Streetwise Professor

Yes, there definitely is an echo.  The BIS has released a paper that, er, echoes several SWP themes.  Most notably, the paper by Daniel Heller and Nicholas Vause notes that variation margin calls can lead to substantial demands on market liquidity.  In high volatility environments, the liquidity needed to fund variation margins would represent over 28 percent of G14 dealer cash and cash equivalents on one day out of 200 for interest rate swaps alone.  CDS margin calls could also result in a substantial cash drain on dealers.

It should also be remembered that these kinds of events are likely to be associated with (either caused by, or causing) tightness in funding markets.   It should also be noted that the BIS just looks at dealer variation margin payments.  In stressed market conditions, however, other market participants—including hedge funds, broker-dealers, and depending on the kinds of regulations that are adopted, certain derivatives end users—will also be subject to big margin calls.  This places further demands on liquidity.   These hedge funds and others would be looking to banks—including notably the big dealers—for funding.  This could lead to major liquidity shortages, and as the BIS notes, central banks are likely to need to inject liquidity either to banks or CCPs in order to mitigate these shortages.  [The zero sum nature of these margin calls raises some interesting issues.  I am currently noodling through some models based on the Holmstrom-Tirole setup to work through these issues.]

It would not be correct to suggest or imply that this is a problem associated with clearing alone.  Many OTC derivatives trades—including trades between dealers—are marked to market daily, and require variation margin payments.  Thus, big price moves would create funding demands to meet margin calls even in the absence of central clearing.  However, note that the increase in initial margins that clearing mandates, and margining mandates for non-cleared derivatives, will increase funding and liquidity needs beyond the level that would be required without these mandates.  Add to this Basel III liquidity requirements, and the heightened potential for liquidity crunches in the new environment are clearly manifest.

The BIS paper also quantifies the potential burden that variation margin payments could place on CCP default funds in the event of a default by one or more clearing members.  It concludes:

With a probability of one in 10,000, non-margin resources at risk from the failure of one particular dealer, two particular dealers or any dealer with sufficiently adversely affected portfolios would respectively be 20%, 37% and  42% of total initial margins for IRS, and 36%, 46% and 65% of total initial  margins for CDS. If prevailing levels of volatility were high, these figures would  equate to $21 billion, $39 billion and $44 billion for IRS, and $13 billion,  $16 billion and $23 billion for CDS.

These are big numbers, and indicate the kinds of resources that CCPs must have on tap to deal with defaults.

Note especially that these resources are likely to be contributed by major banks—which means that major defaults will impact non-defaulting bank balance sheets, contrary to the facile claims that clearing would put a firewall between derivatives defaults and major banks.  It also has implications for the appropriate capital charges for default fund exposures.

The BIS report quantifies roughly the economies of scope that result from clearing (another common theme here), and argues that these economies will permit more economical use of capital.  Left unstated is an important point that I’ve emphasized—but which is too often ignored.  Specifically, if clearing improves capital efficiency, it will reduce the marginal cost of trading derivatives, which will lead to an increasing scale of derivatives trading—and hence greater total counterparty risk.  Even if one assumes that CCPs allocate a given amount of counterparty risk more efficiently than is the case in the bilateral markets (an arguable assumption), it is not evident that this improvement in the allocation of risk would more than offset the effect of an increase in the total amount of risk to be allocated.  This issue deserves far more attention than it has received—which is not a hard statement to make, given that it has received almost no attention whatsoever.

The BIS report also discusses procyclicality of margins—another echo.  This is an extremely important—and extremely vexing—matter.  It is one about which CCPs are quite sensitive.  I don’t have any easy answers, except to say that (a) it is a real issue that deserves attention, (b) it is by no means obvious that CCPs have the appropriate information or incentive to take into account the knock-on effect of margin changes, and that (c) mechanical, value-at-risk driven approaches like those proposed by CFTC, SEC, and the Fed are the worst way to set margins.

Today’s WSJ carries an article related to procylicality in which I am quoted.  The issue is getting attention, and is not going away.  It is not going away in part because it is a very knotty problem.  So I am certain that the echoes will continue for some time to come.

Cheniere Energy is back in the news–and arguably, back from the dead.  Cheniere has been on a roller coaster for about 5 years–right along with the gas market.  In the mid-2000s, when the conventional forecast was that the US was facing gas shortages and persistently high prices, Cheniere was investing in facilities to import liquified natural gas and re-gasify it.  But then the financial crisis and the shale boom caused gas prices to crater, and Cheniere’s import terminal at Sabine Pass looked to be a white elephant.  But prices fell so far in the US relative to the rest of the world that the opposite play appeared promising.  And indeed, a couple of weeks back the company received permission to export LNG.  Its stock price doubled on the news.

Cheniere is looking to configure its facility to be capable of importing or exporting gas.  Like many physical assets, Cheniere’s facility is a real option.  Under the original plan, it was an option to transform foreign gas into domestic gas with a strike price equal to transportation and gasification costs.  With the ability to import or export, it is an option to transform foreign gas into domestic gas, or domestic gas into foreign gas, again with a strike price determined by transportation and transformation costs.

These options can be quite valuable given the volatility of relative prices in the US and elsewhere, with relative price volatility being driven by technology shocks, the development of new fields–and notably, politics.  Developments like Germany’s shutting down of its nukes or the UK’s imposition of punishing taxes on North Sea extraction can have profound effects on relative prices that affect the profitability of real options like those possessed by Cheniere.

Although political developments and uncertainties generate volatility that enhances the value of real options like Cheniere’s facility, politics may also pose its greatest challenge.  Greg Meyer of the FT, who wrote a good article on the company’s change in fortune, pointed out to me this language in the Department of Energy’s decision approving Cheniere’s application to export gas:

We intend to monitor those conditions in the future to ensure that the exports of LNG authorized herein and in any future authorizations of natural gas exports do not subsequently lead to a reduction in the supply of natural gas needed to meet essential domestic needs. The cumulative impact of these export authorizations could pose a threat to the public interest. DOE is authorized, after opportunity for a hearing and for good cause shown, to take action as is necessary or appropriate should circumstances warrant it. Furthermore, DOE/FE will evaluate the cumulative impact of the instant authorization and any future authorizations for export authority when considering any subsequent application for such authority.

This is mercantilist.  No–it is Putinist.  It is a threat to do in the US gas market what Putin did with the Russian grain market–cut off exports in order to depress domestic prices in order to favor particular domestic constituencies.  It is a threat to micromanage trade–transactions undertaken by consenting adults for mutual advantage–through coercion.  It is contrary to free trade principles that the US often piously promotes in lectures to others, but all too often flouts in practice itself.

It is also a piece with this administration’s modus operendi—what Richard Epstein calls “government by waiver” in this typically incisive article.  A government agency arrogates to itself the discretion to permit or disallow individuals and firms to engage in voluntary transactions, with only the vaguest statement of the criteria it will use to make these decisions.  Decisions that can make someone wealthy–or ruin them.  Note that there is not even an assertion–let alone a proof–of a real externality (as opposed to a pecuniary, distributive one) to justify this threat of intervention.  This is purely a threat to use coercion to achieve a politically desirable distribution of wealth between producers and consumers of natural gas.

“Good cause.”  “Threat to the public interest.”  “Essential domestic needs.”  In whose eyes?  Under what criteria?  What public?

All this really means is: we will do what we want when we want for whatever damn reason we want.  It is, as Epstein argues, the antithesis of the rule of law in which general principles are applied uniformly and impersonally; it is a return to the personalized, arbitrary, natural state.  It bears creepy similarities to Putinism.

And as such, it will have–is having–the same consequences.  The DOE’s ominous statement puts Cheniere and any other company thinking about exporting natural gas on notice that a sword of Damocles hangs by a hair over its head.  But this is just one company, one hair, one sword.  There are tens of thousands of swords, tens of thousands of hairs, tens of thousands of companies.  More even: as Epstein notes, Obamacare dangles a sword over every company–and every person–in the US.  Dodd-Frank does the same in financial markets.

The threat of arbitrary government action poses grave risks to every company subject to it.  Which is to say every company, with the risks becoming greater by the day.

This cannot fail to have a depressing effect on investment and hiring.  Given the moribund recovery from the Great Recession–a recovery that was never robust, and which is sputtering noticeably today–it is reasonable to conjecture that there is a link between the hyperactive regulatory policies of this administration and anemic economic performance.  Robert Lucas notes that what made the Great Depression great was not its initial severity, but the failure to recover from it, a failure that persisted for almost a decade.  Lucas conjectures (and he is not alone in this*) that the hyperactivity of the Roosevelt administration–and yes, the Hoover administration before it, conventional wisdom on this score being laughably wrong–prevented recovery from a crash initially caused by faulty monetary policy.  He further conjectures that the eerily similar failure of the US economy to bounce back from the Great Recession is the direct result of “harmful real policies” and “the demonization of business.”

His list of destructive policies, which mirror’s Epstein’s, makes depressing reading:

• Believe it is more accurate to say that the problem is government is doing too much

• Again, I see analogies to the U.S. of the 1930s

• Likelihood of much higher taxes, focused on the “rich”

• Medical legislation that promises large increase in role of government

• Financial legislation that assigns vast, poorly-de?ned responsibilities to Fed, others [this is another example of the Epstein discretion point]

• Are these conditions that foster a revival in business investment, consumer spending?**

Are they indeed.

When every regulator at every government agency has the power–and the active encouragement of the political authorities–to say “Nice little business you got here.  Wouldn’t want anything to happen to it, would you?” one should not be surprised that these businesses are reluctant to invest or hire.  Not in Putin’s Russia.  Not in Obama’s United States.

* Robert Higgs has been the most forceful advocate of this view.  Harold Cole and Lee Ohanian have performed substantial empirical research that supports this contention.  With respect to the L-shaped “recovery” in the US, I argued here on SWP early in the Obama administration that its regulatory onslaught would lead to such an outcome.

** The list could, of course, be expanded dramatically.  It could include, for instance, the flouting of bankruptcy law and the expropriation of creditors as with Chyrsler and GM, and the outrageous decision of the NLRB to prevent Boeing from opening an assembly line in South Carolina.

The deputy governor, financial services of the Bank of England, Paul Taylor, gave a speech warning of the dangers inherent in clearinghouses. All of his major points were raised in my ISDA discussion paper (and which I’ve been flogging in my research and here on SWP for going on 3 years now).  Most notably, he highlighted the dangers of procyclical margins, and the very real possibility of a CCP failure and the devastating consequences such a failure would have. Been there, said that.

Such realism is good to hear, but as I said when Bernanke echoed similar concerns, it would have been a damn sight better had people like Mr. Tucker piped up before the clearing mandate train left the station with Congressional and Parliamentary Casey Joneses at the throttle.

But here’s the truly ironic part.  As I did in my ISDA piece, Tucker grapples with how to resolve a failed CCP:

Two strategies come to mind, which I am airing for debate. The first would be ‘recapitalising’ the CCP so that it can carry on.  The second would be to aim to bring off a more or less smooth unwinding of the CCP’s book of transactions.

On the former route, in the banking sphere the basic strategy is to develop regimes for bondholders to share in the losses after the equity is wiped out; a distressed bank gets ‘recapitalised’ in some way through a reconstruction of its liabilities.  But CCPs do not issue debt, so there is not obviously an economic equivalent of recapitalisation by way of haircutting the debt claims of bondholders.  Recapitalisation would seem to entail an injection of new outside capital.   That should not come from the public sector.  So the only options are the surviving clearing members themselves or a new ‘owner’.  On the face of it, the clearing members would have to be involved, as surely the stricken CCP’s default fund would also need replenishing in order for it to continue.

If the default fund were to be replenished by its surviving clearing members, that could in principle be sorted outat the time or it could be pre programmed.  In practice, making it up at the time must be dangerous.  A pre-programmed allocation of losses would be akin to the old “Down To The Last Drop” rule that used to be employed by a Chicago clearing house [the CME], under which surviving clearing members ultimately had collectively to absorb all losses: mutualisation.  (It was dropped because, as banks became futures-exchange clearing members, bank supervisors didn’t like the unlimited exposure of CMs who were banks.  An example of unjoined-up thinking.) [That’s not the way I heard it explained by those involved in the decisions.] [Emphasis added.]

Breathe deep the irony.  Remember that the primary justification advanced for mandating CCPs was to create a firewall that would limit the exposure of major financial institutions to counterparty losses arising from derivative defaults.  That is, the concern was that the failure of one large financial institution would cause it to default on derivatives trades, imposing losses on other large financial institutions, potentially resulting in their failure.  CCPs were supposed to contain default risks and prevent the from spreading, contagion-like, through the financial system.  But Mr. Tucker argues that for clearing mandates to work, it is necessary to breach the firewall and make big financial institutions the residual claimants of counterparty risk.

Mr. Tucker has just revealed the dirty little secret.  Well not a secret exactly; I’ve been pointing this out for years, notably in my posts on AIG.  Specifically, clearing does not make risks go away.  (No, Gary, there is no magic box.)  It just shifts risk around.  It has to go somewhere.*  Collateralization, by moving derivatives counterparties to the front of the creditor line, shifts risks to other creditors (who may well be large financial institutions, in part).  If collateralization is insufficient, the risks go to the other members of the clearinghouse–which means, it goes to other financial institutions.  Put differently, it vectors the risk right back to the same financial institutions that clearing was intended to protect.

Following the inexorable logic of the situation, namely, that the risk has to go somewhere, Tucker looks for where the risk can go.  Can’t go to bondholders, because a CCP doesn’t have any.  So it must go to clearing members–large financial institutions.**  Which means we’re right back where we started.

Which is another echo.  Several times I’ve predicted that clearing mandates would likely spur a process similar to that in the apocryphal story of the Indian village infested by mice, that brought in cats to eliminate the mice, that brought in dogs to deal with the proliferation of cats, that brought in elephants to drive out the hordes of dogs . . . and then brought back the mice to rid themselves of the rampaging elephants.  Clearing mandates were predicated on the chimerical belief that it was possible to make risk go away, when in fact, its primary effect is to shift risk around.  Which raises the question of where it has to go.  The BOE’s Mr. Tucker has apparently concluded, quite logically, that ultimately it has to rest with large financial institutions where it was in the first place.

In other words, bring back the mice.

* As I’ve noted repeatedly, clearing also affects incentives and therefore can affect the level of risk in the system.  There are a variety of reasons why CCPs may lead to an increase in total risk exposure, mainly by creating moral hazard, and increasing capital efficiency through netting.

** An important caveat here.  The nature of clearing members is not exogenous, and independent of the sharing rule.  Imposing good to the last drop is likely to make big banks reluctant to be clearing members with effectively unlimited exposure to other members.  Instead, GTTLD would likely lead to the creation of affiliates with limited capitalization.  By not recognizing this likelihood, Mr. Tucker is guilty of some “unjoined-up thinking” of his own.

Update.  Whoops.  In my hurry, wrote “Taylor” instead of Tucker.  Thanks MDC.

Clearly in restoration campaign mode, Vladimir Putin has declared that Russian GDP per capital will double by 2015, and that Russia will become one of the world’s top 5 economies.  Why anybody would believe such a statement is beyond me.  Recall that Putin made a similar promise early in his presidency, promising a doubling of GDP by 2010.  Didn’t happen then.  Won’t happen now.

Note that doubling in 10 years requires roughly a 7 percent growth rate.  The country is currently lucky to get slightly north of 4 percent, despite a the dramatic rise in oil prices in the past 18 months.  Russia was pushing it to get 6 percent growth during the boom years.  7 percent per year over 10 years is a fantasy, especially in light of the vulnerability of the economy revealed by its experience during the crisis, and the daily revelation of its fundamental institutional weaknesses and political risks.

Putin is an expert at these long horizon forecasts that promise a pot of gold at the end of the rainbow.  He chooses a time horizon long enough that by the time it arrives, people will have long forgotten the promise.

Ironically, Putin’s resumption of the presidency would only reduce the odds of achieving his stated objective.  Twelve more years of stagnant corruptocracy will not generate growth.

Countries with sparkling growth potential do not experience massive capital outflows.  Countries with glittering prospects do not see major IPOs fail with regularity.  The pulling of the Domodedovo IPO is just another example of the toxicity of the Russian business environment.  Did it have to be pulled because (a) the dodgy corporate structure makes it suspect to Western investors, or (b) Western investors fear expropriation based on the pretext of a dodgy corporate structure?:

Domodedovo had been facing an onslaught of media scrutinty in Russia before the IPO on reports that the company’s management could be forced to sell out to a state-connected private investor.

Meanwhile, the prosecutor general recently released a report that deemed Domodedovo’s offshore ownership structure “unacceptable” and asked Russia’s transport ministry to put together a new bill that would essentially forbid Domodedovo’s current owners from managing the business.

Dmitry Kamenshhik, who owns 100 per cent of Domodedov, was named the 86th-richest man in Russia by Russian Forbes with an estimated net worth of $1.1bn

Analysts and investors say they are sceptical that the increased pressure against the airport at home had nothing to do with the decision to postpone the listing.

“Investors are not ready to pay fair value for a company which could face some risks with the state,” says one analyst, who did not wish to give her name because of the sensitivity of the matter.

“I don’t exclude the possibility that Domodedovo will change its shareholder structure very soon.”

Does it matter whether it is Russian business practice or the vulnerability of Russian businesses to the state that makes investors nervous?  And, pray tell, just what is the rationale for the creation of such an offshore structure?  To make it easier to tunnel assets out of the company–and out of the country?  Or to limit exposure to expropriation?  Both? However you interpret it, it suggests that the prospects for a Russian growth spurt are dismal.  Yes, Yandex just had a wildly successful IPO.  But it is the exception that proves the rule.

I haven’t heard much recently about the privatization campaign that is supposed to raise billions to fill the budget hole that Putin needs to meet his lavish campaign-but-not-campaign promises.  Given the rash of problems with Russian IPOs of companies, especially those with connections to the state, is there any wonder?

Ironically, I read of Putin’s promise to double GDP while in Portugal.  You might recall that once upon a time Putin promised that Russian living standards would reach Portugal’s by 2014.  First, that’s not going to happen.  Second, remembering that while in Lisbon brought to life the real implications of that statement, for the Portuguese capital looks very, very tired.   Unrealistic ambitions to surpass Portugal are revealing indeed.*

* Other parts of Portugal are more encouraging, to be sure.  I am currently in Troia, which is quite nice, and extremely reasonably priced for what you get.  But I have had to shake my head several times at the self-defeating economic attitudes here.  These are best summed up by my conversation with the nice woman at the car rental agency, after a frustrating experience relating to Portugal’s bizarre rules relating to declining insurance coverage based on coverage provided by my credit card company and US insurers, just as I’ve done not just in the US but throughout Europe.  (Essentially, they require you to buy the car.)  She said, with an obvious look of pain in her face: “I am sorry.  Many bad things in Portugal.  But the weather is nice!”  And ironically, while sitting here in the lobby discussing some arrangements with the guest services person at the hotel, just had another example of the rather, uhm, dysfunctional attitude towards the concept of customer service.  And I should say, piecing together what I can of the political ads on TV (a national election is being held next week), I doubt things will improve any time soon.  Which is sad, because it is a very nice country with some very interesting things to see (Sintra, for example), and extremely pleasant and friendly people.

Really?:

Lawmakers in the Parliament voted that clearinghouses should have to hold capital of at least 10 million euros ($14.1 million) to absorb possible losses.

Yeah. That will prevent the next financial crisis.

The International Swaps and Derivatives Association, ISDA, has now officially released my Discussion Paper on central clearing of derivatives.  (This is what I’ve been referring to as my white paper.)  It is the inaugural paper in the ISDA Discussion Paper series.

The link to the press release is here, and the press release contains a link to the PDF.

Any comments would be appreciated.  The paper focuses on most of the hot button issues relating to clearing, and to many of the pending regulatory issues.  Hopefully it will contribute constructively to policy, and more broadly to understanding of the issue.

I’m grateful to ISDA, and in particular ISDA CEO Conrad Voldstad, for providing this opportunity and this platform.  I also appreciate the insights and input of David Murphy, ISDA’s Global Head of Risk and Research.

*Said tongue in cheek, of course.

Chicago finance prof Luigi Zingales has written a short oped on OTC derivatives markets.  Considering the source, it is very disappointing, not to say embarrassing.

Indeed, it seems that Luigi is on the same frequency as Kenneth Griffin of Citadel: their arguments, such as they are, are virtually indistinguishable.

Zingales’s basic argument is that the OTC derivatives market is oligopolistic, and that all sorts of bad things flow from that structure:

Indeed, today the market for derivatives is oligopolistic, with a few banks running huge profit margins. And, regardless of whatever political motivations might lie behind the latest investigations, this market concentration is a real problem. According to a 2009 study by the European Central Bank, the five largest CDS dealers were party to almost half of the total outstanding notional amounts, while the 10 largest CDS dealers accounted for 72% of the trades. The markets for other derivatives are not much better.

As is usual in assertions of dealer oligopoly, there is seldom any comparison to other markets.  The concentration figures Zingales cites are hardly exceptional when compared to other industries, and I daresay to the markets for groceries or gasoline in Chicago.

But worse, Luigi’s argument is very anti-Chicago.  Long, long ago, dating back to the 1960s and 1970s, Chicago eviscerated the structure-conduct-performance paradigm associated with Harvard (and Joe Bain in particular).  Folks like Harold Demsetz and Sam Peltzman pointed out that market structure is endogenous, that concentration can result from the exploitation of cost advantages, that prices can be close to marginal cost even in concentrated markets, and that large profits in such markets are not prima facie evidence of weak or absent competition.

This means that rather than taking the concentration data (as benign as they are by comparison with other industries) and making the leap that this concentration indicates a lack of competition, Zingales should ask why the structure is what it is, what forces generated it, and whether concentration is actually symptomatic of an inefficient, non-competitive market structure.  Put differently, concentration is neither sufficient nor necessary condition for a non-competitive outcome. Regurgitating concentration statistics and proclaiming “QED” is bad economics.

That’s all bad enough, but then he really goes off the rails:

A high degree of concentration distorts the market in several ways. First, when they transact among themselves, large players do not insist on an adequate amount of collateral, relying on the counterparty’s generic creditworthiness (and on the implicit guarantees that governments provided to large firms). Not only does this severely undermine the ability of small firms to compete, but it also contributes to systemic instability of the type that we experienced in 2008, thus increasing the likelihood that taxpayers will have to step in. Market concentration renders mostly illusory the beneficent risk-spreading role that is claimed for derivatives, because the bulk of the risk is borne by very few players.

The point about implicit guarantees is fine–but that’s a policy error that can’t be fixed by jiggering with the market structure.  But the criticism that banks don’t collateralize trades but rely on generalized creditworthiness is wide of the mark for many reasons.  For one, under standard credit support annexes, dealers don’t post independent amounts with one another, but do collateralize via variation margins on a daily basis.  Hence, inter-dealer credit is limited to one-day moves.

For another, Zingales is overlooking the fungibility of credit: initial margins/independent amounts could be funded by borrowing–and banks kind of have access to a lot of borrowing channels.  And since dealers typically rehypothecate collateral, what’s the point of interdealer independent amounts anyways?: with hypothecation A can give collateral to B who can effectively turn around and give it back to A; the actual money flows are a little more complicated, but rehypothecation effectively allows banks to lend each other the collateral that they post with one another.  What’s the point of that?

For yet another, regarding the “undermining the ability of small firms to compete”–can he be serious?  Because of the borrowing point I just made, no doubt if independent amounts on all inter-dealer trades were somehow mandated, who do you think would have the lower cost of funding these margins, the big incumbent banks, or small firms?  I would wager that mandated collateralization would actually favor bigger, more creditworthy firms.

Moreover, Zingales also overlooks other potential scale and scope advantages in derivatives dealing: yes, some of these may be artificial because they arise from TBTF subsidies, but again, that is a problem that needs to be tackled directly.

Zingales then trots out the conventional arguments regarding opacity:

Over-the-counter trading also contributes to the opacity of derivatives markets, further reducing competition and increasing the margin enjoyed by the traders – and the prices that final users (mostly industrial firms) must pay. The combined profits of the key players in this market total $80 billion, which represents a massive tax on the real economy.

To fix this problem, we need to move the bulk of derivative trading onto organized exchanges, where daily collateral requirements would guarantee systemic stability, and price transparency would force competition, reduce margins, and increase the market’s depth. In the United States, the Dodd-Frank Act moves some of the way in this direction, and similar efforts are underway in Europe.

I’ve been over this ground so many times, so I’ll try to keep it brief (for me, anyways).  Zingales presents no evidence that margins are excessive.  End users have choices, including very close exchange-traded substitutes for many OTC derivatives, but they choose to trade OTC instead: like others who have made similar criticisms, Zingales apparently believes that end users are suffering from Stockholm Syndrome or Battered Spouse Syndrome.  When touting exchanges as an alternative, he also overlooks the very real possibility that face-to-face OTC dealings reduce adverse selection costs that end users incur, but would incur on anonymous exchanges.

Moreover, apropos the earlier point about anti-Chicago, if margins are so wide and profits are so fat, why doesn’t entry occur?  Why doesn’t competition work to erode margins and profits here, like in other markets?  Perhaps there’s a story, but Luigi sure doesn’t tell one–and he is far from alone in this.  The statement about profits being a tax is so embarrassing I will pass over it in silence.  The profit number itself is completely contextless; his statements about profits based on absolute magnitude (“boy, that’s big”) remind me of the periodic attacks on oil industry profits that are similarly without any context, or attempt to control for capital deployed, risk, etc.  Given that he alludes to the concentrated riskiness of derivatives positions, perhaps he should at least entertain the possibility that the profits are in fact compensation for risk:  indeed, large profits in “normal” times interspersed with periods of big losses is characteristic of the risk-reward profile associated with tail risk.

As for his proposed “solution,” I can only stand and wonder.  The hook for the entire piece is the EC’s antitrust investigation of the OTC market:

the existence of political motivations does not undermine the legitimacy of the new EU investigations, which will be conducted alongside an ongoing inquiry by the United States Justice Department into anti-competitive practices in the trading, clearing, and pricing of CDS in the US

He starts out his critique of the OTC market by focusing on concentration in the OTC market, and concludes that high concentration is symptomatic of a lack of competition.

Uhm, has he looked at concentration in the exchange space? Is he aware that virtually every major exchange-traded derivatives contract is a monopoly?  Has he looked at concentration trends in exchanges?  Has he noticed the major consolidation wave that has been going on in exchanges since about 2005, and which as picked up again after tailing off during the crisis?

To go on: Is he aware that OTC markets also engage in “daily collateralization”, particularly among dealers?  Is he aware that such daily collateralization is not necessarily stability enhancing, as he asserts? Is he aware that “price transparency” already exists, though in a different form, on OTC markets?  Is he aware that the price transparency on exchanges is accompanied by counterparty opacity that can actually increase trading costs for the uninformed end user due to adverse selection?  And again: if the advantages of exchange trading are so great for end users, why haven’t exchanges made greater inroads in attracting their business, and why have end users in fact gravitated more towards OTC markets where he claims they are getting shafted?

Luigi is a very accomplished economist.  He can do much better than uncritically recycling stale and unpersuasive conventional wisdom.

Please, Luigi: adjust the frequency on your receiver.

Derivatives Reform Proving Difficult.

Regulatory arbitrage raises its ugly head.

‘ET’ [Extraterritoriality] stokes fears about sweeping swap rules.

Clearinghouses Would Not Have Prevented the Financial Crisis.

I’m Shocked! Shocked! to hear that reforming complex markets based on complex contracts among numerous complex financial firms that span myriad jurisdictions around the globe is actually like complicated or something.  I thought Chrissy and Barney and Timmy!  and various Euro-types could rearrange these markets at a whim and make everything all better.

Not really.  I’ve seen a train-wreck from the get go.

Take clearing in particular.  If you’ve spent any time on this at all, you know that the details are incredibly complex.  The economics are challenging, the legal aspects daunting.  My white paper* goes into this in some detail.  This paper does a nice job at explaining some of the legal issues–but still only scratches the surface. If you think you can rearrange something so intricate and have it all work out just swell, you’re in for a rude surprise.  The problem is that you don’t learn what the problems are until they appear, completely unanticipated.

Mark my words.  Re-engineering these markets will lay the foundation for a future crisis.  If only people had heeded Hayek’s aphorism: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

* The white paper is done, and approved.  It should be released formally this week–maybe tomorrow.  Apparently the PR folks at the organization that commissioned the study wanted a few days with it to figure out how to distribute and market it optimally.

The commodity markets have been volatile of late.  The tumult started in silver, which sold off dramatically after reaching post-Hunt highs.  Last week the sell-off broadened to a good chunk of the commodities markets, with oil especially hard hit.  In response to the roiling markets, the CME raised margins sharply on silver, and today on oil and the rest of the energy complex.

This raises the question of the effect of margin changes on prices.  The CME’s head of clearing, Kim Taylor, vigorously defended the CME’s margin increases in silver (and would presumably make the same defense of today’s moves).  Kim’s justification characterizes the clearinghouse’s move as a response to changed market conditions:

Changes to margin requirements are a routine part of market surveillance at CME Clearing, the risk management and compliance unit at CME Group Inc. (CME), which owns Nymex. So far this year, CME has issued over 57 margin change notices.

“I don’t agree that the margin change was a trigger for changes in the market,” said Kim Taylor, president of CME Clearing. Taylor leads a team of sever hundred risk management and compliance professionals who monitor CME’s markets around the clock.

“The market is well tuned so that if there’s a market move that approaches or exceeds our volatility limits” participants know to expect an increase in margin requirements, she said.

The decision to alter trading margins on a contract typically involves risk management professionals involved in day-to-day monitoring of the specific market as well as senior management of the clearing house. The team looks at a variety of quantitative factors like rising volatility and qualitative factors like seasonality and relevant news events in making margin decisions.

“We try to make changes in a way that we can telegraph to the market, so that participants have notice. We try to be routine and predictable and provide no surprises,” Taylor said.

The trading margins are designed to cover around 95% of expected losses, and act as a pre-payment on the coming day’s market move.

“When market conditions become more volatile we would increase margins in anticipation of that, and when volatility decreases we don’t want to create unnecessary capital costs,” Taylor said.

In past instances, CME Clearing has often raised trading margins ahead of certain events in an attempt to damp their impact on trading. For example, the exchange-operator increased trading margins on several products, including crude oil, ahead of Hurricane Katrina to ensure traders were prepared for higher volatility .

“We try to be proactive with either something we can measure or something we can judge to likely effect our markets,”

This is sensible, in a way that I’ll explain in a moment, and the way that CCPs usually act.  Taylor tries to emphasize that the changes are predictable, and in some respects they are, but this is not sufficient to relieve CME of the charge that margin changes can cause market movements.

The changes that CME made, and which Kim explains, are sensible in a microprudential sense.  They help ensure that the CME has a sufficient buffer to absorb defaults by traders.  CCPs try to work on the “loser pays” model, and with more volatility, there are bigger losers–so margins have to be higher to ensure they can pay.

But the implicit assumption here is there isn’t feedback between margins and prices.*  Indeed, that’s the gravamen of Taylor’s argument (“I don’t agree that the margin change was a trigger for changes in the market”).  That is the essence of a microprudential approach.  That assumption, however, is quite tenuous, and almost certainly untrue.  This is particularly the case for big margin changes during unsettled market conditions.

That is, when setting margins, CCPs (and participants in bilateral markets too) typically act as if they are price (and volatility) takers, when in fact they are big enough and their decisions are material enough to be price and volatility makers.  Acting microprudentially, they typically fail to take into account the feedback between their decisions and market prices, or at least do not do so completely.

The feedback mechanism works because frequently market participants will respond to margin changes by liquidating positions.  Those who have already lost money as a result of big price moves are the most likely to liquidate, which tends to exacerbate the original moves.  That’s one reason why you can see bigger than expected moves (as occurred in oil last week) to fundamental shocks.

This is why CCP policies that are prudent in some sense can be macroprudentially dangerous.  Silver, and perhaps oil and other commodities, may be providing an object lesson of what is in store when clearing is extended to vast new markets.  When OTC clearing mandates kick in, the scope for these destabilizing feedbacks will expand dramatically.

Kim suggests that predictability mitigates these impacts, but CCPs are not that predictable, and margin methods are not necessarily that transparent.  So market participants cannot foresee the changes perfectly.  And even if they could, all this means is that they will likely react in anticipation of margin changes. The timing of the response may depend on predictability, but not the existence of the response.

This can create some really strange dynamics and non-linearities.  There’s a big selloff.  Longs anticipate that in response, CCPs will raise margins.  Those that have lost a lot of money know they can’t afford the higher margins, so they preemptively liquidate, exacerbating the selloff.  The bigger price move induces the CCPs to raise margins more than they would have without the preemptive liquidations.

This is exactly the kind of feedback mechanism that can induce chaos (in the technical and conversational senses of the word) in a tightly coupled system like a financial market. This mechanism is particularly prone to chaos if the CCP setting margin doesn’t take into account, or cannot predict accurately, the feedback between its margin changes and the trading of market participants.  And how could it know this effect with any accuracy?

This is a classic example of the tension between microprudential and macroprudential policies that I discussed in some earlier blog posts, and which is a major theme in my forthcoming white paper/discussion paper on clearing.  (This should be available within a week to ten days, if all goes well: final edits and approvals are in the works.)  The information and incentive structures tend to induce microprudentially sensible actions based on the price/volatility taking assumption.  But those actions can be destabilizing. CCPs acting in their own self-interest, and those of their clearing members, may not choose the systemically optimal actions.

It’s worth noting that the CFTC’s Proposed Risk Management Standards for Designated Clearing Organizations effectively codifies this sort of behavior.  Its proposed rule (a) requires that CCPs set margins “actual coverage of the initial margin requirements produced by such models, along with projected measures of the models’ performance, shall meet an established confidence level of at least 99%”, (b) determine the adequacy of margins on a daily basis, (c) backtest the adequacy of margins on a daily basis for products experiencing “significant market volatility,” and (d) backtest the adequacy of margins for all products at least monthly.  Similarly, both the Federal Reserve’s and the SEC’s proposed regulations require the use of risk-based models and at least monthly review of margin levels.

All of these requirements are microprudentially sensible, but will result in margin increases during periods of heightened market volatility.  As just noted, this can create destabilizing feedback effects, particularly during periods of extreme market volatility.

In contrast, the Committee on the Global Financial System recommended the use of a “through-the-cycle approach employing data from a long time series of market movements” when setting initial margins, precisely to reduce the procyclicality in margin that results from adjusting it frequently based on changes in market risks.

Which means don’t look at last week’s commodity mini-crash, or the earlier bigger crash in silver, as historical events.  Look at them as harbingers, as warnings.  Just the normal operation of a tight, mechanical variation margin process can be destabilizing.  Changes in initial and maintenance margins adopted in response to big price moves can destabilize things more.  The financial system can shake off such an occurrence in a market as small as silver, or even one the size of oil.  When it’s a bigger market–and especially when it’s a much bigger market, like some of the huge OTC markets–these changes will shake the markets, perhaps by more than they can withstand.

*Failures to account for feedback between one’s behavior and market prices is a common element in many market crises.  For instance, LTCM’s risk models–like most models in finance–presumed that the hedge fund was a price taker.  But once it became huge, it was no longer a price taker; its trades moved prices and affected liquidity.  Similarly, portfolio insurance strategies took price processes as exogenous, when in fact the strategies themselves affected prices.

Timmy!’s Treasury Department has released a decision exempting foreign currency swaps from Dodd-Frank clearing and SEF rules.  I agree with the decision, because I think clearing and SEF mandates are a bad idea (if you haven’t noticed).  But the “reasoning” behind the Treasury’s decision would embarrass South Park Timmy!  Really.

Where to begin?  First of all, the Notice of Proposed Determination (NOPD) completely undercuts all of the justifications for Frank-n-Dodd clearing mandates.  In multiple ways.

The NOPD tries to distinguish between FX swaps and other swaps: For instance [with my numbering for subsequent reference]:

(1) [f]oreign exchange swap and forward participants know their own and their counterparties’ payment obligations and their full extent of the exposure throughout the life of the contract, whereas the counterparties to other derivatives contracts do not.  (2) Moreover, foreign exchange swap and forward contracts have a very short average length and, therefore, relative to other swaps and derivatives, create significantly lower levels of counterparty credit risk.

(3) Settlement of foreign exchange swap and forward contracts requires the exchange of the full principal amount of the contract . . . whereas the payment obligations of most other derivatives are based on the incremental profit or loss on a transaction.  The physical settlement requirement distinguishes foreign exchange swaps and forwards from other derivates and contributes to a risk profile that is largely concentrated on settlement risk.

To which I say:

(1) So what? And, so misleading.  As the Treasury acknowledges on the prior page, the market value of the FX swap can change.  That’s what creates counterparty risk.  If the dollar crashes (despite Timmy!’s–Turbo Tax Timmy!’s, not South Park Timmy!’s–and Banana Ben’s assurances that it won’t which is primarily why I think it will), those long the dollar under swap agreements will suffer a big loss thereby creating a credit exposure for their counterparties.  That’s what matters.

What’s more, there are a lot of derivatives that are cleared that have this feature.  The counterparties to every physically settled commodity contract, and to every standard stock option, know exactly what the delivery and payment obligations are.  A buyer of a corn futures contract knows the seller has to delivery 5000 bushels of corn, and the seller knows exactly how much money the buyer has to deliver in return.  The buyer of a put on IBM knows exactly what he has to pay on exercise (the strike price times the number of shares), and the seller knows exactly how many shares he will have to deliver.  It’s variations in the market values on these contracts that create credit risk, and that’s the risk that the CME clearinghouse or the OCC take on. If the certainty of delivery and payment obligations meant clearing didn’t add value, why would these kind of products be cleared?  Why have they been cleared for decades?  Why?  Precisely because changes in market values may result in one party to a contract not performing on the fixed and known obligation, and thereby imposing a replacement cost loss on the counterparty.  So how is FX different in any way?

(2) This may be relevant on average, but there are many long tenor FX derivatives.   The NOPD states that 68 percent of FX derivatives mature in less than a week, and that 98 percent mature in less than a year.  This, plus the focus on CLS Bank (the FX settlement service), suggests that they are lumping in all FX trades in their analysis.  By doing so, Treasury mixes apples and oranges.  The logic of Frank-n-Dodd may still compel the clearing of the longer-dated products–which still make up a big chunk of change.  Interesting that the Treasury reports percentages without saying exactly what goes into the calculation, and doesn’t report the amount of principal at risk on longer dated contracts.

(3) Here’s the real whopper.  This actually means that an FX forward or swap has greater counterparty risk than other derivatives (e.g., interest rate swaps) of the same tenor and underlying volatility.   That’s because principal is at risk in a default of an FX swap, but it isn’t at risk in a typical interest rate, equity, or commodity swap.  To quote The Man when it comes to counterparty credit risk, Jon Gregory:

Foreign exchange exposures can be considerable due the high FX volatility driving the risk coupled to the long maturities and the final exchanges of notional required in most swap contracts.  The risk of these instruments is driven by a large final payment and thus the profile increases monotonically until the maturity of the trade (p. 85).

Gregory also has some charts that show FX swap credit exposures being larger than the exposures on IR deals.

All of which pretty much calls Bull! on the Treasury’s “argument” as to why differences between FX swaps and other swaps means that it’s not necessary to clear the former.  If anything, to a Frank-n-Dodd fan, the reverse should be true, at least for longer-dated swaps.  Similarly, the NOPD makes it clear that non-delivery settled forwards are not exempted–even though the lack of principal being at risk means that all else (e.g., tenor, currencies) equal NDSFs entail less counterparty risk.

So, if you believe that counterparty risk is best handled through CCPs–which you have to believe if you are a Frank-n-Dodd clearing mandate pom-pom squad member–you should think longer tenor FX swaps are especially important to clear.

But it gets better!  Or worse, depending on your point of view.  Treasury also argues that a clearing mandate would be burdensome because it could lead firms to eschew risk management.

Seriously!  Let me repeat that: Treasury also argues that a clearing mandate would be burdensome because it could lead firms to eschew risk management.

Don’t believe me?  Read it for yourself:

Commenters argue that additional costs associated with collateral, margin, and capital requirements required by the CCP would potentially reduce their incentives to manage foreign exchange risks.  Such additional costs borne by non-financial end-users could lead to lower cash flows or earnings, which would divert financial resources from investment and discourage international trade, thereby limiting the growth of U.S. businesses.

. . . .

In light of these and similar factors raised by the commenters, Treasury believes that mandating centralized clearing and exchange trading under the CEA for foreign exchange swaps and foreign exchange forwards actually would introduce significant operational challenges and potentially disruptive effects in this market which would outweigh any marginal benefits for transparent trading or reducing risk in these instruments.

So don’t these burdens exist in other markets?  If “additional costs associated with collateral, margin, and capital requirements required by the CCP” lead to less FX hedging, won’t they also lead to less interest rate, credit risk, and commodity price hedging?  If the reduction in risk management is such a serious concern in FX, why not in these other markets?

But we’re not done yet!  Get this: another justification for the exemption is that most FX derivatives are traded by banks either directly or on behalf of clients, and–wait for it–

[b]anks are subject to consolidated supervision, and supervisors regularly monitor their foreign exchange related exposures, internal controls, risk management systems, and settlement practices.

In case you didn’t catch that, FX derivatives should be exempted from clearing because:

Banks are subject to consolidated supervision, and supervisors regularly monitor their foreign exchange related exposures, internal controls, risk management systems, and settlement practices.

Here’s more:

The predominant participants in the foreign exchange swaps and forwards market are banks which have long been subject to prudential supervision.  In fact, nearly all trading within the foreign exchange market involves bank counterparties.  Roughly 95 percent of foreign exchange trading occurs between banks acting in the capacity of either principal or agent.  Compared to non-bank entities, banks have distinct advantages to provide the liquidity and funding necessary to conduct foreign exchange swaps and forwards, which involve the exchange of principal, rather than variable cash flows.  In conjunction with providing the liquidity and funding needs to conduct these transactions, banks are uniquely qualified to have access to CLS to settle transactions on a real-time basis, and thereby meet the payment and short-term funding needs of the end users.

Prudential supervisors regularly monitor the activities, exposures, internal controls and risk management systems of these banks.  In order to meet safety-and-soundness requirements, banks have implemented monitoring systems, limits, internal controls, hedging techniques, and similar risk-management measures.  Counterparty credit risk management is a fundamental issue for banking supervisors and is extensively addressed in bank supervisory guidelines as well as under the Basel Accords.

So let me make sure I have this right:  bank dominated markets need not be cleared because banks are subject to rigorous prudential regulation.

But wait a minute.  The whole point of Frank-n-Dodd was that derivatives trading was uniquely dangerous for banks, and clearing mandates were necessary to reduce the risk of the derivatives-induced collapse of a too big to fail bank, all because prudential oversight hadn’t worked and couldn’t be relied on. Moreover, whereas Dodd-Frank contemplated the exemption of non-bank firms from clearing mandates, margining on non-cleared trades, and capital requirements, the Act forces banks to clear standardized products, and to collateralize non-cleared trades.  All in the name of reducing systemic risk and shifting counterparty risk from banks to CCPs (which are capitalized by banks, but let’s ignore that little detail).

In order for this to make any sense whatsoever, it must be the case that prudential regulation is insufficient to reduce derivatives-related systemic risks.  But the NOPD relies heavily on the adequacy of prudential regulation to justify exempting FX swaps from the clearing mandate.

I ask, in all seriousness: if dominance by banks that are prudentially supervised implies that clearing is not necessary, why are CDS subject to a mandate?  After all, they’re bank dominated.  And don’t banks have “distinct advantages to provide the liquidity and funding necessary to conduct” other kinds of swaps?

F. Scott Fitzgerald said “the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.”  You have to be a genius and hold Frank-n-Dodd and the Treasury NOPD in your mind simultaneously, because they are definitely opposed ideas.  Every substantive justification for the exemption in the NOPD is diametrically at odds with the justifications for the Dodd-Frank clearing mandates.

But the fun isn’t finished!  The NOPD’s rationalization for exempting FX from SEF requirements is also entertaining.  I quote:

Foreign exchange swaps and forwards already trade in a highly transparent market.  Market participants have access to readily available pricing information through multiple sources.  Approximately 41 percent and 72 percent of foreign exchange swaps and forwards, respectively, already trade across a range of electronic platforms and the use of such platforms has been steadily increasing in recent years.14  The use of electronic trading platforms provides a high level of pre- and post-trade transparency within the foreign exchange swaps and forwards market.  Thus, mandatory exchange trading requirements would not significantly improve price transparency or reduce trading costs within this market.

I’m not disputing any of this, but  just think of all the questions that this should raise in the minds of those who argue that it is necessary to force open electronic trading on swap market participants–but which it evidently hasn’t.

Recall that the NOPD makes a big deal out of the fact that FX is bank-dominated–dominated, in fact, by the same banks that dominate IR, credit, and equity derivatives trading.  In IR, credit, and equity, the argument goes that banks have actively fought pre- and post-trade transparency and electronic execution in order to protect their market power.  So . . . why didn’t they try and succeed in doing that in FX?  To create a natural experiment?  I kinda doubt that.

Maybe–just maybe–it’s because trading structure is endogenous and reflects the nature of the instruments traded and the firms that trade them, and there are enough differences across markets to make different trading structures optimal.  Maybe–just maybe–market structures and trading mechanisms have evolved to match in a discriminating way the characteristics of instruments and participants.

I don’t know that’s definitely the case, but it’s certainly a possibility, and it makes economic sense.  It’s certainly a more plausible explanation of cross sectional variation in trading mechanisms than the Treasury or SEF mandate boosters offer–because they don’t offer any.  Another F. Scott Fitzgerald moment here, apparently,  for the very facts in the Treasury NOPD undercut the narrative used to justify SEF mandates that Treasury has advocated strongly in the past.

Of course I seriously doubt that the espousal of completely contrary positions on all these matters is a reflection of first rate intellects at work.  Nor is it an exercise in eristics.  Instead, it is a symptom of complete intellectual muddle and confusion, blended with politics and rent seeking. Timmy!, Dodd, Frank and all the other Sorcerer’s Apprentices have no real understanding of the economic forces they have unleashed, and what will result.  The FX swap exemption is a first order issue, and the completely intellectually discreditable way with it has been handled provides a very sobering preview of how derivatives market regulation generally, and CCP regulation in particular, is likely to be carried out in the future.  If they can’t think carefully and seriously about this, what can they think carefully and seriously about?  Are they incapable of self-reflection?  Of embarrassment?  Do they not see the glaring contradictions between the NOPD and the entire rationale for the Dodd-Frank Act that gave birth to the NOPD in the first place?

I’ve said it often before, but it still bears repeating.  Regulators create systemic risks because they act on the entire system, and there are few of the kind of ameliorative feedback mechanisms that work in markets.  I fear that the NOPD is a harbinger of the kinds of regulation- and regulator-created systemic risks that will haunt derivatives markets for years to come.