Streetwise Professor

One interesting part of the Cœuré speech was his warning that the clearing business was coming to be dominated by a few large banks, that are members of multiple CCPs:

Moreover, it appears that for many banks, indirect access is their preferred way to get access to clearing services so as to comply with the clearing obligation. Client clearing seems thus to be dominated by a few large global intermediaries. A factor contributing to this concentration may be higher compliance burdens, where only the very largest of firms are capable of taking on cross-border activity. This concentration creates a higher degree of dependency on this small group of firms.

There are also concerns about client access to this limited number of firms offering client clearing services. For example, there is some evidence of clearing firms “cherry picking” clients, while other end-users are commercially unattractive customers and hence unable to access centrally cleared markets.

These are all developments that I believe the international regulatory community may wish to carefully monitor and act on as and when needed.

And wouldn’t you know.  He supports a longstanding SWP theme: That Frankendodd and EMIR and Basel create a huge regulatory burden that is essentially a fixed cost.  This increase in fixed costs raises scale economies, and this inevitably leads to an increase in concentration-and arguably a reduction in competition, in the provision of clearing services.

It now seems rather quaint that there was a debate over whether CCPs should be required to lower the minimum capital threshold for membership to $50 million.  That’s not the barrier to entry/participation.  It’s the regulatory overhead.

It’s actually an old story.  I remember a Maloney and McCormick paper from the 80s-hell, maybe even the late 70s-about the effects of the regulation of particulates in textile factories (if I recall).  The cost of complying with the regulation was essentially fixed, and the law essentially favored big firms and they profited from it.  It raised the costs of their smaller rivals, led to their exit, and resulted in higher prices and the big firms profited.  Similarly, I recall that  several papers by the late Peter Pashigian (a member of my PhD committee) found that environmental regulations favored large firms.

The Cœuré speech suggests this may be happening here: note the part about client access to a “limited number of clearing firms.”

And it’s not just pipsqueaks that are exiting the clearing business.  The largest custodian bank-BNY Mellon-is closing up shop:

More banks are expected to follow BNY Mellon’s lead and pull out of client clearing, as flows have concentrated among half a dozen major players following the roll-out of mandatory clearing in the US last year.

The decision of the world’s largest custodian bank to shutter its US clearing unit was the first real indication of how much institutions are struggling with spiralling costs and complexity associated with clearing clients’ swaps trades – a business once viewed as the cash cow of the new regulatory regime.

You might recall that BNY Mellon was one of the firms that complained loudest about the high capital requirements of becoming a member of ICE Trust and LCH.  Again: it’s not the CCP capital requirements that are the issue.  It’s the other substantial cost of providing client clearing services, and regulatory/compliance costs are a big part of that.

Ah yes, another Gensler argument down in flames.  Remember how he constantly told us-lectured us, actually-that Frankendodd would dramatically increase competition in derivatives?  That it would break the dealer hammerlock on the OTC market?

Remember how I called bull?

Whose call looks better now?  Sometimes I wonder if JP Morgan, Goldman, Barclays, etc., weren’t playing the role of Brer Rabbit, and Gensler was playing Brer Fox. For he done trown dem into dat brer patch, sure ’nuff.

Though it must be said that this was not Gensler’s biggest contribution to reducing competition in derivatives markets in the name of increasing competition.  His insane extraterritoriality decisions have fragmented the OTC derivatives markets, with Europeans reluctant to trade with Americans.  The fragmentation of the markets reduces counterparty choice in both Europe and the US, thereby limiting competition.

This is not just a matter of competition.  There are systemic issues involved as well, and these also make a mockery of the Frankendodd evangelists.  They assured the world that Frankendodd and clearing mandates would reduce reliance on a few large, highly interconnected intermediaries in the derivatives markets. That is proving to be another lie, on the order of “if you like your health plan, you can keep your health plan.”  The old system relied on a baker’s dozen or so large, highly interconnected dealers.  The new system will rely on probably a handful or two large, highly interconnected clearing firms.

The most important elements in the clearing system are a small number of major banks that are clearing members at several global CCPs.  The failure or financial distress of any one of these would wreak havoc in the derivatives markets and the clearing mechanism, just as the failure of a major dealer firm would shake the bilateral OTC markets to the core.

Just think about one issue: portability.  If there are only a small number of huge clearing firms, is it really feasible to port the clients of one of them to the few remaining CMs, especially during times of market stress when these might not have the capital to take on a large number of new clients?

What happens then?

I don’t want to think about it: there’s only so much I can handle.

But Cœuré assures us the regulators are on top of it.  Or at least they are thinking about getting on top of it: “the international regulatory community may wish to carefully monitor and act on as and when needed.”  “May wish to act as needed.”  Sure. Take your time! What’s the hurry? What’s the worry?

I won’t dwell on the  irony of those who advocated the measures that got us into this situation pulling their chins and telling us this might be a matter of concern, especially since they were deaf to warnings made back when they could have avoided leading us down the path that led us to this oh-so-predictable destination.

A board member of the ECB, Benoît Cœuré, gave a speech that discussed “the new risks associated with central clearing.” It is evident that Cœuré is a proponent of central clearing, though it is annoying to see him identify multilateral netting as the main benefit (<holds head in hands>).  But it is good to see yet again that central bankers are aware that central clearing does create new risks, and that regulators must be proactive in addressing them.

The problem is that he overlooks the most important risks.  Reading between the lines, like most regulators, Cœuré focuses on the solvency risks of CCPs, and about policy tools that can limit the probability of CCP insolvency and mitigate the adverse impacts of such an insolvency.

But as I’ve written repeatedly in the past, it’s not the insolvency risk per se that should keep people up at night.  Indeed, the measures taken to address the solvency risk can actually exacerbate the real risk a dramatic expansion of central clearing creates for the financial system: liquidity risk.

Liquidity crises are what threaten to bring down financial systems.  For most financial institutions, there is a connection between liquidity risk and solvency: banks become illiquid because (in a world of imperfect information) people believe they might become insolvent.  Maturity mismatches plus imperfect information plus possibility of insolvency combine to create liquidity crises.

CCPs don’t have the maturity mismatches, and they aren’t leveraged.  They cannot experience liquidity crises in the same way banks can.  The direct liquidity risk of CCPs is related to their ability to turn collateral into cash in the event of a member default.

But as I’ve said over and over, clearing affects the needs for liquidity by market participants.  Central clearing can be a source of, or accelerant of, liquidity crises.  Big price moves lead to big margin calls lead to spikes in liquidity demand. These are most likely to occur during periods of financial stress, and can greatly exacerbate that stress.  Moreover, failure of a CCP is most likely to occur due to the inability of traders to fund margin calls due to the shortage of liquidity.   This old article by Andrew Brimmer discusses two episodes I’ve analyzed on several occasions-the Hunts in silver and Black Monday-and shows how it is liquidity/credit/funding of margin calls for CCPs that can create stresses in the financial system.

This is where the systemic risk of clearing arises.  But the subject is totally absent from Cœuré’s speech.  Which is worrisome.

There is also the fallacy of composition problem.  The measures that Cœuré advocates to make CCPs stronger do NOT necessarily make the system stronger.  Strengthening CCPs can actually exacerbate the liquidity problems that clearing causes during a crisis.  The CCP may survive, due to these measures, but the stresses communicated to the rest of the system (and the stress has to go somewhere) can cause other institutions to fail.

This is what scares the bejeezus out of me.  Regulators don’t seem to get the fallacy of composition, and aren’t focused on the liquidity implications of greatly expanded central clearing.

These fears are heightened by reading this DTCC report about collateral and collateral management.

It contains this heading that should make every central banker and financial regulator soil his armor:

Margin Call activity to increase By up to 1000%

Then there’s this:

Operational Capabilities and Settlement Exceptions Management: The potential ten-fold increase in margin call volumes, and the resulting complexity due to market changes, could overwhelm the current operational processes and system infra-structures within banks, buy-side firms and their administrators. As a result, firms will need to invest in technology and also reengineer the settlement, exceptions management and dispute resolution processes in place today. According to a 2011 De- loitte paper, investments in operations required to build and sustain advanced collateral capabilities is estimated at upwards of $50 million annually for top-tier banks.

Be afraid.  Be very, very, very afraid.

The dramatic increase in the scope of clearing substantially increases the operational complexity of the system.  More importantly, it increases the system’s operational rigidity, because cash has to flow quickly, and according to a very precise schedule.  From client to FCM to CCP to FCM to client.  Any failures in that chain can bring down the entire system.

I say again.  Systemic risk in financial systems is largely due to the fact that these systems are tightly coupled.  Clearing increases tight coupling.  This almost certainly increases systemic risk.

More players have to move more money in more jurisdictions as a result of clearing mandates.  As the DTCC report makes plain, this is a new responsibility for many of these players, and they do not have the capability or experience or systems.  Greater operational complexity involving more parties, many of whom are relatively inexperienced, creates grave risks in a tightly coupled financial system.

The irony of all this is that the evangelists of clearing, including notably Timmy! and GiGi in the US, argued that central clearing would reduce the interconnectedness of the financial markets.  Wrong. Wrong. Wrong. Wrong.

It reconfigures the interconnections.  The entire collateral management system the DTCC document describes is a dense web of interconnections.  And to reiterate: under central clearing (and the mandate to margin and mark-to-market uncleared derivatives) these connections (couplings) are tighter than in the old system.  Both old and new systems are highly interconnected.  The connections in the new system are tighter, and are more vulnerable to failure as a result.

I’ll tell you what makes me have to go change my armor: the regulators seem oblivious to this.  To the extent they are focused on collateral, they are focused on initial margin. No! It is variation margin calls during periods of large market movements that will threaten the stability of the system. Now there will be more such calls–1000 pct more, according to DTCC–and more participants are involved, meaning that there are more links and nodes.  The tightly coupled nature of the system means that the breakdown of a few links can bring down the entire thing.

In other words, there seems to be a disconnect on interconnections, most specifically on how clearing has not reduced interconnections but reshaped them, and how the new system’s interconnections are much more rigid, tightly coupled, and time-sensitive.

Not to pick on Cœuré: his speech is just one example of that disconnect.  The thing is that most speeches by regulators and central bankers exhibit the same disconnect.  Target fixation on making CCPs invulnerable does not address the main systemic risk that an expansion of clearing creates.  That systemic risk involves the financial/funding and operational risks of meeting large margin calls in a stressed environment on a precise time schedule.

It’s about liquidity, liquidity, liquidity.  Clearing transforms credit/solvency risk into liquidity risk.  The operational aspects of clearing-the need to move cash and collateral around in large amounts on a tight time schedule-affects the demand for liquidity, and also create points of failure that can cause the liquidity mechanism to seize up, threatening the entire system.

This is what should be the focus, but I’m seeing precious little evidence that it is.  Someday we’ll pay the price.

Risk Magazine’s annual review issue includes a set of short contributions on the progress that has been made on the G-20 OTC derivative reforms.  (If you run into paywall problems: there are ways.  There are ways.)  The contribution by yours truly is under the category Academics (plural) even though I am the only academic in the piece.  I guess I count for double, or something.
But that’s not the best part.  The best part is the headline:

Progress and peril: Davie, Dodd, Maijoor, Pirrong and more on the G-20 reforms.

Sharing top billing with Chris Dodd!  What is the world coming to?  I guess it could be better (or worse): it could have been Barney.  Or Gary.  Or Bart.

To spare you having to scroll through all of the contributions by politicians, lawyers and people who actually work in these markets, here’s my two cents:

When the Dodd-Frank Act was passed, I thought the Sef mandate was its worst part. It has nothing to do with the act’s ostensible purpose – reducing systemic risk – and imposes a one-size-fits-all model for trading swaps that will likely decrease the efficiency of the market. The made-available-for-trade provision of the Sef rule merits the title ‘worst of the worst’. This says if a Sef applies to the CFTC to trade a particular type of swap, and it approves the application, all trading of that type of swap must occur on a Sef. This turns the ordinary competitive process on its head. In most markets, a firm introduces new products, and if it is desirable to consumers, it sells. If the product is flawed, it doesn’t. Under this rule, a firm that introduces a flawed execution method imposes this bad choice on all consumers.

The CFTC could prevent such a perverse outcome by not approving an application. However, the agency’s animus to the traditional dealer-centric trading model and its fetish for transparency means the CFTC sets very low standards for approval. It also demonstrates the CFTC’s bizarre interpretation of cost-benefit analysis: it considers only the trivial cost of filing an application, and totally ignores the massive costs that would result if traders are forced to execute in an inefficient way.

Swap market participants and transactions are diverse. There is no execution model to fit all – counterparties themselves are best placed to determine how to execute their trades. Sef mandates already constrain choice, and made-available-for-trade puts the execution decision in the hands of third parties whose interests are not aligned with those actually trading. Given the size of these markets, if the untried Sefs don’t work as hoped – even for a modest subset of traders – the dislocations and inefficiencies will be immense.

The Risk editors chopped my last line, which was: “I fear that the epitaph of the OTC swap market will be: ‘Died of a Theory.'”  (A line lifted from Jefferson Davis’s epitaph on the Confederacy.)  The Theory, of course, is that traditional means of executing OTC derivatives trades are flawed, if not evil, and that Gary Knows Best in imposing a simulacrum of a centralized, order driven market that has worked well for futures on swaps, which are different in many ways.

Whenever I see a picture of Rusal CEO Oleg Deripaska, I know that Neanderthals still walk the earth.  This particular Neanderthal is in serious financial difficulties these days.  When Rusal IPOd about four years ago, it was priced at HK$10.20/share, and it’s been all downhill since.  The stock is now trading for about 75 percent less, at HK$2.32.  Rusal is levered up to the wazoo, and Deripaska has other pressing obligations, including construction projects at Sochi  made at Putin’s insistence which will almost certainly be huge white elephants.

The main reason for My Favorite Neanderthal’s financial distress is the depressed price of aluminum, which is down by about a third in the past three years.  For a smelter like Rusal, the only saving grace is the high premium of cash aluminum over the prices of metal in LME warehouses.  That premium is inflated by a bottleneck at LME warehouses like Goldman Sachs’s Metro in Detroit.  If that bottleneck is widened, the huge stocks accumulated during the financial crisis will make their way onto the market, crushing premiums and bringing down the price that Rusal (and Alcoa and Chinalco) get for their production.  This would probably be enough to put Rusal and Deripaska over the brink.

Stung by intense criticism, the LME has announced rule changes intended to loosen the bottleneck.  The mooted rule changes are a mortal threat to Deripaska, so he’s suing in London.  This is not surprising, because Deripaska has nothing to lose.

What is somewhat surprising is the specific claim that Rusal/Deripaska are making:

“Rusal has alleged that the consultation conducted by LME was unfair and procedurally flawed, that the LME’s changes to its warehousing policy are irrational and disproportionate, and that Rusal’s human rights have thereby been breached,” Hong Kong Exchange and Clearing, also known as HKEx, said in a news release. [Emphasis added.]

Human rights.  What a riot.  I know that many Russians have sued in European courts claiming that their human rights have been violated by the Russian government.  In 2012, there were over 22000(!) such claims filed in the European Court of Human Rights, which I believe is the largest total for any country.  The Court rejects virtually all these claims, but still enough proceed to make Russia consider invalidating the Court’s decisions.  (Ironically, this story appears today.  Merry Christmas!)

So I guess Rusal is playing turnabout is fair play.  Good luck with that, Oleg. Methinks the LME will prevail, cash aluminum premiums will fall $75/$80 per tonne or so, and Rusal will soon be staring bankruptcy in the face.  And maybe Neanderthals will become extinct after all.  Financially, anyways.

According to one of my industry contacts, this article in the Fiscal Times has “created a lot of unwanted buzz” in DC.  Because our betters find it so very inconvenient when reality intrudes on their fantasies.

The article focuses on the clearing mandate.  It points out that the main effect of the mandate is to shift risk around, and concentrate it in CCPs.  The risk doesn’t go away.  It moves.

Let me think.  Who was pointing this out five years ago?  Modesty prevents me from naming names.

Clearing was sold-most notably by my bêtes noire Geithner and Gensler*-as a magic box that made counterparty risk disappear.  This was a false claim, and arguably a dishonest one.  I find it hard to believe that Gensler, for instance, really believed what he said.  And the alternatives are ugly.  He (and other advocates of the clearing mandate) either made arguments he (they) knew to be untrue, or was (were) utterly ignorant of the implications of the policies that he (they) was (were) implementing and supporting.  Choices: (A) Idiot. (B) Liar. (C) There is no choice (C).

In reality, clearing mainly shifts around counterparty risk, and creates new risks, most notably liquidity risks.

All of these things were foreseeable, and foreseen-by some. Who were ignored, and at times reviled.

Why did this happen? It seems to me that in the heated days of the crisis, there was a desperation to find a solution.  For a variety of reasons, most notably the fact that the major cleared markets dealt with the Lehman situation without much problem, policymakers seized on clearing as the panacea.  And once they had done that, getting the clearing mandate passed became an end in itself.  The decision had been made, all doubts had to be suppressed.

But where does that leave us? With the growing recognition that the alleged panacea was nothing of the sort.  With the creeping recognition that the mandate has created a new set of risks.  A new set of potential sources of systemic instability.  So now policymakers are scrambling to address and to mitigate these problems.

It would have been so much better had these problems been anticipated, in advance, and the law drafted accordingly.

This is not Monday morning quarterbacking. I and others anticipated these problems at noon on Sunday.  But we were left on the sidelines, while the geniuses called and ran the plays. We are going to be dealing with the consequences of that for years to come.

*One blessedly departed from government “service”, and the other blessedly about to do so.

I’ve been hammering on the theme of the systemic risks of central clearing-especially mandated central clearing-for around five years.  And now those concerns are being expressed with greater frequency.  Fed Governor Jerome Powell gave a speech focusing on the most straightforward source of systemic risk in mandated clearing: the concentration of risk in the clearinghouse, which becomes a single point of failure whose collapse could jeopardize the broader financial system.   Bernanke made a similar argument a couple of years back.

Some articles from the last several days highlight more subtle, but in my view more important, concerns.  This Reuters piece mentions several things I’ve focused on over the years: the strains that clearing can put on the liquidity of individual firms, and the system at large; margin pro-cyclicality;  and crucially, the fact that self-preserving actions taken by CCPs may have destabilizing effects elsewhere in the financial system.

This last point demonstrates a danger in the Powell approach which focuses on making CCPs invulnerable, which I’ve referred to as the levee effect.  Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a CCP can redistribute shocks elsewhere in the system in a highly destabilizing way.  CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects.  Indeed, greater reliance on CCPs increases the tightness of the coupling of the financial system, which can be highly problematic under stressed conditions.  Liquidity and funding are the primary channels by which CCP decisions will have external effects on the broader financial markets.

These considerations are related to a broader point, which is that CCPs are merely parts, albeit important ones, of a broader financial system, and they must be evaluated in the context of the entire system.  An article in the International Financing Review by Christopher Whittall provides another illustration of this, again related to liquidity.  He notes that Basel III’s leverage ratio clashes with the tremendous thirst of CCPs for liquidity:

“The move towards central clearing creates a focus on how to fund margin requirements, which should dictate an increase in repo activity from banks. The problem is repo becomes very unappealing for banks under the leverage ratio.”

So sayeth the head of fixed income at a major bank.  CCPs create tremendous funding needs, and particularly contingent funding needs that are especially large in stressed conditions when liquidity is hard to come by.  These needs are hard enough to address in the absence of a leverage ratio, but as the fixed income guy notes, this is an even bigger problem when it is present.  As he says: “Viewed as a whole, we can start to start to see how these different regulations don’t quite hang together from a macro-prudential perspective.”

Exactly.  Illustrating another theme: Regulatory responses to the crisis have tended to focus on the individual pieces with too little attention paid to how regulations of one piece affect the other pieces.  The interaction between the leverage ratio and clearing mandates is a particularly worrisome example.  In any complex system, it is the interaction between interconnected pieces of the system that can lead to abrupt collapses.  Making each piece of the system more robust doesn’t necessarily make the system more robust.  Indeed, the opposite can be true.

Yes, I’ve been a Cassandra on these issues.  So in some sense, it’s good to see that the concerns that prompted my prophesies are now getting more widespread attention.  But methinks that the post-crisis regulatory juggernaut is impossible to reverse, and that although some of the problems in clearing and the interactions between clearing and other aspects of financial regulation can be ameliorated, the basic sources of systemic risk inherent in the new financial and regulatory structure will persist.

Matt Leising had a nice article a few days back about the CFTC’s rule that does not treat US Treasury securities as “qualifying” liquid resources for CCPs.  Instead, under new regulation 33-33 they must obtain “prearranged and highly reliable funding.” Based on Fed rules, this means that a CCP must get  committed line of credit from banks.   This imposes a substantial cost on CCPs, because under new Basel III rules, committed lines impose a large capital charge on the issuing banks.  For purposes of calculating capital, the banks have to assume that the lines are fully drawn.  This capital cost will be passed onto CCPs.

It is ironic that outgoing (resisting the great urge to snark) Chairman Gary Gensler repeatedly argued that one of the main benefits of the Frankendodd clearing mandate is that it would reduce the interconnectedness of the financial markets, especially interconnectedness through derivatives contracts.  Now he has pushed through a regulation that mandates an interconnection among major financial institutions via a derivatives channel: the lines connect derivatives CCPs to major banks.   I have long pointed out that Gensler’s claim that clearing would reduce interconnectedness was grossly exaggerated, and arguably deceptive.  Instead, I pointed out that the mandate would reconfigure-and is reconfiguring-the topology of the network of connections between financial firms.  What the CFTC has done is dictate what that form of interconnection will be.  This particular dictate is extremely problematic.

A CCP needs access to liquidity in the event of a default of a clearing member.  The CCP needs to pay obligations to the winning side of the market, in cash, in a very tight time window.  Failing to make these variation margin payments could impose financial distress on those expecting the cash inflow, and more disturbingly, call into question the solvency of the clearinghouse.  This could spark a run in which parties try to close positions in order to reduce exposure to the CCP.  Given that this is likely to occur in highly unsettled market conditions, such fire sales (and purchases) will inevitably inject substantial additional volatility into price that can exacerbate pressures on the clearing mechanism.

A CCP holding Treasuries posted as IM by the defaulting CM can sell them to raise the cash.  Alternatively, it could repo them out.  During most periods of financial turbulence-and financial crisis-which is likely to be either the cause or effect of the default of one or more large CMs, there is a “flight to quality” and Treasury security prices rise and there is a rush to buy them by investors seeking a safe haven.  Moreover, under such circumstances the Fed will perform its lender of last resort function, and readily accept Treasuries as collateral: even if CCPs could not access the Fed directly*, they could access it indirectly.   Thus, in “normal” crises, Treasuries should be highly liquid, and a ready source of cash that can be used to meet variation margin obligations.

Put differently, from a liquidity perspective, Treasuries are a negative beta asset: they become more liquid when overall market liquidity declines-or verges on collapse.  This is a highly desirable attribute.  Another way to characterize it is that from a liquidity perspective, Treasuries have right way risk.

Bank lines are very different.  Banks become stressed during crisis situations, and face a higher risk of being unable to perform on credit lines under these circumstances.  (Indeed, what if the defaulter is one of the suppliers of a committed line?) Banks fighting for survival but which can perform might try to evade this performance during stressed market conditions, which in a tightly coupled system (and clearing is a source of tight coupling) can be extremely disruptive: a few minutes delay in performing could cause a huge problem.  And if the banks do perform, doing so poses the substantial risk of increasing their risk of financial distress.  That is, committed lines are positive beta from a liquidity perspective: that is, they pose wrong way risks.   If drawn upon, these lines can be an interconnection that is a source of contagion from a derivatives default to systemically important banks, precisely at the time that they are least able to withstand the shock.

In the event, a CCP that does collect Treasuries as IM can likely use these right way assets to raise the cash need to meet its obligations, and can avoid drawing down on its committed line.  But that would mean that the committed line is superfluous, and imposes unnecessary costs on the CCP, and hence on the users of the clearing system.

I also conjecture that having met its liquidity requirements with a committed line, pursuant to the CFTC reg, CCPs would  have a weaker incentive to take Treasuries as collateral, and a stronger incentive to permit the posting of lower quality assets (or incentivizing such posting by reducing haircuts assessed to such collateral) for IM. This would mitigate the cost impact to users that results from the CCP having to secure the committed line, and pay for it (the cost being passed onto the users), thereby reducing the loss of trading/clearing volume and the associated revenues.  This would increase the odds that the line will be drawn on (because the lower quality assets pose a substantial risk of becoming illiquid during a crisis situation-they embed wrong way risk too).  I’ll have to think this through more, because the situation is somewhat complex: it depends on the pricing of the line, which will depend on the likelihood it will be drawn against, and the market conditions at the time it is.  This will depend in part on the quality of collateral that the CCP collects.  I’m not sure of what the equilibrium outcome will be, but I suspect that mandating the obtaining of lines will undermine incentives to demand the posting of high quality collateral.  If it does, this is a bad outcome that increases wrong way and systemic risks.  If it doesn’t, then the cost of the lines is superfluous and a burden on clearing and derivatives trading.

There is one scenario in which Treasuries would not be good collateral: if the financial crisis (and default of a CM or CMs) was the result of a fiscal crisis in the US, or a default (real or technical)  of the kind feared during the last (but the last, most likely) debt ceiling standoff.  But that’s an Armageddon scenario in which banks are likely to be highly stressed and unable to perform, or in which they would incur exceptional and arguably existential costs if they did.  Put differently, there’s likely no good source of liquidity in this scenario, and the CFTC rule will hardly make a difference.

In sum, it is highly unlikely that bank lines are a better source of liquidity, especially under crisis situations, than Treasuries.  Indeed, they are plausibly worse, and actually create an interconnection that can transmit a shock to the derivatives market (and the CCP that clears it) to systemically important banks: this is the exact opposite of what clearing was supposed to achieve. The cost of the lines, which is likely to be substantial, particularly given their necessary size, is a deadweight burden on the markets: all pain, no gain.

Other than that, the rule is great.  And a fitting parting shot from Gensler.

* Frankendodd makes it difficult for US CCPs to obtain Fed liquidity support.  This is a serious mistake that could come back to haunt us in some future crisis.  To work effectively, the LOLR must be able to direct liquidity to where it’s needed,  quickly and efficiently.  CCPs could be a major source of liquidity demand in future crises, which makes isolating them from the Fed highly dangerous, and the invitation to an ad hoc response in some future crisis.

I’ve been beavering away at the clearing section of my next book, which will be titled Market Macrostructure.  It’s been something of a struggle, because there are so many aspects to this issue that it is challenging to organize the material in a logical fashion.  I analogize it to trying to write a history of a complicated battle, where many things are happening simultaneously over space, and these things interact.  Inevitably, the narrative must jump around in either space or time or both, and the writer must summarize some material about one action at one time to relate it to the narrative of what is going on at another place at another time.

So it is with writing an analysis of clearing.  There are many moving parts that interrelate and interact, so there is always the challenge of relating detailed analyses of important pieces to one another, and to clearing as a whole, and to the trading process (execution and clearing) as a whole.

One virtue of this struggle, however, is that it can lead  the writer to new insights.  Conceptualization at a fairly highly level facilitates organization, and the process of conceptualization can lead to new ways of understanding.  So it is, I hope anyways, with the clearing analysis.

This post is my first attempt to crystalize those thoughts; indeed, one of the original purposes of the the blog was to provide a place where I could think out loud and commit to pixels some early thoughts to be refined going forward in more formal writing.

The issue that I have been grappling with is why are some trades cleared, and others not?  Why do we see exchanges that trade cleared contracts operate side by side with bilateral markets trading similar contracts (and sometimes nearly identical ones) that aren’t cleared?  What determines the division of trade between these alternatives?

This is an issue that I’ve been looking at since the ’90s, and I identified some factors, but I was never completely satisfied.  But putting together some pieces that I have written about before, I think I’ve come up with a more complete explanation that captures some of the salient aspects of the economics of clearing and counterparty risk generally.

The first piece is that in theory-and indeed, in most theoretical treatments of clearing by academics (including yours truly)-clearing can operate as a classical risk pooling/insurance mechanism, in which market participants pool counterparty risk.  To the extent that this risk is idiosyncratic, such pooling allocates risk more efficiently and makes risk-averse participants better off.

But as I pointed out in my earliest work, and emphasized more in some later papers, like any risk sharing arrangement, mutualization of counterparty risk creates the potential for adverse selection and moral hazard problems.  Moral hazard problems are likely to be particularly acute.  Clearing participants can affect the distribution of the default losses they impose on the mutualization pool by adjusting the riskiness of their trading positions in the cleared derivatives.  They can also do so by adjusting the risks of their balance sheets, through, for instance, adjusting their trades in non-cleared derivatives (or in derivatives cleared at another CCP), changing their leverage, or adjusting the risk of other assets on their balance sheets

The prospect for moral hazard will inevitably lead to limits on the amount of insurance provided through the clearing mechanism.  That is, not all default risk will be mutualized.

Clearinghouses use margins to limit the amount of risk that is mutualized.  Only losses on defaulted positions in excess of margin posted by the defaulter are mutualized.  The higher the margin cover, the lower the level of risk sharing.

In practice, CCPs utilize a “defaulter pays” model in which margin covers losses on defaulted positions with extremely high probability, e.g., 99.7 percent of the time.  In a defaulter pays model, the amount of risk mutualization is very low.  CCPs are not, therefore, primarily an insurance mechanism.  They insure only tail risks (which has important implications for systemic risk and wrong way risk).

Note LCH.Clearnet’s boast that it had collected far more margin than necessary to cover the realized losses on the Lehman’s derivatives positions that it cleared.   The CME also had more than enough Lehman margin to cover losses on its positions (although there were shortfalls on some product segments that were covered by excessive margins on others).

At the Paris conference I attended in September, the head of Eurex Clearing, Thomas Book, was adamant that the goal of his CCP, and of CCPs generally, was to avoid mutualizing risk if at all possible.  His answer surprised Bruno Biais, whose model of clearing in the paper he presented focuses on the role of the CCP as a default risk insurer.

I confess that I have been inadequately appreciative of this point as well.  Understanding its implications has important consequences, as I hope to show in a bit.

To summarize.  CCPs generally operate on a defaulter pays basis: this is also sometimes referred to as a “no credit” system.  That term will help illuminate the differences between cleared and uncleared markets.  The defaulter pays system means that the amount of risk shared through a CCP is extremely limited.  This limitation on risk sharing is best explained as the consequence of moral hazard.

In contrast to a cleared market operating on the no credit model, dealers in bilateral OTC markets historically extended credit to derivatives counterparties.  Put differently, OTC deals often bundled a derivatives trade with credit provision.  That is, dealers often willingly took on exposure to a default loss when entering into a derivatives deal with a customer.  (This is not true for all types of customers.  For instance, hedge funds typically had to post margin.)  Taking credit exposure is equivalent to extending credit to the counterparty.

Now consider whether a firm will prefer to trade a cleared derivative, requiring the posting of a high margin and which thus embeds no credit, or prefers instead to trade an otherwise identical OTC product that does embed credit.  To fix ideas originally, let’s consider a firm that is cash constrained.  Therefore, if it wants to trade the cleared product, it must borrow to fund the initial margin.  The cleared derivative is a no credit transaction, but that doesn’t mean that moving to clearing necessarily reduces the amount of credit the firm obtains: it can borrow the money needed to post margin, and indeed, may have to borrow it.

One source of credit is dealer banks.  So the firm could either enter into an uncleared bilateral trade with a dealer, or borrow money from the dealer bank to fund the IM.  (The argument doesn’t really depend on dealing with the same bank on the derivatives deal and the borrowing: this just facilitates the exposition.)

Here’s were the loser pays aspect of margin comes in.  Let’s say that the firm is selling a derivatives contract with payoff P. If the firm defaults, the OTC counterparty’s exposure is max[P,0].  But in a loser pays model, the margin M is almost always greater than max[P,0].  Thus, the borrowing from bank to fund margin almost always exceeds the default loss that the bank would incur if it entered into a bilateral deal with the firm.

I can show formally that if the firm already has debt outstanding, under standard pro rata/pari passu default loss allocation mechanisms, holding everything equal,  the bank’s default losses if it extends credit to the firm to fund margin almost always exceed, and never are smaller than*, the default losses that it would incur if it had entered an uncleared bilateral trade with the firm.  This, in turn, will make the cleared transaction more expensive for the cash-constrained firm, and it will prefer to trade the OTC product.

There are at least a couple of reasons why the cleared transaction can be more expensive.  One is what is effectively a debt overhang problem.  In order to induce the bank to lend the margin for posting at the CCP, the firm must promise it higher payments in non-default states than it has to promise the bank in these states when it trades OTC instead.  Since the firm’s managers, acting in the interest of equity, only care about payoffs in non-default states, this means that returns to shareholders are lower when it borrows to fund margin than when it deals OTC.  This can be seen another way.  I can also show formally that the payoffs to the firm’s other creditors are almost always higher, and never lower, if it borrows to fund margin than if it trades OTC.  Thus, the value of the the firm’s non-margin-related debt is higher if it trades a cleared product and funds the margin by borrowing, than if the firm uses the OTC product.  Since the value of the firm’s assets doesn’t differ in the cleared vs. uncleared cases, and since value is conserved, this means that equity is less valuable when the firm trades cleared products than bilateral ones.   Some of the benefit of borrowing to fund margin flows to other creditors; this is where the analogy to debt overhang comes in.

This is most easily seen in the following scenario.  The firm can become insolvent when max[P,0]=0, i.e., the bilateral contract is out of the money to the bank, and the bank suffers no loss due to default, and all the losses of insolvency would fall on other creditors.  However, if the bank had lent the firm money to fund margin, it would suffer a loss on the margin loan in this circumstance.  This loss would reduce the loss suffered by the other creditors.

OTC is cheaper than cleared products in other models of capital structure.  For instance, moral hazard (or adverse selection) mean that the firm will be credit constrained: the amount it can borrow is limited by its collateral, and/or the amount of cash flows that it can credibly pledge to lenders.  The same formal analysis implies that more cash flows in non-default states must go to supporting a margin loan in a defaulter pays clearing model than in a bilateral transaction.  This leaves less cash flows to support other borrowing, so by borrowing to fund margin loans the firm must borrow less to support other investments (which, in this sort of model, it has insufficient equity to fund itself).  Thus, borrowing to fund margins on cleared transactions crowds out borrowing to fund positive NPV investments.

This analysis implies that this cash constrained firm will choose to trade OTC rather than cleared products with defaulter pays margins funded with loans.  The bank is indifferent, because it will price the product or the loan to cover its costs, but the firm is always better off  with the bilateral trade because it has to pay the bank less if it trades OTC than if it borrows to fund margin.

Moreover, the analysis implies that if the firm is forced to clear, it will either scale back its derivatives trading (because the cleared transaction is more expensive), and/or reduce its investments in positive NPV projects. Cutting back derivatives trading is costly if this trading reduces the deadweight costs of debt, for instance.  Indeed, I can show that the cost of margin is especially high when the derivatives trade is a “right way” risk, as would occur when the firm is hedging.

Clearing mandates are therefore expensive for such firms, and there is a legitimate reason to exempt such firms from clearing requirements.  (Note that even if these firms are exempted, other rules affecting dealer banks, e.g., punitive capital charges on OTC derivatives trades, can induce an inefficient use of cleared transactions.)

This analysis explains the preference of many firms, especially corporate end users, for uncleared OTC trades that embed credit, as opposed to cleared transactions that must be funded by increased borrowing.  This, in turn, can explain the growth of OTC markets relative to exchange traded markets from the 1980s onwards.

It is useful to step back a bit here, and understand what is really going on.  In essence, in this model clearing is expensive because it causes one agency problem to exacerbate another.  CCPs adopt defaulter pays because of an agency problem: the moral hazard associated with risk sharing.  Debt is expensive or constrained for firms because of agency problems (e.g., debt overhang problems, or constraints on borrowing due to moral hazard).  Effectively, the firm must obtain more credit to support a cleared position than an uncleared one, and  the cost of debt arising from agency problems makes this higher level of credit more expensive.

This analysis raises the question of why firms would ever choose to clear.  There are a couple of answers to that.

First, there may be other (private) benefits.  For instance, netting economies may be greater with clearing.  Of course, the efficiency effects of netting are equivocal (because netting primarily has the effect of redistributing losses among creditors), but as a positive matter is is pretty evident that netting offers private benefits, and thus the mulitilateral netting that can occur in clearing, but not to the same degree in bilateral trades, could induce some traders to prefer clearing.

Second, the analysis started from the assumption that the firm at issue is cash constrained and hence has to borrow to fund margin on the cleared trade.  Some firms are not.  One example would be an ETF like USO or USNG, which collect the entire notional value of derivatives in cash from their investors.  These firms do not require any credit to meet margins.  Large real money funds, like a Pimco, that collect cash from investors and use derivatives to gain exposure to price risks would be another.

Even many hedgers may not suffer from cash constraints that limit their ability to trade cleared contracts.  Consider commodity trading firms.  They typically use derivatives to hedge inventories of commodities.  Banks, in turn, are willing to lend against these inventories as collateral.  Thus, the commodity trader can fund margin using borrowings secured by commodity inventories, and the lender does not share in default losses pro rata with other creditors.  This type of borrowing is fundamentally different than the borrowing considered above, in which the firm borrows against its balance sheet and default losses are shared with other creditors.

Thus, the simple models would predict that whereas cleared derivatives used to hedge liquid inventories are as cheap or cheaper than uncleared derivatives, it is much more expensive to use cleared derivatives to hedge cash flows on illiquid assets, or to hedge broad balance sheet risks.  This is largely consistent with my understanding of the pattern of usage of cleared and uncleared derivatives.

This model, which combines a model of the cost of risk sharing at a CCP with a model of the capital structure of firms, has both positive and policy implications.  In particular, it can explain the adoption of defaulter pays by CCPs.  It can also explain the disparities between OTC and cleared markets when CCPs utilize defaulter pays.  Moreover, it demonstrates that clearing mandates can be inefficient if they are applied too broadly.  One source of this inefficiency is that the mandate leads to a perverse interaction between agency problems.

Of course, a rationale for clearing mandates is that clearing reduces systemic risk.  Anyone who has read my work will know that I am dubious of that rationale on many grounds, but it is worthwhile to consider the implications of the foregoing analysis for systemic risk.

The model is too sparse to make very strong conclusions, but one consideration does stand out.   If firms borrow from OTC dealer banks to fund margins, holding the rest of the firm’s liabilities and assets constant, these banks suffer larger losses when the firm goes bankrupt if they lend to them to fund margins on  derivatives trades than if they enter into identical uncleared OTC derivatives trades.  As noted before, there is a distributive effect: other creditors suffer smaller losses.  The systemic implications of this redistribution depend on the relative systemic importance of the banks and the other creditors.  Dealer banks are definitely systemically important, but other creditors may be too.  Therefore, it is not evident how this cuts, but if one believes that large financial institutions that serve as OTC dealers are especially crucial for systemic stability, moving to cleared trades would tend to increase systemic risk because clearing actually increases their credit exposures to customers.

But again, caution is warranted here.  The redistribution result holds capital structure and derivatives trades constant, but of course these will be different if firms have to clear than if they don’t.  These changes are difficult to predict, and the systemic riskiness of different configurations is even more difficult to compare given how little we really know about the sources of systemic risk.   But the fact that clearing can lead to adverse interactions between agency problems should raise concerns about the systemic implications of forcing clearing.

*To be more precise.  When P>M, the CCP and the lender suffer default losses, and the sum of these default losses is the same as the bilateral counterparty would incur on an uncleared trade.  Relatedly, other creditors of the bankrupt firm suffer the same default losses in the cleared and uncleared cases when this condition holds.  They suffer smaller losses whenever this condition does not hold and the firm goes bankrupt.

In September, the CFTC’s new SEF rule threw swap market participants into a panic when they realized that footnote 88 buried within the rule would require instruments that were thought to have been outside the scope of the rule to be traded on the new SEFs:

Further muddying the waters is a footnote that was written into the margins of the final rules that could end up having a major impact. Footnote 88 requires certain entities that offer trade execution of swaps on a multiple-to-multiple basis to register as SEFs, even if they only execute or trade swaps that are not subject to the trade execution mandates.

This could lead to a significantly expanded SEF universe, which is already expected to be crowded. Trading participants would have to code and test to these various SEFs, some of which will have hastily assembled their platforms in order to be compliant. The on-boarding process will be rushed for participants in order to generate needed liquidity at the Oct. 2 starting point.

“For some of our members who have decided that they’re going to connect to each one of the platforms that’s available, they’re going to need this unique coding and connectivity to these new platforms,” Nevins says. “That’s a lot of work in a very short period of time.”Those who don’t want to connect to each venue will have to decide quickly which SEFs they want to work with, and they still need to hurry the coding and connection of pipes to the SEFs.

But two can play the footnote game.  Today Bloomberg reports that the banks have found a footnote in the rule that allows them to shelter some trades from the SEF execution mandate.  Footnote 513.  (The number itself should give an indication of how bloated and complex the rule is.)

Wall Street, trying to preserve profits from swap trading in the face of tougher scrutiny from Washington, has found a new way to keep some of its overseas deals private. It’s called Footnote 513.

Banking lawyers have seized on the wording of the footnote, contained in an 84-page policy statement issued in July by the main U.S. regulator of derivatives. The largest banks told swap brokers in late September that the language means certain swaps still don’t fall under the agency’s new trading rules, according to three people briefed on the discussions.

London-based ICAP Plc (IAP), one of the largest swap brokers, told the banks it didn’t agree with their interpretation, said the people, who spoke on condition of anonymity because the discussions weren’t public. Other brokers accepted the banks’ position and have been trading billions of dollars in contracts outside the new regulatory system, the people said.

The deals in question include swaps for foreign clients that are arranged by U.S.-based traders or brokers and then booked through a U.S. bank’s overseas affiliate. Bank lawyers say that if the trade goes through an affiliate it can stay private and doesn’t need to be handled on one of the public electronic trading platforms approved by the Commodity Futures Trading Commission, two people said.

Other than lawyers, who thinks this Duel of Footnotes is anyway to run a railroad?  (I know, I know: most lawyers think this is stupid too.  It’s just that they’ll be about the only ones that profit from it.)

And remember it’s not just footnotes.  It’s commas too.  As I wrote about a year ago, the decision overturning the CFTC’s position limit rule hinged in part on the placement of commas.

The whole structure is still under construction, and it is already requiring a plethora of ad hoc fixes, in the form of exemptions and no action letters, which Commissioner Scott O’Malia trenchantly criticized.

And it’s not just in the US.  The rules and paperwork are metastasizing in Europe too.  As one commentator puts it, “Regulation descends into a Kafkaesque bureaucracy.”  Yeah.  This will work.  Especially when their Kafkaesque bureaucracy clashes with our Kafkaesque bureaucracy.  Kafka squared. Woot!

And it’s not just derivatives.  It’s hedge funds.  And I could go on.

The hedge fund article also points out something I’ve been hammering on for years now: perversely, since compliance costs have a huge fixed cost element, the regulatory onslaught creates scale economies that favor concentration and consolidation, and which can potentially reduce competition.  You are seeing it in hedge funds.  You are seeing it in banking.  You are seeing it in FCMs.

And I do mean perverse, because among the ostensible purposes of these regulations were mitigating the too big to fail problem, and promoting competition.  The dramatic increase in regulatory overhead that favors the big over the small is completely at odds with these purposes.

Moreover, don’t forget another point that I’ve made.  These rules are systemic in nature, in the sense that they affect myriad financial market participants, and in pretty much the same way.  Meaning that if one of the rules is fatally flawed, it could lead to a serious systemic problem.

Which raises the question: what footnote-or what comma-in what rule will create a future crisis?  Perhaps that’s a little hyperbolic, but not outrageously so.

Linking to a speech by Benoit Coeuré of the ECB (who gave the keynote at the Paris conference I spoke at a month ago), ISDA’s Derivativiews blog points out how the reporting of derivatives transactions has been totally botched due to jurisdictional fragmentation:

Mr. Coeuré asks an important question about transparency in his speech: “Does…the supervisor responsible for the supervision of a large cross-border financial institution at a consolidated level have direct and immediate access to information on OTC derivatives transaction that encompass all transactions entered into by all entities of this group? Is the information accessible, in other words can it be easily aggregated across trade repositories and jurisdictions?”

He then goes on to say: “My answer would be a clear no!”

And we agree.

Mr. Coeuré went on to discuss privacy laws, blocking statutes and indemnification clauses in several jurisdictions which restrict access to the detail of OTC derivatives transactions; the inability to aggregate data across trade repositories and jurisdictions; and differences in the type and level of information required for reports across jurisdictions. He ultimately broke the problem into three main issues: information gaps, data fragmentation across trade repositories and jurisdictions and obstacles impeding authorities’ access to data.

ISDA notes that this mess was predictable, and predicted.  I agree: I was one of those who predicted this years back, based in part on my experience with attempting to create an energy data hub in 2003-2004.  Both commercial and political pressures have led to the proliferation of repositories.  Market participants and regulators have beavered away erecting a derivatives Tower of Babel, a collection of databases that serve as a barrier to the sharing of information, rather than a means of sharing information.

I would further note that there are other, deeper problems that call the entire exercise into question.  It may do more harm than good.

First, OTC derivatives represent only a subset of exposures, and therefore even if one had a single, unified database of all derivatives trades one would still have an incomplete picture of interconnections in the system as a whole.

Second, and more fundamentally,  even if regulators were to know the totality of interconnections with only a slight degree of imprecision, what could they do with that information?   The financial system is complex, and it is impossible to know how the system will react to the failure of one node (or several nodes) in that system, or even the threatened failure of some nodes.  Indeed, the actions of market participants depend on their beliefs; the stability of the system depends on how market participants behave; and the beliefs of these market participants is unknowable.  Meaning that even an accurate map of all interconnections is not sufficient to understand the susceptibility of the system to crisis: one has to know about the expectations and beliefs of market participants.

Moreover, if one views a crisis as a period when the financial system goes chaotic (in the technical sense of the term), even the slightest imprecision in measuring the state of the system (where the state includes actual interconnections/exposures and beliefs about these interconnections and the beliefs of others and beliefs about how people will act on those beliefs and on and on) means that one cannot predict how the system will behave: the defining characteristic of a chaotic system is extreme sensitivity to initial conditions, so if you measure those conditions with even the slightest error, you will not be able to predict its evolution, or its response to a shock.  Moreover, it means that one cannot predict the effect of interventions in the system when (a) the system is chaotic or on the cusp of chaos, and (b) one cannot measure the state of the system with near perfect precision.

In other words, even if the Tower of Babel problem is corrected, and one measures derivatives exposures with considerable accuracy, one can have little confidence that regulators will have the information necessary to identify an incipient systemic event, or how their interventions will affect the system.  Indeed, in crisis situations, a little knowledge can be a dangerous thing: interventions in a chaotic system based on an imprecise measurement of the state of the system, let alone an incomplete understanding of the dynamics of the system, can make things worse, not better.

This suggests that the entire enterprise of attempting to map the system is futile, and perhaps even dangerous.   This enterprise is predicated on a mechanical view, a view that characterizes the financial system as stable and predictable if you have enough information.  If instead the system is complex and on the edge of chaos, this view is completely misguided because no amount of information is enough.  Moreover, this view encourages hubris and can result in interventions that destabilize instead of stabilize.

This is the knowledge problem on krokodil.  Centralized intervention in a complex system based on imperfect knowledge is a very dangerous thing indeed.