Streetwise Professor

Go to a conference where derivatives or Frankendodd are discussed, and you can’t escape without hearing somebody’s tongue trip over the word “extraterritoriality” (say it 5 times fast!) -the imposition of Frankendodd rules (such as swap dealer registration) on foreign firms.  Gensler has been quite aggressive in his interpretation of where the CFTC’s writ extends: in his mind, it basically extends everywhere that directly or indirectly could have an impact on US markets.  In an interconnected financial world, that doesn’t limit things much.

Foreign financial institutions (and other firms, such as pension funds and money managers) are less than thrilled.  To say the least.  Some smaller institutions have announced their intention to have no dealings with US firms that could put them in the monster’s grip.

Foreign regulators have also criticized US assertions of authority, both in writing and now in GiGi’s face:

Financial regulators from around the world have rounded on the main US swaps regulator over its attempts to extend new rules on derivatives overseas, warning of destabilising effects on the global financial system.

Supervisors from Japan, Europe and Hong Kong have previously criticised the Commodity Futures Trading Commission in written correspondence. On Wednesday, the regulators set out their concerns during a public meeting at the CFTC in Washington.

GiGi nodded, and then defended the CFTC’s actions.

Regulatory arbitrage is a concern, but unilateral assertions of US authority, and foreign pushback on those assertions, raise various concerns of their own.  In particular, they threaten to balkanize derivatives markets (and financial markets generally) as non-US firms limit their dealings with US entities.  This will reduce liquidity; tend to lead to concentrations of risk; and will impede the efficient allocation of risk.

Per usual, Gensler is appealing to a simplistic version of the financial crisis to justify his position, and not acknowledging the adverse consequences-most notably due to fragmentation-that will result from over-aggressive American initiatives.  Regulatory consistency across jurisdictions (which would mitigate regulatory arbitrage) ironically is undermined by the unilateral efforts of the US regulator to impose its will around the world.

This is particularly amazing given the CFTC’s less than glorious record at regulating a subset of US derivatives markets.  Hubris, anyone?  And unfounded hubris at that?

Speaking of regulatory hubris, David at Deus ex Macchiato is justifiably outraged at the assertion by an Irish regulator that global regulations of OTC markets had “the explicit policy objective” of reducing the size of these markets.  Because of course regulators know exactly how big OTC derivative markets should be and know with metaphysical certainty that the markets will reconfigure themselves to the regulatory fiat in ways that enhance stability.  Yes, these are the most complicated, interconnected markets in the world, so of course guys in Dublin and DC should know exactly how big they should be and exactly how they should be configured.  Because that always turns out just swell.

This is exactly what Hayek meant by “the fatal conceit.”  And I fearlessly predict that this very conceit will be the source of the next crisis.

Soon after the 2oo8 election, I wrote a post titled “No Joy in Mudville” in which I prophesied numerous malign effects of the Obama election: the post got some notoriety, including a pickup by the WSJ Political Diary.  Although I was off on some of the specifics, I think I was right on the essentials.  Four years of cascading progressive statism, with a heavy measure of foreign policy incompetence as an added bonus.  And four years of moribund economic performance.

My pre-election appraisal was that defeating Obama was a necessary but not sufficient condition to stave off serious decline, and perhaps crisis.  I had little hope that Romney or the Republicans would have been able to address the deep structural problems the nation faces, especially if they had prevailed in a close election.  But I am nearly metaphysically certain that Obama and the Democrats won’t, in large part because they don’t perceive that we face serious structural problems arising from unsustainable entitlements, a fiscally incontinent government, and crushing regulatory burdens.  Indeed, they see these as features, not bugs. These were the main planks in Obama’s real platform: no substantive change in entitlements, more government spending-excuse me, “investment”-and more regulation.

Consequently, I predict continued sluggish economic growth-if we’re lucky-with a heightened risk of fiscal (and consequently financial) crisis, timing TBD.  The regulatory burden-most notably the Four Horsemen of Frankendodd, Obamacare, the EPA, and Other Assorted Insanity From Agencies You’ve Never Heard of-will make us pine for the growth rates of the 1970s.  Redistributionist-driven changes to the tax code which will raise marginal rates and particularly increase taxes on capital will create further drag, all the while doing nothing to improve the country’s fiscal situation (and in fact worsening it with non-trivial probability)

Slow growth, combined with continued high levels of government spending, a failure to address entitlement spending, and increased expenditures arising from Obamacare, will accelerate the deterioration of the nation’s fiscal condition.  Given the multiple equilibrium nature of government finances (where small changes in circumstances can lead to a jump from an equilibrium in which lenders are willing to rollover debt to one in which they aren’t), this deterioration increases the risk of a funding crisis that would make what is going on in Europe now look like a pleasure cruise.  (For those of you who take solace in the fact that other people might have it even worse, there’s always Japan, which would love to have our trivial problems.)  Any such crisis would inevitably be accompanied by a huge inflationary spurt, as inflation is de facto default: If it occurs before the Fed has trimmed its bloated balance sheet-and there is no sign that Ben will slim it down anytime soon-the spurt will be that much worse, as all those reserves (the Fed’s liabilities) that have been moving with virtually no velocity will start to turn over at an accelerating rate.

In other words, après nous le déluge doesn’t quite capture it.  Le déluge est maintenant. Well, perhaps not now now, but uncomfortably soon, and certainly en avant notre disparition, actuarially speaking.

There is widespread disquiet about the country’s fiscal and economic circumstances.  Indeed, if only economic and budgetary issues were in play in the election, it is my sense that the outcome would have been different.  But cultural, social, and religious issues prevented Romney from assembling a winning coalition.  The single issue cultural and religious right that blessed us with monstrosities like Mourdock and Akin-who became the poster boys of the Republican Party as a whole, due to the combined efforts of the Obama campaign and a supportive media-drove away many people with libertarian sympathies on both economic and social issues who would have been willing to vote for Romney if only economics and public finances were at issue.

Righteousness has a way of interfering with good judgment, and the ability to make rational calculation.  Cultural and religious conservatives have no way of prevailing on their agenda.  If anything should seem obvious in the aftermath of this election, that should be it.  Obama should have been extraordinarily vulnerable on the economic and budget issues that are conventionally believed to be decisive in national elections, but he prevailed nonetheless.  Why?  Social and cultural issues are the most likely explanation.

The result: a president and a Congress (especially the Senate) that is actively hostile to the agenda of the cultural and religious right instead of one that is at least not an enemy (even though it would be unable and unwilling-unless suicidal-to push that agenda), and inexorable movement towards fiscal catastrophe.

Well played.

If it were only about economics I would have some optimism-not much, but some-that we could address the growth, regulation, spending and entitlement issues.  But it’s not only about economics.  Social and cultural divides make it nigh on to impossible to assemble a coalition (under the aegis of the Republican Party) that can win a national election, and win it decisively enough to permit serious action on these budgetary and economic issues.

No Joy in Mudville, indeed.

In more non-Benghazi news, some clearing stories.  (Contain your excitement, people.)

First, Gretchen Morgenson is still wretched. (So I said this was a post about news.  Sue me.)  She kills CO2 absorbing trees to criticize the very thought of providing CCPs access to central bank liquidity:

But placing them at the bailout trough is wrong, according to Sheila Bair, the former head of the Federal Deposit Insurance Corporation. In a recently published book, Ms. Bair wrote that top officials at the Treasury and the Fed, over the objections of the F.D.I.C., pushed to gain access for the clearinghouses to Fed lending.

The clearinghouses “were drooling at the prospect of having access to loans from the Fed,” she wrote. “I thought it was a terrible precedent and still do. It was the first time in the history of the Fed that any entity besides an insured bank could borrow from the discount window.” .

“The Treasury’s and the Fed’s reasoning was that since another part of Dodd-Frank was trying to encourage more activity to move to clearinghouses, we should provide some liquidity support to them,” she said in an interview last week. “Our argument back was, if you have an event beyond their control with systemwide consequences, then you have the ability to lend on a generally available basis. What they wanted was the ability to lend to individual clearinghouses.”

Look, one of the reasons I think Frankendodd is monstrous is precisely because clearing and collateral mandates impose tremendous contingent liquidity demands.  Last week I spoke at in Osaka at the annual meeting CCP12, an organization of 30+ CCPs (which apparently uses the Big Ten as a naming role model).  An exec at an Aussie CCP asked me what the most worrisome unintended consequence of derivatives “reform” would be.  I answered before the words were out of his mouth: the potential for a liquidity crisis in times of market stress.

That’s what happened 25 years ago, on Black Monday and the following Tuesday morning.  The Fed prevented an apocalypse by leaning on banks to lend to FCMs to meet margin calls.

Clearing mandates without some mechanism to provide additional liquidity, either directly to CCPs or indirectly via clearing members, are a recipe for disaster.  Like Gary Gorton, I am increasingly skeptical of moral hazard being the major concern: the major concern is the inevitability of periodic liquidity crises even in efficiently structured financial markets.  Forcing use of clearing and collateralization of uncleared swaps while simultaneously depriving CCPs or their members of access to central bank liquidity would be like mandating the use of matches in an oil refinery and banning fire extinguishers.

So, not surprisingly, Wretched Gretchen goes the wrong way, yet again.

And speaking of wrong way, ICE has received approval to clear European sovereign CDS.  I’ve written before that clearing sov CDS is very problematic, due to the wrong way risk inherent in these trades.  The sovereign-bank feedback loop means that clearing members-or a CCP’s default fund-are required to make big payouts on sovereign CDS precisely when they are under severe financial strain.

ICE Clear Europe claims that it has taken measures to reduce the wrong way risk.  I am deeply skeptical that these measures are adequate.  (Sorry, Paul-I calls ’em like I sees ’em.)

One thing ICE Clear Europe points to is that margins and default fund contributions will be in dollars, not Euros.  This actually creates a new risk. One thing we’ve seen is that during flare ups of the Eurozone crisis is that European banks have faced serious problems accessing dollar liquidity.  Meaning that in the event of a jump to default by a major European sovereign, Eurozone some banks that are members of ICE Clear Europe may well need to come up with big dollars to pay margin calls, or to cover the costs of a defaulting customer, or to meet default fund contributions, but need to do so precisely when they find dollars very hard to come by.

Meaning that (pace Wretched Gretchen) they will be desperately dependent on Fed support through dollar swap lines.

The other measure ICE has taken is to preclude “affiliates” of a sovereign from clearing CDS on that sovereign. Yeah, have to do that, but that doesn’t really come close to addressing the real wrong way risk.  If Spain or Italy-or even Portugal or Ireland or Greece-jump to default, a Eurozone-wide financial crisis that hits all banks will likely result.  Meaning that all major Eurozone banks-including members of ICE Clear Europe-and not just affiliates of the defaulting sovereign, are likely to be in distress at that time.  Further meaning that they will be in distress precisely at the time they are expected to absorb some costs arising from the default (big margin calls, covering the losses of defaulting customers, or incurring default fund obligations).   That’s the wrong way risk we really need to worry about, and nothing that ICE Clear Europe says in its filing with the SEC provides any inkling that their plan addresses that risk.

I also have serious concerns about the risk modeling here.  Wrong way risk is devilishly complicated, especially in a sovereign risk context especially in Europe (given all the potential cross-country linkages).  I am skeptical in the extreme about the ability to set margins properly, and strongly suspect that any methodology is likely to be highly procyclical.

In brief, I continue to believe that clearing sovereign CDS is highly dangerous.  It’s good that ICE Clear Europe recognizes the inherent wrong way risk problem, but in my (strong) opinion, they haven’t really addressed that problem, and indeed may have introduced another source of wrong way risk via the cross-currency mechanism inherent in their design.

I hope I’m wrong.  I hope for all of us it never comes to a test.

Finally, Deutsche Boerse is going to have to stump up $150 mm or so in new capital for Eurex’s clearinghouse, in order to meet European capital standards.  And that’s cheap! LCH.Clearnet will have to come up with 375 mm Euros (or about $500 mm) in new capital:

However, tough new European regulatory capital rules appear to have caught the industry unaware. Eurex is the second major clearing house to admit to a shortfall after LCH.Clearnet, the Anglo-French group, said it would need to increase regulatory capital by an estimated extra €300m-€375m last month

So much for clearing mandates being a cheap way of mitigating credit risk.

We are just approaching the G-20 deadlines to move most derivatives trading into clearing.  And the fun just can’t wait for the official kickoff.  There will be much more fun-and cost, and risk-to come.

France’s President Hollande says that an EU banking union is the most important issue to discuss at the next Euro summit.

Even though it’s illegal.  Details, details.

Why is he so hot for this?  Two, related reasons.

First, a banking union is a gateway drug to a more complete political integration in Europe.  It is like the coal and steel pact that was the first stage to European integration.  But finance and banking are so pervasive, that it is a far more powerful way to achieve a broader political integration.

Second, it is a way of tying Germany even more tightly to France, and the rest of Europe.  If German financial institutions are tightly enmeshed in a European regulatory structure, it will be much harder for Germany to decide that the Euro isn’t worth the candle and leave.  This is vitally important to France, because it realizes that its financial position is extremely fraught.  This is also why French plans would include every bank in the regulatory net, including local banks like landesbanks, whereas the Germans want the banking union limited to big, systemically important entities.  Every bank that is included in the banking union is like a rope helping to hold down the German Gulliver and putting under the control of the European Lilliputians-acting under French direction, of course.

In other words, a banking union is a lot more about union than banking.  Hollande is being very Machiavellian, and it will be interesting to see how Germany plays this.

So today, 12 October, 2012, is the day when many Frankendodd rules go into effect.  Swap dealer registration for instance: but not position limits!

Yes.  848 pages of legislation (or 2319 pages, depending on how you count)-where commas matter-that spawned thousands of pages of rules (over 9k as of July, and where commas will also matter) that will spawn thousands more pages of interpretations, no action letters, legal rulings, etc.  All in an attempt to re-engineer a devilishly complex, interconnected financial system.  A system that will not stand still, but which will change in response to the law and the regulations, thereby producing myriad unintended consequences.

I’m sure it will turn out just swell.  Timmy! and GiGi and their successors have everything under control.  They’re from the government and there to help you!  Trust them on this!  Don’t you worry your pretty little head over it.

JK.  In reality, Mickey Mouse (how appropriate) gives you a better idea of how things are likely to turn out.

I fearlessly predict that the next financial crisis will follow directly from Frankendodd. It is a monster, which like Frankenstein’s, will escape its master’s control and wreak havoc. Mark my words.

The UK’s Vickers Report and the EU’s recently released Liikanen Group report both recommend a fundamental structural change to the banking system to reduce systemic risk and the likelihood of taxpayer bailouts of banks: “ringfencing.”    The taxpayer guaranteed deposits of a financial institution would be inside the ringfence, and the ringfenced entity that can fund itself with these deposits can engage only in a limited array of activities that are deemed to be of low risk.  Riskier activities, such as derivatives trading and securities underwriting, would have to be undertaken through separately capitalized affiliates that cannot be funded by the ringfenced entity.

This is, in essence, a variation on the Glass-Steagall approach of separating commercial and investment banking.  The Volcker Rule is another way of achieving a separation of deposit taking and trading and underwriting activities.

These structural approaches are completely misguided, in my opinion.  They are unlikely to have the desired effect of reducing systemic risk or insulating taxpayers from the fallout of risky trading activities.

Insured deposits are a potential source of moral hazard, and there is a case to be made for limiting the risks that can be funded with insured deposits.  But historically these activity limits have proved to be a very poor defense against risk taking.  Banks have gotten into trouble while engaging in traditional lending activities; the Latin American debt crisis and the S&L crisis are two prominent examples.  Ditto Northern Rock in the UK.

Moreover, it is beyond naïve to believe that making insured depositors whole is the only, or even the most important, cause of taxpayer funded bailouts.  A failing  investment bank-or a bank-owned trading entity outside the ringfence-poses a potential systemic risk that would likely result in a bailout even if insured deposits are not directly at risk.  Its derivatives counterparties-which are likely other big financial institutions, and which could well be ringfenced banks-would suffer losses if it went other.  Its lenders-which could include, for instance, money market funds that buy its short term debt-are also at risk.   This could lead to destabilizing runs on the money markets.  In brief, even entities outside the ringfence would be highly interconnected with the broader financial system, and with entities inside the ringfence.  The Fed or the ECB would likely deem problems at such interconnected institutions to be systemically threatening, and would find a way to provide support to prevent a failure.

Put differently, an investment bank-like entity outside the ringfence can be too big to fail.

Indeed, looking at the 2008 experience, the most vulnerable institutions were not funded by deposits.  Bear Stearns was an investment bank-it was bailed out.  AIG was not deposit funded-it was bailed out, in large part (IMO) to prevent the failure of another non-deposit funded entity, Goldman Sachs (i.e., the AIG bailout was in part, and likely in large part, a backdoor bailout of Goldman).  Merrill was foisted on Bank of America to prevent its failure.  And of course there is Lehman.  It wasn’t bailed out-but you can be metaphysically certain that inaction won’t be repeated again.

It is quite easy to envision that there will be firms outside the ringfence that are deemed TBTF.  If one of these firms looks acutely vulnerable, central bankers and regulators concerned about systemic contagion will find some way to prop it up.  Taxpayer money will be at risk.

Moreover, the ringfencing idea creates a particular kind of vulnerability that proved to be an acute problem in 2008, and which is pretty well understood theoretically.  The funding of non-deposit funded entities is often quite fragile, and vulnerable to runs.  Like investment banks in ’08, entities outside the ringfence are likely to depend on short-term wholesale funding that can-and will-run if the entity looks shaky, and there is doubt that a bailout would be forthcoming.

Deposit funding is stickier, and a destabilizing-and inefficient coordination game equilibrium-run is less likely to occur with sticky funding.  Thus, putting trading activities outsie the ringfence, and funding these risky activities through the wholesale markets exacerbates a source of financial fragility.

Thus ringfencing increases the risk of liquidity/funding crises that trigger a bailout.  It exacerbates a form of fragility that was devastating in 2008, when it was financial institutions that were outside the Glass-Steagall ringfence that proved most vulnerable to the fallout from the decline in real estate prices.

The knotty issue here is why the funding of trading, market making, securities underwriting and similar activities is typically quite fragile.  The Diamond-Rajan story is that runs are a way of disciplining opportunistic intermediaries.  With the potential for externalities from runs (due to contagion effects) one could make a case that funding is excessively fragile.  But that is hardly an argument for ringfencing, which precludes the ability to use less run-prone deposits to fund these activities: indeed, if anything, it is an argument against ringfencing.

The nostalgia for Glass-Steagall-like structural “fixes” is pervasive.  But structural separation of certain forms of financial intermediation, and separation of certain forms of activity from deposit taking, don’t address a fundamental source of systemic risk: the reliance on short-term, wholesale funding that is vulnerable to runs.  Indeed, it likely makes the problem worse because it increases the reliance of the segments outside the ringfence on such funding.  It is delusional to think that just because taxpayer-guaranteed deposits are not directly at risk, that taxpayers are not on the hook for bailouts.  If a big, interconnected entity that sits outside the ringfence teeters on the brink, regulators and central banks may well deem it too big to fail: No More Lehmans is their motto.  Ringfencing does not isolate derivatives trading, underwriting, etc., from the broader financial system: entities outside the ringfence will still be interconnected.

So even if there is no explicit taxpayer obligation (as with insured deposits), there is an implicit one.  We’ve seen that implicit guarantee invoked before, and we could see it again.  Ringfencing does not address the problem of a non-depository SIFI that is highly interconnected.  Indeed, by increasing the number and size of such entities, it almost certainly makes this problem worse.

HFT is under continued assault, both in the press and from regulators and legislators.  Europe is taking the lead on this, and Mifid II will impose some restrictions on HFT.  The Germans are particularly hot on restricting it, and are proposing other measures as well.

One goal of these regulations is to increase liquidity, and to improve the quality of liquidity.  Perversely, however, certain of the regulations intended to have these effects will do the exact opposite.

In particular, as I’ve argued since soon after the Flash Crash when many of these ideas were first proposed, things like minimum resting times for limit orders will reduce liquidity and make sudden reductions of liquidity more likely precisely when order flows become more toxic.  Limit orders are like options granted by the market maker, and extending the lifetime of the option increases its cost-particularly during times of high volatility and high order flow toxicity.  If you increase the costs that market makers, including those using HFT strategies to make markets,  incur to quote, they will quote wider, they will quote less, and their quotes will become particularly wide and particularly scarce during periods of elevated uncertainty.

In other words: there is no free lunch.  You raise the costs of market making, and liquidity costs go up.  Period.

Larry Tabb makes the point quite well:

So what will happen? If we mandate longer time in force periods, lower cancellation ratios, and higher market maker participation rates, liquidity providers will just widen their spreads to compensate them for the greater risk.

Won’t this force real investors to come in and bid? They may, however investors don’t quote on both sides of a market. They either buy or sell and not both. So many more quoting investors would be needed to make up for fewer market makers and HFT.

But, will HFTs actually leave? Market makers may leave but high-speed traders probably won’t; they will just change their stripes. Liquidity providers will flip to liquidity takers. Given a speed advantage, if it no longer serves a high-speed trader’s purpose to provide liquidity, they can just as easily take it. And since market makers and quoting investors are locked into providing liquidity for at least 500 milliseconds, HFTs will be the first to pick off every stale quote. And with a half second quoting mandate, there will be plenty of stale quotes to go around.

This last point is particularly powerful.  The regulations will penalize liquidity suppliers not just directly, but indirectly, by actively encouraging predatory/opportunistic algorithmic/HFT strategies that look for and pounce on quotes that are stale and not reflective of current information because of the restrictions on the time quotes must be enforced, and on cancellation and participation ratios.  (Note: these last restrictions are likely to create some rather complex time dependencies that can create some unanticipated sources of instability.  A trader’s current quoting behavior will depend on his past cancellation and participation rates, not just on current market conditions.  That adds a complex new feedback to an already complex process.)

The elimination of tiered pricing (e.g., differential pricing for quote makers and quote takers) will also tend to reduce liquidity.  Why don’t exchanges have the incentive and the information to get that right?  They are much better incentivized and informed than regulators.

So as Larry indicates, the regulations will reduce liquidity by raising the cost of quoting directly, and indirectly as well by encouraging predators to feast on those brave enough to quote:

So let’s combine points. Market makers will leave, spreads will widen, investors will post quotes, but HFTs instead of posting will take quotes. With investors’ quotes being frozen, HFTs will just pick off those investors. And once these investors learn this game they will stop posting, and then there will be little incentive for anyone to post quotes as the value of the limit order option grows just as the compensation to the option poster falls.

But won’t HFTs run afoul of HFT rules, you ask. Not really, since many of these rules focus on liquidity posting and not liquidity taking. If you take liquidity, there is no need to post or cancel, so cancellation rates decline to zero, and time-in force rules become immaterial.

Great.

Mifid II will also restrict those scary dark pools, in particular by banning crossing networks.  Which, as Tabb notes, will expose those seeking liquidity to predatory HFT, and other predatory strategies that raise execution costs.  For dark pools exist precisely to reduce the execution costs of those who are uninformed liquidity demanders. They swim in a (dark) pool because they don’t want to swim with the sharks in the open waters of the public markets.   Mifid will deprive them of that safe harbor, with the predictable result that Larry describes:

If all of this comes to pass, spreads will widen, depth will evaporate and there will be fewer places to hide as broker dark pools will face restriction. And the life of the buy-side trader, instead of becoming easier, will become much harder. And who suffers? The people who always suffer: the investors.

In other words, the Sorcerer’s Apprentices are at it again.  They claim to work magic that will make investors’ lives easier, but will in fact unleash forces that will wreak havoc.  And, no doubt, they will use the resulting havoc as the justification for yet more magical regulatory spells.

Not all HFT is good.  Not all algorithmic trading is efficiency enhancing.  It would be worthwhile to explore ways of curbing the inefficient forms of computerized trading without harming good forms.  There is justification for some regulation that can reduce the likelihood and impact of bad algos.   Mifid II is unlikely to have these effects.  Indeed, in my opinion-and in Larry Tabb’s too-it will likely have the exact opposite effect, and will disproportionately damage the beneficial forms of computerized trading and off-exchange trading.

Like the old joke says.  The Euros want to fix computerized trading in the worst way.  And they are succeeding.

The BofE’s Andrew Haldane is getting a lot of attention-and rightfully so-for his critique of complex financial regulation, most notably Basel Faulty.  Yes, there is a lot to criticize in complex financial regulation-and lord knows, I’ve indulged-but it’s essential to emphasize that simplicity is no panacea.  Indeed, complex regulations evolve precisely from the deficiencies of simpler ones.

That is, you have to ask: Why did the rules become complex?  Was complexity valued for complexity’s sake? Or did complexity develop/evolve because of the recognized defects of simpler structure?

Most likely.  Rules become more complex in an attempt to respond to attempts to exploit simpler rules.  There is a regulatory dialectic.  The regulators and the regulated interact in a way that leads to spiraling complexity.

Take bank capital requirements.  Simple capital requirements specify, say, capital equals a certain percentage of assets.  This is fine if assets are identically risky, or the regulated have no ability to tilt their portfolios towards risky assets.

But that’s exactly what happened in the old, simple world with simple capital requirements.  Banks looked for riskier assets in order to expropriate their depositors, lenders, and deposit insurers.  With capital requirements insensitive to risk, banks had a tremendous incentive to make their assets as risky as possible.

There are two responses to this.  One is to limit the nature of the assets banks can hold.  The other is to make capital requirements depend on the riskiness of assets.

Both are great in theory, devilish hard in practice.  Risk-based capital requirements (or limitations on the assets that banks can hold) demand that regulators have the ability to make discriminating evaluations of the relative riskiness of assets.  Even more crucially, they demand that regulators know at least as much as those they are regulating.

Neither condition is likely to hold in practice.  And again, there is a regulatory dialectic, as banks sniff out-or create-assets that are “underpriced” from a capital requirements perspective.  That is, they identify-or create-assets with risk prices implicit in capital charges that do not reflect true risks, and which satisfy the restrictions on the nature of assets that banks can hold.  (Think of AAA ABS of various types.  They’re AAA!  What could go wrong?)  Thus, portfolios end up being riskier than regulators had anticipated.

So they adjust the capital requirements.  But as in any regime of price controls-and capital requirements are essentially risk price controls-the regulators don’t have the necessary information to set the prices properly, meaning that some risks are always underpriced.  The capital requirements become more complex, setting off a new round of attempts to identify the underpriced and overpriced risks.

What starts simple becomes progressively more complex.  Regulations and capital requirements end up being bizarrely baroque not because people like it that way, but because the less baroque rules were exploited.

Put differently: complexity is endogenous, and almost inevitable.  Simple sounds nice, but simple is easy to exploit, and complexity blooms in order to counter this exploitation.

Haldane argues that during the last crisis institutions subject to simple rules were less likely to fail than those subject to more complex ones.  This is superficially plausible, but again, remember that the rules are endogenous, complexity is endogenous.  There was no experiment, natural or otherwise, that randomly assigned some institutions to simple rules and others to more complex ones.  The rules and the institutions co-evolved, endogenously.  I would bet that there was some other constraint on the complexity of the firms subject to the simple rules that made it unduly costly for them to outwit the simple rules.  They stayed simple as a result, so the rules could stay simple too.

Maybe Haldane is right.  Maybe there is a simple but robust way of regulating financial institutions.  But I have my doubts.  Complexity results from the failures of the simple.

Haldane is stating, in an ironically more complex way, the old Indian story of the village beset by mice that brought in cats to rid itself of the rats, then brought in dogs to rid itself of the infestation of cats, then brought in elephants to drive out the resulting packs of dogs-and responded by bringing back the mice to scare away the elephants.  Seeing the effects of complexity (elephants) the simpler problems (mice) don’t look so bad.

But don’t be deceived.  If Haldane were to get his way, the cycle would begin again.  This is the fallen condition of homo economicus.

I’ve written about there being good HFT and bad HFT; HFT that enhances liquidity, and HFT that is predatory and attempts to exploit liquidity demanders (especially large traders).  Moreover, algorithmic trading (which may or may not be HFT, properly speaking) can potentially disrupt markets (e.g., the Knight Capital fiasco some weeks ago).

The question is: whatcha gonna do about the bad?  The knee-jerk response of many is to demand greater government regulation.  I have pointed out repeatedly, however, that this is an area where self-regulation is highly likely to be more efficient.  In particular, exchanges and other trading platforms have an incentive to design pricing structures and rules so as to reduce predatory trading, by HFT shops and others.  Predatory trading increases other market users’ trading costs, which reduces the derived demand for exchange services, thereby reducing the price the exchange can charge and the quantity of trading done on it.  Similarly, exchanges are hurt by disruptions caused by bad algos.

I’ve written a few posts on exchanges that have introduced pricing policies (e.g., charging high prices for “excessive” cancellations) with the specific purpose of reducing opportunistic trading.

Here is another example, this time from Forex:

Foreign exchange brokers are backing a series of changes unveiled by EBS, the world’s largest currency platform, designed to discourage predatory practices by high-frequency traders.

EBS, owned by interdealer broker ICAP, plans to widen the price spreads on its platform, raise targets on quote-to-buy ratios and set new quoting guidelines for Asian markets to discourage investors who exploit delays in technology to make money.

. . . .

Mr Mandelzis said that, while the changes were technical, they were aimed at encouraging genuine liquidity and discouraging disruptive behaviour, such as arbitraging prices.

With respect to dealing with the risk of runaway algos, CME and NYSE LIFFE are installing a kill switch functionality that permits FCMs to halt or limit trading activity by a malfunctioning algo:

Futures commissions merchants will be able to halt or limit trading activity at high speed on CME, operator of the world’s biggest futures exchange, and NYSE Liffe, one of the Europe’s dominant futures and options markets, if a computer begins to malfunction or a customer breaches risk limits.

Exchanges have an incentive to get these decisions right: they lose business if they basically provide hunting grounds for predatory HFTs or are unduly vulnerable to runaway algos.  Exchanges also have the information: they can observe what goes on on their systems, see who does what, and get feedback from customers.  Exchanges have a broad array of tools-outright bans on certain practices, and discriminating pricing policies. Exchanges are also able to move unilaterally and quickly.  In contrast, regulators have low powered incentives; poorer information; typically have blunt tools; and are less able to respond quickly and flexibly.  This is a clear case where self-regulation has advantages over government regulation.

This is particularly true in derivatives markets, where single platforms dominate a particular instrument.  Things may be more complex in equities, due to the potential spillovers across fragmented trading platforms.  But even there, the spillovers may be salutary.  A trading platform that clamps down (through pricing, for instance) on predatory arbs may push them to other platforms, but that just increases the incentive of those platforms to take action.  Moreover, different platforms have an incentive to compete to attract legitimate liquidity suppliers and liquidity demanders (especially the latter, since they are the ones that pay the freight), which means they have an incentive to compete to devise pricing schemes that penalize the predatory.

In brief, the task of reducing predatory computerized trading strategies should be left primarily to exchanges.  Predation will not disappear: it is almost never efficient to eliminate opportunistic/predatory conduct completely (because this would be too costly, primarily due to the fact that eliminating predatory conduct would almost certainly reduce some beneficial conduct), but exchanges have the strongest incentive, the best information, the most discriminating tools, and the greatest flexibility.  There will be an arms race between exchanges and predatory traders, but there would also be an arms race between government regulators and such traders.  Exchanges can run the race more efficiently and effectively.  Leave it up to them.

This Krugman oped is the usual blah, blah, blah, but this line jumped out at me:

This return to financial normalcy did not, however, produce a robust recovery. Fast recoveries are almost always led by a housing boom — and given the excess home construction that took place during the bubble, that just wasn’t going to happen.

“Fast recoveries are almost always led by a housing boom.”  I’m not sure that’s true.  But that’s not relevant.   What stood out is this: “given the excess home construction that took place during the bubble, that just wasn’t going to happen.” In a Keynesian, aggregate-demand-is-dominant viewpoint, why should an overhang of housing stock matter?  OK.  People don’t want to direct “aggregate demand” (WTF that is, but bear with me) to purchasing housing.  So they buy big screen TVs or cars or vacation travel or whatever.  They buy more of what is not surfeit (as Krugman claims housing is).  And the economy chugs along at a pace consistent with the level of aggregate demand, regardless of whether previous (Keynesian) policies have led to over-investment in one asset class.

Krugman could reply that fiscal and monetary policy have created insufficient aggregate demand.  But even if that’s true, the housing overhang is irrelevant.  That’s why that argument is such a clanger; why it stood out.

For once you bring up an excess supply of a particular asset as being material in determining the course of economic growth, you come perilously close to Austria.  Or at least Austrian economics, which emphasizes “malinvestment.”  The Austrian narrative of the Crisis emphasizes malinvestment in housing, driven by monetary policy assisted by pro-housing policy on other dimensions.  You also come dangerously close to acknowledging that structural imbalances, and mismatches between skills (driving a nail, running wire, plumbing a bathroom) and demand (changing bed pans, writing an app, lobbying a Congressman), are relevant in determining economic performance.  That is also an Austrian point.

Krugman has declaimed heatedly and repeatedly against both views many times.  He is clearly of the AD is What Matters school.  But if AD is what matters most, and by far, why should the supply of a particular asset matter a whit?

The current debate over why the recovery has been so pitiful, as compared to say 1983-84, revolves around whether insufficient aggregate demand, or some structural imbalance (driven by previous policy-induced malinvestment) is the underlying cause.  Ed Lazear (for whom I TA’d donkey years ago) has created a buzz with a paper claiming that AD deficiency, rather than structural/skill imbalance is the problem.  Color me unconvinced.  I suggest you look at Sober Look’s recent post for some interesting evidence relating to structural imbalance.  His recent post on the Beveridge Curve is particularly compelling.

This debate is on the fringes of my professional competence.  But I know a logical problem when I see one.  Krugman’s invocation of the overhang of housing as a source of drag on the recovery is clearly a logical problem.  Any explanation based on a structural factor, a structural imbalance, is clearly problematic to any Keynesian.  This is why they get so shrill in responding to evidence and arguments relating to skill imbalances or other structural problems in the economy.  So it is passing strange that Krugman should make it the first-yes, the first-argument in his defense of Obama against charges that the recovery has been pitifully weak.

So is Krugman a heretic? Or just an intellectual hack willing to seize on any argument, no matter how inconsistent with his alleged world view, when he takes to the NYT oped page to defend his political heroes?

I know where my money is.