Streetwise Professor

Exactly 36 minutes after I wrote this:

At least Barney Frank has made a step towards understanding the intricacies of something as complex as clearing.  Would it be too much to hope that he keeps pulling on the string until the entire case for clearing mandates unravels?  Probably.

Matt Leising at Bloomberg sent me this:

Legislation proposed by U.S. Representative  Barney Frank would weaken an Obama administration  guideline requiring the most common private derivatives to be traded on exchanges or regulated systems.

The Massachusetts Democrat, who heads the House Financial Services Committee, released a  draft bill Oct. 2 that allows for no change in how standardized over-the-counter derivatives are currently traded as long as they are reported to regulators. The Obama plan, released in August, specifies “mandatory trading” on exchanges or swap-execution platforms that would have to be registered with the Commodity Futures Trading Commission or the Securities and Exchange Commission.

“Nothing will really change” the way trades are executed under Frank’s draft proposal, said  Kevin McPartland, a senior analyst in New York at TABB Group, a financial-market research and advisory firm. “There’s no reason, at least that I can see, why anybody would go to an exchange.”

Moreover, Frank’s proposed bill does NOT mandate clearing, although it does empower the CFTC to require clearing of some contracts:

The Commission shall monitor swap activity and transaction data  and by rule or regulation identify specific swap contracts that it determines are required to be cleared  consistent with the public interest, after taking into  account the following factors:

[List omitted.]

I keep having this mental image of Barney Frank falling off a horse on the way to Damascus.

In brief: no clearing mandate, but mandated reporting of derivatives trades to a central data repository.  Just what I’ve been advocating on this blog, and in my writings (such as here).  CFTC has the power to mandate clearing, but that’s a far different thing than a Congressional mandate.

Color me shocked.  Pleased, but shocked.

But not everyone is pleased.  CFTC Chairman Gary Gensler for one is put out by the lack of a clearing mandate:

Gary Gensler, the CFTC chairman, said he was concerned about a provision in the legislation to require securities and futures regulators to determine on a contract-by-contract basis whether a particular swap needed to go through a transparent clearinghouse.

“I believe it is best for a clearinghouse that is managing its risk to determine if a particular product should be cleared,” he commented.

Gensler pointed out that an Obama administration proposal for derivatives regulation has a presumption that if any standardized product was accepted for clearing, it and all future iterations of the product must go through a clearinghouse, which is an intermediary between the buyer and seller of the swap.

Gensler and legislators support permitting tailored swaps to continue to trade on the over-the-counter market as long as they meet new reporting, record-keeping and capital requirements.

The CTFC official also took issue with a measure in the Frank proposal that he believes could exempt a broad range of entities from the definition of “major swap participant” and help them avoid regulation.

“The discussion draft, perhaps inadvertently, widened this exception such that the major swap-participant category would exclude any entity entering into a swap for risk-management purposes,” Gensler said. “This could have the unintended consequence of exempting a broad range of entities from the definition of a ‘major swap participant’ and thus exempt such entities from regulatory requirements outlined in the proposal.”

I’d say I feel your pain, Chairman, but I’d be lying.

I am still astounded at this development.  Now if only Geithner, Gensler, Collin Peterson, the Senate Finance and Ag Committees, etc., see the light and experience their own conversions we’d be really getting somewhere.  Hey, a boy can dream, can’t he?  I mean, if Barney Frank comes around to my way of thinking, anything is possible.

Needless to say, I doubt there are many things that Barney Frank and I agree on.  There is still great potential for mischief in a lot pending before his committee.  But, for now I will avoid what my inimitable grandfather called “handing out attaboys one at a time and taking ’em back five at a time.”

For now, I’ll just say: ‘attaboy, Barney.

It seems that some in Congress are slowly making it down the clearing learning curve:

Manufacturers such as  Caterpillar Inc. and  Apple Inc. wouldn’t have to post extra cash as collateral for hedging transactions under legislation proposed to tighten oversight of the $592 trillion derivatives market.

The draft bill released by House Financial Services Committee Chairman  Barney Frank on Oct. 2, drawn from Obama administration proposals, would require the most common and actively traded over-the-counter derivatives contracts to be bought and sold on exchanges or processed through a regulated trading platform. It would impose new rules and collateral requirements, except on so-called end users such as Caterpillar.

. . . .

The draft would expand the administration’s exemption of end-users from collateral and clearing requirements. The administration proposal, released Aug. 11, would give a dispensation only to companies that use so-called hedge accounting. Frank’s proposal would exempt all end-user transactions and would let companies post non-cash items as collateral to satisfy margin requirements, Coleman said.

In brief, the new proposal would not require clearing for any deal in which one of the parties was not a swap dealer.  This is an improvement.  I’ve been arguing here on SWP, in my academic research, and my recent paper for Brookings that the cash flow and liquidity demands that clearing and daily mark-to-market impose are very onerous for hedgers and other market participants.  It seems that corporate end users were able to get that message through to Frank.  Good for them.  It also suggests that there may be a glint of understanding–albeit only a glint–that OTC market arrangements have some economic benefits, and are not instruments of the devil.

But it appears that dealers will be required to clear inter-dealer transactions.  This raises many questions, which if addressed forthrightly, would undermine the case for mandate.

Dealers certainly have had the ability to form inter-dealer clearinghouses in the past.  Why haven’t they?  The common story is that they like non-cleared deals because they profit at the expense of their customers from the lack of fungibility and liquidity.  But that argument holds no water when it comes to purely inter-dealer trades.

More fundamentally, a major fear relating to OTC markets is that the interconnections among dealers are systemically risky.  That is, because of all the inter-dealer trading, the default of one dealer affects the financial condition of others.

But, how does inter-dealer clearing change that?  Default losses are shared among dealers now because they trade with one another.  Default losses will be shared among the same dealers via a clearinghouse.

Moreover, the sharing mechanisms are different in a crucial way–that does not favor clearing.  In a bilateral market, if dealer X defaults, those who trade with X may suffer losses.  In a cleared market, if dealer X defaults, those who originally traded with it do not bear all the loss: it is shared among all the other members of the clearinghouse.  This reduces the incentive of market participants to monitor X’s creditworthiness, because they are not on the hook directly for the entire amount of counterparty exposure they create by trading with X.  The clearinghouse monitors, but as I’ve argued repeatedly (a) the clearinghouse is unlikely to have as good information as the other dealers, and (b) its incentives are weaker because it is a delegated monitor subject to low power incentives.

There’s another landmine hiding here that hasn’t drawn attention.  Note that the members of a clearinghouse recognize that they have delegated their risk exposure to somebody else: the clearinghouse and other clearinghouse members.  They recognize further that the clearinghouse mechanism thereby creates a moral hazard.  What is the conventional response to such a problem?  To limit recourse.  That is, clearinghouse members will limit the risk exposure that they will take on from the clearinghouse.  This is true of every major clearinghouse: the losses that members have to absorb are limited.

Put it all together, and you realize that (a) moral hazard and monitoring issues can lead to poorer control of counterparty risk, and (b) the limitations on member contributions means that a clearinghouse could well fail because of a loss that exceeds the amount of capital its members are obligated to commit.

Thus, the mandate for inter-dealer clearing doesn’t make any sense either.

In fact, one of the main virtues of clearing is that it increases the fraction of their contractually promised payments that non-members receive.  Note that the Board of Trade Clearing Corporation always used to say that no CUSTOMER had ever suffered from a default loss, not that no member had ever suffered from such a loss.  Inter-dealer clearing slices and dices risks differently; it does NOT eliminate them.  Indeed, it can (due to the moral hazard and adverse selection problems) lead to an accumulation of greater risks, and a less efficient allocation of those risks, than is the case in a bilateral market.

In other clearing news, CFTC Chairman Gensler made some interesting remarks in an interview with Futures Industry Magazine (registration required).  Interesting, but misguided.

First, he comes down to requiring clearinghouses take deals from any execution platform: he says clearinghouses should “not be so inextricably linked to an exchange.”  As I’ve argued for several years on SWP and in my academic writings, basic transactions costs considerations likely make vertical integration of execution and clearing economically efficient.  The argument that this arrangement impedes competition (which Gensler makes) fails on traditional Chicago grounds.  It is certain that there is neither persuasive theory nor convincing evidence that would support as radical a step as Gensler advocates.

Second, Gensler advocates that clearinghouses should be open access in the sense that “membership is open to the non-dealer community” and that clearinghouses should have “open governance” in which non-dealers would have a voice.

Now, I’ve shown in some academic writing that closed membership can be exploited to permit the clearinghouse to in effect cartelize a market, so I am somewhat sympathetic to the idea of open access.  However, I’ve also shown in my academic work that membership heterogeneity can be very, very costly.  It increases the costs of governance because it is necessary to accommodate more diverse preferences and interests.  Moreover, heterogeneity means that it is possible to redistribute wealth among the different members through pricing policies, and in the case of a clearinghouse, margin and capital requirements.  To mitigate rent seeking, cooperative organizations like a clearinghouse with disparate members will (a) implement very low-powered incentives, and (b) erect intricate, formal, and cumbersome governance mechanisms (e.g., committee-dominated decision making).  These arrangements are costly.  Thus, requiring open access and open governance would have unintended consequences: clearing organizations would be sluggish organizations with weakly-incentivized managements.

As always, there are trade-offs.  The question is: who is best situated to evaluate these trade-offs?  I think that it is far more efficient for government to let market participants decide on their own arrangements, and limit its interventions to situations in which these cooperative arrangements stifle competition.  Government is ill-suited to evaluate the costs and benefits of alternative ways of sharing risk–including counterparty risk–and of organizing and managing specialized organizations like clearinghouses.  Barney Frank and Gary Gensler should leave these tasks to people who have the expertise and internalize the costs and benefits, and limit the government to policing anti-competitive behavior by collective organizations like clearinghouses.  And even there, a considerable amount of circumspection is in order, for as Ronald Coase pointed out long ago, not every non-standard form of organization or arrangement is necessarily anti-competitive in nature.  It may be designed instead to economize on transactions costs.

At least Barney Frank has made a step towards understanding the intricacies of something as complex as clearing.  Would it be too much to hope that he keeps pulling on the string until the entire case for clearing mandates unravels?  Probably.

Congressional proposals regarding derivatives on carbon dioxide subject these products to the most onerous regulatory regime: they require trading on exchange, just like derivatives on agricultural products.  This probably reflects the fact that those legislators who are most concerned about carbon vapor are the same ones who get the vapors from derivatives.

The International Emissions Trading Association has warned against such a cramped regulatory regime:

The rules for buying and selling pollution credits under a proposed U.S. “cap-and- trade” program shouldn’t be tougher than those being debated in Congress for other markets, the  International Emissions Trading Association said today.

Geneva-based IETA, whose members include  Chevron Corp.,American Electric Power Co. and  Goldman Sachs Group Inc., said in a  report that “future financial services reform legislation should supersede the carbon market oversight provisions” of any cap-and-trade legislation that passes Congress

. . . .

Some lawmakers have expressed concern that a new U.S. carbon market may be more vulnerable than others to manipulation and fraud. They are considering special rules for the cap-and- trade program that would restrict OTC dealing in futures and other derivatives contracts, block the involvement of banks and impose price controls.

‘Out of Step’

These proposals are “out of step” with the new regulations being considered for other markets, IETA said. The group said concerns over manipulation and fraud can be dealt with through “stringent disclosure requirements of all OTC transactions” to the Commodity Futures Trading Commission.

The group said while lax oversight can enable fraud, “overly cumbersome oversight rules can discourage market participation, stifle investment, raise compliance costs, and threaten the program’s environmental performance.

The IETA concerns are quite sensible: the very onerous regulations in the Waxman-Markey (ACES) bill are not.

I’ve written in detail about the problems with the ACES regulatory scheme in a piece for the Brookings Institution that will be coming out in a volume later this fall.  It is available online now (follow the link).

Here are some of the arguments I make there, in brief:

Manipulation of carbon derivatives would not be impossible: even though the costs of delivery are theoretically zero (involving only book entries), just as in Treasury markets there will be frictions that can be exploited by a manipulator.  However, it is better to deter such manipulations ex post than attempt to prevent them by imposing tight trading regulations.

Moreover, an exchange trading requirement will prevent many market participants from realizing the risk management benefits of derivatives.  Most firms that face carbon price risk (in the event of the adoption of a cap and trade scheme) will face long-lived exposures that interact in a complex way with other risk exposures.  For instance, in a cap and trade world a power plant faces risks from power prices, fuel prices, and the quantity of power generated, as well as carbon prices.  Moreover, these exposures are likely to be non-linear in nature (due to the options inherent in plant operations, like the ability to turn it on and off, and perhaps fuel switching options).  In addition, they are likely to be very long-lived, because the plant is long-lived.

In contrast, most liquid exchange traded derivatives are simple, vanilla, linear products (forwards) with short maturities, or simple vanilla options with shorter maturities.  These are not well-suited to managing the complex risks that many carbon-intensive companies are likely to face.

Furthermore, the costs of rigid mark-to-market collateralization are high, and many market users could avoid these costs by trading customized OTC products.

This all means that requiring only exchange trading of carbon derivatives is likely to greatly increase the costs, and reduce the effectiveness, of carbon price risk management.  This will force firms exposed to carbon risk to bear risks that cost more for them to incur than it would cost the potential counterparties of customized derivatives.  By impeding efficient risk transfer, onerous regulations will increase the costs of a cap and trade system.

This is bad public policy.  Congress should be looking for ways to mitigate the costs of a CO2 trading system, not increasing them.  Impeding carbon risk management would do just that.

The CEO of the Australian Stock Exchange (ASX) hit the nail on the head.  Hell, he drove it right through the board:

The chief executive of the Australian Securities Exchange has criticised the Obama administration’s planned regulatory reforms of the US financial system, arguing they are “draconian” and out of touch with market developments.

Robert Elstone, head of the  ASX, said the reforms were too broad, targeting parts of the securities markets – such as the over-the-counter swaps market – that had not been big contributors to the global financial crisis. [Emphasis mine.]

Emphasized, because true.

More truthiness:

The best hope for regulators and governments, he said, was to develop market-oriented people and market-oriented skills to stay abreast of developments in the securities industries.

The OTC swaps market was already transparent, he said, adding that to compel that market to come “on exchange and be centrally cleared” was “overkill”.

“Compel” is the key word.  If somebody builds it, and the market comes, more power to them.  It’s the compulsion in the near complete absence of a plausible, let alone convincing, identification of a market failure that is deeply troubling–and the recipe for future trouble.

Legislators should be forced to watch this line played before their eyes, A Clockwork Orange-stye, until it penetrates their skulls:

“I think that the notion that any corporate or government regulatory agencies are always going to be one or two steps ahead of the market is a flawed notion.”

That’s worth repeating:

“I think that the notion that any corporate or government regulatory agencies are always going to be one or two steps ahead of the market is a flawed notion.”

Right now our generals in Washington are assiduously deconstructing the last war.  Not a good way to prevent the next one.  Especially inasmuch, as Mr. Elstone notes, they aren’t even properly deconstructing the last one.

Where’s our Robert Elstone?  Nowhere to be found.  Not in DC anyways.  And today, that’s where it matters.

I’ll be speaking on a panel on Systemic Risk and Speculation at the CME this afternoon at 2PM Central.  The event will be webcast.  Here’s the link.  Click on the grey box on the right-hand-side of the page to get to the webinar: registration is required.  The panel should be quite interesting.

On the anniversary of the Lehman collapse, Obama gave a speech on reforming the financial system.  Color me underwhelmed.

One solid idea is to create an enhanced resolution authority that would permit the rapid containment of big, systemically important banks.  I think Obama oversells the idea by saying that it eliminates the “too big to fail problem.”  Indeed, this portion of his speech is maddeningly short of detail.  He says the resolution authority he proposes will differ from the existing FDIC approach, but doesn’t say just how.  He said that “So our plan would put the cost of a firm’s failures on those who own its stock and loaned it money.”  Well, in the crisis, the shareholders of Lehman, AIG, WaMu, etc., were wiped out, and for a time, the shareholders of Citi and BofA and other big banks were nearly so.  Lehman bondholders also lost a great deal, but those of other big institutions that did (unlike Lehman) receive government support were spared for the most part.  Therefore, Obama has to be proposing that those who bought bank debt would suffer losses before any government support would be offered.  That would be desirable, but without more detail I don’t know whether this promise is credible.  After all, during the bailouts, Treasury and the Fed could have crammed down bondholders, but explicitly decided not to do so in many instances because it feared the knock-on effects of bondholder losses (e.g., the effects on money market funds, which could have resulted in runs).  So, is the resolution authority Obama speaks of really credible?

Obama also throws some red meat when he says “And if taxpayers ever have to step in again to prevent a second Great Depression, the financial industry will have to pay the taxpayer back — every cent.”

This is at best meaningless, and arguably actually dangerous for it still means that risk is socialized.  “The Industry” doesn’t make risk-taking decisions.  Individual firms and their managers do.  Sharing the risk among industry market participants still creates a moral hazard.  Although this seemingly tough language has gulled the predictably gullible, it will in fact hardly encourage risk taking discipline.  (“[E]very bank, every banker, every hedge fund manager — . . . a mini-regulator, the eyes and ears of the systemic-risk regulator”?  Get real.)  Why should any individual firm incur an effort/cost to monitor the activities of other financial firms except insofar as it can profit from that information?  Free rider problems are rife here.  Given such free rider problems, no firm has an incentive to be its brother’s keeper.

The top concrete proposal in the speech–a Consumer Financial Protection Agency–doesn’t strike me as addressing a first order problem.

Obama emphasizes increasing capital requirements on banks to control risk taking.  This is the Conventional Wisdom approach to preventing the next crisis.  Unfortunately, it is based on a misdiagnosis of the last crisis, and could in fact have the effect of creating the same dynamic that got us in the current situation.

The 90s and 00s were actually a period in which there was considerable effort devoted to crafting an elaborate set of capital requirements–the Basel I and Basel II rules.  Sadly, these very rules were a major contributor to the financial crisis, as the specific rules, notably the risk weights applied to investments in “AAA” securities encouraged large depository institutions to keep massive amounts of mortgage backed debt (in the form of asset backed securities, CDOs, and the like) on their books, rather than to distribute these securities to non-depository investors.  When the mortgage/real estate bubble burst, in stark contrast to the bursting of the internet bubble in 2000, systemically important financial institutions took huge losses that destabilized the entire financial system.

Moral of the story.  Just saying that you will have higher capital requirements is not enough.  The details really matter.  Actions that were considered the epitome of prudence pre-2007/2008 turned out to be anything but.  Indeed, (a) faulty capital requirements can provide a false sense of security, and (b) higher capital requirements can intensify the efforts to engineer efforts to circumvent them.

Obama sells his plan by saying “[a]nd taken together, we’re proposing the most ambitious overhaul of the financial regulatory system since the Great Depression.”  As I’ve said many times before, the greatest lesson of the Great Depression is that people learned the wrong lessons from the Great Depression.  In particular, most of the regulatory structures put in place in the 1930s were based on a misdiagnosis of the actual causes of the Great Depression.  Methinks that history is about to repeat itself.

I am in Hong Kong for the next couple of days.  (By the way, what day is it anyways?)  Consequently, posting will most likely be erratic, and certainly phase shifted by about 12 hours.  Day shall become night and night shall become day, at least insofar as the SWP schedule is concerned.

I am in HK speaking about central counterparties/clearing at the SWIFT SIBOS 2009 event.  In my few hours here, the city has impressed me.  The view from my hotel over the harbor is quite amazing.  The SIBOS event promises to be fascinating.

And . . . who will submit comment #3000?  Currently at 2991 and counting.  A free SWP t-shirt (yes, there is such a thing) to the submitter of #3000 (if you are brave enough to reveal name and address, LOL).  Domestic shipping only;-)

CFTC Chairman Gary Gensler and Commissioner Bart Chilton have mooted the idea of replacing the CFTC’s specific intent standard in manipulation cases with the SEC’s weaker recklessness standard:

Gensler asked securities and commodities experts whether it would be appropriate for the CFTC to use the SEC’s less stringent “recklessness” standard for evaluating manipulation cases, rather than the CFTC’s “specific intent” standard. He noted that the CFTC has only once in its 35-year history successfully won a manipulation case in court.

Other CFTC commissioners also are interested in exploring the issue. CFTC Commissioner Bart Chilton said, “I like the SEC’s manipulation standard. For them, it just has to be reckless (to investigate). We have to prove an intent to manipulate.”

The CFTC’s record in manipulation cases is, not to put too fine a point on it, a mess.  To prove manipulation, it is necessary to prove: (a) the existence of an artificial price, (b) the accused had the ability to cause an artificial price, (c) the accused did cause the artificial price, and (d) the accused had the specific intent to cause an artificial price.  The “specific intent” standard means that the artificial price was more than a foreseeable consequence of actions intended to achieve some other objective (e.g., a firm takes delivery pursuant to a marketing program, and as a result of this action the price is distorted).  Instead, under the specific intent standard, the accused must have deliberately intended to create the artificial price and profit therefrom.

As I wrote about 15 years ago in an article in the Washington & Lee Law Review, these criteria for manipulation are in fact sensible.  It’s the Commission’s application and interpretation of these criteria that have been woeful, not to say idiotic.  The silliest Commission decisions were in re Cox & Frey, and especially in re Indiana Farm Bureau.  Both cases are monuments to economic ignorance, for reasons too numerous to detail here.  (The law review article was upwards of 50 single spaced pages.)

Indiana Farm Bureau is the worst offender.  In this case, a split Commission spelled out its interpretation of specific intent, and made a complete hash of it.  Again I’ll spare you the details, but the most important error the Commission made was to make the accused trader’s intent at the time he initiated a position decisive in determining intent.  Unfortunately, in a corner (the most common and important form of manipulation), it is a trader’s actions when he liquidates a position that are crucial.  A cornerer liquidates too few positions and takes too many deliveries; the latter action distorts prices by forcing the market up the supply curve.

So, under IFB, a trader can enter in a position as a hedge or speculation, and then as the contract nears expiration, squeeze the hell out it if the opportunity presents itself, and escape scott-free.

So, it’s not specific intent that is objectionable.  It is the Commission’s boneheaded interpretation of the concept that needs fixing.  The Commission needs to focus on intent at the time the price distortion takes place, not long before.

As currently interpreted, the Commission essentially gives traders a manipulation option.  Enter into a position for any legitimate commercial purpose (e.g., hedging or speculation) and you have the option to squeeze later on.  It’s like saying that murder is OK, as long as you don’t plan it too far in advance, but just take advantage of any opportunity to knock off somebody who bugs you when it comes up.

A recklessness standard is, in my view, too loose, and too subject to abuse by regulators.  A coherent specific intent standard, rather than the current incoherent one, is preferable.

Gensler raised the possibility of going to Congress to get additional authority:

“It may well be that we can do something within our current authority” to boost enforcement against fraud and manipulation, Gensler said. “It may be that we recommend some changes to Congress.”

That would be advisable.  In my 1996 book on manipulation (#2,217,310 on Amazon!  Available in Kindle format!) I laid primary responsibility for the pathetic state of manipulation jurisprudence squarely on Congress’s shoulders for its failure to define manipulation with sufficient clarity, and failing to set out more specific standards/criteria to prove manipulation.  In its desire to create a statute so broad as to encompass every type of manipulation, Congress created one so vague that it was incapable of being used to combat the most serious forms of this conduct, most notably market power manipulations.  (I made a similar suggestion to Sen. Richard Lugar when he was chairman of the Senate Ag Committee in 1996.)

The sad part about all this is that the effects of manipulation are quite distinct, and the kinds of conduct that can cause these effects are very straightforward.  By failing to apply some basic economic reasoning, Congress and the Commission have made things far harder than they need to be.

So, it is indeed about time for the Commission to get serious about addressing its past failures–and getting Congress to address its failings as well.

Gensler and Chilton spoke glowingly of the SEC’s manipulation standards.  I should point out, though, that the SEC has hardly been that successful in prosecuting manipulation, even given its weaker recklessness standard.

And speaking of reckless, one suggestion made at the CFTC-SEC meeting by Columbia Law Professor John Coffee was to make insider trading illegal in commodity futures markets, as it is in securities markets:

Fraud in the derivatives market may be reduced if the CFTC had SEC-like powers to enforce insider-trading and market- manipulation cases, Columbia University securities law professor John Coffee said in prepared remarks to be delivered today.

The CFTC “needs legislation prohibiting insider trading on commodities and transactions within its jurisdiction” and should be able to impose financial penalties in cases of violations. The SEC “is armed with a greater enforcement club” and can impose penalties without going to court, Coffee said.

“The bottom line here is that it would make sense to harmonize these penalty levels so that both agencies had equivalent powers,” he said.

This suggestion, and the reasoning behind it, are inane. There are substantial differences between securities and commodities markets.  Sanford Grossman summarized the key issue in the Journal of Business in 1986:

In securities law, which regulates insider trading, an insider is a corporate employee or some other person with a fiduciary responsibility to the shareholders of the corporation.  The mere possession of valuable private information by a person who owes no fiduciary duty to the shareholders of a company does not make the person an insider under the securities law.

. . . .

It is important to realize that securities law prohibitions against insider trading are not prohibitions against informed trading . . . These laws are designed to prevent corporate officers from violating their fiduciary responsibility to shareholders, for example, by preventing trade by an insider that increases the wealth of the insider at the expense of shareholders.  A futures contract is not a “security” issued by a commercial trader.  The commercial trader is not under any fiduciary obligation. . . . Hence the rationale for regulating insider trading is absent in the case of futures markets.

In the absence of fiduciary duty as the guiding principle behind any regulation of insider trading by a market with no “insiders” as defined in securities markets, it is likely that any inside trading regulation in commodities markets would attempt to restrict some kinds of informed trading.  This would be a disaster.  It would wreak havoc with the price discovery process, deter some market participants from participating, and create a game of regulatory Russian roulette because any attempts to draw lines between “good” informed trading and “bad” informed trading would be inherently arbitrary.

What was Coffee thinking?  I have no idea, but I must say it’s not the first time I have asked myself that question.  It seems that he’s a guy who knows a lot about securities, and virtually nothing about derivatives, but assumes that they are effectively the same even though there are important differences.  A foolish consistency, Mr. Coffee . . . [And no, I’m not talking about Joe Dimaggio.]

The joint CFTC-SEC meeting about how the two agencies can play better together has spurred numerous suggestions that the agencies merge, or better yet, that the government create an uber-regulator responsible for all aspects of regulation of financial markets and financial firms.

I’ve written before that this is a very bad idea, and in light of the return of attention to this issue, thought it worthwhile to explain again why I think that’s so.  I’ll also lay out an alternative regulatory scheme that I think makes sense than either the existing system, or the uber-regulator alternative.

The argument against a regulator with myriad responsibilities for myriad firms rests in economic theory, notably agency theory.  Avinash Dixit has laid out the argument in a nice book that is somewhat accessible to a non-professional audience, so I’ll just hit the high points.

The idea here is that a regulator is an agent.  Who is the principal?  Well, Congress is the primary principal.  Thus, fundamental mechanism design issues that arise in the context of agency theory as typically applied to a firm (principal) trying to motivate and control its employees (agents) apply to the Congress-regulator relationship too.

Dixit notes that Congress designs regulators.  Moreover, Congress, both through the statutes it passes establishing and governing the regulators, and through the oversight process, provides regulators with incentives.  In particular, Congress can subject a regulator to very strong, “high powered” incentives, or very weak “low powered” incentives.  Agency theory tells us that the power of the incentives will depend on the nature of the organization/regulator.

Specifically, agency theory implies that low powered incentives are generally desirable when an agent has to perform multiple tasks.  The more tasks, typically, the weaker the incentives.  If you provide really high powered incentives, unless it is possible to measure everything the agent does with high and roughly equal precision, the agent will have an incentive to game the incentive system and do the things that provide very high rewards, and neglect the tasks that don’t.  As an example, let’s say you let cops keep a portion of the stolen goods or drugs that they seize.  You can bet that the cops would spend all their time looking for thieves and drug dealers, and have very little incentive to solve murders or intervene in domestic disputes: where’s the money in that?  Moreover, it’s hard to measure the effort or effectiveness or benefit of murder solving or separating Mr. and Mrs. Smith, so it’s hard to design an incentive to reward what you can’t measure.  So, when that 911 call comes from the Smith residence, don’t expect much of a response: the cops will be out looking for the dealers.

The resulting allocation of effort can be very perverse.  To give an incentive for the agents to do things that are hard to measure, you have to provide low powered incentives.  You can’t reward drug seizures, because that would induce the cops to spend all their time looking for drugs, and little time policing other kinds of (less remunerative to them) crimes.  Thus, low powered incentives are necessary to induce an optimal allocation of effort across tasks.

The more alternative things that the agent can do–the more tasks he performs–the more possibility for gaming high-powered incentive systems, and typically the weaker the incentives have to be.  Therefore, it is typically optimal to subject an agent that is  responsible for many tasks with lower powered incentives.

If the agent has many principals, the problem gets even worse.  Each principal has an incentive to get the agent to do what that principal wants, at the expense of the other principals.  So, it may be optimal to subject an agent working on a single task to weak incentives (fixed salary, no bonus, 9-5 hours) if he works for many principals.

Put these problems together, and you usually have to impose extremely weak incentives in order to reduce opportunistic gaming of the incentive system.  A multi-tasking agent working for many principals should typically be subject to very weak incentives.  And having very weak incentives, he is unlikely to work either hard or smart.  That may seem bad, but it’s less bad than having the agent work hard and smart to game a high-powered incentive system.

This means that a big, uber-regulator responsible for regulating everything in the financial space would be a disaster if Congress subjected it to strong incentives.  The uber-regulator would have many, many tasks to perform: oversight over security issuance, disclosure, bank capital and risk taking, derivatives trading practices, and on and on.  Moreover, it would have many principals.  It might seem there is only one–Congress–but Congress is not a unitary body.  It has numerous committees, many of which would have a piece of the responsibility for overseeing the agency.  Moreover, on a given committee, there are multiple Congressmen, each of whom is responsive to distinct interests unique to his district or state.

So, Congress would likely respond to this by providing the regulator with very weak incentives.

Thus, the alternative outcomes with an uber-regulator: an out of control body gaming high powered incentives, or a slothful, inefficient organization subject to weak incentives.  The likely outcome would be the latter, a living illustration of Eugene McCarthy’s statement that “the only thing that saves us from bureaucracy is its inefficiency.”

So what do I propose instead?  A more functional division of regulatory responsibilities, and one that mitigates the multi-tasking/multi-principal problems.  In a nutshell:

• Split off the primary market, accounting, and disclosure parts of the SEC into a separate organization.  Call it the “Securities Commission” or the “Corporate Financial Information Commission.”  This agency would police fraud in the issuance of securities, and fraudulent disclosures and accounting practices.
• Combine the market operation parts of the SEC and the CFTC into a Trading and Markets Commission.  This body would have responsibility for overseeing the operation of exchange and OTC trading mechanisms.  It would essentially be a “microstructure” regulator responsible for secondary market structure issues in securities and derivatives, manipulation and fraud in securities and derivatives trading, and the policing of agents who execute transactions for principals (e.g., stock brokers).  Under this system, there wouldn’t be the turf battles over the regulation of different kinds of financial products, or attempts to design products in order to have their trading overseen by one regulator or the other.  All trading would be under one regulator.  These trading-related matters are largely distinct from the information/disclosure related issues, and there is no good reason to combine all under one regulator.
• Create a prudential regulator with the responsibility of regulating the risks of financial institutions.  This regulator would cover major financial intermediaries, regardless of corporate form, that potentially pose a systemic risk.  Thus, banks, investment banks, large insurance companies, and other levered institutions whose failure would pose a risk to the financial system would be subject to this prudential regulator

This division of authority along more functional lines would mitigate the multi-tasking and multi-principal problems that an uber-regulator would pose.  Of course, there would still be multiple principal and multiple task problems under this allocation of responsibilities, but the organizations would be more focused, and could be provided with stronger incentives to do their jobs than would be the case under a single, overarching regulator.

Is this likely to happen?  Surely not.  But hopefully people will start to awake to the fact that the seeming elegance and simplicity of one-stop regulatory shopping is actually a recipe for the next crisis.  Think that regulators failed last time?  Just wait until you have only one, and you’ll see a real failure.  Just like businesses are subject to diseconomies of scale and scope, regulators are too.  Sure, securities issuance and securities trading are related.  So are steel manufacture and automobile manufacture.  But it proved very inefficient to combine steel and car production in a single firm, and in my view it is very inefficient to combine all of the many aspects of financial market regulation in a single agency or commission.

Exchange Traded Funds (“ETFs”) are attracting a lot of attention given (a) the CFTC’s clear signaling of its intention to impose limits on these funds, and (b) the reactions of fund issuers to this signal, most notably Deutsche Bank’s announcement that it was closing down some ETFs altogether rather than operate under the anticipated position limit regime.

So what’s the big deal?  As with most discussions of the issues surrounding speculation in commodities, the critics of ETFs are maddeningly vague in their criticisms, and don’t provide any evidence of a demonstrable deleterious effect.  The arguments seem to be that big must be bad.

Case in point.  On CNBC this morning I heard an oil trader say that the UNG fund (which trades natural gas futures) is a problem because it holds 30 percent of the nearby contract; routinely liquidates that position as expiration approaches; and that the liquidation of such a big position must be disruptive.

Call me Alfred E. Newman, but in response, I’m thinking: “What?  Me worry?”  This seems like something that the market is perfectly capable of diagnosing and addressing without any meat cleaver regulatory restrictions.

First, note that the operators of funds have strong incentives to minimize their disruptive effect.  If their liquidations are distorting prices, that is costing the funds money.  They would be moving prices against them–inflating the prices of what they buy and deflating the prices of what they sell.  They have an incentive to trade to minimize that impact.  After all, they have to compete for investor funds, not just with other ETFs, but an immense array of other investment vehicles.  If they become so big, or trade so badly, that their execution costs balloon, their performance relative to that of alternative investments will decline, and they will have trouble attracting investment.  So, they have an incentive to mitigate their price impact.

Second, and relatedly, to the extent that a given fund becomes so big that despite its best efforts its liquidations are messy and its execution costs are high as a result, that will serve as a natural constraint on growth.  Put differently, if these execution cost-related problems create diseconomies of scale, again in a highly competitive investment marketplace, the size of these entities will be limited naturally.  It means they have an efficient scale, and competition will constrain their ability to expand beyond that efficient scale.

All sorts of markets for all sorts of things have natural mechanisms for ensuring that firms operate at efficient scale.  Why should financial markets in general, or ETFs be any different?

Third, the CNBC critic and others who point to the large liquidations of big ETFs fail to recognize that there is a natural set of traders who are ready, willing, and able to buy what the ETFs want to sell when they roll: these are the traders who sold short in the first place in order to allow the ETFs to buy.  They almost certainly don’t want to make delivery, and are looking to liquidate/cover their expiring shorts just as the ETFs are looking to liquidate/cover their expiring longs.  That is, the ETF doesn’t need to find a new set of buyers to take its positions.  There is a natural set of buyers out there; the people who sold to them in the first place.  And wouldcha know it, they just happen to want to buy the exact same amount of stuff that the ETF wants to sell.  A match made in heaven.

The main potential problem is how to coordinate the activities of the ETFs and those they want to sell to at expiration.  If the ETF starts to sell when the natural buyers aren’t around, there can be a temporary price impact as liquidity suppliers must bridge the gap until the natural buyers turn up, and the liquidity suppliers demand compensation for the risks that they bear as a result.

But markets have myriad ways to facilitate this coordination.  Indeed, coordination is what markets are all about.

One way to facilitate coordination would be through block trading facilities.  These have been around in equity markets for a long, long time.  They have started to make inroads into futures markets, but exchange rules and government regulations have been less favorable to block trading in futures than in equity markets.  So, one response would be to put rules and regulations in place that make block trades easier.

Another way is through sunshine trading.  It’s been known for a long time (basically, since the mid-1980s when portfolio insurers used the strategy to reduce their execution costs) that a large, uninformed trader who is buying or selling for liquidity-related reasons, rather than because he has private information, can reduce execution costs by announcing his purchases or sales in advance.  If potential counterparties believe that the trader making the announcement is indeed uninformed, then (a) they will not charge transaction cost (in the form of price impact) to compensate for the possibility of trading with somebody with better information, and (b) they can make sure that they are there to take the other side of the announced trade, thereby ensuring that there’s a lot of liquidity available.

Yet another way is to develop crossing networks that don’t contribute to price discovery, but merely cross offsetting positions at some price taken from an exchange, e.g., the settlement price of NYMEX NG futures. Crossing networks are another way that uninformed traders can credibly signal that they are trading for liquidity reasons, and don’t want to have a price impact.  Stock crossing networks have been around for decades.

An alternative to a crossing network is a call market, which is essentially a one shot auction.  So, for instance, NYMEX could set up a call market in the expiring nat gas or WTI contracts.  The ETFs would submit offers to sell, and knowing that the ETF would be there, its natural counterparties could submit offers to buy.  (Since the ETFs look to roll positions, and hence want to buy the next month when selling the expiring contract, it might be desirable to have a call market in spreads.)

Still another way is to use cash settled contracts.  These contracts use “derivative pricing”–they take the price from another market, such as NYMEX, to determine the final value of the contract.  These contracts are essentially “self liquidating”; they don’t require a trade to close out the position.  The position closes out automatically by reference to another market price.

Indeed, UNG has already moved in this direction, using cash settled nat gas swaps as well as nat gas futures to achieve its exposure to natural gas.

In sum, there are many ways to mitigate price impact even of big funds.  Even if a fund controls 30 percent of the open interest in a contract and wants to liquidate, well, damn close to 100 percent of the opposite side of that open interest wants to liquidate too.  There is an almost perfect double coincidence of wants.  It’s just a matter of coordinating those traders.  There are many market mechanisms to do that, and market participants have the incentive to find the efficient mechanism–or more likely, the efficient combination of mechanisms, including efficiently scaled funds, the use of cash settled contracts, crossing networks/call auctions, block trading and sunshine trading, and stuff I haven’t thought of–to achieve this coordination and mitigate price impact.

The key thing to remember is that somebody internalizes the costs of these alleged liquidation-related disruptions.  As a result, that somebody has the incentive to use mechanisms that minimize that impact, and entrepreneurs have incentives to devise new mechanisms that further reduce the impact–if regulations or legal impediments don’t prevent that from happening.

One last thing.  The market share numbers, e.g., the 30 percent number mentioned by the CNBC talking head, don’t bother me in this context.  A big percentage translates into a big position which could pose a manipulative threat if–IF–the party holding it DOESN’T liquidate enough positions, but demands excessive deliveries.  That is, a big trader that liquidates his entire position–which is a big ETF in a nutshell–does not pose a manipulative threat.

So, let the market develop and employ the mechanisms that facilitate the accumulation and liquidation of large positions that individual investors obviously want to hold.  (Note that they are willing to pay premiums to get into some big ETFs.)  The challenge posed by ETFs is nothing new, and markets have figured out ways to address such challenges efficiently for years.   There’s no real need for the regulators to worry their pretty little heads over this one.