Streetwise Professor

Oh, yeah.

The WSJ seized on Ben Bernanke’s “Puddin’head Wilson” speech about the need to be especially vigilant about the risks inherent in huge CCPs, including those engendered or expanded by Frank-n-Dodd mandates (h/t Carl E and Mark B):

One by one, financial regulators who supported the Dodd-Frank law in 2010 are beginning to deny paternity, especially for the bouncing bundle of new derivatives rules. Perhaps they now realize the law created more systemic risk than it eliminated. Witness Federal Reserve Chairman Ben Bernanke speaking in Atlanta recently and warning about the consequences of forcing much of the derivatives market into central clearinghouses.

Mr. Bernanke specifically warned of this “concentration of substantial financial and operational risk in a small number of organizations, a development with potentially important systemic implications.” He went on to say that “strong risk management at these organizations as well as effective prudential oversight is essential.”

It sure is, and the federal regulators who failed to oversee the big banks will now have to oversee both the banks and the new entities housing their derivatives trades. As we’ve noted before, clearinghouses have succeeded in managing risk and enabling efficient markets in many areas of trading over many years. They are especially useful when they develop organically to meet a market need. [Emphasis added.]

Uhm, where have I heard the phrase about CCPs “develop[ing] organically to meet a market need”?  Sounds verrryyy familiar.

Perhaps the WSJ is too aggressive in stating affirmatively that Frank-n-Dood “created more systemic risk than it eliminated.”  But it would not be aggressive at all to state that (a) that is a very real risk, (b) that risk depends in large part on the decisions that regulators make going forward, and (c) that risk received virtually zero attention from legislators and policymakers at Treasury (a very guilty party), the CFTC (similarly guilty), the Fed, or Congress.

The WSJ is on very firm ground in excoriating those who have now found their voices on CCP risks, but who remained conspicuously silent when weighing in on the issue could have slowed down the stampede to clearing:

Add it all up and you have a disturbing number of financial eminences suddenly rushing to get clearinghouse warnings into the public record. Do they know something that the taxpayer doesn’t? It’s hard to tell, because even as the Beltway crowd scrambles to draft clearinghouse warning memos for posterity—and for their posteriors—regulators are also promoting “independent director” rules that will discourage people with knowledge and experience from overseeing these institutions. This is the last thing regulators should be doing if they now understand the risks.

When we started warning against forcing this market into clearinghouses in 2008, the regulators who agreed could have held meetings inside a phone booth, if we still had phone booths. Last May, our story about Senator Chris Dodd’s effort to give clearinghouses access to the Fed’s discount window—and therefore to a taxpayer rescue—attracted scarcely more support. Dodd-Frank was the law of the land by July, with taxpayers officially backing Wall Street derivatives trading for the first time.

Now taxpayers get to watch regulators who did nothing to stop this policy, when their opposition might have made a difference, suddenly offering insightful critiques when it doesn’t.

I share the WSJ’s anger and dismay at the Johnny-come-latelies who now sound alarms.  NOW they tell us.  I wonder if it’s not just CYA, as the Journal would have it, but also another way to assert power and authority, and to expand bureaucratic turf.

The Economics of Contempt is, er, contemptuous of the WSJ stand:

The WSJ says that it’s “not aware of any governments that have ever asked clearinghouses to manage risks as complicated as those mandated by Dodd-Frank.”

That’s funny, because we still don’t know what financial instruments will be subject to Dodd-Frank’s clearing requirement yet! So how does the WSJ know how complicated the risks that clearinghouses will be asked to manage are? They don’t. The CFTC and the SEC don’t even know yet. The WSJ is just making things up.

This is like the people who make the fairly simple and widely-understood point that clearinghouses don’t work well for illiquid or bespoke instruments, and then claim that because of this, Dodd-Frank’s clearing requirement was a bad idea. They apparently don’t have the patience to wait to see which instruments the CFTC and the SEC decide have to be cleared — they want to demagogue the clearing requirement, and they want to demagogue it now, dammit!

FWIW, EOC is a pretty strong Dodd-Frank booster.

IMO, EOC is far too contemptuous of the Journal piece.  Yes, many of the implementation details of Frank-n-Dodd remain to be determined, notable among them just what products will be cleared, and more importantly the process by which that decision will be made.  Yet it is abundantly clear that the intent of the authors of Frank-n-Dodd, the Treasury, and Gensler in particular at the CFTC is to push as many derivatives as possible onto CCPs.  This can be done directly through mandating that particular products be cleared, or indirectly, by imposing punitive margin and capital requirements on non-cleared trades.  We don’t know exactly what they will do, but we know what they want to do–they’ve told us over and over again.  The WSJ editorial is quite fair in speaking to the risks that CCPs could pose if these people get their way.

But even if EOC is right, then we have two alternatives: either clearing mandates and much of Frank-n-Dodd was sound and fury, signifying nothing, or it runs the kinds of risks that the WSJ and, uhm, others identify.  And the sound and fury is not without its costs.  It has created huge uncertainty, and led to the commitment of innumerable resources to trying to understand, shape, plan for, etc., the regulatory changes.

Regardless, the WSJ is spot on in calling out those currently speaking out on their failure to do so when it mattered.

But that’s water over the dam now.  What’s needed is for these newly vocal regulators to put their supposedly new revelations into practice.  Two very practical issues on which they can do so are taking a duly humble approach to the process of determining what gets cleared and what doesn’t (the issue that EOC focuses on), and on CCP membership and governance standards.

Not that I’m holding my breath.

CFTC Commissioner Bart Chilton has been touting research that he claims supports his view that speculation has distorted prices, thereby necessitating position limits.   I’ve read each one.  My conclusion: if this is the best he can come up with, the case for position limits is weaker than I thought.  And that’s saying something.

The citations fall into a couple of categories: superficial quasi-academic studies, and quotations from various figures, including some well-known economists, who have done absolutely no serious research on the subject.

Here are my quick takes on each one.

Since Chilton has had three years to trawl the earth to find work that would support his idee fixe, it is rather amazing that this is the best he can come up with. It’s rather sad, actually, that he believes that he is looking at the problem in a “more sophisticated way.” Although Chilton says that based on his literature review, “[i]t’s simply not the case that ‘there is no evidence that financial investors affect commodity prices,'” that’s not true. What I wrote in Regulation last summer, and what I’ve repeated numerous times on this blog remains true. As yet there is no serious theory, and certainly no serious evidence that speculators have distorted commodity prices.

On Monday, Fed Chairman Ben Bernanke gave a speech on clearinghouses to the Atlanta Fed’s annual conference.  Ironically, Bernanke echoed the theme of my talk at that conference in May, 2009: central counterparties (CCPs, i.e., clearinghouses) could fail, and are a potential source of systemic risk:

Overall, the historical record shows that clearinghouse arrangements have generally withstood even severe crises. This solid performance reflects good planning and sound institutional structures but also some degree of good luck, as crises have also revealed important vulnerabilities, vulnerabilities which prompted subsequent reforms by both the private and public sectors. Clearly, if we do not want to put all our trust in continued good fortune, we will have to continue to be proactive in identifying and remedying weaknesses in these critical infrastructures.

. . . .

Clearinghouses around the world generally performed well in the highly stressed financial environment of the recent crisis. However, we should not take for granted that we will be as lucky in the future. Past crises, including the financial panic of 1907 and the 1987 stock market crash, led to significant reforms and improvements in clearing and settlement that paid off in subsequent periods of financial stress. Given the growing interdependencies among clearinghouses, along with the new mandates for central clearing, now is a good time to reflect on the lessons of the recent crisis and consider whether further improvements are possible. For more than a century, financial stability has depended on the resilience under stress of clearinghouses and other parts of the financial infrastructure.

As we rely even more heavily on these institutions in the United States and around the world, we must do all that we can to ensure their resilience, even as our financial system continues to evolve rapidly and in ways that we cannot fully predict. In short, I think Pudd’nhead Wilson would agree that that is one important basket.

Bernanke discusses some historical episodes in which CCPs teetered on the brink, notably the Panic of 1907 and the Crash of 1987.  He notes, quite rightly, that the expanded role of clearing under Dodd-Frank (and likely in Europe under EMIR) means that CCPs are even more systemically important, and that it is therefore essential to ensure their safety and soundness.

Although Bernanke has taken up a theme that I’ve been flogging for going on 2.5 years now, please don’t get the impression that he got the idea from me.  Bernanke wrote an important paper on clearing and the Crash (RFS, 1990) that was instrumental in helping me understand the “plumbing” of the market and where it can go wrong.  I lived through the Crash, and witnessed first-hand of the near implosion of the clearing system in Chicago, but Bernanke’s article helped me understand some of the issues on a deeper level.   Indeed, I think that one salutary effect of my speaking and writing on the subject has been to make more people in industry and government aware of what Bernanke wrote 20+ years ago.  Credit where credit is due.

I agree with what Bernanke says in this speech, but I think it’s essential to go further.  Bernanke focuses on the potential for CCP failure, and how that can be prevented.  That’s no doubt important, but that’s not the only systemic risk arising from clearing mandates.

Most importantly, the imposition of these mandates will alter the entire financial system.  They will alter the way firms contract, how they borrow, their capital structures, etc.  These changes will have systemic effects and affect the way the system operates in a crisis.

Moreover, I am concerned that a focus on protecting CCPs can lead to the adoption of policies that are destabilizing.  For instance, conventional means of strengthening CCPs can increase their vulnerability to wrong way risk.

As another example, CCP margining can have destabilizing effects.  Although the regulatory tendency to protect CCPs may lead them to agitate for more collateral, and tighter collateralization mechanisms, this can have destabilizing effects during a crisis.  Similarly, having immense amounts of liquid assets tied up in collateral at CCPs can make the system more vulnerable to liquidity shocks.  Put differently, it increases the burden on central banks to respond to liquidity shocks.

Consider the following scenario.  There is a spike in the demand for liquidity.  Vast amounts of liquid assets are tied up in derivatives collateral at CCPs.  One likely response to the liquidity shock is to liquidate derivatives positions to free up the liquid assets–“dead liquidity”–held at CCPs.  This can lead to big price movements that can be destabilizing.  Central banks may need to be especially aggressive in supplying liquidity to avoid these problems.  Perhaps this would require extending credit to CCPs, or to their members, in a way that would effectively permit rehypothecation of margin monies to the Fed.

Again, clearing mandates are a major change to the financial system.  There will be far reaching effects on all aspects of financial contracting.  Most of these are unpredictable and will be dynamic.  But regulators have to be aware of those ripple effects, and understand that those effects will depend on how CCPs operate and how they are regulated.  A microprudential focus on CCPs (which is the default tendency of financial regulators) could have perverse macroprudential effects.

I’m sure Bernanke is aware of that, but a conventional reading of this “watch that basket” speech could lead regulators to focus on the microprudential, and overlook the potentially perverse unintended macro implications of that focus.

I liked Bernanke’s historical discussion.  The Panic of 1907 case is particularly interesting, and I will discuss it in some detail in my forthcoming book.  One thing that is of particular interest, that Bernanke does not discuss, has implications for one current regulatory debate.

Specifically, as shown by Elmer Wicker in his book Banking Panics in the Gilded Age, the New York Clearing Association often failed to deal effectively with panics by mutualizing risk because of heterogeneities among its membership.  Although mutualizing risk would have mitigated adverse selection problems (because there was less uncertainty about the condition of the banking system as a whole than individual banks), it also would have transferred wealth from the healthy banks to the unhealthy ones.  The disagreements among heterogeneous banks undermined coordinated action during several crises–including especially the Panic of 1907.

That is worth keeping in mind today when evaluating proposed rules regarding CCP membership policies.  Encouraging open access through low capital requirements, or aggregate ownership restrictions, as proposed by the CFTC, will lead to more heterogeneous memberships at CCPs.  This will have many perverse consequences, including the real potential for the same kind of problems that undermined the effectiveness of the NYCH in the Gilded Age.

I’m pleased that Bernanke brought this episode into the public eye.  I’m also pleased that he has brought the potential vulnerabilities of the clearing system into the public debate.  His speech is a welcome antidote to the superficial happy talk of Geithner and Gensler and the cheerleaders for Frank-n-Dodd.  Without a sober recognition of the vulnerabilities that a greater reliance on clearing can create, the cure may actually kill us in the next crisis.

And now on two fronts, as it were.

The battle over the “vertical silo” (i.e., vertically integrated in econspeak as opposed to bizspeak) approach to execution and clearing remains under assault in Europe:

European Union states want to extend a draft law curbing risk in privately negotiated derivatives to the whole sector, which could ultimately dent profitability of the world’s first mega bourse merger.

. . . .

But banks say the merged group should be opened up to clearing competition. Extending the law’s scope to regulating listed as well as OTC derivatives would achieve this goal.

It would make it easier for users to clear listed contracts transacted on Deutsche Boerse or Euronext’s LIFFE derivatives platform elsewhere and not be locked into the group’s clearers.

“The inclination among OTC derivatives fans like us is ‘why differentiate between one derivative and another?’,” said David Clark, chairman of the Wholesale Markets Brokers’ Association.

“The big deal in all this is the competition element with Deutsche Boerse. This move to extend the scope of the draft law has got politics written all over it,” Clark said.  [Politics?  Whoda thunk?]

. . . .

Exchanges sense integrated business models are under threat.

“Some are trying to weaken vertical structures by creating clearing links with other structures. That creates systemic risk and shifts focus away from the real issue of dealing with OTC derivatives,” an exchanges industry official said on condition of anonymity due to the sensitivity of the issue.

The battle between the “verticalists” and “horizontalists” in clearing is a decade old and has never resolved, with the same two countries pitted against each other today as back then.

“Verticalists” and “horizontalists”?  Sounds like something out of Swift.  Count me as a verticalist–or more accurately, a marketalist.  That is, that this is something best left to market processes rather than legislation and regulation.

Now a battle on vertical integration is evidently brewing in the US too.  At least in the eyes of some market analysts, ICE’s CEO Jeffrey Sprecher is worried that a horizontalist, non-marketalist US Department of Justice may condition acceptance of a NASDAQ-ICE-NYSE-EuronextLIFFE merger on opening up of the derivatives clearinghouse (from Bloomberg: no link yet):

IntercontinentalExchange Inc. may drop out of its joint bid for  NYSE Euronext if the U.S. Department of Justice raises concerns about the deal’s combined futures business, Sanford C. Bernstein & Co.’s Brad Hintz said.  ICE, the second-largest U.S. futures market, and Nasdaq OMX Group Inc. made an unsolicited offer for NYSE Euronext last week, valued at $11.3 billion, countering Deutsche Boerse AG’s February offer for $9.53 billion. In the proposal, Atlanta-based ICE would take NYSE’s Liffe futures-trading markets, expanding in Europe. New York-based Nasdaq OMX would take NYSE Euronext’s listings, equity and options units.

ICE and CME Group Inc., the world’s largest futures market, own their own clearinghouses, which may create barriers to entry and be anti-competitive, the U.S. Department of Justice said in 2008. Equity and options exchanges –such as those owned by NYSE Euronext and Nasdaq OMX–use centralized  clearinghouses like OCC that aren’t owned by any one market.

“The most important issue facing these competing offers is the possibility that the ICE/NYSE Liffe merger will resurrect DOJ concerns with vertical integration of futures execution and clearing,” Hintz, an analyst at Sanford C. Bernstein in New York, wrote in a e-mailed note today. “If this issue arises ICE will likely drop out of the bidding and the Deutsche Boerse deal moves  forward.”

Yes, be afraid.  Be very afraid.  I have the sense that the DOJ’s Antitrust Division is itching to attack vertical integration in derivatives, the economics be damned.

* This perhaps corny (perhaps?) title was inspired by my recollection that today is the 149th anniversary of the first day of the Battle of Shiloh.  Two of my great-grandmother’s brothers fought in the battle: Eli and John, who served in the 46th Ohio Volunteer Infantry.

Eli was something of what is called a “Jonah” in the Navy–a hardluck guy.  He was captured at Shiloh, and held in a prison camp in Montgomery, AL for a couple of months.  Exchanged, he returned to Ohio.  He claimed he was unable to return to his regiment because of dysentery contracted during his imprisonment.  His military record includes a note from his family doctor, believe it or not.

His efforts to stay home were unavailing, and he was ordered to report to his unit.  He returned to the 46th shortly before the Battle of Chattanooga.  He proceeded to lose his belt and cartridge box, for which he was dunned $10 pay.  He was then assigned duty as a wagon driver–probably not an endorsement of his soldierly qualities.

Maybe he straightened out, or the need for infantrymen was pressing, for he was in the ranks again for the Atlanta Campaign.  Unfortunately for him.  He was shot in the left arm close to the shoulder joint at the Battle of Dallas, GA, 28 May, 1864.  The surgical record indicates that the regimental doctor performed a resection of his left arm, removing the bone from the shoulder to the elbow.  This surgery was required because the ball struck too close to the joint to amputate.

My great-grandmother told my grandfather that “Uncle Eli had a dead arm.”  His arm dangled uselessly at his side, and my great-grandmother remembers him using his right hand to lift up his left to rest it on the dinner table.

John, on the other hand, served without incident or injury from October, 1861 to the muster out of the regiment in July, 1865.  Pretty amazing, given that the regiment fought at Shiloh, the Siege of Vicksburg, Chattanooga (the storming of Tunnel Hill, the bloodiest part of the battle), the Atlanta Campaign (including the Battle of Atlanta on 22 July, 1864), the March to the Sea, and the Battle of Bentonville.  One lucky brother, one unlucky.

Immediately following the announcement of the proposed NYSE-EuronextLIFFE-Deutsche Borse deal, I stated that the main risk to the transaction would be that European antitrust regulators who are not keen, to say the least, on the vertical integration of exchanges and clearinghouses (the “silo” model).  A close watcher of these developments, Anthony Belchambers of the Futures and Options Association, believes this risk is quite real:

European regulators could push merger partners NYSE Euronext (NYX) and Deutsche Boerse AG (DB1.XE) to spin off part of their derivatives clearing business, according to a senior industry lobbyist.

Fusing NYSE Euronext’s London-based Liffe unit with the German company’s Eurex business would create a dominant force in European-listed derivatives, and antitrust officials may target the profitable clearing segment as part of any approval, said Anthony Belchambers, chief executive of the Futures and Options Association, which represents banks and brokers in the region.

“Clearly they’re going to be looking very closely at this,” Belchambers said of the regulators’ stance. He was speaking in an interview on the sidelines of an industry conference organized by the Futures Industry Association, the FOA’s U.S. counterpart.

Deutsche Boerse has in the past successfully fought efforts by some European lawmakers to force the separation of its clearing business, and analysts said a renewed push could effectively sink the planned NYSE Euronext deal.

Belchambers said regulators are likely to focus on exchanges’ control of clearing trades in futures and options contracts listed on their markets, a framework that has enabled market operators like Eurex and Liffe to fend off competitors in fixed-income and stock-index contracts.

This would be a deal killer, most likely; the main attraction of the deal is the potential to exploit clearing efficiencies and profits, and DB considers integrated clearing an essential part of its business model.  I would think that DB would rather stand pat with its current business than merge and amputate its clearing operations.

Given that, will European regulators push it and impose conditions that make the deal unpalatable, especially for DB?  And if they do, will that leave the door open for NASDAQ (perhaps in conjunction with ICE)?  Absent a deal killer, or the serious prospect of a deal killer, I don’t see NASDAQ or NASDAQ + ICE as a serious threat to break up the proposed merger, especially since NASDAQ+NYSE would pose antitrust issues here in the US.

It is ironic that this story about UBS came out on the day I arrived in Switzerland.

UBS has received subpoenas from the SEC, the US Commodity Futures Trading Commission and the US Department of Justice in connection with investigations regarding submissions to the British Bankers’ Association, which sets LIBOR rates. UBS understands that the investigations focus on whether there were improper attempts by UBS, either acting on its own or together with others, to manipulate LIBOR rates at certain times. In addition, UBS has received an order to provide information to the Japan Financial Supervisory Agency concerning similar matters. UBS is conducting an internal review and is cooperating with the investigations.

I wrote several of posts about Lie-bor back before the financial crisis climaxed.  The story seemed to fade from view very quickly, despite the fact that the effects of a distortion in the LIBOR index due to misreporting could lead to the transfer of  Carl Sagan-esque billions and  billions of dollars between swap counterparties and floating rate borrowers and lenders.  Moreover, since unlike in the natural gas misreporting episode where some firms had an incentive to report prices that were too high (and did) and other firms had an incentive to report prices that were too low (and did), here all the potential misreporters had the same incentive: to underreport the rates at which they borrowed.  This would tend to cause the effects of misreporting to be greater, as misreports would have no tendency to cancel out.

I surmised at the time that despite the fact that there was some pretty convincing stories to support the claims, government regulators did not seem to pursue the allegations aggressively because (a) that was the least of the problems in the banking sector and regulators had other fish to fry, and (b) because of those other problems, regulators were beyond loath to compound them and pour additional burdens on banks that were already reeling and threatened to bring down the financial system.  Regulators were looking to put out fires, not start them.  LIBOR was something that regulators, like Scarlet O’Hara, could worry about . . . tomorrow.

Those days of forebearance, it appears, are gone.  If you are a there’s-got-to-be-a-pony-in-there-somewhere kind of person, you might view this investigation as a strong signal that regulators believe that banks are healthy enough to stand the strain–and the potential fines (and perhaps damages in private litigation).  If you’re not, you’re probably saying “when will it all end?”  Be careful what you ask for.

A gratuitous image of a UBS branch, a block from my hotel:

In what will hopefully be the continuation of a spirited and thoughtful exchange of views on OTC derivatives markets, John Parsons and Antonio Mello at Betting the Business respond to my response to their response to my post on Gensler’s beliefs about the efficacy of central counterparties.  Or something like that.

We agree on some key issues, namely, (a) the amount of margin is not the measure of the total amount of credit firms use up when moving from bilateral to cleared trades, and (b) systemic risk is the crucial issue when evaluating the effects of clearing mandates.

I think we also disagree on some issues.

Netting, for one.  MP state:

The reliance on bilateral arrangements meant that exposures that offset one another at the system level were not offset. Individual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures. A major objective of the reform is to encourage the canceling of offsetting exposures and reducing systemic risk by substituting standardized instruments and clearing, among other things, where possible.

As I’ve written repeatedly before, multilateral netting primarily effects priority; netting effectively places derivatives counterparties in front of other creditors in the event that a firm goes bankrupt.  The systemic consequences of this are ambiguous: yes, derivatives counterparties may be systemically important, but other creditors may be too, meaning that it is not obvious whether this reordering of priorities improves stability.

Insofar as the other claims are concerned, I am somewhat puzzled by the statement that “[i]ndividual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures.”  With respect to bilateral offsetting exposures, presumably market makers relied on set-offs in bankruptcy.  With respect to multilateral exposures, market participants internalized any improvements in capital efficiency from netting (or compression).  They also internalized any benefits that resulted from lower risk of replacing defaulted positions with counterparty A that were offset by non-defaulted trades with B, C, D, etc.  Crucially, they recognized that capturing some netting efficiencies multilaterally could undermine some bilateral netting for deals that could not be compressed or cleared because of the nature of these contracts or their liquidity; they internalized these various netting efficiencies.  They internalized the benefits of customization.  They would have internalized the transfer of wealth arising from the shift in priorities inherent in multilateral netting.  Thus, they could trade-off these various effects and internalize the resulting costs and benefits.  Maybe some costs and benefits were not internalized, so it is literally true that the incentives were not sufficient to lead to a completely efficient outcome, but I don’t consider insufficient netting to be the first order problem.  Indeed, to the extent that netting transfers wealth, there can be too much netting.

I’d also note, as was recognized when the CBT was considering whether to adopt clearing in the early-20th century, that by improving the efficiency of capital utilization (by freeing up credit committed to offsetting positions with different counterparties), netting can also lead to increases in the size of net positions and net risk exposures. (This was also an objection to clearing that was raised vociferously in the aftermath of Black Friday in 1869.)  This can increase systemic risks.

MP also criticize the opacity of OTC markets, and suggest that clearing would make things more transparent:

It lacked transparency. Neither the end-users nor the public authorities had adequate information about the market. This lack of information has handicapped end-users in getting good prices. The lack of transparency has hampered competition. The lack of transparency promoted unsound accounting. Opacity perverted incentives. It distorted compensations. We could go on… It also handicapped the authorities in supervising the marketplace. A major objective of the reform is creating transparency, which will then make it possible to improve the functioning of the market.

Transparency is used in different ways here.  It is used to refer to price transparency and position transparency.  There is another type of transparency–counterparty transparency–that MP don’t discuss but which is relevant to the issues they raise.

With respect to position transparency, this is a bad argument in favor of clearing.  It is possible to achieve such transparency via reporting to repositories without the problematic risk sharing and risk pricing aspects of central clearing.  Indeed, a single trade repository is required because (a) there will be multiple clearinghouses, and (b) some products will not be cleared.  If it’s position visibility that you want (especially to regulators), that should be achieved via reporting to a single repository, not by having multiple CCPs.

With respect to price transparency, I think that MP overstate the lack of competition and price information, especially for the more liquid products that are likely to be traded most actively on SEFs.  Most end users I’ve heard discuss the subject state that they have been able to get good price quotes from multiple dealers.  ISDA recently ran an experiment which found that spreads for liquid products are extremely tight–in the .5bp-1bp range.  Moreover, with respect to many standardized OTC products, end users can compare the bids and offers they get to the prices of exchange traded instruments (e.g., Eurodollar futures, crude oil futures) to determine the quality of a dealer’s quotes.  End users also have the ability to utilize those products–to the extent they don’t, that means that the bundle of services provided by the dealer is more valuable to end users than the different bundle available on exchanges.

Moreover, as I’ve written before, trading in a non-anonymous way by soliciting quotes from dealers can actually be cheaper for end users than trading in an anonymous exchange or exchange-like (i.e., SEF) environment with pre-trade transparency.  The verifiably uninformed are typically going to get better prices in non-anonymous settings than in anonymous ones, where spreads are widened and depths reduced in order to protect quoters against being picked off by the informed.

All of this is not to say that OTC bilateral markets were perfect.  Too big to fail provided perverse incentives.  Uncoordinated replacement and hedging of defaulted positions exacerbates price moves.  But clearing presents its own difficulties, so just inventorying the defects of bilateral markets is not sufficient to prove the superiority of clearing.  You have the Churchill democracy issue: something can be the worst thing ever, except for all alternatives that have been tried from time to time.  Moreover, I don’t consider the defects that MP identify to be nearly as problematic as they do.

Thus, it still comes down to a comparative analysis which must make comparisons along numerous dimensions; some of these comparisons may cut one way (e.g., favoring centralized clearing), others may cut the opposite way (favoring bilateral mechanisms).  Moreover, when discussing policy it is important to recognize that clearing bundles many services–risk pricing, risk sharing, netting/compression, default risk management, position reporting–that may be better provided separately.

I still think that a crucial issue that relates to one of my areas of agreement with MP–that firms subject to a clearing mandate will substitute one form of credit for another–deserves further analysis.  I hope that they respond more fully to my analysis of the implications of the degree of substitutibility of different forms of credit.  In my view, that will have very important implications for the effects of clearing mandates.

The most important recommendation in the report of the Flash Crash Advisory Board that I wrote about several days ago is that the SEC consider implementing a “Trade-at” rule in place of the current no trade-through rule.  Trade-at would require a firm receiving an order to direct that order to the market offering the best quote for execution, whereas under no-trade-through, the firm could internalize the order and execute it by matching the best price currently displayed at any execution venue.  Trade-at would largely cripple “dark pools” and internalization (although the Board disclaims any desire to hamper the operation of pools that facilitate block transactions)–what in the old days were referred to as “third markets.”

As I wrote in my original post, trade-at is a red herring when it comes to preventing Flash Crashes.  It’s primary effect will be to alter the way securities markets work in normal times, rather than exceptional ones.

The objection to internalization is that it is a form of “cream skimming” that free rides on price discovery in public markets.  This reduces liquidity in the public markets, widening spreads, reducing depth, and reducing the informativeness of prices.

Free riding is an externality that would lead to a less efficient outcome if you believe that the public market is competitive.  Many of the criticisms of internalization* and recommendations that it be eliminated, or at least constrained via regulation, implicitly assume that the public markets are perfectly competitive.

This is crucial, because if these markets are not perfectly competitive, free riding can actually improve efficiency.  When you have a departure from the first best (due to market power, for instance), what would be a market failure in a first best world can actually improve things.  For example, usually market power is bad.  Pollution is bad.  But if there are no taxes or other restrictions on pollution, it can actually be better for a polluting industry to be monopolized rather than competitive.  A competitive industry pollutes too much, but a monopolized industry restricts output, and therefore reduces pollution.  Market power markups serve the same function as a tax on pollution.  In this instance, two bads are better than one.

So when evaluating the desirability of internalization and dark markets generally, it is imperative to examine the nature of competition in public markets.  If public markets exercise market power, the existence of an externality (cream skimming) is insufficient to justify eliminating it.

Sadly, this is a point virtually absent from academic analysis of the issue, and seldom raised in public policy debates either.  But some people get it:

Kevin Foley, chief executive of Aqua, a block crossing platform, said: “A ‘trade at’ rule is hugely anti-competitive. We haven’t seen the SEC do something [like that] in ages.”

And the prize goes to a Russian guy (and who says I’m always slagging on Russia?):

Dmitri Galinov, head of liquidity strategy in Credit Suisse’s Advanced Execution Services unit, said that a “trade at” rule would have to be paired with reform in the SEC’s regulation of exchange fees, which are higher than fees charged by dark pools and other non-exchange venues.

Exactly right, Dmitri.   As I showed in my 2002 JLEO piece, and an earlier working paper titled “Third Markets and the Second Best,” cream skimming, internalization, block markets, payment for order flow, etc., can improve welfare when exchanges exercise market power.  And as I’ve also shown in my research, (a) network effects and coordination costs give exchanges market power, and (b) there is empirical evidence that exchanges do in fact exercise market power.  Off-exchange trading venues–dark markets in the current parlance, third markets in the old–are a source of competition.  The ability to free ride off prices in the public markets reduces the costs that these competitors incur–that is, it makes them more effective competitors and reduces exchange market power.

Indeed, there is a report in the FT that provides an excellent illustration of how exchanges exercise market power by charging supercompetitive fees: “Anger as Exchanges Raise Closing Auction Fees.”  Once upon a time exchanges exercised market power and generated rents for their members by limiting the number of members: now they do it by charging supercompetitive fees.

The wars over securities market structure drag on.  The criticism of dark pools and internalization is nothing new.  If you believe that public exchanges don’t exercise market power, then you won’t like dark pools and internalization.  If you believe that exchanges do exercise market power, the case isn’t obvious, and you have a strong basis to conclude that free riding is the lesser of two evils.  I’m of the belief that exchanges do exercise market power, and as a result I am highly skeptical of regulations intended to clamp down on internalization and dark pools.

Too often, however, this crucial issue of competition has been overlooked.  Discussing the pros and cons of internalization without coming to grips with exchange market power is to ignore the crucial issue.  It’s good to see that at least some are making the point.

* Kind of ironic that internalization creates an externality!

Gary has a magic box, called a “clearinghouse.”  You put counterparty risk in the box, and it disappears!:

One of the central goals of Dodd-Frank is to redirect much of the OTC derivatives market through exchanges, electronic trading platforms and central clearinghouses that stand behind dealings in derivative contracts.

“What that means to the American public is it’s less likely that the taxpayers stand behind that transaction,” [Gary Gensler] said.

“Instead the clearinghouse stands behind it, and I think that’s what Congress recognized. Moving as much of this into clearinghouses lowers interconnectedness, but also says a clearinghouse stands there, not the taxpayer.”

Uhm, but what stands behind the clearinghouse?  Where does that risk go?  Well, financial institutions—including many major banks—actually stand behind clearinghouses.   Meaning that if counterparty losses are big enough, the banks bear a big chunk of the loss (so things are still interconnected).  Or, if the banks limit the amount of loss they are willing to bear, the clearinghouse can fail.  Who wears the loss in that event?

Gensler might argue that collateralization in clearinghouses makes it highly unlikely the banks will bear any loss, and even less likely that the clearinghouse will fail.  Let’s say that collateralization is indeed extremely robust, so that the risk of clearinghouse failure is vanishingly small.  Does that mean that everything is great?

Well no, really. The risk still hasn’t disappeared.  Given the positions that firms take*, collateralization (and netting, another commonly touted benefit of clearing) affects the distribution of losses arising from the bankruptcy of a derivatives trading firm, not the total amount of the losses.  If collateralization is so robust that derivatives counterparties always get paid, that means that the entire loss arising from a bankruptcy falls on the firm’s other creditors.  So the magician may point to the magic derivatives clearinghouse box and say: “See!  No losses!  They disappeared!”  But they are somewhere, behind the curtain, borne by somebody else; collateralization changes the priority of claims, not their magnitude.**  Most likely, the loss is shifted to unsecured creditors—who may include banks backed by taxpayers, or owners of money market mutual funds who may run if it looks like their funds will break the buck, which can also lead to a Federal bailout (like what happened in September, 2008).

There’s also the issue of where the collateral comes from.  Some of it may come in the form of loans extended by banks that used to extend credit via derivatives trades; like in a real-world magic trick, the credit didn’t disappear, it was just shifted somewhere else.  Some collateral may come from firms foregoing higher yielding, but less liquid investments: this is a real cost as too many resources are tied up in liquid assets and too little invested in more productive projects.

There are other things going on behind the curtain.  Rather than enter into expensive collateral derivatives trades, firms may decide to hedge less, forcing their claimants (including lenders, employees, suppliers, and shareholders) to bear more risk.  Again, the risk doesn’t disappear–it leaves through a trapdoor and winds up someplace else.

And collateral can have perverse effects in a crisis.  The pressure of collateral calls can force firms to liquidate positions, exacerbating price moves.  Or firms may engage in fire sales of other assets to meet the calls, causing price shocks to spill over from the derivatives market to other markets.  How’s that for an interconnection?

Gary also has a magic transparency trick, a visibility cloak if you will.  Exactly the opposite of Harry Potter’s invisibility cloak, it makes the invisible visible:

“I also think transparency helps,” he said, looking back to the widespread uncertainty during the crisis of the value of assets on the books of giants such as American International Group.

“The law now says they have to be valued daily and valuations have to be shared between the counter-parties and if they run a clearinghouse, the clearinghouse has to share it with the public.”

Indeed, this cloak is so magical it can make visible things that don’t even exist.   For, in situations like AIG, the problem was that the values of the assets were uncertain because there were no trades: these things weren’t marked to market, they were marked to a guess—or to a self-serving price that was hard to challenge because there were no real prices to compare it to.   Many of the contracts that Gensler would like to see cleared trade little, if at all—and no trades, no prices.  It is a magical cloak indeed that can make prices and valuations visible when there are no trades to produce actual prices.

Magical thinking about clearing, counterparty risk, and transparency is extremely dangerous.  It creates very real risks.  Those who believe that things like clearing and transparency are magical solutions, and who do not grapple with the complex realities and difficult trade-offs are all too likely to impose rules and regulations that make things worse, not better.  Sad to say, I think that’s happening in spades, both here in the US and in Europe–and that’s not a card trick.  The consequences are pretty sobering to contemplate.

* The amount of margin will affect the sizes of positions and the structure of positions that firms take.  Netting will also affect positions, because (a) netting can actually economize on collateral, and (b) the amount of collateral savings can depend on how extensive cross-margining and portfolio margining are.  It is difficult to know what the net effect of clearing mandates will be on the trades that firms make, and the composition of the firms that make them.  I mention one possible effect below–some hedgers may exit the market, or hedge less.  Indeed, the potential effects are so extensive it is difficult even to list them.  Making it costlier to shift risks via derivatives transactions affects not just risk management decisions, but capital structure decisions (hedging really being just a capital structure choice), investment decisions (the amount and composition of investment), management compensation decisions, and on and on.  All I want to emphasize in the main discussion is that one major effect of collateralization is to affect claim priority, given the total aggregate size of claims against a bankrupt firm.  It secures some claims–which reduces the priority of other claims.

**Same caveat.

Numerous futures markets heavyweights, including CME, ICE, and BlackRock are up in arms over a CFTC rule that would require delisting of a futures contract that had more than 15 percent of its volume traded outside the exchange’s central order book.  Their opposition–anger, really–is justified.

The Commission’s logic is that it wants to protect the price discovery process in centralized markets.  It recognizes that block trades and other off-exchange trades can mitigate price impact on large transactions, e.g., in hedging trades.  Verifiably uninformed traders have an incentive to trade off exchange because this allows them to avoid paying the adverse selection-related costs incurred in an anonymous market; it can also reduce execution risk.  Loss of some uninformed order flow reduces liquidity on the centralized market, and can reduce the informativeness of the prices on that market.

Quantifying the impact of all these changes is impossible.  Much of the effect is to transfer wealth from one group of uninformed traders (those who trade on the centralized market) to another (those who can avail themselves of the block market or other off-exchange trading venues.)  In my JLEO “Market Macrostructure” paper I demonstrate that the net effect can be positive, i.e., the benefit to the latter can exceed the loss suffered by the former.  The cost of a decline in price informativeness cannot be quantified.  Period.  Moreover, even here things are ambiguous.  A decline in the amount of uninformed trading on the central market tends to reduce the amount of informed trading–that’s why price informativeness declines.  But some informed trading is rent seeking–it involves spending real resources to acquire information in order to achieve a transfer of wealth.  This is inefficient.  Reducing this activity actually improves welfare.

In other words, nobody knows how much block trading/off-exchange trading activity is the right amount.  Least of all the CFTC.

One thing is for sure, though.  The marginal cost of block trading doesn’t become infinite when block trading volume is 15 percent of the total.  But that is what the CFTC rule implicitly assumes.  Moreover, even if the marginal cost (including all relevant costs and benefits) of block trading is positive when it totals 15 percent of volume, shutting down the centralized market if block volume exceeds 15 percent makes no sense at all.  A market with “too much” block trading activity still contributes to price discovery.  It still provides a cheaper place to trade than no centralized market at all.  Maybe its value isn’t maximized when there is too much block trading, but shutting it down sure does minimize its value.  It’s like cutting of your nose to spite your face.

Presumably the CFTC believes that no market will ever be shut down.  That any exchange facing delisting of a contract will change the block rules (e.g., increasing the minimum block size) in order to reduce block trading and avoid a shutdown.

But in adopting this change-your-rules-or-the-contract-gets-it strategy, the CFTC presumes that it knows the right amount of block trading.  It knows no such thing.  Indeed, the basis for its threshold is purely arbitrary–a joke, actually:

In the second largest category, involving 128 contracts from all asset classes which included contracts with large and small open interest, the average amount of off-exchange trading over the three-month period ranged from 0% to 15%. The Commission believes that this second category of contracts, where there was actual centralized market trading to observe, provides a reasonable basis for establishing a minimum centralized market trading requirement. Accordingly, from this second category the Commission took the upper range of the maximum average amount of off-exchange trading, and proposes that a maximum of 15% of total trading volume of a contract would be an allowable amount of off-exchange trading in order to protect the price discovery process of trading on the centralized market.

So, the staff looks at some historical numbers for historical off-exchange trading activity (including, apparently, exchange for physicals and exchange for swaps, etc.), the Commission picks a number at the top of the range, and declares it “reasonable” to apply this number to all markets going forward.  That’s not analysis: that’s arithmetic.  It involves no serious consideration of any of the relevant issues and trade-offs relating to on- and off-exchange trading.

The opposition of the exchanges is particularly interesting here.  Exchanges internalize many of the effects of their block trading and EFP rules.  To the extent that block trading reduces liquidity on the centralized market, it reduces the derived demand for trading on that market–and hence reduces the fees an exchange can charge and the quantity of trades there, which combine to reduce the exchange’s revenue from that source.  It can collect revenues from block trades; these revenues reflect the benefits that block trading provides.   Through the effects of its rules on these different revenue streams, the exchange internalizes, albeit perhaps imperfectly, the costs and benefits of those rules on execution costs and liquidity for alternative ways of completing trades.  (This is different, I would add, from internalization or third markets, where a third party “skims” uninformed order flow and does not internalize the effects on the liquidity of a central market.)  Thus, the exchange is in a much better position to know, and has a stronger incentive to know, the liquidity effects of block rules than does the CFTC.  It can balance and has the incentive to balance these effects to craft an efficient rule.  This argues strongly in favor of letting the exchanges make their own rules.

Exchanges don’t directly internalize any benefits flowing from more informative prices.  Nobody does–including the CFTC.  The rent seeking argument I mentioned above means that these benefits may not even be positive–they may be negative, once the costs of information are taken into account.  Imposing an entirely arbitrary standard based on a calculation that a fifth grader could make, and which cannot–cannot–quantify even approximately the benefits and costs at issue is an act of regulatory overstretch that is far too characteristic of this Commission.  It denies those who have some information about some relevant costs and benefits–the exchanges, with regard to the effects of the rules on trading costs–from taking that information into account when establishing their rules.  It substitutes its own judgment for what is the “right” amount of off-exchange trading when that judgment is predicated on complete ignorance.

The Commission has a lot on its plate.  The Commissioners, with some justice, complain about their crushing work load repeatedly.  Here’s a suggestion: they can lighten their burden by avoiding dealing with issues about which the Commission completely lacks the information necessary to craft constructive regulations.  The off-exchange trading rule is a perfect example of that.  One can have nice philosophical arguments about these issues, but a rational regulatory triage strategy would relegate such debates to academics and focus on more pressing matters about which it is possible to get enough information and knowledge to craft sensible rules.

I’m not holding my breath.