Streetwise Professor

FT Alphaville reports that the UK Parliament’s Science and Technology Committee is all hot and bothered about bank ownership, and particularly JP Morgan’s ownership, of LME delivery warehouses:

79. We heard that there were large companies dealing metals within the UK and an allegation was made by the MMTA that a company through a subsidiary may be behaving in an anti-competitive manner: on the London Metal Exchange there are four very large companies that own the very warehouses that people deliver metal into, J.P. Morgan is one of them.

They own a company called Henry Bath. They are, therefore, a ring-dealing member of the exchange and they also own the warehouse. That is restrictive. They were also reported, at one point, to have had 50% of the stock of the metal on the London Metal Exchange.[113] 80.

We would be concerned if the ownership of metals storage warehouses by a dominant dealer on the London Metals Exchange were to be anti-competitive. We would also be concerned if a dealer who had the resources to own over 50% of stock on the London Metals Exchange impeded the correct functioning of the market.

81. We use this report to bring the alleged activities of large dealers on the London Metals Exchange to the attention of the Office of Fair Trading. We would be concerned if a dealer were undermining the effective functioning of the market and we look for assurance that the market is functioning satisfactorily.

The confusion about the anti-competitive effects–or, more correctly, the lack thereof–of vertical integration is pervasive.  This is just another example.   JPM ownership of a delivery warehouse is not per se anti-competitive, and indeed, it is difficult to see how it could be a way of leveraging market power as the Committee insinuates.

Insofar as ownership of 50% plus of deliverable supply is concerned, that is a completely separate issue.  Sumitomo never owned any delivery warehouses, but it (and its pilot fish) cornered the market with abandon in the 1990s.  To my knowledge, none of the other frequent squeezes on the LME in recent years have been facilitated by ownership of warehouses.  What’s more, it’s most effective to attack corners and squeezes directly, rather than through restrictions on asset ownership.

I’ve also written from time to time on how ownership of physical assets is an important part of many commodity trading firms’ strategies.  In particular, commodity trading firms can optimize use of physical assets based on their access to information and their ability to exploit the option value of these assets.

With respect to delivery warehouses in particular, come on.  In the grain markets in Chicago, big merchants like Cargill, Continental, and ADM long owned delivery houses.  They did so for the exact same reason that many energy and metals traders today own physical assets like storage.

Where ownership of physical assets may be somewhat problematic is when it gives the owners privileged access to information.  By trading on that information, the asset owners create an adverse selection problem that reduces market liquidity.

Perhaps the most famous example of this occurred in the Chicago grain markets in the 1860s.  At that time, there was a veritable war between grain brokers and traders and the owners of the grain elevators in Chicago.  The Chicago Board of Trade was the representative of the interests of the brokers and traders, and fought hammer and tong against the “piratical” elevators.

The elevator operators had information about the quantity and quality of grain in store.  This information advantage allowed them to trade profitably.  For instance, elevator operators from time to time learned that grain was getting out of condition–“heating.”  Given this knowledge, they would go short, and cover their positions at a profit when news of the spoilage became public.

This is akin to inside trading, and has deleterious effects on market liquidity: it transfers wealth from the uninformed to the informed.

The elevator operators also allegedly operated a cartel that fixed storage rates at supercompetitive levels.  This again harmed grain merchants–and also farmers.   Elevators also took advantage of their ability to mix grain down to the minimum required to meet grade.  This effectively transferred wealth from those who stored above average quality grain into the warehousemen’s pockets.

The CBOT tried mightily to get the elevator operators to report information about the quality and quantity of grain in their facilities, and to charge reasonable rates.  The elevators basically told them to pound sand.  The CBOT had little leverage over the elevators: the brokers and merchants needed the elevators, but the elevators didn’t need to the CBOT, so threats of expulsion had little effect.

Eventually, the CBOT prevailed on the legislature of Illinois to regulate grain warehouses.  This is actually an extremely important event in American legal and regulatory history, for one of the elevator operators, Ira Munn, challenged the Illinois regulation.  He appealed all the way to the Supreme Court, which decided in favor of the state, thereby establishing the power of states–and the federal government–to regulate business “in the public interest.”  The regulatory state in the US traces its roots to that decision in Munn v. Illinois.

One of my favorite papers discusses this episode in more detail.  You can find it here.

Going back to the hyperventilating Parliamentary Science and Technology Committee and JP Morgan’s ownership of a delivery warehouse, the things that were arguably inefficient in 1867 Chicago are completely absent in 2011 Bath.  The LME announces stocks held in warehouses on a daily basis, meaning that elevator operators don’t have privileged information on quantities in store.  Quality is monitored by independent inspectors.  The fears of vertical integration resulting in a leveraging of market power are neurotic.  Merchant ownership of delivery and storage facilities is a virtually universal feature of the commodity landscape.

In other words: Move along.  Nothing to see here.

The International Swaps and Derivatives Association, ISDA, has now officially released my Discussion Paper on central clearing of derivatives.  (This is what I’ve been referring to as my white paper.)  It is the inaugural paper in the ISDA Discussion Paper series.

The link to the press release is here, and the press release contains a link to the PDF.

Any comments would be appreciated.  The paper focuses on most of the hot button issues relating to clearing, and to many of the pending regulatory issues.  Hopefully it will contribute constructively to policy, and more broadly to understanding of the issue.

I’m grateful to ISDA, and in particular ISDA CEO Conrad Voldstad, for providing this opportunity and this platform.  I also appreciate the insights and input of David Murphy, ISDA’s Global Head of Risk and Research.

*Said tongue in cheek, of course.

Chicago finance prof Luigi Zingales has written a short oped on OTC derivatives markets.  Considering the source, it is very disappointing, not to say embarrassing.

Indeed, it seems that Luigi is on the same frequency as Kenneth Griffin of Citadel: their arguments, such as they are, are virtually indistinguishable.

Zingales’s basic argument is that the OTC derivatives market is oligopolistic, and that all sorts of bad things flow from that structure:

Indeed, today the market for derivatives is oligopolistic, with a few banks running huge profit margins. And, regardless of whatever political motivations might lie behind the latest investigations, this market concentration is a real problem. According to a 2009 study by the European Central Bank, the five largest CDS dealers were party to almost half of the total outstanding notional amounts, while the 10 largest CDS dealers accounted for 72% of the trades. The markets for other derivatives are not much better.

As is usual in assertions of dealer oligopoly, there is seldom any comparison to other markets.  The concentration figures Zingales cites are hardly exceptional when compared to other industries, and I daresay to the markets for groceries or gasoline in Chicago.

But worse, Luigi’s argument is very anti-Chicago.  Long, long ago, dating back to the 1960s and 1970s, Chicago eviscerated the structure-conduct-performance paradigm associated with Harvard (and Joe Bain in particular).  Folks like Harold Demsetz and Sam Peltzman pointed out that market structure is endogenous, that concentration can result from the exploitation of cost advantages, that prices can be close to marginal cost even in concentrated markets, and that large profits in such markets are not prima facie evidence of weak or absent competition.

This means that rather than taking the concentration data (as benign as they are by comparison with other industries) and making the leap that this concentration indicates a lack of competition, Zingales should ask why the structure is what it is, what forces generated it, and whether concentration is actually symptomatic of an inefficient, non-competitive market structure.  Put differently, concentration is neither sufficient nor necessary condition for a non-competitive outcome. Regurgitating concentration statistics and proclaiming “QED” is bad economics.

That’s all bad enough, but then he really goes off the rails:

A high degree of concentration distorts the market in several ways. First, when they transact among themselves, large players do not insist on an adequate amount of collateral, relying on the counterparty’s generic creditworthiness (and on the implicit guarantees that governments provided to large firms). Not only does this severely undermine the ability of small firms to compete, but it also contributes to systemic instability of the type that we experienced in 2008, thus increasing the likelihood that taxpayers will have to step in. Market concentration renders mostly illusory the beneficent risk-spreading role that is claimed for derivatives, because the bulk of the risk is borne by very few players.

The point about implicit guarantees is fine–but that’s a policy error that can’t be fixed by jiggering with the market structure.  But the criticism that banks don’t collateralize trades but rely on generalized creditworthiness is wide of the mark for many reasons.  For one, under standard credit support annexes, dealers don’t post independent amounts with one another, but do collateralize via variation margins on a daily basis.  Hence, inter-dealer credit is limited to one-day moves.

For another, Zingales is overlooking the fungibility of credit: initial margins/independent amounts could be funded by borrowing–and banks kind of have access to a lot of borrowing channels.  And since dealers typically rehypothecate collateral, what’s the point of interdealer independent amounts anyways?: with hypothecation A can give collateral to B who can effectively turn around and give it back to A; the actual money flows are a little more complicated, but rehypothecation effectively allows banks to lend each other the collateral that they post with one another.  What’s the point of that?

For yet another, regarding the “undermining the ability of small firms to compete”–can he be serious?  Because of the borrowing point I just made, no doubt if independent amounts on all inter-dealer trades were somehow mandated, who do you think would have the lower cost of funding these margins, the big incumbent banks, or small firms?  I would wager that mandated collateralization would actually favor bigger, more creditworthy firms.

Moreover, Zingales also overlooks other potential scale and scope advantages in derivatives dealing: yes, some of these may be artificial because they arise from TBTF subsidies, but again, that is a problem that needs to be tackled directly.

Zingales then trots out the conventional arguments regarding opacity:

Over-the-counter trading also contributes to the opacity of derivatives markets, further reducing competition and increasing the margin enjoyed by the traders – and the prices that final users (mostly industrial firms) must pay. The combined profits of the key players in this market total $80 billion, which represents a massive tax on the real economy.

To fix this problem, we need to move the bulk of derivative trading onto organized exchanges, where daily collateral requirements would guarantee systemic stability, and price transparency would force competition, reduce margins, and increase the market’s depth. In the United States, the Dodd-Frank Act moves some of the way in this direction, and similar efforts are underway in Europe.

I’ve been over this ground so many times, so I’ll try to keep it brief (for me, anyways).  Zingales presents no evidence that margins are excessive.  End users have choices, including very close exchange-traded substitutes for many OTC derivatives, but they choose to trade OTC instead: like others who have made similar criticisms, Zingales apparently believes that end users are suffering from Stockholm Syndrome or Battered Spouse Syndrome.  When touting exchanges as an alternative, he also overlooks the very real possibility that face-to-face OTC dealings reduce adverse selection costs that end users incur, but would incur on anonymous exchanges.

Moreover, apropos the earlier point about anti-Chicago, if margins are so wide and profits are so fat, why doesn’t entry occur?  Why doesn’t competition work to erode margins and profits here, like in other markets?  Perhaps there’s a story, but Luigi sure doesn’t tell one–and he is far from alone in this.  The statement about profits being a tax is so embarrassing I will pass over it in silence.  The profit number itself is completely contextless; his statements about profits based on absolute magnitude (“boy, that’s big”) remind me of the periodic attacks on oil industry profits that are similarly without any context, or attempt to control for capital deployed, risk, etc.  Given that he alludes to the concentrated riskiness of derivatives positions, perhaps he should at least entertain the possibility that the profits are in fact compensation for risk:  indeed, large profits in “normal” times interspersed with periods of big losses is characteristic of the risk-reward profile associated with tail risk.

As for his proposed “solution,” I can only stand and wonder.  The hook for the entire piece is the EC’s antitrust investigation of the OTC market:

the existence of political motivations does not undermine the legitimacy of the new EU investigations, which will be conducted alongside an ongoing inquiry by the United States Justice Department into anti-competitive practices in the trading, clearing, and pricing of CDS in the US

He starts out his critique of the OTC market by focusing on concentration in the OTC market, and concludes that high concentration is symptomatic of a lack of competition.

Uhm, has he looked at concentration in the exchange space? Is he aware that virtually every major exchange-traded derivatives contract is a monopoly?  Has he looked at concentration trends in exchanges?  Has he noticed the major consolidation wave that has been going on in exchanges since about 2005, and which as picked up again after tailing off during the crisis?

To go on: Is he aware that OTC markets also engage in “daily collateralization”, particularly among dealers?  Is he aware that such daily collateralization is not necessarily stability enhancing, as he asserts? Is he aware that “price transparency” already exists, though in a different form, on OTC markets?  Is he aware that the price transparency on exchanges is accompanied by counterparty opacity that can actually increase trading costs for the uninformed end user due to adverse selection?  And again: if the advantages of exchange trading are so great for end users, why haven’t exchanges made greater inroads in attracting their business, and why have end users in fact gravitated more towards OTC markets where he claims they are getting shafted?

Luigi is a very accomplished economist.  He can do much better than uncritically recycling stale and unpersuasive conventional wisdom.

Please, Luigi: adjust the frequency on your receiver.

Derivatives Reform Proving Difficult.

Regulatory arbitrage raises its ugly head.

‘ET’ [Extraterritoriality] stokes fears about sweeping swap rules.

Clearinghouses Would Not Have Prevented the Financial Crisis.

I’m Shocked! Shocked! to hear that reforming complex markets based on complex contracts among numerous complex financial firms that span myriad jurisdictions around the globe is actually like complicated or something.  I thought Chrissy and Barney and Timmy!  and various Euro-types could rearrange these markets at a whim and make everything all better.

Not really.  I’ve seen a train-wreck from the get go.

Take clearing in particular.  If you’ve spent any time on this at all, you know that the details are incredibly complex.  The economics are challenging, the legal aspects daunting.  My white paper* goes into this in some detail.  This paper does a nice job at explaining some of the legal issues–but still only scratches the surface. If you think you can rearrange something so intricate and have it all work out just swell, you’re in for a rude surprise.  The problem is that you don’t learn what the problems are until they appear, completely unanticipated.

Mark my words.  Re-engineering these markets will lay the foundation for a future crisis.  If only people had heeded Hayek’s aphorism: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

* The white paper is done, and approved.  It should be released formally this week–maybe tomorrow.  Apparently the PR folks at the organization that commissioned the study wanted a few days with it to figure out how to distribute and market it optimally.

It’s hard to know whether to laugh or cry when reading day after day the expression of newly recognized concerns about the possible consequences of clearing mandates and other efforts to re-engineer the very complex derivatives markets.  All around the world, it is dawning on this Sorcerer’s Apprentice or that one that gee, a wave of the legislative or regulatory wand may just unleash forces that they did not intend with results they may not like.  Newly recognized by some, that is.

For instance, for quite a while now I’ve pointed out that the economies of scale and scope in clearing mean that it will be highly unlikely that this sector is going to be highly competitive.  There are strong natural monopoly elements.  This is an inherent part of the economics of risk and clearing.

One Apprentice awakes to this realization:

Over-the-counter (OTC) derivatives into clearing houses must not reinforce monopolies in the clearing business, otherwise the wider economy will suffer, a British government minister has warned.

. . . .

Mr Hoban said: “But we must not allow new standards for CCPs, combined with a legal obligation to clear derivative products, to embed monopolies in clearing that will result in costs passing back to the wider economy.”

But then he proceeds to bugger up the economics completely (sorry about the language, but he is a Brit):

The comments, by Mark Hoban, financial secretary to the Treasury, are a sign of growing unease in London over a trend gathering pace globally for exchanges to have their own clearing houses in a so-called vertical silo.

. . . .

“To prevent this, our view is that, while linked structures – so called vertical silos – can be effective, they must be subject to fair and open access requirements,” he told a conference organised by Markit, a derivatives data company.

Proponents of vertical silos, which include Deutsche Börse and CME Group, the US exchange operator, say that vertical silos are efficient and that derivatives traders like the fact that they offer a single pool of liquidity in key derivatives contracts, offering more opportunities to get deals done at keener prices.

In the latest draft of Emir, circulating among EU member states, a clearing house that has been authorised to clear [OTC] derivative contracts “shall accept clearing such contracts on a non-discriminatory, and transparent, basis, regardless of the venue of execution”.

Mr Hoban said: “Market participants should be offered a meaningful choice of using all or part of a vertical structure.”

This is getting tiresome.  Again: the very fact that there are strong natural monopoly elements in both execution and clearing is exactly why vertical integration–the dreaded silo–is so common, and in fact is becoming more so (e.g., LME’s recent mooting of setting up its own clearinghouse, following similar efforts by ICE and EuroNextLIFFE).  Straightforward transactions costs economics and even some straightforward neoclassical economics (double marginalization) provide a strong rationale for integration of execution and clearing venues.

Scope economies are the only thing that really push against this.  To the extent that there are greater scope economies in clearing than in execution, vertical integration can be more costly as it means that scope economies are not fully exploited.

But the fact remains that scale and scope economies and transactions costs and double marginalization effects are going to lead to industry structures that are likely to involve a lot of concentration and a lot of integration (in part because there’s a lot of concentration).  Forcing greater use of clearing and exchange-like execution venues is only going to intensify these effects.

Bloviating about mandating “meaningful choice” doesn’t change the fundamental economic drivers.  People who regulate and legislate in blissful disregard of these drivers, and then express Shock!, Shock! that the results they engender are not what they desired are annoying beyond belief. Annoying and pathetic.

The commodity markets have been volatile of late.  The tumult started in silver, which sold off dramatically after reaching post-Hunt highs.  Last week the sell-off broadened to a good chunk of the commodities markets, with oil especially hard hit.  In response to the roiling markets, the CME raised margins sharply on silver, and today on oil and the rest of the energy complex.

This raises the question of the effect of margin changes on prices.  The CME’s head of clearing, Kim Taylor, vigorously defended the CME’s margin increases in silver (and would presumably make the same defense of today’s moves).  Kim’s justification characterizes the clearinghouse’s move as a response to changed market conditions:

Changes to margin requirements are a routine part of market surveillance at CME Clearing, the risk management and compliance unit at CME Group Inc. (CME), which owns Nymex. So far this year, CME has issued over 57 margin change notices.

“I don’t agree that the margin change was a trigger for changes in the market,” said Kim Taylor, president of CME Clearing. Taylor leads a team of sever hundred risk management and compliance professionals who monitor CME’s markets around the clock.

“The market is well tuned so that if there’s a market move that approaches or exceeds our volatility limits” participants know to expect an increase in margin requirements, she said.

The decision to alter trading margins on a contract typically involves risk management professionals involved in day-to-day monitoring of the specific market as well as senior management of the clearing house. The team looks at a variety of quantitative factors like rising volatility and qualitative factors like seasonality and relevant news events in making margin decisions.

“We try to make changes in a way that we can telegraph to the market, so that participants have notice. We try to be routine and predictable and provide no surprises,” Taylor said.

The trading margins are designed to cover around 95% of expected losses, and act as a pre-payment on the coming day’s market move.

“When market conditions become more volatile we would increase margins in anticipation of that, and when volatility decreases we don’t want to create unnecessary capital costs,” Taylor said.

In past instances, CME Clearing has often raised trading margins ahead of certain events in an attempt to damp their impact on trading. For example, the exchange-operator increased trading margins on several products, including crude oil, ahead of Hurricane Katrina to ensure traders were prepared for higher volatility .

“We try to be proactive with either something we can measure or something we can judge to likely effect our markets,”

This is sensible, in a way that I’ll explain in a moment, and the way that CCPs usually act.  Taylor tries to emphasize that the changes are predictable, and in some respects they are, but this is not sufficient to relieve CME of the charge that margin changes can cause market movements.

The changes that CME made, and which Kim explains, are sensible in a microprudential sense.  They help ensure that the CME has a sufficient buffer to absorb defaults by traders.  CCPs try to work on the “loser pays” model, and with more volatility, there are bigger losers–so margins have to be higher to ensure they can pay.

But the implicit assumption here is there isn’t feedback between margins and prices.*  Indeed, that’s the gravamen of Taylor’s argument (“I don’t agree that the margin change was a trigger for changes in the market”).  That is the essence of a microprudential approach.  That assumption, however, is quite tenuous, and almost certainly untrue.  This is particularly the case for big margin changes during unsettled market conditions.

That is, when setting margins, CCPs (and participants in bilateral markets too) typically act as if they are price (and volatility) takers, when in fact they are big enough and their decisions are material enough to be price and volatility makers.  Acting microprudentially, they typically fail to take into account the feedback between their decisions and market prices, or at least do not do so completely.

The feedback mechanism works because frequently market participants will respond to margin changes by liquidating positions.  Those who have already lost money as a result of big price moves are the most likely to liquidate, which tends to exacerbate the original moves.  That’s one reason why you can see bigger than expected moves (as occurred in oil last week) to fundamental shocks.

This is why CCP policies that are prudent in some sense can be macroprudentially dangerous.  Silver, and perhaps oil and other commodities, may be providing an object lesson of what is in store when clearing is extended to vast new markets.  When OTC clearing mandates kick in, the scope for these destabilizing feedbacks will expand dramatically.

Kim suggests that predictability mitigates these impacts, but CCPs are not that predictable, and margin methods are not necessarily that transparent.  So market participants cannot foresee the changes perfectly.  And even if they could, all this means is that they will likely react in anticipation of margin changes. The timing of the response may depend on predictability, but not the existence of the response.

This can create some really strange dynamics and non-linearities.  There’s a big selloff.  Longs anticipate that in response, CCPs will raise margins.  Those that have lost a lot of money know they can’t afford the higher margins, so they preemptively liquidate, exacerbating the selloff.  The bigger price move induces the CCPs to raise margins more than they would have without the preemptive liquidations.

This is exactly the kind of feedback mechanism that can induce chaos (in the technical and conversational senses of the word) in a tightly coupled system like a financial market. This mechanism is particularly prone to chaos if the CCP setting margin doesn’t take into account, or cannot predict accurately, the feedback between its margin changes and the trading of market participants.  And how could it know this effect with any accuracy?

This is a classic example of the tension between microprudential and macroprudential policies that I discussed in some earlier blog posts, and which is a major theme in my forthcoming white paper/discussion paper on clearing.  (This should be available within a week to ten days, if all goes well: final edits and approvals are in the works.)  The information and incentive structures tend to induce microprudentially sensible actions based on the price/volatility taking assumption.  But those actions can be destabilizing. CCPs acting in their own self-interest, and those of their clearing members, may not choose the systemically optimal actions.

It’s worth noting that the CFTC’s Proposed Risk Management Standards for Designated Clearing Organizations effectively codifies this sort of behavior.  Its proposed rule (a) requires that CCPs set margins “actual coverage of the initial margin requirements produced by such models, along with projected measures of the models’ performance, shall meet an established confidence level of at least 99%”, (b) determine the adequacy of margins on a daily basis, (c) backtest the adequacy of margins on a daily basis for products experiencing “significant market volatility,” and (d) backtest the adequacy of margins for all products at least monthly.  Similarly, both the Federal Reserve’s and the SEC’s proposed regulations require the use of risk-based models and at least monthly review of margin levels.

All of these requirements are microprudentially sensible, but will result in margin increases during periods of heightened market volatility.  As just noted, this can create destabilizing feedback effects, particularly during periods of extreme market volatility.

In contrast, the Committee on the Global Financial System recommended the use of a “through-the-cycle approach employing data from a long time series of market movements” when setting initial margins, precisely to reduce the procyclicality in margin that results from adjusting it frequently based on changes in market risks.

Which means don’t look at last week’s commodity mini-crash, or the earlier bigger crash in silver, as historical events.  Look at them as harbingers, as warnings.  Just the normal operation of a tight, mechanical variation margin process can be destabilizing.  Changes in initial and maintenance margins adopted in response to big price moves can destabilize things more.  The financial system can shake off such an occurrence in a market as small as silver, or even one the size of oil.  When it’s a bigger market–and especially when it’s a much bigger market, like some of the huge OTC markets–these changes will shake the markets, perhaps by more than they can withstand.

*Failures to account for feedback between one’s behavior and market prices is a common element in many market crises.  For instance, LTCM’s risk models–like most models in finance–presumed that the hedge fund was a price taker.  But once it became huge, it was no longer a price taker; its trades moved prices and affected liquidity.  Similarly, portfolio insurance strategies took price processes as exogenous, when in fact the strategies themselves affected prices.

The LME has announced that it is considering severing its clearing relationship with LCH.Clearnet (a relationship that goes back to the Tin Crisis of the 1980s) and setting up its own clearinghouse.  This is a perfect illustration of the disconnect between market participants on the one hand, and regulators on the other.  Regulators are extremely suspicious of the “vertical silo” model, but exchanges are migrating in that direction: recently, ICE, EuronextLIFFE, and LSE have set up or moved to set up integrated clearing operations.

As I wrote years ago, both on the blog and in some academic work, vertical integration makes sense for exchanges on transaction costs grounds, even though it involves the sacrifice of some margining and netting economies, especially for relatively narrow exchanges like the LME or ICE (less so for multi-asset class exchanges like CME or Deutsche Borse).  Regulators seem a little slow on the uptake about this point, being instead haunted by hobgloblins screeching that integrated CCPs are anti-competitive (and thereby ignoring well-understood economics).

Moreover, this brings home a point I made in some things I’ve written over the past couple of years about the uncertainties of the evolution of market structure in the aftermath of Dodd-Frank and EMIR.  For instance, in the Journal of Applied Corporate Finance I wrote that “strategic considerations will influence decisively the way that the industry develops.”  By that I meant exactly that transactions-cost driven decisions regarding CCP ownership would play an important role in the industry evolution.  What’s more, these decisions will have implications for the costs and benefits of clearing, and the systemic risk effects of clearing mandates.

The financial markets are an extremely complex system.  Market participants will make decisions regarding things like clearing arrangements based on private costs and benefits, even though those will have systemic effects not internalized by the decision makers.  Legislators and regulators overlooked this almost entirely when deciding that clearing was the magic solution to counterparty risk.  As a result, they have unleashed a process that will have unintended consequences that will in turn spark regulatory and legislative responses.

This process has just begun.  It’s already complicated, and will get more complicated in very short order as dreamy regulators and legislators butt up against commercial reality.

I’ve written over the years that I expect that financial markets will receive more anti-trust scrutiny than has traditionally been the case.  Liquidity effects impede competition in execution.  A variety factors relating to risk, notably diversification and the fact that an option on a portfolio is less costly than a portfolio of options, create strong natural monopoly elements in clearing.  The transactions costs that arise when concentrated upstream and downstream industries interact make vertical integration efficient.  All of these features give rise to potential anti-trust concerns.

Last year the USDOJ was investigating the data provider Markit and ICE Trust CDS clearing for potential anti-trust violations.  Friday it was announced that the European Union is picking up the cudgels, and also investigating Market and ICE Trust:

Lack of transparency in markets can lead to abusive behavior and facilitate violations of competition rules,” Joaquin Almunia, the EU’s competition commissioner, said in an e-mailed statement. “I hope our investigation will contribute to a better functioning of financial markets.

. . . .

“What we are looking at is whether the main players in the market have behaved badly, have entered into anti-competitive agreements or abused a possible dominant position,” Amelia Torres, a commission spokeswoman, told reporters in Brussels today.

ICE in Atlanta didn’t return a phone call and an e-mail seeking comment. ICE’s U.S. clearing arm is owned by dealers including JPMorgan, Goldman Sachs and UBS.

Goldman Sachs declined to comment on today’s probe, said Michael Duvally, a spokesman for the bank in London.

Deutsche Bank

Deutsche Bank, Commerzbank, JPMorgan, Bank of America, BNP Paribas, Morgan Stanley, Barclays, UBS, Credit Suisse, RBS, Societe Generale, HSBC, Wells Fargo and Citigroup also declined to comment.

The agreements with ICE have clauses on preferential fees and profit sharing arrangements “which might create an incentive for the banks to use only ICE as a clearinghouse,” the EU said. That may block other clearinghouses from starting up and limit choice for CDS dealers, it said. [Emphasis added.]

The investigation will also cover fee structures used by ICE to check if they give “an unfair advantage to the nine banks by discriminating against other CDS dealers.”

The italicized portion suggests that the EU has a lot to learn about clearing.  As noted above, and as I’ve written about numerous times here and elsewhere, there are strong efficiency reasons for concentrating trade clearing in a single CCP.  Concentrating clearing maximizes netting possibilities.  It economizes on the use of capital by permitting more efficient margining. Due to diversification and the option-like nature of counterparty risk, the more positions that are cleared through a single CCP, the smaller the capital required to ensure a given probability of CCP default.

This all means that dealers have a very strong incentive absent any fee and profit sharing arrangements to use a single clearinghouse.  Moreover, informational considerations make it desirable for firms to use a single CCP: that way, the CCP has a more complete picture of each firm’s risk, whereas if a dealer clears through multiple CCPs none of them will have a good understanding of the dealer’s true riskiness.  Thus, dealers have a good motive to provide dealers with an incentive to bring all their business to the common CCP, all the better to keep an eye on one another.

This all also means that the market for clearing is almost certainly unlikely to be highly competitive.  That it is delusional to think that there will be robust competition between CCPs in the long run: maybe multiple CCPs will start up and compete for the market, but eventually, the economies of scale and scope that characterize clearing will result in one winner taking all.  CDS dealers, or dealers in any derivative, are unlikely ever to have much choice in clearing–or to want it.

Since dealers are the main users of CCP services, and since a single CCP is likely to dominate any market, it is also the case that dealers are going to control and/or own CCPs in order to limit their vulnerability to the dominant CCP’s market power.  Indeed, this integration also contributes to efficiency by reducing markups over marginal cost and also reducing transactions costs.  Dealer control is also necessary to align risks and control; if dealers are the residual risk bearers in a CCP, it is efficient to have them control the CCP to prevent excessive risk taking.

But as I’ve written ad nauseum over the years, the economies of scale and scope that make clearing a natural monopoly, or close to one, can be exploited to exercise market power.

There are no easy resolutions to these issues.  Clearing–and execution as well–are like other network industries.  And every network industry–every one–has posed similar thorny difficulties.  For the most part, financial exchanges and clearing have escaped the regulatory and anti-trust scrutiny that industries like electricity transmission, gas pipelines, and telecoms have received.  But that’s changing.  The EU investigation is a harbinger of that.  And if the initial announcement is any indication, the EU has not progressed very far down the learning curve on the issues related to clearing.  Until they do, the potential for ham-handed, counterproductive anti-trust and regulatory intervention is quite high.

This also demonstrates one of the potential consequences of force feeding clearing.  Not only is force feeding problematic from a systemic risk perspective, it will also create competitive issues.  And the tension between desires to increase competition and desires to ensure the safety and soundness of CCPs are likely to result in regulatory mistakes–serious regulatory mistakes–in the future.

Timmy!’s Treasury Department has released a decision exempting foreign currency swaps from Dodd-Frank clearing and SEF rules.  I agree with the decision, because I think clearing and SEF mandates are a bad idea (if you haven’t noticed).  But the “reasoning” behind the Treasury’s decision would embarrass South Park Timmy!  Really.

Where to begin?  First of all, the Notice of Proposed Determination (NOPD) completely undercuts all of the justifications for Frank-n-Dodd clearing mandates.  In multiple ways.

The NOPD tries to distinguish between FX swaps and other swaps: For instance [with my numbering for subsequent reference]:

(1) [f]oreign exchange swap and forward participants know their own and their counterparties’ payment obligations and their full extent of the exposure throughout the life of the contract, whereas the counterparties to other derivatives contracts do not.  (2) Moreover, foreign exchange swap and forward contracts have a very short average length and, therefore, relative to other swaps and derivatives, create significantly lower levels of counterparty credit risk.

(3) Settlement of foreign exchange swap and forward contracts requires the exchange of the full principal amount of the contract . . . whereas the payment obligations of most other derivatives are based on the incremental profit or loss on a transaction.  The physical settlement requirement distinguishes foreign exchange swaps and forwards from other derivates and contributes to a risk profile that is largely concentrated on settlement risk.

To which I say:

(1) So what? And, so misleading.  As the Treasury acknowledges on the prior page, the market value of the FX swap can change.  That’s what creates counterparty risk.  If the dollar crashes (despite Timmy!’s–Turbo Tax Timmy!’s, not South Park Timmy!’s–and Banana Ben’s assurances that it won’t which is primarily why I think it will), those long the dollar under swap agreements will suffer a big loss thereby creating a credit exposure for their counterparties.  That’s what matters.

What’s more, there are a lot of derivatives that are cleared that have this feature.  The counterparties to every physically settled commodity contract, and to every standard stock option, know exactly what the delivery and payment obligations are.  A buyer of a corn futures contract knows the seller has to delivery 5000 bushels of corn, and the seller knows exactly how much money the buyer has to deliver in return.  The buyer of a put on IBM knows exactly what he has to pay on exercise (the strike price times the number of shares), and the seller knows exactly how many shares he will have to deliver.  It’s variations in the market values on these contracts that create credit risk, and that’s the risk that the CME clearinghouse or the OCC take on. If the certainty of delivery and payment obligations meant clearing didn’t add value, why would these kind of products be cleared?  Why have they been cleared for decades?  Why?  Precisely because changes in market values may result in one party to a contract not performing on the fixed and known obligation, and thereby imposing a replacement cost loss on the counterparty.  So how is FX different in any way?

(2) This may be relevant on average, but there are many long tenor FX derivatives.   The NOPD states that 68 percent of FX derivatives mature in less than a week, and that 98 percent mature in less than a year.  This, plus the focus on CLS Bank (the FX settlement service), suggests that they are lumping in all FX trades in their analysis.  By doing so, Treasury mixes apples and oranges.  The logic of Frank-n-Dodd may still compel the clearing of the longer-dated products–which still make up a big chunk of change.  Interesting that the Treasury reports percentages without saying exactly what goes into the calculation, and doesn’t report the amount of principal at risk on longer dated contracts.

(3) Here’s the real whopper.  This actually means that an FX forward or swap has greater counterparty risk than other derivatives (e.g., interest rate swaps) of the same tenor and underlying volatility.   That’s because principal is at risk in a default of an FX swap, but it isn’t at risk in a typical interest rate, equity, or commodity swap.  To quote The Man when it comes to counterparty credit risk, Jon Gregory:

Foreign exchange exposures can be considerable due the high FX volatility driving the risk coupled to the long maturities and the final exchanges of notional required in most swap contracts.  The risk of these instruments is driven by a large final payment and thus the profile increases monotonically until the maturity of the trade (p. 85).

Gregory also has some charts that show FX swap credit exposures being larger than the exposures on IR deals.

All of which pretty much calls Bull! on the Treasury’s “argument” as to why differences between FX swaps and other swaps means that it’s not necessary to clear the former.  If anything, to a Frank-n-Dodd fan, the reverse should be true, at least for longer-dated swaps.  Similarly, the NOPD makes it clear that non-delivery settled forwards are not exempted–even though the lack of principal being at risk means that all else (e.g., tenor, currencies) equal NDSFs entail less counterparty risk.

So, if you believe that counterparty risk is best handled through CCPs–which you have to believe if you are a Frank-n-Dodd clearing mandate pom-pom squad member–you should think longer tenor FX swaps are especially important to clear.

But it gets better!  Or worse, depending on your point of view.  Treasury also argues that a clearing mandate would be burdensome because it could lead firms to eschew risk management.

Seriously!  Let me repeat that: Treasury also argues that a clearing mandate would be burdensome because it could lead firms to eschew risk management.

Don’t believe me?  Read it for yourself:

Commenters argue that additional costs associated with collateral, margin, and capital requirements required by the CCP would potentially reduce their incentives to manage foreign exchange risks.  Such additional costs borne by non-financial end-users could lead to lower cash flows or earnings, which would divert financial resources from investment and discourage international trade, thereby limiting the growth of U.S. businesses.

. . . .

In light of these and similar factors raised by the commenters, Treasury believes that mandating centralized clearing and exchange trading under the CEA for foreign exchange swaps and foreign exchange forwards actually would introduce significant operational challenges and potentially disruptive effects in this market which would outweigh any marginal benefits for transparent trading or reducing risk in these instruments.

So don’t these burdens exist in other markets?  If “additional costs associated with collateral, margin, and capital requirements required by the CCP” lead to less FX hedging, won’t they also lead to less interest rate, credit risk, and commodity price hedging?  If the reduction in risk management is such a serious concern in FX, why not in these other markets?

But we’re not done yet!  Get this: another justification for the exemption is that most FX derivatives are traded by banks either directly or on behalf of clients, and–wait for it–

[b]anks are subject to consolidated supervision, and supervisors regularly monitor their foreign exchange related exposures, internal controls, risk management systems, and settlement practices.

In case you didn’t catch that, FX derivatives should be exempted from clearing because:

Banks are subject to consolidated supervision, and supervisors regularly monitor their foreign exchange related exposures, internal controls, risk management systems, and settlement practices.

Here’s more:

The predominant participants in the foreign exchange swaps and forwards market are banks which have long been subject to prudential supervision.  In fact, nearly all trading within the foreign exchange market involves bank counterparties.  Roughly 95 percent of foreign exchange trading occurs between banks acting in the capacity of either principal or agent.  Compared to non-bank entities, banks have distinct advantages to provide the liquidity and funding necessary to conduct foreign exchange swaps and forwards, which involve the exchange of principal, rather than variable cash flows.  In conjunction with providing the liquidity and funding needs to conduct these transactions, banks are uniquely qualified to have access to CLS to settle transactions on a real-time basis, and thereby meet the payment and short-term funding needs of the end users.

Prudential supervisors regularly monitor the activities, exposures, internal controls and risk management systems of these banks.  In order to meet safety-and-soundness requirements, banks have implemented monitoring systems, limits, internal controls, hedging techniques, and similar risk-management measures.  Counterparty credit risk management is a fundamental issue for banking supervisors and is extensively addressed in bank supervisory guidelines as well as under the Basel Accords.

So let me make sure I have this right:  bank dominated markets need not be cleared because banks are subject to rigorous prudential regulation.

But wait a minute.  The whole point of Frank-n-Dodd was that derivatives trading was uniquely dangerous for banks, and clearing mandates were necessary to reduce the risk of the derivatives-induced collapse of a too big to fail bank, all because prudential oversight hadn’t worked and couldn’t be relied on. Moreover, whereas Dodd-Frank contemplated the exemption of non-bank firms from clearing mandates, margining on non-cleared trades, and capital requirements, the Act forces banks to clear standardized products, and to collateralize non-cleared trades.  All in the name of reducing systemic risk and shifting counterparty risk from banks to CCPs (which are capitalized by banks, but let’s ignore that little detail).

In order for this to make any sense whatsoever, it must be the case that prudential regulation is insufficient to reduce derivatives-related systemic risks.  But the NOPD relies heavily on the adequacy of prudential regulation to justify exempting FX swaps from the clearing mandate.

I ask, in all seriousness: if dominance by banks that are prudentially supervised implies that clearing is not necessary, why are CDS subject to a mandate?  After all, they’re bank dominated.  And don’t banks have “distinct advantages to provide the liquidity and funding necessary to conduct” other kinds of swaps?

F. Scott Fitzgerald said “the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.”  You have to be a genius and hold Frank-n-Dodd and the Treasury NOPD in your mind simultaneously, because they are definitely opposed ideas.  Every substantive justification for the exemption in the NOPD is diametrically at odds with the justifications for the Dodd-Frank clearing mandates.

But the fun isn’t finished!  The NOPD’s rationalization for exempting FX from SEF requirements is also entertaining.  I quote:

Foreign exchange swaps and forwards already trade in a highly transparent market.  Market participants have access to readily available pricing information through multiple sources.  Approximately 41 percent and 72 percent of foreign exchange swaps and forwards, respectively, already trade across a range of electronic platforms and the use of such platforms has been steadily increasing in recent years.14  The use of electronic trading platforms provides a high level of pre- and post-trade transparency within the foreign exchange swaps and forwards market.  Thus, mandatory exchange trading requirements would not significantly improve price transparency or reduce trading costs within this market.

I’m not disputing any of this, but  just think of all the questions that this should raise in the minds of those who argue that it is necessary to force open electronic trading on swap market participants–but which it evidently hasn’t.

Recall that the NOPD makes a big deal out of the fact that FX is bank-dominated–dominated, in fact, by the same banks that dominate IR, credit, and equity derivatives trading.  In IR, credit, and equity, the argument goes that banks have actively fought pre- and post-trade transparency and electronic execution in order to protect their market power.  So . . . why didn’t they try and succeed in doing that in FX?  To create a natural experiment?  I kinda doubt that.

Maybe–just maybe–it’s because trading structure is endogenous and reflects the nature of the instruments traded and the firms that trade them, and there are enough differences across markets to make different trading structures optimal.  Maybe–just maybe–market structures and trading mechanisms have evolved to match in a discriminating way the characteristics of instruments and participants.

I don’t know that’s definitely the case, but it’s certainly a possibility, and it makes economic sense.  It’s certainly a more plausible explanation of cross sectional variation in trading mechanisms than the Treasury or SEF mandate boosters offer–because they don’t offer any.  Another F. Scott Fitzgerald moment here, apparently,  for the very facts in the Treasury NOPD undercut the narrative used to justify SEF mandates that Treasury has advocated strongly in the past.

Of course I seriously doubt that the espousal of completely contrary positions on all these matters is a reflection of first rate intellects at work.  Nor is it an exercise in eristics.  Instead, it is a symptom of complete intellectual muddle and confusion, blended with politics and rent seeking. Timmy!, Dodd, Frank and all the other Sorcerer’s Apprentices have no real understanding of the economic forces they have unleashed, and what will result.  The FX swap exemption is a first order issue, and the completely intellectually discreditable way with it has been handled provides a very sobering preview of how derivatives market regulation generally, and CCP regulation in particular, is likely to be carried out in the future.  If they can’t think carefully and seriously about this, what can they think carefully and seriously about?  Are they incapable of self-reflection?  Of embarrassment?  Do they not see the glaring contradictions between the NOPD and the entire rationale for the Dodd-Frank Act that gave birth to the NOPD in the first place?

I’ve said it often before, but it still bears repeating.  Regulators create systemic risks because they act on the entire system, and there are few of the kind of ameliorative feedback mechanisms that work in markets.  I fear that the NOPD is a harbinger of the kinds of regulation- and regulator-created systemic risks that will haunt derivatives markets for years to come.

The CFTC and SEC have released their swap definitions. Among other things, the CFTC rule excludes commodity forward contracts from the swap definition.

The CFTC proposed rule is 300 pages long.  Do you believe that such a massive attempt at definition will not have ambiguities and uncertainties that will require clarification?  Do you believe that market participants will not try to write contracts to take advantage of exclusions and exemptions, and that these attempts will not result in litigation?  Do you believe that a rulemaking that is far broader in its application than pre-CFMA laws and regulations  will not result in the growth of a thicket of decisions, interpretive letters, no action letters, etc., that will be more confusing and more contradictory than that which developed prior to 2000 (before the passage of the CFMA) to clarify the distinction between “futures” that had to be traded on exchanges and commodity forward contracts that didn’t?

If so, have a nice dream.  Reality will be waiting for you when you wake up.

The Commission also voted out a proposal for a hybrid margin segregation mechanism, where customer funds would be segregated operationally (i.e., held in a single account), but would not be at risk to a the default of another customer.

This is a victory for BlackRock and other big money managers who lobbied hard for it.  And yes, they are winners.  But make no mistake, the main effect of this rule is redistributive, meaning that there are losers.  And to the extent that it affects efficiency, the effect is negative because mandatory segregation encourages moral hazard: clearing member customers now have zero incentive to monitor their clearing members.

The distributive effect arises from the fact that removing customers from default risk mutualization means that default losses are just shifted elsewhere, e.g., CCP equity or the CCP’s default fund.  Alternatively, CCPs may choose to up margins to reduce default fund exposure to customer defaults.

The costs of default don’t go away.  They are mainly shifted around.  Low default risk firms (e.g., BlackRock, pension funds) will no longer be at risk and will benefit.  But somebody else will pay.

A much preferable approach would be to establish omnibus segregation as a default standard, but permit clearing members and their clients contract for individually segregated accounts .  This would permit those who value segregation more highly than it costs clearing members to segregate to negotiate mutually beneficial arrangements with clearing firms.  Such contracts would reflect information available only to the contracting parties, but which regulators could not know when setting a one-size-fits-all standard.

This would internalize (i.e., price) many of the costs of segregation which  under the CFTC proposal would be shifted to default fund participants (i.e., other clearing members) and from some customers (the BlackRocks of the world) to others.

For instance, if a large money manager and a clearing member negotiate a segregation arrangement, this would shift risk to the member’s other customers, and to the CCP default fund. The shift in risk to other customers would tend to reduce their demand for the member’s services, leading this firm to internalize some, and perhaps all, of the effects of this risk transfer.

However, the risk transferred to the default fund would not necessarily be priced.  This problem could be addressed by allowing the CCP to set default fund contributions based on segregation, with members with larger sums in segregated accounts being required to make a larger default fund contribution.

I don’t understand the mania for one-size-fits-all rules when private contracting can result in efficient outcomes that take into account individual differences.  Derivatives market participants are by and large quite sophisticated, and capable of trading off the costs and benefits of alternative arrangements, including alternative segregation arrangements.  Permitting individualized negotiation which prices these costs and benefits–which differ among market participants–is the most efficient and effective way of ensuring they optimize that trade off, and do so in ways that reflect differences among them.  Let CCP members who participate in the default fund come up with methods that internalize the potential spillover between segregation and the default fund.

One size fits all rules create a tremendous incentive for affected parties to influence the rulemaking process for their benefit.  BlackRock, Pimco, some big pension funds, etc., seem to have done that in this instance.  They’ve secured a rule that protects them from some risks–by shifting those risks to others, not by reducing them (in fact the overall risk likely has increased due to moral hazard).  The outcome is affected by the costs and benefits of exercising influence, not by the economic costs and benefits of alternative segregation mechanisms.

This is another example–as if we needed more–of a prescriptive regulation dictating an allocation of resources that is perfectly amenable to private contracting.  And one where there are no obvious barriers to private contracting, and where as a result such contracting would lead to an allocation that balances efficiently costs and benefits.