Streetwise Professor

Frankendodd runs hundreds of pages.  The regulations written to bring it to life run to thousands more.  Every word on every page has the potential to wreak havoc: hell, apropos the position limit case, even the commas matter.

Case in point, the CFTC’s proposed rule on protection of customer funds, most particularly Section 1.22.  Some of the relevant language:

The Commission proposes to amend § 1.22 by clarifying that the prohibition on the FCM’s use of one futures customer’s funds to margin or secure the positions of another futures customer, or to extend credit to another person, applies at all times.

. . . .

Further, the Commission is proposing language providing a clear mechanism to ensure compliance with this prohibition, which is to require an FCM to maintain residual interest in segregated accounts in an amount which exceeds the sum of all margin deficits for futures customers.

This is very inside baseball, but has seismic implications.

The basic thing is that some customers are late in meeting margin calls.  This gives rise to margin deficits.  Under the traditional omnibus model used in futures markets for donkey years, futures commission merchants (brokers-“FCMs”) can cover customers’ margin deficits with the margins of other customers.  Effectively, customers lend one another money to address the timing issues that the rigorous mark-to-market and variation margin processes inevitably create.  Moreover, the FCM is ultimately on the hook to cover the losses of a defaulted customer.  The FCM’s customers can lose only if there is a default by a customer that the FCM can’t cover (resulting in an FCM default).

That is, customers effectively lend to one another, and thus there is “fellow customer risk”-a solvent customer can lose as a result of the default of another customer. The CFTC rule is intended to eliminate this risk.

Problem: the risk can’t really be eliminated, merely shifted around.  Related problem: the likely reaction to this attempt to shift risk.

The CFTC seems to want to shift the risk to the FCMs: the “residual interest” language means that the FCM has to have enough of its own money on hand to cover any margin deficits.  This will require the FCM to hold substantial precautionary balances, because (a) the magnitude of margin deficits is likely to be quite variable, and particularly will be large in the aftermath of a big price move (that can’t be predicted in advance), and (b) there are serious penalties to being undersegregated.  Alternatively, FCMs are likely to require customers to post margins far in excess of exchange margin levels, thereby reducing the likelihood that any customer’s account will have a margin deficit, and the amount of residual interest the FCM must hold to cover any such deficits.

Either way, there will be a substantial increase in the amount of cash tied up, and the needs for customers and FCMs to have access to contingent liquidity.  The omnibus model was an effective way for customers to supply liquidity to, and obtain liquidity from, other customers.  Yes, there are risks, but there are corresponding benefits: the near universality of the omnibus model in futures markets, and its survival for decades, provides compelling evidence that the benefits far exceed the costs.

But apparently that’s not good enough for GiGi and the Gang.

The clearing and collateral mandates-combined with Basel III and other regulatory measures-are already requiring substantial increases in the amount of collateral-liquid assets-that will be tied up to support derivatives trades.  This will just add to that.  And insofar as being a customer protection mechanism: uhm, customers will pay for it.  Don’t act as if your are doing them a big favor. (Raising the question if its so valued by customers, why hasn’t some FCM adopted voluntarily what the CFTC wants to impose by fiat?  If it’s so great, customers would flock to firms offering that model.)

It also comes at a terrible time for the FCM industry.  The economics of the business are terrible.  ZIRP has blown a hole in a major source of revenue, volume is down sharply, and competition is intense.  A recent Celent study details the carnage:

“The leading FCMs in the US are struggling with falling revenues and profits,” saysAnshuman Jaswal, PhD, Senior Analyst with Celent’s Securities & Investments Group and author of the report. “This puts them in an unenviable position, especially when we consider the overall impact and related costs of various regulatory implementations taking place in the next couple of years.”

Another data point: SocGen just wrote down its investment in big FCM Newedge.  This is not a thriving industry, and ladling more costs onto it won’t help it one bit.

The ostensible purpose of this new regulation is to prevent another MF Global or Peregrine situation.

Seriously?

MF Global broke every rule in the book about segregation and the treatment of customer money.  Peregrine’s owner ran a huge fraud for 20 years. So creating more rules for troubled or criminal FCMs to break will help?  If the CFTC or SROs couldn’t enforce the old rules and thereby prevent losses of customer funds, why should we expect they’ll do any better with the new ones?

It’s also hard to see how these rules, if they had been in place, would have prevented either the Peregrine or MFG situations.  Furthermore, there are other ways of attacking the exceptional-and MFG and Peregrine were exceptional-without imposing crushing burdens on the ordinary day-to-day operation of the markets, FCMs and their customers.  For instance, the Peregrine fraud could not have continued if Peregrines regulator (the NFA) had direct electronic access to the firm’s accounts, thereby preventing Wasendorf from altering the paper statements he sent on to regulators to cover up his fraud.  Hell, in the MFG case, having more excess margin in customer accounts would have just increased the money that Corzine could have tapped to cover the company’s losses and own margin calls: it is just that excess margin that disappeared somewhere, somehow.  I would further note that since an FCM is most likely to be tempted to get at customer funds when it is in financial jeopardy (which is what happened with MF), adding to its financial burdens could create more problems than it solves.

The cost-benefit analysis the CFTC advanced in support of the rule is just the kind of joke I’ve come to expect.  This is actually a problem that is amenable to calculation.  Collect data on the distribution of customer margin deficits under current rules.  Figure out the 99.9th percentile of this distribution.  (Importantly, condition this distribution on market conditions-find out what that percentile is during very volatile periods.)    Given the rigor of the rule, it is plausible to assume that additional funds equal to this 99.9th percentile will have to be held by customers, FCMs, or both will be held to ensure compliance.  Calculate the return on this sum lost because customers and FCMs are required to hold low-yielding assets in order to comply with the rule.  That’s one component of the cost.

Another cost is the additional operational cost required to ensure compliance.  This will not be trivial: indeed, one reason FCMs might require substantial increases in customer margins is to reduce the operational burdens required to maintain compliance.

One cost that is important is hard to quantify.  As I’ve written repeatedly, spikes in liquidity needs during periods of market stress can be systemically destabilizing.  This rule will: (a) restrict one vital source of liquidity, namely, intracustomer loans; (b) result in far more liquid assets being tied up in brokerage accounts; (c) lead to increases in liquidity demand during periods of high volatility, as FCMs will either have to hold more liquid assets, or will force customers to hold more excess margin, during high volatility periods in order to maintain compliance (i.e., the 99.9 percentile is much bigger during high volatility periods, requiring more margin to meet this threshold-the distribution of liquidity demand spikes caused by this could be calculated); and (d) result in position unwinds by those unwilling to incur the cost of the elevated margins.  All of these effects are pro-cyclical, and tend to exacerbate market instability/volatility.  Liquidity problems are what create or exacerbate crises.  Derivatives market “reforms” have already imposed substantial liquidity burdens: this will only add another.  That is systemically risky.

Benefits?  Uhm, hard to ascertain.  As noted above, the rule is ill-suited to address either a Peregrine or MFG problem, even though those are the examples the CFTC repeatedly invokes in their support.  Moreover, it must be noted that reducing the amount of loss arising from the default of fellow customers is not necessarily a benefit.  This is primarily a transfer of wealth from one party to another.  The relevant issue is whether one risk sharing rule is better than another.

This is another example of the pernicious effects of attempts to “fix” high profile problems such as MF Global and Peregrine.  In response to truly extraordinary episodes, we get “fixes” that (a) don’t really do anything to address the problems they are supposed to be fixing, and (b) impose substantial burdens on the ordinary operations of the markets, operations that have gone on swimmingly for decades under the old way of doing business, thank you very much.

As a rule of thumb, I think it wise to be very suspicious of rules designed to prevent recurrence of an extreme event or events.  That is especially true in this case.   Another example of all pain, no gain.

Is that the CFTC’s motto now?

Sunshine: The New Subprime.

Spain can no longer afford greendoggles:

The Spanish government’s latest bid to cut its growing debts to the country’s energy sector is expected to slash profits at renewable energy companies as Madrid continues to grapple with a €28bn deficit built up through years of subsidies.

Spain’s most recent reform to the energy sector will force renewable energy operators to choose between a fixed price or market price for their power – and remove a previous subsidy – while renewables subsidies will also be delinked from consumer price inflation and instead aligned with Spain’s core inflation measure.

Shares in Acciona, Spain’s second largest wind power operator, have tumbled almost 20 per cent, with Abengoa, Spain’s largest solar thermal power plant developer, also falling sharply since the changes were announced at the end of last week.

This story about the travails of the Utility Formerly Known as TXU doesn’t mention renewables-notably wind-but it should:

Energy Future Holdings Corp., the struggling Texas power company involved in a record leveraged buyout, could end up splitting as it faces significant choke points on debt and seeks counsel from Wall Street restructuring advisers.

The former TXU Corp. has been getting advice from big-name law firms and investment banks ahead of May, when it must start making cash payments on certain debt. In addition, the company faces nearly $4 billion in debt maturing in October 2014. The Dallas-based company was purchased by the private-equity firms and others in 2007 for $32 billion plus about $13 billion of debt.

After a series of complicated transactions over the past several years that rearranged its finances, the company now appears poised to start contemplating a major debt restructuring, be it through a bankruptcy filing or another means, according to a person close to the situation.

The article rightly notes that the collapse in natural gas prices has cratered generating margins (spark and dark spreads, and especially the later).  This is the main reason for EFH’s problems, but not the only reason.  The large increase in wind generation-which benefits quite nicely from  federal subsidies-has put downward pressure on power prices in Texas, and has led to negative prices for power with some regularity.  This is particularly important because Texas operates an energy-only market, with no capacity market, meaning that capital costs must be recouped from energy prices.  With wind subsidy-supressed prices, traditional generation has a hard time paying for itself.  As PUC Commissioner Donna Nelson said:

Federal incentives for renewable energy… have distorted the competitive wholesale market in ERCOT. Wind has been supported by a federal production tax credit that provides $22 per MWh of energy generated by a wind resource. With this substantial incentive, wind resources can actually bid negative prices into the market and still make a profit.

We’ve seen a number of days with a negative clearing price in the west zone of ERCOT where most of the wind resources are installed…. The market distortions caused by renewable energy incentives are one of the primary causes I believe of our current resource adequacy issue… [T]his distortion makes it difficult for other generation types to recover their cost and discourages investment in new generation.

The impact is greatest in the western part of the state, but wind weighs on prices throughout the state.  Except when it’s hot, because that’s when the wind doesn’t blow-but the power is particularly needed.  And wind also imposes substantial reliability challenges, requiring backup generation resources-which find it difficult to recoup costs due to prices that are often artificially low due to the wind subsidy.

The subsidies completely distort price signals, which in turn distort investment incentives and raise the serious risk of shortages of reliable generation resources that can operate hot or cold, rain or shine.

Other than all that stuff, wind is great.

But regulators are hell-bent on tipping the scales in favor of wind:

It’s no secret why FERC is likely to rule against the homeowners in Iowa and Minnesota. The Obama Administration’s green vision is to make wind and solar an ever-larger share of U.S. electricity production, regardless of costs. Think high-speed rail for the electric power network. The only way to make that happen without a political backlash is to spread the costs far and wide.

Wind and solar power are too expensive to compete with natural gas, coal, nuclear and hydropower without government help. The wind lobby already won an extension of its $12 billion production tax credit as part of the recent tax increase. More than half the states also have renewable energy standards forcing residents to purchase wind power. And now the greens want another subsidy for transmission lines.

Because wind makes such economic sense.  The fact that subsidies (and, in some places, the indoctrination of children) are required to support wind development tells you just how much economic sense it makes.  It is a greendoggle of the first order, and one that you might want to think about when the lights or AC go out, especially in Texas on a hot summer’s day.

There has been a spate of world-turned-upside-down stories about the US as a potential exporter of oil and refined products.  The explanation is quite simple.  Supposedly menopausal North American geology has produced a surprise energy baby.  Or, I should say “babies”, for this is a multiple birth, in fact: oil and gas in different locations.

This has resulted in substantial changes in price relationships in oil and gas.  The most visible of these is the Brent-WTI spread, which blew out again to over $20/bbl (better than 20 percent of the WTI price).  But all sorts of spreads have reached record or near record wides.  Canadian oil sells at a deep discount to WTI at Cushing, which sells at a deep discount to the price in the Gulf.  Refining margins are wide.

Commodity trading is all about transformations in space, time, and form.  Spreads price transformations: they are the shadow prices of transformations.  Time spreads price the cost and benefit of transformations in time (through storage).  Locational spreads measure the marginal cost of transformations in space (through transportation).  Spreads between processed and raw materials price the costs of refining/processing.

The spread blowouts in energy  are highly visible evidence of how the spike in domestic energy production, and notably its location and quality, has been at odds with the energy transformation infrastructure that has developed in the US in the past decades.  That transformation infrastructure was-and crucially still is-configured to transform foreign and heavier/sour crudes into refined products for domestic production.  The main direction of movement of crude was south to north, from import points at the Gulf to refineries in the Gulf and Midcontinent.

The new production is in the north, or in Eagle Ford in Texas.  It is sweeter and lighter than the oil that most domestic refineries are configured to process.  Refineries in position (in the Midcon) to process this new output (especially the Bakken) are operating at capacity, giving them fat margins.  The transportation capacity to bring the oil to the Gulf (and to East Coast refineries, many of which have been shuttered in recent years) is highly limited because it was structured to bring oil inland, not ship it to the coast either for refining or (when the law permits), export.

Meaning that in the short run, quantities cannot adjust in response to the oil output shock: there are bottlenecks in transportation, storage, and refining.  Since quantities cannot adjust, prices bear the burden, leading to dramatic movements in spreads that price these transformations.

These spreads are signals about the locations of bottlenecks in the value chain, and the value of making investments in transportation, storage, and refining capacity to ameliorate them.  These investments are expensive, and take time.  Hence, historically anomalous spread levels are like to persist for some time.

Moreover, some investments can exacerbate other bottlenecks.  For instance, building Keystone XL (which will bring oil from Bakken and Canada to the Midcontinent) without adding more Midcon refining capacity and/or more capacity to move oil from Midcon to the Gulf (and perhaps the East Coast) would actually exacerbate the refining and outbound transportation bottlenecks in the Midcontinent.  This would, most notably, cause the Brent-WTI spread to widen further.  There is essentially a race between production capacity in the Midcontinent on the one hand, and the outbound transportation and refining capacity there.  Right now production is winning.  This will tend to cause spreads to change in ways that discourage too much output expansion, and encourage expansion in the ability to consume what is produced in the Midcon.  But there will be a minuet between production and consumption that will go on for years: prices/spreads will play conductor of the music that producers and consumers dance to.

There are economic considerations that limit the speed with which quantities will respond to these price signals.

For one, investment takes time.  You can’t snap your fingers to build a pipeline or add refining capacity, and have it arrive instantaneously in a puff of smoke.

Uncertainty is another.  The ability to invest in refining or pipeline or production capacity is a real option: in the face of uncertainty, it is often optimal to delay decisions to invest pending the arrival of new information about the economic value of those investments.

Sadly, politics is another.  Whether it is a politicized pipeline approval process, Byzantine environmental laws that give enviros and nimby-ists the ability to impede energy investments, or laws that restrict exports, the legal and regulatory systems in the US inflate the cost of investment in energy infrastructure, and crucially add an element of considerable uncertainty that also slows investment due to the real option considerations I just mentioned: the vagaries of politics and political influence are volatile, hard to predict, and can have first-order effects on the profitability (or not) of an investment.   It would have taken some time regardless to make the investments necessary to reconfigure America’s energy infrastructure to accommodate the huge shock to the location and quality of oil production.  Politics and regulation will only slow that response, and make it less efficient and complete than it should be.

And it should be noted that even though much of the law and legislation will be cloaked in the language of public interest, notably environmental paeans and invocations of “jobs, jobs, jobs”, it is largely the product of nakedly self-interested calculations.  This is most notable in the debate over natural gas exports, in which domestic petrochemical producers are trying to prevent-or at least sharply constrain-in order to reduce the cost of their feedstocks and thereby increase their margins.  Similar arguments are already starting to appear in oil just as the prospect of oil exports is being mooted.  It is also notable in transportation: is it any surprise that oil pipelines (notably Keystone) are the target of much opposition, given that Warren Buffett is making oodles of money transporting oil by rail, due to his ownership of the BNSF RR and a major manufacturer of rail tank cars.  (Sort of OT: speaking of Buffet, could the fact that the USDOJ is going after S&P but not Moody’s, despite the fact that their conduct during the pre-crisis period was almost identical, have anything to do with the fact that Saint Warren has a big stake in Moody’s?)

In other words, naked rent seeking is going to play a big role in the speed and efficiency with which firms make the investments necessary to respond to the unexpected domestic energy production shock.  Sadly, the intensely politicized nature of energy, and the swollen nature of the US government and regulatory apparatus (which deems that everything is its business) will dramatically impede this adjustment process.  Meaning that we are likely to be in a world of wide spreads for some time to come.

When the government is the bookie, it’s very hard to beat the spread.  Especially when that government is all too often indistinguishable from the mob.

Hint: collateral crunches are not an ab exercise.  Instead, regulators and legislators around the world are waking up to the reality of what they have wrought: that the regulations that they blithely decided to impose on the derivatives markets are likely to have severe adverse consequences.  Specifically, Europeans have awakened to the fact that clearing and collateral mandates will be extremely burdensome on firms that use derivatives to manage risk, but who pose no real systemic threat.  Thus, a committee of the European Parliament has voted to send clearing regulations back to the European Commission for reconsideration.  There is a realization that a “collateral crunch” is impending as a result of these various regulations:

This has led to talk of a “collateral crunch”, with most central counterparties accepting only government bonds or cash as collateral, assets that may not be readily available. This is more restrictive than at present, with corporate bonds and even equities often accepted as collateral in uncleared bilateral deals, if lodged in sufficient quantity.

The problem may be particularly acute for mutual funds, as an equity or corporate bond fund will simply not possess anything it can use as collateral. Instead it may have to use the securities lending or repo markets to secure suitable assets.

But many pension funds will also be hit. As Mr Haines points out, even the index-linked government bonds that pension funds do tend to hold in abundance are not generally accepted as collateral by central counterparties, even if conventional bonds issued by the same governments are.

Estimates of the cost of using the repo market to access the necessary collateral range from 50 basis points of a pension fund’s assets to several hundred basis points, Mr Haines adds. Alternatively, pension funds may feel pressured to alter their asset allocation so they do have sufficient in-house collateral.

Totally unpredictable, right?  Uhm, not really.

I find it particularly amusing that virtually every article on the effects of Frankendodd and Emir bewail the “unintended consequences.”  A million pardons, but that was a theme here on SWP, and in various presentations I made, before Frankendodd and Emir were actually adopted.  Unintended, but eminently foreseeable-and totally ignored.

The recent angst focuses on initial margin: the amount of capital that has to be tied up to support derivatives positions from the moment they are initiated.  Given that collateral is costly, the large increases in initial margin will require derivatives users to choose between continuing to use them to manage risk, but obtain lower returns, or to eschew derivatives and live with greater risk.

The benefit received in exchange for this very real cost?  Given that many entities so affected pose no systemic risk, it’s quite difficult to identify any gain.

Not that initial margin is unimportant, but the focus on it distracts attention from what I believe to be the true systemic risk inherent in clearing and collateral mandates: the contingent needs for liquidity to make variation margin payments.  Big price moves lead to big variation margin flows.  These will tend to occur when markets are stressed and liquidity becomes scarce.  Thus, the need to make variation margin payments will exacerbate stresses on the market, especially will stress liquidity supply mechanisms.  Given that financial crises are, typically, liquidity crises, this is a major systemic problem.

So by all means pay attention to the drag that the dramatic increase in initial margin requirements will impose.  This is a drag that will be experienced day after weary day.  But do not overlook the truly dangerous unintended consequence of the clearing and collateral mandates in Frankendodd and Emir.  The stress that these mandates will put on liquidity supply mechanisms at the precise instant that these mechanisms are at risk of failure.

What could go wrong?

I say again: regulate/legislate in haste, repent at leisure. The seeds for the next crisis are being sown in the alleged attempts to prevent a recurrence of the last one.  Legislative and regulatory generals fighting the last war.

A tag-team of my favorite blogs-the wonderfully sardonic (and insightful) Rhymes With Cars and Girls and the less sardonic (but equally insightful) Deus ex Macchiato-discuss the fact that model-based risk-weighted capital calculations on the same assets differ substantially between models/banks.

From this, DEM concludes the need to centralize capital calculations:

he answer is clear. Centralize and standardise capital calculation. Throw all those internal models away, and use one common, regulator developed approach. Now that a lot of progress has been made on trade reporting, the data infrastructure exists to do this — or least it wouldn’t be too hard to extend what does exist to do it. Developing the models would be a huge undertaking, but compared to having each large bank do it individually, a central infrastructure would be cheaper and more reliable, and anyway you could pick the best of individual banks’ methodologies. You could even spin out the var teams from four or five leading banks into the new central body — just don’t pick the bank whose IRC is less than 10% of the average answer…

Crimson Reach at Rhymes is more cautious, repeating his theme that All Large Calculations are Wrong.  He concludes:

In other words, it’s a Large Calculation. But as RWCG readers know, all large calculations are wrong. So, I’m skeptical that the answer to this is to ‘centralise’ the calculation – i.e., make it even larger.

I’m on Crimson’s side on this one.  (Sorry, David.)

Centralize capital calculations?  No. No. No. No. No fucking no.

Crimson is right: all Large Calculations Are Wrong.  Including those-and I would suggest, especially those-undertaken by some Centralized Authority, e.g., The Wizard of Financial Oz.

What would you rather have?  Randomly distributed mistakes, or perfectly correlated ones?

The answer, it seems to me, is gob-smackingly obvious.  Randomly distributed.  Perfectly correlated errors are a recipe for systemic risk.  All banks will crowd the risks that the model underprices and avoid the risks that it overprices.  If an adverse shock hits the crowded investment, every bank is screwed simultaneously.  All will need to liquidate their positions in that asset, or in other assets.  Every bank will have fire sales at the same time.

That’s what we want to avoid.  That’s what creates a systemic risk.

We want to diversify model risk, not concentrate it.  Centralized calculation concentrates it.  I actually see an evolutionary benefit in the wide range of model risk weights that DEM bewails.  That represents a diverse ecosystem of entities with divergent views that is less vulnerable to a single shock.  Yeah, that shock will crater some banks, but not all of them. When I think of any-ANY-centralized calculation, I think of the Socialist Calculation Debate.  I also think of monocultures that are dangerously vulnerable-systemically vulnerable-to a single shock.  Think of the devastation that smallpox wreaked on native American populations.  A single shock can crater everybody all at once.

If that happens, who is the buyer in the fire sale?  If there are no buyers in the fire sale, how low can prices go? Pretty damn low.

Crimson is right.  All Large Calculations Are Wrong.  The answer to this problem is exactly the opposite that DEM suggests.  Diversify this risk.  Don’t concentrate it.  Don’t sort on it.

We need less centralized control-freakishness.  Not more.  A lot less.  Mistakes are inevitable.  Create a system that induces them to make uncorrelated mistakes (or at least, mistakes with low correlation).  Don’t induce perfect correlation in errors.  I say again: don’t induce perfect correlation in errors.  Create a diverse ecosystem, not a monoculture.   Imposing uniformity because disagreement is unseemly and reveals the fundamental uncertainty with assessing risk is exactly-exactly-the wrong answer.  It makes errors systematic.  Systematic errors create systematic risk.

Diversified, diverse populations are far more robust than uniform, monocultural ones.  Disagreement is a feature, not a bug.  Enforced agreement is the worst bug of all.  Sort of like smallpox.

This week’s big derivatives story was about a public workshop at the CFTC on the issue of futurization.  I was one of the first people to comment on this issue, last year when ICE announced it was converting all of its energy swaps into energy futures.

That was Futurization 1.0. The conversion merely consisted of renaming “swaps” “futures”.  In all economic dimensions (contract specs, execution, clearing) the contracts remained identical.  But the renaming allowed some energy swap users to escape the dreaded Swap Dealer designation.

Futurization 1.1 was the CME’s conversion.  This illustrates some of the silly impacts of Frankendodd.  The CME has cleared energy swaps for going on 10 years now.  The parties would execute a swap, and submit the swap for clearing through an Exchange of Futures for Swaps (EFS) trade.  So the originally executed swap existed only until it was submitted for clearing, when it was replaced with economically equivalent futures contracts.  But no matter how short the swap’s life, the fact that it was born a swap meant that it counted towards the volume of swaps activity used to determine whether someone was a swap dealer.  So the process has now changed, and market participants use (mainly) block trades of futures to create the positions they want, thereby cutting out the interim swap step.

The transformation of the energy derivatives landscape, and the launch of swap futures by CME and Eris are now raising the question of whether futurization will spread beyond energy.

One motive to eschew swaps in favor of futures is unlikely to exist in interest rates, credit and other financial derivatives: the biggest market participants are likely to trade enough bespoke swaps for which there are no futures equivalents, meaning that they will be treated as swap dealers regardless: this reduces their incentive to substitute futures for swaps.

The main driver of futurization outside of energy will be CFTC regulatory treatment of futures and swaps.  Differential treatment will affect the economics of futures vis a vis swaps, and the prospect of such differential treatment was the center of controversy at the CFTC meeting, and in the larger debate in the industry.

The main sources of differential treatment are execution and margining.  Swaps will have to be executed subject to (allegedly) soon-to-be announced SEF rules, and are subject to immediate reporting.  Most market participants who will substitute futures for swaps will execute these deals via privately negotiated block trades subject to exchange rules.  Crucially, reporting of block futures trades is delayed 15 minutes, a concession to fears that immediate reporting would impair liquidity because block positioners (those supplying liquidity to the block futures market) could find it difficult to lay off their risk if the fact they had just done a big trade was announced immediately.  This would induce them to require larger price concessions for doing block trades.

Which raises the question: why the difference between the futures goose and the swaps gander?  Similar considerations obtain for swaps.

Thus, this rule difference is likely to favor futures executed via block trades as opposed to swaps executed via traditional means (but with immediate post-trade transparency) or via SEFs.  (Economically material differences between the rules governing block trades and SEF trades could also affect the relative costs of trading in these disparate ways, and hence affect the choice between them.)

Margining will be different for swaps and futures.  Futures will be margined assuming a one- or two-day liquidation period (i.e., margins will be based on something analogous to a one- or two-day value at risk).  However, swaps-even cleared swaps-will require a minimum liquidation period of 5 days for calculating initial margin.

This substantially higher margin for swaps results in a substantial economic disadvantage to these contracts compared to futures contracts that generate the exact same cash flows (in the absence of default).   This will likely be another factor pushing the market towards futures-which is a major reason for the fury of swaps dealers.

This differential treatment of economically equivalent contracts just because one is called a “swap” (BAD!) and the other is called a “future” (GOOD!) makes little-or no-economic sense-and reflects the swap-o-phobia that pervades DC, and which was an animating principle behind Frankendodd.

The reason to set margins based on a liquidation period reflects the purchase of IM: it is intended to cover potential losses on a defaulted position before that position can be liquidated by the clearinghouse (i.e., the position can be assumed by another solvent market participant).  The less liquid an instrument,  the longer it takes the CCP to work out of the position, the more it is exposed to potential adverse price moves and hence the more margin cover it needs.

This liquidation period depends on the economic characteristics of the contract, how widely it is traded in the marketplace, the identity, number and capitalization of the firms that trade it, and market conditions at the time of liquidation. All of these conditions should be pretty much the same for two contracts that specify the same contingent cash flows, one of which is called a swap and the other a future.  Consider say a 10 year vanilla IRS and economically equivalent futures contracts that offer the same contingent cash flows.  Abstracting from margining differences, these contracts have identical price risks, and should attract the same kinds of users.  Why should liquidity of one differ from the liquidity of the other in the event of the default of the holder of a big position?

And don’t tell me that futures are traded in light markets and swaps are traded in dark ones.  As already noted, futures traded as substitutes for swaps are and will be typically traded in blocks outside the limit order book.

More importantly: in the event of the default of a big FCM or dealer that should be the reason to be concerned, the CCP is going to try to get rid of the defaulted portfolio in big chunks through some sort of auction process.  The firm winning the auction will then trade out of the position, likely using the central market and block trades.

This isn’t much different than how a swap CCP will handle the default process.  Indeed, LCH obligates its members to assume portions of a defaulted portfolio, and one reason for having stringent CCP membership requirements is to ensure that the members have the capital and trading expertise to manage big pieces of defaulted portfolios.

We actually have a case study of futures and swap default management processes.  When Lehman defaulted, CME auctioned off its interest rate, equity, currency, commodity, and energy positions.  These trades were done at differentials from market prices, to reflect the risk that those taking over the positions would assume and have to work off.  A couple of the positions were under-margined: the firms taking over the positions required the CME to provide more funds than the Lehman margin it had against those positions.  As it turned out, the other positions were over-margined, and across all positions the over-margining exceeded the under-margining, meaning that the CME clearinghouse did not suffer any loss as the result of the default.  But this illustrates the possibility that futures can be under-margined, and that even the putatively more liquid futures contracts can require substantial price concessions to get someone to assume them.

LCH.Clearnet handled the default of the Lehman IRS positions. These totaled $9 trillion in notional-bigger than the Lehman futures positions at CME, and arguably far larger in terms of risk.  ($1 trillion in notional of a 10 year IRS poses substantially more risk than $1 trillion in notional of Eurodollar futures.)  90 percent of the position was hedged within a week.  According to LCH.Clearnet, the costs of trading out of the defaulted position were “well within” the Lehman margins it held.

It’s hard to see much of an economic difference between the CME and LCH experiences.  It doesn’t appear that it was materially more difficult to manage the default of “swaps” than it was “futures.”   The Lehman default does not provide any evidence that swap-o-phobia is anything but a mental illness.

Further, this case study illustrates that there is no reason to believe that absent government regulation, swaps will be under-margined and futures will not.  Indeed, had the Lehman positions been held at 5 separate CCPs, two of them would have been under margined.

Indeed, there are serious reasons to be concerned that government regulations of the margining of economically similar (and in some respects identical) contracts will create systemic risks, rather than mitigate them.

The margin regulations-with larger IM imposed on swaps than futures-are a form of price control, in this case default risk price control.  And we know that price controls work out swell, especially when applied by regulators in a two-sizes-fits-all fashion across all different kinds of instruments posing different risks and cleared by CCPs with potentially disparate financial strength.

Moreover, this price control will tend to induce activity to move towards futures CCPs.  Whereas in the absence of the margin differential clearing activity in, say, interest rate derivatives would be split between futures CCPs and swap CCPs, under the differential regulation, business will tend to tip to the futures CCPs-most notably, CME.  This will tend to lead to greater concentration of credit risk.

Wasn’t the whole point of Frankendodd to reduce concentration? Just asking.

The whole conceit that regulators can set risk prices is quite dangerous, and is likely to be a source of systemic risk because these prices are set on the basis of highly limited information in a politicized process, and because mistakes in setting risk prices (especially price differences between similar products) tend to lead to crowded trades and risk concentration that is highly destabilizing during crisis periods (cf. Basel II).

The case for setting different margins (default risk prices) on very similar-and in some cases identical-derivatives contracts is particularly weak.  It is the characteristics of the products and those who trade them that will drive liquidity and liquidation periods: products called “futures” that share the same economic characteristics as products called “swaps” will pose virtually the same challenges to liquidate in the event of a large default.  Given this, the economics suggest that imposing differential margins based on a name difference-rather than economic differences-can’t make things better, and could well make them worse.

But the Sorcerer’s Apprentices know better. So futures are likely to get an artificial advantage, and swaps an artificial burden. Such distortions are quite dangerous.  My conclusion? Futurize in haste, repent at leisure.

One of the primary reasons I became interested in Russia was the Khodorkovsky prosecution.  (The expropriation of Shell’s Sakhalin II was another.)  My writing about Khodorkovsky brought me in contact with Robert Amsterdam, a member of his legal team.  Amsterdam was one of the first to link to my blog, and add me to his blogroll.  I broadly agreed with his highly critical views of Russia, and Putinism in particular.  I have met him once, and conversed on the phone several times.  Although I concluded that he was likely fairly progressive in his leanings, based on his views about Russia and his work in Thailand, and some of his writings about resource nationalism, I believed that he believed in the rule of law, applied impartially, and that he believed that private property is a bulwark of liberty.

I was therefore extremely dismayed to see that he has joined the Kim Dotcom legal defense.  Amsterdam offers several justifications for this choice.  First, that the prosecution is “essentially bogus.”  Second, that the US government, with the complicity of the government of New Zealand, utilized excessive force in arresting Dotcom.  Third, that the US government took this action for crass political reason, namely, to retain the political and financial support of the motion picture industry.

I find none of these persuasive.  The crucial issue-without which none of the others would arise-is the legitimacy of the prosecution.  That is, is there a legitimate basis for the charges brought against Kim Dotcom and his (alleged) co-conspirators?

Here’s what Amsterdam says:

The prosecution’s case is essentially bogus.  Kim’s lawyer Ira Rothken has picked apart the allegations in a number of interviews, exposing the flaws in every point of the indictment.  As an Internet services intermediary, Megaupload diligently complied with takedown requests to remove infringing materials, and went even further to allow some 180 content-producing companies direct access to the servers to delete infringing materials themselves, which was unprecedented for any cloud storage provider.  Despite never once having been sued by any movie studio or record company, the DOJ wants to hold Megaupload liable for infringement via third party cases of piracy by users – however there exists no federal criminal statute for secondary copyright infringement, so essentially they are trying to unlawfully apply civil law in a criminal law context.  As Rothken has argued, the aggressive persecution of Kim Dotcom and other Megaupload founders has been full of “dirty tactics” by U.S. prosecutors.The prosecution’s case is essentially bogus.  Kim’s lawyer Ira Rothken has picked apart the allegations in a number of interviews, exposing the flaws in every point of the indictment.  As an Internet services intermediary, Megaupload diligently complied with takedown requests to remove infringing materials, and went even further to allow some 180 content-producing companies direct access to the servers to delete infringing materials themselves, which was unprecedented for any cloud storage provider.  Despite never once having been sued by any movie studio or record company, the DOJ wants to hold Megaupload liable for infringement via third party cases of piracy by users – however there exists no federal criminal statute for secondary copyright infringement, so essentially they are trying to unlawfully apply civil law in a criminal law context.  As Rothken has argued, the aggressive persecution of Kim Dotcom and other Megaupload founders has been full of “dirty tactics” by U.S. prosecutors.

Here is the indictment.  Compare and contrast with what Amsterdam writes.

It alleges that although Dotcom and Megaupload took some actions to remove copyrighted material from their sites, it provided financial incentives for users to upload copyrighted material; failed to terminate access from known copyright infringers; made no significant efforts to identify or remove copyrighted material, or prevent it from being uploaded; impeded copyright holders from identifying those using the sites to upload copyrighted material; did not delete material they knew to be copyrighted, even after being informed by the copyright holder;  complied selectively with obligations to remove copyrighted material, but failed to do so when it was in their financial incentive to do so; falsely represented to copyright holders that they had removed copyrighted material, when in fact they had only removed a subset of the links that provided access to that material; monitored law enforcement surveillance of Mega sites, and took active measures to conceal copyright infringement taking place on these sites; personally uploaded pirated copyrighted material; and on and on.

Let’s not pretend like we all fell off the cabbage truck.  It is more than obvious that Megaupload was created to facilitate the uploading and distribution of pirated copyrighted material.  That’s what it was used for.  Megaupload profited from this by selling premium subscriptions and by selling advertising to those who visited the site to view copyrighted material. It’s not hard to connect the Dotcoms here, though Amsterdam pretends there are none to connect.  Megaupload had a direct financial stake in facilitating the uploading and downloading of pirated material.  That’s what brought people to the site.  That’s what induced them to pay for premium subscriptions.  That’s what brought the eyeballs that paid for the ads.  That’s what the indictment alleges.  That it was, in essence, a fence of stolen property.  Intellectual property, yes, but property nonetheless-under United States law.  (More on this below.)  An entity that facilitated the marketing of stolen property, and made money for providing this service.

The indictment’s allegations flatly contradict Amsterdam’s claims that Dotcom and Megaupload were “diligent” in their efforts to protect copyrights.  In contrast, the indictment alleges that these efforts were perfunctory, and intended to feign compliance as a means of covering a concerted scheme to facilitate the distribution of pirated copyrighted materials.  Read some of the emails in the indictment.  It is clear that Dotcom and the others indicted were aware that copyrighted material was being accessed via Mega, that making money off of providing access to these materials was the essence of their business model, and that they took some actions that gave the illusion of compliance while taking other actions to protect the business model.  Sort of reminds one of a fence that runs a legit pawn shop on the side, and from time to time turns over stolen property to the cops.

It is interesting to note that Dotcom’s defense’s attempts to dismiss the charges focus on the very narrow issue of the service of the indictment on Megaupload, rather than the substance of the charges.

Let’s also not pretend that Kim Dotcom has no history.  He has a very long and disreputable history, in fact.   Hacker.  Inside trader.  Fraud.  More than a history, a rapsheet-complete with a conviction.  What’s more, he revels in his outlawry.  Flaunts it, in fact.  For going on two decades, he has reveled in breaking the law and profiting from it.

Dotcom also operates in a milieu that denies the legitimacy of most intellectual property law: some, in fact, deny the legitimacy of any IP law.  These people rationalize that since it is costless to copy, copies should be costless.  That is the socialism of the wired fool (or is it “efool” or “iFool”?).  What is copied has to be created.  If it is copied for free, it is far less likely to be created.

This is the fundamental tension in intellectual property.  It is hard to balance the incentives, but these “copyleftists” (as Catherine Fitzpatrick trenchantly and accurately characterizes them) don’t even recognize there is any need to balance.  This is, quite frankly, idiocy.  I could give lectures on the subject.  Oh.  Wait.  I have.

But the copyleftists self-righteously (how’s that for irony?) shriek that any attempt to constrain their ability to access IP is an unconscionable infringement of freedom.  From this, it is a short step to rationalizing the taking of intellectual property.  If you believe “(intellectual) property is theft” there is no moral bar against appropriating it-“liberating” it.  And from there, it is a shorter step still to believing that any attempt to enforce intellectual property law is a gross injustice, and that the enforcers are the corrupt creatures of the real thieves-those who claim for themselves what should be freely available to everyone.

And that is exactly what Robert Amsterdam is buying into when he defends Dotcom.  If you believe that copyright is legitimate property, and recognize that there laws-including criminal statutes-to protect this property, then you have to acknowledge there is a legitimate basis for the prosecution of Dotcom.

But in arguing that US prosecutors are the corrupt creatures of Chris Dodd and the movie industry, Amsterdam buys into the whole IP as theft meme.  Lord knows I am no fan of the guy who put the Dodd into Frankendodd, but in this instance he is representing a legitimate interest that expects and deserves that its property be protected by law enforcement.

Let me put this another way. Amsterdam has been a vociferous critic of legal nihilism in Russia.  With considerable justification, and I am in agreement with him on this.  But Dotcom and his defenders are total legal nihilists. Some of the copyleftist community are nihilists on what they consider to be principled grounds: the IP is theft principle, to be specific.  Aaron Swartz fell into this category.  Dotcom is a legal nihilist for purely mercenary reasons: to support his .1 percent lifestyle.   But the motive is not really material, even when it is materialistic.  A nihilist is a nihilist.   These people want to annihilate IP law.  For different reasons, but they want to annihilate it.  By signing onto the Dotcom defense Amsterdam is abetting the same legal nihilism that he excoriates in Russia.  There are legitimate means to change the law: breaking it isn’t one of them.

There is further Russia-related irony here.  Who has been among Dotcom’s most vociferous defenders? None other than The Media Outlet Formerly Known as Russia Today.  Yes, that RT.  The Kremlin agitprop operation.  An operation that is, shall we say, hardly Khodorkovsky friendly, and which is the puppet of Khodorkovsky’s main tormentor: Vladimir Putin.  RT loves-loves-Kim Dotcom.  Mikhail Khodorkovsky, not so much.  Does your strange bedfellow steal the covers, Robert?

And further the we-didn’t-fall-off-the-cabbage-truck theme.  Russia is one of the main sources of pirated material, and one of the main consumers of pirated material.  Each VKontakte user watches an average of 8.5 hours of video a month, virtually all of which is pirated. Russia is notorious for its IP piracy-and for the studied refusal of the government to do anything about it.  Indeed, it is equally notorious that the security forces provide the krysha for all varieties of cybercrime, including piracy.

As the operator of the largest market for pirated material (and by market, I mean a venue where buyers and sellers can interact to engage in exchange), Kim Dotcom was in a highly symbiotic relationship with such types.  Highly symbiotic: Dotcom provided a venue-an exchange, if you will-where these types could sell their ill-gotten goods, and made a very lucrative living by doing so.

Meaning this was not a Six Degrees of Kevin Bacon sort of association between Dotcom and the Russian security services.  There are far fewer degrees of separation of Kim Dotcom from the very people who persecute (by his own characterization) Amsterdam’s most famous client: the client who propelled Amsterdam to international prominence (and large billings), yet who continues to rot in a jail cell in Chita. Losing any sleep with your new bedfellow, Robert?

One last point.  Amsterdam makes a big deal out of the fact that Megaupload/Dotcom were “never sued by any movie studio or record company.”  A similar claim is heard repeatedly in regards to JSTOR, MIT, and Aaron Swartz.

Please.  Presumably Amsterdam makes this point to insinuate that the movie studios or record companies didn’t believe that Dotcom was costing them any business: if they did, why didn’t they sue?  But how can he possibly reconcile this insinuation with his other claim: that the movie industry collectively pursued Dotcom with Javert-like obsessiveness?   If movie companies were individually unharmed by Megaupload, why would they fund collective action to force the government to prosecute him?   You can’t have it both ways.

Moreover, taken at face value, Amsterdam’s claim (and similar claims made regarding Swartz) would imply that there is no need for state civil or criminal enforcement of any property right.  Just leave everything to private right of action.  If that’s his position, I would like to hear his defense of it.

There are in fact strong arguments on the other side.

For one, economies of specialization in investigation and enforcement are one reason to have state enforcement.

Free rider problems are another.  Indeed, the Dotcom case illustrates that point clearly.

Amsterdam mentions 180 content providers.   The efforts of any one of these firms to force Megaupload to cease operations, or to operate in a way which protected IP, would redound to the benefit of the other 179.  There is a public good problem/free rider problem here, and given this (severe) problem purely private enforcement leads to too little effort to enforce property rights.  Public enforcement internalizes (at least partially) an externality.

It is interesting to consider what Amsterdam brings to this case.  His law firm’s website does not disclose any experience in US criminal cases, or intellectual property law.  Instead, it primarily touts its expertise in political defense and political advocacy.  That’s quite telling, and of a piece with the efforts of copyleftists and the hacking underworld to politicize every attempt to enforce laws relating to copyright and computer security.  There’s an old saying: if the law is on your side, argue the law.  If the facts are on your side, argue the facts.  If neither the law nor the facts are on your side, pound the table.  In computer and IP related legal matters, the last sentence of the aphorism should be modified to read: “If neither the law nor the facts are on your side, pound the politics.”  That is likely to be Amsterdam’s role in this case.

But in playing this role, he is associating with a very dubious character who facilitated massive theft, and profited therefrom.  Making a political cause celebre of Dotcom will play well with Anons, the EFF crowd, the Googlesphere and others in the anti-IP precincts of the left.  Precincts that are quite well-heeled, by the way, and spend large sums on political influence in order to advance their economic interest-just like the movie industry.  But in so doing, Amsterdam gives ammunition to Putin and his ilk, who will no doubt smirkingly point to Dotcom and say that Amsterdam is willing to defend wealthy guilty-as-sin crooks by politicizing their cases-thereby discrediting his advocacy of Khodorkovsky.  And they’ll have a point.

More indications that Frankendodd, Basel III, and other measures intended to reduce the risk in the banking system, and to address the too big to fail problem, are leading to greater consolidation of the banking sector:

Investment banks must take further actions to improve returns and more will follow firms like UBS AG (UBSN) and Royal Bank of Scotland Plc  that have exited businesses, McKinsey & Co. said.

Only five or six companies will remain “bulge bracket” firms that offer all investment banking and trading products worldwide, the consulting firm said today in a report titled “After the Reckoning.” Others will step back from some businesses to focus on areas where they have a competitive advantage, according to the report.

. . . .

The top three firms in each asset class account for about two-thirds of trading volume in that product, according to the report. Banks that lack such scale or face higher funding costs will probably focus on businesses such as foreign exchange or structured rates and credit, McKinsey said.

So: increased concentration and reduced competition as some banks exit certain businesses.  The sector overall will almost certainly shrink, but the remaining bulge bracket firms will account for a greater fraction of business, and may grow absolutely.  It is also likely that these remaining firms will be as interconnected, or more interconnected, than was previously the case.

One of the themes of my writing on clearing mandates and other aspects of post-Crisis derivatives regulation has been that although these initiatives have been sold as ways of reducing risk in the financial markets, in reality, they shift many risks, transform others, and create new ones.  It is by no means clear that these new laws and regulations have reduced the overall vulnerability of the financial system.

For instance, clearing and collateral mandates are intended to reduce the amount of credit embedded in derivative trades.  But market participants can respond to this by substituting other forms of leverage.  The effects on credit risk and leverage overall are far more equivocal than the advocates of the mandates claim.  As another example, making derivatives more expensive means that some will eschew using them to manage risk.  Risk that was passed to others able to bear it at lower cost will remain with those who bear it at a high cost.  As yet another example-and the one that worries me most-is that clearing and collateral mandates have transformed credit risk to liquidity risk.  Since true crises are usually liquidity crises, this is highly disturbing.

The CFO of Rolls Royce made similar arguments forcefully at a conference a few days back:

European regulatory measures designed to make the financial system safer don’t actually eliminate risk, they simply move it to nonfinancial companies, warns Mark Morris, the finance chief for Rolls-Royce, the British aero-engine maker. And there could be a negative impact on the economy, he says.

Speaking at a conference organized by The Economist Group (a minority owner of CFO), Morris criticized European regulators for seeking to deal with over-the-counter derivatives risk in the financial sector by requiring some contracts to be centrally cleared or to have collateral posted.

The European market infrastructure regulation, known as EMIR, took effect last August but requires the European Commission to enact a series of technical standards before the rules can be fully implemented. Most are expected to be finalized by mid-2013.

“In essence, you can’t destroy risk,” Morris said. “It morphs into something else. If you take market risk and go into a foreign exchange [hedging] transaction with a bank, you’re replacing it with counterparty risk. If you try to replace the counterparty risk by using central clearing or some form of posting of collateral, what you’re doing is you’re replacing counterparty risk with liquidity risk.”

Morris makes some other good points in the article, so I recommend you read the whole thing.

It seems that the Europeans are more sensitive to these concerns than was the case in the US.  The European Parliament may demand changes in EMIR. Apparently they are aware of the legislate/regulate in haste, repent at leisure problem.  Unfortunately, with Frankendodd dismissed such concerns.  Methinks that the repentance stage will come soon.

It is bizarre to observe Obama’s burning desire to reproduce the European welfare state in the US (on full display in his inaugural address) at the same time that model is collapsing before our eyes.  But another element of Obama’s address reveals that his disconnect between a desire to reproduce European policies at the same time as those policies are lapsing into farce is not limited to the welfare state alone. On Monday, Obama pledged a renewed commitment to combating “climate change.”  (When has climate been static, by the way?)  Ironically, on Monday, the FT ran an article describing the near collapse of the EU’s emission trading (cap-and-trade) market:

Carbon prices have fallen to a record low of less than €5 a tonne, pushing the European Union’s eight-year-old emissions trading system into a crisis.

Benchmark EU carbon prices yesterday dropped to a session low of €4.79 a tonne – down nearly 20 per cent over the past week – after Germany’s failure on Friday to sell carbon permits triggered a crisis of confidence.

As the article notes, this follows hard on the collapse of the UN’s Clean Development Mechanism.  Kyoto is dead.  The regional/state markets in the US (REGGI and California) are wheezing, at best.

So why not a new Big Push (cue Douglas Haig) on climate change?  What could possibly go wrong?

Better yet, why bother with the pesky legislative branch when pursuing this endeavor in the face of a truly global record of failure?  After all, Congress might be subject to feedback, and we can’t have that.  Thus, according to Bloomberg, Obama plans to pursue his Quixotic venture (almost literally so, given the prominence of windmills in alternative energy efforts) via executive order and regulation, rather than legislation.  Again: what could possibly go wrong, putting what is arguably the worst, most dangerous government regulator, the EPA in charge of this?

Not to mention that these initiatives at the level of individual nations, or even large multinational blocks, will be costly, and have virtually no impact on global temperatures.  All pain, no gain.  It is utterly insane for California to attempt unilaterally to control emissions: it is only slightly less insane for the US to do so.  But that’s the way Obama wants to go, despite the collapse of similar initiatives around the world.

But maybe that just reflects the fact that these endeavors are driven more by a religious and ideological belief than a commitment to tackle an issue an a practical way that wrestles with empirical and political realities, and weighs costs and benefits.  For people so driven, ostentatious sacrifice and adherence to ritual are valued in their own right, not for their practical consequences.  Incurring a cost signals the depth of commitment, and that’s what matters.  The pain is the gain.  For them, that is.  For the rest of us who are not wedded to such beliefs, not so much.