Streetwise Professor

Last March I noted that in my two previous trips to teach in Geneva, there had been squeezes in the coffee market, and I said I was going to buy coffee spreads before my next trip.  Well, that trip is coming up in about 3 weeks, but somebody in the market (perhaps the Noble Group, according to the FT) beat me to the punch: there is a good squeeze underway in the robusta market, with spreads going from contango to a $182/ton backwardation.  That ain’t a hill of beans.

Note to self: put on the trade earlier next year.

When I was in Geneva last year the Li(e)bor story came to life after having faded from view for several years.  That story has now exploded into prominence, with numerous disclosures over the past several weeks.

Indeed, the story has taken a major turn.  Whereas suspicions as to motive originally focused on the idea that banks were attempting to make themselves look sounder than they were by exaggerating their ability to borrow unsecured, the new stories claim that there is evidence that some traders were manipulating rates specifically to influence the value of derivatives positions tied to Libor.  This is a major development because specific intent to manipulate the price of a derivative is a necessary element of a manipulation case under the Commodity Exchange Act.  If confirmed, these allegations regarding motive dramatically increase the legal stakes for the banks.

Eric Posner and E. Glen Weyl have attracted a lot of attention for their proposal to create an agency that would approve trading of new financial products, in the same way the FDA must approve new drug entities before they can be sold to the public.  Their initiative is fundamentally flawed, both in its diagnosis and its prescription.

There are a variety of problems.  The most basic is their false dichotomy between contracts that are used for speculative purposes, and those that are used for hedging.  In fact, speculation and hedging are highly complementary functions.  The most important function of derivatives markets is to facilitate risk transfer.  This risk transfer often involves a hedger on one side of a transaction, and a speculator on the other.  The speculator may be, as Posner and Weyl claim, trading on the basis of incorrect beliefs.  So be it.  His existence allows the hedger to reduce risk, and makes both parties subjectively better off, although Posner and Weyl seem to suggest that it would be possible to determine objectively that the speculator is acting irrationally.

In other words, much speculation in financial markets facilitates hedging.  To suggest that these activities are antithetical, or unrelated, as Posner-Weyl do, is highly misleading.

Posner and Weyl use mutual funds as an example of a salutary financial innovation.  No disagreement here.  But these can be used for activities that are commonly and properly considered “speculative.”  Moreover, equity and bond futures are widely used to speculate on broad movements in stock and interest rate changes.  But they are also used by pension funds and institutional investors to achieve the same type of objectives as mutual fund investments. So what, really, is the difference between mutual funds and derivatives?

There are indeed well-known problems with speculation.  Much of it (including excessive acquisition of costly information, the development of faster ways to trade) is properly understood as rent seeking.  But these problems are not uniquely associated with particular kinds of instruments, as Posner-Weyl insinuate.  There can be inefficient acquisition of information for speculative purposes in derivatives that are widely used for hedging–including the agricultural futures that Posner-Weyl consider to be salutary. (Although it does not speak highly of their understanding of these markets that they use farmer hedging as their justification of ag futures, though that is hardly the primary hedging use of these instruments.)

Other possible problems highlighted by Posner-Weyl include the use of derivatives for tax avoidance or regulatory arbitrage.  I say “possible problems” because the real problem can be with inefficient regulations or taxes, not the means that are used to mitigate these inefficiencies.  But even abstracting from this difficulty, there is also a fundamental problem distinguishing “bad” derivatives that are used for tax or regulatory avoidance, and “good” derivatives that are used to hedge.

Back in the 1970s and 1980s, simple plain vanilla futures contracts were widely used in a tax reduction strategy called “tax straddles” involving a spread trade (buying one future, selling another with a different delivery day).  The trader would liquidate the losing leg of the trade to generate losses to offset against other gains, or to convert ordinary income into capital gains.  This strategy was eventually disallowed in 1981: the instruments themselves were not banned because they could be used to avoid taxes.

In sum, hedging and speculation are complementary; speculation is not always inefficient;  and inefficient forms of speculation are not confined to specific instruments.  Therefore, regulations designed to impede speculation by requiring the approval of specific products are misguided because impeding speculation interferes with efficient transfer of risk, and because the inefficient uses of derivatives cannot be reduced reliably by preventing the marketing of particular instruments.

This means that charging some financial FDA with the responsibility of choosing which innovations to permit and which to proscribe, based on the goal of eliminating speculation, is basically hopeless.  Such an agency’s choices will be plagued by Type I and Type II errors.

Not to mention that whereas the effects of a drug can be determined with some (though incomplete) precision in clinical trials, there is no comparable way of determining how financial innovations will be used, the volume of their use, or their economic effects (in part because these effects depend on the scale of adoption, and the interaction of these products with other products in the market).  All of these things depend on the choices of myriad individuals, and these choices can change over time: who would have envisioned, in the 19th century when wheat and corn futures were first traded in Chicago, that they would one day be used by index funds to offer diversification opportunities to pension funds?

Drugs are taken by individuals and their effects can be understood by studying individuals who take them: the systemic effects are just the sum of individual effects. Things are very different in financial markets.  The introduction of financial products can lead to very complex responses in the entire system that cannot be understood or quantified in any clinical trial.

When I originally heard of the Posner-Weyl paper, I thought they would focus on how particular instruments can be systemically risky.  They in fact pay very little attention to this issue.  In this regard, it should be noted that the FDA/clinical trial model is completely inapposite.  You cannot study the systemic effect of a financial innovation in an isolated trial: you have to see how it interacts with, and affects, the entire system.

And to try to understand these effects a priori is certainly futile.  The system is too complex, and there is no way to understand how a particular innovation will fare in the market, and how it will affect the entire system.  As a concrete example, no one truly understood the consequences of CDOs on subprime ex ante, just based on the characteristics of the instrument themselves.  The risks embedded in the instruments were not well understood when they were first created, and these risks depended on the scale of their use, which was impossible to predict at the time they were first created.  In the end, there were risks that were not widely understood at the time of introduction, and these risks had systemic import only because these instruments proved very popular and grew to massive proportions completely unanticipated when they were first introduced.

We actually have historical experience with ex ante entry regulations on financial innovation.  Until the 1990s, no exchange could introduce a futures contract unless the CFTC approved it.  The approval was contingent on a CFTC finding that the proposed contract passed an “economic purpose” test, and was designed in a way that would permit it to achieve this purpose.  In some ways, the economic purpose test was analogous to what Posner and Weyl propose today.

This system was costly and reduced competition.  Like many entry barriers, it was exploited by incumbents to hamstring competitors. I am not familiar with any dangerous product that was kept off the market through this procedure, and the introduction of good products was delayed.  All pain, no gain.  Why would we want to repeat that experience.

Maybe Posner and Weyl would disagree with my appraisal of the CFTC precedent.  They don’t seem to be aware of it, in fact.  Before making such sweeping proposals perhaps they should have performed an analysis of a similar system that operated for decades.

Being a Sam Peltzman student, I was never all that impressed with the FDA model in the first place, even in pharmaceuticals.  I am even less impressed with the FDA as a model for the regulation of products that are fundamentally different from drugs.  Especially when those advocating this model make basic errors about the instruments that they believe should be regulated, and the uses to which they are put.

Walter Russell Mead’s excellent blog recently discussed the conflicts over massive natural gas deposits in the eastern Mediterranean:

Naturally, the race to get the gas has reinvigorated old arguments (Cyprus-Turkey) and added fuel to newer disagreements (Israel-Turkey). Israel and Cyprus have been fastest off the blocks, agreeing their common maritime border in 2010 and contracting exploration work to Noble Energy. Turkey, on the other hand, has been slow to react and increasingly confrontational, holding naval exercises and trying to prevent Cyprus from accessing gas that Turkey says belong to Northern Cyprus, which only Ankara recognizes as a country. The confrontation also threatens to further destabilize Israeli relations with Turkey, which appeared to be on the uptick this week when an Israeli delegation arrived in Turkey’s quake-hit Van Province with aid supplies; “You are our true friends” said Van’s vice governor.

The gas reserves in the Levant Basin may be large enough to make Cyprus self-sufficient in energy and turn Israel into a major gas exporter for the next several decades. That, and Israel’s new tilt toward Greece as a way of countering the cold wind in its relations with Turkey, is opening a new era in Israel-Cyprus relations. Netanyahu is on his way to Nicosia this week (the first ever visit of an Israeli PM to the island), and Israel is expected to formally ask to station fighter jets at a southern Cypriot airbase.

Oh joy. Another reason for conflict in a region of the world that counts conflict and strife as its most important export.

Unmentioned in Mead’s post is Russia, the country which has a huge economic stake in the development of a major gas resource right next to its major western European customers.  Eastern Med supplies would far closer to Europe–especially big consumers like Italy–than Russia, and these supplies wouldn’t be subject to the Russian-Ukrainian Punch and Judy routine every winter, or the vicissitudes of Russian domestic considerations.  Meaning that if these resources were developed to their full potential, Gazprom (and Russia) would suffer substantially.  Very substantially.

Which gives Russia a tremendous incentive to foment instability in the region.  Not like that is very hard, either.

It has two major levers in this endeavor.  The first is Cyprus, which is deeply enmeshed with Russia financially and politically.  Russia has been Greek Cyprus’s financial savior, extending it substantial amounts of credit to keep the country from plunging into Greece-like catastrophe.  Even more importantly, Cyprus is the destination or conduit of dirty Russian money, and the location of choice for Russians setting up dodgy shell companies.  (Oh, how entertaining it would be if Cyprus were the target of an invasion by an army of forensic accountants!) (Also recall that the SVR agent who was the money man for the Anna Chapman spy ring miraculously disappeared in Cyprus after being arrested there.)

The second is . . . Syria.  I do not suggest that this is the only for Russian intransigence in that country: that behavior is overdetermined.  But stoking conflict–or standing in the way of resolution of conflict–in Syria does promote Russian interests in the gas business.  Indeed, the economic stakes here are far greater than the oft-cited Russian commercial interests in Syria: some rather shambolic business and infrastructure projects, and arms sales (which appear never to be paid for, at least fully).

Just saying.

I’m sure you’ve noticed that I haven’t written much about clearing lately. (And yes, I can hear the Hallelujah Chorus.)  Simple reason, really.  Most of the clearing related news warrants schadenfreud, and an “I told you so” response.  I enjoy a good Lulz as much as the next guy, but I know it gets old.

But this article hits on so many things at once I have to impose on you all.  It basically gives the lie to all the justifications for the clearing mandates in Frankendodd.

1. The advocates of mandates, notably GiGi and Timmy! asserted repeatedly that clearing would reduce the connectedness of the financial system, and in particular, would reduce the importance of big banks in those connections.  I argued in response that clearing mandates would just change the topology of the network; that it would remain densely connected; big banks would still be tightly connected; and that the new topology was not obviously less systemically risky than the old one.

From the article:

Where do you find the spare $2 trillion needed as collateral for cleared swap trades?

With new regulation in the US and Europe set to move the bulk of the over-the-counter derivatives market towards central clearing from next year, swap buyers and dealers will soon be faced with that very question. Many custody banks believe they could provide the answer.

Already heavily involved in the plumbing of the clearing market, custodians act for almost every major financial services firm without a custody arm – including most dealers and every clearing house.

Most also offer collateral management services, including securities lending and collateral improvement – the process of turning less-liquid securities into eligible collateral to post as surety in transactions.

This experience could prove invaluable with the advent of new swap clearing rules, which come in with the expected implementation of the Dodd-Frank Act in the US from early next year, increasing the demand for collateral transformation services.

David Field, managing director with banking consultancy Rule Financial, said: “The buyside simply doesn’t have enough quality collateral available to lodge for clearing.

Executing brokers are expecting to generate strong post-trade revenues from collateral transformation – but the custody banks are the ones holding the collateral.

This is a huge opportunity for custodians, and several are already investing anywhere between $50m and $100m to position themselves.”

In other words, big custodial banks will be even more tightly connected with all major participants in the derivatives trade because of their comparative advantage in providing collateral transformation, and the strong economies of scope between providing this service and providing other custodial services.

2. The advocates of mandates argued that it would reduce leverage in the system.  I responded repeatedly that this was not at all obvious, and that the most likely effect would be to transform the nature of leverage.  The big move to collateral transformation makes it abundantly clear that this is in fact happening.  I go into this in much more detail in my forthcoming Journal of Applied Corporate Finance article titled “Clearing and Collateral Mandates: The New Liquidity Trap?”

Credit means credit risk.  So the clearing mandate has not eliminated credit risk from the derivatives market, or even reduced it sharply.  It has just transformed it, relocated it.  And it has definitely not eliminated derivatives-related credit risk from big banks.   Indeed, it is moving more risk to some big banks.  BNY-Mellon and JP Morgan are also the most important settlement banks, and play a vital role in the repo market.  This is already a source of systemic risk.  These banks are arguably the most important pieces of the financial infrastructure, and these developments will make them even more important, and also concentrate more risks from disparate markets (e.g., repo and derivatives) in them.

3. The advocates of mandates asserted that it would make the derivatives market less concentrated and more competitive (although nb these are NOT equivalent).  From the article:

Tech-heavy effort

Among the most ambitious to gain business in the swaps market is BNY Mellon, the world’s largest custodian with $25.8 trillion of assets under custody. The bank sees its existing footprint as a springboard towards dominance in the collateral services market for OTC derivatives.

[A director] for collateral management and clearing at BNY Mellon in London, believes it will be a tech-heavy effort. He said: “According to recent Isda Margin Survey figures, roughly 80% of collateral used in the OTC swaps market is cash, with about 15%-20% being fixed-income securities.

If even 20% of the estimated extra $2 trillion of collateral required to clear OTC swaps via central counterparties is in the form of securities, that puts a big onus on the collateral managers to offer smart, quick systems capable of handling huge draws on client collateral daily.”

Rival US custodian State Street has also been boosting its presence in the cleared derivatives markets, launching a swaps clearing operation in September. In a signal of intent, the bank has quietly begun hiring senior futures brokers from established rivals.

Charley Cooper, senior managing director at State Street Global Markets, said: “State Street’s unconflicted approach combined with the operational efficiencies gained from clearing with a custodian, gives us a significant edge in the emerging clearing marketplace.”

A senior derivatives banker said that clients are already looking at custodians as a viable counterparty.
He said: “In the past six months, we’ve seen growing migrations to the custodial clearing business.

Some have a better credit rating than almost every investment bank, and it’s unlikely they will be subject to capital ring-fencing regulations.”

He said that if a major custodian is able to convert even half of its existing custody clients into clearing clients, it could be looking at a share of anywhere between 10% and 20% of the OTC clearing market.”

The incumbents

But existing derivatives flow dealers – especially ones with large custody and treasury businesses – are unlikely to shy away from a revenue-generating opportunity.

Citibank, in particular, is hoping to combine a swaps clearing operation with its custody and treasury services in the US.

Jerome Kemp, global head of exchange-traded derivatives and OTC clearing at Citi, is in no doubt which direction the market is heading.

He said: “We’re looking at a re-dealing of the cards in the derivatives clearing space. Post-Dodd-Frank implementation, clearing will be led by the larger, well-capitalised banks.”

Citi hired aggressively to expand its futures commission merchant business last year, including the hire of Kemp, previously co-head of listed derivatives and clearing at JP Morgan, who arrived with a raft of colleagues.

Kemp thinks the next battleground for the bigger futures commission merchants, which will act as clearers for many firms on the buyside, could hinge on the bundling of services across clearing and asset servicing.

JP Morgan, meanwhile, is also looking to leverage its existing prime services footprint for its hedge fund clients for whom swaps clearing will be a new experience.

The bank has merged its listed and OTC clearing teams, and invested heavily in client roadshows and clearing masterclasses since the Dodd-Frank Act was passed in 2010.

Dale Braithwait, a member of JP Morgan’s OTC clearing team, said: “It’s to our advantage that we’re a big collateral manager too.

For a lot of asset managers, who do not feel they are able to use prime brokerage services, it’s a big benefit to have someone who can act as a custodian and a clearer.”

So there is a big fixed cost to play in this game.  The resulting scale economies tend to increase concentration.  Moreover, there is a strong scope economy across collateral management and transformation services, and other custodial services.  Meaning that the big custodian banks have a strong competitive advantage in providing the new collateral management and transformation services that will become a crucial component of the OTC derivatives markets.

It is particularly ironic that BNY-Mellon will be a major beneficiary of this.  You might recall the execrable NYT piece (written by Louise Story) about the evil derivatives dealer cabal.  One of the most memorable parts of the article was BNY’s whinging about its inability to break into the dealer space.  Read this new piece and you can just imagine BNY execs rubbing their hands together in glee, throwing their heads back, and laughing an evil laugh.  All your cabal belong to us.

So let’s summarize, shall we? Clearing mandates (and requirements to collateralize uncleared swaps) will result in the formation of new links between buyers and sellers of swaps (including dealer banks who do not offer custodial services) and a handful of major custodian banks.  These links will involve the extension of credit, and hence the existence of derivatives-related counterparty risk in which big banks still have substantial exposure.  If anything, the mandates will increase concentration in an important part of the derivatives market.  Moreover, it will arguably increase the concentration of credit risk exposure in a handful of systemically important banks.

Well played!  The actual results of Frankendodd will be the exact opposite of what was claimed by its tireless advocates (And yeah, I’m looking at you, Timmy! and GiGi.  I’m trying not to look at Barney, but that’s a whole other story.)

Unintended consequences, indeed.  Unintended, but predictable–and predicted.

When the NYSE-Deutsche Boerse deal was first announced, I wrote:

The biggest uncertainty surrounding the deal involves European antitrust approval.  As noted above, the merging exchanges are not direct competitors in any major product.  In the US, in the mergers of CME and CBT and CME and NYMEX, that fact was decisive in avoiding  Justice Department challenges.  It should be in Europe too, but I’m not as familiar with European antitrust thinking or precedents so I’m not sure they’ll see it the same way.

The most interesting question involves clearing.  European policymakers have been critical of vertical integration in clearing.  (The USDOJ is too, but only disclosed its (economically nonsensical) objections after the CME-NYMEX merger closed.)  They deem vertical integration as anticompetitive, and have failed to consider seriously the efficiencies that integration can generate (a subject I’ve written a lot about on SWP and my academic research).

Given this skepticism, the Euro antitrust folks may view this merger as an opportunity to open up access to clearing at Deutsche Borse and LIFFE.  That is, I could see them conditioning approval of the merger on the parties’ agreement to open up access to their clearing services.  It will be interesting to see whether they attempt to do so: I estimate that there is a non-trivial probability of this happening.  If they try, it would likely be a deal killer.  DB in particular has been adamant that integration is an essential part of its model and strategy, and LIFFE has adopted that view as well.  A deal becomes much less attractive–and, in my opinion, unattractive–if it requires a fundamental transformation of the exchanges’ business models.

Well, that’s pretty much come to pass.  The European Commission has apparently decided to block the deal.  Initial reports state that the Commission believes that the combined EuronextLIFFE-Eurex derivatives businesses would have too much market power, based on defining the relevant market as European exchange traded derivatives (an indefensible definition, IMO).  But some informed opinion suggests that the real sticking point was the refusal of the exchanges to open up the derivatives clearinghouse.  This was one of the proposed remedies, and one which the exchanges rejected.

So it pretty much played out as I forecast.  The European regulators would demand an end to the vertical silo.  The exchanges would refuse.  The deal would die.   And that appears to be precisely where we are.  The deal is not formally dead, but it was coughing up blood last night (see about the 3 minute mark).

Donkey years ago, when major exchanges were beginning the process of transforming from not-for-profit member owned firms to for-profit investor owned ones, there was a considerable amount of discussion over whether it was appropriate for for-profit exchanges to exercise regulatory functions.  The concern was that they would be subject to conflicts of interest that would undermine their incentive to regulate fraud and manipulation on their marketplaces.

I wrote a paper on the subject at the time, but shelved it in large part because these fears dissipated rather rapidly.  In the aftermath of the MFer debacle, however, they have returned with a vengeance.  Barney Frank just opined that the CME should not be a self-regulatory organization.  Yeah, I know, it’s Barney Frank (and aren’t you leaving Barney, so why not shut up?), but he’s not alone in his call.  Indeed, I get the sense that this is the emerging conventional wisdom.

So perhaps it’s time to revisit and revise that paper–thankfully Word is backward compatible!

I’ll use this post to summarize some of the arguments in that paper, and apply them to the MF/CME situation.

The main conclusion of the paper is that in comparing alternatives–self-regulating non-profit, member owned exchanges and self-regulating investor owned ones, the latter probably have stronger incentives to regulate most forms of bad conduct.

I divided the kinds of misconduct potentially subject to exchange oversight into two categories: misbehavior by agents (such as brokers cheating their customers), and market manipulation.  Based on my extensive analysis of self-regulation of manipulation, I concluded that neither type of exchange can be expected to self-regulate manipulation well.

With respect to agency problems, I concluded that for-profit exchanges are actually likely have a stronger incentive.  Member owned exchanges have more of a potential conflict of interest because the agents are among the exchange owners: some owners benefit directly from the (bad) conduct at issue.  Moreover, there is a collective action problem: perhaps one broker’s misconduct harms the others, by damaging the reputation of the exchange, but this is a public bad from the perspective of other broker-owners and free rider problems undermine the incentive of the brokers to act against it.

If you want a great example of that, look at the conduct on the floors in Chicago that was uncovered in the 1989 FBI sting.

With a for-profit exchange, however, inefficiently lax oversight of agents reduces the derived demand for the exchanges services, reducing its profits.  Put differently, for profit businesses are harmed when the suppliers of complementary services engage in misconduct that harms customers: brokers and exchanges provide complementary services, and misconduct by the former harms customers and reduces the demand for the latter’s services and hence its profits.  This gives the latter–the exchanges–a high powered incentive to police the supplier of (complementary) brokerage services.  Making them self-regulatory organizations permits them to engage in such policing and act on this incentive.

Against this it is sometimes argued that exchanges are likely to go easy on big brokerage firms that are their big customers.  But the ultimate customer is vitally important here too.  It is in the exchange’s interest that these ultimate customers are served by the most efficient, highest quality agents.  Higher cost/lower quality agents translates into lower derived demand for the exchange’s services.  Customers served by a broker that poses undue risks to its clients can go to another broker if the exchange cracks down  on the malfeasor.  The crackdown doesn’t reduce the exchange’s derived demand: it increases it, even if the broker is large.  Indeed, the risk posed by a bad broker to the exchange is all the greater, the bigger that broker is.  Which all means that there are fundamental problems with viewing the brokerage firms like MF as the exchange’s customers.

My argument depends crucially on there being a mechanism by which the self-regulating exchange incurs a cost when it engages in too little oversight.  The most likely mechanism is a reputational one, in which revelation of broker misconduct not caught by the exchange leads demanders of trading services to revise downward their estimate of the quality of the product they are getting (i.e., they conclude that they are at greater risk of being cheated by brokers), trade less (or are only willing to pay lower prices for exchange services), and thereby reduce exchange profits.

In the case of the CME and MF, this mechanism is clearly at work.  In the price of CME stock has fallen about $21/share since immediately prior to the MF blowup.  This represents a decline of market capitalization of $1.4 billion–approximately the same magnitude as the the missing money.  The work in the 1980s of Peltzman & Jarrell shows that it is quite common for product quality problems (that result in recalls) causing losses in market cap to the firm whose products are recalled that are far larger than the cost of the recall itself.  Bad quality outcomes have costly reputational effects.  This provides an incentive to avoid bad quality outcomes.

My paper drew from the property rights literature, which showed how the power of incentives could affect the incentives to supply quality.  That literature shows that a high power incentive system (like for-profit organization) could lead to a less efficient supply of quality than a low power incentive system (like non-profit organization) when quality was non-contractible or non-observable, and other mechanisms (like reputation) don’t cause a for-profit entity to internalize the effects of providing inefficiently low quality.  I concluded that this non-contractibility/non-observability issue was not relevant for the agency problems and other problems (such as informed trading).  Thus, I concluded that for-profit exchanges were likely to be better self-regulators of agent misconduct than non-profit ones.

The MF case doesn’t change my opinion on that.

But that is not necessarily the alternative being advanced by Frank et al. They presumably want to transfer all regulatory authority to the government.  To agencies like the CFTC and the SEC–which also had regulatory oversight responsibilities over MF, and didn’t stop the blowup and the possibly illegal appropriation or transfer of customer money.  Agencies that are subject to very low power incentives (except maybe for ass covering).  The CME is being pilloried for failing to stop the transfer of money that apparently began immediately after its auditors left MF: the SEC didn’t catch Allen Stanford or Bernie Madoff from stealing huge sums over periods of years–years–despite numerous warnings.

So I’m sure that yeah, handing over all regulatory responsibility to the CFTC and SEC will ensure nothing like MF ever happens again. And I also believe, as Christmas approaches, that Santa Claus is going to bring me a new Ferrari.

Actually, to extend Samuel Johnson’s aphorism, such recommendations are like 5th marriages: a triumph of idiocy over experience.

The facts in the MF case are still murky.  The collapse of a brokerage firm is not all that exceptional.  The potential theft of a billion plus in customer seg funds is very exceptional.  The issue is whether the CME could have stopped this theft.  Quite clearly such an action cannot be stopped by any ordinary and routine auditing.  Indeed, the money disappeared immediately after the last audit.  So preventing the theft would have required some extraordinary action, such as taking over control MF’s customer funds, transferring accounts, etc., earlier.  Given the truly exceptional nature of what MF apparently did, any assertion that CME should have done that reeks of hindsight bias: a common theme of the post-event commentary by industry people is that MF did the unthinkable, so it is pretty unrealistic to expect anyone to take actions to prevent the impossible (or unthinkably unlikely).

Self-regulation is imperfect.  Government regulation is imperfect.  Under either system, stuff happens.  Choosing which of these systems is, as Churchill said of democracy, the worst except for all the others that have been tried from time to time, requires a careful comparative analysis that focuses on incentives and information.  I’ve done that type of analysis in the past, and concluded that there is no single answer.  Exchanges do a lousy job at policing manipulation, and that function is best left to ex post legal enforcement–including private enforcement via civil lawsuit.  Exchanges–especially for-profit exchanges–do better at policing bad agents like brokers.  Not a perfect job, but their information and incentives are stronger in this case than in the case of manipulation.

The MF case shows that there is a market feedback mechanism at work that imposes costs on exchanges when people and firms they regulate do bad things.  Self-regulation harnesses that feedback mechanism, and it would be foolish to discard it on a whim based on an incompletely understood single instance like MF.  That’s doubly true given that the proposed alternative–complete reliance on government regulators–has more than its share of examples of proven failure, with Madoff and Stanford again being only the most prominent examples.

Remember.  Perfection is never an option.  Getting the right institutions in place requires a careful comparative analysis of the alternatives.  I can guarantee you Barney Frank hasn’t done that.  Nor have most people who are bold in their opinions on the matter. I’ve carried out such an analysis some years ago, and don’t claim to have the answer, but I know enough to say that (a) the situation is not so cut and dry and Barney et al make it, and (b) there is a colorable case that exchange self-regulation of certain forms of conduct is like what Churchill said about democracy.

And also remember that data is not plural of anecdote, and that anecdote and analysis are not synonyms.  Right now people are making strong recommendations on the basis of a single anecdote, and doing so before it is understood in any detail.  So I will withhold judgment, and when I make it I will endeavor to do so informed by the MF example, but also by a more complete comparative analysis of the incentives and information under the alternatives.

A while back–summer of 2010, if memory serves–I predicted that any CFTC position limit rule would be the subject of legal challenge.  My prediction was that someone would argue that the CFTC did not have the statutory authority to promulgate position limits because it had not made a finding that there was indeed excessive speculation that made it necessary to impose limits.  Subsequently, a DC Appeals Court decision that overturned an SEC regulation due to a failure to carry out an adequate cost-benefit analysis, made it clear that  this would be a major vulnerability for a variety of CFTC rulemakings, position limits among them. The day after the post-Dodd-Frank position limit rule was passed, speaking at a JP Morgan commodity conference, I said a suit challenging the rule would be “coming soon to a courthouse near you.”

Well, soon means about 6 weeks.  Today ISDA and SIFMA filed suit in DC contesting the position limit rule.   These organizations allege that the CFTC:

— Erred in concluding that the Dodd-Frank Act required it to establish position limits without first determining whether they were even necessary;

— Failed to present a reasoned analysis or consider all evidence in setting position limits;

— Failed to conduct an adequate cost-benefit analysis as required by law;

— Conducted a flawed rulemaking process that prevented commenters from meaningfully participating.

I imagine that others–such as the CME and maybe ICE–will follow suit, as it were.  I also expect that other rules will also wind up in court.  The position limit rule is probably the most vulnerable because of the statutory language about excessive speculation, but all of the rules the CFTC has passed are on extremely shaky on cost-benefit analysis grounds.

Frankendodd is under some pressure in Congress, but given the Democratic control of the Senate and the White House, nothing is going to happen on that front.  Instead, pieces of it will be chipped away in court.  Position limits could well be the first chip off the block.  Which is as it should be.

There are many misconceptions about the CME’s responsibilities in the MF Global situation, and the implications of this situation for the CME’s longstanding claims that no customer has lost money as a result of a clearing member default.  These misconceptions are epitomized by this Sun Times article:

CME owns the Chicago Mercantile Exchange, Chicago Board of Trade and the New York Mercantile Exchange, where much MF Global business took place. It legally clears, or guarantees, the trading on its markets and often boasts that no customer has ever lost money because a trading firm failed.

That more than 100-year record may be in jeopardy with MF Global, one of the largest brokerages on the Chicago and New York commodity markets. Former New Jersey governor and Goldman Sachs Group Inc. chairman Jon Corzine led the firm but made a disastrous investment in European debt.

The claim is true, and regardless of what happens with MF it will remain true.  The clearing guarantee is not in play here.

If clearing firm A defaults, customers of clearing firms B, C, etc., will get paid as long as the clearinghouse is solvent.  That has always been the case in the past, and it is true now.

It is possible that customers can lose money under the omnibus account system employed in the US, if there is a default on A’s customer account, and A cannot cover it, then A’s customers bear some of the losses.  As an example of this, the London customers of Griffin trading lost money when that firm went bust in 1999: no US customer customer lost.  (Customers of a COMEX member, Volume Investors, did lose when that firm went under).

There was no default in either MF Global’s house or customer accounts, so the clearinghouse guarantee never came into play.  So the Sun Times account–like many others–is fundamentally misleading.

Moreover, 60 percent of customer margin associated with open positions was transferred to other clearing members.  Most of the missing money in question, from what has been reported, was customer money on deposit at MF Global but not margin associated with open positions.  (That is the case with two MF customers I know personally.)  The CME clearinghouse guarantee has nothing to do with that money.

CME has raised the amount that it is willing to commit to cover any shortfalls from the bankruptcy trustee’s distribution of cash to customers.  This is not the CME’s legal obligation, but is, as I said in an FT article a couple of weeks ago, an indication of the importance of this situation to CME’s reputation.

CME will be subject to scrutiny primarily for its role as the MFer’s Designated Self-Regulatory Organization (and hence responsible for auditing it) prior to the firm’s rapid implosion.  Moreover, as Jeff Carter (a one-time CME floor trader and board member) writes, CME has not done itself any favors with its handling of the “public perception of the crisis.” (Though I have also heard that CFTC is attempting to control what the exchanges–CME and ICE–are saying.  As well it might, as it will also come under considerable scrutiny.)

A big question in my mind is why Corzine isn’t getting the Madoff treatment from the Feds and the media.  He has been called to testify in front of a House committee.  I wonder if he’ll invoke the amendment that comes right after the one about unreasonable searches and seizures.  But it is amazing to me how little critical coverage he has received.  Especially given the bad press that rich bankers are getting these days.

Oh, I forgot.  He’s a progressive Dem in good standing.  What was I thinking?  My bad.

So there are two major things wrong with coverage of the MFer’s tale.  The first is that the role of the CME’s guarantee to its customers is being misrepresented with some regularity–including by the home field rag.  The second is that the most likely culprit–and certainly the person ultimately responsible for the firm’s collapse, and anything that occurred as the firm crashed and burned–is all but invisible.

Back in the summer I argued that sovereign CDS are acutely vulnerable to wrong way risk.  Indeed, the problem is so severe as to call into doubt the viability of these instruments.  From today’s Dow Jones News Wires:

But some market participants said that, if risk aversion from Europe spirals out of control and credit markets freeze, a large firm could fail to meet its obligations in a credit-default swap, setting off a chain reaction that threatens to destabilize the global banking system.

They are urging closer scrutiny of banks’ gross sovereign CDS positions and of the interconnectedness of the banking system.

“When there is a high degree of correlation between the underlying risk and that of the hedge counterparty [in this case, the sovereign and a bank selling CDS], can you rely on a payment from your protection seller?” asked Joyce Frost, partner at Riverside Risk Advisors LLC, a derivatives consultancy.

The correlation may be so strong, she said, that if Italy, for example, continues to deteriorate, the protection purchased from a highly correlated European bank may not be worth as much as originally thought. The value of that hedged position would be worth less than if the CDS were written by an uncorrelated counterparty–a U.S. or Canadian dealer, for example.

This is a phenomenon market experts call “wrong-way risk.”

Katy Burne goes on to argue that “[t]he lack of sovereign CDS clearing makes individual institutions more vulnerable to a messy default.”  This is fundamentally incorrect.  Clearing does not make wrong way risk go away because banks are CCP members, and would be on the hook in the event that a big loss on sovereign CDS caused a bank/clearing member to default.  In particular, the senior tranche of a CDO-like nature of CCP default funds makes them acutely vulnerable to wrong way risk.

Wrong way risk is intrinsic to sovereign CDS.  If big sovereigns are at risk of defaults that would cause payouts on CDS–heck, if even sovereigns that seem small in the scheme of things, like Greece, are in trouble–banks are likely to be in trouble.  The correlation is a fundamental feature of the instrument.  Whether banks are the ultimate counterparties in bilateral trades or via CCPs is immaterial: the problem is there.

The latest estimates of the shortfall in MF Global customer accounts have doubled, to $1.2 billion:

The trustee overseeing the wind-down of MF Global Holdings Ltd.’s brokerage said more than $1.2 billion in customer funds could be missing from the failed firm, more than double the original estimate of missing cash.That estimate of missing funds represents funds that should have been segregated in stand-alone customer accounts by MF Global in accordance with regulations, the trustee said.

Apparently the issue is that MF held about $600 million of its own capital in customer seg accounts to cover potential customer defaults (which as a clearing broker it is on the hook for).  Add that $600 million to the $600 million original shortfall estimate (which apparently was made without taking into account the MF Global capital held in the accounts), and you get to the $1.2 billion figure.

Already ugly.  Getting uglier.

When financial/trading firms implode, they do so with incredible speed. A lot of money sloshes in and out of them every day, and in the desperation and chaos of the implosion controls break down–and are sometimes deliberately broken down.  In the scramble for cash to meet incompatible demands from importuning creditors and clients, a lot of money can go out the door.  This isn’t like the collapse of a manufacturing firm with assets like machines and buildings that are hard to turn into cash quickly, and which keeps little cash on hand.  Firms like MF have mainly liquid assets, and handle large quantities of cash and liquid assets for others.  Thus, there is a much greater risk of illicit transfers in collapse of this type of firm than in others.

Interestingly, this is one reason why financial firms have fragile capital structures.  If they didn’t, it would be quite easy for managers to misappropriate assets.  Capital structure fragility and the associated potential for runs are a disciplinary device: customers and funders who suspect misappropriation can run, and destroy the firm in a trice.

But this disciplinary device is imperfect, as are all such devices.  Sometimes managers misbehave, and these firms implode quickly as customers and funders flee. We are witnessing exactly that with MF Global.