Streetwise Professor

I was talking to some folks at a research/policy institute at another university about regulation of carbon derivatives trading who are attempting to educate Congress (or, more precisely, Congressional staff) on the matter.  They told me that there was a widespread belief on Capitol Hill that customized, OTC derivatives offer little or no social benefit, and that as a result, their use should be highly restricted, if not eliminated altogether. The view is that these instruments create systemic risks, but confer no corresponding benefit that cannot be offered by exchange traded products.

I disagree, for reasons I set out in a Brookings paper released last fall.  But I don’t want to focus on the details of that argument here.  Instead, I just want to flash back to a historical example that demonstrates that limiting the contracting choices of commodity market participants can have extremely perverse effects, and can in fact create systemic risks.

The legislation that restructured the California electricity markets, AB1890, precluded the state’s major utilities from entering into long term contracts for power.  Instead, in order to ensure the “success” of the spot market for power, the utilities were required to buy electricity from generators through an exchange–the Power Exchange (“PX”).  The bill also capped the price that utilities could charge their customers for power.

This legislation created a huge short position for the utilities.  They were exposed to increases in prices on the PX, and could not pass on these costs to customers.  Most importantly, the bill prevented the utilities from managing their price risk by engaging in long term forward contracting.

We all know what happened.  Power prices spiked, and two utilities still subject to the constraints (SoCal Edison and PG&E) suffered huge losses.  PG&E went bankrupt.

The problem would likely have been less severe had the utilities been given the ability to hedge.  Indeed, the absence of forward contracts may have exacerbated the price spikes, because these contracts would have precommitted the generators to supply power, whereas they arguably had an incentive to restrict output on the PX when conditions became tight.

Moral of the story: limiting the ability of firms to manage risks can impose substantial dangers of financial distress on those companies.  Indeed, if they limitations are systemic (as they were in California), they create the risk of a systemic problem.

Now, the analogy should not be stretched too far.  In its infinite, tofu-fueled wisdom, California chose to favor one type of exchange trading (spot auctions on the PX) for different reasons than Congress in its infinite God-knows-what-fueled-wisdom is contemplating favoring exchange trading of carbon (and other) derivatives.  Moreover, the restrictions in California were particularly draconian, especially when combined with the retail price caps.

Nonetheless, the tale should be a cautionary one.  Firms use derivatives contracts to pass risks to others who bear them at a lower cost.  If you constrain their ability to do so, they will wear more risk than they would otherwise.  This raises the likelihood that they will suffer crippling financial losses.  The more draconian the restrictions, and the wider the scope of their application, the greater the likelihood, severity, and extent of these losses.

That is, by avoiding one risk, you create others.  Rational policy requires a prudent trade-off between these various risks.  But fixated as they are on the risk (largely chimerical, IMHO) of OTC markets, most policy makers in DC are blind to the risks they are effectively choosing.  Their ability to weigh these tradeoffs is, moreover, extremely limited due to a fundamental lack of information.  Carbon trading regulation in particular will have systemic effects: it will impact every producer and consumer of energy.  How could Congress possibly have the knowledge to evaluate the risks that they are forcing on such a vast and diverse group of companies when they restrict their ability to choose the instruments that they can use to manage that risk?  Short answer: they can’t.

I would hope that the California experience would at least make policy makers aware of the possibility that restrictions on the contracting choices available to market participants creates risks.  So far, however, the debate appears to have taken no recognition of this very real possibility.  Keeping their eyes fixed on the skies to reduce the risk of being hit by a falling object, they face the very real risk of stepping into an open manhole.

Gary Gensler is following in Timmy! Geithner’s footsteps, striking a populist pose to argue for forcing virtually all derivatives trades onto exchanges:

“Big Wall Street banks” benefit from a provision in derivatives legislation that has been promoted as aid for companies hedging their own risks, Commodity Futures Trading Commission Chairman Gary Gensler said.

“It is the Wall Street banks that benefit from the so- called end-user exemption from transparency, not the businesses that use derivatives,” Gensler said yesterday in a speech to the Atlantic Council in Washington criticizing the provision.

Talk about a false choice.  Gensler’s statement presumes a zero-sum game: if banks win, customers must lose.

Uhm, Gary, ever heard of mutually beneficial transactions?  Gains from trade?  Positive sum games?  How about “win-win”?  No?

And how does Gensler explain that the end-users have been among the most outspoken advocates for exemptions?  The mesmeric powers of Lloyd Blankfein and Jamie Dimon?  Battered spouse syndrome?  Or have a cabal of “Wall Street bankers” kidnapped large numbers of children of derivatives users, with the ransom being paid in lobbying?

And how does Gensler explain the fact that end-users have voted with their checkbooks to trade OTC even when exchange traded alternatives are available?  Does he know their businesses better than they do?

To paraphrase H. L. Mencken, Gensler and the rest of the DC crowd seem to be financial Puritans, haunted by the fear that somewhere, in the darkest recesses of the OTC market, consenting adults may be happy, making mutually beneficial deals.

And Gary, give the apple thing a rest:

“We would not tolerate it if other markets operated similarly to over-the-counter derivatives, where dealers are the only ones with much of the relevant information,” profiting from spreads between bids and offers that are wider than they would be in an open market, Gensler said.

He compared the situation to “buying an apple from the supermarket when the price of the apple is kept private.”

(Note to self: work on controlling the eye-roll reflex.)

Where to begin?  First, in point of fact, we tolerate these kinds of markets in just about everything.  I would wager a pretty sum that even if you wanted to limit the discussion to apples, that most wholesale apple trades were undertaken in “search markets” (like the OTC derivatives market) with negotiated prices, rather than posted prices like in the grocery store.  That’s pretty much the case in cash markets for most commodities.  Second, for vast numbers of other goods, search for counterparties and negotiation of prices is the norm, and posted prices the exception; sometimes the posted prices are just a focal point for the beginning of negotiations, like with cars.  This is especially true for expensive, differentiated goods–as most OTC derivatives are.  There are a variety of different marketing and pricing mechanisms in markets, and these mechanisms are adapted to the characteristics of the goods, the sizes of the transactions, and the individuals and firms that trade them.  Third, it is definitely the case that centralized auction markets (like futures exchanges) are the extreme exception.

In brief, taking his apple metaphor seriously, Gensler apparently believes that myriad goods and services are priced and marketed inefficiently.  Why should he stop at regulating OTC derivatives when virtually every wholesale market, and many retail markets, are obviously in need of his penetrating insights?

The first time I read of Gensler using the apple analogy, I thought it was lame.  The second time it sounded positively stupid.  Word to the wise: never fall in love with your analogies, especially if they’re bad ones.

And as for the assertion that spreads are wider than they would otherwise be, why do end-users choose to trade on OTC markets, even when there are close exchange traded substitutes (e.g., interest rate swaps and Eurodollar futures)?  Again, on an all in basis, the end-users must think they’re getting a better deal.  Or, again, does Cotton Gensler know what’s good for them?

But as entertaining as all the above is, the best thing in the article was at the end:

“There’s a legitimate public policy debate,” he said. “Corporate America is on one side of the debate, I’m on the other.”

Gary Gensler, Lone Crusader, Stickin’ it to The Man!

If this wasn’t so serious, it would be hilarious.

A new Federal Reserve Bank of NY staff report by Darrell Duffie, Ada Li, and Theo Lubke, “Policy Perspectives on OTC Derivatives Market Infrastructure” has received a lot of attention in the press.

There are some good things in the paper.  Notably, it is suitably cautionary about the potential systemic risks posed by central counterparties, and the consequent need for prudential regulation thereof.  It also makes a good case for data repositories, and for the role of the Fed and other government agencies in reducing the costs that intermediaries incur to coordinate risk reducing actions, such as portfolio compression and improvements in the process of confirming deals.

But overall the paper is extremely disappointing.  Its tone is Olympian and prescriptive.  The word “should” is used 61 times 21 pages of text (that includes several space eating tables and charts).

This is extremely dangerous because these prescriptions and dictates are not based on a a rigorous analysis of costs and benefits.  Most disturbingly, there is virtually no discussion whatsoever of the informational demands inherent in the prescriptions.  We’re told that regulators should set the right capital and collateral requirements on non-cleared deals, and that CCPs should maintain “high collateral standards.”

Great.  Thanks for the advice.

Now, give me some numbers.  What is the right capital requirement?  How high is high?

Can’t do that off the top of your heads?  Understood.  Then tell us the information required to establish these requirements.  Tell us the process by which that information will be collected.  Tell us about the incentives facing those using that information, so that we can have some confidence that the regulatory process will select appropriate charges.

In essence, Duffie, Li and Lubka (DLL) are recommending a type of financial central planning, a centralized price setting system.  Regulators set a vector of prices, in the form of capital requirements and collateral charges (or regulate/oversee the collateral charges and other decisions of CCPs).

The first, second, third, . . . Nth question that should come to mind when hearing such a recommendation is: “How do you address the knowledge problem?”  Or, “What information do you need to set these prices?”  Relatedly: “What are the costs of getting the prices wrong (as you certainly will)?”

These prices create a high powered incentive system that very smart, very motivated people will respond to.  If the prices are set wrong, because the regulators don’t have the information necessary to set them properly, or the incentive to do so, or both, these responses can be individually rational but systemically perverse.  Extremely.

This is especially true inasmuch as these are one size fits all charges, so the effects of any mistake are almost by definition systemic.

And it’s not like we don’t have examples of this.  The Basel standards created incentives that drove many of the (correlated) risk taking and investment decisions that contributed substantially to the financial crisis.  Which goes to show that setting these prices improperly can create the very problems the prices are meant to solve.

The knowledge problem here is extremely complex.  To set the relevant prices properly, you have to understand the marginal contribution of any particular transaction to risk.  Moreover, if the objective of the exercise is to reduce systemic risk, you have to have some estimate of the cost of systemic risk, and the contribution of particular transactions to this risk.  We don’t even have an agreed upon definition of systemic risk, let alone a way to measure it or its costs, or the contribution of particular instruments or trades to it, in the complex system that is the financial market.   So just how do we set this price?

DLL don’t even raise any of these questions, let alone answer them.  This is a classic example of what Coase called blackboard economics.

Moreover, adverse selection problems are likely to be rife here.  Again, the highly motivated bankers and traders are going to have much better information than the price-setting regulators.  They are going to find out what risks are underpriced and what risks are overpriced, and trade accordingly.  This is a recipe for trouble.

The fundamental prescriptions regarding incentivizing clearing and raising capital charges on non-cleared trades is also based on a superficial analysis, as is all too common.  DLL argue that an externality is pervasive in OTC trading.  For instance, they claim that traditional capital charges do not “provide a direct incentive to [a] bank to lower the exposure of its counterparties to the failure of the bank itself, that is, the potential losses of others that are based on the bank’s payables.”  They relatedly argue that there is a negative externality in OTC trading, due to the failure of counterparties to take into account the systemic risk inherent in their trades.

I find it hard to believe that DLL take seriously the argument regarding a bank’s failure to consider the effect of its potential default into account when making trading decisions.  Yeah, maybe A doesn’t take into account of its failure on B, but B sure the hell does.  Therefore the prices at which B is willing to deal with A, and the amount it is willing to trade with A, depend on B’s assessment of A’s default risk.  There is no externality here.  The risk is priced.

Surely, in a world of imperfect information, the risk is priced imperfectly.  But that gets us back to the question of who is in a better position to set the price for this risk, and the relative merits of two mechanisms: one in which a one size fits all price is set, and hence errors are likely to have systemic consequences, or one in which many economic agents utilize dispersed information to make individual judgments about the terms on which they are willing to trade.

DLL also predicate their analysis on an assumption that policy should be devised to reduce the likelihood of “runs” on OTC dealers.  This is understandable, and conventional, but it fails to come to grips with recent research on liquidity and financial intermediation (much of it done by Doug Diamond) which shows that runs–and the fragile capital structures that can produce them–might well be a feature, not a bug.  That is, the risk of runs is an incentive mechanism that deters opportunistic behavior by intermediaries.  This is, to be sure, a somewhat controversial position, but it is sufficiently grounded in logic to at least deserve some attention.

In sum, the DLL analysis raises some important concerns, but overall it cannot provide any real policy guidance because it fails to address the fundamental information problems inherent in its policy prescriptions.  It’s like the old Steve Martin routine, “How to Make a Million Dollars Without Paying Taxes”: “First, make a million dollars.”  DLL’s version is “How to Price Performance Risks to Save the Financial System”: “First, price the performance risks properly.”  Gratuitous advice, and advice that can be very costly indeed if the fundamental informational problems are too daunting, as is quite likely to be the case.

Greg Meyer at the Financial Times wrote a piece covering a just-released study I did analyzing the performance of the CME-NYMEX WTI crude futures and ICE Brent crude futures during the financial crisis.

The full study is here: scroll down to the bottom for the PDF.

Cliff’s Note version: (a) the financial crisis was a period of unprecedented volatility in the oil markets, (b) the hedging performance of both pricing benchmarks declined during the crisis, (c) the crisis affected front month WTI more acutely than second month WTI or either front or second month Brent, (d) the performance of second month WTI was comparable to that of both Brent contracts, (e) the most likely cause of the observed price behavior was the major shock to demand, which resulted in a sharp increase in oil in store at Cushing, (f) spread behavior was not something peculiar to WTI, because the fundamental shock affected West Texas Sour crude (also tributary to Cushing) too, (g) oil stocks and WTI spreads continued to covary positively, as you’d expect, though the relationship was weaker during the period of the crisis, but (h) oil stocks and Brent spreads covaried negatively during the crisis.

Timmy! Geithner has been keeping a low profile lately–but maybe it’s just the anti-terror FUBAR that has drawn attention away from him.  But today he gets a banner headline on Bloomberg:

The Federal Reserve Bank of New York, then led by Timothy Geithner, told American International Group Inc. to withhold details from the public about the bailed-out insurer’s payments to banks during the depths of the financial crisis, e-mails between the company and its regulator show.

AIG said in a draft of a regulatory filing that the insurer paid banks, which included Goldman Sachs Group Inc. and Societe Generale SA, 100 cents on the dollar for credit-default swaps they bought from the firm. The New York Fed crossed out the reference, according to the e-mails, and AIG excluded the language when the filing was made public on Dec. 24, 2008. The e-mails were obtained by Representative Darrell Issa, ranking member of the House Oversight and Government Reform Committee.

R asks if this could be the last straw for Timmy!  You’d think, but if Janet Napolitano and John Brennan are still among the employed (I wouldn’t say “gainfully employed”), it’s pretty clear that you can get away with a lot these days.  A whole helluva lot, in fact.

The Bloomberg article is very short on reasons why the FRBNY was so adamant on keeping the details of the AIG deals quiet.  Any GueSses?

No doubt this was of a piece with the Paulson-Bernanke insistence that all big banks take TARP funds, in order to pool the true weaklings with those not in desperate shape, so as to stem potential runs on the weaker institutions.  No doubt revelation of the details would have raised questions as to why it was so, so important to pay off Goldman, DB, etc., and ASAP.

I would love to hear an explanation as to how this could possibly be consistent with Geithner’s insisting to the Special Inspector General that the financial condition of the AIG counterparties was (I quote from memory) “not a relevant consideration” in the government’s decision make said counterparties whole.

Again: he was either lying when he said that, or everything else he has said or done in regards to the AIG intervention is a lie.

This raises another issue.  Geithner, along with others in the administration (notably Gensler at CFTC) has been preaching The Gospel of Transparency when flacking for clearing and exchange trading mandates.  Sunshine and transparency have magical powers, they intone, that will protect us against systemic risk.  Those who oppose transparency are merely greedy special interests protecting their turf.

But the FRBNY’s actions with AIG, and Treasury and Fed actions more generally, make it clear that the powers that be clearly believe that transparency can be damaging under some circumstances.

I’m perfectly willing to stipulate that, and then debate what is the right amount of transparency, and more importantly, what is the appropriate process to determine the level of transparency in various settings.

What I can’t abide is highhanded lectures about the virtues of transparency and the need to force it on individuals and firms, delivered by the likes of Timmy! Geithner, who is more than willing to do big deals away from prying eyes when it suits him.

The UK’s Financial Services Authority (FSA) released a report on OTC derivatives market reforms in December.  In contrast to most government reports I’ve read on the subject, this one is thoughtful and arrives at pretty well reasoned judgments.  It recognizes the trade-offs involved.  It is a little too sanguine on the merits of clearing for my taste, but does not recommend mandates.  It recognizes the burdens of mandated clearing and the associated cash flow risks on end users.  It advocates an increased reliance on data repositories (something I advocated in late-2008 for OTC derivatives, and for energy years before that).  It identifies counterparty risk management as the key issue, and concludes that mandated exchange trading is unnecessary to address this issue, and an unwarranted attempt to impose market structures.

Its analysis of position limits is especially good. I liked this part:

The second limb of the Commission’s proposal is to give regulators the possibility of setting position limits to counter concentrations of speculative positions. Such an approach would go beyond the existing legislative remit in the UK and more importantly we have not seen evidence which supports such an approach. The UK regime applies its position management tools to all participants, without a specific emphasis on those that do not have a desire to hedge physical positions, or take physical delivery. We do  not consider activity by financial participants to be de facto manipulative. We do not therefore consider that there should necessarily be a distinction made between “large speculative” and “large   non-speculative” positions for the purposes of combating manipulation – the focus should be on combating “large positions that lead to manipulation” irrespective of whether they are held by financial participants or not.

And this:

9.20 Over the last two years, certain commentators and market observers have linked the growth in financial, or “speculative”, participation in commodity markets with recent significant price movements, particularly in oil.We recognise that this type of investor has impacted the nature of commodities markets as a whole, for example, as a result of different methods of trading and increased volumes.

9.21 However, the majority of academic studies and evidence do not support the proposition that prices have been systematically driven by this increased inflow of financial interest.  Indeed the majority of commentators have concluded that commodity price movements cannot be solely attributed to the  activities of any one class of investor and are principally attributable to market wide factors.We agree with these conclusions.

Proposals for combating price movements

9.22 The FSA’s regulatory aim (as defined by legislation) is on maintaining fair and orderly markets, not limiting price movements or volatility. In any event, we do not believe a case has been made which demonstrates that prices of commodities, or other financial derivatives, can be effectively controlled through the mandatory operation of regulatory tools such as position limits, whether on exchange or OTC. Analysis of market data where position limits are already in use suggests that this has not shown a reduction in volatility or absolute price movements compared to contracts where they are not.

9.23 We also consider that limiting financial participation more generally would hamper market efficiency. To use oil markets as an example, increased participation has brought significant benefits, such as greater depth and liquidity.

In contrast, on this side of the water, from the Chairman of the FSA’s US counterpart, the CFTC, we get drivel like this.  He’s said it all before.  Arguendo ad AIG.  Horror stories about interconnections.  Completely misleading conclusions based on outrageously inappropriate analogies between impossible to price toxic assets like MBS-based CDOs and vanilla swaps.  Assertions that end-users don’t know their own economic interests, and subject themselves to the predations of a “small group of derivative dealers.”  (His comparison between buying an apple and the OTC derivatives market is especially idiotic.)  Wildly misleading insinuations that clearing will reduce interconnections in the financial system.  Similarly wildly misleading insinuations that OTC trades are not collateralized.  (Before anybody says this about AIG again, read the AIG Special Inspector General’s report.  Please.)  Egregiously misleading insinuations that failure of a clearing member “does not harm its counterparties.”  (Then, pray tell, who eats the loss?  The derivatives fairy?)

Ugh.  What inanity awaits us when CFTC announces its position limit changes?

Overall, the Europeans are quite dismayed at the trajectory of regulatory and legislative initiatives here in the US.  This dismay is documented in a couple of articles by Jeremy Grant in the FT.  This quote is priceless:

Richard Raeburn, EACT chairman, said companies were looking for a “clear carve-out” from the clearing and exchange-trading requirements.

“My fear is that what happens in the US will pre-empt the ability to be sensible over here,” he told the Financial Times.

Yes, Mr. Raeburn, be afraid.  Be very afraid.

The mouse-cat-dog-elephant-mouse dialectic is starting to dawn on a select few, especially in Europe.  Jeremy Grant of the FT reports that the new head of the London Stock Exchange, Xavier Rolet, has issued a pretty clear warning:

Clearing houses in Europe should be regulated by central banks to guard against the risk of a catastrophic failure by one of them, the  London Stock Exchange’schief executive said.

Xavier Rolet, a former  Lehman Brothers and  Goldman Sachs banker, said that it was “very dangerous” for clearing houses’ capital bases and risk models to differ from country to country.

His comments come amid growing concerns that the insistence by policymakers that more financial instruments – such as over-the-counter derivatives – should be processed through clearing houses could overwhelm a clearer and spark a new crisis. [Emphasis added.]

In honor of the new Holmes movie just released on Christmas: no sh*t, Sherlock.

Some other “duh!” moments:

The Financial Services Authority, which regulates clearing houses in the UK, said last week: “The drive to have a significantly greater proportion of OTC derivatives markets centrally cleared will further increase the systemic importance of [clearing houses].”

Mr Rolet said it was possible that a clearing house could be overwhelmed if in the case of a default the clearing house members were unable to cover the margin calls that the clearer would make to cover the losses.

You mean that clearing doesn’t make the risk of default disappear, but just shifts it around in a different–and potentially worse–way?  Next, they’ll tell us there’s no Santa Claus.  I am so disillusioned.

Sarcasm aside (but never far away 🙂 ), Rolet has clearly recognized the dialectic that the mandated expansion of clearinghouses will launch:

He said that clearing houses should have access to the funding provided by central banks through their discount window in the case of an emergency.

“This is not about fear-mongering, but where a clearing house has a substantial amount of ‘binary risk’ products that require a potentially huge collateral [margin] call which the [members of the clearing house] are not able to supply then the question is: who funds it?” said Mr Rolet.

“It seems sensible to us that the central banks should have at least a funding relationship to clearing houses.”

He said Europe needed a “harmonised, integrated clearing industry with standardised regulation” and “lending arrangements” with central banks.

In other words, world governments are responding to fears that interconnected financial institutions are too big to fail and will inevitably receive central bank or treasury or central bank + treasury bailouts by creating new interconnected financial institutions that are too big to fail and providing them with a guarantee of central bank support.

The inherent logical disconnect here is as stark as the old line from Vietnam: “We had to burn the village to save it.”  The only difference is that the Vietnam line was almost certainly apocryphal (the figment of Peter Arnett’s imagination), whereas what is happening in financial markets is all too real.

This is an improvement?  It’s always advisable to start thinking about living with the mice before bringing on the elephants.  If we are serious about attacking too big to fail, rather than creating institutions that concentrate risk and establishing new implicit and explicit commitments to support them in a crisis we should be doing the exact opposite.  Xavier Rolet is doing a great service by pointing out the logical implications of force-feeding central countperparties.  The question is, whether anybody–especially in the US, and particularly in the US Congress (yeah, that means you, Barney & Chris, living, breathing weapons of financial mass destruction)–is paying attention.  Or even cares.

Today’s WSJ carries a story lamenting the “death” of derivatives overhaul.  Like Twain’s, rumors of this death are exaggerated.  The derivatives “reforms” that passed the House before the holiday were not immaterial, even if they were not everything supporters were hoping for (and thank God for that).

The main complaint is that the OTC markets were not killed by forcing all trading onto exchanges, a la the Grain Futures Act of 1922 (how’s that for a model of modernity!?), and that customers were given some exemptions from a clearing requirement.

The article quotes Stanford’s Darrell Duffie’s explanation for resistance to the bill:

For Wall Street, switching to exchanges would have cut their profits in a lucrative business. “Exchanges are anathema to the dealers,” because the resulting added price disclosure “would lower the profits on each trade they handle, and they would handle many fewer trades,” said Darrell Duffie, a finance professor at Stanford business school.

Darrell is a very smart man–a helluva lot smarter than me–but in this instance he is lost in (Hilbert?) space.  Sure the dealers want things their way.  GM wants people to buy their cars, too.  But wanting it doesn’t make it happen.  That’s called magical thinking, which has a rather bad habit of running smack dab into reality.

And here, the reality is that it was customers–those allegedly the victims of the dealers–that argued strenuously for the exemptions.  Again, how does anyone (including Darrell) explain this?: Stockholm Syndrome?  Battered Spouse Syndrome?

Another reality is even plainer: dealers evidently offered end-users a superior bundle of pricing, product design, transparency, and credit and collateral arrangements, as compared to exchange-traded alternatives. Exchanges have striven hard to make inroads into the OTC business.  There was no major entry barrier preventing somebody or several somebodies from starting exchanges.  But OTC grew absolutely and relative to exchanges nonetheless. Like it or not, the OTC market won in a competitive battle against the exchanges.

It would be nice if somebody asked “why?”  They might find the answer somewhat illuminating.

There is also an element of intellectual incoherence here.  (More than an element, actually, but I’m in a giving holiday spirit.)  One of the supposed justifications for clearing is that dealers are too inter-connected.  But as written, the legislation forces clearing on dealers–thereby just creating another form of inter-connection.

The primary economic justification for clearing is to protect customers against dealer (or FCM) default.  After all, for years the Board of Trade Clearing Corporation touted the fact that “no customer has  lost money as a result of a default by a clearing member to  BOTCC.” Note the (emphasized) fact that the CUSTOMERS didn’t lose money as a result of a clearing member to BOTCC.  Other members of BOTCC had to cover the costs of clearing member defaults.  Note too the careful wording–some customers can, and have, lost money as a result of member defaults, but the chain of losses didn’t run through BOTCC.

Put differently, the primary justification for clearing is that it improves the quality of service that customers of intermediaries receive.  A clearinghouse made this argument for decades.  But the legislation leaves out the customers, by and large.  Because the customers want it that way, and have made that preference clear through both their economic choices and their lobbying voices.  So what’s the point?

There are other stories that speak to the incoherence of the whole mandated clearing effort. It is finally dawning on some that the creation of one clearing house will create a massive point of vulnerability, but that multiple clearinghouses will require these to be inter-connected.  Thus, the idea of using clearing to eliminate, or even reduce, systemic risk by eliminating inter-connections is a complete mirage.

These remarks by Pierre Gay, Asia-Pacific head of Newedge, the world’s largest futures broker, are priceless:

But forcing all such business to pass through a central clearer would be “a bit too much”, he argued in an interview with the Financial Times.

“The risk we see is that…it would transfer the risk from bank to bank, to a clearing house, which, being private, would also have to make a profit and we could create a globally risky situation.”

Mr Gay said clearing was one possible solution for OTC derivatives, “but we don’t think it is the only one and we should look at other solutions”.

“If we were able to have a platform where prices became more transparent, where we know what is trading during the day, it would help the bank [and] the buy side to have a better view of what the real price is,” he said.

Mr Gay said it was for regulators to decide how this should be done. However, he stressed it would be possible for banks, brokers and other parties to mark contracts to market themselves.

Other critics of the proposed regulation have pointed out that if central clearers took on a widening spread of risk, they would end up looking very much like investment banks – and might need to be regulated similarly. [Emphasis added.]

You don’t say.

In other words, clearinghouses will perform the same economic function as large dealer banks–of absorbing and allocating default risk.  They don’t make it disappear.  They will be inter-connected.  They will also pose systemic risks.

FT’s Lex has also noticed:

True, regulation that mandates clearing could weaken banks’ hand. But it is not only banks that might resist extending clearing requirements. Clearing houses themselves have fought to retain control of which products can be cleared. They need to mark positions to market in order to collect margin which, in the case of CDS, must reflect the possible payout in the event of an underlying default. Illiquid products, then, are unsuitable.

Whether clearing CDS, or other OTC products, becomes big business is yet to be seen – clearing is, after all, akin to a utility. But it therefore merits careful supervision. If multiple profit-driven clearing houses compete, this could muddy risk management. A seller of protection might appear moderately exposed within one platform but egregiously so across the system. [This is just another way of discussing the interconnection point.]

Regulators, too, should take a dim view of competition that focuses on margin requirements or the type of collateral accepted. Clearing helps to reduce risk in the system – not eliminate it.

Today’s FT has an article by the COO of the exchange BATS which similarly points to the fact that the introduction of multiple CCPs will effectively create the same sort of interconnection concerns and problems as the current dealer structure:

So what are the solutions? The US, for example, has single post-trade providers. While this facilitates competition between trading venues and lowers post-trade costs via processing economies of scale, the monopolistic position of the post-trade service provider results in a lack of efficiency and innovation.

A more pragmatic model is one in which a small number of competing CCPs interoperate. For example, CCPs A, B and C provide interoperating C&S services for multiple MTFs (multilateral trading facilities) and exchanges.

Trading/clearing participants could select their preferred CCP rather than one designated by the MTF or exchange. Participants could also elect to clear all of their business through a single CCP, providing netting possibilities which in turn allow for more efficient margining and settlement. Direct competition would also oblige CCPs to focus on improving cost, efficiency and service.

To date, with the exception of a handful of arrangements, there has been little progress in implementing interoperable clearing models, especially interoperable clearing models involving three or more CCPs.

Within this context, it is important to note that interoperable clearing poses additional risks that need to be appropriately mitigated. In particular, under an interoperable clearing model, CCPs are no longer exposed only to risk from their clearing members but also to financial and operational risk from the CCPs with which they interoperate. Where CCPs were previously “risk aggregating”, they thus also become “risk taking” entities. Again, this must be mitigated.

BATS Europe supports a model under which the CCPs margin each other on a fully collateralised basis, as if the other CCP were just like any other clearing member. This approach minimises the interdependence of CCPs under interoperation and thus seeks to ensure the continued systemic stability of the current system.

The CCPs will continue discussions of whether there can be a more efficient interoperation framework in the future but this is likely to be more complex from a risk, legal, operational and regulatory view point and thus will take significant time to research and implement.

[Emphasis added.]

This dawning understanding that clearing is not a magic bullet, and which might create problems similar to or worse than the ones that it is intended to solve, reminds me of the old story about the Indian village infested by mice, that brought in cats to eliminate the mice, that brought in dogs to deal with the proliferation of cats, that brought in elephants to drive out the hordes of dogs . . . and then brought back the mice to rid themselves of the rampaging elephants.

The belief that clearing somehow eliminates risks is another example of magical thinking.  It is another way of performing a particular economic function.  The fact that it was not the mechanism by which vast numbers of market participants chose to perform this function raises, again, the question “why not?”  Now, it is possible that some particular transaction cost precluded this choice, and that a mandate or some form of regulation will reduce this transaction cost.  But inasmuch as the entire argument for clearing has been predicated on magical thinking, and indulging the Nirvana fallacy, rather than a hard-headed analysis of the REAL trade-offs, there is room for considerable skepticism that this is actually the case.

Instead, as a result of the intellectual laziness and groupthink that has brought us to this point, we are far more likely to find ourselves in the position of those Indian villagers, who didn’t think more than one step ahead; who didn’t consider the consequences of a major intervention into their ecology (and as Vernon Smith points out, markets reflect a form of ecological rationality); and who didn’t pause to wonder whether their intervention could actually make things worse.

Thus, in my view it is to be regretted that the WSJ’s story about the death of derivatives overhaul is an exaggeration.  Would that it were so!

Several of my academic articles are about competition between exchanges.  The basic conclusion of these articles is that the network effects of liquidity make price discovery a natural monopoly.  This means that a competition between two exchanges that do not attempt to “cream skim” uninformed order flow is likely to result in a winner-takes-all outcome, where all trading “tips” to a single exchange.  If a new entrant challenges an existing market, given the stickiness of order flow, the winning exchange is likely to be the incumbent.

Jeremy Grant in today’s FT provides a text-book example of the phenomenon.  About a year ago a group of banks  (UBS, Morgan Stanley, Goldman Sachs, Credit Suisse, BNP Paribas, Societe General, Deutsche Bank, Merrill Lynch and Citi)  that control a large fraction of order flow set up the Turquoise exchange to compete with the London Stock Exchange.  The banks hoped that the competition would force LSE to cut fees.

Turquoise operated an open, limit order book market like the LSE, as well as a dark pool.  Thus, it went head-to-head with LSE in competition in price discovery.  Not surprisingly, the venture never succeeded in attracting a large volume, despite the fact that the banks that started it dominate the equity markets.  The exchange gained at most 8 percent of FTSE 100 volume, and was unprofitable.

As a result, the banks have given Turquoise–yes, given it–to LSE.  LSE has agreed to invest to upgrade Turquoise’s technology, and will use the platform to trade a broader slate of European stocks.

Which all goes to show that, as the theory predicts, competing with an incumbent exchange in “lit” markets is extremely tough, though not impossible (as Eurex showed a decade ago in its competition with LIFFE).  It also demonstrates that control of large amounts of order flow is not a sufficient condition for an entrant to succeed, though it is arguably a necessary one.  It also shows that a for-profit, investor-owned exchange can compete successfully against a mutualized one, and that the return of the mutual model is not predestined.  Finally, this represents a cautionary tale for other nascent exchanges, such as ELX in the US.

FT Alphaville–an (excellent) Financial Times blog–graciously invited me to write a guest post on the financial “reform” legislation that is moving through the House of Representatives (and just passed yesterday).  (Thanks, Stacy-Marie.)  Here it is:

Guest post: Prof Craig Pirrong on moves to overhaul to the derivatives market

Posted by  Guest writer on Dec 11 13:38.

Lawmakers in DC are due to resume debate on major financial reform legislation currently working its way through the US House of Representatives. One closely-watched aspect of that debate is sweepingoverhaul of over-the-counter derivatives markets. Lawmakers are pushing to mandate that most derivatives be centrally cleared and traded either on exchanges or swap execution facilities. Professor Craig Pirrong of the University of Houston discusses some of the proposals.

In attempting to impose standardization on the ways that derivatives are traded, and derivatives counterparty risks are managed and shared, the legislation reflects a one-size-fits-all mentality (not to say fetish) that is sadly typical of most legislative attempts to construct markets.   These standardization directives fail to recognize that market participants are diverse, with diverse needs and preferences, and that as a consequence, it is desirable to have diverse trading mechanisms to accommodate them.

Standardized exchange products with central clearing are well-suited for some products and some users, but more customized arrangements (including customized, bilateral agreements relating to counterparty risk) are preferable for others.   And one should be extremely skeptical about claims that to enhance their profits, greedy bank-dealers force derivatives end users into trading on opaque, concentrated markets instead of transparent exchanges; end users have had the opportunity to choose, and exchanges have competed aggressively to try to attract them, but many end users nonetheless have decided to trade in markets that are allegedly stacked against them.   Is it really wise to predicate a radical restructuring of markets on the view that end users are suffering from the financial analog to battered spouse syndrome?

Ironically, one of the controversies that has come up in the debate over amendments to the proposed legislation involves supposed backsliding from the old time standardization religion.   An  amendment changes language defining “swaps execution facility” to allow trading of swaps through voice brokers to meet the bill’s requirement that swaps be traded on such a facility or an exchange.   Moreover, other language in the amendment allegedly allows banks to continue business as usual.   That is, whereas reform advocates envisioned that under the new law swaps would be traded almost exclusively on exchanges or transparent, exchange-like venues, they claim that the new language would perpetuate the existing ways of trading swaps in scary “dark” markets.

This is not a bad thing at all – contrary to what some have  argued.   A variety of execution mechanisms developed to satisfy the disparate needs of market users with respect to pre-trade and post-trade transparency, credit and collateral arrangements, and product design.   To the extent that the amendments recognize this reality, and give market participants some flexibility in selecting the mechanisms best for them, the authors are to be commended.   To the extent that the bill still imposes unnecessary mandates, they are to be criticized.

One final note: proposals to force derivatives trading onto exchanges have been tried before – back when grandma wore high button shoes.   As financial markets developed, these restrictions proved unworkable and unwise.   The advocates of one-size-fits-all reform would have us repeat the same errors.   Back to the future is not progress.

[The background here is that the first regulation of futures trading in the US, the Grain Futures Act passed in 1922 required all “contracts for future delivery” to be traded on “a designated contract market” (i.e., an exchange).   The Commodity Exchange Act (passed in 1936) extended this to non-agricultural commodities.   This created huge issues starting in the 1980s particularly when new products that had futures-like features started to be traded OTC, and banks starting offering products to retail customers that had interest rates tied to the S&P or gold.   The question became: what was a future?   One-size-fits-all became clearly unworkable.]