Streetwise Professor

Last week I conjectured that a likely starting place for the May 6 crash-boom was the index futures market.  The WSJ ran an article today that claims a 50,000 contract options trade (ironically from the firm associated with Nassim Taleb, of Black Swan fame) touched off the dive.  Eric Noll, an Executive VP at NASDAQ, has submitted testimony to the House Financial Services Committee that also fingers the eMini:

Second, the Chicago Mercantile Exchange was beginning to experience unusual trading activity in the “E-Mini June” at the same time equities markets were experiencing heavy trading in highly correlated equities.  As you can see in Figure 1, the E-Mini began experiencing heavy volumes and prices begin sinking rapidly at 2:42, just before equities prices sink rapidly.  At 2:45:30, E-Mini trading becomes so volatile that the Chicago Mercantile Exchange triggered an automatic 5-second trading halt in E-Mini futures.  The price of the E-Mini future immediately leveled off and began to climb rapidly.  Equities followed that pattern shortly afterwards.

The time lines between the stories don’t exactly line up: the 50K options trade (puts, presumably) was a little after 2:15, but the big action in the eMini occurred at about 2:42.

Felix Salmon is skeptical about the Black Swan link to this particular black swan: “Lots of options trades of that size take place every day, and just because this one happened just before the market fell doesn’t mean it was the cause of the crash.”  Fair enough: 50K cars is not a big deal on most days.  But “every day” and “May 6th” are not the same thing.  That’s kind of the point: a confluence of events particular to that date likely made the ordinary exceptional, and perhaps exceptionally destabilizing.

Put differently, the market went non-linear–chaotic–in that short period of time.  A key feature of non-linear systems is that small perturbations can have big, disproportionate impacts.  The butterfly flapping its wings and all that.  Or a black swan.

In these sorts of situations, chains of usually ordinary events can feed back on one another with destabilizing consequences.  Here’s one scenario.

The market was very turbulent due to the chaos in Greece and Europe.  (“Chaos” in the ordinary sense of the word, not the mathematical/scientific sense.)  Market makers had backed off in the face of this risk.  Markets were not as deep as usual.  An order comes in.  Maybe several in a row.  The price starts to break, and then the feedbacks kick in.  Options hedgers–including, perhaps, Barclays and others hedging the exposure from the options it had bought from Taleb’s fund–start selling as part of a dynamic hedging strategy.  That’s one positive feedback.  Some stops get triggered.  More positive feedback.  Prices get forced down some more.  Given the background volatility, in light of the big price move, market makers human and electronic begin to fade big time.  Liquidity dries up as a consequence, meaning that even small orders move prices a lot.  With dynamic option hedges and stops going on automatic, the process feeds on itself.  Through correlation algos and program trading systems, the price move in the futures pits is communicated to the cash markets.  And off we go.

My sense remains that a market-wide sell-off most likely started in a market index-based contract, not in a single stock, or even a handful of stocks.  Options-based stories, like that in the WSJ, make particular sense, because dynamic hedging can create the positive feedback that leads to non-linear responses to individually small shocks.

But the eMini story alone is not enough.  Like Salmon says, the market deals with that every day.  But an order or orders that would have been no big deal on ordinary days could have been a very big deal if liquidity was already low due to the uncertainty emanating from across the Atlantic.

It would be VERY interesting to see the evolution of the S&P futures and futures options order books on the 6th.  Part of the scenario I sketched out is that the books weren’t as deep as usual as market makers (whether HFT types, or guys sitting at their TT screens) had pulled back due to the uncertainty surrounding Europe.  (It would be interesting to look at other order books too, to see if the decline in liquidity was general.)

And if you want a very amazing demonstration of how liquidity had fled the market, you HAVE TO listen to this play-by-play of action in the eMini pit on the 6th.  One of the most incredible things I’ve ever heard.  I mean, you HAVE TO listen. (Man, it takes me back.)

At times, the market was quoted 10 wide, bid 1060 at 1070.  Normally this is a one-tick market; the bid-offer is a quarter point.  So the bid-ask was 40 times larger than usual.  That’s an illiquid market.  One can only imagine what other markets, normally less liquid than the eMini, were like.

The other fascinating thing about the recording is the incredibly rapid price rebound, with the price jumping by a point at a time in seconds–again, this in a market that usually moves in quarter points.

And note that this was an old school floor market, not some computerized market untouched by human hands.

The WSJ article also discusses the rebound, and supports my conjecture from the 6th: some of the demonized computerized traders played the role of the cavalry, and charged in to save the day by snapping up bargains:

Around 3 p.m., the selling pressure abated. Just as swiftly as the market fell, it recovered ground. One factor behind the swift recovery, traders say, were funds that use computers and formulas to sniff out bargains in the market. These funds swooped in on hundreds of cheap stocks, helping push the market higher.

In ’87, corporate stock repurchases brought the market from the depths.  I hypothesize that value-based quantitative strategies did it last Thursday.

There is a lot of data to be analyzed before a verdict should be rendered.  We are blessed, though, by a superabundance of such data.  An abundance that is the direct result of the computerization of the markets.  In reconstructing the ’87 Crash, it’s impossible to know what was in the order decks of the locals.  It’s also impossible to sequence events in time with any accuracy.  In reconstructing this one, the order books are computerized and time stamped to the fraction of a second.  It will be a massive data processing task, but it’s just that: the data are there to be processed.

In the meantime, withhold rushes to judgment about HFT or algos or computers or whatever.  Take statements like Noll’s with a grain of salt.  No doubt the exchanges will all go around singing a Chuck Berry tune:

It wasn’t me, Sheriff; Uh huh, Sheriff, it wasn’t me
Ah! It must have been some other body, uh uh, Sheriff, it wasn’t me

all the while pointing fingers at other exchanges and algos.  Let folks analyze the data, particularly the evolution of the order books and the flow of orders into those books.  The answer will come in time, and with more precision that has been possible in previous crashes.

NASDAQ has decided to cancel–bust–trades made between 2:40 and 3:00 PM ET if they were at prices more than 60 percent away from the market price prior to 2:40.

Very bad idea.

The orders executed at these prices were almost certainly stop orders.  Old fashioned stop orders.  The kind that have been destabilizing for years, not some newfangled HFT thing.  When stops are hit, they reinforce the price movement that triggered them.

Busting these trades therefore encourages the use of a particularly destabilizing type of order.  If the idea is to reduce the amount of positive feedback in the system, this will have the exact opposite effect.

There is still no definitive understanding of what triggered the selloff.  The P&G story seems bogus–the slide started before that.  Yes, algorithmic trading or program trading of some sort was probably involved.  Let’s try to think of the most likely trigger.

A big index futures sale that really moved the futures price would have triggered sell orders in stocks generally, first in the index component stocks, then in other stocks (as correlation or pair algorithms kicked in). The main effect of algorithms would have been to speed the transmission of the initial shock.  The question is: what would have caused a big index futures trade?  An error?  (CME says its system worked fine, and Citi denies it was involved in any erroneous trade, as had been rumored.)

There are no answers right now, but the methodology for providing the answers should be pretty straightforward, and ironically, the very accurate time sequencing and record keeping made possible by electronic trading will greatly ease the process of implementing that methodology.   Look which markets moved first.  Look at the orders that were associated with those moves.  Then trace the effects from there.  Knowing where the event started, the basics of algo trading strategies makes it straightforward to hypothesize how the shock wave should have traveled.  One can then test those hypotheses to see whether in fact these strategies accelerated the decline.

There are also reports that many HFT traders withdrew from the market when things got crazy.  This isn’t surprising, really.  That’s what market makers do.  (Remember the stories of NASDAQ market makers not answering their phones–or making markets–during the ’87 Crash.  Or clearing firms yanking their locals off the floor on that day.)  This is very consistent with the Greenwald-Stein story of how a big volume shock can lead to higher execution risk which causes a decline in liquidity which in turn makes the market more volatile.  That is another feature inherent in continuous markets, human or automated.  HFT firms that make markets won’t behave that differently than human market makers.  They’ve just embodied the logic in the market makers’ heads into computer code.

Another thing that is consistent with the Greenwald-Stein story is the report that the NYSE liquidity circuit breakers exacerbated problems.  Greenwald-Stein recommended that in the event of a major disruption, the market transition from continuous trading to an auction market.  That’s what NYSE did.  But this apparently resulted in orders being redirected to other execution venues.  The circuit breaker deprived the market of NYSE liquidity for a time, and the wave of orders stressed liquidity in other venues.  But one of the points that was made clear in the aftermath of the ’87 Crash is that circuit breakers have to be coordinated.  Tripping a circuit breaker in one market but not the other can make things worse, not better.

One thing that is not really consistent with G-S is the rapid rise in prices after the plummeting fall.  Indeed, the rise is in some ways more remarkable than the fall.  It is almost vertical, with the Dow moving up more than 4 percent in less than 15 minutes, with most of that distance covered in about 10.  This suggests that value buyers jumped on the opportunity, and drove up prices.  In G-S, the execution risk keeps the value buyers away.

Thus, another important question is: who were these value buyers?  Mightn’t they have been algo/HFT traders?  If so, it is imperative than any rule changes or regulations implemented in response to this event do not cripple those using negative feedback strategies.

I am probably asking for too much there, as the tendency to lump traders into big categories is very strong, and the ability and willingness to make careful distinctions virtually absent.

And it is highly likely that stop order traders who almost certainly exacerbated the price decline will not receive proper scrutiny, and indeed are likely to be pitied as victims; busting trades is consistent with that narrative.  That would be a real pity, and would betray a failure to understand what kinds of orders and trading strategies are destabilizing.  Stop orders should be taxed, if anything, and those using them don’t deserve pity–or mulligans.

One story circulating to explain today’s selloff is a large, mistaken order entry by Citi.  Certainly not outside the realm of possibility.  It’s happened before.  There’s the famous story of the MATIF trader who swung around in his chair to speak to a colleague, and unwittingly rested his elbow on the “Sell 100” key on his trading keyboard, triggering a deluge of sell orders that caused the market to tank before he realized his mistake and started buying furiously.  Or the case of the guy who thought he was in the training mode of the Eurex system, when in fact he was in the live trading mode; he was goofing around, submitting big orders into the “simulated” market that were in fact going into the real market and causing the price to go crazy.  As I recall, this cost his employer (a German bank) $150 million.  Or the error in Japan where somebody submitted an order at a price that was off by several orders of magnitude.

So yes, stuff like this can happen in computerized markets, although systems are being made more robust to these kind of errors.  More robust, not completely so.

And, perhaps, once the original mistaken order went in, and affected prices of Dow stocks, that triggered other programs that caused additional selling.

But I am highly confident that the near immediate snap back was also computer driven, as other algos’ signals indicated that the new prices were too low and submitted buy orders.

The post mortem will be interesting.

The terms “program trading” and “computerized trading” are used so much it’s worthwhile distinguishing the problematic kinds from the beneficial ones.

Computerized trading was widely believed to have exacerbated the 1987 Crash.  The order execution then wasn’t computerized, but portfolio insurance strategies made order submissions contingent on price movements according to a computer algorithm, so the trading was computerized in some relevant sense.

This is the kind of automated trading that is problematic because it can create destabilizing positive feedback effects.  Synthesizing index puts as portfolio insurance through a dynamic trading strategy means that big price declines triggered more sell orders that arguably exacerbated the price declines which caused additional sales, and so on.  Option hedging strategies (e.g., dealers use dynamic hedges to manage the risk of options they’ve traded with customers) can have the same effect.

Stop orders (which probably contributed to what transpired today) can have a similar effect; price declines (rises) trigger sell (buy) orders that can exacerbate price moves.  These kinds of orders are as old as the market.

Margin-driven trades can do the same: those suffering losses on a price decline (increase) sell (buy) and who cannot come up with the necessary margin sell (buy) to close positions–again, as old as the market.

Some computerized trading–and I would argue that most algo trading–is very different.  It is a negative feedback strategy.  That’s what market makers do: they sell into purchases and buy into sales.  Much algo trading is effectively automated market making.  It is, in effect, the realization of what the great Fisher Black imagined in 1971, when he wrote an article in the Financial Analyst’s Journal titled “Towards a Fully Automated  Stock Exchange.”  Black envisioned a fully automated specialist that made markets, and thereby stabilized prices.  Computerized/algo market making programs based on negative feedback would have bought on today’s decline as Black described.  The rapid snap-back is perfectly consistent with that.

Moral of the story: ignore categorical condemnations of computerized or quantitative trading in the aftermath of today’s events.  There’s good, bad, and ugly.  Be careful, and try to distinguish them.

The European Commission is pushing for foreign currency derivatives to be cleared.  This is also a bone of contention here in the US.

It is interesting that those advocating clearing, and also exchange trading, have not attempted to explain the very pronounced cross sectional variation in trading and clearing practices across markets, and the time trends in particular markets.  Virtually all FX derivatives trading is OTC (with currency futures being the hair at the end of the tail of the dog).  The large bulk of linear interest rate derivative trading is OTC (even though the Eurodollar futures and similar markets are immense, they are dwarfed by the even more immense OTC interest rate swaps).  Equity derivatives and interest rate option trading is more evenly split between OTC and exchange.  Moreover, whereas in recent years a good portion of interest rate swap business has migrated to clearing naturally (accounting for about 50 percent of the interbank business), no OTC FX business is cleared.  A decent amount of OTC equity business is cleared.  A considerable part of OTC energy trading in the US is cleared–and was trending in that direction starting from about 2003 without anybody from the government telling market participants to do it.

The lack of clearing in OTC FX is pretty interesting, inasmuch as counterparty risk on an FX swap of a given amount and tenor is greater than that of a corresponding interest rate swap because principal is at risk in the former, but not the latter.  If clearing is such an economical way of allocating counterparty risk, why is it almost completely absent for products in which that risk is pronounced?  Similarly, due to the jump-to-default feature in CDS, these products pose large counterparty risks, but they weren’t cleared either until the dealers came under pressure to do so.  So, the instruments that arguably pose the greatest counterparty risks were not cleared voluntarily.

It would be nice of those who have the Olympian insight to dictate how markets should be structured could explain how they are structured.  If the European Commission is right, then the participants in the FX derivatives market are wrong.  Why?  And why should FX market participants choose a different mix of execution and counterparty risk allocation methods than participants in interest rate swaps and equity and energy derivatives?  Especially since there’s more than a little overlap between the participants in these various markets.

This is an interesting economic puzzle, the solution to which might, just might, be somewhat illuminating.  It might just shed some light on the economic trade-offs involved in clearing.  Just a guess.  But in the haste to prescribe–to dictate–market structure, our legislative and regulatory betters couldn’t be bothered to understand.  They just know.  So everybody should just shut up and get with the program.

Blanche Lincoln has expressed uncertainty as to whether the no Federal assistance clause in her bill will survive to become law.  (Here’s hoping, though the Republicans caved–I’m shocked!, shocked!–at holding up the Dodd bill which Steve Bainbridge rightly calls “evil.”)  Perhaps one reason for her uncertainty is that some anonymous Fed staffers threw some “comments” on the bill over the transom.  (Which raises the questions: why do these staffers feel the need to be anonymous?  Why hasn’t the Board, or Bernanke, taken a stand on this?) (We know with probability 1 that SWP’s cogent critiques had nothing to do with Lincoln’s uncertainty!)

Echoing my original take, the comments trashed the dreaded section 106:

1. Section 106 should be deleted.

a. Lending to financial market utilities. Section 106 would prohibit any federal assistance to swap dealers, major swap participants, swap exchanges, clearinghouses and central counterparties.  This would appear to override the provision of Title VIII that would allow the Federal Reserve to provide emergency collateralized loans to systemically important financial market utilities, such as clearinghouses and central counterparties, to maintain financial stability and prevent serious adverse effects on the U.S. economy.

i. As systemically important post-trade “choke points” in the financial system, it is imperative that these utilities be able to settle each day as expected to avoid systemic problems and allow for a wide range of financial markets and institutions to operate.  The failure of a systemically important utility to settle for its markets would not only call into question the soundness of the utility as a critical market infrastructure but could also create systemic liquidity disruptions for one or more  markets and potentially other financial market utilities.  The increased importance that Title VIII places on central counterparties and central clearinghouses to reduce risk in the financial system necessitates ensuring that short-term secured credit is available to these utilities in times of stress.

b.  “Push–out” of bank swap activities. Section 106 would in effect prohibit banks from engaging in derivative transactions as an intermediary for customers or to hedge the bank’s own exposures.

i. Title VI, which includes the so-called Volcker rule provisions, better addresses the problem of risks from derivatives activities by prohibiting any bank, as well as any company that owns a bank, from taking speculative, proprietary derivative positions that are unrelated to customer needs.

I would disagree only to the extent that I think the Volcker rule is inane too.

The interesting question is where this insanity came from.  In the months leading up to the announcement of the Lincoln bill, mandatory clearing was always on the table; mandatory exchange or exchange-like trading was constantly discussed; but the no Federal assistance provision was never broached.  How can it happen, so late in the day, that such a momentous provision, fraught with the potential for massive consequences (that are almost impossible to forecast with any precision), can appear in a piece of legislation like a bolt from the blue?  The cavalier attitude on display here is frightening.

I have another question, related to the consequences.  During the Crash of ’87 clearinghouses didn’t have direct access to Fed assistance.  Nor do they now, for the most part.  But the Fed clearly provided liquidity support in 1987 that although not directed to CCPs or FCMs directly, indirectly supported them.  The Fed flooded the system with liquidity, and “persuaded” (the quotes are in Bernanke’s article about the event) banks to take the liquidity and lend it to securities firms and FCMs to make sure that they would be able to meet margin calls.  The Fed also permitted Continental Bank to inject capital into First Options, which probably saved OCC; Continental, I believe, received Fed liquidity.

Would it be legal for the Fed to do provide the same indirect support under Section 106?  It seems ambiguous.  The Fed’s actions in 1987 were clearly undertaken with the intent of saving clearinghouses, and had this effect.  Do we really want lawyers (or judges) trying to figure out whether such indirect assistance is legal when the financial system is on the brink?  Or will the fear of such a constraint lead to the kind of backroom dealing and cover-ups that occurred during and after the AIG bailout?  (And which, by the way, may get Timmy! in the legal crosshairs of the TARP Inspector General.)

Has anybody in the Senate even thought about this?

You know, when you play chess, or plan military strategies, you have to think several steps ahead.  You have to play “what if?”  I believe, with almost metaphysical certainty, that nobody who will be voting on this has done so.  More often, they are looking back, and learning false lessons about the past, or ignoring potentially informative experiences, or just engaging in pointless political posing and posturing.  Which bodes very ill for the next future, and the next crisis–when, and not if, it occurs.

Which is just one reason why Congress is the biggest systemic risk.

In some respects, the debate over clearing has been at cross purposes.  Those who advocate clearing, including many in the banking community, often focus on the chaotic events that accompany the default of a large OTC counterparty, such as Lehman or LTCM; advocates of clearing argue that a central counterparty can mitigate the disruptions associated with a large failure.  Those, like me, who are skeptical of mandates (but who are not averse to clearing if freely chosen by market participants, as has occurred in energy, freight forwards, and many interest rate swaps) focus on the incentive and information effects that affect behavior prior to a default.

I confess to being less than clear about the distinction, and therefore think it’s worthwhile to address these issues in more detail.

In essence, the distinction is between ex ante and ex post.  I have focused on the ex ante incentives, whereas others have focused on ex post issues.  Both are important.  (This parallels distinctions that transactions cost economists sometimes draw between agency theory and property rights models, which focus,  on ex ante incentives, and Williamsonian governance theories, which focus on the ex post management of contractual relationships.)

Of course, the ex ante and ex post issues are not unrelated.  Ex ante incentives affect the positions and risks that are undertaken, and hence affect the likelihood of a major default.  Resolution mechanisms affect the cost of dealing with default.  The expected cost of clearing vs. bilateral mechanisms for allocating counterparty risk is, roughly, given by the probability of a major default (which depends on the ex ante incentives) times the cost of such a default (which depends on the ex post resolution mechanism).  It is not evident a priori whether this product is larger under a cleared or uncleared system, hence the grounds for legitimate debate over the merits of clearing.

There is a colorable case that the combination of multilateral netting and the existence of a central counterparty that can coordinate the transfer and replacement of defaulted positions can reduce the cost conditional on a default occurring.  Multilateral netting reduces the magnitude of the positions that need replacing.  This reduces the stress on market liquidity resulting from a default.  Moreover, clearing facilitates the transfer of customer positions to solvent clearing members, thereby avoiding the necessity of replacing these positions via market transactions, further reducing said stress.  Moreover, the information that a CCP possesses about total positions, and its ability to coordinate the hedging/replacement of the defaulted risks can reduce uncertainty and mitigate price impact.  (Although it should be noted that the experience of the CME with the Lehman problem, as documented by the Valukas report, and as suggested by what I have learned from informed sources that the LCH unwind of the Lehman positions was not as breezy as LCH has suggested demonstrate that this is at best a relative statement.)

Some research that grew out of the ’87 Crash sheds light on this last issue.  An interesting paper by Greenwald and Stein (JOB, 1988) shows that normal, continuous trading mechanisms can exhibit poor performance during periods of market stress caused by a large shock to the volume of transactions (especially when this shock is accompanied by an increase in fundamental uncertainty).  In essence, there are execution price risks under these circumstances that create negative externalities.  Potential replacement counterparties are reluctant to trade in these circumstances because of the extreme uncertainty about execution prices during periods of large volume shocks.  This tends to reduce liquidity, which tends to exacerbate the execution price risk.

This means that the uncoordinated replacement of large numbers of defaulted positions by a large number of firms through the use of ordinary, continuous market mechanisms (whether OTC or exchange) can lead to substantial price changes that are not fundamentally driven, but are microstructural in origin.  This can have further knock-on effects, as these (distorted) market prices affect collateral/margin calls, can induce asset fire sales, etc.

Thus, a plausible characterization of a key trade-off between bilateral and cleared structures is: (a) counterparty risks are more efficiently priced and shared in a bilateral setting, and hence moral hazards and adverse selection problems are less acute in that setting; (b) further, hub-and-spoke clearing networks create concentrated points of failure that are more problematic than more distributed (but still concentrated) bilateral networks; but (c) a cleared system reduces replacement cost risks/price impacts conditional on default.

Which raises the question: is it possible to obtain the information benefits associated with bilateral arrangements for some transactions, while mitigating the price impact of an uncoordinated replacement of defaulted positions? Can we have our cake and eat it too?

Put differently, clearing is a bundle of functions including inter alia: (1) the pricing of counterparty risks; (2) the mutualization of losses not covered by collateral; and (3) the management of risk associated with defaulted positions, and the replacement of these positions.  I argue that for many transactions and transactors, bilateral mechanisms are superior for (1) and (2); I recognize that CCPs may do (3) better.  Is there any way to get the benefits of (3), without incurring the disadvantages that CCPs arguably face with (1) and (2)?

I think that this could be possible.  In essence, it would involve pre-commitment to a suspension of normal, continuous trading activities in the event of a default by a large market participant (a dealer, such as Lehman, or a big hedge fund, such as LTCM), and its replacement with an auction-type mechanism.  (This is the essence of the Greenwald-Stein recommendation for “circuit breakers” that replace continuous trading with a call auction.  The key difference is that the Greenwald-Stein circuit breakers are price-contingent, which has some problematic features, whereas what I am proposing is default-contingent.)

ISDA implemented a “Big Bang” auction protocol to facilitate the settlement of CDS positions in the event of the default in a named credit.  Although as I predicted in my post on this subject some years back, this protocol has not eliminated all problems with pricing the debt of defaulted credits (as shown in a recent Markit Magazine article), it has greatly smoothed the process of handling CDS-triggering credit events.  Perhaps something similar could be designed and implemented to deal with a big derivatives default.

ISDA could of course play a central role in shepherding the creation of such a mechanism.  Similarly, regulators, notably the NY Fed, could also play a constructive role, perhaps in both the design and implementation.  I am pretty sure that ISDA would be quite willing to engage in such a cooperative endeavor.

The process would of course be facilitated by the development of robust trade repositories that permit rapid determination of the positions that are defaulted against.  I have supported the creation of such repositories (see my Regulation magazine piece) from the outset.

Just thinking out loud, here are some ideas of a potential structure.

First, a compression round whereby multilateral exposures are netted.  (This would have implications for bankruptcy priorities and bankruptcy law; these implications would have to be weighed carefully and addressed).

Second, an auction round for replacement of positions.  This auction round would follow a disclosure, based on the information in the trade repository, of all the positions, to the potential bidders.

The auction round raises several issues that need to be considered.  Who would be allowed to participate?  Permitting anyone to participate could just be a jump from the frying pan into the fire if some of the winning participants are themselves in dodgy financial condition.  (This is a dilemma that CME faced in its Lehman auction, and likely explains why it limited participation in the auction of Lehman positions).

Another issue is that the number of positions to replaced can be immense, and highly heterogeneous, with many non-standardized contracts.  Perhaps one way to deal with the latter would be to auction off shares of portfolios, e.g., USD interest rate (swap, swaption, etc.) positions; FX positions; equity derivatives; and so on.  This would mitigate cherry picking/adverse selection problems and simplify the bidding.  It would, however, mean the splitting of some individual contracts among multiple counterparties.  (It should be noted, though, that many of the positions would not be cleared or even clearable in any event, so this issue is not eliminated by a clearing mandate.)

Yet another issue is that those assuming positions would be taking on counterparty risk.  Thus, the repository would have to disclose the counterparties to the defaulted contracts to the potential bidders.

So, I realize that there are many thorny operational issues that must be addressed to implement this proposal.  But some would exist under a clearing mandate because not everything would be cleared in any event.  I further realize that FRBNY and the dealer community tried to do some of this on the fly in the “Lehman weekend,” and in LTCM years before.  The Lehman attempt foundered (as Theo Lubke of FRBNY, and several bankers I spoke to, indicated at the ISDA AGM).  But perhaps this is not surprising as extemporizing on the fly in those conditions faces faint chances of success, particularly given the lack of information available to the participants; a pre-planned mechanism that can rely on more complete information is almost certain to work better.  I would also note that in a cleared market something like this will have to be in place in any event.

The logic behind my approach is pretty straightforward.  Whenever things are bundled, the immediate question should be: can efficiency be enhanced by unbundling them?  (A lot of what goes on in finance involves unbundling things and allocating the pieces in a value-enhancing way.)  Sometimes you can’t: so be it.  But sometimes you can.

Clearinghouses bundle counterparty risk pricing, counterparty risk management (including the collateralization mechanism), mutualization, position information collection, and default resolution.  There is no logic that says that those functions have to be bundled.  Repositories can collect and aggregate information, perhaps more effectively than CCPs (because they can incorporate information on non-cleared positions, and information on positions held across CCPs).  CCPs are not always the best at counterparty risk pricing and collateralization mechanics.  Mutualization can have some extremely problematic features.  So why not an approach that unbundles, and allows specialization in these various functions?

Once repositories are created, the development of a robust, coordinated defaulted contract resolution/replacement mechanism would go a long way to improving the efficiency of the OTC derivatives market while permitting it to continue to do what it does best.  This would be an easier process (though not a simple one) than what will be set in motion by the vast expansion of CCPs as contemplated in the pending legislation.  CCPs will have to develop resolution procedures in any event.  Moreover, it is desirable to develop procedures to deal with contracts that are not cleared (which will be the most challenging ones in any event).  But force-fed CCPs will also have to grapple with challenging pricing, risk management, risk sharing, and governance issues as well.  And if there are multiple CCPs, there will have to be some coordination of the resolution procedures.  (If there isn’t there will be trouble.)  So, a mandated and extensive expansion of CCPs will have to solve many more problems than just the resolution mechanism.  So why not just focus on that?

I am sitting in the SF airport, on my way back to Houston after speaking at the ISDA Annual General Meeting.

Wikipedia states that “fin de siecle”

refers to the end of the 19th century, in Europe, France and/or Paris. It has connotations of decadence, which are seen as typical for the last years of a culturally vibrant period (La Belle Époque at the turn of the 20th century), and of anticipative excitement about, or despair facing, impending change, or both, that is generally expected when a century or time period draws to a close.

There was definitely a fin de siecle feel to this ISDA event.  Decadent?  No, but certainly more extravagant that what I am used to.  Anticipative excitement?  Definitely not, but certainly anxiety, bordering on despair, about the impending change facing the OTC derivatives business.

Yesterday, of course, Obama gave a populist speech at Cooper Union in New York, in which he demanded that Wall Street submit meekly to the regulatory proposals racing through the Senate.  Deputy Secretary of the Treasury Neal Wolin carried this message to ISDA.  He gave a hostile, our-way-or-the-highway speech.  I haven’t seen Wolin speak before, so I have no benchmark to compare to, but not only was his speech very sharp-edged, but his body English also communicated a certain hostility.

The audience reaction was as tepid as any I’ve ever seen.  I would probably be exaggerating if I said half the audience gave any applause, and even those clapping were making only the most perfunctory effort.

Mark Brickell, formerly of J. P. Morgan, asked a very provocative question, and one that needed asking.  He asked Wolin whether by forcing things into clearinghouses, weren’t the new proposals creating the ultimate too big to fail institutions, and effectively committing the government to future bailouts?  Wolin’s answer was basically just a flat denial, and did not truly engage the real issue that lay at the heart of the question.

Wolin was also asked about the Lincoln bill’s no Federal assistance provision, which would be the Volcker bill on steroids, requiring not only banks to exit proprietary trading, but customer-facing derivatives market making activities too.  Consistent with other administration voices, Wolin neither endorsed or criticized the measure.  He said something like “there’s a lot in these bills.”  Thanks for that insight.

I was on an academic panel chaired by Chris Culp (Chicago), with David Mordecai (Chicago), and David Mengle (UCLA, which was Chicago West in those days).  Mengle gave a nice talk about close out netting and its essential role in the OTC trading model.  David Mordecai gave a conceptual talk about the broad lessons of the crisis, in which he drew on the insights of Ronald Coase (always a good choice).

I gave the 20 minute Cliffs’ Note version of my case against clearing mandates.  My talk was largely well received, though not by everybody.  One of the things I focused on during my talk was the experience of the 1987 Crash, in which the CME clearinghouse was in serious jeopardy.  Somebody from CME clearing came up afterwards, and was pretty outraged at what I said.  He told me I was “feeding the dealer frenzy.”  No, I am trying to counter the legislative and regulatory frenzy with some back-to-basics analysis of the economics of risk sharing.  He also denied that the CME clearinghouse was in trouble in ’87, which got me a little ticked.  I told him, hey, look, I was there, I lived it, and was told that very specifically by Brian Monieson, a CME board member, in the morning of 20 October, 1987; truth be told, when that was happening this gentleman was in grade school in India.  You can look at contemporary accounts, including the Brady report and the Bernanke article on clearing and settlement during the Crash, and learn the same thing.  You can also look at Tamarkin’s book The Merc.  I was told of the BOTCC problems on the 19th-20th by two well-respected FCMs.  This isn’t a secret.

In various conversations afterwards, many bankers asked me about the ’87 Crash.  For the most part, they were not aware of the history, and were quite interested in it.  (Thanks for making me feel old, guys.)  Several are involved in various clearing efforts today, and found this history quite thought provoking.  That’s a big reason why I make such a big deal out of this.  People are so focused on the last crisis, and preventing a recurrence; regulators and legislators are most guilty of this.  It is important to make people aware that the last crisis was not the first crisis.  That there’s more historical experiences that can inform our current deliberations than what transpired in September, 2008.  The Crash of ’87 is particularly valuable because it gives the lie to the widespread claims about the efficacy of clearing as a solution to systemic risk.

Went to the meeting knowing almost no one, walked away knowing quite a few people.

The reception/dinner last night was a very interesting, almost anthropological experience  Pretty much the sole subject of conversation was the pending legislation; that’s what gave things the fin de siecle feel.  Everyone knows big changes are coming; that a vibrant period is coming to a close; and that the future will be very different.  The only question is: how different?

I think that the prevailing sense is that yes, some regulatory changes are needed and desirable, but that the punitive-for-the-sake-of-being-punitive legislation will be extremely counterproductive.  There was also a sense of despair that their fate was in the hands of those not only with an animus and an agenda, but with only a limited understanding of the way the business really works, and the likely consequences of what is being proposed.

Substantively there was broad agreement that expanded clearing could provide benefits, but that pushing it too far could be a disaster.  (That’s basically my view.  My CME interlocutor might talk to some of his own members to learn that they share similar concerns.)  There was widespread amazement at the exchange trading requirements.  I made a brief comment about the inanity of the Lynch Amendment (which may also be introduced by Sherrod Brown in the Senate) which several people talked to me about; they, as I, cannot believe how anyone would expect that banks are expected to bear counterparty risk by capitalizing a clearinghouse and providing backstop funds without having a commensurate voice or control of the operations of the CCP.

One last note.  The reception last night was held at the Legion of Honor, a beautiful art museum, which has one of the biggest Rodin collections outside of France.  (It also hosts a Cartier exhibit, which reinforced the sense of extravagance.)  The Thinker dominates the entryway to the museum.  On my way out, I looked back at the sculpture.  The sky was crystal clear.  A brilliant half moon hung over The Thinker’s head.  Four stars, in a diamond shape, bracketed the moon.  Quite a sight.

Is the legislation currently working its way through Congress.  According to The Hill, Harry Reid wants the Lincoln derivatives bill incorporated into the Dodd legislation (replacing the “place-holder” derivatives title of the Dodd bill).  Great.

There are many bad features in the Lincoln bill.  Arguably the worst (though the competition is stiff!) is the proscription on any “Federal assistance”, including Fed lending, to financial institutions that trade derivatives, including clearinghouses.  Especially when combined with the mandated expansion of clearing, this is extremely dangerous.

Clearinghouses can blow up.  It has happened historically, and it almost happened with disastrous effects during the ’87 crash.  Arguably the only thing that prevented that from happening was the intervention of the Fed.  I strongly suggest that Lincoln, or her staff, read the Brady report on the Crash to get some understanding of that.  Or better yet, read Bernanke’s “Clearing and Settlement During the Crash” (3 Rev. Financial Stud. 1990 at 133).  A few telling excerpts:

Let us put aside the possibility of government intervention for the moment. Then there seems to be a potential structural problem with the clearinghouse arrangement. The problem is not that some traders who thought they had a guaranteed contract would end up not being paid off; as we have said, perfect insurance against systemwide shocks is not possible. Rather, the problem is that a shock large enough to exhaust the clearinghouse’s capital and assessment powers would have a serious prospective effect on the ability of the clearinghouse and thus of the futures market itself to function. Presumably, over a period of time reorganization and recapitalization would occur. But in the shorter run the poor functioning or shutdown of the futures market might exacerbate the adverse conditions that precipitated the problem in the first place.

That is, the potential for failure of a clearinghouse–just the potential–can lead to a positive feedback mechanism that worsens the crisis.

Bernanke discusses the essential role of the Fed on 19-20 October:

The malfunctioning of the banking side of the clearing and settlements systems during this period is indisputable. [Emphasis added.]

. . . .

The official reports and other observers generally agree that the Federal Reserve’s attempts to alleviate the crisis were very constructive. On Tuesday morning, October 20, the Fed issued a brief statement: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the financial and economic system.” This statement was backed up by three types of actions: First, the Fed reversed its tight monetary stance of the previous weeks and flooded the system with liquidity. Second, the Fed “persuaded” the banks, particularly the big New York banks, to lend freely, promising whatever support was necessary. (The 10 largest New York banks nearly doubled their lending to securities firms during the week of October 19.) Finally, the Fed monitored the situation and took some direct actions where necessary, notably in the case of First Options of Chicago. When that large clearing firm was in danger of defaulting, Fed Chairman Greenspan acted quickly to enable its parent firm, Continental Illinois, to inject funds into its subsidiary; according to some observers, this action may have helped avoid the closing of the options exchange.

. . . .

In retrospect we may ask, what really were the dangers to the integrity of the financial markets posed by the crash? And what were
the benefits of the Federal Reserve’s actions? The technological problems of communications and information availability that plagued the system, while serious, did not in and of themselves threaten to bring down the markets. For the most part, information availability was a critical issue during the crash only in the sense that illiquidity is essentially a problem of imperfect information. (Clearly, though, improvements in these technologies should be made.)

It was the financial problems-the possibility of insolvency by major players-that were potentially the more serious. As we have emphasized, financial problems impaired the market’s functioning in at least two ways. First, concerns about solvency impeded the operation of the payments and clearing systems, contributing to financial “gridlock.” Second, the fear that major brokers, FCMs, or clearinghouses might default created uncertainty about the contract performance guarantee. Both aspects reduced market liquidity and disrupted trading. Conceivably these problems could have forced a market shutdown.

In response to this situation, the Federal Reserve, in its lender-of- last-resort capacity, performed an important protective function. The Fed’s key action was to induce the banks (by suasion and by the supply of liquidity) to make loans, on customary terms, despite chaotic conditions and the possibility of severe adverse selection of borrowers. In expectation, making these loans must have been a money-losing strategy from the point of view of the banks (and the Fed); otherwise, Fed persuasion would not have been needed. But lending was a good strategy for the preservation of the system as a whole.

The principal effect of the loans was to transfer some trader default risk from the clearinghouses and their members to money-center
banks. Under the presumption that the money-center banks were well capitalized, and that in any event their solvency would be guaranteed by the government, this transfer of risk reduced the overall hreat of insolvencies in the system. This allowed the payments process to begin to normalize; it also restored confidence in the clear- inghouse’s guarantee of futures contract performance. The resulting stabilization of the markets served the interest of the banks and the Fed in a wider sense, by avoiding any potential costs that a market breakdown might have imposed on the banking system and the general economy.

In performing its lender-of-last-resort function, the Fed redistributed risks in the system in a socially beneficial way. Conceptually, it
is as if the Fed had provided ex post insurance to the clearinghouse against a shock that it seemed possible would exhaust the insurance capability of the clearinghouse itself. Thus the Fed became the “insurer of last resort.”

What, pray tell, would have happened absent the Fed supplying liquidity to the system?  A disaster.

Note that Bernanke’s analysis recognizes that a clearinghouse’s financial resources are limited.  Would it that those flogging the clearinghouse cure would recognize this, and grapple with its implications in a serious way (as Bernanke did), rather than ignoring this brute fact as they do routinely: no, reflexively.

A dramatic expansion of clearing will increase, in a commensurately dramatic way, the potential for operational and financial failures in the clearing and payment system (like those observed in ’87) during a large price move.  Any policy of mandates MUST acknowledge this, and make sure that mechanisms are in place to address this reality.  By cutting out derivatives, and clearinghouses, from the lender of last resort mechanism, but providing no replacement, the Lincoln bill is courting financial Armageddon.

(Perhaps the Fed would be able to intervene indirectly, by supporting banks and inducing them to support the clearinghouses financially, but constraining the means by which the Fed can supply liquidity to the clearing system increases the likelihood of a failure.)

Bernanke argued in his 1990 article that the Fed has a role in ensuring the integrated banking, clearing, and settlement systems can survive a shock like a stock market crash.  (Again–it is integrated: interconnected.)  Although the Lincoln bill attempts to hive off the derivatives markets from the broader financial system, this is an impossibility.  No, it is worse: it is an absurdity.  The banking and derivatives trading systems are inextricably linked.  Policy must be predicated on that fact.

Maybe the Fed is a flawed institution, but it’s the institution we have.  If Lincoln gets her way, and constrains the ability of the Fed to perform its LOLR function in support of a vastly expanded clearing system, without providing any alternative, she is indeed “reforming” derivatives markets in the worst way.

So I don’t have to?  Because it’s getting tiresome.

But it has to be done, so here goes.

Jeremiah’s latest gurgling appears on the oped page of today’s WSJ.  It starts with a non-sequitur, and careens downhill from there.  Gensler tells a story about his role in the LTCM situation, and then claims that to prevent a recurrence, or a repeat of AIG, it is necessary to reduce the “cancerous interconnections” (Jeremiah Recycled Bad Metaphor Alert!) in the financial system by, you guessed it, mandatory clearing.

Look.  This is very basic.  Do I have to repeat it?  CLEARING DOES NOT ELIMINATE INTERCONNECTIONS AMONG FINANCIAL INSTITUTIONS.  At most, it reconfigures the topology of the network of interconnections.  Anyone who argues otherwise is not competent to weigh in on the subject, let alone to have regulatory responsibility over a vastly expanded clearing system.  At most you can argue that the interconnections in a cleared system are better in some ways than the interconnections in the current OTC structure.  But Gensler doesn’t do that.   He just makes unsupported assertion after unsupported assertion.

If you have any doubts about how interconnected a clearing system is with the banks, just look in detail at what happened on 19-20 October, 1987.

Don’t believe me?  Then consider what Ben Bernanke wrote as an academic in his “Clearing and Settlement During the Crash” (3 Rev. Financial Stud. 1990 at 133):

A prominent part of the institutional structure is the interconnection of the clearing and settlement systems with the banking system.  This interconnection exists at several points.  First, banks are operationally a part of the clearing process. Clearinghouses typically maintain accounts at a number of “clearing banks. Member FCMs are required to maintain an account at a minimum of one of these banks and to authorize the bank to make debits or credits to the account in accord with the clearinghouse’s instructions. This facilitates the settling of accounts and the making of margin calls. Note that the bank’s role may exceed simple accounting if, for example, it must decide whether to permit an overdraft on an FCM’s account.

Second, banks are a major source of credit, especially very short-term credit, to all of the parties, including the customers, the FCMs, and the clearinghouse itself. As was noted above, bank letters of credit can in some cases be used as initial margin. Customers and FCMs often rely on bank credit to facilitate the speedy posting of variation margin, and FCMs would typically have to turn to banks to finance payments made necessary by customers’ defaults or slow payment. In equity markets, banks are often the ultimate source of credit for the purchase of securities on credit.

Finally, it should be noted that while, in the conventional language, most margin postings and settlement payments are made in “cash,” these transactions are, of course, not really made in cash but by the transfer of bank deposits. Thus, the smooth operation of the financial market clearing and settlement system is based at all times on the presumption that the banking system is sound and can satisfy demands for withdrawals of funds.

“A prominent part of the institutional structure is the interconnection of the clearing and settlement systems with the banking system.”  Does it get any clearer?  (No pun intended.)

Ben, would you please drop the “Gentle Ben” demeanor and slap some sense into Gensler?  You actually know something about the subject.  You’re a former educator.  And somebody needs some educatin’.

And consider the implications of a dramatic increase in the scope of the clearing system, including the clearing of many products with unique tail/jump to default risks that have not been cleared before, on the magnitude of the interdependence between the clearing system and the banking and payment systems.  The potential for operational and financial gridlock in the face of a substantial price shock will be greatly amplified if clearing is greatly expanded.

Bernanke goes on to argue that the systemic centrality of the clearing system means that it is highly desirable for the Fed to serve as the “insurer of last resort” to prevent the failure of a clearinghouse or clearinghouses.  So much for Gensler’s assertion that clearing would “greatly reduce . . . the need for future bailouts.”

This is very serious business.  Very serious.  It deserves serious consideration of the real implications of the effects of a vast expansion of clearing.  That consideration must be predicated on an understanding of the real interconnections inherent in a clearing system, not on unsupported and unsupportable denials of the existence of such interconnections.

If the basis for the policies Gensler advocates, and which Congress seems hell-bent on implementing, is a belief that clearing does not entail an intricate web of interconnections (and potentially fragile interconnections) among financial firms, then they are policies built on lies.  And all that a policy based on lies will do is sow the seeds for the next crisis.

Very bad.

Problem one is obviously the ban on “Federal assistance” to any “swaps entity” where “Federal assistance” includes a Fed loan.  It is ironic, and disturbing, that (a) the bill mandates extensive clearing, and thereby makes swaps clearinghouses a central pillar of the financial system, but (b) denies these entities the ability to access liquidity via the Fed.  This goes against the recommendations of Duffie et al in their policy piece for the FRBNY, the European Commission, and now the IMF:

Hence, those [CCPs] deemed to be systemically important should have access to emergency central bank liquidity.  However, any such emergency lending should be collateralized by the same high-quality liquid securities as those typically posted against monetary policy operations. Also, it should not be done in any way that might compromise the central bank’s monetary policy or foreign exchange policy operations. [IMF, Making the OTC Derivatives Markets Safer (April, 2010), p. 20.]

In short, Lincoln’s bill goes against the advice of virtually all those who have analyzed the implications of clearing mandates–including strong supporters of these mandates.

During periods of market stress, and ESPECIALLY in cleared markets, the demand for liquidity increases dramatically.  Firms need liquidity to meet margin calls in response to big price moves.  CCPs that can borrow on behalf of their members can facilitate this process.  Denying these entities access to central bank liquidity facilities is a major mistake, and will in effect make the markets like they were prior to the formation of the Fed in 1913.  Can you say “Panic of 1907”?  I knew you could.

And even allowing CCPs to access liquidity facilities, while denying swap dealers from the same option–effectively requiring banks to hive off derivatives dealing activities–will cause problems.  If the idea is to reduce systemic risks arising from counterparty risk, it is desirable to ensure that market participants, including derivatives market participants, have access to liquidity during periods of market stress.  A firm experiencing a liquidity shock, due, for instance, to a big collateral call, but which is solvent, would be forced by this provision into fire sales or defaults that would exacerbate systemic risks.  It would do so by threatening to transform liquidity shocks into crises.

Lincoln’s bill evidently mistakes a bailout for the exercise of lender of last resort functions.  The latter, if Bagehot’s basic framework is followed, eases liquidity crises by lending freely against good collateral.  (The Fed’s promise to do so in October, 1987 almost surely saved the CME and CBT clearinghouses during the crash).  A bailout transfers wealth from taxpayers to the claimants of an insolvent firm.  Lincoln’s provision threatens to turn liquidity shocks into full-blown crises.

In some respects, Lincoln’s confusion is understandable.  After all, the Bernanke Fed has clearly blurred the line between Bagehot-esque lender of last resort activities and bailouts.  That’s a serious issue, that should be addressed.  But Lincoln’s approach would be a very bad way of doing that.

The bill’s end user exemption is extremely, extremely limited.  That’s also a problem, for reasons I’ve discussed before.  What’s particularly amazing is that the end user exemption is basically limited to commodity producers and consumers (although firms like J. Aron or Morgan Stanley that handle physical commodities are expressly excluded from the exemption).  That means that a firm, say IBM or Merck that uses currency or interest rate swaps would not be eligible for the exemption.

Oi.

The bill also extends position limits to the OTC market.  More pain, without gain.

The proposal requires trading on either exchanges or swap execution facilities, and precludes voice brokerage.  It mandates pre-trade price transparency, and “real time” price reporting.  I’ve commented extensively on these ideas in the past, and find them no more reasonable now than I have before.

About to jump on a plane, so I will add more later.  One last thing.  The bill envisions a massive expansion of responsibilities for the CFTC.  To be honest, the CFTC does not have the capabilities to handle its current responsibilities, let alone the new and extremely complex ones it would have under the bill.  This is a setup for future regulatory failure, in a situation where the regulation is much more pervasive–and systemic. Regulators failed before. They will fail again. The likelihood of failure will be higher, and the consequences of failure more catastrophic, when regulatory responsibilities are expanded greatly and foisted onto an agency that is ill prepared to handle them. Even if the CFTC is funded much more generously, it will face daunting challenges in scaling up, and obtaining the expertise it needs to do a much expanded job. This is a train wreck ready to happen.

OK.  Time for one more thing, something that the bill doesn’t do.  Manipulation is a potential problem in derivatives markets, and existing law and regulation has proved problematic (at best) in deterring it.  I’ve advocated for years that a statutory fix is required, and this bill (or the Frank bill, or the Dodd bill) would present opportunities to do that, but they don’t.  So we have a bill (bills, actually) that does many things it shouldn’t and doesn’t do something it can and should.  Great.