Streetwise Professor

I’ve had several calls from reporters asking my opinion on the Lynch Amendment to Barney Frank’s derivatives regulation bill.  For some reason, Forrest Gump pops into my head every time that question is asked.  You know, the part where he says “stupid is as stupid does.”

As I am sure you all know, the amendment introduced by New Jersey Massachusetts representative Stephen Lynch, imposes restrictions on the ownership and control of the clearinghouses that the Frank bill will require the vast bulk of derivatives to be traded through.  The amendment imposes similar restrictions on ownership of exchanges and swap execution facilities.

Specifically, the amendment defines a class of “restricted owners” that includes swap dealers and major swap participants, and limits the amount of a clearinghouse (or execution facility or exchange) that these restricted owners can own or control collectively to 20 percent.  The justification for this limitation is to reduce conflicts of interest, the specific nature of which are not identified.

This represents yet another example of Congressional micromanagement of the organization and governance of financial institutions.  In my view, it is incredibly wrong-headed.

Let’s focus on clearing organizations.  Remember what they do.  They are a mechanism for pricing (via collateral) and sharing counterparty risk.  Any financial institution that agrees to participate in the sharing arrangement will reasonably expect to have control rights in the organization that oversees this sharing mechanism.  No sane financial institution is going to agree to share in a large fraction of the risk borne by a clearinghouse if it is restricted to having a small share in control.

This means that restricting ownership and control rights will inevitably exert a decisive influence on the allocation of counterparty risk through a clearinghouse.  If the swap dealers and other major swap market participants are limited in the amount of control they can exercise, they will limit the amount of risk they are willing to bear.  So who will bear it?

The traditional clearing firm has been effectively a mutual/cooperative.  Several intermediaries agree to share and manage counterparty risk.  These intermediaries offer various trading services, including brokerage and market making.  Counterparty risk is created as a result of the deals that they intermediate, and they find it in their mutual interest to price and share this risk collectively.

This mutual model has survival value.  Even the exchange clearinghouses that Frank et al apparently consider the ideal to be imposed on everybody are effectively mutuals governed by the major intermediaries.  (Once upon a time, the Board of Trade Clearing Corporation permitted every CBOT member to become a member of the clearinghouse, and adopted a one-member, one-vote voting structure.  However, over time, the organization evolved and became dominated de facto and de jure by the largest futures commission merchants.)  Nor is this an anachronism reflecting merely path dependence and hysteresis.  Indeed, one of the largest clearinghouses, LCH.Clearnet, has recently become a more focused mutual-type organization with increased control by large financial intermediaries; in a major reorganization completed weeks ago, LCH fended off a take-over effort launched by major market users by buying out smaller members and giving the big intermediaries a bigger stake in the organization.

This makes sense if the large intermediaries are the efficient bearers of counterparty risk.  If they are the efficient bearers, they should bear it.  And if they bear it, they will certainly condition their willingness to do so on their ability to control the organization.

Moreover, major market users have another reason to want to control the clearinghouse.  “Trading services” is a bundle of a variety of different services, of which clearing is merely one.  These services are consumed in close to fixed proportions.  Moreover, there is likely to be market power in the provision of several of these services, and clearing in particular has natural monopoly characteristics.  An independent clearing organization could exploit its scale economies, and exercise market power and extract rents from major intermediaries that use its services.  Moreover, to the extent that there is market power in one or more parts of the trading services business, this could exacerbate double marginalization problems, leading to other pricing efficiencies.

User control of the clearing function can prevent such exercise of market power.  The mutual/cooperative form allows the major users to obtain clearing services at cost.  If the major users of clearinghouse services cannot control the clearinghouse, those who do control it have an incentive to extract rents from the major users by charging inefficiently high prices.

Thus, from risk bearing and pricing perspectives, user dominance of clearinghouses makes economic sense.  Maybe, just maybe, that’s why users have dominated clearinghouses nearly everywhere and at all times.  Could it be?  What do you think about that, Rep. Lynch?  Barney?  (Barney is a big backer of Lynch’s amendment.)  Or do you guys just know better?  (We are not worthy!)

To me, what Lynch views with suspicion as a conflict of interest is actually an alignment of interest.  It aligns the control rights with risk exposures.  It similarly aligns the interests of those pricing the service with those who consume it.

If implemented, the Lynch amendment would make the mutual model unworkable.  As a rough estimate, if big users are limited to a 20 percent stake, 80 percent of the risk would have to be borne by somebody else.  Which would be who, exactly?  Equity investors?  Why would they provide capital?  Presumably to get a return.  Which would likely require the clearinghouse to be established as a for profit venture.  A venture that would have an incentive to charge supercompetitive prices for its services to extract rents from big users.  And mightn’t such equity investors have an incentive to take risks, given the asymmetric nature of equity returns arising from limited liability?  Isn’t that directly contrary to the whole reason for mandating clearing in the first place?

Also, does it make sense to weaken the ability and incentive of those with specialized expertise in evaluating counterparty risk to monitor and control the specialized organization established to manage this risk?

This is all so perverse.  Why do Lynch and Frank want to impose a constraint that almost certainly will reduce the efficiency of the organization that they have seized on as the way to improve the operation of the derivatives markets?  Or is this just a backdoor way of throttling the derivatives markets increasing the costs of using them through idiotic restrictions on the way they are organized, owned, and governed?  (Make firms who trade derivatives clear them.  Make clearing more expensive by preventing the implementation of efficient ownership and control structures.  Voila!  Fewer derivatives trades!)

There is one potentially real inefficiency that can arise through user-dominated clearing organizations.  Due to the economies of scale in clearing, it is likely that only a single clearinghouse will survive in equilibrium.  As I’ve shown in my work on exchanges, a cooperative organization supplying a natural monopoly service can generate rents for its members by restricting membership.  It lets in just enough members so that no competing organization can survive, but due to the entry limitations reduces output and raises prices to the ultimate consumers of these services.  “Non-profit” exchanges did that for a long time.

Mandating that a clearing organization permit open access would eliminate this problem, but create another.  In particular, to maintain the financial stability of the clearing organization, it is likely desirable to prevent financially weak firms from joining.  The hard thing is to write rules that would be sufficiently discriminating to prevent the clearing organization from using financial requirements for membership as an excuse for excluding potential members in order to enhance market power rents.

That is a real concern, but the Lynch amendment is an incredibly crude way of dealing with it.  Drafts of the various derivatives regulation bills mandate that no clearing organization should implement anti-competitive policies. It would be better to leave it at that, and delegate enforcement of this provision to the anti-trust authorities than attempt to handle the entry barrier problem with restrictions on organization, ownership and governance that impede efficient risk bearing and monitoring, and encourage other ways of exercising market power.

So sayeth Michael Palin, in the priceless Monty Python Argument Clinic Sketch.  In his recent testimony before the Senate Ag Committee, CFTC Chairman Gary Gensler makes an unconnected series of assertions (many categorically untrue) intended to establish a proposition.  Here’s the SWP annotated version:

First, standard OTC transactions should be required to be cleared by robustly regulated  central counterparties. [That’s the proposition to be “proved.”] By guaranteeing the performance of contracts submitted for  clearing, the clearing process significantly reduces systemic risks.  [Unsupported assertion.  Also not necessarily true.]  Through the  discipline of a daily mark-to-market process, the settling of gains and losses and the  imposition of independently calculated margin requirements, regulated clearinghouses  ensure that the failure of one party to OTC derivatives contracts will not result in losses  to its counterparties.  [Categorically untrue for multiple reasons.  OTC derivatives typically marked-to-market; indeed, the AIG debacle that Chairman Gensler’s trots out repeatedly to scare people into supporting him came to a head due to mark-to-market.  Moreover, mark-to-market provides no guarantee that third parties, including clearing member customers and other members of the clearinghouse, will not incur losses.]  Right now, however, trades mostly remain on the books of large  complex financial institutions.   These institutions engage in many other businesses,  such as lending, underwriting, asset management, securities, proprietary trading and  deposit-taking.  [So?  What are the logical consequences of this?  Mightn’t there be economies of scope in these activities?  If there aren’t, why has the market evolved in this way?  Could it be the case that offering a broad array of financial services to its customers a financial institution generates information that lowers the costs of intermediation?]  Clearinghouses, on the other hand, are solely in the business of  clearing trades.  [So? again.  This is a completely, utterly unsupported assertion related to the economies of scope, or lack thereof, in financial intermediation.  Again begs the question of why, if this is the efficient arrangement, it didn’t prevail in the competition of the marketplace.] To reduce systemic risk, it is critical that we move trades off of the  books of large financial institutions and into well-regulated clearinghouses. [Conclusion completely unsupported by previous statements.]

I believe that all clearable transactions should be required to be brought to a  clearinghouse, regardless of what type of entity is on either side of the trade.   This  would remove the greatest amount of interconnectedness from the large financial  institutions. [Again, no support for this assertion.  Moreover, no explanation as to how a clearinghouse that by its very nature connects large financial intermediaries and their customers “remove[s] the greatest amount of interconnectedness”–WTF that means.]

In Energy MetroDesk John Sodergreen reports that a lobbyist says that Gensler is a rock star in Congress because “no member has a clue what they’re actually proposing in the financial reform area–and Gensler does.”

I judge the first part of this statement (e.g., no Congressional clue) to be true, with near metaphysical certainty.  As the foregoing deconstruction of Gensler’s testimony shows, the post-dash statement is not.  Indeed, how could people who don’t have a clue know whether what somebody is telling them is BS or not?  The endorsement of the self-admittedly ignorant (see my earlier post on the NPR guys who interviewed 13 House Financial Committee members) somehow proves Gensler’s wisdom?  Huh?

[I give John S. kudos.  He managed the very difficult task of saying nice things about me and Gensler in the same edition of the same publication. 🙂  I am billed as “one of the CFTC’s most ardent critics.”  One of?  I guess I have work to do.]

It is a sad day when the main question I have is whether the best metaphor for the current financial regulation reform is the aforementioned Argument Clinic Sketch, or the “Burn the Witch” scene from Holy Grail.  That’s a very hard call.

In an oped in today’s WSJ, Peter Wallison notes a fundamental inconsistency in the government’s defense of the AIG bailout:

Since last September, the government’s case for bailing out AIG has rested on the notion that the company was too big to fail. If AIG hadn’t been rescued, the argument goes, its credit default swap (CDS) obligations would have caused huge losses to its counterparties—and thus provoked a financial collapse.

Last week’s news that this was not in fact the motive for AIG’s rescue has implications that go well beyond the Obama administration’s efforts to regulate CDSs and other derivatives. It’s one more example that the administration may be using the financial crisis as a pretext to extend Washington’s control of the financial sector.

The truth about the credit default swaps came out last week in a report by TARP Special Inspector General Neil Barofsky. It says that Treasury Secretary Tim Geithner, then president of the New York Federal Reserve Bank, did not believe that the financial condition of AIG’s credit default swap counterparties was “a relevant factor” in the decision to bail out the company. This contradicts the conventional assumption, never denied by the Federal Reserve or the Treasury, that AIG’s failure would have had a devastating effect.

Wallison is exactly right: Geithner cannot run around Washington, using arguendo ad AIG to justify (a) the bailouts, and (b) the need for mandatory clearing, more draconian capital requirements, and restrictions on derivatives, while at the same time saying that the financial condition of counterparties was an irrelevancy in the decision to assume AIG’s obligations.  These claims are impossible to reconcile logically.  If one is true, the other is not.  Period.

Wallison then traces out the implications of this inconsistency:

The broader question is whether the entire regulatory regime proposed by the administration, and now being pushed through Congress by Rep. Barney Frank and Sen. Chris Dodd, is based on a faulty premise. The administration has consistently used the term “large, complex and interconnected” to describe the nonbank financial institutions it wants to regulate. The prospect that the failure of one of these firms might pose a systemic risk is the foundation of the administration’s comprehensive regulatory regime for the financial industry.

Up to now, very few pundits or reporters have questioned this logic. They have apparently been satisfied with the explanation that the “interconnectedness” created by those mysterious credit default swaps was the culprit.

But the New York Fed is the regulatory body most familiar with the CDS market. If that agency did not believe AIG’s failure would have actually brought down its counterparties—and ultimately the financial system itself—it raises serious questions about the administration’s credibility, and about the need for its regulatory proposals. If “interconnections” among financial institutions are indeed the source of the financial crisis, the administration should be far more forthcoming than it has been about exactly what these interconnections are, and how exactly a broad new system of regulation and resolution would eliminate or reduce them.

Right again.  If arguendo ad AIG is, as the old phrase goes, no longer operative, then what is the logical basis for this metastasizing regulatory framework?

And make no mistake about it, AIG has been the alpha and the omega of the case for mandatory clearing, exchange trading of derivatives, and more onerous capital requirements.  It’s not just Geithner.  If anything, CFTC head Gensler has been even been more of a repeat offender, subject to the three strikes rule multiple times, as evidenced by his recent testimony before the Senate Ag Committee.   In that testimony, Gensler refers to AIG as “Exhibit A” for the case against OTC derivatives.

So . . . if even “Exhibit A” AIG’s financial condition posed no threat to its counterparties (as would be necessary to make this “not a relevant factor”), what’s the need for a draconian restructuring of the financial markets?  And if the Fed and Treasury were truly concerned of the fallout from an AIG collapse, why insist to an official investigation that this was not the case?  Is this an attempt to maintain the fiction that Goldman and the other banks were totally safe and sound even during the maelstrom of the crisis, and didn’t need the money?  If not, give me a better explanation.

Wallison is quite polite when he calls Geithner’s conflicting stories about AIG “a lack  of candor about credit default swaps.”  The Treasury Secretary has lied about AIG with probability one.  The only question is which of his statements is a lie.  I would wager that the “not a factor” statement is the dishonest one.

Hopefully Wallison is right in the second half of this judgment:

The administration seems to be using the specter of another financial crisis to bring more and more of the economy under Washington’s control.

With the help of large Democratic majorities in Congress, this train has had considerable momentum. But perhaps—with the disclosure about credit default swaps and the AIG crisis—the wheels are finally coming off.

Wallison’s call for a thoroughgoing explanation of “how exactly a broad new system of regulation and resolution would eliminate or reduce” interconnections is spot on.  In particular, as I have been saying over and over, and over and over, and . . . just how does creating a central counterparty among major financial institutions eliminate interconnections?  Indeed, by concentrating failure in a single institution connected to all other major financial institutions, and which arguably operates at an information and incentive deficit relative to the dealers in an OTC market, mandated clearing arguably increases systemic risk.

To put it bluntly.  We can’t have such an epochal change in the structure and regulation of such immense financial markets based on lies plus superficial and specious analysis.  But it is abundantly clear that that is the case, as Wallison’s piece succinctly demonstrates.

My previous post on the Acharya et al (AEFLS) assertion of the purported externality in bilateral OTC markets focused on whether there was actually an unpriced “bad.”  I judged otherwise based on the fact that credit and counterparty risks are repriced repeatedly (and ruthlessly).

There is another reason to reject their analysis.  It should be incumbent on one who justifies the existence of an externality to justify a particular policy to (a) identify the transactions costs that preclude internalization of this externality, and (b) demonstrate that their policy would create a net benefit, by, for instance, reducing transactions costs.  AEFLS don’t even try to do this (another symptom of the Nirvana fallacy).  And when one examines the particulars, it is highly doubtful that the costs of the purported externality are as large as AEFLS insinuate that they are.

The AEFLS story is that contracts between two counterparties to an OTC derivatives deal impose costs on other market participants, notably, the firms’ other counterparties to earlier derivatives deals, and the counterparties’ counterparties, and on and on.  OTC market participants don’t take these costs into account, trade too much, and create too much risk.

Which raises the Coase Question: if these costs are so large, why don’t the affected parties craft a solution that mitigates them?  If, as AEFLS argue, a central counterparty would reduce these costs, why don’t the affected parties create one to internalize the externality and enhance their welfare?

In some cases, e.g., the classical one of a factory that spews pollution that harms myriad individuals, it is plausible that coordination costs (arising from, inter alia, free rider problems) preclude private collective action, and that legislation/regulation mitigates these costs.  But that hardly seems the case here.  The very fact–often cited by the advocates of new, invasive financial regulations–that there are a relatively small number of large institutions that dominate this market means that large numbers-driven coordination problems preclude effective collective action.  Indeed, the institutions that account for virtually all of the activity in the OTC market are already members of a formal organization, the International Swaps and Derivatives Association (ISDA).  ISDA has long served as a mechanism for coordination among, and providing collective goods to, its members.  For instance, ISDA facilitated the standardization of the terms of OTC deals through its standard master agreement.

In brief, the parties that bear the primary burden of this putative externality are relatively small in number; know who each other are; regularly cooperate on a variety of issues of common interest; anticipate interacting with one another well into the future; and have a formal organization to facilitate this coordination.  These conditions would tend to favor private collective action to internalize an externality, especially one allegedly as costly as the one asserted by AEFLS.

But they haven’t done so.  This is like the dog that didn’t bark.  If the danger was there it would have barked.  It didn’t, so . . .

Could there be transactions costs that prevent cooperation?  Just because the canonical sources of such costs appear absent in this instance doesn’t mean they are altogether absent.  One possibility is the kind of problem that Libecap and Wiggins identified in their work on oil field unitization (and that Libecap addressed more generally in his Contracting for Property Rights).  Specifically, that it can be prohibitively costly to negotiate agreements that would (but for these transactions costs) enhance wealth when said agreements have profound distributive effects, and there is private information about these effects.

The complete alteration of risk sharing arrangements would certainly have distributive effects (as I’ve noted in work dating back to the ’90s), especially when the affected parties are heterogeneous (as was almost certainly the case before the crisis, and likely even more so today).  Consequently, one can’t rule out this possibility.

However, it is also plausibly the case that the adoption of clearing would be wealth reducing.  In some sense, then, the heterogeneity-driven coordination cost externality story and the no externality story are observationally equivalent: both predict that market participants would not voluntarily cooperate to create a central counterparty.

To try to untangle the correct explanation of an incontestable fact–that clearing was not adopted voluntarily for the bulk of OTC derivatives transactions–it is necessary to undertake a fact- and context-intensive analysis, rather than play the superficial Pigouvian “I spy an externality” game and stop there, as AEFLS do.  And sad to say, by even getting to this point they are miles ahead of most of the advocates of a radical reshaping of financial market institutions, most notably those in the administration and Congress.

Via SeekingAlpha:

“One of the huge lessons of our work over the last few years has been how shockingly stupid incredibly smart people can be,” said Davidson, who with Blumberg has been reporting on the crisis for nearly two years as part of  National Public Radio’s  “Planet Money” team. “That includes bankers, regulators  and investors.”

OK, that’s a given. Lesser known is this: Our elected officials in Congress — the ones trying to reform our financial services industry as we speak — don’t really understand the issues at hand.

“We spent a day with the Financial Services Committee — Barney Frank’s committee — and it was an amazing experience,” Davidson said. “We talked to 13 congresspeople, 12 of whom admitted that they don’t understand this  at all. And the guy who thought he did really didn’t.”

It’s interesting, then, that these are among the folks calling for investor protections and significant financial reforms. And by “interesting,” I mean “anxiety-inducing.” I’m willing to give them the benefit of the doubt; their intentions are good, after all. But you know what they say about the road to hell.

NB: the directly quoted material in this excerpt is from two NPR reporters.  N. P. R.  Hardly the hotbed of libertarian firebrands.

Personally, I am far less forgiving than the authors of this piece (who are directors of the Maryland Association of CPAs). Anyone who, in full knowledge of their ignorance, nonetheless feels entirely justified in completely restructuring complex markets involving trillions of dollars at risk is a public menace.  A public enemy, in fact, all the worse because they presume to be performing “public service.”

Don’t do me any favors.  The greatest public service these people could perform would be to put away their wands, and stop playing Sorcerer’s Apprentice (or, more accurately, stop playing junior apprentices to Sorcerer’s Apprentice Barney Frank.)

In his megalomaniacal effort to use the financial crisis as a Trojan horse to advance his campaign “on every front to increase the role of government,” Barney Frank is hellbent on fixing things that demonstrably didn’t break.   Even under the extreme stresses of the crisis.   Case in point: he wants to require clearing of foreign exchange derivatives transactions:

If it didn’t break, why fix it?

That is the question being asked by foreign exchange bankers after Barney Frank, chairman of the House Financial Services committee, announced currency derivatives would not, after all, get an exemption from proposed US rules that would require all derivatives trades to be processed through a centralised clearing system.

Mr Frank’s move came as policymakers are debating the detail of legislative proposals designed to increase transparency and reduce risk in the vast over-the-counter derivatives market. While the proposals are not final, the U-turn on his previous stance has stunned the FX market.

Get used to it, guys.   Barney’s all about the u-turns, pace his volte face on clearing and exchange trading in his obviously thoughtfully considered OTC regulation bill.

The FX folks are point out some things I mentioned months ago, such as the fact that clearinghouses can concentrate risk, and therefore exacerbate systemic risks:

Bankers have also warned that clearing in FX could create new concentration dangers which they fear could create fresh systemic risk, given the size and significance of the FX market. The market is already concentrated among a handful of top international banks.

But it is Barbara Matthews that brings out the key point:

Barbara Matthews, managing director of BCM International Regulatory Analytics, believes there is a general issue to be considered about concentrating so many markets on to clearing platforms. She warned that policymakers must be aware that clearing houses could create new “choke points” in the system – not unlike the risk created now by any large bank – which must be considered carefully. “Its perfectly natural in a time of uncertainty to look towards some kind of central arrangement,” she said. “But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.”

That last bit bears repeating: “But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.”

Exactly right.   Those who have advocated clearing mandates–Geithner, Gensler, and Frank most prominently–commonly assert that clearing eliminates counterparty risk.

Wrong.   It doesn’t.   It reallocates it.

The only question is whether they know better and are lying, or are ignorant.   Either way, they selling a bill of goods, and as Barbara Matthews says, are laying the groundwork for the next nasty financial surprise.

Last week I wrote about one justification for exchange trading and clearing mandates–the market power argument.  This week I’ll examine another argument, and render a similarly skeptical verdict.

In a chapter of Restoring Financial Stability, Viral Acharya, Rob Engle, Steve Figlewski, Anthony Lynch and Marti Subrahmanyam argue that bilateral transactions in OTC derivatives markets involve an externality.  Their argument is not stated that clearly, but FWIW here it is verbatim:

[A]ll OTC contracts . . . feature collateral or margin requirements, wherein counterparties post a deposit whose aim is to minimize counterparty risk.  The deposit is marked to market daily, based on fluctuations in the value of the underlying contract and the creditworthiness of the counterparties . . . . The difficulty, however, is that such collateral arrangements are negotiated on a bilateral basis.  Parties in each contract do not take full account of the fact that counterparty risk they are prepared to undertake in a contract also affects other players; indeed, they often cannot take account of this counterparty risk externality in an OTC setting, due to inadequate transparency about the counterparty’s positions and its interconnections with the rest of the market.  While bilateral collateral arrangements do respond to worsening credit risk of a counterparty, such response is often tied to agency ratings, which are sluggish in capturing credit risk information and potentially inaccurate.

An externality means that some cost or benefit is not priced.  By invoking the concept of externality Acharya et al (“AEFLS”) are asserting that something–a bad in this instance–isn’t priced.  They are a very vague on just what this is, but here’s my interpretation of what they mean.

A firm that has already entered into financial contracts affects the risk exposure of its existing counterparties when it enters into new deals.  A firm that has a large number of commitments outstanding can enter into additional contracts that substantially increase its riskiness, thereby harming the incumbent counterparties.  The cost imposed on these incumbent counterparties isn’t, in this telling, priced.

This is, in essence, an asset substitution argument.  And indeed, asset substitution is always a concern in any credit relationship, whether it is between a bank and a borrower, or derivatives counterparties.

But an understanding of the way these markets work suggests that the asset substitution problem is far less important than AEFLS suggest.  One way of controlling this problem in lending relationships is to rely on short term debt, allowing repricing of old debt frequently and thereby limiting the gains from asset substitution.

In OTC derivatives markets, similar mechanisms are at work.  The main dealers rely heavily on short term financing.  Thus, attempts to engage in this type of behavior can lead to substantial increased financing costs, and indeed, a loss of access to short term funding altogether–this is a death sentence to a financial institution, as Drexel found out in the 1980s, Salomon almost experienced in the 1990s, and Bear and Lehman suffered during the crisis.

In fact, Diamond and Rajan argue that the “fragile” capital structure of financial intermediaries–the vulnerability to runs or other mechanisms that result in the rapid withdrawal of access to funding–are intended precisely to  provide such discipline.  Thus the supposed bug–the vulnerability of a big liquidity supplier to failure–is, in some respects, a feature.  Without it, the opportunism that AEFLS worry about would be a greater concern.

OTC dealers also trade derivatives extensively with one another.  Thus, changing creditworthiness can affect their ability to deal in these markets, and the pricing of these deals.

There are, therefore, mechanisms by which financial institutions internalize the costs associated with the riskiness of their dealings.  Of course, these do not work perfectly.  Of course, information is imperfect.  But it is essential to note that myriad lenders and counterparties are continuously interacting with big OTC dealers in a variety of different markets.  They are doing their own credit appraisals.  They are voracious consumers of any bit of information about other players in the marketplace.  The markets for funding and derivatives can serve to aggregate this private information in the prices and credit terms of derivatives trades, and in the funding costs that the institutions pay, thereby pricing (albeit imperfectly) counterparty risks.

Moreover, as Peter Klein pointed out in an earlier post on O&M, it is necessary to make an explicitly comparative analysis when evaluating policy alternatives.  The identification of an imperfection of the OTC market is not sufficient to conclude that it should be replaced by some other alternative that is inevitably imperfect as well.

In this regard, a comparison of the OTC market with the particular alternative that AEFLS advocate–central clearing–demonstrates that OTC markets arguably dominate clearing even on dimensions emphasized by AEFLS.

Most notably, clearinghouses almost NEVER condition margin levels on the creditworthiness of the member firms.  If they do (as, for example, LCH.Clearnet does in limited circumstances) they rely soley on agency ratings.  This reflects a variety of factors, including a lack of information to make such judgments.  Moreover, it reflects the fact that it would be very difficult, in practice, for a clearinghouse to discriminate among its members.  Such discrimination–which could have serious competitive effects–would expose the clearinghouse to intense influence activities.  (Thus, clearinghouses are most likely to work effectively when the members are homogeneous, and heterogeneity can be an impediment to their formation.)  This means that clearinghouses do NOT price counterparty risk in a discriminating way.  In a cleared market, a major determinant of counterparty risk is in the public domain, and not priced.  This is not conducive to an efficient allocation of trades among firms, or in the scale of trading activity.

In contrast, in the OTC market, dealers have a wide variety of sources of information about the creditworthiness of potential counterparties that they take into account when determining the terms on which they are willing to deal with these counterparties.  That is, although their information is imperfect, big dealers almost certainly have better information on the creditworthiness of other dealer firms than a clearinghouse would.  What’s more, the fact that any given firm is being evaluated by multiple counterparties and lenders means that (a) the private information aggregation mechanism noted before can work in the OTC market in a way impossible with a single evaluation by a clearinghouse, and (b) evaluation errors are somewhat diversified in the OTC setting, but with one monitor in a cleared market, if the clearinghouse gets it wrong the problem can be huge.

That is, counterparty information in OTC markets is imperfect, but almost certainly better than in a cleared market.  Moreover, there are a greater array of mechanisms available to price counterparty risk based on this information: not just in margins, but in the pricing of deals (many deals explicitly adjust prices to reflect credit terms), the pricing of the financing that dealers require to operate, and in the sizes of transactions.

I’ve argued extensively in some working papers that as a result of these information advantages, contrary to the claims of AEFLS, counterparty risks are likely to be priced MORE accurately in a bilateral market than a cleared one.  Clearing can offer some offsetting advantages, but the key point is that a trade-off is involved.  In my view, it is highly likely that this trade off frequently favors bilateral, OTC dealings rather than central clearing.

Like so many advocates of clearing, AEFLS fall victim to the Nirvana fallacy.  They point out imperfections in OTC markets, and do not carry out a comparative analysis of the relative imperfections of alternatives.  What’s more, their analysis of the supposed failings of the OTC market is incomplete because they do not fully explore how market participants structure their transactions to deal with the putative market failure they identify.

They’re miles ahead, though, of Barney and Chris and Timmy! and Gary and Mary and the gang.  At least AEFLS try to identify an alleged market failure.  Even though they fall into the classic Nirvana fallacy, at least they point out a potential inefficiency, thereby permitting an rigorous exploration and analysis of this possibility.  Which is way more than can be said for the Sorcerer’s Apprentices attempting to reorganize completely the largest and most complex financial markets in the world.

Cross posted on O&M.

All of the legislative proposals relating to over-the-counter derivatives would impose seismic changes on the way that these instruments are traded, and the performance risks related to them are managed.  Indeed, it is fair to say that these proposals, if implemented would dramatically shrink the OTC market, and perhaps destroy it altogether. Under either the House (Frank) or Senate (Dodd) bills, most derivatives would have to be traded on exchanges, and be cleared.  (Clearing is a way of mutualizing default risks.  At present, default risks in a particular contract are directly limited to the buyer and seller.)  (BTW, when you hear “Frank and Dodd” do you think Fannie Mae and Freddie Mac?  I do.  Does this inspire confidence?  Self-answering question.)   These efforts are strongly supported by Treasury Secretary Timothy Geithner, CFTC head Gary Gensler, and SEC head Mary Shapiro.

These legislative proposals are clearly predicated on a very strong belief: participants in the derivatives markets routinely chose the wrong institutional arrangements.  That this immense market is and was in fact arguably the largest market failure in financial history.

And these markets are indeed immense.  According to Bank of International Settlements data, notional (“face”) values of these instruments totaled $683 trillion in June, 2008 (right before the onset of the financial crisis), and their market values totaled $20 trillion (ballooning to $34 trillion by the end of 2008).

Moreover, these markets had grown dramatically over the years–at a double digit annual pace.  They also dwarfed the market for exchange traded (and cleared) derivatives.  The BIS reports that at the end of 2007, total notional values of outstanding contracts traded on exchanges were $28 trillion, which had shrunk to less than a mere $20 trillion at the end of 2008.  (I won’t go into the quibbles over the interpretation of these numbers, which make true apples-to-apples comparisons impossible.  Suffice it to say, difficulties of interpretation duly considered, the exchange traded markets are huge, but the OTC markets are HUGE.)

But our betters on Capitol Hill think that these collective results of the individual decisions of thousands of informed participants with major skin in the game are wrong, wrong, wrong.  They know better.  EVERYTHING should be traded on exchanges.  EVERYTHING should be cleared.  The emergent order is fundamentally flawed; a constructed one must be substituted for it by legislative fiat.

This assertion of systematic, immense market failure demands a coherent explanation.  It is, to be honest, quite hard to find one.  In this post and some that follow, I’ll examine some of the attempts at explanation.

Cliffs’ Note version of my conclusion: I’m still searching for a coherent story.

One of the most commonly heard stories is that OTC derivatives are enormously profitable for big banks due to the lack of transparency in the market.  Exchange trading and clearing would shrink profit margins, costing the banks big money.  So they have deliberately kept the market dark in order to enhance their market power and their profits.

Of course, all dominant incumbents want to maintain market arrangements that protect their market power and monopoly profits.  This is why GM is enormously profitable due its continued dominance of the automobile market.

Back to our regularly scheduled reality.

To justify the profit protection story, it is necessary to demonstrate the existence of entry barriers.  It is possible for banks to charge their customers supercompetitive prices persistently only if there is no possibility for competitors to undercut these prices (where the idea of “price” should be interpreted broadly to incorporate all of the costs that customers pay to trade derivatives.)  There are, however, strong reasons to believe that such entry barriers don’t exist, or aren’t sufficiently strong to explain the dominance of the OTC markets.

Let’s consider for a minute the legislative proposals.  They want to force trading onto exchanges.  They believe that this trading will be cheaper and more efficient due to greater transparency and competition, and share default risks more efficiently, than the current OTC markets.  But exchanges already exist.  For years they have been striving mightily to make inroads into the OTC derivatives markets.  Futures brokerage firms have also been trying mightily to market their services to the customers of OTC dealers.  Exchanges have launched head-to-head competition in many areas–and failed miserably in most of them.

If exchanges are really cheaper, because OTC dealer banks exercise market power and charge supercompetitive prices, why haven’t the exchanges made greater penetration?  Why haven’t they drawn business from the OTC dealers?  Why has the market share of OTC derivatives grown?

I’ll wait.  Barney?  Chris?  Tim?  Gary?  Mary?  [Humming quietly to myself.]

Put differently: the alternative market arrangement that the DC crowd says is more efficient and cheaper has been available to the allegedly poor, exploited customers of dominant dealers for years, and they’ve chosen to trade with the dealers nonetheless.  How to explain this?  Battered spouse syndrome?  Masochism?  It is a puzzle, no?

But it gets better.  There are many markets in which virtually identical products trade OTC and on exchanges.  In many of these markets, consenting adults knowingly choose to trade the uncleared, bilateral OTC contracts.  Why would that be if OTC markets are beset by market power that inflates the costs that customers pay?

Moreover, there are cases where clearing has developed organically in an OTC market without the benefit of a government mandate.  Most notably, clearing has grown dramatically in OTC energy derivatives since 2003.  This demonstrates that clearing can succeed competitively where customers want it.  This undercuts the idea that clearing (or exchange trading) is at an inherent competitive disadvantage relative to OTC dealer.  Ironically, and tellingly, this development has occurred precisely when the firms that dominate the OTC financial markets–e.g., Goldman Sachs, J.P. Morgan, Morgan Stanley, and other big banks–began to dominate trading in OTC energy derivatives.  How come they didn’t strangle the clearing baby in the crib to create and protect a privileged position in the energy markets?

In sum: there have been vigorous attempts of the putatively cheaper, more efficient exchange trading platforms to enter the market, suggesting that entry barriers do not preclude such competition.  These competitive efforts have often failed, and have certainly failed to displace OTC trading.  Where given a choice, customers sometimes choose cleared or exchange traded products–and oftentimes don’t.

Which calls into serious, serious question the received story as to why the inefficient, opaque, market-power ridden OTC market has survived and thrived. Instead, this “explanation” appears to be yet another of the many Just So Stories that have proliferated in the aftermath of the financial crisis;  a superficially plausible explanation that does not withstand scrutiny.

But on the basis of such Just So Stories, we are supposed to countenance the complete re-engineering of the world’s financial markets.

[Cross posted at Organizations and Markets.]

CFTC Chairman Gary Genlser continues to make concentration and diversity his primary justifications for expanding position limits:

I believe we should consider setting position limits to guard against excessive concentration in the energy futures market,’ said Gensler at a luncheon held by the Natural Gas Roundtable, a nonprofit organization.

The CFTC is weighing whether to set position limits — a maximum market share — for oil and other energy products. The agency already sets limits on agricultural contracts.

‘When the CFTC set position limits for certain agricultural commodities, the agency sought to ensure that the markets were made up of a broad group of market participants with a diversity of views,’ said Gensler.

This raises several questions.

First, what is the statutory basis for position limits designed to reduce concentration and increase diversity? I see none whatsoever.

The relevant statute–available right there on the CFTC’s website–makes it clear that position limits are for the purpose of reducing “excessive speculation” that causes unwarranted price changes:

Excessive speculation in any commodity under contracts of sale of  such commodity for future delivery made on or subject to the rules of  contract markets or derivatives transaction execution facilities causing  sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity, is an undue and unnecessary burden on interstate  commerce in such commodity. For the purpose of diminishing, eliminating,  or preventing such burden, the Commission shall, from time to time,  after due notice and opportunity for hearing, by rule, regulation, or  order, proclaim and fix such limits on the amounts of trading which may
be done or positions which may be held by any person under contracts of  sale of such commodity for future delivery on or subject to the rules of  any contract market or derivatives transaction execution facility as the  Commission finds are necessary to diminish, eliminate, or prevent such  burden.

It couldn’t be much clearer.  Congress has authorized the CFTC to fix trading limits “for the purpose  of diminishing, eliminating,  or preventing such burden [of “sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity”].”  Period.  Full stop.  Not a word about “concentration” or “diversity.”  Like Bart Chilton’s musing about “unintentional manipulations,” Gensler’s advocacy of position limits based on these concepts is completely unmoored from the law.

That is, “excessive speculation” that distorts prices can provide a legal basis for position limits; Gensler’s “excessive speculation” (with no attempt to connect such concentration to price distortions) cannot.

Second, what is the evidence that variations in concentration across markets affect market quality?  I am not aware of any.  That is, what constitutes “excessive” concentration?: how would we know when this level is reached?

Third, what does Gensler believe causes variations in concentration across markets?  Could there be fundamental economic considerations that affect the level of concentration?  Could it be that trying to micromanage concentration through position limits would impose costs because these limits conflict with these fundamental economic considerations.

Fourth, more generally, what are the costs of position limits (e.g., in terms of constraining risk transfer)?  Has Gensler made any effort to weigh the costs against his estimates of the benefits?

Fifth, what levels of concentration are problematic?  Under what theory?  What is the evidence that supports this contention?

Sixth, are there any markets that have reached this level of concentration?

Seventh, is there any evidence that position limits materially impact concentration?

In terms of what concerns concentration poses, concentration levels (per CFTC data) are not large as compared to, for instance, industrial concentration in most markets.  In crude and nat gas, 4 firm concentration ratios range between 25 and 40 percent, while 8 firm ratios are in the 30-50 percent range.

I think that Gensler’s clear desire to shift the grounds of the debate from the (legally required) “excessive speculation” issue to something else (the legally meaningless idea of “excessive concentration”) reflects the fact that there is clear lack of both logic and evidence to support any claim that “excessive speculation” has, in fact, caused “unwarranted” price fluctuations.  Lacking such evidence, Gensler is attempting to hitch a ride on the financial crisis.  As the article quoted above says,  “Chairman Gary Gensler of the Commodity Futures Trading Commission said the financial crisis last fall showed the risk posed by ‘large concentrated actors on the financial stage’.”  He provides no evidence that this concentration caused problems in the futures market even during the height of the crisis (which would, interestingly, undercut his argument that clearing is a panacea to systemic risk).  And even if it did, it still provides no legal basis for position limits, which must as noted above, can be imposed only “for the purpose  of diminishing, eliminating,  or preventing” undue price fluctuations caused by excessive speculation.

By repeatedly invoking “concentration” and almost completely ignoring the sole legal basis for position limits, Gensler may actually call into question the legitimacy of any position limit regulation the Commission does pass.  If Gensler really believes that concentration is a problem, he should advocate amendment of the Commodity Exchange Act to make concentration a justification for imposing limits.  By straying from statutory authority in his advocacy for position limits, Gensler risks becoming another out of control regulator attempting to ensure that no good crisis goes to waste.  He has a lot of company in that, but that’s no excuse.

The amendment that would have limited dealer ownership of clearinghouses to 20 percent  has been stripped from Barney Frank’s OTC derivatives bill:

In a bill passed last week by the House of Representatives’ financial services committee to reform the  over-the-counter derivatives markets, an amendment was inserted at the last minute by Massachusetts congressman Stephen Lynch that appeared to limit the stake banks could collectively own in a clearing house to 20 per cent.

. . .

Susan Milligan, special counsel at the OCC, said it was “purely anti-competitive” and would have favoured for-profit clearers compared with quasi-utility clearers like the OCC.

Steve Adamske, spokesman for the financial services committee, said on Thursday the 20 per cent limit had intended to limit dealer control of clearing houses but legal experts had decided it was invalid as it conflicted with another amendment.

The bill would, however, limit to 20 per cent the voting rights of dealers for “designated contract markets, exchanges and alternative swap execution facilities” – and not for clearing houses.

Wonderful, isn’t it, to observe the careful deliberation with which our Solons weigh decisions that affect trillions of dollars of risk exposures?  Just throw a bit of offal into the grinder–who’ll notice?  And at whose behest was this inserted?

Legislators react with high dudgeon to bankers’ cavalier attitudes towards risk and limited accountability, but they run far greater risks with other people’s money with virtually no accountability every day.  They have no room to talk.  Whatsoever.