Streetwise Professor

June 2, 2013

If Senators Say Something “Stands to Reason” It Probably Doesn’t

A group of senators from western states, led by Diane Feinstein, have sent Gary Gensler a missive accusing the CFTC of violating the letter and spirit of Frankendodd by failing to register major energy companies (e.g., BP, Shell) as swap dealers.  Each paragraph of the letter is more risible than the one before.

They set the scene by recounting the western electricity crisis of 2000-2001.  This is utterly irrelevant to the swap dealer designation, because swaps had nothing to do with what happened then and there.  Indeed, at its core the crisis was driven by a combination of fundamentals and flawed market design, and even the suspect trading strategies involved physical market transactions rather than swaps.  For instance, none of the Enron strategies like “Fat Boy” or “Ricochet” involved swaps or OTC derivatives generally in any way, shape, or form.  (It’s also rather ironic that one of the things that wreaked havoc with California utilities was that they were precluded by law from engaging in forward transactions to hedge the short position forced upon them by the retail price caps in the restructuring legislation.)

Parts of the letter made me laugh.  Most notably, the senators attack the $8 billion de minimus exemption from the registration requirement.  Their “logic” is that since commodity swaps represent a small fraction (less than one percent) of total OTC derivatives activities, the de minimus level for energy swaps activity should be lower than for financial swaps. Not just lower: “vastly lower.”

They say this “stands to reason.”  Whenever anyone says something “stands to reason” s/he really means: “I can’t give you an actual reason, so I’ll just assert that my conclusion is obvious.”

This gets to the issue of just what the swap dealing designation is intended to achieve.  That’s always been somewhat hazy, but the most charitable interpretation is that swaps dealers are deemed potential sources of systemic risk that require extraordinary regulatory scrutiny.  The risk a particular firm poses to the financial system as a whole depends on its size relative to the entire financial system, rather than to any particular market, so even accepted the premises of Frankendodd the swap dealing designation should not vary by market.  (Indeed, from a systemic perspective, even $8 billion/year on a flow basis is ridiculously small.)

The senators also fret over the possibility that allowing the Shells and BPs of the world to escape the designation will limit the CFTC’s ability to deter manipulation and fraud.  Hardly.  Those things are still illegal, and swap dealing designation will have no impact whatsoever on the CFTC’s ability to detect and deter.  (Which may not be saying much, because all too often the CFTC wouldn’t know a manipulation if it hit the CFTC in the face with a waffle iron.)  (I consider it ironic that these Solons refer to the BP propane manipulation, which was discovered, prosecuted, and punished when the swap dealer designation was not even a twinkle in Barney Frank’s eye.  Bad mental image, I know.)

Relatedly, the senators worry about “transparency”, but all swaps trades will still be reported to central repositories.  The only way the dealer designation matters in this regard is it affects/determines who has to report.  (I shall pass over in silence the fact that the CFTC is at present utterly incapable of utilizing the data reported to the repositories, as Commissioner Scott O’Malia has repeatedly pointed out.)

But most importantly, the senators miss the elephant in the room.  No major energy firm has registered as a swaps dealer because energy firms have shifted trading from swaps to futures.  Another premise (flawed, but there  it is) behind Frankendodd is that swaps are somehow more dangerous to the system than futures.  The legislation and the rules under it imposed more onerous requirements on swaps than futures, in large part to encourage the movement of trading to futures markets.

So if these senators actually applied reason, rather than just hiding behind a stand-in for it, they should be overjoyed that no major energy firm has applied to be a swap dealer.  This should be a feature, not a bug.  It means that market activity has shifted to the venue that these very same senators and others who voted for Frankendodd considered to be the preferred model for trading derivatives: open, transparent, and subject to a rigorous regulatory regime.  Most notably, from a systemic risk perspective, futures are cleared, and one of the major requirements imposed on swap dealers is a clearing requirement.  So the specter of the swap dealing designation, with its associated burdens, has actually led firms to transfer trading activity from the satanic swaps markets to the sainted futures exchanges.  Yay!

But arriving at this understanding would require actual, you know, reasoning.  Not much, but some.

And that is a bridge too far when it comes to the World’s Greatest Deliberative Body.  Which may be a correct description: if so, God save the world.

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6 Comments »

  1. Very cogently presented, Prof. But, I don’t think you should “pass over in silence the fact that the CFTC is at present utterly incapable of utilizing the data reported to the repositories, as Commissioner Scott O’Malia has repeatedly pointed out.” The CFTC is in the same early-stage inundation of data and complexity that ultimately overwhelmed that hapless collection of mediocrity in Washington known as the SEC. Which tells me you’ll be addressing this sooner or later.

    Congress permitted the SEC to institute the Consolidated Supervised Entities program in 2004, which effectively made a handful of used-to-be-investment banks SROs reporting to the SEC’s Division of Trading and Markets (an oxymoron if ever there was one at an institution that cannot even comprehend what markets are or do). In return, all they had to do was report their assets’ valuations — numbers they hypothesized based on their own assessments of the value — and their risk positions and leverage ratios under calculations they devised and reported. Apparently, years of this type of reporting went completely unscrutinized, mostly because the folks at the SEC were and are lawyers, and are incapable of understanding what was sent their way. Nor could they determine whether any of it made sense. So the files went unopened. (There’s a whole ‘nother story about how this was orchestrated by none other than Hank Paulson while he was at GS — a used-to-be-investment-bank — then got to undo the damage it created while he was Treasury sect’y. But that story’ll never be written.)

    If the folks trading in futures and derivatives markets are smart, they’ll have learned their lesson from Hank: The best way to get everything you want — i.e., de facto relief from all regulation — is to inundate your regulator with so much complex information and code that they will never even bother to open the files submitted under the regs. Even if they do, no one at the regulator will be able to decipher or understand what they’re looking at.

    So, in the end, everyone wins: Reports get filed per the letter of the law, the regulator can catalogue their arrival and report in whatever manner Congress mandates, and that’ll be the end of it.

    Just for sh*ts and giggles, see this statement of Charlie Cox, that towering intellect who used to supervise those used-to-be-investment banks at http://www.sec.gov/news/press/2008/2008-230.htm announcing the end of that Consolidated Supervised Entities program in 2008. Gosh, he sounds upset. 🙂

    Comment by markets.aurelius — June 2, 2013 @ 5:00 pm

  2. Thanks, @markets. I did a post on the data issue a month or two ago. Don’t worry. I will revisit it 🙂

    It’s funny you mention lawyers at the SEC. They rule the place. A guy I worked with years ago was interviewed to be chief economist. He told me that during the interview, the head of enforcement told him: “I don’t care what you do, just stay the fuck out of my way.”

    That’s working out so well, isn’t it?

    Re Cox. Oh yes, a towering intellect. Type in “Cox” in the search bar to find my Chris Cox story. I think you’ll find it amusing, though not surprising.

    The ProfessorComment by The Professor — June 2, 2013 @ 6:29 pm

  3. Seems there are more Cox references than I remember. Here are the greatest hits. The scary thing is the the was considered one of the smartest people in Congress, and he probably was.

    The ProfessorComment by The Professor — June 2, 2013 @ 6:36 pm

  4. @markets. I mention the CFTC’s inability to utilize the data that market participants provide at such cost here. I am sure there will be many opportunities to come.

    The ProfessorComment by The Professor — June 2, 2013 @ 7:24 pm

  5. Thanks for the posts, Prof. Two things immediately are striking:

    1) When the head of the SEC (e.g. Chris Cox) knows nothing about markets, and can easily be swayed by people who supposedly do (remember the heads of the used-to-be investment banks were on the phone 24/7 with Hank Paulson lobbying really hard for the ban on short selling, too, back when Cox was wringing his hands in dismay), you will always get bad policy. (That actually could be an ironclad rule of markets.)

    and,

    2) It is apparent no one at the SEC in the present day — judging from your recent posts re single-name CDS — is even remotely familiar with Robert Merton’s 1973 article “Theory of Rational Option Pricing.” If they were, it would be immediately apparent how important single-name CDS are to overall market efficiency. I am often stunned by the complete lack of understanding of how important these markets are and how ignorant the regulators are. The SEC and CFTC should be doing everything in their power to complete markets and provide liquid arbitrage opportunities so that mis-pricings are quickly removed. The macro benefits would be durable and long-lasting. Go figure.

    Comment by markets.aurelius — June 3, 2013 @ 7:10 am

  6. […] If Senators Say Something “Stands to Reason” It Probably Doesn’t A group of senators from western states, led by Diane Feinstein, have sent Gary Gensler a missive accusing the CFTC of violating the letter and spirit of Frankendodd by failing to register major energy companies (e.g., BP, Shell) as swap dealers.  Each paragraph of the letter is more risible than the one before. https://streetwiseprofessor.com/?p=7305 […]

    Pingback by The week that was (aka Dazzling Derivatives; issue of 4.6.2013) | The OTC Space — June 5, 2013 @ 7:04 am

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