Streetwise Professor

March 24, 2020

It Really Does Pain Me to Say I Told You So About Clearing, But . . .

In the aftermath of the last crisis, I played the role of Clearing Cassandra, warning that in the next crisis, supersizing of derivatives clearing would create systemic risks not because clearinghouses would fail, but because of the consequences of what they would do to survive: hike initial margins and collect huge variation margin payments that would suck liquidity out of the system at the same time liquidity supply contracted. This, in turn, would lead to asset fire sales, that would distort asset prices which would lead to further knock-on effects.

I wrote a lot about this 2008-2012, but here is a convenient link. Key quote from the abstract:

The author also believes that the larger collateral mandates and frequent marking‐to‐market will make the financial system more vulnerable since margin requirements tend to be “pro‐cyclical.” And more rigid collateralization mechanisms can restrict the supply of funding liquidity, and lead to spikes in funding liquidity demand that can reduce the liquidity of traded instruments and generate destabilizing feedback loops. 

Well, the next crisis is here, and these (conditional) predictions are being borne out. In spades.

Here’s what I wrote a few days ago as a contribution to the Regulatory Fundamentals Group newsletter:

In the aftermath of the last crisis of 2008-2009, G20 nations decided to mandate clearing of standardized OTC derivatives transactions.  The current coronavirus crisis is the first since those reforms were implemented (via Dodd-Frank in the US, for example), and this therefore gives the first opportunity to evaluate the performance of the supersized clearing ecosystem in “wartime” conditions.  


So far, despite the extreme price movements across the entire derivatives universe–equities, fixed income, currencies, and commodities (especially oil)–there have been no indications that clearinghouses have faced either financial or operational disruption.  No clearing members have defaulted, and as of now, there have been no serious concerns than any are on the verge of default. 

That said, there are two major reasons for concern.


First, the unprecedented volatility and uncertainty show no signs of dissipating, and as long as it continues, major financial institutions–including clearing firms–are at risk.  The present crisis did not originate in the banking/shadow banking sector (as the previous one did), but it is now demonstrably affecting it.  There are strong indicators of stress in the financial system, such as the blowouts in FRA-OIS spreads and dollar swap rates (both harbingers of the last crisis).  Central banks have intervened aggressively, but these worrying signs have eased only slightly.  

Second, as I wrote repeatedly during the debate over clearing mandates in the post-2008 crisis period, the most insidious systemic risk that supersized clearing creates is not the potential for the failure of a clearinghouse (triggered by the failure of one or more clearing members).  Instead, the biggest clearing-related systemic risk is that the very measures that clearinghouses take to ensure their integrity–specifically, frequent variation margining/marking-to-market–lead to large increases in the demand for liquidity precisely during circumstances when liquidity is evaporating.  Margin payments during the past several weeks have hit unprecedented–and indeed, previously unimaginable–levels.  The need to fund these payments has inevitably increased the demand for liquidity, and contributed to the extraordinary demand for liquidity and the concomitant indicators stressed liquidity conditions (e.g., the spreads and extraordinary central bank actions mentioned earlier).  It is impossible to quantify this impact at present, but it is plausibly large.  

In sum, the post-2008 Crisis clearing system is operating as designed during the 2020 Crisis, but it is unclear whether that is a feature, or a bug.  

It is becoming more clear: Bug, and the bugs are breeding. There have been multiple stories over the last couple of days of margin calls on hedging positions causing fire sales, with attendant price dislocations in markets like for mortgages. Like here, here, and here. I guarantee there are more than have been reported, and there will be still more. Indeed, I bet if you look at any pricing anomaly, it has been created by, or exacerbated by, margin calls. (Look at the muni market, for instance.)

But those in charge still don’t get it. CFTC chairman Heath Tarbert delivers happy talk in the WSJ, claiming that everything is hunky dory because all them margins bein’ paid! and as a result, derivatives markets are functioning, CCPs aren’t failing, etc.

This is exactly the kind of non-systemic thinking about systemic risk that I railed about a decade ago. Mr. Tarbert has a siloed view: he is assigned some authority over a subset of the financial system, sees that it is working fine, and concludes that rules regarding that subset are beneficial for the system as a whole.

Wrong. Wrong. Wrong. Wrong. WRONG.

You have to look at the system as a whole, and how the pieces of the system interact.

In the post-last-crisis period I wrote about the “Levee Effect”, namely, that measures designed to protect one part of the financial system would flood others, with ambiguous (at best) systemic consequences. The cascading margins and the effects of those margin calls are exactly what I warned about (to the accompaniment a collective shrug by those who mattered, which is why we are where we are).

What we are seeing is unintended consequences–unintended, but not unforeseeable.

Speaking of unintended consequences, perhaps one good effect of September’s repo market seizure was that it awoke the Fed to its actual job–providing liquidity in times of stress. The facilities put in place in the aftermath of the September SNAFU are being expanded–by orders of magnitude–to deal with the current spike in liquidity demand (including the part of the spike due to margin issues). Thank God the Fed didn’t have to think this up on the fly.

It also appears that either (a) the restrictions on the Fed imposed by Frankendodd are not operative now, or (b) the Fed is saying IDGAF so sue me and blowing through them. Either way, such liquidity seizure are what the Fed was created to address.

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March 13, 2020

Wuhan Virus and the Markets–WTF?

What a helluva few weeks it’s been, eh boys and girls? By way of post mortem (hopefully?) rather than prediction, here’s my take.

Under “normal” circumstances, two factors drive asset valuations: expectations of cash flows, and the rate at which investors discount those cash flows. COVID-19–Wuhan Virus, to call it by its proper name–has has profound influence on both.

WV has caused a major aggregate supply shock, and an aggregate demand shock, and these amplify one another. The aggregate supply shock stems from shutdown of productive capacity due to social distancing. And people who aren’t working aren’t earning and aren’t spending, hence the aggregate demand shock.

These developments obviously reduce the income streams from assets (e.g., corporate profits). That’s a negative for stocks.

As an aside, these factors defy traditional policy prescriptions. Monetary and fiscal policy are focused on addressing aggregate demand deficiencies, i.e., trying to move demand-deficient economies (where demand deficiencies arise from price rigidity and nominal shocks) back to the production possibilities frontier. Supply shocks shrink the PPF. Pushing the PPF back to its normal state in current circumstances is a function of public health policy, and even that is likely to be problematic given the huge uncertainties (that I discuss below) and the dubious competence of government authorities (which I discussed last week).

The pandemic nature of WV also makes it the systematic shock par excellence. It hits everyone and every asset class, and cannot be diversified away. A big increase in systematic risk results in a big increase in risk premia, meaning that the already depressed expected cash flows on risky assets get discounted at a higher rate, leading to lower valuations.

A lot higher rate, evidently. Why? Most likely because of the extreme uncertainty about the virus. Data on how infectious it is, how many people have been infected, the fatality rate, how it will be affected by warmer weather, etc., are extremely unreliable. In other words, we know almost nothing about the salient considerations.

This is in part due to lack of testing, and to inherent defects in the testing: those who get tested are disproportionately likely to be symptomatic, exposed, or hypochondriacal, leading to extreme sample selection biases. The tests are apparently unreliable, with high rates of false positives and false negatives. The RNA tests cannot detect past infections. It is in part due to the novelty of the virus. Is it like influenza, and will hence burn out when temperatures warm? Or not?

Another major source of uncertainty is due to the fact that the initial outbreak in China was covered up by the evil CCP regime. (Which now, in an Orwellian twistedness that only totalitarian regimes can muster, is boasting that it will save the world. And which is blaming the United States for its own abject failures. Which is why I insist on calling it the Wuhan Virus–so go ahead, call me a racist. IDGAF.) Thus, data from Ground Zero is lacking, or wildly unreliable. (Ground One–Iran–is equally duplicitous, and equally malign.)

This huge uncertainty regarding a major systematic factor leads to even greater discount rates–and hence to lower stock prices.

And then there is the truly disturbing factor. These textbook causal channels (lower expected cash flows, higher discount rates) have in turn caused changes in asset prices that force portfolio adjustments that move us into the realm of positive feedback mechanisms (which usually have negative effects!) and non-linearities. This represents a shift from “normal” times to decidedly abnormal ones.

When some investors engage in leveraged trading strategies, big price moves can force them to unwind/liquidate these strategies because they can no longer fund their large losses. These unwinds move asset prices yet more (as those who placed a lower valuation on these assets must absorb them from the levered, high-value owners who are forced to sell them). Which can force further unwinds, in perhaps completely unrelated assets.

Not knowing the extent or nature of these trading strategies, or the degree of leverage, it is virtually impossible to understand how these effects may cascade through the markets.

The most evident indicators of these stresses are in the funding markets. And we are seeing such stresses. The FRA-OIS spread (known in a previous incarnation–e.g., 2008–as the LIBOR-OIS spread) has blown out. Dollar swap rates are blowing out. The most vanilla of spreads–the basis net of carry between Treasury futures and the cheapest-to-deliver Treasury–have blown out. Further, the Fed has pumped in huge amounts liquidity into the system, and these alarming spread movements have not reversed. (One shudders to think they would have been worse absent such intervention.)

One thing to keep an eye on is derivatives clearing. As I warned repeatedly during the drive to mandate clearing, the true test of this mechanism is during periods of market disruption when large price moves trigger large margin calls.

Heretofore the clearing system seems to have operated without disruption. I note, however, that the strains in the funding markets likely reflect in part the need for liquidity to make margin calls. Big margin calls that must be met in near real-time contribute to stresses in the funding markets. Clearinghouses themselves may survive, but at the cost of imposing huge costs elsewhere in the financial system. (In my earlier writing on the systemic impacts of clearing mandates, I referred to this as the Levee Effect.)

The totally unnecessary side-show in the oil markets, where Putin and Mohammed bin Salman are waging an insane grudge match, is only contributing to these margin call-related strains. (Noticing a theme here? Authoritarian governments obsessed with control and “stability” have a preternatural disposition to creating chaos.)

Perhaps the only saving grace now, as opposed to 2008, is that the shock did not arise originally from the credit and liquidity supply sector, i.e., banks and shadow banks. But the credit/liquidity supply sector is clearly under strain, and if parts of it break under that strain yet another round of extremely disruptive knock-on effects will occur. Fortunately, this is one area where central banks can palliate, if not eliminate, the strains. (I say can, because being run by humans, there is no guarantee they will.)

Viruses operate according to their own imperatives, and the imperatives of one virus can differ dramatically from those of others. Pandemic shocks are inherently systematic risks, and the nature of the current risk is only dimly understood because we do not understand the imperatives of this particular virus. Indeed, it might be fair to put it in the category of Knightian Uncertainty, rather than risk. The shock is big enough to trigger non-linear feedbacks, which are themselves virtually impossible to predict.

In other words. We’ve been on a helluva ride. We’re in for a helluva right. Strap it tight, folks.

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February 28, 2020

If Only Economists Were So Powerful

Filed under: Economics,Financial crisis,Politics,Regulation — cpirrong @ 7:38 pm

Eminent economist Paul Romer has assumed the role of professional scold. A few years ago he excoriated other eminent economists (notably Robert Lucas) for “mathiness.” Now he is chastising the profession for enabling deregulation that has wreaked havoc across the land.

I have to say his essay is unpersuasive, not to say incoherent. One way of framing the issue is to contrast the view of Keynes:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.

with that of Stigler (speaking of the passage of the Corn Laws):

economists exert a minor and scarcely detectable influence on the societies in which they live . . . if Cobden had spoken only Yiddish, and with a stammer, and Peel had been a narrow, stupid man, England would have moved toward free trade in grain as its agricultural classes declined and its manufacturing and commercial classes grew.

Romer is clearly in league with Keynes, rather than Stigler.

But he fails to make the case. This is true for many reasons. For one, he argues by anecdote, and hence his style is journalistic rather than rigorously scholarly. A few cherry-picked anecdotes–and Romer uses only three–are clearly insufficient to support Romer’s broader claim that the deregulation favored by many economists (not all) was on the whole baleful. There are entire areas of deregulation (e.g., transportation, telecommunications, restrictions on advertising) that he says nothing about, but which were the subject of massive scholarship in the 1970s and 1980s which demonstrated the inefficiency of the existing regulatory structure: the experience in these industries post-deregulation strongly supported the scholarship that criticized existing regulations.

One interesting example is pharmaceutical regulation, something that exercises Romer quite greatly. Sam Peltzman showed in the 1970s that efficacy regulation under the 1962 Drug Act amendments did not result in a reduction in the amount of inefficacious drugs introduced, but did reduce the rate of introduction of new, valuable therapies. All pain, no gain.

Romer has nothing to say about this.

With respect to pharma regulation, Romer blames the opioid crisis on “pliant pretend economist[s]” who “assume[d] the role of the philosopher-king—someone willing to protect the firm’s reckless behavior from government interference and to do so with a veneer of objectivity and scientific expertise.”

He doesn’t quote any economist, pretend, real or otherwise, playing the role of philosopher-king/academic scribbler whose frenzy regulators or legislators distilled into opioids. Instead, he says:

By the 1990s, such arguments were out of bounds, because the language and elaborate concepts of economists left no opening for more practically minded people to express their values plainly. And when the Drug Enforcement Administration finally tried to limit the distribution of these painkillers, pharmaceutical companies launched a massive lobbying effort in favor of a bill in Congress that would strip the DEA of the power to freeze suspicious narcotics shipments by drug companies. It is a safe bet that these lobbyists made their arguments to Congress in the language of growth, incentives, and the danger of innovation-killing regulations. The push succeeded, and the DEA lost one of its most powerful tools for saving lives.

Of course, during earlier eras, regulators allowed many industries to profit massively from products known to be harmful; Big Tobacco is the most obvious example. But until the 1980s, the overarching trend was toward restrictions that reined in these abuses. Progress was painfully slow, but it was progress nonetheless, and life expectancy increased. The difference today is that the United States is going backward, and in many cases, economists—even those acting in good faith—have provided the intellectual cover for this retreat.

So apparently, by highjacking the language economists prevented rational debate, thereby rendering legislators and regulators defenseless against predatory corporations.

Or something.

That is, not only does Romer fail to show that deregulation was on the whole detrimental, he also fails to show that economists had anything much to do with making it happen. He asserts the Keynesian line, but does not come close to proving it.

Indeed, the reverse is true. Romer’s argument actually supports Stigler’s claim, which can be “distilled” thus: money talks. Or to use Keynes’ term: vested interests talk. What economists said or didn’t say or how they said it or what language they said it in (English, Yiddish, Aramaic) was nothing, compared to the lobbying might of the pharma industry. So not only does Romer fail to identify any actual economist who advocated the policy that infuriates him, he fails to show that what any economist said meant squat for the outcome.

Indeed, this is precisely why a certain species of economists (Stigler, and well, yours truly) was/is so skeptical about regulation: it tends to favor the interests of the regulated. It always has, and it always will. Economic efficiency is a secondary consideration, and what economists have to say on the matter has little (if any) bearing on the outcome. If anything, Romer’s piece is a case for Public Choice economics. But that has implications that Romer would no doubt find inimical.

Romer’s other big anecdote is from the financial industry, namely the infamous Goldman Abacus transaction in which Goldman served as the middleman between John Paulson (who wanted to short US real estate) and a hapless German bank.

The stand in for all economists in this anecdote is one sorta economist: Alan Greenspan. Apparently, Greenspan was the Representative Agent for the economics profession. This is beyond simplistic. Insultingly so.

Another bogeyman in Romer’s telling is Michael Jensen:

Michael Jensen, an economist who helped reshape the U.S. financial sector in the late twentieth century. Jensen rightly worried about several problems that bedeviled the market, including how to keep corporate executives from promoting their own interests at the expense of shareholders. His proposed solutions—hostile takeovers, debt, and executive bonuses that tracked the share price of a firm, among other changes—were widely adopted.

Corporate shareholders saw their earnings skyrocket, but the main effect of the changes was to empower the financial sector, which Greenspan, for his part, worked doggedly to unfetter. As Lemann writes, Jensen’s ideas also helped chip away at the power of the traditional Corporate Man—the sort of executive whose pursuit of profit was tempered somewhat by a commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines. Taking his place was Transaction Man, who focused on little more than driving up share prices by any means necessary.

There is so much wild generalization here that I am at a loss of where to begin. For one thing, Jensen’s heyday was the 1980s LBO and hostile takeover boom, which had been largely stymied by regulation by the early-1990s, long before the Financial Crisis. (So much for the power of Jensen’s advocacy! Jensen’s hero, Michael Milken, was in jail, FFS.)

I am at a real loss to trace the connection between Jensen’s advocacy of measures to control managerial agency costs and, say, the real estate securitization boom of the mid-2000s. Romer certainly doesn’t lay out the road map. Here merely cites Jensen’s views and asserts some connection with those of Greenspan, and proclaims QED! The South Park Underwear Gnomes’ argumentation was tighter.

And again, what economists said was almost certainly irrelevant here. There were powerful forces–political as well as economic forces–behind the real estate boom and crash. Homeownership became a totem for politicians of both parties in the 1990s and 2000s. Wall Street was on board, because it realized this could be an engine for profit. Main Street financial institutions were on board for the same reason.

So what if Alan Greenspan was cool with this? If he hadn’t been, he wouldn’t have been around long. Economic and political interests found a convenient mouthpiece: the mouthpiece didn’t create the economic and political forces. At the end of the day, economists would not have mattered, and the financial sector would have gotten the mouthpiece it wanted.

This part made me roll my eyes:

the traditional Corporate Man—the sort of executive whose pursuit of profit was tempered somewhat by a commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines. Taking his place was Transaction Man, who focused on little more than driving up share prices by any means necessary.

Evidence for this “commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines” among 1960s-1970s corporate executives? None whatsoever. This is an ex cathedra pronouncement that bears no relationship to the reality of self-serving corporate management during this era–management that a 1970s Romer probably would have inveighed against as venal and self-serving (as many criticisms of managerial capitalism did).

No, the issue here is not Corporate Man vs. Transaction Man. It is Straw Man (Romer’s, specifically) vs. Reality.

Romer gives economists both too much credit, and too little. By painting all economists who criticized regulation (based on empirical evidence and theory) as stooges, he gives them too little credit. By blaming them for massive public policy failures, he gives them too much. If only we had such influence.

Does economics matter? Yes. Do economists matter? Not really. And the reason for these answers is the same. Economic considerations–distributive considerations in particular, as they operate through the political and regulatory system–drive political and regulatory outcomes. Economists can comment on this, analyze it, and even advocate particular outcomes. But their participation has as much effect on the outcome as a sportscaster’s does on who wins the Super Bowl.

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December 9, 2019

The Four Horsemen of the Repo Apocalypse

Filed under: Derivatives,Economics,Financial crisis,Regulation — cpirrong @ 9:42 pm

The BIS included a box on the September USD repo spike in a chapter to its Quarterly Review titled “Easing Trade Tensions Support Risky Assets.” The piece lays out many damning dots, but does not connect them. Let me give it a try.

In a nutshell, the BIS report says that as a result of the wind down of the extraordinary post-crisis monetary policy measures there has been a dramatic change in the funding structure in US markets. In particular, the “big four [US] banks” (which the BIS delicately–or is it cravenly?–doesn’t name) have flipped from being suppliers of repo collateral (and hence cash borrowers) to being suppliers of cash (and hence collateral borrowers). Further, other US banks are not viable competitors to the big four, nor are other potential cash suppliers such as money market funds because they have hit counterparty credit limits which have constrained their lending capacity. According to the BIS, these events has made The Big Four Banks Who Shall Not Be Named the “marginal lenders” in the repo market. And mark well: prices are set at the margin.

Further, “leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives.”

So here are the dots. Recent structural changes have given the Big Four Banks Who Shall Not Be Named a dominant position in the repo market. Their main potential competitors as suppliers of funds are constrained by size or regulation. There has been a large increase in demand for repo funding.

Not even being willing to name the banks (as if their identities are unknown), the BIS does not even draw the blindingly obvious implication of its analysis–that the Four Repo Horsemen have market power. A lot of market power. Are we supposed to believe that (out of the goodness of their hearts, perhaps) they did not exercise it? I didn’t just fall off the turnip truck.

Even the euphemism Big Four is deceptive, for in reality this group is dominated by one bank–Morgan. And of course Morgan has been loudest in its protestations that it really wanted to lend more, but just couldn’t, dammit, because of those cursed liquidity regulations.

The BIS attempts to run cover, and provide some rather lame excuses for the failure to lend more despite the high rates:

Besides these shifts in market structure and balance sheet composition, other factors may help to explain why banks did not lend into the repo market, despite attractive profit opportunities. A reduction in money market activity is a natural by-product of central bank balance sheet expansion. If it persists for a prolonged period, it may result in hysteresis effects that hamper market functioning. For instance, the internal processes and knowledge that banks need to ensure prompt and smooth market operations may start to decay. This could take the form of staff inexperience and fewer market-makers, slowing internal processes. Moreover, for regulatory requirements – the liquidity coverage ratio – reserves and Treasuries are high-quality liquid assets (HQLA) of equivalent standing. But in practice, especially when managing internal intraday liquidity needs, banks prefer to keep reserves for their superior availability.

Hysterisis? Decaying internal processes and knowledge? Staff inexperience? Complete and utter argle bargle. We’re talking overnight secured lending here, not rocket science structured finance. It’s about as vanilla a banking transaction one could imagine. And LCR provides convenient cover.

The BIS lays out a compelling case that four major institutions have market power in repo. September events in particular are consistent with the exercise of market power, and the alternative explanations are beyond lame. Yet none dare speak its name, or even raise it as a possibility. Not the BIS. Not the Fed. Not the Treasury. Despite the systemic risks this poses.

The Financial Crisis supposedly changed everything. It apparently changed nothing.

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October 5, 2019

The Repo Spike: The Money Trust Revisited?

Filed under: Economics,Financial crisis,Regulation — cpirrong @ 6:42 pm

In the ongoing evaluation of what has been happening in the repo market, market participants have identified post-crisis regulations as a potential source of the problem. In particular, these regulations (including the Liquidity Coverage Ratio) require behemoth banks like JP Morgan and Citi to hold large amounts of reserves, and makes them reluctant to lend them out even when repo rates spike.

Having long said that the various liquidity regulations intended to prevent a recurrence of the last crisis could be the cause of a new one, I am certainly quite sympathetic to this view. However, information that is coming out now suggests another potentially complementary and aggravating factor.

In particular, reserve holdings are very concentrated:


Fed data show large banks are keeping a disproportionate amount in reserves, relative to their assets. The 25 largest US banks held an average of 8 per cent of their total assets in reserves at the end of the second quarter, versus 6 per cent for all other banks. 

Meanwhile, the four largest US banks — JPMorgan Chase, Bank of America, Citigroup and Wells Fargo — together held $377bn in cash reserves at the end of the second quarter this year, far more than the remaining 21 banks in the top 25

Moreover, the big banks have been reducing their reserves:

Analysts and bank rivals said big changes JPMorgan made in its balance sheet played a role in the spike in the repo market, which is an important adjunct to the Fed Funds market and used by the Fed to influence interest rates.
Without reliable sources of loans through the repo market, the financial system risks losing a valuable source of liquidity. Hedge funds, for example, use it to finance investments in U.S. Treasury securities and banks turn to it as option for raising suddenly-needed cash for clients.
Publicly-filed data shows JPMorgan reduced the cash it has on deposit at the Federal Reserve, from which it might have lent, by $158 billion in the year through June, a 57% decline.

Although JPMorgan’s moves appear to have been logical responses to interest rate trends and post-crisis banking regulations, which have limited it more than other banks, the data shows its switch accounted for about a third of the drop in all banking reserves at the Fed during the period.
“It was a very big move,” said one person who watches bank positions at the Fed but did not want to be named. An executive at a competing bank called the shift “massive”.
Other banks brought down their cash, too, but by only half the percentage, on average.
For example, Bank of America Corp (BAC.N), the second-biggest U.S. bank by assets, with a $2.4 trillion balance sheet, took down 30% of its deposits, a $29 billion reduction.

So . . . substantial concentrations of reserves, and declining levels of reserves. Yes, these are all potential consequences of Frankendodd. But they also are potentially symptomatic of market power and the exercise thereof.

This triggered a synapse, which led me to recall a 1993 article from the Journal of Monetary Economics by R. Glen Donaldson. Donaldson’s article was motivated by a study of the Panic of 1907, when a “cash syndicate” (led by . . . J.P. Morgan, in person and through his eponymous bank) lent to cash strapped trust companies facing depositor runs at very high rates.

Donaldson presents a model in which a spike in the need for cash by a set of market participants (trust companies facing depositor outflow, in his model) makes the funds held by a group of other institutions pivotal: these institutions face a downward sloping demand curve for their funds because of constraints on competitive suppliers of funds. The pivotal institutions supply funds (through a repo-like transaction in which they buy securities from the trusts) at a supercompetitive price (by buying the trusts’ securities at subcompetitive prices). In his model, collusion between the pivotal institutions exacerbates the rate spike.

The main implication of the model is that spikes in the demand for funds lead to spikes in interest rates that are bigger than would prevail in competitive conditions.

There is an element of non-linearity in the model, because the big suppliers’ funds are not pivotal in normal conditions, but become so when the demand becomes sufficiently large. This leads to a switch from competitive to monopoly pricing, which in turn causes a spike in rates.

I should note that the regulatory and market power stories are not mutually exclusive, and are indeed complementary. Regulatory constraints can increase the demand for funds (making it more likely that the big suppliers will be pivotal) and can reduce the supply of funds from the smaller suppliers (which lowers the threshold for the switch from competitive to monopoly pricing, and makes the demand curves for the big suppliers funds steeper, leading to a higher monopoly rate).

I therefore consider it a plausible hypothesis that market power contributed to the repo market spike, and that one channel by which regulations contributed to the spike was through its effect on market power.

How can this hypothesis be tested? Conceptually, if regulatory constraints alone caused the spike, then those in possession of large quantities of reserves (e.g., Morgan) were absolutely constrained in their ability to lend additional reserves: the difference between the repo rate and the Fed Funds rate would represent the shadow price on this regulatory constraint.

If a big bank or banks exercised market power, this constraint would not be binding.

Operationalizing this test is likely to be complex, however. Big holders of reserves will inevitably make all sorts of arguments to say that they couldn’t have lent more.

This brings to mind the California electricity crisis in 1999-2000, when generators operated below various capacity measures, but pleaded that constraints (by unplanned outages, or NOX regulations, etc.) reduced their effective capacity below these nominal capacity measures. Given the complexity of operating a power plant, it was very difficult to determine whether the generators were withholding capacity, or in fact offered as much as they were capable of doing.

Despite the difficulty of operationalizing the test, I think it is something for regulators to attempt. There is a colorable case that the repo rate rise was exacerbated by market power, and given the importance of this market, this possibility should be investigated rigorously.

As an aside, the Donaldson model appeared only a few months before my Journal of Business article on market power manipulation. The two articles have a lot in common, despite the fact that they were developed totally independently, and seemingly involve completely unrelated markets (money vs. physical commodities). However, the core arguments are similar: economic frictions can periodically create market power in markets that are usually competitive.

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September 20, 2019

Back to the Fed Future, or You Had One Job

In the Gilded Age, American financial crises (“panics,” in the lexicon of the day) tended to occur in the fall. Agriculture played a predominant role in the economy, and marketing of the new crop in the fall led to a spike in the demand for cash and credit. In that era, however, the supply of cash and credit was not particularly elastic, and these demand spikes sometimes turned into panics when supply did not (or could not) respond accordingly.

The entire point of the Fed, which was created in the aftermath of one of these fall panics (the Panic of 1907, which occurred in October), was to make currency supply more elastic and thereby reduce the potential for panics. In essence, the Fed had one job: lender of last resort to ensure a match of supply and demand for currency/credit, when the latter was quite volatile.

This week’s repospasm is redolent of those bygone days. Now, the spikes in demand for liquidity are not driven by the crop cycle, but by the tax and corporate reporting cycles. But they recur, and several have occurred in the autumn, or on the cusp thereof (this being the last week of summer).

One of my mantras in teaching about commodities is that spreads price bottlenecks. Bottlenecks can occur in the financial markets too. The periodic spikes in repo rates–not just this week, but in December, and March–relative to other short term rates scream “bottleneck.” Many candidates have been offered, but regardless of the ultimate source of the clog in the plumbing, the evidence from the repo market is that there are indeed clogs, and they recur periodically.

The Fed’s rather belated and stumbling response suggests that it is not fully prepared to respond to these bottlenecks, despite the fact that their regularity suggests that the clogs are chronic. As the saying goes, “you had one job . . . ” and the Fed fell down on this one.

And maybe the problem is that the Fed no longer just has one job, and it has shunted the job that was the reason for its creation to the back of the priority list. Nowadays, the Fed has statutory obligations to control employment and inflation, and views its main job as managing aggregate demand, rather than tending to the financial system’s plumbing.

This is concerning, as dislocations in short-term funding markets can destabilize the system. These markets are systemically important, and failure to ensure their smooth operation can result in crises–panics–that undermine the ability of the Fed to perform its prioritized macroeconomic management task.

One of the salutary developments post-crisis has been the reduced reliance of banks and investment banks on flighty short-term funding. The repo markets are far smaller than they were pre-2008, and the unsecured interbank market has all but disappeared (representing only about .3 percent of bank assets, as compared to around 6 percent in 2006). But this is not to say that these markets are unimportant, or that bottlenecks in these markets cannot have systemic consequences. For the want of a nail . . . .

Moreover, the post-crisis restructuring of the financial system and financial regulation has created new potential sources of liquidity shocks, namely a supersizing of potential demands for liquidity to pay variation margin. When you have a market shock (e.g., the oil price shock) occurring simultaneously with the other sources of increased demand for liquidity, the bottlenecks can have very perverse consequences. We should be thankful that the shock wasn’t a Big One, like October, 1987.

Hopefully this week’s tumult will rejuvenate the Fed’s focus on mitigating bottlenecks in funding markets. Maybe the Fed doesn’t have just one job now, but this is an important job and is one that it should be able to do in a fairly routine fashion. After all, that job is what it was created to perform. So perform it.

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September 17, 2019

Funding Market Tremors: Today May Not Have Been “The Big One,” But It Was Bad Enough

The primary reason for my deep skepticism about the wisdom of clearing mandates was liquidity risk. As I said repeatedly, in order to reduce counterparty risk, clearing necessarily increased liquidity risk through the variation margining mechanism. Further, it was–and is–my opinion that liquidity risk is a far graver systemic concern that counterparty risk.

A major liquidity event has occurred in the last couple of days: rates in the repurchase market–the major source of short term funding for vast amounts of trading activity–shot up to levels (around 5 percent) nearly double the Fed’s target ceiling for that rate. Some trades took place at far higher rates than that (e.g., 9.25 percent).

Market participants have advanced several explanations, including big cash demands due to corporate tax payments coming due. Izabella Kaminska at FTAlphavile offered this provocative alternative, which resonates with my clearing story: the large price movements in oil and fixed income markets in the aftermath of the attack on the Saudi resulted in large margin calls in futures and cleared OTC markets that increased stresses on the funding markets.

To which one might say: I sure as hell hope that’s not it, because although there was a lot of price action yesterday, it wasn’t The Big One. (The fact that Fred Sanford’s palpitations occurred because he couldn’t get his hands on cash makes that bit particularly apropos!)

I did some quick back-of-the-envelope calculations. WTI and Brent variation margin flows (futures and options) were on the order of $35 billion. Treasuries on CME maybe $10 billion. S&P futures, about $1 billion. About $2 billion on Eurodollar futures.

The Eurodollar numbers can help give a rough idea of margin flows on cleared interest rate swaps. Eurodollar futures open interest is about $12 trillion. Cleared OTC notional volume (not just USD, but all IRS) is around $80 trillion. But $1mm in notional of a 5 year swap is equivalent to 20 Eurodollar futures with notional amount of $20 trillion. So, as a rough estimate, variation margin flows in the cleared IRS market are on the order of 100x for Eurodollars. That represents a non-trivial $200 billion.

Yes, there are potentials for offsets, so these numbers are not additive. For example, a firm might have offsetting positions in EDF and cleared IRS. Or be short oil and long Treasuries. But variation margin flows on the order of $300 billion are not unrealistic. And since market moves were relatively large yesterday, that represents an increment over the typical day.

So we are talking real money, which could certainly contribute to an increased demand for liquidity. But again, yesterday was not remotely a truly epic day that one could readily imagine happening.

A couple of points deserve emphasis. The first is that perhaps it was coincidence or bad luck, but the big variation margin flows coincided with other sources of increased demand for liquidity. But hey, stuff happens, and sometimes stuff happens all at once. The system has to be able to withstand such simultaneous stuff.

The second is related, and very concerning. The spikes in rates observed periodically in the repo market (not just here, but notoriously in China) suggest that this market can go non-linear. Thus, even if the increased funding needs caused by the post Abqaiq fallout wasn’t The Big One, in a non-linear market, even modest increases in funding needs can have huge impacts on funding costs.

This highlights another concern: inter-market feedback. A shock in one market (e.g., crude) puts stress on the funding market that leads to spikes in repo rates. But these spikes can feedback into prices in other markets. For example, if the inability to fund positions causes fire sales that cause big price moves that cause big variation margin flows which put further stress on the funding markets.

Yeah. This is what I was talking about.

Today’s events nicely illustrate another concern I raised years ago. Clearing/margining make markets more tightly coupled: the need to meet margin calls within hours increases the potential stress on the funding markets. As I tell my classes, unlike in the pre-Frankendodd days, there is no “fuck you” option when your counterparty calls for margin. You don’t pay, you are in default.

This tight coupling makes the market more vulnerable to operational failings. On Black Monday, 1987, for example, the FedWire went down a couple of times and this contributed to the chaos and the potential for catastrophic failure.

And guess what? There was a (Fed-related!) operational problem today. The NY Fed announced that it would hold a repo operation to supply $75 billion of liquidity . . . then had to cancel it due to “technical difficulties.”

I hate it when that happens! But that’s exactly the point: It happens. And the corollary is: when it happens, it happens at the worst time.

The WSJ article also contains other sobering information. Specifically, post-crisis regulatory “reforms” have made the funding markets more rigid/less-flexible and supple. This would tend to exacerbate non-linearities in the market.

We’re from the government and we’re here to help you! The law of unintended (but predictable) consequences strikes again.

Hopefully things will normalize quickly. But the events of the last two days should be a serious wake-up call. The funding markets going non-linear is the biggest systemic risk. By far. And to the extent that regulatory changes–such as mandated clearing–have increased the potential for demand surges in those markets, and have reduced the ability of those markets to respond to those surges, in their attempt to reduce systemic risks, they have increased them.

I have often been asked what would cause the next financial crisis. My answer has always been: the regulations intended to prevent a recurrence of the last one. Today may be a case in point.

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September 18, 2018

He Blowed Up Real Good. And Inflicted Some Collateral Damage to Boot

I’m on my way back from my annual teaching sojourn in Geneva, plus a day in the Netherlands for a speaking engagement.  While I was taking that European non-quite-vacation, a Norwegian power trader, Einar Aas, suffered a massive loss in cleared spread trades between Nordic and German electricity.  The loss was so large that it blew through Aas’ initial margin and default fund contribution to the clearinghouse (Nasdaq), consumed Nasdaq’s €7 million capital contribution to the default fund, and €107 million of the rest of the default fund–a mere 66 percent of the fund.  The members have been ordered to contribute €100 million to top up the fund.

This was bound to happen. In a way, it was good that it happened in a relatively small market.  But it provides a sobering demonstration of what I’ve said for years: clearing doesn’t eliminate losses, but affects the distribution of losses.  Further, financial institutions that back CCPs–the members–are the ultimate backstops.  Thus, clearing does not eliminate contagion or interconnections in the financial network: it just changes the topology of the network, and the channels by which losses can hit the balance sheets of big players.

Happening in the Nordic/European power markets, this is an interesting curiosity.  If it happens in the interest rate or equity markets, it could be a disaster.

We actually know very little about what happened, beyond the broad details.  We know Aas was long Nordic power and short German power, and that the spread widened due to wet weather in Norway (which depresses the price of hydro and reduces demand) and an increase in European prices due to increases in CO2 prices.  But Nasdaq trades daily, weekly, monthly, quarterly, and annual power products: we don’t know which blew up Aas.  Daily spreads are more volatile, and exhibit more extremes (kurtosis), but since margins are scaled to risk (at least theoretically–more on this below) what matters is the market move relative to the estimated risk.  Reports indicate that the spread moved 17x the typical move, but we don’t know what measure of “typical” is used here.  Standard deviation?  Not a very good measure when there is a lot of kurtosis (or skewness).

I also haven’t seen how big Aas’ initial margins were.  The total loss he suffered was bigger than the hit taken by the default fund, because under the loser-pays model, the initial margins would have been in the first loss position.

The big question in my mind relates to Nasdaq’s margin model.  Power price distributions deviate substantially from the Gaussian, and estimating those distributions is challenging in part because they are also conditional on day of the year and hour of the day, and on fundamental supply-demand conditions: one model doesn’t fit every day, every hour, every season, or every weather enviornment.  Moreover, a spread trade has correlation risk–dependence risk would be a better word, given that correlation is a linear measure of dependence and dependencies in power prices are not linear.  How did Nasdaq model this dependence and how did that impact margins?

One possibility is that Nasdaq’s risk/margin model was good, but this was just one of those things.  Margins are set on the basis of the tails, and tail events occur with some probability.

Given the nature of the tails in power prices (and spreads) reliance on a VaR-type model would be especially dangerous here.  Setting margin based on something like expected shortfall would likely be superior here.  Which model does Nasdaq use?

I can also see the possibility that Nasdaq’s margin model was faulty, and that Aas had figured this out.  He then put on trades that he knew were undermargined because Nasdaq’s model was defective, which allowed him to take on more risk than Nasdaq intended.

In my early work on clearing I indicted that this adverse selection problem was a concern in clearing, and would lead CCPs–and those who believe that CCPs make the financial system safer–to underestimate risk and be falsely complacent.  Indeed, I argued that one reason clearing could be a bad idea is that it was more vulnerable to adverse selection problems because the need to model the distribution of gains/losses on cleared positions requires detailed knowledge, especially for more exotic products.  Traders who specialize in these products are likely to have MUCH better understanding about risks than a non-specialist CCP.

Aas cleared for himself, and this has caused some to get the vapors and conclude that Nasdaq was negligent in allowing him to do so.  Self-clearing is just an FCM with a house account, but with no client business: in some respects that’s less risky than a traditional FCM with client business as well as its own trading book.

Nasdaq required Aas to have €70 million in capital to self-clear.  Presumably Nasdaq will get some of that capital in an insolvency proceeding, and use it to repay default fund members–meaning that the €114 million loss is likely an overestimate of the ultimate cost borne by Nasdaq and the clearing members.

Further, that’s probably similar to the amount of capital that an FCM would have had to have to carry a client position as big as Aas’.   That’s not inherently more risky (to the clearinghouse and its default fund) than if Aas had cleared through another firm (or firms).  Again, the issue is whether Nasdaq is assessing risks accurately so as to allow it to set clearing member capital appropriately.

But the point is that Aas had to have skin in the game to self-clear, just as an FCM would have had to clear for him.

Holding Aas’ positions constant, whether he cleared himself or through an FCM really only affected the distribution of losses, but not the magnitude.  If Aas had cleared through someone else, that someone else’s capital would have taken the hit, and the default fund would have been at risk only if that FCM had defaulted.  But the total loss suffered by FCMs would have been exactly the same, just distributed more unevenly.

Indeed, the more even distribution that occurred due to mutualization which spread the default loss among multiple FCMs might actually be preferable to having one FCM bear the brunt.

The real issue here is incentives.  My statement was that holding Aas’ positions constant, who he cleared through or whether he cleared at all affected only the distribution of losses.  Perhaps under different structures Aas might not have been able to take on this much risk.  But that’s an open question.

If he had cleared through another FCM, that FCM would have had an incentive to limit its positions because its capital was at risk.  But Aas’ capital was at risk–he had skin in the game too, and this was necessary for him to self-clear.  It’s by no means obvious that an FCM would have arrived at a different conclusion than Aas, and decided that his position represented a reasonable risk to its capital.

Here again a key issue is information asymmetry: would the FCM know more about the risk of Aas’ position, or less?  Given Aas’ allegedly obsessive behavior, and his long-time success as a trader, I’m pretty sure that Aas knew more about the risk than any FCM would have, and that requiring him to clear through another firm would not have necessarily constrained his position.  He would have also had an incentive to put his business at the dumbest FCM.

Another incentive issue is Nasdaq’s skin in the game–an issue that has exercised FCMs generally, not just on Nasdaq.  The exchange’s/CCP’s relatively thin contribution to the default fund arguably reduces its incentive to get its margin model right.  Evaluating whether Nasdaq’s relatively minor exposure to default risk led it to undermargin requires a more thorough analysis of its margin model, which is a very complex exercise which is impossible to do given what we know about the model.

But this all brings me back to themes I flogged to the collective shrug of many–indeed almost all–of the regulatory and legislative community back in the aftermath of the Crisis, when clearing was the silver bullet for future crises.   Clearing is all about the allocation and pricing of counterparty credit risk.  Evaluation of counterparty credit risk in a derivatives context requires a detailed understanding of the price risks of the cleared products, and dependencies between these price risks and the balance sheet risks of participants in cleared markets.  Classic information problems–adverse selection and moral hazard (too little skin in the game)–make risk sharing costly, and can lead to the mispricing of risk.

The forensics about Aas blowing up real good, and the lessons learned from that experience, should focus on those issues.  Alas, I see little recognition of that in the media coverage of the episode, and betting on form, I would wager that the same is true of regulators as well.

The Aas blow up should be a salutary lesson in how clearing really works, what it can do, and what it can’t.   Cynic that I am, I’m guessing that it won’t be.  And if I’m right, the next time could be far, far worse.

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August 28, 2018

Shed a Tear for Central Bankers Facing Obsolescence? Uhm, No. Jump for Joy.

Filed under: Economics,Financial crisis,History,Regulation — cpirrong @ 7:00 pm
Scott Sumner rightly skewers this central bankers’/macroeconomists’ angst:

That’s according to a paper presented Saturday by Harvard Business School economist Alberto Cavallo at the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole, Wyoming.

Cavallo’s main finding was that competition from Amazon has led to a greater frequency of price changes at more traditional retailers like Walmart Inc., and also to more uniformity in pricing of the same items across different locations. He found that the shift has led to a greater influence of movements in the U.S. dollar exchange rate and gas prices on retail prices.

. . . .

The Cavallo study also showed that from 2008 to 2017, as online purchases accounted for an ever-growing share of total retail sales, the average duration of prices of goods sold at large U.S. retailers like Walmart fell from about 6.5 months to about 3.7 months.

The implications have subtle significance for monetary policy because so-called “sticky prices” — the notion that sellers aren’t able to change prices right away in response to changes in supply and demand — is precisely what gives interest rates power in mainstream models to have any effect on the economy at all. In those models, if prices adjust instantaneously in response to shocks, then there is no role for central bankers to guide supply and demand back into equilibrium.

“For monetary models and empirical work, my results suggest that the focus needs to move beyond traditional nominal rigidities,” Cavallo wrote. “Labor costs, limited information, and even ’decision costs’ (related to inattention and the limited capacity to process data) will tend to disappear as more retailers use algorithms to make pricing decisions.”

Come on.  The right response to Cavallo’s finding is NOT: “OH NOES! Monetary policy will be less effective when prices aren’t as sticky!”  The right response is: “Thank God we won’t need to rely on monetary policy–which can go horribly wrong because central bankers are humans operating with limited information and flawed theoretical understanding–to counteract shocks!”

Sticky prices create a potentially–and I emphasize potentially–beneficial role for monetary policy.  When prices are sticky, monetary shocks–including shocks to the demand for money–can have real effects.  Monetary authorities can in theory–and again I emphasize in theory–counteract these shocks and keep output closer to the optimum level.

However, the actual results often fall far short of the theoretical potential, because (as Sumner argues happened in 2007-2008, and Friedman and Schwartz argued happened regularly in US monetary history from 1867-1960) monetary authorities may misdiagnose economic conditions, and adopt a suboptimal policy, especially when they operate based on flawed heuristics, such as using the level of interest rates as a measure of whether monetary policy is tight or loose.

Thus, having more flexible pricing that allows nominal prices to adjust to shocks to the demand and supply of money makes us less reliant on central banking wizards–a very good thing, when they are often quite like the Wizard of Oz.

As Scott notes, more flexible/less-sticky prices do not eliminate the impact of monetary policy altogether, though for the most part that role should be less interventionist and more rule-based.

One nominal rigidity that more flexible goods prices won’t eliminate is that most debt will be denominated in nominal terms, and thus its real value will change with the prices of goods and services.  More flexible good prices may actually exacerbate the economic impact of nominal debt on real activity.  Although it is possible to imagine financial innovations that lead to more effective indexing or debt, whether the innovation is adopted widely remains to be seen, and there is room for doubt given the coordination issues involved.  Moreover.  there will still be a stock of existing nominal debt to work off even if new debt is indexed in more clever ways.

But even if nominal rigidities disappear, monetary shocks can still cause real fluctuations.  Remember that the Lucasian Rational Expectations models and their successors do not include rigid prices, yet they exhibit real responses to nominal shocks.  Indeed, that was the entire reason why Lucas and his contemporaries devised these models in the first place, as a way of resolving the Friedman conundrum: “money is a veil, but when the veil flutters, the economy stutters.”

In such a world, however, the role of central banks is much more limited.  In such a world, rule-based, rather than discretionary, policies that reduce the frequency and intensity of nominal shocks, are warranted.  That doesn’t leave much for central bankers to do.  They can’t be masters of the universe!

Central bankers no doubt look with dread on such a world.  That dread is implicit in the fretting over more flexible pricing reducing and perhaps eliminating the role of activist central bankers.  But their dread should be our joy.

 

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May 8, 2018

Libor Was a Crappy Wrench. Here–Use This Beautiful New Hammer Instead!

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 8:02 pm
When discussing the 1864 election, Lincoln mused that it was unwise to swap horses in midstream.  (Lincoln used a variant of this phrase many times during the campaign.) The New York Fed and the Board of Governors are proposing to do that nonetheless when it comes to interest rates.  They want to transition from reliance on Libor to a new Secured Overnight Financing Rate (SOFR, because you can never have enough acronyms), despite the fact that there are trillions of dollars of notional in outstanding derivatives and more trillions in loans with payments tied to Libor.

There are at least two issues here.  The first is if Libor fades away, dies, or is murdered, what is to be done with the outstanding contracts that it is written into? Renegotiations of contracts (even if possible) would be intense, costly, and protracted, because any adjustment to contracts to replace Libor could result in the transfer of tens of billions of dollars among the parties to these contracts.  This is particularly like because of the stark differences between Libor and SOFR.  How would you value the difference between a stream of cash flows based on a flawed mechanism intended to reflect term rates on unsecured borrowings with a stream of cash flows based on overnight secured borrowings?  Apples to oranges doesn’t come close to describing the difference.

Seriously: how would you determine the value so that you could adjust contracts?  A conventional answer is to hold some sort of auction (such as that used to determine CDS payoffs in a default), and then settle all outstanding contracts based on the clearing price in the auction (again like a CDS auction).  But I can’t see how that would work here.

Let’s say you have a contract entitling you to receive a set of payoffs tied to Libor.  You participate in an auction where you bid an amount that you would be willing to pay/receive to give up that set of payoffs for a set of SOFR payoffs.  What would you bid?  Well, in a conventional auction your bid would be based on the value of holding onto the item you would give up (here, the Libor payments).  But if Libor is going to go away, how would you determine that opportunity cost?

Not to mention that there is an immense variety of payoff formulae based on Libor, meaning that there would have to be an immense variety of (impractical) auctions.

So it will come down to bruising negotiations, which given the amounts at stake, would consume large amounts of real resources.

The second issue is whether the SOFR rate will perform the same function as well as Libor did.  Market participants always had the choice to use some other rate to determine floating rates in swaps–T-bill rates, O/N repo rates, what have you.  They settled on Libor pretty quickly because Libor hedged the risks that swap users faced better than the alternatives.  A creditworthy bank that borrowed unsecured for 1, 3, 6, or 12 month terms could hedge its funding costs pretty well by using a Libor-based swap: a swap based on some alternative (like an O/N secured rate) would have been a dirtier hedge.  Similarly, another way that banks hedged interest rate risk was to lend at rates tied to their funding cost–which varied closely with Libor.  Well, the borrowers (e.g., corporates) could swap those floating rate loans into fixed by using Libor-based swaps.

That is, Libor-based swaps and other derivatives came to dominate because they were better hedges for interest rate risks faced by banks and corporates than alternatives would have been.  There was an element of reflexivity here too: the availability of Libor-based hedging instruments made it desirable to enter into borrowing and lending transactions based on Libor, because you could hedge them. This positive feedback mechanism created the vexing situation faced today, where there are immense sums of contracts that embed Libor in one way or another.

SOFR will not have this desirable feature–unless the Fed wants to drive banks to do all their funding secured overnight! That is, there will be a mismatch between the new rate that is intended replace Libor as a benchmark in derivatives and loan transactions, and the risks that that market participants want to hedge.

In essence, the Fed identified the problem with Libor–its vulnerability to manipulation because it was not based on transactions–and says that it has fixed it by creating a benchmark based on a lot of transactions.  The problem is that the benchmark that is “better” in some respects (less vulnerable to a certain kind of manipulation) is worse in others (matching the risk that market participants want to hedge).  In a near obsessive quest to fix one flaw, the Fed totally overlooked the purpose of the thing that they were trying to fix, and have created something of dubious utility because it does a poorer job of achieving that purpose.  In focusing on the details of the construction of the benchmark, they’ve lost sight of the big picture: what the benchmark is supposed to be used for.

It’s like the Fed has said: “Libor was one crappy wrench, so we’ve gone out and created this beautiful hammer. Use that instead!”

Or, to reprise an old standby, the Fed is like the drunk looking for his car keys under the lamppost, not because he lost them there, but because the light is better.  There is more light (transactions) in the O/N secured market, but that’s not where the market’s hedging keys are.

This is an object lesson in how governments and other large bureaucracies go astray.  The details of a particular problem receive outsized attention, and all efforts are focused on fixing that problem without considering the larger context, and the potential unintended consequences of the “fix.” Government is especially vulnerable to this given the tendency to focus on scandal and controversy and the inevitable narrative simplification and decontextualization that scandal creates.

The current ‘bor administrator–ICE–is striving to keep it alive.  These efforts deserve support.  Secured overnight rate-based benchmarks are ill-suited to serve as the basis for interest rate derivatives that are used to hedge the transactions that Libor-based derivatives do.

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