Streetwise Professor

I knew that the Commodity Futures Modernization Act (CFMA) was a powerful piece of legislation, but I was unaware just how powerful.  It apparently has the ability to alter the space-time continuum, and affect events even prior to its passage.  How did I learn this?  From a letter signed by senators Feinstein, Cantwell, Snowe and Dorgan to Chris Dodd.  (I haven’t been able to find a copy online.)  The senators state:

As you know, in 2000 Congress made the mistake of exempting energy from commodities regulation in the Commodity Futures Modernization Act.  This exemption, known as the “Enron loophole” led directly to the Western Energy Crisis.

Uhm, compromise language that was ultimately incorporated into CFMA passed the House on 14 December, 2000, and was introduced into the Senate on 15 December.  A conference committee hashed out differences, and the bill was ultimately signed into law (by Bill Clinton) on 21 December, 2000.

Meanwhile, the California/Western energy crisis had been building throughout 2000.  Power prices first spiked in May, 2000.  The first blackouts were in June, 2000.  San Diego Gas & Electric made allegations of market manipulation in August, 2000.  FERC rejected California’s request for a price cap on–wait for it–15 December, 2000.  The peak prices observed during the entire crisis occurred in December, 2000.

In other words, the energy crisis was well underway long before the passage of the CFMA, and reached its crescendo at the very time that the bill was being passed, and well before it could have, let alone did, affect one transaction in energy or anything else.  Since cause must precede effect, for these senators to say, in the very opening paragraph of their letter, that the Act “led directly” to the crisis is complete and utter bilge.

What’s more the underlying causes of the crisis are well known, and had nothing to do with the matters addressed in the CFMA, and everything to do with the wretched market design put in place by the California legislature.  Indeed, to the extent that derivatives were involved at all, it was the legislature’s ban on the ability of CA utilities to enter into long term purchase deals or hedging contracts that exacerbated the crisis.

Insofar as Enron is concerned, its actions (e.g., Death Star, Fat Boy, Ricochet) were designed to exploit flaws in the market design (particularly the design of the Power Exchange–PX–and differing price caps across markets).  They had nothing to do with the kinds of things addressed in the CFMA.

(I would also add that the exemptions in the CFMA were not quite so broad as the senators suggest in their letter.)

So, the senators got off to a very bad start.  What about other matters raised in the letter?  Well, better, but not much.

The basic thrust of the letter is to argue against providing end user exemptions from clearing requirements, or treating end users more liberally generally.  The essence of their argument is that systemic risk is unpriced, and that clearing internalizes this externality.

This represents just another example of clearing as deus ex machina that magically addresses systemic risk concerns.  The authors of the letter, like many others who have discussed the subject, assume that (a) counterparty risks are not priced properly in OTC markets, and (b) central counterparties will do a better job at pricing counterparty risks.  As I’ve written extensively, neither claim is necessarily true, nor even plausible.

The letter commits another factual gaffe when it claims that there was a “systemic failure caused by the Enron bankruptcy.”  Certainly counterparties lost money as a result of the Enron bankruptcy, but there was no systemic failure, particularly if one defines “systemic failure” to mean a contagion effect.

The Enron failure did not cause a major upset in the energy markets.  The implosion of the merchant energy sector occurred some months later.  The key event was the SEC’s announcement that it was investigating Dynegy’s accounting on 25 April, 2002.  Subsequent to that time, merchant energy stocks declined by about 90 percent in value, and other companies went bankrupt (e.g., Mirant).

But this wasn’t a systemic contagion event.  Instead, it was the result of a widespread recognition that the energy trading boom was overdone, that profitability estimates were probably inflated, and profit projections would not be realized due to overbuilding of capacity and other reasons.  That is, every firm in the sector was overvalued, and when the market reached that conclusion, they all fell  in value.  There was a common shock, and the affected firms fell in common.  That implosion would have occurred, clearing or no.

This point about confusing contagion effects (in which the demise of one big firm induces financial distress in otherwise healthy firms to which it is connected) and simultaneous collapses of multiple firms caused by a common shock is quite important, and gets too little attention.  The common shock in the recent financial crisis was real estate price declines, communicated to large financial institutions through their holding highly correlated positions in real estate price sensitive investments.  That’s different than a contagion resulting from the bad decisions or bad luck of one firm bringing down others just through contractual connections.

We can barely expect such more discriminating analysis, alas, from senators who are either completely ignorant of the legislation that they write about, or who don’t understand the basic fact that cause must proceed effect.

Update (3/1/10): SWP daughter #1 wonders if a silver DeLorean and a wild haired professor were seen in the vicinity of either Congress or California when the CFMA passed.

Matt Leising and Shannon Harrington have been on a roll lately.  Today, they report that big buy side firms are resisting Fed calls to clear a targeted percentage of their deals:

The biggest credit-default swaps investors oppose targets for clearing trades as regulators attempt to curb risk in the $25 trillion market.

Pacific Investment Management Co., BlueMountain Capital Management LLC and AllianceBernstein LP are among asset managers and hedge funds that won’t agree to specific goals before the Federal Reserve Bank of New York’s March 1 deadline requiring them to outline the industry’s next steps to move swaps through clearinghouses, according to people familiar with the matter who declined to be identified because the talks are private.

. . . .

The asset managers, while backing efforts to broaden the use of clearinghouses, want assurances that cleared trades would be protected under bankruptcy laws, the people said. They’re also concerned they may be saddled with collateral costs that are double or triple what they’re paying now because they could lose benefits now granted by prime brokers that give credit for offsetting trades, the people said.

For example, hedge funds and other asset managers often will perform trades that seek to profit from price dislocations between index contracts and swaps on companies included in the index. Prime brokers typically will demand collateral on the net amount at risk from offsetting trades.

Tying Up Cash

If one leg of the trade were required to be cleared, while the other contracts aren’t eligible, fund managers may be forced to increase the amount they have to post, tying up cash, the people said.

This is ironic because the best economic case for clearing is that reduces counterparty risk for end-users.  For instance, the classical futures clearinghouse reduces customer default losses (but doesn’t necessarily eliminate them) that could result from the failure of a brokerage firm by shifting the liability to the clearinghouse, and thus, to the other brokerage firms that are members of the clearinghouse.  Note that the Chicago Board of Trade has always argued that no CUSTOMER has lost money as the result of a default; the CME now makes a similar claim.  Thus, if anybody should be clamoring for clearing, it is customers.

But, as the article notes, this doesn’t come for free.  In particular, the article notes that clearing, especially through single-instrument clearinghouses, can eliminate scope economies (achieved, for instance, through netting and cross margining), thereby inflating costs.

So it can be reasonable for customer firms to resist clearing even though if it benefits anybody, it is most likely to benefit them.

Dealer firms have agreed to clear a large fraction of some inter-dealer trades (e.g., CDS trades).  In other markets (e.g., interest rate swaps) banks have elected to clear a decent proportion (around 50 percent) of inter-dealer trades.  But in many respects, inter-dealer clearing offers fewer potential risk sharing advantages than customer clearing (that shifts risks from customers to the dealer-members collectively).

In bilateral markets, there is extensive inter-dealer trading; this creates performance risk between dealers.  Clearing basically does the same thing.  It can reduce some exposure, through multi-lateral netting, but as Duffie and Zhao have shown, and as I have shown, this gain is reduced, and at times non-existent, because clearing can reduce bilateral netting opportunities across a portfolio of instruments.  Thus, the exposure reductions may be limited, especially if the clearinghouse handles only a narrow range of the instruments that dealers trade.  But even if there is some exposure reduction, a lot of what inter-dealer clearing does is to share the same risk among the same players.

The way this risk is allocated can differ somewhat; in particular, it is possible that risk exposures through clearing are less concentrated than the bilateral inter-dealer exposures in non-cleared markets.  But dealers have incentives to limit concentration on their own, and do so through exposure limits and credit limits with each counterparty.  Moreover, dealers have the ability to use their own information to choose these limits in bilateral dealings, whereas the clearinghouse cannot rely on this information.  Thus, clearinghouse members may have exposures that are less concentrated than their bilateral exposures, but they still may be worse off because they take more exposure with some counterparties via the clearinghouse than they would voluntarily take in a bilateral market.  That is, concentrations in bilateral markets are endogenous, and high concentrations can be sensible, based on counterparty risk evaluations.

The resistance of some sophisticated buy side firms to clearing should be another hint to regulators and legislators that mandated clearing is not necessarily a good thing.  If those who, if anyone, would be the biggest beneficiaries of clearing, decide it’s not worth the candle, that strongly suggests that the total benefits are illusory.

Yesterday I was exchanging emails with a couple of folks about CFTC Chair Gary Gensler’s increasingly apocalyptic jeremiads against OTC derivatives.  (Indeed, I think I’ll start referring to him as “Jeremiah.”)  I offhandedly wrote “Pretty soon he’ll be saying that OTC derivatives cause cancer.”  Lo and behold, what do I read in today’s FT:

US taxpayers bailed out AIG with $180bn when that company’s ineffectively regulated $2,000bn derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system.

I personally find it very disturbing that I can channel Gensler’s thinking.

The substance of the oped is more Gensler same-old, same-old.  Clearing is again the deus ex machina of his sermon:

Clearing houses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Transactions are moved off the books of derivatives dealers, which are part of financial institutions that may be both “too big to fail” and “too interconnected to fail”, and on to those of well-regulated central counter-parties. Centralised clearing has helped to lower risk in futures markets for more than a century.

Uhm, just who backs that guarantee, Jeremiah?  Could it be the very same derivatives dealers?  Meaning that the risk really isn’t moved off their books, and that they’re still interconnected?

Arguendo ad AIG makes its stock appearance (see the first quotation).  George Stigler once wrote that data is not the plural of anecdote.  What’s unbelievable is that Gensler (and Geithner and others) can’t even find multiple anecdotes, let alone anything rising close to the level of data.  What’s even more unbelievable is that his use of the AIG anecdote is deeply misleading–so deeply, that Gensler is either very dishonest or very badly informed.  First, although OTC derivatives deals were one source of AIG’s loss, they were not responsible for anything near the entire $180 billion bailout, but Gensler insinuates that they were.  Second, since it is unlikely that the AIG deals were clearable then, or would be today, it is misleading to use them to advocate clearing.  Third, Gensler doesn’t address the counterfactual question of what would have happened if AIG hadn’t written protection on mortgage CDOs; arguably, the crisis would have been worse.

Gensler also asserts that OTC derivatives were the underlying cause of the financial crisis.  He provides no evidence whatsoever–other than the tired AIG trope.  This is a complete misreading of the history of the crisis.  If you don’t believe me, I suggest you read Rene Stulz’s piece on derivatives and the crisis in the most recent issue of the Journal of Economic Perspectives.

Gensler also makes some assertions that are categorically incorrect.  For instance, he says: “The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk.”  It is, in fact, well known that excessive transparency can reduce liquidity.  There is NOT a monotonic relation between transparency and liquidity, as Gensler asserts.

More generally, on the transparency and exchange trading arguments, Gensler implies that market participants that willingly choose to trade on OTC markets instead of readily-available exchange alternatives don’t know their business.

I could go on and on, but I’ll let it rest here for now.

If the substance is tiresomely familiar, Gensler’s rhetoric reaches new heights.  He pegs the metaphor meter with his lurid comparison of the role of OTC derivatives in the financial crisis to the Chicago Fire, and the banks to the cow in Mrs. O’Leary’s barn that kicked over the lantern that ignited the fire.  (At least he spares us the apple story.)  (The reference to Mrs. O’Leary’s cow is actually quite fitting here, as that poor creature is almost certainly the least plausible cause of the Chicago fire; the editor of the Chicago Republican admitted he made up the story for its entertainment value.  He’d be more accurate talking about meteorites or Pegleg Sullivan–he should check out the Alkaline Trio song about old Pegleg.  But accuracy is merely an obstacle, it appears, in Gensler’s shrill attacks.)

(And another parenthetical about the metaphor overload: is cancer “interconnected”?  Usually cancer is used as a symbol of something maliciously that spreads, which is somewhat different from interconnection.)

Perhaps this remarkable performance is actually good news.  Gensler apparently believes that he has to ramp up the rhetoric in order to achieve his (defective) policy goals; that’s usually a sign of desperation, and a lack of success in previous efforts to persuade.

And that lack of success is not surprising.  Yes, it might have something to do with the fact that incumbents don’t want major changes in the ways they do business.  But it’s also due to the fact that faulty analysis unsupported by reliable facts or data is usually unpersuasive.

But perhaps there’s an upside; we have a new entry in the Bulwer-Lytton fiction contest: it qualifies both because it is fiction, and because of its overwrought writing.

In a matter of personal interest:

The U.S. Supreme Court rejected an appeal by Pacific Investment Management Co., clearing the way for a lawsuit seeking more than $600 million for the company’s alleged manipulation of the price of Treasury futures contracts on the Chicago Board of Trade.

The justices today let stand a federal appeals court ruling that said traders could press their suit against the company as a class action. Pimco, manager of the world’s largest bond fund, argued unsuccessfully that many of the investors in the class actually would have made money had the market manipulation taken place as alleged.

The lawsuit, filed in 2005, accuses Pimco of cornering the market for contracts on 10-year Treasury notes during May and June 2005. Pimco allegedly used its holdings to drive up the price for traders who had sold short — that is, contracted to sell notes on a specified later date — and needed to cover their positions.

And that’s all I have to say about that.  Here, anyways.

The House financial regulation “reform” bill passed last year includes the Lynch Amendment, which puts limits on the ownership of central counterparties/clearinghouses by financial intermediaries.  I blogged about this a bit.  The essence of my argument was that although there are potentially competitive concerns arising from dealer control of CCPs, there must be an alignment between economic interest and ownership structure.  Whoever bears the default risk is going to demand an influence over the governance of the CCP.  If you expect the big banks to bear the risk, they are going to require some control over the operations of the clearinghouse.  If you deny them this control, you have to find somebody else to bear the risk.  Competitive concerns are best addressed through anti-trust tools.

Sad to say, the “thinking” behind the Lynch Amendment has jumped the Atlantic, and the European Parliament is contemplating a similar restriction on dealer ownership:

Derivatives dealers should not be allowed to own stakes in central counterparties (CCPs) or their risk management systems – and CCPs should not be allowed to compete with each other, according to advice from the European Parliament’s committee on economic and monetary affairs (Econ).

The (anonymous) reactions of a European banker are spot on, and echo my earlier analysis:

“It’s ludicrous. Clearing houses were mutual organisations. They were originally mutually-owned and their job is to mutualise risk, so to say that users shouldn’t have any influence or ownership of governance or direction – it just betrays complete ignorance of what the function of a clearing house is and how a clearing house can be built and become operational,” says one head of market structure at a European bank.

. . . .

“It is our money in the default fund of the clearing house. For dealers to have some kind of oversight or some kind of say in the functioning of the clearing house is entirely reasonable. We’re not going to support a clearing house if we’re not satisfied with the risk management processes it operates. To think that the smart way to make this all happen is to remove the big dealers from the process is just dumb,” says the head of market structure.

“Complete ignorance.”  “Just dumb.”  That’s about right.

There’s a very simple choice here.  If you don’t want banks to exercise control over a clearinghouse, don’t look to them to bear the default risk.  If you want them to bear the default risk, you’ll have to give them considerable influence, and arguably de facto control.  And if you choose the first alternative, you need to answer: who is going to bear the default risk, and what price are they going to charge to do so?  And if you’re worried about competition, you should worry that the price this non-bank-owned CCP is going to charge, because it will almost certainly have market power.

The Lynch Amendment and its proposed European cousin both reflect a fundamental misunderstanding of just what clearing is about.  It is a risk allocation mechanism.  Which immediately should raise the question: who is going to bear the risk?  Clearing is not a risk fairy that makes risk disappear.  Those that bear the risk will almost certainly demand an active role in the organization that measures and manages it.  So if you make a governance and ownership choice, you’ve ruled out some risk allocation choices.  Our Solons, and Europe, apparently haven’t figured that out; they haven’t provided any idea on whom they expect to bear the risk, and are mandating or threatening to mandate models that have seldom, if ever, been tried in practice.  Which is very scary.

One of the tales about derivatives clearing, told repeatedly by Timmy! Geithner and Gary Gensler is that the clearing fairy magically makes counterparty risk disappear.  The reality is that it doesn’t make it disappear: it just moves it around.  And not necessarily in a better way, as members of the CME clearinghouse clearly understand.

Many of these members are extremely leery of the CME’s plan to clear CDS.  This week, according to Bloomberg and DJ (not online, fortunately), big brokers Newedge and MF Global came out forcefully against the CME proposal precisely because they fear that clearing CDS will allocate the risk their way, and their customers’ way:

Newedge USA LLC, the largest U.S. futures broker, and MF  Global Holdings Ltd. are urging the U.S. to prohibit CME Group Inc. from using customer funds to back credit-default swap  trades alongside futures transactions in its clearinghouse.  The brokers said the lack of an underlying frequently traded contract for credit-default swaps, such as a future based on the swaps, made it too difficult to price the derivatives for risk-management purposes, according to a Feb. 4 joint letter the companies sent to the Commodity Futures Trading Commission.

“We do not believe it would be appropriate for the commission to now require futures customers to effectively cross guaranty CDS risk, however remote some may suggest the likelihood of a cleared CDS default to be,” the firms and CME Group members wrote in the letter. “MF Global and Newedge are not satisfied that the risks to futures customers’ funds and to our own guaranty deposits — risks we never signed up for — may adequately be assessed or contained.”

The Newedge/MF Global broadside gives the lie to other clearing fairy tales: namely, that contractual standardization is sufficient to make instruments appropriate for clearing, and that clearinghouses magically create transparency.  To the contrary, clearinghouses consume transparency/information: they need liquid markets with active price discovery to work effectively, and contractual standardization is not sufficient to ensure such liquidity.

Note their concern that risks may not be adequately assessed.  This requires information  about pricing and risk characteristics.  This information is hard to come by for many CDS, particularly single-name CDS.  Moreover, dealers may have better information than a clearinghouse.

In other words, clearing is not magic.  It doesn’t make risk disappear.  At best, it reallocates it.  Moreover, it can actually create problems, rather than mitigate them, when the clearer lacks the information to price the risks properly.  Newedge and MF Global, and before them Thomas Peterffy, the FIA, and Penson’s Chris Heymeyer, recognize that.  When will those who want to mandate clearing as broadly as possible figure it out?

No, not me–although I am sure that a few of you would disagree.  No, I refer to Senator Maria Cantwell (D-WA) and her confreres, who clearly have some deep seated neuroses and phobias when it comes to anything involving derivatives and speculation.

Cantwell actually earns a twofer today.

First, she is the co-sponsor of a new cap & trade bill.  Although cap & trade isn’t dead, it is coughing up blood; even Obama has recognized that it has no chance of passing soon.  Along with Senator Collins (R, sorta-ME), Cantwell has introduced a bill that would institute a cap & trade regime.  It is, blessedly, much simpler than the grotesquely bloated, complicated, and convoluted ACES bill that passed the House in 2009; apparently Cantwell and Collins believe that ACES is doomed, and that a simpler bill may be the only hope.  Conservation of paper is, alas, its main redeeming feature.

It isn’t really a cap & trade bill.  It’s better described as cap, definitely, trade, not so much.  And the latter feature is what lays bare Cantwell’s phobias.  To read what she and Collins have proposed is to enter bizarro world.  They impose onerous restrictions on the trade of emissions rights and derivatives on them, apparently out of a belief that (a) speculation is evil, and (b) derivatives can only be used for speculation.

There are two completely non-sensical provisions in the bill that relate to trading emissions rights, and derivatives on them.

First, the bill permits only emitters to own certificates, and to purchase them at (an annual) auction.  This means, specifically, that financial institutions cannot buy or trade certificates.  Presumably, this is intended to bar the market to those malign speculators.  But its actual effects will be to make the market extremely illiquid, and to make it unnecessarily costly for those who have more permits than they need to trade them with people who have fewer than they need; financial institutions would be the natural market makers and liquidity suppliers, and baring their participation would starve the market of liquidity.  This will hamper the efficiency of the market, and make it costlier to achieve the emissions reductions imposed by the cap feature of the bill.  Moreover, it is likely that absent such a restriction, certificates could be used as collateral and facilitate end user financing, an alternative that would be precluded under the bill, making it more costly for emitters to finance their purchases of certificates.

Second, and even more bizarrely, the bill prohibits those very end users from trading any derivative contract on emissions.

Let me repeat: the bill prohibits those very end users from trading any derivative contract on emissions.

Huh?

Under a cap and trade scheme (and I mean scheme), end users are exposed to carbon price risk, and over very long time horizons.  They are natural hedgers who need derivatives to manage that risk exposure, but the Cantwell-Collins bill would preclude them from doing that.  The bill creates risk by pricing carbon, but at the same time denies those affected by this risk the ability to manage it.  That borders on cruel and unusual, and just makes it unnecessarily costly to achieve carbon reductions.  Pain with no gain.

But note the bill doesn’t ban derivatives outright, so Cantwell and Collins are apparently perfectly willing to contemplate a carbon casino where only speculators can play (though not in the certificates themselves).  But the speculators will not be allowed to provide valuable risk bearing services to hedgers.  No, it doesn’t make sense to me either.

Seldom have I seen anything so inane coming out of Congress, and that is saying something.

Separately, Cantwell came out with a call for increased regulation of commodity derivatives generally:

The US commodities market should be freed from “reckless speculation” and abusive trading practices, a leading US senator has urged, as she attempts to stop the price of everyday items like petrol and food from being impacted by financial traders.

Senator Maria Cantwell, who is separately trying to revive the Glass-Steagall reforms of the 1930s which would prevent retail and investment banks from operating under the same roof, yesterday called for increased regulation of the commodities and derivatives market.

The Democrat politician is attempting to push regulation of the commodities markets – a hot topic in the summer of 2008 when oil prices topped $140 a barrel – back to the top of the political agenda.

She is calling for stronger powers for the Commodities Futures Trading Commission (CFTC), including the potential to police the unregulated over-the-counter derivatives market, which has worth $25 trillion at the end of June 2009.

And how, pray tell, does the Senator support her case?  By calling on the vaunted expertise of megatool Michael Masters:

Backed by hedge fund manager Michael Masters, of Masters Capital Management, she called for the proposed reforms to take their place alongside wider financial regulatory reforms currently being discussed by the US Congress.

Mr Masters believes that there is a strong correlation between the credit crisis and volatile commodity costs, which have seen a rise not only in oil prices but in basic food staples in recent years.

Correlation, causation.  Whatever.

Masters and I participated in a workshop on oil markets sponsored by the Energy Information Agency back in November.   I can state categorically that he doesn’t understand the economic function of derivative markets, or of the functions that financial intermediaries play in these markets.  He says things like (I quote from memory, but this is almost verbatim) “financial markets are for allocating resources over time, but commodity markets are to get goods from producers to consumers.”  Well, yeah, but commodity markets are also crucially about allocating resources over time, because the time patterns of consumption and production don’t necessary always match exactly.  In fact, they almost never do.  (Think about a seasonal commodity, like corn or natural gas.)

So even beyond risk shifting, you need futures and forward markets to encourage the efficient allocation of commodities over time; getting stuff from producers to consumers inevitably involves intertemporal trade.  What’s more, financial intermediaries are frequently the best able to perform the function of storing and financing commodities.  After all, what they do is facilitate intertemporal resource allocation, and commodity storage and financing is just a specific example of that.  But not in Mastersworld, evidently.

Talk about the blind leading the blind–or is it the phobic leading the phobic?  Maybe group therapy is available at a discount.

After Masters made this statement at the EIA workshop, I replied along the above lines.  Only less politely.  I started by saying something like: “I can’t believe you said that.  It’s one of the dumbest things I’ve ever heard.  Commodity markets are all about allocating resources over time.”  Always trying to win friends and influence people.

I doubt either of these measures is going anywhere.  Fortunately.  But they reveal a disturbing mindset that is all too common on Capitol Hill, and among the pilot fish that swim symbiotically with the senatorial sharks.

Most IPOs “pop” on their first day of trading.  Their prices typically rise, and often by a lot, above the offering price.  The pops tend to be bigger on less developed markets.

Daring to be different, Oleg Deripaska’s Rusal had a negative pop.  Indeed, it was down 10.6 percent below the offering price.  Now, some of this can be attributed to the fact that the Chinese market has been trending down, and went down between the pricing date and the first trading date.  The Chinese aluminum firm Chalco went down 9.7 percent between the day that the Rusal issue was priced, and the first trading day.

But however you measure it, Rusal was a big underperformer, relative to typical IPOs.

In some sense this isn’t a surprise.  UralSib’s Chris Weafer suggested the issue was as much as 50 percent overpriced.

So why did the issue sell out when it was arguably overpriced?  Well, one possibility is that this was a combination of a state bailout of Deripaska/Rusal, and a debt restructuring.  Russian state owned bank VEB took about a third of the issue, and Sberbank and VTB, also Russian state banks took down pieces as well (though I haven’t been able to find out how much).  Moreover, participation was limited by the HKSE to big institutional investors, including many banks who had lent Rusal a large amount of money, some of which was to be repaid with IPO proceeds.  Overpaying by the state banks would effectively provide state support for Rusal.  Overpaying by those who had lent Rusal money, who were then paid for their debt using the IPO proceeds, would be a backdoor way of making the banks take a haircut on the debt.

Given that this whole IPO was pushed by the banks as a way of reducing their exposure to Rusal, overpaying 10 percent for the equity can reasonably be seen as a small price t0 pay to take a few pieces out of the Rusal albatross hanging around their necks.

This is a black eye for the Hong Kong Stock Exchange, though.  The negative pop is just the culmination of a very ugly, ugly process.  I don’t know if there’s soap strong enough to wash the Deripaska/Rusal stench from the HKSE.

Not that they weren’t warned, and not that they should have needed a warning to know.  Deripaska is P-O-I-S-O-N.

I sometimes disagree with Economics of Contempt, but he wrote a post yesterday that pretty much repeats my points that the fact that end users freely choose to trade on dealer markets despite the assiduous attempts of exchanges to woo them means that OTC trading must dominate exchange trading for a large group of firms:

More broadly, notice who the intended beneficiaries of all Mike’s preferred requirements are: not average taxpayers, mind you, but the end-users who trade OTC derivatives. These end-users are predominantly large institutions — bond managers, institutional investors, hedge funds, large corporates, etc. If pre-trade price transparency would be so beneficial to them, then why haven’t they already moved to exchanges? There’s absolutely nothing stopping them — the exchanges have been offering OTC lookalikes for years, with little success. The problem is that no one wants their products. And it’s not like there’s no competition in this space. To the contrary, the competition among the different trade execution venues (ECNs, dark pools, etc.) is incredibly fierce.

Even the price competition in the traditional OTC market is fierce, despite what journalists think. For example, according to Risk‘s 2009 survey of corporate end-users, 65.3% of end-users listed price as the most important factor in choosing a derivatives dealer. Fully 73.5% of end-users negotiated with 2-3 derivatives dealers before agreeing on a trade, and an additional 14.3% of end-users negotiated with 4-5 dealers.

I recommend reading the whole thing.

I don’t necessarily agree with EOC’s advocacy of requiring all trading in “standardized” derivatives go through clearinghouses.  Beyond all of the nettlesome issues relating to just what “standardized” is (and contractual standardization is clearly not a sufficient condition to make clearing practical), all of EOC’s arguments stated in this particular post can be achieved through mandatory reporting, which is different from clearing.  Clearing involves a mutualization of default risk; the informational advantages that EOC touts can be achieved without such (problematic) mutualization.

And one personal quibble.  (I know.  It’s always about me.)  EOC’s post responds to a Mike Konczal piece which is a direct response to something I wrote for FTAlphaville.  EOC:  Would it kill you to (a) acknowledge that, and (b) give some props for the fact that I made several of the arguments you advance in this post . . . before you did?  Just asking.

In the aftermath of the crisis, clearing has been advanced first and foremost as a means of reducing systemic risk.  In my opinion, for the most part, these assertions reflect a superficial understanding of clearing, when they don’t reflect abject ignorance.

Things are actually quite complicated.  I thought it would be worthwhile to present a list (which is long, but probably not exhaustive) of some of the ways in which the adoption of a central counterparty can actually create or worsen systemic risks.  These are presented in no particular order.

1. The adoption of a CCP affects the priority among creditors.  In essence, netting positions improves the priority of the claims of derivatives counterparties (more exactly, of clearinghouse members via the clearinghouse) of a defaulting member.  It also worsens the priority of the claims of the bankrupt/defaulter’s other creditors.  It is not clear a priori that this reallocation of priority improves welfare, or reduces the likelihood of a systemic shock resulting from the default of a large derivatives trading firm.  For instance, worsening the position of those supplying short term credit will exacerbate their losses in bankruptcy/default.  These creditors (e.g., repo counterparties, corporate paper buyers) may be systemically important.  (EG, worsening the losses of CP buyers may result in runs on money market funds that hold CP.)  Moreover, worsening the position of some creditors will tend to make them more likely to run.  This can tip a shaky but surviving firm into failure.  Changing priority will affect capital structure and transactions costs in complex and unknown ways that could have systemic implications, as market participants adjust contracting behavior in response to the change in priorities.  Of course, changing priority in favor of derivatives counterparties could reduce systemic risks by reducing their incentive to run, and reducing the losses they suffer.  But it is by no means clear a priori how this cuts.  This is related to the general point that the first order effects of clearing are to change the allocation of risk, not its total amount.  It is not trivial, to say the least, whether these reallocations reduce or increase systemic risks.
2. A system with customer clearing (as in futures markets, and as is being proposed/advocated/adopted in some OTC clearing organizations) tends to increase the default losses that CCP members suffer, even holding total trading positions constant.  (Customer positions are likely to increase, moreover, as I discuss below.)  Since the CCP members are likely to be systemically important financial institutions, this would tend to exacerbate systemic risks. In a bilateral market, exposures to the default of firm A is limited to A’s counterparties, in relation to their trades with A.  Some end users who trade with A, who would not be members of a CCP, suffer from A’s default, as do other dealers likely to be CCP members.  In contrast, in a CCP with customer clearing, the obligations of A, as a CCP member, to non-members are transferred to other member firms.  That is, adoption of clearing tends to redistribute the burden of default losses from end users who are not CCP members to financial intermediaries who are.  (Indeed, this is one of the advertised virtues of CCPs.  For years, the Board of Trade Clearing Corporation touted the fact that no CUSTOMER had lost money as a result of default: that’s exactly because clearing insured customers by transferring the risk to clearing members, i.e., large financial intermediaries.)  Thus, clearing tends to increase the default losses borne by systemically important financial institutions.  Another example of the effects of clearing on risk allocation that plausibly increase systemic risk.
3. CCPs create a single point of failure, and a concentration of risk.  This can have a variety of effects beyond the obvious one of the systemic shock that would result if a CCP in fact fails.  It means that there is less diversification of the risk of errors, e.g., model risk, or other risks in the evaluation of default risk.  If a CCP’s model/methodology/information for evaluating performance risk is flawed, these flaws are almost by definition systemic because the pricing of risk in all deals is wrong.  In contrast, when multiple parties are evaluating each others’ performance risks using different models or different information, errors will be less correlated.
4. CCPs generally do not price balance sheet risk (due to informational and governance considerations), which can encourage more trading by weaker firms, and can also encourage firms to take on more balance sheet risk (e.g., by taking more risk on non-cleared positions/investments).  This tends to increase risk in the system, and not just in the derivatives market: it can increase risks in other markets too.  It also provides another mechanism by which risks in other parts of the financial system affect the derivatives markets.
5. CCPs mutualize default risk.  Mutual arrangements tend to encourage moral hazard and risk taking.  These can be controlled, but only at a cost.  Moreover, monitoring and control of risk are delegated to an agent typically subject to low powered incentives, and monitoring of the agent by the principals (CCP members) is subject to free riding because the benefits of monitoring accrue to all members but the costs fall completely on the member that incurs them.  In a CCP, deficient monitoring tends to have systemic consequences for reasons discussed above.
6. Clearing can result in the capture of scale economies, but sacrifice scope economies, in the allocation of default risk.  It is not evident that this trade-off, and its effects on the allocation on default risk, is beneficial.
7. The adoption of clearing is likely to have a tendency to increase total positions and trading volume.  This tends to increase overall market risks, and default risks along with them.  Position sizes are likely to rise for several reasons.  First, netting tends to reduce the capital required to support a given size of net position.  Expanding netting through clearing therefore tends to reduce the costs of maintaining positions, leading market participants to hold bigger ones–thereby taking on more risks.  (Another equilibrium effect.)  This cost reducing-position increasing effect is mentioned by advocates of clearing (I can provide cites) as one of its advantages.  More efficient use of capital is generally desirable, but it is important to note that bigger markets pose greater risks–including greater risks of default.  (The effects of netting on position sizes was actually advanced as a reason for not adopting clearing at the CBT in the 1910s-1920s: lack of clearing was said to “encourage conservatism” by limiting the size of positions–and hence risks–that firms could hold with a given level of capital.)  Second, by redistributing default risks from CCP non-members to CCP members, the adoption of a CCP tends to increase the derived demand to trade by end users.  This also encourages growth in market size, and via the channel discussed above, tends to increase the risks faced by systemically important institutions.  Put differently: do advocates of clearing really want derivatives markets to be bigger?  That’s a very likely consequence of clearing.
8. In times of market stress, and large price moves, the rigidity of CCP collateral mechanisms can exacerbate liquidity problems.  Daily and intra-day variation margin payments are financed to a considerable degree through the extension of credit.  Large variation margin obligations resulting from large market price moves therefore translate into large increases in credit demand in stressed market conditions.  As was demonstrated during the Crash of ’87, under these conditions banks may decline to extend credit due to heightened uncertainty and lack of information about who is solvent and who is not.  Failure to obtain credit to make a margin call may force closure of a clearinghouse (again, as almost happened to the CBT and the CME in October, 1987).  Given the systemic, bottleneck nature of a large CCP, this would almost certainly spark a systemic crisis; it would certainly put pressure on central banks to provide liquidity, just as would occur from the failure of a large dealer in the OTC market.  Moreover, the traders who need to make variation margin payments are likely to sell assets.  This can create a positive feedback mechanism with very negative effects, by accelerating and exaggerating asset price declines, thereby necessitating additional margin payments, etc., etc.

Like I said at the outset, this list isn’t exhaustive.  And I certainly don’t know how, on net, all the various effects of clearing would play out from a systemic risk perspective.

But the point is that the advocates of clearing don’t either.  I haven’t seen evidence that they’ve even inventoried the possible effects, let alone made reasoned judgments about the net effect, or if that is even possible given the complexity of the system, the likely complicated equilibrium effects (i.e., how people adjust their behavior in response to the new regime), and the inevitable lack of information necessary to estimate the effects.

In brief, the mandated adoption of clearing will have big effects on the allocation of risk, the total amount of risk in the system, and the incentives of firms and individuals to take on, manage, and monitor risk.  Many of these effects plausibly increase systemic risk.  There are plausibly offsetting effects, but suffice it to say that anyone (and that means you, Timmy!, Gary, et al) who sells mandated clearing as a surefire means to reduce systemic risk are guilty of false advertising, not to say outright fraud.