Streetwise Professor

Whatever emerges from the House-Senate financial regulation conference committee, the CFTC’s power and responsibilities will be greatly expanded.  Most notably, the agency will have vast power and discretion over the OTC derivatives markets.  It apparently will have considerable say in determining what contracts must be cleared and what firms must subject their trades for clearing.  Moreover, it will have responsibility to oversee the operations of central counterparties, which will have important implications for the stability of the financial system; misteps here could induce a serious systemic problem.

Just a few years ago, the chairman of the CFTC, Walt Lukken was bemoaning the agency’s lack of funding, claiming that it had insufficient resources to carry out its (then far narrower) duties.  The agency’s funding has increased, and its head count has increased about 20 percent.  It is slated to increase further to permit it to carry out its new charges.

But, as I’ve pointed out before, the CFTC was never renowned as an extremely effective regulator.  Indeed, it was often something of a Congressional whipping boy because of its perceived shortcomings.  (Example: I remember well the agency’s humiliation when then-Chair Wendy Gramm was forced to stand silent in the background while the Justice Department and the FBI announced indictments against Chicago floor traders for assorted misdeeds.  The clear implication was that the CFTC was not capable of policing the markets.)

Whether that reputation is deserved or not, there is considerable room for skepticism about the CFTC’s ability to handle its new duties.  Any dramatic expansion of an organization into new areas inevitably leads to growing pains and managerial snafus.  That goes double for a dramatic increase in the size and scope of a government organization.  And the stakes are extremely high now, given the systemic importance of clearing.  Requiring the clearing of unsuitable instruments, for instance, could jeopardize the stability of clearinghouses–and hence the financial system.  So could lapses in monitoring the operational or risk management activities of CCPs.

And it must be remembered that the agency will have to handle these new tasks in a hypercharged political environment, one more intense than it has to cope with now.  The stakes will be higher, with big players having a far bigger amount of money affected by CFTC decisions.  With greater stakes will go greater pressure, most notably from Congress, which will respond to constituent pressure.  Can the agency handle it?  Color me skeptical.

Some Commissioners are now openly expressing concerns about the agency’s ability to shoulder the load:

US financial reform regulation could place “overwhelming” burdens on the Commodity Futures Trading Commission, the regulator that would have to assume a new role as watchdog for the swaps markets, officials there said.

Sweeping financial legislation approved by the Senate last week dramatically elevates the role of the CFTC, created in 1974 to police trading in futures and options. The commission would gain broad new powers to oversee previously unregulated over-the-counter derivatives, a universe 10 times larger than regulated markets.

“It’s overwhelming. It’s not like right now we don’t have enough on our plate,” said Jill Sommers, one of two Republicans on the five-member commission.

Senior officials warn that to perform its new role, the CFTC, which has long operated in the shadow of the better-funded Securities and Exchange Commission, will strain its expertise, organisational structure and technology. It would have to propose, take public comment on and then adopt as many as 50 elaborate rules in six months, a timetable that Michael Dunn, a Democratic member of the commission, called “pretty much an impossibility”.

. . . .

Gary Gensler, the CFTC chairman, was among the Obama administration’s staunchest champions of legislative language that would route most derivative trades to clearing houses. This would allow regulators to peer at the size of traders’ positions and, so it is hoped, head off the kinds of risky positions that led to the $180bn (£124bn, €143bn) AIG bail-out. While sharing oversight with the SEC, the CFTC would regulate the majority of derivative deals.

. . . .

CFTC officials acknowledge being snowed under. Probes into oil and silver markets announced in 2008 remain unresolved. Mr Gensler has said the agency was overwhelmed by Ponzi scheme cases. Last week Scott O’Malia, a Republican commissioner, said the agency still gets account information by fax and enters it manually. “This agency is about to be hit with a tsunami of trade data,” he said.

Remember, regulation can create systemic risks.  One way to do that is to place extraordinary burdens on a regulator unprepared to handle it.  Which is what Congress is in the process of doing.

Last week the Senate passed the financial “reform” legislation, which now goes to a conference committee that will produce a bill that combines the Senate bill with that passed by the House months ago.  (Ironically, the vote came when I was at a very nice conference on financial regulation hosted by Notre Dame.)

The Senate bill is best measured in pounds rather than pages.  (Pounds of what I’ll leave to your imagination.)  It is comprehensive, and from what I can tell, it is comprehensively wretched.  Stephen Bainbridge, whose opinion I respect a good deal, strenuously objects to the nationalization of corporate governance embedded in some of the bill’s language.  The infamous Lincoln swaps provision, which I’ve written about, is a horror.  It is some kind of sick joke to remake the entire derivatives market–and the banking sector–with a transparently populist ploy heaved up by a rather undistinguished senator (but I repeat myself) from Arkansas in a desperate attempt to stave off a primary challenge.  (Said ploy being incompletely successful, with Blanche Lincoln facing a runoff against her more lefty opponent.  Which probably gives the provision continued life when it should be put out of our misery with all dispatch.  The joke is even sicker when one considers that if current polls are at all accurate, Lincoln will be demolished in the general election.)  The clearing mandate is also a disaster in waiting.

Rather than deconstruct the whole abortion, I’ll focus on a couple of (relatively minor, in the scheme of things) features that illustrate its intellectual incoherence.

The first relates to market manipulation.  Here is a place where Congress could do some good by rewriting the existing law.  As I’ve written extensively over the past 15 plus years, US manipulation law could use a serious overhaul.  I’ve made concrete recommendations, including in a recent article in the Energy Law Journal.

But instead of doing something reasonable, the Senate passed an amendment proposed by the aptly named Senator Cantwell that does the exact opposite of what I recommend in the ELJ piece.  Specifically, apparently lacking the ability to form an original thought, Cantwell and the Senate fire up the copy machine and essentially Xerox the anti-manipulation language in the Securities and Exchange Act.  The amendment (S3348) outlaws “any manipulative device or contrivance.”

Boy, that’s such a big help.  Makes things crystal clear, no?

Look, a major problem with US commodity manipulation law is its complete failure to define what is  manipulative, and to provide courts and commissions with any guidance as to just what kinds of conduct are manipulative, and what tests should be applied to make that determination.  In its attempt to ensure that the law is sufficiently broad to catch everything that could be construed as manipulative, Congress has instead passed language that is so vague that the law can hardly catch anything.  The amendment’s language does nothing to correct that.

Moreover, Cantwell sings paeans to the securities law’s anti-manipulation provisions and precedents, and the effects of previous utilization of similar language in other commodity manipulation laws:

This language in this amendment is patterned after the law that the SEC uses to go after fraud and manipulation; that there can be no manipulative devices or contrivances.

It is a strong and clear [not!] legal standard that allows regulators to successfully go after reckless and manipulative behavior.

This legislation tracks the Securities Act in part because Federal case law is clear that when the Congress uses language identical to that used in another statute, Congress intended for the courts and the Commission to interpret the new authority in a similar manner, and Congress has made sure that its intention is clear.

In the 75 years since the enactment of the Securities and Exchange Act of 1934, a substantial body of case law has developed around the words “manipulative or deceptive devices or contrivances.”

The Supreme Court has compared this body of law to “a judicial oak which has grown from little more than a legislative acorn.” It is worth noting that the courts have held that the SEC’s manipulation authority is not intended to catch sellers who take advantage of the natural market forces of supply and demand, only those who attempt to affect the market or prices by artificial means unrelated to the natural forces of supply and demand.

Mr. President, Congress granted the same antimanipulation authority to the Federal Energy Regulatory Commission in 2005 in the Energy Policy Act. We did this as a result of the Enron market manipulation. I am very proud of this legislation and its ban on manipulation in electricity and natural gas markets. I say that because there was a similar issue of deregulation of energy markets that led to the Federal regulators not doing their job.

Since we have implemented this language in the electricity markets, the Federal Energy Regulatory Commission, since 2005, has used its authority to conduct 135 investigations. Of those 135 investigations, 41 have resulted in settlements involving civil penalties or other monetary remedies totaling over $49 million.

Two investigations brought about enforcement actions against manipulation, one against Amaranth for $291 million—-

The PRESIDING OFFICER (Mr. Udall of Colorado). The Senator has used 5 minutes.

Ms. CANTWELL. Mr. President, I ask unanimous consent for an additional 1 minute.

The PRESIDING OFFICER. Without objection, it is so ordered.

Ms. CANTWELL. The alleged market manipulation brought enforcement action against Amaranth for $291 million in civil penalties and Energy Trading Partners for $167 million in civil penalties. That is just an example of what a statute with teeth and a regulatory entity can do to actually stop manipulation when given that authority.

Sigh.  There are so many things completely wrong with this it isn’t even funny.  Most importantly, the relevance of SEC precedent to commodity market manipulation is a cross between (a) completely non-existent, and (b) actively counterproductive.  Most importantly, as I point out in the ELJ piece, whereas the most important kinds of commodity manipulations are market power manipulations (e.g., corners) most securities manipulations are information/fraud driven.  The canonical securities manipulation is the pump-and-dump, which has nothing whatsoever to do with market power manipulation that should be the first order target of any commodity anti-manipulation measure.  So, the vaunted SEC precedents are worth exactly bupkus.  No, that’s too generous.  They will be actually counterproductive as enforcement attorneys and judges try to pound a market power manipulation peg into a fraud hole.

The ETP case that Cantwell mentions is a perfect example of this.  I was an expert for ETP in this case, and know it intimately; as an aside, Cantwell is less than accurate in her characterization of the outcome of that case, because the government settled for a lot less ($5 million to the government, plus a set aside of $25 million to pay potential settlements in third party lawsuits) than the $167 million figure she cites, and that was a let’s-get-this-behind-us-gift to FERC, which brought the case.  Substantively, the FERC had to twist itself into knots to try to characterize the conduct it found offensive into the “deceptive device or contrivance” category.  FERC’s theories, uhm, evolved, to put it mildly; actually “devolved” would be a better characterization.  At every iteration, I was reminded of Maxwell Smart: “Would you believe?”  (No, actually.)  Rather than being the shining example that Cantwell paints it to be, the ETP case was a perfect example of the fundamental idiocy of trying to export securities law manipulation concepts and precedents to the commodity markets.

Instead of improving manipulation law, the Cantwell amendment will make it worse, as hard as that is to believe.  I don’t know if I’ve ever written a more depressing sentence.

Cantwell focuses on intent.  But that isn’t the only problem with existing commodity manipulation law.  Artificial price and causation have also posed problems too.  But all are eminently fixable through an application of solid economics, as I discuss in more detail in the ELJ piece, and which I demonstrated in my book on manipulation in the mid-90s and my piece on the Ferruzzi squeeze from 2004.

Another poster child for the intellectual bankruptcy of the Senate bill is its provision to empower the CFTC to extend position limits to OTC energy derivatives.  I have pieces forthcoming in Regulation and the Swiss Derivatives Review analyzing speculation and position limits in commodity markets.  The title of the Regulation piece suffices to convey the conclusions: “No Theory?  No Evidence?  No Problem!”  That is, the CFTC’s current proposal to impose position limits is not grounded in an understanding of the economics of commodity markets, and is completely unsupported by empirical evidence.  The same, obviously, is true of the provision in the just passed legislation.  But we’ll get limits nonetheless.

The Senate provision is particularly troubling because it will likely have effects on the Commission’s futures position limits as well as on OTC limits.  Fear of driving trading to the OTC markets restrained the Commission in its setting of the proposed limits, and led some Commissioners to express reservations about the entire effort.  With OTC position limit authority, those constraints and reservations evaporate.  Now the only competitive constraint on the CFTC is the threat of trading moving overseas.  But that threat is less severe than the competitive threat to the domestic OTC market, so it is quite possible that the Commission will impose more onerous restrictions on both exchange-traded and OTC-traded positions now that it has the OTC authority.

At the Notre Dame conference Chester Spatt warned of the unintended consequences of regulation.  Quite so.  And the Senate bill, and whatever comes out of conference, will spawn myriad unintended–but not unpredictable–consequences, most of them quite pernicious.  When the Insane Clown Posse (AKA the United States Congress) is done “reforming” our financial markets we’ll learn to our regret that however flawed our existing system is, it is a far, far better thing than the product of the constructivist irrationality of Dodd, Lincoln, Cantwell, and Frank et al.

My work on clearing was mentioned in the lead editorial in today’s Wall Street Journal.  For the most part, I agree with the editorial.  Hell, I could have written most of it.  It makes many of the points I’ve been writing about here on SWP, and in working papers and presentations, since the financial crisis began (and even before the crisis).  Even the initial sentence, which refers to the widespread belief that clearinghouses are a “miracle cure” echoes the title of my Regulation magazine piece from January, 2009–“The Clearinghouse Cure.”

The initial point is the most telling one: if clearinghouses make counterparty risk disappear (as its cheerleaders repeatedly suggest) why is there need for any CCP to have access to the Fed discount window?

Exactly.  They don’t make counterparty risk disappear.  They become repositories of counterparty risk that can fail, with potentially disastrous consequences for the broader financial system.

I was on board with the editorial until the last paragraph, in which the Journal says “Congress should strip out Mr. Dodd’s discount window provision. As important, Americans should understand that Congress isn’t ending financial risk in derivatives. It is merely redirecting that risk, while making taxpayers the ultimate backstop.”  Yes, it is merely redirecting that risk.  (Finally!)  No, it isn’t ending financial risk in derivatives.  (Finally!)  No, taxpayers should not be the ultimate backstop.  (Absolutely.)  But access to the Fed discount window does not mean a taxpayer bailout.  At least as long as the Fed acts as a traditional lender of last resort, along Bagehotian lines, lending to provide liquidity against good collateral.

During market shocks, large margin flows create spikes in the demand for liquidity.  It is appropriate for the Fed to accommodate such demands for liquidity through the discount window and market operations.  Bulking up clearinghouses through mandates, but denying them access to liquidity, is a recipe for disaster.

But one of the casualties of the financial crisis, and the Fed’s response to it (and even more so, the ECB’s response to the Greek crisis) has been the  devolution of the LOLR function.  Central banks have treated insolvency crises like liquidity crises, thereby socializing losses.

This is indeed a problem.  But it is a problem that is not limited to derivatives.  If Congress believes that it is a problem, it needs a thoroughgoing reform of the Fed.  Just denying CCPs access to the discount window will not fix it.

But back to the rest of the editorial.  Implicit in the whole debate over the relationship between CCPs and the Fed is the fact that the CCPs can fail.   If they fail, they can cause huge knock-on effects, just like the failure of a large dealer.  Potentially worse, in fact.  And this reality means that in the breech, it is likely that by hook or by crook Congress or the Treasury or the Fed will find some way to bail out a failing CCP.

This is an issue that Congress and the administration have refused to acknowledge.  In his speech at the ISDA Annual General Meeting in San Francisco, Deputy Treasury Secretary Neal Wolin pointedly refused to admit that clearing mandates could create too big to fail institutions, thereby exposing taxpayers to losses.  This refusal to recognize the very real consequences of a clearing mandate is sowing the seeds for the next crisis.

Europe is thrashing about like a gaffed fish on a boat deck.  The proof?  In a sure sign of desperation, and an effective confession of impotence, Germany has instituted a broad ban on short selling:

Germany will temporarily ban naked short selling and naked credit-default swaps of euro-area government bonds at midnight after politicians blamed the practice for exacerbating the European debt crisis.

The ban will also apply to naked short selling in shares of 10 banks and insurers that will last until March 31, 2011, German financial regulator BaFin said today in an e-mailed statement. The step was needed because of “exceptional volatility” in euro-area bonds, the regulator said.

The panic is particularly evident in the hurried nature of the ban–it goes into effect almost immediately.  (In fact, it went into effect a few minutes before I posted this.)

And it don’t stop there, folks.  Germany’s ruling coalition is also calling for implementation of a transaction tax.

Germany.  Shooting the messenger with an MG-42.  Fat lot of good it will do them.

Indeed, if anything, these measures will make things worse.  This is true in part for signaling reasons.  Markets can smell desperation, and react to it.  This is a desperate move that signals utter policy bankruptcy, and an unwillingness to grapple with the underlying problems.  If people want to short, it is because they think things are overvalued.  And nothing shouts overvalued like financially strapped governments with deep structural budgetary problems spending time and effort tilting at speculative windmills, rather than tackling these underlying problems.  And if the Germans thought things were under control, why take such measures?  The immediate inference is that the Germans think things must be pretty bad.

These measures will also make things worse because they will impair liquidity, and shift selling pressure into other markets.  Some “naked short” CDS are in fact hedges.  Dirty hedges, but hedges nonetheless: market participants may short a more liquid credit in order to hedge a position in a related, but illiquid credit (perhaps one for which no CDS is traded at all).  But if they’re doing this, it’s because they want to reduce their exposure.  The ban doesn’t make that desire go away.  So, they’re likely to respond by selling off some of the more illiquid cash positions.  Shorting liquid bank stocks can also be a dirty hedge for exposures in less-liquid bank stocks or debt.  Again, the ban will redirect some selling into less liquid instruments.

The transactions tax, if implemented, could be especially pernicious in these conditions.  It will reduce liquidity.  It will also impede the reallocation of risks to those willing to pay the most for them.  This is hardly the way to bolster the financial sector.

All of the measures Europe has adopted, starting with the bailout, to the not-so-sterilized intervention that has cratered the ECB’s credibility, to the short sale ban, fail to come to grips with the underlying solvency problem.  Indeed, they all signal a basic refusal to deal with that–especially the last.

In the initial EUphoria following the announcement of the $1 trillion initiative, I thought that the key indicator of its ultimate success would be the Euro.  And after an initial spike, it has been down.  Down hard.

It is now trading at a 1.21 handle.  It is down 2 cents since about 11:30 CT today (CME futures).  I haven’t been able to confirm the time that the BaFin announcement was released, but I received an email with a story confirming the ban at 1:30 today.  So I suspect that most of the hard selloff in the Euro was a direct response to the announcement.  (Hey, if you can’t short the governments or the banks, might as well short the currency!)

That’s great for those of us planning a European vacation (volcanoes permitting), but it is a very bad omen for Europe.

It ain’t so great for the rest of the world either.  The European chaos, combined with China’s attempts to de-fizz is weighing on commodity prices: oil is down (below $70/bbl on the WTI) and copper is down too, below $3.00/lb.  This does not bode well for growth in the near term.

Look out below.  Especially in the Eurozone.  And no, a short selling ban doesn’t make much of a parachute.  An anvil is more like it.

This article from the Telegraph summarizes the dreary conclusions of an IMF report which says, contrary to Alfred E. Krugman, the United States faces one of the most daunting fiscal crunches in the years ahead.

Some key findings:

But the really interesting stuff is the detail, and what leaps out again and again is how much of a hill the US has to climb. Exhibit a is the fact that under the Obama administration’s current fiscal plans, the national debt in the US (on a gross basis) will climb to above 100pc of GDP by 2015 – a far steeper increase than almost any other country.

. . . .

But level of debt isn’t the only problem. Then there’s the fact that the US has a far shorter maturity of government debt than most other countries, meaning that even if it weren’t borrowing any extra cash it would have to issue a large chunk of new stuff each year as things are. The killer table to show you that is this one, which shows a country’s “gross financing needs” – in other words how much debt it has to issue in the coming years to keep itself functioning.

. . . .

But all of the above is what explains why the US, according to the IMF’s projections, has more to do than any other country in the developed world (apart from Japan) when it comes to bringing its debt back towards sustainable levels. Here’s the killer table. The column to look at is on the far right: note how the US needs a 12pc of GDP chunk chopped out of its structural deficit (ie adjusted for the economic cycle). That’s $1.7 trillion. Wow – that’s not far off Britain’s total annual economic output.

. . . .

However, the flip side of this is that because it has yet to feel the market strain, the US also has yet to face up properly to the public finance disaster that could befall it if it does not do anything about the problem. America is not Greece, but if it does not start making efforts to cut the deficit within a few years, it will head in that direction. The upshot wouldn’t be an IMF bail-out, but a collapse in the dollar and possible hyperinflation in the US, but it would be horrific all the same. America has time, but not forever.

Imitating his hero Barack Obama, Paul Krugman wails on a straw man.  He argues that since the US has far better prospects than Greece, we have nothing to worry about:

Even more important, however, is the fact that we have a clear path to economic recovery, while Greece doesn’t.

The U.S. economy has been growing since last summer, thanks to fiscal stimulus and expansionary policies by the Federal Reserve. I wish that growth were faster; still, it’s finally producing job gains [barely, just barely–and at a rate far behind that at this phase of the recovery from recessions, especially severe ones]— and it’s also showing up in revenues. Right now we’re on track to match Congressional Budget Office projections of a substantial rise in tax receipts. [Which will still leave us deep in the whole.]  Put those projections together with the Obama administration’s policies, and they imply a sharp fall in the budget deficit over the next few years.  [What policies would those be?  The world wonders.]

Greece, on the other hand, is caught in a trap. During the good years, when capital was flooding in, Greek costs and prices got far out of line with the rest of Europe. If Greece still had its own currency, it could restore competitiveness through devaluation. But since it doesn’t, and since leaving the euro is still considered unthinkable, Greece faces years of grinding deflation and low or zero economic growth. So the only way to reduce deficits is through savage budget cuts, and investors are skeptical about whether those cuts will actually happen.

It’s worth noting, by the way, that Britain — which is in worse fiscal shape than we are, but which, unlike Greece, hasn’t adopted the euro — remains able to borrow at fairly low interest rates. Having your own currency, it seems, makes a big difference. [We should look to Britain for solace?  You’re kidding, right?]

There is no doubt that Greece is doomed.  We’re not doomed, but we are in very deep trouble.  From this I’m supposed to take comfort?

Of course, Krugman beckons his standard villain to explain the US’s budget troubles: conservatives who have starved the government of revenue:

And bear in mind, also, that taxes have lagged behind spending partly thanks to a deliberate political strategy, that of “starve the beast”: conservatives have deliberately deprived the government of revenue in an attempt to force the spending cuts they now insist are necessary.

As if.  Krugman is, how do you say it?  A liar.  That’s it.  In 1970, federal revenues as a fraction of GDP: 19 percent.  1980: 18.9 percent.  1990: 18 percent.  2000: 20.8 percent.  2010: 19.2 percent.   Some starvation.

Then we get a dose of Alfred E. (“What, me worry?”) Krugman:

Meanwhile, when you look under the hood of those troubling long-run budget projections, you discover that they’re not driven by some generalized problem of overspending. Instead, they largely reflect just one thing: the assumption that health care costs will rise in the future as they have in the past. This tells us that the key to our fiscal future is improving the efficiency of our health care system — which is, you may recall, something the Obama administration has been trying to do.

And yes, we know that intentions always produced the desired results!  The road to hell is quite well paved, actually.  Better in fact than even the typical highway to nowhere in the district of the chairman of the Appropriations Committee.  This is just another example of Tinker Bell Economics.

In the case of health care specifically, no honest person seriously believes that the health care bill is going to reduce health care expenditures, or improve the federal government’s budget situation.  And let’s not even talk about the states (which are already anticipating an increasing burden from higher Medicaid costs piled on top of already creaking budgets).

And of course Krugman attributes malign motives to those who express concern about the nation’s fiscal situation:

But we should ignore those who pretend to be concerned with fiscal responsibility, but whose real goal is to dismantle the welfare state — and are trying to use crises elsewhere to frighten us into giving them what they want.

No, people have real concerns, you yutz.  Those concerns have a real basis.  No amount of mooning over Obama’s health care plan can conceal the fact that the entitlement burden threatens the solvency of the US government.   Especially since the burden of government also will likely be a significant drag on growth, worldwide.

It would be more accurate to say that Krugman is trying to downplay the real prospects of a future crisis in order to protect an unsustainable welfare state.  Ignore Greece, or the rest of Mediterranean Europe.  If you look at the rest of Europe, the UK, or major US states, or the US itself, and don’t see the serious risk of a fiscal crackup, you need some dark sunglasses and a cane.

S&P has put LCH.Clearnet on a credit watch for a potential downgrade.  The rating agency did so in response to NYSE Euronext’s decision to set up its own clearing operations, rather than use LCH’s.

This is a very useful reminder that CCPs do not make counterparty risk disappear, as certain people are wont to assert.  (You know who they are.)

But there is another important lesson here.  Nobody knows exactly how the market is going to evolve after the imposition of clearing mandates.  In particular, the structure that will evolve for the clearing business is subject to huge uncertainty.  As the NYSE-Euronext decision illustrates, and as the ICE decision to clear for itself before that,  and as did the decision of the SWX to clear for itself before that, clearing structure is a strategic choice for exchanges.  I wrote about this aspect of clearing ad nauseum before the financial crisis.  At the same time, there are strong scope economies to clearing across multiple instruments.   The push of strategic incentives to vertically integrate and the pull of incentives to exploit scope economies by using multi-exchange platforms like LCH make it very difficult to predict what the configuration of the market will look like.  This, in turn, makes it virtually impossible to understand what the systemic risks will be, and what measures will be necessary to mitigate the systemic risks inherent in clearing.

These systemic risks will depend on the topology of the clearing networks, and this topology will be determined by a complex interaction of incentives to integrate and dis-integrate.  Moreover, the topology is unlikely to be static, as the factors driving the costs/benefits of integration and disintegration will not be static either.  Thus, the interconnections in the system will be quite fluid, and as the financial crisis and the flash crash demonstrate, these interconnections can be the sources of systemic risk, if not understood and managed properly.  Force feeding clearing will only heighten the salience of these interconnections.  It will be a challenge to understand, let alone to manage, this system as would be necessary to realize the happy predictions of those who look on clearing as the cure.

Are the regulators ready for this?  Do the legislators who are enamored with clearing understand this?

There is now pretty convincing reporting that a single trader on the EMini indeed started last Thursday’s market bungee jump.  An Overland, KS fund manager submitted 75,000 EMini orders during the key time period. The firm in question, Waddell & Reed, has issued a statement.  Here’s the key bit:

On May 6, as on many trading days, Waddell & Reed executed several trading strategies, including index futures contracts, as part of the normal operation of our flexible portfolio funds. Such trades often are executed in response to market activity, and are undertaken to protect fund investors from downside risk. We use futures trading as part of this strategy, broadly known as hedging.

Portfolio insurance–the replication of puts on portfolios using dynamic trading strategies–is a strategy intended to protect fund investors from downside risk.  It is a strategy that is executed in response to market activity; prices move, leading the portfolio insurer to trade to keep the delta match; the insurer chases the market (which is how, in effect, it pays the option premium).  The W&R statement could therefore be describing a portfolio insurance strategy, or something quite similar.  (Placing stops at different price points effectively does the same thing.)

Done in an illiquid market, especially in the size indicated (with one firm trading more in less than an hour than the EMini market usually does in an entire hour), this could start the feedback loop that exacerbates market movements.

All of this is completely in line with my earlier conjectures: (1) big trades in a market index were likely to be the precipitating factor, and (2) positive feedback trading strategies were involved.

Again, though, the fascinating–and comforting thing–about this episode is that whereas in earlier episodes (e.g., ’87, ’29), the market crashed and then went “splat”, this time it bungeed back almost immediately.  That’s what sets this episode apart, and I hope that regulators and exchanges make sure they understand why that happened so it can recur in the future if need be, and so they don’t do something stupid that would not materially reduce the possibility of the market from going non-linear but which would prevent rapid self-correction like that which occurred on the 6th.

In their never ending search for bad ideas to embrace, regulators are contemplating imposing participation obligations on market makers:

Proprietary trading firms are concerned that last week’s market tumult could see regulators seek to attach more strings to their trading activity, requiring them to buy and sell shares even when they’d rather not.

Securities and Exchange Commission Chairman Mary Schapiro said Tuesday that regulators are weighing obligations that should apply to such firms, after some “professional liquidity providers” stopped trading amid last Thursday’s heated volatility that saw U.S. markets quickly plunge and then rebound.

The command-and-control mindset is running amok in Washington.

How about some basic economics, OK?  Putting aside how you would even define and enforce such obligations, imposing an obligation that firms make a market when they would rather not voluntarily, or to make a market in a size that is larger than they would choose voluntarily, imposes costs on said firms.  This reduces return on capital.  Since capital must earn a normal return, the mandate-caused reduction in return will lead to an exit of some capital from market making.  This will reduce liquidity in periods in which the constraint to make markets is not binding.  Spreads will be higher, and depth lower, during these times.  This will generate higher profits then that will offset the losses market makers must bear when the constraint binds.  (There could be a perverse dynamic here too.  Less liquidity in normal times increases the likelihood (all else equal) of a big price move that may trigger the constraint.)

One can also foresee the potential of a return to the specialist bargain of the old days.  Specialists had an affirmative obligation to make markets, even when it is unprofitable.  They were compensated in the form of entry barriers and information advantages that allowed them to earn rents in times when the obligation constraint was not binding.  But the effect of this was quite similar to what I just sketched out: trading costs are lower when the constraint binds, trading costs are higher when it doesn’t.

In three words: No Free Lunch.

Futures markets almost never impose such obligations.  There are some exceptions, in which there are designated market maker programs, usually implemented to promote trading in new products.

In essence, market making obligations alter the time pattern of liquidity.  Liquidity is higher in some periods, lower in others.  Overall, liquidity is lower, because the constraint necessarily reduces the capital devoted to making markets.

Does Mary Shapiro, or anybody else, know what the “right” pattern of liquidity supply should be?  Do they have any idea of the effects of such a constraint.  Almost certainly not.

Could competition between exchanges ensure the provision of the right amount/pattern?  There’s room for skepticism.  Assume exchange E imposes the constraint, but exchanges X,Y, and Z don’t.  During normal times X etc. will get more business because market makers on those exchanges incur lower costs and don’t have to charge the premium that E’s market makers do to cover the costs of making markets during volatile times.  During the volatile times, E’s market makers will attract business–just when they don’t really want it.  So exchanges could free ride on any other exchange that imposes the obligation.

Is there an externality or other “market failure” that could justify imposing the obligation on all market makers and exchanges?  The Greenwald-Stein story suggests that yes, that is a possibility.  But the mechanism to deal with that is to switch from continuous trading to a call auction market.  With multiple exchanges, that switch must be coordinated across exchanges.  The lack of such coordination exacerbated problems on 6 May.  Before imposing additional obligations that will harm market quality during normal periods, it would be better to improve intermarket coordination.

Moreover, as the CME experience shows, circuit breakers that focus on stop orders is a reasonable, relatively light-touch functionality that can mitigate some of the most serious problems.  Why not try that before imposing difficult to define, hard to enforce, and costly obligations on market makers?

Sarah Lynch has a VERY interesting story in today’s WSJ about how CFTC economists could find little evidence that speculation distorted commodity prices, and energy prices in particular.  (I’m quoted towards the end.)

Not that I’m surprised.  Hard to find stuff that don’t exist.

An Aug. 21, 2009 memo written by two agency economists and addressed to Treasury Secretary Timothy Geithner points to an internal CFTC debate over position limits. A CFTC spokesman said Mr. Gensler hadn’t read the memo or sent it to Mr. Geithner.

The memo analyzes the impact a lack of position limits may have had on energy markets after Congress voted in 2000 to replace them with a new and less stringent accountability level regime. Accountability levels are non-binding thresholds that merely trigger additional oversight if exceeded.

According to the memo, New York Mercantile Exchange data from between 2000 and 2009 show that the switch to the new accountability regime in 2001 didn’t change energy-price volatility.

“In our analysis of the impact of position limits, we find little evidence to suggest that changes from a position limit regime to an accountability regime, or changes in the levels of position limits impact price volatility in either energy or agricultural markets,” the CFTC memo states. “Our results are consistent with those found in the existing literature on position limits.”

Again.  No surprise.  In 2004 I did a very extensive study on the effect of the move to an accountability regime on volatility in nat gas at the behest of the Industrial Energy Consumers of America.  I found nothing.  IECA was not pleased.

It is revealing that Gensler allegedly never saw the memo.  Nor did Geithner, to whom it was addressed.  But since Gensler assuredly had his mind made up already (and/or had marching orders from Congress), it probably made no difference.

Here’s the most interesting part of the article:

Other internal emails drafted in August 2009 by the agency’s now Acting Chief Economist James Moser reveal he was concerned about how to craft a position limit rule.

Mr. Moser was at the time the agency’s deputy chief economist and sent an email to CFTC Commissioner Jill Sommers’ staff member expressing his views.

“I think of a position limit as a tool,” he wrote. “That tool needs to be calibrated to the problem it hopes to solve. Because we have no statistical evidence of a problem, we are not able to calibrate the tool to fix the problem.”

I feel your pain, Jim.  What you said is spot on.  But your big mistake is your touching belief that policy should be made on the basis of evidence.  How quaint.  (By the way, you can tell everybody you don’t know me.  I’ll understand.)

Lynch’s story also includes a link to a CFTC report on the effects of speculation and commodity funds on prices.  The study is an extension of earlier CFTC work that had drawn the ire of Commissioner Chilton.  The extended report, which as Lynch says expressed the no-speculative-effect view “more forcefully” never saw the light of day until it was unearthed via a FOIA request.  Go figure.

In its position limit NOPR, CFTC disclaims any need to show that speculation actually has caused unwarranted fluctuations in prices before imposing the limits.  It has to say that, because it’s pretty clear that its economists can’t do so.  But this isn’t about economics.  Its about belief, and politics.  Gary Gensler and Bart Chilton have a fixed belief about speculation and a political agenda to implement.  They’re not about to let something as irrelevant as evidence get in their way.  Hopefully the other commissioners feel differently.

As I am quoted saying in the article, CME and FIA have argued that as a legal matter CFTC must make a finding of speculative impact before imposing limits.  I don’t know if they’re right as a matter of law, but I’m sure we’ll find out soon enough.  And if a judge decides it must, GiGi is going to be in a very, very awkward position.

And doesn’t this story make you feel warm all over at the prospect of handing over vast new powers to the CFTC, especially a Gensler led CFTC?  A cavalier approach about economic logic and evidence about speculation in energy markets is bad enough.  Extending such an approach to oversight of trading and clearing of the vast OTC markets would be infinitely more dangerous.