Streetwise Professor

CME Group Chairman Terry Duffy’s testimony before a subcommittee of the House Financial Services Committee is quite informative and fascinating.  Of course he is defending his firm and talking his book, but he makes a very persuasive case on many issues.  What he says does not demonstrate that the May 6 market boomerang did not begin at the CME (sorry about the double negative), but he does make it pretty plain that precautions built into the CME’s Globex system worked to arrest the decline, and that the rebound probably began at CME as a result.

The Duffy testimony provides concrete evidence that stop orders were accelerating the price decline.  An EMini trade at 1062 triggered a stop for a relatively modest 150 contracts.  Execution of this order led the market down to 1058.25: that big move in response to a small order indicates how illiquid the market was (i.e., how low the depth was).  (I will dig up an article by Hasbrouck that estimates depth coefficients using Bayesian methods to see how this compares to the usual market depth.)  This triggered another 150 car stop order which led the market down to 1056.

At this point Globex’s Stop Price Logic kicked in:

Stop Logic

The Globex trading platform is programmed to prevent the continuing execution of cascading stop orders when it detects certain conditions. The Match Engine monitors if the triggering of a stop order or series of stop orders will result in matched prices that exceed the contract’s No Bust Range from the price level that matching limit orders finished matching and caused the triggering of a stop order(s) . The contract is then placed in a reserved state, during which orders may be entered, modified or cancelled but not matched.

The market went into a stop state for 5 seconds.  The decline stopped, and the rebound began as value buyers–almost certainly including some dreaded HFTs–began to buy.

Duffy’s account confirms the main elements of the scenario I sketched out a couple of days back.  The market was relatively illiquid; something triggered a relatively large price move; that triggered stops and a further decline of liquidity, which accelerated the market decline; then value buyers moved in.   Duffy’s testimony also illustrates the essential element in keeping things from going completely non-linear: stopping stop orders.  I repeat: stopping stop orders.

Things were uglier on the cash equity markets.  The price declines in individual stocks, including heavily traded broad market gauges such as the SPY were more severe than on the index futures.  As is well known, some stocks traded at a penny before bungeeing back to reasonable levels.

This reflects, in part, the evolution in the market architecture in the years following the SEC’s approval of Regulation NMS.  As I wrote in this piece in Regulation Magazine, the SEC had a choice between two alternate ways of creating a national market system: a mandated central limit order book (“CLOB”) or what I referred to as an information-and-linkages approach.  The latter means that the mandated dissemination of quote information to permit direction of orders to the best-priced markets, and the requirement that different execution venues redirect orders to other venues displaying better prices.  In Reg NMS, the SEC choose information-and-linkages.

That approach is defensible, and can work well in normal market settings.  The Boomerang illustrates, however, that this architecture has an Achilles heel during periods of extreme stress and low liquidity.  The linkages don’t work properly, the markets fragment, and prices in some venues can diverge wildly from those in others.  During the crash, several venues declared “self-help” which meant that they would not direct quotes to other markets that were not responding within a second.  In other words, every man (market) for himself, and to hell with the women and children.  The linkages broke down.

As a result of NMS, the NYSE has gone from doing about 80+ percent of listed volume to less than 30.  That’s not a big deal in normal times, as information-and-linkages works OK then.  In the stressed time, though, it was a big deal.  Especially since one of the NYSE’s circuit breakers, its Liquidity Replacement Points stopped continuous trading on that market, but didn’t affect others.  So orders ricocheted off the NYSE, bypassing whatever liquidity was there, and overwhelmed liquidity on other markets.

I should note that even centralized markets can fragment.  Back when the pits were big (e.g., T-bonds, T-notes), when trading was active there would be different prices at different points in the pit.  This happened in the ’87 Crash too.  The firm I worked for was doing some simple index arb trades during that period.  Looking at our wondrous Telerate screens, it looked like there were huge arb opportunities.  (There weren’t, because the prices coming from the NYSE were absurdly stale.)  We called down to the floor to see where we could execute the futures leg.  The guy on our floor desk said: “Somebody’s bidding P1 over here, somebody else is bidding P2 over there, and there’s a guy offering P3.  So, I don’t know what the f*cking price is.”  [I don’t remember the exact numbers, except that they were index points apart.  I do remember that last sentence.  Go figure.]  But that can’t happen in a CLOB type electronic system.  (And Globex is effectively a CLOB.)

The Boomerang almost certainly means that the SEC will have to revisit the information-and-linkages approach.  It will have to coordinate the adoption of rules and technical interfaces that prevent the fragmentation, or it will have to consider jettisoning the concept altogether.  At a minimum, the rethink on the information-and-linkages approach will require coordinated circuit breakers.

And the CME experience suggests that the most essential thing to do is to implement a coordinated stop logic analogous to the CME’s.   It is imperative to derail that positive feedback mechanism.  The whole self-help thing (i.e., the every-man-for-himself-delinkage of the information-and-linkage system) also deserves close scrutiny.

The hyperventilating about HFT continues.  Duffy defends it, and defends it well.  Again, HFT is not a homogeneous thing, so it is essential that any evaluation of it take into account the diversity of these strategies.

Also, it bears repeating that the “where did it start?” question is secondary to “why did it spread the way it did?”  and “why were some markets impacted more severely than others?” questions.  And as for those questions, I think the SEC will have a lot of ‘splainin’ to do, Lucy.

No, this isn’t another post about Somali pirates.  It is another post about criminal investigations of financial institutions, relating to their involvement in synthetic CDO on MBS transactions.  This time it is Morgan Stanley in the cross hairs.

The WSJ article is maddeningly short on details.  For instance, it states that there was an option feature in the deals (“a structure that could increase the magnitude of the bullish investors’ exposures to the underlying mortgage bonds”) but it doesn’t say who had the option–the buyer or the seller.  Not that it matters if the feature was in the contract and the parties both knew about it.

These are treacherous waters for several reasons.  First, the WSJ article suggests that the crime is being short and making money on a deal.  Look, with a synthetic CDO there’s always a short.  Even the accusations against Goldman look sketchy; the allegations here look even sketchier because there’s no indication of a Paulson lurking in the background.  And even if MS was short this deal, the article suggests that it was actually net long mortgages.  Is it somehow a crime to reduce length by shorting?  How would that be different than selling some of the mortgage positions it already held?  And even if the short was a speculation not a bet–should that even matter?  But given the superheated atmosphere in Washington, the routine demonization of shorts in general, and the special demonization of those who shorted CDO on MBS (even if on net you were long), you can’t rule out the possibility that shorting itself is the crime.

Does this mean that markets should only have buyers?  Just asking.

Second, as I wrote in my piece on the Goldman criminal investigation, a criminal case against a big financial firm could cause it to unravel, with knock on effects hitting other institutions it trades with, and other entities that buy its paper.  In brief, a criminal case could cause a systemic event.

This is all the more true inasmuch as it appears that the inquiries regarding CDOs are widespread, and touching virtually ever major financial institution.  This could become the mother of all systemic crises.  Given the serious potential fallout, it better damn well be that shorting itself is not the crime.

Michael Lewis makes this trenchant observation, in a mock memo to Lloyd Blankstein:

This time, please, do not wait five months to internalize my new action items. They are:

No. 1: Implicate the rest of Wall Street, as quickly as possible.

It’s always unnatural to hear the name of Goldman Sachs in the same sentence as Deutsche Bank, much less Merrill Lynch. We must put aside our revulsion. The American people might enjoy seeing one firm being driven out of business by a criminal investigation. They’re less likely to allow for the destruction of every big Wall Street firm. They just forked over trillions to keep them afloat.

If being short is the crime, certainly all Wall Street can be implicated.  Or maybe the name given to the deals (“The Dead President” deals, since they were named Buchanan and Jackson*) is the sin.  Sounds bad, must be bad.  (This actually seems like something out of Camus, like in The Outsider.)

Look, this is deadly serious business.  There better be something really substantial in any indictment: and no, being short deals with bad names doesn’t count as substantial.

And even if there was wrongdoing, as I wrote in the Goldman post, indicting firms is an inefficient way to go.  Let those allegedly victimized make their case in court and collect damages.  The fallout from criminal indictments would be disproportionate and indiscriminate.

* It would be ironic if a deal named after Andrew Jackson would bring down a big bank.  And who in their right mind would name anything after James Buchanan, arguably the worst president in US history/

So there is no confusion, like Felix Salmon I believe that even if the trade or trades that precipitated the crash-boom (“the proximate cause,” as FS puts it) originated in the eMini, it is a matter of little moment with no particular regulatory implications.  The whole point is that in a tightly coupled system, under certain conditions (perhaps not typical conditions, but possible ones), a small shock in any one part of the system can have disproportionate effects throughout the system.  The financial markets are tightly coupled; arbitrage and quasi-arbitrage possibilities provide incentives to connect markets in related instruments.  Under most circumstances, that is a good thing.  Under some circumstances, this tight coupling can lead to non-linear responses.

The important phrase is “in any one part of the system.”  There are critical parts of the system that are more likely to be the proximate causes of a non-linear response.  In the financial markets, index products, which include ETFs like SPDRs, index options, and other products in addition to index futures, are more likely to be proximate causes because they by their very nature have more interconnections with other parts of the system.  But it could be any of them.  Thursday maybe it was S&P futures (maybe not).  Some other day it might be OEX or SPDRs.  The very thing that makes them valuable tools, and heavily traded, is the same thing that makes them the likely place where a chain reaction begins.  But it has to be remembered that this is a systemic issue, and obsessing on any one part of the system is a mistake.  Indeed, it can lead to greater problems.

To emphasize, this means I am not picking on eMini or index futures.

I would also like to emphasize that to me the remarkable thing is how rapidly the market bounced back, and all on its own.  It is almost certain, and the initial evidence seems to support this, that index products were the most likely proximate cause for the bounceback.  The tight coupling worked in reverse too, and led to a rapid correction.  That’s a good thing.  The market exhibited remarkable self-corrective properties.

Finally, it bears repeating that events like Thursdays are almost always the result of a conjunction of disparate forces.  The key underlying factor was the Greek saga, and its effects on liquidity.  Gensler’s testimony today suggests that liquidity began to decline around 2:30.  With less capital committed to making markets, prices would have moved more in response to order flow.  Given the potential for positive feedbacks from options hedges (Gensler mentions greater hedging activity, but doesn’t specifically say it was option-driven) and stop orders, and the second round feedback between price moves and liquidity, the broad contours of a big price shock can be discerned.

So, (1) take a systemic perspective, and don’t obsess on any one particular piece of the system as the “cause” of the event, (2) be patient, and look at how conditions were evolving prior to the collapse and rebound in order to identify the conditions in which a garden variety trade originating in market X or market Y can lead to a non-linear response.

* Let me be clear.  I am not imitating one of Obama’s most annoying verbal tics.

Last week I conjectured that a likely starting place for the May 6 crash-boom was the index futures market.  The WSJ ran an article today that claims a 50,000 contract options trade (ironically from the firm associated with Nassim Taleb, of Black Swan fame) touched off the dive.  Eric Noll, an Executive VP at NASDAQ, has submitted testimony to the House Financial Services Committee that also fingers the eMini:

Second, the Chicago Mercantile Exchange was beginning to experience unusual trading activity in the “E-Mini June” at the same time equities markets were experiencing heavy trading in highly correlated equities.  As you can see in Figure 1, the E-Mini began experiencing heavy volumes and prices begin sinking rapidly at 2:42, just before equities prices sink rapidly.  At 2:45:30, E-Mini trading becomes so volatile that the Chicago Mercantile Exchange triggered an automatic 5-second trading halt in E-Mini futures.  The price of the E-Mini future immediately leveled off and began to climb rapidly.  Equities followed that pattern shortly afterwards.

The time lines between the stories don’t exactly line up: the 50K options trade (puts, presumably) was a little after 2:15, but the big action in the eMini occurred at about 2:42.

Felix Salmon is skeptical about the Black Swan link to this particular black swan: “Lots of options trades of that size take place every day, and just because this one happened just before the market fell doesn’t mean it was the cause of the crash.”  Fair enough: 50K cars is not a big deal on most days.  But “every day” and “May 6th” are not the same thing.  That’s kind of the point: a confluence of events particular to that date likely made the ordinary exceptional, and perhaps exceptionally destabilizing.

Put differently, the market went non-linear–chaotic–in that short period of time.  A key feature of non-linear systems is that small perturbations can have big, disproportionate impacts.  The butterfly flapping its wings and all that.  Or a black swan.

In these sorts of situations, chains of usually ordinary events can feed back on one another with destabilizing consequences.  Here’s one scenario.

The market was very turbulent due to the chaos in Greece and Europe.  (“Chaos” in the ordinary sense of the word, not the mathematical/scientific sense.)  Market makers had backed off in the face of this risk.  Markets were not as deep as usual.  An order comes in.  Maybe several in a row.  The price starts to break, and then the feedbacks kick in.  Options hedgers–including, perhaps, Barclays and others hedging the exposure from the options it had bought from Taleb’s fund–start selling as part of a dynamic hedging strategy.  That’s one positive feedback.  Some stops get triggered.  More positive feedback.  Prices get forced down some more.  Given the background volatility, in light of the big price move, market makers human and electronic begin to fade big time.  Liquidity dries up as a consequence, meaning that even small orders move prices a lot.  With dynamic option hedges and stops going on automatic, the process feeds on itself.  Through correlation algos and program trading systems, the price move in the futures pits is communicated to the cash markets.  And off we go.

My sense remains that a market-wide sell-off most likely started in a market index-based contract, not in a single stock, or even a handful of stocks.  Options-based stories, like that in the WSJ, make particular sense, because dynamic hedging can create the positive feedback that leads to non-linear responses to individually small shocks.

But the eMini story alone is not enough.  Like Salmon says, the market deals with that every day.  But an order or orders that would have been no big deal on ordinary days could have been a very big deal if liquidity was already low due to the uncertainty emanating from across the Atlantic.

It would be VERY interesting to see the evolution of the S&P futures and futures options order books on the 6th.  Part of the scenario I sketched out is that the books weren’t as deep as usual as market makers (whether HFT types, or guys sitting at their TT screens) had pulled back due to the uncertainty surrounding Europe.  (It would be interesting to look at other order books too, to see if the decline in liquidity was general.)

And if you want a very amazing demonstration of how liquidity had fled the market, you HAVE TO listen to this play-by-play of action in the eMini pit on the 6th.  One of the most incredible things I’ve ever heard.  I mean, you HAVE TO listen. (Man, it takes me back.)

At times, the market was quoted 10 wide, bid 1060 at 1070.  Normally this is a one-tick market; the bid-offer is a quarter point.  So the bid-ask was 40 times larger than usual.  That’s an illiquid market.  One can only imagine what other markets, normally less liquid than the eMini, were like.

The other fascinating thing about the recording is the incredibly rapid price rebound, with the price jumping by a point at a time in seconds–again, this in a market that usually moves in quarter points.

And note that this was an old school floor market, not some computerized market untouched by human hands.

The WSJ article also discusses the rebound, and supports my conjecture from the 6th: some of the demonized computerized traders played the role of the cavalry, and charged in to save the day by snapping up bargains:

Around 3 p.m., the selling pressure abated. Just as swiftly as the market fell, it recovered ground. One factor behind the swift recovery, traders say, were funds that use computers and formulas to sniff out bargains in the market. These funds swooped in on hundreds of cheap stocks, helping push the market higher.

In ’87, corporate stock repurchases brought the market from the depths.  I hypothesize that value-based quantitative strategies did it last Thursday.

There is a lot of data to be analyzed before a verdict should be rendered.  We are blessed, though, by a superabundance of such data.  An abundance that is the direct result of the computerization of the markets.  In reconstructing the ’87 Crash, it’s impossible to know what was in the order decks of the locals.  It’s also impossible to sequence events in time with any accuracy.  In reconstructing this one, the order books are computerized and time stamped to the fraction of a second.  It will be a massive data processing task, but it’s just that: the data are there to be processed.

In the meantime, withhold rushes to judgment about HFT or algos or computers or whatever.  Take statements like Noll’s with a grain of salt.  No doubt the exchanges will all go around singing a Chuck Berry tune:

It wasn’t me, Sheriff; Uh huh, Sheriff, it wasn’t me
Ah! It must have been some other body, uh uh, Sheriff, it wasn’t me

all the while pointing fingers at other exchanges and algos.  Let folks analyze the data, particularly the evolution of the order books and the flow of orders into those books.  The answer will come in time, and with more precision that has been possible in previous crashes.

One of the arguments in favor of mandated clearing is that (a) CCPs require initial margin to collateralize trades, and (b) many OTC deals do not.  Requiring collateralization, the argument goes, reduces the default risk associated with derivatives.

Even assuming this argument is correct, it does not imply that clearing reduces the risk of failure of a financial firm, or the risk that its failure will have destabilizing spillover effects.  This is because the argument fails to address the equilibrium responses of affected firms.

In essence, collateralization reduces the credit/leverage in a derivatives transaction.  But if firms are forced to reduce leverage in one set of transactions, they can increase it in others.  Indeed, you’d expect this to happen.  If a firm has a given debt capacity, or a given target leverage, it will almost certainly respond to a mandated reduction of leverage in one set of transactions by using the debt capacity/target leverage freed up in this way by increasing leverage elsewhere.  For instance, it could borrow the initial margin amount.  (This is done, to some degree already for cleared transactions.)  A reasonable approximation of the first order net effect of mandated collateralization of some deals is that the firm’s leverage will not change much.  Yes, all else equal more collateral means less leverage, but all else is not equal.

Of course, the firm can’t be made better off by the imposition of a constraint.  Revealed preference implies that the firm is at most indifferent to forced changes to its capital structure, but likely prefers the freely chosen allocation of debt/credit capacity between derivatives transactions and other deals.  For instance, it may be cheaper to obtain credit/leverage through derivatives than through an on balance sheet loan.  (That’s the essence of my argument as to why end users may object to being forced to clear.)  But it is almost certain that firms subject to the clearing mandate will adjust their capital structures in ways that mitigate the impact of the mandate on their overall leverage and counterparty risk.  This is likely especially true for large financial firms that have many substitute funding sources.

Nor is it obvious that the form of the leverage will change all that much.  Even if you believe that the leverage implicit in derivatives trades, when combined with bankruptcy rules, encourages counterparties to run, it is likely that reducing that kind of leverage will encourage substitution into a form of debt that is similarly vulnerable to runs.  Runs are damaging to firms.  That’s why they can be a disciplining device.  By choosing its capital structure, a firm chooses a probability of a run.  This choice must be considered maximizing in some respect.  If you force a reduction of the use of one kind of credit that is vulnerable to runs, firms are likely to substitute towards another form that results in a probability of a run that is close to the original, maximizing choice.

This means that increasing derivatives collateralization will not substantially reduce the likelihood a firm will become bankrupt, or vulnerable to a destructive run.  Its main effect will be to redistribute the losses consequent to such a bankruptcy.  Derivatives counterparties may suffer smaller losses (due to multilateral netting and its effect on priority, and to lower leverage in derivatives deals due to greater collateral), but other counterparties will suffer commensurately greater losses.  As I’ve argued before, a priori one cannot conclude that this reallocation of default losses is more efficient than the one that results from the voluntary contracting decisions of the agents.  (Also note that the derivatives counterparties would often be the counterparties to the offsetting leverage increasing transactions.)

Put differently, the first order effect of clearing, whether through netting or increased collateralization is to change priority, not the amount  of leverage (and hence the risk of bankruptcy/default/run).  Its primary effect is redistributive.  It is not evident, moreover, that this effect is socially beneficial.  If there are externalities due to credit (arising from systemic risk, for instance), why should a credit exposure implicit in a derivatives transaction create a more harmful externality than a credit exposure inherent in some other transaction?

The amount of leverage, rather than the contractual means by which firms add leverage, is arguably the fundamental underlying concern.  Attempting to control leverage at the capillaries by regulating some transactions is pointless: leverage needs to be regulated at the heart.

This means that the most important steps should be to eliminate subsidies to leverage, whether through the tax code or subsidies to debt implicit in TBTF/bailouts.  The next most important measure is capital requirements and liquidity requirements, although I am much more dubious of their efficacy as they are, in essence, price controls set by (relatively) ignorant third parties which can be gamed by the much more knowledgeable parties that are supposed to be constrained by them.  Set the prices wrong and the cure can be worse than the disease; given the information imbalances, the prices are almost certainly wrong.  (The financial crisis, and the contribution of the Basel rules to it, provide a cautionary tale.)

This is another example, as if another was needed, as to how superficial analyses of the effects of clearing mandates create a false sense of security, and thereby encourage complacency.  They don’t fix a problem: they just move it around.  The cat won’t sit on a hot stove again, but in its obsession to avoid the stove it risks stepping in the rat trap.

Freddie Mac has just gone back to the Federal trough for $10.6 billion.  And it and Fannie will be back for more–lots more–in the months and years to come.

The F&F losses are the biggest suffered by any firms as the result of the real estate crash, dwarfing AIG’s losses, for instance.

The that fact that F&F’s losses indicates were bigger than anybody’s demonstrates, quite clearly, that it’s exposures were probably the biggest as well.  Although many, including many liberal-leaning economists, defend the firms from charges that they were culpable for the real estate bubble and subsequent crash, their outsized losses indicate that they were certainly a major contributor, if not the sole cause.

They need to be put out of their misery.  Razed, and the ground sown with salt.  The entire model must be so discredited that no one ever even dreams of resurrecting it.  It is the most classic example of how implicit guarantees reduce funding costs and permit leveraging up to massive size while taking on massive risks.

But Congress appears to have little appetite for putting the Biggest Losers on a path to extinction.  There is a Republican bill floating around that would have that effect, but its prospects are dim at present.  Outrageously, the Dodd bill, like the Frank bill before it, do absolutely nothing to rein in their Frankensteins.  (Or would that be Frankendodds?)

Given what happened in the market today, “Biggest Losers” has other meaning too.

First, the market crash and rebound.  Too early to tell yet, although initial reporting suggests that huge moves in P&G and Accenture, perhaps due to mistaken trades or mistaken quotes or mistaken prints, touched off a panic; the market was already as jumpy as a cat on coke given the European tumult, and this was sufficient to set off a collapse.  No doubt that computerized trading contributed to the precipitous drop, but I would also surmise that the near immediate rebound (which brought us back to a mere 4 percent loss on the day, up from 9 percent) was computer driven too.  I am sure that the quant signals indicated that the market was mispriced and this triggered a flood of automated buy orders.  We’ll see how this plays out.

Second, Greece.  I personally think the Europeans are crazy to bail out the Greeks.  It will not address the long term problems that Greece, and the other PIIGs face.  Indeed, given asynchronous performance required–the Greeks get the money today, and have to promise to go on a really, really strict diet tomorrow–is a recipe for a repeat performance in months or years.  Yes, I understand that a Greek default or restructuring would impose serious hurt on French and German banks, but it is better for the governments of those countries to deal with that fallout directly rather than taking actions that will at best delay the reckoning, and make it worse when it comes.

Insofar as the Euro is concerned–another Big Loser in the short run and the long.  It is down to around $1.26 right now.  (It’s an ill wind that blows nobody good: I’m short the Euro because I’m traveling to Euroland next month.)  But the entire Greek fiasco, and the looming threat of similar problems in Italy, Spain, and Portugal, put the long run viability of the entire project in jeopardy.  I don’t think it is salvageable, or worth saving.

Harvard’s Mark Roe has an oped in today’s WSJ where he opines that clearing is NOT the “magic bullet” for systemic risk.  I definitely agree with that conclusion, as readers of SWP certainly know.

Several of Mark’s arguments echo the ones I’ve been making for the past two years.  First, they can create a moral hazard, and there is room to doubt that they have the requisite information to price counterparty risk properly:

The clearinghouse reduces our incentives to worry about counterparty risk. Your business might collapse before you need to pay up, but that’s not my problem because the clearinghouse pays me anyway. The clearinghouse weakens private market discipline. [That’s the moral hazard point.]

Still, if the clearinghouse is as good or better at checking up on your creditworthiness as I am, all will be well. But one has to wonder how good a clearinghouse will be, or can be. [That’s the information point.]

Second, they can create a systemic risk:

Moreover, if trillions of dollars of derivatives trading goes through a clearinghouse, we will have created another institution that’s too big to fail. Regulators worried that an interconnected Bear or AIG could drag down the economy. Imagine what an interconnected clearinghouse’s failure could do.

AIG needed $85 billion in government cash to avoid defaulting on its debts, including its derivatives obligations. Could one clearinghouse meet even a fraction of that call without backup from the U.S.? True, we could have many clearinghouses, each not too big to fail—but then maybe each would be too small to do enough good.

The Senate bill would allow a clearinghouse to grab new collateral out from failing derivatives-trading banks to cover old, but suddenly toxic, debts the banks owe to the clearinghouse. This could harm other creditors and cause the firm to suffer a run. Nevertheless, to protect itself in a declining market, a clearinghouse would have to make those big collateral calls. That’s good if it protects the clearinghouse. But it’s bad if it starts a run on a weakened but important bank.

. . . .

Clearinghouses can help manage some systemic risk if they’re run right. If not, they can become the Fannie and Freddie of the next financial meltdown.

Third, by allowing multi-lateral netting, clearing gives derivatives counterparties priority over other creditors, a point I first made back in ’08.  This is systemically ambiguous.  There is no guarantee that the derivatives counterparties are more systemically important, or more vulnerable to contagion, than other claimants.  For instance, reducing the payoffs that the buyers of a big intermediary’s short term paper obtain in the event of a bankruptcy by reshuffling priority imposes bigger losses on these creditors.  In the Lehman case, these creditors included money market funds who had bought Lehman commercial paper; the threat of a run on the money market funds led the Fed to guarantee them.

Where Mark and I part company is on bankruptcy treatment of derivatives.  He believes that all aspects of the bankruptcy code that give priority to derivatives counterparties should be eliminated.  Although I (see above) concur that changing priorities can be problematic, I also believe that treating derivatives exactly the same as other debts is problematic too.  Indeed, I think that there is a good argument for several of the safe harbor provisions.

I’ve been planning to write an extended post on this issue, and still hope to, so I’ll just summarize here.  First, the bankruptcy rules allow derivatives counterparties to seize collateral, whereas other creditors are stayed, meaning they cannot do so.  The reason this makes sense is that whereas in traditional debt the amount of exposure is limited to the face amount of the borrowing (plus interest owed), the exposure is potentially unlimited in derivatives.  Derivatives traders use collateral to limit their exposure; staying them would expose them to unlimited risk.

Second, the rules allow termination and close out netting of defaulted derivatives positions.  Without such termination and netting, (a) a defaulter’s counterparties would be locked into positions that generate unhedgeable risk, and (b) could expose such counterparties who have winning and losing positions with the defaulters to having to pay the bankrupt’s estate on the losing positions and not getting much back on the winning ones.  This is particularly problematic in a dealer model in which dealers tend to run matched books (or close to it).  With termination and close out netting, their exposure is related to their net positions.  Without it, it could be as large as their gross positions, which are a multiple of their net.  The dealer market maker model would not be sustainable under these conditions.   No doubt there would be various work arounds, but these are likely to be very costly and impede greatly the ability of the market to serve its risk transfer functions.

So Mark and I would agree that dictating CCPs is a bad idea; we would disagree on the advisability of wholesale changes in the treatment of derivatives in bankruptcy.

I know that Mark also shares my concern about the psychology that underlies the fixation on clearing mandates as the panacea to systemic risk.  There is a palpable obsession with “solving” the systemic risk problem.  Clearing has been seized on as this solution.  Groupthink has taken over, and there is virtually no questioning or critical analysis of clearing as it is, as opposed to clearing as people wish it to be. There is this rather unsettling similarity to a cult; it is like clearing is the space ship that will take the believers to a better place.  Or to a belief that there is a magic pill or painless diet that will cause one to lose weight and keep it off.  The thought is comforting.  It’s easy.  This makes people unwilling to ask uncomfortable questions.

This desire to “solve” systemic risk in one step is especially troubling because it bears the seeds of the next crisis.  The thing that is most likely to breed complacency is a belief that a problem has been solved.  As Mark, and I and others, have argued, clearing is not a foolproof solution, but has its own risks.  Overlooking those risks is a very dangerous thing.

The European Commission is pushing for foreign currency derivatives to be cleared.  This is also a bone of contention here in the US.

It is interesting that those advocating clearing, and also exchange trading, have not attempted to explain the very pronounced cross sectional variation in trading and clearing practices across markets, and the time trends in particular markets.  Virtually all FX derivatives trading is OTC (with currency futures being the hair at the end of the tail of the dog).  The large bulk of linear interest rate derivative trading is OTC (even though the Eurodollar futures and similar markets are immense, they are dwarfed by the even more immense OTC interest rate swaps).  Equity derivatives and interest rate option trading is more evenly split between OTC and exchange.  Moreover, whereas in recent years a good portion of interest rate swap business has migrated to clearing naturally (accounting for about 50 percent of the interbank business), no OTC FX business is cleared.  A decent amount of OTC equity business is cleared.  A considerable part of OTC energy trading in the US is cleared–and was trending in that direction starting from about 2003 without anybody from the government telling market participants to do it.

The lack of clearing in OTC FX is pretty interesting, inasmuch as counterparty risk on an FX swap of a given amount and tenor is greater than that of a corresponding interest rate swap because principal is at risk in the former, but not the latter.  If clearing is such an economical way of allocating counterparty risk, why is it almost completely absent for products in which that risk is pronounced?  Similarly, due to the jump-to-default feature in CDS, these products pose large counterparty risks, but they weren’t cleared either until the dealers came under pressure to do so.  So, the instruments that arguably pose the greatest counterparty risks were not cleared voluntarily.

It would be nice of those who have the Olympian insight to dictate how markets should be structured could explain how they are structured.  If the European Commission is right, then the participants in the FX derivatives market are wrong.  Why?  And why should FX market participants choose a different mix of execution and counterparty risk allocation methods than participants in interest rate swaps and equity and energy derivatives?  Especially since there’s more than a little overlap between the participants in these various markets.

This is an interesting economic puzzle, the solution to which might, just might, be somewhat illuminating.  It might just shed some light on the economic trade-offs involved in clearing.  Just a guess.  But in the haste to prescribe–to dictate–market structure, our legislative and regulatory betters couldn’t be bothered to understand.  They just know.  So everybody should just shut up and get with the program.

The debate over “rules vs. discretion” was a centerpiece of disputes over monetary policy during the 1960s-1980s.  One of the most important contributions to this debate was by John Taylor, who devised an eponymous rule for monetary policy.  A rule that Greenspan and Bernanke flouted, and in so doing, contributed mightily to the financial crisis.

Taylor has an article about rules vs. discretion in today’s WSJ.  It is not about monetary policy, but rules vs. discretion in the resolution of large financial institutions that have failed, or are teetering on the brink of failure.   Taylor comes down firmly on the side of rules:

You do not prevent bailouts by giving the government more power to intervene in a discretionary manner. You prevent bailouts by requiring adequate capital based on simple, enforceable rules and by making it possible for failing firms to go through bankruptcy without causing disruption to the financial system and the economy.

Taylor’s argument is that the capriciousness of a system that gives regulators tremendous discretion gives rise to destabilizing uncertainty.  A rule-based system is more predictable, and more stable.

I too have argued for limiting discretion, though on somewhat different grounds.  My concern is that discretion, especially when there is a possibility that that discretion can be used to commit government funds (or even funds eventually contributed by other financial firms) in order to bail out creditors creates moral hazard.  Political economy considerations will almost certainly favor bail outs; concentrated, politically connected creditors will exert greater influence than diffuse taxpayers.  The prospect for bailouts reduces the cost of credit, which encourages excessive leverage, excessive risk taking, and  insufficient monitoring.  Which, in turn, makes failure more likely.

Although Taylor’s argument and mine on discretion are different, they are complementary.  I have not seen an even mildly persuasive argument in favor of discretion.  Thus, whereas the Chapter 11F bankruptcy option that Taylor advocates (as does George Schultz, one of the only US Treasury Secretaries I wouldn’t swap for Kudrin) is languishing, the discretion-heavy Dodd bill advances apace.

A constant theme here at SWP, in my public speaking, and in my academic work has been the lack of serious thought underlying the financial bills currently slouching through Congress.  These markets are complex (in the usual sense of the word, and the more technical meaning of complex systems characterized by emergent orders and rich feedbacks).  Any major changes will have effects that are almost impossible to predict: and it is quite likely that the legislative effects will be quite different from those intended by its framers.  Or, as I put it in a policy paper for Cato that I just finished (first draft, anyways):

There is a “fire, ready, aim!” feel to many of the policy proposals emanating from Capitol Hill and the administration.  Prescription precedes understanding.  To evaluate the costs and benefits of clearing mandates, this order must be reversed.

The implicit judgment underlying the regulation is that the received structure is fundamentally defective, but there is no explanation as to why that is so.  There is no stepping back to ask: “Could there be an economic rationale for the arrangements that have emerged from the decisions of myriad economic agents?”  There is no grappling with the Coase question: no serious attempt to identify the source of transactions costs that could lead to the massive “market failure” that the advocates of major changes believe exists.

As I’ve said before: fools rush in where angels fear to tread.  Without understanding what is broke, and what isn’t, how can you fix it?

I am reminded of the time I was helping my grandfather fix a tractor.  I had the wrenches out and was ready to just start unbolting stuff.  He said: “Wait just a God damn minute.  Why don’t we try to figure out why it isn’t working first?  If you just take the damned thing apart it will be well and truly broken.”

Is it too much to ask the denizens of the 202 area code to wait a God damn minute and figure out what in the financial system didn’t work and why, before they well and truly break it in ill-considered efforts to “fix” it?

Well at least I have some company in my misery.  Today’s New York Times, of all things, has an article that highlights the foreboding of several other finance scholars:

Others simply argue that it is premature to pass sweeping legislation while so much about the crisis remains unclear and so many inquiries are in progress.

“Until we understand what the causes were, we may be implementing ineffective and even counterproductive reforms,” said Andrew W. Lo, a finance professor at the Massachusetts Institute of Technology. “I understand the need for action. I understand the need for something to be done. But what I expect from political leaders is for them to demonstrate leadership in telling the public that we need to proceed about this in a much more deliberate and rational and thoughtful way.”

. . . .

The most basic critique comes from Professor Lo and others who say that Congress is moving too quickly. The origins of the crisis remain a subject of intense controversy. Investigations continue to unearth surprising information. The Financial Crisis Inquiry Commission, a bipartisan panel created by Congress, is not scheduled to report until December. Why not wait, they ask, until the targets are clearer?

Exactly.  The article quotes others, including Lawrence White of NYU who almost sputters with indignation at the failure of any of the bills to address Fannie Mae and Freddie Mac at all.  But what would you expect from Barney Mae and Chrissy Mac?  Or is it Fannie Frank and Freddie Dodd?  Regardless, addressing that issue would raise the most embarrassing questions, like: WTF are the people who bear tremendous personal responsibility for one of the most costly aspects of the crisis–and what is arguably a key underlying cause of the crisis–doing in charge of “fixing” the system instead of donning sackcloth and squatting on a pile of ashes, begging abjectly for forgiveness?

In another misery-loves-company moment, from a truly unexpected source, Sheila Bair and the FDIC have come out against the derivatives spinoff provision of the Lincoln bill:

Federal Deposit Insurance Corp. Chairman Sheila Bair is opposing a Senate measure that could cut off privileges to banks like Goldman Sachs Group Inc. and JPMorgan Chase & Co.that don’t segregate swaps trading units.

Bair, in an April 30 letter to Senate Banking Chairman Christopher Dodd and Agriculture Committee Chairman Blanche Lincoln, said the proposal championed by Lincoln would create “weakened, not strengthened, protection of the insured bank.”

“If all derivatives market-making activities were moved outside of bank holding companies, most of the activity would no doubt continue, but in less-regulated and more highly leveraged venues,” Bair wrote. “Even pushing the activity into a bank holding company affiliate would reduce the amount and quality of capital required to be held against this activity.”

Not that Bair has gone the SWP full monty: she still favors the Volcker rule and mandatory clearing.  But at least she recognizes the completely insane and ill-considered, unlike Shapiro and Gensler.

But will any of these Cassandra-esque warnings, from Bair or from academics, make a difference?  Sadly, almost certainly not.  This whole endeavor is operating on a strictly political timetable, and is driven by a strictly political considerations.  It is the centerpiece of the Democrats’ attempt to salvage something from the upcoming elections.  And as such, thoughts about the economic rationale or consequences are irrelevancies.