Streetwise Professor

The futures industry is reeling over the latest theft of segregated customer funds, this time by Peregrine Futures’ Russell Wasendorf.  Wasendorf admitted to stealing seg funds in a note left at his side when he attempted suicide after it looked like his scheme was unraveling.  He has been indicted for fraud committed over the 2010-2012 period.  Over $200 million is missing, and his company is undergoing Chapter 7 liquidation.

Following hard on the heels of the MF Global disaster, the Peregrine revelations are raising further fears about what had once been considered sacrosanct: that customer funds are inviolate.  Even the CME Group, which has historically been a stalwart defender of the traditional segregation model in which FCMs are the custodians of customer money, has suggested that changes may be necessary:

Without question, the current system in which customer funds are held at the firm level must be reevaluated.

CME Group recognizes that the demand for its services is reduced to the extent that suppliers of complementary services-such as brokerage-are deemed untrustworthy.

I consider it virtually inevitable that this will be the last nail in the traditional segregation model.  This will lead to a dramatic change in the organization of the FCM industry.  Though (as I discuss a below) that industry was already under tremendous strain.  Peregrine and MF Global are symptoms of that strain.

Other big news this week was JP Morgan’s reporting of a $4.4 billion dollar Q2 2012 loss, and a $459 million restatement of its Q1 results-along with an admission that the “integrity” of the marks in the CIO books.

Do Peregrine, MF Global, and JP Morgan’s travails have anything in common, except for bringing further discredit onto the finance and banking industry?  I think they do.  I think they are all consequences of near-zero interest rates.

The traditional FCM revenue model relied on interest income from customer funds invested by the FCM.  Very low interest rates make that model unviable.  That is a major reason why Corzine felt it imperative to transform MF Global-and to take on more risk.  I conjecture that similar pressures led Wasendorf to commit fraud.  (Though his admission that he had been doing so for 20 years cuts against that interpretation.  A hypothesis: Wasendorf had been engaging in this activity on a smaller scale for years, but escalated it sharply as the financial pressures on Peregrine grew in the low interest rate environment.)

The Morgan story is different, but the extraordinary monetary policies that have driven interest rates to extremely low levels are at the center of the story.  Morgan had about $360-$500 billion in deposits that it needed to invest, but traditional investments such as Treasuries offered such low yields that the bank went hunting for yield, and invested in more risky securities and derivatives to get it.  Yield chasing in Fed-created low interest rate environments has contributed to previous big losses, such as Orange County’s in 1994.

Bernanke and the Fed initially pursued a low interest rate policy in an attempt to prevent another depression, and have continued it in attempt to spur growth.  These are the justifications for these policies, and they are defensible ones.  But these policies cause collateral damage.  Financial blowups-from MF Global to Peregrine to the Whale-are plausibly just that.

Like Freddie Krueger, I’m baaaaaack again, folks.  This time, more regularly, I trust.

Catching up on a few things that have caught my eye since last time-and like Freddie, I brought my knives.

1. The LIEBOR mess continues to metastasize.  It is now sucking in regulators.  Including Timmy! It appears that the dissembling about LIBOR, TIBOR, EURIBOR, etc., was the worst kept secret in the world’s financial centers.  And let’s pray that’s true.  If the Fed, the Bank of England, etc. DIDN’T know that there was a complete disconnect between the rates that banks reported to the BBA and the rates at which they were actually borrowing (or not)-now THAT would be a reason for panic.  In fact, they were all-bankers and regulators alike-operating pursuant to the Juncker Maxim: “When it becomes serious, you have to lie.”
2. I detest manipulation of markets, and have made a life’s work of studying it, calling out manipulators, and now and again testifying against them.  But I find it disgusting to hear high government officials in high dudgeon on the subject, when they are in fact often the most outrageous and shameless manipulators.  The most flagrant example: the Lilliputians who are the collective “leadership” of the EU and the Eurozone.  For what else can you call their repeated fudges, misstatements, lies, etc. related to the latest “solution” to Greece’s problems, or Spain’s, or Italy’s, than “manipulation”?  How many billions have changed hands on the EUphoric rallies that occur after the announcement of such solutions, and on the, umm, “retracements” that occur when the truth comes out.  The agreement on a Spanish bailout, and banking regulation changes, that came out of the most recent Summit of the Lilliputians is only the latest example.  Look.  Europe is screwed.  Metaphysically.  The math does not work.  Cannot work. Even mores, the politics cannot work.  The core is empty.  No real deal is possible.  Accept it.  And once you accept it, mock any pronouncement of the next “solution”.  And for God’s sake don’t buy except on the theory that other suckers buy and you will sell out before they do.
3. FCM Peregrine Financial Group apparently absconded with $220 million of “segregated” customer money.  This is both shocking and depressing 10 months after MF Global.  The scheme has apparently been going on for at least two years.  But the CFTC allegedly gave all FCMs the full anal probe post-MF, and saw-like Sergeant Schultz-NOTHINK! So since they can’t find a rather banal fraud at a middling futures brokerage, it’s truly obvious that they have game to regulate the entire world, and every complex financial institution and complex derivative trade in it.  What could go wrong? No doubt that the Peregrine debacle will lead to calls for more regulation.  Regulation, the only human activity where failure is the primary justification for more of it.
4. The CEO of inter dealer broker GFI, Mike Gooch, has said that hedge funds need to become liquidity suppliers/market makers in order to fill the gap left by banks, post-Volcker Rule.  I predicted this would be the outcome in a couple of posts written soon after the rule was mooted.  There is a serious question here: will this really lead to greater stability during times of financial turbulence?  Given that credit to hedge funds-which comes largely from banks, by the way (funny thing, that!)-typically contracts severely during periods of such turbulence, their market making activities are likely to contract as well during such times.  Meaning that market liquidity supplied by hedge funds will be highly pro-cyclical.  Bank supplied market liquidity is too, but the ones subject to the Volcker Rule-you know, the ones who have sticky insured deposits-are likely to be able to resist these cyclical pressures better than hedge funds because their funding is not as fragile.  So yes, Mike, hedge funds will be needed to fill the gap left by the exit of prop trading banks, but they won’t be there precisely when needed.  Things will work just swell.
5. Gazprom was named the most opaque corporation in the world.  I am shocked and stunned.  It is allegedly the most profitable.  Again, no surprise: government enforced monopoly is a nice gig.  But the company has been forced to make price concessions on contracts to big customers.  It is fighting a rearguard action against the flood of gas being discovered around the world.  It won’t happen overnight, but government mandated monopoly or no, the company’s future is not bright.
6. The to-ing and fro-ing over privatization in Russia continues.  Putin allegedly threw a spanner into Sechin’s ambitions to acquire “privatized” assets, including electricity generators.  But his words are pretty weak: “That does not mean we should limit ourselves to participation by Rosneftegaz.”  So you could envision some competitors in the bidding process, and them prevailing enough times to give the impression that a real privatization is going on.  But this is likely to be a Potemkin privatization, and Sechin et al are likely to prevail.  Sechin certainly thinks so: “Russia’s most influential energy official, Igor Sechin, said on Tuesday the state-owned energy holding Rosneftegaz was given permission to invest cash on its balance sheet in comments which seem to contradict assertions by a top government official [Akardy Dvorkovich].” I would bet on Sechin.  Hands down.
7. There is a spate of bad news about the weakness in China’s economy.  I have been a China bear for going on three years, or more actually.  The first reason for my pessimism has always been China’s ramshackle and rigged financial and banking systems: this predates the crisis.  This post provides an excellent overview of the reasons to find that system “scary.” Yes, the Chinese government has papered over past problems, but there are limits to this, as there are to all things.  Indeed, as the economy has gotten larger, and in the aftermath of the crisis and the massive monetary and fiscal response thereto, the state’s capacity to continue to do this is very questionable.  The second reason is that, contra Tom Friedman or Ray LaHood, I adamantly do not believe that the allocation of capital by the state, directly, and indirectly through financial repression and a hugely distorted banking system, will end well.  In fact, I believe the exact opposite is true.  Suppressing price signals and allocating capital to cronies and state owned enterprises is a recipe for grotesque misallocations of capital.  In the short to medium term, it can lead to impressive GDP numbers.  But spending insane amounts on investment eventually leads to catastrophe if that investment doesn’t produce returns.  That, in a nutshell, is what China looks like to me.  And these two sources of pessimism feed off one another: when the investments don’t generate returns, and in fact generate losses, the banks and trust companies and insurance companies and whatever that provided the finance are toast.  When you force feed a goose, you can at least get good liver pate (but not in California!).  When you force feed investment, eventually you get a bust.

That’s all for now folks.  Catch you again soon. Promise.

Barclays’ has copped to an attempted manipulation of LIBOR.  It has agreed to pay about $450 million to the UK’s FSA, the CFTC, and the USDOJ.  The CFTC filing states that Barclays had two motives for its actions.  First, when Barclays’ reports to LIBOR were high relative to other banks’ (which Barclays people referred to as having their head above the parapet) and thereby raising questions about the bank’s financial condition, it allegedly reduced reported rates in order to allay such fears.  Second, the bank’s traders allegedly influenced rate submissions, and conspired with traders at other banks to change their submissions, in order to advantage derivatives positions.

As I noted in 2008, when the story first broke, the second possibility created substantial legal liability for banks like Barclays that submitted the false reports.  Under the anti-manipulation law in effect in the US at the time, it was necessary to have specific intent to create an artificial price of something like the LIBOR-based Eurodollar futures contract.  The emails divulged today suggest such a specific intent.

Perhaps crucially, the Order only finds that Barclay’s attempted to manipulate, not that it had in fact succeeded.  This will be an important issue going forward.  To prove manipulation, and crucially, to collect damages, it will be necessary to show that Barclay and other submitters of LIBOR quotes indeed distorted the index, that is, they caused an artificial price in a futures contract based on LIBOR or some other interest rate like Euribor.

Proving this will be a very data intensive exercise.  Moreover, there are two distinct issues-the impact of manipulation on the final settlement price of the futures contract (which is based on LIBOR), and the impact of manipulation on futures prices prior to expiration.  The second issue will prove more challenging than the first because the connection is more direct in the final settlement price.  Even that will pose some issues, however, because of the necessity of identifying the “but for”, i.e., what interest rate should banks like Barclays have reported.   This will necessarily require looking at actual interbank transactions, raising the question of how many such transactions there will be during periods of time of money market stress starting in 2007.

These issues are not impossible.  Similar, and arguably even more challenging issues, were confronted in a class action lawsuit against those who misreported  natural gas prices to publishers like Platts.  (Full disclosure: I consulted with plaintiffs in that matter, and wrote a declaration in support of certain aspects of the plan of allocation of settlement monies.)

The whole fiasco does point out, yet again, the overriding importance of basing cash-settled indices on actual transactions, wherever possible.

This is becoming an important issue in oil markets as well, as “Price Reporting Agencies” like Platts and Argus are under great scrutiny.  But oftentimes the problem is not amenable to easy solution.  You can’t have a reliable transaction-based index that is not susceptible to manipulation if (a) there are few transactions, and/or (b) market participants have the option to report transactions.  Pharonic pronouncements from regulators that PRAs make bricks without straw are futile.

None of these issues are new.  I (and my colleagues at UH) dealt with them in 2003 in our efforts to create an “energy data hub” in the aftermath of the price reporting scandal post-Enron.  Voluntary reporting is extremely problematic.  Compulsory reporting (along the lines of one of the few salutary features of Frankendodd) is necessary (but not sufficient for some markets) to produce reliable price indices.  Arranging this on an international market like oil seems virtually impossible to implement, let alone enforce.

This is the longer explanation behind my rather cryptic quote from this WSJ article from last week.

Going back to LIEBOR, the Barclays $450mm coughed up is the first fine, but it won’t be the last one.   In the energy markets, the CFTC collected about $250 million: fines will be many multiples of that in LIBOR and Euribor and TIBOR and whatever.  And believe it or not, the really big money will likely be in civil litigation, and the battles will be much more intense there as well, IMO.

Luigi Zingales is a brilliant guy.  I find his advocacy in the FT of a return to Glass-Steagall less than brilliant.

Zingales identifies four reasons for supporting G-S.  Three are wildly implausible, the fourth hardly persuasive enough to justify a return to 30s-era regulatory structures.

The first reason is that it makes sense to restrict commercial banks’ participation in “very risky activities.”  There are at least two problems with this, when evaluated in the context of the financial crisis.

First, the investments and activities that put commercial banks at risk during each of the last two crises-mortgages and MBS in Financial Crisis I and sovereign debt in Financial Crisis II (the one currently ongoing, particularly in Europe)-were blessed by regulators as low risk activities.  They almost surely would have passed muster under Glass-Steagall.  There were other major banking crises under Glass-Steagall.  It is painfully clear that G-S is not sufficient to prevent banks from taking on risk in sufficient amounts to put individual banks and the banking system at risk.

Second, and I realize I am an apostate on this, although moral hazard is a concern associated with deposit insurance, funding and liquidity risk is as dangerous and arguably more dangerous.  Runs are more likely, the less sticky the funding.  Concentrating riskier activities in institutions like stand-alone investment banks that rely on wholesale markets rather than stickier insured deposits for funding increases the risk of destabilizing runs and makes the system more fragile.   It therefore seems extremely dangerous to allow the institutions with the riskiest funding hold the riskiest assets, and preclude the institutions with the safest funding not hold such risky assets.  Look for other means-such as risk-based deposit insurance premiums or capital requirements-to control the moral hazard problem.

Zingales’s second reason is that Glass-Steagall was simple.  Well, yes, the original bill was (as compared to Frank-n-Dodd or the Volcker Rule portion thereof) but there did grow up a thicket of regulations and interpretations and decisions around it.  This is inherent in any law that attempts to draw lines between activities: such laws generate efforts to engineer products that cross the lines in substance but seem to comply to the letter.  This generates a process of litigation, interpretation, regulatory challenge, etc.

And does anybody believe that if Glass-Steagall were to be brought back, it would be the same today as in the 1930s?  Glass-Steagall was simple in part because it was the product of simpler times  Financial markets are much more complicated today, and splitting the baby would be far harder.  Any attempt to do so would almost certainly result in a Son of Glass-Steagall that is far more complex, and far longer, than the nearly 80 year old original.

I have to say that Zingales’s third reason is cracked:

The third reason why I came to support Glass-Steagall was because I realised it was not simply a coincidence that we witnessed a prospering of securities markets and the blossoming of new ones (options and futures markets) while Glass-Steagall was in place, but since its repeal have seen a demise of public equity markets and an explosion of opaque over-the-counter ones.

I realize this is a newspaper oped, with tight space limits, but Luigi provides no serious evidence to support his realization that coincidence equals causation.  With respect to the demise of public equity markets, trading volumes have skyrocketed, and although there has been an increase in “dark markets”, such things existed in the glory days of G-S, just under a different name (“third markets”, for instance), and there are good economic reasons why this is so.  Moreover, some problems associated with equity markets are attributable to other regulations, notably Sarbanes-Oxley.

With respect to OTC instruments, Zingales’s characterization of cause and effect is muddled and ahistorical.  OTC derivatives began to grow rapidly in the 1980s, while G-S was still in force, but their growth was constrained by regulation.  However, it was legal uncertainty under the CEA that was the main problem, not Glass-Steagall.  This was addressed by the CFMA of 2000, rather than the Gramm-Leach-Bliley  (GLB-wouldn’t it have been funny if there had been a fourth co-sponsor with a name starting with “T”?) of 1999, which repealed G-S.  Commercial banks and investment banks both did OTC derivatives before GLB, and would likely continue to do them under Son of Glass-Steagall.  What’s more, they are constrained-over-constrained, IMO-by Frank-n-Dodd.

Zingales continues in a rather bizarre vein:

To function properly markets need a large number of independent traders. The separation between commercial and investment banking deprived investment banks of access to cheap funds (in the form of deposits), forcing them to limit their size and the size of their bets. These limitations increased the number of market participants, making markets more liquid. With the repeal of Glass-Steagall, investment banks exploded in size and so did their market power. As a result, the new financial instruments (such as credit default swaps) developed in an opaque over-the-counter market populated by a few powerful dealers, rather than in a well regulated and transparent public market.

But the IBs that got into trouble (Bear, Lehman, Merrill, Morgan Stanley) never had access to deposits post-GLB.  Not before, not after.  So the cause-effect link between the repeal of G-S and the explosion in size of IBs that Zingales posits (resulting from the the access to deposit funding for IBs inside CBs) never happened.

No one knows the exact cause (global imbalances, Fed looseness), but the financial system was flooded with funding liquidity in the 2000s.  That is what permitted the IBs to lever up and risk up, not a sudden access to insured deposits.

And by objective measures, markets were more liquid-substantially so-post-G-S.  Spreads were smaller.  Volumes were bigger.  The number of participants was larger: hedge funds proliferated, for instance.  Really, I don’t think anybody noticed the markets getting less liquid post-G-S.  If anything, the concern was that there was too much liquidity, too much trading.

And insofar as CDS are concerned, it is hard to believe that G-S would have (a) prevented the creation of these instruments, or (b) resulted in them being traded by something other than big dealer institutions.  Again, note that stand-alone IBs were major dealers in these instruments, and that they were first developed by a commercial bank (JP Morgan) prior to 1999.  In many respects, the disintermediation of banks by capital markets, a process that started and became quite pronounced under the G-S separation led banks into other, non-lending forms of intermediation.

I would also emphasize that there are intense economies of scale in responding to expansive regulation like Dodd-Frank, meaning that regulation can contribute strongly to consolidation in finance, with its consequent effects on competition, the number of market participants, and systemic risks.

Zingales’s history, in other words, isn’t history at all.

There’s another point here.  If G-S was that important, why didn’t its repeal lead to dramatic changes in market structure, with the demise of stand-alone IBs and the dominance of integrated, full-service universal banks with access to insured deposit funding?  Zingales’s narrative is inherently contradictory: he focuses on the metastasization of IBs post-GLB, but if you believe his story, the repeal should have caused IBs to shrink or die or get absorbed by commercial banks or turn themselves into universal banks funded substantially by deposits.  None of that happened.   Indeed, there were numerous studies in the mid-2000s, notably by the Fed, the Senate Banking Committee, and the St. Louis Fed that all concluded that GLB’s G-S repeal had very limited effects on the structure of US financial markets: most of the major changes in market structure had occurred in the 1975-1998 period.

It is also worth mentioning that the universal bank model that Glass-Steagall eliminated developed in a world without deposit insurance.  Indeed, Glass-Steagall created deposit insurance, which means that at least then implicit subsidies in deposit insurance couldn’t have caused the combination of investment and commercial banking.  Why should we believe that deposit insurance would cause such an integration today?  Especially in light of the fact that the elimination of G-S boundaries did not result in the absorption of investment banking into commercial banks.  Given the role that deposit insurance plays in Zingales’s narrative, this is a major problem for it.

Zingales also claims that the financial system was more resilient under G-S, and points to the contrast between the ’87 Crash (which was not followed by a financial crisis) and the ’08 debacle (which was) as an illustration.   I really don’t see any connection between G-S and how the broader financial markets fared post-Black Monday.  Zingales notes that commercial banks didn’t have problems post-Crash.  Well, investment banks didn’t either, for the most part.  The main difference is that in ’87, most equities were held by real money investors, not financial institutions: ditto the Dot Com crash.

In contrast, in ’07-08, the mortgages that cratered were held primarily by highly leveraged financial institutions-commercial and investment banks; many of these were destined to go to real money investors, but banks and investment banks were caught with them before they could securitize them and market them to real money.  Today, in Europe, sovereign debt is held mainly by leveraged financial institutions.  Banks today don’t hold huge amounts of equities, and an ’87-type event, where the crash originated in the equity market would probably have a similar result today.  The equity crash in ’08 was a response to the crash that was occurring in mortgages.  The events are very different.

And it is quite plausible that these two events were the direct result of regulations, notably the very favorable capital treatment of mortgages and MBS (especially those transformed into AAA securities despite the quality of the underlying collateral) and sovereign debt.

Luigi’s last point is that a divided financial industry is less effective in exerting political influence because commercial banks, investment banks, and insurers have divergent interests.  But again, commercial banks, investment banks, and insurers existed post-GLB.  There was not a wholesale shift to universal banking in the US.  Certainly this could have happened, post-GLB, but it didn’t.  The greatest impetus to consolidation was the crisis itself, when IBs either blew up or were absorbed into commecial banks.  Thus, again, the structural change that could have happened under G-S didn’t happen to that great an extent, meaning that the political economy didn’t change that much either.

Moreover, to the extent that the activities of financial institutions are siloed, as under G-S, they are not competing with one another in the marketplace.  This also limits their need to compete with one another in obtaining favorable legislation or regulation.  Each can focus its efforts on obtaining favorable laws and regulations pertaining to its silo.  Commercial banks focus on favorable rules for commercial banking activities; insurers focus on favorable rules for insurance; investment banks on favorable rules for broker-dealer and securities underwriting.  There is no Galbraithian “countervailing power” mechanism operating that pits investment banks against commercial banks when they are functionally separated a la G-S, because the very separation of these activities means that the firms in one segment are not competing for rents against firms in the other segment.

In brief, it appears that Luigi is aiming his argument at a world that could have arisen after the repeal of Glass-Steagall.  A world in which there was a decisive move to universal banking in the US, resulting in the disappearance of stand-alone investment banks.  Some certainly predicted that outcome in 1999, but it didn’t occur.  There were some changes in market structure, but only modest ones.  It is passing strange that Zingales attributes the growth in investment banks to a law that, under the most straightforward interpretation of his argument, should have led to their demise.  Most importantly, the mechanism that Zingales posits-the availability of cheap insured deposits to fund risk taking by investment banks-didn’t work that way in practice.  Risk taking was funded through the wholesale markets which were awash in money.  That was the vulnerability of the system.

Zingales’s history about the evolution of equity markets, OTC derivatives markets generally, and CDS markets in particular, is also suspect.

So when reading this article, a Mark Twain quote came to mind: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

Global regulators are lumbering towards announcing proposals on the margining of non-cleared swaps, though they will miss the original G-20 deadlines:

Global regulators said on Wednesday they will issue proposals in coming weeks on rules to encourage banks to put derivative trades through a central clearing house, but they won’t be ready for the G20 summit in June.

. . . .

The FSB said it will issue a consultation paper on setting globally agreed margin rules for trades that are cleared directly between two parties rather than through a central clearing house.

“Momentum on OTC derivatives has accelerated in recent months,” FSB Chairman Mark Carney said at a news conference in Hong Kong.

The FSB is expected to push for a minimum margin that banks must post on derivatives trades that aren’t processed through a central clearing house. The aim is to provide an incentive for trades to be centrally cleared, or at least ensure there is a lower risk of an uncleared trade running into difficulties.

Here we go again.  Regulators believe they know how to determine the risks of transactions, and price those risks.

This of course worked out so well with Basel II, which deemed that mortgage loans and mortgage backed securities and sovereign debt were low risk and provided incentives for financial institutions to invest in them.

How’s that working out?

The clearing proposals in particular are frightening for at least two reasons.  First, they are predicated on the view that clearing necessarily mitigates systemic risk, a highly misguided view as I’ve pointed out here for years. Second, and relatedly, the very policy of attempting to encourage the movement of transactions to CCPs will tend to increase the riskiness of CCPs by leading them to clear products that are not well-suited to clearing, thereby increasing the riskiness of CCPs.  And because these CCPs are systemically important, this creates systemic risks.

It is also interesting to note that this one regulatory effort my be undermined by another one.  The New! Improved! Basel Rules will set capital requirements for exposures to CCPs.  The prevailing belief is that this will result in low risk weights (2 percent) on exposures to CCPs.  But an analysis by JP Morgan suggests that actual risk weights are likely to be far higher:

New capital rules outlined under Basel III are designed to incentivise the use of a CCP by levying a relatively small 2% risk weight against a bank’s exposure to a clearing house. This charge is much lower than the punitive charges proposed against traditional bilateral non-cleared trades and is designed to make clearing more financially attractive.

However, in-depth research by JP Morgan analyst Kian Abouhossein and his European banks team has cast doubt on this presumption. Taking a hypothetical clearing house that is only 45% funded against its theoretical capital requirements, they argue that the move towards central clearing could in fact prove far more costly under the new rules than initially thought.

This is because the new Basel III rules are expected to require a higher risk weight for exposure to central counterparties that may be regarded as underfunded; the rules will also levy a higher charge depending on whether the ultimate counterparties to the trade are clearing members, or clients of clearing members. Banks that clear trades on behalf of clients will also be required to take credit valuation adjustment charges against those clients which represent a measure of potential loss in the event that client counterparty goes bust.

In summary, JP Morgan finds therefore that the proposed floor 2% risk weight can only be attained under specific circumstances. In reality, the bank argues, the real risk weighting could shoot up dramatically.

So on the one hand, global regulators are trying to encourage the movement of trades to CCPs, but other global regulators are devising rules that will (unintentionally) make CCP exposures extremely expensive.

I am sure this process of setting prices for counterparty risk will turn out just swell, and lead to an efficient allocation of  these risks.

All these various efforts to regulate margins and capital weighting for counterparty exposures are a species of centralized price control.  All such schemes are doomed to failure.  Doomed.  The regulators lack the information to determine the right prices, and are in fact at an information disadvantage relative to private actors, so these schemes inevitably result in substantial losses arising from adverse selection problems.  Moreover, it is grimly ironic that these schemes are touted as a means of reducing systemic risk, when in fact they are far more likely to create systemic risks.  As I’ve noted repeatedly (and as others, such as Roberta Romano have also pointed out), these regulated pricing schemes tend to encourage everyone to load up on the same risks, and it is these correlated risk exposures that create systemic risk.

These global Sorcerer’s Apprentices believe that they are preventing the next crisis.  It is more likely that they are casting the spell that will bring it about.

On the anniversary of the passage of Frankendodd, I named the swaps execution facility mandate as the Worst of Frankendodd.  There was intense competition for the honor, to be sure, but I stand by that conclusion.

Gary Gensler sortied into enemy territory at the ISDA AGM in Chicago to do his best to defend the worst.  My verdict (based on press coverage): #Fail.

Interestingly, although Gensler used to focus (wrongheadedly) on the supposed competitive benefits of a SEF mandate, in Chicago he tried to portray it as a bulwark against systemic risk:

“Transparency to the public lowers the risk [for] clearinghouses,” he told the conference.

“Clearinghouses can only survive if they have reliable pricing feeds on a daily basis to mark to market their positions, and also have reliable, liquid markets in default scenarios,” Gensler said.

“There is far less risk in a clearinghouse if you have both pre-trade transparency and post-trade transparency.”

Dealers have criticised the move to electronic execution of OTC derivatives, complaining the large size and small volume of trades means such rules are inappropriate for the market.

This is clearly-no pun intended-incorrect, particularly when viewed in the context of Gensler’s desire for extensive pre-trade transparency and near real time reporting of trades.

CCPs will obtain the prices of deals cleared through them, that they can use to determine marks on a periodic basis.  Moreover, they have access to information from member firms that will permit marking deals to market.

Pre-trade transparency is particularly irrelevant in this context.

And Gensler is positively delusional if he thinks that the pre- and post-trade transparency is going to ensure “reliable and liquid markets” in default scenarios-especially if those scenarios involve the default of a systemically important clearing member.   Note that even for normally listed, exchange traded products CME used an auction procedure, rather than normal trading protocols, to handle the Lehman default.  Also note that LCH was able to handle the Lehman IRS portfolio default in a pretty effective and orderly way even without mandated centralized trading.

Gensler appears to believe that OTC derivatives markets, even for cleared products, will be like exchange trade futures.  Hardly.  One size does not fit all.  The nature of the transactions, the transactors, and the products is very different.  That’s why there are different markets and different market structures: the different structures are discriminating ways of accommodating the diversity of trades and traders. Market structures are endogenous, and reflect the characteristics of trades and traders, a point that is lost on Gensler and all too many others.

Indeed, the biggest problem that CCPs will not be obtaining price information on fairly active products, even if those products trade without pre-trade or post-trade transparency: even without SEFs, it will be relatively easy to mark 10 year USD IRS or active credit indices to market.  The problem will be obtaining information on the value of the products that don’t trade.  Gensler apparently believes in the Field of Dreams Theory: if you build a SEF, the trades-and bids and offers-will come, for everything.

No, actually.  Many products traded OTC do not trade frequently.  That’s a major reason why a dealer market structure rather than a centralized auction market structure, predominates there.  Moreover, the life cycle of trading activity in OTC and listed products is quite different.  Exchange traded products start out illiquid, and if they become liquid at all, become progressively more liquid as their maturity/time to expiry declines.  With OTC products, the cycle is the reverse.  Five year and 10 year swaps are quite active and liquid, and a lot of deals are done.  Those deals live on, and the 10 year swap becomes a 9 year swap and then an 8 year swap, and so on, and these products are far less liquid than the benchmark maturities.  You can have all the SEFs in the world, and 3.35 year swaps ain’t going to be trading, and won’t even be bid or offered.  Meaning that it SEFs will matter exactly bupkus for such products.

What’s more, mandated pre- and post-trade disclosure has costs  (mainly in the form of lower liquidity as disclosure of trades and price information raises risks to liquidity suppliers, inducing them to supply less), and these costs will vary by product.  Again, one-size-fits-all is misguided in the extreme.  Gensler dismisses these costs, and pays even less attention to the heterogeneity of products and transactions.

ISDA has pretty much acquiesced to most of the clearing-related rules, but is still fighting hard against the SEF mandate:

A theme of the ISDA conference, which includes large dealers as well as users of derivatives, is that while central clearing reduces systemic risk, regulators should not impose new rules on how derivatives trade, because it could disrupt those established markets and reduce trading volumes.

“Listed and over-the-counter markets are completely different, and it’s important that lawmakers and regulators keep this in mind,” said [ISDA Chairman and Morgan Stanley’s head of Global OTC Clearing Stephen] O’Connor,

He added that the industry was open to more public reporting, but with restrictions such as not revealing the size of very large trades or delaying trade reporting. “We’re not anti-public reporting,” he said.

I agree with O’Connor, but you might say “but he’s biased and protecting the dealers’ gravy train.”  Fine.  But interestingly, a supposed beneficiary of what Gensler wants so badly, isn’t sold on the idea:

Michael Davie, head of LCH.Clearnet’s SwapClear platform, agreed that regulators, clearers and market participants must know what is going on, but public reporting isn’t essential.

As I’ve argued ad nauseum, regulators will know what is going (in terms of positions and trades) due to swap data repositories.  As Davie says, public trade reporting-particularly in near real time-isn’t important for CCPs to do what they need to do.  And as I state above, public reporting of trades won’t help CCPs at all if there are no trades.

No, Gary.  SEF mandates are still the Worst of Dodd-Frank.  And slathering on the systemic risk lipstick won’t make that pig any more attractive.

A quick comment about the ISDA AGM.  A perusal of the press coverage is fascinating.  Virtually every issue-every damn one-that is the subject of intense debate at the AGM was raised here on SWP, or in my academic writing years ago.  Going back to 2008-2009, and sometimes to the late-90s (obviously pre-SWP, but not pre-Pirrong clearing research).  That old Cassandra feeling is particularly powerful right now.  I was invited to participate in the meetings, but had to decline due to another commitment, which alas did not materialize due to the vagaries of court scheduling.  (No! I am not on trial!  Sorry to disappoint some of you.) It would have been a fascinating experience.

John Parsons and Antonio Mello at Betting the Business argue that the dominance of OTC derivatives is not indicative of their efficiency, but instead resulted from the banks underpricing credit risk:

The logic that OTC markets are superior only works on the premise that banks are competing with exchanges on a level playing field. But prior to the financial crisis of 2007-2008 (and until the effort to reform finance is successfully completed), the playing field has been not level: banks have enjoyed some significant privileges. Key among them was the failure of some banks and regulators to properly price the credit risk embedded in derivatives.

This is a very strong statement, and one which John and Antonio do not provide persuasive evidence.  Their evidence is a post at FTAlphaville by David Murphy, which details the history of credit value adjustments (CVA), and a BIS report.  David notes that although in the early days of OTC markets, banks did not charge for the credit embedded in derivatives, they eventually did so.  Parsons-Mello argue, based on the BIS report, that regulators lagged these developments, and did not impose adequate capital charges on OTC derivatives exposures, particularly on CVA exposures which were larger than actual default losses.

There is some empirical evidence that speaks to this issue.  Papers dating back to the 1990s demonstrated that interest rate swap prices vary with counterparty credit risk, although the effect was small primarily because netting and the fact that principal is not at risk in an IRS made the credit exposures relatively small.  Counterparty credit risk in CDS is much larger.  Recent work by Gandhi, Longstaff, and Arora found small pricing effects in intedealer CDS trades, that became larger in the aftermath of the 2008 Crisis.  They conclude that the small effect reflects the fact that most interdealer traders were collateralized, though by variation margin rather than independent amounts (the OTC equivalent to initial margin).  The use of collateralization to reduce credit exposure is inconsistent with the hypothesis that credit risk embedded in derivatives is underpriced.

No doubt Parsons-Mello would interpret the evidence differently than Gandhi et al.

Collateralization is one way to control credit exposure.  Credit limits are another.  Reducing credit limits of firms that suffer adverse shocks to creditworthiness would tend to reduce the impact of such shocks on pricing.  Since credit exposure can be managed on a variety of margins-pricing, collateralization, credit limits-just looking price effects is not sufficient to determine whether credit risks embedded in derivatives are overpriced or underpriced.

The Mello-Parsons argument depends crucially on inconsistent capital treatment across equivalent categories of risk.  It is also somewhat in tension with an argument that they have made before that collateralization mandates do not raise the costs of trading OTC derivatives.  As they have pointed out before (as have I), credit that is embedded in a derivatives trade can be unbundled into a default free (collateralized) derivative and an unsecured credit line.  If capital charges are set consistently across equivalent risks, regulations that reduce credit exposure in a derivatives trade (e.g., a collateral or clearing mandate) can and will be offset by a substitution of an equivalent form of credit, leading to little or no change in overall exposure, just a change in its composition.

There is no reason to believe that regulators set capital charges consistently.  I think that John and Antonio are arguing that they should.  I would suggest that this is an impossibility.  This has been a theme of mine in several posts relating to Basel rules (you can find more related posts by typing “Basel” into the search bar).  The capital charges are inevitably make crude distinctions between different sources of risk.  Banks who understand the true risks far better optimize their activities to take advantage of disparities between their more informed estimates of actual risk and the regulatory risk charges.  Moreover, they tend to do so in a way that is highly correlated across banks because they all face the distorted capital cost structure.  Maybe making derivatives-related capital charges more sensitive to counterparty credit risk will reduce the subsidy of risk arising in derivatives books and the risk exposure there will fall commensurately; but the resulting structure of capital charges are likely to subsidize another risk, leading banks to pile into that activity.

In other words, risk based capital charges are an extremely blunt tool. They are a form of regulated pricing, and like virtually all regulated price structures, lead to acute distortions.  I am skeptical that they are a reliable means of reducing systemic risk.  Indeed, by inducing correlated risk taking across financial institutions, they can actually exacerbate that risk. (Mello-Parsons do recognize the difficulties of setting the capital charges: I think the difficulties are so acute as to make it virtually impossible to get anywhere near right, and very easy to make big mistakes.)

Assessing a CVA-based capital charge also creates the very serious risk of inducing vicious cyles/feedback loops, especially during times of crisis.  CVA charges are based on CDS prices, and CDS prices vary not just with expected default rates and losses, but also embed risk premia and liquidity adjustments that depend on market frictions and market-wide conditions.  Put differently, CDS prices reflect default rates and losses in the equivalent measure, and the market chooses the measure.  During crisis periods in particular, as liquidity dries up and risk limits (e.g., VaR limits) bind, expected default losses in the equivalent measure rise relative to expected default losses in the physical measure, meaning that CDS spreads widen absolutely and relative to what the spreads implied by expected default losses.

With CVA-based capital charges, such widening in CDS spreads will lead to higher CVAs and more variability in CVAs, which depending on how the CVA charge is implemented, could lead to higher capital charges, or to actions intended to reduce capital charges.  Increases in capital charges raise the costs associated with outstanding positions and new deals, thereby leading to reductions in positions, increases in collateral postings, or both.  These will tend to exacerbate market stresses, as firms dump positions to reduce exposures (and CVA) and sell assets to raise cash to meet collateral calls, which will lead to additional price movements that can affect CVAs, and on and on.

Put another way, it binds regulatory capital very tightly to conditions in the CDS market.  The more concerned you are about the functioning of that market, especially during times of stress, the more concerned you should be about hardwiring regulatory capital requirements to the CDS market.

That is, like any market-price based mechanism for setting collateral or capital charges (think of VaR), a CVA-based mechanism is highly likely to be procyclical, and perhaps severely so.  This makes it a major potential source of systemic risk.

In sum, I do not discount the possibility that capital requirements led to an underpricing of credit risk in OTC derivatives, and hence caused these markets to be larger than they should have been, or would have been given requirements that discriminated accurately among different risks in banks’ books.  The evidence one way or the other is rather thin.  I am highly skeptical, however, of the ability of regulators to address this problem without creating others equally severe, given the information advantages that banks have and their ability to optimize their risk taking subject to the (distorted) structure of capital requirements.

Moreover, I am downright frightened of basing derivatives capital requirements on CVA, or any market-price based measure.  It is individually rational for banks to price using CVA, but tying capital charges to this measure will almost certainly lead to procyclical capital charges that are highly correlated across major financial institutions.  That is a very bad-and very scary-idea.

I therefore do not dismiss the Mello-Parsons diagnosis, though I am not completely sold.  I am particularly concerned that any “cure” could be worse than the disease.

The Commodity Futures Modernization Act has been demonized as a major contributor to the financial crisis-unfairly in my view. This view is ahistorical, and fails to understand what led up to its passage.  In brief, the evolution of derivatives markets, and particularly the growth of the swaps market in the 1980s and 1990s created legal and economic challenges that the Commodity Exchange Act, dating from 1922 with a major modification in 1936, was completely unable to handle.  The CEA was passed at a time where “off exchange” transactions meant $10 bets at bucket shops, not huge deals between major banks and corporations.  The categories of market participants and the kinds of derivatives traded that Congress had in mind when drafting this legislation were vastly different from those developed during the wave of financial innovation that began in earnest in the early-1970s. As a result, by the mid-1980s, and certainly by the 1990s, the regulatory framework in place was completely ill-adapted to market conditions.

In particular, the exchange trading requirement of the CEA constrained the ability of market participants to undertake mutually beneficial transactions.  Those entering into perfectly sensible OTC deals risked running afoul of the requirement, which put their transactions at considerable legal risk.  The CFTC responded to this situation by issuing a variety of interpretative statements and no action letters and exemptions that were intended to give relief to these transactions.  Soon a confusing thicket of ambiguous and often contradictory rulings, exemptions, no action letters and interpretations grew up around OTC derivatives trades. The legal, logical, and linguistic contortions became increasingly absurd.  Although these permitted certain transactions to go forward, they did not address the very serious risk that someone could challenge whole categories of OTC trades and instruments in court, and that a judge would find them in violation of the CEA.

This was the genesis of the CFMA.  The “modernization” was intended to create a legal framework that reflected modern market reality, and which gave legal certainty to economically beneficial transactions.  It was an effort to clear the thicket, to replace an often absurd and contradictory set of ad hoc improvisations with a coherent structure.

The fundamental problem that CFMA was intended to address was that legal and legislative categories did not correspond to market reality.  The CFTC reacted by crafting ad hoc fixes.  But in the face of rapid innovation, the bolting of one ad hoc fix onto another created a vast Rube Goldberg contraption that was an accident waiting to happen.

Move forward 10 years from CFMA to Frankendodd.  Frankendodd creates numerous categories of instruments and market participants-swap, securities swap, swap dealer, major swap market participant, and on and on. It then delegates to multiple regulators the task of establishing detailed criteria describing these categories. Frankendodd itself weighs in at 2400+ pages, and the myriad regulations thereunder will run to many thousands of additional pages.

And that will just be the beginning.  The proliferation of categories that do not correspond to market realities today, let alone market realities in the future that develop in response to fundamental economic changes, financial innovations, and the regulations themselves, will lead to serious contradictions between what makes commercial and policy sense, and the letter of the law and the regulations.  The regulators will inevitably respond today the way they did in the 1980s and 1990s-with ad hoc responses intended to address the specific transactions and transactors at issue, with only passing regard for the coherence of the overall set of rulings and interpretations.  A Talmudic mind will be required to sort through it all.

Lawyers will rejoice and prosper-hence the rejoicing-because the most important design consideration for a transaction or a new structure will be how it can be jiggered to satisfy the regulations and interpretations, rather than the most efficient way to achieve a particular economic objective.  And even then there will be considerable uncertainty given the inevitable contradictions in the regulations, interpretations, judicial rulings, and on and on.

In due course, the whole edifice will become utterly unworkable and incoherent, and create a real systemic risk-a risk arising from the serious legal uncertainty that is inevitable.  And the problems arising out of Frankendodd will be all the worse than those arising out of CEA because it is more sweeping, the markets are more complicated and international, and the categories and distinctions and requirements it creates are vastly more numerous.

The ink on some regulations arising out of Frankendodd is barely dry, and this regulatory dialectic is already beginning.  The regulators are already making ad hoc adjustments.  From the FT:

US regulators are exploring ways to give large foreign banks and overseas subsidiaries of US lenders a reprieve from stringent new derivatives rules, potentially alleviating one of the biggest concerns facing global financial institutions.

The US Commodity Futures Trading Commission is looking to grant a temporary exemption to swap dealers that may fall under the jurisdiction of foreign financial authorities from complying with a host of post-financial crisis regulations governing derivatives transactions, people familiar with the matter said.

If you think this exception is the exception, you have another thing coming.  This is just the beginning of the dialectic.  Moreover, the international nature of the derivatives industry, and the creation of laws, rules, and regulations in different jurisdictions around the world will just accelerate it.

Within a period of a few years, derivatives regulations will be another absurd Rube Goldberg contraption.  And in its inimitable fashion, Congress (and the EU-if it still exists) will feel compelled to pass The Derivatives Modernization Act of 2020 (to choose a realistic round number).  Mark my words.

The CFTC had to play Goldilocks and decide the level of OTC swaps activity required to make a firm a swap dealer and thereby subject to the collateral and capital requirements and other obligations entailed in such a designation.  Earlier proposals ($100 million, then $3 billion) were commonly deemed too small.  Industry proposals were deemed to be too big.  The Commission decided on $8 billion, with the possibility of reverting to $3 billion depending on the results of forthcoming data collection and analysis by the Commission.

The usual suspects-like “Better Markets”-claim that the limit is far too big, and represents a huge loophole.  Genlser (no Goldilocks, if you know what I mean) fired back, claiming that the limit was actually quite small, compared to the immense size ($300 trillion notional) in the US swaps market.

These kinds of debates are frustrating in any event, because cutoffs like this economize on information, but are inherently arbitrary.  They focus on the easily measured, rather than the economically significant.  They reduce multi-dimensional problems to a single dimension, which inevitably leads to distortions.  In particular, they provide incentives to devise transactions and structure business to circumvent the rule.

The real questions that should be asked in determining the criteria for swap dealer designation are: What is the market failure that this regulation is intended to address? and What criteria will mitigate that market failure in a cost-effective way?

The whole justification for Frankendodd is that derivatives pose a systemic risk.  Systemic risk, properly understood, involves some sort of externality.  One potential externality is that a default by one large derivatives trading firm can lead to a daisy chain of defaults.  Another is that default costs are passed onto taxpayers in the form of bailouts.  Swap dealer designation, and the consequent regulation of their activities, are supposedly intended to address these externality problems.

Viewed from this perspective, $8 billion in notional amount seems like a very small number.  Based on BIS numbers, market values are about 3 percent of notional amounts.  Applying this to an $8 billion notional gives a market value of $240 million.  The financial system can withstand such a default, and even several such defaults.  Yes, counterparty risk also depends on gross amounts, but even an $8 billion loss is not catastrophic, especially inasmuch as any such loss would be spread over a number of counterparties.

To put things in perspective, look at the notional holdings of firms whose collapse or threatened collapse arguably posed a systemic threat.  LTCM’s derivatives book was $1.25 trillion-in 1998.  That’s 2 orders of magnitude bigger than the $8 billion figure being imposed 14 years later, when the markets are substantially larger.  Lehman’s was about $35 trillion-over 4000 times the  $8 billion threshold.  Bear Stearns: $13.5 trillion, about 1700 times the $8 billion. AIG’s notional was down to $1.6 trillion-200 times the threshold-at the time of its default.   And note that Lehman and AIG failed nearly simultaneously.

I am unaware of any default by a firm with $8 billion notional that created a systemic risk.

So I am in the too small camp.  I don’t know exactly what the number is, but there should be a pretty close correspondence between firms that are deemed to be systemically important and those that are subject to the requirements imposed on swap dealers.

Yes, the default of a firm with $8 or $10 billion in notional would presumably be painful for its counterparties.  But absent any knock-on effects, any externalities, that loss is internalized by the contracting parties.  This does not require any regulation to protect them.  Let them protect themselves, contract as they will, and live with the consequences.

I should also note that swap dealer regulation, which is effectively microprudential in focus, and which attempts to regulate only a part of firms’ capital structure, will not have the desired effects on systemic risk even if it is applied only to systemically important firms.  As I’ve noted repeatedly, firms can contract around this restriction, and will substitute different forms of leverage-and potentially riskier and more fragile forms of leverage-for the leverage squeezed out of derivatives transactions through collateral requirements.

In sum, all this to-ing and fro-ing over the swap dealer rules has resulted in a regulation that is far more inclusive than necessary to achieve its ostensible purpose of reducing systemic risk.  Moreover, the whole idea is fundamentally flawed for a reason I’ve written about often: it is virtually impossible to reduce the risk in the financial system by regulation of the pieces.

Posner & Weyl are continuing to flog their idea of an FDA for financial products.

I wrote about this really, really bad idea in February.  Given the swooning over the Posner-Weyl proposal, that post needs to be re-released.  So here it is.

I don’t need to change a word.  The FDA idea is a very bad one and the metaphor is completely inapposite.  Posner and Weyl are repeating their argument, and so my rebuttal needs no change.

It is good to see that not everyone is swooning.  This blog at The Economist rips into the proposal.  Great!

But gee, the points in the Economist post seem familiar.  Very familiar.  Every damn one.  To the points I made two months ago.

Purely coincidental, I’m sure.