Streetwise Professor

Krugman is bashing Timmy! Geithner for his role in the AIG bailout.   This poses something of a dilemma for yours truly.   My sentiments parallel those of Henry Kissinger during the Iran-Iraq War: too bad they both can’t lose.

All snark aside, the SIGTARP report that has put Timmy! (oh, that was snarky–sorry) on the hotseat raises some questions that have been totally ignored over the debate over whether the Fed should have sent Goldman et al to the barber shop to get a haircut on the valuations of their swaps with AIG.

The indisputable fact is that billions of cash went out the door to Goldman et al as a result of the Fed’s actions.   The Fed took ownership of the CDOs underlying the swaps that AIG had entered with the banks, and effectively paid the banks 100 cents on the dollar.   That is, they ensured that the CDO hedges were perfect (belying the old trader adage that the only perfect hedge is in a Japanese garden).

The question is, therefore, what were the alternatives?   The alternative that has garnered all the attention is that the Fed should have paid less than 100 cents on the dollar.

But that’s not the only alternative.   Hank Greenburg has suggested that the Fed should have simply guaranteed the swaps, thereby vitiating the need to provide any collateral payments.   (I made a similar suggestion in an earlier post on AIG).

The SIGTARP report states clearly (p. 14) that this alternative was considered, but dismissed.   The ostensible reasons for the rejection seem very dubious, indeed.

First, “FRBNY told SIGTARP that a perceived downside of this structure from FRBNY’s perspective was that it could involve FRBNY in long-term credit relationships with supervised institutions.”   Please.   The Fed has gone hog wild in extending credit (through repos, for instance) with supervised institutions.   It has taken all kinds of dodgy collateral at all kinds of dodgy valuations.   That certainly involves taking a long term credit exposure.   (Spare me any protests that there is no credit risk here because these repos are collateralized.   Given the quality of the collateral, and the counterparties, there is an appreciable probability that the Fed will suffer a credit loss on these deals.) And if the Fed’s actions were a response to an existential event, which is the gravamen of its defense of its actions, such prissiness over protocol appears decidedly inappropriate–making this explanation exceedingly implausible.

Further thought (added at around 1900 CT):  Given that the CDS were so far underwater to AIG, if the government had guaranteed them, the likelihood that the Fed would have become a creditor to the banks on the other sides of the deals was exceedingly remote.  That is, it was highly unlikely that the Fed would have been exposed to default losses on these deals, meaning that the “credit relationship” was a fiction.  (Besides, at the time, were most of the counterparties even under Fed supervision?   Most were foreign banks, and even the US counterparties, with the exception of Wachovia, were investment banks that I do not believe were under direct Fed supervision, except perhaps as Treasury primary dealers, rather than as banks.)

Second, “there was a lack of statutory authority of the Federal Reserve to provide such a guarantee.”   Please, again.   There are a variety of structures that effectively create guarantees.   For instance, if the Fed could see its way clear to setting up and capitalizing a special purpose vehicle (SPV) to buy the CDOs, it could have set up and capitalized an SPV, and then novated the deals to the SPV.   If it was concerns about counterparty risk that made the banks so insistent on receiving collateral payments, this structure would have allayed their concerns–and required no cash to go out the door.

In this structure, the government’s risk exposure would have been the same as under Maiden Lane and its purchase of the underlying CDOs: it would have been long the CDOs.

In sum, the rationales given for not providing some sort of guarantee are completely unpersuasive.   Completely.   A guarantee would also not have required agreement on valuation with the counterparties.   They would have been assured of receiving their contractual payments, and that should have been that.

The transparently implausible rationale for eschewing the guarantee alternative tells me that the Fed’s–and Geithner’s–injured and adamant denial that “the financial condition in the counterparties was not a relevant factor” (p. 15) in deciding to pay 100 cents on the dollar is dishonest.   Geithner has said many other things that do not pass the honesty smell test, so it wouldn’t surprise me that if this was the case here as well.

Thus, it is highly likely in my view that this was a backdoor way of providing liquidity to systemically important institutions at a time that their financial condition was in serious question.

In this regard, it could well be that Goldman was the firm that was in greatest need of an injection of cash.   The SIGTARP report states that, unlike the other AIG counterparties, “Goldman Sachs did not hold the underlying CDOs but rather had sold equivalent credit protection to its clients who held those positions.”   Very interesting.   It is likely that these client counterparties were demanding collateral from Goldman.   If so, if Goldman didn’t receive cash from AIG–or the government–it would have needed to find additional cash to make these payments.

Yes, Goldman states that it was hedged by its purchase of credit protection on AIG.   But, (a) in prevailing conditions, there was considerable credit risk in those CDS, meaning that Goldman may not have been paid out 100 percent of what it was owed, and (b) even if the CDS paid out, there would almost certainly have been a cash flow date mismatch, with Goldman needing the cash to make margin calls to its clients immediately, and receiving any cash payments on CDS at some later date.   Given the state of the credit markets at the time, funding this gap would have been an expensive, and dicey, proposition.

Given the supposed First Commandment to Treat All Banks Equal (p. 29), the Fed could not have bought out Goldman and not the other banks.

Against that, if providing liquidity to Goldman alone was the objective, there should have been ways of doing that directly–unless the Fed was concerned that special treatment of Goldman would have commenced a destablizing run on it like the one that cratered Lehman.

I therefore can’t conclude for certain that the AIG bailout was really a Goldman rescue in drag.   One can tell that story, but there are alternative explanations.   However, given that the Fed’s explanation for not taking actions that would have required no cash payments is so weak, my conclusions are that the AIG bailout was an indirect of providing liquidity to systemically important institutions, and that one cannot exclude the possibility that this was an indirect way of providing liquidity to one institution in particular–Goldman.

(One question unanswered by the SIGTARP report: if Goldman didn’t own the CDOs that eventually wound up in Maiden Lane, how did they get there?   Did Goldman buy them from its clients in a mirror image deal that involved swap tearups, and then sell them to Maiden Lane?   It would seem that would be necessary to deal with Goldman’s own sales of protection. )

A couple of other points related to the SIGTARP report.   First, as I emphasized in “It’s a Wonderful Life: AIG Edition,” if AIG hadn’t been born and hence not around to sell protection, the owners of the CDOs would have taken a bath.   Thus, it is not credit default swaps per se that were the ultimate source of the problem; it was the underlying CDOs.   Only to the extent that the existence of AIG contributed to a larger CDO market could CDS have contributed to the financial crisis.   Indeed, the crisis–that is, the losses suffered by big banks–could have been worse if AIG hadn’t taken a $50 billion hit.

Second, one of the narratives has been that AIG didn’t have to post collateral, and hence took on bigger positions than it would have if it had been required to do so.   It indeed didn’t post any initial margin, but it is clear that the deals contemplated the posting of collateral even absent an AIG credit event.   AIG had posted at least $22 billion in collateral prior to its downgrade (Table 1).   Perhaps the necessity of posting initial margin would have reduced AIG’s appetite, but likely not, in my view.   First, by not requiring original margin, counterparties were extending AIG credit, and presumably charged for it; only to the extent that it would have been costlier to finance initial margin payments would the posting of such margin have made AIG reduce its positions.   Second, given that it lost huge sums on mortgage backed in its security lending program and other operations, it is clear that AIG viewed these as very attractively priced risks.   Sure, a slightly higher cost (due to the necessity of posting initial margin) might have induced it to cut back some, but likely not very much.

To conclude: given the availability of another alternative to buying out the banks at 100 percent of par, that would not have required a cash payment, and the weak justifications for avoiding that option, make it highly likely that the AIG bailout was structured in part to provide liquidity to major banks (and perhaps, but not conclusively, one particular bank).   Which makes the Fed’s–and Geithner’s–denial that the financial health of these firms was an irrelevance highly dubious, not to say, a lie.

All of the legislative proposals relating to over-the-counter derivatives would impose seismic changes on the way that these instruments are traded, and the performance risks related to them are managed.  Indeed, it is fair to say that these proposals, if implemented would dramatically shrink the OTC market, and perhaps destroy it altogether. Under either the House (Frank) or Senate (Dodd) bills, most derivatives would have to be traded on exchanges, and be cleared.  (Clearing is a way of mutualizing default risks.  At present, default risks in a particular contract are directly limited to the buyer and seller.)  (BTW, when you hear “Frank and Dodd” do you think Fannie Mae and Freddie Mac?  I do.  Does this inspire confidence?  Self-answering question.)   These efforts are strongly supported by Treasury Secretary Timothy Geithner, CFTC head Gary Gensler, and SEC head Mary Shapiro.

These legislative proposals are clearly predicated on a very strong belief: participants in the derivatives markets routinely chose the wrong institutional arrangements.  That this immense market is and was in fact arguably the largest market failure in financial history.

And these markets are indeed immense.  According to Bank of International Settlements data, notional (“face”) values of these instruments totaled $683 trillion in June, 2008 (right before the onset of the financial crisis), and their market values totaled $20 trillion (ballooning to $34 trillion by the end of 2008).

Moreover, these markets had grown dramatically over the years–at a double digit annual pace.  They also dwarfed the market for exchange traded (and cleared) derivatives.  The BIS reports that at the end of 2007, total notional values of outstanding contracts traded on exchanges were $28 trillion, which had shrunk to less than a mere $20 trillion at the end of 2008.  (I won’t go into the quibbles over the interpretation of these numbers, which make true apples-to-apples comparisons impossible.  Suffice it to say, difficulties of interpretation duly considered, the exchange traded markets are huge, but the OTC markets are HUGE.)

But our betters on Capitol Hill think that these collective results of the individual decisions of thousands of informed participants with major skin in the game are wrong, wrong, wrong.  They know better.  EVERYTHING should be traded on exchanges.  EVERYTHING should be cleared.  The emergent order is fundamentally flawed; a constructed one must be substituted for it by legislative fiat.

This assertion of systematic, immense market failure demands a coherent explanation.  It is, to be honest, quite hard to find one.  In this post and some that follow, I’ll examine some of the attempts at explanation.

Cliffs’ Note version of my conclusion: I’m still searching for a coherent story.

One of the most commonly heard stories is that OTC derivatives are enormously profitable for big banks due to the lack of transparency in the market.  Exchange trading and clearing would shrink profit margins, costing the banks big money.  So they have deliberately kept the market dark in order to enhance their market power and their profits.

Of course, all dominant incumbents want to maintain market arrangements that protect their market power and monopoly profits.  This is why GM is enormously profitable due its continued dominance of the automobile market.

Back to our regularly scheduled reality.

To justify the profit protection story, it is necessary to demonstrate the existence of entry barriers.  It is possible for banks to charge their customers supercompetitive prices persistently only if there is no possibility for competitors to undercut these prices (where the idea of “price” should be interpreted broadly to incorporate all of the costs that customers pay to trade derivatives.)  There are, however, strong reasons to believe that such entry barriers don’t exist, or aren’t sufficiently strong to explain the dominance of the OTC markets.

Let’s consider for a minute the legislative proposals.  They want to force trading onto exchanges.  They believe that this trading will be cheaper and more efficient due to greater transparency and competition, and share default risks more efficiently, than the current OTC markets.  But exchanges already exist.  For years they have been striving mightily to make inroads into the OTC derivatives markets.  Futures brokerage firms have also been trying mightily to market their services to the customers of OTC dealers.  Exchanges have launched head-to-head competition in many areas–and failed miserably in most of them.

If exchanges are really cheaper, because OTC dealer banks exercise market power and charge supercompetitive prices, why haven’t the exchanges made greater penetration?  Why haven’t they drawn business from the OTC dealers?  Why has the market share of OTC derivatives grown?

I’ll wait.  Barney?  Chris?  Tim?  Gary?  Mary?  [Humming quietly to myself.]

Put differently: the alternative market arrangement that the DC crowd says is more efficient and cheaper has been available to the allegedly poor, exploited customers of dominant dealers for years, and they’ve chosen to trade with the dealers nonetheless.  How to explain this?  Battered spouse syndrome?  Masochism?  It is a puzzle, no?

But it gets better.  There are many markets in which virtually identical products trade OTC and on exchanges.  In many of these markets, consenting adults knowingly choose to trade the uncleared, bilateral OTC contracts.  Why would that be if OTC markets are beset by market power that inflates the costs that customers pay?

Moreover, there are cases where clearing has developed organically in an OTC market without the benefit of a government mandate.  Most notably, clearing has grown dramatically in OTC energy derivatives since 2003.  This demonstrates that clearing can succeed competitively where customers want it.  This undercuts the idea that clearing (or exchange trading) is at an inherent competitive disadvantage relative to OTC dealer.  Ironically, and tellingly, this development has occurred precisely when the firms that dominate the OTC financial markets–e.g., Goldman Sachs, J.P. Morgan, Morgan Stanley, and other big banks–began to dominate trading in OTC energy derivatives.  How come they didn’t strangle the clearing baby in the crib to create and protect a privileged position in the energy markets?

In sum: there have been vigorous attempts of the putatively cheaper, more efficient exchange trading platforms to enter the market, suggesting that entry barriers do not preclude such competition.  These competitive efforts have often failed, and have certainly failed to displace OTC trading.  Where given a choice, customers sometimes choose cleared or exchange traded products–and oftentimes don’t.

Which calls into serious, serious question the received story as to why the inefficient, opaque, market-power ridden OTC market has survived and thrived. Instead, this “explanation” appears to be yet another of the many Just So Stories that have proliferated in the aftermath of the financial crisis;  a superficially plausible explanation that does not withstand scrutiny.

But on the basis of such Just So Stories, we are supposed to countenance the complete re-engineering of the world’s financial markets.

[Cross posted at Organizations and Markets.]

I welcome Gillian Tett’s recognition that clearing is not the silver bullet–or the “magic wand”–that will make financial crises a thing of the past.  This bit is particularly spot on:

What is notable about the reform debate this year, is that there has been remarkably little public discussion among politicians – or among regulators – about how to guarantee that any future clearing house will be strong enough to withstand future shocks.

In part, that silence may reflect a lack of imagination. Politicians and regulators have never seen a situation where a clearing house has collapsed; leaving aside one small exception in the commodities world a few decades ago [not quite right: the Hong Kong Clearing Association failed in 1987, and the CME and CBT clearinghouses were under extreme stress too], that has never happened before. However, I suspect the silence may also reflect delicate political sensibilities. If politicians were to demand that a clearing house should be so utterly rock solid that it could withstand financial Armageddon, the future members of any clearing platform would have to make massive financial commitments. That would necessarily limit membership to a small cabal of ultra-powerful banks – not something that most politicians wish to encourage.

However, if a clearing house is made more accessible to a wider pool of members, then it will only have credibility if it is backstopped by the government itself to ensure that trades are always settled. Most politicians are not keen to highlight that option either, given the wider sense of public anger about the degree to which the government is bailing out the financial world.

Tett is in fact too kind about the lack of public discussion.  Politicians–most of whom, truth be told, couldn’t explain to you how clearing actually works, and probably hadn’t even heard of it a year ago–have seized on the clearinghouse as a cure all.  There has been virtually no serious discussion of the economics of clearing, or the economic implications of clearing mandates.  Much of the discussion has been notably distorted and misleading; Timothy Geithner and Gary Gensler have been particular guilty of this.  Nobody has answered (and arguably, nobody has seriously asked) why clearing has not been adopted heretofore, and why non-cleared products have grown relative to cleared ones, if clearing is so great.  (And no, I don’t count the superficial “it will cut the banks profits” argument.)  Instead, clearing is a deus ex machina, invoked to resolve all the thorny issues involved in financial market structure.

Tett’s statement that memberships in clearinghouses lacking a government guarantee would limited to a “cabal of ultra-powerful banks” illustrates the inanity of much of the debate.  We need clearing to permit big banks to share counterparty risk because big banks are too interconnected.  Huh?

The alternative she poses–government guarantees of clearing–is truly scary.  We need to find ways of weaning the system off the government guarantees that currently exist, and which are the main source of moral hazard-induced systemic risk, rather than look to find new things to guarantee.

Tett is sympathetic to clearing, as is indicated her invocation of the lack of the failure of a major clearinghouse.  This is a weak argument, however, because the market structure–and crucially, the choice of clearing vs. bilateral arrangements–is endogenous.  Clearing has been adopted where conditions favor it.  The fact that it has worked in these areas does not imply it will work equally well with other products and other participants.  Indeed, it is quite possible that mandating clearing for products/participants for which it is not well adapted (as indicated by the failure to adopt it voluntarily) will make things worse, rather than better.

Tett’s concluding paragraph makes an important point:

One lesson that financial history shows is that the issues which blow up the financial system are not usually those which caused the last crisis; instead, the biggest threats tend to come from the areas swathed in a lazy consensus, or where there is a strong political impetus to clutch at easy solutions. That might yet apply to the clearing houses. In theory, I still believe that clearing houses could – and should – make the derivatives world safer. In practice, though, they could end up creating new dangers if they are not put on a sound footing – particularly if the fact that no clearing house has ever failed before creates a false sense of security.

We need a serious examination of the costs and benefits of alternative market structures.  Sadly, this has been completely absent.  Instead, we have had superficiality masking as deep analysis; cheerleading instead of critical appraisal.  This will not end well, because, as Tett notes, such superficiality leads to the false sense of security that lays the groundwork for the next crisis.

I have been a Cassandra on this issue for some time now.  It’s good to have some company, even if Gillian Tett still has too rosy a view of clearing for my taste.  But the fact that at least somebody is questioning the conventional wisdom is encouraging.

A couple of other clearing stories that deserve mention.  First, incredibly, Barney Frank has endorsed NJ Rep. Stephen Lynch’s amendment to regulate clearinghouse ownership structures:

Mr. Frank said he hopes in part to address potential conflicts of interest at clearinghouses with a provision pushed by Rep. Stephen Lynch (D., Mass.) that would limit big banks’ controlling stake in clearinghouses to 20%. That provision was included in the bill, but hit a procedural hurdle recently and had to be removed.

“We are encountering resistance to that on the part of many, including my colleagues in the House Agriculture Committee,” Mr. Frank said of the Lynch provision. “As I believe it is important to reduce the stake in the clearinghouses of these firms…I continue to support Congressman Lynch’s amendment.”

WTF was I thinking when I said something nice about this dangerous, dangerous man?  The man who, more than any other, is responsible for the Fannie and Freddie fiasco (the costs of which make the expense of AIG pale in comparison).

Second, and an excellent counterpoint to the Lynch-Frank effort to micromanage the ownership of clearinghouses, LCH.Clearnet has completed a restructuring that gives large banks more control:

The clearer said on Friday that with the redemption finalised, large users now owned 63 per cent of the business, up from 37 per cent. LCH.Clearnet defined large users as those which contributed more than 1 per cent towards group clearing fees and which together represented, in aggregate, more than 80 per cent of the group’s clearing revenues.

LCH.Clearnet is now owned 83 per cent by users of its services and 17 per cent by  NYSE Euronext and the London Metal Exchange.

Sixty-five shareholders, including Euroclear Bank, a unit of Euroclear, the settlement services group, have had their shareholdings either redeemed or “significantly reduced”.

The total number of LCH.Clearnet shareholders is now 105, down from an earlier 120.

Most of LCH.Clearnet’s “large” users are also members of the bank consortium – codenamed “Lily” – that abandoned its takeover attempt last month, largely because the LCH.Clearnet scheme largely satisfied its demands for greater control of the clearer.

The consortium had wanted control of LCH.Clearnet largely for its SwapClear interest rate swaps clearing business, turning the clearer for the London Stock Exchange, Euronext and the London Metal Exchange into more of a clearer of OTC derivatives.

Interesting, isn’t it, how market participants with experience and skin in the game are doing the exact opposite of what politicians who don’t want them to do?  This should at least raise questions as to why market participants favor a mutualized structure with a rough equivalence between risk exposure and control.  Could it be because this offers serious efficiency advantages?  But no, all we get from financial sophisticates like Frank and Lynch is superficial bleating about “conflict of interest.”

Reading all this makes this quote from Hayek (which serendipitously Russ Roberts reminded me of yesterday) all the more apropos:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

When it comes to politicians and regulators, Hayek’s phrase should be amended to say:

The curious task of economics is to demonstrate to politicians and regulators how very, very little they really know about what they imagine they can design.

CFTC Chairman Gary Genlser continues to make concentration and diversity his primary justifications for expanding position limits:

I believe we should consider setting position limits to guard against excessive concentration in the energy futures market,’ said Gensler at a luncheon held by the Natural Gas Roundtable, a nonprofit organization.

The CFTC is weighing whether to set position limits — a maximum market share — for oil and other energy products. The agency already sets limits on agricultural contracts.

‘When the CFTC set position limits for certain agricultural commodities, the agency sought to ensure that the markets were made up of a broad group of market participants with a diversity of views,’ said Gensler.

This raises several questions.

First, what is the statutory basis for position limits designed to reduce concentration and increase diversity? I see none whatsoever.

The relevant statute–available right there on the CFTC’s website–makes it clear that position limits are for the purpose of reducing “excessive speculation” that causes unwarranted price changes:

Excessive speculation in any commodity under contracts of sale of  such commodity for future delivery made on or subject to the rules of  contract markets or derivatives transaction execution facilities causing  sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity, is an undue and unnecessary burden on interstate  commerce in such commodity. For the purpose of diminishing, eliminating,  or preventing such burden, the Commission shall, from time to time,  after due notice and opportunity for hearing, by rule, regulation, or  order, proclaim and fix such limits on the amounts of trading which may
be done or positions which may be held by any person under contracts of  sale of such commodity for future delivery on or subject to the rules of  any contract market or derivatives transaction execution facility as the  Commission finds are necessary to diminish, eliminate, or prevent such  burden.

It couldn’t be much clearer.  Congress has authorized the CFTC to fix trading limits “for the purpose  of diminishing, eliminating,  or preventing such burden [of “sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity”].”  Period.  Full stop.  Not a word about “concentration” or “diversity.”  Like Bart Chilton’s musing about “unintentional manipulations,” Gensler’s advocacy of position limits based on these concepts is completely unmoored from the law.

That is, “excessive speculation” that distorts prices can provide a legal basis for position limits; Gensler’s “excessive speculation” (with no attempt to connect such concentration to price distortions) cannot.

Second, what is the evidence that variations in concentration across markets affect market quality?  I am not aware of any.  That is, what constitutes “excessive” concentration?: how would we know when this level is reached?

Third, what does Gensler believe causes variations in concentration across markets?  Could there be fundamental economic considerations that affect the level of concentration?  Could it be that trying to micromanage concentration through position limits would impose costs because these limits conflict with these fundamental economic considerations.

Fourth, more generally, what are the costs of position limits (e.g., in terms of constraining risk transfer)?  Has Gensler made any effort to weigh the costs against his estimates of the benefits?

Fifth, what levels of concentration are problematic?  Under what theory?  What is the evidence that supports this contention?

Sixth, are there any markets that have reached this level of concentration?

Seventh, is there any evidence that position limits materially impact concentration?

In terms of what concerns concentration poses, concentration levels (per CFTC data) are not large as compared to, for instance, industrial concentration in most markets.  In crude and nat gas, 4 firm concentration ratios range between 25 and 40 percent, while 8 firm ratios are in the 30-50 percent range.

I think that Gensler’s clear desire to shift the grounds of the debate from the (legally required) “excessive speculation” issue to something else (the legally meaningless idea of “excessive concentration”) reflects the fact that there is clear lack of both logic and evidence to support any claim that “excessive speculation” has, in fact, caused “unwarranted” price fluctuations.  Lacking such evidence, Gensler is attempting to hitch a ride on the financial crisis.  As the article quoted above says,  “Chairman Gary Gensler of the Commodity Futures Trading Commission said the financial crisis last fall showed the risk posed by ‘large concentrated actors on the financial stage’.”  He provides no evidence that this concentration caused problems in the futures market even during the height of the crisis (which would, interestingly, undercut his argument that clearing is a panacea to systemic risk).  And even if it did, it still provides no legal basis for position limits, which must as noted above, can be imposed only “for the purpose  of diminishing, eliminating,  or preventing” undue price fluctuations caused by excessive speculation.

By repeatedly invoking “concentration” and almost completely ignoring the sole legal basis for position limits, Gensler may actually call into question the legitimacy of any position limit regulation the Commission does pass.  If Gensler really believes that concentration is a problem, he should advocate amendment of the Commodity Exchange Act to make concentration a justification for imposing limits.  By straying from statutory authority in his advocacy for position limits, Gensler risks becoming another out of control regulator attempting to ensure that no good crisis goes to waste.  He has a lot of company in that, but that’s no excuse.

From The Austrian Economists a timely reminder that this is the 50th anniversary of the second of Coase’s three great papers, on the FCC (which presaged his most important paper on social cost).  (Actually, Coase wrote more than 3 great papers by the standards of the profession, but even by his own high standards three stand out.)

It is gratifying to see a case where a scholar produced his greatest research at around age 50, and then has lived another 50 years (and counting) to observe the transformative effect of that work. (What is it about Chicago and great nonagenarian economists, e.g., Director and Friedman in addition to Coase?)

But perhaps not transformative enough, for much has been written and said on public policy and regulation in the aftermath of the financial shock could have been written or said had Coase never lived.  Which is a shame, and which means that it is highly, highly likely that the legal and regulatory changes that do occur will be pernicious rather than beneficial.

Prior to Coase, it was common for economists to argue that market failures necessitated government corrective.  In particular, those operating in the dominant Pigouvian tradition saw externalities everywhere, and recommended corrective taxes (or other mechanisms) to address them.

Coase asked more basic questions: why do externalities exist? and why, if they are so costly, don’t greedy maximizing individuals do something about them?  This led him to the insight that transactions costs are at the root of any supposed market failure; people do not internalize externalities because the (transactions) costs of doing so exceed the benefits.  This does not eliminate the possibility that government intervention can make things better, because government action may entail lower transactions costs than private alternatives.  But once one recognizes that government policy is not (transactions) costless, the Coasean logic necessarily makes any analysis a comparison between imperfect alternatives, rather than a morality play starring a flawed market and a redeeming government.

This, in turn, necessitates a thorough examination of the sources of transactions costs that make market outcomes less than ideal.  This process of examination frequently identifies underlying conditions, such as information asymmetries, that do not disappear with the passage of a law–and which may in fact be worse in a regulated environment.  In other words, it is often the case that if you are think things are bad now, just think how much worse they’ll be when we fix them!

And that is what is largely missing in the current debate.  In the case of the financial markets, among policymakers and many commentators there has been far too little effort made to answer the question implicit in all of the proposals for a root-and-branch restructuring of the system: why did greedy individuals systematically make such costly choices?  For instance, the proposals to completely restructure–and indeed, largely eliminate–OTC derivatives markets presume that market participants systematically chose the wrong institutional arrangements, at huge cost.  From the Coasean perspective, the greed meme used to justify much government policy actually cuts the other way: greedy individuals have strong incentives to find ways to reduce these costs.

In my view, such an evaluation produces several conclusions which should combine to make those eager for a legislative and regulatory restructuring of the markets far more circumspect.  First, there are strong economic justifications for many of the institutional choices.  Second, by failing to understand better why particular institutional arrangements evolved (i.e., what transactional and transactions cost characteristics affected these arrangements), policymakers run the very serious risk of imposing new institutions that are badly adapted to these fundamental characteristics.  Third, many of the most perverse choices resulted from previous regulations and policies.  (The Calomaris interview that I linked to earlier this week in the Friedman post provides several examples.)

Put differently, things as immense and complex as the OTC derivatives markets are emergent orders, complex systems with rich and inscrutable feedback mechanisms.  These orders have evolved to economize on scarce resources–including to economize on transactions costs.  Intervening to change one part of the system, or several parts of it, will have unfathomable consequences.

Before taking the (often irreversible) step of trying to reshape an emergent order by fiat, it is imperative to understand better why it has taken the shape it has.  Using Coasean, transactions cost concepts is an essential ingredient to achieving such an understanding.  It is also a good antidote to legislative and regulatory hubris.  It is, alas, almost completely lacking in the current policy debate, which bodes ill for the future.

The amendment that would have limited dealer ownership of clearinghouses to 20 percent  has been stripped from Barney Frank’s OTC derivatives bill:

In a bill passed last week by the House of Representatives’ financial services committee to reform the  over-the-counter derivatives markets, an amendment was inserted at the last minute by Massachusetts congressman Stephen Lynch that appeared to limit the stake banks could collectively own in a clearing house to 20 per cent.

. . .

Susan Milligan, special counsel at the OCC, said it was “purely anti-competitive” and would have favoured for-profit clearers compared with quasi-utility clearers like the OCC.

Steve Adamske, spokesman for the financial services committee, said on Thursday the 20 per cent limit had intended to limit dealer control of clearing houses but legal experts had decided it was invalid as it conflicted with another amendment.

The bill would, however, limit to 20 per cent the voting rights of dealers for “designated contract markets, exchanges and alternative swap execution facilities” – and not for clearing houses.

Wonderful, isn’t it, to observe the careful deliberation with which our Solons weigh decisions that affect trillions of dollars of risk exposures?  Just throw a bit of offal into the grinder–who’ll notice?  And at whose behest was this inserted?

Legislators react with high dudgeon to bankers’ cavalier attitudes towards risk and limited accountability, but they run far greater risks with other people’s money with virtually no accountability every day.  They have no room to talk.  Whatsoever.

New York University Stern School of Business professors Aarya, Engle, Figlewski, Lynch, and Subrhmanyam (AEFLS) contributed a chapter advocating centralized clearing of credit derivatives in the recent volume Restoring Financial Stability: How to Repair a Failed System edited by Acharya and Richardson. Although the authors are a distinguished lot, they utterly fail to make the case. Here are a few of the problems with their analysis:

• Their argument rests on the propositions that (a) due to the interconnectedness of the financial system and the implicit public subsidy of systemically important financial institutions, the default by a CDS transactor can impose costs on others, and (b) a clearinghouse can internalize this externality. As a matter of logic, second best considerations imply that even if these propositions are true, they do not support the claim that creation of a clearinghouse (central counterparty) for some derivatives products is efficiency enhancing. As I discuss in more detail momentarily, AEFLS’s propositions imply that such externalities are present in every transaction that systemically important institutions undertake. In such circumstances, it is well known that internalizing one of many externalities can reduce efficiency, rather than improve it.
• Indeed, second best concerns may be most acute when a CCP addresses only one narrow segment of the market—e.g., CDS—as AEFLS do.
• Even under the AEFLS proposal of mandatory clearing of some of the risks that big financial institutions undertake (i.e., the clearing of only some derivatives), the CCP will only see a sliver of the risk exposure of its member firms. Given that overall portfolio risk determines the systemic risk posed by a financial institution, a CCP will have neither the information nor the incentive to price risk (through its collateral or position limit choices) efficiently (which would require understanding and pricing all of the externalities). Indeed, raising the price of default/counterparty risk on one sliver of transactions can induce banks to substitute to other transactions that impose equal or greater external costs. [The analogy to multitasking agents is apt here. Giving high-powered incentives to such an agent on one dimension can have extremely perverse effects on the allocation of effort. ]
• That is, the AEFLS argument proves too much. Or put differently, under the AEFLS theory, every loan, every investment, every dollar of interbank borrowing, every capital structure choice by a big financial institution is beset by externalities. Their logic, in a sense, compels them to conclude that market-based allocation of capital through financial intermediaries is inefficient, and that a centralized mechanism is required to ensure that financial institutions do not take on inefficiently large risks. Everything through a clearinghouse!
• Now, there is some merit to the view that in a world of Too Big To Fail or other implicit or explicit subsidies to bank risk taking that there are (potentially large) externalities. But the foregoing means that a CCP, and especially a CCP focused on a relatively narrow range of products, is a highly defective means of addressing this externality problem. It is defective because it is incomplete, and in a world with multiple externalities, or multiple decision margins with external effects, partial and incomplete internalization does not necessarily enhance welfare.
• Instead, if externalities in financial intermediation are an important concern, it is preferable to devise policies that either (a) eliminate the common source of the externalities (i.e., eliminate the TBTF subsidies that encourage the excessive risk taking), or (b) price all risks consistently across all decision margins and all decision makers. With respect to (b), this would entail theoretically setting capital charges or risk haircuts based on the entire portfolio of systemically important institutions. I say “theoretically” because measurement issues make this impractical. What’s more, institutions themselves will almost certainly have better information about portfolio risks, and crucially, the marginal contribution of a given transaction or class of transactions, to portfolio risks than will the regulators that set the capital charges/haircuts. This gives rise to adverse selection problems in which institutions load up on risks that they know are underpriced and avoid ones that they know (based on their private information) are overpriced. Moreover, as demonstrated with the Basel requirements that made it very attractive to invest in AAA CDOs, incorrect, centrally-set, universally applicable capital charges can induce institutions to engage in highly correlated investment strategies that exacerbate systemic risk.
• [Parenthetically, some (including the EC and the US Treasury) propose applying different capital charges to OTC and cleared deals. This is mystifying. If a deal with given characteristics is executed by financial institution A, the effect of that trade on default losses (across all deals that A does) is the same, regardless of whether the deal is cleared or not. Clearing merely affects the allocation of those losses. Indeed, the clearing can exacerbate the systemic consequences of A’s default. For in a clearing structure, the members of the clearinghouse bear the effects of A’s default, whereas in an OTC structure, counterparties do. Since CCP members are likely to be systemically important institutions, clearing can actually increase the financial cost of a default by A to these other institutions. That is, if A deals with hedge funds OTC and defaults, the hedge funds lose. If A deals with hedge funds, and those deals are cleared, when A defaults the hedge funds are protected, but the CCP members incur a cost.]
• AEFLS also fail to come to grips at all with the information asymmetries and heterogeneity-induced collective action problems that CCPs must face when setting collateral levels.  I’ve beaten that horse’s corpse to a pulp, so I’ll just suggest that those interested in the argument enter “clearing” into the search bar and while away too many hours reading what pops up.
• To put it as succinctly as I can, AEFLS ignore altogether any analysis of the challenging problem of understanding how CCPs will act in practice, given the information and incentive issues that they must confront.  Instead, as is sadly too often the case in CCP advocacy, in AEFLS clearinghouses are a deus ex machina that descends on the financial stage to resolve all of the dilemmas confronting the financial markets.
• AEFLS assert that it is desirable to establish margin levels that “ensur[e] minimal, near zero counterparty risk.” They have no basis whatsoever for concluding that zero CP risk is efficient. Indeed, it is almost certainly not the case, just as it is not the case that it is efficient to ensure that flying is perfectly safe. Reducing risk is costly. The necessary task is to balance the costs and benefits of risk reduction. For instance, in a clearing setting, setting margins equal to the maximum possible loss would eliminate counterparty risk. But collateral is costly. As a result of draconian margins, transactors would forgo some trades—including some trades that could reduce systemic risk (e.g., hedging trades that transfer risk efficiently). It is imperative to avoid such simplistic “zero risk” thinking of the type that AEFLS indulge in. The real world is about trade-offs, and those trade-offs must be acknowledged and considered in evaluating public policy.
• AEFLS recognize that they have to have an explanation as to why CCPs must be mandated if they are such a great thing. They make a rather limp effort on p. 258, stating that “[l]arge players benefit from the lack of transparency in OTC markets since they see more orders and contracts than other players do.” They seem to be arguing that the lack of transparency generates higher profits for dealer firms, and this induces them to resist clearing. Indeed, they have to argue that this private benefit from opacity is so large that it exceeds the benefits that these firms could obtain through better pricing of counterparty risk, netting, etc. (Not that I agree that these benefits exist—that AEFLS do is the point.)
• I made a similar argument over a decade ago, positing that resistance to clearing could be due to a “raising rivals’ cost” strategy.
• I am far from persuaded by these arguments, however, both on theoretical and empirical grounds.
• Theoretically, well hell, big players in every industry want to maintain market advantages that allow them to reap market-power profits. That’s why GM dominates the car business today, and is enormously profitable. Just kidding.
• Taking AEFLS seriously, they posit that the existing market structure inflates the costs of those trading with dealers relative to costs that could be achieved by trading in a more transparent structure. This creates an incentive for institutions offering more transparent mechanisms to enter the market, thereby reducing trading costs for the dealers’ current customers, and inducing them to trade on the new transparent mechanism rather than the more costly dealer market. Indeed, note that exchanges with central clearing have tried to compete with dealers in CDS trading—and failed miserably even in relatively simple index products.
• One could argue (though AEFLS do not) that this could reflect the effect of network externalities which create a coordination problem; an alternative system is more efficient than the incumbent (dealer) system if it attracts enough traders to supply liquidity, but it is costly to coordinate the necessary movement of such a number of traders, leaving the inefficient incumbent in place.
• However, in other segments of the derivatives market, there are exchange traded instruments that are close substitutes for OTC products, yet the OTC market has maintained or increased market share. Eurodollar futures and interest rate swaps are one example. Ditto many FX products and equity derivatives, including equity options. For these markets, there is a closely related, highly liquid exchange traded product, but many prefer to contract in OTC markets instead. Why would market participants agree to be screwed by dealers if the dealer structure is so inefficient, and if dealers profit at their customers’ expense due to opacity and reduced competition? It is incumbent on those advocating a forced change in market structure to answer that question forthrightly and persuasively. AEFLS don’t. Nor do most of the mandate mandarins in Congress, Treasury, or the EC.
• Relatedly, note that bilateral dealings prevail in many markets where margins are extremely thin, and dealer profits are commensurately small. For instance, bilateral dealings are quite common in vanilla interest rate and FX and equity derivative trades where spreads are very small. In vanilla IR swaps, about 50 percent of interdealer trades are cleared, and since dealer-customer trades are typically not cleared, less than a majority of vanilla IR swaps are cleared. Clearing of vanilla FX swaps is non-existent, and many equity derivative trades are not cleared. Given the competition in these markets (where a large number of institutions actively bid and offer to trade vanilla swaps), the “we don’t adopt clearing to protect profits” hypothesis is quite dubious.
• That is, although low margins appear to be a necessary condition to result in a migration of products to clearing, they are not a sufficient condition. This calls into question the theory that the failure to adopt clearing is the result of the exercise of market power by self-interested dealer firms looking to preserve their profits.
• It must also be noted that neither opacity or systemic risk externalities related to TBTF are necessary to explain failures to adopt clearing.  As I noted in an FTAlphaville article over the summer, the CBOT steadfastly refused to adopt clearing for 35 years even though it operated a highly liquid, transparent, centralized exchange.  The same was true of the LME; it failed to adopt clearing until forced to do so even though it also operated a transparent auction market.  Moreover, neither the CBT members nor the LME members were TBTF institutions benefiting from implicit or explicit public subsidies.
• The experience in energy markets, in which post-2003 (and post the 2002 merchant energy meltdown) the market by its own devices migrated to clearing also demonstrates that there are not insuperable obstacles to the organic development of clearing, sans mandate.
• Thus, a serious attempt to understand why clearing has not been adopted more widely by voluntary consent must at least contemplate the possibility that bilateral dealings offer some efficiency benefit that must be traded off against alleged external costs when determining whether compulsory adoption of clearing is justified. This AEFLS—and the rest of the mandate mandarins—signally fail to do.
• Several other issues in AEFLS deserve comment.
• First, they assert, rather than prove, that the correlation in financial institution CDS spreads demonstrates the existence of a contagion effect (p. 256—the use of the “interconnectedness” concept in this context is the key). This is a hypothesis (at best), not a fact. Exposure to a common risk can do so as well. Indeed, Jean Helwege (in a recent Regulation Magazine piece) argues persuasively that the contagion effect is vastly overstated, and the common-risk exposure effect is the real explanation for the CDS spread correlation that AEFLS discuss. As I mentioned before, virtually all major financial institutions made correlated investments in AAA MBS CDOs.  When these tanked, so did the banks (and AIG).  No need to invoke contagion.  Indeed, this raises the very real possibility that more centralization and standardization can increase systemic risks.  Since clearing entails just such an increase in centralization and standardization . . .
• Second, they use the difference between the CDS spread and an equity implied spread produced by Hayne Leland based on a particular model to argue for the existence of “counterparty risks and clearing concerns.” To which I say: when given a choice between the market and a model, I choose the market every time (with all due respect to Hayne Leland). Moreover, this could just be a manifestation of the market price of risk which causes deviations between default rates implied by CDS (which are the default rates in the equivalent, pricing measure) and default rates in the true, “physical” measure.  Given the non-linearity of a CDS exposure, and its strong correlation with overall market conditions, it is very plausible that the market price of risk was large and increasing during the period of the crisis.  (A CDS on a Goldman or other big financial firm was akin to a short put on the market.  Such an instrument has a very high systematic risk exposure, which will lead to a substantial divergence between default rates in the true and pricing measures.)
• Third, they use the AIG episode repeatedly. They ignore the equilibrium implications of the alternative histories that they contemplate (unlike what I have done in It’s a Wonderful Life: AIG Edition and in a recent comment in Regulation.) And again: the plural of anecdote is not data. Moreover, one episode is insufficient to base a restructuring of an entire system based on one episode, and even if this particular episode is so egregious, it is necessary to consider alternative ways of preventing its recurrence. This AEFLS do not do.

In sum, AEFLS fail completely in making a coherent economic case for mandated clearing, especially for a subset of OTC derivatives like CDS. They ignore crucial economic considerations and blithely overlook fundamental trade-offs. If there is a case for mandated clearing, I’d love to hear it. I haven’t heard it yet—least of all from this distinguished group of NYU-Stern professors.

The European Commission released its “Communication to a Cast of Thousands” on “Ensuring efficient, safe and sound derivatives markets: Future Policy Actions.”  It is, at best, a series of policy proposals based on nothing more than assertions delivered from on high.  These assertions are both logically dubious and completely empirically unsupported.

The main policy recommendations are to force the bulk of derivatives trades into centrally cleared platforms and exchange trading.  This will be accomplished by margin and capital requirements, and mandates.

At one level, the EC report identifies the appropriate objective: to encourage market structures that “allow markets to price risks properly” (p. 2).  However, it provides neither theoretical nor empirical support for its assertions that its policy actions will in fact improve risk pricing.  At root, its argument is that centralized price setting dominates decentralized price setting.

As has been known since Hayek and his peers, the relative efficiency of centralized vs. decentralized price setting depends crucially on the information available to those setting the prices.  Recognition of the crucial issue of information is completely lacking in the EC document.

The Olympian tone of the document is well summarized by the statement that it is adopting a new regulatory approach “where legislation allows markets to price risks properly” (p. 2).  In other words, it is legislation that is the essential determinant of whether markets price risks properly or not.  As if.

The document states “the proposed measures will shift derivative markets from predominantly OTC bilateral to more centralised clearing and trading.”  Putting all this together means that the EC is asserting that the existing market structure is history’s greatest market failure.   One would think that such a sweeping claim would require some supporting evidence and theory.  The EC document provides none whatsoever.

The assertion that markets have systematically failed to price risks occurs throughout the document.  For instance, it says: “the function of prices to allocate resources must be restored: derivatives should be appropriately priced in relation to the systemic risk they entail.”  The necessity of a “restoration” implies that: (a) the market has done a bad job in pricing these risks in the past, and (b) regulators can do better going forward.  Although one may agree with (a), it is essential to avoid the Nirvana fallacy: the crucial element of a policy recommendation is the comparative performance of imperfect markets and imperfect regulators.  Thus (b) is the crucial issue.  Sadly, the EC consistently falls prey to the Nirvana fallacy, and asserts without providing the least support that of course regulators will do it better than markets.

The document reeks of the Olympian disdain of Eurocrats in love with their own superiority.  It is the Nirvana fallacy distilled into 9 pages of text.

For instance, we get pearls like: “Such contracts will continue to be cleared bilaterally with counterparties exchanging collateral to cover their exposure.   However, current collateral levels are too low.”  What is the basis for such an assertion?  Who knows?  And, even granting the possibility that some collateral levels may be too low, there is also the possibility of setting them too high.

You’ll search in vain trying to find any reasoned discussion of (a) the relative costs of excessive or deficient collateralization, or (b) the information available to regulators and market participants that they can use to set these levels.

The document suggests that initial margin levels “will be specific to counterparty characteristics.”  This has to mean measurable characteristics.  But what information does a regulator have to measure the counterparty characteristics necessary to set initial margin levels?  Is that information better or worse than the kind of information that large dealers have?  I have very strong priors on the answer to that question: the dealers.

If you think differently, fine.  But before you decide, I suggest that you consider the entire credit rating agency fiasco, in which credit risk evaluations based on measurable characteristics were made by a small number of (centralized) entities.  Not only were these evaluations systematically flawed (thereby raising similar concerns that regulatory decisions regarding initial margin levels will be so too), crucially they were extremely brittle because of the lack of diversity in evaluations and the information on which they were based.  Thus, the errors the agencies made had broad systematic effects.  In contrast, a more diffuse mechanism for establishing initial margins, in which multiple agents possessing different information evaluate counterparty risk and price it appropriately is less susceptible to such systematic errors.  Since systematic errors can translate into systemic risk–as the AAA CDO disaster demonstrated–this is a very serious concern.

Bad pricing of relative counterparty risks across transactors will lead to a misallocation of trading activity and counterparty risk exposure across them.  Those whose counterparty risks are underestimated will trade too much; those whose risks are overestimated will trade too little.  These errors are inevitable, so the crucial question is what sort of market arrangement will minimize the costs of these errors.

This depends on the information available to those making the decisions.  In my view, major dealers will almost inevitably have more information individually than would a central regulator or clearinghouse.  Moreover, since in a market structure like that has evolved heretofore numerous entities are collecting information and making these judgments, there is the possibility of the aggregation of diffuse private information.  This possibility is absent in a highly centralized structure.

Put differently: the EC (and its American counterparts) are acting as if they had never heard of the socialist calculation controversy.  (Which is probably true–all the worse for them if so.)  Namely, how does a central agent set prices in a world with diffuse private information about costs and value?  Information about counterparty risk is highly diffuse, and largely private.  How can a central agent set the “right” prices in such an environment?  Can markets do it better (even if not perfectly)?

We have all too much experience with the defects of central price setting as compared to decentralized price setting in markets (cf. the USSR) to be at all confident with the relative superiority of centralized counterparty risk pricing.  At the very least it is incumbent on the advocates of such a centralized approach to address seriously the possibility (demonstrated by vast experience in many contexts) that centralized price setting in derivatives markets will founder on the same information problem that has wreaked havoc with other efforts to set prices centrally.  Tragically, they don’t even acknowledge the problem, let alone provide a convincing analysis supporting the contention that centralized pricing will dominate private, decentralized pricing.

Similar problems are inherent in the EC’s recommendation of differential capital charges for cleared and non-cleared derivatives contracts.  Again, what is the basis to believe that the regulators have the information to set this differential (or the levels) properly?  This ability is blithely assumed in the EC report; again this crucial issue is not even acknowledged.

It does not inspire confidence that the EC paper invokes the authority of the Basel Committee on Banking Supervision as the model for the setting of capital charges.  That would be the source of the same Basel rules that made it very attractive for systemically important financial institutions to load up on AAA CDOs.  We all know how that worked out.  Another illustration of the socialist calculation problem in action.

Beyond the complete failure to engage the fundamental informational questions, the paper says things that cast serious doubt on the competence of the EC to make such sweeping changes to financial markets.  For instance, there is a statement in the paper that strongly, strongly suggests that the EC does not understand the first thing it is talking about.

Specifically, on p. 6, it asserts, in a completely conclusory way, with no supporting evidence or argument whatsoever, that counterparty risks of “contracts that are cleared on a CCP” are lower than “the counterparty credit risks of those [contracts] where clearing is done bilaterally.”

If one defines counterparty credit risk as being the probability distribution of default losses, this statement is completely wrong.  Holding positions and the portfolios of the transacting parties constant, the probability distribution of default losses is the same between centrally cleared and bilateral contracts.  All central clearing does is change the allocation of those default losses across market participants.  That is, holding the market and credit risk exposures of market participants constant, the total dollar amounts of defaults is the same in every state in the world in cleared and bilateral markets.  Clearing changes the allocation of these given dollar losses across market participants, not their magnitude, or their probability distribution.

It is possible that this re-allocation of risk can be efficiency enhancing, but that is not a given.  Moreover, the fact that the EC apparently believes that CCPs somehow make counterparty risk magically disappear, it is almost certain that it has not thought seriously about the efficiency implications of this reallocation.  Why think about allocation of something that you believe won’t exist due to some form of financial alchemy?

This raises very serious concerns.  Read literally, the EC document implies that the Commission believes that clearing makes default risk disappear.  This is wrong, wrong, wrong.  It is understandable that someone operating under such a delusion would be very enthusiastic about clearing.  It should also be understood, however, that the enthusiasm of someone operating under a delusion is very, very dangerous.

The foregoing analysis assumed that positions would be the same in cleared and bilateral regimes.  However, the adoption of central clearing will almost certainly affect the sizes of positions that market participants take.  This, in turn, will affect overall default risks, and the allocation of these risks.  Indeed, given that clearing involves the mutualization (i.e., socialization) of risk, there is the distinct possibility that the effect of these changed positions will be to increase total default exposures; mutualization means moral hazard, and moral hazard tends to encourage risk taking.  Although CCPs can control this risk taking through margins, this is costly.  I have pointed out in my academic work that clearing can lead to increased overall risk exposures for other reasons as well.  Not that you would know this from reading what the EC–or any American official–has said on the subject.

Nor would you know that under certain types of structures, default losses borne by systemically important institutions can be higher under clearing because under these structures, CCP members guarantee customer trades, whereas in a bilateral market customer counterparties of a defaulting firm suffer default losses.  This is part of the allocational aspect of clearing, and means that systemically important institutions that backstop CCPs can actually suffer greater default losses in a cleared market than they would absent clearing.

I must say again: the case for forcing changes in market structure, most notably forcing adoption of clearing through either carrots (differential margin and capital charges) or sticks (mandates) has not been made.  Not in the least.  The key issues have not even been raised, let alone addressed.  The informational challenges that clearing poses have been assumed away.  Policies based on ignoring core issues do not inspire confidence, to say the least.

Sad to say, the Olympian, arrogant, government-knows-best attitude embodied in the EC paper is also manifest in the pronouncements of US regulators.  Most notably, Gary Gensler of the CFTC has come out in favor of trying to force virtually all trading onto exchanges and clearing.  And none of the arguments he makes in support of this view–none–grapple with the fundamental informational issues.

Unless and until those advocating a radical restructuring of the financial infrastructure, complete with implicit and explicit government pricing of counterparty risk, acknowledge and address the informational and incentive challenges associated with such a change, there can be no confidence that the change will be a beneficial one.  Indeed, given the sorry experience with centralized, hierarchical, regulatory price setting mechanisms in environments where information is private and diffuse, the odds favor the opposite result.

When make cartoon arguments for clearing (and for exchange trading), I have a sinking suspicion that the results will be anything but funny.

None.

By all appearances, both the US and Europe are on the fast track to a complete restructuring of the financial system based on a shockingly incomplete understanding of the true trade-offs.  In so doing, we are laying the groundwork for the next crisis, and a loss of efficiency until that crisis materializes.  Heaven help us.

So, here I lie, flat on my back, having taken a full-speed run at the derivatives regulation football, only to have Barney Frank snatch it back at the last minute during markup.  In contrast to the proposed OTC derivatives bill I praised a couple of weeks ago, the bill as passed by Frank’s committee includes both a clearing mandate, and an exchange trading mandate:

The committee, headed by Representative  Barney Frank, a Massachusetts Democrat, is set to complete action today on the legislation, which would require many derivatives transactions to go through central clearinghouses. The administration wants to subject broker dealers such as  JPMorgan Chase & Co.and derivatives users such as  American International Group to new margin, collateral and disclosure requirements.

. . . .

Frank plans to offer today an amendment that would mandate trading on exchanges or swap execution facilities for standard contracts between dealers and their biggest customers. Barr called that provision “essential.”

As I’ve written repeatedly, here and elsewhere, I believe that both of these provisions are deeply misguided.  I won’t belabor the argument, which the interested reader (or those suffering from insomnia) can find by searching the site or clicking the derivatives category link.   I will just say again that Frank is reinventing the wheel, as an exchange trading mandate was the magic bullet of derivatives reform in 1922.  It eventually proved unworkable, and will do so again–only much, much faster.

Raising the cost of managing risk will lead to greater risks.  It’s not that complicated.

Economics of Contempt (a lawyer and former Dem legislative aide) says that Frank sandbagged the dealers:

Frank really sandbagged the dealers with his exchange-trading amendment. The dealers support a central clearing requirement for standardized swaps, but not an exchange-trading requirement (with at least some justification). Frank’s discussion draft had only required central clearing, and then he surprised everyone on Wednesday with his amendment requiring exchange-trading. It was a politically savvy move if Frank was planning to require exchange-trading all along—don’t give the dealers time build up opposition to the amendment and it’s much more likely to pass. My sense is that Frank simply changed his mind at the last minute, for whatever reason.

“Changed his mind at the last minute, for whatever reason.”  A 180 degree turn at the last minute!  With no substantive reason given!  That’s the way to determine the fate of the world’s largest financial markets!  I feel so much better now.

Barney–I take back every nice thing I said about you.  Indeed, I’ve upped my grandfather’s exchange rate of attaboys taken away per attaboys given from 10 to 100.  Or 1000.

Many clearing/exchange trading developments in the news.  Unlike Barney and Geithner and Gensler and the clearinghouse mandate herd in the US, the Europeans are getting nervous about forcing things:

anks should be “incentivised” but not forced to shift privately-negotiated derivatives contracts onto exchanges to cut risk, the European Union’s executive will say next week, according to people familiar with the situation.

The European Commission is expected to publish a policy discussion paper on regulating the $450 trillion over-the-counter (OTC) derivatives markets on Oct. 20.

“I think they want to keep it a reasonably high level so they have room for manoeuvre. Expectations for October 20 were for more detail but the industry will be disappointed,” a source with knowledge of the paper said on Tuesday.

The largely unregulated market includes credit default swaps (CDS), which are used to bet on whether a company will default on its bonds and have been blamed for amplifying last year’s severe financial crisis that hammered economies worldwide.

The Commission published a preliminary paper in July which focused on the need for standardisation and central clearing of CDS contracts, saying the case has yet to be made on mandatory exchange trading.

“It hints at exchange trading by using the word incentivising transition to try to get more use of standardised products,” the source said of next week’s paper.

The July paper was more open on the issue of exchange trading, only saying it needed further study.

Incentives would likely comprise heavier capital charges on banks which trade OTC contracts that are not standardised or centrally cleared, the source added. Cleared contracts already have a zero weighting for capital requirements.

The latest paper is also expected to push for greater transparency and for a central data repository. It reflects global efforts to regulate derivatives and other lightly supervised parts of the system.

I critiqued the EU’s July report when it came out.  If this report is to be credited, the Europeans seem to have adopted the basic approach I have been advocating–more reporting, no clearing mandate.  But then, I said that about Barney Frank too, so I’m not holding my breath.  In any event, I will read the EU report that comes out tomorrow with interest.

The “incentivizing” approach has some problems too, though.  “Holding more collateral”  is a very general concept.  The key thing is choosing just how much, and how much that varies across products, and crucially–since collateral is all about counterparty risk–how much that varies across counterparties.  Choosing the wrong levels, and choosing the wrong relative collateral levels across deals and counterparties can make things worse rather than better.

The collateral rules will induce gaming and strategic product design to mitigate collateral impacts.  Moreover, as demonstrated in the case of “AAA” CDOs, incorrect choices of capital haircuts can lead financial institutions to take highly correlated positions (i.e., hold essentially the same instruments because their capital charges are too low) that actually exacerbate systemic risk.  Moreover, it is important that relative collateral charges be appropriate across cleared and non-cleared products.  If non-cleared products are charged too much, it could increase the risks that clearinghouses face, and if they don’t price their risks properly, this can also contribute to systemic risk.

I am deeply, deeply skeptical that regulators have the information and knowledge necessary to set these charges.  This is a price fixing exercise.  When have governments EVER demonstrated that they have the information, knowledge, and incentive to set the levels of prices properly, or to set relative prices properly?  “Hold more collateral” sounds great in theory, but is a real source of potential systemic risk when one remembers that you have to specify exactly the amounts of capital every market participant must hold against every instrument, and when one remembers further that setting them wrong can be worse than not setting them at all.

Looking backwards to fix the causes of earlier crises frequently results in a failure to comprehend how the supposed “fixes” lays the groundwork for the next crisis.  Regulation of collateral levels could well do just that, in the same way as Basel capital requirements were a major contributor to the last crisis.

In one last piece of clearing news, the Frank bill also attempts to micromanage the organization, ownership, and governance of clearinghouses:

Derivatives legislation approved by a U.S. House panel yesterday would prohibit swaps dealers such as  Goldman Sachs Group andJPMorgan Chase & Co. from collectively owning more than 20 percent of a clearinghouse.

“An inherent conflict exists between broker dealers and clearinghouses and exchanges,” Representative  Stephen Lynch said when he introduced his provision on Oct. 14. “Brokers and dealers should not be able to capture trading and clearing intermediaries.”

. . . .

The amendment on clearinghouses would restrict swap dealers, “major swap participants,” and any “person associated with a swap dealer or major swap participant” from collectively controlling more than 20 percent of the voting rights in a facility used to clear derivatives contracts. It also would limit membership on boards of the clearinghouses and establish other rules aimed at limiting conflicts of interest.

This restriction on ownership and governance could have serious unintended consequences.  Remember what clearinghouses are.  They are mechanisms to share risk–default risk, in fact. It is well understood that there is typically a close relationship between control rights and cash flow rights/risk exposure (e.g., the ubiquity of 1 share-1 vote).  This makes good economic sense (as Grossman and Hart demonstrated years ago).  A mismatch between risk exposure and control rights means that those with the control don’t bear the full costs of their decisions: the risk is borne by others.  That is a recipe for excessive risk taking and other distorted decisions.

The traditional clearinghouse involves big intermediaries sharing counterparty risk, and since they bear the risk, they control the entity.  This suggests that there will likely be an equilibrium response to the proposed restriction on control rights; firms whose control rights are limited will likely similarly limit the risk exposure they are willing to take.  So, if the big dealers and major trading firms (e.g., hedge funds) that are deemed major swap participants are limited in the control they can exert, they will almost certainly similarly reduce the risk that they will absorb.

If these big dealer firms don’t absorb the risk, who will?  What alternative risk sharing model does the committee have in mind?  I am highly skeptical that the traditional clearinghouse mutualized risk sharing model will work with this governance model.  So what risk sharing model will be used instead?  Will public shareholders bear the risk (through their equity investments)?  That is, will clearinghouses become more like stock insurance companies, rather than mutuals?  Is this wise, given the survival value that the mutual model has demonstrated in clearing over the years?  (If sharing of default risk through the equity markets was the wise thing to do, why hasn’t this been utilized more in the past?)

And the big question: Is there the slightest reason to believe that those who proposed and voted for this restriction have thought even superficially about its consequences?  (I amuse myself sometimes.)

Here we have the spectacle of people who probably hadn’t even heard of clearing a year ago presuming to impose by legislative fiat the most detailed rules specifying what must be cleared, how it must be traded, and how the clearinghouses are organized to do their business.  These decisions will have huge consequences, almost certainly all of them unanticipated and unintended.  And many of these unintended consequences will almost certainly be adverse, perhaps extremely so.

Again, the metaphor of the Sorcerer’s Apprentice comes to mind.  These people think that they are in control, but they are not: they are in fact unleashing forces beyond their control, and the effects are not likely to be good.

The essence of my earlier criticism of Obama’s strategic re-review was that it is idiotic to decide on a strategy without considering the resources necessary to implement it.   Today’s Washington Post reports that this idiocy is apparently habitual in the Obama White House: the reason a re-review is needed is because those performing the original review also failed to evaluate thoroughly the forces needed to implement the counterinsurgency strategy the administration chose:

To some civilians who participated in the strategic review, that conclusion was much less clear. Some took it as inevitable that more troops would be needed, but others thought the thrust of the new approach was to send over scores more diplomats and reconstruction experts. They figured a counterinsurgency mission could be accomplished with the forces already in the country, plus the 17,000 new troops Obama had authorized in February.

“It was easy to say, ‘Hey, I support COIN,’ because nobody had done the assessment of what it would really take, and nobody had thought through whether we want to do what it takes,” said one senior civilian administration official who participated in the review, using the shorthand for counterinsurgency.

The failure to reach a shared understanding of the resources required to execute the strategy has complicated the White House’s response to the grim assessment of the war by the top U.S. and NATO commander in Afghanistan, forcing the president to decide, in effect, what his administration really meant when it endorsed a counterinsurgency plan. Gen. Stanley A. McChrystal‘s follow-up request for more forces, which presents a range of options but makes clear that the best chance of achieving the administration’s goals requires an additional 40,000 U.S. troops on top of the 68,000 who are already there, has given senior members of Obama’s national security team “a case of sticker shock,” the administration official said.

It would be wrong to say I’m speechless. It’s just that most of the words that come to mind are modified with another word that begins with “f” and ends with “ing.”   Reading this kind of thing evokes a load of f-bombs that only a B-52 could carry.

A couple of issues.

First.   Is it really true that NOBODY had done the assessment?   Nobody in the Pentagon?   Really?   Or is it more accurate to say that nobody in Hope and Change-land had done the assessment, or paid attention to the assessment, or had a clue of what counterinsurgency really entails?

Second.   Wasn’t there anybody in the administration capable of asking a question?   Oh, I dunno, like: “How many troops are required and over what time period to implement this strategy?”

Do these people buy a car or a house and not inquire about the price?   Just asking.

This is yet another example of “senior administration officials” damning themselves with their own lame excuses.

Like Casey Stengel once said: Can’t anybody here play this game?

Some other Caseyisms that fit:

“Most games are lost, not won.”

“Been in this game one-hundred years, but I see new ways to lose ’em I never knew existed before.”

The 1962 Mets are not a good foreign policy role model, but Team Obama would have to look up in the standings to see them.   It’s both pathetic, and tragic.