Streetwise Professor

Today Elizabeth Warren and John McCain unveiled the “21st Century Glass-Steagall Act” that would restore the separation of investment banking and commercial banking, along with a few new restrictions on the things commercial banks with access to deposit insurance can invest in.

I really don’t get the nostalgia for Glass-Steagall.  I really don’t.  What’s next?  High Button Shoes for the 21st Century?  Radio tubes for the 21st Century?

Smarter people than McCain and Warren (a bar that a snail could jump, I admit) have pumped for the restoration of Glass-Steagall.  Luigi Zingales is a prominent example. I expressed my criticisms of Zingales’s advocacy of Glass-Steagall a little more than a year ago, and nothing I’ve seen since changes my mind.  Certainly the bloviations of Warren and McCain don’t.

The essence of the argument for a restoration of Glass-Steagall, as well as “ring fencing” regulations in Europe, appears to be that deposit insurance creates a moral hazard: banks with access to insured deposits take on too much risk.  Preventing such banks from engaging in risky investment banking activities supposedly improves the safety of the banking system, and limits taxpayer exposure, by reducing that moral hazard.

There are only two problems with that.

First, access to deposit insurance is obviously not a necessary condition to induce risk taking.  None of the stand-alone IBs that took on leverage out the wazoo in the 2000s, and took exposures to highly risky real-estate related securities-Bear, Lehman, Merrill, Morgan Stanley and even, yes, Goldman-had access to deposit insurance.  And that was in  fact the problem.  Nor did they have statutory access to Fed support in the same way banks do.  They all relied on very fragile wholesale funding that ran like Usain Bolt when things started to look dodgy.

Second, Glass-Steagall-like restrictions on permitted activities/investments are not sufficient, by a long shot, to prevent commercial banks from taking on risks that threaten their solvency, and the stability of the financial system.  Look at all the banking problems in the 70s, 80s, and 90s that occurred despite Glass-Steagall.  Sovereign lending to Latin America.  The S&L crisis.  Lending to Asia before its 1997-1998 crisis.  Commercial lending to the energy industry.  Need I remind everyone that the phrase “too big to fail” was coined to describe Continental Bank, which became insolvent the old fashioned way: engaging in high risk commercial lending in the era of Glass-Steagall?

The “quiet period” of US banking the 50s and 60s was the result of a dense nexus of costly restrictions on banking activity.  Glass-Steagall was a part of that, but not the entire story by a long shot.  It just gets the most press, and the best press.  The complex web of restrictions on banks and financial intermediation during that period-restrictions that imposed substantial costs-is too hard to explain.  So Glass-Steagall has become the poster child for that era. People like Warren and McCain think that Golden Age can be restored by reviving Glass-Steagall.  As if.

I am deeply skeptical of restrictions on the activities of financial intermediaries; I am also skeptical of mandated impositions of market structure (e.g., clearing mandates).  The underlying incentives remain the same, and these Byzantine restrictions induce attempts to circumvent them.  It is better to operate at the level of incentives, through capital requirements, for instance.  Yes, there will be attempts to circumvent these too, but at least they provide some incentive for those with the information to internalize the risk-return trade-offs.  Structural restrictions, not so much.  At all.

Yes, moral hazard induced by deposit insurance matters.  But it matters a lot less than other things.   Breaking up universal banks will still leave large investment banks reliant on wholesale funding with incentives to lever up, and large commercial banks who can blow themselves up just fine, thank you, by making loans.  So the revivification of Glass-Steagall won’t materially reduce systemic risk, but it will induce costly efforts to circumvent the separation, and will sacrifice the synergies between investment and commercial banking activities.

When your diagnosis is wrong, the prescription is likely to be wrong too.  And with financial doctors like Warren and McCain, we should have no illusions that they’ve screwed up both.

Gary Gensler has been an evangelist for transparency in derivatives markets.  He has tirelessly argued that increasing transparency, especially in the OTC markets, will go a long way to making them more competitive and more efficient.

But Gensler apparently believes transparency works no such miracles for the operations of the CFTC.  Energy traders (including the industry and the banks) are completely at a loss to explain the CFTC’s ominous special call for information about exchange of futures for swaps (and other related positions (Risk subscription required-unless you know the trick.)  (I expressed my amazement at this ex post facto scrutiny when the story first broke.)   Why is the CFTC giving EFS the stink eye after years of not merely acquiescing to them, but actively encouraging them as a way of putting energy trading back on its feet after the merchant energy meltdown of 2002-2003?  Who knows?  The CFTC isn’t saying.  Hell, the CFTC isn’t even admitting that it is conducting an inquiry:

The notices contain no information about the CFTC’s motives – and a spokesman for the agency declines even to confirm the existence of the special calls – leaving dealers and their lawyers to guess why the regulator has sud-denly decided to probe a market that it helped set up over a decade ago. Part of the answer is that, however it may appear, this is not a sudden change of heart.

How’s that for transparency?!?

The Risk article does provide some interesting background on previous Commission attempts to crack down on certain kinds of EFS transactions.  Failed attempts, I should emphasize, because the proposal could not get a majority of the commissioners to vote for it.

To me, EFS seem like a tremendous example of financial innovation that solved a serious problem in the energy markets and facilitated an objective that Gensler otherwise embraces enthusiastically: moving OTC transactions into clearing.  The market success of this innovation speaks volumes about its value.  It’s rather hard for me to see what’s objectionable about it.

But maybe I’m wrong.  I’d be more than willing to entertain these objections.  But in order to do that, I’d have to, you know, know what they are.  Which would require some transparency from the Apostle of Transparency.

Dealer banks and the CME squared off in the pages of the FT today, arguing over the systemic risks of CCPs.  Each made some good points; each whiffed on a few; both overlooked the real sources of systemic risk arising from clearing mandates.

First, the banks:

“We are losing track of the nominal risk,” warned Jean-Pierre Mustier, head of investment banking at UniCredit and a former board member at London-based LCH.Clearnet. “We’re moving from a set-up where banks were interconnected, because they had transactions between them, to a system where very lowly capitalised entities, the clearing houses, are supposed to protect the banks from a problem.”

. . . .

Banks have voiced concerns to regulators in Europe and the US that central clearing houses are providing insufficient data on their own risks and demanding lower-quality collateral for swaps transactions. They argue the risks are too opaque, and getting riskier.

“It’s going in the wrong direction,” said the head of credit trading at a large US bank. “The race to the bottom is on.” He and other executives were critical of the CME’s decision to accept corporate bonds as collateral, a step down from the safer instruments usually required for margin.

There are reasons to be concerned about the expansion of the collateral pool to include more risky assets.  This is especially true inasmuch as these assets are likely to become less liquid precisely when a CCP needs to liquidate them: during a systemic even that causes the failure of a large, or several large, clearing members.  This problem could be mitigated by giving CCPs access to central bank liquidity, collateralized by the corporate bonds, etc., they take in as initial margin.  But the fundamental driver here is that clearing mandates have dramatically increased the need for initial margin, and it was inevitable that this would result in expansion of eligible collateral.  It’s not a competitive race to the bottom, it’s facing reality: indeed, CCPs in individual product spaces face relatively little competition.

Concern about initial margin methodology is also reasonable.  Under-margining leads to the mutualization of risk in excess of what CMs had anticipated: over-margining leads to inflated trading costs.  But the crucial problem with any CCP methodology is that it takes into account position risk only, and doesn’t vary margin with the balance sheet risk of the member firms.  This tends to lead to excessive trading by weaker clearing members, as they don’t have to post higher collateral, as their poorer credit would suggest they should.  This is pretty much an inherent feature of clearing, for informational and governance reasons, as I’ve discussed frequently here on SWP in the past.

Now to CME,  as represented by Chairman Terry Duffy:

Terry Duffy, executive chairman of CME Group, said the shift in moving more OTC derivatives transactions was more profound than just transferring the risk and exposure to a counterparty default from banks to clearing houses. “The difference is with a clearing house we do market-to-market [risk management], either twice daily or have the ability to do it much more often,” he said on a visit to London.

“What’s important is making certain the pays and collects are done on a risk basis and not a mark-to-myth or anything else. Because of that, we have a much easier time doing the pays and collects than the banks do if it was a bilateral transaction. In turn, I think some of the banks are just not used to the model of clearing.”

This relates to variation margin, which was/is often collected in OTC transactions (once exposure exceeds negotiated credit limits between the parties.)  Several points to make here.  First, variation margin is basically a way of keeping initial margin levels current.  This doesn’t really address the issue raised by the banks of whether initial margin levels are adequate, banks can determine that, and the quality of the collateral posted as initial margin (and whether the haircuts applied against this collateral are commensurate with the risks).  Second, you can go through the process of marking to market, but the protection provided by that process depends crucially on the quality of the prices.  That depends on market liquidity, trading activity, etc.  You need a market to mark to, and for many products that will be brought into clearing there are serious doubts about the reliability of the prices used for markets.  If there’s a liquid market, the prices it generates more accurate MTM in both bilateral and cleared trades: if there isn’t, both cleared and bilateral MTMs are dodgy.  Third, as I’ll discuss more in detail, the mechanical process of marking to market can actually create systemic risks.

The FT reporter, Phillip Stafford, also mentions that banks complain about the inadequacy of CCP capital, but notes that CCPs also have default/guarantee funds that they can call on to prevent a CCP default. But that’s exactly what the big banks are worried about.  Their exposure to CCPs comes first and foremost through their participation in these funds.   There’s only a thin layer of CCP capital separating a defaulter’s margin (and default fund contribution) from the non-defaulters’ contributions.  If the CCP under margins, that capital can be blown through very quickly, and expose banks to substantial losses.  These losses are most likely to occur, moreover, during stressed market conditions when banks are least able to afford the hit.  This wrong way risk is precisely what banks are complaining about.

Truth be told, although both the banks and the CCPs (to the extent Duffy is representing the clearing industry perspective) have some valid points, they miss the big systemic risks associated with clearing and clearing mandates.  I’m sort of in the middle of my Streetwise Professor Worldwide Personified Clearing Tour, in which I’ve given talks on the systemic risks of clearing in Chicago, Frankfurt, Osaka, Istanbul, DC, and the UK (London and Oxford), and will give another in Paris in September.  (Rough duty, I know, but somebody has to do it.)  Here are some of the greatest hits I play at each stop.

• Clearing, and in particular multilateral netting, basically redistributes credit risk from derivatives counterparties to other creditors of defaulting CCP members.  These other creditors may be as systemically important and vulnerable, or even more systemically important and vulnerable, than CCP members.  For instance, moving to clearing is likely to make runs on money market funds more likely even if it makes runs on dealer banks less likely.  It is not evident that this is a desirable trade-off.
• The variation margining mechanism in clearing is particularly rigid, and can create substantial demand for liquidity precisely when funding liquidity dries up.  This is what almost brought down the CME clearinghouse on the Day After Black Monday in 1987.  This is why rigid marking-to-market and variation margining can be a systemically destabilizing bug, not a stabilizing feature.
• Clearing does not eliminate interconnections between big financial firms: it reconfigures the network of connections.  Moreover, it does so in a way that is rife with wrong way risk.  As noted before, CCP members-mainly big banks-are connected via CCP default funds, and are most likely to incur losses during periods of market stress, when they are least able to afford it.

Regulators are becoming increasingly aware of these problems, and are responding by attempting to make CCPs virtually immune to failure.  But this brings me to another of my greatest hits: beware the fallacy of composition.  Yes, failure of a CCP would be catastrophic, but making one part of the financial system stronger-a CCP, for instance-does not necessarily make the system stronger.  One of the main effects of increasing the financial resources of a CCP is to redistribute credit losses from derivatives counterparties to other creditors of defaulting firms, and to redistribute scarce liquidity.   It is not necessarily the case that this redistribution makes the system stronger.

The analogy that I’ve made here, and that I make on tour, is that of the levee.  Building up the levee around a CCP reduces the likelihood that it will be inundated, but forces the financial flood elsewhere.  Again, it is not evident that it’s better for systemic stability to redistribute the water from CCP members to other parts of the financial system.

My closing number is that CCPs have been vastly oversold as a means of reducing systemic risk.  It’s virtually impossible to know what the net effects are, but it’s likely that CCP mandates reduce systemic risk under some scenarios, but increase it under others.  What’s more, the main systemic risk is not necessarily the failure of a CCP, as bad as that would be, but the spillover effects from clearing to other parts of the financial system.

That is, it’s necessary to analyze the systemic risks of clearing by analyzing the financial system as a whole.  Regulators haven’t done that, for the most part, and the debate between the banks and Terry Duffy doesn’t really do that either.  Their’s is a CCP-centric debate, and although that’s not irrelevant, it doesn’t get at the nub of the matter.  Meaning that the show must go on.

The road to hell is paved with good intentions.  A couple of examples from environmentalist attempts to mitigate climate change.

The first relates to ethanol.  In its infinite wisdom, in 2010 Congress mandated the use of renewable fuels with lower CO2 content than corn ethanol to meet the renewable fuel standard it created in 2005.  Sugar ethanol from Brazil fits the bill.  But given the blend wall and other limits on ethanol usage, this created an excess of corn ethanol in the US, and created an incentive to export excess corn ethanol from the US to Brazil, and import sugar ethanol from Brazil.

The problem being, of course that all the fuel burned to ship ethanol from the US to Brazil, and from Brazil to the US, pours CO2 into the atmosphere.  And the net result: more CO2 emissions than would have occurred absent the mandate to meet the renewable fuel standards with low CO2 producing fuels:

As a result, since the start of 2011, the United States and Brazil have shipped over 1 billion gallons of ethanol back and forth – more than 500 million gallons each way. The emissions generated by the shipping have worsened the carbon footprint of both fuels.

Thomson Reuters Foundation found that this overseas trade has produced more than 312,000 tonnes of carbon dioxide (CO2) since the start of 2011, based on an industry method used to calculate greenhouse gas emissions from shipping. This equals a ratio of one tonne of CO2 emitted for every 10 tonnes of ethanol transported between the two countries.

Not to mention its just wasteful and stupid to expend real resources-fuel, labor, capital-to swap ethanol between hemispheres.

Not to mention that corn-based ethanol is a monstrosity.

The second example: electric cars.  Yes: No noxious fumes or CO2 come out of the (nonexistent tailpipe) of an electric vehicle.  But if you take into account emissions over the lifetime of the vehicle-including the CO2 emitted to generate the electricity that charges the batteries of electric cars-and the other environmental impacts of their construction-including battery disposal and the environmental costs of mining rare earth metals, etc.-it’s likely that electric cars have as bad or worse environmental effects as fossil-fuel powered ones.

Government policies have substantially encouraged the use of renewable fuels, and the development of electric cars, for the purpose of improving the environment.  But the actual effects of these policies often fall far short of the intended effects, and quite frequently  have the exact opposite effect, or unintended consequences that are more costly than the intended environmental benefits.

This illustrates several points.  First, policies frequently create perverse incentives that induce market participants to undertake actions contrary to the intent of the policy: this is what is going on in the ethanol trade.  Second, we live in a second best world.  The theory of the second best implies that when there are multiple “market failures” (i.e., multiple unpriced harms), mitigating one of them (e.g., reducing CO2 emissions) is not necessarily a good thing, because it can exacerbate the other market failures.  That’s the lesson in the case of electric vehicles.

It’s my sense that these problems are most likely to occur when legislators and regulators attempt to dictate technologies, rather than affect incentives through taxes on harms (e.g., CO2 taxes).   That seems to be particularly true of the first problem.  It’s less clear that’s true of the second problem.  For instance, a monomaniacal focus on CO2, whether implemented through taxes or cap and trade or dictating technology, tends to have substantial perverse effects because there are other unpriced harms and benefits.  The encouragement of wind power, for example, results in environmental damage in the form of massive bird kills and abandoned wind turbines.

Economics is sometimes called the dismal science, originally because of the Malthusian connection.  But the name has stuck long after economists have left Malthus far behind.  And for good reason.  We’re killjoys, with a habit of pointing out that things people do with the best of intentions often fail to realize those goals, or worse, are actually counterproductive.

The Fed is reeling at the violent market response to Bernanke’s statements regarding the eventual taper of Quantitative Easing.  High level Fed officials flooded the zone last week, making soothing noises and arguing that the market had overreacted to Bernanke’s words.

There is some solid economic theory that predicts that the public release of “small” pieces of information can lead to big changes in behavior and market outcomes.  Specifically, the theory of Global Games (see a variety of paper written by Morris and Shin, in particular) predicts that the release of objectively trivial information can lead to a discontinuous jump from one equilibrium to another in coordination games.  The Fed is quite consciously playing a coordination game: it is trying to coordinate the expectations of market participants with the understanding that market outcomes depend quite crucially on consensus beliefs and expectations that tend to be self-fulfilling This is precisely why the market hangs on every Fed statement, every Bernanke utterance.  And this is precisely why a seemingly benign public statement with little information content can lead to a big market move.  It’s inherent in the game the Fed is playing.  They really shouldn’t be all that surprised.

The game the Fed is playing is actually even more complicated than those analyzed in the Global Games literature.  Specifically, there is a reflexivity and endogeneity in the Fed expectations game.  That is, in the real world game game, the Fed responds to the market’s response to the Fed’s actions, and on and on.   That’s not taken into account in the Global Games models, makes things even more complicated, and adds another level of beliefs on which the players of the game (which includes the Fed, prominently) must coordinate.

This is why QE and other exceptional monetary policies are so fraught with danger and risk.  This makes chess look like checkers.  Mistakes will be made.  You will pay for them.

Outgoing CFTC Commissioner Jill Sommers always struck me as a careful, precise, controlled person.  Certainly not a bombthrower, or someone prone to outspoken outbursts.  Which is precisely why I did a double take when I read this:

“No one has ever accused Gary Gensler of being reasonable,” Sommers said in her statement. “I may not totally agree with it, but Commissioner Wetjen has put a reasonable proposal on the table that would achieve multiple goals. He understands the importance of working in good faith with other global regulators.”

Whoa. Well said, Commissioner.

Truth be told, Gensler has pretty much worn out his welcome in DC-not to mention the rest of the world.  He is on his way out in July, and there will be few that will lament his departure.  I was just in London, and my criticism of Gensler (you’re shocked, I’m sure), and in particular of his obsession with moving forward with proposed guidance on cross-border regulation, went over quite well.  Based on my observations in London, the EU, and Canada, Gensler is viewed as the Ugly American, intent on imposing his worldview benighted furriners.

But even in the US Gensler has worn out his welcome.  A group of 6 Democratic senators-including Chuckie Schumer, for crissakes-wrote a letter asking Gensler to back off.

Despite his lame duck status, Gensler is stubbornly holding out against this near unanimous criticism.

Or perhaps I should say, because of his lame duck status, Gensler is stubbornly holding out.  For his insistence on plunging ahead in the face of near universal opposition gives every appearance of being the product of pique at not being reappointed to another term as Chairman.

But he has an enthusiastic supporter in Elizabeth Warren.  So there’s that.

Need I say more?

I have written for some time about my doubts about the sustainability of Chinese growth (driven by massive credit expansion that is delivering progressively less and less bang for the renminbi), and my concerns about the stability of the Chinese financial system, especially the shadow banking system.  So far these prognostications have not been realized, but events over the last few days relate directly to these doubts and concerns.

Specifically, China is in the grips of a full-blown liquidity crisis, with overnight repo rates approaching 30 percent, and one week rates well over 10 percent.  The Chinese yield curve has become steeply inverted, which is never a good sign.  The word “panic” is being bandied about quite freely.

News accounts make it seem that the liquidity shortage is the deliberate  policy of the People’s Bank of China.  Indeed, these accounts suggest that the PBOC is withholding liquidity from the market precisely because it too believes that credit-fueled growth is unsustainable, and that the banking and shadow banking sectors have over expanded and need to be cut down to size:

China’s interbank funding costs surged again on Thursday, with the two shortest-term rates hitting record highs, as the central bank again ignored market pressure to inject funds into the market, despite fresh evidence that the economy is slowing.

The People’s Bank of China (PBOC) told the market that it would not conduct repo business in its regular open market operations on Thursday, frustrating widespread expectations that it would use reverse repos to inject cash to ease an acute market squeeze over the last two weeks.

. . . .

“The central bank appears to be determined to force banks and other financial institutions, such as funds, brokerages and asset managers, to de-leverage,” said a trader at a major Chinese state-owned bank in Shanghai.

“That hardline stance suits the recent government policy of clamping down on non-essential businesses by financial institutions, such as shadow banking, wealth management, trust operations and even arbitrage.”

Yes, deleveraging is probably a good idea: the economy had become over leveraged as the result of previous stimulus policies that fed a credit boom. The question is: how to deleverage?  Quite often system-wide deleveraging is a chaotic process, beset with externalities.  Companies that can’t fund dump assets in fire sales, which puts pressure on other institutions holding the same or similar assets: they often join the fire sale stampede.  Institutions start hoarding credit and liquidity, which drives up rates and puts yet further pressure on financial institutions.

In other words, system-wide deleveraging often occurs through a financial panic that causes massive economic damage.  Usually central banks try to stem this process by flooding the system with liquidity.  Bizarrely, China, it appears, seems to be trying to start the process by starving the system of liquidity.  Central banking with Chinese characteristics, as it were.

One interpretation is that the PBOC has found that jawboning and other less drastic policies have failed to stem the growth in credit and shadow banking, so it feels obliged to take stern measures to curb these activities.  But this is a dangerous way to do it, and I am not sure that it is the optimal strategy in the game between the PBOC and other market participants.

Let’s say the PBOC relents and says “You’ve been warned: don’t let it happen again.”  Many market participants will infer that the PBOC’s threats are not credible, and that it will supply liquidity if the system appears on the verge of failure.  The will therefore have little incentive to curb their activities, viewing the PBOC as a paper tiger.  The economy will continue to be over leveraged.

Conversely, let’s say to demonstrate its credibility the PBOC sticks to its guns and refuses to supply liquidity: then there is a risk of a full-blown panic and crisis-and right now.

China is having an episode not unlike the one that hit world markets in August, 2007, when funding markets signaled the onset of the crisis, with the difference being-and it is a big difference-that this appears to be a crisis of choice, and one that could morph from onset to a Lehman moment in days or weeks, not months.

Perhaps the PBOC believes that the situation is so dire that a purgative crisis now is preferable to a worse one that chooses its own time to appear.  If so, it has no one else to blame.  If China’s financial system was hurtling down the road too rapidly, it was because the PBOC (and the Chinese government) had jammed down the accelerator with its credit-driven stimulus measures.  Now it is responding by jamming on the brakes.  A policy of alternating extremes seldom works out well.

There is an apocryphal belief that in Chinese the word “crisis” is represented by the characters for “danger” and “opportunity”.  (JFK is responsible for popularizing this belief.) The most charitable interpretation of the PBOC’s starving the market of liquidity is that it doesn’t view that belief as apocryphal, but as gospel.  That it is running a great danger to seize an opportunity to put the Chinese financial system on a firmer foundation.

Maybe.  But that suggests a conceit on the behalf of policymakers: it presumes that once a panic is sparked, they can control it, and the panic will make financiers more prudent in the future by putting the fear of God into them today.

That’s a very, very risky bet that has a very, very high probability of turning out very, very badly.

As changes in financial market regulation like Frankendodd lurch into effect (with phase two of the clearing mandate becoming effective a couple of days ago), it’s interesting to see the dawning realization about some of the implications.  Implications that I’ve discussed for several years here, or in my academic work.

One of these is the tension between the micro-prudential and macro-prudential roles of collateral.  Micro-prudentially, collateral makes sense for a lender: it increases recoveries in the event the borrower goes bust.  But collateral is much more problematic macro-prudentially, for a variety of reasons.  It can be a highly pro cyclical mechanism that intensifies the effects of financial shocks.  It can be a crisis accelerator.

Andrew Hauser of the Bank of England focuses on this tension in this speech.  Unfortunately, despite this and other evidence of growing attention to this issue, I still think it’s under appreciated and that will lead to problems down the road.

Another issue is one that I raised in my more cynical moments.  Scary thought, I know.  Specifically, I mused that one reason for the broad political support for clearing and collateral mandates, especially among government treasuries (e.g., Timmy!), is that these were a form of financial repression.  That is, a means of increasing the demand for government securities, in order to reduce interest rates and borrowing costs.  The mandates effectively require market participants to hold more government debt in their portfolios.

Bloomberg just noticed this:

New collateral rules for hedge funds, insurers and others in the $633 trillion over-the-counter derivatives market are poised to boost demand for U.S. Treasuries, potentially slowing rising yields as the Federal Reserve considers scaling back unprecedented stimulus.

Swaps traders will need to come up with $800 billion to $4.6 trillion to meet Dodd-Frank Act regulations requiring that the derivatives be backed by clearinghouses that collect upfront collateral such as cash or Treasuries, according to estimates from the Treasury Borrowing Advisory Committee. The regulations take effect today for the second group of firms designated by the Commodity Futures Trading Commission in the market for interest-rate and credit-default swaps.

“This is going to be a new, very powerful engine that drives demand for Treasuries, so you have to expect it will impact yields,” said Ted Leveroni, executive director of derivatives strategy at New York-based trade-processer Omgeo LLC. “There are a lot of firms out there — I know because they’ve told me — that are concerned about having the available collateral.”

The rush for collateral may be an unintended benefit from swaps rules designed to protect against a cascade of bank failures

Um, unintended benefit for whom?  And who says its unintended?  I think it might have been quite intentional-just not acknowledged.

Now that the regulatory changes are being put into place, we’ll see how good my forecasting performance is.  Since I’ve predicted many unintended consequences, most of which are not good, y’all should hope that it’s not very good at all.  But it appears that others are making similar predictions now, at least on these two issues.

And now for something completely different.

HFT has been a bugbear for several years now.  The monster that would eat the equity markets, and then move onto derivatives for dessert. But HFT has apparently fallen on (relatively hard times).  HFT volumes are down.  HFT market shares are down.  And most interestingly, HFT profits are down, by about 50 percent on a per share basis, more on a gross basis because volumes are down.

This should not really be a surprise.  Basic economics predicts when profits in a particular activity are high that entry, the expansion of existing firms, and the development of competing technologies will dissipate those profits.

It’s interesting in this context to think about Schumpeter’s argument in Capitalism, Socialism, and Democracy.  One motivation for the book was to examine whether there was, as Marx and earlier classical economists predicted, a tendency for profit to diminish to zero (where costs of capital are included in determining economic profit).  That may be true in a totally static setting, but as Schumpeter noted the development of new, disruptive technologies overturns these results.  The process of creative destruction can result in the introduction of a sequence of new technologies or products that displace the old, earn large profits for a while, but are then either displaced by new disruptive technologies, or see profits vanish due to classical/neoclassical competitive forces.

Whether it is by the entry of a new destructively creative technology, or the inexorable forces of entry and expansion in a technologically static setting, one expects profits earned by firms in one wave of creative destruction to decline.  That’s what we’re seeing in HFT.  It was definitely a disruptive technology that reaped substantial profits at the time of its introduction, but those profits are eroding.

That shouldn’t be a surprise.  But it no doubt is to many of those who have made apocalyptic predictions about the machines taking over the earth.  Or the markets, anyways.

Dark pools are under a regulatory and legislative assault, in Europe, Canada, and the US.  Scott Patterson wrote a long piece in the WSJ about FINRA’s scrutiny of Dark Pools:

The Financial Industry Regulatory Authority, Wall Street’s self-regulatory body, last month sent 15 examination letters to operators of “dark pools”—lightly regulated, off-exchange trading venues that have been a rising concern for regulators and some investors as more activity shifts away from exchanges.

Finra is seeking details about how the increasingly popular venues operate, what they disclose to clients and whether they adequately police trades. It could bring enforcement action against dark-pool operators or issue recommendations for tighter oversight, depending on the answers it receives and additional examinations, said John Malitzis, executive vice president of market regulation at Finra. The letters are a follow-up to an initial round of questions the regulator circulated last fall.

“We want to understand whether [dark pools] are disclosing to their customers how their orders work [and] whether customers are informed who their orders will interact with,” Mr. Malitzis said in an interview. “A big part of this is to get an understanding of practices that may or may not be problematic.”

Here’s an interesting bit:

Dark pools don’t disclose traders’ buy or sell orders and only publish trade data after transactions occur. About 13% of all stock-market action takes place on dark pools, up from about 4% five years ago, according to Tabb Group, a market-research firm. Most dark pools are run by broker-dealers—firms overseen by Finra that buy and sell assets on behalf of customers as well as trade for their own accounts.

While dark pools command an expanding slice of trading volume, regulators still have little idea about how they operate since, unlike exchanges, they aren’t required to regularly disclose detailed information about their trading systems.

I see.  “more activity shifts away from exchanges”; dark pools “command an expanding slice of trading volume”; their volume has more than tripled in 5 years.  Growing volume! Growing market share!  That sounds sinister, doesn’t it?

Note that the possible nefarious practices under investigation, if they occur, would result in the users of dark pools are getting screwed.  If that’s true, why are they flocking to the pools in increasing numbers?  The most plausible explanation for a growing market share is that dark pools offer better value-not worse-to those who have the opportunity to choose where to trade.

I am particularly skeptical about the idea that dark pools are hugely exploitive because sophisticated buy side firms are among the most extensive and loyal users of dark pools.  Buy side firms analyze their execution costs with considerable detail.  They evaluate execution costs in lit and dark markets, and slice and dice the data in sophisticated ways, uncovering the circumstances under which it is cheaper to execute in one venue or another, and allocate their trades accordingly.

In other words, if they decide to execute more in dark markets, it’s because they have decided after thorough analysis that they are more likely to get screwed in broad daylight on exchanges.

This isn’t rocket science.

There is a potentially more intellectually reputable case against off-exchange trading.  Dark pools utilize a variety of techniques that are designed to screen out informed, or opportunistic, traders.  Uninformed traders-firms or individuals trading for portfolio balance or cash flow or hedging reasons-suffer losses when dealing with the informed.  They can reduce execution costs by trading in venues where there is a lower likelihood of dealing with a better-informed trader.

But this “cream skimming” of uninformed order flow by dark pools that screen out the informed increases the trading costs of those uninformed traders who for whatever reason cannot avail themselves of dark markets: those left behind have a higher likelihood of dealing with someone with better information, and incur higher trading costs (due to adverse selection).

Dark pools free ride off the price discovery in lit markets, and cream skimming impairs price discovery.  Thus it is possible-possible-that this externality reduces welfare.

Possible, but not necessarily so.  The free riding externality reduces welfare if there is no other inefficiency in the lit markets.  But that is not necessarily the case.  As I pointed out about 15 years ago, there are other sources of inefficiency on exchanges.  For instance, exchanges may exercise market power.  In this case, second best considerations imply that the free riding externality may improve welfare because the benefit of increased competition for order flow from the dark market may more than offset the cost of degraded price discovery.  I have produced formal models that show that this can occur under conditions that have existed in securities and derivatives markets.

As another example, much informed trading can be a form of rent seeking.  Market participants expend real resources to produce information because this allows them to profit at the expense of the uninformed.   This profit is a transfer from the uninformed, and unless there is some external benefit arising from more informative securities prices, the real resources expended to gain this transfer are a pure waste.  By reducing the profitability of informed trading, dark pools reduce this rent seeking and improve welfare.

Both of these analyses are applications of the theory of the second best, which says if there are multiple departures from “perfect” conditions (perfect competition, no externalities), eliminating one imperfection may actually make things worse, not better. In the dark pool case specifically, if there are other imperfections (imperfect competition on and between lit markets, rent seeking informed trading), dark pools’ ability to free ride on exchange price discovery may improve welfare because it mitigates these other inefficiencies.

Determining the welfare impacts of dark pools in the presence of these various departures from first-best conditions is devilish hard.  For instance, it is arguably impossible to determine the costs and benefits of informed trading.  It is also difficult to determine the degree of imperfect competition in lit markets, and the costs of this market power.

But what can be said is that the kinds of things FINRA is looking at are totally irrelevant to addressing these issues.  FINRA is focusing on activities that would be agency problems, or fraud.  But it is hard to square the proposition that these problems are widespread with the observation that dark markets are growing relative to lit ones, especially given that most of the patrons of dark markets are quite sophisticated, and devote considerable attention to evaluating the cost and quality of the services that they obtain.

So what is going on here?  Quite likely political economy, capture, and rent seeking.  For the past couple of months exchanges have been importuning regulators to do something about dark pools, precisely because they are bleeding business.  This headline from Bloomberg says it all:

Stock exchanges seek curbs on dark pools to curb exodus.

In other words: exchanges are losing a competitive battle, and are recruiting regulators and legislatures to hamstring the competitors that are eating their lunch.  A very, very, very old story.

I have to give the exchanges credit.  They have done a marvelous job of shaping the narrative, playing skillfully on the quite different connotations of light and dark.  The exchanges are like a Scout master telling a ghost story beside a campfire, his face scarily illuminated by a flashlight.  They have proven masterful at scaring regulators into action against the evils lurking in the dark

My bottom line?  It is possible that dark pools are, on net, inefficient, but the case has not been made.  Moreover, their commercial success should be considered as evidence that they actually enhance welfare.  Indeed, their commercial success is almost impossible to reconcile with claims that dark pools are somehow deceiving or defrauding those who trade on them, especially given that these traders are often quite sophisticated, and quite on guard against getting screwed.

So don’t be afraid of the dark.  Be especially skeptical about stories detailing the horrors allegedly stemming from the activities of entities that are gaining market share.  And always remember that incumbents are past masters at inducing regulators to crack down on inconvenient competitors.  Be afraid of what regulators do in the light, not what goes on in the dark.