Streetwise Professor

January 13, 2010

Gary Appleseed, Populist Crusader

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 7:51 pm

Gary Gensler is following in Timmy! Geithner’s footsteps, striking a populist pose to argue for forcing virtually all derivatives trades onto exchanges:

“Big Wall Street banks” benefit from a provision in derivatives legislation that has been promoted as aid for companies hedging their own risks, Commodity Futures Trading Commission Chairman Gary Gensler said.

“It is the Wall Street banks that benefit from the so- called end-user exemption from transparency, not the businesses that use derivatives,” Gensler said yesterday in a speech to the Atlantic Council in Washington criticizing the provision.

Talk about a false choice.  Gensler’s statement presumes a zero-sum game: if banks win, customers must lose.

Uhm, Gary, ever heard of mutually beneficial transactions?  Gains from trade?  Positive sum games?  How about “win-win”?  No?

And how does Gensler explain that the end-users have been among the most outspoken advocates for exemptions?  The mesmeric powers of Lloyd Blankfein and Jamie Dimon?  Battered spouse syndrome?  Or have a cabal of “Wall Street bankers” kidnapped large numbers of children of derivatives users, with the ransom being paid in lobbying?

And how does Gensler explain the fact that end-users have voted with their checkbooks to trade OTC even when exchange traded alternatives are available?  Does he know their businesses better than they do?

To paraphrase H. L. Mencken, Gensler and the rest of the DC crowd seem to be financial Puritans, haunted by the fear that somewhere, in the darkest recesses of the OTC market, consenting adults may be happy, making mutually beneficial deals.

And Gary, give the apple thing a rest:

“We would not tolerate it if other markets operated similarly to over-the-counter derivatives, where dealers are the only ones with much of the relevant information,” profiting from spreads between bids and offers that are wider than they would be in an open market, Gensler said.

He compared the situation to “buying an apple from the supermarket when the price of the apple is kept private.”

(Note to self: work on controlling the eye-roll reflex.)

Where to begin?  First, in point of fact, we tolerate these kinds of markets in just about everything.  I would wager a pretty sum that even if you wanted to limit the discussion to apples, that most wholesale apple trades were undertaken in “search markets” (like the OTC derivatives market) with negotiated prices, rather than posted prices like in the grocery store.  That’s pretty much the case in cash markets for most commodities.  Second, for vast numbers of other goods, search for counterparties and negotiation of prices is the norm, and posted prices the exception; sometimes the posted prices are just a focal point for the beginning of negotiations, like with cars.  This is especially true for expensive, differentiated goods–as most OTC derivatives are.  There are a variety of different marketing and pricing mechanisms in markets, and these mechanisms are adapted to the characteristics of the goods, the sizes of the transactions, and the individuals and firms that trade them.  Third, it is definitely the case that centralized auction markets (like futures exchanges) are the extreme exception.

In brief, taking his apple metaphor seriously, Gensler apparently believes that myriad goods and services are priced and marketed inefficiently.  Why should he stop at regulating OTC derivatives when virtually every wholesale market, and many retail markets, are obviously in need of his penetrating insights?

The first time I read of Gensler using the apple analogy, I thought it was lame.  The second time it sounded positively stupid.  Word to the wise: never fall in love with your analogies, especially if they’re bad ones.

And as for the assertion that spreads are wider than they would otherwise be, why do end-users choose to trade on OTC markets, even when there are close exchange traded substitutes (e.g., interest rate swaps and Eurodollar futures)?  Again, on an all in basis, the end-users must think they’re getting a better deal.  Or, again, does Cotton Gensler know what’s good for them?

But as entertaining as all the above is, the best thing in the article was at the end:

“There’s a legitimate public policy debate,” he said. “Corporate America is on one side of the debate, I’m on the other.”

Gary Gensler, Lone Crusader, Stickin’ it to The Man!

If this wasn’t so serious, it would be hilarious.

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  1. The only supporting point I see for clearing is that it makes things more transparent. Although it doesn’t reduce risks. Transparency might make it difficult for agents to willfully make bad decisions and blame opacity & complexity of the products for it.

    Comment by Surya — January 13, 2010 @ 10:33 pm

  2. There are key distinctions to be made within the ‘clearing’ process as between:

    (a) transaction registration – which gives legal effect to a contract;

    (b) settlement – and the possibility of ‘netting’ and closing out of equal and opposite transactions;

    (c) guarantee of performance.

    Bringing OTC performance risk on-exchange creates a single point of failure, and concentrates risk with the intermediary central counterparty, and increases the requirment for capital to support the risk.

    It is not necessary to concentrate risk with intermediaries – who are increasingly starved of capital – in this way. It is quite possible to operate a ‘Clearing Union’ approach whereby market participants are subject to a mutual guarantee of bilateral obligations, backed by collateral, or perhaps by provisions made to a default pool in common ownership. Ship hulls are mutually insured on sch a basis through ‘P & I Clubs’, with the risk managed by a service provider eg Thomas Miller and the TT (Through Transit) Club.

    Such a guarantee is an optional ‘bolt on’ to the other elements.

    When giving evidence in respect of global oil markets to the UK Parliament’s Tresury Select Committee I proposed global energy transaction registration, and the creation of an energy market user group – International Energy Trade Association – with exclusive use of transaction registries. This opens up a new mechanism for transparency, and also enables new regulatory ‘teeth’ to be applied – to those who do not meet agreed market standards – through the ability to suspend or terminate the right to register transactions.

    Finally, if transactions are held neutrally by a custodian, it would be possible to deploy netting/settlement tools enabling the identification and close out of ‘chains’ of transactions, similar to the ‘daisy chains’ and book outs which were commonplace in the operation of the Brent/BFOE forward market.

    Comment by Chris Cook — January 14, 2010 @ 8:52 pm

  3. Chris,

    With respect to your contention that transaction registration would effect a mechanism for greater transparency, I would agree. I am not sure, however, that submitting trade details to a central clearing house is the beat way to effect transaction registration.

    For years there has been a group pushing for OTC energy markets transaction registration via a central data hub. One argument for this is that greater transparency would lead to more effective calculation of market risk and more effective pricing of that risk by market participants. There are, however, certain participants who make significant amounts of money off of inefficiencies in the marketplace and the mispricing of risk. As long as these participants continue to offer enormous sums of money to various politicians in order to prevent more the effective calculation and pricing of market risk, the interests of the marketplace will be secondary to the interests of politics.

    In my mind, it would make much more sense to immediately push the energy trading marketplace (willingly or unwillingly) to greater transparency by mandating a central data hub (much like TRACE for corporate bonds) and continue to discuss the proper role of clearing houses while we examine and discuss the effects of market transparency on the pricing of risk in the marketplace than it would be to push the transaction registration function toward a central clearinghouse at this time.

    Comment by Charles — January 15, 2010 @ 11:44 am

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