Streetwise Professor

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.

The latest extra-legal, ad hoc attempt to stave off the cataclysmic consequences of Obamacare, and the utterly inept implementation thereof, is quite something to behold.  Because the vaunted Healtcare.gov website does not incorporate a payment function (such an exotic concept, I know) and because insurers are receiving so much bad information, it is likely that a pathetically small fraction of the pathetically small number of individuals who have run the gauntlet to complete an application will actually pay their premiums in time to be covered by 1 January, 2014.  To avoid the catastrophe of large numbers of individuals finding themselves uncovered in the new year, the administration is “strongly encouraging” (euphemism alert!) insurers to play claims on policies that have not been paid for.  Moreover, since there is mounting concern over access to physicians, the administration is also “strongly encouraging” insurers to pay claims for physicians and hospitals that are not in the networks associated with the policies the insurers have issued. Furthermore, there is further “strong encouragement” that insurers pay to renew prescriptions that are not covered under existing policies.

With respect to the paying claims on unpaid-for policies, the administration is essentially enforcing insurers to extend credit in a business that does not normally extend credit.  In private insurance markets, policies doe not come into effect until premiums are paid.  Given that a good fraction of those on exchanges are likely not to be very creditworthy, this exposes insurers to the risk of substantial credit losses.  Since the policies were priced on the presumption that they did not embed credit, insurers are exposed to losses for which they will not be paid.

Are insurers to be compensated for the inevitable credit losses?  By whom? The Federal Government?  If so-has such compensation been duly authorized by Congress?  (Rhetorical question.)  If Congress hasn’t authorized it, where is the money going to come from?

If not-is this diktat not an unconstitutional taking of the property of insurers?  Does it not compel them to provide services without compensation?

Similarly, insurers designed policies, physician and hospital networks, and premiums to trade-off costs and benefits.  To economize on premiums, they limited network access.  Forcing them to provide costly access to a broader network, but not permitting changes in premiums, is yet another taking

In other words, Sebelius is trying to play Santa Claus, but in so doing, is running afoul of the Takings Clause.  The property of private insurers is being taken without compensation. They are being forced to provide valuable things (credit, access to a broad physician network, prescription coverage) for which they are not being paid.  All to shield the administration from the catastrophic consequences of the baked-in defects of Obamacare, and its comical incompetence in implementing it.

The lawlessness of this administration, especially when it comes to Obamacare, is quite beyond belief.

A friendly bit of advice.  If you are on a flight originating in the EU, and the flight is delayed more than two hours, the airline owes you cash compensation.  If the flight is delayed or cancelled, and you arrive at your destination more than 4 hours after schedule, for flights over 3500 km you are owed 600 Euros, or nearly a cool $1000 at the current exchange rate.  Lesser compensation is due for shorter flights, or smaller delays.

I was on a United flight from Amsterdam to Houston that was cancelled.  I called United to demand my compensation, and they were very, very responsive as soon as I mentioned the EU regulation.

Not that they advertise it, mind you.  I overhead another passenger mention it when we were deplaning upon arrival at IAH.  Per these regulations, the airline is supposed to apprise you of your rights.  But United didn’t in this instance.   So I’m performing a public service by letting you know what is due you.  If they do to you what they did to me and 100+ of my newest friends on Sunday, make the bastards pay.  I only request a 10 percent gratuity, to show your appreciation 😉

Unfortunately, it just works on flights originating in the EU, or airlines registered in the EU.  I had a Dulles-Geneva United flight cancelled in September, for which I get bupkus.  Which made the collecting the 600 Euros all the sweeter this time around.

According to sources quoted by the WaPo, that is.  That’s appalling.

Not that the administration is telling us.  Indeed, it’s blaming you, silly website user person.  You had the termity to hit the back button when the f*cking website didn’t respond the way you’d expected, you know, like the way www.amazon.com or even freaking www.pets.com perform.

No, they’re telling us the website is feeling better! It doesn’t want to go on the cart!

Oh, if only we had one boon worker with a truncheon to put it out if its misery. And put us out of the misery it’s inflicted on us.

The administration is declaring victory in the battle to fix Healtcare.gov.  I declare BS.

Note the metric of success: the administration claims 100K people have “selected plans.”  Never mind that this is 1/8th of the target by 12/1.  The question, framed in futures-speak, is: How many out-trades?

An out-trade is where a buy is not matched by a sell.  Since the backend that communicates information from users to insurers isn’t fixed-and some parts aren’t even built yet-and since there are also bottlenecks in communications between the government and insurers and users regarding eligibility for and amount of subsidies, the number of actual matched buys-and-sells is a fraction of the 100K.  How big a fraction?  Don’t look to the administration for answers.

No, don’t look to them, because they are in full obfuscation mode.  They are engaging in a Potemkin Village strategy.  They are pointing to the newly spruced up facade of the Healthcare.gov system-the user interface, which is now less crappy than it used to be (a very low standard, indeed)-and saying: “See! Look! It is fixed!  Isn’t it beautiful?  The procession can now move on!”  The hidden message: “Pay no attention to the fact that behind the somewhat improved facade, your personal information necessary actually to match you with an insurer so you can actually buy the policy may well be screwed up, or not get to the insurer, or just disappear into the ether.”

Out-trades are messy, costly, and risky: the biggest problem is that you don’t know your risk position because you don’t know whether you have a trade or not.

It is reasonable to surmise, based on what insurers are saying, that the number of out-trades is substantial, and is only likely to increase both absolutely but also as a fraction of applications, as more traffic moves to the site.

The web interface is not the deal.  That is just the facade of PotemkinVillage.gov.  Behind it is nothing, or ramshackle construction.  Sort of like this village in Siberia that adopted the Potemkin strategy in anticipation of a visit by Putin.

And that’s not the worst of it.  Behind that, assuming everything gets working, is a set of horrid, expensive policies.

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.

Obama gave one of his rare press conferences to announce his alleged “fix” of the insurance cancellation problem.  Short version: “It’s broken, and I’m going to break it some more, and crank up the chaos while I do it.”

It was quite the performance.  Arrogance and condescension and displays of bruised ego all intended to distract attention from rank incompetence and hubris. Reading the transcript is quite illuminating.  The incoherence (replete with gibberish, double negatives, etc.) is plainly evident in black-and-white.

The are too many highlights (by which I mean lowlights) to do them all justice.  I’ll just pick one: “What we’re also discovering is that insurance is complicated to buy.”

This, of course, from the president who didn’t want a chart depicting Obamacare to be created because, you know, political opponents would use it to claim that Obamacare is really complicated and stuff.

Obama and Obamacare are going to put scads of satirists out of work, because who can compete?  Obama wants to outlaw self-insurance (eventually): if he outlawed self-satire he’d be looking at 99 to life.

Today Obama allegedly announced a “fix” to the insurance cancellation problem.  His alleged fix is that he will issue a ukase permitting insurance companies to violate the law that is commonly referred to by his name by restoring (or not canceling) policies that do not conform to the ACA requirements.

I guess since it’s “his” law, with his name on it and everything, he can change it at a whim or something.  Lesley Gore should come back and record “It’s my law that I’ll change if I want to, change if I want to.”

So much for the faithfully execute the laws thing: did Obama teach that when he lectured about Constitutional law at Chicago?  Or maybe there’s a secret annex to the Constitution that permits the president to suspend the law if it’s politically inconvenient, or he just feels like it.  Maybe they tell the president about it right before inauguration, when they tell him about the secret nuclear codes.  Funny that no other president seemed to be as familiar with this annex as Obama.

But even overlooking the illegality of the actions, what about the practicality? In fact, his ukase is obviously wholly impractical.  Insurance companies, state regulators (which just tells us that there are other Constitutional issues here, namely federalism), and individuals have all made changes and adjustments predicated on the assumption that the ACA would be implemented as written.  Silly insurance companies.  Silly regulators.  Silly individuals.  But having been silly, it is utterly impossible for them to restore the status quo ante.

In essence, Obama has ordered that toothpaste be put back into the tube.  It can’t happen and it won’t happen.

At which time Obama will turn on the insurance companies, and blame them.  You can see this coming a mile away.

Not that that will help one individual who has lost coverage and can’t get it back.  But Obama really doesn’t care about that.  He is all about limiting the political damage.

Perhaps some insurance companies will challenge this in court, but I doubt it.  They know that the administration can-and will-punish them if they have the temerity to fight back.

It is hard to have too much sympathy for the insurers.  They made their bed, and they can’t really complain about what’s being done to them in it.

Unfortunately, millions of Americans will pay for  the corrupt bargain between insurers and the administration (and Congress).  These are the wages of corporatism.

I wrote quite a while ago.  Obamacare delenda est. Now more than ever.  This is the only fix.

The CFTC has released its new position limits proposed rule.  It is an improvement on the earlier version, but still lacks a serious logical and empirical basis, try as the agency might to muster up a justification.

It is an improvement primarily for two reasons.  First, it has more sensible aggregation standards.  Whereas in the 2011 proposed rule, an entity would have to aggregate positions in every entity of which it had a 10 percent or greater stake in order to determine its overall position for the purpose of determining compliance with the limit, now that threshold has been increased to a more reasonable 50 percent.

Second, the new proposal does not include “class limits”.  Under the 2011 rule, swaps and futures were treated as different classes, and long positions in one class were not offset against economically equivalent short positions in the other.  Thus, a firm could have a zero economic exposure because a swap position was offset by an equivalent futures position, but it could be in violation of the position limit.  This made no economic sense, and was likely a surreptitious way of hamstringing swap dealers’ ability to enter into transactions with the massive passives who bother Chilton (and Gensler) so much.  Along with many others, I submitted comments criticizing this approach, and lo and behold, it has disappeared.  Now position limits are based on net exposures, meaning that a swap dealer can hedge a swap entered into with a customer using futures, in any quantity, without falling afoul of the position limit rule.

Unfortunately, not all nonsensical features of the 2011 proposal have vanished along with the class limits.  Most notably, the 2013 proposal not only includes, but extends the scope of, the “conditional limit” on positions held during the last 5 days of the a contract month.  Under this provision, the limit on delivery-settled contracts during the last 5 days is 25 percent of the deliverable supply, but the limit on otherwise identical cash-settled contracts is 5 times larger (i.e., 125 percent of deliverable supply).

As I commented in 2011-based on a paper I published in the Journal of Business in 2000-this makes no economic sense.  A trader that is long a delivery settled contract can manipulate by standing on excessive deliveries, thereby effectively buying up too much of the deliverable supply.  But a trader that is long a cash-settled contract can have the same price impact by buying the same quantity in the cash market.  Under the conditional limit rule, the holder of the cash-settled contract can get 5 times the benefit from this price impact as the holder of a delivery-settled one. The logic of the 25 percent of deliverable supply limit implies that the CFTC believes that taking delivery of something less than 25 percent of deliverable supply permits the long with a futures position of 25 percent of deliverable supply to manipulate profitably.  This means that the holder of a cash-settled position equal to 125 percent of deliverable supply can manipulate far more profitably.

This rule is passing strange especially considering that the CFTC has filed a manipulation claim against a trading firm-Parnon-that allegedly used cash market purchases to distort futures prices.  The strategy that the CFTC finds illegal in Parnon would benefit both cash-settled or delivery-settled contracts.  Under the conditional limit rule, the agency provides an incentive for the holders of cash-settled contracts to engage in such strategies.

What’s more, whereas the 2011 rule would have potentially constrained such strategies by limiting ownership of physical supplies by the holder of a cash-settled derivatives position to 25 percent of deliverable stocks, the new rule imposes no such constraint.  Instead, it imposes a requirement to report cash market holdings, and hopes that market oversight officials at exchanges will intervene if it looks like a manipulation is in progress.

None of this makes economic sense, and is in fact logically contradictory.  What makes it worse is that whereas in the 2011 proposal the conditional limit applied only to natural gas futures, it now applies to all contracts subject to position limits.

A big chunk of the proposal is a long-winded justification of the rule, in an effort to overcome the legal challenges that saw a federal court reject the 2011 proposal.  It seems to me that the commission is merely restating the arguments that failed in court, so I don’t really see how this helps.

A couple of things struck me as quite interesting.  In both the 2011 and 2013 proposals, the CFTC utilized the Hunt silver case and the Amaranth case as examples of the kind of destabilizing conduct that the rule would prevent. But whereas the 2011 rule argued that large leveraged positions (like those held by the Hunts) posed a threat to market stability, the word “levered” does not appear in the 2013 proposal’s discussion of the kinds of positions that are particularly worrisome.

This is interesting to me, in part, because my criticism of the 2011 rule as over-inclusive focused on the leverage issue.  If leverage is the problem, I argued, why impose the rule on unlevered positions, like those held by ETFs (which are fully collateralized) or real money investors? If leveraged positions were the real problem, the rule was over inclusive because it would apply to unlevered positions too.  Arguably, this argument had some impact, as all reference to the unique dangers posed by leveraged positions disappeared between 2011 and 2013.

But dropping the argument doesn’t eliminate the problem.  The CFTC has not shown how large, unlevered positions with trading decisions made by many individuals (as is the case with ETFs like USO or USNG) pose a threat to market stability in the way the Hunts did, or can cause unwarranted fluctuations in commodity prices.

Relatedly, the 2011 rule argued that position limits would reduce systemic risk.  I commented that it is wildly implausible that even a disorderly liquidation of a large position in a small market could destabilize the financial system.  Would a disorderly liquidation in the milk futures market really pose a threat to world financial stability?  Seriously?

And wouldn’t you know, the 2013 justification does not mention systemic risk.

More generally, the two-two, mind you-cases that the CFTC puts forth to justify its imposition of limits is highly unpersuasive.  I regularly use the Hunt case as an example of how speculation can distort prices.  Or, should I say, the example.  It is pretty much the exception that proves the rule. It occurred over 33 years ago.

Talk about ancient history.  When do we get to the part about the Trojan War?

The commission’s analysis, such as it is, of the Amaranth episode relies heavily on a report from the Senate Subcommittee on Investigations.  This report in no way demonstrates that Amaranth distorted prices, or that the liquidation of its position when it ran into financial trouble caused unwarranted price fluctuations.

A more plausible story is that Amaranth took a huge bet on natural gas spreads based in large part on a view that 2006 would be another big hurricane season.  When September came with no hurricanes, and none in prospect, spreads collapsed and Amaranth lost a lot of money.  The loss does not demonstrate that Amaranth distorted spreads, just that it took a big bet on these spreads, and bet wrong.

It’s not the job of the regulators to prevent market participants from losing big, if those big bets do not distort prices, either when they are initiated, or when they are liquidated.  (In the event, Amaranth’s positions were assumed-quite profitably-by JP Morgan and Citadel, with no notable dislocation in market prices.)

Moreover, even taking the commission’s view, the two episodes do not support the level of limits it proposes to impose.  The 2013 limits (like those proposed in 2013) would limit an individual firm to between 2.5 percent and 10 percent of open interest: the bigger the contract, the smaller the limit as a fraction of open interest.

But the Hunts and Amaranth had around 40-50 percent of the open interest in big contracts-at least 4 times, and arguably close to 20 times the limits the commission has proposed.  So even if you could argue that a 40 percent position could distort prices, or result in unwarranted price fluctuations when the position is liquidated, that doesn’t imply that a 10 percent or 5 percent or 2.5 percent of open interest position would.  There is thus a huge gap between the sizes of the positions that the CFTC claims, based on historical experience, distort markets, and the sizes of the limits it is proposing.

This is related, in a way, to cost-benefit analysis.  The agency is required to compare the costs and benefits of the regulation, but its analysis is perfunctory, at best. In particular, it does not provide a persuasive cost-benefit analysis of any major attribute of the rule, most notably of the size of the limits.  It basically adopts a precautionary principle approach: big positions could cause big problems, so they should be constrained as a precaution.  It asserts-but does not show-that liquidity will not be unduly restricted as a result.  This is insufficient.

Chilton-who has announced his departure-has claimed that the new proposal is immune to legal challenge.  I wouldn’t be so sure.  Even if the court accepts the verbose arguments relating to the commission’s obligation-or not-to make a finding that the limits are necessary, the agency is still vulnerable on the adequacy of its cost-benefit analysis.  Judge Wilkins never ruled on this issue in his 2012 decision, and in my opinion the CFTC is still vulnerable here.

It is not just the cost-benefit trade-off of the rule overall, but the specific choices made.  Most notably, the size of the limits needs to be justified better on a cost-benefit basis.  Similarly, the conditional limit needs to be so justified: and I’ll say that it is impossible-impossible-to do so, if one is constrained to using, you know, rigorous economics.

The rule is unbelievably long.  Five-hundred thirty three double spaced pages.  533.  (395 pages excluding appendices and attachments.) I have read most of it, but have to spend more time digesting the bona fide hedging portion of the rule.  More on that later.

Oh.  There are 846 footnotes: this is where the land mines lurk.  And there was much rejoicing.  By the lawyers, anyways.