Streetwise Professor

One element of Obamacare, the CLASS program (a long term care program) has flatlined.  HHS Secretary Kathleen Sebelius, officially acknowledged what had been known since the get go: the program was not economically feasible.  So she pulled the plug.

CLASS was one of the myriad pieces of legislative-financial legerdemain used to make believe that Obamacare would actually reduce future deficits.

The budgetary impacts of Obamacare were made up out of the whole cloth: CLASS was just the most egregious example of that.  To create the fiction that Obamacare would save money, Congress and the administration resorted to budgetary and accounting tricks that were so outrageous that even the Greeks would have blanched at the thought of using them when presenting their fiscal numbers in to qualify for the Eurozone.

Yes.  That bad.

Obamacare is not only a policy disaster, it is a fiscal time bomb.  One would hope that the premature detonation of CLASS will put Congress and the country on warning, and result in the defusing of the rest of the whole dangerous mess.  That, unfortunately, will have to wait until January 2013, at the earliest.

Last Friday I was part of a group of 8 economists who made presentations to the Board of Governors of the Federal Reserve.  Once or twice a year the Board invites academics to discuss a policy-relevant economic issue.  The subject of Friday’s session was Network Economics, and Alistair Milne and I spoke about network issues in clearing and trading.

The Parthian shot in my presentation was that it was essential not to ignore the unintended effects of derivatives regulation.  In particular, clearing mandates, capital and collateral rules, and the like are all intended to reduce the amount of leverage in the financial system.  But even if you require extensive collateral against derivatives trades, market participants can offset the reduction in leverage inherent in derivatives trades by using the freed up debt capacity to add leverage in other forms.  What goes out through the front door can return through the back door.  This can be particularly dangerous if you think you’ve solved the problem when Mr. Leverage walks out the front and ignore that he’s snuck back in.

Put differently, it is very hard to reduce leverage in the system as a whole by regulating just a piece of firms’ capital structure.

Another example.  Reducing derivatives counterparty credit risk through clearing and netting and collateralization works by increasing the priority of derivatives in bankruptcy.  But if you move derivatives towards the head of the line, somebody else ends up further back.  Like unsecured creditors, including money market funds who buy short term bank debt.  They can be systemically important, too, meaning that the regulations have primarily shifted the locus of systemic risk, and not really reduced it.

Focusing on the collateral issue, the numbers here are huge.  Tabb Group estimates that interest rate derivative collateral alone will total $1.4 trillion.  Credit, equity, and commodity derivatives-related collateral will likely add hundreds of billions to the total: although these markets are smaller, they are riskier, requiring more collateral per dollar of notional.

So where is all this collateral going to come from?  I’ve written about collateral management services, by which banks will effectively lend cash that can be used for margins, with the loans collateralized by assets that CCPs will not accept directly.  In other words, Mr. Leverage is  a Back Door Man.

CME Group’s Craig Donohue talked about the need for such services:

“There will be a need and a value for the collateral transformation services,” Donohue, chief executive officer of CME said today during a panel discussion at the Futures Industry Association annual conference in Chicago.

The types of accepted collateral may need to be expanded as thousands of new users seek to back trades. While cash and government securities will always be the least costly way to pay for margin, some who want to pledge “three chickens and an old Ford” will find it more expensive to have non-standard collateral transformed into acceptable form, said Jeffrey Sprecher, chief executive officer of Atlanta-based Intercontinental Exchange Inc.

The demand has created a “cottage industry” of firms and units within banks that will charge a fee to hold securities or other assets for investors in return for acceptable margin, said Richard Prager, managing director and head of global trading for BlackRock Inc. (BLK)

Cottage industry.  Somehow this brings to mind all the stories about shadow banking system in China that mushroomed after the government tried to crack down on bank lending.

And CCPs are looking to expand the assets they are willing to take as collateral.  This exposes the CCPs to higher risks, including valuation risks.  As an example, LCH.Clearnet (which has already begun accepting gold) is going to accept some corporate debt as collateral (no link yet, but it’s from a Matt Leising Bloomberg story that Matt emailed to me):

LCH.Clearnet Ltd., the biggest interest-rate swap clearinghouse, is considering accepting corporate bonds for the first time to meet an anticipated surge in demand for a broader array of collateral in the $601 trillion over-the-counter derivatives market.

“We want to be able to have more clients come to clearing,” Floyd Converse, head of U.S. sales and marketing for London-based LCH.Clearnet, said in an interview in Chicago this week at the Futures  Industry Association annual conference.  The world’s biggest swaps clearinghouses are expanding the
types of securities they accept as regulations force thousands of new users in the U.S. and Europe to use clearing. Among them, CME Group Inc., the world’s largest futures exchange, is broadening the variety of company debt it accepts as margin for its customers.

(Quick thoughts off the top.  “Investment grade” doesn’t really give the warm and fuzzies, does it?  Will corporate debt be accepted as collateral against CDS trades?  I know LCH.Clearnet doesn’t clear CDS, but there is a reason to wonder whether competitive pressure would lead to such an outcome.  Wouldn’t this expose a CCP to substantial credit correlation risk, which is devilishly difficult to quantify and manage?)

And it is becoming far more widely accepted that CCPs will require central bank liquidity during periods of extreme systemic stress.

All of these stories suggest that mandates are first and foremost just leading to a reshuffling of leverage and risk.  There is room for deep skepticism that this reshuffling will reduce systemic risks.

Indeed, if Gary Gorton is right, and shadow banking was first and foremost a mechanism designed to create informationally insensitive debt that could be posted as collateral, the potential increase in demand for collateral could catalyze a similar process.  This process is systemically risky because it increases fragility and creates substantial tail risks, as this new Gorton paper discusses.

There is also reason to doubt that this is a good use of capital, and could lead to lower growth.  Just what we need.  The cost-benefit trade-off appears particularly unfavorable with respect to collateral posting by long-only buy side investors (e.g., pension funds) and “end users” who do not pose substantial systemic risks.

So, do Ben et al get it?  My sense is that they do, although Bernanke was pretty inscrutable through the entire morning.

One person who obviously doesn’t get it, or is pretending that he doesn’t (which would be even more disturbing) is Gary Gensler.  October is sprinkled with major conferences, and Gensler has been doing the rounds.  Despite all of the advances in understanding of the complexity of the issues involved, Gensler continues to peddle his cartoonish morality play:

“While the crisis had many causes, it is evident that swaps played a central role,” Mr Gensler said. “Swaps added leverage to the financial system with more risk being backed by less capital.

“They contributed, particularly through credit default swaps, to the bubble in the housing market. They contributed to a system where large financial institutions were thought to be not only too big to fail, but too interconnected to fail. Swaps – developed to help manage and lower risk for end-users – also concentrated and heightened risk in the financial system and to the public.”

No recognition of the ability of firms to substitute swap-based leverage with other types of leverage, and their willingness to do so.  No acknowledgement of how mandates re-order priorities in bankruptcy, and the implications thereof.    No appreciation for the potentially destabilizing effects of rigid variation margin mechanisms, and the pro-cyclicality of these mechanisms.   And yeah, Gary: clearing mandates don’t concentrate risk and create their own interconnections.

Gensler is also still pushing the transparency nostrum.  He links the crisis of ’08 to the opacity of the swaps market.  Well, lack of pricing information was arguably an important problem with AIG in particular, his proposed cure–the SEF mandate–will have no effect on this.  The problem with the instruments that AIG bought wasn’t that they weren’t traded on transparent markets: it was that they weren’t traded.  Markets are not the Field of Frickin’ Dreams: If you build it, there’s no guarantee anybody will come.  Comparisons of markets for illiquid products to exchange traded futures are superficial and silly.

In sum, Gensler continues to say foolish things.  Is he a fool, or does he just believe his audience is?  He batters straw men.  He sticks to a cartoonish narrative of the events of 2008.  He pushes nostrums.  He ignores deep complexities, and the huge potential for unintended consequences of the policies he advocates.

Nonetheless, he is not shy about telling others what to do. @OTCderivatives tweets that Gensler said the CFTC should be “top dog” in IOSCO because of the size of US markets.   In London, he chided the Europeans for not including exchange traded derivatives in Emir:

It is critical, though, that those swaps traded on regulated exchanges also are subject to the clearing requirement to bring the benefits of clearing to swaps, regardless of where they are traded – on exchange or off exchange.

This will no doubt thrill the Germans, because an expansion of the Emir remit would also force open access to exchange CCPs.

But given that the Germans have been quite adept at slapping Timmy! around, I doubt that a mere agency head will give them much trouble.

[Interesting aside.  Risk Magazine’s Laurie Carver tweeted that Gensler blew him off to allow “other less aggressive journalists ask him comfy things.”   Go figure.]

To sum up.  Dodd-Frank has set off a very complex dynamic of unintended consequences, many of which will undermine the intent of the law.  One of the figures primarily responsible for implementation of Dodd-Frank has a very simplistic view of the world that ignores these complexities.  What could go wrong?

When I was in London last week, I went to a cafe that is located in what used to be the trading floor of the London Stock Exchange.  History-phile that I am, I thought I would take a picture of the quite attractive building.  I had my phone cam up and was just about ready to take the shot when I felt a burly hand grab my shoulder, and heard a gruff voice–“No photographs ‘ere, sir.”

I thought this ironic, given that one is photographed pretty much everywhere on the street in London.  They can photograph you: you can’t photograph Them, I guess.

This came to mind when I read about the NY Fed’s plan to monitor “key bloggers” and various social media (Facebook, Twitter, etc.) for conversations mentioning the Fed.  More ominous than the passive “listening” part of the program is the active “influencing” part, intended to “identify and reach out to key bloggers and influencers.”

“Reach out” sounds so innocuous.  Brings to mind old ATT ads: “reach out and touch someone.”  But there is always reason to be concerned that the Fed’s touch will not be a light one.  We don’t need the government doing much more outreach and “influencing”, thank you very much.

I’m not big on conspiracy theories, but the potential for mischief here is large, especially given the government’s (and the Fed’s) proclivity to rationalize ever greater intrusions on privacy and liberty as essential for national security.  One can see the Fed convincing itself that to fight “rumors” and “speculation” that call into question the stability of the financial system, it is necessary to exert pressure on those that need to get their minds right, to make sure they get with the program.

This was illustrated by an interaction with an executive from a major French bank that has been in the news of late (which one hasn’t?) who went ballistic when someone else in the conversation asked what financial blogs I read, and I mentioned FTAlphaville and heaven forfend Zerohedge.  I mean ballistic. The Gallic spit was flying before  he turned on his heel and left in a huff.

Yes, there are potentially multiple equilibria in these markets, and social media and blogs can in theory coordinate shifts from good equilibria to bad (“run away!”) equilibria.  But it is quite ominous that the Fed appears to be contemplating the creation of systems and measures that could be used to manipulate information flows.

Hey.  Maybe I’ll ask Ben about this when I see him next week.  Maybe that’s a great way to get SWP at the top of the list!

No, it’s not all Kudrin all the time here at SWP.  I know there are those of you looking for your clearing fix.

A brief thought about an unintended destination on the Road to SEFdom–a vertical silo.

Long time readers will know that my transactions cost economics-based analysis predicts that dominant execution venues will vertically integrate into of post-trade services, including clearing and settlement.  Many dominant markets are already “silos” and others are moving in that direction.  The days of an execution venue obtaining post-trade services from a “horizontal” CCP or settlement provider (like LCH.Clearnet) are numbered except when regulation (like RegNMS) socializes order flow.

Horizontal, independent clearers (or settlement providers) can survive in an OTC market, where there is no centralized execution venue.  Vertical integration economizes on transactions costs and double-marginalization costs when there are back-to-back monopolies (and near monopolies).  No execution venue, no back-to-back monopoly problem.

That’s where the SEF mandate comes in.  By forcing exchange-like execution of swap transactions, there is a very real possibility that a dominant execution venue will emerge–and that the resulting frictions in the dealings between that venue and its clearer will lead to a merger between them (or some sort of long-term, exclusive contract.)

Whether this outcome occurs depends on the rules for SEFs.  There is likely to be a proliferation of SEFs early on, but rules for SEFs will determine whether a handful or one survive for a particular instrument class.  If SEF regulations (a) require them to operate auctions (rather than, say, RFQs), and (b) do not impose obligations on SEFs to direct orders to other SEFs offering better prices, then network effects will lead to tipping to a single venue.  Conversely, if there are SEF order handling rules analogous to RegNMS, multiple SEFs may survive.  Under the first alternative, integration is likely to occur.  Under the second, the likely outcome is for multiple SEFs to be served by one horizontal CCP.

SEF rules are still up in the air, and I have not seen any discussion of inter-SEF obligations–or lack thereof.  In contrast to SEC, CFTC has no tradition of even contemplating, let alone imposing, order handling rules.  The issue has never really come up.  I think the presumption in the agency is there will be rigorous competition among SEFs, but that conclusion depends crucially on SEF rules.  In particular, rules relating to the way SEFs compete.  If SEFs are required to operate auction-like mechanisms, and are under no obligation to direct orders to markets displaying better prices, markets will tip to a single SEF.  This will lead to integration.  If regulators impose order handling obligations, multiple SEFs will survive, and integration is far less likely.

Has anybody thought this through?  Are order handling rules even on the table?

James Hamilton and Jing Wu have a new paper on speculation and oil futures pricing (h/t Brian Goff).  The paper is very carefully done and very impressive econometrically.  It presents some provocative results, but IMO the radical simplifying assumptions James and Jing used in order to come up with something that they could estimate cast serious doubts on the results.  I am also sure that the results will be overinterpreted and misinterpreted to advance political agendas, and regret that the authors provide the hook in a few careless statements that should have been heavily qualified, but weren’t.

Here are my initial detailed comments:

1. The paper focuses on risk premia.  Hallelujah!  The price of risk is what speculators are most likely to affect, because most speculative transactions involve a transfer of risk, rather than the commodity.  A very basic point, but one which is all too frequently overlooked.
2. The most provocative result in the paper is a huge discontinuity of their estimate of the risk premium in oil futures  between the pre-2005 period and 2005-2011 (see Fig. 5).  This discontinuity is an artifact of HW’s splitting of the sample.  They motivate the choice of splitting date by observing that the growth in crude oil futures open interest increased dramatically beginning in 2004.  It would be preferable to do some testing for structural breaks and estimate accordingly.
3. More generally, I am very suspicious of such a sharp discontinuity.  I think it is highly likely that it is symptomatic of other changes going on in the market, and the limitations of their model.  (More on the latter below).
4. The model is not complete, even on its own terms.  Although it discusses the role of speculators (“arbitrageurs” in HW) in absorbing risk from hedgers, hedgers are not formally modeled.  This is a huge hole.  Moreover, “investors”–such as those who trade via index funds–are modeled extremely mechanically.  Yes, once they are in the market, index traders tend to trade mechanically, but the allocation of speculative capital between index funds and other investment opportunities is not as mechanical a process as the paper assumes.  Indeed, in the model the index-fund investors’ trading does not depend at all on risk-return tradeoffs.  They are just automatons that flow in and out of the market based on some autoregressive process. This is extremely problematic: index investor capital allocation decisions are presumably the result of an optimization process that reflects their investment opportunity set and the pricing of risk across these opportunities.  (Again, more on this below).
5. Relatedly, since hedgers are not in the model, there is no effect of index investors shocks on hedger behavior.
6. The model of fundamentals is extremely cramped and limiting.  I am no big fan of affine models generally, but even overlooking that, it is definitely the case that more than one (latent) fundamental factor drives spot oil prices.  Thus, the model becomes a two-factor model, with one (fundamental) factor driving the spot price and the “risk neutral” forward curve and the other (index-investor buying) affecting the shape of the forward curve.
7. One cannot generate interesting forward curve dynamics using a one-factor fundamental model.  One cannot generate interesting and realistic inventory-price relations using a one factor model.  As I show in my forthcoming book, at least two fundamental factors are needed to generate reasonable dynamics.  Furthermore, as I also show in the book, the homoskedastic error structure for the fundamentals variable assumed in the HW paper cannot generate price and inventory behavior observed in the real world.
8. Thus, the fundamentals model is almost certainly seriously mis-specified.  I can understand the modeling choice, but it has consequences.  It is my sense that this mis-specification is so severe that it casts serious doubts on the results.
9. In a frictionless world, risk premia for a particular factor are determined by the covariation between that factor and the pricing kernel.  In markets with frictions (as in the Hirshleifer models of the late-80s, early-90s), idiosyncratic risk of the factor may impact risk premia, in addition to the effect of systematic risk (driven by the covariation).  HW is a single market model: the oil market is all there is, and only factors within the oil market affect risk premia.  This is in essence an old-school Keynesian model of the risk premium.  Again, this is highly problematic.  In particular, since the whole movement of financial investors into commodities strengthens the linkage between broader financial markets and commodity markets, ignoring systematic risk (and hence inter-market covariation) is a serious deficiency.
10. It is a stylized fact that correlations between commodity returns and returns on broad equity indices and FX have changed substantially in recent years.  Although some have asserted a connection between index trading and this change in correlation structures, you can tell fundamentals-based stories as well.  For instance, if supply shocks were dominant in pre-2005, but demand shocks (e.g., the growth of China, the financial crisis) were dominant since, one would tend to observe the oil-S&P correlation to change from negative to positive.  As long as you are not in a Keynesian world with each commodity and investment an island with risk borne only by those living on that island, this change in correlations would lead to a change in risk premia.  The change in sign in the risk premium at the end of the sample corresponds to the financial crisis and associated major recession.  During this time demand shocks were clearly driving oil prices, and the correlation between the S&P and crude prices was very high and positive.  Thus, there was more systematic risk 2007 and later, and this would be expected to affect risk premia, but the model precludes this.
11. The omission of systematic risk in a model of risk premia is a serious, and IMO disabling, limitation.  It is particularly odd to ignore this in a paper that examines “financialization” of a commodity market, since financialization involves financial investors adding commodities to broadly diversified portfolios in order to optimize some risk-return trade-off.
12. These issues all affect how one interprets the HW findings.  What if risk premia did in fact change?  This could well reflect more accurate risk pricing due to the integration of commodities into investor opportunity sets.  Risks are going to be priced differently–and more efficiently–if there is more trade between islands.  A reduction in frictions, and an increase in the connections between markets, should lead to better risk pricing.  So finding a change in risk pricing could represent a very salutary development.
13. Indeed, tying some of these threads together, doesn’t “financialization” reflect a normal economic process of equilibrating prices between segmented markets?  Here, the prices are the prices of risk, and the movement of resources (risk) is more abstract than the movement of physical oil between Cushing and the Gulf.  In the latter example, profit seeking traders will drive the difference in prices in the two markets to the cost of transportation between them.  In the case of risk premia, any innovations (which could well include index investing) that reduces the costs of moving resources (risk bearing capacity) between prices will affect the prices in those markets, and tend to equalize them.  Since in the broader financial markets, oil and other commodities are small relative to the broader capital markets, it should be expected that the risk prices of commodities should account for the bulk of the change toward equalization.  It should also be welcomed.
14. To summarize a bit, the crucial questions include: what risks are priced?  Who participates in the market that determines these prices?  and, What are the investment opportunities available to these participants?  I think on every question, the HW paper is on very, very shaky ground.  The one-dimension model of fundamentals is far too restrictive, and the dynamics are far too simplistic.  Crucial players–hedgers–are left out, and others are treated mechanically.  In a paper that attempts to determine the effect of the movement of well-diversified financial investors into commodities, the Keynesian islands approach is inadequate: these investors have extensive investment opportunities that affect their behavior–and the pricing of risk that is the whole subject of the paper.  Mechanical treatment of one group of agents can make sense in some models, as in noise trader microstructure models.  Mechanical treatment of investors actively and aggressively looking for superior risk-return performance is a serious shortcoming in a model of the pricing of this trade-off.
15. I sympathize with James and Jing.   The impressive empirical cleverness required to estimate even this radically simplified model demonstrates just how challenging is the task of understanding the pricing of commodity risk.  I could readily believe that it could be impossible to estimate a richer model that includes fundamentals subject multiple, potentially heteroskedastic shocks, and three classes of optimizing investors with diverse investment opportunities. But the very complexity of the problem should make people very reluctant to make strong statements about the effects of “financialization” on price behavior.
16. In summary, I believe Hamilton-Wu are eminently correct to focus on risk premia as the variable that could be affected by the entry of a new class of market participant, but the daunting nature of that task is evident.  The radical simplification (again, understandable as a practical matter) needed to permit estimation, which involves abstraction from virtually all of the important economic issues makes their conclusions and results highly dubious as a basis for policy.  But there are plenty of fools out there (and let’s be clear, I do not include the authors in that category) who will no doubt rush in where prudent and thoughtful angels fear to tread.
17. For this reason, I wish they would have abstained from statements likely the valediction in their paper: “We suggest that increased participation by financial investors in oil futures markets may have been a factor in changing the nature of risk premia in crude oil futures contracts.”  This kind of suggestion only encourages the fools.  Every link of the chain of reasoning supporting this suggestion is flimsy.  Most importantly, the suggestion rests on a structural break which corresponds roughly with a period of time during which more financial investors participated in commodity markets.  But many other things changed during the same period.  Indeed, Hamilton himself has repeatedly pointed out that this period was one in which there was a virtual cessation in the growth of oil output.  That’s a pretty important fundamental.  Moreover, this was a period in which emerging markets, notably China, began to impact commodity markets dramatically.  Furthermore, most of the period (say 2007-2011), was one of financial an economic upheaval not observed since the 1930s.  That’s a pretty big change too.  Why put all the focus on index investing?  The model certainly doesn’t support that, because (a) all of these other factors are omitted altogether, and (b) even the model of index investing is crude and mechanical.
18. That is, to attribute the change in risk premia estimated from a clearly mis-specified model to a single change among many that occurred during the period of change is highly, yes, speculative, and an extremely tenuous piece of post hoc ergo propter hoc reasoning.

I do not want to close on a negative note.  I admire that Hamilton and Wu have focused on the right issue and have brought impressive econometric skills to the problem.  Improving our understanding of these issues would best be achieved by following the direction James and Jing have pioneered, by incorporating some of the features discussed above.  It will be a hard road, but worth taking.  Hamilton-Wu is a helpful first step along that road, and I hope that people understand it is only that, and that much hard slogging remains.

******

A few technical asides:

1. The use of NYMEX data in which time to expiration changes presents some complications to the estimation and interpretation.  It would be worthwhile to look at LME metals data (e.g., copper) because (a) it has also been claimed that financial investors have affected metals pricing, and (b) LME trades constant-maturity contracts that are easier to handle empirically.
2. If the focus is on index investors, who by definition trade in multiple commodities in a mechanical way, it seems that cross-sectional evidence would be quite informative.  For instance, did risk premia change in a way similar to that claimed for oil in other markets that are also part of commodity indices?

I am in London for the ISDA Annual Europe Conference, where like in the NY version, I moderated a panel on clearing.  Yesterday’s panel was very informative and interactive, and made for some good copy.  As in NY, it was only possible to scratch the surface, but that in itself is revealing because it tells you just how many knotty issues are still unresolved.  Another thing that came through loud and clear was how interconnected these issues are.

The most entertaining debate centered around interoperability.  The looming fragmentation among CCPs has regulators around the world trying to mitigate the cost and risk increasing consequences of fragmentation by pushing for CCPs to interoperate.  The three major clearers represented on the panel–Michael Davie from LCH.Clearnet, Paul Swann from ICE Clear Europe, and Kim Taylor from CME Clearing–were all pretty negative on the idea, with Michael and Paul being adamantly opposed, and Kim only slightly more accepting of the idea.  Michael wins the quip of the day award for his characterization of the idea: “It’s crackers.”

Jurisdictional fragmentation was foreseeable months ago: I discussed the problem in some detail in my 2010 Cato and Journal of Applied Corporate Finance pieces, and again more recently in my ISDA study.  It is on the front page now, with the face-off between the UK and the ECB over the latter’s insistence that any clearer of Euro-denominated derivatives be domiciled in the Eurozone, with access to the European Central Bank.

There is some economic sense to the ECB’s position, but there is also economic sense to having global CCPs that can maximally exploit economies of scale and scope arising from netting and capital efficiency.  But this just illustrates the ill-thought out nature of clearing mandates.  Global banks can access central bank liquidity in a variety of currencies and net efficiently and collateralize efficiently across multiple currencies.  Forcing clearing eliminates some netting and capital efficiencies (but can potentially improve others), but creates thorny issues about access to central bank liquidity that makes global CCPs problematic.

The Canadians are now grappling with the very difficult tradeoff between efficiencies that come from global CCP scope, and the potential systemic fragility that could arise from concentrating so much risk in a single entity.  A Bank of Canada official, Tim Lane, warned:

In carrying out the G20 mandate requiring all OTC derivatives to be centrally cleared, it is essential to ensure that we do not unduly concentrate risk in a relatively small number of institutions that are direct clearing members of global CCPs,” he said.

These were the very institutions that spread and amplified contagion through the global financial system in 2008, Mr Lane told the annual Sibos settlement and payments conference.

Quite a puzzle, no?  Who could have possibly anticipated this?  (You don’t need to answer that.)

And the COO of the DTCC has warned about the difficulties and dangers of clearing CDS.

“We may be creating a much higher level of risk,’’ he said, by requiring swaps to be turned into standardized products, traded on electronic exchanges and where risks are covered by a central counterparty, backing up the two sides of a trade.

He noted, for instance, that a central counterparty failed during the Asian financial crisis of the ‘90s.

Again, who knew?  Again: no need to answer.

Lawrence Sweet, a senior VP at FRBNY replied:

Risk management procedures must be strong and the new systems “sufficiently robust” to guard against failure of central counterparties or firms involved in the trades.

And, he said, those swap contracts that are too complicated or risky to be put into centrally cleared, electronic markets should not be. The question is “how much can we put in there in a safe way,’’ he said.

And the answer is?!?!  [Crickets.]  Stating a set of desiderata without providing a reasonable strategy for getting there is gratuitous, at best, and reminiscent of the Steve Martin “How to Make a Million Dollars Without Paying Taxes” routine.

Why stop now?  From the FT, Jeremy Grant’s article from yesterday (2 SWP bonus quotes) is summarized by the FIA’s news brief as follows: “Complications arise as regulators detail clearing rules.”   I am so shocked that I am speechless.

Witness what the Sorcerer’s Apprentices have wrought.  Perhaps to some clearing mandates sounded like a good idea at the time, but it’s pretty evident that those very same some hadn’t fully thought through the issue.  Everybody is now dealing with the implications of the mandates on the fly, and are learning that the “solution” is just another package of problems.  Gazing across the fence from OTC World into Clearing Land, the grass in the latter seemed so, so much greener.  Now, having jumped, the jumpers are finding plenty of weeds, and plenty of nettles.

Javier Blas at FT was a standup guy about the sentence in his article on the Singleton that made it sound like I had criticized the CFTC for not inviting those taking contrary views to the August confab about speculation and the Singleton paper.  In response to my venting (who? me?), the sentence has been corrected in the online version to make it clear that I did not make any such claim, and the version online now contains this text:

“This article has been corrected since original publication to reflect that only Philip K.Verleger has criticised the CFTC’s move to invite academics, mainly with one point of view.”

I appreciate the rapid and gracious response.

Interesting to note that Ken Singleton and I are commonly being used to personify contending sides in the commodity speculation debate.  One example is this piece from the FT on Wednesday.

Before going into substance, I need to set the record straight.  Javier Blas is flatly incorrect to say that I criticized “the CFTC’s decision to invite academics who mainly defended only one point of view.”  Flatly incorrect.  I have never said that either publicly or privately, and I defy Mr. Blas to prove otherwise.

Indeed, I was invited, so I know the statement to be untrue and I would not make it becuase (a) I just wouldn’t, and (b) I’m not so foolish as to make a statement that could easily be proven wrong.   I decided not to attend the event for a variety of reasons, most of them personal.

So, a retraction and correction is warranted (though I’m not holding my breath).

Now that’s out of the way, let me revisit one more time why the Singleton paper is being grossly misinterpreted, though not by Ken (at least in ear/eyeshot of me).

To recapitulate, Singleton finds that a measure of index fund participation helps predict future returns on oil futures positions.   This measure has serious, serious problems, as Scott Irwin and Dwight Sanders have shown.  Singleton has acknowledged some of the problems.  But that still leaves a puzzle, as why would a very noisy measure of speculative participation have predictive power?  But I’ll leave that puzzle aside and take as given that speculation leads prices.

The question is: why?  Does this mean that speculation has distorted prices?

In a rather stinging response to Singleton, the IEA does a nice job of summarizing my views as to why it does not necessarily support this conclusion, and could support the exact opposite one:

Finally, as suggested by the University of Houston’s Craig Pirrong in his blog, suppose that Professor Singleton’s findings do indicate that excess returns on crude oil futures are predictable, conditional on measures of speculative activity. Nonetheless, such a predictability of returns would not imply that speculation has distorted prices. Rather, predictability is the result of market frictions that might create hedging demand, leading to an increase in the risk premium. Professor Pirrong suggests that, in such circumstances, speculative positions can predict changes in futures prices. To prevent the predictability  of returns, it might be advisable to reduce constraints on the flow of speculative investment to  commodity markets, rather than limiting them.

(The entire IEA piece is worth reading.)

Singleton advances another argument–and it is only that, because his evidence cannot distinguish his explanation from that just advanced–based on various behavioral finance/learning stories.  There are indeed asset pricing models in which investor learning can lead to self-reinforcing price movements.  The key phrase here is “asset pricing models.”  The key question is whether such asset pricing models are applicable to commodities.

I am highly, highly skeptical.  Assume for sake of argument that speculative activity in a commodity derivatives market has distorted the price of the commodity; convergence implies that if nearby futures prices are indeed distorted, physical prices have to be distorted too.

Millions–and in some cases billions–of individual consumers, and myriad producers, face these prices.  If these producers and consumers are not playing the same learning game that is going on in the futures market, the price distortion will affect their production and consumption decisions.  All else equal, if speculators cause the price to be too high, consumption will be depressed, and production will increased.  This will lead to an accumulation of inventories.  If the price distortion is large, the inventory accumulation is likely to be large.

Now, there are circumstances in which it may be difficult to detect empirically the inventory accumulation.  If supply and demand are extremely–extremely–inelastic, large price moves may result in small inventory changes that are hard to detect in the noisy stock data that are available for some commodities.  Moreover, all else may not be equal.  As Singleton (perhaps cleverly) notes, my research shows that a decline in fundamental uncertainty could lead to a decline in inventory that masks the speculation-induced change.  (Although more plausibly, higher fundamental volatility leads to greater speculation, which would lead to an increase in inventory that could be blamed on speculative price distortions.)

But there are historical episodes–like the Hunts in silver and government price-support programs–in which price distortions have been associated with huge accumulations of inventory.  Those claiming speculative distortion need to provide a credible explanation whenever an alleged price bubble is not accompanied by a rise in inventories.  It can happen, but it’s unlikely–so show me how.

So, for the Singleton story to work, it has to be the case that consumers and producers–or at least a big chunk of them–are playing the same learning game as the investors.  I find this wildly implausible, particularly for consumers.  Would consumers really buy more gasoline today–gasoline which they are going to consume, not store in anticipation of profiting from price appreciation–for speculative reasons because prices have been trending up?  Really? (Perhaps you could argue that they would engage in intertemporal substitution, but this also stretches credulity.)  It might be somewhat more plausible that suppliers would not produce more today in response to a speculative price bubble in anticipation that they can sell at a higher price in the future.

These stories–and they are just that–are not logically impossible, but they are just implausible, to me anyways.  The consumer side is particularly implausible.  To emphasize: most consumers of gasoline or copper or corn or whatever cannot store the commodity, and hence cannot earn a speculative profit.  Thus, they should respond parametrically to prices, and respond to higher prices by reducing consumption.  The decline in consumption in markets (like the US) where consumers are subject to price changes (because there are no price controls or subsidies) during the oil price spike of 2008 supports this view.  So price distortions should lead to inventory accumulation.

This is an excellent illustration of why commodities are a good place to test theories of speculative distortion.  The speculators may play their games in the financial markets, but if they affect prices, consumers and producers who don’t play the game alter their behavior.  Looking for evidence of behavioral changes–consumption and production changes–is a great way to detect price distortions.  That is not possible in asset markets.  Consumers and producers are canaries in the coal mine.

Which all means that to persuade, Singleton, and those who are using his paper to say Eureka!, need to provide a plausible explanation of how learning/behavioral finance effects change the behavior of producers and consumers in ways that what would mean that price distortions do not lead to noticeable changes in quantities like inventory.  That is, he points to models of asset markets in which there are no consumers; to make a realistic and testable model, you would need to include producers and consumers as well–not just demand for a stock of assets, but flow demand and supply.

One last thing.   The Singleton paper has “boom and bust” in the title, and many behavioral finance/learning models predict boom and bust patterns in speculative prices.  There was a boom and bust in oil prices and other commodity prices–but the bust in 2008 was not plausibly the kind of speculative bubble bursting that occurs in the models.  It was definitely driven by a huge collapse in demand resulting from the financial crisis.  Thus the “bust” part of the price movements should not be used as evidence in favor of the theory.  Instead, it fits far better a fundamentals-based story.  As I told many reporters as prices peaked in summer 2008, when they asked what would bring down prices: be careful what you ask for.  A major recession would be the most likely cause of a big price decline.  That’s what happened–not the bursting of a speculative bubble.

Relatedly.  Prices that positively cannot be driven by asset pricing bubbles–because they are are definitively not assets–boom and bust.  During the same period that oil prices were booming and then busting, shipping rates were doing the same thing.  Space on a ship is not an asset.  It is not storable; you use it or lose it.  You can speculate on the price of the ship, but the price of the services of the ship cannot be subject to asset pricing bubbles–because these services are not an asset.  The spike and thudding collapse of shipping rates in 2007-early 2009 is indicative of a rise and fall in the demand for commodities (which are transported by ship), and cannot be explained by speculative distortion induced by learning, etc. Put differently, booms and busts occur in markets in which asset price bubbles are impossible.

To summarize.  1. Singleton’s results are perfectly consistent with rational pricing, no speculative distortions, and financial market frictions.  2.  The conditions that would reconcile the kind of learning/behavioral finance model that would be necessary to explain the lack of inventory accumulation are highly implausible.  If somebody wants to tell a more convincing story about commodity price bubbles, it is necessary to do more than just genuflect to models devised to explain things like the dot-com bubble.   You have to create a model that includes flow demand and supply, and derive testable implications of investor/speculator learning or irrationality for quantities produced, consumed, and stored.   Only then will it even be remotely possible to determine the real implications of these learning models for commodities.

I have a warm spot in my heart for German Finance Minister Wolfgang Schaeuble, because of his periodic slapdowns of Timmy!  (I think there is another slapdown-ready opportunity arising, given Timmy!’s–and Obama’s–recent penchant for giving the Euros gratuitous advice on dealing with their existential crisis.)

But he said a couple of things recently that give me pause.  First (h/t R) is this speech:

German Finance Minister Wolfgang Schaeuble said that while markets are the most efficient means of creating wealth in an economy, they can also be irrational and therefore need regulation.

“Markets are the best means of finding solutions, but they’re not always rational” and can destroy themselves, Schaeuble said today in a speech in Berlin. “That’s why they need rules and bounds.”

It is the job of the government to create an order that promotes, rather than hinders, moral behavior, Schaeuble also said at an event organized by the Catholic Academy in Berlin.

On an abstract level, that’s not really objectionable, because only some anarchists deny the need for market rules.  (Anarchocapitalists believe that rules shouldn’t be imposed, but created by cooperation and consent.)  The questions are: What rules are the right ones?  Where should the bounds be set?  Who decides?  How?

In this speech, Schaeuble gave an example of how he answers these questions, and those answers suggest that his pro-market rhetoric is boilerplate camouflaging another statist control freak:

German Finance Minister Wolfgang Schaeuble on Wednesday called for regulating all innovative financial products and urged banning so-called over-the-counter trade.

“We must apply the rules of transparency to all market participants–hedge funds and private equity funds,” Schaeuble said at an event sponsored by the Konrad Adenauer Foundation and the Catholic Academy ahead of a planned state visit to Germany by Pope Benedict XVI.

“We should ban OTC trade where possible, because we don’t have transparency (in these markets). And then we should try to regulate all innovative financial products. We cannot achieve everything through regulation, but we can try to tighten the rules.”

Another slave to the god of transparency.   Like that will solve everything.  And apparently a market in which consenting adults make mutually advantageous transactions about which they don’t reveal everything is far worse than no market at all.

I would further note that there is no perfectly transparent market.  Futures and stock exchanges have a great deal of pre-trade and post-trade price transparency, but the identity of traders is concealed: the markets are anonymous, and the buyer does not know the identity of the seller.  Thus, even on exchanges not everything is transparent.  OTC, the buyer typically knows the seller, but there is less pre- and post-trade transparency.  There are trade-offs involved, and different mechanisms have developed to permit market participants to choose which kinds of transparency rules work best for them.  The side-by-side existence of exchanges and OTC markets gives choices that can accommodate differences in the costs and benefits of alternative forms and levels of transparency across market participants.

And if transparency is such an unalloyed good in markets, Herr Schaeuble, does the same principle hold for governments?  Is Germany’s government a paragon of transparency?  Do you conduct all of your discussions and decisions in the full public glare?  Does your government have secrets?  Does Europe’s?  Is this a good thing?

We all know the answers to those questions.  It would be quite illuminating to hear why secrecy–very incomplete transparency–is acceptable and even necessary for governments that wield vast coercive powers, but some modicum of secrecy is completely unacceptable for private actors who cannot coerce anybody.

Schaueble’s remarks, and the place where he delivered them, suggest a typical European conservative mindset that is ambivalent, at best, towards markets and individual choice.  Hayek’s essay “Why I Am Not a Conservative” provides an illuminating analysis of this mindset.

So please confine yourself to putting the (verbal) boot into Timmy!, Wolfie.  There are enough control freaks about, thank you.

This week marks the beginning of a whirlwind couple of months in which I give talks or participate in conferences on either clearing or Frank-n-Dodd (there of course being a big overlap there).  Tuesday I moderated a panel at the ISDA Annual New York Conference, and yesterday I participated in a panel on Frank-n-Dodd at a Futures Industry Association event in New York.

First, the FIA event.  What came through loud and clear was the widespread belief that the SEF mandate in Frank-n-Dodd is wholly wrongheaded.  The consensus is that it is an attempt to jam a one-size-fits-all model on an inherently heterogeneous and non-standardized business–the business of executing OTC derivatives transactions.  That heterogeneity reflects the inherent heterogeneity of particular transactions, and the firms that want to execute them.  The market has evolved to accommodate heterogeneity, and the SEF mandate will impose uniformity.  Everybody better fit a 42-regular sportcoat, because that is what Frank-n-Dodd is going to force everybody to wear.

Of course there are dissidents from the consensus: most prominently those who do, or want to, operate SEFs.  Big surprise.  The NYT recently ran an article describing the efforts of these firms to influence policy.  The point you should take away from that article is that the idea of SEFS is not new, that SEFs have tried to gain traction in the market for some time (they are not “Johnny-come-latelys” in the words of one exec quoted in the article), but they have not made a big dent in the marketplace.

The failure to this point of SEFs to transform execution in the swap market, the way electronic trading did for listed derivatives, is a crucial fact.  It is not dispositive proof that the SEF mandate is misguided, but it does raise serious questions about it.  Before remaking the world, it is a pretty good idea to understand why the world is the way it is and why it isn’t the way you want to remake it.  Competition is never perfect, but competitive forces usually work inexorably towards the adoption of more efficient practices.  The rebuttable presumption should be that competition has pretty much gotten it right, and that policy prescriptions that are wildly at odds with existing practice are likely based on ignorance.  Those advocating a wholesale re-engineering of the results of market processes should be required to advance a coherent justification, based on rigorous logic and empirical evidence.

This the SEFocrats have not done.  Not even close.  And no, invoking the magic word “transparency” or advancing theories that presume that half the market is suffering from something akin to battered spouse syndrome don’t cut it.

The SEF rules are a particularly prominent example of the deficiency in cost-benefit analysis in CFTC rulemaking.  I have it on good authority that some analysis will soon be forthcoming that demonstrates that the cost of these rules will be immense.  As for benefits, the six members of the FIA panel couldn’t name one–even when pressed to do so.  We, collectively, couldn’t even come up with a “well you don’t sweat too much for a fat girl” compliment.  (If you don’t like that remark, direct your complaints to Ty Cobb:  I stole it from him.)  So, insofar as cost-benefit analysis is concerned–you should be able to do the math pretty easily.

The title for the post, by the way, is a joint product.  Tom LaSalla of CME Group coined “SEFdom” to describe what Frank-n-Dodd will soon bring on us.  I added the Hayekian allusion.  (Go figure.) I think the comparison is apt.

Insofar as the ISDA panel on clearing is concerned, I walked away from it thinking what I do after hearing any informed discussions of this subject: that it is the most devilishly complex issue you can possibly imagine.  It is one of the world’s biggest onions, and neither I nor anyone who has spent considerable time and effort thinking about it or actually doing it has gotten through even a small fraction of its layers.  The number of serious issues, their complexity, and their interconnectedness, is hard to exaggerate.

Which further demonstrates the frivolity of legislators and regulators around the world,who seized upon it as a panacea and imposed it without due consideration of these complexities.  The idea was hatched out of superficial understanding by panicked people who then proceeded to let others deal with the brain-twisting realities.

One hopes (though I do not expect) that regulators will be sufficiently patient and flexible to permit people who actually know something accommodate these complexities, and make the hard trade-offs that are necessarily involved.  New ideas on ways to perform the same functions as CCPs are still being developed: ISDA chief Conrad Volstad mooted a promising approach that would achieve the purposes of the clearing mandate, but at far lower cost.  These approaches deserve analysis and development before another one-size-fits-all approach is locked in.

I don’t like clearing mandates, but think that clearing has its virtues if it is done right, and in a way that reflects its comparative benefits and costs.  In this way it differs from the SEF mandate, which is why I gave the latter my Worst of Frank-n-Dodd Anniversary Award.  But rigid and superficial conceptions about how the mandate should work (and you know whom I am talking about) raise the very serious possibility that the potential benefits of clearing will be swamped by the unintended costs of imposing it where it is inappropriate, or in a way that is not adapted to its strengths and weaknesses.