Streetwise Professor

There are at last count five major initiatives to create a credit derivatives clearinghouse. The two leading contenders are a CME-Citadel (CIG) initiative, and a collaboration between the Clearing Corporation (and hence the major banks that own it) and ICE (further proof that ICE is firmly aligned with the major banks, as its CBT foray also indicated). This Reuters article gives the CME-CIG venture the inside track. I don’t handicap things quite the same way.

I see two big obstacles to the CME, both essentially political in nature. First, the big banks and CME have been in a cage match for the last couple of years, and the banks will resist transfer of additional power to the CME. The CME will have to depend on buy side support, b/c the buy side hates the banks worse than the CME.

Citadel’s alliance with CME very interesting in this regard. CIG is with the banks in the ELX initiative to compete with the CME in futures trading , but with the CME and against the banks in this effort to compete with the latter. It seems that CIG is trying to play balance-of-power games here, leaning against the dominant party in the exchange and OTC spaces.

Second, the DOJ concerns about CME market power (expressed in the infamous February letter) will become more acute. Their precedent in the CBT merger tied their hands in NYMEX, but it would not do so in contesting CME market dominance in OTC clearing.

The big bank opposition to the CME is probably the biggest hurdle. All of CME’s OTC clearing initiatives have focused on the buy side, and probably for good reason. But support from the big OTC dealers–as long as any of the latter exist–is probably vital for any venture to succeed. But at the same time, the CME has a lot more credibility than the major dealers and the (until recently moribund) Clearing Corp. I would therefore expect some sort of uneasy alliance involving both CME and the dealers and important buy side participants, perhaps resulting from a shotgun wedding arranged by the NY Fed and the Treasury.

It is also interesting to note that both the CME/CIG and CC/ICE ventures plan an execution platform piece to go along with the clearing piece. The execution platform is probably more essential for the CME venture because it has to pry away transactions from the dealers to succeed.

A more transparent pricing and execution system is also an important element of a successful clearing venture. As I have laid out in my academic work, and will discuss further in soon-to-follow SWP posts, clearinghouses don’t create price transparency, they depend on price transparency. Clearinghouses can improve position transparency by collecting and aggregating position information. But clearinghouses use prices determined in the execution market. They do not create these prices. Price information is vital for marking positions and managing collateral, and also for calibrating risk models used to establish collateral levels and monitor clearing member risk. Therefore, initiatives to improve price information are essential to making clearing work. One way to do that is to move trading onto centralized platforms. Another is to centralize the collection and dissemination of price information through the creation of a data hub, a subject I’ve discussed on SWP before.

It will be interesting to see how this will all play out. There will be a political component here, as the sums at stake are immense–as the Reuter’s article discusses. Moreover, the economic issues are quite fascinating. Over the next couple of days I will focus on those issues in more detail in upcoming SWP posts.

Today’s musical selection is Queen’s I Go Crazy. (Some may dispute the verb, or the tense thereof.) What is making me go crazy? The continuing stream of conclusory assertions that someway, somehow, OTC derivatives are at the root of the current financial crisis, and that some past opportunity to regulate these monsters was missed, thereby paving the way for our current difficulties.

This WaPo article is a classic in the genre. Inasmuch as I am quoted in it, perhaps I seem an ingrate to criticize, but criticize I must–although it is better than most. In this narrative, ardent free marketers and patriarchial figures Alan Greenspan, Arthur Levitt, Robert Rubin, and Larry Summers crush the Quixotic crusade of valiant CFTC chair Brooksley Borne to regulate OTC derivatives. If fair Brooksley’s advice had been taken, the article suggests, what went wrong wouldn’t have gone wrong.

That is, to say the least, a very debatable proposition. One thing worth noting is that the focus at the time was interest rate swaps, instruments that have played no role in the collapse of any financial institution. Credit derivatives were in their infancy at the time discussed in the article. Indeed, they were barely a gleam in their inventors’ eyes.

More importantly, although Born warned of the systemic risk posed by OTC derivatives, discussion of how any specific regulation she proposed would have affected current events is completely absent. Nor was Born herself particularly specific at the time.

The article discusses clearing, but importantly misses a key point. The Commodity Exchange Act (CEA) requires contracts for future delivery to be traded on a designated contract market, i.e., and exchange regulated by the government. The concern at the time was that the legal status of OTC swaps ambiguous given this language. Were swaps futures? If they were, any swap not traded on an exchange would potentially be legally unenforceable. This was a major, major concern. In response to this, during this time period the CFTC proposed a set of criteria to distinguish futures–that had to be traded on exchanges–from non-futures, that were exempt from the contract market provision of the CEA. One of the criteria that would have made something a future was centralized clearing. That is, a centrally cleared product was more likely to be considered a future than one that was not centrally cleared.

Thus, if anything, CFTC policy ideas at the time militated AGAINST moving to central clearing of OTC instruments. In essence, the Born-era CFTC approach tied the means of execution (on an exchange) to the means of sharing credit risk (central clearing.) The Commodity Futures Modernization Act (CFMA) essentially avoided this pernicious bundling constraint, and thereby made it more likely that OTC clearing would develop.

There is no reason to force all trading into a particular model, e.g., to force all transactions to occur on exchanges. Many important markets are dealer markets–the Treasury market being a prime example. A CEA-type link between trading mechanism (on exchange) and performance risk sharing mechanism (clearing) creates an unnecessary constraint that raises costs. It requires a one size fits all approach despite the fact that a diversity of trading and risk sharing mechanisms satisfying heterogeneous and diverse needs is likely to be efficient.

The article also denigrates the elimination from the CFMA of a provision calling for federal oversight of a clearinghouse. But, as the article notes, the OTC clearing idea “sat dormant.” If it wasn’t adopted with less onerous regulations, is it reasonable to conclude the industry would have started one if more strict regulations were in place?

The reasons for the dormancy of OTC clearing are important to understand, and not completely understood. I have a slew of clearing-related posts coming, so I will defer fuller discussion until then. For now, suffice it to say that Brooksley Born’s defeat at the hands of the patriarchy had nothing to do with it. As I already noted, the Born ultimatum approach would have actually impeded the development of clearing. It should also be noted that the article’s narrative is contradictory; the article specifically states that Treasury pushed for the idea of an OTC clearinghouse even though Treasury Secretary Rubin is portrayed as one of Born’s antagonists.

Moreover, the article states that the failure of AIG was attributable to its large losses in credit derivatives, and implies that if credit derivatives had been better regulated then (a) AIG’s failure might have been avoided, and (b) the financial crisis would have not been as bad as it is. The latter proposition is the important one, and the basis for it is completely lacking in the article, and in most discussions of the issue.

Ultimately, AIG’s failure is attributable to the fact that it insured against losses on mortgage securities, and these mortgage securities plummeted in value. It is exactly analogous to an insurance company that insured against earthquakes, only to be bankrupted when a trembler of unprecedented power occurred.

That is, in the first instance AIG’s losses on credit derivatives were a symptom of, rather than a cause of, the financial tremors. And as I have written before, it is plausible that (a) AIG was the efficient bearer of this risk, and (b) as a result, the same tremor would have wreaked even greater havoc on less-well capitalized institutions had they not purchased insurance from AIG. No insurance company should be so well capitalized that the probability of default is zero. Thus, the fact that an insurance company failed does NOT imply that constraints on its issuance of insurance would have been welfare improving. In fact, the opposite conclusion is far more likely to be true; constraining or eliminating even incomplete insurance would have almost certainly been inefficient.

To make OTC credit derivatives the villain of the piece requires a more complex argument. One would have to argue that the existence of insurance for mortgage derivatives contributed to the proliferation of subprime debt, and tranched securities created atop it, and to the housing bubble. For these mortgage/real estate factors are at the root of the current difficulties. This causal link is inherently indirect, and very hard (and perhaps impossible) to prove. Moreover, any contribution of credit derivatives is almost certainly of second or third order as compared to the direct causes–loose monetary policy, political encouragement and subsidization (via Freddie and Fannie) of subprime lending, agency problems, rating agency failures, etc.–that fed the housing bubble and the proliferation of subprime debt.

I again reiterate that one needs to be specific as to the content of regulations before passing judgment on their likely effects. In particular, it is very difficult to demonstrate how most regulatory proposals, which frequently focus on various fraud, disclosure, trading mechanism, and manipulation-related issues, mitigate systemic risks.

Furthermore, I would suggest that any attempts to regulate instruments per se are almost inevitably doomed to failure. Regulate one instrument, and in a trice financial engineers will figure out a workaround. This is almost certainly a wealth-reducing arms race. (Were I speaking completely self-interestedly, I would advocate such regulatory efforts, for it would increase the derived demand for my services.) A functional regulatory approach is preferable under these circumstances, but the basic distinction between functional regulation and regulation of particular instruments has been completely overlooked in most of the public debate.

In sum, I go crazy because the public treatment of regulatory issues surrounding derivatives is largely built on myths, incomplete history, and a failure to understand the basic vulnerabilities of any regulatory system. A Reuter’s article aptly states that credit derivatives are “vilified as a major contributor to the current financial crisis.” This is true, but the argument behind the vilification is largely–and arguably completely–nothing but an assertion, repeated over and over again, with little supporting argument and less supporting evidence. This is the perfect hothouse environment in which to grow bad policies and bad regulations that will have serious, adverse unintended consequences down the line.

What is needed is a sober appraisal of the costs and benefits of specific financial innovations, and proposals to regulate their use and development. What we have instead is knee-jerk reactions based on bad analysis. Virtually everyone is calling for more regulation, details to follow. Having seen how regulation often works, I reply: Be damned careful what you ask for.

More from Matt Leising at Bloomberg on yesterday’s oil squeeze:

“This sharp move reflected extreme tightness in the prompt physical market as participants that were short oil scrambled to find physical oil before expiration,” wrote the analysts, led by Jeffrey Currie. Record oil prices have made refiners rely on stocks of existing supply, the analysts wrote, creating “critically low” inventory levels.

Vulnerable to Spikes

“This tight inventory situation has left the oil market with very little cushion and therefore extremely vulnerable to price spikes,” the note said.

Trading was light on Nymex yesterday. About 41,000 crude contracts for October delivery changed hands, 85 percent less than the 15-day moving average volume of 280,000 contracts, according to Bloomberg data.

The traders who sold contracts short might have been betting on price declines due to less-than-expected damage to oil rigs and production from Hurricane Ike as it crossed the Gulf of Mexico.

“Ike did more damage than originally thought,” said Rick Mueller, director of oil markets at Energy Security Analysis Inc. in Wakefield, Massachusetts.

The most recent storm in the Gulf made landfall in Texas on Sept. 13, cutting off power and damaging some refineries. U.S. energy producers resumed output for about 23 percent of oil and 34 percent of natural-gas production in the Gulf after the storms, the Minerals Management Service said yesterday in a statement on its Web site.

This suggests that deliverable supplies were low due to Ike. Low deliverable supplies make the market more vulnerable to a squeeze. Put differently, somebody with a 10 million barrel futures position may not be able to squeeze the market profitably when deliverable supplies are 9 million, but may be able to do so when they are only 5 million or 4 million. Thus, Ike’s disruptions raised the likelihood of a squeeze.

One should not go the next step–as people often do–of concluding that Ike “caused” the price disruptions in the October contract. Just as a forest fire requires BOTH dry tinder AND a spark, a squeeze requires low deliverable supplies AND the affirmative action of a large long (or longs). A large long must demand excessive deliveries. The low deliverable supply only means that the long can get the same price effect–and a bigger profit–by demanding fewer deliveries and liquidating more contracts at an artificially high price. Put differently, the cost of manipulation is burying the corpse of deliveries. With low deliverable supplies, the corpse is small, and the manipulation is easier to carry out. To mix metaphors, and extend the forest fire example, the low deliverable supply is the dry timber, but the uneconomic demands for delivery by a large long or longs is the spark that is necessary for the fire to occur. Low deliverable supply is a precondition that makes the market vulnerable to a squeeze. But somebody has to do the squeezing. Smaller players can squeeze when deliverable supplies are small.

Since the FTC Report on the Grain Trade in 1920-1921, it has been common to label events like those of yesterday as “natural squeezes” because “natural” market conditions made the squeeze possible. The “natural” terminology has been used to excuse the opportunistic exercise of market power by those who exploit these conditions to distort prices. This “reasoning” is wrong, and highly injurious to the market. It essentially gives longs a manipulation option. Hold a large long position to expiration. If something happens to reduce deliverable supply–squeeze away, and make money. If nothing happens, just liquidate at the competitive price. When they come after you for squeezing, just say “Hey, it was a natural squeeze. And natural is good, right? That’s what they tell me at Whole Foods!” It’s worked. And it has undermined market efficiency. Regardless of whether exogenous events made a squeeze more profitable, a necessary condition for the squeeze to occur is for somebody to exercise market power opportunistically. These people should not be allowed to skate.

As commentor Scott Irwin noted, due to the fact the squeeze took place in a very short period of time, it is unlikely that it will have acute deadweight costs, although large amounts of money will change hands as a result. (The fact that the main price action took place in the last half-hour of trading that is used to determine settlement prices–and the final prices on swaps tied to NYMEX CL–suggests that somebody was long swaps as well as futures, and earned profits from the price distortion on a cash settled OTC swap position.)

The main deadweight cost is the effect that the episode will have on the speculation debate. People are already seizing on this as evidence that market manipulation is a serious problem that needs to be addressed by more draconian restrictions on market participants. My take is very different. The contrast between what happened on 9/22 and what happened in the last half of 2007 and the first 8 months or so of 2008 shows that the big price surge in oil that peaked in July was almost certainly NOT the result of manipulation.

Yesterday’s events bear all the hallmarks of a squeeze. It waddled like a squeeze, it quacked like a squeeze, it flew like a squeeze, and it swam like a squeeze, so . . . I would have a hard time arguing that what happened in the October CL price was normal and competitive.

So what yesterday shows is, yeah, manipulation can happen. What happened on 9/22 bears all the hallmarks of a manipulation—and look how different that was from what transpired over the first 7 or so months of 2008. The 9/22 event was intense, but limited to a very short period of time in a single market. It affected one price that moved a lot relative to other prices (e.g., the November price, the prices of heating oil and gasoline). It happened as the contract moved to expiration/delivery. That’s what happens during a squeeze, a manipulation.

In contrast, the runup in oil prices over 2007-July, 2008 was long, sustained, occurred in all markets, was not concentrated around contract expirations, and did not result in one price getting way out of line with all other prices.

Thus, in my view, by contrast, the squeeze of 9/22 shows that what happened in 2007 and the first 7 months of 2008 was NOT manipulative.

The events also showed that when a squeeze happens—people notice. Regulators notice. The subpoenas went out within hours of the event. People will sweat. People will pay. That’s the way to deal with it. By focusing on people who engage in demonstrable wrongdoing, and punishing them severely—not by clamping down on all speculative activity, virtually all of which is quite legitimate. Cut out the cancer—don’t shoot the patient in the head—a surefire cure, but not a very constructive one.

This episode also brings to mind a historical parallel. In May, 1921, the Senate was holding hearings on the regulation of futures trading. A representative of the Chicago Board of Trade, Julius Barnes, testified that there was no need to regulate futures trading because the exchange had the incentive and ability to prevent manipulation. The very moment he was speaking, a large grain trader named Field executed a huge squeeze of the expiring May wheat future. The price of May wheat rose $.17/bu–almost 10 percent–on the last day of trading, and the price of cash wheat fell $.20/bu the day after the contract expired. This spike and crash is symptomatic of a squeeze.

An exasperated Barnes wrote to his business partner: “nothing has embarrassed, in recent years, like the gyrations in Chicago May–the very day we were arguing before the Senate Committee that the governors of these exchanges were making some progress themselves in eliminating manipulation.” A month later, a chastened representative of the CBT, L.F. Gates, testified before the Senate that “The trade recognizes the manipulator as the enemy of the whole organization. We dislike him as much as any of you gentlemen do, and if we could find any way of shitting him out absolutely, we would do it. Maybe you can help us on some of these problems.” In other words, the CBT almost begged for regulation. The Congress obliged, passing the Futures Trading Act, the first major Federal regulation of the futures markets, and the progenitor of the Commodity Exchange Act that governs the markets to this day.

Thus, the actions of a squeezer–Mr. Field–on one day dramatically changed the political landscape, and forced a previously recalcitrant CBT to submit to Federal regulation. Sadly, whoever squeezed the October crude contract on 22 September, 2008 may have a similar legacy. Even though the October CL squeeze in no way validates the wild accusations leveled against oil speculators for causing the price runup to $147 in July, it may well become the “I rest my case” Perry Mason moment that will be used to justify wide ranging restrictions on energy trading. Restrictions that will do little if anything to prevent events like those that occurred on Monday; that will not prevent prices from rising to $147 or higher when fundamentals justify it; and that will impair the efficient operation of the market as a price discovery and risk management tool.

Thanks, buddy, WTF you are.

It is apparent that the decisive factor that drove the Treasury to intervene with AIG is the insurer’s immense position in credit derivatives, notably credit derivatives tied to various mortgage securities. Whereas it seems that in the case of Lehman’s slow motion implosion, market participants had the opportunity to move positions and thereby limit the potential for a cascade of knock-on defaults on derivatives arising from a Lehman default, AIG’s much more rapid plunge permitted no such luxury. Fearing that AIG defaults would trigger defaults or bankruptcies by its counterparties (either because they held offsetting positions with others, or because the loss of the insurance contracts would blow holes in balance sheets large enough to force bankruptcy), the government decided to step in and effectively guarantee AIG’s performance on all its obligations.

The wreck of AIG hard on the heels of the collapse of Lehman hard on the heels of the disappearance of Bear has led to repeated calls for the establishment of a clearinghouse–a central counterparty (“CCP”)–for OTC derivatives, including credit derivatives. In this post I will attempt to discuss some of the issues this possibility raise. Bottom line: a CCP could help a lot, but it is not a panacea. Moreover, the benefits of a CCP depend crucially on the answer to the question: Why hasn’t the market already created a CCP?

What does a CCP do? It insures default/performance risk by mutualization, i.e., sharing of these risks across market participants. Note that in the days (or should I say day) before the AIG collapse, the Treasury essentially tried to create such a mutualization mechanism on the fly when it attempted to coax/coerce banks into lending to AIG. Not surprisingly, this effort failed, and in the event, the government stepped in as the ultimate insurer–meaning that taxpayers are essentially bearing the risk.

One way a CCP would have definitely helped is through the netting of offsetting exposures. In the OTC market, as currently constituted, when A sells a contract to B who sells to C who sells to D, (a) B and C have no market risk exposure (because they have offsetting positions), but (b) there are four sources of performance risk; default by A, B, C, or D is a possibility. For instance, B could suffer a loss on another position that impaired its ability to perform on its contract with either A or C. With clearing, or with some sort of mandatory netting (“ringout”) arrangement, B and C would be taken out of the chain of contracts, and only A and D would pose and face performance risk. B and C could blowup and neither A nor D would care.

In brief, central clearing reduces overall credit and performance risk by reducing the overall magnitude of performance risk exposure. Without netting, performance risk is roughly related to gross positions in the market, whereas with netting, performance risk is reduced to the net exposure.

The CCP also centralizes position information, making it easier for somebody (e.g., the Fed, Treasury) to figure out market exposures. I can only imagine the nightmare that regulators lived trying to figure out who traded how much with whom, and then assembling the jigsaw puzzle to visualize the potential for systemic problems. This is especially true given the dodgy nature of documentation in the credit derivatives market. Although participants have supposedly made progress cleaning up back office problems, these problems haven’t disappeared. This would represent another benefit of a CCP–it would force a rationalization of the confirmation process.

Now let’s figure out how things would have worked out in the AIG case had a CCP been in place. I presume that AIG had a big net position (as otherwise it wouldn’t have been facing multi-billion mark-to-market losses.) So, to the extent its positions weren’t fully collateralized (and I return to the collateral issue below), AIG would have failed to the clearinghouse. These losses would have been covered, to the extent possible, by funds precommited by CCP members in the form of a default fund or its equivalent. In addition, most CCPs have credit lines with banks. If the default fund was inadequate to cover the value of the AIG’s defaulted positions, the CCP would have been able to call on these credit lines, which would have become liabilities of the remaining, solvent members of the CCP. Through this mechanism, or through the CCP’s ability to require members to make additional capital contributions, the losses would have been shared by the other CCP members. A member’s share would be, to a first approximation, an increasing function of the size of the participant and its positions.

Thus, the effects of the CCP would be to diffuse the risk of a single default among all of the members of the CCP. It is likely–though I doubt it can be proven mathematically–that this would reduce the likelihood of the default causing a cascade of knock on defaults. Under the current, non-cleared system, the exposure to an AIG default is related to the direct and indirect gross exposures of each trader in the market to AIG. A firm with a big direct, or even indirect, exposure to AIG, would suffer a big loss from the latter’s default. That big loser would be more likely to be unable to perform on its other obligations than an otherwise identical firm with a smaller gross exposure to AIG. Under a CCP, there would be less dispersion across firms in the exposure to AIG. Thus, under most circumstances it appears less likely that one firm would experience a disproportionate loss from an AIG default.

Here’s a simple example that may capture some of what I am trying to convey. A and B are sellers of CDO insurance. C and D are buyers. C and D have portfolios of CDOs that they have financed with debt and equity. To normalize things, let’s assume that each insurance buyer’s debt is 90 and equity is 10. To make it simple, to emphasize the concentration effect, assume that C buys only from A, and D buys from B. A defaults. This occurs when B has suffered a big loss on his CDO position–let’s say that the CDOs have fallen in value to 50, and instead of paying the 50 it owes, A only pays 20. B no longer has insurance over its entire position. It now a CDO worth 50, and a payment of 20 from A–it thus can only pay 70 of its debt of 90. It defaults on the loan. There is a knockon effect.

Now lets say that the default of 30 is shared among B, C, and D in equal proportions. (NB: In reality, sharing rules are much more complicated.) Let’s say too that B is sufficiently capitalized to be able to cover its insurance obligation and its 1/3 share of the 30 default. Here, C and D receive (on net) 40 of the 50 that they are owed, leaving them with assets of 90 and liabilities of 90. They don’t default. Under the CCP, B and D bear some of the loss that C bears alone with no clearing. This reduces the probability that C will default.

Now, of course exposures are endogenous. In my example, C is a fool for having put all his eggs in one basket. Therefore, you would expect traders to consciously attempt to trade with more counterparties and limit their concentration in the absence of a CCP. Nonetheless, various considerations related to asymmetric information–something I will discuss more below–may in fact induce concentration.

It should also be noted that clearing economizes on collateral. Collateral is related to gross positions in the absence of clearing; with clearing they are related to net positions. This can reduce demands for liquidity during periods of systemic stress. Firms will face smaller collateral calls, and thus have less need for credit or to liquidate assets during periods of market stress.

So if clearing is so great, why hasn’t it happened already? On the answer to that question turns the policy recommendation.

One reason is that there is a coordination or externality problem that means that although it is collectively rational to form a CCP, it is individually irrational, or that the costs of coordinating the creation of a risk sharing arrangement are too high.

For instance, I have argued that some market participants (especially big, highly creditworthy players–like AIG before its collapse’-) may oppose the formation of a clearinghouse because a CCP levels the credit playing field. The biggest, most creditworthy firms have a competitive advantage in a non-cleared OTC market, and a CCP might undermine this advantage. The big guys may therefore not want to participate. And if they don’t play, the clearinghouse will never get off the ground.

Moreover, to the extent that a systemic event caused by a chain of defaults has costs that affect parties other than the intermediaries–a plausible hypothesis–the contracting parties do not internalize all of the costs of their decisions. They therefore do not fully internalize the benefits of the formation of a CCP–and hence may not agree to its creation.

These arguments suggest that the mandatory creation of a CCP would be welfare improving.

There are arguments, however, that suggest that there are substantial costs to the formation of a CCP. In particular, asymmetric information makes it costly to share risks. To the extent that participants in a CCP have private information about their own creditworthiness and the riskiness of the positions they clear, moral hazard and adverse selection problems will occur. These are real costs of risk sharing. The greater these costs, the smaller the benefit of forming a risk sharing arrangement.

As I have argued in a working paper, these costs are greater, the more difficult it is to value the instruments being cleared. Valuation is relatively easy in instruments that are standardized and traded on transparent markets with nearly continuously available, competitively determined prices. Valuation is much more difficult for idiosyncratic instruments that are infrequently traded, and/or which are traded in opaque markets.

The former conditions describe centralized exchange markets for liquid instruments, like T-bond futures. The latter, alas, describes many OTC derivatives, especially credit derivatives, and especially credit derivatives on CDO structures. Hence, it may well be the case that the reluctance to move to a CCP system for more complex instruments is due to the fact that the costs of sharing default risk are higher for these instruments.

Of course, these explanations–coordination/externality vs. high cost–are not mutually exclusive. If I had to make a gut call, I would say that the coordination/externality problems are sufficiently acute that some regulatory effort may be warranted to require the formation of a CCP system. At the same time, any such regulation should take into account the moral hazard and adverse selection problems that are inherent in more complicated instruments, and therefore recognize that risks cannot be shared as extensively for such instruments as is the case for vanilla products traded in transparent markets. This regulation should also recognize that pricing information, transparency, and valuation expertise are required to mitigate the costs of risk sharing for more complex instruments. Therefore, the creation of a clearinghouse might also require measures to improve price transparency and share valuation expertise. This raises other possible sources of resistance. Individual traders profit from private information on prices, and hence are reluctant to share this information. Thus, formation of clearing may require the mandating of disclosure of transaction pricing information. Good luck with that.

In brief, the AIG mess would probably haven’t been as messy if a CCP had been in place. Moreover, it is possible that the absence of a CCP is due to a market failure. However, it should also be recognized that clearing of the kind of stuff that got AIG into trouble ain’t easy–it ain’t like clearing T-notes or even OTC vanilla swaps. It is almost certainly the case that it is uneconomic to share performance risks as widely and extensively in more exotic credit and mortgage products as is the case for vanilla, exchange traded stuff.

I should note that this post was written more hastily than I usually like, but I feel that the issue is sufficiently important and timely to justify a more hurried take. If, upon further consideration, I decide that this analysis is incomplete or incorrect, I’ll make the necessary changes.

Last week I was invited to testify about energy speculation in front of a Senate subcommittee on energy.   I had to decline due to the uncertainty surrounding Ike, but another academic who has also expressed skepticism about the Master’s view of the financial universe accepted–only to be uninvited the day before the hearing.

Draw your own conclusions.

In one of my earliest SWP posts, Whither NYMEX?, I pondered the future of NYMEX. Somewhat later (and in an interview on CNBC) I predicted that NYMEX would wind up in the hands of the CME. That prediction has come to pass with yesterday’s vote by the NYMEX membership to accept the CME’s merger offer. The weeks leading up to the vote saw the chest-puffing bluffing that one can expect from canny experienced traders trying to extract the most from a trade as possible, but the CME management did not budge after raising its offer to the holders of trading rights, and in the end the trading rights members meekly accepted the CME bid.

This outcome was almost inevitable given the lack of any competing bid for NYMEX. This distinguished the NYMEX bid from the CME’s bid for the CBT, where ICE made the Chicago Boys sweat. The lack of a competing bid was in no way surprising, given (a) the contract between CME and NYMEX to trade the latter’s contracts on GLOBEX, and (b) the clearly superior synergies between CME and NYMEX as compared to NYMEX and anybody else. ICE was not a player in this game because of antitrust obstacles that would have been acute particularly in the hothouse environment surrounding energy prices and the criticism that the USDOJ has faced. NYSE-Euronext wasn’t a good fit at all, and wouldn’t have offered nearly the same economies in clearing. NYMEX was also not viable as a standalone in the long run, especially given its weak technological position, doubts about its management, and Byzantine internal politics (factors discussed in Whither NYMEX.) So, when push came to shove, the members had no better option than to accept the CME’s bid.

So, now the question becomes: Whither CME? The decline in the company’s stock price has been pretty stunning, but its fundamentals are still strong. It has, however, effectively completed one phase of its strategy–and of the industry’s evolution: the consolidation of the US futures trading industry on a first rate execution and clearing platform. It can expect continued growth in revenues from growing trading volumes, especially when the credit crisis runs its course. But that organic development is not going to be sufficient to generate the profit growth capitalized even in the company’s currently lower stock price. CME will need to develop a whole new product line. The most likely candidate is OTC clearing. The acquisition of NYMEX is a step in that direction given the New York exchange’s nice OTC energy clearing business. But the big prize is clearing of OTC financial derivatives, notably credit derivatives. That is an immense market, and cracking it faces numerous challenges.

Clearing works best with homogeneous products traded in transparent markets with accurate and reliable pricing. (I have a working paper that argues that traditional impediments to risk shifting–moral hazard and adverse selection–are most acute when products are customized and heterogeneous, require specialized valuation expertise, and when there is not reliable pricing information.) These conditions are not yet met in OTC credit derivatives.

Moreover, CME will face competition in this business. The big banks are not willing to give up this lucrative business without a fight, and even if the CDS market moves to centralized clearing, the big banks have already established a clearing entity in combination with The Clearing House Formerly Known as BOTCC to vie for this business.

CME’s management will spend some time on the integration of its new acquisition, but this should be a relatively straightforward process given that NYMEX contracts already trade on GLOBEX and that there is considerable overlap between clearing memberships on the two exchanges. Once that task is complete, Donahue’s and Duffy’s real work begins–to revolutionize the management of derivatives performance risk by integrating OTC and exchange clearing.

During his testimony before the House Ag Committee on 9 July, 2008, Rep. Bart Stupak (D-MI) asserted that current speculation in the oil markets is just like the Hunts in silver in 1980. The next day, a Republican representative (Bob Goodlatte, R-VA of Virginia, if memory serves) asked me whether the analogy was correct. (Unfortunately, hearing transcripts are not yet available.)

I responded no, they were not, and that indeed the contrast between the Hunt episode and the current oil market provides an excellent illustration of (a) why there is no evidence that speculation is distortion the energy markets, and (b) what kind of evidence you would see when such distortion occurs.

In stark contrast to oil speculators today, the Hunts accumulated huge–and I mean huge–quantities of physical silver. In September, 1979 the Hunts owned about 40mm ounces of silver in deliverable stocks, and COMEX and CBT deliverable stocks were approximately 105mm ounces. By March the Hunts owned approximately 100mm ounces of deliverable stocks, and total COMEX stocks had risen to about 130mm ounces. In addition, I have read that the Hunts also owned about 90mm ounces in Switzerland. In a nutshell, during their silver escapades, as prices were rising dramatically, the Hunts held large and rising amounts of physical silver, and deliverable silver stocks rose substantially (approximately 20 percent).

Moreover, there were manifest signs of distortions in the physical market. Massive amounts of silver coins were melted into bullion. So many coins were melted that the capacity to convert them was strained. As a result, the differential between the price of bullion and the price of coins swelled to unprecedented levels. (This differential represents the shadow price, and the marginal cost, of the conversion. The marginal cost increases with the amount of coins converted.) Large amounts of silver flowed out of India–and into the hands of the Hunts.

The prices of silver were clearly distorted in 1979-1980. These price distortions were reflected in (a) the flow of large stocks of silver into the Hunts’ hands, and (b) distortions in the physical market. This illustrates that if speculators drive up prices–if they are willing to pay more than anybody else for the commodity–they must end up holding the commodity, and that distortions in prices inevitably lead to distortions in the physical market.

None of these signs are present in today’s energy market, or other commodity markets, for that matter. Prices are indeed high, but speculators are not sitting atop large and growing stocks of the physical commodity. If they were, one could say, with Rep. Stupak, that we are seeing the second coming of the Hunts. Since they aren’t, we can’t. Indeed, as I testified in Congress, the differences between silver 1979-1980, and energy in 2007-2008 are very revealing. And what they reveal is that today one should look for other causes of high energy/commodity prices than excessive speculation.

The recent assault against commodity speculation could use a little historical perspective. In particular, history can provide some lessons regarding what happened during previous attempts to restrict–or ban–futures trading.

Example 1. Gold futures during the Civil War. Union fortunes were ebbing during the spring of 1864. In early-June, Grant had suffered a punishing defeat at Cold Harbor, suffering 7000 casualties in a period of an hour. In mid-June, he made a brilliant descent on Petersburg (a major transport hub south of Richmond), but his assaults on 15-17 June made only limited headway. In Georgia, Sherman was making only slow progress against Joseph Johnston, and was mired in the piney forests around Dallas and New Hope Church in late-May. West of the Mississippi, Banks’ Red River Campaign had ended in disaster in late-May, with the US Navy’s Riverine fleet barely escaping capture only through the ingenious efforts of Army engineer Joseph Baily.

Union military failure was reflected in a skyrocketing price of gold in greenbacks (i.e., a collapse of the paper dollar.) Data from The International Center for Finance shows that from the time of Grant’s crossing of the Rapidan on 4 May until 16 June, the value of the Greenback fell from $.557 gold to $.507 gold–a 9 percent drop.

Congress soon found a culprit–gold speculators. Congressmen lashed out at speculators on the New York Gold Exchange, and soon matched their words with deeds. On 17 June, 1864, Congress passed the Anti-Gold Futures Act of 1864. The Act prohibited the trading of gold futures, and for good measure, banned the trading of foreign currency contracts with more than 10 days to maturity. The Act also made it a crime to transact in gold bullion anywhere but the ordinary place of business of the buyer or seller, effectively putting the Gold Exchange out of business.

The exchange closed, but speculation didn’t. Instead, trading activity in spot gold moved to the offices of brokers. And the price of gold continued to plummet. From 17 June to 30 June, the price of greenbacks fell to $.4082–a 21 percent drop. Congress soon recognized the folly of its anti-speculation legislation, and in a commendable example of legislative humility, repealed the Anti-Gold Futures Act on 2 July, 1864.

What had driven down the price of greenbacks during the Act’s short life? In a word: Fundamentals. Bad news continued to flow from the war fronts, indicating a long war–and a continued need to run the printing press to finance it. Grant was definitively stopped in front of Petersburg, and suffered some punishing defeats at the Battle of the Weldon Railroad. Sherman suffered a bloody repulse at Kennesaw Mountain. A large Confederate force under Jubal Early was on its way north through the Shenandoah Valley, with nothing in its way to stop it.

The moral of the story: constraining speculation is easier said than done, and such constraints are too weak to overcome the effects of powerful fundamentals.

Example 2: The German Exchange Act of 1896. This bill implemented many restrictions intended to constrain speculation in agricultural commodities and stocks. The Act gave German state governments the authority to ban futures trading. In addition, in an interesting parallel to one feature of the Stop Excessive Energy Speculation Act, the German legislation empowered the state to appoint a board consisting of agriculturalists and grain processors to oversee the operation of grain exchanges. The Act also eliminated futures trading in the stocks of industrial and mining companies.

The attempt of the Prussian state government to appoint a board to oversee the exchange, with its implied threat of eliminating futures trading on the exchange altogether, led the members of the Berlin Exchange to decamp from their facilities to a theater across the street–evocatively named “The Fairy Palace”–where they continued to carry out their business, but without calling themselves an exchange. The outraged Agrarians railed against this attempted evasion, and pressured the Prussian authorities to announce to the Fairy Palace crowd that if they did not disperse, the police would be called to break up the gatherings of traders there.

According to contemporary accounts, such as an article by Henry Emery in the Political Science Quarterly, and by Ernst Loeb in the QJE the Acts did not have the desired results, and actually had detrimental effects. Although neither author presents any empirical evidence, according to their accounts, speculation did not decline, but shifted into securities not covered or into cash transactions. Market liquidity declined, and prices became more volatile. Transactions costs increased. In foodstuffs, the absence of a central location for price discovery led to more negotiations and haggling between buyers and sellers. In stocks, trade was driven from exchanges into the hands of big banks who internalized orders. Some trading activity was diverted to foreign markets. According to Emery, the passage of the Act and the reduction of trading activity on the exchange was accompanied by a dramatic increase in the commissions that banks earned (and this presumably does not include the effect of the profits that the banks made on the internalized order flow in the absence of competition from a liquid and transparent exchange.) According to Carl Parker, “Governmental Regulation of Speculation” (Annals of the American Academy of Political and Social Science, 1913), the elimination of futures, and the resulting increase in difficulties of short selling, led to more pronounced rallies followed by more pronounced crashes as prices returned to levels dictated by fundamentals.

In time, even the German government recognized that the law was ineffective at best, and pernicious at worst. A 1907 government report stated “[t]he dangers of speculation have increased, the power of the market to resist one-sided movements has weakened, and the possibilities of misusing inside information have enlarged.” The report further stated that the law “has proved injurious to the public, without accomplishing its original purpose.”As a result, in 1908 Germany repealed many of the features of the law. The continued outrage of agricultural interests led to the continuation of the ban on agricultural futures, which lasted until almost 100 years after its passage. Ag futures trading was allowed only in 1998. (Personal aside: after the repeal of the law, I worked on a feasibility study and contract design work for the first German ag futures exchange, the Warenterminborse, or WTB. The exchange continues to operate under the name Risk Management Exchange, or RMX.)

So, the bottom line is that previous efforts to ban futures trading, or sharply constrain it, have failed in their object. They have reduced market quality, increased transactions costs, and impaired competition–without actually reducing speculation or affecting prices in the way that the sponsors of the anti-speculation laws intended.

Will Congress take these lessons into account? Somehow I doubt that a consideration of the facts will overcome the temptation to engage in political pandering and demagoguery.

It looks like the energy markets have dodged a bullet; the Stop Excessive Energy Speculation Act (S. 3268) has failed a cloture vote, and is in limbo despite an earlier 94-0 vote in favor of cloture on the motion to proceed. This sparked a Harry Reid hissy fit (always music to my ears.)

And a good thing too. Although not including some of the most damaging proposals that have been mooted, such as draconian increases in margin or the outright banning of large financial institutions from the energy derivatives markets, it was plenty bad enough.

Some of the bill’s greatest misses include:

• Designating some market participants as “nonlegitimate hedge traders” and limiting the designation of “legitimate hedge traders” to those entities that actually produce or consume physical petroleum or natural gas.
• Establishing an advisory committee consisting of legitimate hedge traders only to make recommendations to the CFTC on position limits applicable to nonlegitimate hedgers and speculators.
• Extending position limits to OTC markets.
• Giving the CFTC the authority to intervene in the OTC market in the event of “a major market disturbance.”

All of these measures are pernicious. The would do nothing to reduce manipulation or improve the efficiency of the energy markets or reduce prices, but would reduce the effectiveness of these markets as risk transfer and price discovery mechanisms and raise compliance costs.

The creation of a separate caste of hedgers–“nonlegitimate”–makes no sense economically. Financial institutions that use the energy markets as part of a portfolio management strategy are as legitimate hedgers as an oil company or an airline. Even the very language “nonlegitimate” is tendentious and offensive.

Moreover, it is a dangerous precedent to give one group of market users a say over what other market users can do. The favored group is likely to use its power to benefit its own members to the detriment of the unfavored ones. Note that many firms that could fit in the “legitimate hedger” category speculate too, and could exploit the powers vested in the advisory committee to favor themselves at the expense of other competitors in the supply of risk bearing services. Similarly, long hedgers (airlines, as an example) would benefit if long speculation, or long portfolio hedging, is constrained. (Long speculators offset the effect of short hedging pressure, and thereby cause the futures price to rise relative to the expected spot price. Long hedgers benefit from a fall in the futures price relative to the expected spot price, and hence would benefit from constrianing other longs in the market.) These entities could also use their position on the advisory committee to advance their interests at the expense of short hedgers and long speculators.

Since speculative limits designed to make speculation more costly are detrimental to the efficient operation of the market (by constraining the ability of the markets to shift risk), extension of these limits to the OTC market will impair the effectiveness of the markets as risk management tools. Moreover, the CFTC (and its fox-in-the-henhouse “legitimate hedger” advisory board) are charged with the responsibility of setting position limits to eliminate “excessive” speculation. Good luck with that. These limits will just become another political and regulatory football over which competing interests will squabble.

The extension of emergency authority to the OTC market is a particularly scary expansion of regulatory authority. Here’s the language in full:

GENERAL.—In the case of a major market disturbance, as determined by the Commission, the Commission may require any trader subject to the reporting requirements described in paragraph (3) to take such action as the Commission considers to be necessary to maintain or restore orderly trading in any contract listed for trading on a registered entity, including—
”(i) the liquidation of any over-the counter transaction; and
”(ii) the fixing of any limit that may apply to a market position involving any over-the-counter transaction acquired in good faith before the date of the determination of the Commission.

The definition of “major market disturbance” is extremely broad and vague:

• `(C) MAJOR MARKET DISTURBANCE- The term `major market disturbance’ means any disturbance in a commodity market that disrupts the liquidity and price discovery function of that market from accurately reflecting the forces of supply and demand for a commodity, including–
• `(i) a threatened or actual market manipulation or corner;
• `(ii) excessive speculation;
• `(iii) nonlegitimate hedge trading; and
• `(iv) any action of the United States or a foreign government that affects a commodity.

In other words, not only does this provision permit the CFTC to intervene in the event of a corner–a real manipulation–it gives the Commission the authority to interfere directly in the market whenever in its infinite wisdom it deems that “excessive speculation” (where excessive is evidently in the eye of the beholder, and is not defined and is not capable of being defined) or “nonlegitimate hedging” is distorting prices. This in effect gives the Commission the authority to second guess the market. Moreover, since regulators are subject to pressure from organized interests who may benefit from an intervention, this opens the door to all sorts of influence activities and will undermine the certainty of contract in the energy markets. Think of it; somebody makes a bad trade, begins to howl about excessive speculation distorting the markets, and just might succeed in buffaloing the CFTC into forcing liquidation of the offending contracts. Great. Read my 1995 JLE piece on self-regulation of commodity markets for a few examples of how these powers can be used to make mischief.

In all honesty I doubt that the CFTC would use these powers. But they are there, and an activist Commission or one subject to intense lobbying or Congressional pressure could well use them, and wreak tremendous havoc in the markets. This is a really bad idea.

I would oppose this provision even if its application was limited to “(i) a threatened or actual market manipulation or corner.” As I have argued for well over a decade in my academic research, it is best to address corners and real manipulations ex post. The likelihood of a wrongful intervention is much greater (due to the lack of good information and the difficult of making decisions under time pressure) when a regulator attempts to intervene while a corner is in progress. Moreover, the regulator is likely to intervene only when the price distortions resulting from the exercise of market power are large, so early intervention is unlikely to mitigate price distortions all that much. Manipulation is perfectly suited for deterrence through harm-based sanctions, like those imposed on BP in the aftermath of its propane adventure. It is inefficient to rely on emergency authority, and its extension to the OTC markets is a bad idea.

Advocates of this type of regulation make ominous allusions to the dangers of “dark markets” not subject to constant government observation and meddling. Like small children, paranoics, and control freaks, they appear to be phobic about things that consenting adults might do out of their sight.

I, for one, am not scared of the dark, or most of the things that go on in the “dark” OTC markets. One thing is for sure; if a real manipulation takes place, it will come to the light in short order. As Frank Easterbrook has written, an undetected manipulation is an unsuccessful manipulation. If somebody corners the market, it will not remain a secret, its perpetrators will be known to other market participants–and to the authorities shortly thereafter. That is the time to bring the legal guns to bear. Until that time, let adults do in the dark what they will.

The BP propane episode is a perfect example of this. It is hard to conceive of a darker, more obscure corner of the energy market than propane. It is traded almost exclusively OTC, and trading activity in that commodity is dwarfed by that for other energy commodities. BP’s actions soon sparked the outcry from affected market participants, and soon parallel civil and criminal investigations were commenced. One trader plead guilty to a felony, and sometime thereafter the company entered into a deferred prosecution agreement with the government and agreed to pay a large civil fine and criminal penalty. We’re talking 9 figures.

It is far better to devote scarce enforcement resources to investigate instances of real potential harm that occur relatively infrequently, rather than spend resources to monitor all market activity on an ongoing basis, since most of that activity is benign at worst, and beneficial at best, and hence most of the resources devoted to oversight are wasted.

In sum, Harry Reid’s pet energy speculation bill is a disastrous piece of legislation. It is built on a foundation of anti-speculation animus that has no basis in economic theory or empirical evidence. It mandates a tremendous expansion of regulatory authority that cannot be used for good, but which has the potential to be used to distort markets, to intervene when intervention is unjustified, and compromise the surety of contract. Hopefully the bill is dead. But just to make sure, let’s drive a stake through its heart and shoot it with a silver bullet and repeatedly drive an M-1 Abrams over it repeatedly.

I gave testimony on the role of speculation in energy markets before the House Agriculture Committee on Friday, 10 July. Here’s my written testimony. I will post a link to the transcript as soon as it appears.

It was an interesting experience. I doubt I changed any Congressional minds, but I think I did provide a framework that may help policymakers sort through the issues. The key lesson I tried to hammer home was that it is imperative to distinguish between the derivative markets and the physical markets. These markets perform different functions. Derivatives markets are markets for risk, and speculative and hedging activities in these markets will affect the price of risk. Absent any use of the derivatives markets to distort the physical market–as during a squeeze, for instance–even very large scale speculation in the derivatives market is unlikely to have an impact on the prices in the physical market (except insofar as that speculation is informed, and therefore influences expectations about future spot prices.)

The other point I tried to emphasize–and this is what I think made the biggest impression, at least on some–is that if “excessive” speculation truly screws up prices, these price distortions necessarily manifest themselves in the form of distortions in quantities; in inventories, in output, in consumption. The reason prices are important is that they direct the flow of resources. If prices are distorted, resource flows will be distorted too. Heretofore, there is no credible evidence of distortions in quantities. Hence, in my view, there is no credible evidence that speculation has been “excessive” in any meaningful (economic) sense of the word.