Streetwise Professor

. . . of SWP discussing clearing, here’s a video (approx. 90 minutes) of my talk on the subject at the Law and Economics Workshop at Columbia Law School from December of last year.  You need to supply your own NoDoz.

There are a lot of jokes about economists that go something like: “An economist and a physicist are on the top floor of a skyscraper.  Someone runs in screaming: ‘The building is on fire. The stairways are all blocked.’  The physicist immediately panics, then looks at the economist, who is amazingly calm.  The physicist says: ‘How can you be so calm?  We’re all gonna die.’  The economist smiles wanly and says: ‘No we’re not.  First, assume a 100-story ladder.'”

That genre of joke came to mind when reading this:

Clearing houses for derivatives can help reduce risk to the financial system, Federal Reserve Governor Daniel Tarullo said in written remarks prepared for House Financial Services Committee testimony tomorrow.

“If properly designed, managed, and overseen, central counterparties offer an important tool for managing counterparty credit risk, and thus they can reduce risk to market participants and to the financial system,” Tarullo said.

Translation: “First, assume a properly designed, managed and overseen central counterparty.”

Yes, if we assume all those things are true, our assumed world is wonderful indeed.

But as I’ve written for the past two-and-a-half years (and I think I can honestly say “you read it here first!”), all that is easier assumed than done.

Reading an article by Samuel G. Hanson, Anil K. Kashyap and Jeremy C. Stein in the most recent issue of the Journal of Economic Perspectives helped crystalize a thought that is implicit in what I’ve written, but which I have not made as explicit as I should.

Specifically: Historically clearinghouses have been microprudential institutions, with the responsibility of ensuring that a particular set of claimants get paid what they are owed due to the default of a single trader or firm, just as bank regulation has been microprudential in its focus on ensuring that depositors get paid in the aftermath of the failure of an individual bank.  But Dodd-Frank and all of the other initiatives around the world give CCPs huge macroprudential responsibilities.

As Hanson et al show, there can be substantial tensions between microprudential and macroprudential regulation: some things that are prudent microprudentially are very dangerous from a macro/market-wide/systemic perspective.   I do not believe that Frank-n-Dodd, Geithner, Gensler, the EC, you name it were or are fully cognizant of the difference.  And therein lies the danger.

Here’s the most obvious example.  CCPs utilize margins–collateral–to control counterparty exposure.   That’s sensible microprudentially.   But as I argued beginning in 2008, and as Brunnermeir and Pedersen formalized in 2009, collateralization and rigid mark to market can be systemically destabilizing.  I referred to this as the “collateral death spiral.”  Prices change a lot, imposing big MTM losses on some parties, who liquidate their positions, exacerbating the price moves, which leads to more liquidations.  This positive feedback mechanism is what creates serious systemic risks.

Brunnermeir and Pedersen emphasize that a purely mark-to-market system that bases margin calls only on price moves, and makes no effort to distinguish between fundamentals-based price moves and those that result from mispricings or liquidity effects are the most systemically dangerous.  And that’s exactly how CCPs work.  They are ruthlessly mechanical. If you talk to people in the futures business, that is a feature, not a bug.  I can’t count the number of times I’ve heard about the virtues of the “discipline of a rigorous daily mark-to-market system.”  Microprudentially–agreed.  Macroprudentially–not true, and more than that, dangerously misleading.

So, there is a fundamental disconnect between Timmy!’s and GG”s paeans to rigid collateralization and mark-to-market and their assertion that mandatory clearing will eliminate the prospect that derivatives will be a source of systemic risk.  Indeed, evaluated properly, the reverse is more likely to be true.  In times of market stress, rigid collateralization can be a doomsday machine.

That is a reality that can’t be assumed away–but has been.   And don’t count on that ladder saving our collective rear ends when–when, not if–the next financial firestorm occurs.

The big news in Exchangeworld is the likely merger of NYSE-Euronext and Deutsche Borse.

This reflects in some sense a return to financial normalcy in the aftermath of the crisis.  The years leading up to the crisis saw a plethora of exchange mergers and combinations, but the pace of consolidation slowed noticeably in 2008-2010.  Now it is picking up again.

Both NYSE-Euronext and DB operate cash equity and derivatives exchanges.  The former operates NYSE, of course, and also European equity markets in the Netherlands, Portugal, France, and elsewhere, and the LIFFE derivatives exchange in London.  The latter operates the German stock market, a US-based options market ISE (a purchase in the pre-crisis boom which turned out to be a rather bad deal for DB) and the Eurex derivatives exchange which trades equity options and a wide range of financial futures.  DB is highly vertically integrated; most importantly, it operates its own execution and clearing platforms in both equities and derivatives.  LIFFE historically outsourced its derivatives clearing to LCH.Clearnet, but is also vertically integrating into clearing (although it still contracts with LCH for some clearing services).

Cost savings are the major driver of this merger.  There are substantial scale and scope economies in execution systems.  In derivatives, moreover, there are substantial scale and scope economies in clearing.  In particular, margining and netting efficiencies reduce customer capital costs.

The competitive effects are likely to be relatively small, even though that has been a focus of a lot of the commentary.  Cash equities are already ruthlessly competitive, especially in the United States: RegNMS socialized order flow, eliminating any tipping effects, as demonstrated by the precipitous decline in NYSE market share from the mid-80s to the mid-20s in the years following RegNMS.

With respect to derivatives, the LIFFE and Eurex do not compete head to head in any major product.  Cross-product competition is relatively tame in futures.  And just as with the CME-CBT merger, putting LIFFE short term interest rate futures and UK government bond futures and Eurex European bond products on the same platform would facilitate spreading trades and enhance liquidity and reduce trading costs and execution risks for customers.

Nor do LIFFE and Eurex compete head-to-head with any CME product.  Thus, the direct competitive effect of the merger on CME is also likely to be relatively mild.  By reducing trading and clearing costs, a LIFFE-Eurex combination may attract some business from CME product groups to its product groups, but again, these inter-product class cross elasticities do not appear to be large.  Order flow has not been socialized by regulatory fiat in derivatives on either side of the Atlantic, meaning that the order flow network effect is still in place.  This means that LIFFE and Eurex could not credibly compete against CME on its home turf (each had conspicuous failures trying): it also means that a combined LIFFE-Eurex will face daunting obstacles in trying to do so.  Indeed, I doubt they will seriously try; twice burned, thrice shy would be a reasonable motto.

Consistent with this, CME Group’s stock price has been up close to 2 percent since the news of the potential tie up became public.

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.

The news of the potential deal has sparked considerable speculation about other tie-ups.  One commonly heard belief is that CBOE is the odd-man out, and that it should tie up with CME.  Other than the fact that both have “Chicago” in their names, these entities don’t have a lot in common, or a lot to gain by combining. In particular, there are no benefits on the clearing side. There are no economies on the regulatory/compliance side.  There are not really big advantages on the system side either.  So, other than savings on letterhead and some management salaries, there is nothing to be gained by merging.

It is likely that many more possible combinations will be mooted and discussed in the coming days.  I’ll be among those discussing them, but that will have to wait.  For teaching calls.  It’s rough work, but somebody has to do it.

I know that more than a few of you get bent out of shape when I bash Obama.  Sorry, but there are times it just can’t be helped–and which it is justly deserved.

Like now, with regards to his two most recent signature economic initiatives: high speed rail and corporate social responsibility.

I mean, seriously.  If trains get you off, buy a Lionel and spare us subsidizing high speed rail to the tune of billions of dollars.  It’s economic insanity.

Don’t take my word for it.  Harvard’s Ed Glaeser has run the numbers, and they don’t add up.  Not even close.  Not even when you incorporate generous estimates of the environmental benefits.  Glaeser always make assumptions that err on the side of making rail look good, and it never does.

What’s more, I haven’t even seen anyone attempt to make the other standard argument for subsidies, namely, that there is some sort of information externality, arising from learning-by-doing, for instance.

Big government types need to get over their Edifice Complex, and stop deluding themselves that subsidizing the inefficient creates wealth.  And in most circumstances–including virtually all of those things like high speed rail, renewables (e.g., windmills and solar), electric autos, etc., that this administration pushes–the fact that something requires a subsidy to come into existence tells you it is a turkey.

Insofar as the corporate responsibility thing goes, Stephen Bainbridge does a brutal takedown based on transactions cost economics considerations.  But there are other equally good reasons to reject forcefully the corporate responsibility theme.  Most importantly, there is the Knowledge Problem.  Good intentions are not enough.  You need to have information.  Corporations that maximize shareholder value (or profits) respond to economic signals in the form of prices.  Prices summarize vast amounts of information about the value of resources in alternative uses, and in a profit-driven system provide an incentive to direct those resources to their highest valued use.  As that noted right wing radical Bertrand Russell said, efficiency is the highest form of altruism.  In striving for efficiency, using resources efficiently in the way prices direct, corporations are acting in a responsible, altruistic way–even if that is not their intent.

Prices and profits are signals that corporate managers and directors can understand and respond to.  Vapory concepts of “social responsibility” provide no real guide as to the costs and benefits of alternative actions.  This is just a concept that can be enlisted to advance political agendas, and to rationalize the direction of valuable resources to those making claims for them that cannot be justified based on economic calculation.  There is always an unlimited supply of people clamoring that they are truly deserving: how is it possible to choose between these competing–and collectively unachievable–demands?  It isn’t.  And it is pointless and wasteful to expect corporate managers and directors to do so, rather than do what they are capable of doing–directing resources to the highest value resources, as indicated by prices.

Sometimes prices are misleading, because of externalities, for instance–or because of government policies (e.g., tariffs, explicit and implicit subsidies).  But as Bainbridge says, there are other, more targeted ways to deal with those problems.  These include specific legislation, regulations, and the tort system.  All are imperfect–believe me, I know–but at least there are procedural checks and balances that force some attempt to justify the benefits and costs, and provide an opportunity for others to challenge these claims.  In contrast, imposing some sort of vague duty on corporate officers to “do good” is subject to no such checks.  Some may try to do good, but may do ill instead because they lack the incentive or information to do real good.  Others may use “social responsibility” to indulge their own preferences while imposing great costs on others whose resources they utilize in the cause.

But more ominously, creating a presumption that corporations have some broader social responsibility subjects them to political pressure, often verging on blackmail and at times crossing over that line.  It effectively subordinates corporations–and hence their living, breathing shareholders, for those who recoil at the idea of assigning personhood to a corporation–to politicians who arrogate to themselves the role of speaking in the public–“social”–interest.  This is exactly why the idea is catnip to progressives like Obama.  They don’t like government power constrained by Constitutional and procedural checks and limits.  They don’t like limits on their discretion.  Passing laws or imposing regulations that are subject to legal challenge are a lot harder than executing a shakedown.  Once corporate executives concede that their responsibility is not limited to maximizing shareholder value, they become political puppets always vulnerable to such shakedowns.  There are always competing claims on corporate resources, and political entrepreneurs more than willing to exert those claims.

If you want to see extreme examples of how this works, look at Chavez in Venezuela, or Putin, both of whom browbeat corporations and investors to direct resources to their pet causes in the name of “social” objectives.  And no, I’m not saying Obama=Chavez.  I’m only saying that looking at something in its most purified or extreme forms is often the best way of identifying the essential principle.

The corporate responsibility movement is just another flavor of corporatism.  A conscription of private resources to achieve political (and usually redistributive) objectives, but without the procedural hurdles that constrain such conscription via legislation, regulation, or adjudication.  Which is exactly why progressives like Obama find it so attractive.

The SEC is continuing to flog the idea of imposing obligations on high frequency traders:

Regarding market structure, Schapiro said more work needs to be done to shore up investor confidence and transparency amid advances in high-speed trading.

“We are examining trading or other obligations that might be required of today’s de facto market makers: the high-frequency traders,” said Schapiro during remarks at SEC Speaks, a conference hosted by the Practising Law Institute.

“We are asking if these firms should be subject to an appropriate regulatory structure, including with respect to their quoting and trading activities.”

As I’ve said numerous times before: ain’t nothing for free.  Obligations impose costs, and the costs may be large as what Schapiro describes would constrain HFTs to offer more liquidity during times of high risk/uncertainty; if the obligations are binding, it means that HFTs must incur very high costs to supply liquidity during these periods as some prefer to make no market at all, or only very wide markets then.  They only act in that way if it is extremely risky–costly–to make markets then.

These costs must be covered.  Since entry into the market is relatively free, market makers earn a competitive rate of return on their capital.  Higher costs in some states of the world depresses that rate of return, leading to an exit of capital and higher trading costs for liquidity consumers at other times.  Thus, imposing obligations will reduce liquidity on average, and redistribute liquidity over time.

It’s also important to remember that the withdrawal of capital will offset even in volatile times the liquidity-enhancing effects of the obligations.  Yes, those market makers who remain will put a bigger fraction of their capital at risk during those periods, but there will be less of it overall to risk.  The net effect is likely to be positive during these volatile times, but probably not as much as Schapiro and others believe.  It seems that they assume that the obligations are costless and will not affect the supply of market making capital.

It is also costly to enforce these obligations.  It is costly to specify them.  This is especially true with HFT.  Liquidity has many dimensions.  How do you specify obligations on all dimensions?  What happens if crucial dimensions are left out of the rules?  How can programmers game the rules?  I have seen no serious discussion of these issues from Schapiro et al.  Economists are often–rightly–ridiculed for assuming the existence of 100 story ladders to rescue them from burning high rises, but regulators and legislators are far, far worse in this regard.

Historically, the NYSE imposed obligations on specialists.  But it compensated the specialists by giving them privileges: these privileges inflated trading costs during periods when the constraints weren’t binding.  Enforcing the constraints wasn’t easy, and in periods of extreme stress–such as 19 October, 1987–it is hard to judge whether they really performed the way their advocates would like.

Other markets–the futures exchanges, most notably, and the OTC stock and derivatives markets–have never imposed obligations.  It’s by no means clear that they’ve suffered as a result.   If these constraints are beneficial, why wouldn’t exchanges implement them unilaterally?

For once, I would like to see a serious analysis of the costs and benefits of obligations.  Schapiro keeps touting them, hyping their benefits but never even acknowledging the costs.

A serious argument would require identification of some sort of externality.  There have been papers (Greenwald-Stein in the aftermath of the ’87 Crash comes to mind) that have done so.  But even in the context of those models, it’s not obvious that market making obligations are the best way to respond to uncertainty shocks.  Greenwald-Stein argue that trading halts–circuit breakers–can handle the problem.  In the old NYSE, specialists could call trading halts when order imbalances became extreme.  This has some advantages over price-based circuit breakers, but in the current decentralized market structure, it’s hard to observe aggregate order imbalances–ironically, this is a consequence of an earlier SEC initiative, RegNMS.

Schapiro talks a lot about market maker obligations.  Well, what about regulator obligations?  Like the obligation to make a serious case based on a well-thought out diagnosis of the problem, and a careful identification of the sources of costs and benefits, and quantification thereof.  Liquidity was in short supply during the Flash Crash, but regulators acting in such a responsible way are in chronic short supply, especially in the world of Frank-n-Dodd.