The increasing concentration of the futures commission merchant (FCM)/clearing broker business has been a pronounced feature of the world derivatives markets in recent years. This has raised concerns among at least some regulators, including CFTC commissioner Summer K. Mersinger. In a speech generally rah-rah-ing clearing mandates, Commissioner Mersinger did raise one discordant note. Specifically, implementation of the Basel III standards would contribute to further concentration in the FCM/CB space:
Second, the Basel III Endgame Proposal would weaken the clearing system by exacerbating the downward trend in the number of entities offering client clearing services. In January 2004, there were 177 futures commission merchants (“FCMs”) registered with the CFTC. Twenty years later, as of January 2024, there are 62 FCMs registered with the CFTC, representing a 65% decline. But over the same period, there has been a dramatic increase in customer funds held at FCMs to support derivatives trading. In January 2004, FCMs held over $87 billion of customer funds. Today, that smaller number of FCMs is holding five-and-a-half times that amount of customer funds—$490 billion. And of that customer money, approximately 60% is concentrated in the top five FCMs. [Footnotes omitted.]
This is a problem because
Third, a further decline in the number of FCMs would create systemic risk. In addition to concentration concerns, a decline in the number of FCMs would raise serious challenges regarding the portability of customer positions should a clearing member fail. Consider this potential scenario: a clearing member defaults, and its customers’ positions need to be ported to a different clearing member; however, porting those positions proves difficult or even impossible because the Basel III Endgame Proposal has both decreased the number of clearing members and reduced client clearing capacity at the remaining clearing members. This outcome of the Basel III Endgame Proposal would increase systemic risk, not reduce systemic risk.
It’s a shame nobody saw this coming.
Oh wait. Someone did. Thirteen years ago: “Moreover, this means of facilitating connections of end users to multiple CCPs tends to encourage the concentration of client business in a small number of clearing member firms. This concentration has systemic implications.”
On this blog, I have also written on numerous occasions how various aspects of Dodd-Frank contribute to consolidation among FCMs. Regulatory overhead is a largely fixed cost, which contributes to scale economies and hence concentration. Moreover, diversification effects and the need for big balance sheets to intermediate large derivatives positions also contributes to concentration. Note that the OTC dealer market has always been quite concentrated for these reasons, and this concentration has migrated to the cleared world as clearing of OTC derivatives has been mandated.
Commissioner Mersinger did not identify the causes of increasing concentration that has already occurred among FCMs: her speech focuses on how the Basel III End Game may make this problem even more acute. But she does not recognize that the central clearing that she lauds in her speech is a major driving force of the trend she laments: “But recent policy proposals in the United States risk upending the success we have experienced through the efforts of the G-20 and the move to central clearing.” In other words, central clearing good, but you are screwing it up, Basel.
I said Basel! Not Basil!
In actual fact, regulation generally, and clearing mandates specifically, have been the major driver of market structure in the post-Frankendodd era. It’s good that regulators are starting to recognize the systemic risks inherent in this structure. It’s disappointing that they don’t recognize that what they praise lavishly (and pat themselves on the back for) is the underlying source of the problem.
It is a challenge to identify the worst of the worst Federal agencies, but the Environmental Protection Agency is clearly a heavy favorite. (The security organs are in a class by themselves. Here I refer to civil regulatory agencies.)
“Three years ago, I set an ambitious target: that half of all new cars and trucks sold in 2030 would be zero-emission,” Biden said in a statement, adding that the country will meet that goal “and race forward in the years ahead.”
Biden said in a statement issued in his name—written by someone else, of course, because he couldn’t form these sentences by himself.
In numbers pulled straight from its collective ass, the EPA claims the reduction in CO2 emissions will produce $100 billion in benefits annually, the vast bulk of which are due to chimerical gains from ameliorating climate change.
As the much-missed Sonic Charm (still mordant on X, but not in the blogosphere) said: all large calculations are wrong. And that goes exponentially for any calculation involving alleged climate benefits and costs. Despite all the claims about scientific consensus (which should make you neuralgic in the aftermath of Covid, where almost all claims about The Science flogged by governments and the media have turned out to be the inversion of the truth), estimates of the impact of changes in CO2 emissions on climate are speculative in the extreme. And those speculations pale in comparison to estimates of the impact of climate changes on welfare, including effects on wealth, income, and living standards.
Climate is a complex system. Economies are complex systems. Only fools and the evil have the hubris to claim to know how small changes in one variable will affect outcomes in the interaction between two complex systems.
Where does the EPA fit here? Both, clearly.
It is particularly perverse that the EPA is attempting to socially engineer economic outcomes—namely, what vehicles people drive—at a time when the manifold defects of EVs are becoming clearly manifest. Their performance sucks in multiple ways, including limited range, declining range over time (as batteries age), poor performance in cold weather, and long recharging times (human time is valuable—did the EPA take that into account? I crack myself up sometimes). Repair costs are astronomical. And the putative environmental benefits are dubious when the entire vehicle lifecycle is considered, or when the environmental impacts of mining the myriad materials EVs need are taken into account. Moreover, there are other environmental costs—notably substantial road degradation and substantially increased particulate emissions from tire wear, both due to the great weight of EVs.
Increased awareness of these effects is turning EVs into the Typhoid Marys of automobiles. Sales are well below what had been projected as consumers have become aware of the clear inferiority of EVs relative to ICE vehicles in doing the things people want—and need—their vehicles to do. EVs are clogging dealer lots, and they don’t want to buy more. Resale values are in the tank. Insurance costs are prohibitive.
EVs are far more expensive to drive off the lot, and are more expensive to operate, than ICE vehicles. Is it any wonder why Ford is drastically cutting its production of electric F-150s, and why every other auto manufacturer is hedging on its previous promises to go all electric in the near future?
Two rental car companies—Hertz and Sixt—have recently pulled the plug on their EV fleets (figuratively and literally) because the economics are so atrocious. The disastrous Hertz plunge into electrics cost the CEO his job.
EV skeptic Toyota is looking pretty damned smart now, ain’t it?
The inadequacies and defects of EVs are particularly pronounced for anyone who lives outside of a major metro area, and the more exurban or rural you are, the less suitable EVs are for you. So this regulation represents another front in the war on suburban, exurban, and rural America.
And maybe that is part of the plan. Recall my post on the war on cars generally. They want you to walk the road to serfdom, and to jam people into villages (soothingly named “15 minute cities”), just like castellans did in the 11th century.
Put differently: from the perspective of the progressive, globalist types who want to eliminate personal mobility (for the proles, that is, not for them), all the aforementioned bugs of EVs are features because they drastically raise the cost of mobility.
Not to mention the strains that increased EV usage will place on already creaking electricity grids and generation systems. The interaction between this regulation, and the EPA’s equally (or even more malign) regulations of power plants, poses extreme risk to the nation’s electricity system.
To compound the lies, the administration claims that this will be a boon for the domestic automobile industry:
Biden added that U.S. workers “will lead the world on autos making clean cars and trucks, each stamped ‘Made in America.‘”
As. Fucking. If. This regulation will wreak havoc on the existing ICE-centric US auto industry (and the entire supply chain for it), with all of the baleful consequences that will have for capital value and employment. The US industry has shown little prospect of having a comparative advantage in EV manufacturing. Note the huge losses Ford has racked up on a per vehicle basis on its electronic version of the stalwart F-150. GM’s EV operation has also frolicked in pools of red ink.
Trump claimed that the US auto industry would face a bloodbath due to Chinese manufacturing of cars in Mexico. That is nothing compared to the ensuing bloodbath—economic bloodbath; it’s a metaphor!—if the EPA guts the ICE industry. (“Guts” is a metaphor too! Can’t assume anything these days, right?)
These regulations are beyond sickeningly perverse. They represent an extreme exercise of arbitrary power in the service of a delusional ideological agenda embraced by a tiny sliver of the citizenry.
And when I say extreme, I mean by the standards of rational behavior, not by the standards of the current American administrative state. Sadly, what the EPA is doing has strong parallels in what virtually every other Biden administrative agency is doing—don’t get me started on GiGi’s SEC. Or the FTC. Or the DoL.
Extremism in the exercise of administrative power is definitely a vice. It is the enemy of personal freedom, personal choice, and economic prosperity.
Rein in the administrative state? Is that even possible? Doubtful. The only sure remedy is the Carthaginian one.
The review will take months and then will be open to public comment which will take further time, Energy Secretary Jennifer Granholm told reporters in a teleconference.
This policy, if one can dignify it with such an appellation, is a sop to the ecoloonies upon whom the administration depends for support:
The growth [in LNG exports] has set off protests from environmentalists, part of Biden’s base. Activists say new LNG projects can harm local communities with pollution, lock in global reliance on fossil fuels for decades, and lead to emissions from burning gas and from leaks of the powerful greenhouse gas methane.
In brief, the administration (regime, really) wants to kneecap the remarkable energy revolution of the past 20 years, which has seen technological innovations that have turned the US from a nation worried about where its next MMBTU would come from to a natural gas production powerhouse, and which have allowed others to share in its bounty with the world.
But you see, to the ecoloonies that’s the bad news. Really bad. Climate change, dontcha know.
But even evaluated on those (dubious) terms, the policy is demented. Because the ecoloonies don’t understand basic economics. They are myopic, linear thinkers who are incapable of analyzing the ultimate impact of their policy.
In their thinking, less LNG exports from the US equals less fossil fuel consumption equals lowers carbon emissions equals saving the polar bears. Even overlooking the (again dubious) last step in the logical chain (hey, I’m a a generous guy) the analysis is flawed. Where it definitely breaks down is the third, and arguably the second, steps.
Yes, reducing US natural gas output (by choking one source of demand) will reduce world natural gas production. But the resulting higher world price will induce higher output by competing producers (e.g., Qatar, Australia, PNG, Africa, etc.), resulting in a net decline in world gas production smaller than the decline in US production–and it is world production that matters when considering “well mixed” GHGs. Further, some production that would have otherwise been exported will be consumed domestically instead, meaning that a given decline in exports does not result in an equal decline in production.
But more importantly, the rise in the price of gas relative to other fuels–notably coal–will induce substitution towards those fuels. Since those fuels are more carbon intensive than natural gas, it is possible, and indeed likely, that the net effect of the policy would be to increase the output of GHGs.
So at the very least, the amount of reduction in GHGs resulting from this policy will be far smaller than the reduction in US LNG exports that it will cause, and plausibly will result in an increase of GHGs.
Well played! All pain, no gain!
But the economic idiocy of ecoloonies is an old story by now. Perhaps you’ve read of the recent finding that the ban on “single use” plastic bags in New Jersey led to a tripling of consumer plastics consumption because of the substitution effects that the ban induced. Again, myopic, linear, one-step ahead thinking led to a policy that produced perverse results.
The foregoing analysis focuses on only one dimension–GHG output. But one also has to consider the cost incurred to achieve any GHG gains (if there are any, that is). But trade-offs (costs vs. benefits) is not something that ecoloonies do. They are monomaniacs, and monomaniacs don’t evaluate trade-offs.
This policy will also shtup European allies, whom in the aftermath of the Russian invasion of Ukraine Biden promised would receive bountiful supplies of US gas.
To paraphrase Animal House: “You fucked up, Europe! You trusted Biden!”
The administration pinky swears that
the pause would not hurt allies, saying the plan will come with exemptions for national security should they need more LNG.
Yeah, because it’s just like turning the faucet on and off, right?
If you believe what they say, you are truly an idiot and probably believe they’ll respect you in the morning.
But none of this should be a surprise. After all, this is an administration that is infested with members of the “elite,” and which counts on the “elite” for its support. According to a recent Rasmussen poll:
An astonishing 77% of the Elites – including nearly 90% of the Elites who graduated from the top universities – favor rationing energy, gas, and meat to combat climate change. Among all Americans, 63% oppose rationing.
Face it. They hate your guts and want you to suffer. This “pause” on LNG exports is just another manifestation of their hatred.
Javier Milei gave a remarkable speech at Davos last week. I won’t say it was a stemwinder, because unlike in his media and campaign appearances, here Milei’s mien was that of an academic delivering a paper at a conference, rather than that of a chainsaw wielding revolutionary. On substance, however, it was extremely provocative–and indeed an anathema to the assembled “elites” in Davos.
Milei's 2024 Davos talk, directly translated to English by AI (by heygen), in his own accent. Better than the dubbed version imo. pic.twitter.com/8OAGELuqxl
Milei robustly advocated the primacy of freedom, and made the moral as well as the utilitarian case for capitalism, and presented a trenchant criticism of socialism, collectivism, and statism. Apostasy–hell, heresy–at Davos. So three cheers!
A good part of Milei’s speech channeled Deirdre McCloskey: he recapitulated McCloskey’s account of the economic miracle of market capitalism that caused a manyfold increase in living standards in a few centuries after millennia of stagnation.
Indeed, Milei presented a maximalist case for the market. Milei is a trained economist, and many who are not trained economists may have missed the import of some of his more arcane and academic arguments. I’ll try to summarize them, and offer some commentary.
As his foil, Milei chose neoclassical economics–the economics of Alfred Marshall, and indeed of two economists (Milton Friedman and Robert Lucas) whom Milei obviously admires given he named three of his beloved dogs after them. Specifically, he took aim at the concept of “market failure” in the vein of Pigou and innumerable economic textbooks since.
Milei is a market Panglossian: he says flat out that there is no such thing as “market failure.” Full stop. Economic failures are solely the responsibility of the state and destructive public policies. Another full stop.
This strongly echoes the Coasean critique of the Pigouvian concept of “market failure.” Neoclassical economics largely ignores transactions costs. What is sometimes referred to as the New Institutional Economics, of which Transaction Cost Economics is a subset, introduces transactions costs as a fundamental concept. When transactions costs are considered, no wealth improving transactions remain unexploited. In this sense it can be said that the market never fails.
Where this argument becomes tenuous is when one considers what determines transactions costs, and whether government regulation can reduce transactions costs and therefore increase the gains from trade and exchange available to be realized through market processes. For example, diffuse harms from air pollution make negotiated deals to maximize welfare challenging. There are free rider problems and large number bargaining problems and asymmetric information problems that make pure “market” arrangements challenging. Perhaps government regulation is a welfare-improving way of overcoming these challenges.
That is, it is possible that sometimes governments can reduce transactions costs, or can be viewed as a transactions cost economizing way of allocating scarce resources. In a transaction cost free world, the allocation of property rights doesn’t matter. With transactions costs, this allocation can affect welfare. By defining property rights, governments might allow the market to reach a better allocation of resources.
But of course, as Milei correctly notes, governments can hardly expected to be altruistic and omniscient, so they are also quite capable of implementing destructive measures rather than constructive ones.
Milei’s market Panglossianism may be exaggerated, but it has the great virtue of pointing out the fundamental analytical problems with textbook “neoclassical” invocations of and treatments of “market failure,” and like Coase did, directing attention at the vitally important consideration these analyses ignore–transactions costs.
Milei also gave a stirring defense of monopoly. In some respects this can be viewed as a specific example of transactions costs in action: as the answer to an old Chicago econ prelim question (maybe it is still used–dunno) demonstrates, in the absence of transactions costs, the “deadweight loss” from monopoly power in the textbook analysis would not exist. Instead, “monopoly power” or “market power” would have only distributive rather than efficiency effects.
But Milei’s defense was somewhat different. The textbook analysis of monopoly is a static one. Following Schumpeter, and certain strands of modern growth theory, monopoly is the engine (or the effect) of the innovation that has driven the massive expansion of wealth and the widespread elimination of poverty that Milei rightly focused on in the beginning of his speech.
This is another maximalist position, but yet again it identifies and amplifies an important consideration that is far too often ignored in public and policy debates.
I would note, however, that it sits somewhat uncomfortably with his view that all failures are government failures. One of the primary dangers of large business enterprises generally, including those that could be characterized as “monopolies,” is that they exercise undue power over governments, and cause them to implement wealth-destroying policies that help these enterprises. How does one reap the benefits of innovation that results from (or may cause) large enterprises without incurring the costs from rent seeking by these enterprises?
As an economist I can quibble with the extent to which Milei pushed some of his economic arguments. But this is mainly a matter of identifying exceptions to the rules he lays down: I definitely see the rhetorical and persuasive benefits of stating the maximalist case, especially to an echo chamber of anti market and anti freedom “elites” who themselves routinely make maximalist claims. It is a challenge to a “smelly orthodoxy,” and such a challenge must be vigorously and provocatively issued in over to stand out against the droning Davos hive.
Once the debate shifts to where Milei went too far, the fundamental truths of his arguments are at least implicitly accepted. And the fundamental truths are these: emergent market orders, including “failures” such as monopoly power, are and have been for centuries the main engine of human progress, and that governments have been the main obstacle to human flourishing .
And this, in turn, will shine a bright light on the dark truth of Davos and the Davosians. Namely, that they are fundamentally anti-humanists who believe that there are too many humans, and humans are too rich. That is, Milei embraces a view of progress that is antithetical to modern misanthropic progressives.
Too many normal people don’t understand that about the Davosians. Attempting to counter Milei’s arguments forces them to reveal that fact. When the only answer to “capitalism made us rich” is “being rich is a bad thing” the battle is all but won.
In the coming year the Supreme Court will rule in two cases that could result in the imposition of substantial constraints on the administrative state. Since federal administrative agencies are progressive pets, the prospect has the left freaking out. And I do mean freaking out.
The first case is Securities and Exchange Commission v. Jarkesy. Here Jarkesy is challenging the legitimacy of the SEC (and by implication other agencies) relying on internal administrative law judges (“ALJs”) to decide enforcement actions brought by the agency. Jarkesy argues that such cases should be tried in Article III courts (i.e., in federal court).
The Constitutional basis for his argument is compelling. Agencies flout the separation of powers: they combine legislative, executive, and judicial functions. In the case of enforcement actions like that against Jarkesy, the SEC brings the charges against the defendant/respondent, prosecutes the case, and if the agency uses an ALJ, tries the case and renders the judgment and assesses the penalty. The case is brought under regulations adopted by the agency in a quasi-legislative role (supposedly under powers delegated by Congress–an issue that is relevant in the other case I will discuss).
Jarkesy argues that being subordinate to, and accountable to, the agency, ALJs are not independent are subjecting him to their judgment violates his Constitutional rights, and in particular his right to due process.
As an empirical matter, Jarkesy has a compelling case. I recall that in an antitrust case, Justice Potter Stewart opined that the “only consistency” in such cases is “that the government always wins.” (That was in the 60s.). And that was before Article III courts. That is even more true in cases before ALJs in agencies like the SEC and FERC. (When is the last time a FERC ALJ decided against the agency in a big matter?)
Jarkesy therefore wants the trier of fact to be an ostensibly independent Article III federal court. He doesn’t want to have his fate decided by an ALJ who is effectively beholden to the commissioners who run the agency who are bringing the charges and prosecuting them.
Reasonable, no? But not to the progs. They are losing their sh!t over the prospect. Case in point, this article in the Atlantic–which is always a reliable barometer of prog opinion.
According to author Noah Rosenblum, this would represent The End of the World as We Know It.
It would “destroy the government”!!!!!!!! (He says this like it’s a bad thing!–JK).
Rosenblum’s argument veers between the hysterical and the dishonest.
This part in particular cracks me up:
Jarkesy’s second claim—that the internal adjudicator who first heard his case held too much independence—is especially galling. These adjudicators should be independent; the alternative would be to put their regulatory powers at the political whim of whichever administration might be in charge.
The relevant question is “independent from whom?” The very essence of Jarkesy’s argument is exactly that ALJs are creatures of “whichever administration may be in charge.” “The political whim of whichever administration might be in charge” is precisely the problem, not the “alternative.”
Article III courts are about as independent of the current administration (whether it be the presidential administration, or the commissioners of an agency) as is possible–and that’s by the Founders’ design. ALJs are definitely not.
Rosenblum loses control over his bowels at the thought that allowing those accused by federal agencies be judged by, you know, federal judges will gut the ability of agencies like the SEC to prosecute financial crimes:
The SEC was created as an independent agency in 1934, after the financial crash of 1929, to thwart the sort of market manipulation that preceded the Great Depression; Congress has granted it additional powers over the years to continue protecting financial markets. Responding to catastrophes and guarding against market manipulation is exactly the kind of work that Congress should empower the executive branch to do. Requiring Congress to legislate in response to every new fraud some crook might dream up would not be a good use of its time. And there’s no reason to think that delegating authority to police markets runs afoul of the Constitution.
Requiring those who “police markets” to prove their cases beyond the relevant burden of proof (preponderance of the evidence in a civil case) to a truly independent trier of fact does not permit manipulators and fraudsters to run rampant, any more than requiring your local police and prosecutor to prove charges before a judge allows murderers and rapists to run rampant.
Given the stakes in federal securities cases, which can easily run into the tens or hundreds of millions, if not more, requiring prosecuting agencies to clear such a hurdle is eminently reasonable.
What is Rosenblum so afraid of? These people would be prosecuted before Article III courts under the same laws and regulations that they are currently prosecuted before ALJs. A decision adverse to the SEC in Jarkesy would not eliminate the Securities Act, or the Exchange Act, or the SEC regulations adopted pursuant thereto. It would just require the SEC to prove cases brought under those acts and regulations in an Article III court rather than on the agency’s home court.
Rosenblum’s ultimate argument is that Jarkesy is a scumbag:
George R. Jarkesy Jr., a right-wing activist and conservative-radio talk-show host.
Heaven forfend that such a MAGA man should have rights! Oh! The humanity!
The kind of ad hominem chickenshit to which the left routinely resorts to today, and uses to stamp “QED!!!!” on its argument. By doing so, Rosenblum betrays the substantive weakness of his arguments.
I note that many seminal Supreme Court cases involving fundamental Constitutional rights have involved scumbags. And the Supreme Court ruled–rightly–that scumbags have rights too.
It is interesting to note that the CFTC now brings most of its manipulation cases–you know, “exactly the kind of work that Congress should empower to the executive branch to do”–in Article III courts. Now, as it happens, there is a tangled and unrepresentative story behind this, namely that the CFTC ALJs proved to be particularly dysfunctional and inveterately opposed to the agency’s enforcement staff. (I have intimate knowledge and experience regarding this history.). But the why is no matter. The reality is that an agency can bring manipulation cases (and fraud cases, for that matter) in federal court. Requiring the SEC (and other agencies) to do so will not “destroy the government” or allow wrongdoers to run rampant.
Indeed, the CFTC’s experience in federal court–most notably, its loss in the DRW/Wilson case–demonstrates the virtue of forcing agencies to play in the big leagues. It reduces the probability of Type II errors, i.e., false convictions.
I also note that there are rights of private action for certain federal securities, antitrust, and commodities law violations. Here private plaintiffs can bring cases in federal court against alleged malfeasors. I believe that such private rights of action are more reliable deterrents of bad conduct than agency actions, for a variety of reasons. (Again, this observation is based on considerable experience and observation.)
The other case that has the progs’ undies in a bunch is FDA v. Alliance for Hippocratic Medicine. This case threatens to demolish so-called “Chevron deference,” a reference to the case Chevron v. Natural Resources Defense Council in which Justice Scalia (!) on behalf of the court opined that courts should defer to agency judgements in cases in which Congress did not unambiguously delegate authority. That is, when there are “gaps” in a statute pertaining to a regulatory agency, Article III courts should defer to agency decisions regarding on how to fill those gaps.
The gravamen of Blinder’s argument is that agencies are experts, and we should defer to their expertise: we are not worthy to challenge them, nor are federal judges!
This has been the mantra of progressives since, well, the Progressive Era. Blinder is channeling his inner Woodrow Wilson. (Scary thought, that.)
There are two major problems with this. The first–and arguably less important–is that their “expertise” is vastly exaggerated. I mean vastly. Again based on extensive personal experience, I conclude that this is definitely the case when it comes to complicated markets (e.g., electricity, commodity derivatives). And yes, I realize that these complexities challenge federal judges, but the relevant question is who is better to resolve these issues: on that, I come down firmly on the side of the judges.
The second is what economists call “agency problems”–which in the present context can be called Agency problems. That is, the progressive view endorsed by Blinder (and Woodrow Wilson et al) is that agency decision makers are acting in the public interest.
This view has been laughable since the 1960s when Stigler posited “capture theory,” and then others like Sam Peltzman and Gary Becker looked at how the regulatory sausage is really made. The Public Choice literature has also utterly discredited the public interest view.
In a nutshell: regulatory agencies have their own agendas and own incentives that are not aligned with the public interest, for myriad reasons.
As valuable and insightful as they are, even the Peltzman-Becker-type analyses are inadequate. They are best suited to model the regulatory laws legislatures pass. They posit a decision maker looking to maximize political support (“votes”). That makes some sense when modeling legislatures that are somewhat accountable to an electorate. But the problem raised by Chevron deference is that regulatory agencies are incredibly insulated from such electoral feedback. If you view Congress as an agent of the public, agencies are agents of agents of the public. As a result, their incentives are extremely attenuated, and they have considerable scope to implement their own agendas regardless of whether they comport with the public interest or not.
Here’s my Cliffs Notes theory of regulation: a large unaccountable bureaucracy combined with Hayek’s “why the worst get on top.” Ideologues with agendas are attracted to agencies with power over their agendas. Ensconced in power, they are largely immune from external check. So ensconced, they wreak havoc, the public be damned.
People, I give you–the EPA.
That’s why deferring to these agencies is disastrous. Their “expertise”–really their specialization in subjects of particular interest to the ideologues who infest them–is positively dangerous when given free rein.
I hope that the Supreme Court decides in Jarkesy’s favor, and also hacks away at Chevron deference. That said, I realize that the Supreme Court usually splits the baby, and that ringing decisions that drastically curtail the scope of agencies’ powers are unlikely. Meaning that the war against the agencies–or more accurately, the war of the agencies against us–will continue.
Gary Gensler has been a menace to the market system for as long as he has been in government. Those of you who have followed this blog for a long time know that I relentlessly criticized him during his tenure as CFTC chairman. He apparently took notice, because he banned me from the CFTC building. I also consider it extremely likely that he was the moving force behind the 2013 NYT supposed hit piece on me–for which I should probably thank him, because on net that has turned out to be a major positive.
Gary Gensler. (Though this is how I like to think of him.)
At CFTC, Gensler was merely an Igor implementing the Frankendodd creation of his congressional masters. As head of the SEC, however, Gensler has become a full-fledged Dr. Frankenstein, stitching together regulatory monsters that threaten to stalk the landscape leaving economic devastation in their path.
I have already written several times about the SEC’s misguided Treasury clearing mandate. But that is only one of Gensler’s Monsters. There are many others.
Perhaps the most monstrous is the SEC’s proposed rule on climate-related disclosures. This would mandate that public companies disclose their carbon emissions–and those of their suppliers. This is at best vast speculative endeavor, and and worst an impossibility. It’s main concrete effect will be to provide a pretext for lawsuits against companies targeted by activists who will allege that the companies’ calculations were wrong, or were lies because alternative internal calculations came up with numbers that differed from those reported in their 10Ks.
The regulation would also require companies to make fulsome disclosures of their climate risks. Another speculative endeavor that cannot produce any meaningful or useful information. It requires each company to characterize the interaction between one complex system–climate–and another complex system–the economy–to predict the adverse consequences of this interaction for it, a small part of the economic system allegedly impacted by climate. Prognostications about climate are themselves wildly uncertain–indeed, arguably the biggest risk is model risk. Predicting how climate will impact economic outcomes at the company level under myriad possible climate scenarios is a mug’s game.
And indeed, it is even worse than that. For there is another element to the problem–government policy. This introduces an element of reflexivity that is particularly devilish. Government policy will respond to climate and economic outcomes as well as interest group pressure, and will affect economic outcomes (though whether these policies will actually affect climate outcomes is dubious). This is arguably by far the biggest risk that companies face.
Meaning that if the regulation comes into force, I recommend the following boilerplate disclosure for all companies: “We face the risk that some government agency will adopt a boneheaded policy that will dramatically raise our cost of doing business or eliminate the markets we service.”
This will also be a boon to lawyers. “Company X failed to disclose the risk associated with [insert climate scenario here] described in [poorly executed paper published in obscure journal].”
And I ask: how will this information improve the allocation of capital? It is more likely that this will just add noise that impedes efficient capital allocation, rather than actionable information that improves it. The hive mind of investors is likely far more adept at evaluating the effects of the climate-economics-policy nexus than the managers of corporations.
I further note that this obligation’s burdens are greater for small companies than big ones. Meaning that it will likely lead to exit and consolidation, and greater concentration. Which other parts of this administration–notably Lina Khan’s FTC–think is a great evil. Ironic, that. Ironic, but not humorously so.
Moving right along, the trendy Gary has targeted the New Thing, Artificial Intelligence. In public statements Gensler has made the at least somewhat plausible argument that interactions between very similar AIs can produce destabilizing positive feedback mechanisms. But the SEC’s proposed AI regulation instead focuses on potential agency problems:
Today’s predictive data analytics models provide an increasing ability to make predictions about each of us as individuals. This raises possibilities that conflicts may arise to the extent that advisers or brokers are optimizing to place their interests ahead of their investors’ interests. When offering advice or recommendations, firms are obligated to eliminate or otherwise address any conflicts of interest and not put their own interests ahead of their investors’ interests. I believe that, if adopted, these rules would help protect investors from conflicts of interest — and require that, regardless of the technology used, firms meet their obligations not to place their own interests ahead of investors’ interests.”
But under the guise of minimizing conflicts of interest, the SEC now proposes requiring advisers and broker-dealers to write new internal procedures and to log all uses of technologies relating to predictive data analytics for agency review. If left unchallenged, the new rules would hamper the American financial industry’s world-beating innovation.
The definition of what must be disclosed is comprehensive:
“an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes in an investor interaction.”
This would basically encompass EVERY analytical function performed by covered entities, including e.g., quant traders’ algorithms, portfolio optimizers, and on and on and on. Basically any use of statistical methods is implicated (note the reference to “correlation matrix”).
Perhaps the “investor interaction” language will limit this to principle-agent applications (as bad as that would be), but it is so broad that it is highly likely that the SEC will interpret it to cover, say, an HFT firms algorithms to predict and analyze order flows. That involves “an investor interaction.”
This all brings to mind previous regulatory initiatives to require disclosure of all trading algorithms–something that was mercifully killed.
And what will the SEC do with this information? This would represent a massive amount of highly technical information that the SEC would not have the capacity or expertise to analyze proactively, and information that would metastasize inexorably. Hell, even storing the information would be a challenge.
Again, like the climate reg, this seems all pain no gain. This disclosure would entail massive cost. And for what? To find an agency violation needle in a massive informational haystack? Agency violations (such as trading ahead) that could not be detected using existing methods?
“Currently, the playing field upon which broker-dealers compete is unlevel,” said SEC Chair Gary Gensler. “Through volume-based transaction pricing, mid-sized and smaller broker-dealers effectively pay higher fees than larger brokers to trade on most exchanges. We have heard from a number of market participants that volume-based transaction pricing along with related market practices raise concerns about competition in the markets. I am pleased to support this proposal because it will elicit important public feedback on how the Commission can best promote competition amongst equity market participants.”
Volume discounts are obviously pervasive throughout the economy in the US and indeed the world. So why should these be somehow so nefarious in stock trading as to require their elimination?
Let’s apply some economics–which alas is an alien concept to Gensler. There are two basic reasons for volume discounts.
One is that it is cheaper to service bigger customers. In which case volume discounts are efficient, and banning them would be unambiguously bad.
Another is that it is a form of price discrimination. For example, big intermediaries may find it easier/cheaper to shift business between exchanges than smaller intermediaries, in which case their demand for the services of a particular exchange would be more elastic than the demand of the smaller firms. Exchanges would then rationally charge lower prices to the more elastic demanders.
The welfare effects of this type of price discrimination are ambiguous, making the case for banning it–even if it can be established that the volume discounts are demand-elasticity-driven discrimination vs. cost-based discrimination–ambiguous as well.
With respect to “concerns about competition,” well, elasticity-based discrimination requires that inter-exchange competition not be perfect in the textbook sense. But if that is what is driving the volume discounts, outlawing them treats a symptom of market power rather than market power itself, and how “imperfectly competing” exchanges will price when they can’t price discriminate is very much an open question–and exactly why the welfare effects of price discrimination are ambiguous.
Gensler seems to be channeling discredited Robinson-Patman like logic that protected the high cost against competition from the low cost. That is anti-competitive, not pro-competitive.
These are only some of the monsters the Frankensteinian Gensler is assembling in his DC laboratory. I could go on, but you get the idea.
There is hope, however. Whereas Gensler’s CFTC actions were largely rooted directly in very specific statutory directives, his work as Dr. Frankenstein is based on extremely expansive interpretations of the SEC’s statutory authority dating back to the 1930s. Such expansive interpretations–not just by the SEC, but many other agencies–are currently being challenged in the courts, including cases pending before the Supreme Court.
It is possible therefore, and indeed to be fervently hoped, that the Supreme Court will hand down decisions that demote Gensler back to Igor implementing very specific Congressional mandates, and end his career as regulatory Frankenstein.
And the benefits of such decisions would extend beyond reining in the SEC, for as bad as it is that agency is probably not the worst offender–the EPA probably is, but the competition for this dubious honor is intense. The administrative state–the American Mandarinate, as I like to think about it–needs to be culled. And with extreme prejudice, and as soon as possible.
Regardless, one question that hasn’t been asked in all the to-ing and fro-ing about Treasury basis trades is why they exist at all, let alone why they get so big. This graph (courtesy of FTAlphaville, based on CFTC data) provides a major clue:
Note the mirror image between leveraged funds (mainly hedged funds) and asset managers (ostensibly non-leveraged funds–the reason for the “ostensibly” will become clear shortly).
To the extent that hedge funds’ short positioning reflects basis trades, the graph suggests the following. Hedge funds take a leveraged market neutral position, buying bonds, funding them via repo, and selling futures. Futures are in zero net supply: the graph shows that the longs on the other side of the hedge funds’ futures short are asset managers.
Most asset managers do not, and in some cases even cannot, take leverage directly. So for example they are constrained in their ability to just buy Treasuries with borrowed money (e.g., via repo). But the basis trade allows them to lever up via futures. So in some sense, the basis trade is just an additional link in a chain of intermediation. Laundering leverage, if you will.
(A more complete picture might add swap dealers to the picture. Some managed money, such as leveraged ETFs, enter into swaps with dealer banks. The dealer banks in turn can hedge by taking offsetting futures positions.)
The hedge funds expect to earn a small margin on the trade–on average, though there is risk. The market is pretty competitive, so to a first approximation that margin (the difference between the actual futures price and the theoretical futures price derived from bond prices, bond vols and correlations, and repo rates) equals hedge funds’ marginal cost of supplying this intermediation. The asset managers on the long side of the futures trade are willing to pay “too high” a futures price (relative to bond prices) because this is a cheaper way of achieving a leverage target than via the available alternatives.
The March 2020 experience shows that the basis trade can be a fragile one that creates some systemic risk: this is why regulators are concerned about basis trades now, to Ken Griffin’s chagrin. Providing this leverage intermediation/laundering creates tail risks for the hedge funds that do so. This raises the question of whether there are regulatory constraints that inefficiently constrain the ability of asset managers to take leverage more directly, rather than via a longer dealer (or money market) to hedge fund to asset manager chain. If so, such constraints could give rise to unnecessary (systemic) risks.
If regulators are concerned about the systemic risks in basis trades, they should take a systemic approach–and understand more fully why basis trades exist in the first place, and why they have periodically become so large. Looking at individual links in the chain (hedge funds, or by Griffin’s lights, banks) can be misleading because it begs the question of why the chain exists in the first place. The link that is driving the process is likely the one that has escaped discussion so far–the asset managers at the end of the chain. Why do they want leverage and why is the basis trade the most cost effective way of supplying a lot of it? Could it be the most cost effective because other, more directly intermediated sources of leverage are unduly expensive because of regulatory or institutional constraints? Definitely worth regulators’ attention.
The market for United States Treasury securities (notes and bonds) has been a source of concern for some years, dating back to the Treasury “flash” event of 15 October 2014, but especially in the aftermath of the “dash for cash” during the March 2020 Covid scare. The relentless selloff of Treasuries in the past year plus has contributed to the angst.
This has led the SEC to propose various changes to the structure of the Treasury market. The most important of these is mandated central clearing of most Treasury cash trades and repos. Well, since Gigi is back in the clearing saddle, I guess I have to mount up too.
Just as with the Frankendodd clearing mandates, the case for Treasury clearing is very weak.
The basic argument is that Treasury market liquidity has eroded, and that clearing will enhance market liquidity. The supposed main cause of the decline in liquidity is that primary dealers face balance sheet constraints that limit their ability to intermediate the Treasury market.
In the Duffie paper and the Duffie, Fleming et al paper he cites, the main evidence of the deleterious effects of balance sheet constraints comes from the “dash for cash” in March 2020. Summarizing a variety of measures of market liquidity using principal components analysis, they show that liquidity usually varies inversely with market volatility, but liquidity declined far more than predicted by volatility alone in 2020. This was due, it is claimed, to the fact that dealers were not able to increase their holdings of Treasuries due to balance sheet constraints. Their ability to make markets was therefore constrained.
There is a big problem with this analysis. Dealers ended up holding far more Treasuries because Covidmania caused a sharp drop in the demand to hold Treasuries by hedge funds and others–they wanted to substitute cash for Treasuries. Part of the demand drop was accommodated by a price decline, but evidently dealers’ demands did not drop as much as the demands of non-dealers: thus, there was a major portfolio adjustment, with hedge funds etc. reducing their holdings and dealers absorbing as much of these sales as their balance sheets allowed.
Thus, this was a structural change in demand that led to major portfolio adjustments. Yes, the portfolio adjustments were accompanied by a decline in conventional measures of liquidity (bid-ask spreads, depth, etc.) but this decline in liquidity was a consequence of the underlying shock, and clearing of cash Treasuries or repos would have had little, if any, impact on this decline. Even if clearing increased dealers’ balance sheet capacity (something I discuss further below), given the underlying Covid-driven (and Covid policy-driven) demand shock it is highly likely that this incremental capacity would have been fully utilized as well and liquidity would have been about as bad.
This extraordinary shock that led to strained dealer intermediation capacity is different than the types of shocks that dealers typically intermediate. The role of Treasury liquidity suppliers–be they dealers or prop trading firms–is the same as the role of liquidity suppliers in any other market, be it stocks or currencies or commodities: to utilize inventory adjustments (balance sheet) to absorb temporary, temporally uncorrelated, and largely cross-sectionally uncorrelated investor (buy side) demand shocks. The dash for cash was a long-lasting shock highly correlated across major investors in Treasuries. It was a systematic shock that led to a long lasting adjustment in dealer portfolios, whereas market makers absorb idiosyncratic shocks that do not require long lasting adjustments to dealer portfolios.
That is, the kind of portfolio adjustments that occurred in response to Covid were fundamentally different in nature from the kind of portfolio adjustments that firms undertake to make markets. A long term transfer of risk rather than a short term transfer.
Therefore, using the dash for cash as the basis for policies intended to improve Treasury market liquidity is fundamentally misguided.
Be that as it may, it provides the underlying logic advanced for clearing mandates: improving liquidity requires increasing dealer balance sheet capacity, and clearing can supposedly do that.
How can clearing improve balance sheet capacity? The mandate defenders offer that hardy perennial as a justification: netting. For both cash Treasuries and repos, the argument goes, netting out offsetting exposures reduces the amount of capital and cash that dealers require to intermediate. For cash transactions, Duffie, Fleming et al estimate that netting would reduce daily settlement volumes substantially (70 percent in March 2020 according to their figures). This, and other factors, allegedly result in freeing up of dealer balance sheet capacity.
This analysis begs an important question: since dealers would internalize the benefits of more economical use of balance sheets that would result from clearing, why is it necessary to mandate it? Why don’t dealers and other market participants voluntarily utilize clearing more extensively in order to economize on the use of a scarce resource–balance sheet? After all, historically voluntary adoption of clearing in the stock market (e.g., NYSE clearing and CBOT clearing in the 19th century) was specifically intended to reduce settlement volumes by netting. In the case of the CBOT, the clearinghouse netted payment obligations but did not mutualize credit risk on derivatives transactions or impose margins (which were negotiated bilaterally).
The alleged failure of profit-motivated entities to reduce cost (from inefficient use of balance sheets) suggest that this does not come for free: at the margin there must be some cost for clearing that is greater than the putative benefit. That is, profit maximizers will balance marginal private benefits and marginal private costs. The benefits of netting from clearing are private, and thus the current degree of penetration in clearing likely reflects an efficient balancing of these marginal benefits and costs. The advocates of a mandate surely have not shown otherwise.
I further note that, as I wrote repeatedly during the Frankendodd era, netting redistributes default risk rather than reduces it. It is by no means clear that the distribution of default risk under central clearing/netting is more efficient than that under bilateral clearing.
Put differently, the advocates of clearing (both cash and repo) have not identified a “market failure”, e.g., a benefit from clearing that market participants do not internalize. Such a failure is a necessary (but not sufficient) condition for regulatory intervention such as a clearing mandate.
With respect to repo clearing, another supposed benefit is the disparity of margins (“haircuts”) in the repo market. Haircuts for some counterparties are low, but for others they are higher. Central clearing would impose uniform, value-at-risk (“VaR”)-based margins.
The operative theory behind central clearing is that the “loser pays”, namely the resources (margin, default fund contribution) posted by a counterparty is sufficient to cover any losses in the event of that counterparty’s default. Ideally, counterparty credit risk in central clearing is zero, though in reality some always remains.
Well, this begs another question: is the optimal amount of counterparty credit risk/default risk zero (or close to zero) in all transactions? Relatedly, is it optimal not to permit the pricing of counterparty credit risk, where the price varies by the creditworthiness of counterparties, with high credit quality entities paying smaller haircuts than lower quality credits? Central clearing makes pricing independent of creditworthiness, whereas bilateral arrangements that advocates of clearing dislike allow pricing of credit risk that reflects assessments of creditworthiness of counterparties.
Since credit risk mitigants (including margins/haircuts) are costly, and since market participants trade-off the costs and benefits of credit risk and its mitigants, allowing choice and competition on this dimension has strong justifications. Certainly the advocates of mandatory Treasury clearing have not identified a “failure” in this market that justifies regulatory intervention in the form of clearing mandates.
Put differently, clearing mandates force market participants to a corner solution–clear everything, and impose margins that make counterparty credit risk de minimis. The existing state of the market, where market participants can choose to clear with a CCP or not, reveals that they strongly do not prefer the corner solution. Furthermore, the advocates of clearing have failed to identify any market failure that implies that the interior solution/equilibrium is inefficient and can be improved by mandating the corner solution.
And the advocates have yet again failed to recognize the trade-off inherent in clearing: that is, the trade-off between counterparty credit risk and liquidity risk. This despite the fact that the reality of this trade-off has been made abundantly clear (no pun intended) repeatedly in the past–and including in particular the Treasury market basis trade turmoil during the dash for cash.
The real issue in Treasury markets right now, and the real threat to their stability, is the massive deficits in the United States, and the resultant increase in Treasury security issuance and Treasury securities outstanding. It is deficits and issuance that are driving the massive increase in the size of Treasury markets, and the consequent strains on the ability of dealers and others to intermediate the swollen market.
This is a challenge that no rearranging the market structure furniture on the deck of SS Treasury Titanic will fix. Furthermore, the economic case for mandating clearing of Treasury cash and repo transactions is laughably weak even if one overlooks that fact that clearing does not get at the real problem. But it appears that Gigi (cheered on by the Fed) will mandate a corner solution that makes the market less efficient, not more.
In March, 2020 the Federal Reserve injected massive amounts of liquidity into the markets in response to a blow-up in Treasury basis trades. I wrote about it here.
In recent weeks, the Fed, the BIS, and the BoE have raised red flags about the renaissance of this trade and the resulting potential for systemic risk a la 2020. Not all are convinced. Goldman Sachs in particular is in Alfred E. Neuman mode: What? Me worry?
We do not think the trade poses a major risk to Treasury markets in the near term . . . Leverage in the system is materially lower than it was in 2019/20 as a result of a series of [initial margin] increases (and price declines). The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.
This assessment is based on a fundamental error that I went on about ad nauseam in the post-Great Financial Crisis clearing debate, specifically, concluding that if leverage goes down in one part of the system it goes down systemically. Wrong. Wrong. Wrong.
Yes, the ostensible purpose of higher margins is to reduce leverage in the margined trades. But especially for the hedge funds and other sophisticated entities who engage in the Treasury basis trade at scale, they can substitute one form of leverage for another.
As a first approximation, a fund has a leverage target or a level of debt capacity, it can fund the higher margin in the less leveraged futures trade by increasing leverage elsewhere. The funds will typically evaluate leverage holistically, not on a trade-by-trade basis.
It is therefore fundamentally logically flawed to conclude that “leverage in the system” (which is in fact source of systemic risk) has declined because it has gone down in one piece of it.
If there are constraints on funds’ ability to offset mandated leverage reductions in one type of trade by increasing leverage elsewhere, that would increase the cost of engaging in that type of trade and would impact the scale of that trade. But what has alarmed the central bankers is exactly that the scale of the trade has increased and now exceeds its 2020 level:
Note that leveraged funds’ Treasury futures shorts are currently substantially larger now than in 2020. Thus, despite higher margins, the scale of the trade is subsantially larger–and it is the scale–and the concentration–of the trade that poses systemic risks.
This bigger scale could be because raising margins doesn’t really constrain the ability of funds to lever up to engage in basis trades. Or it could be that even though the higher margins raise the cost of the trade, the spread has widened sufficiently to offset, or more than offset the higher cost. For example, constraints on dealer balance sheets that impair liquidity in the cash market could depress cash prices relative to futures prices.
Goldman’s errors don’t end there. One thing that could spark a margin spiral is an increase in initial margins that induces mass liquidations that lead to changes in the basis that lead to large variation margin obligations–something that Goldman doesn’t mention.
Alfred E. chimes in again here: “The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.” That is, Goldman’s conclusion is essentially based on a very benign view on Treasury volatility.
There are myriad reasons to take a different view. The US’s acute fiscal situation and the accompanying periodic debt limit dramas. The constrained balance sheets of dealers that limit their ability to supply liquidity to the Treasury market. The prospect for an extremely chaotic election year. And geopolitics, with now two major disturbances ongoing (Ukraine and Israel/Gaza) with one continually on the boil in the background (China/Taiwan). And highly unsettled geopolitics with a feckless and befuddled administration at the tiller.
That is, it isn’t the level of margins that really matters. It is the possibility that margins may increase due to higher volatility. Goldman/Neuman isn’t worried. I think that’s unduly optimistic. Furthermore, an assessment of systemic risk must be based on the likelihood that Goldman’s don’t-worry-be-happy opinion is wrong.
And remind me: did Goldman predict the increase in Treasury volatility in 2019 or 2020? Stuff happens. Unknowns and unknowns and all that.
Furthermore, higher volatility->higher IM->liquidation of basis positions->margin spiral isn’t the only potential source of systemic risk. Other economic shocks can cause leveraged funds to slash positions and leverage, leading to liquidations of basis positions and the triggering of a margin cascade. That is, there is the possibility of fire sales.
These shocks can be systematic–a broad decline in stock or bond markets–or concentrated at a few funds, or even one, due to bad trades in other markets.
The 30 25 year anniversary last month of the LTCM collapse brings the latter to mind. Bad bets on convergence trades forced LTCM to liquidate and delever. Understandably, it attempted to unload its most liquid positions–including short Treasury futures. Treasuries had a massive rally on LTCM day that was not matched by a similar rally in the underlying, less risky Treasuries.
A squeeze–not unheard of in government debt futures markets–can also impose losses on basis trades, leading to liquidations that can exacerbate the price impact. Or a Treasury flash crash (in yields, and hence a flash spike in prices) like on 15 October 2014.
In sum, size does matter. Basis trades have become big again, and the factors that lead Goldman to parrot Alfred E. Neuman are hardly persuasive. From a systemic risk perspective, basis trades represent dry tinder that can explode into flame. Can does not mean will. But the possibility is there, and the effect if the right spark hits the tinder depends on the size of trade. The big scale and concentration of this trade thereby justify far more concern than Goldman expresses.
Federal Trade Commission chair Lina Khan has had her undies in a bunch about Amazon since she wrote an overly long and overly praised Harvard Law Review article about it. Now as a capo in the administrative state, Khan has the power to execute her vendetta, here in the form of a massive antitrust lawsuit against the e-commerce giant.
The case is a farrago of economic ignorance and idiocy. It brings to mind Coase’s remark (which I paraphrase) to the effect that a certain kind of mind sees a non-textbook contracting practice and immediately concludes it is an evil monopolizing practice.
Quite the mystery! I mean, maybe it’s possible but the “somehow” part seems rather miraculous. Ask the 1970s-80s Big Three about how degrading quality raising prices usually works out, market share-wise.
This theory brings to mind the Underpants Gnomes:
So yeah I’d really like some explanation how that works, exactly. Neither Stoller or the FTC provide it.
The specifics of the FTC case are hardly more persuasive. I’ll look at the ones they highlight in their press release.
Leading with their best?
Anti-discounting measures that punish sellers and deter other online retailers from offering prices lower than Amazon, keeping prices higher for products across the internet. For example, if Amazon discovers that a seller is offering lower-priced goods elsewhere, Amazon can bury discounting sellers so far down in Amazon’s search results that they become effectively invisible.
If so, God save them.
As background, Amazon used to have a contractual term that precluded such differential pricing across platforms. The Euros no likey, so Amazon did it by algorithm (which twists Matt Stoller’s undies).
Contract, algo, whatever. However implemented, this is basically a form of resale price maintenance (RPM). My thesis advisor and mentor, the late, great Lester Telser, wrote the seminal article on the subject when I was one (so maybe the FTC should have caught up by now). Telser argued that RPM is efficient when some retailers provide costly “special services”–notably information–to their customers. This creates a potential free riding problem. Sellers can free ride off the information/special services provided by some retailers/platforms and sell at a discount at stores/platforms that don’t offer the costly service.
Amazon provides a lot of information on products, including product reviews. Offering a product on Amazon, a seller’s potential customers can learn about the product there, and in the absence of the restriction that the FTC is attacking, can then go and buy it from a platform that doesn’t incur these costs, thereby free riding on Amazon’s information provision.
Next up is a real doozy:
Conditioning sellers’ ability to obtain “Prime” eligibility for their products—a virtual necessity for doing business on Amazon—on sellers using Amazon’s costly fulfillment service, which has made it substantially more expensive for sellers on Amazon to also offer their products on other platforms. This unlawful coercion has in turn limited competitors’ ability to effectively compete against Amazon.
For one thing, I don’t see how requiring use of Amazon fulfillment on sales via Amazon raises the cost of selling on other platforms. But even putting that head-scratcher aside, where is the “coercion” here? Amazon offers a bundle. They don’t put a gun to your head forcing you to take it.
Further, there is a very good efficiency reason for this bundling. Amazon offers a delivery guarantee. If it vertically integrates into shipping, it has considerable control over whether it performs according to the guarantee. If a seller uses another shipper, Amazon has no such assurance.
Again, there is a free rider problem. Seller gets sales from customers expecting speedy delivery. Seller uses a cheap but less reliable carrier. Goods arrive late, or in bad condition. Whom is the customer mad at? To whom does the customer look for recourse? Amazon.
Vertically integrating into shipping reduces the cost of providing the guarantee that buyers like.
The FTC also apparently doesn’t understand the basic point that if alternative carriers are cheaper than doing it in house, by forcing customers to use a higher cost service Amazon reduces the derived demand for its services and its platform. Since–as the FTC also whines about–Amazon apparently prices to extract large sums from sellers, in the absence of efficiency benefits like those just described, it would be able to, and find it more profitable to let sellers choose their putatively cheaper carrier and charge the sellers a higher price to sell on Amazon.
Next!
Degrading the customer experience by replacing relevant, organic [but are they vegan????] search results with paid advertisements—and deliberately increasing junk ads that worsen search quality and frustrate both shoppers seeking products and sellers who are promised a return on their advertising purchase.
This is basically the Stoller argument. I’ve already discussed its facial absurdity. But it’s also absurd when you dig deeper.
Search ranking is a scarce resource, and an extremely valuable one. Scarce resources have to be allocated somehow. Usually best way to allocate a scarce resource is to price it. (This is done all the time with online advertising, by the way.) So what is the best way to price this resource?
An auction? Possible–Amazon has no doubt considered that. But maybe pricing through advertising is superior. I don’t know, but given that advertising can serve a reputational branding role, and can provide information, it may well be the case that for selling information-intensive goods, or goods of uncertain quality, advertising is better than auction to prioritize search results.
What I do know is that Amazon internalizes the costs and benefits here. Meaning that they have the incentive to choose the best alternative. Lina Khan–not so much.
And I can guarantee that if Amazon allocated search ranking by auction or some other pricing mechanism, that would cause the FTC to have a meltdown too. They apparently believe that “organic” rankings (WTF are those?) sans pricing of any form are best.
Fine. Start your own platform, Lina.
And next:
Biasing Amazon’s search results to preference Amazon’s own products over ones that Amazon knows are of better quality.
Preferencing in the absence of some other efficiency advantage is hard to rationalize–and certainly the FTC provides no such rationale. Again, since Amazon could extract the alleged quality advantage (and perhaps cost advantage) of the third party sellers by raising its prices to them, why offer lower quality products?
Here’s one reason: by offering its own products, and competing on price and perhaps visibility, Amazon is entering the market, creating competition, and inducing third party sellers to reduce prices. Which helps consumers and drives them to use Amazon. That is, by creating competition preferencing is pro consumer.
And finally:
Charging costly fees on the hundreds of thousands of sellers that currently have no choice but to rely on Amazon to stay in business. These fees range from a monthly fee sellers must pay for each item sold, to advertising fees that have become virtually necessary for sellers to do business. Combined, all of these fees force many sellers to pay close to 50% of their total revenues to Amazon. These fees harm not only sellers but also shoppers, who pay increased prices for thousands of products sold on or off Amazon.
Oi. Amazon charges fees. Who knew? Amazon has market power that allows it to charge high fees. Also hardly a revelation.
But this would apparently be a revelation to the FTC: it is not an antitrust violation to exercise market power gained by “superior skill, foresight and industry.” Only nefarious acts to monopolize fall afoul of the antitrust laws.
This one should be a slam dunk for Amazon’s lawyers.
One thing that jumped out at me in the complaint that isn’t in the press release: Amazon’s pricing and policies make it difficult for “single-category ecommerce companies to achieve the scale they need to succeed.”
So, who says they should succeed? Amazon’s success and the success of other platforms (e.g., Walmart) suggests that there are strong economies of scope here, which would make “single-category” platforms inefficient. We don’t want inefficient platforms to survive. If the FTC were to get its way, and somehow handicap Amazon so that inefficient single-category platforms that can’t exploit economies of scope survive, we are worse off.
One interpretation of the anti-Amazon arguments are that it is essentially using its scale and scope economies to price below the cost of alternative platforms, so those platforms don’t enter. This is analogous to Demsetz’s theory of natural monopoly, or the behavior of a dominant firm in a contestable industry (a la Baumol, Panzar, Willig). In these theories, there is no entry, but that’s a good thing because entry would be duplicative (given the scale and scope economies). Moreover, the potential for entry disciplines the incumbent’s pricing, mitigating traditional monopoly triangle losses.
The FTC’s lament about the high prices charged to sellers on Amazon’s platform highlights a major lacuna in its attack: the failure to take into account that Amazon is a two-sided platform. Pricing in two-sided platforms is quite complex, and it is impossible to evaluate Amazon’s pricing justly without taking these complexities into account.
One thing missing from the complaint is one of Khan’s law review criticisms–that Amazon uses the information generated from its operation of the platform to identify profitable entry opportunities, i.e., to identify products that Amazon can produce (or procure) and sell in competition with third party sellers.
Entry is pro-competitive, dontcha know. It tends to lower prices. I’m sure that’s news to you.
Companies perform market research all the time to identify which markets they can enter profitably because they can make products better or cheaper than incumbents. If Amazon can perform this research low cost due to the information it sweeps from the platform–great! Let them use it. (I note that an early theory of vertical integration advanced by Ken Arrow was that such integration produces information that the upstream firm can use to make better decisions.)
In sum, the FTC case against Amazon is pathetic. I would characterize it as economics free. Or maybe more accurately anti-economics.
It is also entirely untethered to any credible theory of how Amazon’s actions harm consumers, or more importantly, how eliminating the practices that the FTC decries would benefit consumers. And as my foregoing arguments show, consumers would almost certainly be harmed if the FTC gets its way.
But this is not a surprise. The Khan FTC has explicitly rejected the Consumer Welfare standard that has guided antitrust since Robert Bork first mooted it in the 1970s.
Now I have my issues with the way courts have interpreted the standard–which, alas, is largely due to how Bork framed it. A close reading suggests that Bork interpreted “consumer welfare” to mean efficiency-enhancing. The courts have typically read it to mean “lower prices to consumers.” Now in many contexts, the courts’ Cliff’s Note version leads to the right results–but not all.
That is only a reason to refine the standard, not to reject it altogether. But reject it the Biden FTC and DOJ have.
Which is why, as a general matter, and in the specifics of the Amazon case (and other cases Khan’s FTC has filed), it is more than fair to say that “FTC” really means “F the consumer.”
