Streetwise Professor

Sorry about the silence, folks.  I was in Geneva doing my annual teaching in the University of Geneva’s Masters program in International Trading, Commodity Finance, and Shipping.  It is a very unique program, and a joy to teach in.  I also spoke at the annual Trading Forum sponsored by the Geneva Trading and Shipping Association (which also sponsors the Masters program).  I spoke about Frankendodd, which is somewhat ironic given that Mary Shelley wrote Frankenstein on the shores of Lac Leman a few miles from Geneva.

Some quick catch up.

First, Bloomberg is threatening to sue the CFTC for discriminating in favor of futures and against swaps.  Bloomberg plans to launch a SEF, and (rightly) believes that the discrimination regarding the margin requirements will seriously impair the prospects for its success.

At the annual FIA gathering in Boca, Gary Gensler doubled down in his support for the discrimination (a Risk Magazine link, so a subscription is required):

“Under clearing rules finalised in 2011, swaps executed on a designated contract market or a Sef have the same margin requirement – one day for energy, metals and agriculture, which is where we as a market have been for years. Interest rate swaps have been cleared for nearly 10 years on LCH.Clearnet. They have used a practice for many years around five-day minimum margining,” Gensler told Risk, after his prepared remarks yesterday at the Futures Industry Association annual conference in Florida.

How’s that for an answer lacking any intellectual content or analysis?  LCH’s done it that way in interest rates for many years, so everybody should do that for everything going forward.

Got it.  Why think when you can merely defer to precedent, regardless of how relevant that precedent is?

Someone is thinking, and echoes my analysis of the inanity of treating economically equivalent instruments differently just because one is called a “future” (good!) and the other a “swap” (bad! bad! bad!):

“If there are two products that are equally standardised, that take the same time to liquidate, that have the same risk, volatility and liquidity characteristics, then both of them should be subject to the same margin requirement. Collateral should be determined on the characteristics of the product in question, not the wrapper,” said Sunil Hirani, chief executive of fledgling interest rate swap and futures exchange TrueEx, speaking on the sidelines of the conference.

“If a contract takes five days to liquidate then it should be subject to five-day value-at-risk, and a one-day liquidation product should be subject to one-day VAR. If a futures contract has worse risk, liquidity and time-to-liquidation characteristics than a swap, but then receives a more favourable margin treatment because it’s in a futures wrapper, that is an injustice,” he added.

My only quibble is that it’s not an injustice, it’s a recipe for regulatory arbitrage and potentially for systemic risk.

Speaking of SEFs, Scott O’Malia told Risk that progress on writing the SEF rules-which had been expected any day-is slow.  Tiresomely, this also bears the fingerprints of Gensler’s meddling hand:

Nonetheless, at a panel discussion on Sefs held earlier in the day, O’Malia recited the Dodd-Frank definition of a Sef and observed pointedly that “the word five does not appear anywhere in there” – an allusion to the controversial proposal that any request for quote (RFQ) via a Sef must go to a minimum of five dealers.

“[CFTC chairman] Gary Gensler’s original position was that he did not want Sefs to include RFQ capability at all,” says one chief executive of a trading platform that plans to register as a Sef. “His initial hope was to restrict all these new venues to a central limit order book model, but when it became clear that an order book would only work for the most liquid swap contracts, he conceded the need to permit RFQ as an execution method, but included the stipulation that quotes must be sought from a minimum of five market-makers.”

And some dealers claim this is now the major impasse, with Gensler said to be refusing to drop the so-called RFQ5 provision from the final language or bring it into line with corresponding Securities and Exchange Commission rules for securities-based Sefs, which state that an RFQ can be sent to a single dealer.

So again, Gensler wants to dictate market structure: every SEF has to have a CLOB foot.  One size fits all.  No appreciation whatsoever for the fact that there is a diversity of market participants and interests that may well be served by a diversity of execution mechanisms.  No appreciation for the fact that the supposed beneficiaries of Gensler’s would-be fiat might actually know their own interests better than he does.  No appreciation for the fact that the discovery process of competition can result in the creation of a set of SEFs that best matches the diverse needs of market users, and that this competition may spur innovation that would result in the creation of an as yet undreamed of trading mechanism that meets market users’ needs far better than a CLOB.

Keeping this Gary Knows Best attitude in mind, be afraid, be very afraid when you read this story of about the next potential target of CFTC inquiries: price setting mechanisms. Taking inspiration from the Li(e)bor issue, the Commission is now (informally) discussing the possibility of investigating other benchmarks, notably the London gold and silver fixes:

“The idea that pervasive manipulation, or attempted manipulation [of interest rates], is so widespread should make us all query the veracity of the other key marks,” said CFTC Commissioner Bart Chilton at a Feb. 26 roundtable in Washington on financial benchmarks. “What about energy, swaps, the gold and silver fixes in London and the whole litany of ‘bors’?” he said, referring to Libor, Euribor and other benchmarks.

What’s rather disturbing is the linking of the gold and silver fixes and “bors”.  These things are very different.  The main problem with Li(e)bor, etc., is that they are not set on the basis of transactions: on this I agree with Gensler, having been making this point in an interest rate and commodity context for going onto 20 years.  (In my 1992 book Grain Futures Markets: An Economic Appraisal, I criticized proposals for cash settled grain contracts due to the lack of cash transactions on which to base an index.)

In contrast, the LBMA fixes are centralized auction mechanisms (Note to Gar: nearly a CLOB!)  Indeed, they are textbook examples of a Walrasian auction.  An initial price is mooted, and the participants indicate the amount they want to purchase or sell at that price: the quantity announced by each participating bank includes customer bids and offers, so buying and selling interest reflects more than just the proprietary trades of the fixing banks.  If at the initial price there are more buys (sells) than sells (buys), the price is increased (decreased), and each fixing participant again indicates its trading interest at the new price.  The process continues until buys equal sells, i.e., until the market clears.

Crucially, participants in the auction who are buyers (sellers) at the clearing price take (make) delivery of metal in an amount equal to their bid (offer) quantity at that price.  That is, the clearing price results in actual trades.  This is miles different than Li(e)bor.

This is not to say that a Walrasian auction cannot be manipulated: for instance, a company with a large long derivatives position that has a payoff tied to the fixing price might want to put in large buy orders in the fix to drive up the clearing price in order to impact favorably the payoff of the derivative.  Here the relevant issue would be the impact of orders on the clearing price.  That’s a totally different issue than in Li(e)bor, but I’m quite concerned that CFTC views all benchmarks as indistinguishable pieces in a mass.

And Gensler’s analysis-free treatment of futurization and SEFs only fuels those concerns. Good policy needs to be predicated on good analysis, not the prejudices and suspicion of the policymaker.  Gary Says So ain’t good enough, even for government work.  But too often that’s what we are getting.  We’ve seen it with futurization and SEFs, which raises legitimate concerns that the same will occur with benchmarks.  The confabulation of LBMA fixes with ‘bors only heightens those concerns.

A side note (added later): The suggestion that the CFTC can examine the London fixes betrays incredible hubris.  How could the US CFTC possibly have any jurisdiction over a UK entity-the LBMA-or the conduct of banks, only one of which (HSBC USA) is a US entity?  Especially given that as far as I am aware there is no CFTC regulated derivatives contract tied to the London gold or silver fixes.  But Gensler is all about extraterritoriality, so don’t put it past him to try.  I hope he tries, actually.  The Brits will go totally ballistic if he does.  Perhaps that’s exactly what’s needed to constrain GiGi’s imperial ambitions.

One other thing.  I didn’t mention anything about clearing, but Gensler’s analysis-free approach has been particularly prominent there.  To say that his “analysis” of clearing over the past 4 years has epitomized a comic book approach to the issue is an insult to the intellectual rigor of comic books.