Streetwise Professor

I am a guest poster on today’s FTAlphaville.  The subject: clearing.  The post riffs off an article in the FT that notes the importance of price information for clearing to work efficiently.  The basic points are that price information is necessary but not sufficient for clearing to work; that clearinghouses are consumers of information, not just producers of it; and that the debate about standardization has focused on what is really a red herring–contractual standardization–and overlooked the difficulties of economic standardization.

Many thanks to Stacy-Marie Ishmael for providing this opportunity.

In the wake of Goldman Sachs’s huge earnings, Morgan Stanley just reported a quarterly loss.  CEO John Mack blamed the loss on the company’s cautious attitude towards risk taking:

A week after  Goldman Sachs Group Inc. proved securities firms still can rake in record profits from taking big risks, Morgan Stanley reported a $159 million second-quarter loss from continuing operations that left Chairman and Chief Executive John Mack conceding that parts of the company got too conservative after surviving its near-death experience last fall.

. . . .

“We are not satisfied with our performance” in “key areas of fixed-income trading and in asset management,” Mr. Mack said in a statement. To turn things around, Morgan Stanley is bringing in new blood in its managerial ranks, expanding its trading with clients and “increasing capital commitments in a disciplined way,” he added.

Translation: Morgan Stanley now plans to rev up its risk taking, which it has been averse to doing since the company came close to perishing or being forced into a government-assisted takeover last fall.

“We were encouraged that they had a more aggressive tone than in past quarters” on trading, said Barclays Capital analyst Roger Freeman. “But the quarter itself doesn’t leave much to be encouraged about. They’ve let opportunity slip by.”

In bond trading, Morgan Stanley’s revenue was barely a third of that reported by Goldman, even after the impact of Morgan Stanley’s own credit spreads were excluded. Stock-trading revenue was less than half what Goldman brought in during the quarter.

Earlier this year, Morgan Stanley executives said they were reluctant to take the sorts of chances that were common before the financial crisis erupted, concluding that the returns wouldn’t be generous enough to justify the possibility of losses.

But hold on!  Felix Salmon reports that Morgan Stanley’s value-at-risk went up by about 25 percent from the fourth quarter of 2008 to the second quarter of 2009.  The WSJ article also reports that the firm increased its leverage from the end of last year.  So much for the “oh-we-lost-money-because-we-were-so-conservative excuse.”  Actually, it should be “we-lost-money-because-we-took-more-risk-and-and-made-bad-calls.”

Salmon expresses puzzlement at MS’s poor performance as compared to Goldman and J.P. Morgan.  I’m puzzled why he’s puzzled.  Goldman took on more risk, sure, and made money.  But you don’t make more money just because you take on risk.  You make money because you bet, and bet right.  And if you bet big and right, you make a lot of money.  That’s what Goldman did. MS’s performance gap isn’t due  it not betting, it’s due to its betting bigger–and wrong.  No mystery here.

And this represents more bad news, because the lesson the firm has apparently drawn from its experience, and no doubt Goldman’s, is that it needs to take on more risk:

On Wednesday, though, Morgan Stanley Chief Financial Officer Colm Kelleher said he feels more “constructive” about taking trading risks as markets stabilize. He said some traders avoided riskier trades during the second quarter, despite management’s willingness to take more risks. “Some of the trading desks didn’t see the opportunity and weren’t prepared to put capital to work,” he explained in an interview.

. . . .

“We’ve been seeing clear signs of stability,” Mr. Kelleher said, noting renewed activity in the bond and commercial-paper markets. But the firm plans to continue to tread carefully, mainly ramping up risks in well-traveled areas such as government bonds and currencies.

“It takes awhile,” he said. Late last year, “we stared into the abyss,” and some traders may still be “gun-shy.”

Why is this bad news?  To me it suggests that seeing Goldman’s performance, and concluding that it too is too big to fail, Morgan Stanley thinks that loading up on risk is the way to go.  Why be a chump and reduce risk, when Goldman has shown you can swing for the fences and rely on Uncle Sugar if the bets don’t go the right way?  

To me, this line blaming the losses on excess conservatism is just bull, and an excuse to use the losses to justify ramping up the risk taking.  Given that equity holders benefit from the Treasury put of a too big to fail institution, they will be cheering MS on.  Me, on the other hand, being one of the guys who is (involuntarily) short the put, will be groaning.

Isolated and inbred populations lack genetic and immunological diversity, making them more susceptible to genetic illness and more vulnerable to epidemics caused by new bacteria or viruses.  That is, this limited diversity increases systemic risk; the population is systemically more vulnerable to shocks.  Europeans died from smallpox, but due to the effects of accumulated exposure had enough immunological diversity to limit its impact: in contrast, it virtually wiped out Amerind populations.

This came to mind when reading Jeffrey Friedman’s excellent “A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure,” an introduction to a Critical Review special issue on the financial crisis.  In this essay, Friedman notes that proscriptive laws and regulations impose constraints that increase the homogeneity of behavior.  That is, systems with fewer such laws and regulations exhibit a greater diversity of behavior.  Moreover, the laws and regulations are predicated on a worldview, and if that worldview is seriously flawed, the resulting homogeneity can be particularly vulnerable to shocks, unintended consequences, or just the perverse results arising from the inherent contradictions in the worldview.  But homogeneity increases systemic risk even abstracting from the possibility for cognitive error.

I’ll let Friedman speak for himself:

By its very nature as a law, a regulation is imposed on every market participant.  This means that even if the regulation takes the form of an inducement rather than a prohibition, it has a homogenizing systemic effect.  The whole point of regulation is to get market participants, on the whole, to behave differently than they otherwise would.  But this means that every regulation imposes one opinion–the regulator’s–on all market participants, even if only by advantaging those who go along with it.

. . . .

The process of competition, like the process of biological evolution, need not have some master note-taker standing above the process and learning its lessons if the process is to work.  This is crucial because such a synoptic perceptor, being human (hence fallible), could not be relied on to learn the right lessons. . . . [T]he regulator is required to be a synoptic perceptor, codifying what he thinks leads to market failure.  If he errs in this analysis, the mistake is imposed on everyone else.

. . . .

But where there are many power centers, as in a capitalist economy, there is more chance of heterogeneity than when there is a single regulator of all the participants.  At worst, in the limit case of complete market homogeneity, unregulated capitalism would be no worse than regulated capitalism, since a theory that is homogeneously accepted by all market participants at that time and place is likely to be accepted by the regulators of that time and place, too.

Just so.  And here’s my favorite:

Geithner may be right or he may be wrong.  He, too, is human, as he demonstrated in his years at the New York Fed when he did nothing to prevent the crisis.  But as much as he may recognize his fallibility, his role as regulator compels him to act as if he were omniscient.

This is all so pertinent in the current setting.  Geithner et al believe–or act as if they believe–that they KNOW the causes of the crisis, and they KNOW how to address them.  Their preferred solution is to impose a set of regulations that will sharply constrain market participants’ behaviors, and induce and/or compel them to utilize a very sharply constrained set of institutions to consummate financial transactions.  They want to compel standardization of financial contracts; compel the use of standardized clearing mechanisms; compel the use of standardized trading mechanisms.  They want to greatly homogenize–“simplify”–the markets for trading financial risks.

But, as Friedman notes, and the inbreeding analogy suggests, such simplicity can create systemic risks of its own.  The resulting lack of diversity means that shocks to which these institutions are acutely vulnerable will lead to a systemic crisis.  And remember that every institution is unduly vulnerable to some shocks, and it is highly unlikely that a particular set of institutions is more robust to all shocks than any other set.  Even if Geithner et al are right that their favored institutions are more resilient to most shocks than the incumbent institutions–a contention that I dispute–the lack of diversity means that when the kind of shock to which these institutions are acutely vulnerable arises, the effects will be systemic and devastating.  And if–as I believe the case–Geithner et al’s analysis is incredibly wrong, we have the worst of both worlds.  We will have created a monoculture in which risks are systemic due to excessive homogeneity, and one that is fundamentally defective because it is predicated on a serious cognitive and analytical error, increasing the likelihood of a system-threatening shock.

Friedman also reprises a theme that I have echoed often on SWP: “The greatest lesson of the Great Depression is that we learned the wrong lessons from the Great Depression.”  Citing the work of Gary Gorton, and the chapter by Bhide in the Critical Review special issue, Friedman notes that how a US-centric view of banking panics led to a failure to understand the role of US laws and regulations in causing them to occur disproportionately in America.  And this misdiagnosis begat deposit insurance.  And deposit insurance begat reserve requirements . . .

And reserve requirements (in large part) begat the financial crisis.  Here Friedman provides a convincing case for something that I’ve believed to be a major cause of the financial crisis: the Basel bank capital rules.  A key factor that distinguishes this financial crisis from other collapses in securities prices (e.g., the Dot-com implosion) is that banks had invested heavily in mortgage backed securities, and asset backed and CDO securities derived from those.  The housing price collapse caused the prices of these instruments to fall, precipitating the crisis because banks and other financial intermediaries had loaded up on them.

But why had they loaded up?  The Basel rules–combined with the institutionalization of credit ratings, another factor Friedman emphasizes–gave preferential capital treatment to these instruments.  And since all banks were subject to the same capital requirements, with a few exceptions (e.g., J.P. Morgan), they nearly uniformly took exposure to the same risk.  Thus, whereas the dot-com burst was not systemic, the housing and subprime burst was.

This is particularly worrisome, because the conventional wisdom (not surprisingly the mantra of Geithner et al) is that tightened capital requirements will be a pillar of regulatory changes.  Indeed, they are seen as an all-purpose tool: Geithner’s “reform” plan proposes to use higher capital charges on OTC derivatives in order to channel more trading onto clearing and exchange platforms–i.e., the proposed financial monoculture.

“TIghter capital requirements” seems like a no-brainer, but the foregoing makes it very, very clear that the details are incredibly important.  They can induce excessive homogeneity in behavior that increases systemic risk.

In sum, “simplified” and “standardized” are not synonymous with “systemically robust.”  Indeed, the exact opposite is likely to be the case.  I believe that there is a strong argument to be made that the diversity of institutions in derivatives markets, e.g., the co-existence of exchanges, cleared OTC, and non-cleared OTC, is a discriminating match between trading mechanisms, instruments, and market participants.  Maybe I’m wrong.  But I am highly, highly confident that this more diversified set of institutions is more systemically robust than the kind of monoculture that the administration and leading legislators are hell-bent on creating, even were I not to believe that their diagnosis of the current crisis and its causes were incorrect.  For even if against the astronomical odds they were right about this, they cannot assume that all crises are alike, akin to Tolstoy’s happy families.  Indeed, they are instead like Tolstoy’s unhappy families–unhappy in their own way.  By creating an institutional monoculture they are merely legislating a particular systemic vulnerability that will be the root of the next 21st century financial crisis.

A reader sent me an email about my post ridiculing Timothy Geithner’s admission that restructuring the OTC derivative markets is really complicated, telling me that (a) I was very mean, and (b) I can be a real smart ass.  (That said, she also thought it was very funny.)  Both (a) and (b) are true–especially the latter, I guess.  My wife is always telling me that sarcasm is the lowest form of wit, but there are some things that are so outrageous that sarcastic ridicule is perfectly appropriate.

And I think that Geithner’s admission that a complete re-engineering of the financial system is extremely difficult is one of those things.  He is playing the Sorcerer’s Apprentice, unleashing forces that he doesn’t comprehend.  Somehow dry, play-it-straight analysis doesn’t seem to be an adequate response to such dangerous arrogance.

Indeed, one of the very pillars of his argument for the need for “reform”, the interconnectedness of the financial system, is precisely the reason why care is especially warranted in this instance.  Highly interconnected, dense networks like the financial markets are complex systems.  Small shocks to such complex systems can lead to discontinuous responses.  And such changes are almost always impossible to predict.

These markets are so complex that one should proceed with great caution before making wholesale changes.  This is especially true when these changes are predicated on a simplistic, not to say incorrect, diagnosis of the nature of the system.  Fools rush in where angels fear to tread.

It would be useful if Geithner–and Obama, for that matter–would read Hayek’s The Pretense of Knowledge or Sowell’s Knowledge and Decisions.  Perhaps such reading would at least temper the presumptuous arrogance that has characterized the administration’s financial regulation initiatives, and its other efforts to remake virtually every other part of the American economy from energy to healthcare.

But I doubt that it will.  And as a result, I would imagine that Mr. Geithner and his colleagues will provide numerous opportunities to exercise my talents in the lowest form of wit.

Tim Geithner has made a startling discovery: completely reorganizing one of the world’s largest financial markets–OTC derivatives–is an extremely difficult task, worthy of Hercules.  According to Forbes:

The Obama Administration has given itself two months to tell Congress what new legislation is needed to control over-the-counter derivatives, and testimony by Secretary of the Treasury Timothy Geithner late last week indicated how incredibly difficult the job of writing a law is going to be.

Scores of House members turned up to express their special concerns: Will grain elevator operators be required to register as users of derivatives? Can utilities continue to enter into the customized OTC contracts they regard as essential to their business? How, Secretary Geithner, are you going to prevent the derivatives business from migrating to Dubai?

Answering his critics, Geithner said repeatedly the government needed “to find the right balance” between conflicting arguments and conceded that regulation will be “an enormously complex process.” But failure is not an option, he said, because the economic crisis has demonstrated how destructive derivatives can be and how urgent the need is to subject them to new oversight.

Imagine that.  A root-and-branch shakeup of a market involving trillions of dollars of complex transactions, hundreds of firms, some of them quite complex and opaque, in just about every financial and commodity product, is going to be complicated.  Who knew?  

Boilerplate about “find[ing] the right balance” and “failure is not an option” (cliche alert!!!) is woefully inadequate.  There are myriad interconnected decisions that the “reformers” will have to make, each one of them bursting with unintended consequences, and potential for workaround and exploitation and regulatory arbitrage.  In going after the devils it thinks it knows (but really doesn’t), the administration will end up tangling with more heretofore unknown devils that it could possibly imagine.  

It would be comforting if the administration had a coherent diagnosis of just how OTC derivatives contributed to the financial crisis; a better understanding of how structural changes could mitigate these problems; and an appreciation of some of the likely adverse consequences of the proposed reforms.  Instead, we get reruns of the AIG melodrama and airy statements about how clearing and improved transparency will work wonders.  

Hence, failure is quite definitely an option.  Sadly, failure is most likely to result if Geither and the administration “succeed” at implementing their “reform” plan.  A plan that presumes one of the largest market failures in history, but which does not state coherently just what that market failure is and how it will be addressed, is a disaster waiting to happen. With no coherent overarching understanding of the source of market failure, there is no way to implement all necessary details of any plan intended to address it.  Moreover, lacking any such overarching understanding, it will be very difficult to distinguish the legitimate arguments of affected market participants from special interest self-pleading.  With so many decisions to be made, and so many affected interests, this will degenerate into a political bazaar like Waxman-Markey, and which health care “reform” promises to be.  And, just like Waxman-Markey, what is likely to emerge is a Frankenstein monster of regulation that is more likely to be the cause of the next crisis, than our deliverance from one.

According to Matt Leising and Justin Blum at Bloomberg, the Justice Department investigation of the CDS markets includes clearing:

A U.S. antitrust probe of the credit-default swaps market includes efforts to guarantee contracts through clearinghouses, according to a Justice Department spokeswoman.

“The Antitrust Division is investigating the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,”  Laura Sweeney, a Justice Department spokeswoman in Washington, said today in an e-mail.

Just what would the anticompetitive practices in CDS clearing be?  Here are some theories the DOJ might be considering and investigating:

• If a subset of big dealers form a clearinghouse, and exclude other market participants from membership, they could reduce competition.  That is, as I’ve shown in my academic work, a cooperative organization that is subject to strong scale and/or scope economies can serve to cartelize an industry.  A smaller than optimal set of members creates a CCP.  It is just big enough such that no other organization can achieve the scale or scope to compete with it, but smaller than optimal, thereby ensuring that its members can charge supercompetitive prices.  What’s more, through the pricing of its services, and the rules for sharing revenue, the members can coordinate pricing, and in some cases, achieve a monopoly pricing outcome.
• The DOJ may actually be more interested in the resistance of the CDS dealers to clearing.  Here the idea would be that the CDS market currently behaves like an oligopoly that is very profitable.  The dealers don’t have to worry that much about competitive entry, because there are few other firms that have the scale to compete effectively.  Clearing would make it easier for other firms to enter in competition with the big dealers, as these competitors would essentially be able to take advantage of the clearinghouse’s scale.  This would undermine a competitive advantage of the big dealers–so if they kneecap or slow walk clearing, they could protect their oligopoly.  Similar arguments would apply to anticompetitive practices in trading.
• The big banks are impeding competition by refusing to deal with potential competitor clearinghouses, such as the CME’s or the just euthanized NYSE-EuronextLIFFE venture.

I don’t know which, if any, of these theories is in DOJ’s mind.  But the antitrust scrutiny of the entire gamut of OTC trading practices is quite interesting, and bears close watching going forward.

Many commentors were giddy with the news of Goldman’s large profits.  Not me.  By a long shot.  

For one thing, it is in large part a commentary on the weakness of the banking system, and the consequent erosion of the competition Goldman faces from other big dealers.  (JP Morgan-Chase is in a similar position.)  

More ominously, Goldman had this record quarter by dramatically increasing its risk exposure:

 Goldman Sachs Group Inc.  ratcheted up risk-taking to an all-time high in the second quarter, increasing equity bets 58 percent to amass record trading revenue and quarterly earnings.

Value-at-risk, a measure of how much money the firm could lose in a day’s trading, rose to $245 million from $240 million in the first quarter, the New York-based firm said yesterday. The figure stood at $184 million last May (see table, below). Most of the increase during the second quarter stemmed from equity-trading risk, which surged to an average of $60 million per day from $38 million in the previous three months.

Goldman Sachs’s  move to become a bank holding company in September to win the financial backing of the Federal Reserve didn’t curb the firm’s appetite for wagering its capital on trading, a formula that fueled Wall Street profit and compensation records in 2007. Second-quarter earnings and revenue also benefited from reduced competition, following the collapse of Bear Stearns Cos. and  Lehman Brothers Holdings Inc.

Goldman knows it is too big to fail.  How does it know this?  Well, the government bailed out AIG not so much for AIG’s sake, but for the sake of big AIG counterparties–most notably Goldman.  Moreover, given the conventional wisdom that the government’s primary error in the financial crisis was its failure to bail out Lehman–a piker compared to Goldman–it doesn’t take a rocket scientist to figure out that it won’t repeat that mistake in the future, and let Goldman go down.  So Goldman knows it can get bigger, and take more risk.  It is the classic heads Goldman wins, tails the sucker taxpayer eats the loss gambit.  If nobody steps in to rein in the firm, it will continue to add risk, thereby enhancing the value of the Treasury put hiding in the equity entry on its balance sheet.  

Somebody should be stepping in–but nobody is. Why not?  Partly, no doubt, it is Goldman’s political heft.  It is likely too that important policy makers don’t want to crack down on a major source of risk capital to the markets in the fear that this would impede a recovery.  Even though in reality, that risk capital is your money and mine, with the exception that we have no chance of capturing the upside, and are left with a good chunk of the downside.  This is a piece with the hair-of-the-dog strategy being pursued by Treasury and the Fed.

Too big to fail is extremely pernicious.  It is the biggest systemic risk, bar none.  The big Goldman profit, and the big Goldman risk, should raise serious concerns that TBTF is alive and well, and rather than roping it in, regulators are feeding it in the short-sighted belief that it is essential to a financial and economic recovery.  This is just laying the groundwork for bigger risks in the future.

Administration officials, most notably Geithner and Gensler, Congressional leaders, and European regulators have touted central counterparties/clearinghouses as a way of dramatically reducing systemic risk.  They have portrayed the CCP as nearly free of the risk of default.  

Apparently the Federal Reserve takes a different view.  (H/T Matt Leising, who made me aware of the issue and reports on it in today’s Bloomberg.)  Evidently responding to the glowing praises of clearinghouses emanating from Geithner et al, on behalf of the members of ICE Trust the law firm of Cleary, Gottlieb, Steen and Hamilton wrote the Fed a letter requesting that

a zero percent risk weight  under the risk-based measure of the Board’s Capital Adequacy Guidelines for state  member banks and bank holding companies (“Risk-Based Capital Rules”) be  assigned to (1) the counterparty credit risk charge on credit default swap (“CDS”)  transactions with ICE Trust, and (2) funds placed with ICE Trust as part of ICE  Trust’s guarantee fund (“GF Contributions”) or as additional margin (“Margin”).” That is, the Cleary lawyer asked the Fed to consider the ICE Trust clearinghouse to be effectively free of default risk, thereby eliminating the necessity of any bank or securities firm with an exposure to the clearinghouse to hold any capital against that exposure.

The Fed demurred, however:

Based on all the facts of record, including the information provided in your  request and other supervisory information, the Board believes that it would be  appropriate to allow current participants in ICE Trust (and their top-tier bank  holding companies) to apply a 20 percent risk weight under the Risk-Based Capital  Rules to claims on ICE Trust, including counterparty credit risk of the CDS  exposures cleared through ICE Trust and claims in the form of Margin and  GF Contributions, for the first-quarter reporting period of 2009 and for subsequent  reporting periods. A 20 percent risk weight for such claims on ICE Trust is  appropriate because the risks ICE Trust poses to counterparties are not materially  different than those posed by other U.S. depository institutions, as well as by banks  in countries that are members of the Organisation for Economic Co-operation and  Development (“OECD banks”). Claims on OECD banks are also risk weighted at  20 percent.

That is, from the Fed’s perspective, ICE Trust is just another bank. Note the key sentence: “the risks ICE Trust poses to counterparties are not materially different than those posed by other U.S. depository institutions.” Thus, an OTC counterparty must hold as much capital against a CDS position cleared through ICE as a CDS deal done with Goldman Sachs–or even BofA or Citi. So much for the magical powers of a clearinghouse to make counterparty risk disappear.

Interestingly, the Fed letter notes that the capital weight required for derivatives traded on exchanges like the the CME that adjust margins daily is zero.  

This decision is very difficult to square with the official boosterism of clearing emanating from the administration, the Hill, and the EC.  It has always seemed to me that the Fed was much more diffident about the efficacy of clearing than Treasury, and this letter makes that difference in enthusiasm quite plain.

There is another interesting angle to this.  In his recent testimony Geithner made it plain that he intended to impose more onerous capital requirements on OTC deals that were not cleared than cleared deals.  The Fed letter essentially puts cleared and non-cleared deals on a level playing field.  So does this mean that other changes are in store, such as raising the capital requirement to above 20 percent on bank-to-bank OTC derivative exposures?  If so, will other inter-bank exposure capital weights be changed, or will there be a differential between OTC derivative risk weights and other inter-bank exposure weights?  Or will the Fed decision be modified subsequently?   Whatever changes are to come, this appears to represent a major disconnect between the Fed–which announced its decision on 5 June–and Treasury, which as recently as last week stated its intention to treat cleared and non-cleared exposures differently.  

Moreover, the Fed’s action gives the lie to Treasury and Congressional and EC boosterism of clearing.  It is a salutary reminder that clearing does not make counterparty risk go away.  Perhaps the Fed’s equation of the risk of ICE Trust and Citi, for instance, is wrong.  But by making it quite plain that the counterparty risk of ICE Trust is north of zero, its decision will hopefully lead to a more productive and informative discussion of the real risks of clearing vs. bilateral dealing.   It’s about time.

In his testimony in a joint hearing of the House Financial Services and Agriculture Committees last week, Treasury Secretary Timothy Geithner stated:

We also will require that regulators carefully police any attempts by market participants to use spurious customization to avoid central clearing and exchanges.

Just how is this “careful policing” supposed to work?  Will those who want to enter into customized transactions have to get pre-approval?  This seems inherently unworkable, due to fact that transactions are frequently time sensitive.  Alternatively, will parties have the ability to enter into transactions without prior restraint, but face the risk that a regulator will subsequently challenge, and disallow the transaction?

Under either alternative, what are the criteria that will be used to separate the unspurious sheep from the spurious goats?  Given the myriad possible reasons for entering into a particular transaction, and designing it in a particular way, it seems nigh on to impossible to identify ex ante a set of criteria that can be employed.  Hence regulators will have incredible discretionary powers.  Presumably there will be legal challenges to regulator decisions, meaning that there will be more than a few court cases arising out of these “policing” efforts.  

The closest analogy that comes to mind is the IRS, which rules on the permissibility and legality of various financial transactions that have tax implications.  We all know the byzantine and costly process associated with such powers.  In essence, the CFTC and/or SEC would have to be empowered to make similar judgments of the commercial rationale for particular transactions, and evaluate the trade-offs that market participants make.  For instance, is a particular transactions structure designed to reduce basis risk, or to escape the clearing requirement?  What will be the standard applied to such evaluations?  Who will have the burden of proof?  

Given the myriad arcane and complex commercial rationales that may exist for entering into derivatives transactions, especially customized ones, it stretches credulity to the breaking point to believe that the SEC or the CFTC have the expertise, not to say the incentive, to make the right call.  There will be many false positives and false negatives.  What’s more, the transactions costs of such a system are likely to be large, just as is the case with the tax code.  Much money will be spent in court trying to reverse the false positives and false negatives.  

Am I done?  Hardly.  Let’s consider the regime in which done deals are subsequent to regulatory challenge ex post.  What happens if a particular transaction is found to be “spurious”?  The deal will be in the money to one party or the other.  How is it to be unwound?  Is it just terminated, costing the in the money party the value of the contract, and allowing the loser to skate?  Is there some termination process whereby the contract is valued?  But if the deal is customized, who does the valuation?  Another source of litigation.  Just what we need.  

Relatedly, there is the possibility that the underwater party to a contract can opportunistically utilize the requirement that a deal not be “spuriously” customized to attempt to escape the onerous obligation to perform.  In the old days, transactors who entered into futures contracts tried to argue that (a) they entered into the futures as a speculative wager, and (b) wagers are uneforceable in court, to escape losing trades.  I foresee such attempts as inevitable if “spurious” customization is banned.  Thus, such a ban will undermine the reliability of contracts and create legal risks.  This is hardly a desirable public policy outcome.

All in all, attempts to distinguish spurious from non-spurious customized transactions, and the Talmudic inquiries necessary to do so, will be extremely onerous.  Moreover, the existence of such a distinction creates substantial legal risk, and the prospect for protracted and expensive litigation.  But perhaps for Geithner et al, these are features, not bugs: regulatory burdens that will serve the larger purpose of suffocating the OTC market.  

And all this begs the question:  Why would anyone want to create a “spuriously” customized contract?  One can understand why one would want to structure a deal solely to reduce tax payments, hence the arms race between the IRS and financial engineers.  It is far harder to understand why someone would want to customize something to escape the obligation of having it cleared, or traded on an exchange.  It is easy to understand why someone would want to customize a deal to achieve specific risk management objectives that cannot be attained using standardized and cleared contracts.  But what’s so bad about clearing that people would want to go to the lengths of designing a customized, illiquid instrument solely to avoid it?  And if the private “bad” of clearing is so big, where’s the public “good” that offsets it?  

This puzzle as to why consenting adults would choose to customize to avoid clearing and exchange or exchange-like clearing is just part of a larger puzzle: if the OTC market is so terrible, why do informed parties utilize it, and why has it grown relative to the exchange traded sector to such an extent that OTC volume and open interest now dwarf exchange volume and open interest?  The entire thrust of the Geithner-Obama policy implicitly assumes the existence of what would have to be the greatest market failure in the history of man, a market failure that has led to trillions and trillions of dollars of transactions that are suboptimal in the way that they are designed, traded, cleared, or settled, or all of the above.   So just what is the market failure?  So far, the administration and its cheerleaders in the media have failed miserably to identify it, let alone to show that its cost is sufficiently massive to justify a vast re-engineering of the financial markets.  Repeating “AIG AIG AIG” over and over again like financial Hare Krishnas doesn’t cut it.

FT’s Energy Source blog kindly links to my piece on oil speculation.  Kate Mackenzie notes my argument on why commercial traders who perceive that they have an information advantage, and who speculate on that information, may support constraints on non-commercial speculators who compete with them.  (Ironically, we have houseguests named “Kate” and “Mackenzie” visiting this weekend.)

There’s another reason why some hedgers may want to crack down on speculation: some hedgers earn a risk premium rather than pay it, and competition from speculators reduces the profit that these hedgers earn.  When there is some segmentation between a particular commodity market (e.g., oil) and the broader financial markets, due for instance to a fixed participation cost like the cost of becoming informed, idiosyncratic risk affects risk premia.  This, in turn, can affect who benefits and loses from greater speculative participation.

The original Keynesian “normal backwardation” story assumes complete segmentation, in which case net hedging pressure–whether short hedging volumes exceed long hedging pressure at an unbiased price–determines the sign of the bias in the futures price (whether the future is above or below the expected spot price at expiration), and the amount of speculative risk bearing capacity determines the magnitude of the bias.  For instance, if short hedging pressure predominates (as Keynes believed) the futures price will be biased downwards (will be less than the expected spot price), meaning that short hedging is costly but long hedgers make a speculative profit; as the downward biased futures prices drift upwards on average to converge with the spot price at expiration, long hedgers profit on their long futures positions.  The bias is a profit for long hedgers, and a cost incurred by short hedgers.  This bias attracts speculators, who bid up the futures price until the expected profit arising from the bias balances the cost of the risk that they incur.  The greater the speculative risk bearing capacity, the lower the bias–and the lower the trading profit of the long hedgers.

This means that entry of speculators helps some hedgers–short hedgers–but HURTS others–long hedgers.  The bidding up of the futures price benefits hedgers who sell futures, and hurts hedgers that buy futures.  Thus, in a Keynesian world, long hedgers oppose speculators.  This means that hedgers will not uniformly support speculation.  Indeed, some market participants should actively support measures to constrain speculation.  

In a world where each commodity futures market is perfectly and frictionlessly integrated with the broader financial market, risk premia are determined solely by the systematic component of the commodity price’s risk.  

In a world between the frictionless world and the Keynesian one, both systematic and idiosyncratic risks affect risk premia, as was shown by Hirshleifer in the late-80s.  In this world, some hedgers will also prefer to crack down on speculation.  For instance, when short hedging predominates, long hedgers prefer to constrain speculation.  That’s because, like in the Keynesian world, they are effectively selling price insurance to the short hedgers, and receive a profit from doing so.  They don’t like the entry of speculators who compete away some of these profits.  

This can also explain why some hedgers would support measures that weaken the linkage between the broader financial market and a particular commodity market.  This weakening allows idiosyncratic risk to affect risk premia, and some hedgers in the market capture this risk premium as a profit even though those on the other side of the market pay it as a cost.  What’s more, the magnitude of this idiosyncratic risk premium depends on the ease of entry by speculators into the futures market.  

This analysis can explain some of the hostility to passive long index investors.  These investors are typically portfolio investors, and their participation in commodity markets helps to strengthen connections between commodity markets and the stock and bond markets.  Moreover, they compete with long hedgers in serving the risk management demands of short hedgers.  In so doing, they compete away some of the profit that long hedgers can earn in a market where short hedging predominates.  

Of course, this story implies that hedgers will not speak with one voice: based on these factors alone, one group of hedgers (e.g., short hedgers in the Keynesian story) will support speculation, while another group (long hedgers in the Keynesian theory) will oppose it.  (If long hedging predominates, the roles will be reversed.)  But combined with the other factors outlined in my earlier post–and perhaps others as well–this means that commercial traders who use futures markets as hedging tools can take very different views on the benefits of speculation.  

This is an old, old, old story in any analysis of regulation.  Although speculation improves the allocation of risk, and leads to overall improvements in welfare, it also has distributive effects.  Due to its effects on competition over information rents, or raising rivals costs considerations, or competition over risk premia, the entry of speculators can redistribute wealth at the same time that it increases (risk adjusted) wealth overall.  

This means that you should be very, very, very . . . skeptical about the protestations of some commercial firms about the evils of speculation.  They don’t necessarily have the interests of the market at large at heart.  Indeed, they almost certainly place their own interests foremost.  What’s more, it is inevitable that for some significant number of commercial firms these interests are contrary to market efficiency.  In derivatives markets, as in virtually every other, some firms can benefit from restrictions on entry or other impediments to competition.  Derivatives regulation, including regulation of speculation, is like other forms of regulation a rent seeking contest in which interested parties attempt to secure rents through the political process.  Sadly, it’s often those with the best lobbyists who win–not those with the strongest economic case.