Streetwise Professor

September 29, 2010

Dear Dad: Send Money. And Power.

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:05 pm

No, this is not a letter/email from a poor–and megalomaniacal–college student.  It is a (slightly) snarky characterization of recent statements coming from the CFTC.

First, the money.  From Reuters (here’s a link to a related story: can’t find this story which was emailed to me):

The U.S. futures regulator could be forced to rein in tough new plans to tighten oversight of the $615 trillion over-the-counter derivatives market if it does not get promised new funding, two of the agency’s commissioners said on Tuesday.

If the Commodity Futures Trading Commission is denied the extra funding requested for fiscal 2011 it will have a hard time hiring staff needed to implement Wall Street reforms, said Jill Sommers  and Bart Chilton, commissioners with the CFTC.

“If we do not have the resources, we shouldn’t have ambitions that go beyond those resources,” Sommers, a Republican commissioner, told Reuters.

In a separate interview, Chilton, a Democratic commissioner, said the agency would be “in real trouble” if it went six months without a boost, and said he worries the CFTC could be in a lurch for the whole year.

“We would … have to pick and choose parts of the bill to implement — and that would mean things would not get done on time, as Congress as suggested,” Chilton said.

There is no doubt that CFTC needs a substantial boost in money and people in order to meet the Frank-n-Dodd requirements.  But given the daunting tasks, some devastating problems are inevitable.  CFTC cannot rely on existing self-regulatory organizations to to much of its heavy lifting in the markets it is now responsible for.  Moreover, dramatically scaling up the size of an organization inevitably creates problems as inexperienced people are brought in and experienced people are pushed beyond their capabilities and competence.  There will be problems.  Even train wrecks.  Plural.

The CFTC reminds me of the dog that finally caught the car, and asks: “Now what do I do with it?”

Second, the power.  Two pieces to this, just today.  The first is Gary Gensler’s floating the suggestion that the CFTC should have authority to set position limits just for energy, ags, or metals, but CDS as well:

Commodity Futures Trading Commission Chairman Gary Gensler said it’s “important” to have limits on trading positions in credit-default swaps as well as for commodities derivatives.

Regulators should have the authority to set position limits both on credit-default swaps and physical commodities derivatives, Gensler told a conference on financial rules in Brussels today. Limits “allow us to better protect against abusive practices.”

“We’ve been setting position limits in agricultural commodities and energy commodities for decades so we can learn from that,” Gensler said in an interview. Details of limits for credit-default swaps “are yet to come.”

Position limits are a bad idea to start with.  And apropos the money part of the post: Yeah.  More things on its plate in markets which it has no experience in regulating.  Just what the CFTC needs.

But this isn’t the only contemplated exercise of power in today’s news.  The CFTC is also considering mandating limitations on financial institution ownership of CCPs, along the lines of the Lynch Amendment that was one of the body parts left out when Frank-n-Dodd was stitched together:

The Commodity Futures Trading Commission is considering limiting banks and investors to owning no more than 20 percent of swaps clearinghouses, exchanges and trading systems, three people familiar with the matter said.

The CFTC, which will present its first proposed rules Oct. 1 for the $615 trillion over-the-counter derivatives market, may not grant exemptions for existing holdings, said the people, who declined to be identified because the talks haven’t been made public. Groups made up of bank holding companies, non-bank financial firms, major swaps users or dealers may not own more than 40 percent of clearinghouses, the people said.

Companies that may have to change their ownership structure include London’s LCH.Clearnet Ltd., the world’s largest interest-rate swap clearinghouse; Tradeweb Markets LLC, a derivatives trading platform; and NYSE Euronext, whose U.S. futures exchange is partly owned by banks.

Kevin McPartland is justifiably flabbergasted:

“What is an LCH.Clearnet going to do, that’s almost completely dealer-owned?” said Kevin McPartland, a senior analyst with Tabb Group in New York. “I can’t see how they’d expect that kind of massive divestiture of these clearinghouses that control trillions of notional” in swaps trades, he said.

Ah, but Kevin, you just haven’t fully grasped Gensler’s grandiosity (see above CDS position limit power grab).  The sorcerer’s apprentices are run amok, my friend.

The “theory” underlying this limitation is that it is necessary to combat conflicts of interest, whereby bank owners of CCPs might decide to eschew clearing of certain products that they profitably trade OTC.  Note that this problem could be avoided by ensuring that collateral and capital on cleared and non-cleared deals is chosen properly.  (Not that I am convinced that regulators can do that, but they think they can, and if they can, micromanaging the governance of CCPs is unnecessary.  And if they can’t: why the hell were they given this responsibility?)

In my view, this is a secondary or tertiary or whatever comes after tertiary consideration.  The key issue is aligning the incentives of those who govern CCPs and those who bear the risks.  Failure to do so will lead to a series of serious problems. The most important is that the CCP will have difficult attracting the capital necessary for it to provide its guarantee function because those that can most efficiently supply the capital will not do so if they are not given control rights commensurate to the risks that they are expected to take on.  If the idea behind mandating CCPs is to ensure the existence of sufficient capital to absorb big default losses, this is extremely counterproductive, to say the least.  And just think of the governance and management headaches that are inevitable when there is such a misalignment of incentives.

Historically CCPs have been dominated by financial institutions–banks, often–that are the residual risk bearers.  The ubiquity and survival of this model suggests strongly that it offers some substantial economic benefits.  Restrictions on CCP ownership and control will undermine this model, and likely make it impractical.  So what will take its place?  And if the substitute is so great, why didn’t market participants adopt it already?

It is hard to know what is more astounding about this idea: its presumptuousness, or the superficiality and incompleteness of the “analysis” supporting it.

Money.  Power.  Methinks there will be many more installments of this melodrama in the months to come.

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