Streetwise Professor

As I’ve written repeatedly in the past years, the mandated move to central clearing will increase substantially demands for liquidity to fund variation margin payments, especially during periods of high volatility and high market stress.  By definition, variation margin payments total zero–every dollar paid is received by somebody else–thus they don’t affect aggregate liquidity, but economic frictions preclude the development of a perfect pooling mechanism.  As a result, market participants will need to pre-plan how to fund their margin payments.

Not surprisingly, banks are crafting funding mechanisms for their buy-side clients (“end users”).  FTAlphaville quotes from a Risk story by Matt Cameron which describes some of the solutions dealer banks are peddling to their clients [emphasis provided by FTA]:

Clearing members say they have a solution. Most buy-side firms will have to access clearing services through these members – typically the large banks – due to strict membership criteria set by the CCPs. These clearing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities – essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP. Given the frequency of margin calls – there could be several per day in volatile markets – some also plan to extend credit lines, where they would meet intra-day margin calls, with the customer settling up in one go at the end of the day or start of the next.

It sounds a perfect solution, but the numbers involved are huge, raising the question of whether there is enough capacity and appetite among dealers to offer this service to the entire universe of end-users. According to research published by Morgan Stanley and Oliver Wyman on February 16, as much as 40–50% of the total annual traded volume of OTC contracts could be cleared by 2012/13 … creating an additional collateral requirement of between $2 trillion and $2.5 trillion … Most dealers say they would only have capacity to extend credit lines and provide collateral transformation services on a fraction of that.

Diving into the Risk article reveals more details–troubling ones.  It notes that unlike dealers, whose books are typically close to matched, end users are likely to have one-way positions with commensurately greater exposure to margin calls.  Which just provides just another reminder that clearing would not have been a panacea for AIG, which had huge directional positions, and was brought down by the need to fund margin calls–and would have been brought down by the need to fund margin calls in a cleared environment.  Indeed, the expansion of clearing threatens to increase the population of potential AIGs.

The article also emphasizes that the contingent funding obligations on banks could be huge, and are likely to be huge precisely when funding market conditions are stressed.  The various solutions proposed by the banks rely very heavily on repo markets, and in particular repo markets for lower quality, less-liquid instruments.  In essence, banks will repo out lower quality assets and use the cash to fund margin calls.  But repo markets for lower quality assets are the ones that are the most problematic during periods of market stress.  Note that haircuts on everything but high quality sovereign paper increased dramatically when the financial crisis took hold.  Companies that depended on the repo market for funding found this source cut off.  The shadow banking system was built on repo, and runs on the repo market are what cratered that system.  The death knell for Lehman was the decision by JP Morgan and BNY Mellon–the clearing banks–to refuse to take low quality assets to collateralize tri-party repo.

So just why exactly is it a good idea to create a system that increases reliance on a fragile funding source?  This creates exactly the kind of feedback mechanism that generates crises.  Adverse shocks lead to price changes that result in big margin calls.  These shocks also impair liquidity of the funding markets that participants rely on to obtain the cash they need to pay the margin calls.  That’s how things spiral from bad to worse to worser yet.

And there are knock-on effects in the asset markets:

“We reserve the right not to fund clients on a unilateral basis.  If we fall short and can’t fund the variation margin call, we will demand the cash from the client.  If the client doesn’t have the cash, it will have to liquidate the assets it does have or we will be forced to close them out . . .” says one dealer.

Great.  This is a perfect example of how individually rational behavior by banks can exacerbate market stress.  The collateral liquidations and  derivatives liquidations will both cause prices to move–generating more margin calls and reducing the value of the collateral available to secure funding of those calls.  Positive feedback again.  And since by design a lot of the collateral that is liquidated will be lower quality stuff traded in illiquid markets the price impacts will be large–and this will make it more difficult for others to use these assets to fund their positions, thereby creating a serious negative externality.

These problems are endemic in financial markets, including uncleared OTC derivatives markets.  But clearing makes the mechanism more rigid and time sensitive.  It increases the tightness of the coupling in the financial markets, and that makes them more vulnerable to chaotic breakdown and cascading failure.

Cameron’s article discusses other alternatives.  One is that CCPs accept lower-quality collateral. But this merely passes the hot potato.  CCPs are simply conduits that transfer margin monies from the losers to the winners.  The winners won’t necessarily accept the collateral that the losers provide, or will place a lower value on it.  Much of the collateral will be hard to value, during periods of market stress particularly.  And if there is a delivery option on collateral, how do you even price collateralized derivatives trades?: the price of the collateralized trade depends on the value of the collateral, which adds an additional risk to the trade.

So if the CCP can’t just pass collateral along from loser to winner because the collateral isn’t fungible like cash, then the CCP has to fund the cash payments to the winners collateralized by the non-cash instruments posted by the losers.  That puts the CCP in the position of a bank, and raises the question: just who is going to lend against that collateral?

Moreover, this undermines one of the main potential benefits of clearing: fungibility of trades across counterparties.  Different counterparties may have different funding capabilities.  Some may have  access to high quality collateral, some may rely more heavily on low quality collateral.  In an OTC market, those counterparties would trade derivatives at different prices reflecting their differing risks and the quality of the collateral that backs the trade.  But in a cleared market in which all trades are fungible–with offsetting positions netted out, meaning that they are treated as perfect substitutes–this pricing mechanism doesn’t work.  Economically important differences are not priced, which distorts incentives.  This will tend to work to the advantage of low-quality counterparties and to the disadvantage of high-quality ones.

In other words, if the collateral really isn’t fungible–like cash is–how can the trades backed by this collateral be fungible?

One of the risks of clearing is that it treats the unequal equally.  Widening the range of collateral that CCPs must accept only exacerbates that risk.

It also puts CCPs in a delicate position–exactly the position that JP Morgan and BNY Mellon found themselves with Lehman.  A firm is in trouble, and is offering to post dodgy paper as collateral.  If the CCP refuses, the firm is likely to default.  That could jeopardize the CCP.  Even if the CCP can absorb the default, it is at risk of being accused by the defaulter’s bankruptcy administrator of violating the bankruptcy laws–which is the situation Morgan and BNY found themselves in post-Lehman.

So maybe the CCP will decide to play European Central Bank for a day–or a week, or a month–and pretend that junk collateral is as good as gold or cash, thereby gambling on the resurrection of the troubled firm.  That just increases the risk of the financial system–and may subject the CCP to a run by firms that are worried about the quality of the collateral it has taken on.

Contrary to the airy promises of their evangelists, clearing mandates therefore do not fundamentally alter the economic problem that must be addressed: how to fund variation margins in periods of market stress.  Indeed, in my view mandates actually exacerbate the problem because they increase the rigidity and time-sensitivity of the system, require the clearing of more instruments less suitable to accurate valuation in short time frames, and reduce the ability to price risk in a discriminating way (because unequal entities and instruments are treated as interchangeable).  What’s more, the mandates tie up vast amounts of high quality collateral in initial margin payments, forcing greater reliance on lower-quality collateral to keep the system running.  And yet more–depending on the scope of the mandates, buy-side entities that pose no real default risks (e.g., pension funds) but do pose potentially serious funding and liquidity risks will be forced to clear.  Since funding and liquidity risks are the Achilles heel of the clearing system, it is absolutely insane to increase funding needs.

No matter how many times you turn over this problem, I think you will conclude that clearing mandates will substantially increase the necessity of central banks to provide liquidity, and lend against dodgy collateral.  Whether the central banks provide cash to CCPs collateralized by non-cash collateral paid by customers, or provide cash to dealer banks collateralized by low-quality collateral, or provide the cash to end-users similarly backed by low-quality collateral (although this alternative is least likely), to fund the vast margin payments during periods of stress they will be lending a lot to somebody.

Savor the irony.  The rallying cry for clearing mandates was “No More Bailouts,” “bailouts” in this instance meaning central bank loans to troubled financial institutions, intended in part to prevent a meltdown in derivatives markets.  But clearing mandates will only increase the demands on central banks to provide extraordinary funding to keep the derivatives markets going.  The parable of the Indian village that brought in cats to rid itself of mice, dogs to rid itself of the cats, elephants to rid itself of the dogs, and then in the end mice to rid itself of the rampaging elephants is apt indeed.

In the Risk article, Matt Cameron notes that seven out of eight regulators he contacted about the story refused comment: “Most said not enough analysis had been conducted.”  Read that again: “Not enough analysis had been conducted.”  Pardon my French, but Jesus H. Christ, wouldn’t you want to do that analysis before embarking on this titanic reengineering of the largest, most complex financial markets the world has ever seen?  “Not enough analysis had been conducted.”  Really?  Really?

But I know it’s true–and you do too.  And that’s the tragedy of it all.

I sometimes try to think of a rational reason for undertaking this huge experiment on a live patient.  In my more cynical moments–pretty much all my moments are cynical, but some more than others–I wonder if this is just a part of the movement to “financial repression”, defined by Reinhart and Rogoff as follows:

Banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payment system. Governments force local residents to save in banks by giving them few, if any, other options.

They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form of taxation. Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation.

Clearing mandates, mandates that non-cleared transactions be collateralized, limits on rehypothecation, segregation rules and on and are “other devices” that increase the demand for government paper.  And just coincidentally, I’m sure, we’re living in an age where governments are desperate for buyers.

Maybe the dots don’t connect.  But maybe they do.  But I guess financial repression is better than financial insanity, which is the only other explanation that comes to mind.

Cold comfort, that.

Deus ex Machiatto has an interesting post on high frequency trading.   His basic take:

I would argue that HFT has reduced trade sizes and decreased liquidity/increased costs for block trades, especially combined with the move to trading the VWAP rather than brokers taking on blocks as a risk trade, but (3) really gives me pause for thought. Is it true?

. . . .

My recipe for HFT is not to withdraw it, but to reduce the impact of its speed by (1) requiring all market participants to trade on a central order book – no dark pools and (2) requiring all quotes to be good for a minimum of half a second. This would affect real trading activity very little while completely wrecking the high frequency strategies that generate flash crash risk.

I am skeptical that requiring trading on a central order book (CLOB) will eliminate flash crashes.  Note that flash crashes have occurred on futures markets with CLOBs.  The eMini on 6 May 2010 is the most notable example, but even in markets without linkages to other markets–such as cocoa and natural gas–(a) have CLOBs, and (b) have experienced flash crashes.  I’m also skeptical that dark pools have anything to do with flash crashes, and am also not convinced that the dark pool structure–which as DEM notes, has effectively supplanted the block market for facilitating large trades–is detrimental to the interests of those who want to trade in size.  After all, a block positioner could still attempt to compete for the business of those who want to trade in blocks: the fact that dark pools have become the venue of choice suggests they outcompete the old way of trading blocks on cost.

That said, I have long been critical of the SEC rules that protect only the top of the book rather than the depth of book.  Top-of-book protection provides a way for HFTs to make money by exploiting fragmentation of liquidity.  Creating a real CLOB entails a whole set of issues (see the linked article above for a brief discussion), but these can be avoided through the creation of a virtual CLOB that protects the entire books of the various liquidity pools.

A related issue is flash quoting, in which the operator of a matching system gives those supplying liquidity on it a first chance to execute orders before they are routed to other venues.  This undermines time priority, which also precludes the creation of a virtual CLOB by integrating the books of multiple venues.  This can also affects the incentives to supply liquidity.

DEM also links to a presentation that notes that HFTs make money by collecting liquidity rebates.  He further quotes a Bank of Canada study:

Some HFT participants to overload exchanges with trade messaging activity; use their technological advantage to position themselves in front of incoming order flow, making it more difficult for participants to transact at posted prices; or withdraw activity during periods of pricing turbulence.

Both these issues relate to the subject of the very first substantive SWP post: exchange pricing.  That is, the prices that electronic exchanges charge their customers.  I wondered then, and I wonder now, why exchanges don’t charge users for causing congestion on their systems.  If quote stuffing and overloading is problematic, exchanges could penalize it through how they charge for message traffic.  You’d think they have the appropriate incentive to do so.  If it is parasitic on the customers who generate revenues for exchanges (because it is undertaken by those whom exchanges typically pay rebates–see below–and harms the people whom the exchanges charge positive prices), the exchanges would have a strong incentive to devise pricing strategies or quoting rules that would tend to deter this conduct.

Exchange pricing is also relevant for rebates.  It makes sense for exchanges to subsidize some activity (providing quotes) that increases the revenues they can realize from other activity (taking liquidity).  Again, exchanges should have the right incentives to balance the costs and benefits and come up with pricing schemes that encourage the right amount of liquidity supply.

It would certainly be odd, I should add, to want to discourage this kind of pricing if one of your concerns is the disappearance of liquidity.

And related to the disappearance of liquidity, I agree that contributes to crash risk–in both old school floor markets and newfangled electronic ones.  But restrictions on quoting–e.g., DEM’s suggestion that quotes be good for one second–could well be  counterproductive in that regard.  The current evidence suggests that order floor became much more toxic on 6 May 2010, and that’s why HFTs stopped supplying liquidity.  Forcing them to keep their quotes good for longer than they would choose to on their own in such circumstances makes it more likely they will not quote at all.  That is, establishing minimum times that quotes must be in effect is likely to accelerate the wholesale withdrawal of quotes altogether during circumstances in which flash crashes are most likely.

I think there are many issues implicated with HFT–not the least of which being whether there is even an approximate match between the social and private benefits of this activity.  Many of the issues associated with it, however, I think are only peripherally related to flash crashes.  HFT may have a role in flash crashes–though exactly what is hard to pin down, and it may also have a role in making them flashier, i.e., shorter.  But many of the controversies involving HFT don’t appear to be connected to flash crashes.  As in many issues involving financial infrastructure these days, many issues are getting mashed together.  This makes coherent analysis hard, and coherent responses even harder.

The more I learn about  the implementation costs and burdens of Frank-n-Dodd, the more monstrous the thing appears.  These burdens will be immense, and affect virtually every company that touches derivatives, regardless of the extent of their involvement.  IT.  Compliance.  Reporting.  And on and on and on.

But Frank-n-Dodd’s chief evangelist, Gary Gensler, has often said not to worry.  The greater transparency created by the law, via the mandating of swap execution facilities and clearing, will drive down execution costs for derivatives.  The savings will offset the burdens of the regulation.  Transparency will make the market more competitive, to the benefit of end users.

Gensler repeated this mantra in an interview in the WSJ:

I think that the core of Dodd-Frank is to bring the benefits of transparency and risk reduction to this marketplace, which has existed for 150 years.Right now, when you enter into bilateral swap transactions, probably most of you have a handful, at most 10, counterparties that you go to. And it might be three or four. And they’re the largest financial institutions.

And I think that openness and competition will come into this marketplace because of transparency, and because for most of the market, it will have to be centrally cleared.

But later he becomes extremely equivocal about these benefits:

MR. FINK:Offstage you mentioned profits of $30 billion that Wall Street makes on derivatives. You figure that would decline to $27 billion?

MR. GENSLER: No, I don’t know what it will decline to. It might go up. What we know is that the derivatives marketplace today is concentrated among large financial institutions.

Dodd-Frank modestly shifts the needle on information because Congress thought that markets are safer and more efficient with that transparency. After the transaction, you will be able to get real-time reporting of transactions in various ways. That’s the new law, called post-trade transparency. Some portion of the market also will have some pretrade transparency, where buyers and sellers meet in platforms.

Those two forms of transparency will modestly shift some of the information advantage. When you do that, you democratize the markets a bit more. The smaller banks might compete for business with some of the larger banks, and so forth.

“[Dealer profits] might go up.”  “Modestly shifts the needle on information.”  “Modestly shift some of the information advantage.”  “Democratize the markets a bit more.”  “The smaller banks might compete for business with some of the larger banks.”  Hardly stirring stuff there.  Pretty limp justification of the competitive benefits of Frank-n-Dodd.  Not exactly the kind of thing that suggests these transparency benefits will offset all of the other massive costs arising from the law.

The title to the WSJ article is “Keep on Hedging.”  Gensler is apparently taking that advice to heart, as he is quite strikingly hedging his advocacy of the cost-reducing effects of improved transparency.

And even these benefits are likely oversold, and perhaps chimerical.  Here’s just a list of some of the reasons to doubt that Dodd-Frank will actually increase competition in a way that reduces end user transaction costs, let alone by enough to overcome the huge regulatory overhead the law creates:

• Post-trade transparency–especially real time post-trade transparency, which the Commission is advocating–need not improve liquidity.  Indeed, it can have the opposite effect.  Liquidity suppliers will be reluctant to trade in size when their trades are exposed immediately after they are made.  This will widen spreads and reduce depth.
• It is not plausible that end users are at a substantial information disadvantage for vanilla products traded in volume, such as vanilla interest rate swaps in major currencies.  They have access to quotes from multiple sources, and can compare quotes for OTC trades to contemporaneous prices for closely related exchange traded products, like Eurodollar futures (for interest rate swaps) or NYMEX futures (for NYMEX lookalike swaps–go figure).
• Spreads on vanilla OTC products are very small.  Margins on these products are razor thin.
• It is well known that institutional traders in many markets prefer to trade on dark markets rather than transparent ones.  This is because their execution costs are lower on these markets.  And “dark market” is a misleading term: as I’ve noted before, there are different kinds of transparency.  Exchange trading, or SEF trading, has pre-trade and post-trade price transparency, but counterparty opacity: the prices are lit, but the counterparties are in the dark.  OTC dealings, or dealings in dark markets, or dealings in block markets, have less price transparency, but more counterparty transparency.  The latter works to the benefit of those who are known to be unlikely to be trading for information-driven reasons.  Forcing trading onto anonymous platforms, especially order driven platforms, raises the trading costs of the verifiably uninformed, which includes many hedgers and end users.  It is categorically false to say that price transparency and counterparty opacity–exchange trading–lowers the trading costs of all liquidity demanders.  Some are made worse off: that’s why they choose to trade off exchange.
• This helps explain why many, many end users oppose the various mandates.  It raises their costs.  They aren’t stupid.  They aren’t victims of battered spouse syndrome.  When they oppose the mandates, they are talking their books.
• Gensler talks like 10 big counterparties is a small number.  Not too many other industries with 10 major competitors.
• And if you believe those 10 firms are colluding, or would like to collude, tacitly on spreads, forcing them to trade through markets with pre-trade transparency is a great way to facilitate such collusion.  Collusion is harder to sustain when buyers and seller strike deals in private.  The colluders can chisel on the agreement through secret price cuts without being caught.  Harder to do when prices are posted publicly: you can see when cheating occurs.  When cheating can be detected, it can be punished, meaning that price transparency can facilitate collusion.  Cf. NASDAQ antitrust case, Stigler’s seminal articles on collusion, the fact that the Justice Department looks with deep suspicion at price sharing arrangements, the fact that public auctions are more susceptible to collusion, etc.
• Order driven markets are prone to tipping to a single dominant platform, which can exercise market power and charge supercompetitive prices.  Surely Genlser is aware that virtually every single futures and futures option contract in the US is dominated by a single exchange.  Mandating exchange-like, order driven markets for vanilla OTC derivatives is likely to result in the same tipping process, and with the charging of supercompetitive trading fees by the winner-takes-all platforms.
• It is almost certain that any benefits arising from compressed spreads–to the extent that they exist, which the foregoing suggests may well not happen–will be distributed very differently from the cost burdens of Dodd-Frank.  As I noted earlier, any firm that is at all involved in derivatives will have to incur substantial costs to comply with the law.  These include IT expenses associated with record keeping, reporting (including the reporting of trades and positions to data repositories), regulatory compliance, oversight, etc.  With regards to regulatory compliance, to achieve any relief from position limits it will be necessary to show that every transaction is a hedge, as opposed to showing that trades are “normally” used to offset price risks.  Similar record keeping burdens will be necessary to demonstrate whether a company is a swap dealer or major swap market participant or not.  It will be necessary to perform all these tasks, and invest in the people and IT overhead needed to perform them, if you trade modest amounts of derivatives or large amounts.  Those who trade smallish amounts will not generate sufficient benefits in terms of lower trading costs–even if those costs materialize, which I doubt–to offset the regulatory overhead.  Some will choose to stay away from derivatives altogether–which may be easier said than done.

In brief: (a) even Gensler is much more guarded in his predictions about the cost-reducing effects of transparency, and (b) for many market participants, transparency and mandated exchange-like trading will actually increase their trading costs.  What’s more, the regulatory burden–you know, the costs that the CFTC adamantly refuses to estimate despite the requirement that it perform a cost-benefit analysis of its rules–is very likely to be crushing: you talk to people in industry, and you realize that they are afraid.  Very afraid.

So remind me again why all this stuff that isn’t remotely related to systemic risk is a good idea.  And only non-masochists may answer, please.

The IEA and the United States have announced plans to release over the next month 60 million barrels of crude oil from strategic stockpiles, including the US’s Strategic Petroleum Reserve.   Oil prices plunged, by about $5/barrel.  Initially, I was reluctant to attribute most of the price drop to the announcement, because the stock market and virtually all other commodities were down hard too, and the dollar rallied.  These broad changes were plausibly due to bad US job numbers and continued angst about Greece, and given the recent correlations between oil and stocks and the dollar, it was likely that a good part of the oil sell-off was related to these factors.  But when the stock market rebounded later in the day, recovering about 3/4ths of its previous losses, and oil only recovered slightly, it was evident that the oil stockpile release had caused a substantial drop in prices.

To understand the implications of the release, assume initially that the release is considered a one-off, with no implications for the future. In that case, it is like a sudden increase in initial availability of oil. Here is a figure based on a dynamic model of a storage economy that relates the amount of inventory carried out (on the vertical axis) to the amount of the commodity initially available (on the horizontal axis).*

A surprise increase in initial availability is a move along the horizontal axis. Since carry-out is an increasing function of initial availability, some of that new supply released from the reserve is added to private inventories. This would tend to dampen the effect of the release on prices, but some of the increased supply would be consumed, prices would fall. Here is a figure of price as a function of initial availability, which shows that as availability rises price falls. But this curve is flatter–more elastic–than the flow demand curve, because of the fact that some increases of initial supply are put into inventory which buffers the impact on price.

But the key thing here is that you can’t assume that the market believes that this will be a one-off, with no implications for the future. The availability-carry-out function depends crucially on the beliefs of market participants about how the SPR will be used going forward. The current use is unprecedented: previously, the reserve was used in extraordinary circumstances, like supply disruptions resulting from the 2005 hurricanes. Now it is being used to micromanage world oil prices–and to micromanage Obama’s political future. This dramatic change in the employment of the SPR will inevitably affect beliefs, and hence (a) the relation between carry-out and initial availability, and (b) price and initial availability.

In my opinion, the most likely outcome is for the change to affect beliefs in a way that leads to a bigger price response than implied by the two earlier figures. The reasoning goes like this. Those making decisions on how much oil to store do so in anticipation of earning a profit by selling out of those inventories when demand spikes up or supplies spike down. These private storers will now reason that there is a higher likelihood that supplies will be released from SPR under those circumstances. This reduces the amount of money they make on selling out of inventory during those condition. This makes holding private inventories less profitable, so they will hold smaller stocks, all else equal. Put differently, market participants will now view the SPR as a competitor for private storage under a wider range of economic circumstances than was previously the case, and this increased competition from public storage will drive out some private storage.

In terms of the graph, this shift in beliefs about the way the SPR will be used shifts the relation between availability and carry-out. In particular, it shifts it down, from the green curve to the blue one.

This shift moves exacerbates the price impact of the release. It means that a smaller amount of the release will be absorbed into private storage, more of it will be consumed, and hence prices will fall by a larger amount.

Going forward, private inventories will be smaller. This will make the market more reliant on public storage to smooth supply and demand shocks. That’s not comforting, because public storage decisions are not driven by commercial and market realities, but political ones, and by decision makers with poorer information and weaker incentives than commercial market participants.

Ironically, one hypothesis advanced to explain the decision is that it is designed to punish long speculators. Well, the government and the IEA have now just provided much speculative fodder: now market participants have to speculate about how SPR management policy has changed, and how it will change going forward. That is very complicated, given that it will be buffeted by numerous factors. These include how OPEC countries react, how the US reacts to the OPEC countries’ decisions, how it plays politically in the US, and on and on.

This uncertainty, the flow of information relevant to deciphering the policy shift, and the feedback mechanism among traders (e.g., the Bayesian learning dynamic mentioned in the Singleton paper) will all contribute to price volatility. In short, by attempting to punish speculation, the administration has only stoked speculation. The “constructive ambiguity” surrounding the release, and future reserve policies, will only further fuel such speculation. SPR policy will now attract the same kind of scrutiny as Federal Reserve policy, where market participants try to interpret Delphic announcements and actions in order to discern the future course of policy. They will try to infer how external events–say, Obama’s political standing–will drive policy: just what is the function that relates SPR releases to Obama’s poll numbers? All of this interpretation and inference will generate trading that will in turn generate price movements, just as is the case with respect to Fed policy. Alleged concern about volatility has led to a policy that will create volatility.

And note that even though this action has hurt some speculators–those who are long–it has been a huge windfall to others.

The numbers are pretty staggering. Based on Commitment of Trader Reports for 21 June, and just looking at NYMEX and ICE WTI and Brent crude oil futures, given a price impact of about $4/barrel, the announcement led to a shift of wealth from longs to shorts of about $17 billion in crude futures and futures options alone. Add in refined products and you’ll increase that more. Add in swaps and other OTC instruments, you will increase that number substantially. Very substantially.

Within categories, again assuming a $4 price impact and looking only at crude futures and futures options, long swap dealers lost $1.9 billion, short swap dealers made $1.7 billion; long managed money lost $1.5 million and short managed money made $460 million, other reporting long speculators lost $556 million and other reporting shorts made $380 million. Again this overlooks the transfers between longs and shorts in the swap market. And also the capital losses on unhedged private inventories; at the end of May, OECD commercial crude and product stocks totaled about 2.7 million billion barrels. US commercial stocks of crude are about 360 million barrels, and crude and product stocks (ex SPR) about 1 billion barrels. Thus, the value of inventories in private hands in the OECD fell by about $10 billion, and in the US about $4 billion–who knows how much inventories fell in value in China. (And by the way, the value of oil in the SPR fell by about $280 million$2.8 billion.)

A lot of money changing hands. A lot.

Earlier this year, I blogged about potential economic justifications for a strategic petroleum reserve, and how the reserve should be used based on such justifications. In brief, something like the SPR can be justified to correct some other market failure that would depress private storage below its optimal level: the most likely candidate for such a market failure would in fact be a government failure, such as the threat of price controls or other interventions during a crisis.

Suffice it to say that the current action cannot be justified in this way. There is no demonstrable market failure being ameliorated here. This use of public storage is not correcting some deficiency in private storage arising from some market failure or government failure. Indeed, perversely, this use of the SPR’s public storage will, as noted above, discourage private storage.

In US law, there are three elements to proving manipulation: causation, intent, and artificial price. It is clear logically and empirically that the SPR release did cause prices to move. It is also abundantly clear that the administration and the IEA had the specific intent to cause price changes: indeed, they are both boasting about the purpose and effect of the policy. Artificial price is somewhat more ambiguous here. No market failure is being corrected, so a colorable case can be made that the price movement is not moving price closer to where it should be in the absence of such a market failure. That supports a claim of artificiality. But given that the SPR might have distorted price in the first place, it is arguable that perhaps prices are now closer to where they “should” be–but that only means that the price was artificial before because the SPR was inefficiently holding oil off the market.

Causation and particularly intent are often the hardest thing to show in a manipulation case: here, in contrast, they are easily proven. Artificiality is not so clear cut here, but I think it is beyond cavil that the impact of the policy will be to enhance volatility in oil prices and lead to fluctuations based on conjectures about the future course of government policy. That interferes with the operation of these markets and will lead to misallocations of resources, which is what artificial prices do, and what the manipulation laws are intended to combat.

This leads me to conclude that there is a strong prima facie case of manipulation: certainly a stronger case than some others the CFTC has filed in the past. I therefore expect that the agency will move swiftly to file a manipulation action.

That was all tongue in cheek, for those slow on the uptake. I of course know that no such action will be forthcoming; the government has vast discretion in use of the SPR. But if you look at the perverse effects of manipulation by commercial and speculative players–massive transfers of wealth between market participants, distortions of consumption and production decisions by private players, unnecessary price volatility–all of them are present in spades here. Indeed, the effects here are huge, far larger than any private manipulation case that I am familiar with (and I am familiar with all of them, I think).

It is especially ironic that this move came during the same week that the Federal Trade Commission announced that it was launching the most recent in a continuing series of investigations of manipulation by oil companies. This happens every time prices are high, with the same result: the FTC finds nothing. It’s one of the longest running farces in Washington.

If it wants to find manipulation, it should restrict its investigation to the 202 area code.

This is not the first time, certainly, that the US government has attempted to intervene in commodity markets to control prices in order to achieve a political objective. The Hoover administration–you know, that laissez faire bunch (not!)–did so with abandon in the grain markets with the onset of the Depression. That turned out badly. I don’t expect this to turn out much better.

* This is the same model as I analyze extensively in my forthcoming book. Just received the galleys, so the end is in sight!

I may have to start calling Timmy! Rodney instead–as in “I don’t get no respect” Rodney Dangerfield.  The latest Timmy!/Rodney  smackdown came from German Member of European Parliament Werner Langen, a major player in European financial regulation: the FT calls it a stinging rebuke, and if you read the article, you’ll find that a fair characterization. Langen accuses Geithner of misstating the changes in derivatives regulation that the G20 agreed to, and attempting to force Europe to do things that it did not commit to do.

The undiplomatic rhetoric–disses, really–directed at Geithner is pretty astounding.  As I said earlier, I cannot recall anything like them directed with such regularity at any other US cabinet official.

Take it away, Rodney!:

Content warning!: this is a post about clearing minutia.  But believe it or not, there are a select few who actually like that kind of thing–so this one’s for you!

I was thinking more about the segregation issue, and particularly the credit and systemic risk issue.  I think I got the essence of the conclusion right, but was not completely happy with the supporting analysis, so I gave it some more thought and came up with something that I think is a more robust.

The issue is whether segregation or futures-style omnibus accounts lead to more market fragility during times of stress.  My original intuition, and my newer analysis says that segregation is more fragile in times of stress; that is, a CCP is more likely to fail with segregation than with omnibus accounts.  The basic reason is that segregation is more dependent on discretionary credit during times of stress; this dependence is a source of fragility.

The potential problem has its origins in the timing of cash flows in a CCP setup.  CCPs make margin calls on brokers (FCMs) that the FCMs have to meet in a short time period, on both house and customer accounts.  Often the FCM has to make payment on the customer account before the customers have made their variation margin payments; to meet the CCP deadline, therefore, credit has to be extended to these customers.  The FCM’s bank may make the payment to the CCP even though there are insufficient funds in the FCM’s account at the bank to cover the payment.  That is, banks for FCMs often extend credit to the FCMs to permit timely payment of margin calls to the CCP.

With omnibus accounts, the payment that the FCM owes on its customer account is the net payment owed to the CCP by all its customers on all their positions cleared through that CCP.  This means that the maximum amount of credit that is needed to ensure that the bank makes the margin payment to the CCP on behalf of the FCM is this net payment owed.

With segregation, it won’t be possible to net customer payments against one another.  This increases the amount of credit banks have to extend to ensure prompt payment of variation margin to CCPs.  And that is where the vulnerability arises.

A very stylized example demonstrates the point.  It is unrealistic in many ways but the elements of unrealism don’t overturn the basic result.  Assume an FCM has zero capital.  It has 10 customers, 5 who have to pay variation margin of 1000 apiece, and 5 who should receive 900 in variation margins apiece.  Thus, the net amount owed on this FCM’s customer account is 500=5x(1000-900).

Assume that the margin payment is due immediately, but none of the customers who owe have posted the necessary cash. With some probability all will stump up the necessary cash in the future, but with some probability none will.  In the latter event, there is a total loss of 5000 that is borne by others in the market: just who bears it depends on the type of account (0mnibus or segregated).

With omnibus accounts, the FCM owes the CCP 500.  If the FCM’s bank lends the FCM the 500, it can meet the margin call and there is no default to the CCP.  If all the customers who owe pay, the FCM can repay the bank, and the bank and the FCMs other customers get paid all they are owed.  However, if the customers who owe don’t pay, the FCM defaults on its loan to the bank for 500, and also cannot pay its customers who are owed money the 5×900=4500 that is due them.

Note that in this example, the risk that the customers who owe variation margin payments will default is borne by the bank and the other FCM customers.  That’s the “fellow-customer” risk in this setup.

Now consider the situation with segregation.  Here, it is not possible to net customer pays and receives.  Thus, it is necessary to provide 5×1000=5000 in credit to the FCM, or the FCM’s customers, to make it possible to meet the CCP deadline.  If the customers end up paying what they owe, everything is the same as with co-mingling.  If they don’t, however, the bank loses 5000–if it decides to extend the credit.

The total credit loss in the two alternatives is the same–5000–but the distribution is different.  The bank is on the hook for 100 percent with segregation, but only 10 percent under omnibus accounts–again assuming that it extends credit in each case.

That is a crucial difference, because the bank has the discretion to extend credit: that is, it is not a given that the bank extends credit.  It can say no.  If it says no, the FCM goes into default on its obligation to the CCP, and the CCP is on the hook for the loss in the event the customers who owe default.   This loss falls on the CCP’s capital, or on its default fund.  This could conceivably threaten the CCP.

Clearly, the bank is more likely to say “no” to a request to borrow 5000 than a request to borrow 500.  Note particularly this situation is likely to arise when the market is under stress.  That’s when big price moves occur that can raise doubts about the ability of customers to meet their margin calls, and when excess margins held at the FCM are going to be blown through.  It’s also when banks are likely to be more averse to taking on credit risk.

With omnibus accounts, there is credit extended, but much of it is not discretionary.  In the example, the FCM’s in-the-money customers provide 4500 of credit.  They have committed to do so by being customers of the FCM, and being on the winning side of their trades.  In effect, customers provide irrevocable letters of credit to other customers–and in return, receive irrevocable LCs from those customers.  These are not traditional LCs because their payoffs are conditional on market prices (and in a more realistic example, on the financial condition of the FCM).  But in essence, if you are a customer of an FCM under an omnibus system, you commit to provide credit to other customers under some circumstances, and in return receive a commitment from other customers to grant credit to you under other circumstances.

That lack of discretion is crucial in preventing a market breakdown.  “Freezing” of credit markets during times of market stress essentially means that lenders choose not to lend.  The more that you rely on the discretion of lenders, the more vulnerable you are to a market freeze.

During the Crash of 1987, the reluctance of banks to lend to FCMs was what threatened the major CCPs. Consider that in the context of the example.  In the example, under segregation, the bank is less likely to extend credit, making an FCM default more likely.  Moreover, since there is no sharing of risk among customers, with segregation the CCP is on the hook for a bigger loss: 5000.  With omnibus accounts, it loses only 500.  CCP failure is obviously more likely when it has to bear a 5000 loss than one a tenth as large.  Thus, with segregation, there is a larger probability that the CCP will absorb a loss, and conditional on a loss occurring, that loss is bigger.  This means a greater likelihood of CCP failure–or the need for greater CCP capital.

In brief, the clearing system is more likely to break down during periods of market stress, the greater the reliance on discretionary credit to meet variation margin calls.  This reliance is greater with segregation, than with futures-style omnibus accounts.  The latter reduces reliance on discretionary credit by the use of (implicit) commitments among FCM customers to lend to each other.  That makes the system more robust.

There is considerable symmetry in the commitments that FCM customers make, but that symmetry is not complete.  Some customers are more creditworthy than others.  They essentially subsidize the less creditworthy customers (unless, as I discuss below, commissions or other terms offset this effect).  Moreover, tail risks that create default risks are not symmetric.  Customers who are long stock index futures, for instance, are likely to experience big margin calls than those who are short because crashes are more likely than spikes.  Customers who are short CDS are more likely to experience big margin calls than those who are long because of jump to default risk.

Even though the exchange of commitments is not necessarily of equal value (i.e., a given customer may provide a commitment that is more valuable than the commitment he receives from the other customers due to these sources of asymmetry), there is an exchange of value.  Moreover, more creditworthy customers should be able to negotiate better commissions to reflect the benefits they are providing to other customers–which helps the FCM attract the business of these other traders.  The ability to negotiate commissions and other terms of agreements between customers and FCMs (e.g., margins) reduces the scope for cross subsidies between customers.  This limits the distributive consequences of omnibus accounts.

These credit issues are likely to arise only in rare circumstances, but those are exactly the circumstances in which a market breakdown and CCP failure would occur.  A liquidity crunch occurs when due to heightened risk and asymmetric information, lenders choose not to lend.  This is most likely to occur during periods of market stress–which is exactly when big margin calls increase the demand for liquidity/credit.  That is, stressed conditions reduce the supply of credit and increase its demand.  It is desirable to reduce reliance on discretionary credit in these circumstances.  Omnibus accounts do just that.  They are a liquidity pooling mechanism by which customers implicitly commit to extend credit to one another.  This commitment reduces the need to rely on discretionary extensions of credit by banks in order to raise the cash necessary to make payments to CCPs.  This, in turn, reduces the likelihood of a CCP collapse.

This analysis strongly suggests that the systemic risks of segregation are far greater than the CFTC acknowledges.  Indeed, in its NOPR on OTC derivatives segregation, the agency argues that segregation reduces systemic risks.  Its analysis fails completely, however, to consider the implications of segregation on the demand for credit during times of market stress.  The foregoing analysis implies that segregation leads to higher demands for liquidity and credit precisely under the conditions in which liquidity and credit are likely to be in short supply.  That, in turn, means that the possibility of market breakdown or CCP failure is greater with segregation.

Market participants will adjust on other margins, of course.  CCPs will presumably require greater margins and greater default fund contributions with segregation: these are also essentially precommitments of resources that substitute for the precommited resources lost under segregation.  They are also costly, and it is nigh on to impossible to know whether these costs are larger or smaller than the costs inherent in a system based on omnibus accounts.

But apropos my earlier post, CCPs, exchanges, FCMs, and their customers have strong incentives to adopt the system that minimizes these costs.  They have skin in the game, and a bigger pie to split when the choose the lowest-cost mechanism.  They also have better information to evaluate these costs than any regulator.  No, their incentives aren’t perfect.  Their information isn’t perfect either.  But perfect isn’t an option, so those aren’t meaningful objections to relying on competition and contract to determine the choice of institutions, rather than regulatory fiat.

Apparently not having enough on its plate, the CFTC has seen fit to vote out a NOPR on collateral segregation for cleared swaps.  The Commission decided to jettison the omnibus customer account model used successfully for donkey years in futures markets, and to require OTC CCPs to segregate collateral in their books and records, while permitting comingling of customer moneys in one account.  This legal segregation/operational comingling of customer collateral is intended to protect customers against “fellow-customer risk,” i.e., the risk that  the margins of non-defaulting customers of a futures commission merchant (FCM) that (a) has defaulted, and (b) has customers in default will be used to meet shortfalls in the defaulting customers’ accounts.

I wrote about this last year in a post titled “Alfred E. Newman Chooses an FCM: the Moral Hazard of Segregation.”  I argued that it is necessary to understand why futures exchanges would choose–and stick with–the omnibus model that exposes customers to the risk of each others’ default.  The most likely answer is that it provides customers with an incentive to monitor their FCMs.  FCMs that are undercapitalized, or which do not manage risk properly, pose a greater risk customers.  By giving customers skin in the game, they have an incentive to monitor the FCM’s capitalization and the adequacy of its risk management.  With segregation, customers can play Alfred E. Newman: “What?  Me worry?”  They have zero, zip, nada incentive to monitor their FCM.  Their money is safe even with an undercapitalized, or even crooked, broker.  This lack of customer monitoring leads to the survival of riskier FCMs, thereby increasing the risk in the system.

The CME and ICE Trust made a similar argument in letters to the CFTC.  Their letters apparently, uhm, cut no ice with a majority of the commissioners.  The CFTC evaluated the argument and rejected it.  In a nutshell, the Commission bought into the argument advanced by big money managers and pension funds that they don’t have the information to monitor FCMs.

This assertion has problems on many levels.  Yes, customer information about the safety and soundness of FCMs is imperfect.  They can’t evaluate that risk perfectly.  But they can see things like whether the FCM is overcapitalized, and by how much.  They can get some kind of idea as to what kind of customers the FCM serves.  They can observe first hand how the FCM manages the risk of that particular customer: does the FCM insist on prompt payment of margins?  Does it collect and evaluate information on the customer’s creditworthiness?  To the extent that a customer perceives that an FCM is slacking off with him, he can infer that’s a more general problem.  So they can–and do–observe signals on FCM safety and soundness.

And note that there is monitoring by multiple customers.  Each one might observe a noisy signal of FCM creditworthiness, but collectively they may get a relatively precise signal.  The literatures on global games and bank runs suggests that there are mechanisms whereby customers who decide whether to patronize an FCM based on a noisy signal of its riskiness can provide effective monitoring.

A sketch of a model would go something like this.  Customers observe a noisy signal on FCM riskiness.  They know other customers are observing noisy signals.  Each customer adopts a cut-off rule that says “I leave if I get a signal that the riskiness of the FCM rises above a certain level.”  In equilibrium, when enough customers get a bad signal, they run.  Sometimes that’s inefficient because they are fooled by bad draws of the signal.  But with enough customers, that’s relatively unlikely.  Instead, runs tend to occur when the FCM is in fact risky.  The prospect of being destroyed in a run gives an FCM an incentive to control its risk.

Things appear to work this way in practice.  Runs on FCMs often precede revelations that there is something seriously remiss.  There was a run on Refco before it imploded.  Ditto Lehman:

Some argue that the futility of relying on risk mutualisation in the default waterfall was illustrated by the fact that Lehman’s omnibus customer account dropped by roughly 75 percent during the week prior to its default. However, others say this proves the current system works.

“It shows market participants have the incentive to monitor the financial health of their FCM. Moving to an LSOC regime may well undermine this incentive,” said Taylor at the CME.

Exactly, Kim.

There is also empirical evidence that monitoring of relatively opaque financial institutions does occur when there is an incentive to do so.  In the 19th century, notes of different banks sold at varying discounts to reflect creditworthiness, and market participants would often run on banks that were perceived to be unduly risky.  Evidence presented by Calomiris and Gorton and others shows that these runs were not Diamond-Dybvig “sunspot” runs, but reflected bad fundamentals.  Rates in the Fed Fund market depend on the creditworthiness of the borrower.  Similarly, prices on CDS depend on creditworthiness of the counterparties.

As I noted earlier, big money managers and pension funds were pushing for segregation–indeed, greater segregation than the CFTC actually settled on.  Their protestations of their inability to monitor should be taken with a grain of salt–and would be quite alarming if true.  No, I think that the main motive is that they do in fact incur costs to monitor FCMs, but that other customers effectively free ride of their monitoring.  Segregation allows them to play Alfred E. Newman, and not worry about their FCMs risk–and thus not have to incur the costs of monitoring.

If the foregoing analysis is correct–and the CFTC’s arguments certainly don’t convince me otherwise–the proposal will increase total risk in the system, and shift costs from one kind of customer (the money managers and FCMs) to other customers.  This will come in the form of higher initial margins and higher default fund contributions because the inability to mutualize risk among customers requires shifting that risk elsewhere.  It will also come in the form of greater–and perhaps much greater–operational costs.  But note that these will all hit the big money managers and pension funds less than smaller entities.  They typically have lower funding costs (and hence are less impacted by the margin increases) and since many of the increased operational expenses are fixed costs, they have a bigger impact on the smaller firms.

Note too there are other possible regulatory responses that can reduce monitoring costs without interfering with incentives to monitor by fiddling with segregation.  In particular, improving FCM disclosures would help.  These could include providing customers with statistics on the fellow-customer risk they face, based, for instance, on stress tests.  CCPs perform such evaluations to estimate the risk they take on from FCMs and their customers, and properly protected and presented, such information would allow customers to make discriminating choices among FCMs based on risks and rewards.

There are other problems with the proposal.  In particular, given the concern about systemic risk in clearing, the proposal is particularly troubling.  CCPs mark-to-market on a daily or twice-daily or greater basis.  Thus, once or twice a day it is necessary for FCMs to meet variatio margin calls on both customer and house accounts.  Frequently the FCM needs to meet the call before the customer has provided the funds.  So in meeting the call, the FCM extends credit to the customer.  Moreover, settlement banks typically extend credit to the FCM to meet the variation margin payment.  In the omnibus system, banks view the credit as being collateralized by the omnibus account.  This is well diversified, usually, across customers and across products in the customer accounts.

Moving to segregation basically makes this credit mechanism unworkable, or at least far more costly than under the omnibus system.

This credit mechanism is extremely important.  Indeed, the possibility of its breakdown during times of market stress is one of the things that poses threat to the viability of a clearing system.  The near failure of this credit mechanism on 20 October, 1987 is what threatened the collapse of the major Chicago CCPs.

So what replaces it? It’s not immediately obvious how credit could be extended to meet variation margin payments in a segregated system in the way it is in an omnibus system.  With segregation, a bank extending credit to an FCM doesn’t have recourse to the entire portfolio of customer funds.  Individual accounts pose more risk, and are more difficult for the bank to evaluate.  It is also more operationally difficult to evaluate creditworthiness and to extend credit on hundreds of single accounts rather than a single omnibus account. So it will be much more costly to use credit to meet the metronomic variation margin calls.

But margin calls will still need to be met, and fast.  With credit being far more costly, FCMs will have to hold more liquid assets, and will likely require customers to post higher margins in order to have the cash necessary to meet the calls: in effect, segregation increases–perhaps dramatically–the precautionary demand for liquid assets. Moreover, during periods of market stress, even these additional holdings of liquid assets may not be enough to meet margin calls.  Riddle me this, Gary: What happens then, when they can’t be financed by credit?

This represents a major change in the operation of the market.  Given that it was possible for CCPs to operate in the past, but chose not to, it is reasonable to conclude they did not do so because it is more expensive than the omnibus system.

There’s also a monitoring angle here too.  Banks that extend credit to FCMs monitor them.  They are not going to extend credit to FCMs that are undercapitalized, or which do not manage properly the risk in the customer accounts.  So the omnibus system gives settlement banks an incentive to monitor FCMs.  Go to segregation, and that bank incentive to monitor vanishes.

There is a broader issue here.  Why does the CFTC perceive that it is necessary to impose a particular mechanism on market participants?  What is the market failure here?

The choice of segregation mechanism, and the specification of the default waterfall more generally, involves complicated trade-offs and incentive effects.  Yes, fellow-customer risk is a bummer, but we don’t live in Nirvana: we can’t make it disappear.  To reduce fellow-customer risk you either have to push the risk elsewhere or pay real costs to reduce it.

Exchanges and CCPs internalize many of the costs and benefits of those trade-offs and incentives.  If they choose an costlier mechanism, or one that allocates risk inefficiently, or one that provides bad incentives to control risk, the demand for their services declines.  They see lower volumes and lower prices as a result.

Now this may not work perfectly to achieve a first best outcome in the omniscient social planner sense.  But exchanges and CCPs (and integrated exchanges that operate CCPs) tend to have better information and stronger incentives than any regulator.  Absent some convincing demonstration that there is some major externality or other problem that leads them to choose badly, there is no basis to prescribe just how they should operate their businesses.

But no.  The CFTC just can’t seem to leave well enough alone.  It has again arrogated to itself the authority to impose a system on the marketplace, without making any showing whatsoever that competition and private contract lead to inefficient outcomes that can be improved by regulatory fiat.  This is especially perverse in this particular instance given that the likely outcome of the dictat is to increase risk–and indeed systemic risk.  All in the name of implementing an act ostensibly implemented to reduce risk.

How much irony can we take?

I cannot recall a situation where a US Secretary of the Treasury, or any cabinet member, for that matter, has been the subject of such scathing rebuttals as Timothy Geithner.  The disdain that his lectures on derivatives regulation unleashed is pretty amazing.  It was not respectful disagreement.  It was disrespectful disagreement.  And not from anonymous sources, but from named representatives of government and industry bodies.  Nor is this a new thing.  The Chinese and German Finance Minister Wolfgang Schaeuble, to name but two, have been brutal in their criticisms of Geithner.

This makes it all the more curious to read in the WaPo piece that I linked to yesterday that Geithner has a very close relationship with Obama, arguably the closest relationship of all the cabinet members.  But perhaps that’s not so curious after all: for all his rhetoric about rebuilding relationships with other nations, Obama apparently has a very poor relationship with the leaders of most other countries–worse relationships than Bush.  This suggests that Obama, a notoriously aloof individual, doesn’t really care about what them furriners think.  And as the foreign criticism of Geithner demonstrates, I think those feelings are reciprocated.

Timmy!, the addressee in a WaPo love letter (h/t R) isn’t feeling the love from outside the 202.  Timmy! lectured—or should I say hectored—the world on derivatives, saying, for all intents and purposes, our way or the highway.

To say this went over like the proverbial, uhm, lead balloon would be the understatement of the year.  The Singapore Monetary Authority and the Hong Kong Monetary authority took umbrage at Geithner’s implication that they were lax regulators.  The CEO of the Futures and Options Association, Anthony Belchambers, was quite biting in his reply:

US Secretary Geithner’s comments do not appear to take any account of the fact that the SEC, arguably, was an equally tragic failure – and by a regulatory authority that was notably “heavy touch” but also in some areas “no touch”!

Ouch!  Can you say “Bernie Madoff”?  I knew you could.

Martin Wheatley, who is leaving his position as the head regulator in Hong Kong to take up the leadership of the UK’s Consumer Protection and Markets Authority (eat your heart out, Elizabeth Warren!) was equally scathing.  More so, actually:

US Treasury secretary Tim Geithner was talking “nonsense” when he warned that the world must follow America’s lead on financial regulation, according to a senior European regulator and outgoing head of Hong Kong’s market watchdog.

“To suggest that the US sets a gold standard that other markets should follow is nonsense,” said Mr Wheatley, speaking on the last day of his six-year stint as head of Hong Kong’s Securities and Futures Commission.

That’s gonna leave a mark.

I guess this is what they call smart financial diplomacy.  It’s having about the same effect as the administration’s “smart diplomacy” more generally.  Which is not a good thing.  International coordination on derivatives and other aspects of financial regulation, but US browbeating will not facilitate this coordination.  The opposite effect is more likely, and all of the WaPo puff pieces in the world won’t make any difference.

Reading the BIS paper I just posted about brought to mind an issue that I think is of paramount importance, but which has been almost completely overlooked.  Like many other analyses of the effects of clearing mandates and rules relating to derivatives, the focus has been on providing mechanisms to reduce the likelihood of default on derivatives positions.  The idea is that losses on derivatives positions can be a channel of contagion between important financial institutions.  So to address this problem, legislators and regulators want to raise collateral requirements and other requirements to ensure that non-defaulting derivatives counterparties receive all that they are owed when a firm defaults.

But focusing on derivatives alone is dangerous.  All of the measures intended to increase the safety of derivatives markets–increasing collateralization, multi-lateral netting, etc.–privileges derivatives and derivatives counterparties.  But that privileging comes at the expense of other claimants of a bankrupt firm.  Let’s say that without greater collateralization and netting, derivatives counterparties would have lost X, but with the greater collateralization and netting, they lose 0.  Sounds great: there is no possibility of derivatives losses cascading from firm to firm.  But not so fast: what means, to a first approximation* is that now somebody else loses X more than they did under the previous rules.  In other words, the loss of X has been shifted from the derivatives counterparties to somebody else. There can still be contagion—just via a different channel.

There is something of a debate about the priority of derivatives in bankruptcy.  Mark Roe has questioned this priority privileging.  I’m in London for a conference at the LSE, and one of the conference papers, by Patrick Bolton and Martin Oehmke, also questions privileging derivatives.  I’m not sold on the specific Roe-Boton-Oehmke arguments because I think they don’t see the whole picture, but I do think it is a very important issue.

It is a particularly important issue in the context of the ongoing regulatory debate because all of the rules intended to reduce the likelihood of derivatives defaults effectively increase the priority of derivatives.  Which means that they reduce the priority of other claimants.  That’s not obviously a good thing.  But since the regulators and legislators have failed to look at the problem holistically, instead focusing on derivatives in isolation without seriously questioning how the changes in derivatives rules will primarily shift risk rather than reduce it, whether it is a good thing or not has escaped attention completely.

A couple of analogies come to mind.  One is target fixation.  Many fighter pilots become so focused on the target they are chasing that they fail to see the guy that just jumped their six and is about to shoot them down.  Being fixated on the derivatives target, regulators and legislators are unaware that they are shifting risks elsewhere—risks that may very well jump them of the future while they are still fixated on derivatives.

Another is levees.  Building up a levee around a particular city protects that city, yes, but the rising water has to go somewhere.  So raising the levees in one place makes the flooding problem worse somewhere else.  Legislators and regulators seem obsessed with raising the levees around Derivatives City, without regard as to how this will affect where the water goes and who gets flooded–Commercial Paper Town and Moneymarketville, for instance.  It could well be the case that keeping Derivatives City high and dry results in even more devastating flooding in other, less privileged precincts.

The Corps of Engineers has created many problems in the past with its attempts to control the Mississippi and Missouri Rivers through its efforts to control floods: there is a very real risk that a (metaphorical) Corps of Financial Engineers will also create havoc despite its intention to do good.

There are of course differences.  A river system is more mechanical than a financial system.  But that actually makes the situation more fraught in financial markets.  Market participants will respond to the privileging of one class of claim—such as derivatives—by adjusting their behavior, by adjusting what they trade, their capital structures, etc.

But maybe it’s not that different.  The design of the levee system will affect where people build and how they build.  Designing the levee system properly requires just that—a systemic approach, not an approach focused on just one part of the system, but its entirety; and an approach that takes into account how people will respond to the design of the levee system.  Unfortunately, that’s not the way that it’s being done in the derivatives markets.  The history of the Mississippi River valley suggests that’s not an encouraging thing.

* As I discuss below, this privileging will affect decisions people make, and thus the amount of risk.  That means the problem is even more complex than what I consider here.  But that only makes the derivatives-centric focus of regulators and legislators even more dangerous.