Streetwise Professor

New York University Stern School of Business professors Aarya, Engle, Figlewski, Lynch, and Subrhmanyam (AEFLS) contributed a chapter advocating centralized clearing of credit derivatives in the recent volume Restoring Financial Stability: How to Repair a Failed System edited by Acharya and Richardson. Although the authors are a distinguished lot, they utterly fail to make the case. Here are a few of the problems with their analysis:

• Their argument rests on the propositions that (a) due to the interconnectedness of the financial system and the implicit public subsidy of systemically important financial institutions, the default by a CDS transactor can impose costs on others, and (b) a clearinghouse can internalize this externality. As a matter of logic, second best considerations imply that even if these propositions are true, they do not support the claim that creation of a clearinghouse (central counterparty) for some derivatives products is efficiency enhancing. As I discuss in more detail momentarily, AEFLS’s propositions imply that such externalities are present in every transaction that systemically important institutions undertake. In such circumstances, it is well known that internalizing one of many externalities can reduce efficiency, rather than improve it.
• Indeed, second best concerns may be most acute when a CCP addresses only one narrow segment of the market—e.g., CDS—as AEFLS do.
• Even under the AEFLS proposal of mandatory clearing of some of the risks that big financial institutions undertake (i.e., the clearing of only some derivatives), the CCP will only see a sliver of the risk exposure of its member firms. Given that overall portfolio risk determines the systemic risk posed by a financial institution, a CCP will have neither the information nor the incentive to price risk (through its collateral or position limit choices) efficiently (which would require understanding and pricing all of the externalities). Indeed, raising the price of default/counterparty risk on one sliver of transactions can induce banks to substitute to other transactions that impose equal or greater external costs. [The analogy to multitasking agents is apt here. Giving high-powered incentives to such an agent on one dimension can have extremely perverse effects on the allocation of effort. ]
• That is, the AEFLS argument proves too much. Or put differently, under the AEFLS theory, every loan, every investment, every dollar of interbank borrowing, every capital structure choice by a big financial institution is beset by externalities. Their logic, in a sense, compels them to conclude that market-based allocation of capital through financial intermediaries is inefficient, and that a centralized mechanism is required to ensure that financial institutions do not take on inefficiently large risks. Everything through a clearinghouse!
• Now, there is some merit to the view that in a world of Too Big To Fail or other implicit or explicit subsidies to bank risk taking that there are (potentially large) externalities. But the foregoing means that a CCP, and especially a CCP focused on a relatively narrow range of products, is a highly defective means of addressing this externality problem. It is defective because it is incomplete, and in a world with multiple externalities, or multiple decision margins with external effects, partial and incomplete internalization does not necessarily enhance welfare.
• Instead, if externalities in financial intermediation are an important concern, it is preferable to devise policies that either (a) eliminate the common source of the externalities (i.e., eliminate the TBTF subsidies that encourage the excessive risk taking), or (b) price all risks consistently across all decision margins and all decision makers. With respect to (b), this would entail theoretically setting capital charges or risk haircuts based on the entire portfolio of systemically important institutions. I say “theoretically” because measurement issues make this impractical. What’s more, institutions themselves will almost certainly have better information about portfolio risks, and crucially, the marginal contribution of a given transaction or class of transactions, to portfolio risks than will the regulators that set the capital charges/haircuts. This gives rise to adverse selection problems in which institutions load up on risks that they know are underpriced and avoid ones that they know (based on their private information) are overpriced. Moreover, as demonstrated with the Basel requirements that made it very attractive to invest in AAA CDOs, incorrect, centrally-set, universally applicable capital charges can induce institutions to engage in highly correlated investment strategies that exacerbate systemic risk.
• [Parenthetically, some (including the EC and the US Treasury) propose applying different capital charges to OTC and cleared deals. This is mystifying. If a deal with given characteristics is executed by financial institution A, the effect of that trade on default losses (across all deals that A does) is the same, regardless of whether the deal is cleared or not. Clearing merely affects the allocation of those losses. Indeed, the clearing can exacerbate the systemic consequences of A’s default. For in a clearing structure, the members of the clearinghouse bear the effects of A’s default, whereas in an OTC structure, counterparties do. Since CCP members are likely to be systemically important institutions, clearing can actually increase the financial cost of a default by A to these other institutions. That is, if A deals with hedge funds OTC and defaults, the hedge funds lose. If A deals with hedge funds, and those deals are cleared, when A defaults the hedge funds are protected, but the CCP members incur a cost.]
• AEFLS also fail to come to grips at all with the information asymmetries and heterogeneity-induced collective action problems that CCPs must face when setting collateral levels.  I’ve beaten that horse’s corpse to a pulp, so I’ll just suggest that those interested in the argument enter “clearing” into the search bar and while away too many hours reading what pops up.
• To put it as succinctly as I can, AEFLS ignore altogether any analysis of the challenging problem of understanding how CCPs will act in practice, given the information and incentive issues that they must confront.  Instead, as is sadly too often the case in CCP advocacy, in AEFLS clearinghouses are a deus ex machina that descends on the financial stage to resolve all of the dilemmas confronting the financial markets.
• AEFLS assert that it is desirable to establish margin levels that “ensur[e] minimal, near zero counterparty risk.” They have no basis whatsoever for concluding that zero CP risk is efficient. Indeed, it is almost certainly not the case, just as it is not the case that it is efficient to ensure that flying is perfectly safe. Reducing risk is costly. The necessary task is to balance the costs and benefits of risk reduction. For instance, in a clearing setting, setting margins equal to the maximum possible loss would eliminate counterparty risk. But collateral is costly. As a result of draconian margins, transactors would forgo some trades—including some trades that could reduce systemic risk (e.g., hedging trades that transfer risk efficiently). It is imperative to avoid such simplistic “zero risk” thinking of the type that AEFLS indulge in. The real world is about trade-offs, and those trade-offs must be acknowledged and considered in evaluating public policy.
• AEFLS recognize that they have to have an explanation as to why CCPs must be mandated if they are such a great thing. They make a rather limp effort on p. 258, stating that “[l]arge players benefit from the lack of transparency in OTC markets since they see more orders and contracts than other players do.” They seem to be arguing that the lack of transparency generates higher profits for dealer firms, and this induces them to resist clearing. Indeed, they have to argue that this private benefit from opacity is so large that it exceeds the benefits that these firms could obtain through better pricing of counterparty risk, netting, etc. (Not that I agree that these benefits exist—that AEFLS do is the point.)
• I made a similar argument over a decade ago, positing that resistance to clearing could be due to a “raising rivals’ cost” strategy.
• I am far from persuaded by these arguments, however, both on theoretical and empirical grounds.
• Theoretically, well hell, big players in every industry want to maintain market advantages that allow them to reap market-power profits. That’s why GM dominates the car business today, and is enormously profitable. Just kidding.
• Taking AEFLS seriously, they posit that the existing market structure inflates the costs of those trading with dealers relative to costs that could be achieved by trading in a more transparent structure. This creates an incentive for institutions offering more transparent mechanisms to enter the market, thereby reducing trading costs for the dealers’ current customers, and inducing them to trade on the new transparent mechanism rather than the more costly dealer market. Indeed, note that exchanges with central clearing have tried to compete with dealers in CDS trading—and failed miserably even in relatively simple index products.
• One could argue (though AEFLS do not) that this could reflect the effect of network externalities which create a coordination problem; an alternative system is more efficient than the incumbent (dealer) system if it attracts enough traders to supply liquidity, but it is costly to coordinate the necessary movement of such a number of traders, leaving the inefficient incumbent in place.
• However, in other segments of the derivatives market, there are exchange traded instruments that are close substitutes for OTC products, yet the OTC market has maintained or increased market share. Eurodollar futures and interest rate swaps are one example. Ditto many FX products and equity derivatives, including equity options. For these markets, there is a closely related, highly liquid exchange traded product, but many prefer to contract in OTC markets instead. Why would market participants agree to be screwed by dealers if the dealer structure is so inefficient, and if dealers profit at their customers’ expense due to opacity and reduced competition? It is incumbent on those advocating a forced change in market structure to answer that question forthrightly and persuasively. AEFLS don’t. Nor do most of the mandate mandarins in Congress, Treasury, or the EC.
• Relatedly, note that bilateral dealings prevail in many markets where margins are extremely thin, and dealer profits are commensurately small. For instance, bilateral dealings are quite common in vanilla interest rate and FX and equity derivative trades where spreads are very small. In vanilla IR swaps, about 50 percent of interdealer trades are cleared, and since dealer-customer trades are typically not cleared, less than a majority of vanilla IR swaps are cleared. Clearing of vanilla FX swaps is non-existent, and many equity derivative trades are not cleared. Given the competition in these markets (where a large number of institutions actively bid and offer to trade vanilla swaps), the “we don’t adopt clearing to protect profits” hypothesis is quite dubious.
• That is, although low margins appear to be a necessary condition to result in a migration of products to clearing, they are not a sufficient condition. This calls into question the theory that the failure to adopt clearing is the result of the exercise of market power by self-interested dealer firms looking to preserve their profits.
• It must also be noted that neither opacity or systemic risk externalities related to TBTF are necessary to explain failures to adopt clearing.  As I noted in an FTAlphaville article over the summer, the CBOT steadfastly refused to adopt clearing for 35 years even though it operated a highly liquid, transparent, centralized exchange.  The same was true of the LME; it failed to adopt clearing until forced to do so even though it also operated a transparent auction market.  Moreover, neither the CBT members nor the LME members were TBTF institutions benefiting from implicit or explicit public subsidies.
• The experience in energy markets, in which post-2003 (and post the 2002 merchant energy meltdown) the market by its own devices migrated to clearing also demonstrates that there are not insuperable obstacles to the organic development of clearing, sans mandate.
• Thus, a serious attempt to understand why clearing has not been adopted more widely by voluntary consent must at least contemplate the possibility that bilateral dealings offer some efficiency benefit that must be traded off against alleged external costs when determining whether compulsory adoption of clearing is justified. This AEFLS—and the rest of the mandate mandarins—signally fail to do.
• Several other issues in AEFLS deserve comment.
• First, they assert, rather than prove, that the correlation in financial institution CDS spreads demonstrates the existence of a contagion effect (p. 256—the use of the “interconnectedness” concept in this context is the key). This is a hypothesis (at best), not a fact. Exposure to a common risk can do so as well. Indeed, Jean Helwege (in a recent Regulation Magazine piece) argues persuasively that the contagion effect is vastly overstated, and the common-risk exposure effect is the real explanation for the CDS spread correlation that AEFLS discuss. As I mentioned before, virtually all major financial institutions made correlated investments in AAA MBS CDOs.  When these tanked, so did the banks (and AIG).  No need to invoke contagion.  Indeed, this raises the very real possibility that more centralization and standardization can increase systemic risks.  Since clearing entails just such an increase in centralization and standardization . . .
• Second, they use the difference between the CDS spread and an equity implied spread produced by Hayne Leland based on a particular model to argue for the existence of “counterparty risks and clearing concerns.” To which I say: when given a choice between the market and a model, I choose the market every time (with all due respect to Hayne Leland). Moreover, this could just be a manifestation of the market price of risk which causes deviations between default rates implied by CDS (which are the default rates in the equivalent, pricing measure) and default rates in the true, “physical” measure.  Given the non-linearity of a CDS exposure, and its strong correlation with overall market conditions, it is very plausible that the market price of risk was large and increasing during the period of the crisis.  (A CDS on a Goldman or other big financial firm was akin to a short put on the market.  Such an instrument has a very high systematic risk exposure, which will lead to a substantial divergence between default rates in the true and pricing measures.)
• Third, they use the AIG episode repeatedly. They ignore the equilibrium implications of the alternative histories that they contemplate (unlike what I have done in It’s a Wonderful Life: AIG Edition and in a recent comment in Regulation.) And again: the plural of anecdote is not data. Moreover, one episode is insufficient to base a restructuring of an entire system based on one episode, and even if this particular episode is so egregious, it is necessary to consider alternative ways of preventing its recurrence. This AEFLS do not do.

In sum, AEFLS fail completely in making a coherent economic case for mandated clearing, especially for a subset of OTC derivatives like CDS. They ignore crucial economic considerations and blithely overlook fundamental trade-offs. If there is a case for mandated clearing, I’d love to hear it. I haven’t heard it yet—least of all from this distinguished group of NYU-Stern professors.

So, here I lie, flat on my back, having taken a full-speed run at the derivatives regulation football, only to have Barney Frank snatch it back at the last minute during markup.  In contrast to the proposed OTC derivatives bill I praised a couple of weeks ago, the bill as passed by Frank’s committee includes both a clearing mandate, and an exchange trading mandate:

The committee, headed by Representative  Barney Frank, a Massachusetts Democrat, is set to complete action today on the legislation, which would require many derivatives transactions to go through central clearinghouses. The administration wants to subject broker dealers such as  JPMorgan Chase & Co.and derivatives users such as  American International Group to new margin, collateral and disclosure requirements.

. . . .

Frank plans to offer today an amendment that would mandate trading on exchanges or swap execution facilities for standard contracts between dealers and their biggest customers. Barr called that provision “essential.”

As I’ve written repeatedly, here and elsewhere, I believe that both of these provisions are deeply misguided.  I won’t belabor the argument, which the interested reader (or those suffering from insomnia) can find by searching the site or clicking the derivatives category link.   I will just say again that Frank is reinventing the wheel, as an exchange trading mandate was the magic bullet of derivatives reform in 1922.  It eventually proved unworkable, and will do so again–only much, much faster.

Raising the cost of managing risk will lead to greater risks.  It’s not that complicated.

Economics of Contempt (a lawyer and former Dem legislative aide) says that Frank sandbagged the dealers:

Frank really sandbagged the dealers with his exchange-trading amendment. The dealers support a central clearing requirement for standardized swaps, but not an exchange-trading requirement (with at least some justification). Frank’s discussion draft had only required central clearing, and then he surprised everyone on Wednesday with his amendment requiring exchange-trading. It was a politically savvy move if Frank was planning to require exchange-trading all along—don’t give the dealers time build up opposition to the amendment and it’s much more likely to pass. My sense is that Frank simply changed his mind at the last minute, for whatever reason.

“Changed his mind at the last minute, for whatever reason.”  A 180 degree turn at the last minute!  With no substantive reason given!  That’s the way to determine the fate of the world’s largest financial markets!  I feel so much better now.

Barney–I take back every nice thing I said about you.  Indeed, I’ve upped my grandfather’s exchange rate of attaboys taken away per attaboys given from 10 to 100.  Or 1000.

Many clearing/exchange trading developments in the news.  Unlike Barney and Geithner and Gensler and the clearinghouse mandate herd in the US, the Europeans are getting nervous about forcing things:

anks should be “incentivised” but not forced to shift privately-negotiated derivatives contracts onto exchanges to cut risk, the European Union’s executive will say next week, according to people familiar with the situation.

The European Commission is expected to publish a policy discussion paper on regulating the $450 trillion over-the-counter (OTC) derivatives markets on Oct. 20.

“I think they want to keep it a reasonably high level so they have room for manoeuvre. Expectations for October 20 were for more detail but the industry will be disappointed,” a source with knowledge of the paper said on Tuesday.

The largely unregulated market includes credit default swaps (CDS), which are used to bet on whether a company will default on its bonds and have been blamed for amplifying last year’s severe financial crisis that hammered economies worldwide.

The Commission published a preliminary paper in July which focused on the need for standardisation and central clearing of CDS contracts, saying the case has yet to be made on mandatory exchange trading.

“It hints at exchange trading by using the word incentivising transition to try to get more use of standardised products,” the source said of next week’s paper.

The July paper was more open on the issue of exchange trading, only saying it needed further study.

Incentives would likely comprise heavier capital charges on banks which trade OTC contracts that are not standardised or centrally cleared, the source added. Cleared contracts already have a zero weighting for capital requirements.

The latest paper is also expected to push for greater transparency and for a central data repository. It reflects global efforts to regulate derivatives and other lightly supervised parts of the system.

I critiqued the EU’s July report when it came out.  If this report is to be credited, the Europeans seem to have adopted the basic approach I have been advocating–more reporting, no clearing mandate.  But then, I said that about Barney Frank too, so I’m not holding my breath.  In any event, I will read the EU report that comes out tomorrow with interest.

The “incentivizing” approach has some problems too, though.  “Holding more collateral”  is a very general concept.  The key thing is choosing just how much, and how much that varies across products, and crucially–since collateral is all about counterparty risk–how much that varies across counterparties.  Choosing the wrong levels, and choosing the wrong relative collateral levels across deals and counterparties can make things worse rather than better.

The collateral rules will induce gaming and strategic product design to mitigate collateral impacts.  Moreover, as demonstrated in the case of “AAA” CDOs, incorrect choices of capital haircuts can lead financial institutions to take highly correlated positions (i.e., hold essentially the same instruments because their capital charges are too low) that actually exacerbate systemic risk.  Moreover, it is important that relative collateral charges be appropriate across cleared and non-cleared products.  If non-cleared products are charged too much, it could increase the risks that clearinghouses face, and if they don’t price their risks properly, this can also contribute to systemic risk.

I am deeply, deeply skeptical that regulators have the information and knowledge necessary to set these charges.  This is a price fixing exercise.  When have governments EVER demonstrated that they have the information, knowledge, and incentive to set the levels of prices properly, or to set relative prices properly?  “Hold more collateral” sounds great in theory, but is a real source of potential systemic risk when one remembers that you have to specify exactly the amounts of capital every market participant must hold against every instrument, and when one remembers further that setting them wrong can be worse than not setting them at all.

Looking backwards to fix the causes of earlier crises frequently results in a failure to comprehend how the supposed “fixes” lays the groundwork for the next crisis.  Regulation of collateral levels could well do just that, in the same way as Basel capital requirements were a major contributor to the last crisis.

In one last piece of clearing news, the Frank bill also attempts to micromanage the organization, ownership, and governance of clearinghouses:

Derivatives legislation approved by a U.S. House panel yesterday would prohibit swaps dealers such as  Goldman Sachs Group andJPMorgan Chase & Co. from collectively owning more than 20 percent of a clearinghouse.

“An inherent conflict exists between broker dealers and clearinghouses and exchanges,” Representative  Stephen Lynch said when he introduced his provision on Oct. 14. “Brokers and dealers should not be able to capture trading and clearing intermediaries.”

. . . .

The amendment on clearinghouses would restrict swap dealers, “major swap participants,” and any “person associated with a swap dealer or major swap participant” from collectively controlling more than 20 percent of the voting rights in a facility used to clear derivatives contracts. It also would limit membership on boards of the clearinghouses and establish other rules aimed at limiting conflicts of interest.

This restriction on ownership and governance could have serious unintended consequences.  Remember what clearinghouses are.  They are mechanisms to share risk–default risk, in fact. It is well understood that there is typically a close relationship between control rights and cash flow rights/risk exposure (e.g., the ubiquity of 1 share-1 vote).  This makes good economic sense (as Grossman and Hart demonstrated years ago).  A mismatch between risk exposure and control rights means that those with the control don’t bear the full costs of their decisions: the risk is borne by others.  That is a recipe for excessive risk taking and other distorted decisions.

The traditional clearinghouse involves big intermediaries sharing counterparty risk, and since they bear the risk, they control the entity.  This suggests that there will likely be an equilibrium response to the proposed restriction on control rights; firms whose control rights are limited will likely similarly limit the risk exposure they are willing to take.  So, if the big dealers and major trading firms (e.g., hedge funds) that are deemed major swap participants are limited in the control they can exert, they will almost certainly similarly reduce the risk that they will absorb.

If these big dealer firms don’t absorb the risk, who will?  What alternative risk sharing model does the committee have in mind?  I am highly skeptical that the traditional clearinghouse mutualized risk sharing model will work with this governance model.  So what risk sharing model will be used instead?  Will public shareholders bear the risk (through their equity investments)?  That is, will clearinghouses become more like stock insurance companies, rather than mutuals?  Is this wise, given the survival value that the mutual model has demonstrated in clearing over the years?  (If sharing of default risk through the equity markets was the wise thing to do, why hasn’t this been utilized more in the past?)

And the big question: Is there the slightest reason to believe that those who proposed and voted for this restriction have thought even superficially about its consequences?  (I amuse myself sometimes.)

Here we have the spectacle of people who probably hadn’t even heard of clearing a year ago presuming to impose by legislative fiat the most detailed rules specifying what must be cleared, how it must be traded, and how the clearinghouses are organized to do their business.  These decisions will have huge consequences, almost certainly all of them unanticipated and unintended.  And many of these unintended consequences will almost certainly be adverse, perhaps extremely so.

Again, the metaphor of the Sorcerer’s Apprentice comes to mind.  These people think that they are in control, but they are not: they are in fact unleashing forces beyond their control, and the effects are not likely to be good.

Exactly 36 minutes after I wrote this:

At least Barney Frank has made a step towards understanding the intricacies of something as complex as clearing.  Would it be too much to hope that he keeps pulling on the string until the entire case for clearing mandates unravels?  Probably.

Matt Leising at Bloomberg sent me this:

Legislation proposed by U.S. Representative  Barney Frank would weaken an Obama administration  guideline requiring the most common private derivatives to be traded on exchanges or regulated systems.

The Massachusetts Democrat, who heads the House Financial Services Committee, released a  draft bill Oct. 2 that allows for no change in how standardized over-the-counter derivatives are currently traded as long as they are reported to regulators. The Obama plan, released in August, specifies “mandatory trading” on exchanges or swap-execution platforms that would have to be registered with the Commodity Futures Trading Commission or the Securities and Exchange Commission.

“Nothing will really change” the way trades are executed under Frank’s draft proposal, said  Kevin McPartland, a senior analyst in New York at TABB Group, a financial-market research and advisory firm. “There’s no reason, at least that I can see, why anybody would go to an exchange.”

Moreover, Frank’s proposed bill does NOT mandate clearing, although it does empower the CFTC to require clearing of some contracts:

The Commission shall monitor swap activity and transaction data  and by rule or regulation identify specific swap contracts that it determines are required to be cleared  consistent with the public interest, after taking into  account the following factors:

[List omitted.]

I keep having this mental image of Barney Frank falling off a horse on the way to Damascus.

In brief: no clearing mandate, but mandated reporting of derivatives trades to a central data repository.  Just what I’ve been advocating on this blog, and in my writings (such as here).  CFTC has the power to mandate clearing, but that’s a far different thing than a Congressional mandate.

Color me shocked.  Pleased, but shocked.

But not everyone is pleased.  CFTC Chairman Gary Gensler for one is put out by the lack of a clearing mandate:

Gary Gensler, the CFTC chairman, said he was concerned about a provision in the legislation to require securities and futures regulators to determine on a contract-by-contract basis whether a particular swap needed to go through a transparent clearinghouse.

“I believe it is best for a clearinghouse that is managing its risk to determine if a particular product should be cleared,” he commented.

Gensler pointed out that an Obama administration proposal for derivatives regulation has a presumption that if any standardized product was accepted for clearing, it and all future iterations of the product must go through a clearinghouse, which is an intermediary between the buyer and seller of the swap.

Gensler and legislators support permitting tailored swaps to continue to trade on the over-the-counter market as long as they meet new reporting, record-keeping and capital requirements.

The CTFC official also took issue with a measure in the Frank proposal that he believes could exempt a broad range of entities from the definition of “major swap participant” and help them avoid regulation.

“The discussion draft, perhaps inadvertently, widened this exception such that the major swap-participant category would exclude any entity entering into a swap for risk-management purposes,” Gensler said. “This could have the unintended consequence of exempting a broad range of entities from the definition of a ‘major swap participant’ and thus exempt such entities from regulatory requirements outlined in the proposal.”

I’d say I feel your pain, Chairman, but I’d be lying.

I am still astounded at this development.  Now if only Geithner, Gensler, Collin Peterson, the Senate Finance and Ag Committees, etc., see the light and experience their own conversions we’d be really getting somewhere.  Hey, a boy can dream, can’t he?  I mean, if Barney Frank comes around to my way of thinking, anything is possible.

Needless to say, I doubt there are many things that Barney Frank and I agree on.  There is still great potential for mischief in a lot pending before his committee.  But, for now I will avoid what my inimitable grandfather called “handing out attaboys one at a time and taking ’em back five at a time.”

For now, I’ll just say: ‘attaboy, Barney.

It seems that some in Congress are slowly making it down the clearing learning curve:

Manufacturers such as  Caterpillar Inc. and  Apple Inc. wouldn’t have to post extra cash as collateral for hedging transactions under legislation proposed to tighten oversight of the $592 trillion derivatives market.

The draft bill released by House Financial Services Committee Chairman  Barney Frank on Oct. 2, drawn from Obama administration proposals, would require the most common and actively traded over-the-counter derivatives contracts to be bought and sold on exchanges or processed through a regulated trading platform. It would impose new rules and collateral requirements, except on so-called end users such as Caterpillar.

. . . .

The draft would expand the administration’s exemption of end-users from collateral and clearing requirements. The administration proposal, released Aug. 11, would give a dispensation only to companies that use so-called hedge accounting. Frank’s proposal would exempt all end-user transactions and would let companies post non-cash items as collateral to satisfy margin requirements, Coleman said.

In brief, the new proposal would not require clearing for any deal in which one of the parties was not a swap dealer.  This is an improvement.  I’ve been arguing here on SWP, in my academic research, and my recent paper for Brookings that the cash flow and liquidity demands that clearing and daily mark-to-market impose are very onerous for hedgers and other market participants.  It seems that corporate end users were able to get that message through to Frank.  Good for them.  It also suggests that there may be a glint of understanding–albeit only a glint–that OTC market arrangements have some economic benefits, and are not instruments of the devil.

But it appears that dealers will be required to clear inter-dealer transactions.  This raises many questions, which if addressed forthrightly, would undermine the case for mandate.

Dealers certainly have had the ability to form inter-dealer clearinghouses in the past.  Why haven’t they?  The common story is that they like non-cleared deals because they profit at the expense of their customers from the lack of fungibility and liquidity.  But that argument holds no water when it comes to purely inter-dealer trades.

More fundamentally, a major fear relating to OTC markets is that the interconnections among dealers are systemically risky.  That is, because of all the inter-dealer trading, the default of one dealer affects the financial condition of others.

But, how does inter-dealer clearing change that?  Default losses are shared among dealers now because they trade with one another.  Default losses will be shared among the same dealers via a clearinghouse.

Moreover, the sharing mechanisms are different in a crucial way–that does not favor clearing.  In a bilateral market, if dealer X defaults, those who trade with X may suffer losses.  In a cleared market, if dealer X defaults, those who originally traded with it do not bear all the loss: it is shared among all the other members of the clearinghouse.  This reduces the incentive of market participants to monitor X’s creditworthiness, because they are not on the hook directly for the entire amount of counterparty exposure they create by trading with X.  The clearinghouse monitors, but as I’ve argued repeatedly (a) the clearinghouse is unlikely to have as good information as the other dealers, and (b) its incentives are weaker because it is a delegated monitor subject to low power incentives.

There’s another landmine hiding here that hasn’t drawn attention.  Note that the members of a clearinghouse recognize that they have delegated their risk exposure to somebody else: the clearinghouse and other clearinghouse members.  They recognize further that the clearinghouse mechanism thereby creates a moral hazard.  What is the conventional response to such a problem?  To limit recourse.  That is, clearinghouse members will limit the risk exposure that they will take on from the clearinghouse.  This is true of every major clearinghouse: the losses that members have to absorb are limited.

Put it all together, and you realize that (a) moral hazard and monitoring issues can lead to poorer control of counterparty risk, and (b) the limitations on member contributions means that a clearinghouse could well fail because of a loss that exceeds the amount of capital its members are obligated to commit.

Thus, the mandate for inter-dealer clearing doesn’t make any sense either.

In fact, one of the main virtues of clearing is that it increases the fraction of their contractually promised payments that non-members receive.  Note that the Board of Trade Clearing Corporation always used to say that no CUSTOMER had ever suffered from a default loss, not that no member had ever suffered from such a loss.  Inter-dealer clearing slices and dices risks differently; it does NOT eliminate them.  Indeed, it can (due to the moral hazard and adverse selection problems) lead to an accumulation of greater risks, and a less efficient allocation of those risks, than is the case in a bilateral market.

In other clearing news, CFTC Chairman Gensler made some interesting remarks in an interview with Futures Industry Magazine (registration required).  Interesting, but misguided.

First, he comes down to requiring clearinghouses take deals from any execution platform: he says clearinghouses should “not be so inextricably linked to an exchange.”  As I’ve argued for several years on SWP and in my academic writings, basic transactions costs considerations likely make vertical integration of execution and clearing economically efficient.  The argument that this arrangement impedes competition (which Gensler makes) fails on traditional Chicago grounds.  It is certain that there is neither persuasive theory nor convincing evidence that would support as radical a step as Gensler advocates.

Second, Gensler advocates that clearinghouses should be open access in the sense that “membership is open to the non-dealer community” and that clearinghouses should have “open governance” in which non-dealers would have a voice.

Now, I’ve shown in some academic writing that closed membership can be exploited to permit the clearinghouse to in effect cartelize a market, so I am somewhat sympathetic to the idea of open access.  However, I’ve also shown in my academic work that membership heterogeneity can be very, very costly.  It increases the costs of governance because it is necessary to accommodate more diverse preferences and interests.  Moreover, heterogeneity means that it is possible to redistribute wealth among the different members through pricing policies, and in the case of a clearinghouse, margin and capital requirements.  To mitigate rent seeking, cooperative organizations like a clearinghouse with disparate members will (a) implement very low-powered incentives, and (b) erect intricate, formal, and cumbersome governance mechanisms (e.g., committee-dominated decision making).  These arrangements are costly.  Thus, requiring open access and open governance would have unintended consequences: clearing organizations would be sluggish organizations with weakly-incentivized managements.

As always, there are trade-offs.  The question is: who is best situated to evaluate these trade-offs?  I think that it is far more efficient for government to let market participants decide on their own arrangements, and limit its interventions to situations in which these cooperative arrangements stifle competition.  Government is ill-suited to evaluate the costs and benefits of alternative ways of sharing risk–including counterparty risk–and of organizing and managing specialized organizations like clearinghouses.  Barney Frank and Gary Gensler should leave these tasks to people who have the expertise and internalize the costs and benefits, and limit the government to policing anti-competitive behavior by collective organizations like clearinghouses.  And even there, a considerable amount of circumspection is in order, for as Ronald Coase pointed out long ago, not every non-standard form of organization or arrangement is necessarily anti-competitive in nature.  It may be designed instead to economize on transactions costs.

At least Barney Frank has made a step towards understanding the intricacies of something as complex as clearing.  Would it be too much to hope that he keeps pulling on the string until the entire case for clearing mandates unravels?  Probably.

Sophia Grene has a nice article in the Financial Times about my post on “Dark Pools.”

Congressional proposals regarding derivatives on carbon dioxide subject these products to the most onerous regulatory regime: they require trading on exchange, just like derivatives on agricultural products.  This probably reflects the fact that those legislators who are most concerned about carbon vapor are the same ones who get the vapors from derivatives.

The International Emissions Trading Association has warned against such a cramped regulatory regime:

The rules for buying and selling pollution credits under a proposed U.S. “cap-and- trade” program shouldn’t be tougher than those being debated in Congress for other markets, the  International Emissions Trading Association said today.

Geneva-based IETA, whose members include  Chevron Corp.,American Electric Power Co. and  Goldman Sachs Group Inc., said in a  report that “future financial services reform legislation should supersede the carbon market oversight provisions” of any cap-and-trade legislation that passes Congress

. . . .

Some lawmakers have expressed concern that a new U.S. carbon market may be more vulnerable than others to manipulation and fraud. They are considering special rules for the cap-and- trade program that would restrict OTC dealing in futures and other derivatives contracts, block the involvement of banks and impose price controls.

‘Out of Step’

These proposals are “out of step” with the new regulations being considered for other markets, IETA said. The group said concerns over manipulation and fraud can be dealt with through “stringent disclosure requirements of all OTC transactions” to the Commodity Futures Trading Commission.

The group said while lax oversight can enable fraud, “overly cumbersome oversight rules can discourage market participation, stifle investment, raise compliance costs, and threaten the program’s environmental performance.

The IETA concerns are quite sensible: the very onerous regulations in the Waxman-Markey (ACES) bill are not.

I’ve written in detail about the problems with the ACES regulatory scheme in a piece for the Brookings Institution that will be coming out in a volume later this fall.  It is available online now (follow the link).

Here are some of the arguments I make there, in brief:

Manipulation of carbon derivatives would not be impossible: even though the costs of delivery are theoretically zero (involving only book entries), just as in Treasury markets there will be frictions that can be exploited by a manipulator.  However, it is better to deter such manipulations ex post than attempt to prevent them by imposing tight trading regulations.

Moreover, an exchange trading requirement will prevent many market participants from realizing the risk management benefits of derivatives.  Most firms that face carbon price risk (in the event of the adoption of a cap and trade scheme) will face long-lived exposures that interact in a complex way with other risk exposures.  For instance, in a cap and trade world a power plant faces risks from power prices, fuel prices, and the quantity of power generated, as well as carbon prices.  Moreover, these exposures are likely to be non-linear in nature (due to the options inherent in plant operations, like the ability to turn it on and off, and perhaps fuel switching options).  In addition, they are likely to be very long-lived, because the plant is long-lived.

In contrast, most liquid exchange traded derivatives are simple, vanilla, linear products (forwards) with short maturities, or simple vanilla options with shorter maturities.  These are not well-suited to managing the complex risks that many carbon-intensive companies are likely to face.

Furthermore, the costs of rigid mark-to-market collateralization are high, and many market users could avoid these costs by trading customized OTC products.

This all means that requiring only exchange trading of carbon derivatives is likely to greatly increase the costs, and reduce the effectiveness, of carbon price risk management.  This will force firms exposed to carbon risk to bear risks that cost more for them to incur than it would cost the potential counterparties of customized derivatives.  By impeding efficient risk transfer, onerous regulations will increase the costs of a cap and trade system.

This is bad public policy.  Congress should be looking for ways to mitigate the costs of a CO2 trading system, not increasing them.  Impeding carbon risk management would do just that.

Regulators seem really, really scared of the dark.  Members of Congress speak in ominous tones about “dark markets” when referring to OTC markets.  Another “dark” subject that has been the subject of horror stories in the recent past–“dark pools”–is making a reappearance.  Last week the Federation of Securities Exchanges wrote a letter to regulators demanding that dark pools be regulated more extensively, and that measures be implemented to move more trading onto exchanges.  In today’s FT, Jeremy Grant reports on regulatory pique at dark pools:

Dark pools operated by banks should improve pre and post-trade transparency and should operate under a more formal structure, the head of Europe’s umbrella group for securities regulators has said.

The comments, by Eddy Wymeersch, chairman of the Committee of European Securities Regulators, are the first by a top regulator since a spat has developed between the banks and some of Europe’s biggest exchanges over the bank’s “crossing networks”, a type of dark pool. Dark pools allow the matching of large blocks of shares without prices being revealed until after trades are completed.

Regulators on both sides of the Atlantic are studying them amid questions over their transparency.

. . . .

Mr Wymeersch said bank dark pools should “at least have post-trade transparency and also, if possible, have pre-trade transparency. They should organise themselves as MTFs, or something similar”.

“It’s a question of reliability of valuation in the entire system,” Mr Wymeersch told the FT at a European Commission conference on over-the-counter derivatives in Brussels.

He said he was “concerned” at the amount of off-exchange equities trading that takes place on crossing netwo

The criticism about dark pools relates to issues of transparency and fragmentation.  It is commonly argued that by fragmenting trading and liquidity, and in particular by siphoning off relatively uninformed order flow, dark pools degrade price discovery on exchanges.

This may be true, but it raises the question as to why it would occur, and if it is necessarily inefficient (relative to realistic alternatives).  I’ve written about this a good deal in my academic research, including a paper published in the Journal of Law Economics and Organization, another in Regulation Magazine, and a couple of working papers, and have raised some issues that most policy discussions overlook.  I’ll try to recap them briefly here.

Dark pools are essentially venues where large traders send orders in the belief that their orders would have a smaller price impact if executed in the dark pool, than if submitted to the exchange. That is, these traders believe that their orders will be less costly to execute.

That is quite possible if dark pools operate effective mechanisms for screening out relatively informed traders.  The crossing networks described above are one way of doing that.  Those submitting orders to crossing networks are not guaranteed an execution; only if there is a contra order that can be matched will the order be executed.  Moreover, crossing networks frequently cross orders periodically, rather than continuously.  These features are unattractive to an informed trader.  If I think I have very good information, I want to make sure that order is executed.  Moreover, if the information is likely to become public shortly, I don’t want to take the risk it will come out before the next cross.

This means that crossing networks can help separate uninformed block traders from informed traders.  As a result, the crossing network is less susceptible to adverse selection; this tends to reduce price impact of large orders.

In this respect, dark pools that screen out informed traders in order to reduce trading costs for large, uninformed traders (e.g., index funds) are no different than upstairs block markets that have been around for decades.  Upstairs block trading was a way of reducing execution costs by screening out the informed: if somebody “bagged the street” and traded a big block right before information was released, that somebody wouldn’t be able to trade blocks again anytime soon.

Theoretically, this “cream skimming” makes markets that don’t screen less liquid: there are fewer uninformed traders (because some have been skimmed off by the dark pools) on the exchanges that don’t screen, so adverse selection problems are more severe there.

Similar issues arise in other activities that draw regulator suspicion, such as payment for order flow and internalization.  Market makers like to internalize orders that they know are less likely to be informed, and send the others onto the exchange.  Similarly, they buy order flow that is likely to be uninformed and execute those orders.

In a world where exchanges are perfectly competitive, this cream skimming would be inefficient because it causes an negative externality imposed on those who trade on exchanges.  But that’s not likely to be the real world in which we operate.  Traditionally, exchanges limited participation (for instance, the number of members on the NYSE didn’t change from 1929 on–it remained at 1366, if memory serves, during that entire period).  Entry barriers reduce competition in market making.  Now, exchanges likely have some market power due to the network effects of liquidity, and can exploit that market power by charging supercompetitive prices.

My academic work shows that in such a world, cream skimming (e.g., the formation of dark pools) is profitable, and what’s more, it can improve efficiency in the sense that it reduces total investor trading costs.  Those that trade on exchanges are made worse off because their trading costs go up, but the execution costs of those who can take advantage of the third market that screens out the informed fall by a larger amount.

These effects occur because the competitive impact of dark pools more than offsets the negative externality.  Dark pools (and other off-exchange venues) enhance competition, reducing deadweight losses arising from market power.

Moreover, dark pools/third markets can reduce the return to informed trading.  Since some expenditures to become informed are pure rent seeking (the informed just extract a rent from the uninformed), reducing the incentive to collect information reduces rent seeking costs.

Thus, the pros and cons of dark pools or other off exchange trading venues that “fragment” trading depend crucially on the competitiveness of exchange trading.  Given that the network effects of liquidity are likely to confer market power on a dominant exchange, it is quite possible, and indeed probable in my view, that dark pools/third markets/off-exchange trading venues are a “second best” response to this market power.  If this is the case, constraining third markets/dark pools may just enhance exchange market power by disabling their competitors.  No wonder exchanges are the most outspoken in their criticisms of dark pools, and the biggest cheerleaders for more regulation.  Go figure!

Put differently, dark pools and other off exchange venues compete against exchanges, and since exchanges are likely to possess market power, this competition can improve welfare even if these dark pools create a negative (liquidity) externality.  That is, the arguments against dark pools focus on the negative externality, which would lead to inefficiency if the market were otherwise perfectly competitive.  But once deviations from perfect competition are admitted, the efficiency case against dark pools and other off-exchange venues fails.  The cost of externality may be smaller than the benefit of greater competition.

This means that any evaluation of the effect of dark pools, and the costs of benefits of alternative regulatory actions, is an inherently complicated exercise.  You can’t just say, “dark pools create a negative externality” and stop there.  You have to evaluate the trade-offs between the liquidity externalities and the competitive effects.  This is a very challenging task, and one that is likely beyond the capability of regulators to get right.

Suffice it to say that the complaints of exchange operators about dark pools should not be taken at face value.  Their gripes are self-interested.  Hobbling dark pools would reduce the competition they face.

Getting market structure right in securities markets is hard because of the network/liquidity effects.  Ham-handed regulatory interventions based on simplistic analyses of externalities and transparency are likely to make things worse, rather than better.

The CEO of the Australian Stock Exchange (ASX) hit the nail on the head.  Hell, he drove it right through the board:

The chief executive of the Australian Securities Exchange has criticised the Obama administration’s planned regulatory reforms of the US financial system, arguing they are “draconian” and out of touch with market developments.

Robert Elstone, head of the  ASX, said the reforms were too broad, targeting parts of the securities markets – such as the over-the-counter swaps market – that had not been big contributors to the global financial crisis. [Emphasis mine.]

Emphasized, because true.

More truthiness:

The best hope for regulators and governments, he said, was to develop market-oriented people and market-oriented skills to stay abreast of developments in the securities industries.

The OTC swaps market was already transparent, he said, adding that to compel that market to come “on exchange and be centrally cleared” was “overkill”.

“Compel” is the key word.  If somebody builds it, and the market comes, more power to them.  It’s the compulsion in the near complete absence of a plausible, let alone convincing, identification of a market failure that is deeply troubling–and the recipe for future trouble.

Legislators should be forced to watch this line played before their eyes, A Clockwork Orange-stye, until it penetrates their skulls:

“I think that the notion that any corporate or government regulatory agencies are always going to be one or two steps ahead of the market is a flawed notion.”

That’s worth repeating:

“I think that the notion that any corporate or government regulatory agencies are always going to be one or two steps ahead of the market is a flawed notion.”

Right now our generals in Washington are assiduously deconstructing the last war.  Not a good way to prevent the next one.  Especially inasmuch, as Mr. Elstone notes, they aren’t even properly deconstructing the last one.

Where’s our Robert Elstone?  Nowhere to be found.  Not in DC anyways.  And today, that’s where it matters.

I’ll be speaking on a panel on Systemic Risk and Speculation at the CME this afternoon at 2PM Central.  The event will be webcast.  Here’s the link.  Click on the grey box on the right-hand-side of the page to get to the webinar: registration is required.  The panel should be quite interesting.

I am in Hong Kong for the next couple of days.  (By the way, what day is it anyways?)  Consequently, posting will most likely be erratic, and certainly phase shifted by about 12 hours.  Day shall become night and night shall become day, at least insofar as the SWP schedule is concerned.

I am in HK speaking about central counterparties/clearing at the SWIFT SIBOS 2009 event.  In my few hours here, the city has impressed me.  The view from my hotel over the harbor is quite amazing.  The SIBOS event promises to be fascinating.

And . . . who will submit comment #3000?  Currently at 2991 and counting.  A free SWP t-shirt (yes, there is such a thing) to the submitter of #3000 (if you are brave enough to reveal name and address, LOL).  Domestic shipping only;-)