Streetwise Professor

So today, 12 October, 2012, is the day when many Frankendodd rules go into effect.  Swap dealer registration for instance: but not position limits!

Yes.  848 pages of legislation (or 2319 pages, depending on how you count)-where commas matter-that spawned thousands of pages of rules (over 9k as of July, and where commas will also matter) that will spawn thousands more pages of interpretations, no action letters, legal rulings, etc.  All in an attempt to re-engineer a devilishly complex, interconnected financial system.  A system that will not stand still, but which will change in response to the law and the regulations, thereby producing myriad unintended consequences.

I’m sure it will turn out just swell.  Timmy! and GiGi and their successors have everything under control.  They’re from the government and there to help you!  Trust them on this!  Don’t you worry your pretty little head over it.

JK.  In reality, Mickey Mouse (how appropriate) gives you a better idea of how things are likely to turn out.

I fearlessly predict that the next financial crisis will follow directly from Frankendodd. It is a monster, which like Frankenstein’s, will escape its master’s control and wreak havoc. Mark my words.

The always thoughtful and considerate David at Deus ex Macchiato responds to my post on ring-fencing.  He concurs in part, and dissents in part.  Or he claims to dissent, but I think we’re more in agreement than he lets on.

His disagreement relates to my claim that entities outside the ring-fence could be too big to fail, and are reliant on fragile funding and hence vulnerable to destabilizing runs.  He basically argues that there are regulatory/supervisory responses to this, e.g., collateralization of OTC derivatives trades, higher capital charges on firms outside the fence looking in, rules intended to reduce the risk of runs on money market funds.

In essence, my interpretation is that David is arguing that it is possible to increase the stability of the shadow banking system through such supervisory/regulatory changes.  I wish I were so sanguine.

But it does provide a good way to frame the trade-off that is involved.  Ring-fencing increases reliance on wholesale funding and shadow banking by preventing the funding of certain activities with stickier deposits.

That’s what makes me concerned.  I think these wholesale/shadow banking funding structures are a source of vulnerability.  That’s basically the interpretation that Gary Gorton gives in his forthcoming book.

Given that, I think we should be very, very concerned about “reforms” that increase reliance on wholesale/shadow bank funding.  As David notes, this must be accompanied by other changes that address the fragility of these funding mechanisms.  I am much more skeptical than David, apparently, that such changes are likely to occur.  And this is the source of my concern about ring-fencing.  Especially about ring-fencing that is not bundled with measures that reduce the fragility of the wholesale/shadow bank funding mechanism.  That’s why ring-fencing alone is particularly worrisome. My priorities would be the reverse: focus on shadow banking and wholesale funding first.

But like I said, I think David is more aligned with me than he lets on.  For he says:

After all, as SWP points out, it wasn’t the universal banks who were most vulnerable: having deposit funding reduced their liquidity risk during the crisis. So perhaps there are systemic benefits to having casino and retail banking mixed? Surely that is something that we should settle before ring fencing.

Abso-effing-lutely.  That’s exactly what we need to settle first: that’s what I meant about “my priorities would be the reverse.”  That’s exactly why the fetishization of ring-fencing as a solution, or at the very least the first step in a solution, is highly dangerous.

To put it differently.   We need a back-to-basics rethink on what activities should be funded by insured deposits or some other form of guarantee; which should rely on wholesale mechanisms; and what can be done (short of some sort of insurance mechanism) to make the wholesale/shadow bank system more stable.  Is there a compelling economic reason why only traditional commercial banking activities should have access to insured funding?  This seems as much of a historical artifact as anything else, something that grew out of the banking system as it was in the 1930s.

Before lunging ahead with structural reforms that seem rooted more in nostalgia than economics, it is imperative that we think a lot more seriously about the right match between funding and the activities that are being funded, and what system of insurance or guarantees can improve the functionality of this match.  After all, during the crisis there was a massive ad hoc extension of guarantees to a wide variety of shadow banking and wholesale funding activities.  Wouldn’t it be better to think about that in advance, instead of making it up as we go along?

And again, that’s what worries me about the focus on ring-fencing.  It punts on this extremely vital issue; potentially force-feeds the shadow banking system; and puts us at risk of more ad hoc bailouts of this system in the future.  Which is precisely why I believe that it is naive-foolish, actually-to believe that ring-fencing protects taxpayers.  It could well put them at greater risk.

So on this big point, I think we agree, David: “Surely that is something that we should settle before ring fencing.”

Gas prices in California are topping $5/gallon, and politicians are in a frenzy, making claims of manipulation.  Diane Feinstein is taking the lead:

Feinstein, in a letter to the Federal Trade Commission (FTC), called for the agency to implement broad monitoring of oil-trading markets and investigate possible “collusion.”

“Publicly available data appears to confirm that market fundamentals are not to blame for rising gas prices in California,” she wrote, citing state data that showed gasoline production last week was almost as high as a year ago and that gasoline and blending components were equal to this time last year.

The California senator cited Reuters’ Friday report on the “short squeeze,” in which traders said refiner Tesoro Corp had to scramble to buy fuel from other companies to meet commitments.

While traders told Reuters that no single party appeared to be withholding supply intentionally and that there was no suggestion anyone conspired to drive up prices, Feinstein wrote: “An FTC investigation is likely the only way to determine whether this reported squeeze took place.”

Look.  I’ve seen this movie many times before.  There is a localized spike in gasoline prices.  Politicians start screaming “We must do something about this at once! Immediately! Immediately! Harrumph! Harrumph!”  The FTC scurries to do an investigation, and finds that fundamentals explain the spike.

They also find something I’ve included in my classes for 10+ years: that Federal environmental policy is directly culpable.  The key here is that these spikes tend to be localized.  Why? Because due to EPA regulations, there are highly localized formulas for gasoline.  Which means that when there is a supply disruption in a particular locale that requires a specific gasoline blend, supplies can’t be shipped in from other markets because the refineries serving those markets produce a different blend.

This happens in the Chicago area with some frequency.

You may think that the environmental benefits of customized gasoline blends are sufficiently great to justify the occasional-and inevitable-price spikes that such a system produces.  If so, you should STHU about the price spikes. But then you wouldn’t be a politician, who wants it all ways all the time.

This story brings up another pet peeve of mine.  (Yes, there are many.  I know.)  Specifically, the promiscuous and imprecise use of terms related to manipulation.

Feinstein seized on a statement in a Reuters report that Tesoro had been the victim of a “short squeeze.”  Now, this term can refer to a a manipulation, in which the holder of a large long forward position-a position larger than the quantity that can be delivered at the competitive price-demands excessive deliveries of the commodity, driving up the price, and liquidating some of its long position at the supercompetitive price.  The demand for excessive deliveries is an exercise of market power.  The firm demanding delivery is deliberately squeezing the shorts.

This term is also commonly used to refer to a situation where a firm or firm is short, and has to cover under tight supply conditions, but where nobody exercises market power. Here the short is squeezed by tight but competitive market conditions.

Note that the same term is used to refer to two very different situations: one in which somebody exercises market power, and one in which nobody does.

I strongly suspect that Tesoro was caught in the second kind of squeeze.  One way to determine this is to see if Tesoro bought back contracts.  If it delivered on 100 percent of its contractual obligations, one of the longs to whom it had sold couldn’t have exercised market power: that requires the liquidation of some contracts at the supercompetitive price.

But use of ambiguous terms that can have diametrically opposed implications fuels political fires from the likes of Feinstein.  (Scary thought.  She’s the smarter and more honorable of the two senators from CA.)

So my prediction. Much harrumphing for as long as prices stay high in CA. The FTC will dutifully investigate. It will conclude that the spike was produced by an adverse supply shock that could not be ameliorated by increasing supply from other markets. The politicians will greet this report with stony silence. But the harrumphing will begin anew with the next spike.

But you’ll never get a harrumph from this guy. Not until there is credible evidence of manipulation.

The UK’s Vickers Report and the EU’s recently released Liikanen Group report both recommend a fundamental structural change to the banking system to reduce systemic risk and the likelihood of taxpayer bailouts of banks: “ringfencing.”    The taxpayer guaranteed deposits of a financial institution would be inside the ringfence, and the ringfenced entity that can fund itself with these deposits can engage only in a limited array of activities that are deemed to be of low risk.  Riskier activities, such as derivatives trading and securities underwriting, would have to be undertaken through separately capitalized affiliates that cannot be funded by the ringfenced entity.

This is, in essence, a variation on the Glass-Steagall approach of separating commercial and investment banking.  The Volcker Rule is another way of achieving a separation of deposit taking and trading and underwriting activities.

These structural approaches are completely misguided, in my opinion.  They are unlikely to have the desired effect of reducing systemic risk or insulating taxpayers from the fallout of risky trading activities.

Insured deposits are a potential source of moral hazard, and there is a case to be made for limiting the risks that can be funded with insured deposits.  But historically these activity limits have proved to be a very poor defense against risk taking.  Banks have gotten into trouble while engaging in traditional lending activities; the Latin American debt crisis and the S&L crisis are two prominent examples.  Ditto Northern Rock in the UK.

Moreover, it is beyond naïve to believe that making insured depositors whole is the only, or even the most important, cause of taxpayer funded bailouts.  A failing  investment bank-or a bank-owned trading entity outside the ringfence-poses a potential systemic risk that would likely result in a bailout even if insured deposits are not directly at risk.  Its derivatives counterparties-which are likely other big financial institutions, and which could well be ringfenced banks-would suffer losses if it went other.  Its lenders-which could include, for instance, money market funds that buy its short term debt-are also at risk.   This could lead to destabilizing runs on the money markets.  In brief, even entities outside the ringfence would be highly interconnected with the broader financial system, and with entities inside the ringfence.  The Fed or the ECB would likely deem problems at such interconnected institutions to be systemically threatening, and would find a way to provide support to prevent a failure.

Put differently, an investment bank-like entity outside the ringfence can be too big to fail.

Indeed, looking at the 2008 experience, the most vulnerable institutions were not funded by deposits.  Bear Stearns was an investment bank-it was bailed out.  AIG was not deposit funded-it was bailed out, in large part (IMO) to prevent the failure of another non-deposit funded entity, Goldman Sachs (i.e., the AIG bailout was in part, and likely in large part, a backdoor bailout of Goldman).  Merrill was foisted on Bank of America to prevent its failure.  And of course there is Lehman.  It wasn’t bailed out-but you can be metaphysically certain that inaction won’t be repeated again.

It is quite easy to envision that there will be firms outside the ringfence that are deemed TBTF.  If one of these firms looks acutely vulnerable, central bankers and regulators concerned about systemic contagion will find some way to prop it up.  Taxpayer money will be at risk.

Moreover, the ringfencing idea creates a particular kind of vulnerability that proved to be an acute problem in 2008, and which is pretty well understood theoretically.  The funding of non-deposit funded entities is often quite fragile, and vulnerable to runs.  Like investment banks in ’08, entities outside the ringfence are likely to depend on short-term wholesale funding that can-and will-run if the entity looks shaky, and there is doubt that a bailout would be forthcoming.

Deposit funding is stickier, and a destabilizing-and inefficient coordination game equilibrium-run is less likely to occur with sticky funding.  Thus, putting trading activities outsie the ringfence, and funding these risky activities through the wholesale markets exacerbates a source of financial fragility.

Thus ringfencing increases the risk of liquidity/funding crises that trigger a bailout.  It exacerbates a form of fragility that was devastating in 2008, when it was financial institutions that were outside the Glass-Steagall ringfence that proved most vulnerable to the fallout from the decline in real estate prices.

The knotty issue here is why the funding of trading, market making, securities underwriting and similar activities is typically quite fragile.  The Diamond-Rajan story is that runs are a way of disciplining opportunistic intermediaries.  With the potential for externalities from runs (due to contagion effects) one could make a case that funding is excessively fragile.  But that is hardly an argument for ringfencing, which precludes the ability to use less run-prone deposits to fund these activities: indeed, if anything, it is an argument against ringfencing.

The nostalgia for Glass-Steagall-like structural “fixes” is pervasive.  But structural separation of certain forms of financial intermediation, and separation of certain forms of activity from deposit taking, don’t address a fundamental source of systemic risk: the reliance on short-term, wholesale funding that is vulnerable to runs.  Indeed, it likely makes the problem worse because it increases the reliance of the segments outside the ringfence on such funding.  It is delusional to think that just because taxpayer-guaranteed deposits are not directly at risk, that taxpayers are not on the hook for bailouts.  If a big, interconnected entity that sits outside the ringfence teeters on the brink, regulators and central banks may well deem it too big to fail: No More Lehmans is their motto.  Ringfencing does not isolate derivatives trading, underwriting, etc., from the broader financial system: entities outside the ringfence will still be interconnected.

So even if there is no explicit taxpayer obligation (as with insured deposits), there is an implicit one.  We’ve seen that implicit guarantee invoked before, and we could see it again.  Ringfencing does not address the problem of a non-depository SIFI that is highly interconnected.  Indeed, by increasing the number and size of such entities, it almost certainly makes this problem worse.

The Bank of Canada has decided that Canadian entities can meet their G-20 clearing obligations by clearing with international CCPs like LCH or CME.

The alternative-which was seriously considered, until fairly recently-was to require the formation of a domestic Canadian CCP through which Canadian financial institutions would be required to clear.  The Bank of Canada was leaning towards a “Canadian solution” because it believed that it could monitor such an institution more effectively, that a domestic CCP would insulate Canada from global financial shocks, and that it would be easier to provide C$ liquidity support to a domestic entity.

I co-authored a study for the Canadian Market Infrastructure Committee (CMIC) which argued that (a) these benefits were illusory because there would be C$ swaps traded by non-Canadian entities and non-Canadian entities would likely be important members of a Canadian CCP due to scale and scope economies, and (b) mandating clearing via a domestic CCP would dramatically increase collateral and liquidity costs of trading C$ swaps due to the fragmentation of netting sets (among other reasons).  As a result, I/CMIC recommended that Canadian banks, investment funds, and insurers be permitted to meet their G-20 obligations with an international clearer that could margin more efficiently.

It’s good to see that BoC acknowledged the force of these arguments, despite its initial preference for a domestic CCP.  Reason sometimes prevails.

I’m less enamored with BoC Deputy Director Timothy Lane’s argument that commodity trading firms (e.g., Cargill, Glencore, Vitol, Trafigura, Dreyfus) are systemically important.  Much more on that subject soon-it consumed much of my summer.  Hopefully he’s open to persuasion on this issue, as he was on the necessity of mandating the use of a domestic CCP for Canadian IRS.  But it would be gratuitous of me to make too much of a bother of the global commodity trading firm (“GCTF”) matter now.  So I say kudos to Mr. Lane, and the BoC, for setting priors aside; evaluating the arguments and evidence; and coming to the right choice (IMO) with respect to clearing of C$ swaps.

HFT is under continued assault, both in the press and from regulators and legislators.  Europe is taking the lead on this, and Mifid II will impose some restrictions on HFT.  The Germans are particularly hot on restricting it, and are proposing other measures as well.

One goal of these regulations is to increase liquidity, and to improve the quality of liquidity.  Perversely, however, certain of the regulations intended to have these effects will do the exact opposite.

In particular, as I’ve argued since soon after the Flash Crash when many of these ideas were first proposed, things like minimum resting times for limit orders will reduce liquidity and make sudden reductions of liquidity more likely precisely when order flows become more toxic.  Limit orders are like options granted by the market maker, and extending the lifetime of the option increases its cost-particularly during times of high volatility and high order flow toxicity.  If you increase the costs that market makers, including those using HFT strategies to make markets,  incur to quote, they will quote wider, they will quote less, and their quotes will become particularly wide and particularly scarce during periods of elevated uncertainty.

In other words: there is no free lunch.  You raise the costs of market making, and liquidity costs go up.  Period.

Larry Tabb makes the point quite well:

So what will happen? If we mandate longer time in force periods, lower cancellation ratios, and higher market maker participation rates, liquidity providers will just widen their spreads to compensate them for the greater risk.

Won’t this force real investors to come in and bid? They may, however investors don’t quote on both sides of a market. They either buy or sell and not both. So many more quoting investors would be needed to make up for fewer market makers and HFT.

But, will HFTs actually leave? Market makers may leave but high-speed traders probably won’t; they will just change their stripes. Liquidity providers will flip to liquidity takers. Given a speed advantage, if it no longer serves a high-speed trader’s purpose to provide liquidity, they can just as easily take it. And since market makers and quoting investors are locked into providing liquidity for at least 500 milliseconds, HFTs will be the first to pick off every stale quote. And with a half second quoting mandate, there will be plenty of stale quotes to go around.

This last point is particularly powerful.  The regulations will penalize liquidity suppliers not just directly, but indirectly, by actively encouraging predatory/opportunistic algorithmic/HFT strategies that look for and pounce on quotes that are stale and not reflective of current information because of the restrictions on the time quotes must be enforced, and on cancellation and participation ratios.  (Note: these last restrictions are likely to create some rather complex time dependencies that can create some unanticipated sources of instability.  A trader’s current quoting behavior will depend on his past cancellation and participation rates, not just on current market conditions.  That adds a complex new feedback to an already complex process.)

The elimination of tiered pricing (e.g., differential pricing for quote makers and quote takers) will also tend to reduce liquidity.  Why don’t exchanges have the incentive and the information to get that right?  They are much better incentivized and informed than regulators.

So as Larry indicates, the regulations will reduce liquidity by raising the cost of quoting directly, and indirectly as well by encouraging predators to feast on those brave enough to quote:

So let’s combine points. Market makers will leave, spreads will widen, investors will post quotes, but HFTs instead of posting will take quotes. With investors’ quotes being frozen, HFTs will just pick off those investors. And once these investors learn this game they will stop posting, and then there will be little incentive for anyone to post quotes as the value of the limit order option grows just as the compensation to the option poster falls.

But won’t HFTs run afoul of HFT rules, you ask. Not really, since many of these rules focus on liquidity posting and not liquidity taking. If you take liquidity, there is no need to post or cancel, so cancellation rates decline to zero, and time-in force rules become immaterial.

Great.

Mifid II will also restrict those scary dark pools, in particular by banning crossing networks.  Which, as Tabb notes, will expose those seeking liquidity to predatory HFT, and other predatory strategies that raise execution costs.  For dark pools exist precisely to reduce the execution costs of those who are uninformed liquidity demanders. They swim in a (dark) pool because they don’t want to swim with the sharks in the open waters of the public markets.   Mifid will deprive them of that safe harbor, with the predictable result that Larry describes:

If all of this comes to pass, spreads will widen, depth will evaporate and there will be fewer places to hide as broker dark pools will face restriction. And the life of the buy-side trader, instead of becoming easier, will become much harder. And who suffers? The people who always suffer: the investors.

In other words, the Sorcerer’s Apprentices are at it again.  They claim to work magic that will make investors’ lives easier, but will in fact unleash forces that will wreak havoc.  And, no doubt, they will use the resulting havoc as the justification for yet more magical regulatory spells.

Not all HFT is good.  Not all algorithmic trading is efficiency enhancing.  It would be worthwhile to explore ways of curbing the inefficient forms of computerized trading without harming good forms.  There is justification for some regulation that can reduce the likelihood and impact of bad algos.   Mifid II is unlikely to have these effects.  Indeed, in my opinion-and in Larry Tabb’s too-it will likely have the exact opposite effect, and will disproportionately damage the beneficial forms of computerized trading and off-exchange trading.

Like the old joke says.  The Euros want to fix computerized trading in the worst way.  And they are succeeding.

I had a chance to read Judge Wilkins’s decision in the position limits litigation on a flight over to London, where I am speaking on the impact of financial regulation, at a conference put on by Lloyds Bank.

There is virtually no economics in the opinion-it is a highly technical analysis of issues related to administrative procedure, statutory interpretation, and the like.  The perfect thing to read while trying to get sleepy as part of my jet lag management strategy.

How technical?  The placement of commas technical.

There are essentially two parts to the decision.  The first relates to § 6a(a)(1) of Frankendodd.  This part is straightforward.  Judge Wilkins ruled that it was unambiguous that the CFTC had to make a finding of the necessity of position limits.  It didn’t.  Back to the drawing board, GiGi.

The second part relates to sections 6a(a)(2), (a)(3) and (a)(5).  Here you have to get into the weeds.  These Judge Wilkins found to be ambiguous.  The ambiguity relates to the words “as appropriate,” as in:

Section 6a(a)(2)(A):

In accordance with the standards set forth in paragraph (1) of this subsection . . . the Commission shall by rule, regulation, or order establish limits on the amount of positions, as appropriate, other than bona fide hedge positions, that may be held by any person . . .

Section 6a(a)(3):

In establishing the limits required in paragraph (2), the Commission, as appropriate, shall set limits –

(A)on the number of positions that may be held by any person for the spot month, each other month, and the aggregate number of positions that may be held by any person for all months; and . . .  [Emphasis added.]

What Judge Wilkins could not determine unambiguously was whether “as appropriate” referred to the setting of limits at all, or the specific quantity of the limits.  The plaintiffs (ISDA and SIFMA) argued that the CFTC had to determine whether it was appropriate to set limits at all.  The CFTC argued that it had to set some limits, and Congress directed it to set the specific quantities appropriately.

This is where the commas come in.  I won’t bore you with the details, but if you are planning any intercontinental travel, I direct your attention to pp. 29-30 of the ruling.  You don’t have to thank me for easing your jet lag.

This matter of ambiguity turns out to be mightily important under the Chevron doctrine which determines whether a court need show deference to an agency’s decision.  And here the CFTC (and yes, I’m looking at you, Gary) is hoist on its own petard.

For the CFTC claimed that the language in the statute is NOT ambiguous.  Citing the Peter Pan (!) case, the Judge ruled that by claiming that the ambiguous wasn’t, the CFTC wasn’t owed any deference, and that there is precedent in his Circuit to vacate and remand the rule:

It is well-settled in this Circuit that “deference to an agency’s interpretation of a statute is not appropriate when the agency wrongly believes that interpretation is compelled by Congress.” Peter Pan, 471 F.3d at 1352, 1354 (internal quotation marks and citations omitted) (vacating and remanding agency decision because agency “premised its construction on the plain language of the statute, which it treated as unambiguous, and because we find that the statutory language is in fact ambiguous . . . .”).

Whoops.  By adamantly asserting that there was no ambiguity in the relevant sections of Frankendodd that the judge did find ambiguous, the CFTC lost any claim to deference.

Where do things go from here?  Probably a ping pong game, with the rule bouncing back between the agency and the courts.

Presumably the CFTC will stitch up some justification for a necessity finding, and go into a long disquisition to meet step two of the Chevron test:

“[I]t is incumbent upon the agency not to rest simply on its parsing of the statutory language. It must bring its experience and expertise to bear in light of competing interests at stake” to resolve the ambiguities in the statute.

I don’t know whether a justification of a necessity finding that is based on bad economics or bad (or no) empirical evidence is vulnerable to legal challenge.  I suspect it would be difficult for the plaintiffs to get the rule overturned because of a weak justification for the necessity finding.  I also suspect that CFTC will be able to pass the Chevron tests if it does recognize the ambiguity-which makes me wonder why they didn’t so recognize it at the outset.

My guess, therefore, is that the CFTC can, after yet more hearings, and comments, and time, correct what Judge Wilkins found wanting.  But that doesn’t mean that it’s out of the woods yet.  Not by a long shot.  For the plaintiffs made four additional challenges of the rule.  The judge did not feel it necessary to rule on these additional charges because he found sufficient grounds in the first to remand the rule back to the agency.

Notable among the additional grounds for challenging the rule is “Insufficient Evaluation of Costs and Benefits under 7 U.S.C. § 19(a).”  Will the CFTC stand pat on its existing cost-benefit analysis, which gives the word “perfunctory” new meaning?  Or will it feel obliged to gin up something better, given that the court was obviously not impressed with some of its other legal reasoning, and given that the SEC has lost a major case due to its failure to do a proper cost-benefit analysis?

The other challenges relate more to the specifics of the rules.

In brief, they have not yet begun to litigate (apologies to John Paul Jones).  The position limit rule has a long, long way to go before it becomes a reality.

This also raises the question of whether other Frankendodd-spawned rules will be challenged.  I’m guessing yes.  And there will be much rejoicing-among lawyers, anyways.

It is a good thing when bad rules are stopped.  The ongoing uncertainty pending definitive legal resolution is more problematic, however.  But that’s our reality, and will be for some time, on position limits, and other aspects of Frankendodd.

The title of my 2010 Regulation piece on CFTC position limits characterized the agency’s attitude as: “No Theory? No Evidence? No Problem!”  I had a problem with that attitude.  So did a couple of industry groups, ISDA and SIFMA, and they sued seeking to block imposition of the limits.  And Federal District Court Judge Robert Wilkens has a problem with it too.  He vacated the rule and remanded it to the agency for reconsideration, and granted the plaintiffs’ summary judgment motion against the rule.

The decision turned on whether the CFTC had to find that position limits were necessary to prevent and diminish excessive speculation.  The agency said no: it had no discretion, that Congress had mandated that it impose limits.  The plaintiffs said yes: the plain language of the statute requires the CFTC to make a finding that limits are necessary because speculation is excessive and is causing unwarranted fluctuations in prices.

The agency further argued that imposition of limits were mandatory, whereas plaintiffs pointed to statutory language saying that Congress had granted the authority to impose limits “as appropriate.”

The judge was quite firm in his findings regarding necessity:

The precise question, therefore, is whether the language of Section 6a(a)(1) clearly and unambiguously requires the Commission to make a finding of necessity prior to imposing position limits. The answer is yes.

But the plaintiffs’ victory was not so clearcut as has been portrayed in the initial reporting on the decision.  The judge noted that the two sides had unambiguous, but diametrically opposed interpretations of the statute.  The judge disagreed with both, finding the statute ambiguous:

In sum, although each party believes the statute is clear and unambiguous, their respective “plain readings” compel different results. Ultimately, however, this Court need not choose between the competing interpretations. As explained below, Section 6a is ambiguous as to the precise question at issue: whether the CFTC is required to find that position limits are necessary and appropriate prior to imposing them. Because the Position Limits Rule is based on the CFTC’s erroneous conclusion that the CEA is unambiguous on this issue, the Court “may neither defer to the agency’s construction nor endorse plaintiffs’ construction.” See Humane Soc’y of U.S. v. Kempthorne, 579 F. Supp. 2d 7, 15 (D.D.C. 2008). Instead, the Court must remand this rule to the agency.

As a result, he chose not to choose between the parties’ diametric interpretations.  So the rule will go back to the Commission.  Presumably it will make a finding of necessity based on some attempt to stitch together some empirical evidence on the adverse impact of speculation.  Presumably the plaintiffs will find this evidence unpersuasive (with good reason) and challenge the Commission’s finding, thereby setting up a further round of litigation.  The results of this litigation would presumably depend on what is a satisfactory basis for a finding of necessity by the Commission.  This seems to me to be a potentially far more contentious issue in which the courts may be more likely to defer to the agency’s discretion and judgment.

This decision does not address another challenge to the limits: that the CFTC failed to perform an adequate cost-benefit analysis as required by statute.  That’s another big issue that would require a more discriminating critique of the substance of the Commission’s analysis by the courts.

So this decision is not the end of position limits.  It is probably the end of the beginning, at best.

The concrete results in the short and medium term are beneficial, however.  A bad rule that has no firm grounding in good economic thinking or empirical evidence, and which would impose substantial costs on markets and market participants, will not go into effect next week as planned.  The Commission will be forced to confront these economic and empirical issues, and defend its judgments on these grounds: “Congress made me do it” will not suffice.

No doubt this process will be time consuming.  It will certainly extend well past the election, and depending on the outcome of the election the matter may become moot.  A Republican CFTC is much less likely to pursue position limits with the Javert-like intensity of a Gensler-led agency.  But even under a Democratic administration, the CFTC’s will to pursue position limits will be sorely tested.  It now faces a greater burden of providing some theory, and providing some evidence, or else it will continue to experience big problems in court.

A good day, a good result, but not a final one.  The position limit wars will continue, but the battlefield looks far different today than it did when Frankendodd lurched out of the castle on The Hill, and when the CFTC did what it perceived to be the monster’s bidding.

The BofE’s Andrew Haldane is getting a lot of attention-and rightfully so-for his critique of complex financial regulation, most notably Basel Faulty.  Yes, there is a lot to criticize in complex financial regulation-and lord knows, I’ve indulged-but it’s essential to emphasize that simplicity is no panacea.  Indeed, complex regulations evolve precisely from the deficiencies of simpler ones.

That is, you have to ask: Why did the rules become complex?  Was complexity valued for complexity’s sake? Or did complexity develop/evolve because of the recognized defects of simpler structure?

Most likely.  Rules become more complex in an attempt to respond to attempts to exploit simpler rules.  There is a regulatory dialectic.  The regulators and the regulated interact in a way that leads to spiraling complexity.

Take bank capital requirements.  Simple capital requirements specify, say, capital equals a certain percentage of assets.  This is fine if assets are identically risky, or the regulated have no ability to tilt their portfolios towards risky assets.

But that’s exactly what happened in the old, simple world with simple capital requirements.  Banks looked for riskier assets in order to expropriate their depositors, lenders, and deposit insurers.  With capital requirements insensitive to risk, banks had a tremendous incentive to make their assets as risky as possible.

There are two responses to this.  One is to limit the nature of the assets banks can hold.  The other is to make capital requirements depend on the riskiness of assets.

Both are great in theory, devilish hard in practice.  Risk-based capital requirements (or limitations on the assets that banks can hold) demand that regulators have the ability to make discriminating evaluations of the relative riskiness of assets.  Even more crucially, they demand that regulators know at least as much as those they are regulating.

Neither condition is likely to hold in practice.  And again, there is a regulatory dialectic, as banks sniff out-or create-assets that are “underpriced” from a capital requirements perspective.  That is, they identify-or create-assets with risk prices implicit in capital charges that do not reflect true risks, and which satisfy the restrictions on the nature of assets that banks can hold.  (Think of AAA ABS of various types.  They’re AAA!  What could go wrong?)  Thus, portfolios end up being riskier than regulators had anticipated.

So they adjust the capital requirements.  But as in any regime of price controls-and capital requirements are essentially risk price controls-the regulators don’t have the necessary information to set the prices properly, meaning that some risks are always underpriced.  The capital requirements become more complex, setting off a new round of attempts to identify the underpriced and overpriced risks.

What starts simple becomes progressively more complex.  Regulations and capital requirements end up being bizarrely baroque not because people like it that way, but because the less baroque rules were exploited.

Put differently: complexity is endogenous, and almost inevitable.  Simple sounds nice, but simple is easy to exploit, and complexity blooms in order to counter this exploitation.

Haldane argues that during the last crisis institutions subject to simple rules were less likely to fail than those subject to more complex ones.  This is superficially plausible, but again, remember that the rules are endogenous, complexity is endogenous.  There was no experiment, natural or otherwise, that randomly assigned some institutions to simple rules and others to more complex ones.  The rules and the institutions co-evolved, endogenously.  I would bet that there was some other constraint on the complexity of the firms subject to the simple rules that made it unduly costly for them to outwit the simple rules.  They stayed simple as a result, so the rules could stay simple too.

Maybe Haldane is right.  Maybe there is a simple but robust way of regulating financial institutions.  But I have my doubts.  Complexity results from the failures of the simple.

Haldane is stating, in an ironically more complex way, the old Indian story of the village beset by mice that brought in cats to rid itself of the rats, then brought in dogs to rid itself of the infestation of cats, then brought in elephants to drive out the resulting packs of dogs-and responded by bringing back the mice to scare away the elephants.  Seeing the effects of complexity (elephants) the simpler problems (mice) don’t look so bad.

But don’t be deceived.  If Haldane were to get his way, the cycle would begin again.  This is the fallen condition of homo economicus.

Meaning “High Frequency Blogging.”  Some quick takes on things that caught my eye.

1. Echoing my looking back, looking forward point (made in July) re Libor, lawyers are very nervous that changes in the rate setting mechanism will call existing contracts-with outstanding amounts in the mere hundreds of trillions-into question.  Yeah, it’s broken, but be damned careful how you fix it-especially if you expect those “fixes” to be retroactive, and affect existing contracts.  Unless you want to subsidize corporate litigators and wreak widespread economic havoc.
2. OTC derivatives rules may be delayed due to “squabbling” among international regulators.  What a shock.  I mean, Carnac the Magnificent couldn’t have seen that coming.
3. The White House is backing off on its claims that the Mohammed video is the sole cause of the assaults on US diplomatic facilities throughout the Middle East.  On 9/11/12.  Jay Carney has a new explanation: an absence of gun control.  Seriously.  When asked about the attack on the US Consulate in Benghazi in which US ambassador Stevens was killed, Carney said: There is an abundance of weapons, including heavy weapons, and there are certainly groups that carry those weapons and look to take advantage of those circumstances—as there are around the region and the world.”  So, on 9/11, some heavily armed dudes were just walking around and decided: “Hey.  Let’s attack something.  Eenie, meenie, meiny, mo [NOT referring to Mohammed, mind you]-The American Consulate!”  Totally random.  Totally.  Not anti-US.  Not at all.
4. The Taliban attack on a US airbase in Afghanistan that destroyed six USMC AV-6 Harriers was a total clusterf*ck.  But O didn’t let that interrupt Jay-Z, Letterman, etc.  Priorities.  Have to have priorities, dontcha know.
5. This piece on China’s Solyndra Economy echoes several points I made in my earlier post recommending that we lose any competition with China on green energy technology.
6. The very excellent Michael Pettis rightly points out dangers for commodities emanating from China’s fraught economic condition.  Like me, Michael is somewhat amazed that people who would decry central planning and heavy handed government efforts to direct the allocation of capital in the US or Europe are in awe of Chinese genius in using central planning and heavy handed government efforts to direct the allocation of capital in China.  This will not end well.  Yeah, I’ve been saying that for a while, but I am convinced that in a few years (if not sooner) China will wish to have Japan’s problems.
7. Finally, to that point, consider the fact that large quantities of inventories of steel in China-allegedly in China, I should say-don’t exist.  And if it happens in steel, it can happen in copper or soybeans or whatever, and likely does.  Phony warehouse receipts have been used to collateralize billions of loans-or the same warehouse receipts have been used to collateralize billions in loans.  Either way, China’s shadow banking system-which depends heavily on loans collateralized by commodities inventory-arguably is far more shadow than bank.  Remember that even modest slowdowns in economic activity can unravel fraud schemes in a hurry.  Such a slowdown is happening in China right now, and it is extremely likely that numerous such frauds will be revealed.  Given the dependence of China on shadow banking, the consequences of this could be seismic.  What say you, Tooltime Tom Friedman?

And on that happy note, I am pulling the kill switch on this HFB experiment.