Streetwise Professor

Betting the Business has a recent post that is a paean to central clearing.  I have some major problems with it.

The problems start with the title: “Central clearing lowers end-user costs.”  That short, unqualified, declaration begs major questions.  Most importantly: If clearing is more efficient, why did cleared markets lose market share to the putatively less efficient alternative, bilateral uncleared OTC trades?

I’m not suggesting that such inefficient outcomes are possible, but I take it as a rebuttable presumption that competitive processes tend to result in the displacement of the inefficient by the efficient.  So I’d like to see a convincing story at least, backed by some anecdotes at least, that would represent a plausible rebuttal.  That’s a low bar: it would be preferable, of course, to have a rigorous model supported by empirical evidence.  But I’ve yet to see anyone clear even that low bar: indeed, very few have tried.  To be honest, BTB don’t in this piece.

And by “convincing,” I don’t mean stories that rely on bankers’ Svengali-like hold on their customers, or customers suffering from some variant of battered spouse syndrome.  These stories are facially implausible, and indeed, counterfactual during the period during which OTC derivatives markets grew dramatically, the 1980s and 1990s.  This was a period in which banks were suffering “disintermediation”: they were losing business and customers to capital markets that customers found more efficient sources of capital.  So, the Svengali thing wasn’t working so good when it came to traditional loan business.  Ironically, many of the big loan customers that banks lost simultaneously began trading OTC derivatives with them.  Also ironically, one of the major reasons that the CDS market began was that banks were losing their traditional loan business.  JP Morgan in particular made a strategic decision to develop CDS business aggressively because it was facing more intense competition from capital markets in making traditional loans.  Which all means that customers–especially big ones–have the ability to adopt more efficient ways of financing and managing risk.

My other big problem with the BTB piece relates to netting:

Central clearing, if managed appropriately, helps to reduce the volume of credit risk by cancelling out many offsetting positions, disappearing some credit risk and leaving us with a smaller, residual credit risk from derivatives trading. One of the problems with OTC markets is that brokers wanting to closely guard their clients don’t have an incentive to cancel out offsetting exposures to counterparties. Critics of the clearing system keep overlooking the fact that risk can in fact disappear. The derivatives market system, depending upon how it is structured and operated, can have more or less total credit risk.

The notion that multilateral netting necessarily reduces risk is incorrect regardless of whether one focuses on credit risks in derivatives alone, or takes the proper perspective of looking at credit risk in toto.

With respect to credit risk in derivatives taken in isolation, clearing some products and not clearing others–which is inevitable given the unsuitability of some products for clearing, and indeed, the refusal of CCPs to clear them–may exploit some scale economies from multilateral netting in a particular product, but can destroy cross-product scope economies.  For instance, clearing a credit index but not all the names in the index destroys the scope economies that a bank can realize by holding positions with customers in both the index and the components.  Or if an interest rate swap is cleared but an interest rate swaption is not, netting economies across these products are lost.  These are simple examples, but they could be multiplied ad infinitum.

Indeed, these cross-product netting opportunities are one very plausible explanation as to why clearing lost ground to bilateral markets dominated by dealers.  Dealers trading multiple products can exploit cross-product netting economies and thereby offer their customers lower costs.

What’s more, when we consider clearing-as-it-will-be-in-this-messy-world, as opposed to the Platonic ideal of clearing, even within a single product clearing mandates may reduce netting economies.  Jurisdictionalism is likely to result in the creation of multiple CCPs for a given product type.  For instance, it is likely that regulators in the US and Europe insist that CCPs for particular products be established in their jurisdictions, and that financial institutions subject to their jurisdiction will use these “home” CCPs.  That creates operational headaches and reduces the netting benefits of clearing.

A proper, systemic approach also demonstrates that the disappearance of risk, like a magician’s trick, is often an illusion that works because the audience’s eyes are fixed in one place, and therefore they miss where the real action is.  As I pointed out several years ago, taking derivatives positions and the capital structures of market participants as given, netting redistributes risk from derivatives counterparties to other holders of liabilities on these derivatives market participants.  Yes, multilateral netting (and bilateral netting supported by collateral, rights of offset, etc., for OTC deals under bankruptcy laws) reduces the credit risk in derivatives trades, but the risk doesn’t disappear down the magician-CCP’s hat: it is reallocated to those who have lent money to the firms that hold positions in the netted derivatives.  Netting puts derivatives counterparties closer to the front of the line of creditors in bankruptcy.

Now the issue of the proper priority of derivatives is a sticky one, and I don’t claim to have the answer.  Giving derivatives counterparties priority tends to reduce their incentive to run, but it can increase the incentive of other creditors to run.  And in equilibrium, capital structures will depend on priority rules.  So it may be the case that clearing reduces the risk of runs on derivatives dealers by their derivatives counterparties, but increases the risk of runs by their repo counterparties, or the buyers of their corporate paper. It’s unclear how that cuts.  (No pun intended.)

Though I don’t have the answer as to the optimal priority rules, I do realize that netting does affect priority–and that this means that statements about netting “making risk disappear” are not generally true, and are typically wrong, because these statements are based on only a portion of the total risks.  The risk no more disappears due to a change of priorities achieved through netting than the rabbit really disappears into the magician’s hat.

It should be noted, moreover, that this issue of netting and priority has long been understood in other contexts, notably in payment systems.  Work in the 1990s and early 2000s (by Charlie Kahn, among others) emphasizes that netting systems and real time gross settlement have different affect the priority of payment system participants relative to other creditors of those systems.

There are some other problems with the BTB analysis, but I’ll just mention them in passing.  They say:

Margins are paid by those who use the system. In the OTC markets, banks either correctly price risk, or trade with clients by granting these subsidies from the taxpayer, or from wealth transfers by their bond holders. Clearing and margining is a potent dissuader of free riding on the system by negligent brokers, and also helps to mitigate agency conflicts between bonus motivated bankers and the bank’s stakeholders, which, we have learned, includes the taxpayers/citizens of each country.

I can’t say that I fully track that paragraph, but I will say that I am struck by the free riding analysis.  It suggests a sort of transubstantiation, where bankers are agency-conflicted, or perversely incentivized due to too big to fail subsidies when acting individually, but somehow become less conflicted and better incentivized when they act collectively through a CCP (and most CCPs will be bank dominated).  It’s not obvious how that works.  Indeed, collective action problems and multi-task/multi-principal agency problems usually result in weaker, not stronger incentives.

In this regard, it should also be noted that the homogenization of credit risk in a CCP creates problems.  CCPs make all trades by all members fungible, even if those members bring differing amounts of credit risk to the system.  This tends to reallocate trading activity away from the more creditworthy to the less creditworthy.

I also consider this unrealistic:

And to protect the public, it is necessary for regulators to see and be able to manage the true volume of credit supporting derivatives trading. Clearing is part of making that possible.

Given the fungibility of credit, you will never unambiguously know how much credit is used to support derivatives trades, even in a cleared system.

I have other issues (I can just imagine you exclaiming: “I’ll say!”), but I’ll leave it at that.  Suffice it to say that there are major holes in this clearing paean, and that it certainly does not provide a firm basis for mandating the adoption of central clearing.

After the close of the markets on Friday, S&P downgraded US long term debt from AAA to AA+.

This is news, but shouldn’t be a surprise.  The rating agencies are like the cop who draws the chalk line around the murder victim’s body.  They just validate the obvious.

No, the arithmetic tells all.  When the government spends roughly 25 percent of GDP, is currently generating revenue at less than 15 percent of GDP, and historically has had receipts no more than 20 percent of GDP, the debt will grow at between 5 and 10 percent of GDP per annum.  The debt is already at high levels, both historically, and relative to levels that have sparked fiscal crises in other countries.  The official debt, moreover, is only a fraction of the government’s commitments.  Add it all up and the blind should be able to see the writing on the wall.  It reads “fiscal crackup coming to a country very near you.”

The administration and its acolytes have two stock responses.  The first is to screech that S&P made a “math error.”  As John Taylor notes, it’s not a math error: it’s a disagreement about assumptions.  The administration claims S&P should have assumed that discretionary spending would grow at the rate of inflation.  You know, because all the king’s horsemen and all the king’s men have pinky sworn on it.  They passed a bill and everything.  In this scenario, due to real GDP growth, spending would fall as a fraction of GDP.

S&P assumed that discretionary spending would rise at 5 percent, roughly the rate of nominal GDP growth (real growth plus inflation).  In this scenario, discretionary spending as a fraction of GDP would remain constant.  Given the historical record, this may in fact be conservative.  But under this assumption, the increase in debt over 10 years totals $2 trillion more than the administration claims.

The administration and its pilot fish have also huffed that S&P’s analysis is “political.”  Uhm, isn’t sovereign risk all about politics?  If not, please tell me what the hell it is about.

The second response is purely political–and Orwellian.  It is to repeat ad nauseum the Big Lie that this is the Tea Party downgrade, attributable lock, stock, and barrel to the failure of the Tea Party caucus in Congress to even countenance taxes as a part of any debt ceiling deal.

Like all Big Lies, this one is based on a kernel of truth: S&P did explicitly mention the unwillingness of the Republicans to include tax increases as a part of any deal as one of the justifications for its decision.

But pinning the blame on the Tea Party is fundamentally dishonest because if its adherents had its way on spending and taxes, S&P would probably give the US a AAAA rating.  Indeed, the singlemost important thing driving the Tea Party is concern bordering on obsession that the country is headed into the fiscal abyss.  The Tea Party caucus’s objection to all the proposed debt ceiling deals was–and is–that the deals did not confront this existential problem in a serious way.   They thought that something has to be done now, and the looming debt ceiling would give them the leverage to make such a confrontation possible.  I think their tactics were counterproductive because they did not take into account the objective correlation of forces (to use the old Soviet military phrase).  But they were–and are–the only sizable group that is taking seriously the underlying structural problems that led to the downgrade.

Ask yourself this: if Obama had gotten his original wish, and the debt ceiling had been raised “cleanly”–no deals on spending or taxes–would S&P have downgraded the US?  I can’t see how it could have been otherwise.  If anything, the Tea Party rebellion made a deal with a higher likelihood of slower deficit growth possible.  Under any reasonably plausible counterfactual, it is highly likely that the objective factor that drove the S&P decision–i.e., debt growth–would have been higher without the Tea Party than with it, because the ancien regime would have just gone on with business as usual.  Which means that the downgrade cannot be credibly laid at the feet of the Tea Party.

The reason the divide between the Tea Party and the ancien regime is so wide is that the two factions have fundamentally different views of the problem, based on fundamentally different views of the proper scope and size of government.  The Tea Party doesn’t consider raising taxes to be a constructive part of any effort to address the problem because its members believe that spending is the problem, not the way the spending is financed.  They believe that the government is too big, it spends to much, it spends badly, and that raising taxes just extends, but only for a little while, the life of Destructive Leviathan–whom they would rather starve than feed.

In contrast, the ancien regime–which is dominated by the left, but which includes much of the Republican Political Class as well–doesn’t believe that the government is too big.  Many of them–especially in this administration and the progressives in Congress–think if anything the government is too small.  From that perspective, the only issue is how to fund Constructive Leviathan, which makes taxes the beginning and end of the conversation.  From this perspective, the Tea Party is completely unreasonable in its refusal to raise taxes, and hence responsible for the downgrade.

That’s the divide, and it’s an unbridgeable one.  That should be the issue on which the 2012 election is fought.  If that election produces a new correlation of forces that moves policy closer to the Tea Party ideal of less spending, entitlement reform, and tax reform, there is a very good chance that the US will be upgraded.  If, in contrast, it merely perpetuates the ancien regime–where continued stalemate would constitute perpetuation–we’ve only taken the first step on the Downgrade Trail.  And if Obama prevails, the rest of the trip is more likely to be a sprint than a stroll.

And I cannot close without reminding you all of Timmy! the Treasury Secretary’s unqualified assertion, repeated often, that a downgrade would not occur.  “No risk,” sayeth Timmy!  Asked a second time, Timmy! repeateth: “No risk.”

Another fail.

But be there gladness in your hearts, peasants, for Timmy! will stay through the 2012 election.  For nothing succeeds with this administration like failure.

Zero Hedge provides a reminder of the approaching automatic triggering of an increased haircut on Spanish and Italian government bonds in RepoClear.  Earlier this year LCH indicated that it would increase margins on Irish bonds when the spread hit 450 bp, and Italian and Spanish debt is reaching that level.

This is the kind of action that is individually rational for a clearer to take, but which can be destabilizing, pace my earlier posts on the hike in silver margins earlier in the year.

The haircut spiral plays a central role in a recent paper by BOE Financial Stability Executive Director Andrew Haldane and two co-authors.  The paper is nicely done, and the use of numerical methods to study the highly non-linear dynamics of complicated financial networks is the right way to go.

I am not persuaded that the paper focuses on the real sources of financial crises, however.  The reason is directly related to my post earlier in the week on clearing and systematic risk.  Haldane et al study how an idiosyncratic shock to the bank-specific haircut of a particular bank can propagate through a complex, densely connected network.  In some cases, such a shock can lead to a systemic crisis resulting from a cascade of banks deciding to hoard liquidity.  Not surprisingly, they find that the likelihood and intensity of such a contagion depends on the connectedness of the network, the skewness of the sizes of firms in the network, and the size and connectedness of the bank hit by the shock.

But I remained unconvinced as an empirical matter that major financial crises, at least in recent years, have developed in this fashion.  For this story to work, a single bank–and in the Haldane et al results, that bank would likely have to be a very big, highly connected one–is hit by an idiosyncratic shock that results in it having to pay higher haircuts on its secured lending.  In the real world, this could happen as the result of a rogue trader risk or some other major operational failing.

Perhaps the canonical example of such an episode would be the Kervial debacle at SocGen.  But even though that occurred when the markets were already stressed (in January, 2008), it didn’t lead to contagion.  I would be interested to hear of other examples, but I can’t think of any that have led to the cascade of failures like that that plays the central role in the Haldane et al analysis.

Instead, the major financial crises, most notably that of 2007-2008, the one that may be impending,  1998, etc., have been marked by an adverse shock hitting virtually all major financial institutions due to the similarity of their balance sheets.  European banks today are on the brink because they are all–all–heavily exposed to Eurozone government debt, and in particular to PIIGS debt.  This is a system-wide shock–a systematic shock, not a diversifiable, idiosyncratic one that is magnified through the web of interconnections among banks.  Such interconnections, margin spirals, liquidity hoarding, and so is a real possibility and could exacerbate the effects of the shock, but the point is that what is going on now, and what went on in 2007-2008, and what went on in 1998 is very different than the mechanism studied in the Haldane et al paper.

Perhaps many of the recommendations that Haldane and his coauthors make based on their analysis of the propagation of an idiosyncratic shock carry over to the case of a common shock hitting virtually all banks.  For instance, bigger liquidity cushions might be stabilizing in this situation as they are in the Haldane et al setup.

But maybe not.  Especially when one considers that for a variety of reasons–financial repression among them–sovereign debt is, and likely will remain a major component of any liquidity buffer.

That doesn’t work so well when the collapse of the creditworthiness of the governments issuing the debt is the root of the crisis, as is the case today.

I recommend the Haldane paper, but I think that it,  and many other papers that are based on tracing out the implications of idiosyncratic shocks to individual banks in a dense network, aim well wide of the mark.  I would like to see empirical work–hell, a case study, or even an anecdote–showing this mechanism working in practice.  If it is instead the case, as I am highly confident that it is, that financial crises are typically the result of an economy-wide, non-idiosyncratic, shock, the mechanism will be different and the policy implications will almost certainly be different.

A conjecture: in such a world, the greatest crisis accelerant is the similarity of balance sheets across major financial institutions.  To some degree, this cannot be avoided.  But there is no doubt in my mind that uniform regulations–and the Basel standards and other coordinated risk-based capital requirements–encourage even greater similarities in balance sheets.  This is a real danger, and if my conjecture is correct, many of the efforts currently underway to harmonize capital and liquidity requirements could make crises more rather than less likely . Basel Faulty and all that

The self-interested role of governments in cramming down more of their burgeoning debt will only exacerbate this problem, as regulators have an incentive to tilt capital and liquidity requirements in favor of holding government debt.  As dodgy as that debt is these days, it’s hard to imagine a better way to create the next crisis.

I’ve been humming It’s the End of the World As We Know It for the last couple of days, and having 2008 flashbacks. Although a much attention has been on the US, the real epicenter is in Europe–though the US will not be immune, and is in poor shape to withstand the shock.

Europe is experiencing, I think, its Wile E. Coyote moment. It has been levitating over the chasm, for a lot longer than Wile E., actually. But with Italy and Spain in dire straits, and Greece, Ireland, and Portugal well-known basket cases, economic gravity is about to reassert itself.

Runs, be they on banks, currencies, countries, or romantic (but unnatural) supernational groupings, are coordination games, with multiple, self-fulfilling equilibria. The global games literature shows the role signals that agents get about the economic circumstances of the bank or currency, etc., play in sparking runs. Small changes in these signals (which are noisy representations of the fundamentals) can induce discontinuous changes in behavior by millions.

To some–like the old goat who is the Italian prime minister–the discontinuity of these changes demonstrate that “the market is wrong.” The abrupt shifts are no doubt disorienting to politicians and policy makers. But it’s not like there isn’t precedent–and it demonstrates the dangers of trying to skate by and avoid making fundamental changes that would appreciably reduce the likelihood of wandering into the run risk zone.

It may be well too late, coming as it has in a week when US government debt (the official stuff, not counting the countless zillions in government liabilities that aren’t in the calculation) breached 100 percent of GDP, but one would hope that American policymakers are taking serious notice. One would hope–but hopes like these are made to be disappointed, I fear. Europe is playing Ghost of Christmas Future. We should take heed, but probably won’t. The debt deal charade, and the hyperbolic reaction of the left to it (e.g., Rep. Doyle’s lament that the evil Tea Partiers have left the government without “any money to spend”, give or take $4 trillion) and the impending election mean that nothing serious will be done voluntarily before 2013.

Too many are taking solace in the fact that interest rates on US debt remain low–and indeed, are going lower as money flees Europe. But the European experience shows, yet again, that these things can turn on a dime. Or a trillion or two.

The aftershocks are being felt everywhere. Japan is playing beggar-thy-neighbor with its currency. Moreover, these events put a particularly interesting twist on Putin’s recent tirade before a Nashi audience about the parasitical US.

One consequence of the market shock has been a steep decline in the price of oil. Brent crude is down about $10/bbl in the last two days. A sustained economic downturn would put further pressure on the price.

Putin’s electoral strategy is to use oil rents to promise all sorts of goodies, including both guns and butter–a huge defense procurement binge and higher social spending. It is likely that this would be reversed post-election, as even with $120 oil these promises are unaffordable. Putin thought he was in fat city with turmoil in the Middle East and emerging market growth propping up the price. But now he realizes that–yet again–his grandiose plans are hostage to things outside of his control.

No doubt, like me, he is having very unpleasant flashbacks to 2008, when his dreams last came crashing to earth due to economic turmoil in the US. You know it just makes him hysterical to realize that he is at the mercy of the US. That his fate is driven largely by a country and a society he despises.

Put differently: if the US is parasitical (and there are certainly parasitical aspects to US policies, although the main host is productive Americans), then Putin and Russia are little more than parasites living on the bigger parasite. (H/T R), but I cleaned it up: check her out on Twitter for the unexpurgated version).

No, Vladimir. There will be plenty of pain to go around. You no doubt will rage at the injustice of it all. But few will listen, as they will have their own problems to deal with.

PS. I included this in the “Financial Crisis” category. I may have to add a new category to distinguish posts on the next financial crisis from the last one.

Central counterparties work on the principle of mutualization.  CCP default funds are a mechanism for mutualizing–sharing–counterparty loss risk, where the CCP-insurer has some protection in the form of a “deductible” that consists of the defaulter’s margin plus default fund contribution.

Insurance works when risks are diversifiable.  So, to the extent that the risks of default exhibit relatively little correlation across clearing members (CMs), mutualization through a CCP can improve the allocation of risk: through diversification, the variability of the average default loss across all CCP members is smaller than the variability of any CM’s default loss profile.

It should be noted that these diversification effects work in OTC markets too: market participants who deal with multiple counterparties diversify exposure to counterparty losses.  Moreover, in OTC markets, it is often possible to hedge counterparty risk through the CDS market.  [Which raises a question: how do you hedge CCP credit risk?  It is highly unlikely that CDS will be traded on CCPs.  Perhaps using a portfolio of CDS on CMs?  But who clears those CDS?  Sounds like the wrong way risk from hell.]

CCPs have been sold as a means of reducing systemic risk.  The basic story is that in bilateral OTC markets, the failure of one entity can cause the failure of other entities in falling-domino-like fashion.  In this telling, a CCP reduces interconnectivity of the financial market, and thereby reduces the likelihood of that the failure of one firm–even a big one–will cause the failure of others.  Put differently,  in this view default/counterparty risk is insurable because it is diversifiable, and therefore mutualization can improve the allocation of risk.

But is the domino-model really a good description of systemic risk?  Is the system really threatened by the isolated, idiosyncratic failure of one firm, even a big one?

Here’s an alternative story, in which a big, system-wide shock hitting many institutions simultaneously is the source of systemic crisis.  Some examples: Black Monday in 1987, the Asian and Russian crises in 1998, and the subprime meltdown of 2007-2008.

In such episodes, there are large price moves across asset classes.  These price moves often blow through margins–and by a lot.  During the subprime crisis, for instance, even well-before the Lehman episode, some prices moved by huge amounts.  In August, 2007–more than a year before Fannie-Freddie, Lehman, and AIG–David Viniar of Goldman lamented that there had been several 25 standard deviation moves in multiple markets.  In a “normal” (Gaussian) world, 25 sd moves don’t occur.  Period.  People don’t set margins based on the possibility of 25 sigma moves.  So when such moves occur–and they occur in the real, non-normal world–margins get blown through.  Meaning that if someone defaults, they’re well into the default fund, and the protection of the “deductible” is gone.

Moreover, such earth-shaking episodes are typically associated with adverse shocks to bank (CM) balance sheets.  What’s more, such events raise serious doubts about the solvency of banks/CMs: adverse selection problems can run rampant, causing markets to freeze.  This tends to cause funding and liquidity to dry up.  Due to actual insolvency, and illiquidity driven by widespread fears of potential insolvency, those facing big margin calls may face substantial difficulty in meeting them.   Thus, they are more likely to default.  This is what happened to AIG and Lehman.

Since the shock hits all financial institutions simultaneously, and since the shock is big, this risk of default is not idiosyncratic; it is highly correlated across firms.  Given such a shock, if one firm defaults, others are at elevated risk of default too.

If defaults that breach margins occur, the surviving CMs who contribute to the default fund must absorb the loss, and take a hit to their capitals.  But this hit occurs exactly when capital is very valuable/costly for them.  That is, hits to the default fund are likely to come at the absolute worst times–during adverse moves in the overall market.

It is possible that a CCP’s default exposure in such a circumstance could crater the clearinghouse.  But even if the CCP survives, its surviving members suffer a loss (via to their exposure to the default fund) when they can afford it least.

This has some interesting implications.  In particular, it means that the systematic risk of default fund capital is very high, which in turn means that default fund capital is extremely expensive.  The default fund is like a deep out of the money short put on the market.  Such puts are essentially bets on systematic risk, and hence are very expensive.

The expense of such capital means that CMs are likely to want to minimize the amount they post.  They have every incentive to try to construct risk measures that make CCPs look safe, with very low risk of default, in order to reduce their exposure to the default fund.

Think that this can’t be done?  Think again: that was essentially the entire game in CDOs.  As Coval-Jurek-Stafford show in an AER paper, “super senior” CDOs were claims that had low probabilities of default, but that defaults would occur precisely during periods of crisis–analogous to the foregoing characterization of the risk profile of default funds.  C-J-S present empirical evidence that these CDOs–which were AAA rated–were grossly underpriced, meaning that those who were buying these securities didn’t fully appreciate how heavily they loaded on systematic risk because analysis–and ratings–were framed almost exclusively in terms of unconditional default probabilities, and the rating agencies and many investors and regulators ignored the fact that defaults would occur when the value of capital was very high.  I can see the same thing happening with CCPs–who will reflect the interests of their members–focusing on default probabilities to justify their capitalization to regulators.

Another interesting implication is for what instruments should be cleared.  Instruments that have big losses during big systematic shocks–those that load heavily on systematic risk–are exceptionally dangerous for CCPs.  This means that clearing things like senior or supersenior tranches (or derivatives on them) is exceptionally dangerous.

This has a corollary: anybody that uses AIG to justify clearing mandates doesn’t know what the hell they’re talking about.  AIG’s positions in derivatives on supersenior tranches were, as C-J-S show, systematic risk time bombs.  Clearing those things would dramatically increase the systematic risk of default funds, because they would expose default funds to losses precisely during systemic crises.

Some people know this.  Jon Gregory, for instance.  When discussing “market coverage of a CCP”, he states:

Finally, CDO tranches (especially supersenior) would be expected to have serious correlation [i.e., systematic risk] impact since in a scenario where there are losses on these tranches it is likely that many CCP counterparties [and CMs] are in a distressed state.

The above analysis is to some degree subjective but one general point–probably beyond argument–is that the most important trades products to be traded through CCPs are arguably the most risky from the point of view of the stability of the CCP.  There has been much recent interest to trade all CDS index products and single-name products through CCPs. . . . The general point is that the products that market participants will most want and need to trade through a CCP will be the precise products that are most difficult to handle in this way (pp. 381-382).

In sum, the belief that CCPs can reduce systemic risk is predicated on a particular narrative of  the likely source of a future crisis.  This view is that the failure of a single institution, arising from some shock idiosyncratic to it (a bad trading decision, an operational risk such as a rogue trader) can lead to the failures of other institutions via a contagion mechanism.

But, in my view, that isn’t an accurate characterization of the actual crises that have occurred over the years.  These have been associated with broad-based shocks that hit large numbers of institutions simultaneously.  Again: Black Monday, Asia/Russia, subprime.

There have been multiple examples of large, one-off collapses of highly interconnected and leveraged institutions that have not resulted in a cascade of failures that led to a systemic crisis.  To name several off the top of my head: MG (1992), Barings (1995), Amaranth (2006). For a while, it looked like the Hunt collapse in 1980 could have broader, systemic consequences, but that fear evaporated rather quickly.

The contrast between the effects of the collapse of Amaranth in 2006 and the crisis surrounding the problems of LTCM in 1998 is particularly instructive.  Amaranth was actually bigger than LTCM (though it should be noted that the markets were bigger too), and had large OTC positions.  The difference was that Amaranth’s collapse was not caused by a systematic shock, whereas LTCM’s was.  LTCM engaged in strategies that blew up because of major shocks arising in Asia and Russia.  It was thus on the verge of failure precisely when liquidity had dried up, and its (big bank) counterparties were in bad financial shape because of the crisis.

The Amaranth collapse was effectively a diversifiable risk, and potentially clearing improved the allocation of that risk (many of Amaranth’s positions were cleared).  But the bilateral markets could have likely handled it quite well too.  In contrast, LTCM’s risk was not diversifiable.  Clearing would have still passed the risk of its failure onto stressed financial institutions, and likely resulted in some similar emergency measure to mitigate the impact of its huge losses.  (I’ve long argued that the same would have been the case with AIG.)

Along these lines, FTAlphaville has a very interesting post describing some forthcoming research which shows that incorporating “common jumps” into models of index option prices go a long way towards explaining the volatility skew, and reconciling the skews of index components and the skew of the index:

According to a technical paper published on Risk.net by Alex Langnau, global head of analytics at Allianz Investment Management and Daniel Cangemi, head of FICC trading at EFG Financial Products, Wall Street’s next top (risk) model is actually a copula that attempts to explicitly link correlation skew to systemic risk so as to improve tail risk management of large portfolios.

The basic premise lies in the idea that the downside risk of a portfolio of assets is generally substantially higher than the downside risk of its components — because assets tend to correlate more strongly in times of crisis.

. . . .

As the authors conclude this could become extremely useful for trying to figure out the additional risk attached to asset portfolios:

We have presented a generalisation of the Merton jump option formula to multi-assets as well as diffusive skews and found that common jumps are an appropriate and intuitive way to define copulas that describe the systemic risk of a portfolio.

Financial institutions should start treating systemic risk as market data across asset classes and start to mark, risk-manage and price these effects in a systematic way.

This suggests that these common jumps are of first order importance.  And these common jumps aren’t diversifiable.  What I argue above is that the major risk that CCPs face arises from such system-wide, common shocks.  And in the event, mutualization is all but irrelevant.  Except, perhaps, to the extent that CMs attempt to limit their exposure to this risk via the default fund by undercapitalizing CCPs, thereby threatening the ability of these vital–and soon to be even more vital–pieces of market infrastructure to survive a systematic shock.  In which case, mutualization makes things worse because if some CCPs don’t survive, the knock-on effects from the original shock will be even more catastrophic.

In some respects, the issues I’ve discussed here reflect an older literature on bank runs.  One view of bank runs is that they are idiosyncratic in origin (i.e., a bad shock–perhaps even a sunspot–hits a single bank, leading to a run), but have systemic effects due the interconnectedness of the financial system.  In this view, widespread panics spread like a wildfire from a single, isolated spark.

An alternative view, associated most strongly with the work of Calomiris and Gorton, is that runs occur when depositors receive adverse information about the aggregate economy, which raises concerns about the viability of all banks.  In this view, panics involving runs at many financial institutions reflects the fact that all banks are exposed to a common risk.

The Calomiris-Gorton view, and the evidence they amassed to support it is persuasive.  In more recent times, major periods of crisis have been associated with a common shock hitting many financial institutions, rather than from the contagion of an idiosyncratic shock to one big institution laying low otherwise healthy institutions.  In these types of events, mutualization of risk isn’t of much help, and can actually make things worse.  Meaning that clearing mandates were sold largely on the basis of a misleading portrayal of, or misunderstanding of, the real dynamics of financial crises.

One takeaway from this is that there should be a very hard look at CCP capitalization, and at measuring the cost of default fund capital.  The exposure that default funds face to systematic risk affects the cost of capital–and hence the cost of clearing.  That cost should be taken into consideration when deciding the scope of clearing mandates–that is, when deciding what should be cleared.   For the analysis suggests that clearing can be very expensive, and that a major source of cost has been largely overlooked.  Forcing too much to be cleared can create costs with no corresponding benefit.

This morning’s recon mission for derivatives-related stories turned up bumper crop of realizations that should have been painfully obvious, but were not made when it could have made a difference–meaning that the real pain is to come.

First, from the FT:

Quite simply, the regulators succumbed to the sheer volume of rulemakings and an avalanche of comments from the industry. There was not enough time to meet the deadline, and it became clear that implementing Dodd Frank was going to be far more complicated than initially thought.

Thought by whom, exactly?  We need to know, because anybody who admits to not foreseeing a train wreck should be disqualified from further comment or participation in these matters, (a) for not foreseeing the obvious, and (b) for copping to such cluelessness.

Next, from Financial News.  In response to the rhetorical question “Are clearing houses ‘too big to fail'”, Ben Wright writes (heh):

It is a real concern that not enough people have asked this question before now and even more worrying that no one has provide a satisfactory answer.  [The answer is almost certainly yes, though I guess that is unsatisfactory substantively.]  As the possibility of some form of huge sovereign credit event grows ever-more imminent, a solution need to be found, and fast.

It’s a little late to start thinking about packing a parachute when you’re already 30,000 feet up. But that’s Frank-n-Dodd in a nutshell (with an emphasis on the “nuts”).

Wright also recalls a speech by the BoE’s Paul Tucker (which I blogged about in June), in which this worthy

said clearing houses had to think of themselves as system risk managers and start behaving as such.  Clearing houses should, therefore, steer clear of procyclical margin practices, monitor the soundness of their members, and plan for their disappearance.

No disagreements here, except that it is insane to think that CCPs will think of themselves as “system risk managers.”  Because they aren’t “the system”, but only part of it.  They will act in their interest and the interest of their members.  That is quite different from–and often contrary to–acting in the interest of “the system.”  Clearing does not internalize most of the key externalities that create systemic risk, and all the wishing and should-ing in the world won’t change that fact.

And from Dow Jones:

Dealers and clearing experts have urged regulators to introduce so-called living wills for clearing houses, warning that a “credible” plan for unwinding critical pieces of market infrastructure is “vital to financial stability”. The comments come amid growing fears that the US government’s inability to raise its debt ceiling could prompt a global credit event.

. . . .

Roger Barton, founder and managing director at Financial Reform Consultancy, said: “It is arguable that the whole issue of clearing house resolution should have been addressed earlier.”

“Arguable”?  Go out on a limb there, Roger.

I wonder if it’s possible to fashion a parachute from the seat covers and a few stray blankets in the overhead bins.

Then there’s this article on portability in Risk.  It’s long (and gated), but the moral of the story is easily stated: this is a major issue, with systemic implications, but which is totally up in the air.  (Lot of company up there.)  There’s one on portability in the FT, coming to pretty much the same conclusion.

What, never heard of portability?  Apparently the Sorcerer’s Apprentices hadn’t either.

I could go on.  In recent days there have been numerous articles about myriad issues in clearing–collateral, margining, capital requirements, and on and on–all of which are (a) unresolved, and (b) of first order systemic importance.  All the important details were left to the end–most likely because those that demanded the system remade it, and wrote legislation demanding its remaking didn’t even know what the relevant details are.

An entire system that evolved organically with all of the complexity and interconnectedness that implies is being re-engineered on the fly.  Anyone even marginally cognizant of the complexity of the system would have been too humble to even contemplate remaking it root and branch.

But unfortunately, the marginally cognizant weren’t in charge.  The imperious, overconfident, ignorant, and foolish were–some were all of the above.

That never works out well.

Yes, today marks the one year anniversary of the day when The Monster slouched off of Capitol Hill (aka Frank-n-Dodd Castle) to begin its rampage of error and terror in the countryside.

Believe it or not, I’m not grateful, despite the never-ending source of material that it has provided in the past 12 months.

It is hard to pick the Worst of Frank-n-Dodd.  There is much to choose from, and the competition is intense.  There is one element, though, that is particularly indefensible, and which happens to be in the news now, so it will get special billing in this Special Anniversary Post: The Swaps Execution Facility (SEF) mandate.

It is indefensible for a variety of reasons.  For one thing, the ostensible purpose of Frank-n-Dodd is to reduce systemic risk, and it is very difficult to make a case that requiring trading of swaps on exchange-like platforms has anything to do with systemic risk.  It is particularly interesting to note that the Europeans, who are on board with the Dodd-Frank stuff that at least is related to systemic risk (like clearing and margining of derivatives) are deeply skeptical, not to say contemptuous, of the SEF requirement.  They show no signs of adopting anything even like it.

Moreover, the SEF requirement seems to reflect some extremely childish understanding of markets.  Exchanges– transparent and good.  OTC markets–dark and scary.

This cartoonish view of markets completely fails to recognize the tremendous diversity of transactors and instruments in the market place.  It is sensible that this diversity has given rise to a diversity of trading mechanisms adapted to the traders and instruments.  Shoving everything into a one-size-fits-all framework with intense pre-trade and post-trade transparency–and transactor anonymity–presumes that all traders and all traded instruments are effectively alike.

Wrong.  Gary Gensler regales everyone with tales of how the improved transparency is going to reduce transactions costs for the buy side and end-users, and these benefits will more than offset the other, uhm, inconveniences arising from Frank-n-Dodd.  Which is kind of weird, because the buy side and end-users have been largely critical of the SEF mandate, and comfortable with the current way of doing business.  As I’ve said before, Gensler’s Fairy Tale presumes that the supposed beneficiaries of the SEF mandate are suffering from some sort of battered spouse syndrome, and love and protect their bankers despite the abuse that the latter allegedly dish out on a daily basis.

It’s also weird because the OTC markets grew absolutely and relative to exchanges–by a large margin–pre-crisis.  Given the choice, the buy side and end-users more often than not chose to trade OTC. Absent mass ignorance of self-interest, this very strongly suggests that it was cheaper for the buy side and end users to trade on these markets.

Has Gensler, or any of the other SEF evangelists, provided a convincing explanation of these facts?

No,they haven’t.  They haven’t even tried.

A non-cartoonish analysis of transactions and transactors makes it perfectly clear why the OTC markets have flourished.  A big part of that is the very basic fact that for many traders exchanges with pre- and post-trade transparency but trader anonymity are more costly places to trade.  Uninformed traders (e.g., big hedgers or pension funds) trading in size typically trade more cheaply in face-to-face markets with negotiated prices, rather than in anonymous auction markets where their orders get lumped with the trades of the informed, and hence get filled at worse prices.  This is why dark markets, block markets, etc., have always been with us, and why OTC markets are frequently the venue of choice for big buy side and commercial traders.

The SEF mandate is bad enough, but as hard as it is to believe, the CFTC proposals are even worse.  Gensler and Chilton in particular clearly want to make OTC markets as exchange-like as possible, and are pushing SEF rules that would sharply constrain the diversity of execution platforms.  The CFTC is taking an even more extreme approach to this than is the SEC.

Which is why it is encouraging to see that this is one part of Frank-n-Dodd that is the target of a legislative effort for overhaul.  Representative Scott Garrett (R-NJ) has sponsored a bill that would sharply limit the kinds of requirements the CFTC or the SEC could impose on SEFS:

H.R. 2586 prohibits the CFTC and the SEC from interpreting the SEF definition to: 1.) require a minimum number of participants to receive or respond to quote requests, 2.) require a SEF to display or delay quotes for any specific period of time, 3.) limit the means of interstate commerce that market participants can use to execute swap transactions, or 4.) require one trading system (i.e. RFQ) to interact with another trading system (i.e. Limit Order Book) on the same SEF.  These prohibitions are necessary to preserve investor choice of execution, promote transparent price discovery for market participants, and decrease the costs of hedging for American businesses, farmers, and retirement plans, all of which contribute to economic growth and job creation.

I’d prefer no SEF requirement at all, but at least this bill would give market participants a lot more lee-way to develop systems that accommodate the diversity of trades and traders.

As to its prospects–I have no idea.  But hopefully this is a harbinger of efforts to chain The Monster and bring some relief from its depredations.  That would be a good thing–despite anything Timmy! says.

Laurie Carver of Risk passed along this BIS/Basel Committee on Banking Supervision Consultation Paper that proposes a methodology for measuring whether a bank is a “global systemically important bank” or G-SIB.  Laurie perceptively points out that a bank’s OTC derivatives exposure is included as one of the factors in the proposed index that will be used to determine systemic significance, but that cleared derivatives exposure is not. Since capital charges will depend, under the proposal, on the index score, this means that OTC derivatives exposures will affect capital requirements, but cleared exposures will not.

This is a major mistake.  A bank’s exposure to CCPs, and perhaps more importantly, CCP exposures to banks, are of major systemic importance.  The failure of a large bank with a large book of cleared derivatives, both proprietary and client, would pose a substantial risk to the CCP, the other banks that are members of the CCP, and to the broader financial system.  Moreover, via the liquidity channel, large cleared exposures can also be destabilizing, as when a big bank needs large sums of cash in a hurry to meet margin calls on cleared trades.  Indeed, due to the rigid timing deadlines of CCP margin payments, it is my belief that cleared exposures put more stress on the liquidity channel than OTC deals.

Put differently, CCPs are a channel of contagion, and a potential source of shocks that create contagion.  What’s more, they don’t internalize all the externalities that the BIS cites to justify stricter regulation of big banks.  Indeed, as I’ve argued repeatedly, CCPs actually create some perverse incentives (in particular, moral hazards) that can increase systemic risks.

It is particularly disappointing to see this glaring oversight at this late date.  Although the proper time to debate the clearing issue was over a year ago (the Frank-n-Dodd anniversary just passed), it did seem that serious people were coming to recognize that the idea that CCPs were a panacea for derivatives-driven systemic risk was an unrealistic dream, and were therefore thinking far more seriously about how to deal with the systemic risks arising from CCPs.  Even the Basel Committee had genuflected to this understanding, and incorporated a capital charge for cleared exposures into the Basel III proposal.  Hence, the Consultation Paper seems to be a retrograde step back to the unrealistically optimistic view of CCPs as safe.

This attitude is very dangerous.  The longer it persists, and the more widespread it remains, the higher the likelihood that cleared derivatives will play a major role in creating or exacerbating some future financial crisis.

Update: Laurie kindly pointed out that my description of the implications of the G-SIB index score was misleading.  The G-SIB score affects only the systemic risk capital surcharge; cleared derivatives are included in the standard capital calculations.  Bad drafting aside, the basic point stands: the proposal implicitly assumes that cleared derivatives do not contribute to systemic risk.  Danger, Will Robinson!

Betting the Business (i.e., John Parsons and Antonio Mello) notes that the Coalition of Derivatives End Users has backed off its more extreme claims about the effects of clearing and margin mandates.  John and Antonio have been correct to point out that Frank-n-Dodd requirements may just result in the credit implicitly bundled in derivatives deals being unbundled, by the extension of a loan or a credit line.  (This is something that I also pointed out in my Cato piece last year).  But they have not explicitly addressed an implication that I pointed out, and specifically asked them to analyze.  Specifically, if margin requirements merely result in making implicit credit explicit, how do these requirements affect the aggregate amount of credit in the system?   This is the crucial question because the amount of leverage in the system is the first-order driver of systemic risk.

The End User Coalition’s letter makes this point:

Margin lending facilities offered by banks (and especially if offered by [Swap Dealers] or [Major Swap Participants] [as will almost surely be the case], would merely re-allocate and re-label risk, but not materially reduce it.  What was formerly a derivatives exposure risk would be converted to a lending facility risk.  A counterparty default from a derivatives obligation would have the same impact on a bank as a default on a margin lending facility obligation.  In other words, changing the form of the risk does not eliminate the risk (p. 10).  [Emphasis in original.]

. . . .

Some have suggested that end-users that traditionally pledge non-cash collateral cold continue their operations by using a secured financing facility.  Like the margin lending facility discussed earlier in Section II.B.3., a secured financing facility does little or nothing to remove risks from the system.  Instead, it simply changes the name of the risk from derivatives exposure to financing facility exposure (pp. 11-12).

Exactly.  And exactly as I’ve pointed out for well over a year.

Revealed preference suggests that implicit and explicit credit are not perfect substitutes.  Indeed, the End User Coalition letter points out (on p. 12) why a secured lending facility may be an imperfect substitute for using non-cash collateral in a derivatives deal.   Thus, the imposition of the constraint will be costly for firms, and will lead to less hedging.

But the Parsons-Mello main point–and the important implication–remains unchanged: substitutions of one form of credit for another will limit, and perhaps sharply so, the effects of margin and clearing and capital mandates on the amount of leverage in the system.  Since leverage is the source of systemic risk–what’s the point?

I also think that P-M are too dismissive of contentions that the regulations as written will result in deadweight losses.  This is because the amount of margin required can be so large as to require firms to alter drastically their capital structures, and such alterations are costly and can result in some of the inefficiencies the Coalition laments.  As the Coalition letter points out, for non-cleared swaps, the margin requirement is quite onerous: the margin must be sufficient to cover 99 percent of 10 day price moves.  That’s a lot.  This will likely require firms to (a) hold far larger amounts of their assets in liquid instruments, and hence less in more productive assets, (b) reduce their derivatives usage, or (c) most likely, both.

Margins and liquidity are costly.  That’s why firms strive to manage liquidity tightly, and are quite sensitive to margin: the amount of collateral and the form in which it must be held are definitely not matters of indifference to them.  A big margin requirement, and a requirement that the margin be posted in liquid assets, will definitely be a binding constraint, and its shadow price will be non-trivial. I don’t know what it is, but I know it’s not zero–primarily because firms optimize with respect to margin costs.

All this means that, at best, the margin requirement and capital requirement rules on end users will merely lead to a relabeling of credit and will not alter the economic substance of end user’s balance sheets.  (Similar arguments hold for financial institutions too.)  At worst, the constraints will result in costly changes to these balance sheets: excessive holding of liquid assets (can you say financial repression?), deficient investments in higher returning illiquid assets (i.e., the productive assets that enhance productivity), and too little hedging.  I read M-P to mean that the margin requirements on end users will merely lead to a relabeling, and that the requirements will not alter balance sheets.  I think that is far too sanguine.

And for what, exactly?  Under the best circumstances (i.e., no change in the economic substance of balance sheets), systemic risk doesn’t change a whit.  Under the worst circumstances, capital is misallocted, risks are misallocated, and there is no reduction in systemic risk (because end users do not contribute to it in a material way).  So, in the best of outcomes: no gain and no pain; in the worse ones, all pain and no gain.

Such a deal.

One final quibble with Betting the Business.  They state:

But of course an implicit credit line embedded in the bid-ask spread has great advantages to dealer banks. It is hidden, bundled with the derivative contract sold and therefore difficult to figure out by client end-users, who never really know how much they are paying for the amount of credit extended. Welcome to the opaque world of OTC markets.

Who cares how the cost components of a derivatives deal break out?  The end user cares only about the all-in cost, and the bid or offer is sufficient for end users to figure that out.  They can solicit quotes from multiple dealers and choose the most favorable one.  They can compare the quotes to the prices of related, exchange traded instruments to evaluate the reasonableness of the prices they are quoted.

Do you really care how the cost of a gallon of gasoline breaks down between the price of the crude, refining margins, transportation, retailing margin, etc?  No: you care about what it costs you to fill up.  If one station quotes $4.60 and another $4.65 for gasoline of equivalent quality, do you care why?  Or, to use the famous example of a pencil: do you really care about what each step of the process of putting a pencil in your hands cost?  No: you care about the price of the pencil.

That’s the information economizing role of prices at work.  It works in OTC markets as it does in pencils and gasoline.

The Bank of England’s Andrew Haldane gave a speech on high frequency trading that highlighted its risks.  He cites evidence that various measures of persistence in stock prices have risen since 2005, and attributes this to the advent of HFT.  Maybe.  But many other things have changed in the same time period, so giving privileged status to HFT as the cause is quite a stretch.  Short of a natural or controlled experiment (e.g., randomly assigning stocks that can and cannot be traded using HFT), attributing broad changes in pricing behavior to any single factor is highly conjectural.

His argument rests on the assertion that market making is more fickle during times of stress due to HFT.  I would say that market making is more fickle during times of stress, full stop.  Liquidity has always dried up during crashes and crises, no matter what the technology.  The floors in Chicago were depopulated during the ’87 Crash.  Many locals–liquidity suppliers–who didn’t leave voluntarily were pulled off the floors by their clearing firms.  And many those that remained stood with their hands concealing their badges lest somebody try to win the outtrade lottery by claiming that he had made a profitable trade.  NASDAQ market makers didn’t answer their phones during the Crash, and many specialists evaded their affirmative obligations to make markets (so much for one of Haldane’s suggested fixes).  No HFT, but no liquidity and a crash all the same.

I wrote about a lot of the proposals that Haldane mooted in the immediate aftermath of the Flash Crash.  Market making obligations are hard to enforce, as Haldane notes.  The argument for them, as I laid out last year, is that they could affect the time pattern of liquidity supply.  Such constraints necessarily reduce the return on capital, which will lead to an exit of market making capacity.  This will raise costs in tranquil times, in the hope that the obligations imposed on market makers will lead a larger proportion of a smaller population of market makers to remain active during turbulent times, thereby improving liquidity during those times.  Given the strong incentives to evade the obligations during turbulent times, and the difficulties of specifying and enforcing what those obligations are due to the high dimensionality of the services that market makers perform, this is quite a gamble: in more technical economic jargon, market making behavior is not contractible.  There is no guarantee that the greater participation rate will more than offset the loss in capacity, leading to a more desirable allocation of liquidity supply between stable and turbulent times.

Haldane also plumped for minimum order times.  Despite David of Deus Ex Machiatto’s best efforts, I remain wholly unconvinced of the wisdom of this.  Ditto Eric Hunsader of Nanex’s very nice and thoughtful comment.  David presents a calculation of the option value, and hence the cost, of mandating a one-second quote-in-force rule.  The calibration technique is a natural one, but I am skeptical of its applicability.  The price of an option with a maturity of a month that David is using to calibrate is based on private and public information flows over a period of days, which is fundamentally different than the market makers’ pricing problem, which is driven by private information flows over very short time scales.  The whole point about market microstructure theory is that price behavior is fundamentally different at small time scales, so in my view it is unlikely that a one month option can be scaled down to value an option granted on a far shorter time scale.

But quibbles about calibration and scaling aside, this begs a huge question: if it is so cheap to grant options under all market conditions, why doesn’t competition ensure that said options are in fact supplied at their allegedly negligible cost (fractions of a basis point, per DEM)?  After all, competition–as a graph in Haldane’s presentation shows–has driven down spreads to very low levels in normal times.  The wholesale exit of market making capacity during turbulent times–in many cases, the refusal to trade at any price–indicates that it is very costly, and for some prohibitively costly, to grant options under these circumstances.  It is a cost problem, and this cost problem is endemic to financial trading, regardless of the technology.

It has long been known that situations of extreme adverse selection–a problem completely abstracted from in the option calibration problem, by the way–can lead to a breakdown of trading, or at the very least, a sharp reduction in trading activity.  When lemons risk becomes too great, markets freeze up or shut down.

An old paper by Glosten in the Journal of Business suggests that this is a rationale for having a designated market maker or specialist: in his model, a monopoly specialist market is less vulnerable to breakdown than a competitive one.  But that’s a different solution than mandating quoting by competitive market participants.  In the Glosten model, competitive markets are subject to breakdown under conditions of extreme information asymmetry.  That’s true regardless of the technology.

Glosten’s paper, I might add, was published in 1985, before HFT was a gleam in a geek’s eye.  There is indeed little new under the sun, and the focus on technological novelty obscures the enduring nature of the fundamental economic problems of liquidity supply.

Indeed, I believe it to be almost certain that imposing a restriction on quoting times will not improve liquidity, and will usually make it worse.  Imposing a constraint increases costs, and increasing costs invariably reduces supply.  A quoting time rule says: “If you quote, your quote must be in force for x seconds.”  The “if” is the key thing here: a market maker can avoid the constraint by not quoting at all, and if the cost of extending the x-second option becomes too large due to severe lemons problems, that’s exactly what he will do–or will program his machine to do.  Not exactly the best way to induce liquidity supply.

So a quoting-time rule alone is extremely counterproductive.  Hence Haldane’s musing about market making obligations–which are noncontractible and hence not effectively enforceable, and hence not much use either.

In other words, if you want to encourage liquidity supply in the worst way, imposing constraints is that way!

Going back to basics, if you think that there is a market failure (e.g., a periodically occurring severe lemons problem), a natural way to address that failure is to subsidize what is being undersupplied, not to tax it.  Just how to subsidize is not obvious, but one thought would be to widen tick sizes.

Another more productive approach would be to constrain the kinds of trading strategies that can be destabilizing, most notably stop orders.  The CME’s stop order logic clearly helped put the brakes on the Emini Flash Crash.  Extending that logic to other markets would be salutary.

This is an area where fragmentation and the associated difficulties of coordination across linked platforms raises difficulties not present in a CLOB, as David emphasized.  But that’s where regulators could play a constructive coordinating function.  Haldane and other regulators have discussed coordinated circuit breakers–a coordinated stop order logic would be an excellent place to start.

Free associating  somewhat (for that’s what blogs are for!), I can envision a way to make such limits forward looking, rather than backward looking.  The Easley-O’Hara-Prado order flow toxicity measure could help identify times in which market breakdowns are more likely, and this could be used to trigger constraints on stop orders.  All circuit breakers under consideration are conditional on price movements, which often involves shutting the barn door after the horse has bolted.  Something forward looking based on real time monitoring of quoting behavior and the adverse selection risk of order flow would be preferable.  This would put computing technologies to work reducing the risk of flash crashes.

I also think it is worthwhile to explore measures directed at parasitic types of trading.  In particular I am still convinced that pricing of exchange capacity–e.g., charging prices for submitting and canceling orders, where said prices vary with system usage–is a promising avenue to explore.

One final note.  During his talk, Haldane mentions the importance of “moving from analysing market microstructure to market macrostructure.” Hear! Hear!  That’s what I’ve been on about for the last 15 plus years.

I claim credit for coining the term “macrostructure” in this context: maybe somebody used it first, but if so I wasn’t aware of it in ’98 or ’99 when I started describing my research using that term.*  I have a paper in the JLEO from 2002 titled “Securities Market Macrostructure,” and the title of my next book will be “Financial Market Macrostructure.”  I actually had to fight the editorial board at Cambridge UP to get them to sign on to that title; they wanted a more plain-spoken title and thought that “macrostructure” was not commonly enough used in economics to fit the bill.  Glad I prevailed–and glad Mr. Haldane is popularizing the phrase.

As I use it, macrostructure modeling involves deriving the implications of microstructural forces for the organization of securities and derivatives markets–the number of exchanges; how trading is divided between exchanges and OTC markets; fragmentation of trading; how exchanges are organized and governed, etc.  My perhaps heterodox views on fragmentation, dark markets, etc., are firmly rooted in this way of analyzing market structure.  Maybe Mr. Haldane and others often disagree with those heterodox views, but it is encouraging to see that the idea of building an understanding of market structure and regulation on firm microstructure foundations is gaining acceptance.

* I’d be interested to hear from anyone who can provide an example of the term “macrostructure” used in this way (which I describe more fully in the text below) that pre-dates 1998 or so, when the word popped into my head.  I wouldn’t want to deny the actual innovator the props he or she deserves.