Streetwise Professor

May 23, 2024

A Fascinating Flashback to the Halcyon Days of Floor Trading In Chicago

Filed under: Commodities,Derivatives,Exchanges,Regulation — cpirrong @ 11:47 am

This Brokers, Bagmen, and Moles podcast really took me back. It tells the complex and convoluted tale of the FBI sting operation on the floors of the CBOT and CME, and the trials that followed in the 1987-1990 period.

I worked for an FCM (located in the CME building at 30 S. Wacker) during one year that the sting occurred. Leo Melamed appears prominently in the podcast (and not in a good way, I might add): I frequently saw him in the elevator there. I had just started teaching at Michigan in January 1989 when the Chicago Tribune (to the fury of the FBI and DOJ) broke the story of the investigation. In something of a Walter Block moment, I wrote a paper (not published, nor even submitted) explaining, and to some extent justifying, the conduct that put some traders in jail (though not the right ones, from the perspective of podcast producer Anjay Nagpal).

I hadn’t thought about that paper in a long time, but the podcast resurrected it from the recesses of my memory. In a nutshell, as described in the podcast, a major aspect of the allegedly fraudulent conduct engaged in by floor brokers and locals revolved around the issue of “out trades.”

Out trades were an inherent feature of floor trading. Out trades were mistakes. Two traders could trade, and agree that they traded with one another, but disagree on the price. Those were relatively easy to resolve. Bigger problems occurred when, say, ABC said he sold to XYZ and XYZ said he didn’t buy from ABC. Or when ABC said he sold to XYZ and XYZ said he sold ABC.

These types of errors were endemic in the bustle and commotion of the pits. And they were often material. In essence, if an out trade occurred when a broker traded for a customer, and the error was detrimental to the customer, the broker had to make up the loss. In the case of ABC being a broker, and the price moved down subsequent to the time the trade should have occurred, and the broker corrected the error by selling for the customer at the lower price, ABC had to pay the customer the difference. If the error worked in the customer’s favor, he got to keep the benefit.

Especially in volatile markets and for big orders, six figure errors were not unheard of, and five figure errors were pretty common.

In essence, brokers were short a random number of options (the randomness being due to the unpredictable nature of out trades). This was a cost of doing brokerage business, and could be an appreciable cost.

And this was the hook for my paper. The bulk of the allegations against the traders was that in the aftermath of an out trade, a broker would make a trade with a local (i.e., an independent floor trader) that was profitable to the broker, but unprofitable to the local. This local was called the “bagman,” hence the middle word in the title of the podcast (and a book). The broker would later pay back the local by making off-market trades that cost customers money but were profitable for the local. For example, selling to the local at a price below the best bid in the pit.

When I first read the allegations, this struck me as an insurance arrangement, and hence the paper was titled (if I recall correctly–I’m looking for an old copy) “Broker Fraud as Out Trade Insurance.” In essence, the losses from out trades were spread out among all (or least many) of the broker’s customers. The bagmen were like insurance companies: eating a loss was a claim. The profits from off-market trades were the premiums. The customers paid the premiums in the form of unfavorable trading prices. (I also argued that broker associations, also controversial, were in large part an insurance arrangement).

My argument was that this was plausibly an efficient arrangement, as it led to a more efficient sharing of out trade risk, where out trade risk is inherent to open outrcry trading, just as fire risk is inherent to owning a house or accident risk is inherent to driving.

So were customers hurt? Well, if these practices were indeed insurance, customers actually benefited. A more efficient sharing of out trade risk reduced the cost of supplying brokerage services. With a highly competitive market for brokerage services, this lower cost would be passed on in the form of lower commissions, or better service, or more perks (like picking up bar tabs or losing more to the customer on the links).

Of course, it was almost certain that some of this type of trading was not undertaken to insure out trade risk. Some brokers no doubt took advantage of the widespread nature of the practice (where its ubiquity was driven by its putative efficiency) to rip off customers on some trades. However, as I argued in the paper, the ultimate effect of that kind of behavior on customers was mitigated by competition among brokers. The ability to harvest those kinds of illicit profits reduced the reservation commission that brokers charged.

(In making this argument, I riffed on an example from (then) Donald McCloskey’s price theory/micro text. He argued that the practice whereby shipyard labor cutting wood on sailing ships pocketed and sold shavings from the wood they cut had little impact on the cost of building or repairing ships, because labor market competition reduced wages by an amount commensurate with the value of the wood thus taken. McCloskey used this to illustrate the idea–originating with Adam Smith–of compensating wage differentials).

So the argument was basically not only was this not worth a federal case (or what was at the time the most expensive FBI investigation in history), it was arguably efficient, or at most a victimless crime (in equilibrium, anyways).

Other allegations included things like trading after the close. Again, in many cases this could be viewed as efficient, and beneficial to customers: trading at the close was often insanely chaotic, making it impossible to execute all orders before the bell rang.

Labor unions know that one of the most effective ways of disrupting a production process is to “work to rule”, i.e., adhere strictly to every agreed upon rule. In any tightly coupled system (e.g., an assembly line, an airline operating on a schedule, or a trading floor), allowing for some play in the joints–some departures from strict adherence to the rules–can allow it to operate more efficiently. Strict adherence to the rules would likely have interfered substantially with the efficiency of the floor trading process.

Or think of the mess that an NBA game would be if refs called every foul. “No harm no foul” is a reasonable way to call a game.

To the outrage of other defendants–who claimed that nothing untoward happened on the floor–the lawyer for two defendants (a guy named David Durkin, interviewed in the last episode of the podcast) argued that yeah, this stuff happened all the time, and it wasn’t fraud. He didn’t make exactly the same argument as I did, but his argument rhymed with mine. That is, the intent of these violations of the rules was not to defraud, which would be necessary to achieve a criminal conviction. (The argument was not tested at trial. For perfectly understandable reasons, guys facing RICO charges and 20 years in Club Fed took a deal and pled out for terms of 8-10 months. One could argue that the relatively big delta between the deal and the penalty if they had lost reflected the government’s assessment that the argument could have indeed been persuasive to a jury.).

Take it as you will. All I can say is that nothing in the podcast made me change my mind from what I came to believe 35 years ago. (Time flies!)

The podcast delves deeply into the genesis of the investigation. This material was pretty new to me. I had heard nothing previously to challenge the public explanation that ADM’s Dwayne Andreas was ticked off (no pun intended) at being ripped off by the floor, and sicced the FBI on the exchanges. But after listening to the podcast, like Nagpal I find it unpersuasive. Would that really be sufficient motivation for the DOJ and FBI to launch such an ambitious investigation? (Perhaps they didn’t realize how hard it would be, and doubled down once they got in–the sunk cost fallacy at work.). Was it really aimed at the exchanges themselves, or the bigwigs there? Was it really launched to investigate mob money laundering? After all these years, these remain open questions, despite Nagpal’s dogged efforts to answer them.

The podcast also featured extensive interviews with various traders–some convicted, some not, and some not even charged. Those brought back memories of the floor in all its glory, color, character, and characters. And the accents! Having been away for years, the distinctive Chicago accents were truly noticeable and entertaining: at the time, as a fish in those waters, they would have seemed to be normal.

My only criticism of the podcast is in its attempt to draw Big Lessons. Nagpal’s big lessons were: (a) this conduct was rife; (b) it was fraudulent and harmed customers; (c) it was so rife that bigwigs–notably Leo Melamed–participated in it; (d) the fact that the bigwigs skated was a travesty of justice; and (e) the episode demonstrates the fundamental flaws in exchange self-regulation.

Here Nagpal gets preachy. Though in the last episode (in which Durkin plays a prominent role) he does start to wonder whether the bad stuff really wasn’t so bad after all, and that some of the bad guys really weren’t that bad.

As someone who wrote a lot about self-regulation in the 90s in particular (in large part due to the experience of dealing with it in the aftermath of the Ferruzzi episode), I am surely not in the self-regulation hallelujah chorus. However, I vigorously disagree with Nagpal’s contention that putting the futures exchanges under the aegis of the SEC would represent an improvement (not least because stock exchanges regulated by the SEC are also self-regulatory organizations). In the case of the investigation of the floor, the assumption that self-regulation failed presumes that the conduct was truly predominately fraudulent: as argued above, that’s debatable.

And yes, exchange governance is political–as discussed in detail in my 1995 and 2000 JLE articles. But government regulation is politicized too.

Overall, though, those are quibbles. In laying out in detail the complex facts, and letting the principals speak at length, Brokers, Bagmen, and Moles sheds considerable light on a long forgotten but epochal moment in the history of Chicago’s exchanges. It’s a kind of unvarnished history and I hope that others make similar contributions before the old floor traders, like old soldiers, just fade away like the sound in the pit after the closing bell.

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April 2, 2024

Missing the Big Point on FCM Concentration and Systemic Risk

Filed under: Clearing,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 1:58 pm

The increasing concentration of the futures commission merchant (FCM)/clearing broker business has been a pronounced feature of the world derivatives markets in recent years. This has raised concerns among at least some regulators, including CFTC commissioner Summer K. Mersinger. In a speech generally rah-rah-ing clearing mandates, Commissioner Mersinger did raise one discordant note. Specifically, implementation of the Basel III standards would contribute to further concentration in the FCM/CB space:

Second, the Basel III Endgame Proposal would weaken the clearing system by exacerbating the downward trend in the number of entities offering client clearing services.  In January 2004, there were 177 futures commission merchants (“FCMs”) registered with the CFTC.  Twenty years later, as of January 2024, there are 62 FCMs registered with the CFTC, representing a 65% decline. But over the same period, there has been a dramatic increase in customer funds held at FCMs to support derivatives trading.  In January 2004, FCMs held over $87 billion of customer funds.  Today, that smaller number of FCMs is holding five-and-a-half times that amount of customer funds—$490 billion.  And of that customer money, approximately 60% is concentrated in the top five FCMs. [Footnotes omitted.]

This is a problem because

Third, a further decline in the number of FCMs would create systemic risk. In addition to concentration concerns, a decline in the number of FCMs would raise serious challenges regarding the portability of customer positions should a clearing member fail.  Consider this potential scenario: a clearing member defaults, and its customers’ positions need to be ported to a different clearing member; however, porting those positions proves difficult or even impossible because the Basel III Endgame Proposal has both decreased the number of clearing members and reduced client clearing capacity at the remaining clearing members.  This outcome of the Basel III Endgame Proposal would increase systemic risk, not reduce systemic risk.

It’s a shame nobody saw this coming.

Oh wait. Someone did. Thirteen years ago: “Moreover, this means of facilitating connections of end users to multiple CCPs tends to encourage the concentration of client business in a small number of clearing member firms. This concentration has systemic implications.”

(See also here, from the Chicago Fed.)

On this blog, I have also written on numerous occasions how various aspects of Dodd-Frank contribute to consolidation among FCMs. Regulatory overhead is a largely fixed cost, which contributes to scale economies and hence concentration. Moreover, diversification effects and the need for big balance sheets to intermediate large derivatives positions also contributes to concentration. Note that the OTC dealer market has always been quite concentrated for these reasons, and this concentration has migrated to the cleared world as clearing of OTC derivatives has been mandated.

Commissioner Mersinger did not identify the causes of increasing concentration that has already occurred among FCMs: her speech focuses on how the Basel III End Game may make this problem even more acute. But she does not recognize that the central clearing that she lauds in her speech is a major driving force of the trend she laments: “But recent policy proposals in the United States risk upending the success we have experienced through the efforts of the G-20 and the move to central clearing.” In other words, central clearing good, but you are screwing it up, Basel.

I said Basel! Not Basil!

In actual fact, regulation generally, and clearing mandates specifically, have been the major driver of market structure in the post-Frankendodd era. It’s good that regulators are starting to recognize the systemic risks inherent in this structure. It’s disappointing that they don’t recognize that what they praise lavishly (and pat themselves on the back for) is the underlying source of the problem.

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March 16, 2024

Riding the Volatility Short Bus

Filed under: Derivatives,Economics,Exchanges — cpirrong @ 9:06 am

There’s been a bit of a hullabaloo of late regarding the resurgence of short volatility trades in equities. This comes at a time when volatility is low by historical standards, which has led some to conclude that the shorting of volatility is causing the low volatility.

Wrong, wrong, wrong–or at least the correlation between the two is insufficient to demonstrate causation. This is another example of the error of reasoning from a price/price change.

The “logic” here is particularly dubious for derivatives (“selling vol” is a synonym for selling options) because they are in zero net supply. Quantity bought is equal to quantity sold. So “short volatility trades come roaring back” also means “long volatility trades come roaring back.” Determining what drives what is not immediately obvious.

Here’s another story. Some believe volatility is to cheap and want to buy it. Or some what to hedge volatility risk, and at the current low levels it appears attractive to do so. So rather than pushing into the vol market, shorts are being pulled in.

You can’t tell which is happening just looking at the level of vol and open interest. And here’s the key thing: derivatives are risk transfer markets. What is determined in these markets are primarily risk premia. And so to see who’s pushing and who’s pulling, you need to look at risk premia.

The long pull story should see the vol risk premium rise, specifically implied vols should rise relative to expected future vols (in the physical measure). A crude proxy for this is implied vols rising relative to realized vols.

The short push hypothesis predicts the opposite. It doesn’t predict that the level of implied vol should fall absolutely: it predicts that implied vols should fall relative to realized vols.

And according to CBOE’s vol maven Mandy Xu, it’s the former and not the latter:

Second, if volatility selling strategies were to blame for the low levels of the VIX index, you would expect the volatility risk premium (VRP) to shrink as the implied-realized volatility spread narrows (i.e. the VRP is what option sellers aim to monetize and thus should decrease as more sellers enter into the market). Instead, what we’ve seen over the past year is the opposite — the S&P 1M volatility risk premium (as measured by the difference between the VIX index vs SPX 1M realized volatility) actually increased quite meaningfully, from 1.5% in 2022 to 3.6% in 2023. Implied volatility may be low, but it’s not trading particularly cheap compared to realized volatility (SPX 1M realized vol went from averaging 24% in 2022 to just 13% in 2023).

Xu also notes that the vol curve has been more skewed to the call wing, i.e., out-of-the-money call vols have been rising relative to ATMs. This could be explained by a demand to hedge against volatility spikes from today’s current levels (a scenario that played out in the “Volmageddon” of 2018). (Pay attention class–by which I mean my real, actual classes–we’ll be discussing that after Spring Break.)

So the short vol crowded trade driving down vols story is certainly logically weak and factually unsupported, and the alternative that the rise in vol-related derivatives notionals is driven by buyers does have support in the data.

Remember children: never argue from a price change. Especially in derivatives markets with arguments based on open interest/volume.

There does appear to be some interesting intermediation going on. There has been a lot of activity in individual stock options (e.g., Nvidia). It appears that some buying pressure has been accommodated by hedge funds selling those options, and buying index options. This is a form of spread trading (in a way not dissimilar from the infamous basis trades) that hedge funds specialize in. It would tend to contribute to higher notionals in index vol positions–both long and short. There is also spreading between short-dated (especially “zero day”) options and longer-dated options.

Regardless of the underlying driver here (index vol bets or individual stock vol bets) it does appear that the surge in volatility trading has been buyer driven, not selling driven, as indicated by the behavior of risk premia.

Sadly, it is the Bank for International Settlements (BIS) that has pushed the “vol shorts have pushed down implied vols (absolutely–but not relative to realized vols). So it’s fair to say that the BIS is riding the volatility short bus. Which is embarrassing.

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December 5, 2023

Luddism in the Oil Futures Markets

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — cpirrong @ 1:06 pm

The old, old game of Pin the Tail on the Speculator has been updated. According to Bloomberg, the speculators who now “disrupt” the oil markets are not human: they are bots. Specifically, bots operated by Commodity Trading Advisors (CTAs).

This argument consists of two parts. The first being that the crude oil futures markets have been disrupted. The second being that the CTAs are the cats behind the disruption. Both plinths are defective.

Insofar as disruption is concerned, Bloomberg claims “Trading oil has perhaps never been more of a roller coaster ride than it is today.” Further:

Just in the past two months, prices threatened to reach $100 per barrel, only to whipsaw into the $70s. On one day in October, they swung as much as 6%. And so far in 2023, futures have lurched by more than $2 a day 161 times, a massive jump from previous years.

Bloomberg

Never more of a roller coaster ride? Well, let’s do something crazy. Like look at historical data.

The conventional measure of the wildness of the ride is volatility. The annualized daily volatility of crude oil during the alleged Rule of the Bots (the last two years) is 41.62 percent. The historical volatility (2010-2020) is 41.2 percent. (This omits 4/20/20 and 4/21/20, the day of the negative oil price and the following day.) Excluding the COVID months of 2020 produces a somewhat lower vol of 36 percent, not that much smaller than in the last two years. Further, extended excursions of realized volatility to above 40 percent are not unusual in the historical record. So to say that oil prices have been more volatile recently than has historically the case is categorically false.

With respect to the big daily moves, the Bloomberg analysis is fatally flawed because it looks at dollar price moves: big dollar price moves are more likely when prices are high than they are low, and by historical standards oil prices have been high in the last several years. It is appropriate instead to focus on percentage price changes (which is how vols are calculated, btw).

Rather than count the number of times an arbitrary threshold (like $2/bbl) is breached, it is more rigorous to look at a statistical measure of the frequency of extreme events: the “kurtosis.” Kurtosis bigger than zero means a distribution has fat tails relative to a Gaussian (“normal”) distribution, i.e., extreme moves up or down are more likely than under a normal distribution. The bigger the kurtosis, the more likely extreme moves are, i.e., the fatter the tails of the distribution.

Looking at the kurtosis of daily percentage changes rubbishes the Bloomberg analysis. The kurtosis in the last two years is 4.15, whereas from 2010-2020 it was 27.9! That is, the frequency of extreme daily price moves in years of alleged CTA disruption is far, far smaller than was the case prior to their alleged emergence as the dominant force in the. markets.

Interestingly, the kurtosis of dollar price changes is not that different between eras: 6.9 post-2020 vs. 7.2 2010-2020. So even extreme dollar price moves are less frequent in the alleged CAT era than previously. The difference is smaller, which demonstrates the need to take into account the level of prices in an analysis of “extremes.”

So the predicate for the article–that oil prices have been unusually volatile and unusually susceptible to extreme moves in the past couple of years–is not supported by the data.

As for the alleged causal factors, the dominance of CTAs is not evident in the data. CTAs are included in the “Managed Money” category of the CFTC’s Commitment of Traders Report. Here is a graph of the net position of Managed Money going back to 2006:

There was a peak in 2017-2018–a drilling boom in the US, to which I will return shortly–followed by a decline–a drilling drought–followed by a rebound to levels comparable to the 2017-2018 levels. Indeed, managed money net positions have actually been relatively low in the past year (with the exception of a recent spike) as compared to the post-2015 period as a whole. Certainly no Alice to the moon spike in CTA presence apparent here.

Bloomberg claims that the CTAs have become dominant in large part due to a sharp decline in producer hedging:

That coincided with the collapse of another source of futures and options trading: oil-production hedging. During the heyday of shale expansion about a decade ago, drillers would lock in futures prices to help fund their growth. But in the aftermath of the pandemic-induced price crash, a chastened US oil industry increasingly focused on returning cash to investors and eschewed hedging, which can often limit a company’s exposure to the upside in a rising market. By the first quarter of this year, the volume of oil that US producers were hedging by using derivatives contracts had fallen by more than two-thirds compared with before the pandemic, according to BloombergNEF data.

It should be noted that this claim that CTAs have achieved greater dominance due to an ebbing of hedging is implausible on its face. Futures are in zero net supply. If producers have reduced their net positions, necessarily non-hedgers–including CTAs–must have reduced their net positions.

Hedging has indeed declined. In the oil market, much (if not most) producer hedging is via the swaps market rather than direct producer participation in the futures market. Banks buy swaps from producers, and then hedge their exposure by selling futures. Here is a chart of net Producer and Merchant Plus Swap Dealer exposure from the CFTC COT data:

Note that there was a big increase in hedging activity (by this measure) in 2017-2018 that was reversed, followed by a partial resurgence, but in the last couple of years hedging activity has indeed ebbed, and reverted to its 2016 levels.

But note that this pattern of hedging mirrors closely Managed Money net positions. As is necessarily the case. If there is less hedging, speculators necessarily hold smaller positions. Meaning that this statement is nonsensical:

The recent wave of dealmaking by US oil producers threatens to further accelerate the decline in hedging. And it’s highly likely that CTAs will continue to fill the vacuum left by those traditional market players.

It’s not as if CTAs–or speculators generally–are “fill[ing] a vacuum.” If hedgers reduce positions, speculators do too.

The Bloomberg writers may dimly glimpse the truth, though they don’t realize it.

How did CTAs come to become so dominant? Like many current phenomena, the answer starts in the depths of the pandemic.

As shutdowns engulfed the world in 2020, fuel consumption collapsed by more than a quarter. All hell broke loose in the crude market. The benchmark US oil price briefly dropped to minus $40 a barrel and investors were in wholly new territory. Some funds that took longer-term views based on supply-and-demand fundamentals quickly pulled out.

Such bear markets proved to be “extinction events” for traditional funds, which made way “for algo supremacy,” the bulk of which are CTAs, said Daniel Ghali, senior commodity strategist at TD Securities. Russia’s invasion of Ukraine gave the CTAs another foothold. Spiking volatility in the futures market drove many remaining traditional investors to the exits, and open interest in the main oil contracts tumbled to a six-year low.

So if CTAs have indeed become more prevalent, it is because they have supplanted other speculators who exited the market. Futures are risk transfer markets. If some of those who previously took on the risk from hedgers have exited the market, either hedgers must hedge less or other speculators must step in. It seems that both things have been happening.

That’s not some ominous development–it’s markets at work. And CTAs shouldn’t be damned–they should be praised for stepping into the breach.

And another paragraph in the Bloomberg article suggests at what is actually happening here:

The unpredictability of this year’s market swings haven’t been kind to human traders, many of whom are making less money on oil than they did last year when they raked in record gains, according to market participants.

What is likely driving this story is whinging by the traditional specs, who have been outcompeted by the bots. “No fair! They are making money and I’m not! They must be cheating.”

Reminds me of my epigram from my manipulation book, where riffing on Ambrose Bierce’s Devil’s Dictionary I wrote something to the effect that a market is manipulated when it moves against me.

Again, this is markets at work. The fact that bots are doing well relatively to trad specs means that they are better at predicting market movements, or have lower costs of bearing risk, or both.

It does not mean that they are making the markets move.

So this Terminator Tackles the Oil Market narrative is really nothing more than Luddism. A new technology outcompetes the old. The incumbents complain. End of story.

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November 15, 2023

Gary Gensler: From Igor to Frankenstein

Filed under: Clearing,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 4:53 pm

Gary Gensler has been a menace to the market system for as long as he has been in government. Those of you who have followed this blog for a long time know that I relentlessly criticized him during his tenure as CFTC chairman. He apparently took notice, because he banned me from the CFTC building. I also consider it extremely likely that he was the moving force behind the 2013 NYT supposed hit piece on me–for which I should probably thank him, because on net that has turned out to be a major positive.

Gary Gensler. (Though this is how I like to think of him.)

At CFTC, Gensler was merely an Igor implementing the Frankendodd creation of his congressional masters. As head of the SEC, however, Gensler has become a full-fledged Dr. Frankenstein, stitching together regulatory monsters that threaten to stalk the landscape leaving economic devastation in their path.

I have already written several times about the SEC’s misguided Treasury clearing mandate. But that is only one of Gensler’s Monsters. There are many others.

Perhaps the most monstrous is the SEC’s proposed rule on climate-related disclosures. This would mandate that public companies disclose their carbon emissions–and those of their suppliers. This is at best vast speculative endeavor, and and worst an impossibility. It’s main concrete effect will be to provide a pretext for lawsuits against companies targeted by activists who will allege that the companies’ calculations were wrong, or were lies because alternative internal calculations came up with numbers that differed from those reported in their 10Ks.

The regulation would also require companies to make fulsome disclosures of their climate risks. Another speculative endeavor that cannot produce any meaningful or useful information. It requires each company to characterize the interaction between one complex system–climate–and another complex system–the economy–to predict the adverse consequences of this interaction for it, a small part of the economic system allegedly impacted by climate. Prognostications about climate are themselves wildly uncertain–indeed, arguably the biggest risk is model risk. Predicting how climate will impact economic outcomes at the company level under myriad possible climate scenarios is a mug’s game.

And indeed, it is even worse than that. For there is another element to the problem–government policy. This introduces an element of reflexivity that is particularly devilish. Government policy will respond to climate and economic outcomes as well as interest group pressure, and will affect economic outcomes (though whether these policies will actually affect climate outcomes is dubious). This is arguably by far the biggest risk that companies face.

Meaning that if the regulation comes into force, I recommend the following boilerplate disclosure for all companies: “We face the risk that some government agency will adopt a boneheaded policy that will dramatically raise our cost of doing business or eliminate the markets we service.”

This will also be a boon to lawyers. “Company X failed to disclose the risk associated with [insert climate scenario here] described in [poorly executed paper published in obscure journal].”

I could go on. But in Congressional testimony John Cochrane did a lot of the heavy lifting for me, so I direct you there.

And I ask: how will this information improve the allocation of capital? It is more likely that this will just add noise that impedes efficient capital allocation, rather than actionable information that improves it. The hive mind of investors is likely far more adept at evaluating the effects of the climate-economics-policy nexus than the managers of corporations.

I further note that this obligation’s burdens are greater for small companies than big ones. Meaning that it will likely lead to exit and consolidation, and greater concentration. Which other parts of this administration–notably Lina Khan’s FTC–think is a great evil. Ironic, that. Ironic, but not humorously so.

Moving right along, the trendy Gary has targeted the New Thing, Artificial Intelligence. In public statements Gensler has made the at least somewhat plausible argument that interactions between very similar AIs can produce destabilizing positive feedback mechanisms. But the SEC’s proposed AI regulation instead focuses on potential agency problems:

Today’s predictive data analytics models provide an increasing ability to make predictions about each of us as individuals. This raises possibilities that conflicts may arise to the extent that advisers or brokers are optimizing to place their interests ahead of their investors’ interests. When offering advice or recommendations, firms are obligated to eliminate or otherwise address any conflicts of interest and not put their own interests ahead of their investors’ interests. I believe that, if adopted, these rules would help protect investors from conflicts of interest — and require that, regardless of the technology used, firms meet their obligations not to place their own interests ahead of investors’ interests.”

The SEC remedy for this litany of horrors?

But under the guise of minimizing conflicts of interest, the SEC now proposes requiring advisers and broker-dealers to write new internal procedures and to log all uses of technologies relating to predictive data analytics for agency review. If left unchallenged, the new rules would hamper the American financial industry’s world-beating innovation.

The definition of what must be disclosed is comprehensive:

“an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes in an investor interaction.” 

This would basically encompass EVERY analytical function performed by covered entities, including e.g., quant traders’ algorithms, portfolio optimizers, and on and on and on. Basically any use of statistical methods is implicated (note the reference to “correlation matrix”).

Perhaps the “investor interaction” language will limit this to principle-agent applications (as bad as that would be), but it is so broad that it is highly likely that the SEC will interpret it to cover, say, an HFT firms algorithms to predict and analyze order flows. That involves “an investor interaction.”

This all brings to mind previous regulatory initiatives to require disclosure of all trading algorithms–something that was mercifully killed.

And what will the SEC do with this information? This would represent a massive amount of highly technical information that the SEC would not have the capacity or expertise to analyze proactively, and information that would metastasize inexorably. Hell, even storing the information would be a challenge.

Again, like the climate reg, this seems all pain no gain. This disclosure would entail massive cost. And for what? To find an agency violation needle in a massive informational haystack? Agency violations (such as trading ahead) that could not be detected using existing methods?

But that’s not all!

Gensler also looks askance at exchange volume discounts. Why? Because NO FAIR:

“Currently, the playing field upon which broker-dealers compete is unlevel,” said SEC Chair Gary Gensler. “Through volume-based transaction pricing, mid-sized and smaller broker-dealers effectively pay higher fees than larger brokers to trade on most exchanges. We have heard from a number of market participants that volume-based transaction pricing along with related market practices raise concerns about competition in the markets. I am pleased to support this proposal because it will elicit important public feedback on how the Commission can best promote competition amongst equity market participants.”

Volume discounts are obviously pervasive throughout the economy in the US and indeed the world. So why should these be somehow so nefarious in stock trading as to require their elimination?

Let’s apply some economics–which alas is an alien concept to Gensler. There are two basic reasons for volume discounts.

One is that it is cheaper to service bigger customers. In which case volume discounts are efficient, and banning them would be unambiguously bad.

Another is that it is a form of price discrimination. For example, big intermediaries may find it easier/cheaper to shift business between exchanges than smaller intermediaries, in which case their demand for the services of a particular exchange would be more elastic than the demand of the smaller firms. Exchanges would then rationally charge lower prices to the more elastic demanders.

The welfare effects of this type of price discrimination are ambiguous, making the case for banning it–even if it can be established that the volume discounts are demand-elasticity-driven discrimination vs. cost-based discrimination–ambiguous as well.

With respect to “concerns about competition,” well, elasticity-based discrimination requires that inter-exchange competition not be perfect in the textbook sense. But if that is what is driving the volume discounts, outlawing them treats a symptom of market power rather than market power itself, and how “imperfectly competing” exchanges will price when they can’t price discriminate is very much an open question–and exactly why the welfare effects of price discrimination are ambiguous.

Gensler seems to be channeling discredited Robinson-Patman like logic that protected the high cost against competition from the low cost. That is anti-competitive, not pro-competitive.

These are only some of the monsters the Frankensteinian Gensler is assembling in his DC laboratory. I could go on, but you get the idea.

There is hope, however. Whereas Gensler’s CFTC actions were largely rooted directly in very specific statutory directives, his work as Dr. Frankenstein is based on extremely expansive interpretations of the SEC’s statutory authority dating back to the 1930s. Such expansive interpretations–not just by the SEC, but many other agencies–are currently being challenged in the courts, including cases pending before the Supreme Court.

It is possible therefore, and indeed to be fervently hoped, that the Supreme Court will hand down decisions that demote Gensler back to Igor implementing very specific Congressional mandates, and end his career as regulatory Frankenstein.

And the benefits of such decisions would extend beyond reining in the SEC, for as bad as it is that agency is probably not the worst offender–the EPA probably is, but the competition for this dubious honor is intense. The administrative state–the American Mandarinate, as I like to think about it–needs to be culled. And with extreme prejudice, and as soon as possible.

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November 3, 2023

Treasury Clearing Mandates: Rearranging the Market Structure Furniture on the Deck of SS Treasury Titanic Is Pointless

Filed under: Clearing,CoronaCrisis,Economics,Exchanges,Politics,Regulation — cpirrong @ 3:29 pm

The market for United States Treasury securities (notes and bonds) has been a source of concern for some years, dating back to the Treasury “flash” event of 15 October 2014, but especially in the aftermath of the “dash for cash” during the March 2020 Covid scare. The relentless selloff of Treasuries in the past year plus has contributed to the angst.

This has led the SEC to propose various changes to the structure of the Treasury market. The most important of these is mandated central clearing of most Treasury cash trades and repos. Well, since Gigi is back in the clearing saddle, I guess I have to mount up too.

The main justifications of the mandate come from Darrell Duffie and various collaborators at the New York Fed (notably Michael Fleming). The IMF has also produced an analysis outlining justifications of the mandating of clearing.

Just as with the Frankendodd clearing mandates, the case for Treasury clearing is very weak.

The basic argument is that Treasury market liquidity has eroded, and that clearing will enhance market liquidity. The supposed main cause of the decline in liquidity is that primary dealers face balance sheet constraints that limit their ability to intermediate the Treasury market.

In the Duffie paper and the Duffie, Fleming et al paper he cites, the main evidence of the deleterious effects of balance sheet constraints comes from the “dash for cash” in March 2020. Summarizing a variety of measures of market liquidity using principal components analysis, they show that liquidity usually varies inversely with market volatility, but liquidity declined far more than predicted by volatility alone in 2020. This was due, it is claimed, to the fact that dealers were not able to increase their holdings of Treasuries due to balance sheet constraints. Their ability to make markets was therefore constrained.

There is a big problem with this analysis. Dealers ended up holding far more Treasuries because Covidmania caused a sharp drop in the demand to hold Treasuries by hedge funds and others–they wanted to substitute cash for Treasuries. Part of the demand drop was accommodated by a price decline, but evidently dealers’ demands did not drop as much as the demands of non-dealers: thus, there was a major portfolio adjustment, with hedge funds etc. reducing their holdings and dealers absorbing as much of these sales as their balance sheets allowed.

Thus, this was a structural change in demand that led to major portfolio adjustments. Yes, the portfolio adjustments were accompanied by a decline in conventional measures of liquidity (bid-ask spreads, depth, etc.) but this decline in liquidity was a consequence of the underlying shock, and clearing of cash Treasuries or repos would have had little, if any, impact on this decline. Even if clearing increased dealers’ balance sheet capacity (something I discuss further below), given the underlying Covid-driven (and Covid policy-driven) demand shock it is highly likely that this incremental capacity would have been fully utilized as well and liquidity would have been about as bad.

This extraordinary shock that led to strained dealer intermediation capacity is different than the types of shocks that dealers typically intermediate. The role of Treasury liquidity suppliers–be they dealers or prop trading firms–is the same as the role of liquidity suppliers in any other market, be it stocks or currencies or commodities: to utilize inventory adjustments (balance sheet) to absorb temporary, temporally uncorrelated, and largely cross-sectionally uncorrelated investor (buy side) demand shocks. The dash for cash was a long-lasting shock highly correlated across major investors in Treasuries. It was a systematic shock that led to a long lasting adjustment in dealer portfolios, whereas market makers absorb idiosyncratic shocks that do not require long lasting adjustments to dealer portfolios.

That is, the kind of portfolio adjustments that occurred in response to Covid were fundamentally different in nature from the kind of portfolio adjustments that firms undertake to make markets. A long term transfer of risk rather than a short term transfer.

Therefore, using the dash for cash as the basis for policies intended to improve Treasury market liquidity is fundamentally misguided.

Be that as it may, it provides the underlying logic advanced for clearing mandates: improving liquidity requires increasing dealer balance sheet capacity, and clearing can supposedly do that.

How can clearing improve balance sheet capacity? The mandate defenders offer that hardy perennial as a justification: netting. For both cash Treasuries and repos, the argument goes, netting out offsetting exposures reduces the amount of capital and cash that dealers require to intermediate. For cash transactions, Duffie, Fleming et al estimate that netting would reduce daily settlement volumes substantially (70 percent in March 2020 according to their figures). This, and other factors, allegedly result in freeing up of dealer balance sheet capacity.

This analysis begs an important question: since dealers would internalize the benefits of more economical use of balance sheets that would result from clearing, why is it necessary to mandate it? Why don’t dealers and other market participants voluntarily utilize clearing more extensively in order to economize on the use of a scarce resource–balance sheet? After all, historically voluntary adoption of clearing in the stock market (e.g., NYSE clearing and CBOT clearing in the 19th century) was specifically intended to reduce settlement volumes by netting. In the case of the CBOT, the clearinghouse netted payment obligations but did not mutualize credit risk on derivatives transactions or impose margins (which were negotiated bilaterally).

The alleged failure of profit-motivated entities to reduce cost (from inefficient use of balance sheets) suggest that this does not come for free: at the margin there must be some cost for clearing that is greater than the putative benefit. That is, profit maximizers will balance marginal private benefits and marginal private costs. The benefits of netting from clearing are private, and thus the current degree of penetration in clearing likely reflects an efficient balancing of these marginal benefits and costs. The advocates of a mandate surely have not shown otherwise.

I further note that, as I wrote repeatedly during the Frankendodd era, netting redistributes default risk rather than reduces it. It is by no means clear that the distribution of default risk under central clearing/netting is more efficient than that under bilateral clearing.

Put differently, the advocates of clearing (both cash and repo) have not identified a “market failure”, e.g., a benefit from clearing that market participants do not internalize. Such a failure is a necessary (but not sufficient) condition for regulatory intervention such as a clearing mandate.

With respect to repo clearing, another supposed benefit is the disparity of margins (“haircuts”) in the repo market. Haircuts for some counterparties are low, but for others they are higher. Central clearing would impose uniform, value-at-risk (“VaR”)-based margins.

The operative theory behind central clearing is that the “loser pays”, namely the resources (margin, default fund contribution) posted by a counterparty is sufficient to cover any losses in the event of that counterparty’s default. Ideally, counterparty credit risk in central clearing is zero, though in reality some always remains.

Well, this begs another question: is the optimal amount of counterparty credit risk/default risk zero (or close to zero) in all transactions? Relatedly, is it optimal not to permit the pricing of counterparty credit risk, where the price varies by the creditworthiness of counterparties, with high credit quality entities paying smaller haircuts than lower quality credits? Central clearing makes pricing independent of creditworthiness, whereas bilateral arrangements that advocates of clearing dislike allow pricing of credit risk that reflects assessments of creditworthiness of counterparties.

Since credit risk mitigants (including margins/haircuts) are costly, and since market participants trade-off the costs and benefits of credit risk and its mitigants, allowing choice and competition on this dimension has strong justifications. Certainly the advocates of mandatory Treasury clearing have not identified a “failure” in this market that justifies regulatory intervention in the form of clearing mandates.

Put differently, clearing mandates force market participants to a corner solution–clear everything, and impose margins that make counterparty credit risk de minimis. The existing state of the market, where market participants can choose to clear with a CCP or not, reveals that they strongly do not prefer the corner solution. Furthermore, the advocates of clearing have failed to identify any market failure that implies that the interior solution/equilibrium is inefficient and can be improved by mandating the corner solution.

And the advocates have yet again failed to recognize the trade-off inherent in clearing: that is, the trade-off between counterparty credit risk and liquidity risk. This despite the fact that the reality of this trade-off has been made abundantly clear (no pun intended) repeatedly in the past–and including in particular the Treasury market basis trade turmoil during the dash for cash.

The real issue in Treasury markets right now, and the real threat to their stability, is the massive deficits in the United States, and the resultant increase in Treasury security issuance and Treasury securities outstanding. It is deficits and issuance that are driving the massive increase in the size of Treasury markets, and the consequent strains on the ability of dealers and others to intermediate the swollen market.

This is a challenge that no rearranging the market structure furniture on the deck of SS Treasury Titanic will fix. Furthermore, the economic case for mandating clearing of Treasury cash and repo transactions is laughably weak even if one overlooks that fact that clearing does not get at the real problem. But it appears that Gigi (cheered on by the Fed) will mandate a corner solution that makes the market less efficient, not more.

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October 16, 2023

Alfred E. Goldman

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — cpirrong @ 12:52 pm

In March, 2020 the Federal Reserve injected massive amounts of liquidity into the markets in response to a blow-up in Treasury basis trades. I wrote about it here.

In recent weeks, the Fed, the BIS, and the BoE have raised red flags about the renaissance of this trade and the resulting potential for systemic risk a la 2020. Not all are convinced. Goldman Sachs in particular is in Alfred E. Neuman mode: What? Me worry?

FT Alphaville quotes Goldman’s rates strategy team as follows:

We do not think the trade poses a major risk to Treasury markets in the near term . . . Leverage in the system is materially lower than it was in 2019/20 as a result of a series of [initial margin] increases (and price declines). The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.

This assessment is based on a fundamental error that I went on about ad nauseam in the post-Great Financial Crisis clearing debate, specifically, concluding that if leverage goes down in one part of the system it goes down systemically. Wrong. Wrong. Wrong.

Yes, the ostensible purpose of higher margins is to reduce leverage in the margined trades. But especially for the hedge funds and other sophisticated entities who engage in the Treasury basis trade at scale, they can substitute one form of leverage for another.

As a first approximation, a fund has a leverage target or a level of debt capacity, it can fund the higher margin in the less leveraged futures trade by increasing leverage elsewhere. The funds will typically evaluate leverage holistically, not on a trade-by-trade basis.

It is therefore fundamentally logically flawed to conclude that “leverage in the system” (which is in fact source of systemic risk) has declined because it has gone down in one piece of it.

If there are constraints on funds’ ability to offset mandated leverage reductions in one type of trade by increasing leverage elsewhere, that would increase the cost of engaging in that type of trade and would impact the scale of that trade. But what has alarmed the central bankers is exactly that the scale of the trade has increased and now exceeds its 2020 level:

Note that leveraged funds’ Treasury futures shorts are currently substantially larger now than in 2020. Thus, despite higher margins, the scale of the trade is subsantially larger–and it is the scale–and the concentration–of the trade that poses systemic risks.

This bigger scale could be because raising margins doesn’t really constrain the ability of funds to lever up to engage in basis trades. Or it could be that even though the higher margins raise the cost of the trade, the spread has widened sufficiently to offset, or more than offset the higher cost. For example, constraints on dealer balance sheets that impair liquidity in the cash market could depress cash prices relative to futures prices.

Goldman’s errors don’t end there. One thing that could spark a margin spiral is an increase in initial margins that induces mass liquidations that lead to changes in the basis that lead to large variation margin obligations–something that Goldman doesn’t mention.

Alfred E. chimes in again here: “The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.” That is, Goldman’s conclusion is essentially based on a very benign view on Treasury volatility.

There are myriad reasons to take a different view. The US’s acute fiscal situation and the accompanying periodic debt limit dramas. The constrained balance sheets of dealers that limit their ability to supply liquidity to the Treasury market. The prospect for an extremely chaotic election year. And geopolitics, with now two major disturbances ongoing (Ukraine and Israel/Gaza) with one continually on the boil in the background (China/Taiwan). And highly unsettled geopolitics with a feckless and befuddled administration at the tiller.

That is, it isn’t the level of margins that really matters. It is the possibility that margins may increase due to higher volatility. Goldman/Neuman isn’t worried. I think that’s unduly optimistic. Furthermore, an assessment of systemic risk must be based on the likelihood that Goldman’s don’t-worry-be-happy opinion is wrong.

And remind me: did Goldman predict the increase in Treasury volatility in 2019 or 2020? Stuff happens. Unknowns and unknowns and all that.

Furthermore, higher volatility->higher IM->liquidation of basis positions->margin spiral isn’t the only potential source of systemic risk. Other economic shocks can cause leveraged funds to slash positions and leverage, leading to liquidations of basis positions and the triggering of a margin cascade. That is, there is the possibility of fire sales.

These shocks can be systematic–a broad decline in stock or bond markets–or concentrated at a few funds, or even one, due to bad trades in other markets.

The 30 25 year anniversary last month of the LTCM collapse brings the latter to mind. Bad bets on convergence trades forced LTCM to liquidate and delever. Understandably, it attempted to unload its most liquid positions–including short Treasury futures. Treasuries had a massive rally on LTCM day that was not matched by a similar rally in the underlying, less risky Treasuries.

A squeeze–not unheard of in government debt futures markets–can also impose losses on basis trades, leading to liquidations that can exacerbate the price impact. Or a Treasury flash crash (in yields, and hence a flash spike in prices) like on 15 October 2014.

In sum, size does matter. Basis trades have become big again, and the factors that lead Goldman to parrot Alfred E. Neuman are hardly persuasive. From a systemic risk perspective, basis trades represent dry tinder that can explode into flame. Can does not mean will. But the possibility is there, and the effect if the right spark hits the tinder depends on the size of trade. The big scale and concentration of this trade thereby justify far more concern than Goldman expresses.

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October 8, 2023

Michael Lewis Jumps the Shark, Which Is Too Bad, Because In a Just World He’d Fall and Get Eaten

Filed under: Blockchain,Cryptocurrency,Economics,Exchanges — cpirrong @ 6:31 pm

Michael Lewis is out with a book on Sam Bankman-Fried and FTX–just in time for SBF’s trial! What great timing!

I am sure that when Lewis started the project, he did not anticipate that he would have to use the trial of the person whom he had intended to be the hero of his story to turn the FTX lemon into marketing lemonade. But so he has.

Lewis was interviewed by 60 Minutes Last week, where he offered this gem:

This isn’t a Ponzi scheme. In this case, they actually had a great, real business. If no one had ever cast aspersions on the business, if there hadn’t been a run on customer deposits, they’d still be sitting there making tons of money.

Other than that, how was the play, Mrs. Lincoln? Or, if it wasn’t for that damned Russian winter Napoleon’s descendants would still be ruling France!

Where to begin? First, Ponzi schemes are not the only form of financial fraud so by rejecting that FTX was a Ponzi he does not prove it was not a fraud. Second, and more importantly, this begs the question of why there was a run. Did the customers just decide to run on a whim? Or maybe it was sunspots (a la last year’s Nobel winners Diamond and Dybvig)!

Yeah, sunspots, that’s it. Other than that, SBF would be sitting fat and happy. (Though mainly fat–he’s lost weight in the pokey.)

Uhm, no, actually, aberrations in the sunspot cycle didn’t spark a collective frenzy by depositors. The simple fact is that SBF was using customer monies for all sorts of purposes, ranging from funding a lavish lifestyle for himself (and his loathsome parents) to covering losses at the FTX-affiliated hedge fund (the very existence of which should have been the first red flag). The “aspersions” cast upon “the business” were basically factual revelations that “the business” was a financial disaster that used customer monies in violation of laws, duties, customs, and promises.

In other words, there was a run for the reason that there are usually runs: the customers of an entity operating on first-come, first-serve basis learned that said entity was financially suspect. Get your money, and let the devil take the hindmost.

And as for “great real business”–apparently not only did Michael Lewis drink deep from the crypto Kool Aid, he’s still binging on it. There were numerous reasons to be skeptical about crypto since it began (and I expressed skepticism from virtually the time of its emergence about a decade ago), and the dubiousness of the entire endeavor has only deepened. To claim that crypto exchanges were viable businesses that would make “tons of money” on an ongoing basis is utterly delusional.

The simple fact is that Michael Lewis is a deeply, deeply, deeply compromised narrator here. He was “embedded” in FTX for months. He had unparalleled access to the chubby wunderkind. And then the whole thing imploded in scandal.

Meaning that Michael Lewis has to–has to–make his would-be hero SBF a tragic one, wrongly and unjustly brought down by powers beyond his control. For consider the alternatives.

The first is that Michael Lewis had a front row seat to a massive fraud, and that he–the alleged eagle eyed chronicler of the corruption, shenanigans, misdeeds, and absurdities of mainstream finance (investment banks, the stock market, etc.)–missed what was going on in front of his very eyes.

The second is that Lewis knew something was wrong, or at least suspected it, and remained silent.

The first alternative would be a major blow to Lewis’ credibility and reputation. The second would basically make him an accessory to a major crime.

To escape this dilemma, Lewis must insist–and demand that you believe him, and not your lyin’ eyes–that there was nothing wrong at FTX. Indeed, everything was right at FTX, except shit happened. Or something. Given his massive conflict of interest, Lewis’ arguments are utterly untrustworthy, and smacking of special pleading.

I have heard it said that SBF fooled a lot of people, so you need to cut Lewis some slack. Uhm, no. If your whole shtick is your financial gnosticism, your unique ability to perceive and interpret the greedy, grubby, self-interested behavior of financial market denizens, “I wuz fooled just like everybody else” doesn’t cut it when a greedy, grubby, self-interested shlub ran his scheme in front of your very nose.

It is quite clear what has happened here. Lewis’ well-worn–but quite lucrative–MO is to pick out some misfit hero or heroes fighting against the financial Man, and make him/her/them the protagonist of a just so story. Misfit David vs. Goliath.

SBF was to all appearances a gift to Lewis from the literary Gods. Crypto was the vanguard in a supposed revolution against the traditional financial system and institutions that Lewis had inveighed against for years. SBF fit the quirky misfit role to a “T.” He also talked in lofty phrases about his effective altruism, his lack of personal financial motivation, and his desire to use the wealth generated by his genius to make the world a better place.

It had the makings of the Michael Lewis book to top all Michael Lewis books, and SBF to be the hero of all Michael Lewis heroes.

And then it all went horribly, horribly wrong.

So what’s Michael Lewis to do? Since the elites (which includes Michael Lewis) don’t do mea culpas, let alone retire to a monastery, the only thing he could do–spin like a dreidel.

It is immensely amusing to me that Lewis clearly doesn’t understand the fundamental absurdity of his arguments. If you are really a crypto true believer, which Lewis clearly is, it is because you believe that a trust-based financial system is fundamentally flawed, and that trustless crypto is the answer. But Lewis also argues that FTX’s “great real [crypto] business” failed due to an irrational loss of trust. Both of those things cannot be true.

So Lewis has jumped the shark here. But due to his spinning, and his existing reputation, it is quite likely that’s a bad thing–but only because it means that the shark won’t eat him, as would be a just outcome.

I criticized Lewis’ Flash Boys when it came out 9+ years ago, so I have been a skeptic for a long time. But I have nothing on Scott Locklin, who wrote this in the immediate aftermath of the FTX implosion (and who also ridiculed Lewis’ Flash Boys). Locklin makes me look like a milquetoast. Definitely worth a read

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September 28, 2023

Come On Down! And Will the Last Business in Chicago Turn Off the Lights? Thanks.

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 4:50 pm

Texas governor Greg Abbot has extended an invitation to the CME Group to relocate from Chicago to Texas. The exchange group may well be moveable because the city’s new mayor, Let’s Go Brandon Johnson, has mooted a $1 or $2 per transaction tax on futures, options, and securities transactions in order to fill the city’s gaping fiscal hole–despite the fact that this is currently illegal under Illinois law.

Now you might not think that a buck is a big deal, given that a T-note or crude oil contract has a nominal value of around $100 grand. But it is a big increment to the cost of executing a contract. For example, the bid-ask on a crude oil futures trade is usually about $10, and the brokerage commission adds on only a few bucks. So the tax would increase transactions costs on the order of 5 or 10 percent.

I note that the industry fought for years at efforts to impose a 15 cent futures transaction tax. What Johnson is proposing is substantially greater than that.

Now, if Johnson’s objective was actually to raise revenue, this would be an incredibly stupid idea. Rule one of taxation: tax what can’t move. Although in the floor days uprooting the exchange and taking it outside the city or the state would have been very difficult, that’s not the case in the electronic era.

Have servers, will travel. Yes, CME Group (and CBOE–which given recent developments might end up in CME) has corporate employees there, but if any city should understand that is no impediment to relocation, Chicago should given the exodus of several major corporate HQs from the Chicago area in recent years–Caterpillar, Boeing, and Tyson Foods being prominent examples.

Moreover, even before the CME says hasta la vista motherfuckers, it faces competition in some of its products from ICE, and a tax would shift business there.

Numerous trading firms (notably Citadel) have fled Chicago for reasons–namely the marked decay of the city. (And I do mean marked: even in the last two years the decline has accelerated dramatically.) The CME has certainly already put those factors on the scale when making its decision, and a sizable transaction tax would almost certainly tip the balance heavily in favor of joining the exodus.

Notice that I framed my analysis as a conditional statement: if Johnson’s objective was actually to raise revenue. One cannot be too sure these days. Mayors of city after city have taken actions, or failed to take actions, that seem designed to drive out all but the underclass and turn the polities they govern (I use the term loosely) into crime-ridden, drug infested wastelands. In fact, it’s hard to name a big city whose elected officials haven’t done that or aren’t doing it.

American Spectator writer Scott McKay calls it “weaponized government failure:” “deliberate refusal to perform the basic tasks of urban governance for a specific political purpose.” The “specific political purpose” being to drive out middle class voters who pose the main political threat to the Brandon Johnsons and their ilk.

Framed as a hypothesis, I’m hard pressed to come up with contrary evidence.

Whether that’s the true purpose behind Johnson’s transaction tax brainwave, if he moves forward with it it’s a near lock that CME will hit the road. An electronic exchange is footloose and fancy free and not beholden to any place. Where once there were “locals” whose physical presence was necessary to operate an exchange, there are now what may be called “globals” who can and do supply liquidity from anywhere.

And if it moves, Texas is a good place. No income tax for one thing. Reasonable housing costs. And as for the weather, as I told my late mom when she fought coming here: “Look, you spent four months a years indoors in Chicago. You’ll spend four months a year indoors in Houston. Just different months.”

So come on down, Terry Duffy. I’ll be here to greet you. With bells on.

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May 30, 2023

I Sorta Agree With Jerome Powell and Gary Genlser on Something: Sign of the Impending Apocalypse?

Filed under: Clearing,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 1:00 pm

The Fed and the SEC have expressed concerns about Treasury “basis trades” wherein a firm purchases a cash Treasury security funded by repo-ing it out and sells Treasury futures. Their concern is somewhat justified. As mentioned in the linked article, and analyzed in detail in my paper in the Journal of Applied Corporate Finance (“Apocalypse Averted“) the spike in the cash-futures Treasury basis caused by COVID (or more accurately, the policy response to COVID) caused a liquidity crisis. The sharp basis change led to big margin calls (thereby creating a demand for liquidity) and also set off a feedback loop: the unwinding of positions exacerbated the basis shock, and thereby reinforced the liquidity shock.

This is just an example of the inherent systemic risk created by margining, collateralization, and leverage. The issue is not a particular trade per se–it is an inherent feature of a large swathe of trades and instruments. What made the basis trade a big issue in March 2020 was its magnitude. And per the article, it has become big again.

This is not a surprise. Treasuries are a big market, and leveraging a small arb pickup is what hedge funds and other speculators do. It is a picking-up-nickels-in-front-of-a-steamroller kind of trade. It’s usually modestly profitable, but when it goes bad, it goes really bad.

All that said, the article is full of typical harum-scarum. It says the trade is “opaque and risky.” I just discussed the risks, and its not particularly opaque. That is, the “shadowy” of the title is an exaggeration. It has been a well-known part of the Treasury market since Treasury futures were born. Hell, there’s a book about it: first edition in 1989.

Although GiGi is not wrong that basis trades can pose a systemic risk, he too engages in harum-scarum, and flogs his usual nostrums–which ironically could make the situation worse:

“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.

Zero margin? Really? Is there anyone–especially a hedge fund–that can repo Treasuries with zero haircut? (A haircut–borrowing say $99 on $100 in collateral is effectively margin). And how exactly do you trade Treasury futures without a margin?

As for nostrums, “The SEC has been seeking to push more hedge-fund Treasury trades into central clearinghouses.” Er, that would exacerbate the problem, not mitigate it.

Recall that it was the increase in margins and variation margins on Treasury futures, and the increased haircuts on Treasuries, that generated the liquidity shock that the Fed addressed by a massive increase in liquidity supply–the overhang of which lasted beyond the immediate crisis and laid the groundwork for both the inflationary surge and the problems at banks like SVB.

Central clearing of cash Treasuries layers on another potential source of liquidity demand–and liquidity demand shocks. That increases the potential for systemic shocks, rather than reduces it.

In other words, even after all these years, GiGi hasn’t grasped the systemic risks inherent in clearing, and still sees it as a systemic risk panacea.

In other words, even though I agree with Gensler (and the Fed) that basis trades are a source of systemic risk that warrant watching, I disagree enough with GiGi on this issue that the apocalypse that could result from our complete agreement on anything will be averted–without the intervention of the Fed.

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