Streetwise Professor

While doing her research at Heritage, Renee came across this 2000 article in Regulation by Thomas Oatley. It discusses the Basel capital standards, and is amazingly prescient:

Faced with this simple risk classification scheme, banks altered their lending behavior in ways that  regulators did not expect. For example, the risk classification provides incentive for banks to hold riskier loan portfolios than they would have held otherwise. Because the regulations assign the same risk  weighting and capital costs to all loans within a given category, banks have incentive to shift toward higher-risk, higher-interest assets within each category. For example, a loan to a triple-A rated corporation receives the same risk weighting as a loan to a heavily indebted start-up firm, even though the loan to the start-up has a much higher probability of default. Because the banks charge higher interest to the start-up, they are more inclined to make that loan than to lend money at a lower interest rate
to the secure corporation.

The risk classification scheme also offers incentive for banks to engage in regulatory capital arbitrage. When capital requirements are not based on a standard like the probability of insolvency, banks can often restructure their portfolios in order to reduce their regulatory capital requirements without reducing their risk. By securitizing assets, banks can unbundle and repackage risks to transform on-balance sheet assets into off-balance sheet assets that fall into lower risk weight categories. While reliable information on the scale of regulatory capital arbitrage is not available, the Federal Reserve has estimated that securities used to engage in regulatory capital arbitrage account for more than 25 percent of total assets of the United States’ ten largest banks. In several individual cases, those securities account for close to 50 percent of total assets.

The problems created by regulatory capital arbitrage pertain less to the off-balance sheet assets and more to the on balance sheet assets. Banks can only securitize high quality assets at acceptable cost; thus, regulatory capital arbitrage moves higher quality assets off banks’ balance sheets in operations referred to as “cherry picking.” This causes the average credit quality of banks’ on-balance sheet assets to deteriorate as high quality assets disappear and low quality assets remain. Against this lower-quality  balance sheet, the Basle Accord’s eight percent capital requirement may be insufficient and banks’ capital ratios may provide a misleading measure of banks’ true financial condition. Because market participants use capital ratios to determine the health of lending institutions, the weakened quality of this information may harm market discipline. [Emphasis added.]

That is an eerily accurate description of a process that accelerated in the 2000s, and culminated in the Financial Crisis.  Whether it was AAA CDOs or Greek government debt, banks loaded up on investments that received highly favorable capital treatment under Basel.  And it was those things that blew up the banks–and could blow them up again.

Ironically, Basel was intended to increase the rigor of capital regulation to make banks safer.  But as I’ve written repeatedly over the past year, capital requirements essentially impose price controls.  In this instance, the prices relate to risk.  But the price controls underprice some risks, and those are the ones that attract financial institutions like moths to the flame.

Enhanced capital requirements are again being touted as a way of preventing the next crisis.  But the Basel Rules were a response to a crisis–the Latin American debt crisis–that paved the way for the next one.

If the incentive system encourages financial institutions to take on tail risks (due, for instance, for implicit government guarantees), those institutions will find the vulnerabilities in the capital requirements through which they can smuggle such risks onto their balance sheets, like hackers identifying and exploiting each new vulnerability in Windows.

The existence of vulnerabilities is inevitable–no centrally created set of risk prices will be even close to right.  Which means that enhanced capital requirements provide a false sense of security.

The problem is that the ability of the institution that can price risks more accurately–the capital markets–is fatally undermined by the very real prospect of bailouts of institutions that fail.  That is the Original Sin, and as long as we remain in that fallen state, a future crisis is almost inevitable, capital requirements or no.  Indeed, the main effect of capital requirements as implemented will be to determine exactly what causes the crisis, not the likelihood of its occurrence.

I have long been fascinated by Black Friday, 24 September, 1869.  On that day, a massive corner in gold collapsed, throwing the American financial system into chaos.

My initial interest in the subject stemmed from my interest in corners: the opening paragraph of my book on manipulation (#2,306,956 on Amazon!  Available on Kindle!) uses the story of the collapse of the Fisk-Gould gold corner as the hook into the subject.  The episode shows how corners work; how they can fail; and interestingly, illustrates some of the game theoretic aspects of corners.  Specifically, Fisk and Gould were in a prisoners’ dilemma, and in the event, Gould ratted out on Fisk, selling when prices were driven up at the end by a surge of Fisk buying.  When Fisk stopped buying, the price collapsed, leaving Fisk with a boatload of losses, and Gould with a nice gain.  (Gould was actually selling to his erstwhile partner Fisk in some of his trades.)

But Black Friday also relates to one of my other obsessions–clearing.  Since about 1997, I’ve used the story of Black Friday to show that (a) clearinghouses can fail, and (b) that the consequences of said failure are catastrophic.

Here’s the story in a nutshell.  Gold trading started in the US in 1862, when during the Civil War the US government issued fiat currency (“greenbacks”) and made them legal tender.  Almost immediately, there was speculation on the value of gold vs. paper dollars.  The business began in the streets of New York, but soon became big enough that interested firms and individuals started a Gold Exchange and moved the business indoors.  The business boomed during the Civil War, and the price of gold ebbed and flowed with Union military victories and reverses.

Originally, deals were settled by the delivery of gold to the buyers’ offices in exchange for cash.  This, of course, resulted in robberies, sticky-fingered messengers, etc.  So the Gold Exchange adopted rules permitting delivery of bank certificates signifying ownership of gold in vaults.  That resulted in the a fraud scandal in which a trader counterfeited gold certificates (shades of the CO2 market, circa 2009-2010!).

As a result, in 1866, a Gold Exchange Bank was chartered in New York.  The Bank operated a clearing division.  Each day, traders submitted settlement statements to the Bank.  The bank calculated net pays and net owes in cash and gold.  Traders delivered their net obligation to the clearinghouse, in exchange for net payments owed them.

The Gold Exchange Bank was not a mutual organization, like a modern CCP.  But it did back trades out of its capital.  The Gold Exchange absorbed any losses attributable to the failure of any broker, and made whole those who were owed money on the daily settlements.  Thus, like a modern CCP, it insured against default risk.

The system worked like a charm from its inception in late-1866 until Black Friday.  But on that day, clearances were many times larger than usual: the usual day saw about $80 million in clearances, but (incomplete) records for the 24th indicated clearances of about $350 million.  More importantly, several important brokers–namely those who traded for Fisk–didn’t submit reports, and didn’t pay anything into the clearinghouse.

Chaos ensued.  Those owed money were clamoring for their funds.  But there was a huge whole in the Bank’s accounts.  It owed money to those who profited from the price collapse, but hadn’t received the funds from those who had lost.  It tried to finesse the situation by paying out partial settlements to those owed money.  But a trader filed an injunction stopping the Bank from doing this, and appointing a receiver to handle the settlements.  The Bank was closed for some days while the receiver unwound the tangled mess of obligations.  The Bank ended up losing close to $500,000.

The failure of the clearinghouse brought the New York financial market to a near standstill.  Liquidity dried up, as vast sums sat in the Bank’s vaults awaiting resolution of its obligations: short term money was only available at a rate of 1 percent per day.   The freeze-up of the financial markets brought foreign trade to a standstill as importers and exporters could not obtain the typical finance.

There are other interesting aspects to the story.  For instance, the Bank’s (state) regulators were overwhelmed by the situation.

In a nutshell: a big price move makes some big traders unable to meet their obligations to the clearinghouse.  The clearinghouse has insufficient capital to make up the shortfall, and shuts down.  There are serious, broader market spillovers and impacts on the real economy: that is, the clearinghouse was deeply interconnected with the broader financial markets, and consequently, with the real economy.

An old example, yes, but an illustration that clearinghouses can fail in times of market stress, and that these failures can lead to substantial market dislocations.

The episode also provides some other cautionary lessons.  For instance, collateralization–margining–was common on gold trades.  Indeed, not only was there daily variation margining, traders often posted initial margins (“independent amounts” in current OTC market parlance).  So margining was not sufficient to prevent defaults in the face of large market moves.

In the gold market of the 1860s, the clearinghouse did not collect margins: they were collected by individual traders.  This would differentiate a modern CCP from the Gold Exchange Bank.  However, the episode demonstrates that collection of margins was not sufficient to prevent default, either by deterring default-risky speculation, or by effectively eliminating the credit in any derivatives trade.  (If the net settlements paid and received by the Gold Bank took the margins already collected by the individual traders into account, the fact that the Bank did not collect the margins itself would be immaterial.  In this case, the Bank would be on the hook for default losses in excess of margins–exactly as is the case with a modern CCP.  The historical record that I have examined is not specific on this point.)

In brief: Clearing does not preclude the possibility of Black Days, with defaults and metastasizing financial chaos.

The best primary source on the episode is testimony taken by Rep. James A. Garfield’s House Committee on Banking and Currency in its Gold Panic Investigation.  That document is available on Google Books.  There’s a lot of tedious stuff, a lot of tendentious stuff, but a few (ahem) nuggets that make the read worthwhile, especially using GB’s search capabilities.

One last thing.  In conjunction with more recent events, Congress’s investigation reveals government’s love-hate relationship with clearing.  In the recent Frank-N-Dodd legislation, clearing intended to be the panacea to prevent systemic crises.  In 1925, acting under authority granted by the Grain Futures Act, the Secretary of Agriculture forced the Chicago Board of Trade to adopt clearing in order to clamp down on excess speculation.

In the Garfield investigation, in stark contrast, clearing was routinely damned by many Congressmen as the cause of excessive speculation and a systemic crisis.  As the minority report put it:

We have no doubt that the clearing-house, which is a nuisance to legitimate traffic and commerce, and the Gold Exchange Bank, which was an instrument used for the certification of fabulous amounts not represented by money (the “phantom gold,” which played so conspicuous a part in the drama,) are obnoxious to the sweeping criticisms of the majority report.  The clearing-house gave great facilities for gambling.  Seventy millions a day was its general average, and not half of it legitimate business.

“You can,” says Mr. Fisk, “make more transactions through the clearinghouse with $5,000 than with $100,000 without it.”  Men without means are by it enabled to deal in immense sums of gold, or phantom gold. . . . The gambling hells of Hamburg are Monaco are not more pernicious as temptations.  Their evils are few compared to those inflicted upon all our country and its business by this time and labor saving machine [a description given of clearing by one witness] to facilitate gold gambling.

The majority resolved to tax the clearing system out of business:

That the Committee of Ways and Means be instructed to inquire into the expediency of reporting a bill to levy such a tax on such transactions as those of the Gold Exchange and the Gold Exchange clearing-house, as, in their judgment the interests of the country shall require.

So, depending on when you ask, clearing is either: (a) the savior of the financial system and a deterrent to destabilizing speculation, or (b) a catalyst of destabilizing speculation that threatens the stability of the financial system.  Damned if you do: Damned if you don’t.

The truth is, of course, it is neither.  Which all suggests that considerable caution is warranted in believing financial morality tales spun by Congressmen in high dudgeon, the heroes and villains of which are interchangeable from episode to episode.

There’s nothing like a historical debate to get the juices jangling here on SWP, and methinks Sergei (“The Tarantula”) Lavrov has provided the material (H/T LR).  Where does one begin?  Where does one end?  There’s just so much here.

Lavrov is Orwellian in his invocation of Orwell:

It is difficult to interpret such attempts to politicize history as anything other than euphoria in the spirit of “winner takes all” (presumably in the Cold War), that is, the right to interpret history according to the well-known method so well described by George Orwell.

Lavrov then proceeds to politicize history in a quintessentially Orwellian fashion.

Here are some of the high points (or low points, depending on how you look at it):

The history of World War II has been rewritten many times. Elements of this approach, which was dictated by considerations of ideology and political expediency, were also present in the Soviet Union. At the same time, even during the Cold War nobody ever tried to equate the Nazi regime and the Stalinist dictatorship. It occurred to no one to compare the Nazi threat, which meant the enslavement and destruction of entire peoples, to the policies of the Soviet Union, which was the only force capable in the beginning of opposing the military machine of Nazi Germany and, in its final phase, of ensuring its defeat, which was accelerated by the opening, however late, of a second European front in 1944.

Nice of him to mention the “second European front in 1944”–but no mention of the earlier efforts.  More importantly, there is a very revealing lacuna here.  Yes, Naziism meant the enslavement and destruction of entire peoples.  But Stalinism, and Bolshevism generally, had a body count that rivaled Hitler’s: and among the people enslaved and slain wholesale by Bolshevism and Stalinism were Russians.  To say that the USSR was not monstrous in the same way that Nazi Germany does not imply that the USSR was monstrous in its own, special, murderous way.

Historical revisionism has been used to attempt to link August 23 and September 1, 1939 – the conclusion of the Soviet-German Non-Aggression Pact and Germany’s attack on Poland. These two events are taken completely out of historical context, ignoring the Munich Agreement of 1938, which led to the dismemberment and occupation of Czechoslovakia; the Anglo-German Declaration, which was signed at the same time and was essentially a non-aggression agreement between Great Britain and Nazi Germany (the so-called ” peace in our time” agreement); and a whole series of other events that prepared the way for German aggression and directed it towards the East. As always, the sequence of events was critical. Were it not for the Munich Agreement, much of what followed would not have occurred.

By denouncing the Molotov-Ribbentrop Pact the Russian Parliament has admitted that the Soviet Union made a mistake. And we are justified in expecting that in other nations which dealt with the Nazis it was done not at the political leadership level but at the political decision-making level. The West, like Soviet Russia, was not blameless. Why is this difficult to admit now that the Cold War has seemingly ended?

M-R is always good for a food fight around here, so let’s have at it.  Me first.

First, the linkage of 23 August and 1 September 1939 is not, as Lavrov suggests, a latter day invention of revisionists.  It was understood that the events were linked at the time.

Second, M-R was not foreordained by Munich.  Stalin made a deal in which he thought he would profit.  We’ve been over this before, so I won’t belabor it.  He was wrong in his calculation, but make no mistake: he made a calculation that he would advance his interests by dealing with Hitler.  Period.

Third, Lavrov’s implication here is that those in the West have completely overlooked Munich and heaped blame for the war only on the poor, misunderstood USSR.  That is complete bullshit.

Look.  I grew up in the United States during the ’60s and ’70s.  During that time, Munich was emblematic of the moral and strategic failure of Western governments.  Any proposal to make a compromise with international adversaries–most notably, the USSR–was met with accusations that such efforts would represent another Munich.  Every American president wanted to avoid another Munich at all costs.  One American president, Kennedy, wrote a book excoriating the weakness of the French and British over Munich.  I heard about Munich from the time I could remember: I seldom heard about Molotov-Ribbentrop.  To say, as Lavrov does, that M-R has been singled out for calumny while Munich has been swept under the rug is complete, utter, tripe. Only marginal loons like Pat Buchanan extol Munich.  It wasn’t difficult for virtually everyone in the West to come to honest grips with Munich before the Cold War ended.  It isn’t difficult now.

It is difficult to understand that the Western nations were prevented for reasons other than ideological preferences from implementing in 1945-1946 the principles that later led to the lessening of tensions during the 1970s, that is, from choosing to “engage” the Soviet Union. This would have encouraged Stalin to follow a moderate policy in Europe, but this chance was lost—not just for Europe but for the Soviet Union itself.

If it’s difficult for you to understand, Sergei, you are past all hope.  Yeah.  Sure.  Stalin would have been the soul of cooperation and moderation had the US and the UK just “engaged” him and not reverted to pre-war anti-Bolshi policies.  This is so self-evidently risible that it doesn’t require deconstruction.

What about the Phony War, which points to the unsavory plans of the Western Allies toward the Soviet Union in connection with Nazi Germany’s attack on Poland?

Who even knows what “unsavory plans of the Western Allies toward the Soviet Union” Lavrov is talking about.  Hey Sergei: Your paranoia is showing!  And about the Phony War.  Riddle me this: if the USSR, with the world’s largest military, was so incapable of taking on the Germans even with the potential support of Poland and perhaps the Western Allies that it was forced to treat with Hitler, how could you possibly expect the Western Allies to confront Hitler aggressively after Poland had fallen and the USSR was neutral?  And the USSR wasn’t so neutral, was it?  During the Phony War–and when the war turned anything but phony when the Germans attacked west–where did the Wehrmacht’s gas come from?  The fodder for its horses?  The food for its soldiers?  Do I need to tell you?

The establishment of a sustainable model of economic and social development—socially oriented with universal suffrage and supported by a significant middle class—was only possible during the Cold War and on the basis of new technology.

So just when is Russia going to adopt a sustainable model, then?

Freedom came from the East . . . .

Those who falsify history forget about what they gained as a result of the Red Army’s liberation campaign, including territory. The victory over Fascism and the events preceding the war, like it or not, gave all countries of Central, Eastern and Southeast Europe, as well as the former Soviet Union, their modern boundaries, which most members of the Euro-Atlantic family have no objection to. Would we like to return to the past—to a Europe burdened by the territorial problem?

Somehow, it seems to have escaped the notice of those in the path of the Red Army that anything approaching “freedom” came in its wake.  To suggest otherwise is truly Orwellian.  Moreover, I guess Sergei believes that the Poles, for instance, should overlook the inconvenience of nearly 50 years of brutal occupation because it gained territory in the aftermath of WWII.  Recall, moreover, that Stalin’s whole point of enlarging Poland was to gain territory under Soviet control at German expense.  It was hardly a gift to the Poles.  And if we want to discuss “territorial problems,” how about discussing, oh I dunno, Abkhazia, South Ossetia, Moldova?

Lavrov’s attempts at economic exegesis betray a cluelessness about the the subject which is very difficult to exaggerate:

It was in response to the “challenge of the Soviet Union and socialism” that Western Europe’s economic development model became socialist.

Uhm, post-War Western Europe was not a libertarian’s paradise, but it wasn’t an example of a socialist development model either.  The welfare state and socialism are two different things.

Erroneous conclusions were eventually drawn from the end of the Cold War. Some thought that in the absence of the “Soviet threat” it was no longer necessary to restrain market forces by government regulation, so that it now became possible to engage in “financial alchemy,” including the financial pyramids from which liberal capitalism began at the start of the 18th century. The devastating consequences of such shortsightedness and the unwillingness to understand the historical pattern that Europe followed in the “hothouse” conditions of the Cold War are all too obvious to ignore and continue along the same path. Moreover, this mistake should not be repeated in the sphere of “strict security,” which is no less important in terms of its consequences for the future of Europe.

I see, the end of the Soviet threat (scare quotes aren’t necessary, Sergei: the threat was real enough) led to the unleashing of capitalism, red in tooth and claw, which begat the financial crisis.

Yeah.  Whatever.  I mean this is totally ahistorical drivel.  Overlooking that the connection between economic liberalization and the financial crisis is extremely remote, even assuming such a connection, ask the question: when did this move to liberalizing economies in the West begin?  With Carter, tentatively, in the late-1970s, Thatcher in 1979, and Reagan in 1981.  In other words, at the height of the Cold War.  The Cold War waxed its hottest at any time since the early-1960s at precisely the same period that restraints on market forces were relaxed throughout the West.  So much for your theory of cause and effect.

I could go on, but I’ll stop here.  I’m sure that this is enough to get the comments flying.  Have at it, folks!

* For newcomers, and those who have forgotten.  Last year I gave a talk about Russian energy policy to a group of US Foreign Service officers.  (I’ll talk to another group in 2 weeks.)  Afterwards, one guy came up to me and related the story of an intelligence specialist, Russian by birth, who said: “Sergei Lavrov is fascinating, in the same way a tarantula is fascinating.”

Commentor Matt asked my views about the clearing portion of the Squam Lake Report on Fixing the Financial Crisis, which was written by a group of distinguished finance academics.  Since I know that the rest of you were waiting with bated breath but were just to shy to ask, here it goes.

In a nutshell: superficial, question begging, and at times contradictory.

The superficiality is perhaps understandable, because the report was intended to be a high-level overview understandable by policy makers and the public.  But it does undermine the persuasiveness of the report.  Indeed, it makes it potentially dangerous if policy makers aren’t fully aware of the limitations of the analysis.

The Report identifies “two important advantages of clearinghouses” (p. 113): netting and “by standing between counterparties and requiring each of them to post appropriate collateral, a well-capitalized clearinghouse prevents counterparty defaults from propagating.”

Many problems here.  First, as the Report itself acknowledges (pp. 116-117), although clearing has the potential to exploit more completely netting economies, if CCPs are fragmented, adoption of clearing can actually result in a loss of netting economies.

Second, netting benefits are largely private, and if counterparty risk is costly and collateral is a costly way to mitigate it (propositions that the Report accepts), why don’t market participants organize their transactions and create institutions to exploit efficiently these netting economies?  Indeed, mightn’t the growth of large dealers and the failure to implement clearing more comprehensively be the best way to exploit netting economies across the full range of derivatives products (and other scope economies between derivatives and non-derivatives businesses)?  The survivorship principle would suggest so.  These are important, but begged, questions that bear directly on the relative merits of cleared and bilateral markets.

Third, the Report veers into Steve Martinesque How to Make a Million Dollars Without Paying Taxes territory in assuming that CCPs will (or enjoining them to) choose “appropriate” collateral and are “well-capitalized.”  Define “appropriate.”  Define “well-capitalized.”  What are the informational requirements to make these determinations?  Who has the information?  Do the CCPs?  Will regulators?  What are the incentives of CCPs (and their members) to choose “appropriate” margins and be “well-capitalized”?  How do those incentives compare to those in place in a bilateral OTC market?  If negative externalities from default propagation among systemically important financial institutions are a flaw in the existing financial infrastructure, why would one expect a CCP whose residual risk bearers are systemically important financial institutions to choose margin levels and capitalization to internalize that externality?  More begged questions.

Fourth, the statement that CCPs “prevent counterparty defaults from propagating” is not necessarily correct.  Clearinghouses can fail, and lead to the propagation of defaults.  Indeed, one of the self-contradictory parts of the Report acknowledges this: “even a well-capitalized clearinghouse can fail.  The failure of a clearinghouse for all OTC derivatives is likely to have enormous systemic consequences” (p. 117).  Once you recognize this, you need to take seriously the issue of whether CCPs are more or less vulnerable to this propagation than bilateral structures.  The Report fails to address this crucial issue.

The Report is similarly schizophrenic on AIG.  In the chapter on clearing, it states that clearing would not have been sufficient to prevent “the AIG catastrophe” (p. 114).  But in its conclusions, it states “[f]inally, by giving AIG an incentive to use and clear standardized CDS contracts, our recommendations would have reduced AIG’s systemic importance” (p. 149).  Well, which is it?

The former judgment is correct; the latter, not.  Even based on the limited and rather one-sided characterization of the virtues of clearing, it is plain that clearing would not have made much of a difference in the AIG case.  Netting wouldn’t have made a damn bit of difference, because AIG wasn’t a dealer with a lot of offsetting positions.  It had a huge net position on one side of the market.  The same financial firms that would have been harmed by an AIG failure in September, 2008 would have been on the hook in an alternative world where the AIG deals had been cleared, either as members of the CCP, or as counterparties with large net positions that would have been owed money by the CCP, or likely both.  “Appropriate collateral” probably wouldn’t have made a whit of difference either.  The conventional wisdom at the time was that the instruments AIG traded were of very low risk, and hence it is highly likely that original margin amounts wouldn’t have been so large as to dissuade AIG from taking big positions.  Indeed, AIG’s creditworthiness and the low perceived risks of the positions led its counterparties to enter into big trades without demanding independent amounts; if a CCP had demanded cash collateral up-front, AIG could have used that creditworthiness and low perceived risk to borrow to fund the margin.  Moreover, the Report fails to analyze the full implications of a reduction in AIG’s positions resulting from clearing, or higher capital requirements, or whatever.  Since the AIG trades essentially transferred risks, how would hampering AIG’s ability to take on that risk have affected the amount of that risk in the financial system and the efficiency of the distribution of that risk?  The answers to those questions aren’t obvious, nor are they self-evidently that a reduction in AIG’s positions would have mitigated the effect of a real estate price collapse on the financial system.

The Report repeatedly assumes away crucial problems of implementation of its recommendations.  For instance, it recommends “appropriate differences between capital requirements that are cleared and not cleared.”  Again: What is appropriate?  What information do you need to make that determination?  Who has the information?  Do they have the incentive to use it?  Can such price controls–and that’s what they are–be gamed by parties better informed than those who set them?  Could the systemic consequence of such gaming be worse than the disease that the capital requirement differentials are designed to cure?

Relatedly, it recommends that due to the systemic importance of CCPs, regulators require “appropriate collateral” (there’s that “A” word again); “strong operational controls”; and “sufficient capital.”  All of the questions raised in the previous paragraph are begged on these issues as well.

The authors of the Report mimic Goldilocks on the issue of the structure of the clearing sector (pp. 116-117).  Too many CCPs are bad, because this fragmentation can impede exploitation of netting economies.  Too few CCPs are bad, because that makes the financial system too vulnerable to the failure of one of these behemoths.  So how many is just right, Goldilocks?  And how are we going to get there?

The answer:

[r]egulators and lawmakers should not intentionally or unintentionally promote the proliferation of redundant or specialized clearinghouses.  The proliferation of clearinghouses would create unnecessary systemic risk by eliminating opportunities to reduce counterparty risk (p. 117).

Thanks a lot.

Indeed, the evolution of this industry going forward will determine the effects of clearing mandates, or other measures to favor clearing.  For far more reasons than the Report mentions, it is quite possible that the industry will evolve in a way that worsens the stability of the financial system.  And there are strong reasons to believe that the industry will not necessarily evolve in a salutary way.

First, the pervasive scale and scope economies mean that the industry is unlikely to evolve in an efficient, competitive fashion, or that the resulting structure will be systemically more robust.  These economies tend to favor consolidation into a relatively small number of systemically vital, and vulnerable, CCPs.  Moreover, this structure can impede competition (a point that the Report acknowledges).

Second, the Report’s rather naive injunction to regulators and lawmakers aside, jurisdictional considerations will tend to induce fragmentation.  Every major jurisdiction wants a piece of the clearing pie, for economic reasons, and for reasons of political control.  It is also likely that governance and control issues will also lead some market participants to favor specialized  (by product or geographically) CCPs (over which they can exert influence) over broader ones.

Third, political economy considerations completely ignored in the Report–but not in the real world–will also affect the evolution of the infrastructure.  Market participants will attempt to influence legislators and regulators on capital levels, margin levels, operational risk controls, the numbers of CCPs, etc.  We are already seeing industry pressure regarding membership requirements for CCPs–an issue that has both competitive and systemic risk implications.

Just who knows what kind of structure will evolve from these cross-currents of economic and political forces (with the politics rooted, of course, in economics and rents)?  I don’t know for sure, but am deeply concerned that the political economy dynamics will seriously distort the process in a way that reduces the efficiency of the market during normal times, but doesn’t reduce–and may increase–its vulnerability to crises in abnormal ones.  The Olympian, and superficial, analysis of the Report doesn’t come to grips–at all–with these weighty matters.

In brief, the clearing chapter (and related material) in the Squam Lake Report is too incomplete, and sometimes flawed on those issues that it does address, to provide actionable policy guidance.  And since that’s the purpose of the Report, it it is unsuccessful on its own terms.

Frank-N-Dodd mandates that all cleared swaps trade on either a contract market (i.e., an exchange) or a “swap execution facility.”  There’s been a lot of uncertainty about just what a swap execution facility (“SEF”) is, but the bill provides enough clues to get a pretty good idea.

The short answer: a lot like an exchange.  A whole lot.

Some key points:

• An SEF must permit multiple participants to trade by accepting bids and offers made by multiple participants.  This means that an SEF must be a “many-to-many” execution platform.  A “many-to-one” platform, such as an electronic system in which a bank or broker-dealer posts bids and offers that customers can execute against wouldn’t qualify.
• They must permit “impartial access,” although that term is not defined.  But it suggests a mechanism in which no one can be excluded.  (Here the link to clearing is important.  If anybody is allowed to enter bids and offers that others can execute against, they must be effectively equivalent as potential counterparties.  Clearing standardizes–homogenizes–credit risk across counterparties.)
• The bill specifies that the goal of the section on SEFs is to promote pre-trade transparency.
• SEFs must establish and enforce rules to deter trade abuses.  They must have the capacity to investigate to detect rule violations.
• Relatedly, they must collect information that can be used to establish whether rule violations have occurred.
• They must permit trading only in non-manipulable swaps.
• They must monitor trading to ensure that rules are adhered to.  In particular, they must engage in real time monitoring of trading, and have systems to permit accurate and comprehensive trade reconstructions.
• SEFs must monitor trading in swaps markets to prevent manipulation.
• The bill states that SEFs “shall” impose position or accountability limits.
• SEFs are required to adopt rules to provide for the exercise of emergency authority.
• They are to make public “timely” information on price and trading volume and other trading data, as prescribed by the CFTC or the SEC (for security-based swaps). That is, they must offer “timely” post-trade transparency, but just what constitutes “timely” is an open question.  (Yet another thing on regulators’ plates.)

If you compare this list to the obligations imposed on contract markets (i.e., futures exchanges), you’ll see that SEFs are subject to almost all of the same obligations as contract markets.

In essence, SEFs must be a many-to-many execution platform that is also self-regulating entity that polices for trade practice violations and manipulation.  The combination of many-to-many with “impartial access” and extensive pre-trade and post-trade transparency effectively requires the creation of a public exchange; the mandated link between clearing and SEF execution is also very (futures) exchange-like.

It seems unlikely that “dark pool” like structures would meet these requirements; these are often not many-to-many, frequently don’t permit the making or executing against bids/offers (e.g., crossing networks), and offer limited pre- and post-trade transparency (hence the “dark” in “dark market”).  Traditional dealer-client execution wouldn’t cut it either: that’s not many-to-many.  Moreover, the real time trade monitoring and the ability to engage in accurate and comprehensive trade reconstructions seems to be an insuperable obstacle for voice brokers, meaning that effectively the bill requires the creation of electronic exchanges.

This suggests that (a) market participants will have a very limited choice of methods for executing transactions in swaps, and (b) these choices are far different than market participants have opted for currently.  Congress, in its infinite wisdom, is forcing pretty close to a one-size-fits-all trade execution system on the market.

The lack of diversity in execution methods compatible with the SEF mandate contrasts sharply with the incredible diversity of market participants.  It is well known that these diverse participants would like to have access to a variety of execution methods compatible with their particular needs.  For instance, those wanting to trade in very large quantities often prefer–and often strongly prefer–not to trade on many-to-many exchange-type markets because of information leakage, price impact, front running, etc.  The incredible array of execution platforms in equity markets testifies to this, as does the variety of derivatives execution methods, which range from order driven exchange markets to voice brokered markets to electronic dealing systems to telephone markets.

What is the rationale for restricting choice in execution?  The only hint of a justification is the desire for greater transparency.  But it is well known that  transparency has costs as well as benefits.  Mandating a high level of pre- and post-trade transparency just begs the question of why market participants would systematically choose the wrong level of transparency (i.e., a level that does not maximize the difference between costs and benefits), and why even if some market participants might profit from a sub-optimal level of transparency, competitive forces don’t prevail in overcoming the self-interest of a subset of participants.  Moreover, transparency isn’t the only thing that matters to market participants.  Other aspects of execution affect their costs and benefits as well.  A myopic focus on transparency alone ignores these other relevant dimensions.

The clash between the diversity of market participants and the my-way-or-the-highway SEF rules will result in chronic conflict in coming years.  There will be a demand, and likely a very strong demand, for the creation of alternative execution mechanisms to accommodate diverse trader needs.  There will be conflicts with regulators, and litigation, over whether these alternative mechanisms fall afoul of the SEF requirements.  There will be lobbying for exemptions, exceptions, and new laws permitting the creation of new kinds of facilities.

In 2005, I wrote that there was a 30 years war over securities market structure that was effectively started by the Securities Act Amendments’ mandate of a National Market System in 1975: that is now on its way to becoming a hundred years war (with the fallout from the Flash Crash just being the catalyst for another intense battle in that war).  The SEF mandate will spark a long running battle in derivatives market structure as well.  This is not the end of battles over derivatives market structure: this is the beginning.

The SEF rule is a Procrustean bed: an “arbitrary standard to which exact conformity is forced,” “a scheme or pattern into which someone or something is arbitrarily forced.”  Just why such conformity is optimal in a market with a wide range of buyers and sellers of different sizes, different trading objectives, different demands for immediacy and liquidity, etc., is hard to comprehend.  I understand that the nature of trading markets makes it that they are unlikely to be highly competitive (and I’ve written about that extensively in my academic work), and that as a result some inefficiencies (notably market power) can persist.  But competitive forces do exist, and especially given modern electronic trading technologies, it is possible for these competitive forces to respond to, and accommodate, diverse transacting preferences.

But rather than let market forces work, albeit imperfectly, Congress would rather play Procrustes, forcing traders large and small onto the same type of trading platform.

Where’s Theseus when you need him?

Patrick Pearson is head of market infrastructure for the EC’s financial market regulator.  He apparently hasn’t read the memo declaring that clearing mandates will usher in the era of the Big Rock Candy Mountain:

Central clearing  . . . is a concept so dear to regulators [sic] hearts that it has become something of a mantra — particularly since the demise of Lehman Brothers and the counterparty risks that were brutally revealed by that event.  So when Patrick Pearson . . . stood up to address an ABS conference in London on June 15 his words took some in the audience by surprise.  “Clearing houses don’t reduce counterparty risk,” he stated.  “They simply redistribute it.  Central counterparties (CCPs) can act as a channel for risk.  Their failure s far more dangerous than the failure of one single counterparty.”

. . . .

“If we shift massive amounts of OTC derivatives onto an exchange–are they safe enough to manage the risk? . . . . We don’t know.  There are 13 clearing houses in Europe.  If one defaulted there would likely be multiple defaults of clearing houses across the region.  Just imagine how the markets would react.”

Hallelujah.  How long have I been waiting for a regulator or legislator recognize those basic facts.

The author of this piece, Louise Bowman, recognizes that Pearson has gone off the happy talk reservation and committed the dire sin of telling the truth:

Hang on!  The market has long worked on the assumption that central counterparty clearing will be mandated in Europe — it is just a matter of when . . . . The question is therefore what the highly eloquent Pearson was trying to say.  In addition to questioning whether central clearing reduces counterparty risk he suggested that exchange trading of OTC derivatives might not be adopted in Europe–something that has also been seen as almost inevitable given the regulators’ drive for transparency in this market.

It is encouraging that not everyone in a position of regulatory responsibility has drunk deep the Klearing KoolAid.  It will be interesting to see how things develop in Europe.  It will be especially interesting to see whether an extended debate over clearing and exchange trading mandates lead to rather testy interactions between US and European officials, as alas, KoolAid seems to be the only thing served on Capitol Hill, Pennsylvania Avenue, and 21st St.

Pearson is, so far, pretty much a voice in the wilderness.  One hopes, however, that he catalyzes a more constructive debate on these issues.  There is a growing group of clearing skeptics among academics and practitioners.  Pearson’s outspokeness raises the possibility that the skeptics’ arguments might actually receive a serious hearing at least somewhere it matters.

I have read the derivatives and clearing titles of the Frank-N-Dodd act, so you don’t have to: you can thank me later.

Here are some random thoughts.

First, a good chunk of it is mind-numbing language dividing authority between the CFTC and SEC, and instructing the agencies on how to coordinate and cooperate.  Note to self: if they start rationing anesthetics under Obamacare, read one of these legislative monstrosities.  It will certainly beat biting a bullet and taking a swig of bourbon for inducing a pain-dulling stupor.

Second, the fading of the Lincoln provision is quite artfully done.  I had to read the damn thing several times to figure out just how they did it.  The bill starts out with: “NO FEDERAL BAILOUTS OF SWAPS ENTITIES” and then says with the exception of insured depository institutions.  Pretty big exception.  So where did the exclusion of commodities and equity swaps come from?  Well, the bill permits:

Acting as a swaps entity for swaps or security-based swaps involving rates or reference assets that are permissible for investment by a national bank under the paragraph designated as ‘‘Seventh: of section 5136 of the Revised Statutes of the United States ( 12 U.S.C. 24), other than as described in paragraph (3).”

And what does this “Seventh” paragraph say? It says that banks are allowed to:

Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes according to the provisions of this title.

So swaps based on rates or reference assets including typical bank activities including borrowing and lending, FX, and  bullion (presumably precious metals) are all OK.  The paragraph specifically precludes trading in stocks, meaning that equity derivatives are out.  Commodities (other than bullion) aren’t mentioned, so they’re not covered by the exception, and must be spun off.  (The ability to trade bullion-based derivatives means that my calculations of the share of bank derivatives business that will have to be spun off were biased upwards, since a decent fraction of bank commodity trading is in gold and silver.)

Third, the bill does an amazing amount of punting on key issues.  The problem is that the punts won’t be fielded by Darren Hester, Billy “White Shoes” Johnson, or Gale Sayers.  Instead, they will be returned by the same shlubs that fumbled so often in the most recent crisis–the existing regulators (think Madoff, Alan Stanford, AIG, and oh yeah, dodgy FSU shell companies.)  If you look at all the things that the CFTC has to do in the next 12 months, you just know the agency will be overwhelmed.

Fourth, two things relating to margins jumped out at me.

The bill states:

MARGIN REQUIREMENTS.—The margin required from each member andparticipant of a derivatives clearing organization shall be sufficient to cover potential exposures in normal market conditions. [Emphasis added.]

But supposedly the whole objective of the clearing mandate is to reduce systemic risk, in part by requiring increased collateralization.  But periods of systemic instability are, by definition, highly abnormal.  So what’s the point of mandating clearing, and then just allowing the CCPs to impose margins just sufficient to cover normal every day price moves?  This language will give CCPs tremendous leverage in fighting off regulatory efforts to increase collateral.  Not that I mind that, but it suggests a complete disconnect between what the legislation promises and what it can actually deliver.  It promises a collateralization mechanism that will reduce the likelihood of chain reaction failures under stressed market conditions, but then only requires the posting of collateral sufficient to cover losses under non-stressed conditions.

The other thing relates to margins on non-cleared derivatives.  The bill gives prudential regulators the power to set margins (and capital requirements) on these trades:

Each registered swap dealer and major swap participant for which there is a prudential regulator shall meet such minimum capital requirements and minimum initial and variation margin requirements as the prudential regulator shall by rule or regulation prescribe.

Meaning that the prudential regulators (e.g., the Fed, OCC, FDIC) can set margin requirements.  Prudential regulators will set margins that will:

be appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.

This is potentially quite dangerous.  It is a form of price control, and such controls will have perverse effects (as they always do).

In the present instance, I have been critical of clearing mandates in large part because CCPs do not have as good information as dealer banks to set appropriate margin levels.  Regulators will be even less well informed, and at a greater informational disadvantage relative to those trading the instruments.  This is particularly true for the instruments at issue–the exotic swaps that will not be cleared even under a clearing mandate.

Better informed market participants will readily identify which risks regulators have underpriced, and which ones they have overpriced.  They will overtrade the underpriced risks, meaning that defaults risks will be greater than the regulators think.

We’ve seen this before.  The recourse rule that gave very favorable capital treatment to AAA securities encouraged banks to load up on them, with disastrous consequences.  Since the regulators’ pricing errors will apply to all market participants, these errors will have systemic effects, encouraging myriad financial institutions to overtrade the same risks.  As I’ve written before, regulation and legislation create systemic risks because they apply to broad swathes of market participants.  This is another example of that.  Getting the risk prices wrong–as regulators will inevitably do–means creating incentives for all affected institutions to overload on the underpriced risks.

I just came across the blog Deus Ex Macchiato, because its (anonymous) author kindly linked to a couple of my posts.  I took some time going through the blog, and was quite impressed.  It’s very much worth following if you are interested in banking, finance, derivatives, and market infrastructure related issues.  I only wish I knew of it earlier.

DEM is a clearing skeptic–one of a select breed.  The post that attracted my attention lists 10 misconceptions about CCPs.  Spot on.  There are many more, but the ones DEM lists are important indeed.

I consider the name of the blog somewhat ironic, given that I’ve frequently referred to CCPs as deus ex machina, that will descend from the heavens to solve all our systemic risk problems.

A couple of notes to DEM, if you stumble across this:

1. I’ve written a lot more about clearing on SWP and elsewhere than the couple of things you link to, if you’re interested.  I’ve also written working papers that I’d be glad to point you to.
2. I know you’re anonymous, but I’d be interested in sharing thoughts more directly.  You can get in touch with me at [email protected] if that’s of interest to you.  Glad to do it in strict confidence.  Use a pseudonymous email address if that’s more to your liking.

I transfered from the Naval Academy to the University of Chicago as a junior.  I knew that I had gone from the alpha of academic institutions to the omega when I learned soon after my arrival in Chicago of the Lascivious Costume Ball.  No such thing in Annapolis, let me assure you.  How lascivious?  Well, I remember one woman in my dorm who went as Eve, complete with a snake and three strategically placed fig leaves.  (Maybe they were lettuce leaves.  I wasn’t checking that closely.)

What brought that to mind, you ask?  A review of the Office of the Comptroller of the Currency’s data on bank derivatives activities.

No.  Seriously.

Why?  Well, the data make it abundantly plain that the financial regulation bill that emerged from conference gave Arkansas Senator Blanche Lincoln the merest of fig leaves to cover a near complete retreat from her earlier position.

Recall that the original Lincoln plan would have required banks to spin off all derivatives trading activities (or lose their access to the Fed discount window).  The final bill allowed banks to retain interest rate, FX, and some credit trading, and spin off only commodities, equity, and some credit derivatives (as I understand it, CDS on junk securities).  The OCC data shows that the spun off activities are small beer, indeed, compared to the stuff that banks are allowed to keep.

Here are the market values, by category (gross positive values followed by gross negative values):

$ in billions

Q1 2010  Q4 2009  Change  %Change  Q1 2010  Q4 2009 Change  %Change

Interest Rates 3,147 3,121 27 1% 3,052 3,023 30 1%

FX 347 354 (7) -2% 345 344 1 0%

Equity 77 91 (14) -15% 78 90 (12) -13%

Commodity 41 50 (9) -18% 40 49 (8) -17%

Credit 390 437 (47) -11% 370 409 (39) -10%

Total 4,002 4,053 (51) -1% 3,886 3,915 (29) -1%

So, equity and commodity gross positive values total $118 billion, compared to a $4 trillion total–or about 3 percent of the total.  (Gross negative values give a similar share.)  Credit totals $390 billion, but only a relatively small fraction of that will have to be spun off.  This means that based on market values, banks will be required to spin off less than 10 percent of the total value of positions.

Here are the notionals:

Interest Rate Contracts 181,981 179,555 2,426 1% 84%

Foreign Exchange Contracts 17,596 16,553 1,043 6% 8%

Equity Contracts 1,571 1,685 (114) -7% 1%

Commodity/Other 940 979 (39) -4% 0%

Credit Derivatives 14,364 14,036 329 2% 7%

Total 216,452 212,808 3,645 2% 100%

Commodities are rounding error.  Equity and commodities is about 1 percent of notional.  Even adding in all of credit, and you don’t get to 10 percent.

It would be nice to have a risk breakdown, but that’s not in the OCC data.

Regardless, it is clear that the banks kept the big part of the business, and gave up a few minor pieces of the business to provide Lincoln with some political cover.

It’s not a big deal to the banks, but it is a pretty big deal to the commodities business.  Spinning off commodities will make it more expensive for dealers to make markets.  Some may decide it’s not worth the bother.  So this will reduce the liquidity of the commodities derivatives markets, and make it costlier to hedge.

This is just one of several hits to the commodity business in the bill.  Indeed, commodities are arguably the biggest loser.

The bill says the CFTC “shall” impose position limits on OTC commodities.  This will also impair liquidity and raise hedging costs by constraining the ability of speculators to offer risk bearing capacity.  Indeed, the effect will likely extend to exchange traded markets as well, because one factor that was limiting the CFTC’s aggressiveness on energy futures position limits was the fear that tight limits would force more business OTC.  The agency now has the power to shut that escape valve, and thus is likely to impose more draconian limits on both OTC and exchange traded products.

Moreover, the bill adopts the Senate bill’s more restrictive exemption from clearing requirements for end users.  The CFTC has some discretion on crafting this exemption, but the current leadership has made it clear that it is opposed to generous exemptions. More onerous clearing (and hence margining) requirements for end users will further raise the costs they incur to hedge.

In sum: the compromise bill shafts commodities not once, not twice, but three times.  This will force commodity producers, processors, and marketers to bear more risk, and to incur higher costs to manage risks.

And for what?  The spinoff of banks’ commodity business certainly won’t have the slightest effect on systemic risk given the trivial size of the trade relative to the other activities they still undertake.  The niggardly end user exemptions will not affect systemic risk either.  The position limits will not reduce price distortions in the market.

Bottom line: the commodities business will be riskier and less efficient, and there is no corresponding benefit to offset this cost.  All to give a politically desperate senator a fig leaf.

Several reporters have called me to ask about the implications of BP’s travails for its trading operations, and more crucially, for the markets broadly.  Here are some key points:

1. BP probably has the largest energy trading operation of any firm in the world.
2. There is a non-trivial risk of BP going bankrupt as a result of ballooning liabilities associated with the Gulf spill.  Don’t believe me?  Look at the company’s gargantuan CDS spreads.
3. BP’s counterparties are well aware of this, but are adopting a public “what, me worry?” response to any queries about BP’s counterparty risk.  Nobody wants to raise doubts that could be self-fulfilling and spark a run.
4. That said, in private they all are lacing up their running shoes, and putting contingency plans in place.  Nobody wants to be last in line if it looks like the company is teetering towards bankruptcy.  And knowing that the government is first in line to begin with cannot inspire confidence among those who have exposure to BP.
5. Things can move from “what, me worry?” to “Panic! Run for your lives! Devil take the hindmost!” very quickly, and in response to small shocks.  That is, situations like this are inherently non-linear, and small things can spark a run or a cascade that results in the collapse of BP’s trading operation in a stunningly short period of time.  I’m NOT saying this is a certainty.  I’m not even saying it is the most likely outcome.  I am just saying that such an outcome cannot be dismissed.  We’ve seen it happen too many times before.
6. The broader market consequences of a BP failure depend crucially on whether, in the event of a bankruptcy, its positions are in or out of the money.  Enron’s failure, which was not caused by losses on its trading book, was not that disruptive to the energy markets because counterparties generally owed Enron money, rather than the reverse; hence, these counterparties did not suffer losses with consequent knock-on effects.  Moreover, its failure did not cause large market price movements that worsened the company’s losses.  A BP bankruptcy similarly would not be caused by losses on its trading book, but by metastasizing liabilities from the spill.  It is possible that BP could go bankrupt, but there would not be knock-on effects because its trading book is profitable and it doesn’t owe counterparties money.
7. A known unknown is what effect a BP bankruptcy would have on energy prices, and what effect these price movements would have on the amount BP owes its counterparties.  Hypothetically, if its bankruptcy moves energy prices, and these price moves impose losses on BP, its trading partners will suffer some losses as the result of a BP bankruptcy and default.  The problem is, we won’t have any idea what the price response to a BP bankruptcy will be until it happens.

This situation is not an imminent crisis, but bears watching.  If it moves, it will not move slowly, but with stunning speed.