing mandate is in both bills currently being merged in conference between House and Senate, so it’s a done deal here, and the European Commission has made it plain that it will require the bulk of deals to be cleared.

It would have been nice if people had spoken up rather earlier, when it was possible to influence the debate.  As it is, I don’t think it’s an exaggeration to say that I was nearly alone, at least among academics, in my criticism of clearing mandates when they were first mooted.  And who am I, anyways?  People have finally figured out that this is a big deal, and that Sorcerer’s Apprentices may wreak havoc with ill considered rules on clearing.  So they are saying this now, but now is too late.

This is, to my mind, a black mark against the academic community.  It has, for the most part, paid virtually no attention to matters of market infrastructure, despite their crucial importance; the subject has been relegated to, at best, specialty journals, and often not even there.  My stock remark in this regard is that in the military it is said that amateurs talk tactics, professionals talk logistics, and in finance professionals talk counterparty risk and how to manage it, but academics are amateurs who ignore it by and large.  At the margin, the value of an imperfect paper on clearing or counterparty risk is far greater than the value of yet another paper on testing asset pricing models or on some aspect of corporate finance.  But that value isn’t recognized, and such things are devilishly hard to get published, so that Nth paper on asset pricing or capital structure gets written and perhaps published.  As a result, academics have far too little to say, and hence far too little influence, on what is perhaps the most important of the seismic changes that will take place in financial markets by legislative fiat.

(As an aside, some academics have weighed in on clearing issues late in the game, including some very prominent ones.  Much of what they have to say is an embarrassment, unfortunately.)

At best, serious thinking and research might affect the implementation of the clearing regulations.  Legislation will leave a lot of the specifics to regulators like the CFTC (God help us all), and perhaps some serious academics could lead to Pareto improvements by weighing in now, even at this late date.

* This is one of my grandfather’s expressions. (He had many, which I have appropriated, often to the mystification of those to whom I am speaking.) It always mystified me, so I asked him to explain it.  Apparently there was a product to treat baldness, back in the 30s or 40s, called Herpicide.  (Yeah, like I’d put something with THAT name on my head.)  Apparently you had to use it just when you were starting to lose your hair; it wouldn’t work–they said–if you waited too long.  To make the point, they ran an ad campaign with pictures of cue-ball headed men, with the caption “It’s A Little Late for Herpicide.”  So now you know.

Yesterday Putin did his best King Canute impression, and ordered a group of financial regulators, including the finance ministry, to draft plans for an exchange to trade steel, coal, coking coal, and other metals.  By 1 August.  Putin believes the exchange will, in the words of the Moscow Times article just linked to, “avert price rows between producers and industry.”

In other words, even though no exchange anywhere has created successful spot or futures markets for steel and coking coal, and really for thermal coal either, in the 150 odd years since the advent of modern futures trading, Putin has commanded that Russia, which has never really created a successful commodity exchange for anything ever, do it in less than 2 months.

Yeah.  Right.

My reference to Canute was a slight to Canute, of course.  The Danish (English/Norwegian/Swedish) king knew that he couldn’t make the waves cease their beating: he just wanted to make the point to court sycophants.  Putin, by contrast, apparently thinks that his command will make it so.  I can just imagine the furtive and panicked looks between those in Putin’s audience charged with implementing the (impossible) task.  I can also imagine the “jump? how high boss?” responses to his command.

This is another case of Putin, Man in a Hurry, as I dubbed him soon after I began this blog.  It is clear that he has tired of the squabbling between the upstream and downstream firms in the Russian ferrous metals sector.  He evidently believes (or at least hopes) that a command that a market magically appear will relieve him of mediating this conflict to maintain the equilibrium in the natural state.

Ain’t gonna happen.  Markets don’t just magically appear.  As has been documented in the academic literature, most notably by Dennis Carlton, auction type futures markets are devilishly hard to start.  Far more contracts fail than succeed, despite the concerted efforts of experienced exchanges to identify the most promising candidates, to work to design contracts that will suit the needs of the target industry, and to build industry support through favorable fees, liquidity support programs, etc.

Steel and coking coal are particularly challenging for a variety of reasons.  “Steel” is not a homogeneous product, but consists of a dizzying array of differing physical types and shapes.  Some kinds of steel, e.g., scrap, are fairly standardized and traded, but its prices don’t necessarily track the prices and values of other types of steel.  Coking coal is also characterized by substantial differences in grades and uses.  Moreover, for coal in particular, location matters because it is relatively expensive to ship.

Industry structure matters too.  Futures markets tend to work best with relatively disaggregated value chains, where the same product is often bought and sold repeatedly, and where there is relatively little concentration on either the buy or sell sides.  (Structure is not independent of product characteristics, of course.  Relatively homogeneous goods tend to have a larger number of buyers and sellers, and greater turnover, than more specialized goods unique to one producer or tailored to fit the needs of a particular consumer.)

Firms in an industry will not necessarily support the introduction of more transparent pricing mechanisms, either, as Carlton points out in another paper.  The steel industry has been quite outspoken in criticizing plans for steel and iron ore derivatives markets.  (India’s Tata Group is a good example of this.)

I would imagine all these factors go double in Russia–if not more than double.  With central planning, the absence of a free pricing mechanism, and a preference for giganticism, Soviet firms tended to be few in number and dependent on a small number of suppliers and customers.  Moreover, just as was the case with the US electricity business prior to deregulation, integration and price regulation led to patterns of investment in plant and equipment that tended to create holdup problems; Steel plant S was highly dependent on coking coal from mine M because the lack of freely negotiated prices meant that outside options weren’t that valuable in constraining opportunism.  (In US electricity, firms that supplied both generation and transmission didn’t worry about holdups between these two stages of the value chain, and hence created generation and transmission infrastructures that were subject to bilateral monopoly problems when the products were unbundled in deregulation.)  Russia inherited this structure, but then eliminated the central planning and price control that was necessary to keep transaction costs  in check.  Hence Putin’s pricing problems.

In Russia, the holdup problems inherent in the mismatch between the pattern of capital investments made when government control over prices suppressed (but didn’t eliminate) pricing disputes, and the pattern that firms would choose if they had to worry about opportunism problems, has exacerbated the price conflicts that are vexing Putin.  But the problem is that saying “presto, change0, make me an exchange-0” doesn’t make these fundamental problems go away.  Indeed, they are antithetical to the effective operation of a centralized spot or futures market.  And what’s more, the prices for the stuff not traded on exchange–which would be most of the steel and coal products actually produced and consumed in Russia–would still have to be negotiated between the parties.  Yes, centralized market prices would provide some information about the underlying fundamentals that affect the values of steel, etc., but there would still be considerable room for dispute about the price relationships between the standardized and non-standardized products.  As a result, there would still be considerable potential for holdup.

I would imagine this plan will go nowhere, as it is as futile as commanding the tides to stop.  It is futile because it ignores all of the transaction- and product-specific features of the products in question, and the necessity of structuring transactions in ways that respect these features.  Putin is apparently like Gary Gensler, who thinks that auction markets should be good for everything, when experience (and economics) shows that they are really good for very few things indeed and pretty much unworkable for everything else.

Putin’s heavy metal headache is a fitting curse for a Sovietophile who is enamored with raw materials and basic industries and who has been the enemy of property rights and the rule of law.  He is suffering this malady in large part because of (a) an industrial structure inherited from Soviet times, and (b) the inability of Russia to move beyond its resource focused development, which (c) which reflects in no small part the fact that the precariousness of property and legal rights in Putin’s natural state is an anathema to entrepreneurship and tends to favor the persistence of oligarchic structures because oligarchs can bargain with the state on relatively equal terms, and can thereby protect themselves against expropriation without having to rely on courts.  Putin’s problem, then, is inherent in Putinism.

Irony can be a real b*tch.

So, good luck with that steel exchange thing, VV.  And don’t say I didn’t tell you so.

Whatever emerges from the House-Senate financial regulation conference committee, the CFTC’s power and responsibilities will be greatly expanded.  Most notably, the agency will have vast power and discretion over the OTC derivatives markets.  It apparently will have considerable say in determining what contracts must be cleared and what firms must subject their trades for clearing.  Moreover, it will have responsibility to oversee the operations of central counterparties, which will have important implications for the stability of the financial system; misteps here could induce a serious systemic problem.

Just a few years ago, the chairman of the CFTC, Walt Lukken was bemoaning the agency’s lack of funding, claiming that it had insufficient resources to carry out its (then far narrower) duties.  The agency’s funding has increased, and its head count has increased about 20 percent.  It is slated to increase further to permit it to carry out its new charges.

But, as I’ve pointed out before, the CFTC was never renowned as an extremely effective regulator.  Indeed, it was often something of a Congressional whipping boy because of its perceived shortcomings.  (Example: I remember well the agency’s humiliation when then-Chair Wendy Gramm was forced to stand silent in the background while the Justice Department and the FBI announced indictments against Chicago floor traders for assorted misdeeds.  The clear implication was that the CFTC was not capable of policing the markets.)

Whether that reputation is deserved or not, there is considerable room for skepticism about the CFTC’s ability to handle its new duties.  Any dramatic expansion of an organization into new areas inevitably leads to growing pains and managerial snafus.  That goes double for a dramatic increase in the size and scope of a government organization.  And the stakes are extremely high now, given the systemic importance of clearing.  Requiring the clearing of unsuitable instruments, for instance, could jeopardize the stability of clearinghouses–and hence the financial system.  So could lapses in monitoring the operational or risk management activities of CCPs.

And it must be remembered that the agency will have to handle these new tasks in a hypercharged political environment, one more intense than it has to cope with now.  The stakes will be higher, with big players having a far bigger amount of money affected by CFTC decisions.  With greater stakes will go greater pressure, most notably from Congress, which will respond to constituent pressure.  Can the agency handle it?  Color me skeptical.

Some Commissioners are now openly expressing concerns about the agency’s ability to shoulder the load:

US financial reform regulation could place “overwhelming” burdens on the Commodity Futures Trading Commission, the regulator that would have to assume a new role as watchdog for the swaps markets, officials there said.

Sweeping financial legislation approved by the Senate last week dramatically elevates the role of the CFTC, created in 1974 to police trading in futures and options. The commission would gain broad new powers to oversee previously unregulated over-the-counter derivatives, a universe 10 times larger than regulated markets.

“It’s overwhelming. It’s not like right now we don’t have enough on our plate,” said Jill Sommers, one of two Republicans on the five-member commission.

Senior officials warn that to perform its new role, the CFTC, which has long operated in the shadow of the better-funded Securities and Exchange Commission, will strain its expertise, organisational structure and technology. It would have to propose, take public comment on and then adopt as many as 50 elaborate rules in six months, a timetable that Michael Dunn, a Democratic member of the commission, called “pretty much an impossibility”.

. . . .

Gary Gensler, the CFTC chairman, was among the Obama administration’s staunchest champions of legislative language that would route most derivative trades to clearing houses. This would allow regulators to peer at the size of traders’ positions and, so it is hoped, head off the kinds of risky positions that led to the $180bn (£124bn, €143bn) AIG bail-out. While sharing oversight with the SEC, the CFTC would regulate the majority of derivative deals.

. . . .

CFTC officials acknowledge being snowed under. Probes into oil and silver markets announced in 2008 remain unresolved. Mr Gensler has said the agency was overwhelmed by Ponzi scheme cases. Last week Scott O’Malia, a Republican commissioner, said the agency still gets account information by fax and enters it manually. “This agency is about to be hit with a tsunami of trade data,” he said.

Remember, regulation can create systemic risks.  One way to do that is to place extraordinary burdens on a regulator unprepared to handle it.  Which is what Congress is in the process of doing.

Last week the Senate passed the financial “reform” legislation, which now goes to a conference committee that will produce a bill that combines the Senate bill with that passed by the House months ago.  (Ironically, the vote came when I was at a very nice conference on financial regulation hosted by Notre Dame.)

The Senate bill is best measured in pounds rather than pages.  (Pounds of what I’ll leave to your imagination.)  It is comprehensive, and from what I can tell, it is comprehensively wretched.  Stephen Bainbridge, whose opinion I respect a good deal, strenuously objects to the nationalization of corporate governance embedded in some of the bill’s language.  The infamous Lincoln swaps provision, which I’ve written about, is a horror.  It is some kind of sick joke to remake the entire derivatives market–and the banking sector–with a transparently populist ploy heaved up by a rather undistinguished senator (but I repeat myself) from Arkansas in a desperate attempt to stave off a primary challenge.  (Said ploy being incompletely successful, with Blanche Lincoln facing a runoff against her more lefty opponent.  Which probably gives the provision continued life when it should be put out of our misery with all dispatch.  The joke is even sicker when one considers that if current polls are at all accurate, Lincoln will be demolished in the general election.)  The clearing mandate is also a disaster in waiting.

Rather than deconstruct the whole abortion, I’ll focus on a couple of (relatively minor, in the scheme of things) features that illustrate its intellectual incoherence.

The first relates to market manipulation.  Here is a place where Congress could do some good by rewriting the existing law.  As I’ve written extensively over the past 15 plus years, US manipulation law could use a serious overhaul.  I’ve made concrete recommendations, including in a recent article in the Energy Law Journal.

But instead of doing something reasonable, the Senate passed an amendment proposed by the aptly named Senator Cantwell that does the exact opposite of what I recommend in the ELJ piece.  Specifically, apparently lacking the ability to form an original thought, Cantwell and the Senate fire up the copy machine and essentially Xerox the anti-manipulation language in the Securities and Exchange Act.  The amendment (S3348) outlaws “any manipulative device or contrivance.”

Boy, that’s such a big help.  Makes things crystal clear, no?

Look, a major problem with US commodity manipulation law is its complete failure to define what is  manipulative, and to provide courts and commissions with any guidance as to just what kinds of conduct are manipulative, and what tests should be applied to make that determination.  In its attempt to ensure that the law is sufficiently broad to catch everything that could be construed as manipulative, Congress has instead passed language that is so vague that the law can hardly catch anything.  The amendment’s language does nothing to correct that.

Moreover, Cantwell sings paeans to the securities law’s anti-manipulation provisions and precedents, and the effects of previous utilization of similar language in other commodity manipulation laws:

This language in this amendment is patterned after the law that the SEC uses to go after fraud and manipulation; that there can be no manipulative devices or contrivances.

It is a strong and clear [not!] legal standard that allows regulators to successfully go after reckless and manipulative behavior.

This legislation tracks the Securities Act in part because Federal case law is clear that when the Congress uses language identical to that used in another statute, Congress intended for the courts and the Commission to interpret the new authority in a similar manner, and Congress has made sure that its intention is clear.

In the 75 years since the enactment of the Securities and Exchange Act of 1934, a substantial body of case law has developed around the words “manipulative or deceptive devices or contrivances.”

The Supreme Court has compared this body of law to “a judicial oak which has grown from little more than a legislative acorn.” It is worth noting that the courts have held that the SEC’s manipulation authority is not intended to catch sellers who take advantage of the natural market forces of supply and demand, only those who attempt to affect the market or prices by artificial means unrelated to the natural forces of supply and demand.

Mr. President, Congress granted the same antimanipulation authority to the Federal Energy Regulatory Commission in 2005 in the Energy Policy Act. We did this as a result of the Enron market manipulation. I am very proud of this legislation and its ban on manipulation in electricity and natural gas markets. I say that because there was a similar issue of deregulation of energy markets that led to the Federal regulators not doing their job.

Since we have implemented this language in the electricity markets, the Federal Energy Regulatory Commission, since 2005, has used its authority to conduct 135 investigations. Of those 135 investigations, 41 have resulted in settlements involving civil penalties or other monetary remedies totaling over $49 million.

Two investigations brought about enforcement actions against manipulation, one against Amaranth for $291 million—-

The PRESIDING OFFICER (Mr. Udall of Colorado). The Senator has used 5 minutes.

Ms. CANTWELL. Mr. President, I ask unanimous consent for an additional 1 minute.

The PRESIDING OFFICER. Without objection, it is so ordered.

Ms. CANTWELL. The alleged market manipulation brought enforcement action against Amaranth for $291 million in civil penalties and Energy Trading Partners for $167 million in civil penalties. That is just an example of what a statute with teeth and a regulatory entity can do to actually stop manipulation when given that authority.

Sigh.  There are so many things completely wrong with this it isn’t even funny.  Most importantly, the relevance of SEC precedent to commodity market manipulation is a cross between (a) completely non-existent, and (b) actively counterproductive.  Most importantly, as I point out in the ELJ piece, whereas the most important kinds of commodity manipulations are market power manipulations (e.g., corners) most securities manipulations are information/fraud driven.  The canonical securities manipulation is the pump-and-dump, which has nothing whatsoever to do with market power manipulation that should be the first order target of any commodity anti-manipulation measure.  So, the vaunted SEC precedents are worth exactly bupkus.  No, that’s too generous.  They will be actually counterproductive as enforcement attorneys and judges try to pound a market power manipulation peg into a fraud hole.

The ETP case that Cantwell mentions is a perfect example of this.  I was an expert for ETP in this case, and know it intimately; as an aside, Cantwell is less than accurate in her characterization of the outcome of that case, because the government settled for a lot less ($5 million to the government, plus a set aside of $25 million to pay potential settlements in third party lawsuits) than the $167 million figure she cites, and that was a let’s-get-this-behind-us-gift to FERC, which brought the case.  Substantively, the FERC had to twist itself into knots to try to characterize the conduct it found offensive into the “deceptive device or contrivance” category.  FERC’s theories, uhm, evolved, to put it mildly; actually “devolved” would be a better characterization.  At every iteration, I was reminded of Maxwell Smart: “Would you believe?”  (No, actually.)  Rather than being the shining example that Cantwell paints it to be, the ETP case was a perfect example of the fundamental idiocy of trying to export securities law manipulation concepts and precedents to the commodity markets.

Instead of improving manipulation law, the Cantwell amendment will make it worse, as hard as that is to believe.  I don’t know if I’ve ever written a more depressing sentence.

Cantwell focuses on intent.  But that isn’t the only problem with existing commodity manipulation law.  Artificial price and causation have also posed problems too.  But all are eminently fixable through an application of solid economics, as I discuss in more detail in the ELJ piece, and which I demonstrated in my book on manipulation in the mid-90s and my piece on the Ferruzzi squeeze from 2004.

Another poster child for the intellectual bankruptcy of the Senate bill is its provision to empower the CFTC to extend position limits to OTC energy derivatives.  I have pieces forthcoming in Regulation and the Swiss Derivatives Review analyzing speculation and position limits in commodity markets.  The title of the Regulation piece suffices to convey the conclusions: “No Theory?  No Evidence?  No Problem!”  That is, the CFTC’s current proposal to impose position limits is not grounded in an understanding of the economics of commodity markets, and is completely unsupported by empirical evidence.  The same, obviously, is true of the provision in the just passed legislation.  But we’ll get limits nonetheless.

The Senate provision is particularly troubling because it will likely have effects on the Commission’s futures position limits as well as on OTC limits.  Fear of driving trading to the OTC markets restrained the Commission in its setting of the proposed limits, and led some Commissioners to express reservations about the entire effort.  With OTC position limit authority, those constraints and reservations evaporate.  Now the only competitive constraint on the CFTC is the threat of trading moving overseas.  But that threat is less severe than the competitive threat to the domestic OTC market, so it is quite possible that the Commission will impose more onerous restrictions on both exchange-traded and OTC-traded positions now that it has the OTC authority.

At the Notre Dame conference Chester Spatt warned of the unintended consequences of regulation.  Quite so.  And the Senate bill, and whatever comes out of conference, will spawn myriad unintended–but not unpredictable–consequences, most of them quite pernicious.  When the Insane Clown Posse (AKA the United States Congress) is done “reforming” our financial markets we’ll learn to our regret that however flawed our existing system is, it is a far, far better thing than the product of the constructivist irrationality of Dodd, Lincoln, Cantwell, and Frank et al.

My work on clearing was mentioned in the lead editorial in today’s Wall Street Journal.  For the most part, I agree with the editorial.  Hell, I could have written most of it.  It makes many of the points I’ve been writing about here on SWP, and in working papers and presentations, since the financial crisis began (and even before the crisis).  Even the initial sentence, which refers to the widespread belief that clearinghouses are a “miracle cure” echoes the title of my Regulation magazine piece from January, 2009–“The Clearinghouse Cure.”

The initial point is the most telling one: if clearinghouses make counterparty risk disappear (as its cheerleaders repeatedly suggest) why is there need for any CCP to have access to the Fed discount window?

Exactly.  They don’t make counterparty risk disappear.  They become repositories of counterparty risk that can fail, with potentially disastrous consequences for the broader financial system.

I was on board with the editorial until the last paragraph, in which the Journal says “Congress should strip out Mr. Dodd’s discount window provision. As important, Americans should understand that Congress isn’t ending financial risk in derivatives. It is merely redirecting that risk, while making taxpayers the ultimate backstop.”  Yes, it is merely redirecting that risk.  (Finally!)  No, it isn’t ending financial risk in derivatives.  (Finally!)  No, taxpayers should not be the ultimate backstop.  (Absolutely.)  But access to the Fed discount window does not mean a taxpayer bailout.  At least as long as the Fed acts as a traditional lender of last resort, along Bagehotian lines, lending to provide liquidity against good collateral.

During market shocks, large margin flows create spikes in the demand for liquidity.  It is appropriate for the Fed to accommodate such demands for liquidity through the discount window and market operations.  Bulking up clearinghouses through mandates, but denying them access to liquidity, is a recipe for disaster.

But one of the casualties of the financial crisis, and the Fed’s response to it (and even more so, the ECB’s response to the Greek crisis) has been the  devolution of the LOLR function.  Central banks have treated insolvency crises like liquidity crises, thereby socializing losses.

This is indeed a problem.  But it is a problem that is not limited to derivatives.  If Congress believes that it is a problem, it needs a thoroughgoing reform of the Fed.  Just denying CCPs access to the discount window will not fix it.

But back to the rest of the editorial.  Implicit in the whole debate over the relationship between CCPs and the Fed is the fact that the CCPs can fail.   If they fail, they can cause huge knock-on effects, just like the failure of a large dealer.  Potentially worse, in fact.  And this reality means that in the breech, it is likely that by hook or by crook Congress or the Treasury or the Fed will find some way to bail out a failing CCP.

This is an issue that Congress and the administration have refused to acknowledge.  In his speech at the ISDA Annual General Meeting in San Francisco, Deputy Treasury Secretary Neal Wolin pointedly refused to admit that clearing mandates could create too big to fail institutions, thereby exposing taxpayers to losses.  This refusal to recognize the very real consequences of a clearing mandate is sowing the seeds for the next crisis.