Streetwise Professor

Recognition is dawning that clearing mandates-the supposed silver bullet for making the derivatives market safe-are not the panacea that their advocates claimed.  Recently, major regulators in the US and the UK have warned about the dangers of concentrating so much risk in CCPs.  The recognition is spreading to the press too, as illustrated by this article in The Economist:

The source of all this angst is the clearing-house, a mundane bit of financial-market plumbing that sits between buyers and sellers in transactions. And the reason why people are fretting is that G20 policymakers have seized upon clearing as the solution to some big problems in the over-the-counter derivatives market.

. . . .

That feeds worries about the other effect of lots more clearing: a new concentration of risk. Moving derivatives trades to clearing-houses mitigates the effect of a default of a clearing member (Lehman Brothers’ cleared trades were handled smoothly in 2008, for example). But it makes the impact of a clearing-house itself going down much worse. They may lack the heft of big banks, but few financial institutions are more interconnected. Failures are rare but they do happen: Hong Kong’s futures clearing-house ran out of resources in 1987, for example, and it took a government bail-out and the closure of the main stockmarket for things to get back to normal.

This should not be a surprise-after all, it’s not like what happened in Hong Kong-or in Chicago-in 1987 was a big secret.  And it’s not as if nobody, ahem, has been raising this point for going on four years now.

And that italicized part is just too rich.  Didn’t Timmy! and GiGi constantly-and I mean constantly-tell us that clearing eliminated interconnections in the financial system? Yes they did! I guess that explanation is now seen to be the BS it always was.  I’ve been calling BS on that for about three years.  I’m waiting for the dynamic duo to admit they were either ignorant, or liars.  There is no third alternative.

The aforementioned regulators are demanding that CCPs be made immune from failure.  The Economist agrees:

The more systemic they become, the more tightly clearing-houses should be regulated. That means more clarity over their collateral and margining policies. It means agreeing on plans for recapitalising a failing entity without tapping the taxpayer. And it means getting clearing-houses to hold more equity: LCH.Clearnet had just €333m ($463m) of capital in 2011, compared with collateral and cash under management that averaged €73 billion. Clearing can achieve many things. Solving the too-big-to-fail problem is not one of them.

Sigh. On the one hand, it is good to see growing awareness of the systemic vulnerabilities that CCPs create.  On the other, it is distressing that regulators and commentators seem to have target fixation and can focus on only one thing at a time.  Put differently, they fail to consider how the financial system will adjust to attempts to make one part of the system safer.

I’ve also written about this ad nauseum.  The point is that raising margins, or increasing the size of default funds, or changing margin calculations, or tightening up restrictions on eligible collateral, or other measures to improve the safety of CCPs will induce reactions and adjustments elsewhere in the financial system, and these adjustments have systemic implications.

For instance, requiring more collateral is likely to lead to the growth of systemically-fragile collateral transformation services and other shadow banking mechanisms to secure collateral to post for CCP margins.  Expanding CCP member commitments to default funds increases their exposure to wrong way risks, and is an important source of interconnection in the financial markets.

I return to the 1987 Chicago experience.  Yes, the big exchange CCPs were under stress, but a major source of stress in the financial system as a whole was due to the extraordinary need for liquidity to meet margin calls-the very mechanism that is put in place to protect CCPs against default.  Sometimes “safety” equipment can be downright dangerous.

I return to a metaphor I’ve used before: that of flood controls.  Building up levees to protect one location can increase the risk of a catastrophic flood elsewhere in a river system.  It is good that more regulators and market observers recognize that CCPs are a source of systemic risk, but the levee-building reflex is worrisome in the extreme.  It suggests an inability to think about the financial system as a whole, a system that reacts to changes imposed on one part of it.  These responses are not necessarily salutary, and can be downright frightening.

The responses need to be anticipated, to the extent possible.  But it is often difficult to do that with accuracy.  Which means that it is necessary to proceed cautiously when making the levee around CCPs higher and higher.  There will be responses to this process, and it is likely best to proceed cautiously and incrementally, seeing what the responses are to the gradual changes, and then adjusting accordingly.  Wholesale changes made in a hurry focused monomaniacally on one part of the system are a recipe for an major disaster elsewhere in the system.

I say again: to understand how policy changes affect systemic risk you need to think of the financial system as an organic whole, a system that responds often unpredictably to changes imposed on one part of it.  Although it is encouraging to see that the magical thinking about clearinghouses is being replaced by sober concern, it is far less encouraging that the concern is leading to policies focused on individual institutions that do not pay adequate attention to how the system will respond.

In other words: Don’t build financial levees without giving very deep study how other financial currents will react to the levees during flood times.

An UNCTAD paper by David Bicchetti and Nicolas Maystre analyzing high frequency data from commodity futures markets has received a tremendous amount of attention in the few days since its release. The paper purports to present evidence that high frequency trading has distorted commodity prices, hence the flurry of attention to what is in fact a rather unexceptional paper.  Indeed, the only thing exceptional about it is the authors’ extreme over-interpretation and sensationalization of the results, and their failure to consider seriously more reasonable interpretations of their findings.  Their characterization of their findings borders on academic malpractice, and raises questions about their sincerity.

The empirics are rather straightforward.  Bicchetti and Maystre calculate rolling correlations between EMini S&P 500 futures returns and the returns on 6 commodity futures contracts-WTI, corn, soybean, wheat, sugar, and live cattle.  These correlations are calculated at various frequencies ranging from 1 second to 1 hour.

They find that correlations were typically around zero before jumping substantially around September, 2008. Based on this, they conclude that “the financialization of commodity markets has an impact on the price determination process.  . . . In fact, the strong correlations between different commodities and the S&P 500 at very big frequency are really unlikely to reflect economic fundamentals.”  They further claim that “HFT strategies, in particular the trend-following ones, are playing a role.”

Their basis for this claim is extremely thin.  They note that HFT trading has become increasingly important in recent years.  They note that correlations jumped in 2008.  They conclude that the former caused the latter.

Really?

Gee, now what happened in September, 2008?  Let me think.  Think. Think. Think. Oh, I remember now-we had a financial crisis!

Could that maybe explain the change in correlations?

Damn right, it could-and did.  First, note that the correlations between the S&P 500 and commodity prices are going to be driven primarily by whether supply or demand shocks are driving commodity prices.  Take oil as an example.  When supply shocks are important, one would expect zero or even negative correlations between oil prices and stock prices.  An adverse oil supply shock should lead to higher oil prices and lower stock prices.

When demand shocks predominate, however, positive correlations are to be expected.  Adverse aggregate shocks depress both oil prices and stock prices.

Thus, correlations depend on the composition of shocks.  When demand shocks (driven by shocks to income) predominate, correlations should be positive; when commodity-specific supply shocks predominate, correlations should be zero or negative.  (With the ags, since supply shocks are unlikely to be correlated with aggregate income or growth, one would expect near-zero correlations.  With oil, supply shocks can have macro effects, so negative correlations can arise.)

Starting in the fall of 2008 there was a dramatic increase in the flow of information about demand-related shocks.  The predominant feature of those months was a dizzying flow of macroeconomic-related news.  Would major economies be thrown into depression? Would the financial sector collapse?  Would economies recover?  How rapid would the recovery be? What were governments doing to trying to stem the collapse and rekindle growth?  The composition of economic shocks shifted decisively towards demand/income-related shocks that dwarfed commodity-specific supply-related shocks.

In this environment, commodity-specific supply-related information was swamped by systematic demand-related information.  You would expect-clearly-this to lead to positive co-movements between stock prices and commodity prices, because both were being driven by demand related information.

Moreover, financial shocks during the crises that  constrained risk-bearing capacity that were quite prevalent during this period would have affected both stocks and commodities, and in the same way.  These shocks to risk bearing capacity would have affected expected returns on commodities and equities in the same way.  This would have also contributed to substantial positive covariation.

The very discontinuity in the correlations around the time of Lehman supports this view.  Algorithmic trading and HFT trading (they are different) were both growing throughout the mid-to-late-2000s.  There was no discontinuous jump in the utilization of these strategies at the time of Lehman.  But there was a discontinuous jump in the correlations.  A much more plausible interpretation of the data is that a discontinuous change in the nature of economic shocks (becoming predominately economy-wide demand-related shocks) and correlated shocks to risk bearing capacity (that led to correlated shocks in expected returns) attributable to the (discontinuous) financial crisis explains the discontinuous change in correlations.  The authors offer no plausible explanation-none-of how a continuous growth in HFT could lead to a discontinuous jump in correlations precisely in September, 2008.

Indeed, their measure of HFT-the ratio of volumes to trades-flattened out precisely during this period, after having fallen since the beginning of 2007.  If this is a measure of HFT, it should have jumped down discontinuously at the time correlations jumped up if in fact HFT was driving correlatons.  But the exact opposite happened.  The authors let this obvious problem with their interpretation pass in silence.  This is inexcusable.

There is other information in the report that strongly supports the view that fundamentals were in fact driving the correlations.  In particular, the WTI-S&P correlation dropped substantially in January-April, 2011.  This is precisely the period in which the Arab Spring and in particular the outbreak of civil war in Libya led to substantial supply shocks in the oil market.  As noted above, supply shocks for oil should lead to opposite movements in oil prices and stock prices.  An increase in the flow of supply-related information should lead to lower correlations between stock and oil prices.  The Arab Spring and Libyan events led precisely to such an upsurge in supply shocks, and correlations fell exactly as would be expected if fundamentals were actually driving prices.  Under the HFT interpretation, there would have had to have been a drop in HFT utilization during this period, which certainly did not occur.

In sum, the evidence presented in the widely hyped Bicchetti-Maystre paper in fact strongly supports the view that fundamentals were driving commodity and stock prices during the sample period.  In particular, the main piece of evidence that B-M emphasize-the jump of correlations in September, 2008-corresponds to an obvious regime change in which economy-wide shocks that would affect both stock prices and the demand for commodities occurred more frequently and with greater severity.  One would predict-and in fact I did so predict contemporaneously-that such a change would lead to a substantial change in the correlations between stock and commodity prices. (I made this prediction publicly at a symposium held at the Bauer College shortly after the beginning of the crisis, and actually made the conditional prediction in the summer of 2008 that the only thing that would bring down oil prices was a serious economic downturn.)  The change in oil-stock price correlations around the time of the Libyan crisis is also consistent with the hypothesis that price movements reflected information about fundamental supply and demand conditions.

In contrast, there were no discontinuous changes in “financialization” or the utilization of HFT either in September, 2008 or during the Arab Spring/Libyan period.

In sum, the actual evidence presented in the paper strongly supports the hypothesis that fundamentals drive prices.  It does not provide any support for the hypothesis that “financialization” or HFT is distorting prices and overriding the impact of fundamentals.  Indeed, there is strongly contrary evidence.

Thus, although the empirical analysis in this paper is unobjectionable, the interpretation is contrary to the actual results and a reasonable reading of the economic and financial history of this period.  Indeed, the interpretation is so at odds with the data and history that the motives of the authors are open to serious question.  They jump on the anti-financialization, anti-HFT bandwagon even though (a) the actual data does not support that interpretation, and (b) other, quite opposed, interpretations are much more reasonable. Whenever there is a yawning gap between the most reasonable interpretation of an empirical analysis, and the interpretation that the authors advance, one may reasonably question the intellectual honesty of those interpretations.

And I do so question.

I therefore recommend examining the various graphs presented in the paper in light of an understanding of how the composition of economic shocks should affect correlations, and an understanding of what was happening during the sample period of the study.  I further recommend completely disregarding the Bicchetti-Maystre interpretation of their results, because it betrays no understanding of either the economics or the history.

The advocates of mandated OTC derivatives clearing insisted-insisted-that mandated clearing would simplify the market, and reduce dangerous interconnections between financial institutions.  The canonical illustration of this point was something like this, with the first diagram being the messy bilateral, pre-clearing mandate market, and the second being the neat and tidy clearing mandate market:

Uhm, not really. Not at all. These diagrams presume that the only interconnections between OTC derivatives users are via the derivatives markets themselves. In fact, derivatives users are connected via credit and liquidity support mechanisms as well, and the adoption of clearing which results in the unbundling of the credit and liquidity arrangements embedded in derivatives trades will lead to the forging of new connections that will make the post-mandate system as complicated and interconnected and fragile, and perhaps more complicated and interconnected and fragile, then it was before.

These interconnections are of different types.  Some are operational.  Consider this from an illuminating article in Wall Street & Technology:

A new swaps ecosystem needs to be established in order to enable central clearing. “You’re talking about a whole reinvention of the entire market,” says Henry Hunter, global head of product development at MarkitServ, a provider of middleware and online confirmation and affirmation services to the buy and sell sides in the derivatives space. “That’s a massive infrastructure change that is happening over a period of years.”

Wholesale reinventions always go well.  Always.  But it gets better:

“It’s a complicated mess,” says MarkitServ’s Hunter, who notes there could be as many as six different players involved in any trade — the client, the executing broker, an execution venue (i.e., the SEF), a CCP, a clearing member acting for the client, and possibly a clearing member acting for the dealer as well. “Managing that choreography can get complicated, so that’s where the middleware comes in.”

And the mess doesn’t stop there. Clearing brokers have the burden of modifying their electronic trading infrastructures and processing systems. According to Morgan Stanley’s Brock Arnason, executive director and global product manager for the Matrix platform, “The infrastructure that is required to support a clearing business is quite significant.” Clearing brokers must capture their clients’ voice and electronic trades and then run them through validation rules to determine clearing eligibility, he explains.

Think of all the operational linkages described in those short paragraphs.  Think of all the possible problems that can arise, particularly in stressed market conditions.  The financial system is a tightly coupled one as it is, and the rigid schedule on which clearing must work, to initiate trades, close them, and margin them, makes it all the more tightly coupled.  The choreography could very well go wrong, and is most likely to go wrong precisely at the most dangerous time.

In addition to the operational connections, there are financial connections, especially related to collateralization: I’ve written about this extensively on SWP, and in places like my recent J. Applied Corp. Fin. paper.  More from the WS&T article:

One of the most disruptive changes on the buy side under the new derivatives rules will be the need to manage margin calls from the clearinghouses on cleared swaps. “Some clients are going from never having to post initial margin to now always posting margin,” comments Morgan Stanley’s Swankoski. When clearing becomes mandatory, “All clients, big or small, are going to have to post initial margin on their cleared transactions.”

. . . .

To help buy-side firms complete this process, the clearing brokers are looking to provide collateral transformation services, according to Forkan. “They’re now building in services to ensure that organizations that post one type of asset can convert it into another type of asset,” he says. “That is a cost of clearing that the asset management community is going to have to bare. Given the huge investment that the banks have made in technology and infrastructure, they are keen to offer services that generate profit — it’s a large opportunity for the global banks to grab market share among the asset managers that need services.”

To reiterate, the advocates of clearing asserted that collateralization would reduce leverage in the system by preventing the bundling of credit in derivatives trades.  But as I’ve said repeatedly, this will just lead to the substitution of unbundled credit for the proscribed bundled leverage.  Collateral transformation is an example of this.  Moreover, this form of credit, when joined with the rigidity of the margining process for cleared transactions (and for non-cleared trades which Frankendodd requires to be marked-to-market on a daily basis), these new credit arrangements are likely to be more fragile than the bundled ones they replace.

In brief, there will continue to be a dense web of interconnections between market participants-the second diagram above is a very misleading of the post-Frankendodd world, which will continue to look like the first diagram.  Moreover, These interconnections are likely to be even more fragile.

And we’re not finished!  Another point that I’ve made for the past several years is also becoming increasingly recognized.  Namely, the breaking of netting sets will arguably lead to greater complexity, greater collateral demands, and potentially greater total risk exposures.

With respect to operational complexity:

Another big challenge for buy-side firms will be managing their existing bilateral OTC derivatives business alongside cleared swaps to gain a holistic picture of counterparty risk. Since not all trades will be required to be cleared, buy-side firms will have both a bilateral book of trades that they are still managing as well as daily collateral calls for the cleared book of swaps, says Omgeo’s Leveroni. “You will end up with a mixed clearing environment and operational complexity that you didn’t have before,” he cautions.

. . . .

“The buy side is going to struggle with having enough collateral to post for the book of business,” Leveroni says. “This is worrying a lot of people. You want to make sure you manage that collateral right, so you only send cash to the cleared call and you send the corporate bond to your bilateral call. You have to be smart in the collateral you send to each call. Those are the real risks to the buy side.”

With respect to increased needs for collateral, consider this from Matt Leising:

Derivatives users will face significant challenges to meet new collateral requirements as the trades are forced into clearinghouses, according to industry executives.

Investors have pledged about $200 billion to back futures trades around the world, Bill de Leon, a managing director at Pacific Investment Management Co., said today on a panel discussion at the Futures Industry Association annual conference in Boca Raton, Florida. That amount could be 10 times as large for the majority of trades in the $708 trillion over-the-counter derivatives market, he said.

“This is going to be one of the biggest challenges going forward,” said Jeffrey Jennings, the global head of listed derivatives at Credit Suisse AG. Exchanges such as CME Group Inc. (CME) are expanding the collateral they accept to allow corporate bonds to be pledged and are offering to reduce margin across assets like futures and interest-rate swaps. “That’s not going to be enough,” he said.

. . . .

Other plans by brokerages to offer to transform for their customers unacceptable margin into cash or U.S. Treasuries that are accepted by clearinghouses won’t solve the problem, and may add to risk during volatile times, said David Olsen, global head of OTC clearing for JPMorgan Chase & Co. (JPM)

“In my opinion, collateral transformation is really just a marketing term for repo,” he said. The collateral obtained from selling securities to garner cash or Treasuries in the repurchase market don’t fit many type of derivative users, such as pensions, that may have 30-year swaps they need to maintain, he said.

With respect to the fact that fragmentation of clearing across jurisdictions and instruments and the elimination of netting economies across cleared and non-cleared positions (a point I’ve made, as have Duffie-Zhu) consider this very readable paper by David Murphy.

It is not an exaggeration to say that every claim made by Frank, Dodd, Geithner, Gensler, and all the other clearing fanboys and fangirls around the world are extreme exaggerations at best, and often flatly wrong.  New vulnerabilities have been substituted for old.  New interconnections have supplanted those that prevailed in the bilateral world-and many of the new interconnections are more problematic.  Financing and liquidity and credit arrangements remain deeply meshed with derivatives transactions.  Mandated clearing eliminates some netting benefits, while creating others, and it is by no means clear that the mandates have reduced exposures.

The whole top down restructuring of the derivatives markets-which represent a complex, emergent order-does not lead to the replacement of a complex and sometimes chaotic system with a simple and ordered one.  It will result it a new complex system that will emerge in response to the new laws and regulations.  The regulations were motivated, in essence, by fears of the instabilities and non-linearities in the old order: but the new system will have its own instabilities and non-linearities. Indeed, I believe that a mandated, top-down attempt to impose a new order is likely to result in a less supple, more rigid, and less stable system than the (imperfect and sometimes unstable) one it is intended to supplant.

An analogy that comes to mind is the Corps of Engineers.  For decades the Corps has intended to impose order on a complex system of rivers.  The results have been less than happy.  The imposed order has too often proved illusory, and attempts to control the system have resulted in an increased likelihood of catastrophic floods and the destruction of valuable natural ecosystems. Attempts to control complex systems are usually futile, and tend to result in the replacement of more frequent small crises with a few mega-crises (this is a point also made by Taleb and Bookstaber).

In this regard it is always useful to remember Hayek’s warning about the illusion of control: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Chris and Barney and Timmy! and Gary think they know a lot more than they really do.  They see like a state (to use James Scott’s phrase), and as Scott shows, these attempts to re-engineer complex systems from above almost always end in grief.

But as the continued existence and persistence of the Corps of Engineers shows, the illusion of control and the faith that top-down re-engineering of complex systems can work is enduring.  The idea is hard to kill, and ironically, its failures often lead to demands for more and more and more control.  I expect, alas, that this will be the case in the derivatives markets.

The Li(e)for investigation is metastasizing at an incredible place.  Both Bloomberg and FT have run long pieces on the problems with the rate-setting mechanism, and how to fix them.  Investigations (10, according to FT) are proceeding around the world, in the US, UK, Europe, Japan, Canada, and Singapore.  There is a criminal investigation in the US.  Numerous banks are scurrying to cooperate in the hopes of receiving leniency-the prisoner’s dilemma in action.

Some of the reporting is confusing.  There are at least two different motives for the alleged misstatements, one likely being more legally fraught for the banks.  The first motive is that during the throes of the crisis, banks had an incentive to misreport the rates at which they could borrow unsecured in order to avoid the perception that they were on the brink.  The other motive is that traders wanted to influence LIBOR in order to advantage derivatives positions tied to LIBOR-the latter likely presents the banks and individual traders  with far more acute legal problems.

Then there remains the issue of what to do about it.  The most obvious remedy is to base LIBOR on actually borrowing transactions, in the same way as is done with EONIA and SONIA overnight (hence the “ON”) borrowings.  This is a reprise of the data hub idea I advocated for energy trades back in 2003(!).

There is pushback against this idea, however.  One argument is that particularly during times of stress only a few banks are actually able to borrow unsecured for 3, 6, or 12 months, so the rate would be based on transactions from a small set of institutions.

I don’t get this objection, frankly.  So it’s better to base the most important reference rates in the world on what banks that cannot borrow unsecured say they could borrow at, than to base it on the rates that banks that actually do borrow unsecured pay?  Really? The first alternative is an oxymoron.  The second might result in rates from only a few banks being used, but far, far better to base an index that is supposed to reflect the actual cost of unsecured borrowing (by those able to do it) as represented by real transactions then to use the oxymoronic fantasy rates of those who can’t do it.

And if nobody can borrow unsecured in any volume-that’s important information in and of itself.  That raises the question of the advisability of basing so many derivatives contracts on something that has an appreciable probability of not existing from time to time. Better to recognize reality than MSU and pretend it’s real.

Here’s a thought: BBA could continue to report a LIBOR based on the traditional methodology, but just modify its name to LIBORGIGO. Truth in advertising, dontcha know.

This raises a broader point.  Cash settlement is often raised as a panacea for contract design.  Delivery-settled contracts have problems-so go to cash settlement! But as I’ve argued since 1990, in many markets cash settlement is problematic due to the opacity of cash markets, and/or the absence of cash market transactions.  Cash settlement works where there is a liquid and vibrant and transparent cash market (e.g., S&P500 stock index futures) or centralized collection of cash transactions prices (e.g., live hogs).  Everywhere else, problematic indeed.

LIBOR is the most pronounced example of that today.  Natural gas was so in the late-90s and early-00s.  Right now, the Platts’ methods for oil price assessments are under considerable scrutiny.  Market participants have always been skeptical (though they often mute their criticism given Platts’s heft), but IOSCO has issued a very critical and questioning appraisal, and raises the question of whether further regulation is necessary.

It’s deja vu all over again, folks.  Been there, done that.  Went through all these issues with the energy data hub in ’03.  I can show you the scars.  I can tell you some stories (e.g., the trade group guy who asked me what it would take to get me to back off with my proposal.)

The fundamental problems are that cash settlement is hard if there aren’t, well, a lot of cash transactions going on.  Even if there are a decent number of cash trades, that doesn’t help if people don’t report.  Given the public good nature of more informative price indices, there are under-incentives to report.  Indeed, it can be worse than that: reporting can be a private bad.

This raises a justification for mandatory reporting, and that is actually one of the defensible parts of Frankendodd.  That can’t fix the problem of a lack of transactions, but it can make the most of the transactions that are there.

But this also points out the value of delivery-settled derivatives.  The ability to make delivery  gives market participants the opportunity to put their money where their mouths are in a way that is impossible with cash settlement, especially cash settlement based on self-reported prices and assessments. Even if delivery doesn’t occur all that much, the ability to make delivery keeps prices honest (noting, of course, that the delivery mechanism can be abused, but further noting that’s a problem that can be addressed by appropriate anti-corner measures.)

In a cri du coeur published in the New York Times, resigning Goldman executive director Greg Smith claims that the firm “sidelines” the interests of its clients “in the way it operates and thinks about making money“:

Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.

Smith also claims that this wasn’t the case when he joined the firm 12 years ago, when apparently Goldman was all about helping little old ladies cross the street and rescuing kittens stuck in trees.  The firm’s dastardly turn is all the doing of Lloyd Blankfein and Gary Cohn.

Please. Goldman is, for the most part, what Goldman was. If you want a look at the firm’s “moral fiber” pre-2000, pre-Blankfein & Cohn, review the history of LTCM’s collapse.  The teetering hedge fund came to Goldman for help.  Goldman said it had to review LTCM’s books first, which LTCM in its desperation  permitted-only to have Goldman trade against every position in that book.

When dealing with any investment bank, and Goldman in particular, caveat emptor is the only rule to follow.  And it always has been.

My surmise is that Smith’s perception that things have changed is a very solipsistic one.  As he’s progressed up the organization-rapidly, to a very high position-he’s privy to things now that he wasn’t as a doe-eyed intern. What he’s seen has changed not because what is to be seen has changed: just that he wasn’t in a position to see it before.

What’s amazing is that an obviously very smart guy wouldn’t consider that possibility.  What’s even more amazing is the credulousness of the financial press in its reaction to Smith’s piece.  It’s obvious they haven’t thought of that possibility either.

Nicholas Sarkozy said this about Greece: “”Today the problem is solved.”

Uhm, not so fast, Sarko.  The Greek economy is imploding.  The political situation there is still fraught.  The feasibility and credibility of the austerity pledges are highly questionable.  Realistic forecasts suggest that even with the 100 billion or so (largely coercive) writedown in government debt, Greece’s obligations are not sustainable.

The markets are already giving their verdict.  The new Greek debt (to be issued to private holders of the old debt) is trading on a when-issued basis at very high yields:

Markets showed investors have no faith that the bond swap will draw a line under the country’s troubles. Under Greece’s austerity and reform programme, its debt burden in 2020 should fall to where Portugal’s is now.

If investors believed Athens could succeed, yields on Greek and Portuguese bonds should be similar. But on the grey market, the new Greek bonds were yielding 17-21 percent, far above Portuguese levels around 11-14 percent.

And it’s not like Portugal’s yields are any great shakes.  Indeed, Portugal is itself at serious risk of default.

What do 17-21 percent yields mean? Here’s what they mean:

Initial quotes in the “when-issued” market for the new Greek 2042 government step-up bond range between 17% and 22% of face value, according to traders with knowledge of the matter. Small-sized trades are going through the broker market as dealers “test the water,” according to one trader.“We are quoting the new 2042 bond between 20 and 22 cents to a euro…there is some interest to trade these securities but volume is still quite small,” said a London-based market maker.

Sarkozy is whistling past the graveyard.  Official European entities, like the ECB, are Greece’s primary creditors.  All of Europe is on the hook for its debts: the effective subordination of the new debt in private hands is a main reason why the new debt is trading at such heavy discounts, but even given the senior status of Greek debt in official hands, it is unlikely those official creditors will receive full payment. Given the imploding economy and potential for political backlash in Greece, it is rather naive to think this is solved.  This may be the end of the beginning, but it is nowhere near the end.

Europe might have bought some time, but the key thing is what they do with it.  Sarkozy’s confident statement suggests they may well be wasting it.

The Economist just ran a long piece about the unintended, and largely unforeseen, consequences of collateral and clearing mandates.*  And they aren’t all good.  Anything but.

I say largely unforeseen because I’ve been jumping up and down about these consequences here on SWP, in some academic papers (including one to be published in the next issue of the  Journal of Applied Corporate Finance), and numerous presentations.  I have repeatedly emphasized that it was a fallacy that requiring more collateral would necessarily reduce the amount of leverage in the system, make the leverage in the system less fragile, or reduce interconnectedness among financial institutions. I have consistently argued that market participants would substitute alternative forms of leverage and utilize other financing techniques (e.g., collateral transformation and liquidity swaps) as fragile or more fragile than the leverage embedded in derivatives, and that these new forms of financing would just change the topology of the network of connections among firms in the financial markets, and that the new topology would be as or more complex than the pre-mandate topology.

It was always particularly maddening to see regulators and others present pictures of the OTC derivatives market with a spaghetti bowl of interconnections between market participants, and contrast it to a neat and tidy picture of a cleared market with a few neat lines connecting market participants with the CCP.  There was no consideration of how the necessity of funding collateral and making variation margin payments would lead to the creation of financing arrangements among firms that would resemble the spaghetti bowl picture.  No consideration of how the very complex financial system would adjust on the myriad margins available to it.

In some respects, I can make some allowances for the regulators and legislators who imposed this on the world.   Those allowances are mainly a function of low expectations.  I am less forgiving of the academic community.  Many people smarter than I whom I respect have bought into the neat and tidy picture, and have dismissed concerns that the various Frankendodd mandates (and their European cousins) will create a new set of problems that may be worse than the ones that were supposedly fixed.

I think that in large part, this failure to anticipate the real effects of mandates, and the blithe confidence in the efficacy of collateral in particular, reflects the standard partial equilibrium, ceteris paribus way that economists use to approach problems.  This method is very powerful, and I utilize it regularly, but it has its limits.  In particular, it blinds one to the systemic responses to big changes like Frankendodd, to the fact that market actors will respond to these shocks on many dimensions.  As I’ve said repeatedly, there has been a systematic failure to consider how the financial system as a whole would respond to massive interventions designed to reduce systemic risk.

This is a particularly hard problem to analyze mathematically and formally due to its inherent complexity.  The daunting nature of the task, and the fact that formal mathematical modeling is almost required by top tier journals, has, in my opinion, made it unattractive for academics to pursue these issues.  The constraints of the accepted toolset have led to the slighting of an extremely important and interesting issue.

But this is not to say that the problem is immune to analysis that can generate meaningful insights and falsifiable predictions.  Indeed, largely disdained non-formal (“literary”) approaches can do so-and have done so.  I started from a very simple premise, that there were fundamental economic considerations that had led market participants to choose financing arrangements and contracts with certain amounts of leverage and fragility.  Constraining the ability to use those sorts of financing arrangements would induce actors to substitute towards arrangements with similar properties.  Non-formal analysis also shed light on how these mechanisms would operate during periods of systemic stress.

Based on these non-formal approaches, I made predictions about how the markets would evolve under clearing and collateral mandates.  Those predictions can be tested by empirical observation (though again, more descriptive than formally econometric).  That’s as “scientific” (in the Friedman Methodology of Positive Economics sense) as the densest, or most elegant, mathematical model.

And as it turns out, in this instance, some of those predictions are being borne out.  In ways that make me appreciate Cassandra.

I think it is more important to focus on important problems and find the best tools for the job at hand, rather than let narrow conceptions about the appropriate tools define and the problems you work on.  The latter mindset has limited academic economists’ influence on big things like Frankendodd.

The one-eyed man is king in the land of the blind.  Non-formal methods provide sight-and insight-on issues to which formal methods are often quite blind.  Given the incentive structure in academia, however, I am skeptical that the lesson will be learned.

* Link fixed. H/T Phil R.

Eric Posner and E. Glen Weyl have attracted a lot of attention for their proposal to create an agency that would approve trading of new financial products, in the same way the FDA must approve new drug entities before they can be sold to the public.  Their initiative is fundamentally flawed, both in its diagnosis and its prescription.

There are a variety of problems.  The most basic is their false dichotomy between contracts that are used for speculative purposes, and those that are used for hedging.  In fact, speculation and hedging are highly complementary functions.  The most important function of derivatives markets is to facilitate risk transfer.  This risk transfer often involves a hedger on one side of a transaction, and a speculator on the other.  The speculator may be, as Posner and Weyl claim, trading on the basis of incorrect beliefs.  So be it.  His existence allows the hedger to reduce risk, and makes both parties subjectively better off, although Posner and Weyl seem to suggest that it would be possible to determine objectively that the speculator is acting irrationally.

In other words, much speculation in financial markets facilitates hedging.  To suggest that these activities are antithetical, or unrelated, as Posner-Weyl do, is highly misleading.

Posner and Weyl use mutual funds as an example of a salutary financial innovation.  No disagreement here.  But these can be used for activities that are commonly and properly considered “speculative.”  Moreover, equity and bond futures are widely used to speculate on broad movements in stock and interest rate changes.  But they are also used by pension funds and institutional investors to achieve the same type of objectives as mutual fund investments. So what, really, is the difference between mutual funds and derivatives?

There are indeed well-known problems with speculation.  Much of it (including excessive acquisition of costly information, the development of faster ways to trade) is properly understood as rent seeking.  But these problems are not uniquely associated with particular kinds of instruments, as Posner-Weyl insinuate.  There can be inefficient acquisition of information for speculative purposes in derivatives that are widely used for hedging–including the agricultural futures that Posner-Weyl consider to be salutary. (Although it does not speak highly of their understanding of these markets that they use farmer hedging as their justification of ag futures, though that is hardly the primary hedging use of these instruments.)

Other possible problems highlighted by Posner-Weyl include the use of derivatives for tax avoidance or regulatory arbitrage.  I say “possible problems” because the real problem can be with inefficient regulations or taxes, not the means that are used to mitigate these inefficiencies.  But even abstracting from this difficulty, there is also a fundamental problem distinguishing “bad” derivatives that are used for tax or regulatory avoidance, and “good” derivatives that are used to hedge.

Back in the 1970s and 1980s, simple plain vanilla futures contracts were widely used in a tax reduction strategy called “tax straddles” involving a spread trade (buying one future, selling another with a different delivery day).  The trader would liquidate the losing leg of the trade to generate losses to offset against other gains, or to convert ordinary income into capital gains.  This strategy was eventually disallowed in 1981: the instruments themselves were not banned because they could be used to avoid taxes.

In sum, hedging and speculation are complementary; speculation is not always inefficient;  and inefficient forms of speculation are not confined to specific instruments.  Therefore, regulations designed to impede speculation by requiring the approval of specific products are misguided because impeding speculation interferes with efficient transfer of risk, and because the inefficient uses of derivatives cannot be reduced reliably by preventing the marketing of particular instruments.

This means that charging some financial FDA with the responsibility of choosing which innovations to permit and which to proscribe, based on the goal of eliminating speculation, is basically hopeless.  Such an agency’s choices will be plagued by Type I and Type II errors.

Not to mention that whereas the effects of a drug can be determined with some (though incomplete) precision in clinical trials, there is no comparable way of determining how financial innovations will be used, the volume of their use, or their economic effects (in part because these effects depend on the scale of adoption, and the interaction of these products with other products in the market).  All of these things depend on the choices of myriad individuals, and these choices can change over time: who would have envisioned, in the 19th century when wheat and corn futures were first traded in Chicago, that they would one day be used by index funds to offer diversification opportunities to pension funds?

Drugs are taken by individuals and their effects can be understood by studying individuals who take them: the systemic effects are just the sum of individual effects. Things are very different in financial markets.  The introduction of financial products can lead to very complex responses in the entire system that cannot be understood or quantified in any clinical trial.

When I originally heard of the Posner-Weyl paper, I thought they would focus on how particular instruments can be systemically risky.  They in fact pay very little attention to this issue.  In this regard, it should be noted that the FDA/clinical trial model is completely inapposite.  You cannot study the systemic effect of a financial innovation in an isolated trial: you have to see how it interacts with, and affects, the entire system.

And to try to understand these effects a priori is certainly futile.  The system is too complex, and there is no way to understand how a particular innovation will fare in the market, and how it will affect the entire system.  As a concrete example, no one truly understood the consequences of CDOs on subprime ex ante, just based on the characteristics of the instrument themselves.  The risks embedded in the instruments were not well understood when they were first created, and these risks depended on the scale of their use, which was impossible to predict at the time they were first created.  In the end, there were risks that were not widely understood at the time of introduction, and these risks had systemic import only because these instruments proved very popular and grew to massive proportions completely unanticipated when they were first introduced.

We actually have historical experience with ex ante entry regulations on financial innovation.  Until the 1990s, no exchange could introduce a futures contract unless the CFTC approved it.  The approval was contingent on a CFTC finding that the proposed contract passed an “economic purpose” test, and was designed in a way that would permit it to achieve this purpose.  In some ways, the economic purpose test was analogous to what Posner and Weyl propose today.

This system was costly and reduced competition.  Like many entry barriers, it was exploited by incumbents to hamstring competitors. I am not familiar with any dangerous product that was kept off the market through this procedure, and the introduction of good products was delayed.  All pain, no gain.  Why would we want to repeat that experience.

Maybe Posner and Weyl would disagree with my appraisal of the CFTC precedent.  They don’t seem to be aware of it, in fact.  Before making such sweeping proposals perhaps they should have performed an analysis of a similar system that operated for decades.

Being a Sam Peltzman student, I was never all that impressed with the FDA model in the first place, even in pharmaceuticals.  I am even less impressed with the FDA as a model for the regulation of products that are fundamentally different from drugs.  Especially when those advocating this model make basic errors about the instruments that they believe should be regulated, and the uses to which they are put.

For weeks the Perils of Pauline melodrama regarding Greece has focused on the euphemistically-labeled “Private Sector Initiative”, the negotiations between an organization that sort of speaks for banks and the Greek government.  But that was always a sideshow: it was never the crux of the matter. The main act, the real issue, was whether Greece would knuckle under to (primarily German) demands that it cede control of its budget, and much of its social and economic policy, to outsiders.

The Germans are acting on the principle of he who pays the piper calls the tune. Very logical, from a logical German perspective.  But not really in this situation, because the piper is not usually into the payer for hundreds of billions as is the case here.  Which gives the piper a tremendous amount of leverage, on the old principle that if you owe the banker $1000 and can’t pay, you have a problem: if you owe the banker several hundred billion and can’t pay, the banker has a problem.

Negotiations between the German payers and the Greek piper are on the brink of failure:

The two sides were still far apart over projected cuts of 25 per cent in private sector wages, 35 per cent in supplementary pensions and the closure of about 100 state-controlled organisations with thousands of job losses.

Eurozone officials are deliberately refusing to allow Greece to sign off on a €200bn bond restructuring plan because the threat of default is the leverage they have to convince recalcitrant Greek ministers to implement necessary cuts.

Greek unions are going to strike Tuesday.  Greek politics are highly fractious. But the fundamental issue is that the Greeks have tremendous bargaining power.  They would be not much worse off–if at all–by accepting the terms being thrust upon them than they would by defaulting: the European deal is essentially paying debt comes first, and only after that is paid can the Greeks spend anything on themselves.  Not a very attractive deal for the Greeks.  The Germans, et al, however, would be much worse off if Greece defaulted.  Given this, the Greeks have considerable bargaining power.

Yes, there is tremendous room for a mutually beneficial deal.  But given the political nature of the problem, the fact that there are multiple items to be negotiated, and multiple parties involved (with multiple affected groups within each), transactions costs are high and the chances of a failure are acute.  And even if a deal is signed, the ability of the Germans, et al, to force the Greek government to live up to any agreement it make,s is quite limited.  Rioting in the streets of Athens, social turmoil, widespread strikes are likely if the government caves.  Not going to be much money going north if that happens.

So maybe Pauline will be pulled from the tracks at the last instant.  But IMO it’s more likely that she ain’t.

I’m sure you’ve noticed that I haven’t written much about clearing lately. (And yes, I can hear the Hallelujah Chorus.)  Simple reason, really.  Most of the clearing related news warrants schadenfreud, and an “I told you so” response.  I enjoy a good Lulz as much as the next guy, but I know it gets old.

But this article hits on so many things at once I have to impose on you all.  It basically gives the lie to all the justifications for the clearing mandates in Frankendodd.

1. The advocates of mandates, notably GiGi and Timmy! asserted repeatedly that clearing would reduce the connectedness of the financial system, and in particular, would reduce the importance of big banks in those connections.  I argued in response that clearing mandates would just change the topology of the network; that it would remain densely connected; big banks would still be tightly connected; and that the new topology was not obviously less systemically risky than the old one.

From the article:

Where do you find the spare $2 trillion needed as collateral for cleared swap trades?

With new regulation in the US and Europe set to move the bulk of the over-the-counter derivatives market towards central clearing from next year, swap buyers and dealers will soon be faced with that very question. Many custody banks believe they could provide the answer.

Already heavily involved in the plumbing of the clearing market, custodians act for almost every major financial services firm without a custody arm – including most dealers and every clearing house.

Most also offer collateral management services, including securities lending and collateral improvement – the process of turning less-liquid securities into eligible collateral to post as surety in transactions.

This experience could prove invaluable with the advent of new swap clearing rules, which come in with the expected implementation of the Dodd-Frank Act in the US from early next year, increasing the demand for collateral transformation services.

David Field, managing director with banking consultancy Rule Financial, said: “The buyside simply doesn’t have enough quality collateral available to lodge for clearing.

Executing brokers are expecting to generate strong post-trade revenues from collateral transformation – but the custody banks are the ones holding the collateral.

This is a huge opportunity for custodians, and several are already investing anywhere between $50m and $100m to position themselves.”

In other words, big custodial banks will be even more tightly connected with all major participants in the derivatives trade because of their comparative advantage in providing collateral transformation, and the strong economies of scope between providing this service and providing other custodial services.

2. The advocates of mandates argued that it would reduce leverage in the system.  I responded repeatedly that this was not at all obvious, and that the most likely effect would be to transform the nature of leverage.  The big move to collateral transformation makes it abundantly clear that this is in fact happening.  I go into this in much more detail in my forthcoming Journal of Applied Corporate Finance article titled “Clearing and Collateral Mandates: The New Liquidity Trap?”

Credit means credit risk.  So the clearing mandate has not eliminated credit risk from the derivatives market, or even reduced it sharply.  It has just transformed it, relocated it.  And it has definitely not eliminated derivatives-related credit risk from big banks.   Indeed, it is moving more risk to some big banks.  BNY-Mellon and JP Morgan are also the most important settlement banks, and play a vital role in the repo market.  This is already a source of systemic risk.  These banks are arguably the most important pieces of the financial infrastructure, and these developments will make them even more important, and also concentrate more risks from disparate markets (e.g., repo and derivatives) in them.

3. The advocates of mandates asserted that it would make the derivatives market less concentrated and more competitive (although nb these are NOT equivalent).  From the article:

Tech-heavy effort

Among the most ambitious to gain business in the swaps market is BNY Mellon, the world’s largest custodian with $25.8 trillion of assets under custody. The bank sees its existing footprint as a springboard towards dominance in the collateral services market for OTC derivatives.

[A director] for collateral management and clearing at BNY Mellon in London, believes it will be a tech-heavy effort. He said: “According to recent Isda Margin Survey figures, roughly 80% of collateral used in the OTC swaps market is cash, with about 15%-20% being fixed-income securities.

If even 20% of the estimated extra $2 trillion of collateral required to clear OTC swaps via central counterparties is in the form of securities, that puts a big onus on the collateral managers to offer smart, quick systems capable of handling huge draws on client collateral daily.”

Rival US custodian State Street has also been boosting its presence in the cleared derivatives markets, launching a swaps clearing operation in September. In a signal of intent, the bank has quietly begun hiring senior futures brokers from established rivals.

Charley Cooper, senior managing director at State Street Global Markets, said: “State Street’s unconflicted approach combined with the operational efficiencies gained from clearing with a custodian, gives us a significant edge in the emerging clearing marketplace.”

A senior derivatives banker said that clients are already looking at custodians as a viable counterparty.
He said: “In the past six months, we’ve seen growing migrations to the custodial clearing business.

Some have a better credit rating than almost every investment bank, and it’s unlikely they will be subject to capital ring-fencing regulations.”

He said that if a major custodian is able to convert even half of its existing custody clients into clearing clients, it could be looking at a share of anywhere between 10% and 20% of the OTC clearing market.”

The incumbents

But existing derivatives flow dealers – especially ones with large custody and treasury businesses – are unlikely to shy away from a revenue-generating opportunity.

Citibank, in particular, is hoping to combine a swaps clearing operation with its custody and treasury services in the US.

Jerome Kemp, global head of exchange-traded derivatives and OTC clearing at Citi, is in no doubt which direction the market is heading.

He said: “We’re looking at a re-dealing of the cards in the derivatives clearing space. Post-Dodd-Frank implementation, clearing will be led by the larger, well-capitalised banks.”

Citi hired aggressively to expand its futures commission merchant business last year, including the hire of Kemp, previously co-head of listed derivatives and clearing at JP Morgan, who arrived with a raft of colleagues.

Kemp thinks the next battleground for the bigger futures commission merchants, which will act as clearers for many firms on the buyside, could hinge on the bundling of services across clearing and asset servicing.

JP Morgan, meanwhile, is also looking to leverage its existing prime services footprint for its hedge fund clients for whom swaps clearing will be a new experience.

The bank has merged its listed and OTC clearing teams, and invested heavily in client roadshows and clearing masterclasses since the Dodd-Frank Act was passed in 2010.

Dale Braithwait, a member of JP Morgan’s OTC clearing team, said: “It’s to our advantage that we’re a big collateral manager too.

For a lot of asset managers, who do not feel they are able to use prime brokerage services, it’s a big benefit to have someone who can act as a custodian and a clearer.”

So there is a big fixed cost to play in this game.  The resulting scale economies tend to increase concentration.  Moreover, there is a strong scope economy across collateral management and transformation services, and other custodial services.  Meaning that the big custodian banks have a strong competitive advantage in providing the new collateral management and transformation services that will become a crucial component of the OTC derivatives markets.

It is particularly ironic that BNY-Mellon will be a major beneficiary of this.  You might recall the execrable NYT piece (written by Louise Story) about the evil derivatives dealer cabal.  One of the most memorable parts of the article was BNY’s whinging about its inability to break into the dealer space.  Read this new piece and you can just imagine BNY execs rubbing their hands together in glee, throwing their heads back, and laughing an evil laugh.  All your cabal belong to us.

So let’s summarize, shall we? Clearing mandates (and requirements to collateralize uncleared swaps) will result in the formation of new links between buyers and sellers of swaps (including dealer banks who do not offer custodial services) and a handful of major custodian banks.  These links will involve the extension of credit, and hence the existence of derivatives-related counterparty risk in which big banks still have substantial exposure.  If anything, the mandates will increase concentration in an important part of the derivatives market.  Moreover, it will arguably increase the concentration of credit risk exposure in a handful of systemically important banks.

Well played!  The actual results of Frankendodd will be the exact opposite of what was claimed by its tireless advocates (And yeah, I’m looking at you, Timmy! and GiGi.  I’m trying not to look at Barney, but that’s a whole other story.)

Unintended consequences, indeed.  Unintended, but predictable–and predicted.