Streetwise Professor

Almost exactly a year ago, I testified before the House Ag Committee and wrote an oped for the WSJ on the effect–or lack thereof–of speculation on oil prices.  The issue was high on the political agenda at the time, as oil prices hit $147/bbl, and gas prices were above $4/gal.  The collapse in prices during the financial crisis put the issue on the backburner, but it is back with a vengeance.  To loud Congressional hosannahs, the CFTC has announced its intent to impose a far reaching regime of position limits on energy and other commodities “in finite supply“–pray tell, what traded commodities are in infinite supply?

So, I guess I have to roll that rock up the hill, yet again.  (I have posts on the subject of “excess speculation” and position limits from 2006, 2007, 2008, and 2009.)  

At the risk of becoming even more of a repetitive bore than usual, I’ll restate my objections to the intellectual basis to these policy initiatives, and the policy initiatives themselves.  Before doing so, it is worthwhile to define “excessive speculation,” something those that hurl around the phrase with abandon almost never do.  I define “excessive” speculation as that which drives prices away from the competitive price consistent with available information.  That is, excessive speculation distorts prices.  Now, my objections:

• The mechanism by which speculators allegedly distort prices is almost never specified, and when it is, it makes no sense.  Advocates of the “excessive speculation” hypothesis routinely say that speculators inject artificial demand into the market.  Given that most speculators almost never actually take delivery, and thus offset their positions as they become prompt, they are not influencing either supply or demand for the physical commodity.  This is a point that has been recognized since at least 1902 in a report authored by the US Industrial Commission, which included several Congressmen and Senators.  Which I guess goes to show that Congressional IQ exhibits an inverse Flynn Effect.  
• This is especially the case for commodity index traders, who almost all trade cash settled instruments, and hence can in no way influence supply or demand.
• That is, none of the boatloads of money allegedly flowing into commodity funds actually goes into, you know, actual commodities.  Some of the money in commodity-linked investments is purely notional (e.g., in commodity swaps, or index swaps).  Some goes into T-bills (in the form of margin, or in fully collateralized commodity trades).  
• The evidence of a distorting speculative effect is laughable.  Distortions in prices should lead to distortions in quantities, e.g., in commodity stocks.  No reliable evidence of such an effect exists.  Indeed, I have looked at one commodity–copper–in close detail as part of a chapter of my upcoming book on commodity price modeling.  People were screaming about a speculative bubble in copper last year at the same time as the (louder) screams about a speculative bubble in oil.  But copper stocks (and the stocks of other industrial metals) were drawn down sharply at the same time prices were spiking: this is exactly what one would expect to observe with a positive demand shock.  Indeed, I am working on calibrating a rational expectations theory of storage model to copper data, and this model can explain the twists and turns of prices and stocks during the extreme events of the last several years.  That is, speculative irrationality is not required to explain the movements in copper prices AND inventories over the 1997-2009 period.  (I’ll post more on this when I finish a couple more parts of the analysis next week, hopefully.)
• Some of the “evidence,” logically ungrounded as it is, doesn’t even support the assertion of a speculative effect.  For instance, a common piece of “evidence” is that prices rose right along with measures of long speculative interest in the oil markets.  (This was a Michael Masters favorite).  Set aside the correlation-causation post hoc/propter hoc problems, and the potential for spurious regression problems whenever one examines the relation between two highly autocorrelated series.  Just look at the graph in this WSJ story:

Sure, prices and long non-commercial positions were both trending up in 2005-2008 (not that that means a damn thing).  But look at what happens in late-08 and early-09.  Prices and long spec positions are mirror images: prices were plunging when long interest was rising, and then, just as long spec interest peaked and began to fall, prices ceased their fall and moved strongly upwards.  How can you possibly explain this if the market dances to the speculators’ tune?  The speculative Pied Piper story says that these measures should move up and down together, not in opposite directions.  Now, this Masters style analysis is B.S., but those who used it to rationalize their assertions of a speculative effect are hoist on their own petard: they vouched for the validity of non-commercial long open interest as a measure of the “excess” demand for oil caused by speculation, but the most recent experience is decidedly inconsistent with that story.  Not that that they have even paused for thought, but continue to flog the same story.  

• Not to mention that numerous analyses, relying primarily on Granger causality, have failed to find any reliable connection between changes in speculative positions and price changes.  Or the analysis (by the CFTC!) showing that commercial traders tend to be market leaders and speculators are followers.

The calls for government regulation have gone international, and gone beyond calls for mere position limits.  Gordon Brown and Nicholas Sarkozy penned a WSJ editorial advocating widespread governmental “supervision” (Euphemism alert!) of the energy markets (including cooperation with OPEC):

For two years the price of oil has been dangerously volatile, seemingly defying the accepted rules of economics. First it rose by more than $80 a barrel, then fell rapidly by more than $100 before doubling to its current level of around $70. In that time, however, there has been no serious interruption of supply.

The oil market is complex, but such erratic price movement is cause for alarm. The surge in prices last year gravely damaged the global economy and contributed to the downturn. The risk now is that a new period of instability could undermine confidence just as we are pushing for recovery.

Where does one even begin the ridicule (beyond noting the point that whenever French and British politicians agree, it must be a really bad idea)?  Regarding volatility.  Uhm, the past two years have been among the most volatile in the memory of most living people–you have to go back to the 1930s to find anything remotely similar.  In 2007-FH2008, Chinese (and Asian growth generally) greatly spurred demand for commodities.  Note that in addition to commodity prices, shipping charter prices skyrocketed, even though the price of something perishable like transportation on a ship can hardly be distorted by speculative buying, because it has to be consumed and hence is impossible to hoard.  That was followed by a financial collapse and economic recession of severities unseen since aforementioned 1930s.  Look at every measure of uncertainty, notably such things as the VIX volatility index.  These things have been at dizzying heights since last August (and had begun their rise even earlier, in 2007).  What would be weird is if oil prices (and commodity prices generally) HADN’T been volatile during this period.  

Regarding “serious interruption of supply.”  Uhm, Gordo, Nicky–there’s this concept called “demand.”  Believe it or not, it’s one of the “accepted rules of economics.”  Don’t take my word for it.  It’s in all the textbooks.  Price evolution in the recent period is clearly demand driven, not supply driven.  Prices spiked when demand spiked.  Prices plummeted when demand cratered.  

And there have been supply shocks.  Nigeria is an ongoing source of supply shocks, and during the price spike last summer losses of sweet Nigerian crudes in the face of very high demand for distillates (driven in part by European regulations regarding clean diesel) led to big spreads between benchmark sweet crudes like WTI and Brent and sourer crudes.  What’s more, OPEC output cuts (especially by Saudi Arabia) played a key role in the firming of prices following the price collapse in October-January.

I should also note that recent research by Lutz Kilian (nicely summarized in his JEL piece) shows that movements in oil prices hew more closely to movements in proxies for demand than measures of supply.  James Hamilton disputes Kilian’s contention that supply shocks are unimportant, but Kilian does demonstrate that demand is clearly an important price driver.  (I also have some reservations about some of Kilian’s analysis, most importantly his conclusion that changes in demand for precautionary inventories is also an important driver of prices.  I don’t disagree with the logic, having written several posts and an academic paper–which will also be another chapter in the book–showing rigorously how that can work in practice.  My problem is that Kilian does not measure factors that could affect precautionary inventories directly, but instead attributes oil price movements not explained by supply or demand measures to an “oil market specific” factor which he asserts is related to the precautionary inventory effect.  I am currently working on developing some more direct measures that would influence precautionary inventory holdings.  I have a good handle on measuring demand side risks that could influence such holdings, but measuring supply side risks is far more difficult.)

In recent months, the oil market and world equity markets have exhibited unprecedented positive correlation (something I called attention to in October-November).  Oil and equities swooned together; they rallied together March-June; and have been selling off together in the last couple of weeks.  This reflects the dominant role of demand in commodity prices at present.  Both equities and commodities are responding to rapidly evolving views in a highly uncertain situation about the likelihood and strength of economic recovery.  They are also responding to government policies, notably aggressive quantitative easing strategies that raise the specter of inflation.  

Now, you could argue that this is speculative.  And indeed it is.  Both equity market and commodity market participants are speculating on the future course of the world economy.  But is it destablizing speculation?  

What’s more, to the extent that energy prices (and commodity prices) are reflecting information/perceptions/sentiment about the future course of economic recovery, and are reflecting the same information/perceptions/sentiment as equity markets and bond markets, why would anyone think that position limits on commodity derivatives would break this linkage?  Once embedded in equity prices, information/perceptions/sentiment about future economic growth become public information that will be embedded in prices even if speculators are forced to trade less.  

The arguments against position limits as a policy are well known.  Speculators absorb risk from hedgers, and supply liquidity.  They therefore impair ability of the markets to serve their essential risk shifting function.  They therefore increase the costs of managing risk, and impose harm on hedgers.

This makes a mockery of the distinction that politicians and regulators draw between the “good hedgers” with price exposures inherent in their businesses that need to be managed, and “bad speculators” who have no underlying exposure to manage, but are taking on risk like gamblers in a casino.  But there is a symbiotic relationship between hedging and speculation.  To whom do hedgers transfer the risk if not to speculators?  And if there are no speculators, how is it possible to hedge risks?; after all, hedging doesn’t make risk magically disappear, it just transfers it to somebody willing to hold it–a speculator.  Thus, politicians and regulators who invariably say that they just want to protect “legitimate” commercial participants from the predations of evil speculators are more full of it than usual.

That said, there is an apparent puzzle: many of the most ardent critics of speculation are physical market participants.  But it’s not necessarily a puzzle, for the same reason that nobody should be amazed that Walmart supports Obama’s health care plan: many firms benefit from regulations that make markets less efficient.

In the commodities case, here are a couple of examples.

It is well known that some commercial market participants are informed traders who make money on the basis of their information.  A Cargill, for instance, has an extensive information network that allows it to trade profitably.  (I sat at the trading desk of Continental Grain some years back, and observed that the traders had access to information around the world about weather conditions and grain flows due to their physical presence in numerous markets.  This gave them an information edge.)  Such firms don’t hedge mechanically.  They trade futures and other derivatives strategically to optimize a risk-return trade-off.  Their information advantage allows them to time the placement and unwinding of their hedges so as to make money.  

Competition from informed speculators tends to erode the competitive/information advantage that informed commercial firms have.  Hamstringing such competition could provide a greater benefit to such firms than would result from the loss of liquidity from speculators.  

As another example, a reduction in market liquidity resulting from speculative position limits almost certainly has disparate impacts on commercial firms.  Some firms, due to capital structure, operational leverage, real options, or other reasons, get more benefit out of hedging than other firms in the same industry.  A regulation that reduces market liquidity raises everybody’s costs, but the first type of firm’s costs go up more than the second type of firm’s.  Thus, the second type of firm may actually support regulations that make hedging costlier or less effective because it raises their rivals costs more than its own costs go up.  

So, the support of some commercial firms for restrictions on speculation is not necessarily a puzzle.  In my view, it more likely reflects an opportunistic use of the regulatory process to distort competition in a way that profits some firms.  This is a ubiquitous phenomenon, observed in many industries and many regulations: why should derivatives trading be any different?  

Well, that’s all I have to say for now, though I doubt this will be last word on the subject, hardy perennial that it is.  Like Sisyphus, I am resigned to the unending task of rolling the rock of enlightened reason up the slope of benighted ignorance, only to see it slip back down again:)

A trader at British oil brokerage PVM Oil Associates has been identified as a rogue trader who entered buy orders for 9mm barrels of Brent crude futures on ICE Futures in London during the illiquid early morning hours, causing a spike in the price of oil–and costing PVM $10 million.  To me, the most interesting aspect of this is the potential for can’t-change-their-mind-won’t-change-the-subject fanaticism of American legislators railing against the “London loophole”:

Unauthorised trading in oil futures in London and the corridors of power in the US Congress may not seem to have much in common.

But London’s markets have become easy targets for US lawmakers eager to show that loose practices on foreign energy markets are hurting US consumers.

Traders, so the theory goes, are carrying out nearly half the world’s global crude oil futures trades on ICE Futures Europe under the eyes of the Financial Services Authority.

The  PVM case  could re-ignite such concerns, just as US politicians are again railing against “excessive speculation” in energy and commodity markets.

This week Bart Chilton, a commissioner at the US futures watchdog, the Commodity Futures Trading Commission, said it was looking for signs of excessive speculation in commodity markets, with specific attention on oil prices.

Last month senator Carl Levin, a Michigan Democrat who has long campaigned for  tighter regulation of energy markets, said the US futures markets regulator needed to enforce strict position limits to curb speculation that last year caused record  wheat prices  that could not be explained by the dynamics of supply and demand.

A year ago, Mr Levin became convinced that improper trading of oil futures was taking place in the UK’s financial centre without sufficiently tight supervision by regulators.

A version of the West Texas Intermediate crude oil contract is traded in London on ICE Futures Europe, and regulated by the FSA. It is similar to the WTI contract traded on the New York Mercantile Exchange, regulated by the US futures watchdog, the CFTC.

Dubbing this the “London Loophole”, Mr Levin forced the CFTC to forge closer ties with the FSA, including a system by which the FSA would report irregular market activity much more quickly to the US.

Yet it does not seem to have worked as intended in the PVM case. CFTC officials claimed they were kept in the dark for several hours in spite of last year’s agreement for closer co-operation.

The FSA said on Friday: “We work very closely with the CFTC to ensure fair and orderly markets. The way we oversee the commodity markets is adequate for the UK regime.”

If there was any delay, regulatory experts say that could easily have been due to the time it took for FSA officials to get a clear picture of what had taken place at PVM, not a break-down in communications with the CFTC.

“The last thing they want to do is start rumours if they don’t know all the facts,” said one.

For the record: rogue trading is an international problem. A few choice examples: Singapore’s China Aviation Oil (2004, $550 million); France/Germany, SocGen’s Jerome Kervial, (2007-2008, $6.5 billion) (yes, with a “b”); Japan/Singapore, MItsui Oil Asia (2006, $81 million).  

Oh, and the United States.  We don’t know whether the 22 September, 2008 spike in the oil price–which dwarfed the recent spike apparently caused by the PVM trader–was due to a rogue trader, but it is highly suspect nonetheless.

And who can forget the MF Global trader in Memphis who lost $141.5 million in a day on Minneapolis wheat?  

I could go on.  

Where does rogue trading occur?  Well, where trading occurs.  There is a lot of trading in London, so it is inevitable that some rogue trading will occur there.  When assessing the adequacy, or not, of regulatory oversight in a market, it would be worthwhile to control for the magnitude of trading activity.  On that score, Singapore looks like a more dodgy place (with the infamous Nick Leeson/Barings episode in addition to the two cases listed above).  So, actions relating to the London Loophole (a vastly overrated financial bogey man in any event) are unlikely to have any effect on the frequency of rogue trading.  

It is primarily a problem of internal controls, but there is no system of controls that is capable of eliminating rogue trading altogether.  (Moreover, as with anything, there is a trade off, and it would be inefficient to invest in controls sufficient to eliminate such trading.)   And the US is hardly immune to the problem.  So although regulatory jingoism may feel good, it can happen here.  And it does.

The Senate Permanent Subcommittee on Investigations released a report on “Excessive Speculation in the Wheat Market.”  The report blames index funds in particular for driving up wheat prices, and particularly for driving a wedge between wheat futures prices and the price of cash wheat, both prior to and at contract expiration.  

The methodology of the report should be tiresomely familiar by now.  It notes concurrent events–(a) increased volume of trading by long-only index investors, and (b) higher prices and lack of convergence–and asserts (a) caused (b).  To be fair, the report does make comparisons between Chicago wheat and Kansas City wheat, which have experienced different degrees of index participation (measured by fraction of open interest) and convergence problems, but this analysis is weak because it does not attempt to determine whether other differences between the contracts might also be responsible for the differences in behavior.  (A bit more on this below.)    

However, the report largely ignores the rigorous empirical evidence that has examined the relations between index fund trading and price changes, and found no reliable evidence of such a connection.  Moreover, there are numerous commodities embedded in the indices, and the following the logic of the hypothesis, increasing index activity should affect price levels and cash-futures relations in all of these markets.  The report does not undertake a rigorous cross-sectional or time series of the cross-section analysis of the relation between index participation and the basis or convergence.

There are also serious logical problems with the analysis.  The main issue relates to the convergence of deliverable cash and futures prices as a contract moves to expiration.  It is very difficult indeed to see how index funds could possibly be implicated for this phenomenon.  Index funds roll from the expiring contract to the first-deferred contract before expiration. They therefore cannot have a direct impact on the expiring futures price at expiration.  Indeed, during the roll, long-only funds are selling the expiring futures, which per the crude story embedded in the report should cause that futures price to decline relative to the cash price.  In brief, I cannot think of any reasonable argument explaining how index funds can prevent convergence when they are out of the market altogether when the absence of convergence has occurred.  

Relatedly, the report repeatedly states that the index funds are creating demand for wheat (and other commodities).  Uhm, no, actually.  They don’t take delivery, and don’t consume the physical wheat or hold it off the market.  For every contract they buy, they also sell, so they don’t create any demand.  Moreover, although unexpected flows of buy orders can cause price reactions even if the orders are submitted by the uninformed (because other market participants don’t know exactly who is submitting the orders and there is a positive probability that the buy is from an informed trader), index activity is pretty well understood, and unlikely to result in the market being systematically surprised as would be required to support the report’s conclusion.  

The analysis also begs the question of why smart money hasn’t piled in to offset the purported effect of the dumb index money.  After all, in the scheme of things, the Chicago wheat futures market isn’t that large.  If the investment of the index funds was sufficient to drive up prices, not that much investment would be required to have an offsetting effect.  During the time that the basis and convergence anomalies were most pronounced, the world was awash in liquidity and capital desperate for returns.  Not only was money piling into indices, it was also going into hedge funds and managed futures funds whose whole business is to identify mispricings and jump on them.  That is, if this was an era of “excessive speculation” as the report laments, why didn’t other evil speculators trade ruthlessly against the dumb money?  

All this said, the absence of convergence during the period studied (most pronounced in wheat, but also present in corn and soybeans) is a puzzle.  It would seem to present a fabulous opportunity for operators of delivery facilities (e.g., Cargill, ADM and The Andersons) to make huge money buying cash, selling expiring futures, and delivering, and continuing to do that until convergence was achieved.

In a competitive market, the spread between expiring futures and cash prices should equal the marginal cost of making delivery.  This should be true, regardless of whether index funds are inflating the entire price structure or not.  What could explain such an extremely high shadow cost of delivery?  

One difference between Chicago and Kansas City is that the former’s contracts use a shipping receipt delivery mechanism which is effectively a call option on delivery elevator capacity, whereas the latter’s is a traditional in-store warehouse receipt delivery mechanism.   The report doesn’t mention this difference, which in theory could have an effect on futures-cash spreads (as I outlined in posts last summer).  However, it is difficult to believe that this option-based story is sufficient to explain the very large futures-cash spreads at expiration.  

Where convergence is concerned, the first focus of inquiry should be the behavior of delivery elevators and their operators.  It needs to be asked: “Why don’t you deliver more when the expiring future is so far above the cash?”  It is an extremely serious failing of the report that it does not ask this question.  Interestingly, the names “ADM,” “Cargill,” and “The Andersons” appear only once in the report–and then only to state factually that they operate delivery facilities.  It is beyond belief that any serious study of the convergence issue would not attempt to dig into this real mystery of why operators of delivery facilities do not pick up the money that appears to be there in large amounts for the taking.  This is not an accusation of any wrongdoing–perhaps there is an explanation, and the apparent large sums of money to be had are chimerical because there is some cost that the delivery facility operators incur that is not obvious to me and other observers of this phenomenon.  But it should be the primary focus of any examination of convergence.  In the Senate report, this issue doesn’t even rise to the level of afterthought: it isn’t thought about at all.

The flagrant failure to engage the primary puzzle suggests that this was not a serious endeavor to understand an admittedly anomalous regularity in the wheat market.  Instead, it suggests that the Subcommittee and its chairman, Levin, had predetermined agenda: Speculation bad!  Index speculation bad!  The report goes nowhere close to proving that point.  Indeed, its watery-thin empirics, shaky logic, and failure to ask the most basic question prove only that one shouldn’t look to legislative reports for a serious discussion of serious issues.  They are polemics, not science.

The European Commission has just released a Commission Staff Working Paper  on “Ensuring efficient, safe, and sound derivatives markets.”  Not surprisingly, it comes out in favor of extending central clearing, especially to credit default swaps.  It must be said that the EC’s paper is far superior to the product of the US Treasury Department (a low bar, to be sure).  That said, I believe that many of the arguments and conclusions are fundamentally wrong.  The paper does the best job I have seen in making the case for extending clearing, but in so doing has unintentionally pointed out the flaws in that case.  Indeed, the basis for many of the paper’s conclusions actually supports the exact opposite of what the paper recommends.

At a high level, the failings of the paper are: (1) it identifies alleged benefits of central clearing, virtually all of which are private benefits, but completely begs the question “if these (private) benefits are as large as the EC says, why haven’t private parties adopted central counterparties (CCPs) more widely?”; (2) relatedly, it does not provide any explanation of why the market share of products purportedly traded on inefficient market structures has increased in recent years; (3) it fails to take into account the endogeneity of market structure, or explain how these structures arose and why–or why not–they are inefficient; and (4) although it clearly identifies the unique risks associated with CDS, it draws the exact wrong conclusion about how default risks from CDS should be borne–bilaterally or through a CCP.

The paper’s main case for CCP clearing (set out in section 2.4.2 and 2.4.2.2) focuses on netting, and the benefits associated therewith including “more efficient use of collateral” and “operational efficiencies.”  But these are benefits captured by the members of a CCP, and provide no rationale for mandating the adoption of clearing.  There’s no externality related to these issues that needs internalizing.  Relatedly, the paper asserts that a CCP is “considered a zero risk counterparty” and hence frees regulatory capital.  Really?  Clearinghouses can fail.  Cf. Hong Kong, 1987, and the near failures in Chicago at the same time, and the near failure on COMEX on “Silver Tuesday” 1981.  If regulators really treat it this way, a CCP would be a source of regulatory arbitrage, again meaning that market participants would have a strong–too strong, in fact–incentive to adopt it.  

With respect to risk sharing and collateral, the paper mistakenly claims that all collateral can be used to cover the costs of a default.  This is obviously wrong–as the box on SwapClear default management process in section 3.2.5.1 shows.  

The paper fails to mention that netting is not necessarily a social benefit, and can facilitate redistribution from one group of firms to another.  This redistribution can also give excessive incentive to form a clearinghouse.  

The paper also fails to recognize that more rigid collateral mechanisms can reduce the utility of a market as a hedging mechanism, and forcing adoption of these mechanisms can actually increase risks some firms face by precluding otherwise mutually beneficial hedging trades.

The paper touts that a CCP “an institution whose sole focus is risk  reduction.” But the world involves trade-offs, and an organization with a “sole focus” is not able to make such trade-offs. If the CCP prices risk appropriately, and therefore charges the right amount of collateral, then other market participants will make the appropriate decisions. But as I’ve argued extensively here, in my Regulation Magazine piece, and in working papers and presentations, for many transactions the clearinghouse is at an informational disadvantage relative to dealers in appraising risk–in which case it is less likely to price risk appropriately.

Moreover, the paper does not consider the incentives that the CCP faces. Yes, it has one job, but how strong are its incentives to do that job? A CCP is typically subject to low-powered incentives (e.g., non-profit form), which is understandable since it is an agent, and an agent of multiple principals; whereas a dealer bears many of the costs of poor counterparty risk management, as an agent the CCP does not. Moreover, although the CCP is touted as a solution to systemic risk, if systemic risk gives rise to externalities that affect those beyond its membership, this benefit is overstated: the CCP does not internalize all relevant externalities and therefore takes too few measures to address systemic risk.

The clear logical implication of the EC paper is: “If clearing is so great, somebody should have done it by now.”  Like virtually all advocates of the idea, the EC paper does not raise, let alone answer, that objection.  To do so, the EC must identify the market failure, and show how its proposed solution would ameliorate it. It has not done so.  It has not even recognized the necessity of doing so.  

The paper also asserts that clearing can “solve[] disruptive information problems” by improving information on positions.  But this can be achieved without the mutualization of risk that clearing entails.  

The paper sets out in great detail the dramatic growth in OTC trading, and the limited penetration of clearing, even in relatively standardized sectors.  Again, given the asserted benefits of clearing and other changes to OTC market structure, this calls for an explanation that is completely absent from the paper.  There must be something else going on here sufficient to overcome the supposed advantages of a CCP.

The paper does provide a very nice description of the variations in structure across different OTC products.  Note that these structures arise endogenously.  This raises the questions: (1) why do different products (e.g., interest rate swaps and CDS) have different structures? and (2) are these structures inefficient?  The endogenous variation suggests that there are fundamental differences across products and participants, and that different structures have evolved to accommodate these differences.  The paper sets out no serious argument or evidence that these variations are accidental, or inefficient.  As a result, it provides no basis for recommendations on how to change market structure via regulation.  

This failure to grapple with endogeneity–the causes of variations in market structure across products–leads to silly inferences, such as: “CCPs have proven to be resilient even under stressed market conditions . . . and showed their ability to ensure normal market function in the case of failure of a major market player” (2.4.2.1).  Yes . . . but this does not imply that similar results would obtain if all products were cleared.  The products that are cleared, and which worked successfully, have attributes that differ from the attributes of products that are not cleared–a point that the paper makes very forcefully.  Therefore one cannot conclude that requiring clearing of other products would work as well.  It could also be stated that other non-cleared products, e.g., CDS, also worked successfully in the face of the failure of a major dealer.

This issue of the differences across products is essential, and one that the paper raises repeatedly before drawing the wrong conclusion.  For instance, in the Executive Summary, and elsewhere, the paper says that CDS are different because of their “binary and discontinuous pay-out structure, concentrated dealer market structure, difficulty in valuing the rights and obligations contained in the contract, especially for the less liquid single name part of the market, lack of solid risk management measures and disproportionate dimension of the derivatives market with respect to the underlying market.”  I agree, completely.  

But I disagree with the conclusion drawn from these differences: “CDS have particular risks . . . all of which are difficult to mitigate . . . . For all these reasons, CCP clearing is desirable.”  But all of these features pose major informational challenges to clearing, and in my view, make it sensible to share risks bilaterally; the conclusion therefore does not follow from the stated premise.   Similarly, the paper points out the valuation difficulties involved in setting collateral from some products, due to the difficulties of valuation.  Again, agreed.  But the relevant question is who can do this better, bilateral parties or a CCP.  For some products, a CCP can do just fine, but for other products, it is quite likely that dealers can do a better job.  

These very considerations are why many operators of clearinghouses–who at first blush would seem to have an interest in a clearing mandate–have come out almost universally against such a requirement.  Note, this is not allegedly self-interested dealers talking: it is the clearing operators.  They recognize the unique risks of clearing some products, notably CDS, and believe that these risks make some products inappropriate for clearing.  That’s been the gravamen of my argument all along, but the paper completely overlooks this point–even though the clearing operators expressed their reservations very publicly weeks before the paper was released.  

Relatedly, in section 2.4.1.4 the paper identifies as a “Potential weakness of bilateral clearing” to be the fact that it relies on “each party’s internal ‘risk engine’ . . . . These risk engines are essential parts of a bank’s comparative advantage and while the broad contours may be similar each bank has a slightly different approach to risk assessment.  Overall, the crisis has highlighted the difficulty of designing models that adequately measure market risk.”  True, again.  But the relevant–unasked–question is: in this imperfect world, who can design the better model?  (Not perfect, but better.)  Due to the very “comparative advantage” aspect the paper identifies, dealers and other big traders have stronger incentives and better information to build better models than a CCP.  (A point I first made back in the 1990s.)  Moreover, an argument can be made that diversification in models is beneficial as a way of reducing the market’s exposure to model risk, whereas a clearinghouse chooses one model, and exposes the market in a big way to its (inevitable) limitations.  

In sum, in my view the paper presents a very thorough and accurate overview of the various OTC markets and products, and the unique characteristics of these products.  It then either ignores the implications of these differences altogether when making its recommendations, or makes recommendations that do not follow from its factual analysis.  Indeed, its recommendations are often the opposite of what a thorough consideration of the implications of these differences would imply.  

That is, the paper is very effective at pointing out the wide variation in the informational and risk characteristics of the various products traded in the OTC market.  It also effectively characterizes the wide variation in trading structures.  But it fails altogether at connecting these two inherently interconnected things.  Moreover, it focuses on the private benefits of its favored “solution” (clearing), even though this cannot be the appropriate basis for its policy recommendation.  There must be some sort of externality or other market failure that results in the adoption of inefficient institutional arrangements, but the paper fails altogether to identify what this externality or other market failure.

In brief, whereas the Treasury Department earns an F+ (and I am a generous grader), the EC merits a gentleman’s C.  It at least provides a factual basis for a considered analysis of the trade-offs entailed with different market structures.  I disagree with the conclusions it draws from its facts, but it’s a start, and a big improvement over Treasury’s arguendo ad AIG.

Soon after posting my piece on the Treasury White Paper where I repeated my argument about the failure of most regulators and commentors to think through the equilibrium responses that would likely occur as a result of regulatory changes, I came across this Seeking Alpha post by David Enke that makes the point nicely:

Gensler believes that “central clearing will further lower risk,” but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily.

One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem.  

Just so.  Couldn’t have said it better myself.  

The statement about “eliminat[ing] the efficient use of the OTC market” gets to the nub of the issue.  The Geithners, Genslers, and legislators looking to clamp down on the OTC market seem to believe that “efficient use of the OTC market” is an oxymoron.  I think that they are they are wrong, and in their misguided distrust of these markets, they will make things worse, not better.

I was quoted in this week’s Economist in an article raising doubts about whether OTC clearing is all that it is cracked up to be.  It is good to see good reporters at reputable publications chipping away at the happy talk conventional wisdom surrounding clearing.  The last sentence in the piece is especially important, and poses a question I’ve often asked here at SWP: “If the benefits of CCPs in OTC markets are so overwhelming, why did they not emerge on their own?”  Kudos to Adam Creighton and the Economist.

Finally had a chance to look over the much anticipated Treasury White Paper on “reforming” financial regulation.   It’s a long document, addressing many issues with which I am not that conversant, so I will focus my attention on the Paper’s recommendations for OTC derivatives.

The Paper begins its analysis with an extended discussion of what it asserts was a “lax regulatory regime for OTC derivatives–and, in particular, for credit default swaps” (p. 44):

In the years prior to the crisis, many institutions and investors had substantial positions in CDS–particlarly CDS that were tied to asset backed securites (ABS), complex instruments whose risk characteristics proved to be poorly understood even by the most sophisticated market participants.   At the same time, excessive risk taking by AIG and certain monoline insurance companies that provided protection against the decelines in the value of such ABS, as well as poor counterparty risk management by many banks, saddled our financial system with an enormous–and largely unrecognized–level of risk.   When the value of the ABS fell, the danger became clear. . . . Lacking authority to regulate the OTC derivatives amrket, regulators were unable to identify or mitigate the enormous systemic threat that had developed (pp. 44-45).

Based on this rather tendentious reading of the history of highly non-standardized, illiquid instruments, and on this reading alone, the Treasury makes the following policy recommendation:

To contain systemic risks, the Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).

This has to be one of the most collossal non-sequiturs on record.   Highly non-standardized financial derivatives allegedly led to a systemic crisis–so we should mandate clearing for standardized products.   As an exercise in logic, by comparison to this the “Burn the Witch” scene in Monty Python in the Holy Grail is a model of precise reasoning.

Thus, as has been true all along, the case for clearing of standardized OTC derivatives levitates, with no evident means of logical or empirical support.   This could be a great Vegas magic act.

In retailing, this is known as the “bait-and-switch.”   Regulators often punish stores that engange in such conduct.   Here, we’re out of luck–because the regulators are the ones perpetrating the bait-and-switch.

A coherent case for mandating clearing would require a demonstration that OTC derivatives suitable for clearing pose a systemic threat, at least illustrated by anecdotes analogous to the now tired arguendo ad AIG.   (The absence of any such anecdotes is very, very telling–not to mention that argument-by-anecdote is a very de minimus standard because “data” is not the plural of “anecdote.”)   What’s more, the argument would require a rigorous comparative analysis of the systemic risks posed by alternative mechanisms–bilateral and centrally cleared.   Instead, we are repeatedly entertained by next part of the magic act: assertions that clearing makes these risks disappear!

Even the arguendo ad AIG has its defects.   To wit:

• If “the most sophisticated market participants” failed to recognize the risk characteristics of the CDS on ABS, how possibly could one expect a CCP to do any better?   Yet another magic trick: the CCP as deus ex machina, that magically appears to solve all of the difficulties that had stumped the most sophisticated.   Indeed, if anything, the CCP is likely to be a less sophisticated evaluator of risks.   So wouldn’t forcing things onto clearinghouses potentially make things worse?
• “Excessive risk taking by AIG and the monolines . . . saddled our financial system with an enormous . . . level of risk.”   This betrays a serious misunderstanding of the role of derivatives.   As I argued in It’s a Wonderful Life, AIG Edition, AIG et al took on existing risks associated with existing ABS.   If AIG et al hadn’t taken on the risk, it would have remained somewhere else in the financial system.   And it’s almost certain that it would have remained with Goldman, SocGen, DB, etc.   So, if the decline in ABS prices was so big to threaten the existence of those firms unless AIG paid off on its CDS, their existence would have been even more threatned without AIG’s equity absorbing a portion of the loss.   The bailout would have been bigger, not smaller.   The only substantive difference is that it would have gone to these firms directly, rather than being laundered through AIG.
• More generally, this points to a continuing defect with the Treasury analysis, and most other analyses of regulatory changes: the equilibrium responses to these changes.   It is clear that Treasury, and Washignton generally, now views OTC derivatives as the financial equivalent of Satan, and wants to crack down on them.   Let’s say this happens, and OTC derivatives shrink, or even disappear.   How will market participants respond?   Will there be less hedging because an instrument that revealed preference suggests is superior to available alternatives is constrained?   If so, will the system become more susceptible to disruption, not less?   By focusing on the seen, and failing to inquire at all about the endogenous, equilibrium effects of changes in regulation that are largely unseen, regulators are likely to make things worse, not better.
• As I’ve noted before, “standardization” is a red herring in many respects.   Standardized instruments may be unsuitable for clearing due to serious information problems.

Other policy recommendations also float in the air, untethered by logic or evidence.   For instance, the White Paper asserts in a decidedly conclusory way that “[m]arket efficiency and price transparency should be improved in derivatives markets by requiring the clearing of standardized products . . . and by moving the standardized part of these markets onto regulated exchanges and regulated transparent electronic execution systems . . . . Furthermore, regulated financial institutions should be encouraged to make greater use of regulated exchange traded derivatives.”

Note the implicit assumption that incumbent arrangements are inefficient, and result in an inefficient level of price transparency.   Why should inefficient market arrangements persist?   Surely, they can.   And if they do, it should be possible to present argument and evidence demonstrating this.   No luck if you are looking for anything about that in the White Paper, or virtually any government discussion of this issue.

Another lighter-than-air argument relates to “market integrity”: “Market integrity concerns should be addressed by making whatever amendments to the CEA and the securities laws that are necessary to ensure that the CFTC and the SEC . . . have clear, unimpeded authority to police and prevent fraud, market manipulation, and other market abuses involving all OTC derivatives” (p. 46).   What the necessary laws might be, the Paper doesn’t bother to say: I guess that’s the mind reading portion of the act.   Again, you would think that if there are demonstrable gaps in the existing authorities to punish manipulation, etc., it would be possible to cite chapter and verse to support the claim.   No such citations here.

I can only hope–and I am sure that it is just that–that the level of analysis is superior in the remainder of the White Paper.   All I can say is that the case laid out regarding the dangers of OTC derivatives, and the improvements that would result from the policy recommendations, is completely lacking.   Completely.   Like I said above, the policy recommendations regarding OTC derivatives levitate, unsupported by any serious analysis or evidence.   Out of such sloppy group-think legislative and regulatory disasters are made.   So get ready for an explosion when the spark of reality ignites the gas holding aloft this regulatory Hindenberg.

John Dizard wrote an interesting piece on mandatory CDS clearing in the FT:

There’s a new series of disaster scenarios being talked out, most publicly in Congressional hearings on financial system reform. The two parties, buyside and sellside, are assembling their coalitions.

As is usually the case, the sellside, which is to say the big New York dealers, have so far been fastest off the mark. However, too many people on the buyside are watching this time to allow the sellside an easy win judged by friendly officials.

The CDS dealers now have their ICE Trust clearing platform up and running, have somewhat rationalised the documentation and terms, and have substantially reduced the volume of outstanding CDS contracts. They call the ICE Trust a “central clearinghouse”, by the way, which I would not. A real clearinghouse, of the sort that is used by commodities futures exchanges, is heavily, independently, capitalised, and can call on the resources of its clearing members to meet any shortfalls in capital caused by a failure. It also has clear margining requirements that are substantial in relation to the risks, which must be satisfied daily with cash on pain of liquidation.

The ICE Trust platform, in contrast, is a limited liability company. So no mandatory capital calls. The margining is modest in relation to value of the positions, and is more flexible and forgiving than that on public exchanges. The ICE Trust is a thinly capitalised bank, owned by other banks, and deals only through banks. Even well capitalised non-banks have to go through the likes of Tarp recipients. The security of the CDS clearing is based on trust and the taxpayers who underwrite the security of the banking system.

I share Dizard’s concerns about the capitalization of ICE Trust, although I believe he is wrong about “no mandatory capital calls.”  Chuck Vice, President of ICE, told me that ICETrust members can be required to contribute an amount equal to their original contribution to the guaranty fund in the event of a default that exhausts that fund.  The problem is, even with that feature, the clearinghouse may be less than adequately capitalized.  Moreover, I don’t think that the issue is that ICE margining is more modest and relaxed than at other clearinghouses.  My concern is that ICE doesn’t have the information to set the margins as effectively as bilateral OTC market dealers.  

Dizard also notes something that I mentioned some months back: the reluctance of some Chicago clearing member firms to embrace CDS clearing:

The Chicago traders, who had resented the New York dealers’ monopoly on CDS clearing, gradually realised that clearing CDS on single names (companies or countries) was a poisoned chalice. A Lehman or AIG-like failure could decapitalise all their other markets.

The FT has more information on exchange jitters on an OTC clearing mandate:

The word “standardised” sounds innocuous enough. But its use in a US policy document on the future of over-the-counter derivatives has set alarm bells ringing at derivatives exchanges.

Tim Geithner, US Treasury secretary, has said that to contain systemic risks he wants US laws to be changed to require clearing of “all standardised OTC derivatives through regulated central counterparties [CCPs]”.

This marks a sweeping change to the way OTC derivatives are handled, implying a shift away from the dealers at banks who brokered such contracts to the formal exchanges that have long jealously eyed the huge OTC markets.

But what does “standardised” mean? How much of the OTC markets can and should be shifted on-exchange, whether cleared or – as Mr Geithner also wants – traded?

Nobody has a clear answer, since OTC derivatives come in many shapes and sizes, ranging from straightforward interest rate swaps to more tailored products such as “average price options” used by grain processors to hedge against movements in crop prices.

Exchanges, many of which own their own clearing houses, might be expected wholeheartedly to welcome the Geithner proposals. But they are warning against a strict definition of “standardisation”.

Craig Donohue, chief executive of CME Group, the largest US futures exchange, which owns a clearing house, says: “Standardised is not the right way to do it.”

He and others are concerned that lawmakers in the US Congress may come up with a strict definition that would force a shift of OTC contracts into clearing houses that are ill-equipped for the task.

They warn that such a move could expose clearing houses to unnecessary risks that could even damage the financial system at a time when regulators are looking at ways to protect it against future crises.

Kim Taylor, president of CME clearing, says: “There is a danger in having regulatory mandates that are too broad, that would require clearing of products that clearing houses don’t feel comfortable risk managing.”

Declan Ward, executive director at NYSE Liffe in charge of clearing, says the danger is that certain OTC products with unique specifications negotiated to deal with particular risks are relatively illiquid. Coupled with lack of transparency in pricing “you are adding risk to a CCP”.

These are important points.  “Standardization” is not the only issue.  Certainly, more complex, non-standardized derivatives are problematic to clear.  Illiquidity and lack of reliable pricing information for seldom-traded instruments–standardized or not–can also raise major problems for clearing, as Declan Ward and Kim Taylor suggest: and as I’ve written in my academic work going back to 1997.  

CME’s Craig Donohue favors letting the market sort out what is, and what’s not, appropriate for clearing:

Mr Donohue says: “I worry that those kinds of definitions wouldn’t have all that much durability given the level of innovation.” Like other exchange heads, he argues that the market must have a role in deciding which OTC products should be cleared. A recent jump in the number of OTC energy derivatives being cleared through the CME’s Clearport clearer has been driven purely by market demand, he points out.

MarketWatch provides additional evidence of skepticism, including from a regulator (Britain’s FSA) and the DTCC:

Broad proposals for tighter regulation of the over-the-counter derivatives market have already been put forward in the U.S. and Europe authorities are widely expected to follow suit.

Alexander Justham, director of markets at Britain’s Financial Services Authority, said the derivatives market has grown without transparency.

The natural response is the “vanilla-ization” of contracts, by standardizing the terms so they can be traded on an exchange or cleared through a so-called central counterparty (CCP), which acts as an intermediary and absorbs the loss if one party defaults, Justham said.

“But not everything can be put on an exchange and not everything can be cleared,” he cautioned at a recent Mondo Visione conference in London.

Other commentators agreed, saying clearing houses would struggle to handle some of the more complex derivatives.

“The danger is that too much reliance will be placed on CCP clearing,” said Diana Chan, CEO of clearing house EuroCCP, which is a unit of the U.S.-based Depository Trust & Clearing Corp.

In order to be suitable for clearing, a derivative contract must be relatively easy to price, so the CCP can collect the right amount of margin, and trading must be sufficiently liquid for positions to be closed quickly, Chan said.

AIG’s downfall

Credit-default swaps have been at the center of the argument over derivatives because of their role in the near collapse of American International Group Inc.

CDS are similar to an insurance contract and pay out if a company defaults on its debts.

But volumes soared in the lead up to the credit crisis, and the opaque nature of the market meant it was almost impossible to track where the exposure to these derivatives lay.

Justham said a straight-forward CDS on, say, supermarket chain Tesco, might be suitable for trading on an exchange. But more complex contracts, such as bespoke agreements linked to several different credit events, wouldn’t work.

Even liquid contracts such as simple credit-default swap can pose problems, because when the underlying debt gets close to default, that liquidity can dry up very quickly, said Roger Liddell, CEO of LCH.Clearnet, a clearer mostly held by its users.

Glad to have company, folks.

Mandatory clearing, and the associated greater rigidity in margining, could also dramatically reduce the utility of the derivatives markets as hedging vehicles.  Rigid, daily mark-to-market payable in cash, subjects hedgers to cash flow risks.  Even if a derivatives position and an underlying position have mark-to-market values that are almost perfectly correlated, cash margining with daily mark-to-market generates cash flow changes on the derivatives hedge position that may not be matched by offsetting cash flows on the position being hedged.  This mismatch can greatly reduce the utility of hedging, and lead firms to do less of it–and hence result in them bearing more price risk.  That’s a highly undesirable outcome, and a cost that advocates of mandatory clearing do not address.  OTC markets permit more flexibility in managing these cash flow considerations, which is one reason why hedgers often prefer OTC markets to cleared exchange markets.

(As an aside, it’s also one reason why the LME fought introducing clearing even in the aftermath of the tin crisis, and even when forced to do so, implemented a clearing system that permitted more flexibility and use of credit.  This was intended specifically to meet the needs of metal hedgers, who would often have a gain on a hedged metal position, but since this gain did not generate a cash inflow, would be required to stump up additional cash to pay the MTM loss on the hedge under standard futures margining practice.)  

In sum, there are a lot of reasons to have a variety of methods for trading derivatives, and for allocating the default/performance risks associated with them.  These go a long way to explaining just why such a variety of methods exist, side-by-side.  As I’ve said before, the advocates of a mandate have not even attempted to provide a credible explanation as to why market participants would avail themselves of a variety of different mechanisms, if one is decidedly superior.  In contrast, there are numerous, well-articulated (if I do say so myself;-) arguments as to why they do so, and why it is best to let them do so.  As the foregoing articles suggest, moreover, numerous market participants–including those, such as exchanges and the DTCC, who might otherwise seem to have an interest in supporting a mandate because it would send business their way–also recognize that these considerations are quite important.  One hopes that they are sufficiently persuasive to convince Congressmen, regulators, and our Secretary of the Treasury, all enamored with clearing, that it is not a good idea to try to pound a square peg into a round hole.

Recent legislative proposals would outlaw short selling of credit default swaps, i.e., only bond owners can buy protection.  (Remarkably, such a provision is included in the Waxman-Markey climate change bill.)  As if to prove that there is little new under the sun, Larry Neal of the University of Illinois presented a paper at the Manufacturing Markets Workshop in Florence, which closes with the following:

The most enduring, and ultimately most controversial, piece of legislation to arise in the eighteenth century was Barnard’s Act (7 Geo. II, cap 8).  Parliament passed the act originally in 1733 for a period of three years to see what effect it might have and then made it permanent in 1736 after it appeared that the limited number of securities available had not suffered any adverse effect s of the act. . . . The act was intended to eliminate time bargains in public securities altogether by requiring the seller of government stock for a forward contract have possession of the stock at the time of the contract, essentially eliminating options business on forward contracts or the settlement of forward contracts by paying the cash difference between the forward price agreed and the spot price at the time agreed for the completion of the contract.  Sir John Barnard thought that this would eliminate sudden movements in the prices of various forms of government debt by eliminating the pernicious business of stock-jobbing.

After his presentation, Larry noted to me that the primary effect of the Act was to drive forward trading from London to Holland.

I’ve been critical of current legislators and the Administration for seizing on a regulatory framework mandating exchange trading first established in 1921-1922 to serve as the model for current regulatory proposals.  Perhaps I was too critical: an early-20th century precedent appears progressive indeed, as compared to the early-18th century precedent of the short sale ban.  

In a nutshell: these various “new” regulatory proposals are not new at all.  They have been tried before.  And found wanting.  They are simplistic, based on a misdiagnosis of the operation of the market, and are nostrums that will at best will not make things worse, although it is more likely that they will dramatically reduce the efficiency of the market and may well increase systemic risk.  Another example of “learned nothing, forgotten nothing.”

I was somewhat surprised to see both CME and ICE come out in opposition to mandatory OTC derivatives clearing:

Top managers from two major financial exchange groups on Monday warned the U.S. government not to go too far in forcing central clearing of over-the-counter derivatives, a troubled, multi-trillion-dollar market whose future is central to both companies.

Terrence Duffy, executive chairman of CME Group Inc <CME.O>, said in prepared remarks to be delivered on Tuesday to a congressional panel that government-mandated clearing of all over-the-counter derivatives could drive business overseas.

. . . .

ICE’s Sprecher said in prepared remarks that forcing illiquid, unstandardized derivatives contracts into a clearinghouse could actually increase market risk.

“While ICE certainly supports clearing as much standardized product as possible, there will always be products which are either non-standard, not sufficiently liquid, or that do not have enough interest in them for clearing to be practical, economic or necessary,” he said.

“While the illiquid and unstandardized contracts should not be forced to be cleared, firms dealing in these derivatives should report them to regulators, so regulators have a clear and total view of the markets.”

Jeff Sprecher has it exactly right.  You can get the transparency without going to the full risk sharing inherent in clearing.  What’s more, mandatory clearing can actually increase risks.  

I was invited to testify at these hearings, but had to decline due to my prior commitment to a conference.  Hopefully I’ll have the opportunity to do so at a later date, and give it to them with the bark off, for it is evident that there is much ignorance on these issues in both the press and Congress:

First, the press:

Many OTC derivatives flew off the rails in 2007 when the housing bubble burst and credit tightened, leaving banks, such as the now defunct Lehman Brothers, with huge losses. Credit default swaps played a major role in the troubles at American International Group <AIG.N> that led to its government bailout.

The connections in the sentence about Lehman Borthers are completely incoherent.  This is just stringing together a bunch of things that happened and asserting a causal connection.  Lehman had OTC derivatives.  There were housing and credit crises.  Lehman had huge losses.  The OTC derivatives of the kind at issue in clearing were not Lehman’s main problem.  How about some real reporting, and some real forensics, about the connection between OTC derivatives, including CDS and interest rate swaps, and what happened to Lehman.  What I’ve quoted above is far to common, and is just lazy repackaging of somebody else’s lazy BS.  And for the billionth time, AIG is the reddest of herrings in the OTC derivatives debate.  Give it a rest.  Please.  

Now, Congress:

As lawmakers and the Obama administration move to crack down on OTC derivatives, the House Capital Markets Subcommittee is set to hold a hearing to “advance the discussion in Congress on … meaningful regulation of this dark corner of the financial services industry,” said Representative Paul Kanjorski, Democratic subcommittee chairman, in a statement.

Can we please give the “dark corner” and “dark market” metaphors a rest too?  Yesterday, maybe?  And WTF does “meaningful” mean?  Bad regulation can be meaningful.  Just what is the appropriate regulation, and how do the proposed regulations–especially mandatory clearing–make the markets more efficient?    

Don’t wait up for an answer.  These people don’t even know to ask the questions.  We just get bromides about dark markets.  

I know who’s in the dark.  And it ain’t the markets.