Streetwise Professor

Back in Houston after time in Geneva, and a quick day trip to Paris for a conference.  The conference was sponsored by the ECB, Banque de France, and the Bank of England.  It was an examination of the progress in OTC derivatives regulation since the G20 declaration in Pittsburgh in September, 2009.

For the most part, the audience was central bankers, and the theme was “Yay! Look what we’ve accomplished!”  And of course, I had to rain on that parade.  My paper was titled “Bill of Goods: CCPs and Systemic Risk”, and the themes were (a) most of the arguments about how clearing would reduce systemic risk (e.g., the effects of netting) are wrong, and (b) clearing and collateral mandates created new sources of systemic risk.  Meaning that the G20 sold us a bill of goods in Pittsburgh.

So call me Mr. Popular.

A good part of the rest of the program on Wednesday was the Craig show.  The next panel was chaired by someone from the ECB, who gave a rather injured defense of the Pittsburgh agenda: I wasn’t mentioned by name, but it was pretty clear that she was attempting-ineffectually, IMO-to rebut me.  Several of the panelists said “as someone said in the previous panel”-and then referred to something that I had said.

Then a representative from the BIS presented, to much fanfare, the results of the Macroeconomic Assessment that I criticized heavily before I left for Europe.  After presenting the results, he discussed criticisms and caveats, and spent most of the time attempting-even more ineffectually, IMO-to rebut the arguments I raised in my post.

Very flattering.  Thanks.

The next panel was another group of academics.  The authors of two of the three papers, Bruno Biais and Hector Perez-Saiz (from the Bank of Canada), stated that their papers were motivated/inspired by my earlier research (which Biais called “seminal”).

Even more flattering.

My panel generated some interesting discussion and questions.  Many related to Dale Rosenthal’s paper about the potential inefficiencies that can occur when defaulted positions are replaced (or hedged).

As I’ve written for 3-plus years, the one main benefit of CCPs is that a centralized mechanism (e.g., an auction) for replacing/hedging defaulted positions is likely to be more efficient than an uncoordinated scramble in a bilateral OTC market.  The question is whether this function can be unbundled from the other functions performed by CCPs, which may not reduce systemic risk, and may in fact increase it.

Indeed, since there will be massive quantities of non-cleared derivatives, many of them of the more complex variety, the clearing mandates will not eliminate the replacement/hedging problem.  Even if the cleared derivatives are handled in an orderly auction process, these massive quantities of non-cleared derivatives will not.  These positions will have to be dealt with, and there is a serious risk that the process of replacing them will be very chaotic and destabilizing.

I confess to amazement that in all of the post-Pittsburgh regulatory efforts, this issue has escaped attention.  The focus on clearing, margins, SEFs, etc., has apparently taken up all the oxygen.  This is truly unfortunate, because a centralized auction mechanism to replace or hedge defaulted positions is likely to be far more effective and efficient than a non-centralized mechanism.  Put the other way, the decentralized mechanism is likely to be chaotic and destabilizing and excessively volatile.

Again, the clearing mandate does not solve this problem because many derivatives, especially the most exotic and illiquid (and hence problematic) ones will be outside CCPs, and CCP auction processes.

Which got me thinking (during a conversation with Dale Rosenthal during a break) of how this issue could be addressed.  What popped into my head? The swap dealer designation.

For the most part this designation is all pain, no gain.  How could we make lemonade out of this lemon?  Well, the thought that comes to mind is that designated swap dealers could be required to participate in the auction/hedging of a positions defaulted on by another swap dealer (or dealers).

I am somewhat reluctant to advance this proposal, because I am usually skeptical about mandating anything.  But there is arguably a public good (in the technical sense of the term) element to the process of  replacing/hedging defaulted positions: as the Rosenthal paper suggests, there are potentially many coordination and strategic behavior problems when this process is decentralized.  Consequently, it is worth some further thought.  (The clearing and collateral and capital obligations of swap dealer designation do not have as compelling a public good justification.)

The details will be challenging. In particular, since not all swap dealers will trade all of the types of instruments in a defaulted portfolio, it is not immediately obvious how to determine, in advance, each designated dealer’s auction obligations: that is, it’s not obvious how to specify which auctions each dealer must participate in.  For instance, it makes little sense to require BP or Cargill to participate in auctions for interest rate swaptions.  So who has to participate in what auctions?  Given the plethora of categories (interest rates, credit, equity, FX, commodities) and currencies, there is likely to be a plethora of auctions, and thus it will be difficult to say who is obligated to participate in what auctions.

However it is specified, this obligation will arguably make the swap dealer designation more onerous, and firms will attempt to structure their businesses to avoid falling afoul of it.  But the biggest dealers will not be able to avoid it.  What’s more, if I am correct that a centralized mechanism for handling defaulted positions is a public good, the creation of such a mechanism will actually redound to the benefit of all market participants, including the swap dealers.  After all, they are likely to have the biggest positions to hedge and replace in the event of a major default, and would benefit from a reduction in the risk of this process, and an improvement in the efficiency of the pricing mechanism in the aftermath of a major default.

This is something that at least deserves some consideration.  And, of course, regulators appear to have ignored it altogether in their focus on clearing and margins.  Which is another reason why I am not a G20 cheerleader, 4 years after Pittsburgh.

Greenwald’s latest story is that the NSA spied on Brazil’s national oil company, Petrobras.  A long day of intense meetings in Geneva, so  I’ll be brief in my analysis.

Typical BS Greenwald story.  Starts out with an alleged fact based on a Snowden document.  (No one ever mentions that one can deceive by telling only part of the truth, but I’ll pass over that.)  Then proceeds with paragraph after paragraph of speculation of what the NSA could be doing.  In this case, the speculation is that NSA is engaged in commercial espionage for the benefit of US corporations.

Evidence for this? Bupkus.

Then, at the very end, Greenwald quotes a US denial, in this case by Clapper.  Clapper says that, duh, the US has an interest in economic matters, and that NSA does not engage in commercial espionage.

Does Greenwald have any evidence to dispute NSA does not engage in commercial espionage?  No.  But on his Twitter tl, he says that Clapper is lying.  Because, of course, the only reason that the US could be interested in Petrobras is for commercial purposes.  That is, he asserts and assumes that spying on a national oil company is for the purpose of benefitting US companies.

Um, not really.  Note two other very salient reasons.  First, the US Export-Import Bank lent Petrobras $2 billion.  Second, Petrobras has been the frequent subject of corruption allegations, including an accusation of money laundering made by a . . . wait for it . . . whistleblower.  Some allegations involve Dilma herself.

Gee, I thought Glenn was all about lionizing whistleblowers.

I guess that’s selective.  Go figure.

But enough expecting some sort of intellectual consistency.  Let’s just recognize that (a) the US government, and most governments, take an interest in major economic developments, especially in energy, and employ all elements of their national power to obtain information on this, (b) this does not imply that the governments use this information to advantage their domestic companies, though many do-notably China and France, (perhaps the US is an exception that proves the rule) (c) Greenwald provides no evidence, but merely asserts, that the NSA used information on Petrobras to advantage US companies, in one of his by now tiresome “can therefore does” exercises in illogic, and (d) most importantly, the US had a direct economic stake in Petrobras, and a strong reason to know whether the company was corrupt, and whether government officials involved with the company were corrupt.

Funny that Greenwald never mentions the ExIm Bank deal or the corruption allegations involving Petrobras and Brazilian public officials.  After all, that might provide some context, and we can have THAT interfering with our narrative, can we?

I’ve written about Germany’s bizarre Energiewende program before.  It massively subsidizes renewables, and pays for the subsidy with a huge premium slapped onto electricity rates, although some big industrial consumers are immune.  The most wasteful part of the program is the huge subsidies for wind, especially offshore wind.  Now Der Spiegel chimes in with a very, very long article savaging the program. (Complete with a bonus snark at greens posing as “saviors of the world.”)

I agree with most of what’s in the article, though I am hardly a big fan of the Swedish approach that Der Spiegel touts as an alternative: it’s just a less bad, and less expensive, than the German way.  If anthropogenic CO2 is a problem, slap a tax on it and let people figure out how to respond efficiently, rather than subsidizing specific technologies and suppliers.  The regressivity of the scheme is also not the worst thing about it, though it’s hardly a feature.  What is interesting is that the allegedly “social” Germans, who carp about American inequality, would implement such a regressive scheme.

One other thing to note, which might lead me to discount the brutal nature of the article if I didn’t know about Energiewende from other sources.  The article is clearly aimed at Merkel and her government: the program is laid entirely at her feet.  Thus, the article is a part of Der Spiegel’s unremitting attacks on Frau Merkel in the lead up to the election that will be held in a couple of weeks.  The most prominent part of those attacks is, of course, the Snowden coverage.

Ironically, the Der Spiegel site appears to be down now.  No doubt part of a US operation to silence the brave Laura.

But maybe it’s German intelligence.  For today Reuters reveals that-brace yourselves-Germany has an intelligence service.  And an intelligence service that collects electronic intelligence on foreigners no less!  Who knew? It even has at least one “naval reconnaissance vessel” that plies international waters scooping up information from the international ether.  (“Reconnaissance”, of course, being a fancy name for “spy”.)

Syrian brigade and division commanders had been asking the Presidential Palace to allow them to use chemical weapons for the last four-and-a-half months, according to radio messages intercepted by German spies, but permission had always been denied, the paper said.

This could mean Assad may not have personally approved the attack close to Damascus on August 21 in which more than 1,400 are estimated to have been killed, intelligence officers suggested.

Germany’s foreign intelligence agency (BND) could not be reached for comment.

Bild said the radio traffic was intercepted by a German naval reconnaissance vessel, the Oker, sailing close to the Syrian coast.

The BND couldn’t be reached? What, are they secretive or something?

And they also intercept phone calls!  I think I’m going to faint:

Members of the foreign affairs committee present at the briefing told Reuters Schindler had said that although the BND did not have absolute proof Assad’s government was responsible, it had much evidence to suggest it was.

This included a phone call German spies intercepted between a Hezbollah official and the Iranian Embassy in Damascus in which the official said Assad had ordered the attack.

But I’m sure Germany would never intercept anything on the Internet, so Laura and Jake can continue to take refuge in Berlin in good conscience.  I’m also sure that it knows exactly who the bad guys are so it only intercepts their communications, and only when they’re plotting bad things.  No NSA needle in a haystack programs for Fritz.

In further irony, Der Spiegel originally posted a story about the interception of the phone call . . . in a brief web posting without a byline.  (I’d link that, but like I say, Der Spiegel’s website is down now.)

Update: The Der Spiegel site is back up now.

I’m supposed to be in Geneva right now, but United Airlines decided that what I really wanted to do was to sit around Dulles for 5 hours waiting for them to figure out they couldn’t fix a mechanical problem, and then to sit around a hotel for a day waiting for today’s flight.  Luckily I was able to get the last seat on that plane, so I don’t have to do something like Dulles-Newark-Frankfort-Geneva like some of the other folks on the canceled flight.

So that gives me some time to catch up on reading (and blogging).  And it takes some time to read this loooonnnnggggg Bloomberg encomium to Gary Gensler, which describes his valiant St. George-like battles against the big, bad banking dragons.

The basic theme is that anything the banks don’t like must be good, and anything the banks do like must be bad. The profile confirms that’s Gensler’s view of the world, and Silla Brush and Robert Schmidt pretty much adopt that template.

If only the world were that simple.  Yes, regulatory capture by major financial institutions is a major danger, and happens.  Freddie and Fannie illustrate that in spades, for sure.  So one should always approach the lobbying efforts of large incumbent players, especially large financial institutions, with incredible skepticism.

But at the same time, one has to remember that regulators do stupid things, and adopt regulations that are grossly counterproductive and impose costs far in excess of any conceivable benefits.  Banks potentially subject to such regulations reasonably fight against those, which means that bank opposition to a regulation is not a sufficient statistic to determine whether it is a good or bad policy.

The two regulations that Gensler fought for that are covered extensively in the Bloomberg piece are definitely examples of bad regulations.  The article devotes the largest share of pixels to the battle over the request for quote battle.  You may recall that I named Gensler’s RFQ proposal as the Worst of the Worst of Frankendodd.  The SEF mandate itself is seriously misguided, and mandating how many quotes those wanting to buy or sell a swap must obtain is totally cracked: it is predicated on the paternalistic belief that those who are doing the trading don’t have the ability to make the appropriate trade-offs between information leakage and greater competition to get their business.

The article also details the battle over the de minimis level of trading activity that would determine who has to register as a swap dealer, and thereby incur the additional compliance, collateral, and capital burdens.  Gensler wanted the level set at a piddling $100 million, which would catch pretty much everyone of even modest size in the CFTC’s swap dealer web.

If the purpose of the swap dealer designation is to reduce systemic risk, the level of trading activity is a very poor means of determining which entities should be subject to the higher level of regulation and scrutiny.  And seriously, many firms that must register as swap dealers under the $3 billion level eventually settled upon-against Gensler’s furious opposition-are not systemically risky, either.

Relatedly, the article identifies futurization as an end run around regulation.  As I’ve written before, futurization is a predictable response to regulations that treat economically identical instruments differently.  Swaps are treated more punitively, due to more onerous collateral standards, and because swap trades count towards the de minimis swap dealer trading level but identical futures don’t.  So, duh, people will choose futures over swaps that are otherwise economically equivalent.  If this also allows firms that aren’t systemically important to escape the burdens of swap dealer registration, that’s all for the better.

Moreover, it should be noted that futurization has been over-hyped.  Its main effect has been in energy.  There is no way that the real swap dealers who are systemically important-the JP Morgans, Citis, etc.-are going to be able to avoid being designated as swap dealers by switching their business to futures.  (Don’t interpret that to mean that I believe that swap dealer designation will materially reduce systemic risk.)  A lot of their business is in instruments for which futures are not a viable substitute.  In contrast, in energy (and commodities generally) for the bulk of the business futures and swaps are close substitutes.

Indeed, there is an irony here.  Large quantities of energy swaps were “NYMEX lookalikes” virtually equivalent to futures traded on NYMEX (and then the CME after it acquired NYMEX): firms traded the swaps because under the CFMA, they were subject to a lighter regulatory touch than futures.  So the energy swaps business was largely a product of regulation, and when the regulation changed, the business changed.  The business went to where the regulatory burden was lowest.  Go figure.  Given that part of the premise of Frankendodd is that the futures regulatory structure was the right model that made an appropriate trade off between costs and benefits, the migration to futures should be considered an improvement even by Frankendodd supporters.  It brought the business back to where it should have been all along, according to the advocates of Frankendodd.

The article also writes a lot about extraterritoriality, a subject that makes my eyes glaze over.  The most revealing aspect of this battle is Gensler’s regulatory imperialism, and his stubborn resistance to near universal opposition.  In Gensler’s view-and in the article-everybody was out of step but Gary.

One interesting omission (as if you think anything could be omitted in a 20 page article) is anything related to position limits, another Gensler hobby horse.  Perhaps this is because he eventually prevailed in the Commission, and got it to pass a rule to his liking, so it doesn’t fall into the category of where Gensler’s views lost out to intense political opposition.  But it does fall into the category of a regulation that was opposed vigorously by the banks, who prevailed-at least for now-in getting the regulation stopped.  The difference is that they fought and won that battle in court (though appeals are ongoing).

The article does devote some coverage to the systemic risk of clearinghouses.  Ironically, it indicates that Gensler is aware that CCPs concentrate counterparty risk, which can be problematic.  This is quite contrary to many of his public statements on the issue, including in an FT oped mentioned in the Bloomberg piece, in which Gensler suggests that CCPs are a magic box that makes risk disappear.  So was he misinformed before, and has he come to a better understanding of the way things really work?  Or was he deceptive in his earlier advocacy?

It’s good to know that there is some recognition of this issue, but sadly, the diagnosis of how CCPs contribute to systemic risk is cramped and simplistic.  Yes, the failure of a CCP is a major worry, but as I point out in the paper I will present in Paris next week (assuming UA cooperates!) measures to keep CCPs immune from failure can create systemic risks too.  There is too little systematic thinking about systemic risk.

In politics and journalism, good versus evil narratives are easy and comforting.  The problem with that is that when you are talking about something as complicated as derivatives regulation, the world isn’t that simple.  Rent seeking and capture happen, resulting in industry-friendly regulations that may create or perpetuate systemic risks, or fail to mitigate real problems.  But regulatory stupidity happens too.  This is especially likely when you have a regulatory crusader who believes that he is on the side of good fighting evil, and who approaches complicated markets with a very narrow set of simple beliefs, rigidly held: Transparency good! More transparency better! (Ironic, given that SEFs reduce transparency about the identity of counterparties, even if they increase pre- and post-trade price transparency).  Clearing good!  Banks bad and anti-competitive!

As you know, I believe that the intellectual assumptions underlying Frankendodd are fundamentally flawed.  The adverse consequences of those fundamental bugs are only exacerbated when the individual with the primary responsibility for implementing the law believes the bugs are actually features, and approaches his task with a Jesuitical zeal that treats any opposition as the result of malign and self-interested motivations.  Gensler’s rigidity and self-righteousness, and apparent unwillingness to contemplate the possibility that people were opposing him because, he was, you know, actually wrong, have made the process costlier and more contentious, and made the resulting regulations more costly and less beneficial.  Consequently, Gensler’s defeats on these issues-which are minor in the scheme of things, really-are to be welcomed, not lamented.

This article by Chris Whittal in International Financing Review does a good job at summarizing my beef with the BIS’s Macroeconomic Assessment Group on Derivatives.  I appreciate Chris taking the time to speak with me and broadcasting my analysis to a broader audience.

A couple of people have expressed interest in my paper on clearing mandates and systemic risk.  So here it is.

In a nutshell: the arguments that clearing (and non-cleared derivatives) collateral mandates will reduce systemic risk are fundamentally flawed.  Ironically, this is because the analyses do not take a truly systemic approach.

My counterarguments will be familiar to those reading my posts on clearing over the past five years (!) but this piece lays them out in one place.  One stop shopping, as it were.  Or maybe one stop slashing.  (One of my lawyer clients remarked to his partner yesterday that I wrote “slashing” blog posts.  I said “Don’t leave out the burning!”)

A quick reprise on the BIS study purporting to show that Frankendodd and EMIR will increase economic growth by better than .1 percent per year.

A footnote in my earlier post questioned whether multilateral netting via single-category CCPs really reduced exposures substantially, if at all, compared to cross-product bilateral netting.  The BIS study assumes-without any support that I can identify-that multilateral netting via CCPs is four times (!) as effective in reducing exposures as bilateral netting.

Again, I’m aware of no theoretical or empirical support for this number.  The standard Duffie-Zhou theoretical analysis doesn’t reasonably support such a conclusion, and that is a purely theoretical exercise.  Such a remarkable assertion should require some empirical support.

More importantly, this assumption begs a huge question: since derivatives counterparties internalize the benefits of netting (even when it imposes external costs on other claimants), if multilateral netting compresses exposures by so much, why weren’t banks falling over themselves years ago to move trades to CCPs, thereby reducing (shifting, actually) risk and freeing up capital? Why is it necessary to unleash Frankendodd to force dealer banks to pick up this money off the sidewalk?  I thought they were greedy SOBs.

I see only two answers.  First, that the netting economies really aren’t that large.  Second, the dealer banks recognized that that increased netting merely transferred exposures to other creditors, who would adjust the prices of credit accordingly, making the (alleged) reduction in derivatives exposures not worth the cost of setting up and operating a CCP, posting collateral, etc.

Either way, there is no way to reconcile the BIS report’s claims that (a) netting of derivatives exposures is true net benefit, and (b) this net benefit can be achieved only as a result of regulation that forces dealer banks to clear to achieve multilateral netting economies.  Indeed, to the extent that netting redistributes wealth from non-derivatives creditors to derivatives counterparties, dealer banks would have an excessive incentive to adopt clearing/multilateral netting.

In other words, the BIS report implicitly assumes that greedy bankers stupidly overlook oodles of money ready to be stuffed into their pockets.

Why do I get the impression that this was a put-up job intended to give the G20 something to crow about at the upcoming meeting in St. Petersburg?

John Kiff of the IMF tells me via Twitter (where he tweets as @kiffmeister) that the report recognizes some of the problems I identified in my post, namely that there are other sources of systemic risk than the counterparty risk channel that is the basis for the analysis.  Yeah, that’s true, but I have looked through the report carefully, and can find no recognition whatsoever of the fact-and it is a fact-that collateral and netting have redistributive effects.

The BIS has released a report titled “Macroeconomic impact assessment of OTC derivatives regulatory reforms.” It concludes that the benefits of these reforms-including Frankendodd-will greatly exceed the costs, because (a) financial costs of a financial crisis are immense, and (b) the reforms will greatly reduce the probability of a financial crisis.  Specifically:

In its report, the MAGD focuses on the effects of (i) mandatory central clearing of standardised OTC derivatives, (ii) margin requirements for non-centrally-cleared OTC derivatives and (iii) bank capital requirements for derivatives-related exposures. In its preferred scenario, the group found economic benefits worth 0.16% of GDP per year from avoiding financial crises. It also found economic costs of 0.04% of GDP per year from institutions passing on the expense of holding more capital and collateral to the broader economy. This results in net benefits of 0.12% of GDP per year. These are estimates of the long-run consequences of the reforms, which are expected to apply once they have been fully implemented and had their full economic effects.

Don’t believe it for a minute.  The methodology of the analysis is irretrievably flawed.  The net benefits are the free-est of lunches, because the report does not take into account the redistributive aspects of the collateralization and netting that results from clearing, capital, and uncleared derivatives collateral mandates.  That is, it fails to recognize that the reduction in counterparty credit losses on derivatives that result from the “reforms” are accompanied by an increase in losses suffered by somebody else.  It accounts for a transfer as a social gain.

In broad strokes, the BIS analysis goes as follows.  Financial institutions are connected to one another by OTC derivatives trades.  One way of measuring this interconnection is the CVA-the credit value adjustment on derivatives trades.  The CVA is (roughly speaking) loss given default per dollar of exposure times credit exposure times the probability of default.  If a given bank, B say, takes a hit of X to its balance sheet, due to a bad investment, or a rogue trader loss, or whatever, its probability of default goes up.  This raises the CVA.  This is immediately recognized as a mark-to-market loss, dollar for dollar, by its counterparties.  These counterparties tend to be systemically important banks, and the loss makes them more leveraged.  The greater leverage makes them riskier, and more subject to default.  This raises their probability of default, which imposes CVA losses on their counterparties, and on and on.  In this way, a shock to one bank propagates throughout the system, and feedback effects intensify the original effect.  The end result is that major financial institutions become more leveraged, and the more leveraged the system, the more prone it is to a very costly crisis.

But Frankendodd lurches to the rescue!  By collateralizing and increasing netting*, Frankendodd reforms reduce credit exposure in derivatives.  Therefore, the CVA hit from a given rise in the probability of default is smaller.  The leverage in the system doesn’t rise nearly as much when bank B takes the hit of X to its balance sheet.  So a given shock has a substantially smaller impact on systemic leverage, and hence systemic risk.  Yay!

Not so fast, people.  Notice the flaw in the logic?  Remember what started the cascading effect in the pre-Frankendodd world: an increase in the probability of default at B due to some adverse shock to its balance sheet.  Collateral and clearing mandates reduce the exposure of derivatives counterparties to this shock.  But a default doesn’t just affect derivatives counterparties: it hurts all of B’s creditors.  Roughly speaking, the total cost incurred by B’s creditors as a result of an increase in the probability of default due to the loss of X is loss given default times total liabilities times the change in the probability of default.  Given total liabilities, this does not change when derivatives are collateralized or netted more extensively.  This, in turn, means that the decline in derivatives CVA that results from more derivatives collateral and netting is matched by an increase in losses suffered by other creditors.  The “reforms” shift around the losses: they do not reduce them in aggregate.

That is, the “reforms” don’t reduce the losses that result from the balance sheet shock that raises B’s probability of default: they redistribute them.  Note, moreover, that many of the same big financial institutions that benefit from the decline in derivatives CVA are hurt by the loss on B’s other liabilities, because these institutions are exposed to one another through a variety of claims, not just derivatives.  Moreover, some of the others (non-bank creditors) that suffer from the redistribution may be systemically important too: money market funds that invest in the short term debt of financial institutions (including B) are one example.  Repo is another example.  Thus, the overall effect of Frankendodd and EMIR on systemic risk is quite equivocal.  It shifts around losses, and there is no guarantee that the shift in losses improves the stability of the financial system.

But the BIS study does not treat the redistributive effects of the derivatives reforms.   It treats them has a net gain.  This is fundamentally, basically, and irredeemably wrong.  Wrong, wrong, wrong.  When evaluating systemic risk, it ignores the systemic redistribution of losses.  As a result, it overestimates the gains of the regulatory changes.

To a first approximation, given the redistributive nature of their effects, the benefits of the reforms is zero.  The BIS recognizes that they involve costs.  Meaning that to a first approximation, Frankendodd and EMIR reduce wealth, rather than increase it.

But that’s just a first approximation.  To understand fully the effects, you’d have to know how losses are redistributed, and the systemic importance of those who suffer bigger losses and of those who realize smaller ones.  You’d also have to understand how financial contracts will change in response to the new set of creditor priorities inherent in the Frankendodd and EMIR rules.   Financial contracts-capital structures, if you will-will change in response to the new rules.  Claims will be repriced.  There is going to be a new, different equilibrium structure of financial contracts.  Maybe this new structure is less fragile.  Maybe it is more so.  I don’t know: the system is so complex that it will respond to this big shock in surprising ways.  All I do know is that this where you need to look to figure out the effects of the so-called reforms on systemic risk, and this ain’t where the BIS looks.  It counts benefits conferred on some subset of claimants, while ignoring the costs imposed on others (that are approximately equal in magnitude).

In other words, the BIS is hawking a free lunch, and as Friedman said, there ain’t no such thing.

The BIS study also has a particular model of systemic risk: the counterparty credit contagion model.  B takes a hit, that spreads to C, D, and E, which then spreads to F, G, and H, and on and on, until most everyone drops dead like Aztecs fell to the smallpox.  This is a common way of formalizing systemic risk, but reminds me of the story of the drunk looking for his keys under the lamppost because the light is better there, not because he lost them there.  If you look at the history of financial crises, they almost never look like the systemic crises in these contagion models.  An idiosyncratic shock at one institution doesn’t bring a house of cards crashing down.  The collapses of individual institutions (Bear, Lehman) are symptoms of a deeper-and systemic-rot.

In sum, the BIS analysis is fundamentally flawed, and hence gives a wildly misleading estimate of the social benefits of the clearing and collateral mandates embedded in Frankendodd and EMIR and regulations adopted by other G20 nations.  It is a sad, sad example of a reputable institution falling prey to free lunch fallacies.

It is particularly sad because it’s not as if this hasn’t been pointed out before.  I raised the problem five years ago.  So you may say-well, who are you anyways?  Well, Harvard’s Mark Roe, one of the most accomplished bankruptcy scholars in the legal academy, has made the same point (and graciously cited my work).  And, truth be told, it is a staple of the bankruptcy literature.  And it’s also sad because I hear such “logic” over and over from regulators (e.g., scholars and policymakers at the Fed).  They presume to identify systemic benefits based on analyses that look at only a portion of the system.

And speaking of sad.  Could the BIS please spring for a typesetting program like LaTeX that prints readable equations?  Please?

* It is by no means clear that moving more trades to clearing will reduce credit exposures in derivatives via netting, especially given the fragmentation of CCPs by product and jurisdiction.  CCPs permit multilateral netting, but (a) bilateral trades can be compressed multilaterally, and (b) cross-product netting of exposures within dealer books can be larger than multilateral netting in single-category CCPs.  But that’s really a secondary issue.  The most important thing to remember is that the primary effect of netting is to redistribute default losses from derivatives counterparties to non-derivatives creditors.

Nasdaq shut down for 3 hours yesterday, the second electronic trading SNAFU of the week (the first being the Goldman option fiasco).  The problem?  Another example of the effects of a SLOB (simulacrum of a limit order book).  One of the links in the US SLOB is the SIP (Security Information Processor) connecting NYSEArca and Nasdaq.  This sends information about quotes from one exchange to the other.  This information is necessary to link the markets: in order to prevent locks and crosses, and to direct orders to the best priced market, each venue needs to know the quotes at the others.  According to Nasdaq, irregularities in the SIP were causing problems with its system, so it shut down to prevent a more catastrophic failure.

Moral of the story: links are major points of failure in a SLOB.  (Though it is interesting to note that on the same day Globex was displaying crossed markets in the bean complex, and Globex is a true CLOB not a SLOB.  But trading continued.)

My first thought on hearing of the shutdown was a SLOB problem.  My second was hacking.  There has been a spate of stories of late about exchanges being major potential targets of hackers/cybercriminals.

This is one of the reasons why I take an interest in Appelbaum, Snowden, Anonymous, etc.  Exchanges, and financial infrastructure generally, are major targets of these psychopaths for at least a couple of reasons.  First, some are just criminals, who like Willie Sutton target banks and the like because that’s where the money is.  Second, the hacker movement is a hotbed of anti-capitalist ideology that motivates attacks on capitalist institutions.

Meaning that the defenses of our financial infrastructure are vitally important.  And this is another source of major concern, which the Snowden affair puts front and center.  Infosec workers are recruited from the same milieu as the hackers.  The membrane between hackers on the outside and supposed defenders on the inside is very permeable.  There is lots of talk about the color of hacker hats, but ethically and ideologically the distinctions between black, white, and grey hats are quite blurry, and the boundaries are transgressed often.

Snowden is a classic example of that.  Former head of the NSA, General Hayden, said that perforce NSA and the government generally has to recruit from this group, but find ways to protect from those with a “romantic attachment to absolute transparency at all costs.”  Yes, the transparency romantics are a potential problem, but I think they’re the least of our worries: transparency romanticism is often a public pose for those motivated by malign anti-US and anti-capitalist beliefs.

The narcissism and grandiosity that Snowden exhibits are also all too common in this community, both inside government and financial institutions, and outside.  Indeed, there is a very strong and widespread tendency of these people to view themselves as superior in some way, and justified in acting as judge, jury, and executioner when it comes to the release of information, and operations against targets that violate their highly tuned-and self-righteous-moral senses.  Again, Snowden is a perfect example: he arrogated to himself the ability to decide what was illegal and immoral.  So did Bradley Manning, though he (and yes, he is still a he and he was a he when he made this statement, so I’m passing on the Chelsea thing) repudiated that in his pre-sentencing statement.

Indeed, this is a common theme in the infosec community.  Take a look at the attached video by a Pied Piper of this community, ex-priest (and, alas, University of Chicago grad) Richard Thieme.  (H/t @libertylynx, who also raised many of the points below.) This guy is lionized in this community.  He matters.  He is viewed as the voice of many. Check out the fawning, personality cultish comments to the video.

Thieme basically asserts that infosec specialists answer to a higher law, in part because there is a nexus between law enforcement and criminality, and in part because traditional legal distinctions (e.g., foreign vs. domestic) have been obliterated by technology and shadowy, scary supra-state actors.  Check out the rants around minute 32:00.  And for a dose of virulent anti-bank rhetoric, which really has to be heard to be believed, fast forward to minute 43 or so.

You know that there are infosec people in banks-and exchanges-who idolize this guy, and buy into his message.  The message is banks are criminal.  The government is criminal.  So it’s not criminal to attack them. Indeed, one can be justified in doing so.  Yes, many of the would-be attackers are on the outside, but as Snowden shows, there are inevitably many on the inside. And some on the inside have no problem in dealing with Appelbaum and the like. Case in point, an infosec guy I interacted with on Twitter until he blocked me. (Thin skin seems to be another occupational hazard.) He would countenance no criticism of Appelbaum.

Meaning that the most dangerous threats to exchanges and financial infrastructure may be those who are hired to defend them.

So this is one of the reasons I write about Snowden, and Appelbaum, and Assange, and Greenwald, and the rest of this crowd. Their agendas and connections need to be understood-and broadcast. For these avatars of transparency are notoriously protective of their own activities and connections. Given the inevitability that some of those to whom they are connected are on the inside of vital financial and government institutions, this is a matter of grave concern. And a matter that mainstream journalism has been shockingly negligent in investigating and reporting.

Appelbaum and Poitras are in Berlin now, and Berlin-land of the Pirate Party-is arguably the epicenter of this community. But it is an international community, and what happens in Berlin doesn’t stay in Berlin. It could be coming to a bank or exchange near you. If it hasn’t happened yet, it’s not for lack of trying, or the lack of potential acolytes within these very institutions.

The CME has seen increased volumes in its cash settled Brent contract in the aftermath of its launch of a program that pays rewards to those who trade the contract.  This is a standard way to attract volume to a contract competing against an incumbent/dominant contract.  Indeed, it’s probably the only way to do it.

Eurex tipped the Bund market away from LIFFE in 1998 after implementing a fee holiday, which LIFFE smugly refused to match, so confident was it of its liquidity advantage.  But Eurex had enough organic order flow that it was fairly liquid already, and the fee cut made it cheaper to trade Eurex Bunds, as I document in my paper “Bund for Glory: Or, It’s a Long Way to Tip a Market” (which will be a chapter in a book I’m currently writing).  The market tipped within a period of mere months.

Other exchanges didn’t repeat LIFFE’s near fatal mistake, and responded to fee cutting entrants by cutting their own fees to match.  This is how CBOT saw off Eurex’s attempt to enter the US Treasury futures market in 2003, and how CME torpedoed EuronextLIFFE’s attempt to enter into the Eurodollar futures market a few years later.

Here’s the deal: incumbents have a huge liquidity advantage that entrants must overcome.  How can this be done?  The only way, really, is to cut fees, or actively reward volume to attract enough liquidity to compete with the incumbent.  And the odds are still long, especially if the incumbent follows the CBOT script, and matches the reduced fees.

But if you want to encourage inter-exchange competition, you have to look favorably on entrants using strategies that reward volume as a way of building liquidity to make themselves into viable competitors.

This basic fact makes this FT article very disappointing.   It criticizes the CME initiative, and only quotes those who are critical or dismissive of the endeavor.  Yeah, it’s probably true that the only reason why those who participate in the incentive program trade is to collect the rewards.  But their order flow can attract order flow from others: other traders see that there is two-way activity, and can be more confident that if they establish a position, it won’t be a Hotel California that they can check into, but can’t leave.  Meaning that it’s BS to say, as one anonymous source to the story says, “there is no economic benefit to the trades whatsoever.”  The economic benefit is that it can make the entrant a more viable competitor to the incumbent.

And quoting Bart Chilton.  Please.

The quote that claims that spread trades-which dominate the activity in the CME Brent contract-“make no loss because they buy and sell at the same price” is just a crock.  Yes, spread trades are lower risk, but calendar spreads do move.

The CME is engaging in a penetration pricing strategy.  The only real strategy that permits competition against an incumbent.  If you like competition, you should like a strategy that harnesses the greed of trading firms to generate liquidity and volume.  Because, quite frankly, that’s the only way to compete.

But if you like monopoly, go ahead and denigrate what the CME is doing.

It would also be interesting to see how ICE built market share in its WTI cash settled contract that competes with the CME’s flagship oil contract.  It is my recollection that ICE rebated fees for firms that brought volume to the ICE contract.  (The structure of the ICE inducement, and Eurex’s in Bunds, were interesting.  They basically made it a tournament, with rebates/bonus payment being limited to the top three-if memory serves- order flow providers.  That provides a very high powered incentive while controlling the cost of the program.)  If my recollection is correct, doesn’t that mean that sauce for the goose is sauce for the gander?

Competition in futures markets, where order flow is not socialized, is highly imperfect.  Incumbents have huge advantages.  Aggressive price competition-pentration pricing, specifically-is about the only way that an entrant can hope to dent the incumbent monopolist’s huge liquidity advantage, and even that is a highly dicey proposition.  The FT story would have been much better had it recognized this reality rather than taking an all too critical view, and containing only quotes that were no doubt music to Jeff Sprecher’s ears.