Streetwise Professor

There’s an old military adage: no plan survives first contact with the enemy.*  Obamacare has met its enemy, and that enemy is reality.

The reality that the government is horrid at IT.  (Amazingly, Obama blamed government red tape-namely, contracting requirements-for the failure of his red tape machine to work.  Seriously.  I could not make up that sh*t.)  The reality that the need to stock the insurance pool with healthy individuals who would be charged prices well above cost would lead to the cancellation of the private policies that many healthy individuals have (despite an Obama promise that if you like your plan you can keep it).  The reality that any scheme built on cross-subsidies is inherently coercive.  The reality that any system that imposes what are effectively price controls on suppliers will result in reductions in quality (i.e., increasingly limited choices of physician, despite an Obama promise that if you like your doctor you can keep him/her.)

And more brutal counteroffensives from reality are to come. There are reports that the administration will attempt to mitigate the sticker shock that many are experiencing (or will inevitably experience) on the exchanges by increasing eligibility for subsidies.  This means that the reality will be that Obamacare will inflate the deficit (despite an Obama promise, duly endorsed by the CBO-arguably under a combination of duress and deceit-that ACA would reduce the deficit.)  And then there will be the reality that Obamacare will not reduce health care costs: how can a plan that extends coverage (both in terms of the comprehensiveness of the policies and the number of people covered) reduce costs?  More reality will bite later.  For instance, the effects on labor supply, due to the effect of Obamacare on effective marginal tax rates. Or effects on the structure of employment, as some companies substitute to part time employment for full time in order to avoid employer mandates.

All of this was predictable.  All of it.  And ironically, those who predicted it are being demonized as wreckers and saboteurs.  If only.  Wrecking this nightmare would prevent the wreckage of a substantial chunk of the US economy-and millions of lives.

* In the US this expression is often attributed to Eisenhower, but it probably traces its origin to a remark by von Moltke the Elder.

Both, actually.

The administration’s response to every one of the mounting pile of FUBARs is “Obama didn’t know.”  The latest: Obama didn’t know about impeding Healtcare.gov fiasco.  And he didn’t know that the NSA was collecting electronic intelligence on Merkel and other foreign leaders.  Add this to the IRS, Benghazi, etc., etc., etc.

This happens so frequently that it is becoming as regular a bit in the Obama Show as Sergeant Schultz’s “I know nothing! I see nothing!’ bit was in Hogan’s heroes.  Obama’s denials are about as plausible as Schultz’s.  It’s just not nearly as funny in real life.

As the fiascos mount, scapegoats must be found!  It is going to get very, very crowded under the bus.

The NSA situation is the worst, with Obamacare running a close second.  Sources within the NSA have claimed that the White House and the State Department gave permission for the surveillance of Merkel and others.  The White House denies, denies, denies, and points to a statement from the NSA to support the denial:

With the issue mushrooming into a major diplomatic headache between the U.S., Germany and other allies, the administration stepped up its insistence that Obama knew nothing, though it has yet to explicitly acknowledge that the snooping occurred in the first place. An NSA spokesperson said Sunday that agency head Gen. Keith Alexander “did not discuss with President Obama in 2010 an alleged foreign intelligence operation involving German Chancellor Merkel, nor has he ever discussed alleged operations involving Chancellor Merkel. News reports claiming otherwise are not true.”

Spare me.  That denial is so narrowly drawn that an amoeba could run laps around it in seconds. Taking it at face value, Alexander has never discussed this with Obama.  Fine.  What about any of the thousands of other NSA employees?  CIA employees?  His briefer (when he deigns to have a briefing)?  His briefing books (which Valerie Jarrett assures us that he peruses with god-like discernment).  Hasn’t been a mention of anything that Merkel said not from a public source that would make even the slow witted ask: “How do we know that”?  The specificity and narrowness of the denial seems to be a lawyerly evasion by the agency, and may in fact be so specific and narrow as to signal that yes, indeed the NSA informed Obama: what is left out is the elephant in the room.

This is a horrible situation.  Political survival instinct and Capitol Hill outrage and cowardice will produce a battle between the political branches and the intelligence community, from which the intelligence community will not back down, and in which it has some substantial advantages.  Information is power.  The Bush administration was wounded deeply by the CIA’s war against the White House.  This is a battle that Obama fights with extreme handicaps, but it’s a battle we don’t need period.  Better to just tell the Europeans to grow up, or to ignore them until the storm passes.  (The Schaefer piece provides an analysis of the reasons to monitor Merkel even before she became PM that echo those I made over the weekend.)

The health care situation is not much better.  Today’s storm, overtaking the ongoing website farce, is that the Obama administration knew that millions would lose their individual coverage once Obamacare went into effect.  The administration-sit down, because this may shock you-denies.  The know nothing! They see nothing!

So here’s the choice: either the people responsible for implementing and designing Obamacare failed to anticipate this consequence, which is devastating for millions of people, despite the fact it was eminently predictable, or it is lying.  Great to have choices, ain’t it?

With respect to predictability, it’s clear as day.  To “work” (on its own terms, not that working on its own terms is a good thing), healthy individuals have to be attracted to-or forced onto-the exchanges so they can be charged premiums that exceed the costs that they will incur, in order to subsidize those who impose more costs than they will pay in premiums.  Due to the nature of the individual insurance market, those who are able to buy on this market are likely to be healthy, low risk individuals: indeed, the inability of high risk individuals to get coverage was one of the reasons given for the need to implement Obamacare in the first place.  So the privately, individually insured represented a pool of people tailor made to force onto exchanges.

And how was that done?  By a bait-and-switch.  The Obama promise of “if you like your health insurance policy you can keep it” was supposedly implemented by grandfathering existing policies.  But the grandfathering rule was written so narrowly that any change in the policy-coverage, deductible, co-pay, etc.-negated the grandfathering.  So even modest changes that occur with regularity in these policies have led to mass cancellations of policies that are not grandfathered and do not offer the coverage mandated by the ACA, thereby creating a population of sheep to be sheared on the exchanges.

And speaking of ruminants, of course scapegoats must be found! And you guessed it: the insurance companies are being rounded up and rounded on, most notably by the loathsome, mendacious and incompetent Valerie Jarrett:

FACT: Nothing in #Obamacare forces people out of their health plans. No change is required unless insurance companies change existing plans.

Get ready for the daily five minutes of hate.  Where by “five minutes” I mean twenty-four hours.

Wherever you cast your gaze, your eyes light on a debacle.  Consider that Russia is exploiting Obama’s inept handling of Egypt, where he managed the clever feat of getting everyone to hate him (no Cairo Speech II, I’m guessing-nor Brandenberg Gate II either):

Russian President Vladimir Putin is considering paying a state visit to Egypt to take advantage of frayed ties between Washington and Cairo and possibly gain access to Mediterranean ports, the Sunday Times of London reported.

Nearly 40 years of US policy up in smoke. The Choom Gang rides again.

The headline says it all: it emphasizes that Putin is exploiting the “US vacuum.”  That is the Obama foreign policy in two words: the second coming of the Hoover Administration.

Indeed, the appellation “Hoover Administration” is fitting in so many ways, because you know what vacuum cleaners do, right?

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.

The Economist has come a long way since Bagehot.  I said long way, not good way.

The latest case in point: its support for two “whistleblowers”, Edward Snowden and Hervé Falciani:

WHAT Edward Snowden is to mass surveillance, Hervé Falciani is becoming to private banking. In 2008 the now 41-year-old native of Monaco walked out of the Geneva branch of HSBC, where he had worked for three years, clutching five CD-ROMs containing data on thousands of account holders. The theft lobbed a bomb into Europe’s private-banking market, spawning raids and tax-evasion investigations continentwide. In the latest, this week, Belgian agents swooped on the homes of 20 HSBC clients, including some with ties to Antwerp diamond dealers.

I am having a devil of a time trying to reconcile this simultaneous boosterism of Snowden and Falciani.  The pro-Snowden narrative is that he has revealed a vast program of government collection of information on private individuals.  So what did Falciani do?  He stole information on private individuals from his employer, HSBC, and provided it to governments.  So if you are hung up on the government having access to your private information, maybe-maybe-you could lionize Snowden.  But then you’d have to hate on Falciani.  But not The Economist.  It loves both of them.

And here’s a big difference between them. A huge difference, and one that makes The Economist’s position even more bizarre.

In the US and UK, there are extensive measures in place to prevent the information collected by NSA and GCHQ from being used in criminal prosecutions.   Indeed, one of the most recent Snowden leaks is that GCHQ waged a long fight AGAINST using intercepts in criminal prosecutions. (The Guardian is pathetically spinning this as another huge scandal.  WTF?)

But governments, notably the French and German governments (doesn’t that peg the irony meter?) are gleefully using the information Falciani stole from his employer to prosecute individuals.

So I guess intrusive surveillance of your private information, including your financial information, is A-OK with The Economist as long as it is for the purpose of ensuring that you render unto Caesar what is Caesar’s.  But collection and retention of some private information (e.g., metadata) that may be used if it is subsequently connected with known terrorists, and only then under rigorous protocols, is somehow an outrage.

Look, people. If you are concerned about your liberty and privacy, you have far more to fear from your country’s tax authorities than its intelligence services.  Quite frankly, the NSA couldn’t give a rat’s ass about your financial affairs, unless those somehow intersect with the financial affairs of terrorists.  The IRS, on the other hand, cares very much.  Very much.

And let’s get one thing straight right now.  Let’s drop any pretense that Snowden’s actions were driven by his deep, deep, deep concern for individual privacy.  Yeah, that was the teaser in his original disclosures: and those disclosures weren’t really news.  That’s the story that he uses to wrap himself in the mantle of righteousness. But virtually every Snowden leak since June has been about US government intelligence operations directed at other countries.  Which is, you know, what intelligence services do.  And which you should be damned glad the NSA, CIA, etc., do in fact do.

If you have any doubts, consider the following.  Snowden stole 30,000 documents from the Defense Intelligence Agency. How is that related to US civil liberties and privacy?  It is infinitely more likely that such documents would be related to the US military’s attempts to monitor and understand and analyze US enemies and potential enemies.  What was my first clue? Maybe “Defense” in the title of the agency whose documents Snowden stole.

And lo and behold, what is the first piece of information released from this ill-gotten trove? A revelation that a NATO country is collecting information on the Russian military:

In one case, for instance, the files contain information about a program run from a NATO country against Russia that provides valuable intelligence for the U.S. Air Force and Navy, said one U.S. official, who requested anonymity to discuss an ongoing criminal investigation. Snowden faces theft and espionage charges.

Let’s shave with Occam’s Razor again, shall we?  Snowden hides out in the Russian consulate in Hong Kong. Snowden decamps to Russia. Snowden hides out with the FSB. (Spare me the BS about him not being in control of Russian security services. I didn’t fall head first off the cabbage truck.) Snowden’s lawyer is a well-known FSB apparatchik. Snowden steals US military intelligence documents. One of these documents is released revealing the cooperation of a NATO country with the US in an intelligence collection operation directed against Russia. (Good!-and I mean good that we’re collecting such information, not that this is being revealed.) Not to mention that many of Snowden’s revelations are wreaking havoc with America’s relationships with its allies.  And never forget Putin’s zero sum mindset: what hurts the US, helps Russia.

So what’s more likely?  That Snowden (and his enablers Poitras and Greenwald) are oh-so-concerned about the privacy of Americans and Europeans and Brazilians? Or that this lot is-and likely has been all along-tools of Putin and Russian intelligence, and are revealing information that is damaging to the US and beneficial to Russian interests?

The Romans had an expression for this: cui bono? The answer in this instance: Putin bono. So Snowden is either a useful idiot, or an active collaborator.  As Orwell would have put it: He is objectively pro-Russian, and pro-Putin.

Snowden and Poitras and Greenwald are rendering unto Putin.  Every damned day. It’s beyond obvious.  But it’s never pointed out, particularly by those who should know better. And yeah.  I’m looking at you, Luke Harding.  Why won’t you investigate the nexus between Snowden and The Mafia State?  It seems a natural.  What are you afraid of?

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.

In some earlier posts discussing the role of banks in commodity markets, I suggested that the decision should not be a binary one: banks in, or banks out.  Instead, the preferable approach would be to levy capital charges on bank commodity operations that reflected the risks of these operations, thereby attempting to ensure that banks internalize the TBTF costs associated with them and scale their commodity businesses accordingly.

The WSJ reports that the Fed is leaning towards this approach:

Federal Reserve officials are considering imposing a new capital surcharge on Wall Street banks that own oil pipelines, metals warehouses and other lucrative physical-commodities assets, according to people familiar with the matter.

Such an approach could encourage banks to pare back their involvement in physical commodities, which has increasingly raised concerns among regulators and lawmakers.

While no decision has been made, imposing a surcharge would allow the Fed to sidestep a legal jam caused by existing laws that set Goldman Sachs Group Inc. and Morgan Stanley apart from peers and give the former investment banks broad leeway to own commodities.

The devil, of course, is in the details.  The question is whether the surcharge will be set in a way that accurately reflects the relevant risks, or whether instead it will be set at punitive levels to achieve via misdirection what the Fed is apparently reluctant to do in a straightforward fashion (due to fears of legal challenge): i.e., precluding banks from participating in physical commodity markets.

In other words, this proposal is fine in principal, but could be a disaster in practice.  If the Fed really wants to drive banks out of commodity markets, I would much prefer it do so forthrightly, rather than by hiding behind capital surcharges that it chooses to achieve that outcome.

The EPA bowed to reality, and has admitted that the blend wall is real.  That is, (a) the vast bulk of autos in the US can only use gasoline with 10 percent of less ethanol, and (b) the mandated level of biofuel consumption exceeds 10 percent of US gasoline consumption.  The gap between the mandated use of biofuels and the actual use of biofuels had led refiners to scramble to by Renewable Identification Numbers (“RINs”) that they can substitute for actual biofuels to meet their mandate obligations.  But the supply of RINs is limited, and their price had skyrocketed started in the spring.  The available supply of RINs for 2014 would have been totally inadequate to cope with the increase in the mandated quantity for that year.  A quantity set by Congress in 2007 when it had no idea what market conditions would be it kicked in, and in defiance of technological realities.  Congress anticipated a steady increase in gasoline consumption, but stagnant economic growth and other factors have led to stagnant gasoline consumption, leading to the current yawning gap between the mandated quantity of biofuels and the quantity that can actually be utilized.

As a result, the EPA has decided to cut the mandated quantity for 2014 by nearly 1/6th, or 3 million gallons.

Economically this is the right result, but legally and procedurally it is a monstrosity.  Congress did give EPA the discretion to waive the mandate, but limited that discretion.  The agency can modify the mandate for two reasons.  Here’s how Reuters describes it:

This can be used to reduce the volumes in two cases: if enforcing the law were to cause economic hardship; or if it were simply not feasible due to “inadequate domestic supply”.

Making the “economic hardship” case is hard, so the EPA is using the second justification.  No.  Seriously.

The plain language of the law makes it clear that inadequate domestic supply of biofuels is the criterion for granting the waiver.  But we have a surfeit of biofuels, if anything: we can produce more of them than can be consumed.

Here’s the gobbledygook the agency uses to justify its decision:

“We interpret the term ‘inadequate domestic supply’ as it is used under the general waiver authority to include consideration of factors that affect consumption of renewable fuel,” the agency wrote in the proposed rules.

Uhm, “consumption” is related to demand, not supply.  But whatever.

The EPA seems inspired by this famous bit from Through the Looking Glass:

‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’

‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’

‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all.’

EPA is clearly determined to be master of the words in the Renewable Fuel Standard, and make them mean just it what it chooses them to mean.

The Reuters article states that the EPA’s action is sure to draw a legal challenge from the biofuels industry, and that’s no doubt true.

I yield to no one in my loathing for the Renewable Fuels Association, but they have the law on their side in this case, even if the law is indeed an ass. If the rule of law is to mean anything, laws must be enforced as written, not waived at will, especially when the justification for the waivers flies in the face of the black letter language of the statute.

If we really want a country of laws, the laws need to be enforced and followed, not waived.  We need to work to rule.  To bring home to Congress its folly, and to force it to change the law to bring it into conformity with economic reality, the RFS must be enforced, down to the last comma.

And the principle should be applied more broadly.  Obamacare is a prime example.  Ever G*d damned provision on every one of its 2000 plus pages should be enforced, no ifs, ands, buts or waivers, to make manifest its absurdity, thereby making possible a substantive change in the law-and perhaps scrapping it.

Maybe in the scheme of things RINsanity isn’t a big deal.  But it illustrates quite powerfully the degeneration of the rule of law in the US and the increasingly arbitrary nature of American government.

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.

SEC Chair Mary Jo White has made something of a stir with her recent speech on equity market structure.  One interesting thing was her attempt to downplay regulation as a cause:

Although some have argued otherwise, these developments are not attributable solely to regulatory choices. Competition plays a powerful role. Well before Regulation NMS, market participants were trading in dark pools and trading with highly automated strategies. Many jurisdictions around the world with different regulatory structures than ours are dealing with analogous issues related to off-exchange venues and automated trading.

This is a slippery and somewhat disingenuous argument. It starts out with an Obama-esque straw man: I don’t know of any credible analyst of these issues who claims the problems in market structure are “attributable solely” to regulatory choices.  Having knocked down that straw man, she focuses on somewhat off-topic technological issues and thus totally sidesteps saying what role regulation, and notably RegNMS have played.

I generally agree with her emphasis on empirical evidence as the basis for policy choices.  But the empirical research has to consider all potential issues-including potential regulatory culpability.

The part of White’s speech that attracted the most comment relates to exchange competition and the self-regulatory model:

Exchange Competition and Self-Regulatory Model

Another set of assumptions about our current market structure is related to the nature of exchange competition and the nature of the self-regulatory model itself.

Equity exchanges today operate fully electronic, high-speed trading systems using a business model that mostly was developed by electronic communications networks, or ECNs, prior to Regulation NMS. Indeed, in many ways, today’s exchanges are yesterday’s ECNs.

Exchanges differ from ECNs, however, in significant respects. Exchanges, for example, continue to exercise self-regulatory functions, even as they operate as for-profit entities.

This model for exchanges has encountered challenges. As I noted earlier, for example, the “lit” exchanges no longer attract even one-half of long-term investor orders.

From time to time, equity exchanges have adopted trading models that use different fee structures or attempt to focus on different priorities, such as order size or retail investor participation. These models have been met with mixed success, which raises the question as to whether exchanges have a real opportunity to develop different trading models that preserve pricing transparency and are more attractive to investors.

As is true for all important aspects of our current market structure, the current nature of exchange competition and the self-regulatory model should be fully evaluated in light of the evolving market structure and trading practices. This evaluation should include whether the current exchange regulatory structure continues to meet the needs of investors and public companies. Does it provide sufficient flexibility for exchanges to implement transparent trading models that can effectively compete for investor orders? Does the current approach to self-regulation limit or support exchange trading models?

This evaluation should also assess how trading venues can better balance their commercial incentives and regulatory responsibilities. For example, is there an appropriate balance for exchanges in key areas, such as the maintenance of critical market infrastructure? And are off-exchange venues subject to appropriate regulatory requirements for the types of business they today conduct?

One thing that jumps out at me is the suggestion that there is a tension between the for-profit model and self-regulatory responsibilities, with the corollary suggestion (rather obliquely made) that for-profit exchanges should be stripped of some regulatory responsibilities.

Let me break it to everyone: there is a tension between the not-for-profit model and self-regulatory responsibilities as well.  Not-for-profit exchanges were not charitable organizations.  They were established and run by very profit driven intermediaries (brokers, liquidity suppliers) who adopted the non-profit form to prevent redistribution of wealth among heterogeneous members.  This form was economically rational in floor trading days, when intermediaries and exchanges had highly specific capital that needed protection against expropriation. A big technological shock-the move to electronic trading-meant that the non-profit form was not longer needed to protect these specific investments, or to prevent exchanges from using pricing of their services to redistribute wealth among members.

As I wrote about extensively during the mid-90s, traditional exchanges did a good job at some self-regulatory functions, and a bad job at others.  Manipulation was one that exchanges policed quite badly, for instance: contract enforcement was one they did quite well.

In these papers, I identified a couple of factors that affected the effectiveness of exchange self-regulatory efforts.  One was whether the exchanges internalized the benefits.  In the case of manipulation, for instance, the effects of corners and squeezes on the derived demand for the services of exchange members did not reflect the effects of corners and squeezes on market participants generally.  The price and quantity of exchange services depends on the impact of manipulation on marginal customers, but inframarginal customers bore the brunt of manipulations.  Moreover, some effects were public bads, such as the effect of manipulation on the informativeness of prices.

Another factor is the distributive effects across exchange members.  Self-regulations that led to overall efficiency gains but hurt some members were often not adopted due to such conflicts: the battles over grain warehouses in Chicago in the 1860s and 1870s is an example.

Similar problems afflict for profit exchanges, though internalization problems are probably the most acute now: the movement to the for-profit form has reduced the conflicts within exchanges.

Back around 2000, when the move to for-profit exchanges was gaining momentum, I wrote a paper on the implications of this for self-regulation.  I put it aside.  I should probably dust it off and revise, but the basic conclusion holds true, I think: for-profit exchanges have good incentives to regulate some things, bad incentives to regulate others.  The task is to identify these various strengths and weaknesses, and allocate regulatory responsibilities accordingly, always keeping in mind that the alternative-public regulation-has its weaknesses and strengths too.

The one major issue that has brought this to the fore is the breakdowns in the SIPs that connect exchanges and are necessary for the information-and-linkages approach adopted by the SEC in RegNMS (and Congress under the original NMS mandate) to work.  This is predictable, based on the analysis presented above.  SIPs have some attributes of public goods, and no exchange internalizes the benefits and costs of SIP performance.  Not surprising, then, that this has proved to be a weak link in the current market structure.  But since SIPs have natural monopoly characteristics, it’s not an easy task to determine how they should be owned, priced, and governed.  But the question hasn’t been framed this way, which means that it’s unlikely to be answered properly.  (Recall that the old Intermarket Trading System was also a chronic problem in the pre-RegNMS world: it was sort of a joke, actually.)  SIPs are analogous to transmission in electricity, and transmission has always proved the most difficult part of the system to regulate and price.  (Yes, there are important technological differences, but the similarities are relevant.)

Some things in White’s speech appear contradictory.  For instance, she questions whether a one-size-fits-all market structure is appropriate, then denigrates exchange efforts to experiment with different models: “These models have been met with mixed success, which raises the question as to whether exchanges have a real opportunity to develop different trading models that preserve pricing transparency and are more attractive to investors.”  It seems to me that exchanges have had plenty of opportunities, and that the mixed success suggests that the potential for differentiation (including moving away from one-size-fits-all) is rather limited.

There is one form of differentiation that White seems to be quite suspicious of: trading on dark venues:

A steadily increasing percentage of trading occurs in “dark” venues, which now appear to execute more than half of the orders of long-term investors.

Combine this with her desideratum for trading: models “that preserve pricing transparency and are more attractive to investors.”  Well, here we have a great example of a non-one-size-fits-all model that is obviously more attractive to some investors, but it bothers White (and regulators generally).  One of the things that makes dark venues popular to long-term investors is precisely the lack of price transparency.   Ironically, the SEC has always claimed the markets should favor long-term investors, and indeed White starts her speech by arguing that the markets cannot serve their capital formation function without long-term investors.  Thus, the “and” in that phrase is problematic.

One interpretation is that White doesn’t want one-size-fits-all, but that the varieties that have evolved-dark venues that accommodate long-term investors and lit venues that accommodate some long-term investors and most others-aren’t to her liking.  This is not a convincing position.  It begs the question of why the long-term investors White favors prefer a venue she disfavors.  It also doesn’t come to grips with the literature which shows that off-exchange trading venues reduce trading costs for uninformed, liquidity traders-which can include long term investors who initiate and liquidate positions for non-information driven reasons.  It also is in tension with her statement that for-profit exchanges with a strong profit motive are trying to innovate: if they are losing business to dark venues as a result of, say, predatory conduct carried in lit markets, they have an incentive to devise rules and pricing structures that curb the predatory conduct and thereby attract the return of those who have fled to dark venues.

It also bears emphasis, for this point is often forgotten, that dark venues have always been with us, and that large, long-term investors have been the users of these venues.  Back in the day, this was the function of block markets.  Dark venues have largely replaced the block markets, serve the same function, and service the same investor base.  That’s true even though much of the trading on dark venues is not in blocks (although some dark markets are essentially for block trading).  As Duane Seppi demonstrated years ago, block trading and the protocols surrounding it were ways of screening out informed traders.  Dark venues have other means of performing the same function, without imposing the constraint that trades occur in blocks.

Summing up, it’s good to see these market structure issues get such serious attention.  It’s less encouraging to see that regulators are focusing on secondary or tertiary issues (e.g., whether self-regulation is incompatible with for-profit exchanges) and have certain preconceptions that makes them unduly suspicious of departures from one-size-fits-all trading that accommodate the needs of an important category of market users-indeed, the category that the SEC has long said it desires to protect. (As an aside, which I may expand upon later, the SEC’s preferences, and its suspicion of dark markets, is likely driven by political economy considerations.  Namely, exchanges exert more political influence, and have influenced the SEC to advance their interests.)

In my opinion, the SEC’s immediate priority should be fixing the SIP (if it deems that links-and-information is sacrosanct).  This fix should look at ownership, organization, and governance, based on an understanding of the public good attributes of the SIP.  (Longer term, the RegNMS links-and-information approach needs a new look.)  In addition, the empirical approach that White rightly advocates should look at dark venues through objective eyes, free from prejudices which are all too apparent (as the very term “dark” demonstrates).  It’s especially important that the reasons for the commercial success of dark markets be understood and explained before it is lamented.  A case can be made that the non-one-size-fits-all model that works best could consist of dark and light venues operating side-by-side, serving different investor clienteles.   It’s certainly a model that has existed over time, and in a wide variety of different countries.  Maybe there’s something to it.  Perhaps we should understand what that might be, before monkeying with market structure any more.

My frequent sparring partner, John Kemp of Reuters, reads the IHS study justifying the benefits of bank involvement in commodity markets, and is not convinced. I agree that the report is rather lame, but am not convinced by Kemp’s critique, and the policy implications he draws.

One of Kemp’s points is that banks are not essential to the purchase, sale, transportation, storage, or processing of commodities.  Other entities, most notably commodity trading firms like Vitol or Glencore or Trafigura, can provide the same services as the banks.

This is true, but beside the point.  There are few types of firms that are utterly essential, with no substitutes.  Even banks are not irreplaceable in the functions that Kemp, and others, agree is appropriate for them.  Their core function of providing credit can be performed by the capital markets.  Or loan sharks.

The fact that banks can profit as a result of their activities in physical commodities should create a rebuttable presumption that they are providing economic value.  In a reasonably competitive market, where costs and benefits are internalized, firms that survive do so because they can provide a good or service of equal or better quality at equal or lower cost to other potential suppliers.  Indeed, in these circumstances, all active sellers have marginal costs that are approximately equal: cost functions determine the relative outputs of the active suppliers.   Driving out suppliers who can profitably service part of the market will drive up prices, reduce output, and reduce welfare: some of the output supplied by the eliminated firms will go unproduced, and the rest produced at higher cost.

Competition is not the issue. The market for commodity intermediation is highly competitive: even the big banks account for a relatively small share of activity, and the biggest players account for no more than 5-6 percent of trading activity in any major commodity market.  And even if banks accounted for a big share, that could be due to a cost advantage.

Which brings me to Kemp’s second objection, which potentially has more merit.  The above says “where costs and benefits are internalized.”  Kemp brings up, quite properly, the possibility that banks get a subsidy as a result of too big to fail, and hence the true costs of their activities are not internalized.

The immediate implication of this is that banks are too big, and that there market share in physical commodity activities is too big.  But “too big” does not mean that the right share is zero.  Banning bank participation in physical commodity markets, or excluding them from certain activities, is likely to be an overreaction, not a Goldilocks (“just right”) strategy.  They might be too big now, but zero is almost certainly too small.

Note too that eliminating banks from physical commodity markets, or restricting their participation, does not eliminate the TBTF subsidy.  Yes, they might not be able to exploit the subsidy by getting too big in commodities, but they are not going to let the subsidy money burn a hole in their collective pockets.  Won’t let them exploit the subsidy in commodities?  They’ll find someplace else to do it.  Restricting activity in one market segment will not appreciably reduce the TBTF subsidy that banks reap.

The right way to address this problem is to find ways to get banks to internalize the true costs.  This is best done by capital requirements that reflect the risks of the activities banks engage in, and the costs associated with bail outs.  Restrictions on permissible activities are a meat cleaver approach that will not mitigate the TBTF subsidy.

Kemp also goes on about the metals warehouse games.  As I’ve said repeatedly, both here and in media interviews, banks are not uniquely positioned to engage in such sorts of shenanigans.  If the conditions are right, whoever owns the warehouses will play the games. The best way to deal with this problem is ex post deterrence, either through private action (e.g., the numerous class action lawsuits against Goldman for its alleged warehouse manipulations) or government enforcement actions.

The role of banks in physical commodity markets will remain under scrutiny-and attack-for the foreseeable future. Many of these attacks are predicated on ignorance, not to say stupidity.  Kemp isn’t guilty of those things, but his analysis is nonetheless misguided.  Even when he identifies a real potential problem-the TBTF subsidy-eliminating banks from the physical commodity market is not the appropriate way to address it.

This illustrates a general point I’ve mentioned in many forums.  Attempting to address TBTF problems, and systemic risk problems, through structural interventions such as clearing mandates, SEF mandates, Glass-Steagall, or preventing banks from participating in commodity markets, is inefficient and likely ineffectual.  It is better to operate at the level of fundamental incentives, by getting banks and other financial intermediaries to internalize the costs and benefits of their activities. This is an easy principle to state in the abstract, though hard to implement in practice: just what is the right capital charge overall, and how should different bank activities contribute to this charge?  Not an easy question to answer.  Although imperfect, that’s still a better way of addressing these problems than mandating market structures.