Streetwise Professor

I have read the derivatives and clearing titles of the Frank-N-Dodd act, so you don’t have to: you can thank me later.

Here are some random thoughts.

First, a good chunk of it is mind-numbing language dividing authority between the CFTC and SEC, and instructing the agencies on how to coordinate and cooperate.  Note to self: if they start rationing anesthetics under Obamacare, read one of these legislative monstrosities.  It will certainly beat biting a bullet and taking a swig of bourbon for inducing a pain-dulling stupor.

Second, the fading of the Lincoln provision is quite artfully done.  I had to read the damn thing several times to figure out just how they did it.  The bill starts out with: “NO FEDERAL BAILOUTS OF SWAPS ENTITIES” and then says with the exception of insured depository institutions.  Pretty big exception.  So where did the exclusion of commodities and equity swaps come from?  Well, the bill permits:

Acting as a swaps entity for swaps or security-based swaps involving rates or reference assets that are permissible for investment by a national bank under the paragraph designated as ‘‘Seventh: of section 5136 of the Revised Statutes of the United States ( 12 U.S.C. 24), other than as described in paragraph (3).”

And what does this “Seventh” paragraph say? It says that banks are allowed to:

Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes according to the provisions of this title.

So swaps based on rates or reference assets including typical bank activities including borrowing and lending, FX, and  bullion (presumably precious metals) are all OK.  The paragraph specifically precludes trading in stocks, meaning that equity derivatives are out.  Commodities (other than bullion) aren’t mentioned, so they’re not covered by the exception, and must be spun off.  (The ability to trade bullion-based derivatives means that my calculations of the share of bank derivatives business that will have to be spun off were biased upwards, since a decent fraction of bank commodity trading is in gold and silver.)

Third, the bill does an amazing amount of punting on key issues.  The problem is that the punts won’t be fielded by Darren Hester, Billy “White Shoes” Johnson, or Gale Sayers.  Instead, they will be returned by the same shlubs that fumbled so often in the most recent crisis–the existing regulators (think Madoff, Alan Stanford, AIG, and oh yeah, dodgy FSU shell companies.)  If you look at all the things that the CFTC has to do in the next 12 months, you just know the agency will be overwhelmed.

Fourth, two things relating to margins jumped out at me.

The bill states:

MARGIN REQUIREMENTS.—The margin required from each member andparticipant of a derivatives clearing organization shall be sufficient to cover potential exposures in normal market conditions. [Emphasis added.]

But supposedly the whole objective of the clearing mandate is to reduce systemic risk, in part by requiring increased collateralization.  But periods of systemic instability are, by definition, highly abnormal.  So what’s the point of mandating clearing, and then just allowing the CCPs to impose margins just sufficient to cover normal every day price moves?  This language will give CCPs tremendous leverage in fighting off regulatory efforts to increase collateral.  Not that I mind that, but it suggests a complete disconnect between what the legislation promises and what it can actually deliver.  It promises a collateralization mechanism that will reduce the likelihood of chain reaction failures under stressed market conditions, but then only requires the posting of collateral sufficient to cover losses under non-stressed conditions.

The other thing relates to margins on non-cleared derivatives.  The bill gives prudential regulators the power to set margins (and capital requirements) on these trades:

Each registered swap dealer and major swap participant for which there is a prudential regulator shall meet such minimum capital requirements and minimum initial and variation margin requirements as the prudential regulator shall by rule or regulation prescribe.

Meaning that the prudential regulators (e.g., the Fed, OCC, FDIC) can set margin requirements.  Prudential regulators will set margins that will:

be appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.

This is potentially quite dangerous.  It is a form of price control, and such controls will have perverse effects (as they always do).

In the present instance, I have been critical of clearing mandates in large part because CCPs do not have as good information as dealer banks to set appropriate margin levels.  Regulators will be even less well informed, and at a greater informational disadvantage relative to those trading the instruments.  This is particularly true for the instruments at issue–the exotic swaps that will not be cleared even under a clearing mandate.

Better informed market participants will readily identify which risks regulators have underpriced, and which ones they have overpriced.  They will overtrade the underpriced risks, meaning that defaults risks will be greater than the regulators think.

We’ve seen this before.  The recourse rule that gave very favorable capital treatment to AAA securities encouraged banks to load up on them, with disastrous consequences.  Since the regulators’ pricing errors will apply to all market participants, these errors will have systemic effects, encouraging myriad financial institutions to overtrade the same risks.  As I’ve written before, regulation and legislation create systemic risks because they apply to broad swathes of market participants.  This is another example of that.  Getting the risk prices wrong–as regulators will inevitably do–means creating incentives for all affected institutions to overload on the underpriced risks.

I just came across the blog Deus Ex Macchiato, because its (anonymous) author kindly linked to a couple of my posts.  I took some time going through the blog, and was quite impressed.  It’s very much worth following if you are interested in banking, finance, derivatives, and market infrastructure related issues.  I only wish I knew of it earlier.

DEM is a clearing skeptic–one of a select breed.  The post that attracted my attention lists 10 misconceptions about CCPs.  Spot on.  There are many more, but the ones DEM lists are important indeed.

I consider the name of the blog somewhat ironic, given that I’ve frequently referred to CCPs as deus ex machina, that will descend from the heavens to solve all our systemic risk problems.

A couple of notes to DEM, if you stumble across this:

1. I’ve written a lot more about clearing on SWP and elsewhere than the couple of things you link to, if you’re interested.  I’ve also written working papers that I’d be glad to point you to.
2. I know you’re anonymous, but I’d be interested in sharing thoughts more directly.  You can get in touch with me at [email protected] if that’s of interest to you.  Glad to do it in strict confidence.  Use a pseudonymous email address if that’s more to your liking.

I transfered from the Naval Academy to the University of Chicago as a junior.  I knew that I had gone from the alpha of academic institutions to the omega when I learned soon after my arrival in Chicago of the Lascivious Costume Ball.  No such thing in Annapolis, let me assure you.  How lascivious?  Well, I remember one woman in my dorm who went as Eve, complete with a snake and three strategically placed fig leaves.  (Maybe they were lettuce leaves.  I wasn’t checking that closely.)

What brought that to mind, you ask?  A review of the Office of the Comptroller of the Currency’s data on bank derivatives activities.

No.  Seriously.

Why?  Well, the data make it abundantly plain that the financial regulation bill that emerged from conference gave Arkansas Senator Blanche Lincoln the merest of fig leaves to cover a near complete retreat from her earlier position.

Recall that the original Lincoln plan would have required banks to spin off all derivatives trading activities (or lose their access to the Fed discount window).  The final bill allowed banks to retain interest rate, FX, and some credit trading, and spin off only commodities, equity, and some credit derivatives (as I understand it, CDS on junk securities).  The OCC data shows that the spun off activities are small beer, indeed, compared to the stuff that banks are allowed to keep.

Here are the market values, by category (gross positive values followed by gross negative values):

$ in billions

Q1 2010  Q4 2009  Change  %Change  Q1 2010  Q4 2009 Change  %Change

Interest Rates 3,147 3,121 27 1% 3,052 3,023 30 1%

FX 347 354 (7) -2% 345 344 1 0%

Equity 77 91 (14) -15% 78 90 (12) -13%

Commodity 41 50 (9) -18% 40 49 (8) -17%

Credit 390 437 (47) -11% 370 409 (39) -10%

Total 4,002 4,053 (51) -1% 3,886 3,915 (29) -1%

So, equity and commodity gross positive values total $118 billion, compared to a $4 trillion total–or about 3 percent of the total.  (Gross negative values give a similar share.)  Credit totals $390 billion, but only a relatively small fraction of that will have to be spun off.  This means that based on market values, banks will be required to spin off less than 10 percent of the total value of positions.

Here are the notionals:

Interest Rate Contracts 181,981 179,555 2,426 1% 84%

Foreign Exchange Contracts 17,596 16,553 1,043 6% 8%

Equity Contracts 1,571 1,685 (114) -7% 1%

Commodity/Other 940 979 (39) -4% 0%

Credit Derivatives 14,364 14,036 329 2% 7%

Total 216,452 212,808 3,645 2% 100%

Commodities are rounding error.  Equity and commodities is about 1 percent of notional.  Even adding in all of credit, and you don’t get to 10 percent.

It would be nice to have a risk breakdown, but that’s not in the OCC data.

Regardless, it is clear that the banks kept the big part of the business, and gave up a few minor pieces of the business to provide Lincoln with some political cover.

It’s not a big deal to the banks, but it is a pretty big deal to the commodities business.  Spinning off commodities will make it more expensive for dealers to make markets.  Some may decide it’s not worth the bother.  So this will reduce the liquidity of the commodities derivatives markets, and make it costlier to hedge.

This is just one of several hits to the commodity business in the bill.  Indeed, commodities are arguably the biggest loser.

The bill says the CFTC “shall” impose position limits on OTC commodities.  This will also impair liquidity and raise hedging costs by constraining the ability of speculators to offer risk bearing capacity.  Indeed, the effect will likely extend to exchange traded markets as well, because one factor that was limiting the CFTC’s aggressiveness on energy futures position limits was the fear that tight limits would force more business OTC.  The agency now has the power to shut that escape valve, and thus is likely to impose more draconian limits on both OTC and exchange traded products.

Moreover, the bill adopts the Senate bill’s more restrictive exemption from clearing requirements for end users.  The CFTC has some discretion on crafting this exemption, but the current leadership has made it clear that it is opposed to generous exemptions. More onerous clearing (and hence margining) requirements for end users will further raise the costs they incur to hedge.

In sum: the compromise bill shafts commodities not once, not twice, but three times.  This will force commodity producers, processors, and marketers to bear more risk, and to incur higher costs to manage risks.

And for what?  The spinoff of banks’ commodity business certainly won’t have the slightest effect on systemic risk given the trivial size of the trade relative to the other activities they still undertake.  The niggardly end user exemptions will not affect systemic risk either.  The position limits will not reduce price distortions in the market.

Bottom line: the commodities business will be riskier and less efficient, and there is no corresponding benefit to offset this cost.  All to give a politically desperate senator a fig leaf.

The issue of the systemic risks posed by a clearing mandate that expands the scale and scope of central counterparties has come to the fore of late.  Too late, perhaps, but even at this late date it is an advance.

The focus of this concern is now on whether CCPs will be too big to fail, and whether they should have access to the Fed’s liquidity provision facilities.

Now that the financial defo . . . I mean “reform” bill is on the verge of passage, with (a) a clearing mandate, and (b) a provision granting CCPs access to the Fed, as one of the people who raised the profile of this issue I should restate my views.

First, yes, the clearing mandate will make CCPs a much more integral part of the broader financial system; CCPs can fail; a failure would be catastrophic; and hence CCPs are likely too big to fail.

TBTF is pernicious.  So how to deal with it?  In this instance, by not mandating clearing and thereby creating new TBTF institutions.

But it looks like a clearing mandate is inevitable, so the question becomes: given that CCPs are crucial financial institutions whose failure threatens the stability of the financial system, should they have access to the Fed?

Here, my answer is a qualified yes.  The Fed has legitimate lender of last resort functions that involve the supply of liquidity to solvent institutions during times of liquidity crises.  CCPs can be prodigious consumers of liquidity, especially during times of market stress that induce big price movements that trigger big flows of margin money.  A solvent CCP could face a severe liquidity crunch in such circumstances, and access to Fed liquidity, either directly, or indirectly (a la 1987) can prevent this liquidity crunch from causing the failure of a CCP–which would have serious systemic consequences.  These consequences include the closure of markets, large moves in asset prices, and asset fire sales.  Thus, if one could trust the Fed to be a classical Bagehotian LOLR, lending to solvent institutions against good collateral, permitting CCP access to the Fed’s liquidity programs could improve the stability of the financial system.  This would make a disastrous meltdown of CCPs due to liquidity problems less likely.

But that “if one could trust the Fed” clause is why my answer is a qualified one.  The truth is that the Bernanke Fed has stretched and bent the Fed’s legitimate LOLR functions beyond recognition in a way that must have Bagehot spinning in his grave.  Many of its actions (e.g., AIG) can legitimately be seen as bailouts that exacerbate moral hazard problems going forward.  As a result, there is reason for legitimate concern that giving the Fed a new set of institutions to bail out is a very bad thing indeed.

But the problem is that although cutting off CCPs from the Fed altogether would preclude it from bailing them out, it would also preclude legitimate liquidity support.  It is difficult to say, here and now and in the abstract, whether this package deal is superior to the alternative–a risk of bailouts, but the ability to prevent future liquidity crises from blowing up CCPs.   As it stands, that is the choice.  It is a stark one, and not an easy one to make.

This illustrates a fundamental problem with a lot of the financial regulation debate.  The issues that are being debated are the consequence of underlying problems that remain unaddressed.  In the present instance, the underlying issues are (a) the role, power, and discretion of the Fed, and (b) clearing mandates that expand clearing, and expand it into more problematic and difficult areas.  Clearing mandates have been a given from almost the beginning.  The Fed’s role has been debated, but it has emerged from the process as powerful, or more powerful than before.  The failure to address these underlying issues is why we are confronted with the Hobson’s choice between risking CCP bailouts and being unable to respond to CCP liquidity crises.

The increasing angst over the Hobson’s choice should have led to a serious rethink of clearing mandates.  To spark such a rethink was one reason why I have hammered on this issue for some time.  But that hasn’t happened; since the whole rationale for clearing was to reduce systemic risk, to proceed apace with mandates even as it became evident that CCPs created their own systemic risks and then argue over how to deal with that consequence was irresponsible in the extreme.  It should have also led to a more searching evaluation of how to constrain the Fed to its legitimate Bagehotian LOLR role.  That hasn’t happened either.

Well, Congress has made its choices, and we’ll all have to live with them.  It’s summertime, but the living ain’t easy.

Can you say that any more?  Well, even if use of the word “retarded” is increasingly frowned upon, there are some special cases in which its use is so evocative, and hence so appropriate, that it should be blessed.

The compromise on the Lincoln amendment is one such case:

The bill also includes a provision, authored by Sen. Blanche Lincoln (D., Ark), which would limit the ability of federally insured banks to trade derivatives. This provision almost derailed the bill following vehement objections from New York Democrats. Ms. Lincoln worked out a deal in the early hours of Friday morning that would allow banks to trade interest-rate swaps, certain credit derivatives and others—in other words the kind of standard safeguards a bank would take to hedge its own risk.

Banks, however, would have to set up separately capitalized affiliates to trade derivatives in areas lawmakers perceived as riskier, including metals, energy swaps, and agriculture commodities, among other things.

Under any modern understanding of what “risk” means, this makes no sense.  Ever heard of diversification, or the fact that “risk” of a particular position is attributable to its contribution to the payoff distribution of the entire portfolio of risks, not anything inherent to the position itself?  (Meaning that even if energy prices are volatile, doing energy swaps may not be that risky in a portfolio context.)  Under any modern understanding of the economics of financial intermediation (in which information about counterparties is vital) this makes no sense either.  (Meaning that the costs of intermediation are lower if information obtained in trading one instrument with a counterparty can be used when dealing in other instruments.)  Under any modern understanding of counterparty risk, where maximizing netting opportunities can be quite valuable, this makes no sense; splitting up businesses in an arbitrary fashion like this reduces scope economies from netting and other things.  It also makes no sense even on its own terms, because yes, banks use interest rate and credit derivatives to manage their own risks, but from my understanding of the provision, banks will still be able to be dealers in these products, and the whole basis of Lincoln’s proposal (to the extent that it had one) is that dealing is a particularly risky activity.  Not that I am buying into that argument; I’m only pointing out that is that’s what you believe, this provision is contrary to that belief.

This is transparently a compromise to save the face of a senator in over her head, who made a wild legislative proposal to stave off a primary challenge.  The banks were willing to throw a couple of bones in order to save their biggest books; metals, energy, and ags are small potatoes compared to interest rates and credit.  Lincoln gets to do what senators do best–pose.  The banks largely escape major damage.

Even by sausage making standards, this is revolting.  It is good that the most egregious parts of the Lincoln proposal have been jettisoned.  It is bad news, however, for liquidity and hedging in the disfavored products, especially commodities.  This, along with the position limit measure in the bill, and the clearing mandate, will increase the costs of managing commodity price risks in particular.

All pain, no gain: the only thing that can be said is the pain could have been a lot worse.

He being Gary Gensler, and his story being that mandated clearing will improve the stability of the financial system by eliminating interconnectedness:

“Over-the-counter derivatives are meant to lower risk on our economy, and to some extent they do,” Mr. Gensler says. “But they have concentrated risk in a few big banks…through their interconnectedness.” He says forcing them onto clearinghouses would shift the risk from any single institution to the clearinghouse. It can more easily offset, for instance, bets that interest rates will rise with bets that they will fall. That would make it possible to allow a big financial firm that is floundering to fail, restoring market discipline.

Repeating the same BS over and over doesn’t turn it into gold.  Clearinghouses are interconnected.   And they will almost certainly be too big to fail–and they can fail, a point that Gensler has never acknowledge.  Even the New York Times sort of gets it (although I disagree with a lot of what they say in this editorial).  “Interconnection” is just about the worst argument to make in support of clearing mandates.

Gensler has company in Europe. Gertrude Tempell-Gugerel of the European Central Bank supports central clearing mandates, for equally inane reasons.  She starts out with a non sequitur (since Lehman and AIG failed, clearing must be better–wrong), and goes downhill from there:

Therefore central clearing has become part of the G20’s agenda and mandatory clearing is seen as a tool to address the risks in OTC derivatives trading. Should a counterparty involved in OTC trading go bankrupt under central clearing, it would not create the chain reaction that the default of Lehman Brothers triggered. A central counterparty (CCP) would allow an institution with offsetting positions to net their exposures and substantially reduce counterparty risk.

In addition, a CCP would need to comply with high risk management standards and require counterparties to post appropriate collateral. Moreover, mandatory reporting of contracts to trade repositories would significantly enhance information on OTC derivatives exposures, to the benefit of authorities and market participants alike.

No chain reaction is possible when there is a clearinghouse?  Really?  What is the color of the sky on the planet where that is true?  Netting already takes place to a considerable extent.  Indeed, clearing done badly can actually REDUCE the amount of netting, if clearing is fragmented by product and even within products (e.g., multiple competing interest rate swap or CDS CCPs). And for the billionth time (perhaps I exaggerate), netting like this is a private benefit: if the benefit is as great as Gert (and many other regulators) say, why haven’t private parties fallen all over themselves to exploit it?  Mightn’t there be some costs that more than offset this putative benefit?   “High risk management standards”–why not impose them on banks?  And what about the information disadvantage that CCPs are likely to suffer vis a vis dealer banks?  That goes unmentioned.  Collateral can be the trigger for a systemic crisis.  Moreover, Tempel-Gugerel overlooks the likely equilibrium responses to a clearing mandate.  Rather than extending credit implicitly in derivatives transactions (as is often the case now) big banks are likely to extend credit to their customers to permit them to post margins, leaving the overall amount of leverage in the system pretty much unchanged.  Since it’s leverage that is ultimately the source of systemic risk, this obsession with collateral is likely to provide a false sense of security.  The information benefits can be achieved by mandatory trade reporting to a repository (which I’ve advocated for well over 7 years) without requiring mutualized counterparty risk sharing, or centralized risk pricing (in the face of severe information disadvantages).

The advocates of clearing mandates have had almost two years to come up with credible arguments, and to attempt to rebut counter arguments.  They’ve done neither.  They keep recycling the same old BS, and don’t even acknowledge, let alone address, the myriad arguments that have been raised against clearing mandates.

Policies built on willful ignorance do not end well.

Matt Leising and Shannon Harrington report that smaller firms are accusing the big dealers of blocking access to clearinghouses:

Rules intended to lessen the risk of a systemwide failure are “working to restrict access to only the incumbent dealers,” the Swaps and Derivatives Market Association said in a statement sent today to Theo Lubke, senior vice president at the Federal Reserve Bank of New York. The group of more than 20 brokers including Jefferies & Co., Imperial Capital LLC and Newedge USA LLC formed in February to lobby Congress and regulators for access to derivatives clearing.

Intercontinental Exchange Inc., CME Group Inc. and other companies that operate clearinghouses for the $615 trillion privately negotiated derivatives markets enforce capital requirements and trading rules intended to bolster the ability of the clearinghouses to withstand losses. Those requirements, though, prevent all but the world’s largest banks, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Barclays Plc, from sending trades to the clearinghouses, according to the statement by the brokers group.

“The effort to protect clearing, however, is actually a proxy war to limit competition to the incumbent dealers’ $100 billion in profits for derivatives execution,” the brokers group said. Mike Hisler, a spokesman for the association, and Ray Zorovich, the group’s policy assistant, are listed as contacts on the statement. Hisler also is a partner at New York- based Hexagon Securities LLC, a member of the association.

This was only a matter of time.  I’ve written academic articles dating back well into the 1990s that in the presence of large scale economies in a particular service (e.g., trading), including scale economies arising from network effects, a suboptimally small coalition of suppliers can form a cooperative firm that offers this service (see, for instance, my 1999 J. of Financial Markets and 2002 J. of Law, Econ., and Org. articles).  The cooperative is smaller than optimal, but just big enough that no competing coalition can form because it cannot achieve the same scale economies.  Because it is suboptimally small, and faces no competition, the members of the dominant coalition/cooperative firm earn rents.

I applied this argument to clearing in the early-2000s, and again in a couple of papers done in 2007 and 2008.  So, what Matt and Shannon report is no surprise to me.  None whatsoever.  It was a direct implication of the work I’ve done for going on 15 years.

Indeed, when many asked me whether dealer opposition to clearing was motivated by their desire to limit competition, I would often reply that forming a clearinghouse that limited entry was perhaps the best way to cartelize the industry, and make even more profits.

But that’s not the end of the story.  I’ve also written that there are good economic reasons to limit entry into a clearinghouse.  In particular, rigorous financial requirements are necessary to ensure the safety and soundness of the CCP.  Moreover, I’ve also written that the transaction costs/organizational costs of operating a clearinghouse will be greater, the more heterogeneous the membership: this provides further justification for limiting membership to a relatively homogeneous group of firms.  Setting margin, capital levels, etc. is more difficult, and the process more rancorous, the more heterogeneous the membership.  (The effects of heterogeneity on governance was the focus of my 2000 JLE piece on exchange organization.)

In brief: just as is the case in virtually all trading services, market structure issues in clearing are extremely, extremely knotty because of the pervasive scale and scope economies.  The pronounced scope and scale economies create opportunities for the exercise of market power, most notably by the formation of cooperative firms that restrict entry and face no competition.  This is the way that exchanges earned rents for their members for years, and years, and years.  At the same, time, open entry is particularly problematic for CCPs given the effects of heterogeneity on governance costs, and the extreme importance of financial stability.

Battles over market structure in securities have been raging for decades, due in large part to similar considerations.  Ditto recently in futures markets.  (Note the battles that raged over the CME-CBT and CME-NYMEX mergers.)

Note that this battle over entry is going to create serious legislative and regulatory conflicts because, as I have pointed out ad nauseum (including in a forthcoming Policy Paper for Cato) there is a fundamental tension between enhancing competition and reducing systemic risk in CCPs.  Conventional political economy considerations are going to play out here.  The pressure of the SDMA and other firms will inevitably lead to regulatory interventions that will open up entry and access, and thereby threaten to compromise the financial soundness of CCPs.

The irony is almost too much to take.

There are no free lunches.  None.  Only very difficult trade-offs.

Is their any evidence that any legislator or regulator has given serious consideration to this problem?  Not that I’ve seen.  But now, with clearing mandates on the horizon, there will be years of knock down-drag out fights over CCP rules, membership requirements, etc.  At every turn, there will be a tension between the systemic risk issues and the competition issues.  The results will not be pretty: they will be driven by the political economy considerations that dominate all such issues.  Economic efficiency and the soundness of the financial system will take a back seat, a distant back seat, to rent seeking.  We know how that usually works out.

No regulator or legislator can say that s/he wasn’t warned.  They just weren’t paying attention, or thinking seriously about the subject.  Oh yes, they said: just mandate clearing and we can go live on the big rock candy mountain.  As if.

For some reason Mark 6:4 just popped into my head.

I think I’ve made the analogy before on SWP, but it bears repeating.  There’s an old story about the Indian village that is beset by mice, and brings in cats to get rid of them.  The village is soon overrun by the cats, so they bring in dogs to scare off the cats, but then the dogs become a plague, so they bring in the elephants . . . and then realize that mice weren’t such a bad problem after all, so they bring back the mice to scare off the elephants.  The moral: short sighted “solutions” to a problem adopted without consideration of all of the consequences can lead to worse problems than you started with.

The criticism of CCP membership problems is just a harbinger of things to come: after too long, the mice might look pretty good by comparison.

Kudos to Jeremy Grant at FT’s Trading room, who published not one, not two, but three articles expressing serious reservations about clearing mandates.  One is by Sanjit Das, another by Shearman and Sterling attorney Barney Reynolds, and the third byReuben Lee.   Each echoes points I’ve been making over the last 20 months.

The Reynolds piece was interesting, though I don’t quite track his claim that end user clearing will result in said end users posting collateral to a clearing house, and to the dealer it trades through, to cover the dealer’s collateral costs.  But Reynolds does make a key point: namely, that the impacts of clearing on the normal day to day operations of the market should be taken into account, not just the systemic risk implications.   He says that clearing rules should be set “with a view to preserving commercial hedging activity, not merely with a view to protecting financial institutions from another black swan event.”

Since it is quite possible that CCPs are vulnerable to black swan events, systemic risk considerations are close to a push.  This means that the efficiency effects of clearing under normal market conditions should be given considerable weight, and as Reynolds argues, and as I argue, OTC bilateral dealings have clear advantages on this score.

But it doesn’t really matter, does it?  The clearing train has probably left the station, both in the US and Europe.  A clearing mandate is in both bills currently being merged in conference between House and Senate, so it’s a done deal here, and the European Commission has made it plain that it will require the bulk of deals to be cleared.

It would have been nice if people had spoken up rather earlier, when it was possible to influence the debate.  As it is, I don’t think it’s an exaggeration to say that I was nearly alone, at least among academics, in my criticism of clearing mandates when they were first mooted.  And who am I, anyways?  People have finally figured out that this is a big deal, and that Sorcerer’s Apprentices may wreak havoc with ill considered rules on clearing.  So they are saying this now, but now is too late.

This is, to my mind, a black mark against the academic community.  It has, for the most part, paid virtually no attention to matters of market infrastructure, despite their crucial importance; the subject has been relegated to, at best, specialty journals, and often not even there.  My stock remark in this regard is that in the military it is said that amateurs talk tactics, professionals talk logistics, and in finance professionals talk counterparty risk and how to manage it, but academics are amateurs who ignore it by and large.  At the margin, the value of an imperfect paper on clearing or counterparty risk is far greater than the value of yet another paper on testing asset pricing models or on some aspect of corporate finance.  But that value isn’t recognized, and such things are devilishly hard to get published, so that Nth paper on asset pricing or capital structure gets written and perhaps published.  As a result, academics have far too little to say, and hence far too little influence, on what is perhaps the most important of the seismic changes that will take place in financial markets by legislative fiat.

(As an aside, some academics have weighed in on clearing issues late in the game, including some very prominent ones.  Much of what they have to say is an embarrassment, unfortunately.)

At best, serious thinking and research might affect the implementation of the clearing regulations.  Legislation will leave a lot of the specifics to regulators like the CFTC (God help us all), and perhaps some serious academics could lead to Pareto improvements by weighing in now, even at this late date.

* This is one of my grandfather’s expressions. (He had many, which I have appropriated, often to the mystification of those to whom I am speaking.) It always mystified me, so I asked him to explain it.  Apparently there was a product to treat baldness, back in the 30s or 40s, called Herpicide.  (Yeah, like I’d put something with THAT name on my head.)  Apparently you had to use it just when you were starting to lose your hair; it wouldn’t work–they said–if you waited too long.  To make the point, they ran an ad campaign with pictures of cue-ball headed men, with the caption “It’s A Little Late for Herpicide.”  So now you know.

Yesterday Putin did his best King Canute impression, and ordered a group of financial regulators, including the finance ministry, to draft plans for an exchange to trade steel, coal, coking coal, and other metals.  By 1 August.  Putin believes the exchange will, in the words of the Moscow Times article just linked to, “avert price rows between producers and industry.”

In other words, even though no exchange anywhere has created successful spot or futures markets for steel and coking coal, and really for thermal coal either, in the 150 odd years since the advent of modern futures trading, Putin has commanded that Russia, which has never really created a successful commodity exchange for anything ever, do it in less than 2 months.

Yeah.  Right.

My reference to Canute was a slight to Canute, of course.  The Danish (English/Norwegian/Swedish) king knew that he couldn’t make the waves cease their beating: he just wanted to make the point to court sycophants.  Putin, by contrast, apparently thinks that his command will make it so.  I can just imagine the furtive and panicked looks between those in Putin’s audience charged with implementing the (impossible) task.  I can also imagine the “jump? how high boss?” responses to his command.

This is another case of Putin, Man in a Hurry, as I dubbed him soon after I began this blog.  It is clear that he has tired of the squabbling between the upstream and downstream firms in the Russian ferrous metals sector.  He evidently believes (or at least hopes) that a command that a market magically appear will relieve him of mediating this conflict to maintain the equilibrium in the natural state.

Ain’t gonna happen.  Markets don’t just magically appear.  As has been documented in the academic literature, most notably by Dennis Carlton, auction type futures markets are devilishly hard to start.  Far more contracts fail than succeed, despite the concerted efforts of experienced exchanges to identify the most promising candidates, to work to design contracts that will suit the needs of the target industry, and to build industry support through favorable fees, liquidity support programs, etc.

Steel and coking coal are particularly challenging for a variety of reasons.  “Steel” is not a homogeneous product, but consists of a dizzying array of differing physical types and shapes.  Some kinds of steel, e.g., scrap, are fairly standardized and traded, but its prices don’t necessarily track the prices and values of other types of steel.  Coking coal is also characterized by substantial differences in grades and uses.  Moreover, for coal in particular, location matters because it is relatively expensive to ship.

Industry structure matters too.  Futures markets tend to work best with relatively disaggregated value chains, where the same product is often bought and sold repeatedly, and where there is relatively little concentration on either the buy or sell sides.  (Structure is not independent of product characteristics, of course.  Relatively homogeneous goods tend to have a larger number of buyers and sellers, and greater turnover, than more specialized goods unique to one producer or tailored to fit the needs of a particular consumer.)

Firms in an industry will not necessarily support the introduction of more transparent pricing mechanisms, either, as Carlton points out in another paper.  The steel industry has been quite outspoken in criticizing plans for steel and iron ore derivatives markets.  (India’s Tata Group is a good example of this.)

I would imagine all these factors go double in Russia–if not more than double.  With central planning, the absence of a free pricing mechanism, and a preference for giganticism, Soviet firms tended to be few in number and dependent on a small number of suppliers and customers.  Moreover, just as was the case with the US electricity business prior to deregulation, integration and price regulation led to patterns of investment in plant and equipment that tended to create holdup problems; Steel plant S was highly dependent on coking coal from mine M because the lack of freely negotiated prices meant that outside options weren’t that valuable in constraining opportunism.  (In US electricity, firms that supplied both generation and transmission didn’t worry about holdups between these two stages of the value chain, and hence created generation and transmission infrastructures that were subject to bilateral monopoly problems when the products were unbundled in deregulation.)  Russia inherited this structure, but then eliminated the central planning and price control that was necessary to keep transaction costs  in check.  Hence Putin’s pricing problems.

In Russia, the holdup problems inherent in the mismatch between the pattern of capital investments made when government control over prices suppressed (but didn’t eliminate) pricing disputes, and the pattern that firms would choose if they had to worry about opportunism problems, has exacerbated the price conflicts that are vexing Putin.  But the problem is that saying “presto, change0, make me an exchange-0” doesn’t make these fundamental problems go away.  Indeed, they are antithetical to the effective operation of a centralized spot or futures market.  And what’s more, the prices for the stuff not traded on exchange–which would be most of the steel and coal products actually produced and consumed in Russia–would still have to be negotiated between the parties.  Yes, centralized market prices would provide some information about the underlying fundamentals that affect the values of steel, etc., but there would still be considerable room for dispute about the price relationships between the standardized and non-standardized products.  As a result, there would still be considerable potential for holdup.

I would imagine this plan will go nowhere, as it is as futile as commanding the tides to stop.  It is futile because it ignores all of the transaction- and product-specific features of the products in question, and the necessity of structuring transactions in ways that respect these features.  Putin is apparently like Gary Gensler, who thinks that auction markets should be good for everything, when experience (and economics) shows that they are really good for very few things indeed and pretty much unworkable for everything else.

Putin’s heavy metal headache is a fitting curse for a Sovietophile who is enamored with raw materials and basic industries and who has been the enemy of property rights and the rule of law.  He is suffering this malady in large part because of (a) an industrial structure inherited from Soviet times, and (b) the inability of Russia to move beyond its resource focused development, which (c) which reflects in no small part the fact that the precariousness of property and legal rights in Putin’s natural state is an anathema to entrepreneurship and tends to favor the persistence of oligarchic structures because oligarchs can bargain with the state on relatively equal terms, and can thereby protect themselves against expropriation without having to rely on courts.  Putin’s problem, then, is inherent in Putinism.

Irony can be a real b*tch.

So, good luck with that steel exchange thing, VV.  And don’t say I didn’t tell you so.

Whatever emerges from the House-Senate financial regulation conference committee, the CFTC’s power and responsibilities will be greatly expanded.  Most notably, the agency will have vast power and discretion over the OTC derivatives markets.  It apparently will have considerable say in determining what contracts must be cleared and what firms must subject their trades for clearing.  Moreover, it will have responsibility to oversee the operations of central counterparties, which will have important implications for the stability of the financial system; misteps here could induce a serious systemic problem.

Just a few years ago, the chairman of the CFTC, Walt Lukken was bemoaning the agency’s lack of funding, claiming that it had insufficient resources to carry out its (then far narrower) duties.  The agency’s funding has increased, and its head count has increased about 20 percent.  It is slated to increase further to permit it to carry out its new charges.

But, as I’ve pointed out before, the CFTC was never renowned as an extremely effective regulator.  Indeed, it was often something of a Congressional whipping boy because of its perceived shortcomings.  (Example: I remember well the agency’s humiliation when then-Chair Wendy Gramm was forced to stand silent in the background while the Justice Department and the FBI announced indictments against Chicago floor traders for assorted misdeeds.  The clear implication was that the CFTC was not capable of policing the markets.)

Whether that reputation is deserved or not, there is considerable room for skepticism about the CFTC’s ability to handle its new duties.  Any dramatic expansion of an organization into new areas inevitably leads to growing pains and managerial snafus.  That goes double for a dramatic increase in the size and scope of a government organization.  And the stakes are extremely high now, given the systemic importance of clearing.  Requiring the clearing of unsuitable instruments, for instance, could jeopardize the stability of clearinghouses–and hence the financial system.  So could lapses in monitoring the operational or risk management activities of CCPs.

And it must be remembered that the agency will have to handle these new tasks in a hypercharged political environment, one more intense than it has to cope with now.  The stakes will be higher, with big players having a far bigger amount of money affected by CFTC decisions.  With greater stakes will go greater pressure, most notably from Congress, which will respond to constituent pressure.  Can the agency handle it?  Color me skeptical.

Some Commissioners are now openly expressing concerns about the agency’s ability to shoulder the load:

US financial reform regulation could place “overwhelming” burdens on the Commodity Futures Trading Commission, the regulator that would have to assume a new role as watchdog for the swaps markets, officials there said.

Sweeping financial legislation approved by the Senate last week dramatically elevates the role of the CFTC, created in 1974 to police trading in futures and options. The commission would gain broad new powers to oversee previously unregulated over-the-counter derivatives, a universe 10 times larger than regulated markets.

“It’s overwhelming. It’s not like right now we don’t have enough on our plate,” said Jill Sommers, one of two Republicans on the five-member commission.

Senior officials warn that to perform its new role, the CFTC, which has long operated in the shadow of the better-funded Securities and Exchange Commission, will strain its expertise, organisational structure and technology. It would have to propose, take public comment on and then adopt as many as 50 elaborate rules in six months, a timetable that Michael Dunn, a Democratic member of the commission, called “pretty much an impossibility”.

. . . .

Gary Gensler, the CFTC chairman, was among the Obama administration’s staunchest champions of legislative language that would route most derivative trades to clearing houses. This would allow regulators to peer at the size of traders’ positions and, so it is hoped, head off the kinds of risky positions that led to the $180bn (£124bn, €143bn) AIG bail-out. While sharing oversight with the SEC, the CFTC would regulate the majority of derivative deals.

. . . .

CFTC officials acknowledge being snowed under. Probes into oil and silver markets announced in 2008 remain unresolved. Mr Gensler has said the agency was overwhelmed by Ponzi scheme cases. Last week Scott O’Malia, a Republican commissioner, said the agency still gets account information by fax and enters it manually. “This agency is about to be hit with a tsunami of trade data,” he said.

Remember, regulation can create systemic risks.  One way to do that is to place extraordinary burdens on a regulator unprepared to handle it.  Which is what Congress is in the process of doing.