Streetwise Professor

No, this isn’t a review of a punk rock CD: It’s the latest installment in an ongoing series on the ruble’s gyrations in the foreign exchange (“FX”) market, and the title is a commentary on what is becoming a more likely outcome by the day.

Well, gyrations is not quite the right word; it connotes movement in all directions, but the ruble has been moving only one way–down.  Today (per MICEX), the ruble closed at 35.4886, about a 1.8 percent move.  Although the currency gained a bit on the Euro (which was down against the dollar), it is approaching the 41 rubles vs. the basket that central bank head Sergei Ignatiev has pledged to defend unless Urals crude plunges to $30 and remains there for an extended period.  Speculators are taking this as a challenge, it appears.  

The behavior of the ruble in the days since the band was widened to 10 percent suggests to me that the government is spending FX to defend the band, even before it is reached.  The currency has been down several days in a row, and is on an extended losing streak since the widening of the band.  Absent intervention, you’d expect the number of losing days and gaining days to be about equal.  Runs of consecutive days with adverse moves can happen, but are relatively unlikely.   In contrast, if the central bank is trying to slow the fall in the currency, and is preventing it from reaching its equilibrium level on a single day, you’d see losses day after day–which is what’s going on.  

Moreover, I’ve looked at the intraday charts on MICEX this week.  Each day the currency has gapped lower (RUB/USD–higher USD/RUB) right at the open, and then hovered there, with at most a slight movement over the remainder of the day.  Again, this suggests that the central bank is effectively setting limit orders at progressively lower levels each day, and then maintaining that level within the day.  

All of this would burn through reserves.  

The central bank–and Putin–have put their credibility on the line.  They have said that 41 vs. the basket is the limit absent a collapse in the oil price.  The market is pushing there very hard.  The conditions for a speculative attack are clearly evident.  The government’s/bank’s credibility is on the line  How much will it spend to defend it?  If it tries, NOFX is a real possibility.

Indeed, other news provides further evidence that the condition is ripe for a speculative attack.  Kudrin stated that government revenues will likely fall 40 percent in 2009.  He states further that most–but not all–of the reserve fund will be spent to cover the budget shortfall.  Of course, if oil prices fall further (and the chronic economic weakness around the world makes that a very real possibility), all of the reserve funds will go down the chute.  It should also be noted that although Kudrin anticipates that the situation will turn around in 2010, government revenues usually lag economic recovery.  Therefore, even if the Russian economy–and the world economy–begins to turn around in late-2009 or early-2010, it is likely that revenues will remain weak well into 2010.  This means that even if some of the reserve fund survives 2009, it may be dissipated in 2010.

It’s of course better for Russia that it has such a cushion than not.  But, as I noted in several posts when the crisis began in the late-summer and early-fall, the existence of the currency stockpile and the reserve funds likely provided a false sense of security, and arguably led to a delayed response to the crisis.  I specifically noted that one thing the crisis proved is how quickly it is possible to blow through $600 billion, and that’s being proven right in the Russian instance.  

The weak government revenue picture is just more blood in the water that will attract yet more sharks to the ruble market.   Given the budget picture, it’s hard to see how the central bank can credibly defend the currency at the 41 level. Trying to do so will (a) waste–waste–the country’s currency reserves, because it will merely delay the inevitable, and (b) exacerbate the weakness in the real economy, particularly the manufacturing sector.  

So, push is coming to shove.  As the FX rate approaches the band, the speculators will test the government’s commitment to maintaining that band absent a further, severe erosion of fundamentals.  Flexing to defend the ruble will be very expensive, and arguably ruinously expensive.  The next week or two should be very interesting.  Although currency and capital controls have not been widely discussed, if the attack is as severe as I expect it to be, I wouldn’t be surprised to see such measures implemented.  

It is no picnic to be a policy maker anywhere in the world right now, but Russia has to be among the worst.  This could explain Putin’s rather bizarre behavior at Davos, where he alternated between giving lectures about the virtues of a free market (!) and delivering testy–nay, ferocious–responses to genuine (if naive) offers of assistance from Michael Dell.  

Putin has essentially placed a huge long bet on the ruble.  He has staked his credibility on avoiding a precipitous drop in the currency, cost what it will.  Like many traders on a losing streak, he is effectively doubling down by stating that the band will not be widened further.  Doubling down can work, but the odds are usually quite unfavorable.

Hence, the coming days could be quite significant, not just economically, but politically.  With Medvedev showing signs of independence, and the ruble battle reaching a climax, the long-anticipated tension–and perhaps rupture–in the diumvirate could be coming.

I have always held Congress in low regard, but never so low as now.  Capitol Hill has become a veritable vortex of stupidity.  

Exhibit 1: The laughably mis-characterized “stimulus” bill, which will do nothing of the sort.  If a private business engaged in such blatant false advertising, the FTC would shut it down tomorrow.  This bill is nothing more than a Trojan Horse stuffed with every political boondoggle conceived over the last decade.

Exhibit 2: “A draft bill circulated in Congress that would change how over-the-counter derivatives are regulated might ban most trading in the $29 trillion credit-default swap market.”  The bill forces central clearing of CDSs.  As I’ve argued ad nauseum, this is a bad idea.  But that’s not the worst of it:

House of Representatives Agriculture Committee Chairman  Collin Peterson  of Minnesota unveiled an updated draft bill today that would prohibit credit-default swap trading unless investors owned the underlying bonds. The draft, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the$684 trillion  over-the-counter derivatives market to be processed by a clearinghouse.

This requirement that CDS traders “own the underlying bonds” would prevent the credit derivatives market from performing its vital risk transfer function.  Note to Congress, and to Rep. Peterson: Hedgers (who own the bonds) want to reduce their exposure to that risk.  They do so by buying protection FROM SOMEBODY THAT DOESN”T OWN THE BOND.  That is, the bond owner can’t hedge unless he can buy protection, almost always from somebody who doesn’t own the bond.  The CDS market effectively transfers risk from the current bondholder to a speculator.  This is a transaction between consenting adults that presumably makes both of them better off-or else they wouldn’t do the deal.   Put differently, if you want to permit bond holders to reduce their exposure to the risk of that bond’s default, you need to let somebody else increase that exposure.  

But this is apparently lost on Rep. Peterson, and the bill’s supporters.  They have apparently internalized the view that hedging is good but that speculation is bad.  But you can’t have hedging without speculation.  

This is especially true in the corporate debt market.  In commodities, you have natural long exposures (e.g., oil producers) and natural short exposures (e.g., airlines) who can hedge by trading with one another.  Speculators are necessary only to the extent that the hedging demands of the natural longs and natural shorts don’t match completely.  In corporate bonds, there is a lot of natural long exposure looking to hedge, but not a significant natural short exposure.  Hence, speculators–market participants willing to absorb exposure to default risk–are especially important.  

Some reporting I’ve seen about the bill talks about how its supporters denigrate “naked shorting” via the CDS market.  Sheesh, just when I’m glad to see Christopher Cox’s taillights fade to black, here are legislators parroting his moronic moralizing about perfectly legitimate–and essential–actions.  

Peterson is (as I recall) a former insurance commissioner in Minnesota.  Perhaps he would understand this analogy: his bill makes as much sense as one that would allow only firms that own high rise buildings to insure high rise buildings.  

This measure is exactly NOT what is needed in the market right now.  If anything, our shaky banking system needs better, more robust mechanisms to manage credit risks.  It definitely does not need the decapitation of the existing mechanism for managing these risks, as imperfect as that mechanism may be.  

I actually wonder why the bill even bothers to mandate creation of a clearinghouse.  The provision I’ve just discussed means that there won’t be any trades to clear.  So what’s the point of creating a clearinghouse?  

Who knows whether this absurd provision will actually become law.  Of course it will be distressing–and very costly to the market and to the economy–if it does.  But even if it doesn’t, it is bad enough that such a clearly idiotic proposal, predicated in a complete and willful misunderstanding of the role of derivatives markets, has made it this far.  It is a testament to a truly frightening combination of ignorance and arrogance that is rife in Congress.    So convinced of their own rectitude, and their own ability to control complex markets, they meddle ceaselessly in what they do not understand.  They are modern day sorcerer’s apprentices, who wreak havoc in the vain belief that they are doing good.  

I say again: I hope Bismarck was right when he said there is a special providence for fools, drunkards, small children, and the United States of America, for we have fools and drunkards (on power) governing America, and imposing crushing burdens on small children–and the children of today’s small children.

The NYT reports that the Obama administration is planning to require central clearing of CDS products:

The administration is also preparing to require that  derivatives  like  credit default swaps, a type of insurance against loan defaults that were at the center of the financial meltdown last year, be traded through a central clearinghouse and possibly on one or more exchanges. That would make it significantly easier for regulators to supervise their use.

. . . .

Officials said some credit default swaps with unique characteristics negotiated between companies might not be able to trade on exchanges or through clearinghouses. But standardized or uniform ones could.

“We want to make sure that the standardized part of those markets move into a central clearinghouse and onto exchanges as quickly as possible,” Mr. Geithner testified. “I think that’s really important for the system. It will help reduce risk and the system as a whole.”

The new trading procedures for derivatives could also enable regulators to impose capital and collateral requirements on companies that issue credit default swaps that would make them safer investments.  American International Group, one of the largest issuer of such swaps, never had to post collateral and nearly collapsed as a result of issuing a huge volume of such instruments that it was unable to support.

I’m tired of writing about why mandatory clearing and/or mandatory exchange trading is a bad idea, and perhaps you’re tired of reading about it.   Suffice it to say that it is possible to improve transparency to regulators without creating a clearinghouse and the associated risk sharing mechanism that can actually exacerbate systemic risks.   Moreover, I have yet to see any serious consideration from regulators about the effects of concentrating risk in a single entity that almost certainly has less information that existing bilateral market participants.  Nor have they presented any serious comparative analysis of the costs and benefits of alternative default risk sharing mechanisms.  The analysis presented in public, including in Congressional testimony, does not even reach the level of superficial.  

For those who want a more detailed analysis supporting my position on the undesirability of forcing clearing, I suggest my piece in the most recent issue of Regulation.  I’ll link to my gruesomely long analysis when I have a chance to move the latest version into my webspace.    

I should also note that this is only one issue among many that makes me less than impressed with Geithner.  His comments on China were foolish.  His behavior on his taxes was no mistake, and cast serious doubts on his judgment.  

But, perhaps we’ll be lucky to escape with only mandatory clearing, rather than something more draconian.  Also in today’s NYT, Gretchen Morgenstern  Morgenson [HT John M] argues for far more onerous restrictions on the CDS market, perhaps including its outright elimination.

Morgenstern’s  Morgenson’s “argument” and “evidence” in support of this position are seriously lacking, to say the least.  She completely misses the point on the role of CDS market in particular, and the operation of risk sharing (i.e., insurance) markets in general.   Consider this example of her clueless prose:

Normally, if a company goes bankrupt, a trustee steps in and helps it get back on its feet. The process can be brutal for creditors, suppliers and employees. But the ill effects of a bankruptcy are magnified if billions of dollars in insurance must also be paid out by companies that wrote protection on a beleaguered company’s debt.

To observe how idiotic this is, consider the following rewrite:

 But the ill effects of a hurricane are magnified if billions of dollars in insurance must also be paid out by companies that wrote protection on a stricken city’s property.

Uhm, Gretchen, babe, think of how brutal the process of a bankruptcy would be for, say, “creditors” if NONE of them can insure against bankruptcy.   Do you think it’s just possible that some creditors are better off because they are able to insure against the event of a bankruptcy by buying protection through the CDS market?  

Sure, it sucks for the protection seller–or the company that insures houses against hurricanes–when it has to pay out.  But the whole idea behind this market, and the market for property insurance, is that it would suck a whole lot worse if creditors/property owners had no ability to protect against such adverse events.  It’s an ex ante mutually beneficial exchange of risks.  It’s beyond weird to criticize these instruments because they perform their risk transfer function in the way the parties agree.  

Morgenstern  Morgenson cites two supporters of heavy regulation of CDS markets,  Sylvain R. Raynes and  Christopher Whalen.  Whalen argues for 50 percent margins on CDS trades.  Just where does that number come from?  Any thought to the possibility that excessive collateralization can be unduly costly?  No evidence of any thought, whatsoever. Raynes wants to euthanize all outstanding CDS contracts, effectively unwinding them.  That is, he wants to require termination of outstanding insurance contracts that consenting adults entered.  So, how is this supposed to make them better off? Moreover, the existing counterparties have the ability to reverse deals, if it is in their mutual interest.  The fact they don’t do so, tells you something–or should.  But apparently not Mr. Raynes–or Ms. Morgenstern  Morgenson.

Here’s another pearl of (populist) wisdom:

Obviously, something must be done to eliminate the possibility that taxpayers will wind up paying off entities that essentially bet against the American economy.  

Betting against the American economy!  How unpatriotic!  

Note the “essentially” in that sentence.  She had to say that because those buying protection didn’t ACTUALLY do any such thing–they bought protection against a bankruptcy in order to preserve their wealth in such an event.  But to make it sound really bad, she has to demonize prudent financial strategies.  

There’s an argument as to whether the government should make counterparties whole, or let them receive only incomplete coverage because the protection seller can’t perform.  You can make that argument without stupid BS about “betting against the American economy.”  I mean, grow up.

Here’s another howler:

Mr. Raynes’s proposal would treat hedgers — buyers who bought C.D.S.’s to protect themselves because they actually hold the underlying debt — differently from speculators who bought C.D.S.’s simply to bet against a troubled company.

Some basic finance here, people–derivatives markets are markets to trade risk.  Usually they REQUIRE speculators to operate effectively; without speculators, who will take the risk from hedgers?  (Insurance companies are “speculating” on fires, hurricanes, and other bringers of human misery.  Want to get rid of them too?) This demonization of speculators, and proposals to treat them differently, is more populist boob bait; various proposals to regulate energy derivatives mooted over the summer contained similar inanities.  

Moreover, it will never work.  I defy anyone to find a way to separate hedging sheep from speculative goats that a couple of lawyers won’t be able to circumvent in about 10 minutes.

I’m all for a serious debate about CDS markets, and ways to improve their efficiency.  Unfortunately, a serious debate has yet to begin–at least on the pages of the New York Times.

Like its American regulator counterparts, the European Commission has been pushing major banks to form a CDS clearinghouse.  In December, the Commission secured a draft industry agreement whereby a clearinghouse would be set up by mid-2009. Although they had agreed in principle to the arrangement, the banks, have refused to commit, and Charlie McCreevy is peeved:

“A firm engagement was expected from the involved industry and regulators. This engagement has not been given,” a spokesman for EU Internal Market Commissioner Charlie McCreevy said.

The introduction of central clearing for over-the-counter (OTC) contracts is a core plank of EU efforts to apply lessons from the credit crunch to make markets less risky for investors.

“The commissioner will therefore have to consider the appropriate next steps,” the spokesman said.

According to Reuters, “The deal collapsed over McCreevy’s insistence that clearing of EU-based trades must be done inside the 27-nation bloc.”  Perhaps.  But perhaps this is a pretext.  There seems to be foot dragging in the US as well.  Methinks that there is a more fundamental concern among the banks about plunging into clearing.

The conventional wisdom is that the reluctance stems from the banks’ belief that clearing will increase competition, and thereby erode profit margins.  I’ve made similar speculations over the years (dating back to the 1990s, with respect to interest rate and currency swaps), but I’m not fully–or even largely–convinced that this is the case.  

The formal modeling I’ve done shows that under certain circumstances, clearing helps the least creditworthy members of a CCP at the expense of the more creditworthy ones.  That is, the effect on profits is not uniform.  Thus, one would expect more division among potential members, with some enthusiastically supporting clearing, with others being more reticent.  That doesn’t seem to be the case now.

Moreover, although it’s definitely not a perfectly competitive industry, the OTC derivatives market is a heck of a lot more competitive, with more viable major players, than most major industries.  There are a good dozen major dealer firms–name another big industry with as many major players.  It’s unlikely that clearing would encourage substantial entry into the industry.  Indeed, if the major incumbents are the members of the clearinghouse, they could probably use their control thereof to impede entry.  (I’ve also shown that a clearinghouse can facilitate cartelization of the industry.)  I am skeptical, therefore, that the move to clearing would dramatically increase the competitiveness of the market for intermediating CDS trades.  

So why the resistance?  I suspect it boils down to the understanding among the major dealers that clearing involves costs to them that exceed the benefits they will reap.  There is obviously the cost of setting up and operating the clearinghouse, but in my view this cost pales in comparison to the costs associated with asymmetric information inherent in clearing CDS trades executed by huge financial institutions posing balance sheet risks.

Think of it this way.  Why are banks reluctant to lend to one another today?  Because of concerns about the balance sheet risks of the borrowers, and the borrowers’ superior information about their own financial condition.  That is, banks face adverse selection problems when lending to other banks.  This is always true, but it is especially true today.  But a clearinghouse arrangement effectively forces banks to take on an exposure to the balance sheet risks of other clearinghouse members.  If they are reluctant to do this in the interbank market, why should one expect them to rush out and do it through a clearinghouse?  

The reluctance therefore reflects, in my opinion, an understanding by the banks that the private costs exceed the private benefits.  Moreover, in my further opinion, these costs are real costs–to the banks and to society.  

Forcing a clearing solution, as Charlie McCreevy is clearly (no pun intended) contemplating in Europe, reflects a different belief.  He must believe the competition argument I dismissed above, or that there are other systemic benefits that the banks are ignoring.  

I am skeptical that clearing unambiguously reduces systemic risks.  Indeed, I can make an argument that clearing can increase systemic risk.  I’ve written about this at length in a working paper, and will expand on the argument in a future SWP post.  Suffice it to say for now that the arguments as to why clearing reduces systemic risk are incomplete, and not generally true.  They ignore the distributive impacts of clearing, the potential effect of clearing on the size of the markets, and the potential for clearing to exacerbate moral hazard and adverse selection problems due to mispricing of default risk.

Maybe I’m wrong.  But maybe I’m not.  At the very least, the banks’ resistance should provoke some serious questions.  Maybe their position is self-serving.  But maybe it reflects a deeper understanding of the true intricacies and dangers of clearing than is possessed by regulators on either side of the Atlantic.  Before plunging ahead with a clearing solution, regulators would be well-advised to undertake a much more far-reaching analysis of this complex issue than they have performed so far (at least, they have given very little public indication that they have in fact thought about these issues in a serious way.)

This is serious business that will have serious consequences.  Fools rush in where angels fear to tread, and rushing to force clearing without thorough regard for the potential pitfalls would be a foolish thing indeed.

The WSJ published an editorial expressing deep skepticism of regulators’ rush to force the creation of a CDS clearinghouse. The editorial’s argument incorporates many elements I’ve raised repeatedly on SWP (and since I know several folks at the Journal read SWP, perhaps the blog contributed to their thinking.) Most importantly, the piece emphasizes the potential for balance sheet risk and moral hazard inherent in the central clearing structure:

[T]he Fed-imposed architecture should still cause taxpayer concern. That’s because it takes the widely dispersed risk in the CDS marketplace and attempts to centralize it in one institution. If not structured correctly, it may reward the participating firms with the weakest balance sheets. For this reason, some of the dealers who have resisted a central counterparty because it threatens their profits may now embrace it as a way to socialize their risks.

. . . .

Here’s how the New York Fed’s central counterparty would change the market: Right now, CDS trades are conducted over-the-counter as private contracts between two parties. They are reported to the Trade Information Warehouse, so the market has some transparency, but nobody is on the hook besides the two parties to the agreement. This provides an incentive for each party to make an informed judgment on whether the counterparty can be relied upon to pay debts. The buyer of credit protection — who is paying annual premiums for the right to be compensated if a company defaults on its bonds — has every reason to study the balance sheet of the seller of a CDS contract. [The superior ability and incentive of bilateral counterparties to evaluate creditworthiness is the essence of my argument about the virtues of bilateral markets.]

. . . .

[T]his system also introduces new risks, because all participants become liable for the potential failure of the weakest members. How does one appropriately judge the credit risk of a participant? ICE Trust and the Fed haven’t released details. Sources tell us that participants will need to have a net worth of at least $1 billion, and, more ominously, that the Fed wants a high rating from a major credit-ratings agency as a crucial test of financial health.

$1 billion net worth? That’s a real screamer. Just what was Lehman’s net worth before it went bust? AIG’s? So . . . $1 billion is supposed to provide some sort of comfort? And, given that balance sheets are notoriously opaque (especially now, when it is impossible to determine market values for large swaths of the assets of big banks and investment banks who would be members of the clearinghouse) relying merely on balance sheet information to assess creditworthiness is extremely dangerous. Extremely. Just because there’s $1 billion on the books doesn’t mean you can take that billion to the bank.

The editorial’s main original contribution is to highlight the FRBNY’s anointing of the big three rating agencies (S&P, Moody’s, & Fitch) to provide validation of the creditworthiness of clearinghouse participants. (It isn’t clear whether this means that CCP members have to achieve a certain credit rating, or the customers they clear for.)

As the Journal says, these guys are always the last to know. All too often they serve the same function as the crime scene unit guy who draws the chalk line around the corpse on the sidewalk. Or, to put it differently, they’re coroners rather than diagnostic physicians. When it comes to evaluating counterparty risk, however, autopsies aren’t all that useful.

Moreover, the rating agencies have no real skin in the game. Sure, they might take a reputational hit if they miss the impending implosion of a credit, but that hardly compares to suffering a major loss when a counterparty defaults. And hell, if the FRBNY is forcing the rating agencies on the ICE clearinghouse even in the aftermath of their abject failure over the past couple of years, even the reputational penalty doesn’t seem that great. If anything, it seems that incompetence is being rewarded, rather than punished. A party to an OTC trade has a much stronger incentive–and almost certainly, better information–to evaluate counterparty risk than the three ratings stooges.

The editorial also raises the excellent point that it is almost inevitable that the Fed would inevitably bail out the clearinghouse if it failed. Indeed, that implication inheres in the Fed’s rationale for the clearinghouse, namely, to reduce systemic risk. The Fed and other regulators argue that OTC market participants are so interconnected that a major failure poses a risk of contagion. But, wait a minute–a central counterparty connects these very same market participants, so it could also be the source of contagion, rather than a force preventing it. It is by no means clear that a central counterparty structure is less susceptible to contagion. Indeed, for reasons I’ve set out in a (tediously long) academic paper, it could actually be more susceptible. That, plus the inevitable too big to fail aspect, means that a CCP could create additional moral hazard. Great.

It is somewhat encouraging to see that a major publication has not imbibed the CDS clearinghouse Kool-Aid. It is also encouraging that the WSJ recognizes that a clearinghouse just slices and dices and redistributes default losses, rather than eliminate them (“all participants become liable for the potential failure of the weakest members”). Too much sloppy reporting, editorializing, and politicking traffics the lie that a CCP somehow makes this risk disappear, through some mysterious financial alchemy. Wrong again. Clearing is a risk sharing mechanism, not a risk eliminating mechanism. Big difference.

Hopefully, now that some of the hyperventilating over credit derivatives has abated a bit, cooler heads will prevail, and will examine the real (rather than imagined) costs and benefits of clearing before forcing a flawed solution on the market. Perhaps the WSJ editorial is the harbinger of such a welcome development. Here’s hoping.

More detail on the havoc wreaked by that Mr. Magoo of American finance, SEC Chair Christopher Cox, and his short-sighted short sales ban:

The panic that swept through the capital markets after Lehman declared bankruptcy was one form of human frailty that Citadel’s sophisticated mathematical models could never have anticipated. The second and perhaps more devastating one occurred on Wednesday, Sept. 17, when news broke that the Securities and Exchange Commission was considering a temporary ban on short-selling 900 stocks – 799 of them financial stocks.

The proposed ban was good news for the banks and brokers. It meant that Morgan Stanley (MS, Fortune 500), Citigroup (C, Fortune 500), and others didn’t need to worry that hedge funds could drive them to the brink.

Yet the news was horrifying for hedge funds like Citadel. Scores of Citadel’s positions – particularly in convertible arbitrage, which requires shorting – would simply blow up if the ban went into effect.

According to sources, Griffin phoned Christopher Cox, the SEC’s chairman. Griffin pleaded with Cox, telling him the ban could mean certain death to many hedge funds – including Citadel. Cox, according to these sources, was unmoved and merely responded with the party line about how the country was going through a national financial crisis and the SEC needed to do what it had to.

There was nothing Griffin could do or say to sway him, and on Friday, Sept. 19, the ban was made official. (The SEC declined to comment for this story.)

Citadel was now hemorrhaging money. Over the weekend and throughout the following week, Griffin talked with his portfolio managers and told them to dump the dogs and keep the racehorses, meaning preserve the positions that they believed had long-term upside as they engaged in a selloff.

By the end of September, Citadel’s funds were down 20%. In early October, Griffin sent a letter to investors stating that September had been the “single worst month, by far, in the firm’s history. Our performance reflected extraordinary market conditions that I did not fully anticipate, combined with regulatory changes driven more by populism than policy.”

“The SEC needed to do what it had to.”   I sure hope that is nothing even close to a direct quote of what Cox told Griffin, for if that’s what counts as reasoned policy, we’re in even deeper trouble than I thought–and I thought we were in major trouble.

I guess it could have been worse.   He could have said “A man’s gotta do what a man’s gotta do.”

In a moment of clear thinking (pun intended), Britain’s antitrust authority, the Office of Fair Trading, has decided not to pursue further analysis of exchange ownership of clearinghouses:

The OFT has decided not to undertake any work in the market for derivatives clearing, after inviting views earlier this year.

The OFT called for submissions on the broader issue of competition in this market in May after it concluded that ICE Clear Europe’s regulatory provisions did not have a significantly adverse effect on competition.

In reaching its decision, the OFT considered both the submissions it received from interested parties, and recent developments in the market. It concluded that, whilst some potential concerns about the competition effects of vertical integration between derivatives exchanges and clearing the transactions on them were raised, no specific action is required at present because:

• Regulatory initiatives from both the US and EU suggest that now would not be an appropriate time for the OFT to take further action other than to monitor developments closely.
• The industry is characterised by rapidly changing market developments and product and technological innovation which further indicate action at this time is not appropriate.
• Consumers in derivatives trading in the majority are large, globally active companies which have demonstrated that they are able to react to market developments.

Whilst it has decided not to prioritise work in this area at present, the OFT will continue to monitor market developments closely.

In the second item, contrary to a SWP prediction, ELX has chosen the Options Clearing Corporation to clear its futures business.   Since there was a large overlap between the ELX founders, and the group of firms that invested in the Clearing Corporation Formerly Known as BOTCC, I had predicted that ELX would choose the ClearingCorp.   My conjecture is that the purchase of the CCorp by ICE scuppered those plans.   Getting clearing services from a potential competitor, ICE, was probably not that appealing a prospect.   The whole CDS clearing issue was not on anybody’s radar screen when ELX was first mooted, and the banks invested in CCorp.   The CDS clearing thing took on a life of its own, and the ICE initiative made sense, and pushed the ELX to the back burner.

There are two competing models in CDS clearing.   The CME model is to clear these products through its existing clearing structure, effectively “co-mingling” futures risks and CDS risks.   The alternative model, embraced by ICE and Eurex, will clear CDS and futures products seperately.

As I’ve mentioned on a few occasions, there is considerable tension among CME clearing members over the co-mingling idea.   This article from DJ News Wires details the competing claims and complaints over the various models:

CME argues that “co-mingling” futures and CDS contracts in its clearinghouse will avoid an additional capital call on banks and dealers.

The strategy has generated warnings from some of CME’s largest partners in the futures industry, who are concerned they will be exposed to CDS risk.

Patrice Blanc, chief executive of Paris-based Newedge, said co-mingling futures and CDS clearing is “dangerous,” and that it could “create huge systemic risk” for market participants.

Clearing CDS contracts is “a much more complex issue than it’s been made out to be,” Blanc said in a recent interview with Dow Jones Newswires.

Thomas Peterffy, CEO of electronic brokerage firm and CME clearing member Interactive Brokers, has also come out against mixing futures and CDS risk on CME’s platform.

Co-mingling of futures and CDS risk could threaten the integrity of a clearinghouse, says Roger Liddell, CEO of London-based clearinghouse LCH.Clearnet.

He also cautioned that clearing CDS trades may be more complicated than many believe.

“There is a risk in assuming that everyone can clear everything,” Liddell said at the Futures Industry Association’s 2008 Expo in Chicago last week.

I concur with the various cautions voiced by Liddell, Blanc, and Peterffy.   They are, in effect, in agreement with my assessment that CDS clearing presents acute balance sheet and product risks that are inherently more costly to share through a clearinghouse, due to asymmetric information problems.

Now, “co-mingling” is synonym for “diversification.”   In a world of complete information, the CME’s Kim Taylor would be exactly right:

Kim Taylor, president of the CME clearinghouse, has acknowledged the concerns. She argues that combining the risk of futures and CDS contracts in one clearinghouse provides diversification, lower overall risk and cutting trading costs.

Taylor, speaking on a panel at the FIA event, noted that risk management for the clearinghouse as a whole has become more efficient when CME has brought new product lines into its clearinghouse, notably the energy and metals contracts from the New York Mercantile Exchange.

In a world of complete information, with no information asymmetry, there are economies of scope in clearing.   Through the diversification effect, the riskiness of a combined CDS and futures portfolio would be lower than the sum of the risk of the stand alone CDS portfolio and the risk of the stand alone futures portfolio.   Moreover, clearing across products economizes on margins.   Again, due to the diversification effect, with a combined portfolio one can achieve the same default loss profile for a smaller margin than one can with seperate portfolios.

So, co-mingling sounds like a no brainer.   So why aren’t savvy market participants buying this?   I think the answer is pretty clear.   They understand that this is not a situation of complete information.   Due to information problems, moral hazard and adverse selection problems make it costly to clear CDS trades.   CME clearing members are quite right to be very leery of importing the product and balance sheet risks associated with credit default swaps into a futures clearing system that has worked very well.

I quote from the Book of Duh:

Top executives from four major financial exchanges told federal lawmakers Monday they believe the clearing of certain kinds of credit derivatives should be mandated by law.

. . . .”Clearing should be mandated for most [credit-default swap] instruments,” said Johnathan Short, vice president and general counsel for Atlanta-based ICE.

Terry Duffy of the CME chimed in (this is from Bloomberg–no link yet): “We do believe there should be a mandate for clearing of credit-default swaps.”

Eurex also joined the party, although they were a little more restrained in their remarks, with the exchange’s Thomas Book (whom I participated with in a panel at the SFOA in September) asking only for:

As a consequence, Congress should take into account whether the regulatory enhancements that it is considering will reinforce and be supportive of the migration of (credit-default swap) transactions from the current bilateral structure to regulated and transparent (central counterparties)

Well of course the exchanges want Congress to force clearing onto exchanges because, as Thomas so mellifluously put it:

It should be noted that although the benefits of clearing are significant for the integrity of financial markets, it cannot be assumed that centralized clearing will be automatically and broadly accepted by current (over-the- counter) market participants.

That is, the banks are unlikely to do it voluntarily, so it’s necessary to force them to clear. And if they’re forced to clear, guess who’s just licking their chops to do that business?: ICE, CME, Eurex.   Surely a coincidence.

Which begs the question, often asked here: If it such a great idea, why don’t the banks do it on their own initiative?

[Crickets chirping.]

I’ve beaten this horse so many times that I’m sure PETA is already filing a complaint with local law enforcement, so I’ll try to keep it brief and make my getaway.

One should pay considerable deference to the survivorship principle.   Although path dependence can complicate matters, the survival of a particular institutional arrangement in the face of viable alternatives suggests that it offers efficiency advantages over these alternatives. I have laid out a case as to the likely sources of such an efficiency advantage of bilateral arrangements over central clearing: lower costs associated with asymmetric information.

Only if one can identify some sort of market failure (e.g., a coordination problem) or externality is a mandated change in default risk sharing arrangements justified.   Although there has been a lot of serious talk about “systemic risk” and “financial stability,” there has been no real identification of a concrete externality, or a demonstration that mandated clearing would fix it.     Apropos yesterday’s analysis of the Allen-Gale book, the discussion of clearing has been carried out without reference to any credible theoretical or logical framework.

So, my challenge to the advocates of clearing: What externality that justifies the impostion of clearing?   If the individual firms who would belong to a clearinghouse don’t internalize the externality, why would a clearinghouse?   Why, despite the fact that the concept of clearing is very well known and tested, have wide swaths of the OTC market deliberately eschewed it?   What are the likely equilibrium responses to the imposition of clearing?   How exactly will clearing reduce systemic risk?

The political economy of this is very interesting.   The congressional committee (House Ag) with jurisdiction over the futures markets and the exchanges is pushing legislation to mandate clearing.   (Chairman Peterson has indicated that he hopes to have a bill in January.)   This suggests that this is being driven by politics and the concentrated economic interests of the exchanges, rather than a serious deliberation over the pros and cons.   (Well, “Duh” again.)

I will close with an entertaining quote from a Chicago trader and CME clearinghouse member who understands very well the risks (notably the balance sheet risks) that CDS clearing could pose:

Howard Simons, one of the Chicago traders who always loathed the New York CDS dealers, speaks for many of his comrades in rejecting the trading of CDS on the futures exchanges. “The clearing members of the CME [Chicago Mercantile Exchange] think trading this stuff is the stupidest idea in the world. I didn’t work my whole life so some investment bank can take all our capital. Do I look like Hank Paulson?”

One of the most succinct descriptions of balance sheet risk ever uttered.   Couldn’t have put it better myself.

It is almost axiomatic that financial crises in general, and this financial crisis in particular, represent market failures that require government regulation to correct.   But this conclusion is logically defective for two reasons.   First, as hard as it might be to believe, financial crises can occur in a first-best, or constrained first best equilibrium.   Second, because there is no guarantee that governments that are subject to the same information constraints that likely make financial crises possible, and which suffer other defects in addition, will make things better rather than worse.

These points are made quite well in a book providentially published in 2007, Understanding Financial Crises, by Franklin Allen and Douglas Gale.   (I don’t know Douglas Gale, but I can say that Franklin Allen is not only a great economist, he is one of the true gentlemen of the profession–a truly nice man.)   I imagine the book would be rough sledding for non-economists (but, not as hard as the even more technical papers upon which it is based), but it does lay out in a systematic and persuasive way some relatively straightforward models of financial crises and contagion.

In several of the models, financial crises–such as widespread bank failures–occur even with optimal contracts.   A couple of extended quotes are worth reading:

[W]e want to challenge the conventional wisdom that financial crises are always and everywhere a ‘bad thing.’   It may well be true that financial crises impose substantial costs on the economy . . . . At the same time any regulation of the financial system involves costs.   The most important of these costs are the distortions imposed on the financial system by a regulatory regime that restricts what financial institutions may and may not do.   To measure the costs and benefits of any policy, we need to have a clear understanding of the conditions for efficiency in the financial system, including the conditions for efficient financial crises. (p. 153)

As long as we have complete markets for hedging aggregate risk and intermediaries can use complete contingent risk-sharing contracts, the equilibrium in a laisser-faire economy will be incentive efficient.   If intermediaries are forced by transaction costs to use incomplete contracts, the equilibrium will be constrained efficient.   In either case, it is wrong to suggest that financial crises constitute a source of a market failure.   A central planner subject to the same information constraints or the same transaction costs could not do better than the market. . . . Incomplete contracts . . . distort the choices that an intermediary would otherwise make; relaxing these constraints by defaulting in some states of nature allows the intermediary to provide the depositor with superior risk sharing and/or higher returns.   (pp. 188-189)

To provide a justification for regulation of the financial system, we first need to identify a source of market failure (constrained inefficiency).   Then we need to identify a practical policy that can remedy or at least ameliorate that failure. . . . Our view is that it is not enough merely to show that there exists a welfare-improving policy.   We also need to characterize the policy and show that it can be implemented.   A badly designed intervention could make things worse.     If the welfare-improving policy is too complicated or depends on information that is unlikely to be available to the policymaker, such mistakes are likely.   (p. 191)

[T]he optimal allocation [of resources] can involve financial crises.   So it is not the case that eliminating systemic risk is always optimal.   A careful analysis of the costs and benefits of crises is necessary to understand when intervention is necessary.   This analysis is typically missing from proposals for capital adequacy regulations such as the Basel Accords.   Incomplete financial markets provide one plausible source of market failure and a possible justification for capital regulation. (p. 214)

These quotes just give a flavor of the conclusions, without shedding light on the careful analysis that underlies them.   But the analysis is there.   The models are very bare-bones, and I imagine that some will conclude as a result that the analysis is therefore unrealistic.   But I derive a very different conclusion.   Things are very devilishly complicated in even the simple models, and even in the simple models seemingly “obvious” policies like increased capital requirements or regulations on bank balance sheets can have beneficial or baleful effects depending on the values of parameters that are impossible to measure in practice (e.g., the coefficient of relative risk aversion).   Thus, the models show that in even simple economies “obvious” solutions can have perverse, unintended consequences.   The potential for such policy failures is even greater in the more complex real world.

The chapter on financial regulation (Chapter 7) is particularly provocative and insightful.   Allen and Gale present a model in which markets are incomplete and there are random liquidity shocks.   In such an environment, bank capital can improve risk bearing; bank equity investors can help insure depositors against liquidity shocks.   But bank capital is costly.   Evaluation of the optimal amount of bank capital requires a comparison of the benefits of the cost of equity capital with the benefits of insurance.   This is not a trivial task even in the simple model.   Moreover, the answer is not always that forcing banks to hold more capital than they would under choose to hold absent any regulation improves welfare.   In some cases, forcing banks to hold less capital can increase welfare (p. 200).   The authors’ warning is well warranted:

It is not known how robust these results are when the model specification is altered or generalized, but even if the results turn out to be special they reinforce the lesson that, when general-equilibrium effects are involved, it is very difficult to predict the macroeconomic effect of changes in capital structure across the financial system.   Until we have a general theory to guide us, caution in policy making seems to be advisable.

In the current environment, this discussion of the response to the Great Depression is particularly worth chewing over:

Looking back, there is no sign of formal theory guiding these [Great Depression-era policy] changes.   Everyone seems to have agreed the experienceo f the great Depression was terrible; so terrible that it mut never be allowed to happen again.   According to this mind set, the financial system is fragile, adn the purpose of prudential regulation is to prevent financial crisis at all costs.   Why does the mindset of the 1930’s continue to influence thinking about policy? [Why] does policy making continue to be an empirical exercise, with little attention   to the role of theory?   This empirical procedure is unusual.   Indeed, the area of financial regulation is somewhat unique n the extent to which the empirical developments have so far outstripped theory.   In most areas of economics, when regulation becomes an issue, economists have tried to identify some market failure that justifies the proposed intervention.   Sometimes they have gone further and derived the optimal form of regulation.   This has not been the usual procedure with financial regulation, however.

Re that last comment: if that was true in last year, it is infinitely more true today   There are more proposals to “reform” the banking and financial systems than you can shake a stick at.   Most of these are based on casual empirical observations of “what went wrong” that are, at best, journalistic and impressionistic.   The proposals do not reliably identify what the market failures are, or how proposed regulatory changes would remedy those market failures.   They don’t trace through the likely responses of market participants to the proposed regulations, or the costs and benefits associated with these responses.

I’m not trying to be Panglossian here, suggesting that we are in the best of all (financial) worlds.   But I am suggesting that there is a major outbreak of the nirvana fallacy going on–i.e., there is a naive belief that the market has failed and that government regulation can only make it better.   Both of these beliefs are of a religious variety, and only weakly grounded on rigorous logic or empirical evidence–if they are grounded at all.

Allen and Gale don’t have all the answers–and they admit as much–but they do pose some very provocative questions and challenges.   These questions and challenges are especially apposite today.   Anyone giving the book a fair read should come away with a healthy skepticism of any proposed regulatory fix to prevent the occurrence of the next crisis.     Especially if that fix seems intuitive or obvious.