Streetwise Professor

The CFTC-SEC joint report on the May 6 Flash Crash.  I am underwhelmed.  It provides some new details, but (a) leaves the most important questions unanswered, and (b) fails to perform some rather straightforward analyses that would go a long way to providing a much stronger basis for its conclusions–or disprove them.

The report supports most of the conjectures I (and others) made in the immediate aftermath of the crash.  In the chaos of the time, with the profound uncertainty surrounding the Greek crisis, liquidity on the major markets went down.  In particular, the depth on the buy side of the S&P Emini contract on the CME declined dramatically.  Into that declining liquidity came a sequence of large sell orders entered as part of a hedge implemented by a firm not named in the report, but widely reported to be Waddell and Reed.  Given the diminished liquidity, the sell orders pushed down the market, which triggered arbitrage trades that dragged down other markets as well.

Whenever you see a big price move in a short period, you look for positive feedbacks.  The positive feedback I conjectured in this case at the time was a dynamic put replication strategy, in which the hedger sells more as price declines in order to match the delta of a put position.  Although the report indicates that the W&R strategy was a hedge, it does not discuss in detail what triggered the initiation of the strategy: why did the hedge kick in just then?  Key question, but an unanswered one.  It is plausible that the earlier selloff had triggered the initiation of the W&R program.

But the report does suggest that once the original order was submitted, there was a positive feedback mechanism, but a truly novel one, and something different than dynamic put replication.  In particular, the algorithm that W&R employed based its sell orders on market volume.  It had a given number of contracts to sell (75K), and the timing of those sales at any time was conditioned on trading volume in the immediately prior minutes.  According to the report, the initial big price drop triggered a substantial amount of HFT trading activity.  This was mainly offsetting: HFT buys and sells were almost exactly equal in magnitude.  But this generated volume; this volume caused the W&R program to submit more sell orders; and this reinforced the price decline.

This is a plausible story, but the Commissions could have done more to support it.  In particular, the Report asserts a causal connection: W&R sell orders; price decline; big uptick in HFT trades; more W&R orders; more price declines.  These causal hypotheses are readily tested in a standard vector autoregression framework.  The elements of the vector could include price changes (on a second or five second time frequency, for example); (signed) W&R orders; HFT buys; HFT sells; and the buys and sells of other trader types.  It would also be worthwhile to include buy side and sell side depth changes in the vector to see whether liquidity was responding dynamically to any of these other variables, and vice versa.

This framework would permit a more definitive attribution of the price move to the various factors identified in the report, and permit a better understanding of the actual dynamics and feedbacks.  If, indeed, the mechanism posited in the Report is correct, the VAR analysis would demonstrate this.

A better understanding of the various feedback mechanisms would also facilitate the development of better market surveillance tools.  Most importantly, it would provide information that would permit more discriminating regulation of HFT–or demonstrate that no such regulation is necessary.

But the most disappointing part of the report is that although it documents the decline in EMini liquidity, and discusses in general terms the potential causes of this (uncertainty surrounding Greece, rising volatility as indicated by the VIX), it does not undertake a thorough empirical investigation.  With normal liquidity, the W&R orders likely would not have had any appreciable price impact.  With the emaciated liquidity of the afternoon of 6 May, the sell program plausibly had the price impact the Commissions attributed to it.  So understanding why liquidity declined is essential to an understanding of why the Flash Crash occurred.

In other words, if the sell program was the match, the lack of liquidity was the dry tinder.  That’s what needs a more thorough investigation.

Again, the VAR framework would be very useful in this regard.  One could investigate the dynamic relations between buy and sell side depth changes, volatility changes, price changes, customer order flows, and other factors that could affect liquidity.  This would permit a more discriminating analysis of what triggered the decline in liquidity that made the Flash Crash possible.

The analysis could be extended to include a larger sample period, in order to get a more complete understanding of what drives liquidity in these markets.  Without understanding this, it is impossible to understand the role of HFT.  A more thorough understanding of the dynamics of liquidity supply would also help exchanges monitor markets for potentially destabilizing developments.  This could permit the development of smarter circuit breakers.

The report makes clear, as should have been evident soon after the Crash happened, that the CME’s stop order logic played a crucial role in stopping the cascading prices.  This was a pretty smart circuit breaker, but a better understanding of the dynamics of liquidity supply would permit the development of even smarter ones.

And this shouldn’t be a one time, fire-and-forget exercise.  The dynamics of liquidity supply will almost certainly evolve over time.  Frequent updating of the analysis would help identify these changes, and permit a similar updating of market monitoring and circuit breaker mechanisms.

In brief, we know a little more about the causes of the Crash, but not much more than we did on the day and the days immediately following. The Commissions’ staffs obviously trolled through massive amounts of data, for which they should be congratulated.  But it was possible to do so much more with that data.  Maybe the staffs did, but it didn’t make it into the Report.  Standard analytical tools applied to that data could provide a far more detailed understanding of the complex feedback mechanisms that contributed to that Crash, and which could recur in future ones.  Let’s hope that analysis gets done, either by the Commissions, the exchanges, or independent scholars.  Armed with such an analysis, it will be possible to craft better policy responses.  Without it, policy mistakes are more likely.

The Hunt brothers are the poster children for the old joke: “Want to make a small fortune trading commodities?  Start with a large one!”  [Ba Dum Ching!]

Their not-so-excellent silver adventure is also an interesting object lesson in other ways.  In particular, it shows that clearing, initial margin, rigorous daily mark-to-market variation margin, and exchange trading are do not immunize the broader financial markets from contagion originating in the derivatives markets.

It is no doubt true that initial and variation margin reduce the credit exposure in a specific derivatives trade.  But that doesn’t mean that requiring collateralization of derivatives trades in a way that dramatically reduces credit exposure in a particular trade reduces the amount of leverage in the system; or reduces the likelihood of default against that borrowed money as the result of an adverse price move in the derivatives market.

This is because the creditworthy will get credit, until they aren’t.  If you deny them one channel to obtain credit (e.g., by charging hefty margins on futures trades) they can get credit through other channels.  They can use that credit to support their speculations in derivatives markets.  And if those speculations go the wrong way, it can cause the formerly creditworthy to default.  If they’ve borrowed enough, the whole system can have trouble.

That’s exactly what happened in the Hunt case.  The Hunts borrowed, from various sources, approximately $1.3 billion to support their silver market activities. That’s the equivalent of about $3.5 billion today.  They used the borrowings to pay margins and to buy physical silver.  When the price of silver fell, they couldn’t pay back their loans.  This almost led to the failure of several major brokers and banks, and could have sparked a full-scale banking crisis.  In a process not too different from that involved with the rescue of LTCM in 1998, banks restructured the Hunts debt in order to avoid a crisis: the Fed’s (and Paul Volcker’s) role in this was and is very murky, but (a) it was decidedly contrary to stated Fed policy at the time, (b) Volcker could have killed it if he had wanted, but (c) it happened.  So draw your own conclusions.

Here are the details.  After skyrocketing in late-1979, the price of silver started to drift down in 1980.  The Hunts needed cash to meet margin calls, and they borrowed money–about $233 million–from their main broker, Bache.  The loan was collateralized by silver.  Bache, in turn, rehypothecated the capital and used it to back borrowing of the money from First National Bank of Chicago.  In addition, the Hunts borrowed large sums from Swiss Bank, as did their pilot fish in this endeavor, a group of Saudi investors who were trading through the firm IMIC.  In addition, IMIC borrowed money from Merrill Lynch and commodity broker ACLI.

Most of these borrowings were used to meet margin calls.  Most of these borrowings were collateralized with physical silver.

Prices continued their downward drift, and on 17 March, 1980 the Hunts missed a margin call.  Bache covered it.  IMIC also missed margin calls on 3/25.  Broker Conti covered it.

The price decline the accelerated, and threatened to turn into a rout, when the Hunts announced an ad hoc, not to say harebrained, scheme to sell silver bonds.  This signaled to anybody paying attention that the heretofore supremely confident silver bulls were having serious cash flow issues.  The prospect of their silver hoard (and that of their IMIC shadow) being dumped on the market put prices under serious pressure.

On the 26th, the Hunts told Bache they could not meet any additional margin calls.  Bache panicked, and tried to get the CFTC and COMEX to close the silver market, and force settlement of all outstanding contracts at a price that would allow the Hunts to pay them back.  COMEX and CFTC refused.

The market therefore opened on the 27th–“Silver Thursday.”  Bache liquidated Hunt positions, and sold silver held as collateral.  It made the sales in London through a UK subsidiary, incurring losses–but Bache NY promised to cover the losses.

There were serious concerns that day that Bache would go under.  The CFTC deemed other brokers to be vulnerable, notably ACLI, Conti, Merrill, and Paine Webber .  A default by any one of these would have put the COMEX clearinghouse in jeopardy: a default by more than one, almost certainly would have.  The Fed’s (now) venerable Gerald Corrigan, openly worried about the viability of the COMEX clearinghouse.  Given the realized and potential losses, a COMEX clearing failure was a real possibility.  Again: clearing is not a panacea.

To raise cash to meet its obligations to the clearinghouse, Bache dumped stocks as well as silver.  They were not alone.  Stocks declined rapidly, the Dow losing about 5 percent, before recovering to close almost unchanged.  (Another interesting sidelight of this episode: a “Flash Crash” years before anybody even dreamed of HFT.*)

But Bache was able to scrape together enough money to meet its obligations to the clearinghouse and pay off its loans.  The owners of ACLI and Conti injected capital. Things seemed to be under control.  Disaster seemed to have been averted.

Not so fast.  When prices were sky high, silver giant Engelhard was having a difficult time meeting margin calls on its short COMEX silver futures positions.  So it had entered into exchange-for-physical (EFP) deals with the Hunts, whereby the Hunts agreed to take the Engelhard short positions (which were offset against some Hunt longs), and agreed to buy physical silver from Engelhard for delivery at the end of March, 1980.  Again–more credit, this time, extended by Engelhard to the Hunts.

When the delivery date came, based on the sales price in the EFP contracts and the prevailing price of silver, the Hunts were underwater by $335 million.  Engelhard insisted on cash.  The Hunts said sorry, ain’t got no cash.

Engelhard could have forced the Hunts into default and bankruptcy.  If that had happened, the entire Hunt debt pyramid, all $1 billion plus, would have been in default.  Several banks would have been at risk of failure–First Chicago, the nation’s 9th largest bank, most notable among them.

But Engelhard blinked–or did the country a favor, depending on how you look at it.  It accepted some Hunt oil properties in the Beaufort Sea instead of cash.

Another bullet dodged.  But the banks still realized that the Hunts were in hock to them for huge sums, and a good chunk of the brother’s wealth was still in silver that was worth a fraction of what they had paid for it.  There was still a serious risk of default, and the Hunts had a lot of bargaining leverage.  The prospect of a protracted war in bankruptcy court was hardly appetizing to the banks.

So they bit the bullet (sorry–free association at work), and renegotiated the loans with the Hunts.  The loans to the brothers were paid off by a new loan to the Hunt family oil firm, Placid Oil.  Finally, the problem was taken care of.

The role of the Fed and Chairman Volcker in this loan is shrouded in mystery. Congress pressed Volcker for answers, and he, in classical central banker fashion, obfuscated and stiffed them.  But it should be noted that the loan was starkly at odds with the Fed’s new policy of restricting credit, most especially credit for commodity speculation.  Volcker had insisted that the loan include the condition that the Hunts cease speculating in all commodities, not just silver.  Moreover, given the Fed policy and its power, if Volcker had wanted to stop the loan, there is no doubt he could have.  Thus, there is evidence of both active and tacit Fed approval of the ultimate solution.

This arrangement foreshadows the solution, 18 years later, to the LTCM problem.  Then, as in 1980, the Fed shepherded a group of private banks to finance the resolution of the victim of a derivatives blowup.

To sum up.  Here we have a market that was (a) exchange traded, (b) cleared, (c) subject to initial margins, and (d) subject to rigorous daily variation margins.  All of the things that our latter day financial reformers assert will purge derivatives-related financial contagion from the system.  Yet a derivatives-related financial contagion occurred nonetheless.

Why is that?  The reasons are pretty clear.  The real source of potential derivatives related contagion exists when (a) a large entity takes on a substantial price risk through the derivatives market (or the underlying market, e.g., silver, or both), and (b) that entity is highly leveraged.  The clearing, margining, etc., is intended to reduce the leverage extended to the entity via the derivatives transactions.  But even if it doesn’t get credit via the derivatives trade, a creditworthy entity can use its debt capacity to get credit elsewhere.  If it does so, and its speculative bet goes wrong, it may default.  If it borrow enough, the default may lead to a financial crisis.

The default may impact the clearinghouse.  Clearing members may be among the defaulter’s creditors.   The default may lead to missed margin payments.

But even if the clearinghouse survives, a crisis may occur nonetheless.  It’s the total amount leverage that matters most, far more than the form of that leverage.  If a given position is collateralized, thereby reducing the credit exposure inherent to it, but that collateral is effectively borrowed, the risk to the system isn’t any different than if the position isn’t collateralized but the entity doesn’t do any other borrowing.  All that really changes is who ends up carrying the can in the event of a default.

This is a Modigliani-Miller-like result.  It means that regulating the credit in one part of a position doesn’t really matter if the entity can obtain credit elsewhere.  If that entity has a given debt capacity, or target debt level, they’ll get the credit somewhere.  This means that you can’t really affect the systemic risk posed by big speculators by limiting their access to one channel of credit.

Which further means that requiring the clearing and collateralization of speculative positions will not substantially reduce the systemic risk posed by speculative trading.  Nor will exchange trading.  You can take risk on an exchange or off.  You can get credit through a derivatives trade, or elsewhere.  Either way, a big speculator can put together the same price risk + leverage position.  It is that risk+leverage exposure that matters, not how you get there.  Clearing and exchange trading mandates just affect the route, not the final destination.

The Hunt episode should thus serve as a cautionary tale.  Like the story of the Gold Panic of 1869, it shows that cleared, exchange traded markets pose systemic risks too.  Married with some rather straightforward economic logic, these episodes show that you should not expect that mandating how things are traded and how they are collateralized will materially affect systemic risks.  Those who assert the contrary are missing the forest for the trees, and instilling a false sense of security.

PS.  That shouldn’t cause you too much extra work, Allan:)

* Speaking of the Flash Crash, I’ve read the CFTC-SEC joint report. I will post on it tomorrow.  Teaser: the report leaves the most interesting and important questions unanswered.

Weather in Ghana has been good to the cocoa crop this year, which is putting downward pressure on prices:

After four years of shortages that sent the price of cocoa to its highest level in three decades, traders almost unanimously believe that the cocoa market is set to move into a surplus in the 2010-11 marketing year, which starts on Friday.

The looming oversupply has sent cocoa prices down by a third in the past two-and-a-half months.

The surge in production in west Africa, which accounts for nearly 70 per cent of the world’s supplies of the commodity used in chocolate, is a setback for investors such as hedge funds Armajaro and Clive Capital, which bet on rising prices earlier this year.

The cost of cocoa in London – the benchmark – has fallen to about £1,900 a tonne, down from a 33-year high of £2,732 a tonne set in July.

So Tony Ward must be hurting, right?  After all, he told the world–the world–that due to his super-sophisticated weather forecasting system, a proprietary network of weather stations, and the best weather data in the world, he knew a crop shortage was coming. So he must have been way long, and the price fall must have crushed him.

Well no, actually:

Investors say that Anthony Ward, the founder of Armajaro’s flagship CC+ fund, has suffered less than expected, however, as bearish hedges cushioned the fund from the price drop.

Oh, really?  Hedges, huh?

This means that the story he was flogging in July and August was complete bilge.  He wasn’t bullish on the new crop. It would be more accurate to say that he was bullsh*t on the new crop.

Which also means that his cover story for taking delivery in July was also complete bilge/bullsh*t.

Not that I am the least bit surprised.  The story made no sense anyways: it’s nuts to take delivery of the old crop at a big backwardation just because you think the new crop price is going to shoot up.  If you think that, buy the new crop, not the old crop. Duh.

Here’s a far more credible explanation of what happened.  Armajaro cornered the cocoa market.  Being clever, Ward knew the most difficult part of cornering is burying the corpse, so he did that by obtaining a burial plot in advance: the “bearish hedges” mentioned in the article.  All of the new crop shortage stories were just so much eyewash to fool the gullible.

Of whom, as this article and others indicate, FT reporters–most notably Javier Blas–are the foremost.  If they won’t get a room, could they at least get a clue?

Jeremy Grant has an article titled “Concerns mount over clearing reforms” in today’s FT.   (Who knew?!)

It’s a good piece (and not just because he is kind enough to include a rather long quote from me).  Jeremy does a good job explaining the fundamental tensions inherent in the clearing mandates between risk bearing efficiencies, systemic risks, and competition.

The most succinct, and spot on, quote in the article is from the OCC’s Susan Milligan: “How this all plays out nobody yet knows.”

Least of all its creators, Dodd and Frank, and those in charge of implementing it, notably Gensler’s CFTC.  Hell, even Dodd admitted exactly as much.

We are witnessing not one, but multiple Mr. Magoos, driving merrily along leaving destruction and chaos in their wakes.   And it’s not just derivatives, but health care, banking, manufacturing, you name it.  I repeat: I sure hope Bismarck was right.

In this post-crisis (or is it continuing crisis?) world, Lloyd Blankfein and Goldman Sachs (a/k/a “The Giant Squid”) may not be considered the most savory company to keep, but that’s where I find myself today.  That’s because Goldman CEO Blankfein is also raising the alarm about the systemic risks posed by a vast expansion of derivatives clearing:

Lloyd Blankfein, Goldman Sachs Group Inc.’s chairman and chief executive officer, said using clearinghouses increase risks in an “extreme” crisis.

“I agree that clearinghouses make things less risky for the regular crisis, but in an extreme crisis that could affect the clearinghouse itself” and it’s “dramatically more risky,” Blankfein said at a finance and regulation conference in Brussels today. “We have to make sure that something that we do to reduce the risk in a once-in-a-20-year storm doesn’t increase the risk in a once-in-a-50-year storm.”

That may be an unintended consequence of the current regulatory push, Blankfein said, adding that clearinghouses themselves will need to be regulated and have capabilities to analyse the risk of financial instruments they clear.

“Otherwise, the clearinghouse becomes the biggest systemic risk in the world,” he said.

I’ve made the point often before, so I won’t belabor it now.* Needless to say, I agree.

Blankfein makes an interesting distinction here: “regular crisis” vs. “extreme crisis.”  I can hear it now: “Don’t worry!  This is only a mere regular crisis!”  That makes me feel so much better!

Welcome to the party, Lloyd.  You’re paying, right?

* I will recommence the belaboring process soon, though.  I am currently doing some research for an extended post on the Hunt silver episode, and what it tells us about the efficacy–and risks–in cleared, exchange traded markets.

No, this is not a letter/email from a poor–and megalomaniacal–college student.  It is a (slightly) snarky characterization of recent statements coming from the CFTC.

First, the money.  From Reuters (here’s a link to a related story: can’t find this story which was emailed to me):

The U.S. futures regulator could be forced to rein in tough new plans to tighten oversight of the $615 trillion over-the-counter derivatives market if it does not get promised new funding, two of the agency’s commissioners said on Tuesday.

If the Commodity Futures Trading Commission is denied the extra funding requested for fiscal 2011 it will have a hard time hiring staff needed to implement Wall Street reforms, said Jill Sommers  and Bart Chilton, commissioners with the CFTC.

“If we do not have the resources, we shouldn’t have ambitions that go beyond those resources,” Sommers, a Republican commissioner, told Reuters.

In a separate interview, Chilton, a Democratic commissioner, said the agency would be “in real trouble” if it went six months without a boost, and said he worries the CFTC could be in a lurch for the whole year.

“We would … have to pick and choose parts of the bill to implement — and that would mean things would not get done on time, as Congress as suggested,” Chilton said.

There is no doubt that CFTC needs a substantial boost in money and people in order to meet the Frank-n-Dodd requirements.  But given the daunting tasks, some devastating problems are inevitable.  CFTC cannot rely on existing self-regulatory organizations to to much of its heavy lifting in the markets it is now responsible for.  Moreover, dramatically scaling up the size of an organization inevitably creates problems as inexperienced people are brought in and experienced people are pushed beyond their capabilities and competence.  There will be problems.  Even train wrecks.  Plural.

The CFTC reminds me of the dog that finally caught the car, and asks: “Now what do I do with it?”

Second, the power.  Two pieces to this, just today.  The first is Gary Gensler’s floating the suggestion that the CFTC should have authority to set position limits just for energy, ags, or metals, but CDS as well:

Commodity Futures Trading Commission Chairman Gary Gensler said it’s “important” to have limits on trading positions in credit-default swaps as well as for commodities derivatives.

Regulators should have the authority to set position limits both on credit-default swaps and physical commodities derivatives, Gensler told a conference on financial rules in Brussels today. Limits “allow us to better protect against abusive practices.”

“We’ve been setting position limits in agricultural commodities and energy commodities for decades so we can learn from that,” Gensler said in an interview. Details of limits for credit-default swaps “are yet to come.”

Position limits are a bad idea to start with.  And apropos the money part of the post: Yeah.  More things on its plate in markets which it has no experience in regulating.  Just what the CFTC needs.

But this isn’t the only contemplated exercise of power in today’s news.  The CFTC is also considering mandating limitations on financial institution ownership of CCPs, along the lines of the Lynch Amendment that was one of the body parts left out when Frank-n-Dodd was stitched together:

The Commodity Futures Trading Commission is considering limiting banks and investors to owning no more than 20 percent of swaps clearinghouses, exchanges and trading systems, three people familiar with the matter said.

The CFTC, which will present its first proposed rules Oct. 1 for the $615 trillion over-the-counter derivatives market, may not grant exemptions for existing holdings, said the people, who declined to be identified because the talks haven’t been made public. Groups made up of bank holding companies, non-bank financial firms, major swaps users or dealers may not own more than 40 percent of clearinghouses, the people said.

Companies that may have to change their ownership structure include London’s LCH.Clearnet Ltd., the world’s largest interest-rate swap clearinghouse; Tradeweb Markets LLC, a derivatives trading platform; and NYSE Euronext, whose U.S. futures exchange is partly owned by banks.

Kevin McPartland is justifiably flabbergasted:

“What is an LCH.Clearnet going to do, that’s almost completely dealer-owned?” said Kevin McPartland, a senior analyst with Tabb Group in New York. “I can’t see how they’d expect that kind of massive divestiture of these clearinghouses that control trillions of notional” in swaps trades, he said.

Ah, but Kevin, you just haven’t fully grasped Gensler’s grandiosity (see above CDS position limit power grab).  The sorcerer’s apprentices are run amok, my friend.

The “theory” underlying this limitation is that it is necessary to combat conflicts of interest, whereby bank owners of CCPs might decide to eschew clearing of certain products that they profitably trade OTC.  Note that this problem could be avoided by ensuring that collateral and capital on cleared and non-cleared deals is chosen properly.  (Not that I am convinced that regulators can do that, but they think they can, and if they can, micromanaging the governance of CCPs is unnecessary.  And if they can’t: why the hell were they given this responsibility?)

In my view, this is a secondary or tertiary or whatever comes after tertiary consideration.  The key issue is aligning the incentives of those who govern CCPs and those who bear the risks.  Failure to do so will lead to a series of serious problems. The most important is that the CCP will have difficult attracting the capital necessary for it to provide its guarantee function because those that can most efficiently supply the capital will not do so if they are not given control rights commensurate to the risks that they are expected to take on.  If the idea behind mandating CCPs is to ensure the existence of sufficient capital to absorb big default losses, this is extremely counterproductive, to say the least.  And just think of the governance and management headaches that are inevitable when there is such a misalignment of incentives.

Historically CCPs have been dominated by financial institutions–banks, often–that are the residual risk bearers.  The ubiquity and survival of this model suggests strongly that it offers some substantial economic benefits.  Restrictions on CCP ownership and control will undermine this model, and likely make it impractical.  So what will take its place?  And if the substitute is so great, why didn’t market participants adopt it already?

It is hard to know what is more astounding about this idea: its presumptuousness, or the superficiality and incompleteness of the “analysis” supporting it.

Money.  Power.  Methinks there will be many more installments of this melodrama in the months to come.

In today’s FT:

LCH.Clearnet, Europe’s largest independent clearing house, and the London Stock Exchange have been rebuffed by one of their biggest rivals, Deutsche Börse group, in an attempt to break into trading and clearing of off-exchange equity derivatives.

The moves are a sign that the commercial interests of some exchanges and clearing houses could undermine efforts by global regulators to enact sweeping reforms of the vast over-the-counter derivatives markets.

. . . .

One US-based clearing industry expert said: “It is an interesting conflict where you have regulators saying you have to clear and you have to have competition in clearing but there are monopoly providers out there thwarting that. This is going to create a problem for that vision.”

This is from a piece that just came out (link to follow when available) in the Journal of Applied Corporate Finance (written in July):

First, the extensive scale and scope economies associated with clearing make it likely that the clearing industry will be highly oligopolistic, and that strategic considerations will influence decisively the way that the industry develops. Moreover, scope economies across trade execution and clearing (Pirrong, 2010b) will also affect the strategic and efficiency forces that will shape industry structure.  Strategic considerations will almost certainly drive a wedge between what is optimal for the individual decision makers, and what is optimal for the economy. [Emphasis added.]

From my Cato piece (written in May):

Moreover, the evolution of market structure in response to a mandate is difficult to predict. Given the scale and scope economies, it is unlikely that the market for CCPs will be competitive. In the presence of such indivisibilities and network effects, competitive processes do not necessarily result in the evolution of an efficient market structure. Furthermore, the distributional effects of the formation of CCPs, private information about these effects, and the ability of market participants to influence the regulatory process in order to achieve distributive gains makes it likely that the process of coordination and cooperation needed to create and structure CCPs will be plagued with inefficiencies.

So color me surprised.  Not.  There will be many more articles like that in today’s FT.  Bet on it.

Value at risk, VaR, is the most common means of measuring risk.  It provides useful information: it quantifies the magnitude of loss that can be incurred on a portfolio with a given probability.  But it is dangerously incomplete: it does not tell you how much you can expect to lose, conditional on the VaR boundary being breached.  VaR, in short, doesn’t tell you how bad bad can be.

This is relevant in the clearing debate.  CCPs choose margin levels in order to ensure that the probability that price moves will wipe out margin balances is sufficiently small.  This is exactly equivalent to calculating a VaR.

And hence, it is subject to the same problems as VaR.  This means that when evaluating the financial capacity of a CCP to withstand a large price shock that not only is the margin level (the VaR equivalent) that is important: the potential loss conditional on margins being blown through is important too.  If the loss conditional on margins being breached is X, but a CCP only has resources of X/2, during a crash (or a spike) that breaches margin levels–an event that will occur with positive probability–then on average the CCP will default.

This is not a purely hypothetical situation.  This important paper by David Bates and Roger Craine shows that in the days following the 1987 Crash, the loss on outstanding S&P500 futures positions conditional on breach of margin was huge, likely far beyond the financial resources available to the CME clearinghouse.

This raises the questions: do CCPs take this information into account when determining their financial resources?; will new CCPs do so; and importantly, do they have the incentive to do so?

This last question is crucial. Financial institutions have problematic incentives to take proper consideration of tail risk.  Indeed, that is arguably one of the major reasons for financial crises.  So why should CCPs, which are coalitions of self-same financial institutions, take into account the tail risks that they ignore independently?  Particularly inasmuch as collectives typically have weaker incentives (due, for instance, to free rider problems).

This is yet another, crucial issue, that has not received adequate attention amidst the paeans to clearing in the run up to and the days since the passage and Dodd-Frank; the same can be said of Europe too.

VaR was the subject of much criticism prior to the crisis: that criticism has only intensified since.  And for good reason.  That should be kept in mind when one hears assurances that CCP margins will prevent derivatives from being the source of a future financial crisis, because margin setting is in essence a VaR exercise.

Jeff Carter at Points and Figures wrote a nice post on my Cato clearing piece, for which I am appreciative. He is pretty much in agreement with me that mandates are a bad idea.  He is concerned with the command-and-control mindset inherent in Frank-n-Dodd, and supports the development of voluntary “Coasean” approaches.  Hear, hear.

Jeff does take issue with my characterization of the way that CCPs work today:

That meant that if you blew up, and caused major losses you could not afford, the rest of the clearinghouse members would have to pony up cash to cover the loss. If the loss were big enough to blow through all the cash that all the members had, the clearing house would go bankrupt. There hasn’t been a bankrupt clearing operation in the modern day, since 1900, history of trading that I know of.

Exchange clearinghouses are no longer mutually held, and have not been since the last major exchange went public in 2003. Instead, the clearing house takes out an insurance policy to cover potential problems. It also has lines of credit with several different bankers. This simple fact doesn’t change our agreement that government mandated clearing is a poor solution, but it does change the calculus of analysis a little.

I take issue with his taking issue.  Yes, exchanges are demutualized, but counterparty risk is still mutualized.  Take the CME, for instance.  This CME document, in the sections labeled “Default by a Clearing Member” and “Summary of Resources Backing Clearing” beginning on p. 11 demonstrates that the losses of default are borne by other clearing members.  First the CME dips into the guarantee fund–which the clearing members fund.  Then the CME can assess the clearing members.  (The CME also commits up to $100 million of its own capital.)  The assessments are limited to 275 percent of each CM’s original contribution.  The total from the CME contribution, the guarantee fund, and the assessment comes to about $7.5 billion.  The costs of default by a clearing member are thus shared among–mutualized by–other clearing members.

Jeff mentions insurance, but there is no third party insurance that pays in the event of a default at the major exchanges.  (There is no mention of insurance in the CME document.)

Jeff also mentions credit lines, and indeed CCPs have lines with major banks.  In the aftermath of Black Monday, 1987, exchange CCPs realized that they needed a more reliable source of liquidity.  On Black Monday, major banks (the clearing banks) balked at funding big CM margin calls; this is where Fed pressure and liquidity injection was important.  To avoid this problem going forward, the CCPs obtained lines of credit that they could call on to obtain liquidity, just as Jeff says.

It is important to note that these credit lines are just that.  If a CCP draws on the line, it–or more accurately, its members–still owes the bank the money.  The lending bank incurs a loss attributable to a CM default only if the CCP itself becomes insolvent.  That is, the credit line is a source of liquidity: it is not in the first instance a means of sharing the default risk with the bank.  Only if the CCP becomes insolvent do the lending banks suffer any default losses.

The CME document linked above makes that clear.  It calls the credit lines a “Temporary Liquidity Facility.”  It’s a source of liquidity to be used in extremis: it’s not a form of insurance.

There’s an irony, here, of course, and one that gives the lie to many of the claims in support of clearing.  Clearing mandate advocates, notably Gensler, talk about clearing reducing financial interconnectedness, and reducing the potential for contagion.  But clearing in times of stress demands ready access to liquidity.  This inevitably requires a connection between the clearing and banking systems.  It can’t be avoided.  If a clearinghouse runs into a big problem, and draws the credit line, it is possible that the CCP will not be able to pay it back.  In the event, the CCP problem would become a banking problem, and the lending banks would bear some of the default loss.  (Of course, to the extent that banks are clearing members, they will bear default losses too.)

The credit lines also expose the CCPs to bank credit.  If the bank extending the line is itself in financial difficulty, which may well be the case during the kind of crisis that would necessitate the CCP to call on its line, the clearinghouse may not actually obtain the needed liquidity.  So the contagion can work both ways.  From the CCP to the bank, or the bank to the CCP.

Again, the point is that clearing changes the topology of the network of connections among financial institutions: it doesn’t eliminate these interconnections.  One way or another, derivatives default losses are ultimately borne by major financial institutions, clearing or no.  No two ways about it.

Damn.