Streetwise Professor

Vladimir Putin was in fine form  in a speech in Berlin the other day, shrieking hysterically about the savage Europeans and their thieving energy policies:

Russian Prime Minister Vladimir Putin on Friday lashed out at European Union laws aimed at liberalising the continent’s energy market, saying they hinder investment and amount to uncivilised “robbery”.

Putin, speaking to an investor forum before talks with German Chancellor Angela Merkel, said the EU should consult Russia when drafting such important legislation.

“Our companies, together with German partners, legally acquired distribution assets in Lithuania. Now they are being thrown out there with reference to the Third Energy Package. What is this? What is this robbery?” Putin said.

“We often hear from our partners both in Europe and North America: ‘If you want to be members of a global family of civilised nations, you should behave in a civilised way.’ What is this then? Have our colleagues forgotten the basic principles?”

Nothing like sticking Putin’s beloved Gazprom to make him squeal like a piggy.

No doubt Putin believes that mandated unbundling of distribution pursuant to EU legislation, duly passed, is analogous to the expropriation of Yukos or Sakhalin II. Check that.  He actually thinks the latter were righteous and just: if you really want to hear him lose it, just say “Khodorkovsky.”   It’s unbundling that’s the crime.

Unbundling is a widely employed method to enhance competition in network industries.  It can work well, or it can work badly at enhancing competition.  But maybe that’s exactly what has Putin steamed: he’s not too big on promoting competition in the energy sector.

Moreover, it is not undertaken to expropriate property from one party to line the pockets of the state, or some individuals or firms favored by the state.  Moreover, the EU directive is meant to be applied uniformly across all companies, not selectively against individual companies who have fallen into disfavor, or who have something somebody else wants. Note that a German company, E.ON Ruhrgas, is also affected by the unbundling in Lithuania that vexes Putin, so it is not a measure directed at Russia or a Russian company alone.

In brief, Putin’s idea of “civilized” and the Anglo-Euro-American idea of civilized when it comes to property and regulation are quite different. There is a failure to communicate, and the failure is largely cultural.

I especially liked Putin’s assertion that the EU should “consult” with Russia when drafting its legislation.  Uhm, somehow I’m thinking that that’s just another Russian one way street.  Putin would shriek even louder if the Euros were to demand a voice in shaping Russian law, such as it is.  (Indeed, he has–as has Medvedev–told other nations to butt out when they expressed criticism of Russian legislation or legislative proposals.) Indeed, few things get him more incensed than any action by foreigners that he perceives slights Russia, treats it as an inferior to be instructed, or threatens to put Russia “on its knees.”

Lord knows that Merkel has her hands full, with the accelerating implosion of the Eurozone.  But I wonder just how much of Putin she’s going to take: she’s taken quite a bit already.  I also know that German business pushes her to deal with Russia to advance its interests, but Merkel has to know that there is a huge imbalance of economic power between Germany and Russia–and it don’t favor Russia.  So I imagine there will come a day when she slaps Putin down.

If, that is, she’s still in power to do it.  The meltdown in Europe puts her between the importuning PIIGS (and now maybe Belgium too) demanding German money to save the Euro and the EU and a German public that resists bailing out its spendthrift neighbors.  She may well be turned to powder between these political grindstones, leaving some other German chancellor to put up with Putin’s tantrums.

In my recent piece on clearing in the Journal of Applied Corporate Finance, I wrote:

It is equally unknown what clearing market structure will evolve, and how close this structure will come to approximating the ideal structure.  In this regard, it is essential to keep in mind two facts.

First, the extensive scale and scope economies associated with clearing make it likely that the clearing industry will be highly oligopolistic, and that strategic considerations will influence decisively the way that the industry develops.   Moreover, scope economies across trade execution and clearing (Pirrong, 2010b) will also affect the strategic and efficiency forces that will shape industry structure.  Strategic considerations will almost certainly drive a wedge between what is optimal for the individual decision makers, and what is optimal for the economy.  This is particularly true inasmuch as there is no market mechanism evident that would induce CCPs to internalize the systemic externalities associated with their failure.

. . . .

Second, industry evolution will inevitably be a highly politicized process.  Dodd-Frank gives regulators enormous discretionary authority over the operation of CCPs.  Interested parties will influence the regulatory process for their private benefit.  Political tradeoffs, rather than efficiency considerations, also threaten to cause serious divergences between the structure that evolves in practice, and the one that would optimize the relevant economic tradeoffs.  The effects of politics are particularly pronounced in this context because finance is a truly international industry, and hence jurisdictional issues and competition between jurisdictions will play a decisive role in determining the industry’s ultimate configuration.  For instance, governments in major financial centers (e.g., the US, London, the EU, and individual countries in the EU, Japan, Singapore, and Hong Kong) have all expressed a strong interest in domiciling CCPs, for both economic and political reasons.  But accommodating these interests would fragment clearing, reducing netting benefits and raising serious concerns about coordination during a crisis.  Moreover, regulatory competition between jurisdictions to favor their local CCPs could compromise financial market stability.

There is another mandate in Frank-n-Dodd, this one for reporting all swaps transactions to trade respositories.  The scale and scope economy issues, and the jurisdictional and political issues are also present for repositories, and a recent article in eFinancial News demonstrates that the problems in the likely evolution of clearing market structure that I identified above, with the associated inefficiencies, are coming to pass with the repositories:

However, repositories are not a cure all. While the concept of a trade repository is not controversial, there are issues to address. Most notably, the sudden explosion of repository providers is leading to fragmentation, a problem familiar in other areas of the market, such as the clearing landscape.

Market participants are concerned that fragmentation would undermine the purpose of repositories to provide a single integrated view of derivative risk. The DTCC’s Douglas said: “The problem with trade repositories is that if everyone wants to build their own, how can regulators be sure that they are seeing the whole picture?”

l;”>The market has also raised concerns that multiple repositories may lead to double-reporting, while others highlight the implicit problem of dividing repositories along asset-class lines.

Richard Metcalfe, head of global policy at the International Swaps and Derivatives Association, which supports repositories in principle, warns that this approach does not show the trade data in its fullest context. He said: “You are looking at derivatives in isolation from positions that dealers might be hedging or adding to.”

This problem may be partially addressed by developing interconnectivity between the different trade repository providers. Interconnectivity would help build a full regulatory picture but would still afford dealers a choice of reporting venue, according to Philip Brown, head of client relations for Europe and the Americas at Clearstream.

. . . .

“>But the legislation is not yet finalised and the industry will have to move fast before the proliferation of repositories in both US and Europe renders the task of standardisation slow, tedious, and painful.

Metcalfe said: “I think the key issue is can we ensure that supervisors work together internationally to ensure that the information can be aggregated.”

It’s easier to create repositories than CCPs.  That’s why the process of creating them is further along than for CCPs.  But you can expect that all of these problems will occur in spades as development of clearinghouses proceeds in the coming months and years.

It’s also important to remember that repositories just consolidate data, not risk, so the consequences of getting it wrong are not as severe, by far, with repositories as compared to CCPs.  Fragmentation seriously impairs the allocation of risk, by reducing netting possibilities, reducing diversification, and limiting cross margining.  It also will create the potential for serious coordination problems in the event of a crisis; poor coordination across CCPs could greatly exacerbate the effects of a crisis.

Which all means that when you see the difficulties already becoming manifest in trade repositories, you should be very concerned about the effects of a clearing mandate.  Frank-n-Dodd, and what the EC is doing, can mandate clearing, but they can’t mandate market structure.  That is going to evolve in a messy way, driven by the nature of indivisibilities and politics–as the repository experience is showing.  And a messy evolution in clearing is a very sobering prospect, given that our legislative and regulatory betters have decided it wise to put all our eggs in that basket.

This was unintended, but not unpredictable.  At least it shouldn’t have been.  But one hopes that even for the dreamers and the slow learners, that what is happening in trade repositories is a cautionary tale that will open their eyes to what is likely to transpire in clearing.

Frank-n-Dodd mandated clearing.  The CFTC is now promulgating a raft of rules regulating the clearing process.  One of these rules limits the ability of clearinghouses to determine to whom they offer clearing services, and how:

The Commodity Futures Trading Commission approved a proposed rule to force the world’s largest banks to offer swaps clearing services to smaller firms, a change that would promote competition in the $615 trillion market.

. . . .

“Swaps dealers or major swaps participants are prohibited from interfering with or attempting to influence decisions related to the provision of clearing or the acceptance of clearing customers,” according to the proposed rule. The potential regulation now enters a 60-day public comment period before any final CFTC vote.

I’ll defer comment now on this particular rule because it hasn’t been posted on the CFTC website yet, and want to read the full rule rather than going on just the news report.  But this does relate to a general issue that I’ve been thinking about lately: CCP governance.  So I’ll provide some general analytical observations on this subject that are likely to be relevant as the CFTC and SEC proceed on clearing issues.

I’ll focus on CCP membership and its implications for the way CCPs are run.  In particular, in addition to controversy about who should be allowed to open clearing accounts and who should have a say in who can do so, there is also controversy about who should be able to become a CCP member, and CCPs’ ability to set membership standards and to exclude some firms from membership.  This issue came up at the roundtable I participated in on 22 October.  There is a group of smaller banks and brokerage firms that are pressing to become CCP members, and to limit the ability of CCPs to set standards that could result in their exclusion.  This is likely to be a big issue going forward.

As I’ve written for years, there are difficult trade-offs here.  On the one hand, there is the issue of market power.  I’ve shown–in work going back into the 1990s–that when there are substantial scale economies, as is the case in clearing, it is possible for a CCP–even if it is member-owned, and a not-for-profit–to exercise market power by limiting membership.  That is, a suboptimally small “club” of intermediaries can get together and form a CCP, without fear of competition from another CCP due to the scale economies.

On the other hand, allowing open access can jeopardize the financial security of the CCP.  I want to focus on this issue.

A key point here is heterogeneity.  CCPs with heterogeneous members, in particular firms that vary in their financial strength, risk management capabilities, etc., face difficulties that CCPs with more homogeneous members do not.  These difficulties, in fact, can undermine the ostensible public purpose behind mandating CCPs: reducing systemic risk.

CCPs are firms that have to be governed and managed.  It is well known that heterogeneity increases the costs of governing cooperative organizations.  Henry Hansmann’s The Ownership of Enterprise provides numerous examples of this.  Conflicts between members are more likely, the more heterogeneous they are.  In particular, some members can attempt to use the organization to transfer rents from other members.  In my 2000 JLE paper “A Theory of Financial Exchange Organization” I explain a lot of the supposedly inefficient and cumbersome governance mechanisms in futures and stock exchanges as a rational way of mitigating rent seeking among the heterogeneous members of these exchanges.

Let’s take the case of a CCP in particular.  A CCP mutualizes risk, and therefore creates potential moral hazard problems.  The CCP can mitigate these problems by imposing capital requirements, and crucially, by choosing margin/collateral policies.

When CCP members are heterogeneous, in particular, when some are better capitalized than others, or when some incur higher costs to post collateral than others, the members will disagree on what the appropriate margins should be.  The better capitalized firms and those who incur lower costs to post collateral will prefer higher margins.  The more poorly capitalized firms and those who incur higher collateral cots will prefer low margins.

The well capitalized firms are concerned that since clearing makes the cleared products fungible, customers don’t care who they trade with.  Since risks are shared, every member is effectively a perfect substitute from the perspective of customers.  Thus, clearing tends to make it easier for less-well capitalized firms to get business.  But since default risk is mutualized, this reallocation of trading activity towards the less-well capitalized firms tends to force the better-capitalized firms to suffer more default losses.  One way (albeit, imperfect) to control this problem is to raise the costs that the less-well capitalized firms incur (relative to the costs of the better-capitalized ones).  Since collateral is typically costlier for the lower-cap firms, this can be done by charging relatively high margins.

Thus, I would expect that more highly capitalized firms would prefer higher margins than the less highly capitalized firms.  (Similar arguments can be made relating to other risk control policies that CCPs might adopt.)  The more heterogeneous the membership, the more acute the conflict between the members.

The CCP governance mechanism has to have some way of dealing with these conflicts, and making decisions.  Some decisions are going to be made by voting.  With one-member, one-vote kinds of systems, the median member will drive the outcome.  A CCP with a few big members and a larger number of small members may therefore tend to choose policies that favor the smaller members.  This is not likely to be optimal from a systemic risk perspective, and is also likely to result in larger members doing things to limit their exposure.  This in turn limits the risk sharing benefits that a CCP can offer.

Other kinds of voting rules can mitigate these problems, e.g., rules that are based on size or capitalization in some way, with bigger/better-capitalized members having more votes.  But smaller members are unlikely to be satisfied with merely belonging to a CCP but having to defer to the bigger members on key policy issues.  Hence if they pressure regulators and Congress to craft regulations that require CCPs to admit them, they are also likely to pressure regulators and Congress to craft regulations of CCP voting rules that give them some influence over CCP decisions.

Other decisions will be implemented by CCP management.  But CCP managers will be accountable to the members, and subject to influence by them.  Here again, voting rules will matter.  Moreover, Peltzman-Becker pressure group considerations suggest that managers, like politicians, will adopt policies that balance support among the various constituencies.  Median-voter type considerations again exist.  This means that CCPs with more heterogeneous members are likely to adopt policies that appeal to the median member.

In brief, when trying to determine the riskiness of CCPs, you have to consider how they are governed and managed.  Moreover, you have to recognize that governance and management depend on the composition of the membership.  And in particular, that CCPs with more heterogeneous members will behave differently than CCPs with more homogeneous ones.

One concern that is oft-expressed is that there will be a “race to the bottom,” with CCPs competing on margin and thereby compromising safety and creating systemic risks.  Given the economies of scale and scope in clearing, I doubt that the competition between CCPs will end up being all that intense, although there may be an initially period of intense competition that results in the market tipping to one or two dominant CCPs.

This analysis of CCP governance suggests another concern, and one that I think is more of a real worry.  Namely, that member heterogeneity can lead CCPs to adopt policies that benefit the median member, but which are not optimal from a systemic risk perspective.   Clearing inherently faces a moral hazard problem.  This moral hazard problem can create systemic risk.  Member heterogeneity makes it more difficult to control this moral hazard problem.  Internal pressures from riskier members–who can essentially pass their risks and the associated costs on to less risky ones–can lead CCPs to choose margin and other risk control policies that are not systemically optimal.  Internal pressures to reduce margins, rather than a race to the bottom between competing CCPs, is something to be concerned about.

One other historical note that illuminates another important cost of heterogeneity.  In Banking Panics of the Gilded Age, Elmus Wicker shows that with one notable exception (the Panic of 1873), the New York Clearinghouse was unsuccessful in dealing with financial panics and contagion.   (NYCH was a bank clearinghouse, not a derivatives clearinghouse, but there are important similarities.  Most importantly, NYCH had the ability to mutualize some risks.)  Wicker argues that conflicts between heterogeneous members were the main impediment in dealing with panics.  Although mutualization of risks would have mitigated panic (because the banks collectively were more likely to be solvent than any individual bank), mutualization transferred wealth from the stronger banks to the weaker ones.  The inability to overcome this distributive conflict stymied the ability of the NYCH to respond to crises in an effective way.   Thus, not only can heterogeneity increase the likelihood of a problem at a CCP (due to its effect on the severity of moral hazard problems), it can reduce the effectiveness of a CCP in dealing with a crisis situation.

This means that regulators should be extremely careful when crafting rules for CCP membership and voting policies.  Yes, there are legitimate grounds for concern that CCPs will use membership policies to exercise market power.  But there are also grounds for concern that forcing CCPs to admit more firms will lead to more heterogeneity, and that this can raise governance costs and jeopardize the financial safety of CCPs.  Similarly, regulation of governance and voting procedures to give more power to smaller members can also raise governance costs and jeopardize safety.  Inasmuch as the ostensible purpose of CCPs is to improve the stability of the financial system, it would be perversely ironic if political pressures induced regulators to adopt rules on CCP membership and governance that created systemic risks.  Tread carefully, people.

The next brawl on the Frank-n-Dodd fight card is over segregation of customer funds in the clearing model.  From the FT:

The “risk” that is in the spotlight centres on how customer assets, such as margins required to cover potential losses on derivatives trades, are held.

Under the current futures model, “futures clearing merchants” (FCMs), which handle cleared derivatives hold these assets in pooled accounts. If one of the FCMs’ customers defaults, and causes the FCM to go under too, then the clearing house can tap into this pooled account – also called an “omnibus” account – to cover any losses that are not met by margin payments or the clearing house’s default fund.

For investors these accounts are an important safety net. And they want the pooled accounts to be replaced by a system of separate, or segregated, accounts. Then, if another investor defaults, their assets are safe.

“It is an extreme event, but it is not impossible,” said Richard Prager at BlackRock at the meeting organised by the CFTC.

. . . .

If regulators opt for segregated accounts, clearing houses won’t be able to tap into these in the event of a default. Instead, clearers say the current system of using omnibus accounts gives them an extra shield. The removal of this shield would mean they would have to find funds elsewhere, potentially driving up clearing costs for users.

Kim Taylor from CME Clearinghouse said the removal of omnibus accounts could require a 60 to 100 per cent rise in the default fund, the capital put up by the backers of clearing houses. Such a rise in capital costs could lead banks to “think twice” about being in the clearing business, she said.

Point number 1 (which everybody saying anything about clearing should repeat until they internalize it): a primary effect of any priority rule–and the difference between segregation vs. omnibus accounts is first and foremost a difference in who is in what loss position in default–is to shift risk around.  Under the omnibus model, the customers of an FCM are at risk to its other customers and the FCM itself.  If some customers default, and the FCM does not have the resources to cover this, under the omnibus system the clearinghouse can seize the entire customer margin held in the omnibus account to make whole those at other FCMs (including the other FCMs themselves) who are owed money.  This means that non-defaulting customer funds at the defaulting FCM can be used to cover the losses of the defaulting customers at that FCM (though not the losses on the FCM house account).  Under segregation, this can’t happen.  But that doesn’t mean the losses go away: they are borne by the other clearinghouse members who don’t default.  These firms are obligated to pay up to make those owed money whole.

In other words, with an omnibus account system, customer default losses are shared among FCM customers and members of the CCP.  Under segregation, they are shared only among members of the CCP.  The rule shifts losses around.

Note that this is somewhat ironic if the policy objective of a CCP mandate is to reduce the counterparty risk losses suffered by the large, systemically important financial institutions that are among the members of CCPs.  Segregation rules force said firms to bear larger default costs than omnibus rules: losses are shifted in their direction.  (And compared to bilateral markets, it can also be the case that large systemically important financial institutions will bear larger default losses under clearing than without it.)

In other words, just looking at the risk piece, the choice between segregation and omnibus is a choice between different sharing rules.  Default losses are actually spread more widely under the omnibus system, as non-defaulting customers are in a potential loss position.

But whenever you look at insurance arrangements, you have to consider the incentive effects, and most notably, the potential for moral hazard.  The crucial thing to understand here is that the segregation system is more vulnerable to moral hazard than the omnibus system.

This is true for at least a couple of reasons.

First, customer incentives to monitor FCMs are stronger with omnibus accounts.  A customer realizes that if the FCM doesn’t monitor its customers appropriately, or lets them assume excessively risky positions, he is at risk of loss from the FCM’s carelessness.  He therefore has an incentive to choose an FCM carefully, and to monitor that FCM, and potentially move to another FCM (“exit”)  or raise hell with his current one (“voice”) if he finds that FCM is slacking in watching its customers.

Second, under segregation, customers don’t care about the riskiness of the FCM’s trading or financing.  Remember a customer is in a loss position under an omnibus system when (a) there is a default in some customer accounts, and (b) the FCM can’t cover this loss.  Condition (b) is more likely to occur, the riskier the FCM’s own trading, financing, etc.  Therefore, a customer is more likely shy away from a high flying FCM that trades aggressively, or levers up to the max, or chooses fragile forms of leverage when under an omnibus system.  Under segregation, the customer channels Alfred E. Newman: “What, me worry?”  He will choose an FCM only on the basis of commissions, services, the quality of the Christmas party and golf outings, etc.  This means that under segregation, customer accounts will be at riskier FCMs, on average, than under omnibus accounts.

More moral hazard means that default losses will be greater on average under segregation.  And since non-defaulting CCP members are on the hook for the entire default loss with segregation, this means that CCP members have more capital at risk under segregation than with an omnibus system.  That’s why Kim Taylor concludes: “Such a rise in capital costs could lead banks to ‘think twice’ about being in the clearing business, she said.”  A bigger share of a bigger amount translates into a lot more capital.

Given this, it’s no surprise that the omnibus account system has had survival value.  It is a way of controlling moral hazard.  It reduces the insurance benefits of clearing (from the customers’ perspective), but it reduces the costs of providing this insurance.  As is the case with virtually every insurance system, including the most prosaic automobile policy, you need something like a deductible to mitigate moral hazard. Insurance is almost never complete due to the perverse effects of moral hazard. Omnibus accounts play the role of mitigating some moral hazards in clearing.

I would hope that regulators ask why the omnibus system evolved, survived, and dominated before prescribing the sharing rule that CCPs adopt.  (I’ve told one regulator exactly that.)  The survival principle tells you something.  Before changing what is, ask why it is.  Believe it or not, there is very likely to be a good reason for it.  And with omnibus accounts, that reason is control of risk.

I have to quote just one more thing from the FT article:

But the issue highlights the complexities – and costs – of reforms.

Well, no sh*t.  Some people (sounds of throat clearing) have been saying that for literally years.  If only the Sorcerers’ Apprentices had appreciated that before passing Frank-n-Dodd.

I exchanged IMs with Renee yesterday, in which she was describing the attitudes of virtually all of the students in her economic development class towards US debt with China.  She wrote: “people are crazy paranoid about the chinese taking over the US with our dollars. . . . they are all asking, what happens when they call in our debt.”  To which I responded: “They gave us stuff.  We gave them paper.  Pretty good deal.”

Lo and behold, what should I read in today’s WSJ, but an excellent oped by John Cochrane, from my alma mater, the Booth School at the University of Chicago, saying the same thing:

What’s the right policy toward China? They put a few trillion dollars worth of stuff [same word, even] on boats and sent it to us in exchange for U.S. government bonds. Those bonds lost a lot of value when the dollar fell relative to the euro and other currencies. Then they put more stuff on boats and took in ever more dubious debt in exchange. We’re in the process of devaluing again. The Chinese government’s accumulation of U.S. debt represents a tragic investment decision, not a currency-manipulation effort. The right policy is flowers and chocolates, or at least a polite thank-you note.

Yet Mr. Geithner thinks that the Chinese somehow hurt us. There is at work here a strange marriage of Keynesianism and mercantilism—the view that U.S. consumers supported the world economy by spending beyond our means, so that other people could have the pleasure of sending things in exchange for pieces of paper [again–same word choice].

Cochrane is also spot on in skewering the policy Goldilocks who claim to be able to discern what level of trade, investment, and saving is “just right”:

This is all as fuzzy as it seems. Markets and exchange rates are not always right. But it is a pipe dream that busybodies at the IMF can find “imbalances,” properly diagnose “overvalued” exchange rates, then “coordinate” structural, fiscal and exchange rate policies to “facilitate an orderly rebalancing of global demand,” especially using “medium-term targets” rather than concrete actions. The German economics minister, Rainer Brüderle, called this “planned economy thinking.” He was being generous. Planners have a clearer idea of what they are doing.

He also makes a point that I’ve belabored over the past two years, but which I’ve seldom seen in print:

So Mr. Geithner knows that trade surpluses in the end come down to saving and investment. And he knows that in the U.S. people are trying to save right now. Our government is undoing their efforts with massive fiscal deficits. Mr. Geithner recognizes that most of the trade “imbalance” comes down to a big fat fiscal imbalance centered in Washington, D.C.

Abso-effing-lutely.  It drives me crazy (short trip, I know) to hear “analyses” of Keynesian-style stimulus policies that are predicated on the belief that Americans are programmed automatons, rather than deciding, active, acting, and reacting, agents.  They want to restore their ravaged balance sheets, and do so by saving.  They understand, perhaps not intellectually, quoting Ricardo, but certainly intuitively, that expanded government spending today is nothing but tomorrow’s tax bill.  So they react to stimulus, and threats of more stimulus (and “threat” not “promise” is the right word), by making decisions that largely reverse government actions.  Maybe not 100 percent, but substantially.  Which means that the fact that stimulus has not stimulated shouldn’t be surprising to anybody who understands that American households are not inert blobs that can be manipulated at will by Washington mandarins.  (I understand that excludes a good fraction of the 202 area code and vast swathes of the commentariat.)

No, talk of governments or the IMF correctly discerning “imbalances” and crafting appropriate policies in response is like Cochrane says: a pipedream (if not worse).  The main thing that is unbalanced in the American economy right now is the administration’s economic policy, and those responsible for it.  And Timmy! is at the top of the list.

One more thing about the Chinese and debt.  The implicit presumption underlying the fear of Renee’s classmates is that the creditor has the power and calls the tune.  But as far too many of Donald Trump’s bankers have found out to their dismay over the years, if you lend somebody enough, he has tremendous power over you.

With respect to China, we already have the stuff, thank you.  We’ve promised to give you stuff in return in the future.  Just what is the mechanism for enforcing that promise?  This has been the conundrum in sovereign debt markets from time immemorial.  Just look at how the Greeks can tie the Euros in knots.  I’m not saying it will come to this, but insofar as debt is concerned, China is more vulnerable in many ways than the US.  They have the Benjamins, yes, but (a) the amount of stuff the Benjamins can buy is outside of their control (and in the control of another Ben, ironically), and (b) there is always the risk that we tell them that their Benjamins are no longer exchangeable for stuff.

Tyler Cowen notes that yields on inflation protected securities, TIPS, have turned negative.  He links to this NYT story for more details.

Tyler argues that this negative TIPS yield indicates that expected real interest rates are negative.  But as I note in a comment to his post, that’s not right.  TIPS have an embedded option resulting from an asymmetric exposure to positive and negative inflation rates.  If inflation is positive, the Treasury gives you the contractual coupon on the TIPS on a principal that is increased by the inflation rate.  If inflation is negative, Treasury gives you the contractual coupon, but doesn’t adjust the principal.  So you get a real return equal to the coupon when inflation is positive, and a real return equal to the coupon minus the rate of inflation if the price level declines; that’s bigger than the coupon.  In contrast, with a nominal Treasury, your real return is the coupon minus the rate of inflation regardless of whether that inflation rate is positive or negative.

Investors bid down the coupon on the TIPS to reflect the value of this option.  The time value of this option is particularly big when (a) expected inflation is approximately zero (as this makes the option at the money), and (b) there is a lot of uncertainty about the future inflation rate.

That’s a pretty fair description of current market conditions.  Inflation is hovering around zero now, but there are real risks of either a big spike in inflation or a deflation.  There is intense debate in the investing and policymaking communities about whether inflation or deflation is now the bigger risk.  You look at the ballooning monetary base, and you recognize that if velocity picks up even a bit and the Fed doesn’t react quickly, and prices could shoot up.  The plummeting dollar and rising commodity prices are also inflationary signs.  But there is also real concern about deflation, a liquidity trap, etc.

So to me, that means that there is huge uncertainty about the future course of the price level, and that translates into a big value of the option embedded in TIPS.  That in turn, in a situation of an expected inflation rate of zero and relatively low real returns given the sluggishness of the economy, can produce negative TIPS yields.  As a result, I don’t see the negative yields as an indication of negative real returns.  Instead, they are an indication of the huge uncertainty about the future course of prices.

Here’s what I posted as a comment on Tyler’s site:

You need to take into account the terms of the TIPS when drawing conclusions about expected real rates of return. Taking these terms into account, a negative TIPS yield does *not* necessarily mean a negative real rate of return.

The crucial thing to remember is that the principal amount of TIPS is increased when inflation is positive, but the principal amount of TIPS is *not* decreased when there is deflation. As an example, if I own TIPS and there is a 10 percent deflation, I earn a 10 percent real rate of return on my TIPS holdings because the principal amount on the TIPS stays constant, but the real value of that principal rises by 10 percent.

Thus, negative yield could be signaling a high probability of deflation. This means that you cannot conclude that a negative TIPS yield implies a negative real rate of return. If the expected change in the price level is -2 percent, and the TIPS yield is -.5 percent, the expected real rate of return is 1.5 percent.

But an expected deflation should affect nominal yields too. If the real rate of return is 1.5 percent, given an expected change in the price level of -2 percent, nominal bonds should be yielding -.5 percent too.

Right now, TIPS in the 2 year maturity range are yielding about -.85 percent. Nominal 2 year yields are about +.35 percent. TIPS in the 5 year maturity range are yielding about -.3 percent, whereas 5 year nominal yields are about 1 percent.

The features of TIPS can result in negative TIPS yields and positive nominal yields when there is *uncertainty* about inflation. TIPS have an option-like nature. TIPS investors are protected against inflation when the price level goes up, but can benefit from deflation. In contrast to this asymmetry, nominal bond investors are hurt by inflation and helped by deflation in a symmetric way. That is, a TIPS is like a nominal bond plus a call option on inflation struck at zero.

There’s another way to look at this. In real terms, the payoff to the TIPS is its yield minus min[price level change,0]. The payoff (in real terms) to the nominal bond is its yield minus (price level change). The “min” expression in the TIPS payoff and its absence in the nominal bond payoff means, again, that the TIPS embeds an option.

This embedded option reduces the TIPS yield relative to the nominal yield. If the expected inflation rate is zero, then the nominal yield equals the real return. But the TIPS yield must be below the real rate of return to compensate for the value of the embedded option. The more uncertainty about price level changes, the more valuable is this option, and the more depressed is the TIPS yield. The difference between the nominal and TIPS yield is basically the time value (or the “extrinsic” value) of the price level change option. This time value is greater, the more volatile the inflation rate.

So right now, where a zero expected inflation rate is not an unreasonable assumption, the yield on nominal Treasuries is a more reliable estimate of the real rate of return. I would interpret the present situation as being: (a) low but positive real rates; (b) approximately zero expected inflation; but (c) substantial uncertainty about the future change in the price level. This substantial uncertainty is understandable, given the unprecedented nature of the current economic situation, and the equally unprecedented nature of monetary policy.

I was in DC yesterday, participating in a joint SEC/CFTC Roundtable on CDS clearing.  These Roundtables are intended to provide information to staffers charged with the daunting task of writing the avalanche of rules mandated by Frank-n-Dodd.  This particular Roundtable focused on margin setting, default resolution, and CCP access and governance.

The quality of the panelists was quite impressive, and the discussion largely informative.  My main impression was that in 3 hours the panelists were able, at best, to scratch the surface of the surface on a relatively small subset of issues confronting the agencies.  That’s a pretty sobering fact.

Substantively, the issue that engendered the most back-and-forth related to the access and governance issue.  Not to say I told you so, but I told you so–and have been doing so since about 1997, and especially since 2006 or thereabouts.

As I’ve written, the fundamental tensions are clear-cut (no pun intended).  Yes, limiting access can be a way of exercising market power, and those on the outside might lose out on economic rents.  But against that, more expansive rules on CCP access raise serious concerns about risk and governance.

More expansive access means that less financially secure firms are in the CCP, which increases default risks.  But that’s not all.  More expansive access means that CCP membership will be more heterogeneous. This opens new cans of worms.

First, CCP margining and guarantee fund calculations depend primarily on the risks of the portfolios of cleared derivatives, but the default risk posed by any individual member depends not just on those risks, but on the interaction between these risks and the balance sheet risks posed by that member’s other assets and liabilities.  CCPs generally take that risk into account in a crude way, if at all, and do not really take into account the correlation between balance sheet risks and the portfolio risks–which is absolutely critical.

This is problematic because it means that the price levied for default risk does not vary across members in a discriminating way.  This distorts the trading activity across members: riskier ones tend to trade too much, and less risky ones too little.  The more heterogeneous the membership, the more difficult the problem.  A one-size-fits-all margin calculation (or one with limited conditioning on member-specific information) inevitably distorts incentives, all the more the more heterogeneous the members.

Second, heterogeneity raises governance costs.  Heterogeneity means that members differ in their desired margining and capital policies.  There is more politicking and rent seeking, the greater the heterogeneity.  This is costly in and of itself, and also can lead to distorted decisions regarding risk pricing and policy.  Indeed, this heterogeneity tends to lead to more cumbersome, committee-driven governance processes.

Things will only become more problematic if, as seems almost inevitable, there is a requirement to include other constituencies, such as end users, in critical governance functions (most importantly, the risk committee).

This is an interesting economic issue, in the abstract, related to club theory: what is the optimal membership of the clearing “club”?  It is a hard question, but heterogeneity imposed by regulatory fiat–engineering of the organization and governance of CCPs–is rife with potential for disaster.  There is a serious potential for misalignment of incentives and distortions in risk taking.  Which kind of defeats the entire purpose of a clearing mandate.

The issues in clearing are all the more acute because fundamental economic forces, related to the nature of netting and diversification, create economies of scale and scope that make clearing a natural monopoly, or at least a natural oligopoly.  This means that the normal club good outcome in the absence of such strong economies, with the formation of multiple heterogeneous clubs with relatively homogeneous memberships, isn’t viable in this context.  So the market power-access-governance battles are likely to be intense and never-ending.  We’ve seen such battles in security markets for years, and they will be coming soon to a derivatives market near you.  No need to hurry to watch, though, for they will never go away because the fundamental economic drivers are enduring and  inhere in the nature of the service.  (This is the subject of my next book, BTW.)

One question from an SEC staffer made me uneasy.  (I’ll try to remember to post a link to the transcript when it comes online here.)  The premise of the question was that a premise of Dodd-Frank was that the OTC market is too concentrated, and insufficiently competitive, and that clearing was a way of opening up the market and making it more competitive.  The staffer expressed concern that access policies would have to be regulated to achieve this outcome.

That would make access policy a political football.  Again, I am sympathetic to the view that CCPs can potentially utilize their membership and access policies to exercise market power.  But I am also very sensitive to the very real possibility that a la Fannie and Freddie, political pressure to benefit some market participants will lead to policies that compromise the financial strength of CCPs.

My response to the staffer’s question was that it was mistaken to start from the premise that the market was too concentrated and insufficiently competitive.  I said that before making policy choices, it was imperative to try to understand why the market structure evolved as it had.  Concentration was not mandated.  It was the result of an economic process.  I can think of “bad”  reasons why the market became too concentrated (TBTF subsidies, for instance), but I can also think of “good” reasons (economies of scale and scope).  Policies not based on an understanding of the underlying economics are likely to have fundamental flaws that will manifest themselves in the worst way.  Fighting against fundamental economic forces is a recipe for policy failure.

I am appreciative of the opportunity to have participated in this Roundtable, and hope I made a positive contribution to the debate.  I am sure, however, that I will have other opportunities to do so–as will many others.  That is because we have not yet even begun to fight, really, on matters of clearing market structure, organization and governance.  The war will be a long one.  This is a reflection of the fact that Frank-n-Dodd failed to come to grips with most of the most fundamental issues inherent in its litany of mandates.

PS.  Here’s an article by Matt Leising and Shannon Harrington at Bloomberg that mentions some of my remarks at the Roundtable.  Thanks, as always, guys.

Russia has announced plans to curb foreign borrowing, and to oversee the foreign financing of big Russian companies (h/t LR):

Russia is limiting access to the Eurobond market to prevent a repeat of the surge in foreign- currency indebtedness that triggered company bailouts in 2008 as borrowing costs tumble.

The government created a group last week to monitor overseas debt by state companies and “systemically” important financial institutions. OAO Gazprom, Russia’s largest company, and diamond monopoly ZAO Alrosa are among state-controlled borrowers planning their first Eurobond sales in at least a year as the economic rebound sends yields to a record low.

“Issuance by major borrowers at the same time could destabilize and worsen market conditions,” Deputy Finance Minister Alexei Savatyugin said in an interview on Sept. 30 after his appointment to head the Inter-Agency Working Group for Monitoring the Conditions on the Financial Market.

This reflects a couple of related factors.  First, it is an admission by the Russian government that it cannot pre-commit not to bail out big Russian companies, like Rusal or Severstal in the event of another financial crisis.  In particular, it cannot precommit not to bail out, when the failure to do so would result in these companies falling into the hands of foreigners.  To limit the potential demand of these companies on the public purse ex post, the government believes it necessary to control their foreign borrowing ex ante.

Second, this may be part of an effort to bolster Russian banking and capital markets.  Historically, due to the underdeveloped nature of Russian financial markets, foreign currency earnings (primarily from commodity exports) have flowed to foreign banks, where they are then directed back to Russia in the form of loans or direct investments.  Medvedev in particular has made plain his desire to foster the development of Russian financial markets, and limiting access to foreign finance is one way of doing that.  I am skeptical that this force feeding will work.  The underdevelopment of Russia’s financial markets is fundamentally a structural problem, driven by the lack of the institutions (property rights, contractual rights, investor protection, rule of law) that are necessary for financial markets to work properly.

The announcement provides a glimpse of the reasons why investors are always jumpy whenever the Russian government sticks its nose into the markets:

The advisory group may cause concern because of the potential for the government to meddle in company plans, said Neil Shearing, a senior emerging-market analyst at Capital Economics in London.

“Everything will depend on the implementation,” Shearing said. “Greater state involvement always starts red warning lights flashing in this regard.”

Ya think, Neil?

These institutional weaknesses, and their effects on the Russian economic environment are reflected in this story from the FT’s Beyond BRICs blog:

Emerging markets are starting to resemble pole-vaulters who, no matter how high the bar is raised, jump over it effortlessly. Back in April, the Institute of International Finance – a global club of banks – had predicted private capital inflows to emerging markets would total $709bn this year; it now recognises emerging markets will pass that level with ease. So the IIF has raised the bar: its new estimate is $825bn – that’s $116bn higher.

However, while the greatest pole-vaulters were Russian, the most favoured emerging markets are certainly not. Russia will actually receive less capital inflows than initially thought – with Russian stocks attracting barely half of what was predicted in April.

The IIF estimates that inflows into Russia will be $67.5bn this year, down from $72.4bn estimated in April. Russian equities, which were expected to bring in $12.5bn, will now account for just $6.7bn of the total.

The explanation?  I’m glad you asked:

The explanation, says Philip Suttle, chief economist at the IIF, is two-fold. On the one hand, Russia’s economy continues to suffer from state intervention and dubious governance. On the other, the extent of the country’s own boom and bust – with banks suffering from having granted excessive consumer credit – has been overlooked.

As a result, optimism that a firming oil price would bring foreign investors into Russia appears to have been misplaced. It appears that, however often analysts say Russian equities are attractively priced, few foreign investors want to move first.

Yes: institutional weakness and the residual effects of a financial crisis that hit Russia harder than just about any G-20 nation.  To which I would add the realization, based on recent experience, that the country is still uniquely vulnerable to another such shock.  Given the shakiness of the developed world economies, the probability of such a shock is bounded well away from zero.  (For instance,  look out for the effects of the ongoing foreclosure firestorm–it could crater banks worse than the original crisis, or force the government into an extraordinary HAMP/TARP-on-PCP bailout.)

Foreign direct investment was an important contributor to Russia’s 2000-2008 growth, especially in 2005-2008.  It has gone, and not come back.  The above report indicates that it is unlikely to come back anytime soon, even though other BRIC countries are worrying about too much money flowing from overseas.

And about that “Russian equities are attractively priced” bit.  Yes, Russian equities are cheap.  They are cheap for a reason: the risks of investing there are huge. Thunderbird is cheaper than Romanée Conti.  Quality matters.  You get what you pay for.

Investor angst over Russian government interference was plainly evident at the Russia Calling! forum sponsored by VTB. [Russia calling?  Sorry.  Wrong number.  Nobody home.  We don’t want any.  Whatever I have to say to make you go away.]  Julia Ioffe describes the Q&A that Putin endured–barely:

Someone asked about a corrupt court decision — said to have been worth some $300 million — and Putin, who tends to say nothing about the extremely independent Russian judiciary — promised to look into it. Someone asked about the privatization of a chunk of VTB. Someone asked about Gazprom’s market capitalization.

Then a lady got up, and asked Putin to address the fact that, “all the investors I meet with have big concerns, and they see that when the [Russian] government enters [into a deal/holding/etc.], the share price falls to nothing.” The conference, after all, was partly to convince foreign investment to come back to Russia, which it hasn’t really done since many billions fled in the fall of 2008.

Putin tried to convince her that that was not the case, that they sold out of enterprises like that for money. That the arrival of companies like Transneft (state oil transport concern) was good for them.

Lady: “Are they scared of you?”

Putin: “There’s no need to be scared of us.”

Then the lady brought up Yukos and the whole room froze. “There’s no meeting that goes by,” she said, “where investors haven’t asked about it.”

“Yukos is a special case,” Putin thundered, suddenly losing his jokey, back-slapping demeanor. He was pissed. Seriously, seriously pissed.

Ah, yes, the Pavlovian Putin, who begins salivating like a rabid dog at the very mention of Yukos and Khodorkovsky.  [That woman questioner has brass–kudos to her!]

Putin may not like it, but those kinds of things live on in memory.  Putin actually doesn’t make things any better by putting Khodorkovsky on trial again (his lame assertions that he didn’t even know there was a second trial being completely risible).  Putin mentioned that “it had been proven by a court” that Yukos’s security head had been involved in murder.  Even if this is true, has Khodorkovsky ever been charged, let alone convicted of this of this specific offense?  Even in a Russian kangaroo court?  No.  So shut up about it.

Look, if Putin gets “pissed” because Khodorkovsky is a martyr, he has no one to blame but himself now, for Putin has consciously extended his martyrdom indefinitely.  It is a testament to how much Putin hates–and likely fears–Khodorkovsky that he continues the relentless prosecution even though it undermines his goal of attracting more investment to Russia.  Ditto Browder and the egregious official response to the Magnitsky affair.

You know, Vladimir, you reap what you sow.  The years of expropriation, theft, and corruption have left their mark in the minds of foreign investors.  I don’t see any way for Russia to erase that mark any time soon.  It will definitely not happen as long as Putin and the siloviki are in the saddle.

This article (now gated, unfortunately) makes some spot-on points about the regulatory train wreck to come.  In particular, it makes pretty clearly a point that I’ve written about a few times here on SWP: namely, that all of the mom-and-apple-pie paeans to transparency are simpleminded, and fail to take into account substantial variability across instruments and the people who trade them.

He article quotes Mary Schapiro, and then goes off on her with some tart sarcasm, and justifiably so:

The challenge for the SEC, as Schapiro sees it, is to “cultivate” a market structure for security-based swaps “that reflects the virtues of the current equities market: competition, access, liquidity and transparency.”

We should be grateful to Schapiro for this insight [I can sense the snark coming!], but it is alarming rather than reassuring exactly what way the equities market is similar to and should serve as the blueprint for a new derivatives industry is, at this stage, somewhat mystifying to all except the SEC [yup, right on cue–very British snark, too.]

She went on to say that incorporating the same degree of transparency that exists in the equity market will produce greater liquidity and lower transactions costs.  To enhance this transparency, all security-based swap trades will be reported immediately in real time.

The regulators are very keen on transparency at the moment, but whether this will result in lower costs and greater liquidity through all aspects of the derivatives market is not proven [by a long shot, surely].

Author Simon Boughey then discusses the single name CDS market particularly, providing an interesting case study of a Gaz de France bond hedge.  He concludes by saying:

If the regulators make a god of transparency, then this sort of trade would result in great transaction costs rather than lower ones, transaction costs that will be passed on to the customer and ultimately to the shareholder

Hear, hear.

The CFTC’s Gensler, of course, is as bad–or worse–an offender as Schapiro when it comes to overselling the virtues of transparency and trading on centralized markets.  Who can forget his apple metaphor?  (Believe me–I’ve tried.)  (Though it is interesting to note that Gensler has deigned to consider the possibility that voice brokering “may be OK” on block trades, although he’s still all hot for real time reporting and transparency.)

Both Mar’ and Gar’ are regulatory versions of Procrustes, trying to jam all trading of all types of instruments for all types of counterparties into a single model: centralized markets with extensive pre- and post-trade transparency.

It is sort of amazing–scary, but amazing–to try to reverse engineer their mental models of the financial markets.  The markets as we know them have evolved a variety of trading mechanisms.  These mechanisms vary pretty systematically by instrument, and the kind of firms that trade them.  Equity markets are different from FX are different from corporate bonds.  There are even differences within categories: there is a diversity of order execution mechanisms in equity, for instance.

How do Mr. and Mrs. Procrustes explain these variations?  Is it all just random to them?  How can that be?  Have they ever tried to test their randomness hypothesis?  Have they considered alternatives, like, oh, I don’t know, maybe that under the pressures of competition and the drive to reduce costs and improve the utility of market users, relatively efficient structures adapted to the nature of transactions and transactors have evolved?  Even if they take the view that cabals of interested parties design markets for their own selfish ends, how do they explain why different markets have different trading mechanisms and protocols?  If centralized exchange trading with lots of price transparency is so great, why has that prevailed only in some segments of the equity and derivative markets?

The arrogance, and the narrowness, of their view of the world is truly quite staggering.  In their minds, quite clearly, the financial markets are one big market failure, with a few exceptions–exchange traded equities and derivatives.  And they know better.  They know how things should trade.

This mindset, at root, denies the roles of competition, innovation, creative destruction, and survival of the efficient in determining/selecting market institutions and structures.  It is a command-and-control, we-know-better mindset.  It is a truly pessimistic mindset, too, for it effectively denies the ability of dispersed individual decision makers to make economically efficient choices.

I believe in contrast that one should try to explain and understand how market structures are what they are, and change the way that they have, before dictating sweeping changes to them.  A useful starting point for any theory is to assume that market institutions economize on costs, and that market participants operate in reasonably competitive environments, to derive the implications of these assumptions for instruments/goods with different characteristics, and then test these implications against the observed structures.  Then identify the anomalies–the things the theory can’t explain–and try to understand them better.

Believe it or not, this exercise is not Panglossian.  You won’t always conclude that we are in the best of all worlds.  In my own work, I’ve shown how various frictions can lead to less than first best outcomes.  But I’ve also shown that many seemingly curious institutions and organizational choices–such as not-for-profit, mutual organization of exchanges, or vertical integration between execution and clearing–make economic sense.

But this approach leads to a much more nuanced understanding of complex institutions and practices, and a much more practical way of identifying possible ways to improve the way the markets work.

In contrast, the you’ll-fit-in-this-bed-and-like-it approach epitomized by Schapiro and Gensler is simpleminded, ignorant, and arrogant.

Stretching or crushing markets to fit a standard template will dramatically reduce the efficiency, effectiveness, and adaptiveness of our financial markets.  But that’s what Mary and Gary Procrustes have in mind.

CFTC Commissioner Jill Sommers gave a speech at a conference titled “Clearinghouses as Mitigators of Systemic Risk” that makes interesting reading.

As the title of the conference might suggest, Sommers was quite conversant in the clearing catechism:

Generally, a comprehensively regulated clearinghouse should help reduce systemic risks by facilitating the netting of transactions and by mutualizing credit risks. When a contract between a buyer and seller is submitted to a clearinghouse for clearing, the contract is “novated” to the clearinghouse. As such, the clearinghouse is substituted as the counterparty to the contract and then stands between the buyer and the seller. Clearinghouses then guarantee the performance of each trade that is submitted for clearing. Clearinghouses use a variety of risk management practices to assure the fulfillment of this guarantee function and to avoid losses at the clearinghouse. Moreover, the CFTC has closely monitored these risk management practices at the clearinghouse level and at the futures commission merchant level to ensure risk is properly being managed. The Commission has always recognized that the clearinghouse must protect itself from unnecessary risk, and if it failed to do so, large segments of the markets and market participants could be put at unnecessary risk as well.

Clearinghouses mitigate risk through the daily discipline of marking to the market price, at least once each business day, each position cleared through the use of prices that are independently determined by the clearinghouse. All gains and losses that arise as a result of the mark-to-market process are settled (i.e., paid and received) each day. Clearinghouses also require the daily posting of margin to cover the daily changes in the value of all positions as extra protection against potential market changes that are not covered by the daily mark-to-market. The methodology used by clearinghouses to calculate such margin requirements are subject to regulatory review and approval.

. . . .

With the mandated use of a regulated clearinghouse coupled with effective risk management practices, the failure of a single large trader, like AIG, would be much less likely to jeopardize all of the counterparties to its trades. I must stress, however, all risk is not eliminated, but it is substantially reduced. One of the lessons that emerged from the recent financial crisis was that institutions were not just “too big to fail,” but also too interconnected through non-transparent swaps that the institutions did not effectively manage. By mandating the use of central clearinghouses, institutions would become much less interconnected, mitigating risk and increasing transparency. Throughout this entire financial crisis, trades that were carried out through regulated exchanges and clearinghouses continued to be cleared and settled.

Needless to say, I’m a heretic.  Mandated clearing doesn’t necessarily increase netting opportunities, and even if it does, since it effectively reorders creditor priority it does not necessarily reduce systemic risk.  And if netting reduces costs so much, why didn’t firms adopt clearing voluntarily?  The “daily discipline of marking to the market price” is problematic if “the market price” is difficult to determine, due to illiquidity/lack of trading.  What’s more, regular posting of variation margin is not unique to CCPs, and is quite common in OTC deals.  Furthermore, the variation margin mechanism can be exactly what touches off or exacerbate market panics.  AIG is a terribly misleading example.  CCPs do not reduce interconnectivity; they just change the topology of the interconnections.  Furthermore, CCPs are tightly embedded in the financial marketplace, most notably in the credit system.  To pretend otherwise is foolish.

Sommers’s other remarks are more intriguing.  She recounts of the CFTC’s previous policies towards OTC derivatives and clearing in particular:

In July 1989, the Commission published its 1989 Swaps Policy Statement. This statement reflected the Commission’s view that most swap transactions, although possessing elements of futures or option contracts, were not appropriately regulated as such under the Act and Commission regulations. This was important because the Commodity Exchange Act required all futures contracts to be traded on exchange. The policy statement allowed these transactions to continue trading off-exchange by creating a “non-exclusive safe harbor” for transactions satisfying certain requirements. The safe harbor requirements included five elements: (1) individually-tailored terms; (2) absence of exchange-style offset; (3) absence of clearing organization or margin system; (4) the transaction is undertaken in conjunction with a line of business; and (5) a prohibition against marketing to the public.

In other words, prior to the CFMA of 2000, any attempt to introduce netting (item (2)) or clearing and margining (item (3)) into the OTC market would have run afoul of the Commodity Exchange Act’s requirement that all futures contracts must be traded on exchanges (designated contract markets); netted and/or cleared swaps would have been considered futures.

This should be remembered, but is typically not.  I’ve often wondered whether CFTC policy, and the CEA more generally, discouraged the evolution of OTC clearing, and channeled the industry along the path that Dodd-Frank has now declared an anathema.  We’ll never know for sure, but it must be recognized that during the formative years of the OTC market, the law and regulation effectively foreclosed–precluded–the development of institutions that Congress and the CFTC now deem essential for financial stability.  The irony.

Sommers adds some refreshing honesty about the monster that is Frank-n-Dodd.  Most notably, she discusses the swaps execution facility mandate:

An area that I am very interested in, as are many other market participants, is what the requirements of trading swaps on a SEF will be. The CFTC and SEC heard a great deal of concern about this issue from market participants at a joint roundtable on September 15th. CFTC staff has recently estimated that 30-40 entities will register as SEFs or designated contract markets. The designated contract market model is easy for the Commission and market participants to deal with. We know how they work, and market participants know how they work. SEFs are new, and the relevant statutory language is not very clear. When you read the new statutory language in conjunction with existing statutory language, it raises some questions.

Section 1(a)(34) of the CEA defines “trading facility.” It is a definition that the CFTC and market participants have been working with for years. In essence, a trading facility is a physical or electronic facility or system wherein multiple participants can execute or trade agreements by interacting and accepting bids or offers of multiple other participants. A many-to-many type model.

In defining what a SEF is in Section 721 of Dodd-Frank, Congress did not require that a SEF be a trading facility. Instead, Congress defined a SEF as a “a trading system or platform” in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that (A) facilitates the execution of swaps between persons; and (B) is not a designated contract market.” (emphasis added).

So clearly, by this definition Congress intended that a trading facility could be a SEF, but that a SEF did not have to be a trading facility because Congress used the words “trading system or platform” to define SEFs. In my view, by introducing the term “trading system or platform” when we already have “trading facility” as a defined term means that Congress must have intended a SEF to be different from a trading facility.

Her confusion is palpable.  And understandable.  If the status quo ways of executing swaps were OK, Dodd-Frank would not have added  an SEF requirement.  If Dodd-Frank intended an SEF to be the same as a trading facility, it would have said so.  Thus, Frank-n-Dodd says what SEFs aren’t–the status quo or trading facilities–but doesn’t say what they are.  It is particularly confusing because some of the requirements that SEFs must meet–interaction between bids and offers submitted by multiple participants–characterize trading facilities.  So Congress essentially handed the CFTC an enigma and walked away.  One can feel for Sommers, her fellow Commissioners, the staff–and the industry.

She also mentions the confusion over the definition of swap dealer:

One of the areas that has caused a great deal of concern among many market participants is whether they will be classified as a swap dealer or major swap participant. Such a classification brings with it the imposition of capital, margin, recordkeeping and retention and business conduct rules, and rules for segregating customer funds. Currently six rule writing teams are working on this area. One is working on a series of definitions, including swap dealer and major swap participant, one is working on registration requirements, and others are working on business conduct standards, capital, margin, and segregation issues.

The CFTC’s Chairman has stated that initial estimates are that there could be in excess of 200 entities that will be swept up into the definition of swap dealer based upon current ISDA primary member status. Registering and regulating that many swap dealers will be a huge task for the CFTC and will have very important implications for those entities and their businesses. Comparatively, we now have about 127 FCMs that are registered with the Commission. In my view it is critical that we ensure that this new regulatory regime intersects seamlessly with our existing regime to ensure that registrants and their customers suffer no disruption in their business and hedging strategies. I have asked staff to estimate the number of entities that may be swept into the definition of major swap participant. Unfortunately, they have not yet been able to do so. This uncertainty raises concerns about ensuring a disruption-free transition, an issue that the Commission and staff will be closely monitoring.

Note, and beware.  If Gensler’s 200 number is even ballpark, CFTC will have responsibility over more than twice as many entities as is currently the case.  Moreover, these new entities are often larger, more complex, and certainly more diverse than the population of FCMs currently under its ambit.  Big hedge funds, supermajor oil companies, big money managers, and universal banks are all likely to be considered swap dealers, or major swap market participants.  These are very different animals, and far more complicated ones, than the FCMs.  Moreover, they are all different from one another in crucial ways, but they have to be shoehorned into one of two standardized categories.  This is unlikely to end well.

Sommers also notes that CFTC is tasked with establishing position limits, but doesn’t have the data necessary to do the job properly:

Complicating all of that are the provisions of Dodd-Frank. The CFTC and SEC have 360 days to issue regulations establishing swap data repositories to which swap data will be reported. The Commission has 180 days for energy and 270 days for agriculture to propose aggregate position limits across futures markets and equivalent OTC markets. The problem is, Dodd-Frank requires us to propose position limits months before a mechanism is in place for obtaining the necessary data from the OTC swap markets. In order to propose appropriate limits, we must know the size of these markets. Without the necessary data for OTC markets, we will not really have all the information we need to propose appropriate limits. But, the law is the law so we will propose limits and hope they are at such a level that they do not cause damage to these markets.

Sommers also indulges in hope over experience:

CFTC and the SEC. Historically, the SEC and CFTC have not been very successful proposing joint rules, even when directed by Congress to do so. This time, however, may actually be different.

Seeing will be believing.  And even if everybody has been playing well together so far, the tough decisions have yet to be confronted, and the affected interests have yet to play one agency against another, as will occur inevitably.  Add to that normal inter-agency rivalry, compounded by a profound change in relative authority, and it is pretty plain that serious disputes are inevitable.

Sommers’s speech is a good overview of the issues and challenges facing the CFTC.  Reading her speech and Frank-n-Dodd gives me the same feeling that I had on some Christmas mornings when tasked with assembling some rather complicated toy, and having to rely on directions originally written in Chinese, then translated into Korean, before being translated into English.  The main difference being that if I threw up my hands in frustration, there would be just one disappointed little girl.

I wish Sommers and the CFTC luck.  They’re going to need it.  And so will we.