Streetwise Professor

R passed along this video interview with Jacob Appelbaum, the would be tortured Romantic martyr for freedom on the internet. SOPA, and the recent arrest of Megaupload megaload Kim Schmitz are the focus of the interview, but there are detours into Iraq and other peripherally related subjects.

Given Appelbaum’s prominence as an advocate, and his involvement in Wikileaks–an involvement that is bringing substantial official scrutiny–his rather juvenile and hysterical remarks deserve some discussion.  Indeed, they deserve attention precisely because this juvenile and hysterical level of argument is all too common in the SOPA/PIPA debate.

A few of the lowlights:

• Around :17 in the video, he claims that SOPA is a censorship regime like Syria or China.  Uhm, no, actually.  None of the content of the web that Syrian or Chinese censors wish to stamp out–notably, political speech–is covered by SOPA.  SOPA is clearly aimed at commercial sites that sell copyrighted material.  Such dishonesty, and the attempt to conscript truly oppressed individuals in his cause, is a clear giveaway that he cannot make an argument against SOPA on its (de)merits, but must instead invent and grotesquely exaggerate flaws in order to prevail on emotion and ignorance.  If you have to lie and inflame emotions to make your case, you probably have no case.
• At 1:07 Appelbaum bemoans the arrest of Schmitz: a “guy who [was] arrested for running a website where other people upload files.”  Mr. Appelbaum, legal expert, finds such actions “supersketchy” [warning!: technical legal jargon] and un-American.  News for Mr. Appelbaum.  There is a component of American copyright law called contributory infringement, whereby an individual facilitates infringement by another.  This is, in essence, aiding and abetting.  This is no different than fencing stolen property.  As to the possibility that Megaupload was used to share some files legitimately, that is not a defense, any more than an art dealer who fences stolen paintings is not able to skate because he also engages in legitimate sales.  Apparently, these established features of the law are “supersketchy” too.
• Insofar as contributory infringement is concerned, US courts have demonstrated some ability to distinguish between different technologies.  This is what did in Napster, but the Supreme Court found in favor of Sony when it was accused of contributory infringement in the Betamax case.  Too many SOPA hysterics fail to realize that courts will–will–weigh in on these issues, and enforcement of the law.  Appelbaum, and too many others, overlook this basic fact.  Do they really think that all the courts in the US, up to the Supreme Court, would meekly permit the most lurid scenarios that they posit to occur?
• At 1:33 or so, he begins a juvenile discussion of copyright.  The gravamen of his argument is that the property owner is not deprived of property by copying.  This is, in a sense true.  The fundamental conundrum of intellectual property is that the marginal cost of reproduction is close to zero, and that intellectual property is non-rivalrous.  Two people can consume a song: only one can use a car at a time.  People have understood this for donkey years (since the work of Plant in the 1950s).  But people have also understood that there is a fundamental tension between static efficiency–which is impeded by copyright–and dynamic efficiency–which it can advance.  If copying is not restricted, and the price of a work (e.g., a song or a movie) is driven to zero as a result, there is no incentive to create the good in the first place, especially if the fixed cost of production is high (as is often the case, especially with a movie).  This is a knotty economic problem that is found in many settings–including the subject of my PhD thesis, ocean shipping.  This always leads to difficult legal and policy choices.  There is no easy way to determine the set of rights that optimally balances the static costs of copyright (too little of existing creations are consumed) against the dynamic benefits (more creations exist).  This is why copyright law–and IP law generally–is so much more contentious and controversial than law involving conventional, rivalrous property.  So have the debate over the messy ways to achieve balance.  Don’t be juvenile and just assume the tension away by focusing only on the static inefficiencies of copyright.  That’s just what Appelbaum–and many SOPA opponents–do.
• At 2:20 he claims that Schmitz was arrested without reasonable process.  Really?  The Feds got a warrant, and presumably went through the normal process.  If they committed procedural violations, Mr. Schmitz will have every opportunity to make that case.  And if he does, he walks.  Appelbaum actually asks, rhetorically, “why not give him [Schmitz] a day in court?”  Does Appelbaum really believe that Schmitz is not going to get a day in court?  Really?  Arrest is the beginning of the process.  There are many legal battles yet to fight, and Herr Schmitz will have the legal counsel he needs to fight them.  Jeez: has Appelbaum never watched Law and Order? You know, the show where the first part shows how the cops develop a case and arrest people, and where the second part shows how the courts judge people who the cops arrested?  It’s not that freaking complicated.
• At about 3:14 Appelbaum says that the arrest was unjustified because SOPA was intended to give the government powers to enforce IP law overseas, the implication being that since SOPA has not passed, the government exceeded its authority in arresting Schmitz.  Can anyone actually be this stupid?  Well, yes, actually: anyone who actually believes this crap.

SOPA is really just a new mechanism for enforcing existing rights, not an assertion or creation of new rights.  Under existing law, it is possible to go after people who infringe copyright even if they are overseas: that’s what USDOJ did in New Zealand.  The point is, that is very expensive and difficult, especially if the authorities in the countries where the pirates operate are not cooperative.  That is, if Schmitz had operated in Russia or China, he would have been at much less risk from arrest by US authorities than he did by operating in New Zealand.   What SOPA does is provide an alternative way to enforce copyright against infringers in uncooperative jurisdictions.

Appelbaum and others–notably Google–suggest that the mechanism is novel and outrageous, in that it utilizes third parties (search engines, payment systems) to help enforce copyrights.  It is neither novel nor outrageous.  In the words of Posner and Landes (in The Economic Structure of Intellectual Property Law) it is beneficial to have “a legal mechanism for placing the ultimate liability” for preventing the violation of a copyright on the party that can do so most cheaply.  That’s not always the infringer: it can be the provider of a service complementary to the infringement.  Would Appelbaum–or you–prefer to have copyright enforced by Feds breaking down doors, or by Paypal cutting off a pirate?  Which is more intrusive, and more subject to abuse, and more costly in the event of a mistake?   This is exactly the logic behind the doctrine of contributory infringement, a recognized part of current law, and applies to SOPA.  It is a way of reducing the costs of enforcing copyright.

This points out one of the issues that is often confused.  Many people object to SOPA because they really object to copyright law, as it exists.  If that’s true, don’t focus on the mechanism of enforcing the copyright law: focus on copyright law itself.  Again, it is an economically difficult issue, and people of good will can differ on this.  Battles are inevitable.  But fight the battles over the relevant issues of how best to delineate copyrights, rather on than on the issue of how to enforce rights as they exist.  That addresses the issue at the root.

• At around 4:19 Appelbaum argues that SOPA represents the normalization of the surveillance and censorship state.  He asks, in a tired trope, “who are the real terrorists?”, and drags the Iraq War into the discussion.  More overstretch, and more dishonest and emotionally manipulative exploitation of human tragedy to advance a position on a completely unrelated issue–and a demonstration that much of the opposition to SOPA and copyright is inextricably mixed with an implacable hatred for the US.    The truly disgusting part of this discussion is that the creator of Tor advocates people use it and other techniques to escape surveillance–without acknowledging that Tor is also used by hackers to surveil, invade privacy, destroy lives through “doxing”, and steal.  An honest individual would recognize that his creation can be used for good and evil: like Nobel, say, who was tormented by the use of his invention of dynamite to kill.  But Appelbaum is hardly so honest, or self-reflective.  He refuses to acknowledge the very sharp double edge of the sword he has created, and the malign purposes to which it has been put.  He presents himself as a crusader for right, protecting the innocent against the predation of the state, but denies responsibility for the harm that occurs when non-state actors–his hacker buddies and fanboys (emphasis on “boys”)–prey on innocent people.

This interview is a perfect distillation of anti-SOPA hysteria and dishonesty.  There is room for legitimate debate on copyright, and the proper extent of copyright coverage.  This Appelbaum, and other opponents of SOPA, too often fail to do.  Instead they appeal to emotion, make wild analogies, engage in hysteria, and make demonstrably risible assertions about the law.  The ultimate irony is that by opposing SOPA, they are likely to increase reliance on coercive enforcement of copyrights (like the raid on Megaupload), and to induce the socially wasteful expenditure of resources to protect IP via technical means.  If copyright exists, and those copyrights are valuable, holders have an incentive to enforce those rights, and they will do so–and you may not like the way they do it.  If you have a problem with copyright law, as it exists, there is plenty of room to make legitimate argument.  Do that, and spare us the “who is the real terrorist?” crap.

Note: Catherine Fitzgerald has been on to Appelbaum for a while.  Here are a  couple of her posts that are definitely worth a read.  She refers to him as “an open-source cultist and thuggish heckler of critics on Twitter. He’s also a liar, claiming that US soldiers deliberately killed children in Iraq when they could not have possibly known that there were children in a vehicle of a driver who stopped to help wounded, armed persons whom were shot at by the US soldiers from a helicopter. The entire incident — tendentiously released by WikiLeaks — had enough problematic features to it and a need for investigation and more caution without tarting it up and lying about it. That they can and do lie and do so shamelessly taints everything about WikiLeaks.”

Oh, and Mr. X and others who have advanced the theory that Catherine Fitzpatrick Fitzgerald=LaRussophobe, you should note that Fitzpatrick Fitzgerald is a strong supporter of SOPA, but LR has written numerous tweets in opposition, and has advocated signing the Google anti-SOPA petition.  This could be a masterly act of misdirection, but I’ll defer to Occam’s razor.

So Obama has rejected–at least for now, for heaven forfend he make a firm decision–the Keystone XL Pipeline.  He claims that the rejection was not on the merits, but due to the fact that the Republicans had given him too little time–a mere 60 days–to determine whether the pipeline was in the national interest.  This after 3 plus years of the pipeline application began wending its way through the labyrinthine pipeline of the Federal approval process. So it’s not like this just landed on his desk with no prior analysis.  It’s more like: get on with it, Mr. Vote Present.

This from the guy who on every other day berates the same Republicans for foot-dragging obstructionism.  The guy who says he is going to do something every day to create jobs even if Congress doesn’t go along because it is just too slow.

I guess Obama is just President Goldilocks.  This is toooo fast.  This is toooo slow.  But he hasn’t found just right yet.

And the guy who is supposedly sooooo smart that he is bored because his mind is racing ahead of everyone (just ask Valerie Jarrett!) apparently needs a little extra time on this exam.

Please.  This was just another political dodge, wrapped up in a whinging excuse about being hustled along by meanie Republicans.

The administration’s cavils about the pipeline are economically inane:

The truth is that just two of the Administration’s programs – the DOE Loan Guarantee Program and the EPA’s Mercury and Air Toxics Standards – will create more than 10 times the amount of jobs generated by the Keystone XL pipeline, which will only generate a few thousand temporary jobs. In terms of reducing America’s dependence on oil, the Administration’s fuel economy standards alone will save more than twice the amount of oil the Keystone pipeline would deliver.

That is just moronic.  As I’ve noted before, these people cannot tell a cost from a benefit.  It doesn’t get any dumber than that.

Keystone will likely create economic value, as indicated by the fact that private capital is willing to invest.  In contrast, the DOE loan guarantee program–“Chu Capital,” as my colleague Paul Gregory calls it–exists because the green elephants it funds cannot attract private capital: a very strong indication that they do not generate value, and in fact destroy it.  Hell, these companies cannot survive even with lavish subsidies.

The EPA programs–what to say?  These will impose huge costs.  Huge.  The people employed to implement the program are just part of the cost.  The distortions in the power market–less efficient generation, lower reliability–represent a far larger cost: indeed, those employed are expending effort to create distortions, so costs are incurred to incur more costs–who could object to that?  All in exchange for a risibly small health benefit.  This is carbon-tax-by-stealth.  The EPA’s cost-benefit analysis is arguably the worst in the federal government–which is saying something.

This administration would apparently believe that hiring ten times as many people who would be employed on Keystone to blow up oil wells and power plants would count as a huge boost to employment, and would be a far better policy than approving Keystone.* Something to brag about on the WH website.

I better shut up.  They might take that seriously.  I wouldn’t put it past them.

Is there not one economist of rank in this administration with enough self-respect to call bullshit?  After all, such economic stupidity reflects very badly on them, especially inasmuch as their silence connotes assent.

* Not to mention that it is completely illogical to imply that these things are mutually exclusive.

When the NYSE-Deutsche Boerse deal was first announced, I wrote:

The biggest uncertainty surrounding the deal involves European antitrust approval.  As noted above, the merging exchanges are not direct competitors in any major product.  In the US, in the mergers of CME and CBT and CME and NYMEX, that fact was decisive in avoiding  Justice Department challenges.  It should be in Europe too, but I’m not as familiar with European antitrust thinking or precedents so I’m not sure they’ll see it the same way.

The most interesting question involves clearing.  European policymakers have been critical of vertical integration in clearing.  (The USDOJ is too, but only disclosed its (economically nonsensical) objections after the CME-NYMEX merger closed.)  They deem vertical integration as anticompetitive, and have failed to consider seriously the efficiencies that integration can generate (a subject I’ve written a lot about on SWP and my academic research).

Given this skepticism, the Euro antitrust folks may view this merger as an opportunity to open up access to clearing at Deutsche Borse and LIFFE.  That is, I could see them conditioning approval of the merger on the parties’ agreement to open up access to their clearing services.  It will be interesting to see whether they attempt to do so: I estimate that there is a non-trivial probability of this happening.  If they try, it would likely be a deal killer.  DB in particular has been adamant that integration is an essential part of its model and strategy, and LIFFE has adopted that view as well.  A deal becomes much less attractive–and, in my opinion, unattractive–if it requires a fundamental transformation of the exchanges’ business models.

Well, that’s pretty much come to pass.  The European Commission has apparently decided to block the deal.  Initial reports state that the Commission believes that the combined EuronextLIFFE-Eurex derivatives businesses would have too much market power, based on defining the relevant market as European exchange traded derivatives (an indefensible definition, IMO).  But some informed opinion suggests that the real sticking point was the refusal of the exchanges to open up the derivatives clearinghouse.  This was one of the proposed remedies, and one which the exchanges rejected.

So it pretty much played out as I forecast.  The European regulators would demand an end to the vertical silo.  The exchanges would refuse.  The deal would die.   And that appears to be precisely where we are.  The deal is not formally dead, but it was coughing up blood last night (see about the 3 minute mark).

An adviser to German Finance Minister Wolfgang Schaeuble has told a Greek paper that the 50 percent haircut deal (PSI) is no longer operative:

The planned 50 percent writedown of Greek government bonds held by private creditors as part of a debt swap won’t be enough to make the country’s debt sustainable, an adviser to German Finance Minister Wolfgang Schaeuble told To Vima in an interview.

The write down, which aims to lower Greece’s debt to 120 percent of gross domestic product in 2020, will have to be greater and shouldn’t be voluntary, Oxford University professor Clemens Fuest told the Athens-based newspaper.

I’ve just seen on Twitter a 60 percent number being batted around–no link as of yet.

In addition to the scuppering of the 50 percent “deal” agreed to in October, the significant part of this statement is that the haircut shouldn’t be voluntary.  This suggests that governments are tiring of the negotiations, and believe that immediate action is necessary.  Indeed, given the horror with which Euro officialdom had previously contemplated the possibility of an involuntary haircut of this magnitude–which would trigger CDS, if ISDA wants to maintain a shred of credibility–this drip-drip-drip of leaks indicates that said officialdom recognizes that the can has arrived at the end of the road.

Back in October, at one of the many Euro summits, the European government leaders uhm, persuaded the Institute of International Finance, representing large banks and insurers holding Greek debt, to accept a 50 percent “voluntary” haircut on their holdings.  ISDA’s credit event determination committee fell into line, and ruled that since it was “voluntary”, the writedown did not constitute a credit event that would trigger CDS payouts.

Germany was the main country pushing for these haircuts, euphemistically termed “Private Sector Involvement” (PSI).  There have been stories in the last week that Germany is pushing for even bigger haircuts–on the order of 75 percent.  Not to be outdone, a member of the council of the European Central Bank–which has always been twitchy about PSI–has mooted a counterproposal: 0 percent.

Glad to see that the bargaining range is narrowing!  Pretty soon Germany will be demanding that the bondholders pay the Greeks and the bondholders will be demanding that the Greeks pay the banks double what they owe.

Germany’s insistence on PSI is strange in many ways.  The conventional rationale is that it is necessary to punish–and hence deter–morally hazardous risk taking.  But given that the whole pretense of the Eurozone was that all government debts were created equal, and given that Basel treated Greek debt as riskless as Germany’s, any moral hazard is ultimately traceable to European governments and regulators.  How dare those banks do what they were told to?

Moreover, the Greek PSI had to walk a thin line.  The story was that only Greek debt would get a haircut: this was necessary to prevent disastrous runs on Portuguese, Italian, and Spanish debt.  But it is hard to give a coherent rationale for that: investing in Greek debt was morally hazardous, but investing in Portuguese debt wasn’t?  Really.

No political promise is credible–especially in Europe right now, and especially given that the logical basis of the promise is dubious at best.  Pushing for a bigger haircut on Greek debt is bad news for Portuguese, Italian, and Spanish debt because bigger haircuts on Greek debt raises the expected haircut on the debt of these other countries.  It raises both the size of the haircut, conditional on one occurring, and the probability that haircut will actually be applied to these other countries (i.e., that the promise will be broken): if Germany is so insistent on haircuts for Greece today, why won’t they be just as insistent for Portugal tomorrow, despite their fine words to the contrary.  (This is the essence of the ECB councilor’s argument.)

Finally, the big problem with a Greek default has always been that banks and insurers would suffer huge losses that would jeopardize their solvency.  That is, a Greek default that led to big writedowns would impose big losses on German, French, Dutch, etc., banks.  These losses could be big enough to require some taxpayer bailouts.  But a big “voluntary” haircut would do the same thing.  Thus, Germany’s insistence on a big PSI always seemed like financial S&M.

One last thing about this divergence of views.  It makes it clear that despite all of the stirring pronouncements, nothing is settled in Europe.  Nothing.  Everything is still up for negotiation.  And the parties are moving apart on key issues, not closer.  Today’s surge in Italian and Spanish yields and subsequent ECB intervention is in part a manifestation of the realization that that we are not even at the middle of the beginning.

The President of the KC Fed, Thomas Hoenig has joined a rather loud chorus clamoring for “Glass Steagall-type” measures to prevent another financial crisis (h/t R). (It should give Mr. Hoenig some pause that LaRouchies are very outspoken advocates of Glass-Steagall, btw.)

I find this nostalgia for Glass-Steagall to be bizarre and disconnected from the realities of Financial Crises I and II. The theory behind Glass-Steagall (and GS-lite measures like the Volcker Rule and the swaps pushout provision of Dodd-Frank) is that banks with insured deposits are subject to moral hazard, and will take on too much risk.  This problem can be reduced by restricting the activities in which banks with insured deposits can undertake.  That is, the problem is deemed to be giving banks too much discretion on the asset side of the balance sheet, when the liability side is insured.

But this bears no relationship to what happened in the 2008 crisis, or the one currently going on.

For starters, most of the major institutions that cratered in 2008 were not universal banks that funded capital market activities (such as underwriting) with insured deposits.  Indeed, the opposite was true.  They were investment banks/broker dealers (Bear, Lehman, Merrill); GSEs (Fannie, Freddie); insurance companies (AIG); commercial or universal banks heavily dependent on wholesale funding; and SIVs (many of which did have connections to commercial banks, admittedly).

Indeed, one could make the case that those who prescribe Son of Glass-Steagall to cure our financial ilss have the diagnosis exactly backwards.  Many of the institutions that cratered–notably the IBs and SIVs–did so precisely because they did not have sticky funding (like insured retail deposits): they relied on short-term, uninsured funding like repo and commercial paper.   Others, like RBS, had some retail deposits, but notably were very dependent on wholesale (uninsured) funding, and that dependence had grown over time.  All of these institutions suffered classic runs.

In this interpretation, it is the concentration of risk in institutions that do not fund primarily through insured deposits that is the problem.  David Murphy has a new paper that looks at Lehman and RBS, and arrives at a similar conclusion.  This would imply that Glass-Steagall is utterly off-point.

The history of banking in the US supports this view as well.  Banking panics occurred throughout the 19th and first-third of the 20th centuries due to funding fragility.  These panics destroyed banks that engaged in traditional banking activities like commercial and real estate lending.  Yes, there were runs on investment houses too (Jay Cooke & Co., Barings) but the point is that it’s the liability side of the balance sheet that matters more than the asset side.  There was tremendous diversity in the asset side of the balance sheets of firms that suffered runs prior to deposit insurance: there was very little diversity on the liability side.  All were funded with short term liabilities that could run at the drop of a hat.

Similarly, S&Ls raped and pillaged deposit insurance even though they were very “narrow banking” institutions with significant restrictions on the asset side of the balance sheet (though those restrictions were eased by Garn-St. Germain in 1984).

As a last point, Financial Crisis II is concentrated in European banks heavily dependent on wholesale funding, and the underlying source of the problem is assets that regulators deemed to be utterly safe for commercial banks–highly rated sovereign debt.  Relatedly, many of the assets that caused commercial and universal banks in the US problems in 2008 were again deemed by regulators to be super-safe, carrying very low (and in some cases zero) capital charges. The assets that are raising/raised questions about the solvency of financial institutions would have been perfectly copacetic even in a Glass-Steagall world.

Which all suggests that the Glass-Steagall focus on the asset side of the balance sheet is completely misguided.  The fragility in the financial system comes from the liability side, and regulators and legislators are terrible at identifying the assets that are “safe” for insured institutions to hold.  Given this, measures to stabilize funding–like deposit insurance, or the existence of a lender of last resort–are key to establishing stability.

Of course this raises moral hazard concerns, but the Friedman-Kraus analysis in Engineering the Financial Crisis convinces me that this was not an important part of Financial Crisis I.  Gorton also argues that the moral hazard effects of deposit insurance have been overstated.  The S&L Crisis was a large part a moral hazard problem, but it occurred in large part because of grossly negligent regulators who (under pressure from Congress) let insolvent thrifts continue to operate rather than shutting them down when their financial condition weakened in the late-70s and early-80s: regulators (and Congress) let readily containable moral hazard flourish.  That crisis also shows that banks have plenty of room to engage in morally hazardous behavior even when they are very narrow institutions with extensive restrictions on the asset side.

Identifying the fragility of liabilities as the true vulnerability of the system of course raises important questions: why do financial institutions routinely rely on run-prone funding, as they have done for centuries? Diamond-Rajan argue that fragile funding plays an important disciplinary role: the threat of a run limits the ability of banks to act opportunistically and expropriate those who lend to them.  This implies that trying to reduce reliability on fragile funding will have a cost: There will be more opportunism.  The hard thing is to design regulations that balance between micro incentives (to control opportunism) and macrostability (arising from the fact that the fragile funding that controls opportunism is vulnerable to jumps to bad coordination game equilibria).

But though I don’t have an answer to what the right balance is, I am pretty confident that it is appropriate to focus more on the liability-side issues as opposed to the asset-side issues.  Which further implies that pining for a return of Glass-Steagall is misguided, and positively dangerous, because it distracts attention from the real problems.

Retiring Congressman Barney Frank, the Frank of Frankendodd, felt compelled to share some parting wisdom on whether in the aftermath of MF Global it was appropriate for the CME to exercise self-regulatory powers:

“I have no doubt about the CME’s integrity, but nobody should be in the position of having a dual role,” Rep. Frank said. “We should make sure [a conflict of interest] doesn’t arise, that the temptation isn’t there, that people are not unconsciously influenced

. . . .

Rep. Frank pointed to the separation of the Nasdaq Stock Market, now owned by Nasdaq OMX Group Inc., from the National Association of Securities Dealers.

That process began in 2000 and saw the NASD become a full-time regulatory body now known as the Financial Industry Regulatory Authority, or Finra. Part of the rationale of that move was to separate the regulatory function from a for-profit exchange operation.

“I think it would be better if they did what NASD did,” Rep. Frank said.

He said that.  He really did.  He held up Finra–the Finra that couldn’t find Madoff and Stanford with a map and both hands–as the model to emulate.  Seriously.

Of course the Finra (or government regulation) models are superior because the people who work for them are saintly, and never subject to temptation.  They are never subconsciously influenced.  They are Spock-like creatures, incapable of being captured, influenced, or duped.

And they have the best information and the strongest incentives.

Sure they do.

As I said in my weekend post, perfection is not an option here.  A serious analysis of incentives and information is required.  And of course, as I said in that post, Barney Frank doesn’t provide any serious analysis.  His is the epitome of Beltway superficiality: he invokes “conflict of interest” as if that is the only relevant consideration, and cites some example that is ridiculous on its face.

And he doesn’t get called on it.

Would somebody please–please–ask the man a serious question in response to such bleatings?  Would somebody please  challenge him on the Finra lunacy?

* Because doors are expensive.  Note: click on the link only if you have a strong stomach.

Donkey years ago, when major exchanges were beginning the process of transforming from not-for-profit member owned firms to for-profit investor owned ones, there was a considerable amount of discussion over whether it was appropriate for for-profit exchanges to exercise regulatory functions.  The concern was that they would be subject to conflicts of interest that would undermine their incentive to regulate fraud and manipulation on their marketplaces.

I wrote a paper on the subject at the time, but shelved it in large part because these fears dissipated rather rapidly.  In the aftermath of the MFer debacle, however, they have returned with a vengeance.  Barney Frank just opined that the CME should not be a self-regulatory organization.  Yeah, I know, it’s Barney Frank (and aren’t you leaving Barney, so why not shut up?), but he’s not alone in his call.  Indeed, I get the sense that this is the emerging conventional wisdom.

So perhaps it’s time to revisit and revise that paper–thankfully Word is backward compatible!

I’ll use this post to summarize some of the arguments in that paper, and apply them to the MF/CME situation.

The main conclusion of the paper is that in comparing alternatives–self-regulating non-profit, member owned exchanges and self-regulating investor owned ones, the latter probably have stronger incentives to regulate most forms of bad conduct.

I divided the kinds of misconduct potentially subject to exchange oversight into two categories: misbehavior by agents (such as brokers cheating their customers), and market manipulation.  Based on my extensive analysis of self-regulation of manipulation, I concluded that neither type of exchange can be expected to self-regulate manipulation well.

With respect to agency problems, I concluded that for-profit exchanges are actually likely have a stronger incentive.  Member owned exchanges have more of a potential conflict of interest because the agents are among the exchange owners: some owners benefit directly from the (bad) conduct at issue.  Moreover, there is a collective action problem: perhaps one broker’s misconduct harms the others, by damaging the reputation of the exchange, but this is a public bad from the perspective of other broker-owners and free rider problems undermine the incentive of the brokers to act against it.

If you want a great example of that, look at the conduct on the floors in Chicago that was uncovered in the 1989 FBI sting.

With a for-profit exchange, however, inefficiently lax oversight of agents reduces the derived demand for the exchanges services, reducing its profits.  Put differently, for profit businesses are harmed when the suppliers of complementary services engage in misconduct that harms customers: brokers and exchanges provide complementary services, and misconduct by the former harms customers and reduces the demand for the latter’s services and hence its profits.  This gives the latter–the exchanges–a high powered incentive to police the supplier of (complementary) brokerage services.  Making them self-regulatory organizations permits them to engage in such policing and act on this incentive.

Against this it is sometimes argued that exchanges are likely to go easy on big brokerage firms that are their big customers.  But the ultimate customer is vitally important here too.  It is in the exchange’s interest that these ultimate customers are served by the most efficient, highest quality agents.  Higher cost/lower quality agents translates into lower derived demand for the exchange’s services.  Customers served by a broker that poses undue risks to its clients can go to another broker if the exchange cracks down  on the malfeasor.  The crackdown doesn’t reduce the exchange’s derived demand: it increases it, even if the broker is large.  Indeed, the risk posed by a bad broker to the exchange is all the greater, the bigger that broker is.  Which all means that there are fundamental problems with viewing the brokerage firms like MF as the exchange’s customers.

My argument depends crucially on there being a mechanism by which the self-regulating exchange incurs a cost when it engages in too little oversight.  The most likely mechanism is a reputational one, in which revelation of broker misconduct not caught by the exchange leads demanders of trading services to revise downward their estimate of the quality of the product they are getting (i.e., they conclude that they are at greater risk of being cheated by brokers), trade less (or are only willing to pay lower prices for exchange services), and thereby reduce exchange profits.

In the case of the CME and MF, this mechanism is clearly at work.  In the price of CME stock has fallen about $21/share since immediately prior to the MF blowup.  This represents a decline of market capitalization of $1.4 billion–approximately the same magnitude as the the missing money.  The work in the 1980s of Peltzman & Jarrell shows that it is quite common for product quality problems (that result in recalls) causing losses in market cap to the firm whose products are recalled that are far larger than the cost of the recall itself.  Bad quality outcomes have costly reputational effects.  This provides an incentive to avoid bad quality outcomes.

My paper drew from the property rights literature, which showed how the power of incentives could affect the incentives to supply quality.  That literature shows that a high power incentive system (like for-profit organization) could lead to a less efficient supply of quality than a low power incentive system (like non-profit organization) when quality was non-contractible or non-observable, and other mechanisms (like reputation) don’t cause a for-profit entity to internalize the effects of providing inefficiently low quality.  I concluded that this non-contractibility/non-observability issue was not relevant for the agency problems and other problems (such as informed trading).  Thus, I concluded that for-profit exchanges were likely to be better self-regulators of agent misconduct than non-profit ones.

The MF case doesn’t change my opinion on that.

But that is not necessarily the alternative being advanced by Frank et al. They presumably want to transfer all regulatory authority to the government.  To agencies like the CFTC and the SEC–which also had regulatory oversight responsibilities over MF, and didn’t stop the blowup and the possibly illegal appropriation or transfer of customer money.  Agencies that are subject to very low power incentives (except maybe for ass covering).  The CME is being pilloried for failing to stop the transfer of money that apparently began immediately after its auditors left MF: the SEC didn’t catch Allen Stanford or Bernie Madoff from stealing huge sums over periods of years–years–despite numerous warnings.

So I’m sure that yeah, handing over all regulatory responsibility to the CFTC and SEC will ensure nothing like MF ever happens again. And I also believe, as Christmas approaches, that Santa Claus is going to bring me a new Ferrari.

Actually, to extend Samuel Johnson’s aphorism, such recommendations are like 5th marriages: a triumph of idiocy over experience.

The facts in the MF case are still murky.  The collapse of a brokerage firm is not all that exceptional.  The potential theft of a billion plus in customer seg funds is very exceptional.  The issue is whether the CME could have stopped this theft.  Quite clearly such an action cannot be stopped by any ordinary and routine auditing.  Indeed, the money disappeared immediately after the last audit.  So preventing the theft would have required some extraordinary action, such as taking over control MF’s customer funds, transferring accounts, etc., earlier.  Given the truly exceptional nature of what MF apparently did, any assertion that CME should have done that reeks of hindsight bias: a common theme of the post-event commentary by industry people is that MF did the unthinkable, so it is pretty unrealistic to expect anyone to take actions to prevent the impossible (or unthinkably unlikely).

Self-regulation is imperfect.  Government regulation is imperfect.  Under either system, stuff happens.  Choosing which of these systems is, as Churchill said of democracy, the worst except for all the others that have been tried from time to time, requires a careful comparative analysis that focuses on incentives and information.  I’ve done that type of analysis in the past, and concluded that there is no single answer.  Exchanges do a lousy job at policing manipulation, and that function is best left to ex post legal enforcement–including private enforcement via civil lawsuit.  Exchanges–especially for-profit exchanges–do better at policing bad agents like brokers.  Not a perfect job, but their information and incentives are stronger in this case than in the case of manipulation.

The MF case shows that there is a market feedback mechanism at work that imposes costs on exchanges when people and firms they regulate do bad things.  Self-regulation harnesses that feedback mechanism, and it would be foolish to discard it on a whim based on an incompletely understood single instance like MF.  That’s doubly true given that the proposed alternative–complete reliance on government regulators–has more than its share of examples of proven failure, with Madoff and Stanford again being only the most prominent examples.

Remember.  Perfection is never an option.  Getting the right institutions in place requires a careful comparative analysis of the alternatives.  I can guarantee you Barney Frank hasn’t done that.  Nor have most people who are bold in their opinions on the matter. I’ve carried out such an analysis some years ago, and don’t claim to have the answer, but I know enough to say that (a) the situation is not so cut and dry and Barney et al make it, and (b) there is a colorable case that exchange self-regulation of certain forms of conduct is like what Churchill said about democracy.

And also remember that data is not plural of anecdote, and that anecdote and analysis are not synonyms.  Right now people are making strong recommendations on the basis of a single anecdote, and doing so before it is understood in any detail.  So I will withhold judgment, and when I make it I will endeavor to do so informed by the MF example, but also by a more complete comparative analysis of the incentives and information under the alternatives.

Coverage of MFer John Corzine’s House testimony yesterday has focused on his repeated denial of any intent to dip into customer seg funds.  That’s walking a thin legal line, and it’s unclear that lack of intent would be sufficient to evade time in the pokey.  That part of his testimony seemed weasely, at best.

But this piece suggests idiocy:

Why did you bet the survival of the firm on European sovereign debt?

“We looked at the ratings, but they were not the only consideration. We looked at what counterparties would charge for initial margin. We would look at how individual securities were looked at by regulatory authorities around the globe – what they were able to use as collateral. We look at prices in markets to determine whether people thought the default or restructuring risk was being priced into it.

“There were many considerations along with the ongoing dialog that, which after the fact clearly can be second guessed, that the European community was going to take a much more forceful steps to avoid bankruptcy or insolvency.”

Looked at initial margins?  What about the risk of variation margin or the equivalent?  What about the risk of ratings trigger-induced increases in haircuts?

Initial margin isn’t what killed the trade.  It was increases in margin–additional collateral calls based on adverse movements in the price of the European debt, and perhaps collateral calls based on the downgrade–that sunk the company.

In other words, what killed the firm was its inability to fund the trade over its life in the face of adverse price moves.  Note that nowhere in Corzine’s answer does he mention mark-to-market risk, funding risk, haircut risk, variation margin risk, or anything related.  Given the firm’s leverage and the leverage in the trade, that oversight is beyond idiotic.  The main risk of a trade like that to a firm like MF was that prices would move against it and it wouldn’t have the resources to fund the additional collateral calls.

That’s exactly what happened–and per Corzine’s answer, that risk played no role in his decision to make the trade.  None.  That is just beyond belief.

Could he really have overlooked that risk?  Or was he just weaseling again, leaving out the crucial risk of the trade from his account, in the hope nobody would notice?