Streetwise Professor

FT Alphaville–an (excellent) Financial Times blog–graciously invited me to write a guest post on the financial “reform” legislation that is moving through the House of Representatives (and just passed yesterday).  (Thanks, Stacy-Marie.)  Here it is:

Guest post: Prof Craig Pirrong on moves to overhaul to the derivatives market

Posted by  Guest writer on Dec 11 13:38.

Lawmakers in DC are due to resume debate on major financial reform legislation currently working its way through the US House of Representatives. One closely-watched aspect of that debate is sweepingoverhaul of over-the-counter derivatives markets. Lawmakers are pushing to mandate that most derivatives be centrally cleared and traded either on exchanges or swap execution facilities. Professor Craig Pirrong of the University of Houston discusses some of the proposals.

In attempting to impose standardization on the ways that derivatives are traded, and derivatives counterparty risks are managed and shared, the legislation reflects a one-size-fits-all mentality (not to say fetish) that is sadly typical of most legislative attempts to construct markets.   These standardization directives fail to recognize that market participants are diverse, with diverse needs and preferences, and that as a consequence, it is desirable to have diverse trading mechanisms to accommodate them.

Standardized exchange products with central clearing are well-suited for some products and some users, but more customized arrangements (including customized, bilateral agreements relating to counterparty risk) are preferable for others.   And one should be extremely skeptical about claims that to enhance their profits, greedy bank-dealers force derivatives end users into trading on opaque, concentrated markets instead of transparent exchanges; end users have had the opportunity to choose, and exchanges have competed aggressively to try to attract them, but many end users nonetheless have decided to trade in markets that are allegedly stacked against them.   Is it really wise to predicate a radical restructuring of markets on the view that end users are suffering from the financial analog to battered spouse syndrome?

Ironically, one of the controversies that has come up in the debate over amendments to the proposed legislation involves supposed backsliding from the old time standardization religion.   An  amendment changes language defining “swaps execution facility” to allow trading of swaps through voice brokers to meet the bill’s requirement that swaps be traded on such a facility or an exchange.   Moreover, other language in the amendment allegedly allows banks to continue business as usual.   That is, whereas reform advocates envisioned that under the new law swaps would be traded almost exclusively on exchanges or transparent, exchange-like venues, they claim that the new language would perpetuate the existing ways of trading swaps in scary “dark” markets.

This is not a bad thing at all – contrary to what some have  argued.   A variety of execution mechanisms developed to satisfy the disparate needs of market users with respect to pre-trade and post-trade transparency, credit and collateral arrangements, and product design.   To the extent that the amendments recognize this reality, and give market participants some flexibility in selecting the mechanisms best for them, the authors are to be commended.   To the extent that the bill still imposes unnecessary mandates, they are to be criticized.

One final note: proposals to force derivatives trading onto exchanges have been tried before – back when grandma wore high button shoes.   As financial markets developed, these restrictions proved unworkable and unwise.   The advocates of one-size-fits-all reform would have us repeat the same errors.   Back to the future is not progress.

[The background here is that the first regulation of futures trading in the US, the Grain Futures Act passed in 1922 required all “contracts for future delivery” to be traded on “a designated contract market” (i.e., an exchange).   The Commodity Exchange Act (passed in 1936) extended this to non-agricultural commodities.   This created huge issues starting in the 1980s particularly when new products that had futures-like features started to be traded OTC, and banks starting offering products to retail customers that had interest rates tied to the S&P or gold.   The question became: what was a future?   One-size-fits-all became clearly unworkable.]

Timmy! Geithner is joining the pitchfork-and-torches crowd.   First, he blasts financial executive pay, and demands immediate changes:

“It is very important that we change the way these executives are paid, the form of compensation, this year,” Geithner said in an interview yesterday for Bloomberg Television’s “Political Capital with Al Hunt,” which is being aired throughout the weekend. “We have to end that era of irresponsibly high bonuses.”

Then he disputes Goldman’s contention that it didn’t need assistance at the height of the crisis:

Tim Geithner on Friday rejected Goldman Sachs‘ claim that it could have withstood the financial crisis without government intervention, adding that all banks were at risk of being wiped out.

“None of them would have survived a situation in which we had let that fire try to burn itself out,” the US Treasury secretary said on Friday in an interview with Bloomberg Television.

The Bloomberg article has more from Timmy!:

“None of them would have survived” had the government stood aside and let the crisis run its course, he said. “The entire U.S. financial system and all the major firms in the country, and even small banks across the country, were at that moment at the middle of a classic run, a classic bank run.”

Why, oh why, won’t anyone ask Geithner how he can, out of one side of his mouth, speak in such apocalyptic tones about the state of the financial system during the time of the AIG and Lehman collapses, and out of the other side of his mouth, tell the SIGTARP that the financial condition of AIG’s counterparties was not a relevant consideration in the decision to proceed with the AIG bailout?   How is it possible for these two things to be true?   I’ll answer my own question: It’s not.   He’s lying.

But this all raises the question of why, now, does Geithner feel compelled to go all populist?   My surmise: the left wants his head, and this is his attempt to save it.

This thought popped into my head last night reading the FT piece, and lo and behold, this morning I read the latest Taibbi screech in Rolling Stone*:

Not only are the mop-headed weenie of a Treasury secretary’s fingerprints on virtually all the gross giveaways in the new reform legislation, he’s a living symbol of the Rubinite gangrene crawling up the leg of this administration.   Putting Geithner against the wall and replacing him with an actual human being not recently employed by a Wall Street megabank would do a lot to prove that Obama was listenting this past election day.   And while there are some who think Geither is about to go–“he almost has to,” says one Democratic strategist–at the moment the president is still letting Wall Street do the talking.

And you thought I was cruel to Timmy!

Taibbi and I come at this from different universes.   Taibbi sees Geithner as a Wall Street stooge whose legislative proposals are a big fat wet kiss to the big banks.   I see these same proposals as dangerously interventionist and inefficient (especially as related to derivatives), although I do believe that many of the policies Geithner has implemented and proposed do play into the banks’ hands and exacerbate moral hazard problems.   Taibbi and I agree, I would imagine though, on Geithner the man as utterly untrustworthy.

The Taibbis of the world and his ilk are much more dangerous to Geithner’s future than classical liberal/libertarian types like me.   Hence his sudden populist turn, and his turning on Goldman in particular.

I doubt, however, that will be sufficient to save him and his job.   The only thing that can do that is a fairly strong improvement in the American economy.   As the administration’s top economic policymaker, he is acutely vulnerable if the recovery stalls, or another major financial problem hits, or the stock market takes a hit.   And we all know that Obama has no compunctions about heaving people over the side when they become liabilities: he is the anti-Bush in all things, including in the loyalty department.

Thus, yesterday’s unemployment number (widely misinterpreted though it was), did far more for Geithner’s job prospects than bashing Goldman.   With JP Morgan’s Jamie Dimon actively campaigning for his job, the left howling for his head, and Barack “what do you mean we?” Obama having his back, Geithner is a hostage to the nation’s economic fate.

* I have no clue why I get Rolling Stone delivered to me.   I didn’t subscribe. My kids swear they didn’t.   I can find no record of having paid for it.   Fan mail?   Practical joke? Got me.

I’ve had several calls from reporters asking my opinion on the Lynch Amendment to Barney Frank’s derivatives regulation bill.  For some reason, Forrest Gump pops into my head every time that question is asked.  You know, the part where he says “stupid is as stupid does.”

As I am sure you all know, the amendment introduced by New Jersey Massachusetts representative Stephen Lynch, imposes restrictions on the ownership and control of the clearinghouses that the Frank bill will require the vast bulk of derivatives to be traded through.  The amendment imposes similar restrictions on ownership of exchanges and swap execution facilities.

Specifically, the amendment defines a class of “restricted owners” that includes swap dealers and major swap participants, and limits the amount of a clearinghouse (or execution facility or exchange) that these restricted owners can own or control collectively to 20 percent.  The justification for this limitation is to reduce conflicts of interest, the specific nature of which are not identified.

This represents yet another example of Congressional micromanagement of the organization and governance of financial institutions.  In my view, it is incredibly wrong-headed.

Let’s focus on clearing organizations.  Remember what they do.  They are a mechanism for pricing (via collateral) and sharing counterparty risk.  Any financial institution that agrees to participate in the sharing arrangement will reasonably expect to have control rights in the organization that oversees this sharing mechanism.  No sane financial institution is going to agree to share in a large fraction of the risk borne by a clearinghouse if it is restricted to having a small share in control.

This means that restricting ownership and control rights will inevitably exert a decisive influence on the allocation of counterparty risk through a clearinghouse.  If the swap dealers and other major swap market participants are limited in the amount of control they can exercise, they will limit the amount of risk they are willing to bear.  So who will bear it?

The traditional clearing firm has been effectively a mutual/cooperative.  Several intermediaries agree to share and manage counterparty risk.  These intermediaries offer various trading services, including brokerage and market making.  Counterparty risk is created as a result of the deals that they intermediate, and they find it in their mutual interest to price and share this risk collectively.

This mutual model has survival value.  Even the exchange clearinghouses that Frank et al apparently consider the ideal to be imposed on everybody are effectively mutuals governed by the major intermediaries.  (Once upon a time, the Board of Trade Clearing Corporation permitted every CBOT member to become a member of the clearinghouse, and adopted a one-member, one-vote voting structure.  However, over time, the organization evolved and became dominated de facto and de jure by the largest futures commission merchants.)  Nor is this an anachronism reflecting merely path dependence and hysteresis.  Indeed, one of the largest clearinghouses, LCH.Clearnet, has recently become a more focused mutual-type organization with increased control by large financial intermediaries; in a major reorganization completed weeks ago, LCH fended off a take-over effort launched by major market users by buying out smaller members and giving the big intermediaries a bigger stake in the organization.

This makes sense if the large intermediaries are the efficient bearers of counterparty risk.  If they are the efficient bearers, they should bear it.  And if they bear it, they will certainly condition their willingness to do so on their ability to control the organization.

Moreover, major market users have another reason to want to control the clearinghouse.  “Trading services” is a bundle of a variety of different services, of which clearing is merely one.  These services are consumed in close to fixed proportions.  Moreover, there is likely to be market power in the provision of several of these services, and clearing in particular has natural monopoly characteristics.  An independent clearing organization could exploit its scale economies, and exercise market power and extract rents from major intermediaries that use its services.  Moreover, to the extent that there is market power in one or more parts of the trading services business, this could exacerbate double marginalization problems, leading to other pricing efficiencies.

User control of the clearing function can prevent such exercise of market power.  The mutual/cooperative form allows the major users to obtain clearing services at cost.  If the major users of clearinghouse services cannot control the clearinghouse, those who do control it have an incentive to extract rents from the major users by charging inefficiently high prices.

Thus, from risk bearing and pricing perspectives, user dominance of clearinghouses makes economic sense.  Maybe, just maybe, that’s why users have dominated clearinghouses nearly everywhere and at all times.  Could it be?  What do you think about that, Rep. Lynch?  Barney?  (Barney is a big backer of Lynch’s amendment.)  Or do you guys just know better?  (We are not worthy!)

To me, what Lynch views with suspicion as a conflict of interest is actually an alignment of interest.  It aligns the control rights with risk exposures.  It similarly aligns the interests of those pricing the service with those who consume it.

If implemented, the Lynch amendment would make the mutual model unworkable.  As a rough estimate, if big users are limited to a 20 percent stake, 80 percent of the risk would have to be borne by somebody else.  Which would be who, exactly?  Equity investors?  Why would they provide capital?  Presumably to get a return.  Which would likely require the clearinghouse to be established as a for profit venture.  A venture that would have an incentive to charge supercompetitive prices for its services to extract rents from big users.  And mightn’t such equity investors have an incentive to take risks, given the asymmetric nature of equity returns arising from limited liability?  Isn’t that directly contrary to the whole reason for mandating clearing in the first place?

Also, does it make sense to weaken the ability and incentive of those with specialized expertise in evaluating counterparty risk to monitor and control the specialized organization established to manage this risk?

This is all so perverse.  Why do Lynch and Frank want to impose a constraint that almost certainly will reduce the efficiency of the organization that they have seized on as the way to improve the operation of the derivatives markets?  Or is this just a backdoor way of throttling the derivatives markets increasing the costs of using them through idiotic restrictions on the way they are organized, owned, and governed?  (Make firms who trade derivatives clear them.  Make clearing more expensive by preventing the implementation of efficient ownership and control structures.  Voila!  Fewer derivatives trades!)

There is one potentially real inefficiency that can arise through user-dominated clearing organizations.  Due to the economies of scale in clearing, it is likely that only a single clearinghouse will survive in equilibrium.  As I’ve shown in my work on exchanges, a cooperative organization supplying a natural monopoly service can generate rents for its members by restricting membership.  It lets in just enough members so that no competing organization can survive, but due to the entry limitations reduces output and raises prices to the ultimate consumers of these services.  “Non-profit” exchanges did that for a long time.

Mandating that a clearing organization permit open access would eliminate this problem, but create another.  In particular, to maintain the financial stability of the clearing organization, it is likely desirable to prevent financially weak firms from joining.  The hard thing is to write rules that would be sufficiently discriminating to prevent the clearing organization from using financial requirements for membership as an excuse for excluding potential members in order to enhance market power rents.

That is a real concern, but the Lynch amendment is an incredibly crude way of dealing with it.  Drafts of the various derivatives regulation bills mandate that no clearing organization should implement anti-competitive policies. It would be better to leave it at that, and delegate enforcement of this provision to the anti-trust authorities than attempt to handle the entry barrier problem with restrictions on organization, ownership and governance that impede efficient risk bearing and monitoring, and encourage other ways of exercising market power.

So sayeth Michael Palin, in the priceless Monty Python Argument Clinic Sketch.  In his recent testimony before the Senate Ag Committee, CFTC Chairman Gary Gensler makes an unconnected series of assertions (many categorically untrue) intended to establish a proposition.  Here’s the SWP annotated version:

First, standard OTC transactions should be required to be cleared by robustly regulated  central counterparties. [That’s the proposition to be “proved.”] By guaranteeing the performance of contracts submitted for  clearing, the clearing process significantly reduces systemic risks.  [Unsupported assertion.  Also not necessarily true.]  Through the  discipline of a daily mark-to-market process, the settling of gains and losses and the  imposition of independently calculated margin requirements, regulated clearinghouses  ensure that the failure of one party to OTC derivatives contracts will not result in losses  to its counterparties.  [Categorically untrue for multiple reasons.  OTC derivatives typically marked-to-market; indeed, the AIG debacle that Chairman Gensler’s trots out repeatedly to scare people into supporting him came to a head due to mark-to-market.  Moreover, mark-to-market provides no guarantee that third parties, including clearing member customers and other members of the clearinghouse, will not incur losses.]  Right now, however, trades mostly remain on the books of large  complex financial institutions.   These institutions engage in many other businesses,  such as lending, underwriting, asset management, securities, proprietary trading and  deposit-taking.  [So?  What are the logical consequences of this?  Mightn’t there be economies of scope in these activities?  If there aren’t, why has the market evolved in this way?  Could it be the case that offering a broad array of financial services to its customers a financial institution generates information that lowers the costs of intermediation?]  Clearinghouses, on the other hand, are solely in the business of  clearing trades.  [So? again.  This is a completely, utterly unsupported assertion related to the economies of scope, or lack thereof, in financial intermediation.  Again begs the question of why, if this is the efficient arrangement, it didn’t prevail in the competition of the marketplace.] To reduce systemic risk, it is critical that we move trades off of the  books of large financial institutions and into well-regulated clearinghouses. [Conclusion completely unsupported by previous statements.]

I believe that all clearable transactions should be required to be brought to a  clearinghouse, regardless of what type of entity is on either side of the trade.   This  would remove the greatest amount of interconnectedness from the large financial  institutions. [Again, no support for this assertion.  Moreover, no explanation as to how a clearinghouse that by its very nature connects large financial intermediaries and their customers “remove[s] the greatest amount of interconnectedness”–WTF that means.]

In Energy MetroDesk John Sodergreen reports that a lobbyist says that Gensler is a rock star in Congress because “no member has a clue what they’re actually proposing in the financial reform area–and Gensler does.”

I judge the first part of this statement (e.g., no Congressional clue) to be true, with near metaphysical certainty.  As the foregoing deconstruction of Gensler’s testimony shows, the post-dash statement is not.  Indeed, how could people who don’t have a clue know whether what somebody is telling them is BS or not?  The endorsement of the self-admittedly ignorant (see my earlier post on the NPR guys who interviewed 13 House Financial Committee members) somehow proves Gensler’s wisdom?  Huh?

[I give John S. kudos.  He managed the very difficult task of saying nice things about me and Gensler in the same edition of the same publication. 🙂  I am billed as “one of the CFTC’s most ardent critics.”  One of?  I guess I have work to do.]

It is a sad day when the main question I have is whether the best metaphor for the current financial regulation reform is the aforementioned Argument Clinic Sketch, or the “Burn the Witch” scene from Holy Grail.  That’s a very hard call.

In an oped in today’s WSJ, Peter Wallison notes a fundamental inconsistency in the government’s defense of the AIG bailout:

Since last September, the government’s case for bailing out AIG has rested on the notion that the company was too big to fail. If AIG hadn’t been rescued, the argument goes, its credit default swap (CDS) obligations would have caused huge losses to its counterparties—and thus provoked a financial collapse.

Last week’s news that this was not in fact the motive for AIG’s rescue has implications that go well beyond the Obama administration’s efforts to regulate CDSs and other derivatives. It’s one more example that the administration may be using the financial crisis as a pretext to extend Washington’s control of the financial sector.

The truth about the credit default swaps came out last week in a report by TARP Special Inspector General Neil Barofsky. It says that Treasury Secretary Tim Geithner, then president of the New York Federal Reserve Bank, did not believe that the financial condition of AIG’s credit default swap counterparties was “a relevant factor” in the decision to bail out the company. This contradicts the conventional assumption, never denied by the Federal Reserve or the Treasury, that AIG’s failure would have had a devastating effect.

Wallison is exactly right: Geithner cannot run around Washington, using arguendo ad AIG to justify (a) the bailouts, and (b) the need for mandatory clearing, more draconian capital requirements, and restrictions on derivatives, while at the same time saying that the financial condition of counterparties was an irrelevancy in the decision to assume AIG’s obligations.  These claims are impossible to reconcile logically.  If one is true, the other is not.  Period.

Wallison then traces out the implications of this inconsistency:

The broader question is whether the entire regulatory regime proposed by the administration, and now being pushed through Congress by Rep. Barney Frank and Sen. Chris Dodd, is based on a faulty premise. The administration has consistently used the term “large, complex and interconnected” to describe the nonbank financial institutions it wants to regulate. The prospect that the failure of one of these firms might pose a systemic risk is the foundation of the administration’s comprehensive regulatory regime for the financial industry.

Up to now, very few pundits or reporters have questioned this logic. They have apparently been satisfied with the explanation that the “interconnectedness” created by those mysterious credit default swaps was the culprit.

But the New York Fed is the regulatory body most familiar with the CDS market. If that agency did not believe AIG’s failure would have actually brought down its counterparties—and ultimately the financial system itself—it raises serious questions about the administration’s credibility, and about the need for its regulatory proposals. If “interconnections” among financial institutions are indeed the source of the financial crisis, the administration should be far more forthcoming than it has been about exactly what these interconnections are, and how exactly a broad new system of regulation and resolution would eliminate or reduce them.

Right again.  If arguendo ad AIG is, as the old phrase goes, no longer operative, then what is the logical basis for this metastasizing regulatory framework?

And make no mistake about it, AIG has been the alpha and the omega of the case for mandatory clearing, exchange trading of derivatives, and more onerous capital requirements.  It’s not just Geithner.  If anything, CFTC head Gensler has been even been more of a repeat offender, subject to the three strikes rule multiple times, as evidenced by his recent testimony before the Senate Ag Committee.   In that testimony, Gensler refers to AIG as “Exhibit A” for the case against OTC derivatives.

So . . . if even “Exhibit A” AIG’s financial condition posed no threat to its counterparties (as would be necessary to make this “not a relevant factor”), what’s the need for a draconian restructuring of the financial markets?  And if the Fed and Treasury were truly concerned of the fallout from an AIG collapse, why insist to an official investigation that this was not the case?  Is this an attempt to maintain the fiction that Goldman and the other banks were totally safe and sound even during the maelstrom of the crisis, and didn’t need the money?  If not, give me a better explanation.

Wallison is quite polite when he calls Geithner’s conflicting stories about AIG “a lack  of candor about credit default swaps.”  The Treasury Secretary has lied about AIG with probability one.  The only question is which of his statements is a lie.  I would wager that the “not a factor” statement is the dishonest one.

Hopefully Wallison is right in the second half of this judgment:

The administration seems to be using the specter of another financial crisis to bring more and more of the economy under Washington’s control.

With the help of large Democratic majorities in Congress, this train has had considerable momentum. But perhaps—with the disclosure about credit default swaps and the AIG crisis—the wheels are finally coming off.

Wallison’s call for a thoroughgoing explanation of “how exactly a broad new system of regulation and resolution would eliminate or reduce” interconnections is spot on.  In particular, as I have been saying over and over, and over and over, and . . . just how does creating a central counterparty among major financial institutions eliminate interconnections?  Indeed, by concentrating failure in a single institution connected to all other major financial institutions, and which arguably operates at an information and incentive deficit relative to the dealers in an OTC market, mandated clearing arguably increases systemic risk.

To put it bluntly.  We can’t have such an epochal change in the structure and regulation of such immense financial markets based on lies plus superficial and specious analysis.  But it is abundantly clear that that is the case, as Wallison’s piece succinctly demonstrates.

Several sites on the web (EG) have linked to my  recent post on the AIG bailout, and included a hattip to Jim Chanos.  Just curious if that is the “noted short seller” (and billionaire)  Jim Chanos (a hedge fund manager noted for his very prescient call on Enron).  If so, it would be a hoot.

The sites mentioned have quoted the part of the post which notes that unlike the other banks that received payments via the Maiden Lane III SPV, Goldman had sold protection on CDOs to its customers, and thus was potentially exposed to collateral calls from them.  This means that with no cash flows from AIG (or Uncle Sugar), Goldman would have needed to find a few spare billion lying around to meet its obligations–at a time of a market meltdown.  (Think of how the market would have responded had Goldman not met the calls, or been observed scrambling around to do so.)

There is an indirect, oblique, and very understated confirmation that this cash flow mismatch issue was a real one for Goldman in its reply to (“Wretched”) Gretchen Moregenson’s most recent article on the AIG bailout:

Did we benefit from Maiden Lane III then? In one sense, yes – there a was a timing benefit in terms of money received sooner than might otherwise have been the case.

“Timing benefit in terms of money received sooner.”  How benign it seems, worded that way.  But in the chaotic conditions of mid-September, 2008, when cash was not king–because it was God–that timing benefit could have been the difference between life and death for Goldman.

As I said in the original post, the story is incomplete, and questions remain.  For instance: why go through the subterfuge of providing a cash injection to Goldman via a bailout of AIG rather than providing support directly to GS?  I can think of at least one reason: in those panicked days, even the suggestion that Goldman needed government support would have unleashed Armageddon.  Or at least, it was reasonable for Paulson, Bernanke, and Geithner to fear that it would have unleashed Armageddon.  But we–I–don’t know based on the record whether that was a decisive consideration.

I would say, though, that based on the same record we can’t say that it wasn’t.  I would say further that additional inquiries on this issue are likely to be far more probative than continued flogging of the “the Fed should have forced the banks to take a haircut” angle.

Despite the efforts of Goldman and its defenders to say “move along, nothing to see here,” there are still loose ends.  The most notable of which is the one that distinguished Goldman from the other banks that received Maiden Lane funds–the fact that it was in the middle of a contractual chain.

Anyways, it would be interesting to know if Jim Chanos has been touting SWP.  Just between us, Jim 🙂

My previous post on the Acharya et al (AEFLS) assertion of the purported externality in bilateral OTC markets focused on whether there was actually an unpriced “bad.”  I judged otherwise based on the fact that credit and counterparty risks are repriced repeatedly (and ruthlessly).

There is another reason to reject their analysis.  It should be incumbent on one who justifies the existence of an externality to justify a particular policy to (a) identify the transactions costs that preclude internalization of this externality, and (b) demonstrate that their policy would create a net benefit, by, for instance, reducing transactions costs.  AEFLS don’t even try to do this (another symptom of the Nirvana fallacy).  And when one examines the particulars, it is highly doubtful that the costs of the purported externality are as large as AEFLS insinuate that they are.

The AEFLS story is that contracts between two counterparties to an OTC derivatives deal impose costs on other market participants, notably, the firms’ other counterparties to earlier derivatives deals, and the counterparties’ counterparties, and on and on.  OTC market participants don’t take these costs into account, trade too much, and create too much risk.

Which raises the Coase Question: if these costs are so large, why don’t the affected parties craft a solution that mitigates them?  If, as AEFLS argue, a central counterparty would reduce these costs, why don’t the affected parties create one to internalize the externality and enhance their welfare?

In some cases, e.g., the classical one of a factory that spews pollution that harms myriad individuals, it is plausible that coordination costs (arising from, inter alia, free rider problems) preclude private collective action, and that legislation/regulation mitigates these costs.  But that hardly seems the case here.  The very fact–often cited by the advocates of new, invasive financial regulations–that there are a relatively small number of large institutions that dominate this market means that large numbers-driven coordination problems preclude effective collective action.  Indeed, the institutions that account for virtually all of the activity in the OTC market are already members of a formal organization, the International Swaps and Derivatives Association (ISDA).  ISDA has long served as a mechanism for coordination among, and providing collective goods to, its members.  For instance, ISDA facilitated the standardization of the terms of OTC deals through its standard master agreement.

In brief, the parties that bear the primary burden of this putative externality are relatively small in number; know who each other are; regularly cooperate on a variety of issues of common interest; anticipate interacting with one another well into the future; and have a formal organization to facilitate this coordination.  These conditions would tend to favor private collective action to internalize an externality, especially one allegedly as costly as the one asserted by AEFLS.

But they haven’t done so.  This is like the dog that didn’t bark.  If the danger was there it would have barked.  It didn’t, so . . .

Could there be transactions costs that prevent cooperation?  Just because the canonical sources of such costs appear absent in this instance doesn’t mean they are altogether absent.  One possibility is the kind of problem that Libecap and Wiggins identified in their work on oil field unitization (and that Libecap addressed more generally in his Contracting for Property Rights).  Specifically, that it can be prohibitively costly to negotiate agreements that would (but for these transactions costs) enhance wealth when said agreements have profound distributive effects, and there is private information about these effects.

The complete alteration of risk sharing arrangements would certainly have distributive effects (as I’ve noted in work dating back to the ’90s), especially when the affected parties are heterogeneous (as was almost certainly the case before the crisis, and likely even more so today).  Consequently, one can’t rule out this possibility.

However, it is also plausibly the case that the adoption of clearing would be wealth reducing.  In some sense, then, the heterogeneity-driven coordination cost externality story and the no externality story are observationally equivalent: both predict that market participants would not voluntarily cooperate to create a central counterparty.

To try to untangle the correct explanation of an incontestable fact–that clearing was not adopted voluntarily for the bulk of OTC derivatives transactions–it is necessary to undertake a fact- and context-intensive analysis, rather than play the superficial Pigouvian “I spy an externality” game and stop there, as AEFLS do.  And sad to say, by even getting to this point they are miles ahead of most of the advocates of a radical reshaping of financial market institutions, most notably those in the administration and Congress.

Via SeekingAlpha:

“One of the huge lessons of our work over the last few years has been how shockingly stupid incredibly smart people can be,” said Davidson, who with Blumberg has been reporting on the crisis for nearly two years as part of  National Public Radio’s  “Planet Money” team. “That includes bankers, regulators  and investors.”

OK, that’s a given. Lesser known is this: Our elected officials in Congress — the ones trying to reform our financial services industry as we speak — don’t really understand the issues at hand.

“We spent a day with the Financial Services Committee — Barney Frank’s committee — and it was an amazing experience,” Davidson said. “We talked to 13 congresspeople, 12 of whom admitted that they don’t understand this  at all. And the guy who thought he did really didn’t.”

It’s interesting, then, that these are among the folks calling for investor protections and significant financial reforms. And by “interesting,” I mean “anxiety-inducing.” I’m willing to give them the benefit of the doubt; their intentions are good, after all. But you know what they say about the road to hell.

NB: the directly quoted material in this excerpt is from two NPR reporters.  N. P. R.  Hardly the hotbed of libertarian firebrands.

Personally, I am far less forgiving than the authors of this piece (who are directors of the Maryland Association of CPAs). Anyone who, in full knowledge of their ignorance, nonetheless feels entirely justified in completely restructuring complex markets involving trillions of dollars at risk is a public menace.  A public enemy, in fact, all the worse because they presume to be performing “public service.”

Don’t do me any favors.  The greatest public service these people could perform would be to put away their wands, and stop playing Sorcerer’s Apprentice (or, more accurately, stop playing junior apprentices to Sorcerer’s Apprentice Barney Frank.)

In his megalomaniacal effort to use the financial crisis as a Trojan horse to advance his campaign “on every front to increase the role of government,” Barney Frank is hellbent on fixing things that demonstrably didn’t break.   Even under the extreme stresses of the crisis.   Case in point: he wants to require clearing of foreign exchange derivatives transactions:

If it didn’t break, why fix it?

That is the question being asked by foreign exchange bankers after Barney Frank, chairman of the House Financial Services committee, announced currency derivatives would not, after all, get an exemption from proposed US rules that would require all derivatives trades to be processed through a centralised clearing system.

Mr Frank’s move came as policymakers are debating the detail of legislative proposals designed to increase transparency and reduce risk in the vast over-the-counter derivatives market. While the proposals are not final, the U-turn on his previous stance has stunned the FX market.

Get used to it, guys.   Barney’s all about the u-turns, pace his volte face on clearing and exchange trading in his obviously thoughtfully considered OTC regulation bill.

The FX folks are point out some things I mentioned months ago, such as the fact that clearinghouses can concentrate risk, and therefore exacerbate systemic risks:

Bankers have also warned that clearing in FX could create new concentration dangers which they fear could create fresh systemic risk, given the size and significance of the FX market. The market is already concentrated among a handful of top international banks.

But it is Barbara Matthews that brings out the key point:

Barbara Matthews, managing director of BCM International Regulatory Analytics, believes there is a general issue to be considered about concentrating so many markets on to clearing platforms. She warned that policymakers must be aware that clearing houses could create new “choke points” in the system – not unlike the risk created now by any large bank – which must be considered carefully. “Its perfectly natural in a time of uncertainty to look towards some kind of central arrangement,” she said. “But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.”

That last bit bears repeating: “But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.”

Exactly right.   Those who have advocated clearing mandates–Geithner, Gensler, and Frank most prominently–commonly assert that clearing eliminates counterparty risk.

Wrong.   It doesn’t.   It reallocates it.

The only question is whether they know better and are lying, or are ignorant.   Either way, they selling a bill of goods, and as Barbara Matthews says, are laying the groundwork for the next nasty financial surprise.

Last week I wrote about one justification for exchange trading and clearing mandates–the market power argument.  This week I’ll examine another argument, and render a similarly skeptical verdict.

In a chapter of Restoring Financial Stability, Viral Acharya, Rob Engle, Steve Figlewski, Anthony Lynch and Marti Subrahmanyam argue that bilateral transactions in OTC derivatives markets involve an externality.  Their argument is not stated that clearly, but FWIW here it is verbatim:

[A]ll OTC contracts . . . feature collateral or margin requirements, wherein counterparties post a deposit whose aim is to minimize counterparty risk.  The deposit is marked to market daily, based on fluctuations in the value of the underlying contract and the creditworthiness of the counterparties . . . . The difficulty, however, is that such collateral arrangements are negotiated on a bilateral basis.  Parties in each contract do not take full account of the fact that counterparty risk they are prepared to undertake in a contract also affects other players; indeed, they often cannot take account of this counterparty risk externality in an OTC setting, due to inadequate transparency about the counterparty’s positions and its interconnections with the rest of the market.  While bilateral collateral arrangements do respond to worsening credit risk of a counterparty, such response is often tied to agency ratings, which are sluggish in capturing credit risk information and potentially inaccurate.

An externality means that some cost or benefit is not priced.  By invoking the concept of externality Acharya et al (“AEFLS”) are asserting that something–a bad in this instance–isn’t priced.  They are a very vague on just what this is, but here’s my interpretation of what they mean.

A firm that has already entered into financial contracts affects the risk exposure of its existing counterparties when it enters into new deals.  A firm that has a large number of commitments outstanding can enter into additional contracts that substantially increase its riskiness, thereby harming the incumbent counterparties.  The cost imposed on these incumbent counterparties isn’t, in this telling, priced.

This is, in essence, an asset substitution argument.  And indeed, asset substitution is always a concern in any credit relationship, whether it is between a bank and a borrower, or derivatives counterparties.

But an understanding of the way these markets work suggests that the asset substitution problem is far less important than AEFLS suggest.  One way of controlling this problem in lending relationships is to rely on short term debt, allowing repricing of old debt frequently and thereby limiting the gains from asset substitution.

In OTC derivatives markets, similar mechanisms are at work.  The main dealers rely heavily on short term financing.  Thus, attempts to engage in this type of behavior can lead to substantial increased financing costs, and indeed, a loss of access to short term funding altogether–this is a death sentence to a financial institution, as Drexel found out in the 1980s, Salomon almost experienced in the 1990s, and Bear and Lehman suffered during the crisis.

In fact, Diamond and Rajan argue that the “fragile” capital structure of financial intermediaries–the vulnerability to runs or other mechanisms that result in the rapid withdrawal of access to funding–are intended precisely to  provide such discipline.  Thus the supposed bug–the vulnerability of a big liquidity supplier to failure–is, in some respects, a feature.  Without it, the opportunism that AEFLS worry about would be a greater concern.

OTC dealers also trade derivatives extensively with one another.  Thus, changing creditworthiness can affect their ability to deal in these markets, and the pricing of these deals.

There are, therefore, mechanisms by which financial institutions internalize the costs associated with the riskiness of their dealings.  Of course, these do not work perfectly.  Of course, information is imperfect.  But it is essential to note that myriad lenders and counterparties are continuously interacting with big OTC dealers in a variety of different markets.  They are doing their own credit appraisals.  They are voracious consumers of any bit of information about other players in the marketplace.  The markets for funding and derivatives can serve to aggregate this private information in the prices and credit terms of derivatives trades, and in the funding costs that the institutions pay, thereby pricing (albeit imperfectly) counterparty risks.

Moreover, as Peter Klein pointed out in an earlier post on O&M, it is necessary to make an explicitly comparative analysis when evaluating policy alternatives.  The identification of an imperfection of the OTC market is not sufficient to conclude that it should be replaced by some other alternative that is inevitably imperfect as well.

In this regard, a comparison of the OTC market with the particular alternative that AEFLS advocate–central clearing–demonstrates that OTC markets arguably dominate clearing even on dimensions emphasized by AEFLS.

Most notably, clearinghouses almost NEVER condition margin levels on the creditworthiness of the member firms.  If they do (as, for example, LCH.Clearnet does in limited circumstances) they rely soley on agency ratings.  This reflects a variety of factors, including a lack of information to make such judgments.  Moreover, it reflects the fact that it would be very difficult, in practice, for a clearinghouse to discriminate among its members.  Such discrimination–which could have serious competitive effects–would expose the clearinghouse to intense influence activities.  (Thus, clearinghouses are most likely to work effectively when the members are homogeneous, and heterogeneity can be an impediment to their formation.)  This means that clearinghouses do NOT price counterparty risk in a discriminating way.  In a cleared market, a major determinant of counterparty risk is in the public domain, and not priced.  This is not conducive to an efficient allocation of trades among firms, or in the scale of trading activity.

In contrast, in the OTC market, dealers have a wide variety of sources of information about the creditworthiness of potential counterparties that they take into account when determining the terms on which they are willing to deal with these counterparties.  That is, although their information is imperfect, big dealers almost certainly have better information on the creditworthiness of other dealer firms than a clearinghouse would.  What’s more, the fact that any given firm is being evaluated by multiple counterparties and lenders means that (a) the private information aggregation mechanism noted before can work in the OTC market in a way impossible with a single evaluation by a clearinghouse, and (b) evaluation errors are somewhat diversified in the OTC setting, but with one monitor in a cleared market, if the clearinghouse gets it wrong the problem can be huge.

That is, counterparty information in OTC markets is imperfect, but almost certainly better than in a cleared market.  Moreover, there are a greater array of mechanisms available to price counterparty risk based on this information: not just in margins, but in the pricing of deals (many deals explicitly adjust prices to reflect credit terms), the pricing of the financing that dealers require to operate, and in the sizes of transactions.

I’ve argued extensively in some working papers that as a result of these information advantages, contrary to the claims of AEFLS, counterparty risks are likely to be priced MORE accurately in a bilateral market than a cleared one.  Clearing can offer some offsetting advantages, but the key point is that a trade-off is involved.  In my view, it is highly likely that this trade off frequently favors bilateral, OTC dealings rather than central clearing.

Like so many advocates of clearing, AEFLS fall victim to the Nirvana fallacy.  They point out imperfections in OTC markets, and do not carry out a comparative analysis of the relative imperfections of alternatives.  What’s more, their analysis of the supposed failings of the OTC market is incomplete because they do not fully explore how market participants structure their transactions to deal with the putative market failure they identify.

They’re miles ahead, though, of Barney and Chris and Timmy! and Gary and Mary and the gang.  At least AEFLS try to identify an alleged market failure.  Even though they fall into the classic Nirvana fallacy, at least they point out a potential inefficiency, thereby permitting an rigorous exploration and analysis of this possibility.  Which is way more than can be said for the Sorcerer’s Apprentices attempting to reorganize completely the largest and most complex financial markets in the world.

Cross posted on O&M.