Streetwise Professor

In the Second World War, the UK and US used “Huff-Duff”–high frequency direction finding–to determine the location of U-boats by triangulating their radio signals.  In modern finance, “high frequency” is all about high frequency trading, but it is a form of Huff Duff; high frequency traders are attempting to determine the direction of prices by homing in on signals present in high frequency financial price data.

Financial Huff-Duff–or “HFT,” for “High Frequency Trading”–is currently a source of intense controversy.  This type of trading allegedly accounts for billions of dollars of profits by big trading houses that invest vast sums in high power computers co-located on exchanges, and sophisticated algorithms designed by equally high power quants and programmers.  There is widespread concern that HFT is fundamentally unfair, and allows the big houses to take advantage of other market participants.  There is also concern that this type of trading is nothing but an arms race that throws substantial real resources for a merely relative advantage; that is, it is rent seeking that does not improve resource allocation.

HFT does provoke numerous interesting questions. A back-to-basics approach might help light on some of these issues.  These thoughts are preliminary, but try to apply some basic finance concepts at a high level to get a better grasp on the costs and benefits of HFT.

Specifically, I think it is valuable to use market microstructure theory to analyze HFT as a form of automated market making.  (Historical sidenote: Fischer Black raised the possibility of automated “specialists”–i.e, market makers–over 40 years ago.  Another testament to how forward looking Black was, and how wide-ranging his mind was.  Although the Black-Scholes model is his most well-known contribution, he made many others as well, all by applying in a very careful way basic economic and finance principles to very complex problems.)

It is well known that market makers face a fundamental problem: they are vulnerable to being “picked off” by other traders with better information.   That is, market makers face an adverse selection problem that imposes losses on them when they trade with the better informed.  Thus, market makers attempt to condition they prices at which they are willing to buy or sell–their quotes, or bids and offers–on the best information they have available, and in so doing incorporate a margin that compensates them for the losses they expect to incur by trading with the better informed.

One way market makers obtain information is by examining the order flow.  Order flow can communicate valuable information.  Indeed, one of the advantages of being an NYSE specialist was preferential access to order flow information.

One thing that HF traders do is apply algorithms to try to extract information–signals–from the vast amounts of orders flowing through electronic markets.  Some information from the order flow in one stock is useful in determining the value of that stock.  The information in the order flow in one stock may also be useful in determining the value of other, related stocks.  For instance, information in the order flow on ExxonMobil might help predict the value of Conoco stock.

By trolling through vast amounts of order flow and quote information very quickly, and applying algorithms that have proven successful in extracting information signals from this torrent of data, HF traders enter or alter quotes into the marketplace.  Some of the orders are entered in a single market.  Some are entered into multiple markets.

That is, they do what human market makers do, but just a lot faster.  They extract information from order flow, and use it to adjust their quotes.  They are, in essence, the automated specialists that Fischer Black described in the 1960s.  It just took 40+ years for computing technology and the automation of markets to catch up to Fischer’s vision.

Speed can be very important in this regard, as one of the major risks that market makers face is the “stale quote” problem.  A market maker that enters a quote and doesn’t change it when new information arrives is at risk of having that order executed at a very unfavorable price.  Manual market makers can be distracted, or have limited ability to collect and process information.  Thus, they are vulnerable to being picked off.  They adjust for this possibility by quoting wider spreads–higher offers, lower bids.  The quicker they can react, the tighter the spreads they can quote.

Automating the process of updating quotes effectively eliminates the distraction/cognitive limit/stale quote problem.

To the extent that processing vast amounts of information, and applying sophisticated algorithms also allows HF traders to identify informed traders more reliably, it also reduces their vulnerability to adverse selection.  I am on less certain ground here, not knowing with certainty whether HFTs can do this, but identification of informed orders and taking that into account when deciding whether to trade against those orders or the price at which to trade against those orders, would help separate the informed from the uninformed orders.

In sum, HFT allows market makers to collect more information, process it more quickly, and change quotes rapidly in response to new information.  To the extent that HFT algorithms can also identify informed orders more reliably, it also allows them to avoid the adverse selection problem.  All of this should tend to permit them to quote tighter markets than manual market makers who cannot process as much information as rapidly.

How does the entry of HFT affect the welfare of other traders?  Well, for sure it hurts market makers who do not make the same investment in hardware and software to extract information from order flow.  The marginal cost of HFTs is lower than the marginal costs of market makers who do not have the same information.  The competitive process will tend to result in the elimination of old-school, LFT market makers, and the dominance of HFTs.  Entry of HFTs will occur until their investments in hardware, software, and people earn a competitive return.  That is a natural competitive process, analogous to automobiles leading to the drastic decline in the saddle-making business.  Tough luck for saddle-makers, but not for society at large.

Privately informed traders may also suffer as a result of HFT, especially to the extent that HFTs can better distinguish between relatively informed and uninformed orders.  This is not necessarily a bad thing, though, because privately informed trading can be a rent seeking activity.  That is, people invest in getting information for the purpose of extracting a rent from somebody else.  (Much informed trading in market microstructure models is in fact parasitic if it is costly to collect information.)

This is a hard call, though, because to the extent that HFT reduces the profit of informed trading, it would tend to reduce incentives to collect information, making prices less informative.  It is nigh on to impossible, however, to determine just what the social value of that information is.  Unless the information embedded in prices as the result of informed trading improves the allocation of resources (e.g., companies make better capital investment decisions because they can extract information from stock prices), informed trading is not socially valuable.  The problem is, no one has, and I would argue no one can, quantify the value of that information.

This also relates to a widely-heard defense of HFT–that it makes markets more informatively efficient faster.  The use of real resources to speed the incorporation of information into prices is valuable only to the extent that this better information leads to better resource allocations.  It is hard to see how speeding the incorporation of information into prices from minutes into seconds into milliseconds into microseconds would really improve resource allocation.  Thus, I find this defense unpersuasive.  Indeed, by exploiting information that is in the public domain (nobody owns the price and quote information), and making money off it, HFT may have a rent seeking component as well.  That is, that information may not be socially valuable, but it is privately valuable to the party who can find it and act on it first.  Spending resources on computers, software, and people to collect that rent is wasteful.  Thus, there may be a rent seeking component to HFT.

This means that from a rent-seeking perspective, it is difficult to determine whether HFT is a plus or a minus.  It can discourage some sorts of rent seeking activity, but may involve a rent seeking element itself.  Moreover, this rent seeking waste must be balanced against the potential efficiency gains that arise from deterring other parasitic informed trading, and reducing the costs of making markets.

Relatively uninformed investors should benefit from HFT, especially if there is substantial competition between HF traders.  To the extent that HFT reduces market making costs, it narrows spreads and increases market depth, both of which redound to the benefit of uninformed “liquidity” traders, such as those trading to make portfolio adjustments, or because of cash needs.

Put differently, HFT tends to favor price takers, and harm non-HFT price makers.

Market microstructure thinking also sheds some light on one of the most controversial elements of HFT–so called “flash orders.”  In a flash order, some HFTs are given an opportunity to execute against some orders before anybody else; this opportunity lasts for very small fractions of a second.  That is, the HFT is given an option to trade against an order; if it declines, the order is made available to everybody.

The optionality in this might be troublesome, but it might not be.  If HFTs can more reliably identify informed orders, they will pass on the option to trade when they identify an order that is likely to be informed, and let the order go into the market.  They will exercise the option when they perceive that the order is unlikely to be informed, or when it is mispriced (conditional on the information the HFT has).  This exposes others to a greater adverse selection problem–a larger fraction of the orders exposed to the market at large are informed.  This would tend to cause spreads in these other markets to widen.

The equilibrium consequences of this are complex, as it would affect order submission strategies, including the decisions by order submitters as to where to send their orders.  My hunch is that it would tend to result in liquidity traders (i.e., the relatively uninformed) sending their orders to venues that permit flash orders.  Informed traders would have no incentive to direct orders to these venues, as it would be unlikely that their orders would be executed there.

This segmentation of markets has complicated efficiency implications.  I’ve delved into similar types of issues in some of my research, including a paper in the JLEO in 2002 (“The Macrostructure of Securities Markets”) and a working paper called “Third Markets and the Second Best.”  “Cream skimming” uninformed orders–and flash trading may represent that kind of trading–worsens the terms of trade for some, and improves it for others.  Under some conditions, the net effect can be positive–the gainers gain more than the losers lose.  Under other conditions, the net effect can be negative.

Thus, the debate over flash orders is just another incarnation of a very old debate about fragmentation and competition between trading venues.  Cream skimming and fragmentation have been criticized for years, but as I’ve shown cream skimming and fragmentation can be welfare improving if there are other inefficiencies in the market (e.g., market power, entry barriers).

The cream skimming aspect comes into play if HFT can more reliably identify privately-informed trades, i.e., if it is a way of mitigating adverse selection by deterring informed trading.  If HFT is itself a form of informed trading, i.e., HFTs process huge amounts of data and hence can determine which counterparty orders are over- or under-priced, then flash orders are more problematic.  Then they allow those that have made investments in real resources–the ability to trade really fast–to make exploiting information that isn’t really socially valuable.  Without flash orders, the benefit of trading against mispriced orders would be captured by somebody, but importantly, by somebody who hadn’t spent as much on hardware, software, and people.  The mispricing is a zero sum game; to the extent it is possible to limit the cost of playing that game, it is efficiency enhancing to do so.

Thus, what it comes down to is whether HFT reduces the costs of making markets, most notably by mitigating adverse selection problems, or contributes to adverse selection problems.  It is likely that HFT does both.  The net effect, therefore, is hard to determine.  Showing that HFT has reduced execution costs would tend to favor the argument that HFT has been efficiency enhancing.  Isolating the effect of HFT on trading costs is quite difficult, however.  As a result, I expect the debate will rage on.

The quality of the debate would be improved, IMHO, however, if those participating in it would adopt a microstructure approach, and focus on the key questions of how HFT affects the costs of market making, and whether it tends to mitigate or exacerbate information asymmetries.  It might do either.  It might do both.   Until you know the mix, you can’t make a reasoned judgment on the subject.  Unfortunately, in all the ink and pixels that have been spilled in writing about the subject, these crucial questions have been largely overlooked.  Hopefully that will change, and soon.

Following the CFTC hearings on position limits in energy reminds me of Through the Looking Glass:

‘Let the jury consider their verdict,’ the King said, for about the twentieth time that day.

‘No, no!’ said the Queen. ‘Sentence first – verdict afterwards.’

‘Stuff and nonsense!’ said Alice loudly. ‘The idea of having the sentence first!’

‘Hold your tongue!’ said the Queen, turning purple.

‘I won’t!’ said Alice.

‘Off with her head!’ the Queen shouted at the top of her voice. Nobody moved.

Chairman Gensler is an odd casting choice for the Red Queen, but he clearly has his heart in the part, given his opening remarks at the hearing:

But Gensler, the former Goldman Sachs’ executive who almost didn’t get the chairman’s nomination this year because of his past role in shielding over-the-counter derivatives from regulation, adopted a tough tone throughout the hearing.

“No longer must we debate the issue of whether or not to set position limits,” he said.

Then what are the hearings about?

And there’s this:  “There seemed, at least, that the commission is hearing support. I think it’s more a question of how, than whether.”

And his understudy, Bart Chilton, is clearly ready for the part:  “Whatever manner the agency proceeds, ‘going slow’ is not an option.”

Given that position limits are a mantra of the Senators to whom Gensler genuflected to get the job, it’s not really a surprise that they are now deemed inevitable.

Position limits in general are dubious at best.  There is little in the way of viable theories, and even less in the way of persuasive empirical evidence, that speculators distort prices in general, or cause prices to be excessively volatile.  There is no plausible theory or evidence that speculators caused energy prices to be artificially high in 2008.  As a consequence, position limits will almost certainly not reduce volatility for energy products, or reduce the frequency of price spikes.

After all, we’ve had considerable experience with position limits in agricultural commodities.  Note that the CFTC is essentially proposing to extend to energy and other commodities “in finite supply” (again, and examples of other types of commodities are . . . ) the same type of regime that has been in place for ags for years.  Yet, despite these limits, there has been substantial volatility in ag prices–including last year.  Moreover, there have been large spikes and crashes in ag prices despite the existence of a position limit regime there.  This should not be a surprise, as the theory of storable commodity pricing predicts that such price behavior is characteristic of efficiently functioning, competitive markets undistorted by speculation.

This perhaps explains the monomaniacal focus on index investors.  Via hedging exemptions, these types of firms have been able to amass positions in individual commodities (as parts of larger portfolios) in excess of the position limits.  Since position limits are in place in ag commodities, the fanatical opponents of speculation (fanatical in the Churchillian sense of “can’t change their minds and won’t change the subject”) need to focus on participants not subject to the limits.  Never mind that extant empirical evidence provides no support for the hypothesis that index investors are moving prices.  Or that the “theory” that these funds contribute to “demand” are completely bogus.  (It would be interesting for someone to see whether price correlations across components of major commodity indices have increased in recent years; if index investors are the dog and prices are the tail, since index investors act in a mechanical fashion across markets, they should induce very similar price movements across markets.)

Position limits have been around since the Grain Futures Act was supplanted by the Commodity Exchange Act in 1936.  I’m sure you’ve noticed what a dramatic effect they had on volatility–even before the rise of index investors.

So, we’re about to go for yet another run on the hamster wheel.

It is interesting to me to note that something that is almost impossible to be distorted by speculation–shipping rates–experienced almost the same spike and plunge as energy over the 2007-2009 period.  Shipping rates aren’t assets; they are the rental rate on assets.  Even if you have a speculative bubble in the prices of ships (i.e., a lot of ships are built on spec in anticipation of higher rates in the future), this should result in a fall in shipping rates; the entry of large numbers of ships should depress charter rates.  You can’t store the ability of a ship to make a voyage today for use in the future; you either use the space today, or you don’t.  You can’t buy up today’s space in anticipation of a higher rate in the future.  So, when you have price spikes in a non-storable like shipping space, you can’t attribute that to a speculative asset bubble, cuz it ain’t an asset.

What’s more, shipping rates are driven by global industrial activity.  The eerie similarity of the trajectory of oil prices and shipping rates (as measured by the Baltic Freight Index, for instance) therefore strongly suggests that underlying fundamentals, namely strong world industrial demand, drove both oil prices and shipping prices over the period of the energy price spike.  Indeed, I have some preliminary econometric evidence (more to come later) that shows that the Baltic Freight Index is strongly correlated with, and in fact leads, the price of oil.  (Lutz Killian has similar evidence, up through 2007: mine goes through April, 2009).

And then there’s  the issue of the details of implementation.  Given the complexity of the markets, the greater variety of products and instruments, and the greater variety of market users and strategies, designing a coherent position limit regime will be nigh on to impossible.

One disturbing matter relates to the aboveforementioned index investors, and financial market participants in commodities more generally.  Gensler stated:  “While I believe that we should maintain exemptions for bona fide hedgers, I am concerned that granting exemptions for financial risk management can defeat the effectiveness of position limits.”

So, “financial risk management”–by which I presume Gensler means investors that use commodity derivatives to improve the risk-return performance of their portfolios–are not bona fide hedgers apparently.

This reflects a widespread mindset, redolent of what Thomas Sowell calls the “physical fallacy” that physical commodity derivatives are properly for physical market players, and that others should not participate.  That is, commodity markets and financial markets should be separate.  To put it more pungently, those holding this mindset endeavor to make the commodity derivatives markets a kind of ghetto, limited to a certain group of players.

This makes no sense from the perspective of financial theory.  Integration of disparate markets with disparate risks improves the sharing of those risks, leading to a more efficient allocation and pricing of those risks.  Segregated markets–ghettoized markets–don’t permit the full scope of risk sharing, and lead people to bear more risks than is necessary.

In earlier posts I have explained why some commodity market participants may prefer that these markets be ghettoes, rather than having them integrated in the broader financial markets.  This can explain the support for position limits from some quarters of the commodity community.  No doubt these are some of the sources of support Gensler has been hearing from.

Thus, the whole position limit hysteria–which is a particular symptom of the broader underlying disturbance of speculator hysteria–is, as Alice said, stuff and nonsense.*

And for saying that, I may anticipate the sentence: “Off with his head!”

*”Stuff ‘n’ Nonsense” is also the title of an excellent Supersuckers rocker.

I am a guest poster on today’s FTAlphaville.  The subject: clearing.  The post riffs off an article in the FT that notes the importance of price information for clearing to work efficiently.  The basic points are that price information is necessary but not sufficient for clearing to work; that clearinghouses are consumers of information, not just producers of it; and that the debate about standardization has focused on what is really a red herring–contractual standardization–and overlooked the difficulties of economic standardization.

Many thanks to Stacy-Marie Ishmael for providing this opportunity.

Isolated and inbred populations lack genetic and immunological diversity, making them more susceptible to genetic illness and more vulnerable to epidemics caused by new bacteria or viruses.  That is, this limited diversity increases systemic risk; the population is systemically more vulnerable to shocks.  Europeans died from smallpox, but due to the effects of accumulated exposure had enough immunological diversity to limit its impact: in contrast, it virtually wiped out Amerind populations.

This came to mind when reading Jeffrey Friedman’s excellent “A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure,” an introduction to a Critical Review special issue on the financial crisis.  In this essay, Friedman notes that proscriptive laws and regulations impose constraints that increase the homogeneity of behavior.  That is, systems with fewer such laws and regulations exhibit a greater diversity of behavior.  Moreover, the laws and regulations are predicated on a worldview, and if that worldview is seriously flawed, the resulting homogeneity can be particularly vulnerable to shocks, unintended consequences, or just the perverse results arising from the inherent contradictions in the worldview.  But homogeneity increases systemic risk even abstracting from the possibility for cognitive error.

I’ll let Friedman speak for himself:

By its very nature as a law, a regulation is imposed on every market participant.  This means that even if the regulation takes the form of an inducement rather than a prohibition, it has a homogenizing systemic effect.  The whole point of regulation is to get market participants, on the whole, to behave differently than they otherwise would.  But this means that every regulation imposes one opinion–the regulator’s–on all market participants, even if only by advantaging those who go along with it.

. . . .

The process of competition, like the process of biological evolution, need not have some master note-taker standing above the process and learning its lessons if the process is to work.  This is crucial because such a synoptic perceptor, being human (hence fallible), could not be relied on to learn the right lessons. . . . [T]he regulator is required to be a synoptic perceptor, codifying what he thinks leads to market failure.  If he errs in this analysis, the mistake is imposed on everyone else.

. . . .

But where there are many power centers, as in a capitalist economy, there is more chance of heterogeneity than when there is a single regulator of all the participants.  At worst, in the limit case of complete market homogeneity, unregulated capitalism would be no worse than regulated capitalism, since a theory that is homogeneously accepted by all market participants at that time and place is likely to be accepted by the regulators of that time and place, too.

Just so.  And here’s my favorite:

Geithner may be right or he may be wrong.  He, too, is human, as he demonstrated in his years at the New York Fed when he did nothing to prevent the crisis.  But as much as he may recognize his fallibility, his role as regulator compels him to act as if he were omniscient.

This is all so pertinent in the current setting.  Geithner et al believe–or act as if they believe–that they KNOW the causes of the crisis, and they KNOW how to address them.  Their preferred solution is to impose a set of regulations that will sharply constrain market participants’ behaviors, and induce and/or compel them to utilize a very sharply constrained set of institutions to consummate financial transactions.  They want to compel standardization of financial contracts; compel the use of standardized clearing mechanisms; compel the use of standardized trading mechanisms.  They want to greatly homogenize–“simplify”–the markets for trading financial risks.

But, as Friedman notes, and the inbreeding analogy suggests, such simplicity can create systemic risks of its own.  The resulting lack of diversity means that shocks to which these institutions are acutely vulnerable will lead to a systemic crisis.  And remember that every institution is unduly vulnerable to some shocks, and it is highly unlikely that a particular set of institutions is more robust to all shocks than any other set.  Even if Geithner et al are right that their favored institutions are more resilient to most shocks than the incumbent institutions–a contention that I dispute–the lack of diversity means that when the kind of shock to which these institutions are acutely vulnerable arises, the effects will be systemic and devastating.  And if–as I believe the case–Geithner et al’s analysis is incredibly wrong, we have the worst of both worlds.  We will have created a monoculture in which risks are systemic due to excessive homogeneity, and one that is fundamentally defective because it is predicated on a serious cognitive and analytical error, increasing the likelihood of a system-threatening shock.

Friedman also reprises a theme that I have echoed often on SWP: “The greatest lesson of the Great Depression is that we learned the wrong lessons from the Great Depression.”  Citing the work of Gary Gorton, and the chapter by Bhide in the Critical Review special issue, Friedman notes that how a US-centric view of banking panics led to a failure to understand the role of US laws and regulations in causing them to occur disproportionately in America.  And this misdiagnosis begat deposit insurance.  And deposit insurance begat reserve requirements . . .

And reserve requirements (in large part) begat the financial crisis.  Here Friedman provides a convincing case for something that I’ve believed to be a major cause of the financial crisis: the Basel bank capital rules.  A key factor that distinguishes this financial crisis from other collapses in securities prices (e.g., the Dot-com implosion) is that banks had invested heavily in mortgage backed securities, and asset backed and CDO securities derived from those.  The housing price collapse caused the prices of these instruments to fall, precipitating the crisis because banks and other financial intermediaries had loaded up on them.

But why had they loaded up?  The Basel rules–combined with the institutionalization of credit ratings, another factor Friedman emphasizes–gave preferential capital treatment to these instruments.  And since all banks were subject to the same capital requirements, with a few exceptions (e.g., J.P. Morgan), they nearly uniformly took exposure to the same risk.  Thus, whereas the dot-com burst was not systemic, the housing and subprime burst was.

This is particularly worrisome, because the conventional wisdom (not surprisingly the mantra of Geithner et al) is that tightened capital requirements will be a pillar of regulatory changes.  Indeed, they are seen as an all-purpose tool: Geithner’s “reform” plan proposes to use higher capital charges on OTC derivatives in order to channel more trading onto clearing and exchange platforms–i.e., the proposed financial monoculture.

“TIghter capital requirements” seems like a no-brainer, but the foregoing makes it very, very clear that the details are incredibly important.  They can induce excessive homogeneity in behavior that increases systemic risk.

In sum, “simplified” and “standardized” are not synonymous with “systemically robust.”  Indeed, the exact opposite is likely to be the case.  I believe that there is a strong argument to be made that the diversity of institutions in derivatives markets, e.g., the co-existence of exchanges, cleared OTC, and non-cleared OTC, is a discriminating match between trading mechanisms, instruments, and market participants.  Maybe I’m wrong.  But I am highly, highly confident that this more diversified set of institutions is more systemically robust than the kind of monoculture that the administration and leading legislators are hell-bent on creating, even were I not to believe that their diagnosis of the current crisis and its causes were incorrect.  For even if against the astronomical odds they were right about this, they cannot assume that all crises are alike, akin to Tolstoy’s happy families.  Indeed, they are instead like Tolstoy’s unhappy families–unhappy in their own way.  By creating an institutional monoculture they are merely legislating a particular systemic vulnerability that will be the root of the next 21st century financial crisis.

A reader sent me an email about my post ridiculing Timothy Geithner’s admission that restructuring the OTC derivative markets is really complicated, telling me that (a) I was very mean, and (b) I can be a real smart ass.  (That said, she also thought it was very funny.)  Both (a) and (b) are true–especially the latter, I guess.  My wife is always telling me that sarcasm is the lowest form of wit, but there are some things that are so outrageous that sarcastic ridicule is perfectly appropriate.

And I think that Geithner’s admission that a complete re-engineering of the financial system is extremely difficult is one of those things.  He is playing the Sorcerer’s Apprentice, unleashing forces that he doesn’t comprehend.  Somehow dry, play-it-straight analysis doesn’t seem to be an adequate response to such dangerous arrogance.

Indeed, one of the very pillars of his argument for the need for “reform”, the interconnectedness of the financial system, is precisely the reason why care is especially warranted in this instance.  Highly interconnected, dense networks like the financial markets are complex systems.  Small shocks to such complex systems can lead to discontinuous responses.  And such changes are almost always impossible to predict.

These markets are so complex that one should proceed with great caution before making wholesale changes.  This is especially true when these changes are predicated on a simplistic, not to say incorrect, diagnosis of the nature of the system.  Fools rush in where angels fear to tread.

It would be useful if Geithner–and Obama, for that matter–would read Hayek’s The Pretense of Knowledge or Sowell’s Knowledge and Decisions.  Perhaps such reading would at least temper the presumptuous arrogance that has characterized the administration’s financial regulation initiatives, and its other efforts to remake virtually every other part of the American economy from energy to healthcare.

But I doubt that it will.  And as a result, I would imagine that Mr. Geithner and his colleagues will provide numerous opportunities to exercise my talents in the lowest form of wit.

Tim Geithner has made a startling discovery: completely reorganizing one of the world’s largest financial markets–OTC derivatives–is an extremely difficult task, worthy of Hercules.  According to Forbes:

The Obama Administration has given itself two months to tell Congress what new legislation is needed to control over-the-counter derivatives, and testimony by Secretary of the Treasury Timothy Geithner late last week indicated how incredibly difficult the job of writing a law is going to be.

Scores of House members turned up to express their special concerns: Will grain elevator operators be required to register as users of derivatives? Can utilities continue to enter into the customized OTC contracts they regard as essential to their business? How, Secretary Geithner, are you going to prevent the derivatives business from migrating to Dubai?

Answering his critics, Geithner said repeatedly the government needed “to find the right balance” between conflicting arguments and conceded that regulation will be “an enormously complex process.” But failure is not an option, he said, because the economic crisis has demonstrated how destructive derivatives can be and how urgent the need is to subject them to new oversight.

Imagine that.  A root-and-branch shakeup of a market involving trillions of dollars of complex transactions, hundreds of firms, some of them quite complex and opaque, in just about every financial and commodity product, is going to be complicated.  Who knew?  

Boilerplate about “find[ing] the right balance” and “failure is not an option” (cliche alert!!!) is woefully inadequate.  There are myriad interconnected decisions that the “reformers” will have to make, each one of them bursting with unintended consequences, and potential for workaround and exploitation and regulatory arbitrage.  In going after the devils it thinks it knows (but really doesn’t), the administration will end up tangling with more heretofore unknown devils that it could possibly imagine.  

It would be comforting if the administration had a coherent diagnosis of just how OTC derivatives contributed to the financial crisis; a better understanding of how structural changes could mitigate these problems; and an appreciation of some of the likely adverse consequences of the proposed reforms.  Instead, we get reruns of the AIG melodrama and airy statements about how clearing and improved transparency will work wonders.  

Hence, failure is quite definitely an option.  Sadly, failure is most likely to result if Geither and the administration “succeed” at implementing their “reform” plan.  A plan that presumes one of the largest market failures in history, but which does not state coherently just what that market failure is and how it will be addressed, is a disaster waiting to happen. With no coherent overarching understanding of the source of market failure, there is no way to implement all necessary details of any plan intended to address it.  Moreover, lacking any such overarching understanding, it will be very difficult to distinguish the legitimate arguments of affected market participants from special interest self-pleading.  With so many decisions to be made, and so many affected interests, this will degenerate into a political bazaar like Waxman-Markey, and which health care “reform” promises to be.  And, just like Waxman-Markey, what is likely to emerge is a Frankenstein monster of regulation that is more likely to be the cause of the next crisis, than our deliverance from one.

According to Matt Leising and Justin Blum at Bloomberg, the Justice Department investigation of the CDS markets includes clearing:

A U.S. antitrust probe of the credit-default swaps market includes efforts to guarantee contracts through clearinghouses, according to a Justice Department spokeswoman.

“The Antitrust Division is investigating the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,”  Laura Sweeney, a Justice Department spokeswoman in Washington, said today in an e-mail.

Just what would the anticompetitive practices in CDS clearing be?  Here are some theories the DOJ might be considering and investigating:

• If a subset of big dealers form a clearinghouse, and exclude other market participants from membership, they could reduce competition.  That is, as I’ve shown in my academic work, a cooperative organization that is subject to strong scale and/or scope economies can serve to cartelize an industry.  A smaller than optimal set of members creates a CCP.  It is just big enough such that no other organization can achieve the scale or scope to compete with it, but smaller than optimal, thereby ensuring that its members can charge supercompetitive prices.  What’s more, through the pricing of its services, and the rules for sharing revenue, the members can coordinate pricing, and in some cases, achieve a monopoly pricing outcome.
• The DOJ may actually be more interested in the resistance of the CDS dealers to clearing.  Here the idea would be that the CDS market currently behaves like an oligopoly that is very profitable.  The dealers don’t have to worry that much about competitive entry, because there are few other firms that have the scale to compete effectively.  Clearing would make it easier for other firms to enter in competition with the big dealers, as these competitors would essentially be able to take advantage of the clearinghouse’s scale.  This would undermine a competitive advantage of the big dealers–so if they kneecap or slow walk clearing, they could protect their oligopoly.  Similar arguments would apply to anticompetitive practices in trading.
• The big banks are impeding competition by refusing to deal with potential competitor clearinghouses, such as the CME’s or the just euthanized NYSE-EuronextLIFFE venture.

I don’t know which, if any, of these theories is in DOJ’s mind.  But the antitrust scrutiny of the entire gamut of OTC trading practices is quite interesting, and bears close watching going forward.

Administration officials, most notably Geithner and Gensler, Congressional leaders, and European regulators have touted central counterparties/clearinghouses as a way of dramatically reducing systemic risk.  They have portrayed the CCP as nearly free of the risk of default.  

Apparently the Federal Reserve takes a different view.  (H/T Matt Leising, who made me aware of the issue and reports on it in today’s Bloomberg.)  Evidently responding to the glowing praises of clearinghouses emanating from Geithner et al, on behalf of the members of ICE Trust the law firm of Cleary, Gottlieb, Steen and Hamilton wrote the Fed a letter requesting that

a zero percent risk weight  under the risk-based measure of the Board’s Capital Adequacy Guidelines for state  member banks and bank holding companies (“Risk-Based Capital Rules”) be  assigned to (1) the counterparty credit risk charge on credit default swap (“CDS”)  transactions with ICE Trust, and (2) funds placed with ICE Trust as part of ICE  Trust’s guarantee fund (“GF Contributions”) or as additional margin (“Margin”).” That is, the Cleary lawyer asked the Fed to consider the ICE Trust clearinghouse to be effectively free of default risk, thereby eliminating the necessity of any bank or securities firm with an exposure to the clearinghouse to hold any capital against that exposure.

The Fed demurred, however:

Based on all the facts of record, including the information provided in your  request and other supervisory information, the Board believes that it would be  appropriate to allow current participants in ICE Trust (and their top-tier bank  holding companies) to apply a 20 percent risk weight under the Risk-Based Capital  Rules to claims on ICE Trust, including counterparty credit risk of the CDS  exposures cleared through ICE Trust and claims in the form of Margin and  GF Contributions, for the first-quarter reporting period of 2009 and for subsequent  reporting periods. A 20 percent risk weight for such claims on ICE Trust is  appropriate because the risks ICE Trust poses to counterparties are not materially  different than those posed by other U.S. depository institutions, as well as by banks  in countries that are members of the Organisation for Economic Co-operation and  Development (“OECD banks”). Claims on OECD banks are also risk weighted at  20 percent.

That is, from the Fed’s perspective, ICE Trust is just another bank. Note the key sentence: “the risks ICE Trust poses to counterparties are not materially different than those posed by other U.S. depository institutions.” Thus, an OTC counterparty must hold as much capital against a CDS position cleared through ICE as a CDS deal done with Goldman Sachs–or even BofA or Citi. So much for the magical powers of a clearinghouse to make counterparty risk disappear.

Interestingly, the Fed letter notes that the capital weight required for derivatives traded on exchanges like the the CME that adjust margins daily is zero.  

This decision is very difficult to square with the official boosterism of clearing emanating from the administration, the Hill, and the EC.  It has always seemed to me that the Fed was much more diffident about the efficacy of clearing than Treasury, and this letter makes that difference in enthusiasm quite plain.

There is another interesting angle to this.  In his recent testimony Geithner made it plain that he intended to impose more onerous capital requirements on OTC deals that were not cleared than cleared deals.  The Fed letter essentially puts cleared and non-cleared deals on a level playing field.  So does this mean that other changes are in store, such as raising the capital requirement to above 20 percent on bank-to-bank OTC derivative exposures?  If so, will other inter-bank exposure capital weights be changed, or will there be a differential between OTC derivative risk weights and other inter-bank exposure weights?  Or will the Fed decision be modified subsequently?   Whatever changes are to come, this appears to represent a major disconnect between the Fed–which announced its decision on 5 June–and Treasury, which as recently as last week stated its intention to treat cleared and non-cleared exposures differently.  

Moreover, the Fed’s action gives the lie to Treasury and Congressional and EC boosterism of clearing.  It is a salutary reminder that clearing does not make counterparty risk go away.  Perhaps the Fed’s equation of the risk of ICE Trust and Citi, for instance, is wrong.  But by making it quite plain that the counterparty risk of ICE Trust is north of zero, its decision will hopefully lead to a more productive and informative discussion of the real risks of clearing vs. bilateral dealing.   It’s about time.

In his testimony in a joint hearing of the House Financial Services and Agriculture Committees last week, Treasury Secretary Timothy Geithner stated:

We also will require that regulators carefully police any attempts by market participants to use spurious customization to avoid central clearing and exchanges.

Just how is this “careful policing” supposed to work?  Will those who want to enter into customized transactions have to get pre-approval?  This seems inherently unworkable, due to fact that transactions are frequently time sensitive.  Alternatively, will parties have the ability to enter into transactions without prior restraint, but face the risk that a regulator will subsequently challenge, and disallow the transaction?

Under either alternative, what are the criteria that will be used to separate the unspurious sheep from the spurious goats?  Given the myriad possible reasons for entering into a particular transaction, and designing it in a particular way, it seems nigh on to impossible to identify ex ante a set of criteria that can be employed.  Hence regulators will have incredible discretionary powers.  Presumably there will be legal challenges to regulator decisions, meaning that there will be more than a few court cases arising out of these “policing” efforts.  

The closest analogy that comes to mind is the IRS, which rules on the permissibility and legality of various financial transactions that have tax implications.  We all know the byzantine and costly process associated with such powers.  In essence, the CFTC and/or SEC would have to be empowered to make similar judgments of the commercial rationale for particular transactions, and evaluate the trade-offs that market participants make.  For instance, is a particular transactions structure designed to reduce basis risk, or to escape the clearing requirement?  What will be the standard applied to such evaluations?  Who will have the burden of proof?  

Given the myriad arcane and complex commercial rationales that may exist for entering into derivatives transactions, especially customized ones, it stretches credulity to the breaking point to believe that the SEC or the CFTC have the expertise, not to say the incentive, to make the right call.  There will be many false positives and false negatives.  What’s more, the transactions costs of such a system are likely to be large, just as is the case with the tax code.  Much money will be spent in court trying to reverse the false positives and false negatives.  

Am I done?  Hardly.  Let’s consider the regime in which done deals are subsequent to regulatory challenge ex post.  What happens if a particular transaction is found to be “spurious”?  The deal will be in the money to one party or the other.  How is it to be unwound?  Is it just terminated, costing the in the money party the value of the contract, and allowing the loser to skate?  Is there some termination process whereby the contract is valued?  But if the deal is customized, who does the valuation?  Another source of litigation.  Just what we need.  

Relatedly, there is the possibility that the underwater party to a contract can opportunistically utilize the requirement that a deal not be “spuriously” customized to attempt to escape the onerous obligation to perform.  In the old days, transactors who entered into futures contracts tried to argue that (a) they entered into the futures as a speculative wager, and (b) wagers are uneforceable in court, to escape losing trades.  I foresee such attempts as inevitable if “spurious” customization is banned.  Thus, such a ban will undermine the reliability of contracts and create legal risks.  This is hardly a desirable public policy outcome.

All in all, attempts to distinguish spurious from non-spurious customized transactions, and the Talmudic inquiries necessary to do so, will be extremely onerous.  Moreover, the existence of such a distinction creates substantial legal risk, and the prospect for protracted and expensive litigation.  But perhaps for Geithner et al, these are features, not bugs: regulatory burdens that will serve the larger purpose of suffocating the OTC market.  

And all this begs the question:  Why would anyone want to create a “spuriously” customized contract?  One can understand why one would want to structure a deal solely to reduce tax payments, hence the arms race between the IRS and financial engineers.  It is far harder to understand why someone would want to customize something to escape the obligation of having it cleared, or traded on an exchange.  It is easy to understand why someone would want to customize a deal to achieve specific risk management objectives that cannot be attained using standardized and cleared contracts.  But what’s so bad about clearing that people would want to go to the lengths of designing a customized, illiquid instrument solely to avoid it?  And if the private “bad” of clearing is so big, where’s the public “good” that offsets it?  

This puzzle as to why consenting adults would choose to customize to avoid clearing and exchange or exchange-like clearing is just part of a larger puzzle: if the OTC market is so terrible, why do informed parties utilize it, and why has it grown relative to the exchange traded sector to such an extent that OTC volume and open interest now dwarf exchange volume and open interest?  The entire thrust of the Geithner-Obama policy implicitly assumes the existence of what would have to be the greatest market failure in the history of man, a market failure that has led to trillions and trillions of dollars of transactions that are suboptimal in the way that they are designed, traded, cleared, or settled, or all of the above.   So just what is the market failure?  So far, the administration and its cheerleaders in the media have failed miserably to identify it, let alone to show that its cost is sufficiently massive to justify a vast re-engineering of the financial markets.  Repeating “AIG AIG AIG” over and over again like financial Hare Krishnas doesn’t cut it.

FT’s Energy Source blog kindly links to my piece on oil speculation.  Kate Mackenzie notes my argument on why commercial traders who perceive that they have an information advantage, and who speculate on that information, may support constraints on non-commercial speculators who compete with them.  (Ironically, we have houseguests named “Kate” and “Mackenzie” visiting this weekend.)

There’s another reason why some hedgers may want to crack down on speculation: some hedgers earn a risk premium rather than pay it, and competition from speculators reduces the profit that these hedgers earn.  When there is some segmentation between a particular commodity market (e.g., oil) and the broader financial markets, due for instance to a fixed participation cost like the cost of becoming informed, idiosyncratic risk affects risk premia.  This, in turn, can affect who benefits and loses from greater speculative participation.

The original Keynesian “normal backwardation” story assumes complete segmentation, in which case net hedging pressure–whether short hedging volumes exceed long hedging pressure at an unbiased price–determines the sign of the bias in the futures price (whether the future is above or below the expected spot price at expiration), and the amount of speculative risk bearing capacity determines the magnitude of the bias.  For instance, if short hedging pressure predominates (as Keynes believed) the futures price will be biased downwards (will be less than the expected spot price), meaning that short hedging is costly but long hedgers make a speculative profit; as the downward biased futures prices drift upwards on average to converge with the spot price at expiration, long hedgers profit on their long futures positions.  The bias is a profit for long hedgers, and a cost incurred by short hedgers.  This bias attracts speculators, who bid up the futures price until the expected profit arising from the bias balances the cost of the risk that they incur.  The greater the speculative risk bearing capacity, the lower the bias–and the lower the trading profit of the long hedgers.

This means that entry of speculators helps some hedgers–short hedgers–but HURTS others–long hedgers.  The bidding up of the futures price benefits hedgers who sell futures, and hurts hedgers that buy futures.  Thus, in a Keynesian world, long hedgers oppose speculators.  This means that hedgers will not uniformly support speculation.  Indeed, some market participants should actively support measures to constrain speculation.  

In a world where each commodity futures market is perfectly and frictionlessly integrated with the broader financial market, risk premia are determined solely by the systematic component of the commodity price’s risk.  

In a world between the frictionless world and the Keynesian one, both systematic and idiosyncratic risks affect risk premia, as was shown by Hirshleifer in the late-80s.  In this world, some hedgers will also prefer to crack down on speculation.  For instance, when short hedging predominates, long hedgers prefer to constrain speculation.  That’s because, like in the Keynesian world, they are effectively selling price insurance to the short hedgers, and receive a profit from doing so.  They don’t like the entry of speculators who compete away some of these profits.  

This can also explain why some hedgers would support measures that weaken the linkage between the broader financial market and a particular commodity market.  This weakening allows idiosyncratic risk to affect risk premia, and some hedgers in the market capture this risk premium as a profit even though those on the other side of the market pay it as a cost.  What’s more, the magnitude of this idiosyncratic risk premium depends on the ease of entry by speculators into the futures market.  

This analysis can explain some of the hostility to passive long index investors.  These investors are typically portfolio investors, and their participation in commodity markets helps to strengthen connections between commodity markets and the stock and bond markets.  Moreover, they compete with long hedgers in serving the risk management demands of short hedgers.  In so doing, they compete away some of the profit that long hedgers can earn in a market where short hedging predominates.  

Of course, this story implies that hedgers will not speak with one voice: based on these factors alone, one group of hedgers (e.g., short hedgers in the Keynesian story) will support speculation, while another group (long hedgers in the Keynesian theory) will oppose it.  (If long hedging predominates, the roles will be reversed.)  But combined with the other factors outlined in my earlier post–and perhaps others as well–this means that commercial traders who use futures markets as hedging tools can take very different views on the benefits of speculation.  

This is an old, old, old story in any analysis of regulation.  Although speculation improves the allocation of risk, and leads to overall improvements in welfare, it also has distributive effects.  Due to its effects on competition over information rents, or raising rivals costs considerations, or competition over risk premia, the entry of speculators can redistribute wealth at the same time that it increases (risk adjusted) wealth overall.  

This means that you should be very, very, very . . . skeptical about the protestations of some commercial firms about the evils of speculation.  They don’t necessarily have the interests of the market at large at heart.  Indeed, they almost certainly place their own interests foremost.  What’s more, it is inevitable that for some significant number of commercial firms these interests are contrary to market efficiency.  In derivatives markets, as in virtually every other, some firms can benefit from restrictions on entry or other impediments to competition.  Derivatives regulation, including regulation of speculation, is like other forms of regulation a rent seeking contest in which interested parties attempt to secure rents through the political process.  Sadly, it’s often those with the best lobbyists who win–not those with the strongest economic case.