Streetwise Professor

In 2009 I called China the “Michael Jackson economy,” meaning that it was kept going by artificial stimulants, but that inevitably their cumulative effects would cause  serious, and perhaps fatal problems.  They mask the effect of the underlying ailment, and have severe side effects.   China responded to the 2008 financial crisis by engaging in massive stimulus, and has inflated credit bubbles whenever growth stuttered in the past several years.  Moreover, allocation of credit and investment in the economy is subject to substantial direct and indirect government control.  Local governments invest massive amounts in infrastructure and housing projects, and the banking system is tilted to direct credit to large state enterprises that invest primarily in heavy industry-steel manufacture and shipbuilding, for instance.

This “investment” can prop up GDP statistics, but they are recorded at cost, not value.  (I recommend this David Henderson piece about the perversity of GDP fetishism, and how GDP can grossly mis-measure well-being.)

If the investments are ill-conceived, they will not pay for themselves in the future, and economic output and consumption will suffer.  And investments guided primarily by the visible hand in an authoritarian state are almost certainly ill-conceived.  They are driven by considerations like political connections, prestige, and the imperative to maintain employment in existing enterprises and regions to buy labor-and political-peace.  This latter effect is particularly deleterious, as it means that rather than there being a natural corrective mechanism for past mistakes, mistakes tend to be self-perpetuating.

The Wall Street Journal has a fascinating article about one major malinvestment that fits this story almost perfectly.  Yes, it is likely an extreme case, but there are enough similar stories to suggest that that the malivinestment problem in China is severe.  Moreover, the bloated fraction of investment to GDP, and the falling delta between changes in credit and changes in income provide some quantitative support for these anecdotes.  Add in the dodginess of Chinese economic data, and there is serious reason to believe that China is heading for a very rocky period.  When the interactions with the financial system are considered, the prospects look even more dire: when the investments don’t generate sufficient return to pay back the loans, realistic outcomes range from a Japan-like zombie-fication of the banks to a full-blown financial crisis.

China’s new premier is promising 7+ percent GDP growth.  That could be the problem: the only way to get it is to double down on the artificial stimulants, thereby exacerbating the malinvestment problem.  Living with lower GDP growth, and permitting Chinese businesses and individuals to reallocate resources to those that generate value rather than statistics, would be far preferable in the short, medium, and especially long run.

A major adjustment is needed, but I would have little confidence in the Party and the system that created the mess in the first place to manage this adjustment effectively or efficiently.  The political economy suggests that incumbent industries, firms, and interests, all of which have strong political influence, will disproportionately influence government economic policy.  This impedes adjustment, and substantially increases the odds of zombie-fication, of the financial system and entire industries.  China could use some creative destruction, but I do not believe this is politically feasible.

China is one of those few matters on which Krugman and I agree.  Krugman mentions that this could be bad for commodity prices, and that would definitely be true if China goes cold turkey and stops trying to perpetuate its old growth model.  That will lead to a substantial decline in the demand for commodities such as industrial metals, iron ore, coal, and oil.  But if the political economy story is correct, it will attempt to support the existing commodity-intensive structure of production and delay the adjustment process.  In the event, commodity prices will likely fall, because a reprise of 2009’s extreme dosage of stimulants is likely infeasible.  But government attempts to cushion the adjustment process will cushion the impact on commodity prices too.

But it is true that the course of commodity prices will depend crucially on how the Chinese government handles the painful withdrawal from its past stimulus binge.  Cold turkey would be very bearish (how’s that for a mixed metaphor!?!) Hair of the dog far less so.  This implies that a crucial fundamental in commodity markets in coming months and even years, and perhaps the crucial fundamental, will be Chinese politics.

Who woulda thunk that commodities-especially ones like aluminum-would become such a huge story.  Maybe it’s the summer news doldrums, but in the last week there have been two major, related stories using up loads of ink and pixels.  The stories are: (1) the Federal Reserve’s announcement that it is evaluating whether to continue permitting banks it regulates trade physical commodities, and own physical assets like storage facilities and power plants used to transform commodities in space, time, or form, and (2) the role of banks like Goldman and Morgan in the industrial metals storage business.  The latter story was the subject of an extensive piece in the NYT on Sunday.  The stories are related because the metals warehouse controversy is Exhibit A in the case against allowing banks to be involved in physical commodities.

First the warehouse story.  I wrote about this issue back in January.  There is smoke here.  The premiums in physical aluminum above the LME in-store price is an indication of a bottleneck in getting material out of warehouses.  The question is whether this bottleneck is being artificially exacerbated by game playing-manipulation, perhaps-by the warehouse operators.  The NYT article does cast some light on some mysterious practices, but it does not seal the deal in my mind.  Not to say that manipulation is not occurring, just that the NYT piece doesn’t convince me.

One puzzle is that the operators of warehouses, who cannot own physical metal in them, pay third parties a bonus over the LME price approximately equal to the cash market premium in order to put their material in store, and thereby put themselves at the mercy of the loadout queue.  Presumably, those taking these deals only do so because they are compensated for the higher storage expenses they incur once their metal gets stuck in the roach motels.  If Goldman (or any other warehouseman) paid everyone these premiums, Goldman couldn’t make any money by running the roach motel: it would pay in premium what it collects in storage fees.  It would compensate the roaches for the costs of getting stuck in the motel.  Which suggests that they only pay some customers the premium to attract metal.  What would be interesting to know is how this would permit the warehousemen to collect storage for a longer period from others whose metal is in the warehouses, but who don’t get paid the bonus.  Are there side deals with the storers who receive the premiums?   Does the mere fact that there is more metal in the warehouses increase the ability of the operators to slow down load-out, and thereby collect storage for a longer period?    This seems to be the most curious practice, but the articles I’ve read don’t shed enough light on how they could be part of a manipulative scheme.

Tom Maguire of Just One Minute does a good job at debunking the math in the Times piece: the profits accruing to Goldman and the costs imposed on soda and beer quaffing consumers alleged by the Times don’t withstand scrutiny.  To which I would add another point.  Namely, these calculations assume that the cash premiums reflect an inflation in price.  Any uneconomic act that exacerbates the bottleneck in the transformation of metal in store to metal outside LME warehouses has effects on prices on both sides of the bottleneck: it reduces the price of metal in store, and increases the price at the Coca Cola or Budweiser facility.  So even if the premium is inflated, this does not mean that the price paid by consumers (directly or indirectly) is inflated by the same amount because part of the inflation is due to a depression of the in-store price.  Those with metal in store, or producers who put their metal into store, bear some of the cost.

Now on to the bigger issue, which the hue and cry over bankers owning metals warehouses is intended to illustrate: namely, whether banks should be involved in physical commodity markets.  This is the subject of a Senate hearing today, where one of the main anti-bankers, Ohio Senator Sherrod Brown, is leading the charge to get the banker-squids’ tentacles off our commodities.

I find most of the reasons advanced for keeping banks out of physical commodities, and the ownership of commodity transformation assets, to be unpersuasive.  What’s so special about commodities?  Are they uniquely risky?

I think not, and believe that there are good economic reasons for banks to enter into the commodities business.

In addressing this issue, it’s important to be specific about the kinds of risk involved.  Price risk, spread risk, and operational and reputational risks are perhaps the most important to consider.

The conventional view is that commodity prices are extraordinarily volatile, and hence pose extraordinary risks on those who hold them.  One thing to note is that for a leveraged investor like a bank it is possible to transform a relatively low volatility flat price exposure into a much riskier exposure.  So one thing that matters is whether, taking leverage into account, bank positions in commodities are riskier than their positions in more traditional lines of business.  Moreover, it is risk at the portfolio level that matters, and the correlation between the price exposures and other elements of the banks’ portfolios.  A highly volatile position may not increase portfolio risk substantially if it is uncorrelated with other exposures, or negatively correlated.

But there’s a more important point.  Most commodity trading by commodity trading firms and banks does not consist of punts on the flat price, on whether the price of oil or copper is going to rise or fall.  Instead, most commodity trading is a margin business or a fee business.  Money is made on margins or fees in transportation, storage, and processing.  These margins-spreads-tend to be much more stable than flat prices.  Asset ownership, or contractual control of physical assets (of the type that JP Morgan has over California power plants that have attracted FERC’s ire), is a position on the value and cost of transformation, and spreads and margins measure these values and costs.  The riskiness in these spreads/margins, and the ability to manage spread/margin risk through paper trades, is what drives the risk of bank commodity plays.  My reading of the coverage has turned up virtually no understanding of this issue.

Moreover, the profitability of physical assets can provide a natural hedge for other bank businesses.  Most banking his highly pro-cyclical: it profits when the economy booms, and does badly when the economy tanks.  Some commodity assets are countercyclical.  Storage is a classic example.  The amount of oil or metal in storage-and revenues from storing these things-goes up when the economy weakens.  This is basic economics.  So metal or oil storage-a fee business-is a natural hedge against the strongly procyclical traditional banking and dealing businesses.

Taking these factors into consideration, it is wrong to believe that commodity businesses are unduly risky, compared to other banking activities.

Operational risks are perhaps more problematic.  A major oil spill, for instance, leads to substantial costs on the operator of the ship or pipeline or terminal that spills it.  A bank that owns or charters a tanker that ends up on a reef is potentially exposed to a substantial risk of loss.  But much of this risk can be passed on to insurance companies via the insurance market.  What’s more, the risk doesn’t go away if banks can’t touch physical oil: someone has to bear it.  The question is whether banks are less efficient bearers of this risk than others (where others include insurance companies).

Many of the stories that have come out in recent days focus on the reputational and legal risks associated with commodity trading.  For instance, JP Morgan’s impending settlement with FERC of allegations that it manipulated the California electricity markets has received considerable play.  Well, this is not a problem unique to commodities.  Traditional banking businesses, and other less traditional activities now widely considered to be legitimate activities for banks, have huge reputational and legal risks.  Consider Libor.  Or the Toure trial.  Or mis-selling.  Or mortgage servicing/foreclosures.

I could go on. And on. And on.  If you think that keeping banks out of commodities you’ll reduce their rep or legal risks, I have a bridge to sell you.

Furthermore, even if it is shown that banks have engaged in dodgy activity in commodities, that doesn’t mean that getting banks out of commodities will eliminate the dodgy activities.  Consider the warehouse issue.  If LME rules and cash market frictions make it profitable for warehouse operators to manipulate markets, forcing banks to sell off these assets won’t reduce the manipulation: the new owners will take ownership of the strategies along with the storage sheds.  Note that Glencore-not a bank!-has been accused of playing similar games.   Keeping banks out of commodities may affect who plays dodgy games, and profits therefrom, but won’t have much of an impact on the amount of dodginess in the markets.  That dodginess ultimately derives from economic opportunity (which is driven by frictions in the market) and regulation (flawed rules and rule enforcement mean that market participants calculate there’s a substantial probability of escaping punishment for misdeeds).  Barring banks from the market won’t change either of these things.  If crime pays, someone will commit it.  If you care about reducing the deadweight losses from manipulative activities, you shouldn’t really care about who profits from them.  You need to fix the problem at the level of incentives and enforcement of rules: keeping banks out of the market doesn’t do that.  Period.

The foregoing is basically a rebuttal-or at least a skeptical questioning-of the case against bank ownership of commodity assets, or participation in physical commodity markets.  What about the affirmative case for such participation?

For several years, in response to shrieks about the evil effects of the “financialization” of commodity markets, I’ve made the following basic point: a good deal of commodity trading is about allocating commodities over time, and allocating risk.  Both of these are fundamental financial functions: finance is about trading off the future and the present, and allocating risks.  Banks are linchpins of the financial system, and engage in intermediation of risk and of resources over time.  Why should we exclude them from a sector where the allocation of resources over time and the allocation of risk are vitally important?  That is the comparative advantage of banks: why keep them out?

Indeed, banks have gained market share in commodities in large part because they can perform the time- and risk-allocation functions more efficiently than others.  If banks have the lowest funding costs, it makes sense that they fund some inventories.  Banks have expertise in risk management and hedging, making it sensible that they utilize this expertise in the management of commodity price risks.  In other words, the success of banks in commodities is a feature, not a bug, because it reflects their comparative advantages in allocating risks and resources over time.

Moreover, there is often a synergy between financing and risk management activities, and banks can exploit these synergies.  For instance, one physical market activity that banks engage in is offtake agreements, whereby they provide say crude oil to a refinery, and receive the refinery’s output which they market.  This bundle of transactions involves a funding element-the bank is basically providing working capital to the refinery.  It also involves a risk management element: the bank is managing the price risks on the crude and refined product side (as well as the logistical/operational risks).

Crucially, by taking on the risk, the bank is reducing the moral hazard that would be involved if it was providing working capital financing to the refinery.  Yes, if it just extended loans or credit lines to the refinery, the bank would presumably impose requirements on the refinery to hedge its risks, but there are inherent agency problems associated with such an arrangement that can be avoided by putting the price risks on the bank.   Moreover, the operational and logistical risks cannot be hedged, and pose a potential moral hazard.

The most telling objection that might be raised against these arguments is that banks have gained market share in commodities because they are subsidized as a result of too big to fail.  I would note that the investment banks that made the first and biggest forays into commodities-Morgan Stanley, Goldman, Bear-did so when they did not have access to insured deposits for funding or to the Fed window, though one could argue that they still were subsidized by the belief that they were too big for the Fed to allow to fail.

But even if you buy into the subsidy argument, that’s no reason to single out commodities.  The subsidy leads to an excessive expansion of big banks generally, across all lines of business.   Meaning that keeping them out of commodities will not materially reduce the perverse effect of the subsidies.  Implicitly or explicitly subsidized banks will exploit that subsidy to the hilt, and if they can’t do it in commodities, they’ll do it somewhere else.  TBTF has to be tackled at the roots, not the branches or the leaves-and particular lines of business like commodities are the latter.

One last point.  It is beyond ironic that the banks are under attack for their commodity dealings.  GFMA wanted to hamstring banks’ competitors in commodity trading-namely, the commodity trading firms.  Perhaps they should have paid more attention to making the affirmative case for their participation in these markets, than they did attempting to raise their non-bank rivals’ costs.

The word karma comes to mind.

Today Elizabeth Warren and John McCain unveiled the “21st Century Glass-Steagall Act” that would restore the separation of investment banking and commercial banking, along with a few new restrictions on the things commercial banks with access to deposit insurance can invest in.

I really don’t get the nostalgia for Glass-Steagall.  I really don’t.  What’s next?  High Button Shoes for the 21st Century?  Radio tubes for the 21st Century?

Smarter people than McCain and Warren (a bar that a snail could jump, I admit) have pumped for the restoration of Glass-Steagall.  Luigi Zingales is a prominent example. I expressed my criticisms of Zingales’s advocacy of Glass-Steagall a little more than a year ago, and nothing I’ve seen since changes my mind.  Certainly the bloviations of Warren and McCain don’t.

The essence of the argument for a restoration of Glass-Steagall, as well as “ring fencing” regulations in Europe, appears to be that deposit insurance creates a moral hazard: banks with access to insured deposits take on too much risk.  Preventing such banks from engaging in risky investment banking activities supposedly improves the safety of the banking system, and limits taxpayer exposure, by reducing that moral hazard.

There are only two problems with that.

First, access to deposit insurance is obviously not a necessary condition to induce risk taking.  None of the stand-alone IBs that took on leverage out the wazoo in the 2000s, and took exposures to highly risky real-estate related securities-Bear, Lehman, Merrill, Morgan Stanley and even, yes, Goldman-had access to deposit insurance.  And that was in  fact the problem.  Nor did they have statutory access to Fed support in the same way banks do.  They all relied on very fragile wholesale funding that ran like Usain Bolt when things started to look dodgy.

Second, Glass-Steagall-like restrictions on permitted activities/investments are not sufficient, by a long shot, to prevent commercial banks from taking on risks that threaten their solvency, and the stability of the financial system.  Look at all the banking problems in the 70s, 80s, and 90s that occurred despite Glass-Steagall.  Sovereign lending to Latin America.  The S&L crisis.  Lending to Asia before its 1997-1998 crisis.  Commercial lending to the energy industry.  Need I remind everyone that the phrase “too big to fail” was coined to describe Continental Bank, which became insolvent the old fashioned way: engaging in high risk commercial lending in the era of Glass-Steagall?

The “quiet period” of US banking the 50s and 60s was the result of a dense nexus of costly restrictions on banking activity.  Glass-Steagall was a part of that, but not the entire story by a long shot.  It just gets the most press, and the best press.  The complex web of restrictions on banks and financial intermediation during that period-restrictions that imposed substantial costs-is too hard to explain.  So Glass-Steagall has become the poster child for that era. People like Warren and McCain think that Golden Age can be restored by reviving Glass-Steagall.  As if.

I am deeply skeptical of restrictions on the activities of financial intermediaries; I am also skeptical of mandated impositions of market structure (e.g., clearing mandates).  The underlying incentives remain the same, and these Byzantine restrictions induce attempts to circumvent them.  It is better to operate at the level of incentives, through capital requirements, for instance.  Yes, there will be attempts to circumvent these too, but at least they provide some incentive for those with the information to internalize the risk-return trade-offs.  Structural restrictions, not so much.  At all.

Yes, moral hazard induced by deposit insurance matters.  But it matters a lot less than other things.   Breaking up universal banks will still leave large investment banks reliant on wholesale funding with incentives to lever up, and large commercial banks who can blow themselves up just fine, thank you, by making loans.  So the revivification of Glass-Steagall won’t materially reduce systemic risk, but it will induce costly efforts to circumvent the separation, and will sacrifice the synergies between investment and commercial banking activities.

When your diagnosis is wrong, the prescription is likely to be wrong too.  And with financial doctors like Warren and McCain, we should have no illusions that they’ve screwed up both.

Dealer banks and the CME squared off in the pages of the FT today, arguing over the systemic risks of CCPs.  Each made some good points; each whiffed on a few; both overlooked the real sources of systemic risk arising from clearing mandates.

First, the banks:

“We are losing track of the nominal risk,” warned Jean-Pierre Mustier, head of investment banking at UniCredit and a former board member at London-based LCH.Clearnet. “We’re moving from a set-up where banks were interconnected, because they had transactions between them, to a system where very lowly capitalised entities, the clearing houses, are supposed to protect the banks from a problem.”

. . . .

Banks have voiced concerns to regulators in Europe and the US that central clearing houses are providing insufficient data on their own risks and demanding lower-quality collateral for swaps transactions. They argue the risks are too opaque, and getting riskier.

“It’s going in the wrong direction,” said the head of credit trading at a large US bank. “The race to the bottom is on.” He and other executives were critical of the CME’s decision to accept corporate bonds as collateral, a step down from the safer instruments usually required for margin.

There are reasons to be concerned about the expansion of the collateral pool to include more risky assets.  This is especially true inasmuch as these assets are likely to become less liquid precisely when a CCP needs to liquidate them: during a systemic even that causes the failure of a large, or several large, clearing members.  This problem could be mitigated by giving CCPs access to central bank liquidity, collateralized by the corporate bonds, etc., they take in as initial margin.  But the fundamental driver here is that clearing mandates have dramatically increased the need for initial margin, and it was inevitable that this would result in expansion of eligible collateral.  It’s not a competitive race to the bottom, it’s facing reality: indeed, CCPs in individual product spaces face relatively little competition.

Concern about initial margin methodology is also reasonable.  Under-margining leads to the mutualization of risk in excess of what CMs had anticipated: over-margining leads to inflated trading costs.  But the crucial problem with any CCP methodology is that it takes into account position risk only, and doesn’t vary margin with the balance sheet risk of the member firms.  This tends to lead to excessive trading by weaker clearing members, as they don’t have to post higher collateral, as their poorer credit would suggest they should.  This is pretty much an inherent feature of clearing, for informational and governance reasons, as I’ve discussed frequently here on SWP in the past.

Now to CME,  as represented by Chairman Terry Duffy:

Terry Duffy, executive chairman of CME Group, said the shift in moving more OTC derivatives transactions was more profound than just transferring the risk and exposure to a counterparty default from banks to clearing houses. “The difference is with a clearing house we do market-to-market [risk management], either twice daily or have the ability to do it much more often,” he said on a visit to London.

“What’s important is making certain the pays and collects are done on a risk basis and not a mark-to-myth or anything else. Because of that, we have a much easier time doing the pays and collects than the banks do if it was a bilateral transaction. In turn, I think some of the banks are just not used to the model of clearing.”

This relates to variation margin, which was/is often collected in OTC transactions (once exposure exceeds negotiated credit limits between the parties.)  Several points to make here.  First, variation margin is basically a way of keeping initial margin levels current.  This doesn’t really address the issue raised by the banks of whether initial margin levels are adequate, banks can determine that, and the quality of the collateral posted as initial margin (and whether the haircuts applied against this collateral are commensurate with the risks).  Second, you can go through the process of marking to market, but the protection provided by that process depends crucially on the quality of the prices.  That depends on market liquidity, trading activity, etc.  You need a market to mark to, and for many products that will be brought into clearing there are serious doubts about the reliability of the prices used for markets.  If there’s a liquid market, the prices it generates more accurate MTM in both bilateral and cleared trades: if there isn’t, both cleared and bilateral MTMs are dodgy.  Third, as I’ll discuss more in detail, the mechanical process of marking to market can actually create systemic risks.

The FT reporter, Phillip Stafford, also mentions that banks complain about the inadequacy of CCP capital, but notes that CCPs also have default/guarantee funds that they can call on to prevent a CCP default. But that’s exactly what the big banks are worried about.  Their exposure to CCPs comes first and foremost through their participation in these funds.   There’s only a thin layer of CCP capital separating a defaulter’s margin (and default fund contribution) from the non-defaulters’ contributions.  If the CCP under margins, that capital can be blown through very quickly, and expose banks to substantial losses.  These losses are most likely to occur, moreover, during stressed market conditions when banks are least able to afford the hit.  This wrong way risk is precisely what banks are complaining about.

Truth be told, although both the banks and the CCPs (to the extent Duffy is representing the clearing industry perspective) have some valid points, they miss the big systemic risks associated with clearing and clearing mandates.  I’m sort of in the middle of my Streetwise Professor Worldwide Personified Clearing Tour, in which I’ve given talks on the systemic risks of clearing in Chicago, Frankfurt, Osaka, Istanbul, DC, and the UK (London and Oxford), and will give another in Paris in September.  (Rough duty, I know, but somebody has to do it.)  Here are some of the greatest hits I play at each stop.

• Clearing, and in particular multilateral netting, basically redistributes credit risk from derivatives counterparties to other creditors of defaulting CCP members.  These other creditors may be as systemically important and vulnerable, or even more systemically important and vulnerable, than CCP members.  For instance, moving to clearing is likely to make runs on money market funds more likely even if it makes runs on dealer banks less likely.  It is not evident that this is a desirable trade-off.
• The variation margining mechanism in clearing is particularly rigid, and can create substantial demand for liquidity precisely when funding liquidity dries up.  This is what almost brought down the CME clearinghouse on the Day After Black Monday in 1987.  This is why rigid marking-to-market and variation margining can be a systemically destabilizing bug, not a stabilizing feature.
• Clearing does not eliminate interconnections between big financial firms: it reconfigures the network of connections.  Moreover, it does so in a way that is rife with wrong way risk.  As noted before, CCP members-mainly big banks-are connected via CCP default funds, and are most likely to incur losses during periods of market stress, when they are least able to afford it.

Regulators are becoming increasingly aware of these problems, and are responding by attempting to make CCPs virtually immune to failure.  But this brings me to another of my greatest hits: beware the fallacy of composition.  Yes, failure of a CCP would be catastrophic, but making one part of the financial system stronger-a CCP, for instance-does not necessarily make the system stronger.  One of the main effects of increasing the financial resources of a CCP is to redistribute credit losses from derivatives counterparties to other creditors of defaulting firms, and to redistribute scarce liquidity.   It is not necessarily the case that this redistribution makes the system stronger.

The analogy that I’ve made here, and that I make on tour, is that of the levee.  Building up the levee around a CCP reduces the likelihood that it will be inundated, but forces the financial flood elsewhere.  Again, it is not evident that it’s better for systemic stability to redistribute the water from CCP members to other parts of the financial system.

My closing number is that CCPs have been vastly oversold as a means of reducing systemic risk.  It’s virtually impossible to know what the net effects are, but it’s likely that CCP mandates reduce systemic risk under some scenarios, but increase it under others.  What’s more, the main systemic risk is not necessarily the failure of a CCP, as bad as that would be, but the spillover effects from clearing to other parts of the financial system.

That is, it’s necessary to analyze the systemic risks of clearing by analyzing the financial system as a whole.  Regulators haven’t done that, for the most part, and the debate between the banks and Terry Duffy doesn’t really do that either.  Their’s is a CCP-centric debate, and although that’s not irrelevant, it doesn’t get at the nub of the matter.  Meaning that the show must go on.

I have written for some time about my doubts about the sustainability of Chinese growth (driven by massive credit expansion that is delivering progressively less and less bang for the renminbi), and my concerns about the stability of the Chinese financial system, especially the shadow banking system.  So far these prognostications have not been realized, but events over the last few days relate directly to these doubts and concerns.

Specifically, China is in the grips of a full-blown liquidity crisis, with overnight repo rates approaching 30 percent, and one week rates well over 10 percent.  The Chinese yield curve has become steeply inverted, which is never a good sign.  The word “panic” is being bandied about quite freely.

News accounts make it seem that the liquidity shortage is the deliberate  policy of the People’s Bank of China.  Indeed, these accounts suggest that the PBOC is withholding liquidity from the market precisely because it too believes that credit-fueled growth is unsustainable, and that the banking and shadow banking sectors have over expanded and need to be cut down to size:

China’s interbank funding costs surged again on Thursday, with the two shortest-term rates hitting record highs, as the central bank again ignored market pressure to inject funds into the market, despite fresh evidence that the economy is slowing.

The People’s Bank of China (PBOC) told the market that it would not conduct repo business in its regular open market operations on Thursday, frustrating widespread expectations that it would use reverse repos to inject cash to ease an acute market squeeze over the last two weeks.

. . . .

“The central bank appears to be determined to force banks and other financial institutions, such as funds, brokerages and asset managers, to de-leverage,” said a trader at a major Chinese state-owned bank in Shanghai.

“That hardline stance suits the recent government policy of clamping down on non-essential businesses by financial institutions, such as shadow banking, wealth management, trust operations and even arbitrage.”

Yes, deleveraging is probably a good idea: the economy had become over leveraged as the result of previous stimulus policies that fed a credit boom. The question is: how to deleverage?  Quite often system-wide deleveraging is a chaotic process, beset with externalities.  Companies that can’t fund dump assets in fire sales, which puts pressure on other institutions holding the same or similar assets: they often join the fire sale stampede.  Institutions start hoarding credit and liquidity, which drives up rates and puts yet further pressure on financial institutions.

In other words, system-wide deleveraging often occurs through a financial panic that causes massive economic damage.  Usually central banks try to stem this process by flooding the system with liquidity.  Bizarrely, China, it appears, seems to be trying to start the process by starving the system of liquidity.  Central banking with Chinese characteristics, as it were.

One interpretation is that the PBOC has found that jawboning and other less drastic policies have failed to stem the growth in credit and shadow banking, so it feels obliged to take stern measures to curb these activities.  But this is a dangerous way to do it, and I am not sure that it is the optimal strategy in the game between the PBOC and other market participants.

Let’s say the PBOC relents and says “You’ve been warned: don’t let it happen again.”  Many market participants will infer that the PBOC’s threats are not credible, and that it will supply liquidity if the system appears on the verge of failure.  The will therefore have little incentive to curb their activities, viewing the PBOC as a paper tiger.  The economy will continue to be over leveraged.

Conversely, let’s say to demonstrate its credibility the PBOC sticks to its guns and refuses to supply liquidity: then there is a risk of a full-blown panic and crisis-and right now.

China is having an episode not unlike the one that hit world markets in August, 2007, when funding markets signaled the onset of the crisis, with the difference being-and it is a big difference-that this appears to be a crisis of choice, and one that could morph from onset to a Lehman moment in days or weeks, not months.

Perhaps the PBOC believes that the situation is so dire that a purgative crisis now is preferable to a worse one that chooses its own time to appear.  If so, it has no one else to blame.  If China’s financial system was hurtling down the road too rapidly, it was because the PBOC (and the Chinese government) had jammed down the accelerator with its credit-driven stimulus measures.  Now it is responding by jamming on the brakes.  A policy of alternating extremes seldom works out well.

There is an apocryphal belief that in Chinese the word “crisis” is represented by the characters for “danger” and “opportunity”.  (JFK is responsible for popularizing this belief.) The most charitable interpretation of the PBOC’s starving the market of liquidity is that it doesn’t view that belief as apocryphal, but as gospel.  That it is running a great danger to seize an opportunity to put the Chinese financial system on a firmer foundation.

Maybe.  But that suggests a conceit on the behalf of policymakers: it presumes that once a panic is sparked, they can control it, and the panic will make financiers more prudent in the future by putting the fear of God into them today.

That’s a very, very risky bet that has a very, very high probability of turning out very, very badly.

As changes in financial market regulation like Frankendodd lurch into effect (with phase two of the clearing mandate becoming effective a couple of days ago), it’s interesting to see the dawning realization about some of the implications.  Implications that I’ve discussed for several years here, or in my academic work.

One of these is the tension between the micro-prudential and macro-prudential roles of collateral.  Micro-prudentially, collateral makes sense for a lender: it increases recoveries in the event the borrower goes bust.  But collateral is much more problematic macro-prudentially, for a variety of reasons.  It can be a highly pro cyclical mechanism that intensifies the effects of financial shocks.  It can be a crisis accelerator.

Andrew Hauser of the Bank of England focuses on this tension in this speech.  Unfortunately, despite this and other evidence of growing attention to this issue, I still think it’s under appreciated and that will lead to problems down the road.

Another issue is one that I raised in my more cynical moments.  Scary thought, I know.  Specifically, I mused that one reason for the broad political support for clearing and collateral mandates, especially among government treasuries (e.g., Timmy!), is that these were a form of financial repression.  That is, a means of increasing the demand for government securities, in order to reduce interest rates and borrowing costs.  The mandates effectively require market participants to hold more government debt in their portfolios.

Bloomberg just noticed this:

New collateral rules for hedge funds, insurers and others in the $633 trillion over-the-counter derivatives market are poised to boost demand for U.S. Treasuries, potentially slowing rising yields as the Federal Reserve considers scaling back unprecedented stimulus.

Swaps traders will need to come up with $800 billion to $4.6 trillion to meet Dodd-Frank Act regulations requiring that the derivatives be backed by clearinghouses that collect upfront collateral such as cash or Treasuries, according to estimates from the Treasury Borrowing Advisory Committee. The regulations take effect today for the second group of firms designated by the Commodity Futures Trading Commission in the market for interest-rate and credit-default swaps.

“This is going to be a new, very powerful engine that drives demand for Treasuries, so you have to expect it will impact yields,” said Ted Leveroni, executive director of derivatives strategy at New York-based trade-processer Omgeo LLC. “There are a lot of firms out there — I know because they’ve told me — that are concerned about having the available collateral.”

The rush for collateral may be an unintended benefit from swaps rules designed to protect against a cascade of bank failures

Um, unintended benefit for whom?  And who says its unintended?  I think it might have been quite intentional-just not acknowledged.

Now that the regulatory changes are being put into place, we’ll see how good my forecasting performance is.  Since I’ve predicted many unintended consequences, most of which are not good, y’all should hope that it’s not very good at all.  But it appears that others are making similar predictions now, at least on these two issues.

A group of senators from western states, led by Diane Feinstein, have sent Gary Gensler a missive accusing the CFTC of violating the letter and spirit of Frankendodd by failing to register major energy companies (e.g., BP, Shell) as swap dealers.  Each paragraph of the letter is more risible than the one before.

They set the scene by recounting the western electricity crisis of 2000-2001.  This is utterly irrelevant to the swap dealer designation, because swaps had nothing to do with what happened then and there.  Indeed, at its core the crisis was driven by a combination of fundamentals and flawed market design, and even the suspect trading strategies involved physical market transactions rather than swaps.  For instance, none of the Enron strategies like “Fat Boy” or “Ricochet” involved swaps or OTC derivatives generally in any way, shape, or form.  (It’s also rather ironic that one of the things that wreaked havoc with California utilities was that they were precluded by law from engaging in forward transactions to hedge the short position forced upon them by the retail price caps in the restructuring legislation.)

Parts of the letter made me laugh.  Most notably, the senators attack the $8 billion de minimus exemption from the registration requirement.  Their “logic” is that since commodity swaps represent a small fraction (less than one percent) of total OTC derivatives activities, the de minimus level for energy swaps activity should be lower than for financial swaps. Not just lower: “vastly lower.”

They say this “stands to reason.”  Whenever anyone says something “stands to reason” s/he really means: “I can’t give you an actual reason, so I’ll just assert that my conclusion is obvious.”

This gets to the issue of just what the swap dealing designation is intended to achieve.  That’s always been somewhat hazy, but the most charitable interpretation is that swaps dealers are deemed potential sources of systemic risk that require extraordinary regulatory scrutiny.  The risk a particular firm poses to the financial system as a whole depends on its size relative to the entire financial system, rather than to any particular market, so even accepted the premises of Frankendodd the swap dealing designation should not vary by market.  (Indeed, from a systemic perspective, even $8 billion/year on a flow basis is ridiculously small.)

The senators also fret over the possibility that allowing the Shells and BPs of the world to escape the designation will limit the CFTC’s ability to deter manipulation and fraud.  Hardly.  Those things are still illegal, and swap dealing designation will have no impact whatsoever on the CFTC’s ability to detect and deter.  (Which may not be saying much, because all too often the CFTC wouldn’t know a manipulation if it hit the CFTC in the face with a waffle iron.)  (I consider it ironic that these Solons refer to the BP propane manipulation, which was discovered, prosecuted, and punished when the swap dealer designation was not even a twinkle in Barney Frank’s eye.  Bad mental image, I know.)

Relatedly, the senators worry about “transparency”, but all swaps trades will still be reported to central repositories.  The only way the dealer designation matters in this regard is it affects/determines who has to report.  (I shall pass over in silence the fact that the CFTC is at present utterly incapable of utilizing the data reported to the repositories, as Commissioner Scott O’Malia has repeatedly pointed out.)

But most importantly, the senators miss the elephant in the room.  No major energy firm has registered as a swaps dealer because energy firms have shifted trading from swaps to futures.  Another premise (flawed, but there  it is) behind Frankendodd is that swaps are somehow more dangerous to the system than futures.  The legislation and the rules under it imposed more onerous requirements on swaps than futures, in large part to encourage the movement of trading to futures markets.

So if these senators actually applied reason, rather than just hiding behind a stand-in for it, they should be overjoyed that no major energy firm has applied to be a swap dealer.  This should be a feature, not a bug.  It means that market activity has shifted to the venue that these very same senators and others who voted for Frankendodd considered to be the preferred model for trading derivatives: open, transparent, and subject to a rigorous regulatory regime.  Most notably, from a systemic risk perspective, futures are cleared, and one of the major requirements imposed on swap dealers is a clearing requirement.  So the specter of the swap dealing designation, with its associated burdens, has actually led firms to transfer trading activity from the satanic swaps markets to the sainted futures exchanges.  Yay!

But arriving at this understanding would require actual, you know, reasoning.  Not much, but some.

And that is a bridge too far when it comes to the World’s Greatest Deliberative Body.  Which may be a correct description: if so, God save the world.

Harry D’Angelo and Rene Stulz have an interesting paper about bank leverage.  It makes a simple point.  Banks’ liabilities-notably, deposits-are someone else’s asset. That asset provides a benefit, namely liquidity, that depositors can’t realize by trading in capital markets, due to some friction.  This intermediation is what makes banks special.  As a result, depositors are willing to hold bank liabilities in exchange for a lower return than bank assets. Banks therefore have an incentive to create these liabilities-that is, to leverage up-to the maximum extent possible, in order to capture as much of this liquidity premium as possible.  This leveraging is a good thing, because it supplies an asset that is highly valued by those who incur high costs to access capital markets directly.

In the D’Angelo-Stulz model, bank equity is the capitalized value of this below market borrowing rate/liquidity premium.  If the liquidity premium is modest, the  supply of liquid claims results in a high debt to assets ratio.  Again, this high leverage is a good thing, because it is the consequence of the efficient supply of intermediation.  Banks access the capital market effectively engage in a form of asset transformation that generates value: those who cannot access the capital markets, or at least not as efficiently, cannot engage in this asset transformation, and they are willing to pay banks who can.  Through diversification and risk management, banks can engage in asset transformation that is valued by depositors.

This paper is most useful as a corrective to the rather annoying Admati et al “Bankers’ New Clothes” arguments that banks are excessively leveraged and should therefore be subjected to far more rigorous capital requirements, e.g., 25 percent equity.   Admati et al rely heavily on Modigliani-Miller type arguments, and D’Angelo-Stulz show that high leverage can be efficient when there is a single deviation from MM assumptions.  Bank debt (at least some forms of it-more on this below) provides a valuable device in the presence of a friction, and therefore issuance of this debt (in lieu of equity) is socially beneficial.

That said, there are some issues with the paper.

First, the formal model is very rudimentary.  It posits that those without access to the capital market are willing to pay an exogenously specified premium for bank liabilities that offer liquidity, i.e., guaranteed purchasing power.  But willingness to pay does not determine the equilibrium price of liquidity.  In a competitive banking market, the equilibrium price of liquidity is determined by the cost of producing it as well.  This is not modeled in the paper.  The marginal cost of engaging in intermediation/asset transformation must be upward sloping in order for banks to earn producer surplus (which, when capitalized, would be the value of bank equity).

Presumably, equity is one of the means by which banks are able to engage in asset transformation that provides reliable liquidity to those holding bank liabilities.  In essence, equity is a means of bonding contractual performance (a point I learned from reading Yoram Barzel years ago).  In the banking context, equity provides a cushion that ensures that depositors will be able to realize the face value of their claims at will-which is the essence of liquidity.  Thus, the reliability of the liquidity banks supply, and hence the premium that depositors are willing to pay, depends on the amount of equity (as well as on the asset side of bank balance sheets).  The paper does not address this interaction, taking equity value as a pure residual value driven by an exogenous liquidity premium that does not depend on bank equity.

Second, although deposits that provide liquidity to investors without ready access to the capital market are one part of bank leverage, banks, and especially systemically important ones, borrow in other ways, and the resulting liabilities do not have the same money-like characteristics as deposits.   The paper does not explain the entire capital structure of banks.  Indeed, it predicts that banks should be financed almost exclusively by the issuance of money-like liabilities.  They aren’t, so the paper doesn’t explain why banks issue debt that does not provide liquidity benefits instead of equity.  (Perhaps it could be argued that banks provide liquidity indirectly, e.g., by issuing corporate paper that is purchased by money market funds which provide money-like claims to investors.  But this still doesn’t explain the issuance of longer term debt.)

Third, this analysis relates primarily to commercial banks that issue deposits.  What about investment banks?  They are highly leveraged, and it’s not so clear that their liabilities offer the kinds of liquidity benefits that drive the results in the paper.  (Theories that argue that banks are too highly leveraged because of deposit insurance subsidies or access to central bank liquidity (at subsidized rates) don’t apply to investment banks either, because those didn’t have access to deposit insurance of central bank liquidity support.)

Fourth, the paper discusses systemic risk, but this discussion is a little glib.  Debt that provides valuable liquidity services under normal circumstances is fragile, and susceptible to runs.  When runs occur, money-like bank liabilities do not provide liquidity.  Presumably, this affects the liquidity premium, which means that it is unclear that banks issue too much debt.  But the paper can’t really address this question because the value of liquidity is specified exogenously.

All this said, the paper is still valuable because it makes an important point.  Existing theories of banks posit that banks are leveraged because debt addresses some sort of agency or information problem.  These are essentially supply-side factors. The D’Angelo-Stulz theory identifies a demand-side driver of bank leverage.

Bank leverage is a big issue now, with Basel III and Brown-Vitter.  Good policy regarding leverage (and hence, capital requirements) requires an understanding of its costs and benefits. Calling attention to the demand for bank liabilities, and the benefits they provide, is an important contribution to such an understanding.

The FSB is contemplating designating commodity trading firms like Cargill and Glencore as systemically important.  No, not that FSB: The Financial Stability Board, a group of global regulators established in the wake of the financial crisis.

The reason for this is, apparently, that these firms are engaged in shadow banking.  The linked Reuters story mentions two types of activity.

First, commodity trading firms extend trade credit and working capital to their customers.  Second,  some use securitization to raise funding.

The FSB is rightly concerned about shadow banking, but the kinds of activities that commodity trading firms engage in is quite different from some of the activities implicated in the crisis.

Some forms of securitization contributed significantly to the crisis.  Most of the most dangerous forms involved significant maturity transformation, and direct ties to big banks.  SIVs that funded portfolios of mortgage securities with short-maturity corporate paper, that were backed by liquidity puts provided by sponsoring banks are the prime example of this.  When investors began to doubt the value of the underlying assets, there were runs on the SIVs: they could not rollover their paper, and sponsoring banks ended up taking the now toxic assets back onto their balance sheets.  This was a big problem because the banks were highly leveraged; their main business is to provide credit; and they are essential components of the payment system.

The securitizations that commodity trading firms have engaged in, like the Trafigura program mentioned in the Reuters piece, are (a) far more limited, and (b) very different.   In particular, these structures do not involve the kind of maturity mismatch that was the Achilles heel of the SIVs.  Indeed, if anything, to the extent there is maturity transformation it is the opposite of the type that proved problematic in the crisis.  The underlying assets are very short dated (such as receivables) and/or very liquid (like inventories of aluminum in LME warehouses).  The assets typically have shorter maturities than the liabilities issued to fund them.  Indeed, one of the challenges of these structures is to replenish the assets as they mature.  Traditional SIVs had to rollover their liabilities: commodity trade securitizations have to replenish their assets.  The former is far more problematic than the latter because the run risk is far greater.

Moreover, historically the default rates on the trade receivables that are securitized are very, very small.  The extent data are for all trade receivables, not just commodity trade receivables, but the credit losses are trivial.

I also find little reason to be unduly concerned over the  the granting of trade credit and extension of working capital funding through prepayments and other arrangements.  Consider prepays, where a trading firm may provide funding to a refiner, say.  The commodity trader may fund the input (crude oil), and in exchange receive refined products.   The refined product is essentially collateral for the financing provided to buy the input.  Moreover, the value of this collateral can be hedged in most cases, limiting the credit exposure of the commodity firm extending the credit.   This is often quite different than extending credit to fund illiquid, hard to value, long maturity assets that cannot be hedged.

The commodity trading firm has a comparative advantage in marketing the output.  Moreover, due to its knowledge of the industry and the particular firms involved, it likely has information that makes it the most efficient creditor.  It knows more about the market and the particular borrowers than most banks.

The foregoing suggests that the credit risk and maturity transformation risk involved in commodity trading firm shadow banking activities is far less than that involved in the kinds of shadow banking that proved highly problematic during the crisis.  But credit losses are conceivable.  What would happen if commodity trading firms suffered big credit losses?

It’s hard to see how this could seriously threaten the stability of the financial system or the global economy.  Commodity trading firms aren’t that big: if Glencore is too big to fail, so is Kraft, or a similarly sized company.  Their assets are dwarfed by those of the big SIFI banks: they are about as big as many middling banks you’ve probably never heard of.  Moreover, the commodity trading firms are far less leveraged than big banks.  Furthermore, their capital structures are far less fragile, because they involve little maturity transformation: their short term liabilities are largely matched against short term assets, such as hedged commodity inventories.  The firms provide financial intermediation, but unlike banks, that’s not their primary function, so they are not as vital to the credit supply process as banks.  They are not essential elements in the payments infrastructure.

Commodity firms provide valuable logistical services, but the assets, human and physical, that they utilize are readily redeployed.  If one company goes bust, its assets can be redeployed so that the trade in commodities can continue.

Some of the shadow banking activities that commodity firms engage in actually take risk out of the banking system.   A major reason for the development of securitization in commodity markets was that big banks-especially French banks facing difficulties in securing dollar funding-cut their funding to commodity firms.  So the firms turned to securitization and thereby transferred the risk to the capital markets.  And unlike the case with SIVs sponsored by banks, there isn’t a backdoor by which this risk can make its way back to bank balance sheets.

I would also note that commodity trading firms do not benefit from deposit insurance, and so don’t pose the same moral hazard concerns as banks that do.

So I find few parallels between the kinds of shadow banking that proved so dangerous during the crisis, and the kinds of shadow banking that commodity firms engage in.

Commodity firms are first and foremost logistics specialists that engage in financing transactions to facilitate that business. A couple of other historical experiences suggest that such logistical intermediaries are not systemically important.

In 2002, the entire merchant energy sector in the US imploded.  These firms-companies like Enron, Dynegy, Mirant, and Williams-were primarily logistical intermediaries that provided financing and risk management services to their clients, just as global commodity trading firms do.  Not just one of these firms imploded.  The whole industry did: the stock prices of the firms in this business fell by about 90 percent between April and July of 2002.  But gas and power continued to flow. The impact on the US economy was barely measurable.

Furthermore, the experience of the Fukishima earthquake and tsunami suggests that even if the failure of one or more major commodity firms did disrupt commodity logistics for a time, the implications of this for the global economy would likely be small.  The earthquake and tsunami created huge disruptions in supply chains, especially in automobiles and electronics.  Trade was severely disrupted.  But the impact on the global economy was almost immeasurably small.  Studies undertaken by several governments found that the Japanese disaster shaved a tenth of a point or two off global GDP growth.  The financial aftershocks were minimal, even in Japan.  If the world economy can survive such a literal seismic shock that seriously disrupted supply chains in high valued manufacturing, it can almost certainly survive the failure of a big commodity trader.  Or two. Or three.  Especially since the Fukishima disaster destroyed or disrupted physical assets in a way that the financial distress of a commodity firm with redeployable assets would not.

I’d be more persuaded by the FSB’s concerns if it would provide a description of the mechanism by which commodity trading firms can be the source of financial contagion, or the channel through which contagion can be communicated from the financial sector to the real economy.  As those who have read my writings on clearing can attest, I can have a pretty vivid imagination about how contagion can propagate, and despite giving this considerable thought, I haven’t found a plausible mechanism.

In some sense, it seems that the FSB is like Mark Twain’s cat that wouldn’t sit on a hot stove after it had been burned, but it wouldn’t sit on a cold one either.  Once burned by shadow banking of one kind (the kind tightly tied into the banking system), it seems afraid of any kind of shadow banking.

And I have a pretty good idea who is stoking those fears.  I know, as the result of personal experience, that major banks involved in commodity markets are chafing under the restrictions imposed on them, and resent the fact that commodity firms that are their competitors in certain activities are not subject to the same restrictions.  I know they have been importuning the FSB to identify commodity trading firms as systemically important, and to impose bank-like disclosure and capital requirements on them.  All the better to hamstring the competition.

How I know this, I can’t say.  But I’m just sayin’.  You can take it to the bank, as it were.

Too big to fail is a self-fulfilling phenomenon, in large part.  It would be far less of a problem if governments could credibly commit not to bail out certain firms.  It becomes much harder to make such credible commitments when those firms are identified as systemically important.  Therefore, regulators should be very reluctant to confer the “systemically important” label.  Very reluctant.   Objectively, there are few reasons to consider big commodity trading firms-even the biggest ones-systemically important. All the more reason to eschew conferring that designation on them.

In other words, sitting on a cold stove isn’t dangerous.  The FSB should be smarter than the cat in Puddin’ Head Wilson.

HSBC’s Gary Dunn said something at the ISDA AGM that I think is very important:

Dunn pointed out the risk characteristics of a CCP are very similar to that of collateralised debt obligations, the tranched credit products that were prevalent in the run-up to the 2008 financial crisis.

In the CCPs default waterfall, the initial margin payments from clients and default fund contributions from clearing members are comparable to the equity or first loss and mezzanine tranches of a CDO. In other words, these are the first sources of funds that get eaten into to cover any losses.

According to Dunn, the super senior tranche (which in the case of CDOs tended to attract Triple A ratings, but often subsequently sustained losses during the credit crisis) is the additional steps the clearing house might take when all other funds are exhausted, whether it is haircutting, asking for more capitalisation from clearing members of possibly even a government bailout.

“If you start modelling the risks of a CCP as a CDO, you realise the correlation risks in a CCP aren’t at the moment fully appreciated, very much like they weren’t when we had CDOs and CDO squareds,” said Dunn.

“The probability of a CCP failing is still relatively low, but there is a reasonable probability that people or banks lose money even if a CCP doesn’t fail,” he added.

I can hear you saying: “Where have I read that before?”  Or: “When have you said that before?”  In January, 2011, now that you ask 😛

Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts.  Default funds are analogous to protection written on supersenior tranches.  The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices.  Indeed, margins are usually set to absorb 95-99 percent of market moves.  Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin.  If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.

This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances.  Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.

So it seems that CCPs are potentially vulnerable to wrong way risk.  They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem.  Which raises the question: are the dangerous dependencies likely to be present?  That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?

This is a big deal. Wrong way risk is particularly poisonous, and a source of systemic risk in systemically important institutions like big CCPs. Policymakers have been largely oblivious to this very important problem.  I’ve been on about it for over two years, but we see how that matters.  Maybe if people like Gary Dunn start raising the alarm this issue will get the attention it deserves.

But, of course, Anat Admati, etc., will dismiss this as self-interested scaremongering by banks, and will criticize me as being some sort of tool (which she has, by the way).

I understand perfectly that such self-interested scaremongering occurs.  But I also understand that sometimes there is a wolf.  This is one of those times.