Streetwise Professor

I’ve written frequently about the problematic evolution of financial market structure under a clearing mandate.  One concern is the proliferation of CCPs.  One potential reason for this proliferation is that exchanges will want to control their own CCPs.

Long before before the crisis, I wrote about this vertical integration issue, in detail.  I dismissed worries that vertical integration is anti-competitive.  But I did note a fundamental tension.  Large, multi-product (and hence likely multi-exchange) CCPs have advantages from a risk-bearing perspective (although perhaps not from a systemic risk perspective).  But vertical integration likely economizes on transactions costs.  Thus, “siloed” CCPs can make sense even if it does not optimize risk bearing.  But the trade-off is a real one, and hard to evaluate.

I know some, notably the Bank of England, are worried about silos because they are concerned that they inflate the costs of managing counterparty risk.  But transactions costs are real costs too.

Apropos all this, today the FT has an article about how LSE is putting together its own CCP. It has cleared through LCH, but for strategic reasons thinks it necessary to control its clearing.  Given that LSE was once held out as the exemplar of how exchanges didn’t need to control their clearing, this is big news.  It also puts an exclamation point to my arguments that the evolution of the clearing business is not going to be driven purely to reduce systemic risks.  Clearing decisions are going to be made by for profit firms with their own particular agendas.  This means that the evolution of the market is likely to be quite complicated, and lead to results that the clearing mandate evangelists have not contemplated.  The implications of this structure for systemic risk are by no means obvious.

And a story in WSJ Europe raises yellow flags, and perhaps red ones, about the EU’s clearing mandate plans.  Read it. It will all sound very familiar to regular SWP readers.  Like in the US, however, it is unfortunate that people are coming to grips with the complexities of clearing mandates–and the potential dangers–only after they are a fait accompli.

Tyler Cowen wrote a post about my Cato clearing piece, for which I am grateful.  Tyler was tepid in his appraisal: and I am tepid of my appraisal of his appraisal.

On a minor point, he says I say “not necessarily” too often.  Well, I am primarily responding to arguments that say or assume things to be necessary when they are not.  Moreover, even when things are not necessarily true, they may be true, and it would be overstatement to say otherwise.  I tried to be precise in my evaluations, and neither overstate nor understate the case.

More substantively, Tyler makes the two arguments that are least likely to persuade me: arguendo ad AIG, and “look, the CME did just fine during the crisis.”  Regarding the former, I think that (a) Tyler is guilty of hindsight bias, assuming that CCPs would have seen AIG’s positions to be exceptionally risky when nobody else did; (b) this is a red herring, as AIG positions would never have been cleared; and (c) the AIG case is far more complicated, as I argued extensively on SWP many moons ago.  With regard to the latter: (a) things at CME were dicier that he lets on, something else I’ve written about, and (b) this argument is fraught with selection bias, as CME cleared the stuff that was easiest to be cleared.  Even Tyler admits that clearing CDS with their jump to default risk would be very difficult; this is true of other instruments currently traded OTC too.

My biggest objection is that Tyler really doesn’t come to grips with any of the substantive arguments in the paper, including inter alia those relating to: (a) the question of how a putatively and seriously inefficient market structure could not just survive  but thrive and grow relative to the putatively more efficient alternative; (b) the information regarding default risk and the incentives of CCPs vis a vis dealers; (c) relatedly, moral hazard and adverse selection issues; (d) the differences in costs that hedgers will bear due to cash management costs, etc., (e) the potential loss of netting economies in clearing due to fragmentation; (f) relatedly, the possibility that the industry will evolve inefficiently due to the effects of strong scope and scale economies, jurisdictional issues, and the use of clearing for strategic purposes by exchanges; (g) the ability of affected firms to alter their financial contracting (capital structures) to undo most if not all of the leverage-reducing that is purportedly one of the benefits of CCPs and more restrictive collateralization; and (h) most importantly, the potential for systemic risk arising from CCPs.  I could go on, but these are the biggies.

Tyler does, in a way, address (h), but unpersuasively, IMO.  For instance, he says: “it seems to me that clearinghouses would have had a strong profit incentive to monitor or limit the kind of risk-taking which led to the A.I.G. debacle.”  Even overlooking the AIG reference, this is problematic.  There are two cases.

The first is that CCPs are mutual organizations or effectively mutual organizations, dominated by large financial intermediaries.  In that case, the CCPs would effectively inherit the incentives of these intermediaries, which Tyler apparently thinks are inadequate to induce them to police risks efficiently.  In addition, there would be all the problems associated with moral hazard, cooperative governance, and agency problems associated with multiple principals.  (Ironically, Tyler effectively concedes this point in one of his older posts that he links to where he expresses reservations about ICE Trust.)

The second case is that CCPs are for profit firms, collecting fees, potentially in competition with one another, and taking on tail risk.  Indeed, the entire business of a CCP is taking on tail risk.  But we know that pricing that risk is hard, and that moreover, shareholder incentives often lead financial institutions to underprice that risk, or to take on too much of it (which amounts to the same thing).

So Tyler, in effect, is reduced to arguing that CCPs are easier to regulate: “The key point is that a clearinghouse can more easily be forced to carry heavy capitalization and said capitalization, unlike with a current bank, cannot so easily be undone by off-balance sheet transactions or hidden leverage.  The clearinghouse has different incentives and is much easier to regulate and therefore we should put some more trust in them.”

Somehow, putting more trust in regulators is hardly calculated to build confidence.  The point that CCPs are likely to have simpler capital structures that make it harder to take on hidden leverage is a good one, but in many respects the portfolio of risks a CCP takes on is very complicated and difficult for a regulator to appraise properly.  Again, it is all tail risk, and in a mandated environment, said risk will involve more complicated, less liquid, more difficult to evaluate instruments, and crucially, will also depend on the balance sheet risks posed by the firms it clears.  These firms can take on hidden leverage, off-balance sheet transactions, etc., so regulators have to look through the CCP back to the same institutions that allegedly are the problem in the incumbent structure.

Furthermore, as I argue above, CCP incentives are far more problematic than Tyler lets on.  Moreover, CCPs, whether for-profit firms or mutuals, have the incentive to influence regulators in the same way banks do.  Putting all this together, I don’t think it is quite as easy as Tyler does to determine the right level of CCP capital or to monitor its operations.

I’ve written many times that I do not know for sure what the optimal organization of counterparty risk allocation and pricing mechanisms is.  Nobody does.  I have often emphasized that I intend to raise issues and arguments that are grounded in good economics but which have gone unraised and unanswered in the conventional paeans to clearing.  If advocates of clearing have a good case, they could meet these arguments head on, which they have not done so far.

After reading Tyler’s piece, I have to say that most of the substantive arguments I’ve raised still remain unengaged.  So skeptical I remain.  I appreciate Tyler’s taking the time to take my piece seriously, and am encouraged that he recognizes the need for a comparative approach., but would respectfully suggest that he should take a harder look at the real problems that CCPs must confront.  I think if he does that, he’ll have more concerns about clearing mandates than he has expressed heretofore.

Felix Salmon is a big fan of Basel III, but admits to concerns about the perpetuation of the Basel II risk weightings after reading this by Noah Millman in the Economist:

More important, the new regulatory scheme could fail in several ways. The most serious failure in Basel III is that it doesn’t address the principal contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights. One of the key components of Basel II was to increase the amount of capital banks had to hold against riskier assets. Extremely low-risk assets, meanwhile, could be held with very little or even no capital. Risk, moreover, was calculated primarily by reference to the rating assigned by one of the recognised ratings agencies. The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitisation was a way to “manufacture” apparently risk-free assets out of risky pools. What brought banks like Citigroup and Bank of America to their knees wasn’t direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.

Since it did not change this risk-weighting, Basel III effectively doubles down on Basel II.

Martin Wolf at the FT echoes these concerns, even more forcefully:

These new ratios are also very much the children of Basel II, the previous regulatory regime: they rely on what should by now be discredited risk-weightings – one of the points Martin Hellwig of Germany’s Max Planck Institute makes in a superb recent paper on the intellectual bankruptcy of current approaches to regulation of capital. We might think of the new requirements as a “capital inadequacy ratio”.

The Hellwig paper is worth a read.

Needless to say, I agree with these concerns about Basel III.  It’s better than Basel II because it has higher capital levels (even though Wolf thinks they are grossly inadequate), but it shares the fundamental flaw: the attempt to price risks, which is doomed to failure because those setting the prices are going to have less information than those responding to them, who can moreover design their portfolios and design securities and financial instruments to exploit mispricing of risks.

I wrote about this several times, most recently in Basel Faulty.

Yes, there is a bigger cushion in Basel III, and the liquidity requirement is an improvement.  But Basel III perpetuates the most problematic feature of Basel II.  In particular, I think it bears repeating that since the mispricing will distort the incentives of all covered entities, it tends to lead them to trade the same way, which is lethal in response to a systemic shock.

It is nice to see that this is becoming increasingly recognized, but it is discouraging that the message does not appear to be coming through loud and clear–or even garbled–where it matters, in Basel.

In a speech Tuesday, SEC Chairwoman Mary Schapiro suggested imposing affirmative obligations on high frequency traders:

The SEC should consider whether traders with the “best access” to markets should be obligated to buy and sell stocks to preserve liquidity, Schapiro said today in a speech at the Economic Club of New York. The agency is also examining whether stock quotations should have to stand for a minimum amount of time. Such a change would stop high-frequency traders from repeatedly placing and canceling orders in milliseconds.

“Some could argue that May 6 was an aberration — another perfect storm — and now that it has passed markets have naturally adapted leaving no need for a comprehensive review of our market structure,” Schapiro said. “I disagree.”

Schapiro hearkened back to an earlier era, when some (and I emphasize some) market makers had affirmative obligations:

“In the old manual market structure, the market participants with the best access to the markets — the specialists and the dominant exchanges — were subject to significant trading obligations,” Schapiro said. “These traditional obligations have fallen by the wayside.”

First, a little history.  The affirmative obligation to make markets–to “lean against the wind”–was not universal.  Yes, NYSE specialists had such an obligation.  But NASDAQ market makers did not.  Nor did futures or options market makers.  Moreover, it should be noted that in exchange for their affirmative obligation, specialists were the beneficiaries of many privileges; I’ll return to this point below.

Also in a historical vein, (a) affirmative obligations are not a panacea, (b) market makers frequently attempt to avoid their obligations in times of stress, and (c) evaporating liquidity in times of stress is driven by fundamental economics, not technology, meaning that HFT-oriented markets are not uniquely vulnerable to this problem: there is, in brief, no Golden Age to which we can return through the waving of the regulatory wand.

These points are best illustrated by the events of the 1987 Crash.  The Brady Report documents that specialists were not uniformly acting as price stabilizers.  On the 19th, 26 percent of specialists were trading in a way that exacerbated price trends; on the 20th, as many specialists were trading in this way as were leaning against the wind.  The Report concluded that the behavior on the 20th reflected the fact that many specialists exhausted their capital on the 19th, which limited their ability to supply liquidity on the 20th:

The limited nature of some specialists’ contributions to price stability may be have been due to the exhaustion of their purchasing power following attempts to stabilize the markets at the open on October 19.

Moreover, even though HFT was not even a gleam in the eyes of its creators in 1987, liquidity suppliers in other markets responded to the intense uncertainty by drastically reducing the amount of liquidity they supplied.  Of NASDAQ, the Brady Report said:

During the week of October 19, some market makers formally withdrew from making markets.  In addition, some market makers ceased performing their function, merely by not answering their telephones during this period.  .  .  .  There were also widespread reports that many market makers, who normally stand ready to buy and sell hundreds and sometimes thousands of shares at their quoted prices, were only willing to fulfill their minimum obligation by buying and selling 100 shares at the quoted price.  Another indication of deterioration in market making performance is the withdrawal by some market makers from the SOES [Small Order Execution System] system, thus reducing from 1,000 to 100 the number of shares they were obligated to buy or sell.

In addition, bid-offer spreads also widened during the period.

Interestingly, the Brady report noted that although futures locals had no obligation to supply liquidity, they were “as a group somewhat more aggressive than normal in taking net positions on October 19.”  But, this herculean effort also exhausted their capital, and limited their ability to make markets late in the 19th and on the 20th.  I can attest, from personal observation, that by the afternoon of the 19th, most locals were out of the pits: they had been yanked out by their clearing firms.  Many of the remaining locals were standing with their arms crossed over their badges, to reduce the possibility that somebody would write down their ID on a trade ticket, hoping to win the outtrade lottery.

So: Don’t blame the loss of liquidity during periods of stress on technological innovation.  It happened in the horse and buggy days too.  Also: don’t expect that affirmative obligations are sufficient to ensure that markets are immune to crashes.

As I wrote in the immediate aftermath of the Flash Crash in May, the no free lunch principle works here.  The imposition of affirmative obligations to supply liquidity when it is unprofitable to do so will reduce the return on market makers’ capital.  Absent some other compensation, this will lead to the exit of market making capital.   As a result of this exit, investors will pay the cost of the affirmative obligation in the form of higher spreads/greater price impact during times when the affirmative obligation constraint is not binding.  Moreover, the exit of market making capital will offset to some degree the effects of the obligation: when the constraint binds, market makers will be risking a greater fraction of their capital to make markets during stressed times than they would in the absence of the constraint, but this greater fraction will be applied to a smaller pool of capital.  It should also be noted that one of the costs of fulfilling the obligation is that market making capital will be depleted during times of stress, thereby reducing liquidity subsequently (until new capital can flow into liquidity supply).

The previous paragraph contains the phrase “absent some other compensation.”  In the old days of the specialist system, specialists had various privileges that allowed them to trade profitably–at the expense of their customers.   These privileges were rationalized, in part, as a means of compensating specialists for their affirmative obligations.  Again: no free lunch.  Investors end up paying for the obligation.

The primary effect of affirmative obligations is to change the pattern of liquidity supply over time.  Less liquidity supply in “normal” times (due to the exit of market making capital, or profits that market makers earn from privileges extended to compensate for the costs of the obligations), less liquidity in post-stress periods, and perhaps more liquidity supply in stressed times.

It is possible that this altered pattern of liquidity supply is welfare enhancing.  But Schapiro’s remarks, and much of the post-Flash Crash commentary, does not acknowledge the costs of imposing affirmative obligations.  Thus, the proper cost-benefit trade-off question has not even been posed, let alone answered.

The old Greenwald-Stein paper written in the aftermath of the ’87 Crash theorizes that there are market failures during times of market stress, and that there is insufficient liquidity supplied during these periods.  But it is not clear that affirmative obligations are the most efficient way to address that problem.  Perhaps some other strategy, such as shifting from continuous to call trading during such periods, would be more efficient, especially inasmuch as this does not distort liquidity supply in “normal” times, as the affirmative obligation would.

It must also be recognized that defining and enforcing an affirmative obligation in the current market is much more difficult than was in the case with the NYSE under the specialist system.  The “right” obligation is by no means obvious.  HFT firms will design their systems to mitigate, not to say evade, the obligation arising under any set of criteria.  The details here will be very important, and very difficult to get right.

Another thing that Schapiro mentioned in her speech was the high rate of order cancellations, which she suggested indicate that much HFT liquidity supply is chimerical.  To address these, she mooted the idea of a minimum time for which orders must be in force.

Oi.

Limit orders are  short options.  Options are costly.  Mandating a minimum time quotes must be maintained increases the cost of those options.  Market makers will respond accordingly, by increasing spreads and reducing depth.  Again, investors will pay.  No free lunch, again.

Moreover, this recommendation cuts against the concern that liquidity dries up in stressed times.  The option inherent in a quote is more costly when markets are volatile: that’s exactly why market makers reduce their commitments during volatile times.  A minimum quote time will make market makers even more reluctant to supply quotes in volatile/stressed times.  So this measure, by itself, could make liquidity strikes more likely, not less.  To offset this, by imposing affirmative obligations, would result in higher liquidity costs in normal times: the no free lunch principle, yet again. (It would also make enforcement more difficult and costly, as market makers would have a greater incentive to evade the obligations.)

Bottom line: there is no quick fix to the evaporation of liquidity during stressed times.  Evaporation is driven by fundamental economic considerations: it is more costly to make markets during volatile periods.  Rule changes will not alter that fundamental fact.  That fundamental fact holds across trading technologies.

The costs of rules intended to increase liquidity supply in volatile times will be paid for.  Period.  The only question is when and how.  A reasoned policy debate would focus on identifying and quantifying the relevant trade-offs.  And it is my obligation to affirm that hasn’t happened yet.

The FT ran a rather bizarre editorial on end user exemptions from clearing mandates.  As seems to be the wont of clearing advocates of late, it is strident, but hardly persuasive.

Here’s the core of the argument:

But the fact that reform might impose higher costs on non-financials is precisely the reason for sticking to it. Costly margin requirements indicate that the derivatives companies purchase not only insure them against adverse market movements but can require them to make substantial payments should market conditions move against them. If OTC derivatives are cheaper than taking out insurance, this suggests that the systemic risks of the OTC market and the banks that dominate it are being borne by taxpayers. Ending this subsidy would force corporations to bear the fair economic cost of their actions.

This is apparently the S&M theory of public policy: unless a policy inflicts pain, it is ineffective.  The more costly a policy is, the better it must be!

Here’s my most charitable characterization of the argument:  Due to Too Big to Fail, banks subsidize their customers.  In particular, they subsidize them by taking on default risk and not charging for it.  Therefore, it is necessary to impose costs on these customers in the form of collateral requirements in order to eliminate the subsidy.

Here is one testable implication of this theory: in the absence of TBTF subsidies, all deals will be fully collateralized.

This implication is refuted by experience.  For instance, prior to the formation of the Chicago Board of Trade Clearing Corporation (under government pressure), margining was discretionary.  Exchange rules permitted parties to demand margin: it did not require it.  Routinely brokerages extended credit to their customers and to other brokerages that they traded, and did not require the posting of initial margins, and only required posting of variation margins when a pre-established  credit limit was breached.  These brokers were not the beneficiaries of any TBTF subsidy.  So, credit exposure via incomplete collateralization existed even in the absence of a TBTF subsidy.

Moreover, this theory doesn’t explain why the credit terms extended by OTC dealers vary by customer and deal.  Such variation in credit terms means that dealers are evaluating credit and charging for it based on the nature of the customer and the trade.  Of course, it is possible that these terms are too generous overall (due to TBTF) but the behavior of dealers belies the simplistic story that the FT spins, to the effect that dealers don’t care about credit risk in doing derivatives deals, and hence it is necessary to deny them the discretion to choose their own credit terms.

Furthermore, the FT editorial, like much of the pro-clearing discussion, implicitly assumes that everything else will remain the same after the imposition of a clearing mandate; collateralization will reduce counterparty risk in derivatives trades, and other credit risks will remain unchanged, so overall banks will face fewer default risks.  This is certainly incorrect, and market participants will respond to a mandate by taking actions that undo much of its effect.

For instance, the mandate that all deals be collateralized effectively tells dealers: Thou shall not extend credit through derivatives transactions.  But there are multiple ways that dealers can extend their customers credit.  In particular, if precluded from extending unsecured credit through a derivatives trade, they can substitute other forms of unsecured credit for that they would have offered their customers via derivatives.  Now, revealed preference implies that this is not the preferred arrangement, as otherwise end users and dealers would have chosen it in the first place.  But the use of other forms of credit to finance, effectively, margin/collateral will almost certainly be a second best response to the mandate.  Thus, collateral requirements will do far less to reduce the amount of credit and leverage in the system than their advocates believe.

Moreover, and perhaps more importantly, if TBTF subsidies are the Original Sin, merely foreclosing one way to exploit these subsidies will have little effect on the riskiness of banks.  So if dealers are foreclosed from exploiting TBTF subsidies in their derivatives business, they have every incentive to find other ways to do so.  And they are sure to be creative.

That is, TBTF subsidies are like water.  They will find some outlet.  Dam up one outlet, and the water will find its level through some other channel.  So maybe OTC derivatives won’t be the source of the next crisis (just as they weren’t the source of the last crisis), but if TBTF continues to exist, risk taking will be continued to be subsidized, some excessive risks will be undertaken somewhere, and inevitably, this will cause problems down the road.

But whatever the next crisis, we may be able take comfort that derivatives will not have caused it.  Very cold comfort.

There will be other unintended consequences.  Even though dealers and other intermediaries are likely to try to design financing methods and provide services that reduce the operational and financial burden of end user collateral requirements, again by revealed preference, these alternatives are more burdensome to end users than the incumbent system.  As a result, some end users will decide not to hedge; others will hedge less.  Others will adopt different capital structures that are less efficient.  As a result, more end users will suffer financial distress, and others will incur costs in the form of less efficient investment policies, etc.  These are real costs.  And they can result in defaults–just not on derivatives trades.  Are we really better off when a firm that eschews hedging because of the higher burden inherent in collateralization defaults on its debt to a bank when the risk it would have hedged comes to pass?

If TBTF is the real problem, it is counterproductive to try to address it through micromanaging the ways that financial institutions  attempt to exploit the TBTF subsidy.  Deal with the real problem–the subsidy–rather than attempt to anticipate and foreclose every possible way that clever bankers can attempt to milk this subsidy.  Deal with TBTF upstream, not downstream.

Like a child’s security blanket, clearing and collateral mandates give some a sense of warmth and security.  And a false sense of security, as it turns out, because they do not eliminate or even reduce substantially the true source of danger in financial markets.

On Friday I attended a conference on OTC clearing sponsored by the Chicago Fed.  The conference was excellent, and organizers Ed Nosal and Robert Steigerwald of the Fed, and Darrell Duffie of Stanford, did an excellent job of assembling a stellar group of speakers.  I had the privilege of moderating (Me?  A moderator?) one of the panels.

The speakers represented all of the major constituencies; sell side/dealers, buy side, end users, exchanges, CCPs, regulators.  Perhaps not surprisingly, there was little consensus on important issues relating to governance, organization, capital requirements, collateral, the number or size of CCPs, or any of the important matters that still remain to be decided.  It is evident that the coming months and years will be fraught with uncertainty as the industry gropes towards equilibrium in the Brave New World of Dodd-Frank.

The lunchtime speaker was Citadel founder Kenneth Griffin.  Griffin gave a paean to central clearing, and to Dodd-Frank more generally.  Clearing is cheaper operationally and administratively.  It reduces risk.  It economizes on capital.  It is the cure for all that ails the financial markets.

So if it is so wonderful, what stands in the way of its adoption?  Per Griffin: a small, self-interested cabal of dealers who reap billions and billions of profits at the expense of end users, and who will lose their ill-gotten gains in a cleared world.

This narrative is a familiar one, the stock theme of the advocates of central clearing.  And as I’ve said on numerous occasions, this story begs far more questions than it answers.  Most importantly, if the efficiencies of clearing are so manifest, and the market power losses so large, why don’t basic competitive forces undermine dealer dominance?  An inefficient business, with high monopoly markups on top of that, is a juicy target for entry by more efficient suppliers.  You would expect such a business to suffer erosion in market share; quite rapid erosion, in fact.  But the reverse has happened to dealers in recent years, as OTC markets have grown absolutely and relatively.

Maybe competition doesn’t work, or works differently, in OTC derivatives markets.  If so, it would be nice to have a convincing model, backed by empirical evidence, to explain such an anomalous outcome, so different from the received understanding in economics, and from the experience in many other industries.  Needless to say, Griffin didn’t provide either model or evidence.

He didn’t help himself by quoting OCC data about concentration in US OTC markets.  This is akin to the drunk looking for his wallet under the lamppost.  The OCC data are readily available and easy to use, but they are incomplete because they only cover US banks.  More comprehensive surveys indicate that there are currently 10 or 11 major international dealer firms; there were 14 prior to the crisis.  I’d be interested to hear Mr. Griffin identify other industries with 10-14 major competitors, and argue that they are similarly uncompetitive.

Moreover, it is well known that concentration figures can be very misleading measures of competitiveness.  They do not measure the effects of potential competition.  Moreover, concentration ratios are endogenous.  As Demsetz showed long ago, industries can become concentrated and profitable as efficient producers gain market share at the expense of less efficient rivals.

It’s not just me, folks.  After Griffin’s talk, I chatted with an economist, a former colleague with a very responsible non-academic policy and research-oriented job who was unpersuaded by Griffin’s jeremiad.   This individual said: “He ignores the IO [industrial organization] questions.”  Exactly.  Why is the industry organized this way?  Why doesn’t competition erode market power and market power rents?  Why don’t putatively more efficient organizations and institutions (clearing, in Griffin’s view) displace less efficient ones?  Why do the inefficient survive?

He brought up energy, in which clearing has made strong inroads in the past 8 years, to bolster his point.  The problem is that the case of energy suggests quite the opposite.  Clearing grew in energy naturally, organically, without a push from Dodd, or Frank, or the Fed or anybody else.  If this can happen in energy, and this is efficient, why can’t it happen in other sectors of the OTC market?

Inquiring minds, open to persuasion, want to know.  Griffin didn’t deliver.  What he did deliver was a sermon, complete with saints and devils.

Moreover, the Citadel commander’s argument presumes that end users–who, as he properly notes, must be the ultimate source of any dealer market power profits–are the victims of some sort of battered spouse syndrome.  For end users are among the most vociferous opponents of clearing mandates.  FMC Treasurer Thomas Deas was quote outspoken on this score at the session immediately prior to Griffin’s speech.  Why are end users the most ardent defenders of a system that is supposedly rigged against them, and robs them blind?

Griffin also failed to analyze seriously the trade-offs of alternative ways of allocating and pricing counterparty risk.  No suggestion of any comprehension of issues relating to the information and incentives to price and manage counterparty risk.  No mention of moral hazard or adverse selection.  No discussion of how the industry will evolve and how this will affect the ability of clearing to realize its full potential.  Most importantly, no mention of the potential systemic risks in clearing–a point mentioned prominently in the opening remarks at the conference delivered by Chicago Fed President Charles Evans.

He did acknowledge objections to clearing mandates–but in an incomplete way, and in caricature.

If the substance was, to me, unpersuasive, the delivery and tone were off-putting in the extreme.  “Supercilious” hardly does it justice.

The serious people who spoke on all sides of the clearing issue during the conference proper raised many interesting arguments and issues.  They made it plain that the way forward will be complex, and that it is by no means evident that the way mapped out by Frank-n-Dodd will improve the efficiency, stability, and safety of the financial markets.  Griffin’s talk was, in contrast,unserious, one-sided, and ultimately unconstructive.  Manichean sermons, delivered in sneering and belligerent tones, are like that.

I saw the headline of this Matt Leising article, “Lehman Derivatives Records a Mess,” and reflexively thought it would be about its OTC trades (of which there were, if memory serves, over 900,000 if memory serves).

I was wrong.  It was about its exchange traded–and cleared–positions:

Barclays PLC had no idea how big Lehman Brothers Holdings Inc.’s futures-and-options trading business was when it considered taking over the defunct bank’s derivatives trades at exchanges in 2008, a Barclays executive said.

“Lehman’s books were in such a mess that I don’t think they knew where they were,” Elizabeth James, a director of Barclays’s futures business, testified today in U.S. Bankruptcy Court in Manhattan. James worked on Barclays’s purchase of Lehman’s brokerage during the 2008 financial crisis.

She said she received an e-mail from former Barclays trading executive Stephen King saying Lehman had “absolutely no idea” if it had sold $2 billion more options than it had bought, or whether it owned $4 billion more than it had sold.

. . . .

Transferring margin together with trading positions “is normal practice in the ETD business,” she told U.S. Bankruptcy Judge James Peck, referring to Lehman’s exchange-traded derivatives. “You’d be crazy if you didn’t.”

She said Lehman’s lack of records initially prevented her from performing “due diligence” to discover what Lehman’s and its customers’ positions were, where Lehman kept its bank accounts, and who its brokers were.

James said she had seen a tabulation of Lehman’s positions at the Options Clearing Corp. showing that the daily margin requirements for its trades had varied by as much as $1 billion within a few days in September 2008.

Moral of the story: moving more trading to exchanges, exchange-like systems, and clearing will not necessarily lead to greater clarity about the positions that big entities like Lehman hold.  One of the arguments for clearing has been that it will improve regulatory transparency, and help regulators figure out where the risk is and who is exposed to whom.  Even overlooking the basic fact that it is possible to have centralized trade reporting without mutualizing credit risk through clearing, the Lehman story shows that this alleged advantage has been vastly oversold.

Big complicated firms have big, complicated, and dynamic positions that are hard to keep track of, regardless of where and how they are traded.  There is a long, long, long way to go before even approaching the ideal of “mapping” risk in the financial system.  More centralized collection of information is a necessary, but by no means sufficient, condition to achieve this goal.

The Lehman story should be a cautionary tale to all those who naively believe that waving a legislative wand and casting a spell that drives trading to exchanges will magically eliminate all of the huge operational difficulties associated with measuring and managing risk.

Ruh-roh.

An airport trade is when somebody puts on a trade far bigger than he can afford.  He then heads to the airport with a one way ticket to a foreign nation, preferably one without an extradition treaty.  If the trade is a winner, the guy enjoys a blowout vacation then returns as the conquering hero.  If the trade is a loser–well, welcome to Margaritaville.

There are rumors ricocheting around the internet and news that Chinese Central Bank Chairman Zhou Xiaochuan has defected to the United States.  The original version of the rumor, according to Stratfor, related to a huge loss on Chinese investments in US securities:

The rumors appear to have started following reports on Aug. 28 which cited Ming Pao, a Hong Kong-based news agency, saying that because of an approximately $430 billion loss on U.S. Treasury bonds, the Chinese government may punish some individuals within the PBC, including Zhou.

Uhm, no.  Completely implausible.  US Treasury data show that in mid-2009, China owned about $760 billion in Treasuries, and about $450 billion in agency securities.  There is no way that it could have lost $430 billion on these positions, obviously.  Especially since Treasuries have been up recently.  Indeed, people are speaking of a Treasury bubble.

To lose huge money on Treasuries in this market you’d have to be short.  Friend and frequent commentor Charles does a quick back of the envelope calculation, and figures that somebody would have to be short about $4.5 trillion in Treasuries.  Zero Hedge calculates $3.5 trillion.  Either way, no way.  Like anybody could put on such a position with nobody knowing.

But Zhou hasn’t been seen.  Internet searches on his name have been blocked in China, as have websites carrying the rumor.  The rumors of  defection are flying fast and furious.  Chinese repo rates spiked.  There’s smoke, so what’s the fire?

One story is that this is all part of a power struggle in the leadup to a transfer of power in 2012.  Given the opaque nature of Chinese politics, this is plausible.

But here’s another, more ominous possibility.   Helicopter Zhou has overseen massive injections of liquidity into the Chinese market to fight the financial crisis.  There are widespread worries about a housing bubble, and the cracking thereof, with disastrous consequences for banks.  Similarly, there are myriad reports about massive quantities of bad loans, including huge amounts to local governments.  The recent bank “recapitalization” plan, which seems to have more in common with a three card monte game than a real recapitalization, only adds to concerns.

Put all this together, and it is plausible that Zhou has realized that the whole structure is on the verge of collapse, and that he is the natural fall guy.  So, he’s getting out while the getting is good.  The biggest airport trade, ever.

This bears watching.  If the rumors are true, and his defection/departure has anything–anything–to do with a deteriorating financial and economic situation in China, we are all in for a hell of a ride.  What exactly?  Who knows?  Commodity prices would likely crash.  But beyond that, given the opacity of the Chinese economy, financial system, and political system, it’s difficult to know how they would react and what the effects of their actions would be, either in China or the larger world.

Keep your eye on this one.

It is flattering to know that the always insightful (and knowledgeable) David at Deus ex Macchiato found insightful my observation that capital requirements can result in crowded trades–and hence systemic risk.  I think the idea is pretty straightforward.  It’s all about incentives.

Risk-based capital requirements are like a regime of price controls, in this instance, risk price controls.  If some risks are mispriced, and particular, priced too low, all affected institutions face the same incentives to take on those particular risks.  The more institutions that fall under the capital regime, the more institutions that will take on these underpriced risks.  That’s why I am very leery of global capital regimes, a la Basel.  If they screw up the prices–and screw them up they will, with metaphysical certainty–the effect of the perverse incentives will be global.

David suggests the need for regulators to set up capital arbitrage groups to address this problem.  The foregoing suggests that these groups should look for the stuff that everybody is doing–those are the risks that are likely to be mispriced.

The problem is that because everybody is doing it, if the regulators try to crack down, the political pushback will be intense.  For evidence of this, see this dispiriting paper about how those who went into the subprime craze succeeded in getting Congress to add fuel to the craze, rather than crack down on it.  Moral of the story: subsidies (underpricing) tend to create constituencies that favor the continuation of the subsidies.  (Cf. the American sugar program, or farm programs generally.)  As a result, I think that cap arb groups inside regulators will be about as effective as the war on drugs.

Not everybody is so impressed with my argument.  Synthetic Assets, for example:

Craig Pirrong and David at Deus ex Macchiato are worried that the minimum capital requirements set by Basel III will face the same problems as those created by earlier versions of Basel:  As banks seek to minimize their capital positions they are all pushed by the regulations into the same trades, this leads to the growth of unregulated financial sectors and crowded trades.

The question I have for proponents of this view is:  Why would a bank seek to minimize its capital position, when the purpose of capital is to protect the firm against unpredicted — or even unpredictable — losses?  There’s a reason Jamie Dimon has been feted for his “fortress balance sheet” approach to the crisis that everyone — including Chuck Prince — could see coming.

Whenever minimum capital requirements are the determinants of bank behavior, that’s a good indicator of a deep structural problem with the financial system, because it means that you have a financial system populated by banks that are more concerned with maintaining profitability in the short-run than with ensuring that the bank is a viable entity in the long-run.  In short, when banks are maintaining only minimal levels of capital, you have pretty clear evidence that repeated bailouts have resulted in the complete perversion of financial system incentives.

SA–with all due respect, you miss the point.  Neither I nor David (if I can speak for him) anywhere claim that banks set capital levels at the absolute minimum.  It is evident though, that they do economize on costly capital (their shareholders demand it), and make asset allocation decisions strategically in response to the incentives inherent in capital rules.  There is no way to explain what transpired in the lead up to the crisis without understanding the crucial role of capital requirements, most notably the extremely favorable capital treatment accorded to AAA rated CDOs, SIVs, etc.  You’d have an easier time explaining Hamlet and leaving out a certain prince from your telling.

Yes, banks held more than the minimum in capital.  But that was extremely misleading about the true risks in the system, because the capital requirements were fatally distorted.  The capital required against certain instruments (government debt being another example) was too small relative to the true risks of those instruments.  So too many banks loaded up on them. (This exacerbated the underpricing problem because the capital requirements didn’t take into account how the correlation in trading activity across entities increased the risks of their portfolios.)  JPM was the decided exception that proves the dreary rule.

This is a story about relative prices.  In a risk based capital regime, some risks are mispriced relative to others.  Banks load up on those mispriced risks.  Since all face the same distorted pricing signal, they tend to trade the same way.  They held more capital than they were required to, but that provided a false sense of security because the required levels of capital did not accurately reflect the risks.

There is, in fact, dysfunction in the financial system.  That dysfunction, in the first instance, is the result of the deadly combination of implicit and explicit guarantees that stoke moral hazard, and woefully inadequate and scarily expansive capital requirements that are intended to make it difficult for banks to exploit that moral hazard, but fail to do so.

That’s why I find it chilling that regulators around the world are touting capital requirements as the panacea that will prevent the next crisis, when in fact universal or near-universal requirements are more likely to be the cause of the next crisis.  It is inevitable that any requirements will misprice some risks.  Banks, motivated in part by the explicit or implicit safety net that means that they do not internalize risks, will methodically seek out those underpriced risks.  With identical, or even highly similar, capital requirements across jurisdictions, their portfolios will be overweighted towards those underpriced risks.  Everything will look just fine because the banks will say–“look, we have so much more capital than the minimum, so no need to worry.”  But the minimum is way too small.  And when those overweighted investments get hit by an adverse shock, it is a correlated shock, meaning that there is a substantial risk that the death spiral will begin, as everybody tries to get out of crowded trades.

And that’s why I think Basel–I, II, III. . . or IV, or XXIV–has been faulty, and will be faulty.  The fault is inherent in any global system to set risk prices.  The knowledge problem will kill you, every damn time.

FT Alphaville summarizes the Troika Dialog argument touting Russia as the BRIC to bet on.  According to TD:

Russia has more raw materials, a more educated and middle-class population, a strong macroeconomic framework, a better track record, more resilience to global warming, and is cheaper. Moreover, it has unique commodity assets and a clear and successful European path to follow.

Color me extremely unimpressed.  If this is the best case, Russia’s future is bleaker than I thought.

1. Raw materials are a curse to growth and long term economic prospects, not a benefit.  That has been particularly true in Russia’s case, but it is difficult to find raw material intensive economies that have been stalwart growth performers.  It’s a lot easier to find such economies that are basket cases.

2. Yes, Russia has a more educated populace than other BRICs.  But that is already reflected in the higher per capita income of Russia compared the other BRICs (another attribute that TD touts).  Moreover, as is true of much of Russian capital, the educational prowess–the human capital–of the Russian population is pretty much a Soviet legacy that is depreciating rapidly.  The current Russian educational system is pretty much a disaster, and a shadow of the Soviet system.  Corruption is rife: today, Russian educators put the cheat in ???????.  The future of Russian education is hardly encouraging.

3. TD vastly understates Russia’s crippling economic defects:

Apart from oil price dependency, which is an aspect of macroeconomic fragility, Russia’s weaknesses are poor corporate governance, which restricts the returns to minority shareholders, and regulation, which restricts ROE levels (e.g. utilities). We reject the fashionable view that other issues like weak population growth, poor infrastructure, or poor government are necessarily damaging to ROE levels.

Poor corporate governance is the understatement of the century.  FTAlphaville has a more complete list:

It ranks worst for corruption, corporate governance, and most institutions in international rankings. In financial services – such as investor protection, ethical behaviour of companies, strength of auditing, and market sophistication – again it fall short of the other Brics, according to the World Economic Forum. And it ranks second worst on the business cost of terrorism (behind India), and both violent crime and organised crime (to Brazil).

But even that list is seriously incomplete.  A more complete list would include: the absence of reliable property rights, the lack of contract enforceability, the corruption of the legal system and the absence of the rule of law, the constant threat of expropriation, the arbitrariness of government.  I could go on.

In brief, the TD analysts are being pretty thick.

Timothy Garten Ash had a more reasonable assessment a couple of months back, but it still focuses on traditional macro and structural issues and underemphasizes Russia’s fundamental problem: its institutional deficit.

These are all issues that primarily speak to Russia’s long term prospects.  Its second quarter growth numbers came out, and they show things aren’t doing all that well in the short run either.  Russian GDP grew 2.5 percent year-on-year from July, 2009 to July, 2010.  The economy actually declined month-on-month.  Although the fires certainly contributed to this decline, it is not a a favorable sign.

This is anemic even by comparison to the US.  From trough (2Q 2009) to the present (hopefully not the peak, though it might be a local one given the real prospects for a double dip), the United States grew 3.1 percent.  This was after a 4.2 percent decline from the peak in 4Q 2007 to the bottom in 2Q 2009.

In comparison, the Russian economy declined 7.9 percent in 2009, about twice the US decline.  Twice the decline and a smaller rebound is hardly stellar performance, especially since the standard of comparison–the US–has not been a stellar performer itself.

Things are even worse if evaluated on an output gap basis.  Given that Russia was growing at 5+ percent into mid-2008, the output gap is now about 15.5 percent.  Since the US was growing at about 2.5 percent, the gap her is around 5.5 percent.

The sluggish growth in Russian GDP is particularly underwhelming given that oil prices have more than doubled off their crisis lows.  This should have given Russia a favorable jolt, while serving as drag on the US.

The Finance Ministry is sticking by its forecast of 4 percent growth in 2010.  Highly unlikely, especially given the effects of the drought; the fires; and the serious prospect for a global slowdown in the last third of the year.

Short run or long run: neither looks too hot.