Streetwise Professor

Betting the Business has a recent post that is a paean to central clearing.  I have some major problems with it.

The problems start with the title: “Central clearing lowers end-user costs.”  That short, unqualified, declaration begs major questions.  Most importantly: If clearing is more efficient, why did cleared markets lose market share to the putatively less efficient alternative, bilateral uncleared OTC trades?

I’m not suggesting that such inefficient outcomes are possible, but I take it as a rebuttable presumption that competitive processes tend to result in the displacement of the inefficient by the efficient.  So I’d like to see a convincing story at least, backed by some anecdotes at least, that would represent a plausible rebuttal.  That’s a low bar: it would be preferable, of course, to have a rigorous model supported by empirical evidence.  But I’ve yet to see anyone clear even that low bar: indeed, very few have tried.  To be honest, BTB don’t in this piece.

And by “convincing,” I don’t mean stories that rely on bankers’ Svengali-like hold on their customers, or customers suffering from some variant of battered spouse syndrome.  These stories are facially implausible, and indeed, counterfactual during the period during which OTC derivatives markets grew dramatically, the 1980s and 1990s.  This was a period in which banks were suffering “disintermediation”: they were losing business and customers to capital markets that customers found more efficient sources of capital.  So, the Svengali thing wasn’t working so good when it came to traditional loan business.  Ironically, many of the big loan customers that banks lost simultaneously began trading OTC derivatives with them.  Also ironically, one of the major reasons that the CDS market began was that banks were losing their traditional loan business.  JP Morgan in particular made a strategic decision to develop CDS business aggressively because it was facing more intense competition from capital markets in making traditional loans.  Which all means that customers–especially big ones–have the ability to adopt more efficient ways of financing and managing risk.

My other big problem with the BTB piece relates to netting:

Central clearing, if managed appropriately, helps to reduce the volume of credit risk by cancelling out many offsetting positions, disappearing some credit risk and leaving us with a smaller, residual credit risk from derivatives trading. One of the problems with OTC markets is that brokers wanting to closely guard their clients don’t have an incentive to cancel out offsetting exposures to counterparties. Critics of the clearing system keep overlooking the fact that risk can in fact disappear. The derivatives market system, depending upon how it is structured and operated, can have more or less total credit risk.

The notion that multilateral netting necessarily reduces risk is incorrect regardless of whether one focuses on credit risks in derivatives alone, or takes the proper perspective of looking at credit risk in toto.

With respect to credit risk in derivatives taken in isolation, clearing some products and not clearing others–which is inevitable given the unsuitability of some products for clearing, and indeed, the refusal of CCPs to clear them–may exploit some scale economies from multilateral netting in a particular product, but can destroy cross-product scope economies.  For instance, clearing a credit index but not all the names in the index destroys the scope economies that a bank can realize by holding positions with customers in both the index and the components.  Or if an interest rate swap is cleared but an interest rate swaption is not, netting economies across these products are lost.  These are simple examples, but they could be multiplied ad infinitum.

Indeed, these cross-product netting opportunities are one very plausible explanation as to why clearing lost ground to bilateral markets dominated by dealers.  Dealers trading multiple products can exploit cross-product netting economies and thereby offer their customers lower costs.

What’s more, when we consider clearing-as-it-will-be-in-this-messy-world, as opposed to the Platonic ideal of clearing, even within a single product clearing mandates may reduce netting economies.  Jurisdictionalism is likely to result in the creation of multiple CCPs for a given product type.  For instance, it is likely that regulators in the US and Europe insist that CCPs for particular products be established in their jurisdictions, and that financial institutions subject to their jurisdiction will use these “home” CCPs.  That creates operational headaches and reduces the netting benefits of clearing.

A proper, systemic approach also demonstrates that the disappearance of risk, like a magician’s trick, is often an illusion that works because the audience’s eyes are fixed in one place, and therefore they miss where the real action is.  As I pointed out several years ago, taking derivatives positions and the capital structures of market participants as given, netting redistributes risk from derivatives counterparties to other holders of liabilities on these derivatives market participants.  Yes, multilateral netting (and bilateral netting supported by collateral, rights of offset, etc., for OTC deals under bankruptcy laws) reduces the credit risk in derivatives trades, but the risk doesn’t disappear down the magician-CCP’s hat: it is reallocated to those who have lent money to the firms that hold positions in the netted derivatives.  Netting puts derivatives counterparties closer to the front of the line of creditors in bankruptcy.

Now the issue of the proper priority of derivatives is a sticky one, and I don’t claim to have the answer.  Giving derivatives counterparties priority tends to reduce their incentive to run, but it can increase the incentive of other creditors to run.  And in equilibrium, capital structures will depend on priority rules.  So it may be the case that clearing reduces the risk of runs on derivatives dealers by their derivatives counterparties, but increases the risk of runs by their repo counterparties, or the buyers of their corporate paper. It’s unclear how that cuts.  (No pun intended.)

Though I don’t have the answer as to the optimal priority rules, I do realize that netting does affect priority–and that this means that statements about netting “making risk disappear” are not generally true, and are typically wrong, because these statements are based on only a portion of the total risks.  The risk no more disappears due to a change of priorities achieved through netting than the rabbit really disappears into the magician’s hat.

It should be noted, moreover, that this issue of netting and priority has long been understood in other contexts, notably in payment systems.  Work in the 1990s and early 2000s (by Charlie Kahn, among others) emphasizes that netting systems and real time gross settlement have different affect the priority of payment system participants relative to other creditors of those systems.

There are some other problems with the BTB analysis, but I’ll just mention them in passing.  They say:

Margins are paid by those who use the system. In the OTC markets, banks either correctly price risk, or trade with clients by granting these subsidies from the taxpayer, or from wealth transfers by their bond holders. Clearing and margining is a potent dissuader of free riding on the system by negligent brokers, and also helps to mitigate agency conflicts between bonus motivated bankers and the bank’s stakeholders, which, we have learned, includes the taxpayers/citizens of each country.

I can’t say that I fully track that paragraph, but I will say that I am struck by the free riding analysis.  It suggests a sort of transubstantiation, where bankers are agency-conflicted, or perversely incentivized due to too big to fail subsidies when acting individually, but somehow become less conflicted and better incentivized when they act collectively through a CCP (and most CCPs will be bank dominated).  It’s not obvious how that works.  Indeed, collective action problems and multi-task/multi-principal agency problems usually result in weaker, not stronger incentives.

In this regard, it should also be noted that the homogenization of credit risk in a CCP creates problems.  CCPs make all trades by all members fungible, even if those members bring differing amounts of credit risk to the system.  This tends to reallocate trading activity away from the more creditworthy to the less creditworthy.

I also consider this unrealistic:

And to protect the public, it is necessary for regulators to see and be able to manage the true volume of credit supporting derivatives trading. Clearing is part of making that possible.

Given the fungibility of credit, you will never unambiguously know how much credit is used to support derivatives trades, even in a cleared system.

I have other issues (I can just imagine you exclaiming: “I’ll say!”), but I’ll leave it at that.  Suffice it to say that there are major holes in this clearing paean, and that it certainly does not provide a firm basis for mandating the adoption of central clearing.

John Lothian has an interview with Deutsche Boerse’s Head of Media Relations, Frank Herkenhoff.  Compare:

John Lothian: The vertical integration of your clearing house is continuously criticized by your competitors…

Frank Herkenhoff: Vertical integration between trading and clearing generates significant user benefits. Vertical integration allows maximum innovation in trading and clearing services, by aligning incentives at the trading and clearing level, as well as promoting systemic stability. Vertical integration is efficient as it reduces double marginalization and transaction costs. NYX had already initiated the move to vertical integration, independent of this transaction. The integrated business model has proven to be efficient and secure and has consequently become a role model for the industry over the past years.

And contrast:

The execution, clearing, and settlement of financial transactions are all subject to substantial scale and scope economies which make each of these complementary functions a natural monopoly.  Integration of trade, execution, and settlement in an exchange improves efficiency by economizing on transactions costs.  When scope economies in clearing are more extensive than those in execution, integration is more costly, and efficient organization involves a trade-off of scope economies and transactions costs.  A properly organized clearing cooperative can eliminate double marginalization problems and exploit scope economies, but can result in opportunism and underinvestment.  Moreover, a clearing cooperative may exercise market power.  Vertical integration and tying can foreclose entry, but foreclosure can be efficient because market power rents attract excessive entry.  Integration of trading and post-trade services is the modal form of organization in financial markets, which is consistent with the hypothesis that transactional efficiencies explain organizational arrangements in these markets.

This is the abstract from a paper about vertical integration in clearing that I wrote in 2006, and then updated in 2007: similar material will be in the monograph I’m working on now.

If you have way too much time on your hands, and delve into the paper, you’ll see that I discuss explicitly how the alignment of incentives between execution and clearing facilitates innovation, and improves coordination of responses to systemic shocks.  I go into great detail about double marginalization.  The parallels between Herkenhoff’s last sentence (integration is the role model) and the last sentence of my abstract (integration is the modal form of organization) are also pretty obvious. So Herkenhoff hits basically all the points I made in my paper.

Coincidence?

The Exchange Formerly Known as the Chicago Mercantile Exchange–now dubbed the CME Group–has announced that the tax situation in its current corporate home of Illinois is “untenable“:

“Our tax situation is untenable,” [CEO Craig] Donohue told Reuters, noting that CME is taxed more heavily than any of its global competitors. The company is talking with at least three states — Texas, Florida and Tennessee — about relocating some of its business to take advantage of lower tax rates there, Donohue said.

Did he say Texas?  Well, come on down!  Plenty of room!  Might I suggest Houston?

I am a native Chicagoan, and a latter-day Texan. As someone who still identifies with Chicago, and who is deeply proud of the city’s history, I am truly saddened by the circumstances that led to the CME thinking seriously about pulling up stakes.  It is the company that arguably has the deepest, longest, and most emotional tie with the city.  Their destinies and identities have been linked for almost 160 years, if you include the CBT, and nearly 100 just looking at CME alone.  The exchanges have long been iconic symbols of the city.  When derivatives exchanges began to spring up around the world beginning in the 1980s, they all looked to emulate Chicago.   The futures exchanges were the city’s unique and enduring contribution to the world of finance.

But, as they say in Texas, bidness is bidness.  Illinois has become an unbelievably hostile environment for business.  As Walter Russell Mead has blogged about regularly, the Blue State model is broken beyond repair.  And Illinois is about the bluest and brokenest state in the country–in many senses of the word “broke.”  “The City That Works”–Chicago’s old-time motto–is no longer operative.  The state is well into the fiscal death spiral: bloated spending leading to high taxes that drives out business and people.  The writing was on the wall before the last election, but the new governor and the legislature refused to make fundamental changes in the way the state spends and operates, deciding instead just to ratchet up taxes.  When businesses and people can move, that never works.  Never.

So the mystic chords of memory only go so far, and the CME owes it to its shareholders to make a rational decision.  And a rational decision means start humming “Southbound.”  The tax environment is better, and the regulatory environment is too.  In Texas specifically, tort reform has made a big difference in the business environment.

And unlike Boeing (also a Chicago company, as of recently), CME Group won’t have to worry about the NLRB if–or should I say when?–it decides to move.

Like the bumper stickers say, I wasn’t born in Texas, but I got there as soon as I could.  And damned glad I did, for a variety of reasons.  Paradoxically, it is in many ways more like the US of a long time ago, but its future is a lot brighter than that of virtually any other “progressive” place in the US–including progressive Illinois and Chicago.

Though actually that’s not really a paradox, IMO.

Yes, today marks the one year anniversary of the day when The Monster slouched off of Capitol Hill (aka Frank-n-Dodd Castle) to begin its rampage of error and terror in the countryside.

Believe it or not, I’m not grateful, despite the never-ending source of material that it has provided in the past 12 months.

It is hard to pick the Worst of Frank-n-Dodd.  There is much to choose from, and the competition is intense.  There is one element, though, that is particularly indefensible, and which happens to be in the news now, so it will get special billing in this Special Anniversary Post: The Swaps Execution Facility (SEF) mandate.

It is indefensible for a variety of reasons.  For one thing, the ostensible purpose of Frank-n-Dodd is to reduce systemic risk, and it is very difficult to make a case that requiring trading of swaps on exchange-like platforms has anything to do with systemic risk.  It is particularly interesting to note that the Europeans, who are on board with the Dodd-Frank stuff that at least is related to systemic risk (like clearing and margining of derivatives) are deeply skeptical, not to say contemptuous, of the SEF requirement.  They show no signs of adopting anything even like it.

Moreover, the SEF requirement seems to reflect some extremely childish understanding of markets.  Exchanges– transparent and good.  OTC markets–dark and scary.

This cartoonish view of markets completely fails to recognize the tremendous diversity of transactors and instruments in the market place.  It is sensible that this diversity has given rise to a diversity of trading mechanisms adapted to the traders and instruments.  Shoving everything into a one-size-fits-all framework with intense pre-trade and post-trade transparency–and transactor anonymity–presumes that all traders and all traded instruments are effectively alike.

Wrong.  Gary Gensler regales everyone with tales of how the improved transparency is going to reduce transactions costs for the buy side and end-users, and these benefits will more than offset the other, uhm, inconveniences arising from Frank-n-Dodd.  Which is kind of weird, because the buy side and end-users have been largely critical of the SEF mandate, and comfortable with the current way of doing business.  As I’ve said before, Gensler’s Fairy Tale presumes that the supposed beneficiaries of the SEF mandate are suffering from some sort of battered spouse syndrome, and love and protect their bankers despite the abuse that the latter allegedly dish out on a daily basis.

It’s also weird because the OTC markets grew absolutely and relative to exchanges–by a large margin–pre-crisis.  Given the choice, the buy side and end-users more often than not chose to trade OTC. Absent mass ignorance of self-interest, this very strongly suggests that it was cheaper for the buy side and end users to trade on these markets.

Has Gensler, or any of the other SEF evangelists, provided a convincing explanation of these facts?

No,they haven’t.  They haven’t even tried.

A non-cartoonish analysis of transactions and transactors makes it perfectly clear why the OTC markets have flourished.  A big part of that is the very basic fact that for many traders exchanges with pre- and post-trade transparency but trader anonymity are more costly places to trade.  Uninformed traders (e.g., big hedgers or pension funds) trading in size typically trade more cheaply in face-to-face markets with negotiated prices, rather than in anonymous auction markets where their orders get lumped with the trades of the informed, and hence get filled at worse prices.  This is why dark markets, block markets, etc., have always been with us, and why OTC markets are frequently the venue of choice for big buy side and commercial traders.

The SEF mandate is bad enough, but as hard as it is to believe, the CFTC proposals are even worse.  Gensler and Chilton in particular clearly want to make OTC markets as exchange-like as possible, and are pushing SEF rules that would sharply constrain the diversity of execution platforms.  The CFTC is taking an even more extreme approach to this than is the SEC.

Which is why it is encouraging to see that this is one part of Frank-n-Dodd that is the target of a legislative effort for overhaul.  Representative Scott Garrett (R-NJ) has sponsored a bill that would sharply limit the kinds of requirements the CFTC or the SEC could impose on SEFS:

H.R. 2586 prohibits the CFTC and the SEC from interpreting the SEF definition to: 1.) require a minimum number of participants to receive or respond to quote requests, 2.) require a SEF to display or delay quotes for any specific period of time, 3.) limit the means of interstate commerce that market participants can use to execute swap transactions, or 4.) require one trading system (i.e. RFQ) to interact with another trading system (i.e. Limit Order Book) on the same SEF.  These prohibitions are necessary to preserve investor choice of execution, promote transparent price discovery for market participants, and decrease the costs of hedging for American businesses, farmers, and retirement plans, all of which contribute to economic growth and job creation.

I’d prefer no SEF requirement at all, but at least this bill would give market participants a lot more lee-way to develop systems that accommodate the diversity of trades and traders.

As to its prospects–I have no idea.  But hopefully this is a harbinger of efforts to chain The Monster and bring some relief from its depredations.  That would be a good thing–despite anything Timmy! says.

Back in the late-90s and early-00s I often remarked that it was interesting how exchanges had drawn so little anti-trust scrutiny, despite the fact that may were effectively monopolies.  I also predicted that they would get more scrutiny when they became for-profit, and more like conventional firms.

That prediction is being borne out today, and how.  Exchanges, particularly merging exchanges, are the subject of considerable attention from anti-trust authorities.  ICE CEO Jeffrey Sprecher–who ironically had hoped that anti-trust objections to the CME-CBT deal would open the door for an ICE-CBT merger–has seen the writing on the wall:

Exchanges will have to “rethink their global strategies” because of unexpectedly strong scrutiny of proposed bourse tie-ups from antitrust regulators, according to IntercontinentalExchange (ICE), one of the world’s biggest exchanges.

A string of proposed mergers has come unstuck in recent months, either through nationalist opposition in the home market of exchanges perceived as the targets of takeovers, or as antitrust authorities have moved to stymie combinations amid concerns they could reduce competition.

. . . .

Jeff Sprecher, ICE chief executive, said: “There’s been a marked change in the way regulators look at exchanges generally. The good news is that they are looking to exchanges to provide more transparency to prevent another meltdown.

“The bad news is that they want to ensure a lot more exchanges to ensure competition. So the impediments are now higher than they were a few years ago and I think it’s going to cause everyone to rethink their global strategies,” he told the Financial Times.

A major sticking point for anti-trust regulators has been vertical integration between execution and clearing.  The USDOJ Anti-trust Division’s Parthian shot at the CME from early-08 is one example of this.  Battles currently going on in Europe are another.

But the vertical silo wars have now gone beyond execution and clearing to encompass other vertical restrictions, including exclusive arrangements for use of data centers.  Last week, Swedish competition authorities raided the country’s stock exchange as part of an investigation of its deal with Verizon over exclusive access to a data center.

This area is fraught with potential for policy error, because as Sam Peltzman notes in his chapter on Aaron Director in Cohen and Wright’s Pioneers of Law and Economics, and as Posner notes in his Antitrust Law, anti-trust policy over vertical restrictions and vertical integration has long been a mess.

The brief against integration, particularly between execution and clearing venues, is that clearing is a natural monopoly, and that the operator of a clearing monopoly can thwart competition in execution by creating a vertical silo, and providing clearing services exclusively to its integrated execution arm. That is, that the clearing monopolist can leverage his market power into execution, which would otherwise be competitive.

As Peltzman notes, and as Director argued well over a half-century ago, this fear of leveraging one monopoly into two is commonsensical–and more often than not, wrong.   The essence of the Chicago critique is that the monopolist (in this case, the operator of the clearing service) can extract all of the monopoly rent by choosing the monopoly price for his product.  Keeping out potentially more efficient suppliers of complementary services (e.g., execution, which is highly complementary to clearing) just reduces the profit the monopolist could extract.  The monopolist wants complements sold for the lowest price possible, in order to push out the demand curve for the monopoly good as far as possible.  Thus, keeping out a more efficient supplier of the complementary good, or reducing competition in the sale of the complementary good, is counterproductive.

Chicagoans starting with Director explained vertical restrictions as a form of price discrimination (which has ambiguous welfare consequences) or as a means of addressing free rider problems (as in Telser’s model of resale price maintenance) or as a way to eliminate double-marginalization problems.  Transaction costs economists devised other efficiency-related explanations for vertical integration.

But the suspicion of vertical integration and ties and exclusive dealing and other vertical restraints lives on.  Hence the fighting over silos in the exchange space.

Post-Chicago, there have been several attempts to produce models which lead to anti-Chicago implications, i.e., to show that monopoly leveraging is possible.  In this post I will discuss those models, and show that they don’t apply to the facts of the exchange case.  In a future post, I will discuss the efficiency rationales for integration and exclusivity.

The most prominent post-Chicago leveraging model is by Whinston.  In his model, there is a monopoly good M.  Some customers want to consume that good along with another good C that could be produced by competitive firms.  But some customers don’t want to buy M.  They wish to consume C alone.

In Whinston’s model, the M monopolist may want to tie or vertically integrate into C (and not sell to other producers of C) if entry into C production requires payment of a fixed cost.  By tying/integrating, those who want to buy M have to buy C from the M producer too.  Thus, potential entrants into the C market can sell only to those who want to buy C alone.  If there are too few of those customers, or fixed costs are too high, it will be unprofitable to enter into the production of C.  Then the monopolist can sell C to the stand-alone customers at a monopoly price.

This model clearly doesn’t fit the facts in the clearing-execution case.  Those products are highly complementary.  Indeed, they are consumed in nearly fixed proportions–if you want to trade, you need to clear, and if you clear, you need to trade.  The whole point of the Whinston model is about monopolization of a product some customers do not find complementary to M. The monopolist uses his power over the customers who have strong complementarity to gain a monopoly over customers who do not experience any complementarity with M.   This is clearly at odds with the assertions of those who assert that clearing monopolies use their power to achieve execution monopolies, because those assertions rely heavily on the notion that clearing is an essential service–i.e., highly complementary to execution, and a service that all traders consume.  That’s completely at odds with the Whinston story, so it is of no help to the anti-silo crowd.

Carlton and Waldman have an interesting model that embeds complementarity, but arrives at similar conclusions to Whinston’s model.  But whereas Whinston argues that ties/integration can be used to extend a monopoly to a non-complementary good, Carlton-Waldman devise a model in which a monopolist ties a complementary good to protect his M monopoly.

C-W present a two-period model.  A firm has a monopoly over M.  It is guaranteed this monopoly for 1 period, but in the second period, a competitor can enter.  The M monopolist can also produce a good C, and a firm that can enter the M market in the second period can produce C in the first period.

In one model, the rival incurs a fixed cost to enter the C market.  By tying the complementary good in the first period, the M monopolist deprives the entrant of any sales in the first period.  The profits from producing C and M in the second period may not be sufficient to cover entry costs, meaning that with the tie entry may not occur in either market, thereby preserving the M monopoly.  In contrast, without a tie, the entrant can produce C in the first period, and make a profit that contributes towards covering fixed costs: he can make a profit because his C good is superior to that of the monopoly producer of M.  The profit from entering C production in the first period may cover fixed costs of entering the C market.  Then, in the second period, it may be profitable to enter the M market as well.  In this case, tying protects the M monopoly.

In the second model, there is customer lock in due to network effects.  By tying in the first period, the monopolist of M locks in a lot of consumers of C, and deprives the entrant of any sales in the first period.  The customer lock-in reduces the profitability of entry into M and C production in the second period, likely by enough to make such entry unprofitable.  Again, the tie protects the M monopoly.

These models work best to explain ties in highly technologically dynamic industries where monopolies are likely to be short-lived in any event.  That doesn’t seem to fit the exchange-clearing case.  Moreover, there is no legal or economic bar on entry into clearing and execution simultaneously: the necessity of sequential entry is the key driver of the C-W results.  Indeed, integrated exchanges have entered in competition with incumbents, and execution platforms have secured clearing services by contract, so simultaneous entry has occurred.

A third type of model relies on contracting externalities to explain how exclusive dealing and integration can impair competition.  One example of this is a model by Hart and Moore.  In H-M, an upstream monopolist can sell to multiple downstream retailers.  In the exchange case, the upstream firm would be the clearing monopoly, and the retailers execution venues.

In the H-M model, the upstream monopolist negotiates with the downstream firms individually and secretly.  Moreover, they negotiate over output–the quantity sold: this is a key assumption.  H-M show that under these conditions, the monopolist cannot credibly commit to sell the monopoly output Q_m.  For instance, if he sells .5Q_m to one firm, he has an incentive to sell more than .5Q_m to the other: he cannot credibly commit to selling .5Q_m to the second firm once he has sold that amount to the first firm.  Thus, total output exceeds the monopoly output and the monopolist’s profit is smaller.  Indeed, he can only achieve the Cournot duopoly profit.  If he sells to N retailers, he can get only the N-firm Cournot profit.

By integrating, or selling to only a single retailer, the monopolist effectively commits to the monopoly output.  This may come at a cost.  For example, there may be diseconomies of scale in retailing, or retailers may be differentiated and service different customer clienteles.  But the gains from eliminating the commitment problem may exceed the costs arising from diseconomies of scale or underproduction of variety/customization.

The monopolist obviously has incentives to avoid the commitment problem that drives the exclusionary result.  For instance, he could charge the monopoly price, post that price publicly, and let the downstream firms buy as much as they want–which would be .5Q_m.  This would require the avoidance of secret price discounts.  Reputation may ensure this in a repeated game.  The retailers could monitor competitors’ sales to see if the monopolist were cheating.

Moreover, this doesn’t seem to match up well with the mechanics of the exchange case.  “Output” is not the choice variable; prices are.  And trading volumes are readily observable, making it possible to detect whether a clearing monopolist were offering secret price cuts.

A similar model is one in which a downstream monopolist buys from two upstream suppliers who compete in an input market in which the supply curve for the input slopes up.  Similar commitment problems preclude achievement of the monopsony outcome in the input market.  This model has the same choice variable problem as the H-M model, and what’s more, it is difficult to imagine what the relevant input with the upward-sloping supply would be.  Computer programmers?  Servers?  Again, it doesn’t fit the exchange case well at all.

Another model of anti-competitive integration is by Ordover, Saloner, and Salop.  In that model, two downstream firms D1 and D2 compete, as do two upstream firms U1 and U2.  If D1 and U1 integrate, and the integrated firm refuses to sell to D2, D2 now has to buy an input from a monopoly supplier U1.  D2 pays a higher price for the input, which makes it a less formidable competitor for the integrated firm, which therefore becomes more profitable.

This model is quite fragile.  What’s more, an example in a related paper by Riordan and Salop makes it hard for me to take the theory seriously.  Their example of how this could work is that the purchase of Autolite–a spark plug maker–by Ford could raise the price of spark plugs to GM and Chrysler, thereby allowing Ford to raise the price of cars.  Really.  They couldn’t come up with a better example.  (Posner snarkily dismisses the applicability of this theory by pointing out the complete absence of credible examples.)

Moreover, it doesn’t fit at all the arguments of the anti-silo advocates.  Their premise is that clearing is a natural monopoly.  But the OSS model depends crucially on integration reducing competition upstream (i.e., in clearing).  That can’t happen if clearing is already a monopoly.  OSS is not a theory of monopoly leveraging.

In brief, there are a variety of rather special models that arrive at anti-Chicago conclusions, and which suggest that vertical restrictions and vertical integration can be anti-competitive.  None of these models, however, fit the facts of securities or derivatives trading.  Moreover, many are completely at odds with the arguments made by those who claim that integration between clearing and execution is monopoly leveraging.

Which means that the anti-silo forces are on very shaky intellectual ground.  There is no existing, rigorous, logically consistent theory that is (a) consistent with the facts of the exchange case, and (b) rationalizes their conclusion that integration is anti-competitive monopoly leveraging.

In his industrial Organization text, Tirole warns:

Few topics in industrial organization are as controversial as market foreclosure.  . . . Though market foreclosure is a “hot” issue among those concerned with anti-trust proceedings and with regulation, economists still have a very incomplete understanding of its motivation and effects.  Nor can they always explain successfully why a particular tool is employed to achieve foreclosure.  (Tirole, The Theory of Industrial Organization, p. 193).

True, that.  And given that Tirole is hardly a wild-eyed libertarian, those convinced that vertical silos in exchanges are anti-competitive foreclosure should take his words as cautionary.

Posner once upon a time was more of a libertarian than Tirole, but his words are also worth considering:

The general prohibition in section 2 of the Sherman Act against monopolizing is adequate to deal with the rare case in which a firm imposes a tie-in with the purpose or likely effect of monopolizing the market for the tied (or for that matte the tying) product.  A special tie-in doctrine, inevitably with a life of its own, is unnecessary and inappropriate.  (Antitrust Law, 2d. Ed., p. 207). [Emphasis added.]

Whinston recognizes that many of the models of vertical exclusion are quite special cases, limited primarily to “triangular” situations (i.e., two upstream firms and one downstream, or two downstream firms and one upstream).  Thus, like Tirole, he cautions against drawing strong conclusions on the basis of special models.

In his “Should Antitrust Be Modernized” (J. Econ. Perspectives, 2007), Dennis Carlton cautions that rules intended to identify anti-competitive exclusive acts “could potentially challenge a wide array of core competitive behaviors” and hence become “dangerous” (p. 170).   Peltzman, in the chapter on Director I alluded to earlier, takes a more benign view of the effects of errors in precluding certain types of vertical restrictions.  Sam explains courts’ hostility to vertical restrictions by a monopolist to the belief that it is unlikely that outlawing such restrictions is unlikely to have a serious detrimental impact on competition, that any benefits of the restriction are likely to be indirect, and that courts typically discount any such indirect effects.  Transaction costs economics suggest that these benefits may be large, however, so such discounting is problematic at best.

In sum, the existing models that demonstrate that vertical restrictions can leverage monopoly don’t fit the facts of the clearing-execution case and are so highly stylized that even their developers caution against taking them too seriously in practical situation.  Moreover, thoughtful analysts of anti-trust discount their applicability.

Based on this, antitrust authorities–and those who criticize integration between clearing and execution, or between exchanges and data centers, for that matter–should be much more circumspect in their attacks on silos: the cases in which integration or vertical restrictions are anti-competitive are the exception, rather than the rule.  This circumspection should be all the greater because there are compelling efficiency rationales for vertical integration and other vertical restrictions involving clearing and execution.  I’ve laid out some of those rationales in working papers, and will devote a future post to the subject.

The Bank of England’s Andrew Haldane gave a speech on high frequency trading that highlighted its risks.  He cites evidence that various measures of persistence in stock prices have risen since 2005, and attributes this to the advent of HFT.  Maybe.  But many other things have changed in the same time period, so giving privileged status to HFT as the cause is quite a stretch.  Short of a natural or controlled experiment (e.g., randomly assigning stocks that can and cannot be traded using HFT), attributing broad changes in pricing behavior to any single factor is highly conjectural.

His argument rests on the assertion that market making is more fickle during times of stress due to HFT.  I would say that market making is more fickle during times of stress, full stop.  Liquidity has always dried up during crashes and crises, no matter what the technology.  The floors in Chicago were depopulated during the ’87 Crash.  Many locals–liquidity suppliers–who didn’t leave voluntarily were pulled off the floors by their clearing firms.  And many those that remained stood with their hands concealing their badges lest somebody try to win the outtrade lottery by claiming that he had made a profitable trade.  NASDAQ market makers didn’t answer their phones during the Crash, and many specialists evaded their affirmative obligations to make markets (so much for one of Haldane’s suggested fixes).  No HFT, but no liquidity and a crash all the same.

I wrote about a lot of the proposals that Haldane mooted in the immediate aftermath of the Flash Crash.  Market making obligations are hard to enforce, as Haldane notes.  The argument for them, as I laid out last year, is that they could affect the time pattern of liquidity supply.  Such constraints necessarily reduce the return on capital, which will lead to an exit of market making capacity.  This will raise costs in tranquil times, in the hope that the obligations imposed on market makers will lead a larger proportion of a smaller population of market makers to remain active during turbulent times, thereby improving liquidity during those times.  Given the strong incentives to evade the obligations during turbulent times, and the difficulties of specifying and enforcing what those obligations are due to the high dimensionality of the services that market makers perform, this is quite a gamble: in more technical economic jargon, market making behavior is not contractible.  There is no guarantee that the greater participation rate will more than offset the loss in capacity, leading to a more desirable allocation of liquidity supply between stable and turbulent times.

Haldane also plumped for minimum order times.  Despite David of Deus Ex Machiatto’s best efforts, I remain wholly unconvinced of the wisdom of this.  Ditto Eric Hunsader of Nanex’s very nice and thoughtful comment.  David presents a calculation of the option value, and hence the cost, of mandating a one-second quote-in-force rule.  The calibration technique is a natural one, but I am skeptical of its applicability.  The price of an option with a maturity of a month that David is using to calibrate is based on private and public information flows over a period of days, which is fundamentally different than the market makers’ pricing problem, which is driven by private information flows over very short time scales.  The whole point about market microstructure theory is that price behavior is fundamentally different at small time scales, so in my view it is unlikely that a one month option can be scaled down to value an option granted on a far shorter time scale.

But quibbles about calibration and scaling aside, this begs a huge question: if it is so cheap to grant options under all market conditions, why doesn’t competition ensure that said options are in fact supplied at their allegedly negligible cost (fractions of a basis point, per DEM)?  After all, competition–as a graph in Haldane’s presentation shows–has driven down spreads to very low levels in normal times.  The wholesale exit of market making capacity during turbulent times–in many cases, the refusal to trade at any price–indicates that it is very costly, and for some prohibitively costly, to grant options under these circumstances.  It is a cost problem, and this cost problem is endemic to financial trading, regardless of the technology.

It has long been known that situations of extreme adverse selection–a problem completely abstracted from in the option calibration problem, by the way–can lead to a breakdown of trading, or at the very least, a sharp reduction in trading activity.  When lemons risk becomes too great, markets freeze up or shut down.

An old paper by Glosten in the Journal of Business suggests that this is a rationale for having a designated market maker or specialist: in his model, a monopoly specialist market is less vulnerable to breakdown than a competitive one.  But that’s a different solution than mandating quoting by competitive market participants.  In the Glosten model, competitive markets are subject to breakdown under conditions of extreme information asymmetry.  That’s true regardless of the technology.

Glosten’s paper, I might add, was published in 1985, before HFT was a gleam in a geek’s eye.  There is indeed little new under the sun, and the focus on technological novelty obscures the enduring nature of the fundamental economic problems of liquidity supply.

Indeed, I believe it to be almost certain that imposing a restriction on quoting times will not improve liquidity, and will usually make it worse.  Imposing a constraint increases costs, and increasing costs invariably reduces supply.  A quoting time rule says: “If you quote, your quote must be in force for x seconds.”  The “if” is the key thing here: a market maker can avoid the constraint by not quoting at all, and if the cost of extending the x-second option becomes too large due to severe lemons problems, that’s exactly what he will do–or will program his machine to do.  Not exactly the best way to induce liquidity supply.

So a quoting-time rule alone is extremely counterproductive.  Hence Haldane’s musing about market making obligations–which are noncontractible and hence not effectively enforceable, and hence not much use either.

In other words, if you want to encourage liquidity supply in the worst way, imposing constraints is that way!

Going back to basics, if you think that there is a market failure (e.g., a periodically occurring severe lemons problem), a natural way to address that failure is to subsidize what is being undersupplied, not to tax it.  Just how to subsidize is not obvious, but one thought would be to widen tick sizes.

Another more productive approach would be to constrain the kinds of trading strategies that can be destabilizing, most notably stop orders.  The CME’s stop order logic clearly helped put the brakes on the Emini Flash Crash.  Extending that logic to other markets would be salutary.

This is an area where fragmentation and the associated difficulties of coordination across linked platforms raises difficulties not present in a CLOB, as David emphasized.  But that’s where regulators could play a constructive coordinating function.  Haldane and other regulators have discussed coordinated circuit breakers–a coordinated stop order logic would be an excellent place to start.

Free associating  somewhat (for that’s what blogs are for!), I can envision a way to make such limits forward looking, rather than backward looking.  The Easley-O’Hara-Prado order flow toxicity measure could help identify times in which market breakdowns are more likely, and this could be used to trigger constraints on stop orders.  All circuit breakers under consideration are conditional on price movements, which often involves shutting the barn door after the horse has bolted.  Something forward looking based on real time monitoring of quoting behavior and the adverse selection risk of order flow would be preferable.  This would put computing technologies to work reducing the risk of flash crashes.

I also think it is worthwhile to explore measures directed at parasitic types of trading.  In particular I am still convinced that pricing of exchange capacity–e.g., charging prices for submitting and canceling orders, where said prices vary with system usage–is a promising avenue to explore.

One final note.  During his talk, Haldane mentions the importance of “moving from analysing market microstructure to market macrostructure.” Hear! Hear!  That’s what I’ve been on about for the last 15 plus years.

I claim credit for coining the term “macrostructure” in this context: maybe somebody used it first, but if so I wasn’t aware of it in ’98 or ’99 when I started describing my research using that term.*  I have a paper in the JLEO from 2002 titled “Securities Market Macrostructure,” and the title of my next book will be “Financial Market Macrostructure.”  I actually had to fight the editorial board at Cambridge UP to get them to sign on to that title; they wanted a more plain-spoken title and thought that “macrostructure” was not commonly enough used in economics to fit the bill.  Glad I prevailed–and glad Mr. Haldane is popularizing the phrase.

As I use it, macrostructure modeling involves deriving the implications of microstructural forces for the organization of securities and derivatives markets–the number of exchanges; how trading is divided between exchanges and OTC markets; fragmentation of trading; how exchanges are organized and governed, etc.  My perhaps heterodox views on fragmentation, dark markets, etc., are firmly rooted in this way of analyzing market structure.  Maybe Mr. Haldane and others often disagree with those heterodox views, but it is encouraging to see that the idea of building an understanding of market structure and regulation on firm microstructure foundations is gaining acceptance.

* I’d be interested to hear from anyone who can provide an example of the term “macrostructure” used in this way (which I describe more fully in the text below) that pre-dates 1998 or so, when the word popped into my head.  I wouldn’t want to deny the actual innovator the props he or she deserves.

As I’ve written repeatedly in the past years, the mandated move to central clearing will increase substantially demands for liquidity to fund variation margin payments, especially during periods of high volatility and high market stress.  By definition, variation margin payments total zero–every dollar paid is received by somebody else–thus they don’t affect aggregate liquidity, but economic frictions preclude the development of a perfect pooling mechanism.  As a result, market participants will need to pre-plan how to fund their margin payments.

Not surprisingly, banks are crafting funding mechanisms for their buy-side clients (“end users”).  FTAlphaville quotes from a Risk story by Matt Cameron which describes some of the solutions dealer banks are peddling to their clients [emphasis provided by FTA]:

Clearing members say they have a solution. Most buy-side firms will have to access clearing services through these members – typically the large banks – due to strict membership criteria set by the CCPs. These clearing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities – essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP. Given the frequency of margin calls – there could be several per day in volatile markets – some also plan to extend credit lines, where they would meet intra-day margin calls, with the customer settling up in one go at the end of the day or start of the next.

It sounds a perfect solution, but the numbers involved are huge, raising the question of whether there is enough capacity and appetite among dealers to offer this service to the entire universe of end-users. According to research published by Morgan Stanley and Oliver Wyman on February 16, as much as 40–50% of the total annual traded volume of OTC contracts could be cleared by 2012/13 … creating an additional collateral requirement of between $2 trillion and $2.5 trillion … Most dealers say they would only have capacity to extend credit lines and provide collateral transformation services on a fraction of that.

Diving into the Risk article reveals more details–troubling ones.  It notes that unlike dealers, whose books are typically close to matched, end users are likely to have one-way positions with commensurately greater exposure to margin calls.  Which just provides just another reminder that clearing would not have been a panacea for AIG, which had huge directional positions, and was brought down by the need to fund margin calls–and would have been brought down by the need to fund margin calls in a cleared environment.  Indeed, the expansion of clearing threatens to increase the population of potential AIGs.

The article also emphasizes that the contingent funding obligations on banks could be huge, and are likely to be huge precisely when funding market conditions are stressed.  The various solutions proposed by the banks rely very heavily on repo markets, and in particular repo markets for lower quality, less-liquid instruments.  In essence, banks will repo out lower quality assets and use the cash to fund margin calls.  But repo markets for lower quality assets are the ones that are the most problematic during periods of market stress.  Note that haircuts on everything but high quality sovereign paper increased dramatically when the financial crisis took hold.  Companies that depended on the repo market for funding found this source cut off.  The shadow banking system was built on repo, and runs on the repo market are what cratered that system.  The death knell for Lehman was the decision by JP Morgan and BNY Mellon–the clearing banks–to refuse to take low quality assets to collateralize tri-party repo.

So just why exactly is it a good idea to create a system that increases reliance on a fragile funding source?  This creates exactly the kind of feedback mechanism that generates crises.  Adverse shocks lead to price changes that result in big margin calls.  These shocks also impair liquidity of the funding markets that participants rely on to obtain the cash they need to pay the margin calls.  That’s how things spiral from bad to worse to worser yet.

And there are knock-on effects in the asset markets:

“We reserve the right not to fund clients on a unilateral basis.  If we fall short and can’t fund the variation margin call, we will demand the cash from the client.  If the client doesn’t have the cash, it will have to liquidate the assets it does have or we will be forced to close them out . . .” says one dealer.

Great.  This is a perfect example of how individually rational behavior by banks can exacerbate market stress.  The collateral liquidations and  derivatives liquidations will both cause prices to move–generating more margin calls and reducing the value of the collateral available to secure funding of those calls.  Positive feedback again.  And since by design a lot of the collateral that is liquidated will be lower quality stuff traded in illiquid markets the price impacts will be large–and this will make it more difficult for others to use these assets to fund their positions, thereby creating a serious negative externality.

These problems are endemic in financial markets, including uncleared OTC derivatives markets.  But clearing makes the mechanism more rigid and time sensitive.  It increases the tightness of the coupling in the financial markets, and that makes them more vulnerable to chaotic breakdown and cascading failure.

Cameron’s article discusses other alternatives.  One is that CCPs accept lower-quality collateral. But this merely passes the hot potato.  CCPs are simply conduits that transfer margin monies from the losers to the winners.  The winners won’t necessarily accept the collateral that the losers provide, or will place a lower value on it.  Much of the collateral will be hard to value, during periods of market stress particularly.  And if there is a delivery option on collateral, how do you even price collateralized derivatives trades?: the price of the collateralized trade depends on the value of the collateral, which adds an additional risk to the trade.

So if the CCP can’t just pass collateral along from loser to winner because the collateral isn’t fungible like cash, then the CCP has to fund the cash payments to the winners collateralized by the non-cash instruments posted by the losers.  That puts the CCP in the position of a bank, and raises the question: just who is going to lend against that collateral?

Moreover, this undermines one of the main potential benefits of clearing: fungibility of trades across counterparties.  Different counterparties may have different funding capabilities.  Some may have  access to high quality collateral, some may rely more heavily on low quality collateral.  In an OTC market, those counterparties would trade derivatives at different prices reflecting their differing risks and the quality of the collateral that backs the trade.  But in a cleared market in which all trades are fungible–with offsetting positions netted out, meaning that they are treated as perfect substitutes–this pricing mechanism doesn’t work.  Economically important differences are not priced, which distorts incentives.  This will tend to work to the advantage of low-quality counterparties and to the disadvantage of high-quality ones.

In other words, if the collateral really isn’t fungible–like cash is–how can the trades backed by this collateral be fungible?

One of the risks of clearing is that it treats the unequal equally.  Widening the range of collateral that CCPs must accept only exacerbates that risk.

It also puts CCPs in a delicate position–exactly the position that JP Morgan and BNY Mellon found themselves with Lehman.  A firm is in trouble, and is offering to post dodgy paper as collateral.  If the CCP refuses, the firm is likely to default.  That could jeopardize the CCP.  Even if the CCP can absorb the default, it is at risk of being accused by the defaulter’s bankruptcy administrator of violating the bankruptcy laws–which is the situation Morgan and BNY found themselves in post-Lehman.

So maybe the CCP will decide to play European Central Bank for a day–or a week, or a month–and pretend that junk collateral is as good as gold or cash, thereby gambling on the resurrection of the troubled firm.  That just increases the risk of the financial system–and may subject the CCP to a run by firms that are worried about the quality of the collateral it has taken on.

Contrary to the airy promises of their evangelists, clearing mandates therefore do not fundamentally alter the economic problem that must be addressed: how to fund variation margins in periods of market stress.  Indeed, in my view mandates actually exacerbate the problem because they increase the rigidity and time-sensitivity of the system, require the clearing of more instruments less suitable to accurate valuation in short time frames, and reduce the ability to price risk in a discriminating way (because unequal entities and instruments are treated as interchangeable).  What’s more, the mandates tie up vast amounts of high quality collateral in initial margin payments, forcing greater reliance on lower-quality collateral to keep the system running.  And yet more–depending on the scope of the mandates, buy-side entities that pose no real default risks (e.g., pension funds) but do pose potentially serious funding and liquidity risks will be forced to clear.  Since funding and liquidity risks are the Achilles heel of the clearing system, it is absolutely insane to increase funding needs.

No matter how many times you turn over this problem, I think you will conclude that clearing mandates will substantially increase the necessity of central banks to provide liquidity, and lend against dodgy collateral.  Whether the central banks provide cash to CCPs collateralized by non-cash collateral paid by customers, or provide cash to dealer banks collateralized by low-quality collateral, or provide the cash to end-users similarly backed by low-quality collateral (although this alternative is least likely), to fund the vast margin payments during periods of stress they will be lending a lot to somebody.

Savor the irony.  The rallying cry for clearing mandates was “No More Bailouts,” “bailouts” in this instance meaning central bank loans to troubled financial institutions, intended in part to prevent a meltdown in derivatives markets.  But clearing mandates will only increase the demands on central banks to provide extraordinary funding to keep the derivatives markets going.  The parable of the Indian village that brought in cats to rid itself of mice, dogs to rid itself of the cats, elephants to rid itself of the dogs, and then in the end mice to rid itself of the rampaging elephants is apt indeed.

In the Risk article, Matt Cameron notes that seven out of eight regulators he contacted about the story refused comment: “Most said not enough analysis had been conducted.”  Read that again: “Not enough analysis had been conducted.”  Pardon my French, but Jesus H. Christ, wouldn’t you want to do that analysis before embarking on this titanic reengineering of the largest, most complex financial markets the world has ever seen?  “Not enough analysis had been conducted.”  Really?  Really?

But I know it’s true–and you do too.  And that’s the tragedy of it all.

I sometimes try to think of a rational reason for undertaking this huge experiment on a live patient.  In my more cynical moments–pretty much all my moments are cynical, but some more than others–I wonder if this is just a part of the movement to “financial repression”, defined by Reinhart and Rogoff as follows:

Banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payment system. Governments force local residents to save in banks by giving them few, if any, other options.

They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form of taxation. Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation.

Clearing mandates, mandates that non-cleared transactions be collateralized, limits on rehypothecation, segregation rules and on and are “other devices” that increase the demand for government paper.  And just coincidentally, I’m sure, we’re living in an age where governments are desperate for buyers.

Maybe the dots don’t connect.  But maybe they do.  But I guess financial repression is better than financial insanity, which is the only other explanation that comes to mind.

Cold comfort, that.

David at Deus ex Machiatto responded to my response to his post on HFT.  A brief surrebuttal, if I may.

First, regarding CLOBs.  I wrote in the Regulation piece “Thirty Years War” that I linked to in my reply that the SEC had a choice between mandating a CLOB, and an “information and linkages” approach, and chose the latter.  Its implementation of the information-and-links approach was flawed, however, because they didn’t go all the way: the limitation to top-of-book protection is the most obvious flaw.

Moreover, a linkage-based approach is problematic during periods of market stress.  Any tightly coupled system is prone to failure.  David mentions that a CLOB has a single off switch, but that coordinating a shut-down of  multiple linked markets is more difficult.  That’s definitely true.  Failures of linkages–which are prone to happen during periods of high traffic and high volatility–can propagate through a linked system in unpredictable, chaotic, and destructive ways.  All this argues for a CLOB.

But, linkages are inevitable even if all trading in a particular instrument (e.g., a particular stock) takes place on a single CLOB.  In equities, for instance, cash and futures and options and futures markets should be interrelated and interactive, but cannot be run through a single CLOB.  Thus, linkages between such markets are inevitable, these linkages can break, and this tightly coupled system is prone to destructive feedbacks during periods of market stress.  Now with the proliferation of cross-market/asset strategies, linkages are pervasive and there cannot be a true single off switch.

But this is not an artifact of computerization of the markets and HFT.  It was a problem in the Crash of ’87, for instance.  The years immediately following saw a lot of chin pulling about how to coordinate among interrelated markets.

With respect to dark markets, darkness is a mechanism for segmenting privately informed traders and those who are trading for reasons other than private information.  In the old days, with block markets, non-anonymity (counterparty transparency), reputation (“no bagging the street”), and repeat dealing were the mechanisms for doing this.  Similarly, payment for retail order flow and ex post evaluation of trading performance of various sources of order flow was a segmenting mechanism.  As long as you have some people that are trading for reasons other than private information, you will have mechanisms to help them signal their lack of information.  If you force dark markets to light up, you will see the evolution of a mechanism that performs the same functions.  As surely as the light follows the darkness.  Or something.

David and I will agree to disagree about forcing limits on order exposure.  My argument against a say 1 second minimum exposure time is based on the fact that quotes are like free options.  Forcibly extending time-in-force increases the cost of that option to the quoter.  This is especially the case during periods when order flow is toxic–as was clearly the case during the hours leading up to the Flash Crash–that cost can become appreciable.  Many quoters will decide not to quote or radically reduce size.

In other words, the supposed cure is likely to actually exacerbate the problem of liquidity supplier flight which was at the root of the Flash Crash.  Making something more expensive is not the way to get more of it.  Minimum exposure rules would raise dramatically liquidity supply costs during periods when order flow is toxic, so you will get even less liquidity then.

Remember on exchange floors the rule is that a quote is good only “as long as the breath is warm.”  That’s because locals wanted to limit the value of the options they were extending.

There’s no free lunch here.  If you impose a constraint, and the constraint binds–there is a cost associated with that.  Somebody is going to pay it.

The “warm breath” metaphor reminds me that many of the things you see in HFT have close analogies to floor trading.  Sharply limited quote exposure times is one.  Colocation gives HFT traders a time-and-space advantage like that that floor traders possessed.  Even flash trading has its parallels: it is just another time-space advantage for a subset of traders who specialize in liquidity supply.  (Though to the extent that flash trading is used primarily to exploit the lack of full book protection the analogy breaks down.)

I’m sure we haven’t reached the end of this discussion, but that’s all for now.  As the title of my Regulation piece suggested, these battles over market structure and trading rules have gone on a long, long time, and will continue for as long as asset and derivatives markets exist.

Deus ex Machiatto has an interesting post on high frequency trading.   His basic take:

I would argue that HFT has reduced trade sizes and decreased liquidity/increased costs for block trades, especially combined with the move to trading the VWAP rather than brokers taking on blocks as a risk trade, but (3) really gives me pause for thought. Is it true?

. . . .

My recipe for HFT is not to withdraw it, but to reduce the impact of its speed by (1) requiring all market participants to trade on a central order book – no dark pools and (2) requiring all quotes to be good for a minimum of half a second. This would affect real trading activity very little while completely wrecking the high frequency strategies that generate flash crash risk.

I am skeptical that requiring trading on a central order book (CLOB) will eliminate flash crashes.  Note that flash crashes have occurred on futures markets with CLOBs.  The eMini on 6 May 2010 is the most notable example, but even in markets without linkages to other markets–such as cocoa and natural gas–(a) have CLOBs, and (b) have experienced flash crashes.  I’m also skeptical that dark pools have anything to do with flash crashes, and am also not convinced that the dark pool structure–which as DEM notes, has effectively supplanted the block market for facilitating large trades–is detrimental to the interests of those who want to trade in size.  After all, a block positioner could still attempt to compete for the business of those who want to trade in blocks: the fact that dark pools have become the venue of choice suggests they outcompete the old way of trading blocks on cost.

That said, I have long been critical of the SEC rules that protect only the top of the book rather than the depth of book.  Top-of-book protection provides a way for HFTs to make money by exploiting fragmentation of liquidity.  Creating a real CLOB entails a whole set of issues (see the linked article above for a brief discussion), but these can be avoided through the creation of a virtual CLOB that protects the entire books of the various liquidity pools.

A related issue is flash quoting, in which the operator of a matching system gives those supplying liquidity on it a first chance to execute orders before they are routed to other venues.  This undermines time priority, which also precludes the creation of a virtual CLOB by integrating the books of multiple venues.  This can also affects the incentives to supply liquidity.

DEM also links to a presentation that notes that HFTs make money by collecting liquidity rebates.  He further quotes a Bank of Canada study:

Some HFT participants to overload exchanges with trade messaging activity; use their technological advantage to position themselves in front of incoming order flow, making it more difficult for participants to transact at posted prices; or withdraw activity during periods of pricing turbulence.

Both these issues relate to the subject of the very first substantive SWP post: exchange pricing.  That is, the prices that electronic exchanges charge their customers.  I wondered then, and I wonder now, why exchanges don’t charge users for causing congestion on their systems.  If quote stuffing and overloading is problematic, exchanges could penalize it through how they charge for message traffic.  You’d think they have the appropriate incentive to do so.  If it is parasitic on the customers who generate revenues for exchanges (because it is undertaken by those whom exchanges typically pay rebates–see below–and harms the people whom the exchanges charge positive prices), the exchanges would have a strong incentive to devise pricing strategies or quoting rules that would tend to deter this conduct.

Exchange pricing is also relevant for rebates.  It makes sense for exchanges to subsidize some activity (providing quotes) that increases the revenues they can realize from other activity (taking liquidity).  Again, exchanges should have the right incentives to balance the costs and benefits and come up with pricing schemes that encourage the right amount of liquidity supply.

It would certainly be odd, I should add, to want to discourage this kind of pricing if one of your concerns is the disappearance of liquidity.

And related to the disappearance of liquidity, I agree that contributes to crash risk–in both old school floor markets and newfangled electronic ones.  But restrictions on quoting–e.g., DEM’s suggestion that quotes be good for one second–could well be  counterproductive in that regard.  The current evidence suggests that order floor became much more toxic on 6 May 2010, and that’s why HFTs stopped supplying liquidity.  Forcing them to keep their quotes good for longer than they would choose to on their own in such circumstances makes it more likely they will not quote at all.  That is, establishing minimum times that quotes must be in effect is likely to accelerate the wholesale withdrawal of quotes altogether during circumstances in which flash crashes are most likely.

I think there are many issues implicated with HFT–not the least of which being whether there is even an approximate match between the social and private benefits of this activity.  Many of the issues associated with it, however, I think are only peripherally related to flash crashes.  HFT may have a role in flash crashes–though exactly what is hard to pin down, and it may also have a role in making them flashier, i.e., shorter.  But many of the controversies involving HFT don’t appear to be connected to flash crashes.  As in many issues involving financial infrastructure these days, many issues are getting mashed together.  This makes coherent analysis hard, and coherent responses even harder.

The IEA and the United States have announced plans to release over the next month 60 million barrels of crude oil from strategic stockpiles, including the US’s Strategic Petroleum Reserve.   Oil prices plunged, by about $5/barrel.  Initially, I was reluctant to attribute most of the price drop to the announcement, because the stock market and virtually all other commodities were down hard too, and the dollar rallied.  These broad changes were plausibly due to bad US job numbers and continued angst about Greece, and given the recent correlations between oil and stocks and the dollar, it was likely that a good part of the oil sell-off was related to these factors.  But when the stock market rebounded later in the day, recovering about 3/4ths of its previous losses, and oil only recovered slightly, it was evident that the oil stockpile release had caused a substantial drop in prices.

To understand the implications of the release, assume initially that the release is considered a one-off, with no implications for the future. In that case, it is like a sudden increase in initial availability of oil. Here is a figure based on a dynamic model of a storage economy that relates the amount of inventory carried out (on the vertical axis) to the amount of the commodity initially available (on the horizontal axis).*

A surprise increase in initial availability is a move along the horizontal axis. Since carry-out is an increasing function of initial availability, some of that new supply released from the reserve is added to private inventories. This would tend to dampen the effect of the release on prices, but some of the increased supply would be consumed, prices would fall. Here is a figure of price as a function of initial availability, which shows that as availability rises price falls. But this curve is flatter–more elastic–than the flow demand curve, because of the fact that some increases of initial supply are put into inventory which buffers the impact on price.

But the key thing here is that you can’t assume that the market believes that this will be a one-off, with no implications for the future. The availability-carry-out function depends crucially on the beliefs of market participants about how the SPR will be used going forward. The current use is unprecedented: previously, the reserve was used in extraordinary circumstances, like supply disruptions resulting from the 2005 hurricanes. Now it is being used to micromanage world oil prices–and to micromanage Obama’s political future. This dramatic change in the employment of the SPR will inevitably affect beliefs, and hence (a) the relation between carry-out and initial availability, and (b) price and initial availability.

In my opinion, the most likely outcome is for the change to affect beliefs in a way that leads to a bigger price response than implied by the two earlier figures. The reasoning goes like this. Those making decisions on how much oil to store do so in anticipation of earning a profit by selling out of those inventories when demand spikes up or supplies spike down. These private storers will now reason that there is a higher likelihood that supplies will be released from SPR under those circumstances. This reduces the amount of money they make on selling out of inventory during those condition. This makes holding private inventories less profitable, so they will hold smaller stocks, all else equal. Put differently, market participants will now view the SPR as a competitor for private storage under a wider range of economic circumstances than was previously the case, and this increased competition from public storage will drive out some private storage.

In terms of the graph, this shift in beliefs about the way the SPR will be used shifts the relation between availability and carry-out. In particular, it shifts it down, from the green curve to the blue one.

This shift moves exacerbates the price impact of the release. It means that a smaller amount of the release will be absorbed into private storage, more of it will be consumed, and hence prices will fall by a larger amount.

Going forward, private inventories will be smaller. This will make the market more reliant on public storage to smooth supply and demand shocks. That’s not comforting, because public storage decisions are not driven by commercial and market realities, but political ones, and by decision makers with poorer information and weaker incentives than commercial market participants.

Ironically, one hypothesis advanced to explain the decision is that it is designed to punish long speculators. Well, the government and the IEA have now just provided much speculative fodder: now market participants have to speculate about how SPR management policy has changed, and how it will change going forward. That is very complicated, given that it will be buffeted by numerous factors. These include how OPEC countries react, how the US reacts to the OPEC countries’ decisions, how it plays politically in the US, and on and on.

This uncertainty, the flow of information relevant to deciphering the policy shift, and the feedback mechanism among traders (e.g., the Bayesian learning dynamic mentioned in the Singleton paper) will all contribute to price volatility. In short, by attempting to punish speculation, the administration has only stoked speculation. The “constructive ambiguity” surrounding the release, and future reserve policies, will only further fuel such speculation. SPR policy will now attract the same kind of scrutiny as Federal Reserve policy, where market participants try to interpret Delphic announcements and actions in order to discern the future course of policy. They will try to infer how external events–say, Obama’s political standing–will drive policy: just what is the function that relates SPR releases to Obama’s poll numbers? All of this interpretation and inference will generate trading that will in turn generate price movements, just as is the case with respect to Fed policy. Alleged concern about volatility has led to a policy that will create volatility.

And note that even though this action has hurt some speculators–those who are long–it has been a huge windfall to others.

The numbers are pretty staggering. Based on Commitment of Trader Reports for 21 June, and just looking at NYMEX and ICE WTI and Brent crude oil futures, given a price impact of about $4/barrel, the announcement led to a shift of wealth from longs to shorts of about $17 billion in crude futures and futures options alone. Add in refined products and you’ll increase that more. Add in swaps and other OTC instruments, you will increase that number substantially. Very substantially.

Within categories, again assuming a $4 price impact and looking only at crude futures and futures options, long swap dealers lost $1.9 billion, short swap dealers made $1.7 billion; long managed money lost $1.5 million and short managed money made $460 million, other reporting long speculators lost $556 million and other reporting shorts made $380 million. Again this overlooks the transfers between longs and shorts in the swap market. And also the capital losses on unhedged private inventories; at the end of May, OECD commercial crude and product stocks totaled about 2.7 million billion barrels. US commercial stocks of crude are about 360 million barrels, and crude and product stocks (ex SPR) about 1 billion barrels. Thus, the value of inventories in private hands in the OECD fell by about $10 billion, and in the US about $4 billion–who knows how much inventories fell in value in China. (And by the way, the value of oil in the SPR fell by about $280 million$2.8 billion.)

A lot of money changing hands. A lot.

Earlier this year, I blogged about potential economic justifications for a strategic petroleum reserve, and how the reserve should be used based on such justifications. In brief, something like the SPR can be justified to correct some other market failure that would depress private storage below its optimal level: the most likely candidate for such a market failure would in fact be a government failure, such as the threat of price controls or other interventions during a crisis.

Suffice it to say that the current action cannot be justified in this way. There is no demonstrable market failure being ameliorated here. This use of public storage is not correcting some deficiency in private storage arising from some market failure or government failure. Indeed, perversely, this use of the SPR’s public storage will, as noted above, discourage private storage.

In US law, there are three elements to proving manipulation: causation, intent, and artificial price. It is clear logically and empirically that the SPR release did cause prices to move. It is also abundantly clear that the administration and the IEA had the specific intent to cause price changes: indeed, they are both boasting about the purpose and effect of the policy. Artificial price is somewhat more ambiguous here. No market failure is being corrected, so a colorable case can be made that the price movement is not moving price closer to where it should be in the absence of such a market failure. That supports a claim of artificiality. But given that the SPR might have distorted price in the first place, it is arguable that perhaps prices are now closer to where they “should” be–but that only means that the price was artificial before because the SPR was inefficiently holding oil off the market.

Causation and particularly intent are often the hardest thing to show in a manipulation case: here, in contrast, they are easily proven. Artificiality is not so clear cut here, but I think it is beyond cavil that the impact of the policy will be to enhance volatility in oil prices and lead to fluctuations based on conjectures about the future course of government policy. That interferes with the operation of these markets and will lead to misallocations of resources, which is what artificial prices do, and what the manipulation laws are intended to combat.

This leads me to conclude that there is a strong prima facie case of manipulation: certainly a stronger case than some others the CFTC has filed in the past. I therefore expect that the agency will move swiftly to file a manipulation action.

That was all tongue in cheek, for those slow on the uptake. I of course know that no such action will be forthcoming; the government has vast discretion in use of the SPR. But if you look at the perverse effects of manipulation by commercial and speculative players–massive transfers of wealth between market participants, distortions of consumption and production decisions by private players, unnecessary price volatility–all of them are present in spades here. Indeed, the effects here are huge, far larger than any private manipulation case that I am familiar with (and I am familiar with all of them, I think).

It is especially ironic that this move came during the same week that the Federal Trade Commission announced that it was launching the most recent in a continuing series of investigations of manipulation by oil companies. This happens every time prices are high, with the same result: the FTC finds nothing. It’s one of the longest running farces in Washington.

If it wants to find manipulation, it should restrict its investigation to the 202 area code.

This is not the first time, certainly, that the US government has attempted to intervene in commodity markets to control prices in order to achieve a political objective. The Hoover administration–you know, that laissez faire bunch (not!)–did so with abandon in the grain markets with the onset of the Depression. That turned out badly. I don’t expect this to turn out much better.

* This is the same model as I analyze extensively in my forthcoming book. Just received the galleys, so the end is in sight!