Streetwise Professor

The BIS included a box on the September USD repo spike in a chapter to its Quarterly Review titled “Easing Trade Tensions Support Risky Assets.” The piece lays out many damning dots, but does not connect them. Let me give it a try.

In a nutshell, the BIS report says that as a result of the wind down of the extraordinary post-crisis monetary policy measures there has been a dramatic change in the funding structure in US markets. In particular, the “big four [US] banks” (which the BIS delicately–or is it cravenly?–doesn’t name) have flipped from being suppliers of repo collateral (and hence cash borrowers) to being suppliers of cash (and hence collateral borrowers). Further, other US banks are not viable competitors to the big four, nor are other potential cash suppliers such as money market funds because they have hit counterparty credit limits which have constrained their lending capacity. According to the BIS, these events has made The Big Four Banks Who Shall Not Be Named the “marginal lenders” in the repo market. And mark well: prices are set at the margin.

Further, “leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives.”

So here are the dots. Recent structural changes have given the Big Four Banks Who Shall Not Be Named a dominant position in the repo market. Their main potential competitors as suppliers of funds are constrained by size or regulation. There has been a large increase in demand for repo funding.

Not even being willing to name the banks (as if their identities are unknown), the BIS does not even draw the blindingly obvious implication of its analysis–that the Four Repo Horsemen have market power. A lot of market power. Are we supposed to believe that (out of the goodness of their hearts, perhaps) they did not exercise it? I didn’t just fall off the turnip truck.

Even the euphemism Big Four is deceptive, for in reality this group is dominated by one bank–Morgan. And of course Morgan has been loudest in its protestations that it really wanted to lend more, but just couldn’t, dammit, because of those cursed liquidity regulations.

The BIS attempts to run cover, and provide some rather lame excuses for the failure to lend more despite the high rates:

Besides these shifts in market structure and balance sheet composition, other factors may help to explain why banks did not lend into the repo market, despite attractive profit opportunities. A reduction in money market activity is a natural by-product of central bank balance sheet expansion. If it persists for a prolonged period, it may result in hysteresis effects that hamper market functioning. For instance, the internal processes and knowledge that banks need to ensure prompt and smooth market operations may start to decay. This could take the form of staff inexperience and fewer market-makers, slowing internal processes. Moreover, for regulatory requirements – the liquidity coverage ratio – reserves and Treasuries are high-quality liquid assets (HQLA) of equivalent standing. But in practice, especially when managing internal intraday liquidity needs, banks prefer to keep reserves for their superior availability.

Hysterisis? Decaying internal processes and knowledge? Staff inexperience? Complete and utter argle bargle. We’re talking overnight secured lending here, not rocket science structured finance. It’s about as vanilla a banking transaction one could imagine. And LCR provides convenient cover.

The BIS lays out a compelling case that four major institutions have market power in repo. September events in particular are consistent with the exercise of market power, and the alternative explanations are beyond lame. Yet none dare speak its name, or even raise it as a possibility. Not the BIS. Not the Fed. Not the Treasury. Despite the systemic risks this poses.

The Financial Crisis supposedly changed everything. It apparently changed nothing.

It’s impossible to turn around these days without being beset by control freaks.

Exhibit 1. Michael Bloomberg, who is running for president. Bloomberg is infamous for his desire to control everything, from what you eat to what you drive to how you defend yourself. Bloomberg thinks taxing “sugary drinks” (among other things) is a great thing, despite the regressivity of this tax, because it’s good for the poor:

And if you buy a gun do defend yourself, you’re pretty stupid–so he will take them away:

“And if you want to have a gun in your house, I think you’re pretty stupid…” – Michael Bloomberg, 2014
https://t.co/XWmcPjP4V6

— John Cardillo (@johncardillo) November 29, 2019

Pretty sure his security detail is heavily armed. But that’s the credo of his ilk: for me, but not for thee.

Bloomberg also sucks up to the world’s leading control freaks, the Chinese Communist Party. When (amazingly) confronted about this by (amazingly) a PBS interviewer, Mikey totally flacked for them:

.@MikeBloomberg tells @FiringLineShow that China's leader is addressing pollution to satisfy constituents & secure his political future.
"The Communist Party wants to stay in power in China and they listen to the public," he says. pic.twitter.com/B9SoAXJwrM

— Firing Line with Margaret Hoover (@FiringLineShow) September 27, 2019

And behold the stunning dishonesty here–the lengths to which he goes to avoid criticizing the CCP. Bloomberg wants to control the entire energy system in order to reduce the emissions of global greenhouse gases (GHG). The Chinese are building coal plants at a frenzied pace, yet when confronted on this, Bloomberg treats the Chinese coal plants as merely an issue of local particulate pollution in places like Beijing.

As an aside on this issue: the silence of the Davos Douches (control freaks all) who sucked up to Xi on this issue, and so many others involving China, is deafening.

Exhibit 2. Elizabeth Warren, reprising her “you didn’t earn that” bullshit:

It's a point I've made since my very first campaign: Nobody in this country got rich on their own. They relied on infrastructure we all paid for, employees we all paid to educate. So if you're successful, good for you—now pay it forward so everyone has a chance at success. pic.twitter.com/FAuZhggAGk

— Elizabeth Warren (@ewarren) November 29, 2019

What pretzel logic. Because you might have benefited from some public goods, you are obligated to let Lizzie decide what she will take from you in order to pay for all the non-public goods that she wants.

I have a better idea: I’ll gladly pay taxes for public goods that earn a return in excess of the cost of capital, and Lizzie can STFU.

Exhibit 3. Angela Merkel. Zere vill be NO free speech for you!:

Chancellor Merkel ?pic.twitter.com/9bsCB5W6FP

— Marcel Dirsus (@marceldirsus) November 27, 2019

Nice hand gestures there. Wonder where she picked those up?

Such a good little Ostie, ain’t she?

Exhibit 4: “Scientists”:

About 11,000 scientists call for population control in mass climate alarm https://t.co/jX7uJ5gKUv

— Bloomberg (@business) November 30, 2019

The irony of this is that those so wise in the ways of science

are obviously lecturing the developed world, which in their wisdom they apparently haven’t recognized is depopulating. Population growth is overwhelmingly concentrated in very low income Africa, the Middle East, Asia, and the Subcontinent, whose peoples (a) will never hear what these scientists are demanding, and (b) would ignore it in any event.

So what are these scientists proposing? What coercive powers will they deploy against brown people in order to achieve their vision?

No doubt Bloomberg has the answer: if they don’t submit voluntarily, kill them. You know, for their own good.

Elizabeth Warren, among other Democratic candidates, have promised to eliminate fracking in the US. The WSJ has a dialog between pro-ban and anti-ban advocates. It demonstrates just how unmoored from reality the fracking ban side is.

The anti-ban participant, Sam Ori, executive director of the Energy Policy Institute at the University of Chicago, points out that as a result of the fracking revolution, US production accounts for 8 percent of the world total, and eliminating this would dramatically increase prices:

One year after the implementation of a ban, shale-oil production would be down by more than a third. After two years, production would be down 55%. You’re talking about triple-digit oil prices and a possible global economic shock

To which the ban supporter, Kassie Siegel, director of the Climate Law Institute at the nonprofit Center for Biological Diversity, replied: What? Me worry? My magical thinking will save the day!

I think an oil-price prediction is largely a red herring, because I am not talking about banning fracking in a vacuum. My organization and others propose a fracking ban along with other smartly designed programs to speed the development and deployment of clean technologies, support local communities, and offset oil and gas price increases. Government policies that drive a rapid just transition to clean-energy technology can create the largest economic stimulus since World War II.

I’m talking about policies like accelerated clean car and truck standards that rapidly decrease oil consumption in the transport sector and moving the power sector to 100% renewable energy. Other policies like reinstating the crude-oil export ban would also counteract price increases from banning fracking and restricting the supply of oil and gas.

Well-designed government policy in other areas, like tobacco and asbestos, addresses both supply and demand. Climate policy must do the same. The barrier to this is opposition from the fossil-fuel industry, not any insurmountable economic or policy problem.

And don’t you think we need to be a little bit skeptical of anyone’s ability to accurately predict oil prices?

Unpacking this idiocy in its entirety would exhaust my time and my patience. So just a few comments.

“Well-designed government policy” and “smartly designed programs.” Such a comedian! Because we know government programs are always well-designed and smartly designed. Did I say “always”? Sorry. I meant “never.”

Case in point. The brilliant European strategy to reduce CO2 by forcing the replacement of gasoline engines with diesel. Whoops! Not only was it colossally expensive, it was a major mistake because (a) it barely affected emissions of CO2, and (b) greatly increased auto emissions of harmful particulates.

Further, since China is the largest emitter, and the largest growing emitter, of CO2, Ms. Siegel is relying upon the wise beneficence of the CCP to achieve her goals.

Need I say more?

“Accelerated clean car and truck standards that rapidly decrease oil consumption in the transport sector.” First, this is costly, not just directly in terms of replacing a huge stock of existing capital, but indirectly by forcing people to drive lower-quality automobiles. How do we know they are lower quality? Because people don’t buy them voluntarily: they have to be compelled.

Second, auto emissions are a drop in the CO2 bucket.

“Moving the power sector to 100% renewable energy.”

Excuse me a minute. I have to walk my unicorn.

OK. I’m back. One-hundred percent renewables is utterly unrealistic and enormously costly, including in terms of reliability and transmission–and fires started (in places by California) by transmission needed to support renewables generation. Fires which, by the way, emit massive amounts of CO2.

Look at Germany, which I wrote about a few days ago. They are running into a renewables wall well short of 100 percent, and have incurred massive costs (imposed on energy consumers) to get this far.

I note that Ms. Siegel doesn’t mention cement, or steel, or other industrial emitters (which put autos in the shade, btw).

Not to mention that fracking oil has f-all to do with power generation, and fracking gas that supplants coal reduces CO2 emissions.

“Other policies like reinstating the crude-oil export ban would also counteract price increases from banning fracking and restricting the supply of oil and gas.”

Yo. Einstein. We have oil and gas to export because of fracking. If we ban fracking, we’ll have no exports, and the export ban will have zero, zip, nada impact on prices.

Further, export bans reduce the price in the exporting country, but raise prices in the importing country. So I guess Ms. Siegel is an economic nationalist. I bet she looks stunning in her MAGA hat.

“And don’t you think we need to be a little bit skeptical of anyone’s ability to accurately predict oil prices?”

Yo. Von Neuman. This has nothing to do with predicting the level of oil prices. Demand curves slope down. You reduce production, prices go up. In fact, oil demand curves slope very steeply, so if you reduce production a little prices go up a lot.

Not rocket science. Just the law of demand.

And these are the brainiacs who are going to make sure that we have “well-designed” and “smartly designed” government policies.

God save us.

In the ongoing evaluation of what has been happening in the repo market, market participants have identified post-crisis regulations as a potential source of the problem. In particular, these regulations (including the Liquidity Coverage Ratio) require behemoth banks like JP Morgan and Citi to hold large amounts of reserves, and makes them reluctant to lend them out even when repo rates spike.

Having long said that the various liquidity regulations intended to prevent a recurrence of the last crisis could be the cause of a new one, I am certainly quite sympathetic to this view. However, information that is coming out now suggests another potentially complementary and aggravating factor.

In particular, reserve holdings are very concentrated:

Fed data show large banks are keeping a disproportionate amount in reserves, relative to their assets. The 25 largest US banks held an average of 8 per cent of their total assets in reserves at the end of the second quarter, versus 6 per cent for all other banks. 

Meanwhile, the four largest US banks — JPMorgan Chase, Bank of America, Citigroup and Wells Fargo — together held $377bn in cash reserves at the end of the second quarter this year, far more than the remaining 21 banks in the top 25

Moreover, the big banks have been reducing their reserves:

Analysts and bank rivals said big changes JPMorgan made in its balance sheet played a role in the spike in the repo market, which is an important adjunct to the Fed Funds market and used by the Fed to influence interest rates.
Without reliable sources of loans through the repo market, the financial system risks losing a valuable source of liquidity. Hedge funds, for example, use it to finance investments in U.S. Treasury securities and banks turn to it as option for raising suddenly-needed cash for clients.
Publicly-filed data shows JPMorgan reduced the cash it has on deposit at the Federal Reserve, from which it might have lent, by $158 billion in the year through June, a 57% decline.

Although JPMorgan’s moves appear to have been logical responses to interest rate trends and post-crisis banking regulations, which have limited it more than other banks, the data shows its switch accounted for about a third of the drop in all banking reserves at the Fed during the period.
“It was a very big move,” said one person who watches bank positions at the Fed but did not want to be named. An executive at a competing bank called the shift “massive”.
Other banks brought down their cash, too, but by only half the percentage, on average.
For example, Bank of America Corp (BAC.N), the second-biggest U.S. bank by assets, with a $2.4 trillion balance sheet, took down 30% of its deposits, a $29 billion reduction.

So . . . substantial concentrations of reserves, and declining levels of reserves. Yes, these are all potential consequences of Frankendodd. But they also are potentially symptomatic of market power and the exercise thereof.

This triggered a synapse, which led me to recall a 1993 article from the Journal of Monetary Economics by R. Glen Donaldson. Donaldson’s article was motivated by a study of the Panic of 1907, when a “cash syndicate” (led by . . . J.P. Morgan, in person and through his eponymous bank) lent to cash strapped trust companies facing depositor runs at very high rates.

Donaldson presents a model in which a spike in the need for cash by a set of market participants (trust companies facing depositor outflow, in his model) makes the funds held by a group of other institutions pivotal: these institutions face a downward sloping demand curve for their funds because of constraints on competitive suppliers of funds. The pivotal institutions supply funds (through a repo-like transaction in which they buy securities from the trusts) at a supercompetitive price (by buying the trusts’ securities at subcompetitive prices). In his model, collusion between the pivotal institutions exacerbates the rate spike.

The main implication of the model is that spikes in the demand for funds lead to spikes in interest rates that are bigger than would prevail in competitive conditions.

There is an element of non-linearity in the model, because the big suppliers’ funds are not pivotal in normal conditions, but become so when the demand becomes sufficiently large. This leads to a switch from competitive to monopoly pricing, which in turn causes a spike in rates.

I should note that the regulatory and market power stories are not mutually exclusive, and are indeed complementary. Regulatory constraints can increase the demand for funds (making it more likely that the big suppliers will be pivotal) and can reduce the supply of funds from the smaller suppliers (which lowers the threshold for the switch from competitive to monopoly pricing, and makes the demand curves for the big suppliers funds steeper, leading to a higher monopoly rate).

I therefore consider it a plausible hypothesis that market power contributed to the repo market spike, and that one channel by which regulations contributed to the spike was through its effect on market power.

How can this hypothesis be tested? Conceptually, if regulatory constraints alone caused the spike, then those in possession of large quantities of reserves (e.g., Morgan) were absolutely constrained in their ability to lend additional reserves: the difference between the repo rate and the Fed Funds rate would represent the shadow price on this regulatory constraint.

If a big bank or banks exercised market power, this constraint would not be binding.

Operationalizing this test is likely to be complex, however. Big holders of reserves will inevitably make all sorts of arguments to say that they couldn’t have lent more.

This brings to mind the California electricity crisis in 1999-2000, when generators operated below various capacity measures, but pleaded that constraints (by unplanned outages, or NOX regulations, etc.) reduced their effective capacity below these nominal capacity measures. Given the complexity of operating a power plant, it was very difficult to determine whether the generators were withholding capacity, or in fact offered as much as they were capable of doing.

Despite the difficulty of operationalizing the test, I think it is something for regulators to attempt. There is a colorable case that the repo rate rise was exacerbated by market power, and given the importance of this market, this possibility should be investigated rigorously.

As an aside, the Donaldson model appeared only a few months before my Journal of Business article on market power manipulation. The two articles have a lot in common, despite the fact that they were developed totally independently, and seemingly involve completely unrelated markets (money vs. physical commodities). However, the core arguments are similar: economic frictions can periodically create market power in markets that are usually competitive.

Hannah Arendt once wrote that “one of the greatest advantages of the totalitarian elite in the twenties and thirties was to turn any statement of fact into a question of motive.” This quote came to mind when reading Matt Stoller’s hit piece on Aaron Director on the Stigler Center’s Pro-Market blog.

Director was one of the major moving forces behind the Chicago revolution in antitrust scholarship in the 1950s and 1960s. Although he published little himself, through his teaching, and his interactions with other faculty in economics, law, and business at Chicago, Director challenged the consensus on antitrust, especially in areas like vertical restraints. The challenge that he inspired pretty much overturned this consensus, and it is fair to say that the Chicago became the replacement paradigm. A good portion of the industrial organization and antitrust scholarship of the past 50 years has been aimed at challenging the Chicago view, but nonetheless, many of its key insights remain regnant.

Stoller does not mount a serious attempt to critique Director’s actual contributions, or to explain them, as Sam Peltzman does in his two posts on Director. Rather than challenging Director and his followers on the facts, or on the analysis, Stoller instead questions Director’s motives. It is attack by ad hominem.

In Stoller’s telling, for much of his life, Director was a good progressive, and a devotee of Henry Simons. As such, he was an antimonopolist who favored aggressive antitrust enforcement. But then Simons died, and Director “suddenly” converted to a right-wing pro-business fanatic in order to appease a major funder who according to Stoller was an “extreme right-wing[er]” and quasi-fascist:

Director suddenly decided that conservative ideas were compatible with corporatism after all. Monopolies, apparently, were always created by government. At this moment, Director broke with the conservative tradition and birthed neoliberalism, the anti-government, pro-monopoly philosophy that now dominates policymaking globally. Director convinced George Stigler and Milton Friedman of the new creed. Both had opposed corporate monopolies, but flipped to support Director’s new movement. The Chicago School was born.

Thus, Director was nothing but an intellectual Judas, who sold out his firm convictions for a few pieces of silver.

This begs so many questions it isn’t funny. Take Stoller’s premise as fact. How, pray tell, did Director convince such notoriously strong minded people like Stigler and Friedman? Did he pay them off? No really–how did he persuade them?

And how did he persuade others, such as Bork, who was a major force in reshaping antitrust law? And how did the Chicago school antitrust/industrial organization ideas midwifed by Director have such a profound effect on the economics and legal academy outside of Hyde Park, and then the courts? Especially since they were initially so contrary to the professional consensus, and indeed attracted substantial (and often hysterical) opposition?

There must have been something to the ideas, eh? But not in Stoller’s telling. Instead, according to him, Harold Luhnow got his money’s worth by getting Director to turn from anti-monopolist to pro-monopolist, and somehow (mesmerism?) Director convinced myriad intellectuals (and judges) to go along.

The closest that Stoller comes to addressing any of the scholarship that Director inspired is a drive by shooting on John McGee’s Journal of Law and Economics (1958) paper that contended that, contrary to the overwhelming conventional wisdom, Rockefeller’s Standard Oil did NOT engage in predatory pricing.

Stoller refers to a paper which disputes McGee’s findings. Fine. But he is presented with the problem that, as shown by Joshua Wright, McGee’s article had far less of an impact on academic and legal thinking on predatory pricing than the 1975 Areeda-Turner article. But no problem! Just turn this question of fact into one of motive: “It didn’t hurt [Areeda-Turner’s] motivations, of course, that they were both on the payroll of IBM, which was at that moment in a bitter series of antitrust lawsuits which included, you guessed it, predatory pricing claims.”

Disgusting.

Stoller writes: “With support on the right and the left, courts soon accepted Director’s ideas, laundered through McGee, Turner, and Areeda.” Again: through what powers of mind control did Director get “liberal Democrats” from Harvard to launder his dirty ideas? Inquiring minds want to know!

But Stoller’s distortion of history doesn’t end here. His explanation for the rationality of predatory pricing goes like this:

Contra Director’s logic, predatory pricing is quite rational. A competitor to a corporate goliath can’t borrow an infinite amount of money to lose until prices come back, nor can a competitor just shut down until prices go back up. No bank would lend to a competitor of Standard Oil, just as no one today will lend to a retailer competing to lose money against Amazon. 

Wow. That logic sounds familiar! Yes, I remember now: in 1966 one of my thesis advisors, Lester Telser (a contemporary of McGee’s in the PhD program at Chicago), published an article titled “Cutthroat Competition and the Long Purse” which explored that very same logic.

It gets better.

Lester’s article was published in what Stoller portrays as the main vehicle for Director’s malign influence: the Journal of Law and Economics. Better yet, Telser thanks Director for his input. Better yet: Telser’s article was published in an issue honoring Director, on the occasion of his retirement from Chicago and editorship of the JLE.

Of course, you would never know this, if you read Stoller. Stoller also fails to mention that Sam Peltzman told an anecdote regarding Director and predatory pricing in a JLE article on “Aaron Director’s Influence on Antitrust Policy,” published as a sort of obituary at the time of Director’s death in 2004. In Sam’s telling, Director, in his typical Socratic style, led his students through an analysis of predatory pricing . . . in which he concluded that the defendant in a predatory pricing case “most likely was guilty as charged.”

It is particularly astounding that Stoller should overlook this anecdote, given that it was republished on the very same Pro-Market website. So it’s not like Stoller had to, I dunno, get onto JStor and do some real research on whom he was supposedly analyzing.

Stoller also fails to acknowledge that Director’s alleged ability to mesmerize did not even extend to nearby offices at the University of Chicago Law School: Richard Posner, for example, acknowledged that predation could occur.

Stoller also evidently has no clue as to how academia works. Provocative articles like McGee’s inevitably spur others to challenge it. And indeed, there have been numerous articles over the years that identify conditions in which predation can work. As it turns out, however, the conditions are much more fragile than Stoller lets on.

In sum, Stoller’s post on Director is an appalling piece of work. It fails to join Director’s actual work, and relies on vicious ad hominem to discredit the work which he does not like by attempting to discredit the motives of the person.

I don’t really give a damn about Matt Stoller. What I do find especially disgusting is that the Stigler Center at the Booth School of Business would lend its imprimatur to a piece that violates the fundamental norms and ethics of scholarship. If Pro-Market wanted to provide a critical view of Director, the Chicago School of antitrust has a lot of serious critics who could analyze his work and the work that he inspired. Instead, Pro-Market provides a platform for an intellectually disreputable attack on alleged motives, and one that provides no substantial evidence for its central claim, and which begs so many questions as to be self-refuting.

Appalling, and an affront to the long tradition of economics and law at Chicago.

The most contentious battle in American securities markets right now is being waged over exchange pricing of data, in particular over proprietary order book feeds. The battle pits the exchanges against market users (e.g., HFT firms, institutional traders) with the latter claiming that the prices charged by the former border on the extortionate.

The critics actually have a very good point. The economics of the situation imply that the prices the competing exchanges charge are ABOVE the price a monopoly would charge.

No. Really.

So how could competing firms charge a supra-monopoly, let alone supra-competitive, price? The answer to this question is something pointed out by the first true mathematical economist, Augustin Cournot, in his Principes Mathematique, published in 1838. In that book, Cournot laid out “the problem of complements.” Cournot showed that imperfectly competitive firms overprice complementary goods. (Cournot’s example involved zinc and copper in the production of brass. They are complements used in fixed proportion.)

The basic issue is that when goods are complements, if firm A raises its price firm B that produces a complement to A’s good cannot steal sales from A by cutting its price (as would be the case of A’s and B’s goods were substitutes). This reduces the incentive to cut price, and actually provides an incentive to increase prices in order to get a bigger piece of the surplus that is generated when the consumer buys both goods.

This situation fits the stock market case perfectly. Execution services on US exchanges (e.g., NYSE, BATS) are substitutes, but data services are complements.

Consider an HFT firm. One source of profits for this firm is to exploit price discrepancies across exchanges. This requires having near immediate and simultaneous access to prices across all exchanges. Or consider a buyside firm that is trying to minimize execution costs by a clever order routing strategy. Optimizing the allocation of orders across exchanges requires knowing the order book on all the exchanges.

In other words, there are many market participants who have to collect the entire set (of exchange data). This makes the data provided by competing exchanges complements, which by the Cournot logic, forces prices above the competitive level, and indeed, above the monopoly level.

Furthermore, the problem becomes worse, the larger number of exchanges. This is a situation in which lower concentration leads to less competitive outcomes. (Robin Hansen made a similar point recently.)

This is yet another example of the only law that is never repealed: the law of unintended consequences. The intent of RegNMS was to increase competition in the execution of stock trades, and it has done a marvelous job of that. However, the unintended effect of this “fragmentation” (i.e., the increase in the number of execution venues and decline in concentration across exchanges) has been to create and exacerbate a complements problem in data.

A couple of final points. Perhaps one could make a second-best argument here: low execution fees and high data fees may be a good way of covering the fixed costs of operating exchanges (a la Ramsey pricing). Perhaps, but unproven.

What is the right regulatory response? Not clear. I addressed similar conundrums in my 2002 Market Macrostructure article. Natural monopoly-style/pricing regulation could mitigate the overpricing problem, but entails its own costs (e.g., undermining incentives to innovate). The issue is particularly challenging here because efficiency-enhancing competition on one dimension (execution) leads to inefficient problems-of-complements competition on another (data).

As I argued in Market Macrostructure, it really comes down to an issue of property rights. Should exchanges have exclusive ownership of their data? Should this ownership be attenuated in some way, such as limitation on prices, or a required pooling of data that would be sold by a monopolist, with revenues shared by the exchanges? Here is a case where a monopoly would actually improve outcomes.

Maybe that is the way to split the baby, politically. Exchanges would get rents, but efficiency would be improved. Not a first-best solution, but maybe a second best one, and one that could represent a Coasean bargain between exchanges and their customers. And perhaps the regulator–the SEC–could help facilitate and coordinate that deal.

In the Gilded Age, American financial crises (“panics,” in the lexicon of the day) tended to occur in the fall. Agriculture played a predominant role in the economy, and marketing of the new crop in the fall led to a spike in the demand for cash and credit. In that era, however, the supply of cash and credit was not particularly elastic, and these demand spikes sometimes turned into panics when supply did not (or could not) respond accordingly.

The entire point of the Fed, which was created in the aftermath of one of these fall panics (the Panic of 1907, which occurred in October), was to make currency supply more elastic and thereby reduce the potential for panics. In essence, the Fed had one job: lender of last resort to ensure a match of supply and demand for currency/credit, when the latter was quite volatile.

This week’s repospasm is redolent of those bygone days. Now, the spikes in demand for liquidity are not driven by the crop cycle, but by the tax and corporate reporting cycles. But they recur, and several have occurred in the autumn, or on the cusp thereof (this being the last week of summer).

One of my mantras in teaching about commodities is that spreads price bottlenecks. Bottlenecks can occur in the financial markets too. The periodic spikes in repo rates–not just this week, but in December, and March–relative to other short term rates scream “bottleneck.” Many candidates have been offered, but regardless of the ultimate source of the clog in the plumbing, the evidence from the repo market is that there are indeed clogs, and they recur periodically.

The Fed’s rather belated and stumbling response suggests that it is not fully prepared to respond to these bottlenecks, despite the fact that their regularity suggests that the clogs are chronic. As the saying goes, “you had one job . . . ” and the Fed fell down on this one.

And maybe the problem is that the Fed no longer just has one job, and it has shunted the job that was the reason for its creation to the back of the priority list. Nowadays, the Fed has statutory obligations to control employment and inflation, and views its main job as managing aggregate demand, rather than tending to the financial system’s plumbing.

This is concerning, as dislocations in short-term funding markets can destabilize the system. These markets are systemically important, and failure to ensure their smooth operation can result in crises–panics–that undermine the ability of the Fed to perform its prioritized macroeconomic management task.

One of the salutary developments post-crisis has been the reduced reliance of banks and investment banks on flighty short-term funding. The repo markets are far smaller than they were pre-2008, and the unsecured interbank market has all but disappeared (representing only about .3 percent of bank assets, as compared to around 6 percent in 2006). But this is not to say that these markets are unimportant, or that bottlenecks in these markets cannot have systemic consequences. For the want of a nail . . . .

Moreover, the post-crisis restructuring of the financial system and financial regulation has created new potential sources of liquidity shocks, namely a supersizing of potential demands for liquidity to pay variation margin. When you have a market shock (e.g., the oil price shock) occurring simultaneously with the other sources of increased demand for liquidity, the bottlenecks can have very perverse consequences. We should be thankful that the shock wasn’t a Big One, like October, 1987.

Hopefully this week’s tumult will rejuvenate the Fed’s focus on mitigating bottlenecks in funding markets. Maybe the Fed doesn’t have just one job now, but this is an important job and is one that it should be able to do in a fairly routine fashion. After all, that job is what it was created to perform. So perform it.

The primary reason for my deep skepticism about the wisdom of clearing mandates was liquidity risk. As I said repeatedly, in order to reduce counterparty risk, clearing necessarily increased liquidity risk through the variation margining mechanism. Further, it was–and is–my opinion that liquidity risk is a far graver systemic concern that counterparty risk.

A major liquidity event has occurred in the last couple of days: rates in the repurchase market–the major source of short term funding for vast amounts of trading activity–shot up to levels (around 5 percent) nearly double the Fed’s target ceiling for that rate. Some trades took place at far higher rates than that (e.g., 9.25 percent).

Market participants have advanced several explanations, including big cash demands due to corporate tax payments coming due. Izabella Kaminska at FTAlphavile offered this provocative alternative, which resonates with my clearing story: the large price movements in oil and fixed income markets in the aftermath of the attack on the Saudi resulted in large margin calls in futures and cleared OTC markets that increased stresses on the funding markets.

To which one might say: I sure as hell hope that’s not it, because although there was a lot of price action yesterday, it wasn’t The Big One. (The fact that Fred Sanford’s palpitations occurred because he couldn’t get his hands on cash makes that bit particularly apropos!)

I did some quick back-of-the-envelope calculations. WTI and Brent variation margin flows (futures and options) were on the order of $35 billion. Treasuries on CME maybe $10 billion. S&P futures, about $1 billion. About $2 billion on Eurodollar futures.

The Eurodollar numbers can help give a rough idea of margin flows on cleared interest rate swaps. Eurodollar futures open interest is about $12 trillion. Cleared OTC notional volume (not just USD, but all IRS) is around $80 trillion. But $1mm in notional of a 5 year swap is equivalent to 20 Eurodollar futures with notional amount of $20 trillion. So, as a rough estimate, variation margin flows in the cleared IRS market are on the order of 100x for Eurodollars. That represents a non-trivial $200 billion.

Yes, there are potentials for offsets, so these numbers are not additive. For example, a firm might have offsetting positions in EDF and cleared IRS. Or be short oil and long Treasuries. But variation margin flows on the order of $300 billion are not unrealistic. And since market moves were relatively large yesterday, that represents an increment over the typical day.

So we are talking real money, which could certainly contribute to an increased demand for liquidity. But again, yesterday was not remotely a truly epic day that one could readily imagine happening.

A couple of points deserve emphasis. The first is that perhaps it was coincidence or bad luck, but the big variation margin flows coincided with other sources of increased demand for liquidity. But hey, stuff happens, and sometimes stuff happens all at once. The system has to be able to withstand such simultaneous stuff.

The second is related, and very concerning. The spikes in rates observed periodically in the repo market (not just here, but notoriously in China) suggest that this market can go non-linear. Thus, even if the increased funding needs caused by the post Abqaiq fallout wasn’t The Big One, in a non-linear market, even modest increases in funding needs can have huge impacts on funding costs.

This highlights another concern: inter-market feedback. A shock in one market (e.g., crude) puts stress on the funding market that leads to spikes in repo rates. But these spikes can feedback into prices in other markets. For example, if the inability to fund positions causes fire sales that cause big price moves that cause big variation margin flows which put further stress on the funding markets.

Yeah. This is what I was talking about.

Today’s events nicely illustrate another concern I raised years ago. Clearing/margining make markets more tightly coupled: the need to meet margin calls within hours increases the potential stress on the funding markets. As I tell my classes, unlike in the pre-Frankendodd days, there is no “fuck you” option when your counterparty calls for margin. You don’t pay, you are in default.

This tight coupling makes the market more vulnerable to operational failings. On Black Monday, 1987, for example, the FedWire went down a couple of times and this contributed to the chaos and the potential for catastrophic failure.

And guess what? There was a (Fed-related!) operational problem today. The NY Fed announced that it would hold a repo operation to supply $75 billion of liquidity . . . then had to cancel it due to “technical difficulties.”

I hate it when that happens! But that’s exactly the point: It happens. And the corollary is: when it happens, it happens at the worst time.

The WSJ article also contains other sobering information. Specifically, post-crisis regulatory “reforms” have made the funding markets more rigid/less-flexible and supple. This would tend to exacerbate non-linearities in the market.

We’re from the government and we’re here to help you! The law of unintended (but predictable) consequences strikes again.

Hopefully things will normalize quickly. But the events of the last two days should be a serious wake-up call. The funding markets going non-linear is the biggest systemic risk. By far. And to the extent that regulatory changes–such as mandated clearing–have increased the potential for demand surges in those markets, and have reduced the ability of those markets to respond to those surges, in their attempt to reduce systemic risks, they have increased them.

I have often been asked what would cause the next financial crisis. My answer has always been: the regulations intended to prevent a recurrence of the last one. Today may be a case in point.

ICE is on the verge of launching Bitcoin futures. The official start date is 23 September.

The ICE contract is distinctive in a couple of ways.

First, it is a delivery settled contract. Indeed, this feature is what made the ICE product so long in coming. The exchange had to set up a depository, the Bakkt Warehouse. This required careful infrastructure design and jumping through regulatory hoops to establish the Bakkt Trust Company, and get approval from the NY Department of Financial Services.

Second, the structure of the contracts offered is similar to that of the London Metal Exchange. There are daily contracts extending 70 days into the future, as well as more conventional monthly contracts. (LME offers daily contracts going out three months, then 3-, 15-, and 27-month contracts). The daily contracts settle two days after expiration, again similar to LME.

The whole initiative is quite fascinating, as it represents a dual competitive strategy: Bakkt is simultaneously competing in the futures space (against CME in particular), and against spot crypto exchanges.

What are its prospects? I would have to say that Bakkt is a better mousetrap.

It certainly offers many advantages as a spot platform over the plethora of existing Bitcoin/crypto exchanges. These advantages include ICE’s reputation, the creation of a warehouse with substantial capital backing, and regulatory protections. Here is a case in which regulation can be a feature, not a bug.

Furthermore, for decades–over a quarter-century, in fact–I have argued that physical delivery is a far superior mechanism for price discovery and ensuring convergence than cash settlement. The myriad issues that were uncovered in natural gas when rocks were overturned in the post-Enron era, the chronic controversies over Platts windows, and the IBORs have demonstrated the frailty, and vulnerability to manipulation of cash settlement mechanisms.

Crypto is somewhat different–or at least, has the potential to be–because the CME’s cash settlement mechanism is based off prices determined on several BTC exchanges, in much the same way as the S&P500 settlement mechanism is based on prices determined at centralized auction markets.

But the crypto exchanges are not the NYSE or Nasdaq. They are a rather dodgy lot, and there is some evidence of manipulation and inflated volumes on these exchanges.

It’s also something of a puzzle that so many crypto exchanges survive. The centripetal forces of liquidity tend to cause trading in a particular instrument to gravitate to a single platform. The fact that this hasn’t happened in crypto is anomalous, and suggests that normal economic forces are not operating in this market. This raises some concerns.

Bakkt potentially represents a double-barrel threat to CME. Not only is it competing in futures, if it attracts a considerable amount of spot trading activity (due to a superior trading, clearing, settlement and custodial platform, reputational capital, and regulatory safeguards) this will undermine the reliability of CME’s cash settlement mechanism by attracting volume away from the markets CME uses to determine final settlement prices. This could make these market prices less reliable, and more subject to manipulation. Indeed, some–and maybe all–of these exchanges could disappear if ICE’s cash market dominates. CME would be up a creek then.

That said, one of the lessons of inter-exchange competition is that the best mousetrap doesn’t always win. In particular, CME has already established liquidity in the futures market, and as even as formidable competitor as Eurex found out in Treasuries in the early-oughties, it is difficult to induce a shift of liquidity to a competitor.

There are differences between crypto and other more traditional financial products (cash and derivatives) that may make that liquidity-based first mover advantage less decisive. For one thing, as I noted earlier, heretofore cash crypto has proved an exception to the winner-takes-all rule. Maybe the same will hold true for crypto futures: since I don’t understand why cash has been an exception to the rule, I’d be reluctant to say that futures won’t be (although CBOE’s exit suggests it might). For another, the complementarity between cash and futures in this case (which ICE is cleverly exploiting in its LME-like contract structure) could prove decisive. If ICE can get traction in the fragmented cash market, that would bode well for its prospects in futures.

Entry into a derivatives or cash market in competition with an incumbent is always a highly leveraged bet. Odds are that you fail, but if you win it can prove enormously lucrative. That’s essentially the bet that ICE is taking in BTC.

The ICE/Bakkt initiative will prove to be a fascinating case study in inter-exchange competition. Crypto is sufficiently distinctive, and the double-barrel ICE initiative sufficiently innovative, that the traditional betting form (go with the incumbent) could well fail. I will watch with interest.

In the aftermath of the El Paso and Dayton shootings, “red flag” rules are all the rage. Identify people who are at high risk of committing such atrocities, and prevent them from buying weapons.

Most of the arguments in favor of this rely on statements like “many mass shooters have characteristic X (e.g., mental illness), so let’s prevent those with characteristic X from buying guns.” As appealing as these arguments sound, they founder due to a failure to understand fundamental probability concepts which imply that for extremely rare events like mass shootings, red flags are extremely unreliable.

Most of the arguments in favor of red flags rely on estimates of P(X|M), i.e., the probability that someone who committed a mass murder (“M“) had characteristic X. For example, “70 percent of mass shooters present evidence of mental illness.” Or Y percent play violent video games or post racist rants online.

But what we really need to know in order to implement red flags that do not stigmatize, and deny the rights of, people who present a low risk of committing a mass shooting is P(M|X): “what is the probability that someone with characteristic X will commit a mass shooting?” Although most people argue as if P(X|M) and P(M|X) are interchangeable, they are not, as Thomas Bayes demonstrated in the 18th century when he demonstrated something now called Bayes’ Theorem.

As Bayes showed, P(M|X)=P(X|M)P(M)/P(X) where P(M) is the unconditional probability someone is a mass shooter, and P(X) is the unconditional probability that someone has characteristic X.

The problem with attempting to determine whether someone with X poses a risk is that mass shooters are extremely rare, and hence P(M) is extremely small.

USA Today estimated there were 270 odd mass shootings between 2005 and 2017. A Michael Bloomberg-funded anti-gun group counts 110. Given a population of around 300 million, even using the higher number a rough estimate of P(M) is 9e-7: a 9 with six zeros in front of it. Therefore, even if P(X|M)=1 (i.e., all mass shooters share some characteristic X) , for any characteristic X that occurs fairly frequently in the population P(M|X) is extremely small.

Consider a characteristic where there is fairly good data on on P(X): schizophrenia. It is estimated that 1 percent of the population is schizophrenic. Plugging .01 for P(X) gives a value of P(M|X) of 9e-5, or about 1 out of 10,000. Meaning that the likelihood a random schizophrenic will commit a mass shooting is .001 percent.

This actually overstates matters, because P(X|M)<1. Indeed, since mass shootings are in fact quite heterogeneous, P(X|M) is likely to be far less than one for most characteristics.

Things get even worse if one broadens the scope of the characteristic used to define the red flag. If instead of using schizophrenia, one uses serious mental illness, by some measures P(X)=.2. Well, if you increase the denominator by a factor of 20, P(M|X) falls by a factor of 20. So instead of a probability of .001 percent, the probability is .00005 percent.

And again, that is an exaggeration because it assumes P(X|M)=1.

Meaning that putting a red flag on schizophrenics or those who have experienced some mental illness will be vastly overinclusive.

Of course, life is a matter of trade-offs. One must weigh the costs imposed on those who are wrongly stigmatized (“false positives”) with the benefit of reducing mass shootings by imposing restrictions based on an overinclusive, but at least somewhat informative signal (i.e., a signal with P(X|M)>0).

For some there is no trade-off at all. For those primarily on the left who believe that guns are an anathema and have no benefit whatsoever, even a 99.99995 percent false positive rate is not at all costly. However, a very large number of Americans do think bearing arms is beneficial, these false positives come at a high cost.

That’s where the debate should really focus: the rate of false positives and the cost of those false positives vs. the benefits of true positives (which would represent mass shootings avoided). What Bayes’ Theorem implies is that for an act that someone is extremely unlikely to commit, that false positive rate is likely to be extremely high. It also implies that debating in terms of P(X|M) provides very little insight. P(M) is small, and for any fairly common characteristic, P(X) is fairly large, so P(X|M) has relatively little impact on the rate of false positives.

Again, what Bayes’ Theorem tells us is that for a rare event like mass shooting, vastly more innocent people than true risks will be red flagged. The costs of restricting those who pose no risk must be weighed against the benefits of reducing modestly the risk of a very rare event. Further, it must be recognized that implementing red flag rules are costly, and in these costs should be included the invasions of privacy that they inevitably entail. Yet further, red flag rules are certain to be abused by those with a grudge. And yet further, many of those with characteristic X will escape detection, or will be able to evade the legal restrictions (and indeed have a high motivation to do so).

In the aftermath of mass shootings, there is a hue and cry to do something. The hard lesson taught by Parson Bayes is that there is not a lot we can do. Or put more precisely, those things that we can do will inevitably stigmatize and restrict vastly more innocent people than constrain malign ones.