Streetwise Professor

The European Commission released its “Communication to a Cast of Thousands” on “Ensuring efficient, safe and sound derivatives markets: Future Policy Actions.”  It is, at best, a series of policy proposals based on nothing more than assertions delivered from on high.  These assertions are both logically dubious and completely empirically unsupported.

The main policy recommendations are to force the bulk of derivatives trades into centrally cleared platforms and exchange trading.  This will be accomplished by margin and capital requirements, and mandates.

At one level, the EC report identifies the appropriate objective: to encourage market structures that “allow markets to price risks properly” (p. 2).  However, it provides neither theoretical nor empirical support for its assertions that its policy actions will in fact improve risk pricing.  At root, its argument is that centralized price setting dominates decentralized price setting.

As has been known since Hayek and his peers, the relative efficiency of centralized vs. decentralized price setting depends crucially on the information available to those setting the prices.  Recognition of the crucial issue of information is completely lacking in the EC document.

The Olympian tone of the document is well summarized by the statement that it is adopting a new regulatory approach “where legislation allows markets to price risks properly” (p. 2).  In other words, it is legislation that is the essential determinant of whether markets price risks properly or not.  As if.

The document states “the proposed measures will shift derivative markets from predominantly OTC bilateral to more centralised clearing and trading.”  Putting all this together means that the EC is asserting that the existing market structure is history’s greatest market failure.   One would think that such a sweeping claim would require some supporting evidence and theory.  The EC document provides none whatsoever.

The assertion that markets have systematically failed to price risks occurs throughout the document.  For instance, it says: “the function of prices to allocate resources must be restored: derivatives should be appropriately priced in relation to the systemic risk they entail.”  The necessity of a “restoration” implies that: (a) the market has done a bad job in pricing these risks in the past, and (b) regulators can do better going forward.  Although one may agree with (a), it is essential to avoid the Nirvana fallacy: the crucial element of a policy recommendation is the comparative performance of imperfect markets and imperfect regulators.  Thus (b) is the crucial issue.  Sadly, the EC consistently falls prey to the Nirvana fallacy, and asserts without providing the least support that of course regulators will do it better than markets.

The document reeks of the Olympian disdain of Eurocrats in love with their own superiority.  It is the Nirvana fallacy distilled into 9 pages of text.

For instance, we get pearls like: “Such contracts will continue to be cleared bilaterally with counterparties exchanging collateral to cover their exposure.   However, current collateral levels are too low.”  What is the basis for such an assertion?  Who knows?  And, even granting the possibility that some collateral levels may be too low, there is also the possibility of setting them too high.

You’ll search in vain trying to find any reasoned discussion of (a) the relative costs of excessive or deficient collateralization, or (b) the information available to regulators and market participants that they can use to set these levels.

The document suggests that initial margin levels “will be specific to counterparty characteristics.”  This has to mean measurable characteristics.  But what information does a regulator have to measure the counterparty characteristics necessary to set initial margin levels?  Is that information better or worse than the kind of information that large dealers have?  I have very strong priors on the answer to that question: the dealers.

If you think differently, fine.  But before you decide, I suggest that you consider the entire credit rating agency fiasco, in which credit risk evaluations based on measurable characteristics were made by a small number of (centralized) entities.  Not only were these evaluations systematically flawed (thereby raising similar concerns that regulatory decisions regarding initial margin levels will be so too), crucially they were extremely brittle because of the lack of diversity in evaluations and the information on which they were based.  Thus, the errors the agencies made had broad systematic effects.  In contrast, a more diffuse mechanism for establishing initial margins, in which multiple agents possessing different information evaluate counterparty risk and price it appropriately is less susceptible to such systematic errors.  Since systematic errors can translate into systemic risk–as the AAA CDO disaster demonstrated–this is a very serious concern.

Bad pricing of relative counterparty risks across transactors will lead to a misallocation of trading activity and counterparty risk exposure across them.  Those whose counterparty risks are underestimated will trade too much; those whose risks are overestimated will trade too little.  These errors are inevitable, so the crucial question is what sort of market arrangement will minimize the costs of these errors.

This depends on the information available to those making the decisions.  In my view, major dealers will almost inevitably have more information individually than would a central regulator or clearinghouse.  Moreover, since in a market structure like that has evolved heretofore numerous entities are collecting information and making these judgments, there is the possibility of the aggregation of diffuse private information.  This possibility is absent in a highly centralized structure.

Put differently: the EC (and its American counterparts) are acting as if they had never heard of the socialist calculation controversy.  (Which is probably true–all the worse for them if so.)  Namely, how does a central agent set prices in a world with diffuse private information about costs and value?  Information about counterparty risk is highly diffuse, and largely private.  How can a central agent set the “right” prices in such an environment?  Can markets do it better (even if not perfectly)?

We have all too much experience with the defects of central price setting as compared to decentralized price setting in markets (cf. the USSR) to be at all confident with the relative superiority of centralized counterparty risk pricing.  At the very least it is incumbent on the advocates of such a centralized approach to address seriously the possibility (demonstrated by vast experience in many contexts) that centralized price setting in derivatives markets will founder on the same information problem that has wreaked havoc with other efforts to set prices centrally.  Tragically, they don’t even acknowledge the problem, let alone provide a convincing analysis supporting the contention that centralized pricing will dominate private, decentralized pricing.

Similar problems are inherent in the EC’s recommendation of differential capital charges for cleared and non-cleared derivatives contracts.  Again, what is the basis to believe that the regulators have the information to set this differential (or the levels) properly?  This ability is blithely assumed in the EC report; again this crucial issue is not even acknowledged.

It does not inspire confidence that the EC paper invokes the authority of the Basel Committee on Banking Supervision as the model for the setting of capital charges.  That would be the source of the same Basel rules that made it very attractive for systemically important financial institutions to load up on AAA CDOs.  We all know how that worked out.  Another illustration of the socialist calculation problem in action.

Beyond the complete failure to engage the fundamental informational questions, the paper says things that cast serious doubt on the competence of the EC to make such sweeping changes to financial markets.  For instance, there is a statement in the paper that strongly, strongly suggests that the EC does not understand the first thing it is talking about.

Specifically, on p. 6, it asserts, in a completely conclusory way, with no supporting evidence or argument whatsoever, that counterparty risks of “contracts that are cleared on a CCP” are lower than “the counterparty credit risks of those [contracts] where clearing is done bilaterally.”

If one defines counterparty credit risk as being the probability distribution of default losses, this statement is completely wrong.  Holding positions and the portfolios of the transacting parties constant, the probability distribution of default losses is the same between centrally cleared and bilateral contracts.  All central clearing does is change the allocation of those default losses across market participants.  That is, holding the market and credit risk exposures of market participants constant, the total dollar amounts of defaults is the same in every state in the world in cleared and bilateral markets.  Clearing changes the allocation of these given dollar losses across market participants, not their magnitude, or their probability distribution.

It is possible that this re-allocation of risk can be efficiency enhancing, but that is not a given.  Moreover, the fact that the EC apparently believes that CCPs somehow make counterparty risk magically disappear, it is almost certain that it has not thought seriously about the efficiency implications of this reallocation.  Why think about allocation of something that you believe won’t exist due to some form of financial alchemy?

This raises very serious concerns.  Read literally, the EC document implies that the Commission believes that clearing makes default risk disappear.  This is wrong, wrong, wrong.  It is understandable that someone operating under such a delusion would be very enthusiastic about clearing.  It should also be understood, however, that the enthusiasm of someone operating under a delusion is very, very dangerous.

The foregoing analysis assumed that positions would be the same in cleared and bilateral regimes.  However, the adoption of central clearing will almost certainly affect the sizes of positions that market participants take.  This, in turn, will affect overall default risks, and the allocation of these risks.  Indeed, given that clearing involves the mutualization (i.e., socialization) of risk, there is the distinct possibility that the effect of these changed positions will be to increase total default exposures; mutualization means moral hazard, and moral hazard tends to encourage risk taking.  Although CCPs can control this risk taking through margins, this is costly.  I have pointed out in my academic work that clearing can lead to increased overall risk exposures for other reasons as well.  Not that you would know this from reading what the EC–or any American official–has said on the subject.

Nor would you know that under certain types of structures, default losses borne by systemically important institutions can be higher under clearing because under these structures, CCP members guarantee customer trades, whereas in a bilateral market customer counterparties of a defaulting firm suffer default losses.  This is part of the allocational aspect of clearing, and means that systemically important institutions that backstop CCPs can actually suffer greater default losses in a cleared market than they would absent clearing.

I must say again: the case for forcing changes in market structure, most notably forcing adoption of clearing through either carrots (differential margin and capital charges) or sticks (mandates) has not been made.  Not in the least.  The key issues have not even been raised, let alone addressed.  The informational challenges that clearing poses have been assumed away.  Policies based on ignoring core issues do not inspire confidence, to say the least.

Sad to say, the Olympian, arrogant, government-knows-best attitude embodied in the EC paper is also manifest in the pronouncements of US regulators.  Most notably, Gary Gensler of the CFTC has come out in favor of trying to force virtually all trading onto exchanges and clearing.  And none of the arguments he makes in support of this view–none–grapple with the fundamental informational issues.

Unless and until those advocating a radical restructuring of the financial infrastructure, complete with implicit and explicit government pricing of counterparty risk, acknowledge and address the informational and incentive challenges associated with such a change, there can be no confidence that the change will be a beneficial one.  Indeed, given the sorry experience with centralized, hierarchical, regulatory price setting mechanisms in environments where information is private and diffuse, the odds favor the opposite result.

When make cartoon arguments for clearing (and for exchange trading), I have a sinking suspicion that the results will be anything but funny.

None.

By all appearances, both the US and Europe are on the fast track to a complete restructuring of the financial system based on a shockingly incomplete understanding of the true trade-offs.  In so doing, we are laying the groundwork for the next crisis, and a loss of efficiency until that crisis materializes.  Heaven help us.

Old hat to SWP readers (I wrote about this repeatedly from last December through March), but apparently “news” to the NYT:

While OPEC members limped through a period of painful production cuts this year, Russian oil companies enjoyed an extraordinary run.

The year that has gone by since Russian officials floated — and then retracted — a proposal to coordinate production limits with the Organization of the Petroleum Exporting Countries illustrates why the Kremlin is unlikely ever to actually do so.

Already the world’s largest oil producing nation, Russia, pumping prodigiously through the downturn, this summer passed another milestone. As Saudi Arabia tightened its belt to live by OPEC cuts, Russia surpassed it to become the world’s largest exporter.

. . . .

Improbably, the once-neglected oil sector has emerged as one of Russia’s few growth industries, helped by the tax cuts, a devaluation of the ruble that aided exporters and a change of policies that may invite foreign companies back into the sector.

“OPEC made a concerted effort to stem its exports,” said Alex Fak, an oil analyst at Troika investment bank in Moscow. “The result of that action was higher oil prices. So Russia was encouraged to produce more and sell more. Which is what it did.”

Yet, for a time, officials had seemed ready to revise the long-held axiom that Russian national interests were not served by cooperating with OPEC. Sharp price declines had turned Russian oil companies, just a few months earlier seen as money printing presses for the government, into money losers. Far from propping up the Russia government, which relies on oil exports for about 40 percent of its budget, they needed help themselves.

Anyone who really believes that Russian officials were ready to cooperate with OPEC is incredibly credulous.  The Russians are notorious for playing double games, and for double crossing.  I just wonder if OPEC was as credulous as the New York Times.

So, here I lie, flat on my back, having taken a full-speed run at the derivatives regulation football, only to have Barney Frank snatch it back at the last minute during markup.  In contrast to the proposed OTC derivatives bill I praised a couple of weeks ago, the bill as passed by Frank’s committee includes both a clearing mandate, and an exchange trading mandate:

The committee, headed by Representative  Barney Frank, a Massachusetts Democrat, is set to complete action today on the legislation, which would require many derivatives transactions to go through central clearinghouses. The administration wants to subject broker dealers such as  JPMorgan Chase & Co.and derivatives users such as  American International Group to new margin, collateral and disclosure requirements.

. . . .

Frank plans to offer today an amendment that would mandate trading on exchanges or swap execution facilities for standard contracts between dealers and their biggest customers. Barr called that provision “essential.”

As I’ve written repeatedly, here and elsewhere, I believe that both of these provisions are deeply misguided.  I won’t belabor the argument, which the interested reader (or those suffering from insomnia) can find by searching the site or clicking the derivatives category link.   I will just say again that Frank is reinventing the wheel, as an exchange trading mandate was the magic bullet of derivatives reform in 1922.  It eventually proved unworkable, and will do so again–only much, much faster.

Raising the cost of managing risk will lead to greater risks.  It’s not that complicated.

Economics of Contempt (a lawyer and former Dem legislative aide) says that Frank sandbagged the dealers:

Frank really sandbagged the dealers with his exchange-trading amendment. The dealers support a central clearing requirement for standardized swaps, but not an exchange-trading requirement (with at least some justification). Frank’s discussion draft had only required central clearing, and then he surprised everyone on Wednesday with his amendment requiring exchange-trading. It was a politically savvy move if Frank was planning to require exchange-trading all along—don’t give the dealers time build up opposition to the amendment and it’s much more likely to pass. My sense is that Frank simply changed his mind at the last minute, for whatever reason.

“Changed his mind at the last minute, for whatever reason.”  A 180 degree turn at the last minute!  With no substantive reason given!  That’s the way to determine the fate of the world’s largest financial markets!  I feel so much better now.

Barney–I take back every nice thing I said about you.  Indeed, I’ve upped my grandfather’s exchange rate of attaboys taken away per attaboys given from 10 to 100.  Or 1000.

Many clearing/exchange trading developments in the news.  Unlike Barney and Geithner and Gensler and the clearinghouse mandate herd in the US, the Europeans are getting nervous about forcing things:

anks should be “incentivised” but not forced to shift privately-negotiated derivatives contracts onto exchanges to cut risk, the European Union’s executive will say next week, according to people familiar with the situation.

The European Commission is expected to publish a policy discussion paper on regulating the $450 trillion over-the-counter (OTC) derivatives markets on Oct. 20.

“I think they want to keep it a reasonably high level so they have room for manoeuvre. Expectations for October 20 were for more detail but the industry will be disappointed,” a source with knowledge of the paper said on Tuesday.

The largely unregulated market includes credit default swaps (CDS), which are used to bet on whether a company will default on its bonds and have been blamed for amplifying last year’s severe financial crisis that hammered economies worldwide.

The Commission published a preliminary paper in July which focused on the need for standardisation and central clearing of CDS contracts, saying the case has yet to be made on mandatory exchange trading.

“It hints at exchange trading by using the word incentivising transition to try to get more use of standardised products,” the source said of next week’s paper.

The July paper was more open on the issue of exchange trading, only saying it needed further study.

Incentives would likely comprise heavier capital charges on banks which trade OTC contracts that are not standardised or centrally cleared, the source added. Cleared contracts already have a zero weighting for capital requirements.

The latest paper is also expected to push for greater transparency and for a central data repository. It reflects global efforts to regulate derivatives and other lightly supervised parts of the system.

I critiqued the EU’s July report when it came out.  If this report is to be credited, the Europeans seem to have adopted the basic approach I have been advocating–more reporting, no clearing mandate.  But then, I said that about Barney Frank too, so I’m not holding my breath.  In any event, I will read the EU report that comes out tomorrow with interest.

The “incentivizing” approach has some problems too, though.  “Holding more collateral”  is a very general concept.  The key thing is choosing just how much, and how much that varies across products, and crucially–since collateral is all about counterparty risk–how much that varies across counterparties.  Choosing the wrong levels, and choosing the wrong relative collateral levels across deals and counterparties can make things worse rather than better.

The collateral rules will induce gaming and strategic product design to mitigate collateral impacts.  Moreover, as demonstrated in the case of “AAA” CDOs, incorrect choices of capital haircuts can lead financial institutions to take highly correlated positions (i.e., hold essentially the same instruments because their capital charges are too low) that actually exacerbate systemic risk.  Moreover, it is important that relative collateral charges be appropriate across cleared and non-cleared products.  If non-cleared products are charged too much, it could increase the risks that clearinghouses face, and if they don’t price their risks properly, this can also contribute to systemic risk.

I am deeply, deeply skeptical that regulators have the information and knowledge necessary to set these charges.  This is a price fixing exercise.  When have governments EVER demonstrated that they have the information, knowledge, and incentive to set the levels of prices properly, or to set relative prices properly?  “Hold more collateral” sounds great in theory, but is a real source of potential systemic risk when one remembers that you have to specify exactly the amounts of capital every market participant must hold against every instrument, and when one remembers further that setting them wrong can be worse than not setting them at all.

Looking backwards to fix the causes of earlier crises frequently results in a failure to comprehend how the supposed “fixes” lays the groundwork for the next crisis.  Regulation of collateral levels could well do just that, in the same way as Basel capital requirements were a major contributor to the last crisis.

In one last piece of clearing news, the Frank bill also attempts to micromanage the organization, ownership, and governance of clearinghouses:

Derivatives legislation approved by a U.S. House panel yesterday would prohibit swaps dealers such as  Goldman Sachs Group andJPMorgan Chase & Co. from collectively owning more than 20 percent of a clearinghouse.

“An inherent conflict exists between broker dealers and clearinghouses and exchanges,” Representative  Stephen Lynch said when he introduced his provision on Oct. 14. “Brokers and dealers should not be able to capture trading and clearing intermediaries.”

. . . .

The amendment on clearinghouses would restrict swap dealers, “major swap participants,” and any “person associated with a swap dealer or major swap participant” from collectively controlling more than 20 percent of the voting rights in a facility used to clear derivatives contracts. It also would limit membership on boards of the clearinghouses and establish other rules aimed at limiting conflicts of interest.

This restriction on ownership and governance could have serious unintended consequences.  Remember what clearinghouses are.  They are mechanisms to share risk–default risk, in fact. It is well understood that there is typically a close relationship between control rights and cash flow rights/risk exposure (e.g., the ubiquity of 1 share-1 vote).  This makes good economic sense (as Grossman and Hart demonstrated years ago).  A mismatch between risk exposure and control rights means that those with the control don’t bear the full costs of their decisions: the risk is borne by others.  That is a recipe for excessive risk taking and other distorted decisions.

The traditional clearinghouse involves big intermediaries sharing counterparty risk, and since they bear the risk, they control the entity.  This suggests that there will likely be an equilibrium response to the proposed restriction on control rights; firms whose control rights are limited will likely similarly limit the risk exposure they are willing to take.  So, if the big dealers and major trading firms (e.g., hedge funds) that are deemed major swap participants are limited in the control they can exert, they will almost certainly similarly reduce the risk that they will absorb.

If these big dealer firms don’t absorb the risk, who will?  What alternative risk sharing model does the committee have in mind?  I am highly skeptical that the traditional clearinghouse mutualized risk sharing model will work with this governance model.  So what risk sharing model will be used instead?  Will public shareholders bear the risk (through their equity investments)?  That is, will clearinghouses become more like stock insurance companies, rather than mutuals?  Is this wise, given the survival value that the mutual model has demonstrated in clearing over the years?  (If sharing of default risk through the equity markets was the wise thing to do, why hasn’t this been utilized more in the past?)

And the big question: Is there the slightest reason to believe that those who proposed and voted for this restriction have thought even superficially about its consequences?  (I amuse myself sometimes.)

Here we have the spectacle of people who probably hadn’t even heard of clearing a year ago presuming to impose by legislative fiat the most detailed rules specifying what must be cleared, how it must be traded, and how the clearinghouses are organized to do their business.  These decisions will have huge consequences, almost certainly all of them unanticipated and unintended.  And many of these unintended consequences will almost certainly be adverse, perhaps extremely so.

Again, the metaphor of the Sorcerer’s Apprentice comes to mind.  These people think that they are in control, but they are not: they are in fact unleashing forces beyond their control, and the effects are not likely to be good.

Louis Uchitelle of the International Herald Tribune, for heaving up this:

The prize committee, in making the awards, seemed to be influenced by the credit crisis and the severe recession that in the minds of man mainstream economists have highlighted the shortcomings of an unregulated marketplace, in which “economic actors” [nice scare quotes there, Louie], left to their own devices will act in their own self-interest.  Classical free-market theory holds that in doing so they enhance everyone’s well being.

The committee, in effect, said that theory was too simplistic and ignored the unstated relationships and behaviors that develop within companies that compete.  “both scholars have greatly enhance our understanding of nonmarket institutions,” the committee said.

Clue telegram for Mr. Uchitelle (a telegram because it’s pretty clear that his clue phone has been disconnected due to nonpayment): Williamson and Ostrom both analyze the private behavior of economic actors acting in their self-interest to enhance wealth and well-being.  Williamson, for instance, shows how economic agents design and choose various forms of organization and governance to mitigate transactions costs and thereby enhance wealth.  Similarly, Ostrom shows how groups of individuals can craft mechanisms to mitigate wasteful exploitation of common pool resources; these individuals are again acting in their self-interest to achieve results that enhance wealth and welfare.

Although Uchitelle seems to be reaching desperately to argue that the Nobel committee was making a ringing dirigiste statement, in fact Williamson’s and Ostrom’s work is actually quite supportive of the view that maximizing agents left to their own devices can craft mechanisms that address many contracting and transactions costs problems conventionally thought to require government action to redress.  Although Williamson argued that transactions costs considerations can make some kinds of regulation beneficial (e.g., the avoidance of auction mechanisms for cable TV franchises), he was also extremely influential in demonstrating that much regulation of vertical relations (e.g., anti-trust actions against vertical integration) was completely wrongheaded because it failed to understand the fundamental economic purpose (transactions cost mitigation) of these arrangements.

Uchitelle’s choice of words reveals his desperation quite clearly.  The committee “seemed to be influenced.”  Translation: They didn’t come out and say it, so I put my words in their mouths.  “The committee, in effect, said.”  Again, the committee didn’t say so explicitly so Uchitelle had to divine its hidden meaning and share it with the world. Also, the “unregulated marketplace” is the flimsiest of straw men.  In effect, Mr. Uchitelle, you are a liar.

Uchitelle’s understanding of economics is laughable.  “Classical free-market theory”? WTF is that?  He presents the most reductive caricature of neo-classical economics, and tries to pass that off as “classical free-market theory.”  Sophisticated economists who are broadly supportive of letting individuals craft their own contractual arrangements, and suspicious of government interference in such individual efforts, do not rely on textbook Walrasian markets to make their arguments.

Indeed, given the ways in which neo-classical economics (since Pigou) has been hijacked to justify heavy-handed government intervention, it is my distinct impression that most New Institutional Economists (including Coase, as well as Williamson and Ostrom) who think about institutions, contracting, and organization more broadly have a greater appreciation of the virtues of private arrangements, and the vices of public ones, than “mainstream” purely neo-classically trained ones.  They take their cue from Coase, who long ago noted that economists operating from a purely neo-classical framework saw every non-standard contracting relationship as a manifestation of market power and monopoly because they had only “pure competition” and “monopoly” hammers in their toolkit.  New Institutionalists understand that “markets” should be interpreted broadly to include all private contracting relationships, not just price allocation mechanisms, and that they are efficient, economizing, wealth maximizing responses to a variety of economic challenges.

Interestingly, the above quote from Uchitelle comes from the International Herald Tribune on Dead Tree that I picked up this morning in the Casa Pairsal in Collioure, France.  When I went online to find the electronic version, Mr. Uchitelle’s deathless prose quoted above was not to be found.  Instead, his online article acknowledged:

Neither Ms. Ostrom nor Mr. Williamson has argued against regulation. Quite the contrary, their work found that people in business adopt for themselves numerous forms of regulation and rules of behavior — called “governance” in economic jargon — doing so independently of government or without being told to do so by corporate bosses.

. . . .

Summarizing their findings, the award announcement said: “Rules that are imposed from the outside or unilaterally dictated by powerful insiders have less legitimacy and are more likely to be violated. Likewise, monitoring and enforcement work better when conducted by insiders than by outsiders. These principles are in stark contrast to the common view that monitoring and sanctions are the responsibility of the state and should be conducted by public employees.”

When I googled various combinations of uchitelle, international herald tribune, williamson and quotes from the print version I read this morning–nothing came up.  When I omitted the quotes from the print version, the version just quoted appeared.  Apparently somebody discovered Uchitelle’s misleading editorial cross-dressing as a news story, consigned it to the memory hole, and had him draft a (somewhat) more accurate story–or drafted it for him.

But even this alternative version gives a distorted view.  In fact, Williamson has argued against particular regulations (e.g., old style anti-trust actions against vertical integration).  Moreover, to call private organization and governance decisions admittedly adopted “independently of government” “regulation” is deeply dishonest, given the government involvement clearly connoted in the word “regulation.”  Look at the last quoted sentence of the committee statement: “These principles are in stark contrast to the common view that monitoring and sanctions are the responsibility of the state and should be conducted by public employees.”  That doesn’t seem like ringing regulation advocacy to me, at least as the word “regulation” is utilized by just about everybody outside of Uchitelleworld.

It is also interesting that Uchitelle gets a quote from Joe Stiglitz of all people.  That is a sufficient statistic for both Uchitelle’s bias and his cluelessness.

Yes, Williamson and Ostrom–and New Institutional Economists in general–are largely heterodox.  They are critical of much economics that is rooted in neo-classical formalism.  But to conscript them and their research into an “anti-market” pro-regulation campaign is farcical.  It tells us much more about Mr. Uchitelle’s prejudices, and those of the papers that run his drivel, than it does about Williamson, Ostrom, or New Institutional heterodoxies.  There is a debate here.  It deserves to be understood by a wider audience.  The Williamson-Ostrom prize (like the Coase, North, and Smith prizes before it) is a wonderful opportunity to do just that.  But nooooooooooooo.  The NYT and IHT feel obliged instead to turn this debate into another act in a morality play in which Mr. Market is the villain.

So wise up, folks.  If you’re looking to learn something about economics, cancel your subscription to the New York Times.

Exactly 36 minutes after I wrote this:

At least Barney Frank has made a step towards understanding the intricacies of something as complex as clearing.  Would it be too much to hope that he keeps pulling on the string until the entire case for clearing mandates unravels?  Probably.

Matt Leising at Bloomberg sent me this:

Legislation proposed by U.S. Representative  Barney Frank would weaken an Obama administration  guideline requiring the most common private derivatives to be traded on exchanges or regulated systems.

The Massachusetts Democrat, who heads the House Financial Services Committee, released a  draft bill Oct. 2 that allows for no change in how standardized over-the-counter derivatives are currently traded as long as they are reported to regulators. The Obama plan, released in August, specifies “mandatory trading” on exchanges or swap-execution platforms that would have to be registered with the Commodity Futures Trading Commission or the Securities and Exchange Commission.

“Nothing will really change” the way trades are executed under Frank’s draft proposal, said  Kevin McPartland, a senior analyst in New York at TABB Group, a financial-market research and advisory firm. “There’s no reason, at least that I can see, why anybody would go to an exchange.”

Moreover, Frank’s proposed bill does NOT mandate clearing, although it does empower the CFTC to require clearing of some contracts:

The Commission shall monitor swap activity and transaction data  and by rule or regulation identify specific swap contracts that it determines are required to be cleared  consistent with the public interest, after taking into  account the following factors:

[List omitted.]

I keep having this mental image of Barney Frank falling off a horse on the way to Damascus.

In brief: no clearing mandate, but mandated reporting of derivatives trades to a central data repository.  Just what I’ve been advocating on this blog, and in my writings (such as here).  CFTC has the power to mandate clearing, but that’s a far different thing than a Congressional mandate.

Color me shocked.  Pleased, but shocked.

But not everyone is pleased.  CFTC Chairman Gary Gensler for one is put out by the lack of a clearing mandate:

Gary Gensler, the CFTC chairman, said he was concerned about a provision in the legislation to require securities and futures regulators to determine on a contract-by-contract basis whether a particular swap needed to go through a transparent clearinghouse.

“I believe it is best for a clearinghouse that is managing its risk to determine if a particular product should be cleared,” he commented.

Gensler pointed out that an Obama administration proposal for derivatives regulation has a presumption that if any standardized product was accepted for clearing, it and all future iterations of the product must go through a clearinghouse, which is an intermediary between the buyer and seller of the swap.

Gensler and legislators support permitting tailored swaps to continue to trade on the over-the-counter market as long as they meet new reporting, record-keeping and capital requirements.

The CTFC official also took issue with a measure in the Frank proposal that he believes could exempt a broad range of entities from the definition of “major swap participant” and help them avoid regulation.

“The discussion draft, perhaps inadvertently, widened this exception such that the major swap-participant category would exclude any entity entering into a swap for risk-management purposes,” Gensler said. “This could have the unintended consequence of exempting a broad range of entities from the definition of a ‘major swap participant’ and thus exempt such entities from regulatory requirements outlined in the proposal.”

I’d say I feel your pain, Chairman, but I’d be lying.

I am still astounded at this development.  Now if only Geithner, Gensler, Collin Peterson, the Senate Finance and Ag Committees, etc., see the light and experience their own conversions we’d be really getting somewhere.  Hey, a boy can dream, can’t he?  I mean, if Barney Frank comes around to my way of thinking, anything is possible.

Needless to say, I doubt there are many things that Barney Frank and I agree on.  There is still great potential for mischief in a lot pending before his committee.  But, for now I will avoid what my inimitable grandfather called “handing out attaboys one at a time and taking ’em back five at a time.”

For now, I’ll just say: ‘attaboy, Barney.

It seems that some in Congress are slowly making it down the clearing learning curve:

Manufacturers such as  Caterpillar Inc. and  Apple Inc. wouldn’t have to post extra cash as collateral for hedging transactions under legislation proposed to tighten oversight of the $592 trillion derivatives market.

The draft bill released by House Financial Services Committee Chairman  Barney Frank on Oct. 2, drawn from Obama administration proposals, would require the most common and actively traded over-the-counter derivatives contracts to be bought and sold on exchanges or processed through a regulated trading platform. It would impose new rules and collateral requirements, except on so-called end users such as Caterpillar.

. . . .

The draft would expand the administration’s exemption of end-users from collateral and clearing requirements. The administration proposal, released Aug. 11, would give a dispensation only to companies that use so-called hedge accounting. Frank’s proposal would exempt all end-user transactions and would let companies post non-cash items as collateral to satisfy margin requirements, Coleman said.

In brief, the new proposal would not require clearing for any deal in which one of the parties was not a swap dealer.  This is an improvement.  I’ve been arguing here on SWP, in my academic research, and my recent paper for Brookings that the cash flow and liquidity demands that clearing and daily mark-to-market impose are very onerous for hedgers and other market participants.  It seems that corporate end users were able to get that message through to Frank.  Good for them.  It also suggests that there may be a glint of understanding–albeit only a glint–that OTC market arrangements have some economic benefits, and are not instruments of the devil.

But it appears that dealers will be required to clear inter-dealer transactions.  This raises many questions, which if addressed forthrightly, would undermine the case for mandate.

Dealers certainly have had the ability to form inter-dealer clearinghouses in the past.  Why haven’t they?  The common story is that they like non-cleared deals because they profit at the expense of their customers from the lack of fungibility and liquidity.  But that argument holds no water when it comes to purely inter-dealer trades.

More fundamentally, a major fear relating to OTC markets is that the interconnections among dealers are systemically risky.  That is, because of all the inter-dealer trading, the default of one dealer affects the financial condition of others.

But, how does inter-dealer clearing change that?  Default losses are shared among dealers now because they trade with one another.  Default losses will be shared among the same dealers via a clearinghouse.

Moreover, the sharing mechanisms are different in a crucial way–that does not favor clearing.  In a bilateral market, if dealer X defaults, those who trade with X may suffer losses.  In a cleared market, if dealer X defaults, those who originally traded with it do not bear all the loss: it is shared among all the other members of the clearinghouse.  This reduces the incentive of market participants to monitor X’s creditworthiness, because they are not on the hook directly for the entire amount of counterparty exposure they create by trading with X.  The clearinghouse monitors, but as I’ve argued repeatedly (a) the clearinghouse is unlikely to have as good information as the other dealers, and (b) its incentives are weaker because it is a delegated monitor subject to low power incentives.

There’s another landmine hiding here that hasn’t drawn attention.  Note that the members of a clearinghouse recognize that they have delegated their risk exposure to somebody else: the clearinghouse and other clearinghouse members.  They recognize further that the clearinghouse mechanism thereby creates a moral hazard.  What is the conventional response to such a problem?  To limit recourse.  That is, clearinghouse members will limit the risk exposure that they will take on from the clearinghouse.  This is true of every major clearinghouse: the losses that members have to absorb are limited.

Put it all together, and you realize that (a) moral hazard and monitoring issues can lead to poorer control of counterparty risk, and (b) the limitations on member contributions means that a clearinghouse could well fail because of a loss that exceeds the amount of capital its members are obligated to commit.

Thus, the mandate for inter-dealer clearing doesn’t make any sense either.

In fact, one of the main virtues of clearing is that it increases the fraction of their contractually promised payments that non-members receive.  Note that the Board of Trade Clearing Corporation always used to say that no CUSTOMER had ever suffered from a default loss, not that no member had ever suffered from such a loss.  Inter-dealer clearing slices and dices risks differently; it does NOT eliminate them.  Indeed, it can (due to the moral hazard and adverse selection problems) lead to an accumulation of greater risks, and a less efficient allocation of those risks, than is the case in a bilateral market.

In other clearing news, CFTC Chairman Gensler made some interesting remarks in an interview with Futures Industry Magazine (registration required).  Interesting, but misguided.

First, he comes down to requiring clearinghouses take deals from any execution platform: he says clearinghouses should “not be so inextricably linked to an exchange.”  As I’ve argued for several years on SWP and in my academic writings, basic transactions costs considerations likely make vertical integration of execution and clearing economically efficient.  The argument that this arrangement impedes competition (which Gensler makes) fails on traditional Chicago grounds.  It is certain that there is neither persuasive theory nor convincing evidence that would support as radical a step as Gensler advocates.

Second, Gensler advocates that clearinghouses should be open access in the sense that “membership is open to the non-dealer community” and that clearinghouses should have “open governance” in which non-dealers would have a voice.

Now, I’ve shown in some academic writing that closed membership can be exploited to permit the clearinghouse to in effect cartelize a market, so I am somewhat sympathetic to the idea of open access.  However, I’ve also shown in my academic work that membership heterogeneity can be very, very costly.  It increases the costs of governance because it is necessary to accommodate more diverse preferences and interests.  Moreover, heterogeneity means that it is possible to redistribute wealth among the different members through pricing policies, and in the case of a clearinghouse, margin and capital requirements.  To mitigate rent seeking, cooperative organizations like a clearinghouse with disparate members will (a) implement very low-powered incentives, and (b) erect intricate, formal, and cumbersome governance mechanisms (e.g., committee-dominated decision making).  These arrangements are costly.  Thus, requiring open access and open governance would have unintended consequences: clearing organizations would be sluggish organizations with weakly-incentivized managements.

As always, there are trade-offs.  The question is: who is best situated to evaluate these trade-offs?  I think that it is far more efficient for government to let market participants decide on their own arrangements, and limit its interventions to situations in which these cooperative arrangements stifle competition.  Government is ill-suited to evaluate the costs and benefits of alternative ways of sharing risk–including counterparty risk–and of organizing and managing specialized organizations like clearinghouses.  Barney Frank and Gary Gensler should leave these tasks to people who have the expertise and internalize the costs and benefits, and limit the government to policing anti-competitive behavior by collective organizations like clearinghouses.  And even there, a considerable amount of circumspection is in order, for as Ronald Coase pointed out long ago, not every non-standard form of organization or arrangement is necessarily anti-competitive in nature.  It may be designed instead to economize on transactions costs.

At least Barney Frank has made a step towards understanding the intricacies of something as complex as clearing.  Would it be too much to hope that he keeps pulling on the string until the entire case for clearing mandates unravels?  Probably.

Nice Vladimir is welcoming with open arms foreign investors to share in Russia’s bounties:

Russia’s prime minister, Vladimir V. Putin, whose government took control of several oil companies when he served as president, gave a speech Tuesday saying the state must now step back from the economy and let private enterprise take the lead in pulling Russia out of recession.

The speech, at a banking forum in Moscow, echoed recent assurances by his ministers and economic advisers that Russia is becoming more attentive to the concerns of investors. Mr. Putin also reiterated their suggestions that a new round of privatizations could be in the cards for Russia, Andrew E. Kramer of The New York Times writes from Moscow.

The speech on economic policy was noteworthy for its exceptionally warm endorsement of a role for private investors. That had not been the case in recent years.

“We understand how deceptive blind faith in an omnipotent state is, how illusory are the hopes that total intervention in economic life might fix everything and put everything in its place,” Mr. Putin said.

He went on to praise private enterprise. “To the extent that the situation stabilizes, that the effects of the crisis are overcome, we plan to consistently and purposefully reduce state intervention in the economy,” he said, adding that a new round of privatizations could follow.

The government already has been extending an olive branch to the petroleum industry, offering new investments and a greater role in a sector at a meeting with oil company executives last week.

Bad Vladimir is telling foreign investors who responded to his past blandishments to shut up and pay up or else:

Russian prime minister Vladimir Putin on Friday gave  Renault an ultimatum to either help fund  Avtovaz or see its 25 per cent stake in Russia’s biggest carmaker reduced.

“Either they (Renault) participate in funding the enterprise or we will have to agree with them on dividing up our stakes,” Mr Putin told government officials.

More from Lex:

Vladimir Putin’s warning that  Renault must provide further financing for  Avtovaz, the Russian carmaker, or see its 25 per cent stake diluted will send Siberian shivers down investors’ spines. These may prove unwarranted. Arguably, Avtovaz’s Russian state owners have in effect funded an $800m capital increase, so minority investor Renault should also contribute.

Investors will worry, however, that this could become another example of Moscow renegotiating a deal with a foreign investor under duress, as happened with Royal Dutch Shell.

One possible scenario is that the Kremlin wants to unite Russia’s lumbering automakers into one holding company, merging Avtovaz with Oleg Deripaska’s Gaz. And with Russia’s state-controlled Sberbank set to take 27.5 per cent of Germany’s Opel alongside Canada’s Magna, Opel – rather than Renault – is the favoured foreign partner.

An analogy might be United Aircraft Corporation, into which Russia combined several aircraft makers in 2006. EADS, the Franco-German parent of Airbus, became a UAC shareholder as it already had a stake in one of its constituents. In a hamfisted attempt to draw it into a closer partnership, another state-owned Russian bank then bought 5 per cent of EADS.

Yet trying to sideline Renault in Avtovaz would be worse than the Shell debacle. Shell’s agreement governing the Sakhalin-2 project was arguably unfair to Russia. Renault’s $1bn-plus investment in Avtovaz, by contrast, came only in late 2007 – after the state had retaken control of Avtovaz.

It seemed to be an example of the new model of state-dominated economic development, with minority foreign investors, favoured by Mr Putin. Moscow can hardly expect to rewrite the rules yet again.

Uhm, Lex, dude:  Wanna bet?

Lex tries to put the best gloss on Putin’s predatory threat, but Russia’s unilateral decision to pump funds into Avtovaz doesn’t obligate Renault to do the same.   If Putin wanted to negotiate an arrangement with the French automaker, he could have done it.  To take an action, presumably based on calculations of his/Russia’s self-interest in no way justifies a demand that Renault take similar actions–again based on Putin’s/Russia’s self-interest.  (Similarly, any “unfairness” in the Shell Sakhalin II deal in no way justifies the thuggish and high-handed way in which Russia wrested control from the Anglo-Dutch group.)

Note to GM (that is, to US taxpayers): What is happening to Renault is likely a harbinger of your future as a minority shareholder in Opel.  Good luck with that.

All those listening to or reading Putin’s siren call in his speech about Russia’s “becoming more attentive to investors” should ignore his words, and heed his deeds.  The precipitous drop in foreign investment is the main reason for Russia’s appalling economic performance over the past year–one of the worst in the world among major economies, and far worse than its ostensible BRIC peers.  (Yeah, yeah.  Spare me the “Whatabout Ukraine?  Whatabout Lithuania?”  If that’s your standard of comparison, than you’ve effectively proved my point about Russia not being a real, genuine “major economy,” but just another, dysfunctional, post-Soviet relic.)

Russia–under relatively rosy scenarios–will be lucky to achieve growth rates in 2010 that are half of what it experienced before the crisis.  Very lucky.  It is desperate to attract investors back.  Putin and his clique will say anything–anything–no matter how risible to do that.  Things as risible as:

“We understand how deceptive blind faith in an omnipotent state is, how illusory are the hopes that total intervention in economic life might fix everything and put everything in its place,”

“To the extent that the situation stabilizes, that the effects of the crisis are overcome, we plan to consistently and purposefully reduce state intervention in the economy,” he said, adding that a new round of privatizations could follow.

Pay no attention to the little man in front of the curtain.

There will be no doubt a new round of privatizations to get new Western money rolling in from whatever suckers foolish enough to overlook history and believe Putin’s conversion to his newfound religion.  Putin would be more than glad to sell the same horse two times, three times, whatever.  Just look at Renault and see what happens when he’s got your money.  Like I wrote before: he’s always asking more, more, more.

Until Russia credibly protects property rights, investing there is a very good way to lose.

By now everyone should know who the real Vladimir Putin is.  He’s the one that threatens to steal property–and does–not the one who dresses up as Adam Smith.

Don’t say you weren’t warned.  Again, and again, and again.

The Federal Deposit Insurance Corporation is running out of money, and is thinking of ways to get it, like getting banks to prepay future deposit insurance premia and special assessments.

I know we’re not quite there yet, but this brings to mind events of 20+ years ago, during the S&L crisis.  In the late-1970s and early-to-mid 1980s, many S&Ls were insolvent, and the Federal Savings and Loan Insurance Corporation (FSLIC) didn’t have the money to seize them, and pay acquirers to take them over.  (An insolvent thrift’s deposit liabilities exceeded its assets.  To get somebody to take over the deposit liabilities, FSLIC had to pay the difference between liabilities and assets out of the insurance fund.)  Congress steadfastly refused to provide the money needed to replenish the FSLIC fund, so FSLIC resorted to various measures to keep going.  Mainly, it created “regulatory capital” out of thin air to permit insolvent thrifts to keep operating.  A bad thing, that, because such “zombies” had an incentive to double down and gamble their way out of insolvency.  Many didn’t, and lost even more money, thereby increasing the size of the financial hole FSLIC had to fill.

Another thing FSLIC did was sell off insolvent thrifts and instead of giving the acquirers a lump sum to cover the hole in the balance sheet of the acquired thrift, promised them a stream of payments (“yield maintenance,” for instance) that covered the difference between the cost of funding the deposits and the earnings on the bad assets.  It did this in a slug of deals in December, 1988.

Problem was that FSLIC grossly underestimated the cost of this financial support to the Treasury.  The assistance was tax advantaged, but FSLIC didn’t take this into account.  Moreover, in calculating the costs of the deals, it assumed that the acquirers would work out and sell the bad assets quickly, shortening the time that the government had to provide the support.  But since (due in part to the tax advantage) the assistance effectively paid an above market rate of return as long as the bad assets were on the books, the acquirers had the incentive to milk the assistance for as long as possible, thereby inflating the costs far above what the government estimated.

(Along with three colleagues, the late Vic Bernard and Roger Kormendi, and current dean of the U Chicago B-School, Ted Snyder, I performed an evaluation of the December ’88 deals that showed how badly the FSLIC blundered.  In retrospect, the numbers–in the billions–seem like chump change compared to what’s gone on in banking recently.)

A big part of the problem is that middling level government folks, well meaning to be sure, were matched up against heavyweights like the Bass brothers when negotiating these deals.  It wasn’t a fair game, by far.  The financial sharpshooters had no problems structuring deals that were very profitable to them, and very costly to the government.  It was an asymmetric information problem writ large.

Moral of the story: when government guarantors run short of money to cover their obligations in a timely, final way, they can do very stupid, costly, things.  Starved of the necessary funds by Congress, FSLIC fed moral hazard problems, and entered into hasty, cash-conserving transactions that provided benefits to acquirers that proved very hard for the government to value, and which wound up being very expensive.  These measures made the insolvency problem worse, and inflated the cost of resolving it.

FDIC doesn’t appear to be in such straits yet, but the fact that it is looking for “creative” ways to fund itself raises red flags.  The FSLIC experience suggests that it would be better to provide FDIC with the funds it needs today to meet its obligations to insured depositors, rather than rely on creativity which, in the stress inherent in these circumstances, can lead to decisions that make sense to FDIC in the short run, but which are very costly in the long run (and in present value terms).  That is, just as with businesses, cash flow problems can lead government guarantors to make inefficient, costly decisions.  Better to grasp the nettle now, give FDIC the wherewithal to meet its obligations, and figure out how to claw back the money from the banking industry later.

The CEO of the Australian Stock Exchange (ASX) hit the nail on the head.  Hell, he drove it right through the board:

The chief executive of the Australian Securities Exchange has criticised the Obama administration’s planned regulatory reforms of the US financial system, arguing they are “draconian” and out of touch with market developments.

Robert Elstone, head of the  ASX, said the reforms were too broad, targeting parts of the securities markets – such as the over-the-counter swaps market – that had not been big contributors to the global financial crisis. [Emphasis mine.]

Emphasized, because true.

More truthiness:

The best hope for regulators and governments, he said, was to develop market-oriented people and market-oriented skills to stay abreast of developments in the securities industries.

The OTC swaps market was already transparent, he said, adding that to compel that market to come “on exchange and be centrally cleared” was “overkill”.

“Compel” is the key word.  If somebody builds it, and the market comes, more power to them.  It’s the compulsion in the near complete absence of a plausible, let alone convincing, identification of a market failure that is deeply troubling–and the recipe for future trouble.

Legislators should be forced to watch this line played before their eyes, A Clockwork Orange-stye, until it penetrates their skulls:

“I think that the notion that any corporate or government regulatory agencies are always going to be one or two steps ahead of the market is a flawed notion.”

That’s worth repeating:

“I think that the notion that any corporate or government regulatory agencies are always going to be one or two steps ahead of the market is a flawed notion.”

Right now our generals in Washington are assiduously deconstructing the last war.  Not a good way to prevent the next one.  Especially inasmuch, as Mr. Elstone notes, they aren’t even properly deconstructing the last one.

Where’s our Robert Elstone?  Nowhere to be found.  Not in DC anyways.  And today, that’s where it matters.

I’ll be speaking on a panel on Systemic Risk and Speculation at the CME this afternoon at 2PM Central.  The event will be webcast.  Here’s the link.  Click on the grey box on the right-hand-side of the page to get to the webinar: registration is required.  The panel should be quite interesting.