Streetwise Professor

July 23, 2009

Hoping that Bismarck Was Right

Filed under: Uncategorized — The Professor @ 9:51 pm

Pressure is at near record lows in that vortex of stupidity, Washington, DC.  Noted financial wizard Maxine Waters proposes to ban credit default swaps. Financial prude Colin Peterson doesn’t want to go that far–he just wants to ban naked ones.  The Senate holds hearings on puzzling developments in the wheat market, and instead of making inquiries regarding the true mysteries, continues its monomaniacal campaign against the least likely culprit, passive index funds.  Regulators testify in front of Congress, and offer pearls like this:

“Regulators would be able to see (the clearinghouses) and rigorously oversee them,” Gensler said. “I believe over time you might see a consolidation and a concentration in this, but initially the statute would allow for more than one.”

Gary, there you go, making me break out the Ginsu again.*

Yeah, maybe the statute would allow for more than one, but it is well known that there are strong scale and scope economies in clearing.  (I’ve written on this before, and if you don’t believe me, take a look at Darrell Duffie’s paper on the subject.)  It is almost certainly most efficient to have only one clearinghouse that clears pretty much everything.  Having multiple clearinghouses in fact undermines the main benefits of clearing.  Moreover, due to these very same scale and scope economies, natural economic forces are likely to lead to consolidation resulting in the survival of a single big clearinghouse.  Where huge risk will be concentrated.  Too big to fail on steroids.  Worried about the interconnection of big financial players?  Well, this clearinghouse will be a single entity connecting all major financial intermediaries.  So, if you mandate clearing, you are mandating an extreme concentration of risk.

So, it is deeply irresponsible of Gensler to recognize, on the one hand that there might be (understatement alert!) concentration and consolidation, and then blow off the serious systemic risk questions this implies with a lame statement about what statutes would allow–but couldn’t mandate.

The lack of thought over these extremely important and complex issues is endemic.  Here’s Peterson:

“Barney and I are going to have mandatory clearing,” said Peterson. Under that approach, all contracts would go to central counterparties. If a clearinghouse rejected a contract as being specialized, the SEC or CFTC would set the margin and collateral requirements for it.

“I imagine SEC and CFTC will set higher margins” and reserves, said Peterson.

The Agriculture Committee bill passed in February would allow the CFTC to suspend trading of “naked” credit default swaps (CDS). The reform bill would go a step farther, said Peterson — “We’ll probably ban naked credit default swaps.”

“I imagine SEC and CFTC will set higher margins.”  (Cue John Lennon.)  OK, pick a number.  Tell me the methodology for picking the number.  What cosmic wisdom will inform the SEC and the CFTC when they determine what the right margin level is?  Will the agencies just pick a nice round number, like 50 percent, and then keep it there, for I dunno, 35 odd years?  Will this number be the same for all firms, regardless of their creditworthiness?  What information will the agencies have?  Can they possibly have better information than sophisticated market participants?  Will their choice of margin be uncontaminated by political pressure?  (Clearing operators, for example, will lobby the agency to raise OTC margins in order to impede competition from the OTC markets.)  In brief why should we believe for a minute that the CFTC, the SEC, or their future spawn have the knowledge or the incentive to determine the appropriate margin levels more effectively than market participants?

We are talking about trillions of dollars here.   The largest financial markets in the world.  And this is the level of thought that is going into to completely re-engineering them.  One hopes that Bismarck was right, and there is indeed a special Providence for fools, children, drunkards, and the United States of America.  We’ll need it.

*In a recent newsletter, futures industry maven John Lothian made this comment about one of my earlier posts on Gensler: “Gary Gensler gets the ginsu knife treatment (figuratively) from the Streetwise Professor, Craig Pirrong.”

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1 Comment »

  1. How about ideas like this,
    “One proposal would be for bank regulators to set significantly higher capital requirements for securitization transactions – one that requires 100% from regulatory capital for opaque and illiquid transactions.” (

    From the Friedman report, we know that the capital requirement regulation and the ability to avoid it through the AAA ratings obtained as a result of securitization played a key role in the build up of the toxics. Hence, wouldn’t a change in the cap requirements to reflect our lack of understanding of these a good idea?

    Of course – this might simply mean that more banks (perhaps some big name ones) go insolvent right away. Is that why such proposals are not being considered?

    Comment by Surya — July 24, 2009 @ 12:41 am

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