Streetwise Professor

On the anniversary of the passage of Frankendodd, I named the swaps execution facility mandate as the Worst of Frankendodd.  There was intense competition for the honor, to be sure, but I stand by that conclusion.

Gary Gensler sortied into enemy territory at the ISDA AGM in Chicago to do his best to defend the worst.  My verdict (based on press coverage): #Fail.

Interestingly, although Gensler used to focus (wrongheadedly) on the supposed competitive benefits of a SEF mandate, in Chicago he tried to portray it as a bulwark against systemic risk:

“Transparency to the public lowers the risk [for] clearinghouses,” he told the conference.

“Clearinghouses can only survive if they have reliable pricing feeds on a daily basis to mark to market their positions, and also have reliable, liquid markets in default scenarios,” Gensler said.

“There is far less risk in a clearinghouse if you have both pre-trade transparency and post-trade transparency.”

Dealers have criticised the move to electronic execution of OTC derivatives, complaining the large size and small volume of trades means such rules are inappropriate for the market.

This is clearly-no pun intended-incorrect, particularly when viewed in the context of Gensler’s desire for extensive pre-trade transparency and near real time reporting of trades.

CCPs will obtain the prices of deals cleared through them, that they can use to determine marks on a periodic basis.  Moreover, they have access to information from member firms that will permit marking deals to market.

Pre-trade transparency is particularly irrelevant in this context.

And Gensler is positively delusional if he thinks that the pre- and post-trade transparency is going to ensure “reliable and liquid markets” in default scenarios-especially if those scenarios involve the default of a systemically important clearing member.   Note that even for normally listed, exchange traded products CME used an auction procedure, rather than normal trading protocols, to handle the Lehman default.  Also note that LCH was able to handle the Lehman IRS portfolio default in a pretty effective and orderly way even without mandated centralized trading.

Gensler appears to believe that OTC derivatives markets, even for cleared products, will be like exchange trade futures.  Hardly.  One size does not fit all.  The nature of the transactions, the transactors, and the products is very different.  That’s why there are different markets and different market structures: the different structures are discriminating ways of accommodating the diversity of trades and traders. Market structures are endogenous, and reflect the characteristics of trades and traders, a point that is lost on Gensler and all too many others.

Indeed, the biggest problem that CCPs will not be obtaining price information on fairly active products, even if those products trade without pre-trade or post-trade transparency: even without SEFs, it will be relatively easy to mark 10 year USD IRS or active credit indices to market.  The problem will be obtaining information on the value of the products that don’t trade.  Gensler apparently believes in the Field of Dreams Theory: if you build a SEF, the trades-and bids and offers-will come, for everything.

No, actually.  Many products traded OTC do not trade frequently.  That’s a major reason why a dealer market structure rather than a centralized auction market structure, predominates there.  Moreover, the life cycle of trading activity in OTC and listed products is quite different.  Exchange traded products start out illiquid, and if they become liquid at all, become progressively more liquid as their maturity/time to expiry declines.  With OTC products, the cycle is the reverse.  Five year and 10 year swaps are quite active and liquid, and a lot of deals are done.  Those deals live on, and the 10 year swap becomes a 9 year swap and then an 8 year swap, and so on, and these products are far less liquid than the benchmark maturities.  You can have all the SEFs in the world, and 3.35 year swaps ain’t going to be trading, and won’t even be bid or offered.  Meaning that it SEFs will matter exactly bupkus for such products.

What’s more, mandated pre- and post-trade disclosure has costs  (mainly in the form of lower liquidity as disclosure of trades and price information raises risks to liquidity suppliers, inducing them to supply less), and these costs will vary by product.  Again, one-size-fits-all is misguided in the extreme.  Gensler dismisses these costs, and pays even less attention to the heterogeneity of products and transactions.

ISDA has pretty much acquiesced to most of the clearing-related rules, but is still fighting hard against the SEF mandate:

A theme of the ISDA conference, which includes large dealers as well as users of derivatives, is that while central clearing reduces systemic risk, regulators should not impose new rules on how derivatives trade, because it could disrupt those established markets and reduce trading volumes.

“Listed and over-the-counter markets are completely different, and it’s important that lawmakers and regulators keep this in mind,” said [ISDA Chairman and Morgan Stanley’s head of Global OTC Clearing Stephen] O’Connor,

He added that the industry was open to more public reporting, but with restrictions such as not revealing the size of very large trades or delaying trade reporting. “We’re not anti-public reporting,” he said.

I agree with O’Connor, but you might say “but he’s biased and protecting the dealers’ gravy train.”  Fine.  But interestingly, a supposed beneficiary of what Gensler wants so badly, isn’t sold on the idea:

Michael Davie, head of LCH.Clearnet’s SwapClear platform, agreed that regulators, clearers and market participants must know what is going on, but public reporting isn’t essential.

As I’ve argued ad nauseum, regulators will know what is going (in terms of positions and trades) due to swap data repositories.  As Davie says, public trade reporting-particularly in near real time-isn’t important for CCPs to do what they need to do.  And as I state above, public reporting of trades won’t help CCPs at all if there are no trades.

No, Gary.  SEF mandates are still the Worst of Dodd-Frank.  And slathering on the systemic risk lipstick won’t make that pig any more attractive.

A quick comment about the ISDA AGM.  A perusal of the press coverage is fascinating.  Virtually every issue-every damn one-that is the subject of intense debate at the AGM was raised here on SWP, or in my academic writing years ago.  Going back to 2008-2009, and sometimes to the late-90s (obviously pre-SWP, but not pre-Pirrong clearing research).  That old Cassandra feeling is particularly powerful right now.  I was invited to participate in the meetings, but had to decline due to another commitment, which alas did not materialize due to the vagaries of court scheduling.  (No! I am not on trial!  Sorry to disappoint some of you.) It would have been a fascinating experience.

The Commodity Futures Modernization Act has been demonized as a major contributor to the financial crisis-unfairly in my view. This view is ahistorical, and fails to understand what led up to its passage.  In brief, the evolution of derivatives markets, and particularly the growth of the swaps market in the 1980s and 1990s created legal and economic challenges that the Commodity Exchange Act, dating from 1922 with a major modification in 1936, was completely unable to handle.  The CEA was passed at a time where “off exchange” transactions meant $10 bets at bucket shops, not huge deals between major banks and corporations.  The categories of market participants and the kinds of derivatives traded that Congress had in mind when drafting this legislation were vastly different from those developed during the wave of financial innovation that began in earnest in the early-1970s. As a result, by the mid-1980s, and certainly by the 1990s, the regulatory framework in place was completely ill-adapted to market conditions.

In particular, the exchange trading requirement of the CEA constrained the ability of market participants to undertake mutually beneficial transactions.  Those entering into perfectly sensible OTC deals risked running afoul of the requirement, which put their transactions at considerable legal risk.  The CFTC responded to this situation by issuing a variety of interpretative statements and no action letters and exemptions that were intended to give relief to these transactions.  Soon a confusing thicket of ambiguous and often contradictory rulings, exemptions, no action letters and interpretations grew up around OTC derivatives trades. The legal, logical, and linguistic contortions became increasingly absurd.  Although these permitted certain transactions to go forward, they did not address the very serious risk that someone could challenge whole categories of OTC trades and instruments in court, and that a judge would find them in violation of the CEA.

This was the genesis of the CFMA.  The “modernization” was intended to create a legal framework that reflected modern market reality, and which gave legal certainty to economically beneficial transactions.  It was an effort to clear the thicket, to replace an often absurd and contradictory set of ad hoc improvisations with a coherent structure.

The fundamental problem that CFMA was intended to address was that legal and legislative categories did not correspond to market reality.  The CFTC reacted by crafting ad hoc fixes.  But in the face of rapid innovation, the bolting of one ad hoc fix onto another created a vast Rube Goldberg contraption that was an accident waiting to happen.

Move forward 10 years from CFMA to Frankendodd.  Frankendodd creates numerous categories of instruments and market participants-swap, securities swap, swap dealer, major swap market participant, and on and on. It then delegates to multiple regulators the task of establishing detailed criteria describing these categories. Frankendodd itself weighs in at 2400+ pages, and the myriad regulations thereunder will run to many thousands of additional pages.

And that will just be the beginning.  The proliferation of categories that do not correspond to market realities today, let alone market realities in the future that develop in response to fundamental economic changes, financial innovations, and the regulations themselves, will lead to serious contradictions between what makes commercial and policy sense, and the letter of the law and the regulations.  The regulators will inevitably respond today the way they did in the 1980s and 1990s-with ad hoc responses intended to address the specific transactions and transactors at issue, with only passing regard for the coherence of the overall set of rulings and interpretations.  A Talmudic mind will be required to sort through it all.

Lawyers will rejoice and prosper-hence the rejoicing-because the most important design consideration for a transaction or a new structure will be how it can be jiggered to satisfy the regulations and interpretations, rather than the most efficient way to achieve a particular economic objective.  And even then there will be considerable uncertainty given the inevitable contradictions in the regulations, interpretations, judicial rulings, and on and on.

In due course, the whole edifice will become utterly unworkable and incoherent, and create a real systemic risk-a risk arising from the serious legal uncertainty that is inevitable.  And the problems arising out of Frankendodd will be all the worse than those arising out of CEA because it is more sweeping, the markets are more complicated and international, and the categories and distinctions and requirements it creates are vastly more numerous.

The ink on some regulations arising out of Frankendodd is barely dry, and this regulatory dialectic is already beginning.  The regulators are already making ad hoc adjustments.  From the FT:

US regulators are exploring ways to give large foreign banks and overseas subsidiaries of US lenders a reprieve from stringent new derivatives rules, potentially alleviating one of the biggest concerns facing global financial institutions.

The US Commodity Futures Trading Commission is looking to grant a temporary exemption to swap dealers that may fall under the jurisdiction of foreign financial authorities from complying with a host of post-financial crisis regulations governing derivatives transactions, people familiar with the matter said.

If you think this exception is the exception, you have another thing coming.  This is just the beginning of the dialectic.  Moreover, the international nature of the derivatives industry, and the creation of laws, rules, and regulations in different jurisdictions around the world will just accelerate it.

Within a period of a few years, derivatives regulations will be another absurd Rube Goldberg contraption.  And in its inimitable fashion, Congress (and the EU-if it still exists) will feel compelled to pass The Derivatives Modernization Act of 2020 (to choose a realistic round number).  Mark my words.

The CFTC had to play Goldilocks and decide the level of OTC swaps activity required to make a firm a swap dealer and thereby subject to the collateral and capital requirements and other obligations entailed in such a designation.  Earlier proposals ($100 million, then $3 billion) were commonly deemed too small.  Industry proposals were deemed to be too big.  The Commission decided on $8 billion, with the possibility of reverting to $3 billion depending on the results of forthcoming data collection and analysis by the Commission.

The usual suspects-like “Better Markets”-claim that the limit is far too big, and represents a huge loophole.  Genlser (no Goldilocks, if you know what I mean) fired back, claiming that the limit was actually quite small, compared to the immense size ($300 trillion notional) in the US swaps market.

These kinds of debates are frustrating in any event, because cutoffs like this economize on information, but are inherently arbitrary.  They focus on the easily measured, rather than the economically significant.  They reduce multi-dimensional problems to a single dimension, which inevitably leads to distortions.  In particular, they provide incentives to devise transactions and structure business to circumvent the rule.

The real questions that should be asked in determining the criteria for swap dealer designation are: What is the market failure that this regulation is intended to address? and What criteria will mitigate that market failure in a cost-effective way?

The whole justification for Frankendodd is that derivatives pose a systemic risk.  Systemic risk, properly understood, involves some sort of externality.  One potential externality is that a default by one large derivatives trading firm can lead to a daisy chain of defaults.  Another is that default costs are passed onto taxpayers in the form of bailouts.  Swap dealer designation, and the consequent regulation of their activities, are supposedly intended to address these externality problems.

Viewed from this perspective, $8 billion in notional amount seems like a very small number.  Based on BIS numbers, market values are about 3 percent of notional amounts.  Applying this to an $8 billion notional gives a market value of $240 million.  The financial system can withstand such a default, and even several such defaults.  Yes, counterparty risk also depends on gross amounts, but even an $8 billion loss is not catastrophic, especially inasmuch as any such loss would be spread over a number of counterparties.

To put things in perspective, look at the notional holdings of firms whose collapse or threatened collapse arguably posed a systemic threat.  LTCM’s derivatives book was $1.25 trillion-in 1998.  That’s 2 orders of magnitude bigger than the $8 billion figure being imposed 14 years later, when the markets are substantially larger.  Lehman’s was about $35 trillion-over 4000 times the  $8 billion threshold.  Bear Stearns: $13.5 trillion, about 1700 times the $8 billion. AIG’s notional was down to $1.6 trillion-200 times the threshold-at the time of its default.   And note that Lehman and AIG failed nearly simultaneously.

I am unaware of any default by a firm with $8 billion notional that created a systemic risk.

So I am in the too small camp.  I don’t know exactly what the number is, but there should be a pretty close correspondence between firms that are deemed to be systemically important and those that are subject to the requirements imposed on swap dealers.

Yes, the default of a firm with $8 or $10 billion in notional would presumably be painful for its counterparties.  But absent any knock-on effects, any externalities, that loss is internalized by the contracting parties.  This does not require any regulation to protect them.  Let them protect themselves, contract as they will, and live with the consequences.

I should also note that swap dealer regulation, which is effectively microprudential in focus, and which attempts to regulate only a part of firms’ capital structure, will not have the desired effects on systemic risk even if it is applied only to systemically important firms.  As I’ve noted repeatedly, firms can contract around this restriction, and will substitute different forms of leverage-and potentially riskier and more fragile forms of leverage-for the leverage squeezed out of derivatives transactions through collateral requirements.

In sum, all this to-ing and fro-ing over the swap dealer rules has resulted in a regulation that is far more inclusive than necessary to achieve its ostensible purpose of reducing systemic risk.  Moreover, the whole idea is fundamentally flawed for a reason I’ve written about often: it is virtually impossible to reduce the risk in the financial system by regulation of the pieces.

Yesterday Obama delivered another of his it-must-have-been-some-other-body-it-wasn’t-me (h/t Chuck Berry) speeches on energy.  And, true to form, he delivered another clarion call to round up the usual suspects: evil speculators, whom he confabulates with manipulators .  (And I am being generous, because confabulation is inadvertent, whereas I Obama’s slander is almost certainly deliberate):

That’s what’s happening right now.  It’s those global trends that are affecting gas prices.  So even as we’re tackling issues of supply and demand, even as we’re looking at the long-term in terms of how we can structurally make ourselves less reliant on foreign oil, we still need to work extra hard to protect consumers from factors that should not affect the price of a barrel of oil.

That includes doing everything we can to ensure that an irresponsible few aren’t able to hurt consumers by illegally manipulating or rigging the energy markets for their own gain.  We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher — only to flip the oil for a quick profit.  We can’t afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick.  That’s not the way the market should work.  And for anyone who thinks this cannot happen, just think back to how Enron traders manipulated the price of electricity to reap huge profits at everybody else’s expense.

. . . .

That includes doing everything we can to ensure that an irresponsible few aren’t able to hurt consumers by illegally manipulating or rigging the energy markets for their own gain.  We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher — only to flip the oil for a quick profit.  We can’t afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick.  That’s not the way the market should work.  And for anyone who thinks this cannot happen, just think back to how Enron traders manipulated the price of electricity to reap huge profits at everybody else’s expense.

He used the word “manipulate” or “manipulation” 11 times in his relatively brief remarks.  In typically dishonest fashion, he isn’t responding to specific, credible evidence of manipulation; he provides no evidence that manipulation is rampant or is at all responsible for current price levels.  Hell, he can’t even come up with a current example, having to reach back more than a decade to Enron (itself a dubious example).  He merely insinuates and implies.  But the average listener or reader will conclude from his remarks that manipulation is causing their pain at the pump.  Rather than encouraging a sober and realistic appraisal of the role of speculative trading in energy, he is feeding suspicions and encouraging a witch hunt.

Moreover, note the repeated and casual identification of manipulation and speculation.  This is itself a manipulative use of language.  Manipulation is not even a proper subset of speculation: hedgers can be some of the most dangerous manipulators.  It further encourages the popular suspicion that financial trading in commodity markets is inherently dishonest and crooked.

Insofar as concrete steps are concerned, he is demanding substantial increases in resources for the CFTC to oversee the energy markets and a substantial hike in the criminal and civil penalties for manipulation.  With respect to oversight, I’ve said more times that I should have to that the undetected manipulation is the unsuccessful manipulation.  If manipulation distorts prices, that distortion will be manifest.  Moreover, those harmed by the manipulation have every incentive to bring the manipulation to the attention of the regulators.  The idea that manipulation is rife and is having huge impacts on prices, but it is necessary to surveil the markets intrusively using “modern tools” to find it is an oxymoron.  Which means that greater penalties imposed ex post are defensible.

It doesn’t inspire confidence that Obama justifies the greater CFTC resources by quoting another of GiGi’s inane metaphors.

The other major concrete step is to give the CFTC authority over margins for energy derivatives.  This is another hardy perennial: similar proposals were made with respect to stock index futures in the aftermath of the 1987 Crash.

Obama’s justification for this is risible: “Congress should give the agency responsible for overseeing oil markets new authority to protect against volatility and excess speculation by making sure that traders can post appropriate margins, which simply means that they actually have the money to make good on their trades.”  So which is it? Are margins to ensure contract performance, or are they to reduce volatility and excess speculation?  If the former, there is zero evidence that CME Group or ICE or OTC market participants aren’t charging margins that are sufficiently high to control efficiently counterparty risk.  If the latter, there is (a) no evidence that there is excess speculation in energy, or that it is elevating volatility, and (b) no evidence that tweaking margins will have any impact on volatility.  Indeed, hiking margins can raise volatility by reducing the amount of speculative capital available to absorb fluctuations in hedging demand.

In sum, the parts of Obama’s markets aimed at speculator-manipulators are intellectually confused, empirically baseless, and deeply irresponsible because they encourage a witch hunt atmosphere by slandering (by slimy insinuations) legitimate market actors as criminal manipulators.

Well played.  Because of all the practice, no doubt.

A few other things stand out.  First, he repeats the “we use more than 20 percent of the world’s oil and we only have 2 percent of the world’s proven oil reserves” mantra.  Hell, even he admits he says this repeatedly: “But as I’ve said repeatedly.”  Repetition of a dubious factoid does not make the conclusion it is intended to support true. Indeed, that’s a staple of the Big Lie.

Second, he continues to take credit for increased US oil output when in fact he and his administration don’t have a damn thing to do with it, except that it could have been higher yet without some of their counterproductive policies.

Third, take a look at this remark: “We’ve added enough new oil and gas pipeline to circle the Earth and then some.”  To which my first response is:  What do you mean “we” kimosabe? Again, a guy who has never done anything that would risk getting a callous taking credit for the actions of those that actually put hands to shovel and made some truly shovel ready projects realities.  Moreover, it raises the question: if building so much pipeline capacity is such a great thing, why is he doing everything in his power to stall or stop Keystone?  Is that uniquely damaging? (To the environment, I mean, not to the fortunes of Buffett’s BNSF.)

A rule of thumb to keep in mind.  Whenever Obama talks about energy generally, and speculation specifically, it is safe to conclude you are being manipulated: that’s not at all speculative.

* Title suggested by R.

Posner & Weyl are continuing to flog their idea of an FDA for financial products.

I wrote about this really, really bad idea in February.  Given the swooning over the Posner-Weyl proposal, that post needs to be re-released.  So here it is.

I don’t need to change a word.  The FDA idea is a very bad one and the metaphor is completely inapposite.  Posner and Weyl are repeating their argument, and so my rebuttal needs no change.

It is good to see that not everyone is swooning.  This blog at The Economist rips into the proposal.  Great!

But gee, the points in the Economist post seem familiar.  Very familiar.  Every damn one.  To the points I made two months ago.

Purely coincidental, I’m sure.

Recognition is dawning that clearing mandates-the supposed silver bullet for making the derivatives market safe-are not the panacea that their advocates claimed.  Recently, major regulators in the US and the UK have warned about the dangers of concentrating so much risk in CCPs.  The recognition is spreading to the press too, as illustrated by this article in The Economist:

The source of all this angst is the clearing-house, a mundane bit of financial-market plumbing that sits between buyers and sellers in transactions. And the reason why people are fretting is that G20 policymakers have seized upon clearing as the solution to some big problems in the over-the-counter derivatives market.

. . . .

That feeds worries about the other effect of lots more clearing: a new concentration of risk. Moving derivatives trades to clearing-houses mitigates the effect of a default of a clearing member (Lehman Brothers’ cleared trades were handled smoothly in 2008, for example). But it makes the impact of a clearing-house itself going down much worse. They may lack the heft of big banks, but few financial institutions are more interconnected. Failures are rare but they do happen: Hong Kong’s futures clearing-house ran out of resources in 1987, for example, and it took a government bail-out and the closure of the main stockmarket for things to get back to normal.

This should not be a surprise-after all, it’s not like what happened in Hong Kong-or in Chicago-in 1987 was a big secret.  And it’s not as if nobody, ahem, has been raising this point for going on four years now.

And that italicized part is just too rich.  Didn’t Timmy! and GiGi constantly-and I mean constantly-tell us that clearing eliminated interconnections in the financial system? Yes they did! I guess that explanation is now seen to be the BS it always was.  I’ve been calling BS on that for about three years.  I’m waiting for the dynamic duo to admit they were either ignorant, or liars.  There is no third alternative.

The aforementioned regulators are demanding that CCPs be made immune from failure.  The Economist agrees:

The more systemic they become, the more tightly clearing-houses should be regulated. That means more clarity over their collateral and margining policies. It means agreeing on plans for recapitalising a failing entity without tapping the taxpayer. And it means getting clearing-houses to hold more equity: LCH.Clearnet had just €333m ($463m) of capital in 2011, compared with collateral and cash under management that averaged €73 billion. Clearing can achieve many things. Solving the too-big-to-fail problem is not one of them.

Sigh. On the one hand, it is good to see growing awareness of the systemic vulnerabilities that CCPs create.  On the other, it is distressing that regulators and commentators seem to have target fixation and can focus on only one thing at a time.  Put differently, they fail to consider how the financial system will adjust to attempts to make one part of the system safer.

I’ve also written about this ad nauseum.  The point is that raising margins, or increasing the size of default funds, or changing margin calculations, or tightening up restrictions on eligible collateral, or other measures to improve the safety of CCPs will induce reactions and adjustments elsewhere in the financial system, and these adjustments have systemic implications.

For instance, requiring more collateral is likely to lead to the growth of systemically-fragile collateral transformation services and other shadow banking mechanisms to secure collateral to post for CCP margins.  Expanding CCP member commitments to default funds increases their exposure to wrong way risks, and is an important source of interconnection in the financial markets.

I return to the 1987 Chicago experience.  Yes, the big exchange CCPs were under stress, but a major source of stress in the financial system as a whole was due to the extraordinary need for liquidity to meet margin calls-the very mechanism that is put in place to protect CCPs against default.  Sometimes “safety” equipment can be downright dangerous.

I return to a metaphor I’ve used before: that of flood controls.  Building up levees to protect one location can increase the risk of a catastrophic flood elsewhere in a river system.  It is good that more regulators and market observers recognize that CCPs are a source of systemic risk, but the levee-building reflex is worrisome in the extreme.  It suggests an inability to think about the financial system as a whole, a system that reacts to changes imposed on one part of it.  These responses are not necessarily salutary, and can be downright frightening.

The responses need to be anticipated, to the extent possible.  But it is often difficult to do that with accuracy.  Which means that it is necessary to proceed cautiously when making the levee around CCPs higher and higher.  There will be responses to this process, and it is likely best to proceed cautiously and incrementally, seeing what the responses are to the gradual changes, and then adjusting accordingly.  Wholesale changes made in a hurry focused monomaniacally on one part of the system are a recipe for an major disaster elsewhere in the system.

I say again: to understand how policy changes affect systemic risk you need to think of the financial system as an organic whole, a system that responds often unpredictably to changes imposed on one part of it.  Although it is encouraging to see that the magical thinking about clearinghouses is being replaced by sober concern, it is far less encouraging that the concern is leading to policies focused on individual institutions that do not pay adequate attention to how the system will respond.

In other words: Don’t build financial levees without giving very deep study how other financial currents will react to the levees during flood times.

The Li(e)for investigation is metastasizing at an incredible place.  Both Bloomberg and FT have run long pieces on the problems with the rate-setting mechanism, and how to fix them.  Investigations (10, according to FT) are proceeding around the world, in the US, UK, Europe, Japan, Canada, and Singapore.  There is a criminal investigation in the US.  Numerous banks are scurrying to cooperate in the hopes of receiving leniency-the prisoner’s dilemma in action.

Some of the reporting is confusing.  There are at least two different motives for the alleged misstatements, one likely being more legally fraught for the banks.  The first motive is that during the throes of the crisis, banks had an incentive to misreport the rates at which they could borrow unsecured in order to avoid the perception that they were on the brink.  The other motive is that traders wanted to influence LIBOR in order to advantage derivatives positions tied to LIBOR-the latter likely presents the banks and individual traders  with far more acute legal problems.

Then there remains the issue of what to do about it.  The most obvious remedy is to base LIBOR on actually borrowing transactions, in the same way as is done with EONIA and SONIA overnight (hence the “ON”) borrowings.  This is a reprise of the data hub idea I advocated for energy trades back in 2003(!).

There is pushback against this idea, however.  One argument is that particularly during times of stress only a few banks are actually able to borrow unsecured for 3, 6, or 12 months, so the rate would be based on transactions from a small set of institutions.

I don’t get this objection, frankly.  So it’s better to base the most important reference rates in the world on what banks that cannot borrow unsecured say they could borrow at, than to base it on the rates that banks that actually do borrow unsecured pay?  Really? The first alternative is an oxymoron.  The second might result in rates from only a few banks being used, but far, far better to base an index that is supposed to reflect the actual cost of unsecured borrowing (by those able to do it) as represented by real transactions then to use the oxymoronic fantasy rates of those who can’t do it.

And if nobody can borrow unsecured in any volume-that’s important information in and of itself.  That raises the question of the advisability of basing so many derivatives contracts on something that has an appreciable probability of not existing from time to time. Better to recognize reality than MSU and pretend it’s real.

Here’s a thought: BBA could continue to report a LIBOR based on the traditional methodology, but just modify its name to LIBORGIGO. Truth in advertising, dontcha know.

This raises a broader point.  Cash settlement is often raised as a panacea for contract design.  Delivery-settled contracts have problems-so go to cash settlement! But as I’ve argued since 1990, in many markets cash settlement is problematic due to the opacity of cash markets, and/or the absence of cash market transactions.  Cash settlement works where there is a liquid and vibrant and transparent cash market (e.g., S&P500 stock index futures) or centralized collection of cash transactions prices (e.g., live hogs).  Everywhere else, problematic indeed.

LIBOR is the most pronounced example of that today.  Natural gas was so in the late-90s and early-00s.  Right now, the Platts’ methods for oil price assessments are under considerable scrutiny.  Market participants have always been skeptical (though they often mute their criticism given Platts’s heft), but IOSCO has issued a very critical and questioning appraisal, and raises the question of whether further regulation is necessary.

It’s deja vu all over again, folks.  Been there, done that.  Went through all these issues with the energy data hub in ’03.  I can show you the scars.  I can tell you some stories (e.g., the trade group guy who asked me what it would take to get me to back off with my proposal.)

The fundamental problems are that cash settlement is hard if there aren’t, well, a lot of cash transactions going on.  Even if there are a decent number of cash trades, that doesn’t help if people don’t report.  Given the public good nature of more informative price indices, there are under-incentives to report.  Indeed, it can be worse than that: reporting can be a private bad.

This raises a justification for mandatory reporting, and that is actually one of the defensible parts of Frankendodd.  That can’t fix the problem of a lack of transactions, but it can make the most of the transactions that are there.

But this also points out the value of delivery-settled derivatives.  The ability to make delivery  gives market participants the opportunity to put their money where their mouths are in a way that is impossible with cash settlement, especially cash settlement based on self-reported prices and assessments. Even if delivery doesn’t occur all that much, the ability to make delivery keeps prices honest (noting, of course, that the delivery mechanism can be abused, but further noting that’s a problem that can be addressed by appropriate anti-corner measures.)

The first post I wrote on SWP related to the pricing of message traffic on electronic trading systems. This has become a major issue in the debate over HFT, with (as I noted last week), the SEC musing about impose by regulatory fiat pricing schemes that would penalize cancellations.

But as Jeremy Grant notes in a couple of articles in the FT, exchanges are already implementing pricing schemes to deal with “stupid algos”-and I would argue, “evil algos” too. There is a process of market experimentation going on, with some disagreement among exchanges. Deutsche Borse is considering a pricing scheme similar to that the SEC is considering-imposing a tax on all cancellations above some level. ICE has criticized this idea, arguing that such a scheme does not discriminate between “good” cancellations and “bad” ones: that was my objection to the SEC idea. Instead, ICE assess charges for cancellations based on how far the orders are away from the inside market. Orders close to the inside bid-ask are more likely to be liquidity enhancing, and less likely to be opportunistic efforts to clog the exchange systems. This is far more discriminating approach.

But there is a bigger point here: who should be making these decisions, exchanges or regulators? A strong case can be made for the former.  Exchanges internalize many, and arguably most, of the costs and benefits.  Opportunistic algos reduce the derived demand for exchange services, costing the exchange money.  Good algos that contribute to liquidity increase the derived demand for exchange services, making the exchange money.  Exchanges have an incentive to get the pricing right to encourage the good and discourage the bad, and moreover are likely to have better information, and to be less susceptible to rent seeking influence activities, than government regulators.

Different exchanges engage in different experiments on pricing.  This contributes to a discovery process that is likely to reach an efficient outcome than the process that legislatures and regulators use to set prices and procedures.  Exchanges that develop effective pricing policies gain imitators: those that don’t, lose business.

Yes, it is possible that there are externalities that exchanges don’t take into consideration.  But only fools believe that regulators can understand, quantify, and correct these externalities.  Indeed, the process by which regulators internalize such effects is often highly distorted and inefficient, due to constraints on information and public choice problems.

Exchanges are clearly aware of the relevant issues, are highly motivated to address them in a discriminating and effective way, and are in fact trying to do just that.

The Economist just ran a long piece about the unintended, and largely unforeseen, consequences of collateral and clearing mandates.*  And they aren’t all good.  Anything but.

I say largely unforeseen because I’ve been jumping up and down about these consequences here on SWP, in some academic papers (including one to be published in the next issue of the  Journal of Applied Corporate Finance), and numerous presentations.  I have repeatedly emphasized that it was a fallacy that requiring more collateral would necessarily reduce the amount of leverage in the system, make the leverage in the system less fragile, or reduce interconnectedness among financial institutions. I have consistently argued that market participants would substitute alternative forms of leverage and utilize other financing techniques (e.g., collateral transformation and liquidity swaps) as fragile or more fragile than the leverage embedded in derivatives, and that these new forms of financing would just change the topology of the network of connections among firms in the financial markets, and that the new topology would be as or more complex than the pre-mandate topology.

It was always particularly maddening to see regulators and others present pictures of the OTC derivatives market with a spaghetti bowl of interconnections between market participants, and contrast it to a neat and tidy picture of a cleared market with a few neat lines connecting market participants with the CCP.  There was no consideration of how the necessity of funding collateral and making variation margin payments would lead to the creation of financing arrangements among firms that would resemble the spaghetti bowl picture.  No consideration of how the very complex financial system would adjust on the myriad margins available to it.

In some respects, I can make some allowances for the regulators and legislators who imposed this on the world.   Those allowances are mainly a function of low expectations.  I am less forgiving of the academic community.  Many people smarter than I whom I respect have bought into the neat and tidy picture, and have dismissed concerns that the various Frankendodd mandates (and their European cousins) will create a new set of problems that may be worse than the ones that were supposedly fixed.

I think that in large part, this failure to anticipate the real effects of mandates, and the blithe confidence in the efficacy of collateral in particular, reflects the standard partial equilibrium, ceteris paribus way that economists use to approach problems.  This method is very powerful, and I utilize it regularly, but it has its limits.  In particular, it blinds one to the systemic responses to big changes like Frankendodd, to the fact that market actors will respond to these shocks on many dimensions.  As I’ve said repeatedly, there has been a systematic failure to consider how the financial system as a whole would respond to massive interventions designed to reduce systemic risk.

This is a particularly hard problem to analyze mathematically and formally due to its inherent complexity.  The daunting nature of the task, and the fact that formal mathematical modeling is almost required by top tier journals, has, in my opinion, made it unattractive for academics to pursue these issues.  The constraints of the accepted toolset have led to the slighting of an extremely important and interesting issue.

But this is not to say that the problem is immune to analysis that can generate meaningful insights and falsifiable predictions.  Indeed, largely disdained non-formal (“literary”) approaches can do so-and have done so.  I started from a very simple premise, that there were fundamental economic considerations that had led market participants to choose financing arrangements and contracts with certain amounts of leverage and fragility.  Constraining the ability to use those sorts of financing arrangements would induce actors to substitute towards arrangements with similar properties.  Non-formal analysis also shed light on how these mechanisms would operate during periods of systemic stress.

Based on these non-formal approaches, I made predictions about how the markets would evolve under clearing and collateral mandates.  Those predictions can be tested by empirical observation (though again, more descriptive than formally econometric).  That’s as “scientific” (in the Friedman Methodology of Positive Economics sense) as the densest, or most elegant, mathematical model.

And as it turns out, in this instance, some of those predictions are being borne out.  In ways that make me appreciate Cassandra.

I think it is more important to focus on important problems and find the best tools for the job at hand, rather than let narrow conceptions about the appropriate tools define and the problems you work on.  The latter mindset has limited academic economists’ influence on big things like Frankendodd.

The one-eyed man is king in the land of the blind.  Non-formal methods provide sight-and insight-on issues to which formal methods are often quite blind.  Given the incentive structure in academia, however, I am skeptical that the lesson will be learned.

* Link fixed. H/T Phil R.

Mary Shapiro weighed in on high frequency trading again.   Well, sort of:

The rules the SEC is contemplating are vague, but could involve fees on high volumes of order cancellations or a minimum time enforced for quotes. “While we haven’t landed on concrete things that we will do next,” Schapiro said, “all these ideas are live and subject for discussion within the agency.”

The WSJ has a little more:

Among the ideas the agency is considering, she said, is the implementation of obligations for certain high-frequency traders to provide quotes near the national best bid and offer prices—the highest buy and lowest sell orders across the market—during a certain percentage of the trading day.

The SEC also is weighing imposing fees on order cancellations, which constitute “a vast majority of orders” submitted by high-frequency firms, Ms. Schapiro said. An estimated 95% to 98% of orders submitted by high-speed traders are canceled as the firms rapidly react to shifts in prices across the stock market, according to Tabb Group, which tracks trends in electronic trading. The possible fee, previously mentioned in a joint advisory committee of the SEC and CFTC, would likely be a tiny fraction of a cent per canceled order, experts say.

Imposing obligations is not costless.  Requiring people to quote when they don’t want to quote means that they will quote poorer prices. With respect to cancellations, yes, some abusive HFT strategies do allegedly involve quote stuffing followed by cancellations.  But many salutary HFT strategies, including the cyber equivalent of scalping-market making-also involve large numbers of cancellations. Market makers are at risk of being picked off, or of trading at stale prices, and hence want to cancel orders, and perhaps submit new ones at different prices, when new information arrives.  And in an electronic environment, new information arrives rapidly.  Locals scalping in futures pits were only obligated to trade at their quotes “as long as their breath was warm” to limit their exposure to these problems: cancellations by HFT traders making markets serve the same purpose. Taxing cancellations could well impair these legitimate uses of cancellations more than the abusive ones, leading to less liquidity and costlier trading.  This is a very blunt tool indeed.

The fundamental issue is that HFT is not one thing.  There are a variety of HFT strategies, some of which are beneficial, others arguably opportunistic.  Moreover, it is quite possible that a given HFT firm uses a variety of strategies, some of which are beneficial, some of which are opportunistic.  The focus should be on trying to identify order submission patterns that are characteristic of opportunistic strategies, and those that are characteristic of beneficial ones (e.g., market making) and develop pricing or enforcement measures that are targeted at the abusive strategies.  Meat axe approaches like taxing cancellations are indiscriminate, and risk doing far more harm than good.

Shapiro doesn’t inspire confidence when she says things like this:

Schapiro expressed concerns of her own Wednesday, lamenting the current volume of trading that is “unrelated to the fundamentals of the company that’s being traded.”

“It’s got very little to do with whether you think IBM’s got a great business plan and solid earnings growth in its future … and a lot more to do with what’s the minuscule aberrational price move that you can take advantage of because you’ve co-located your computer with the exchange and can jump on that in microseconds,” she said.

“And that worries me in some ways.”

There has always been trading unrelated to fundamentals, that has been technical in nature and focused on profiting from minuscule price moves. That’s what most market making is about. Indeed, the existence of that kind of trading produces the liquidity that facilitates long term trading.  And there have always been time and space advantages in trading. Why do you think people paid hundreds of thousands, and sometimes millions, of dollars to be on the exchange floor? The views? The charming company? No.  Because being on the floor gave you an edge.

Shapiro’s testimony suggests that the SEC is befuddled by HFT.  This is understandable, because there’s a lot about it that is not well understood, and because it is surrounded in a fog of mystery and controversy. But her testimony also suggests a deep-seated suspicion of HFT, and preference for indiscriminating solutions that will throw the baby out with the bath.

Not too swift.