Streetwise Professor

October 5, 2010

Mary and Gary Procrustes

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 5:15 pm

This article (now gated, unfortunately) makes some spot-on points about the regulatory train wreck to come.  In particular, it makes pretty clearly a point that I’ve written about a few times here on SWP: namely, that all of the mom-and-apple-pie paeans to transparency are simpleminded, and fail to take into account substantial variability across instruments and the people who trade them.

He article quotes Mary Schapiro, and then goes off on her with some tart sarcasm, and justifiably so:

The challenge for the SEC, as Schapiro sees it, is to “cultivate” a market structure for security-based swaps “that reflects the virtues of the current equities market: competition, access, liquidity and transparency.”

We should be grateful to Schapiro for this insight [I can sense the snark coming!], but it is alarming rather than reassuring exactly what way the equities market is similar to and should serve as the blueprint for a new derivatives industry is, at this stage, somewhat mystifying to all except the SEC [yup, right on cue–very British snark, too.]

She went on to say that incorporating the same degree of transparency that exists in the equity market will produce greater liquidity and lower transactions costs.  To enhance this transparency, all security-based swap trades will be reported immediately in real time.

The regulators are very keen on transparency at the moment, but whether this will result in lower costs and greater liquidity through all aspects of the derivatives market is not proven [by a long shot, surely].

Author Simon Boughey then discusses the single name CDS market particularly, providing an interesting case study of a Gaz de France bond hedge.  He concludes by saying:

If the regulators make a god of transparency, then this sort of trade would result in great transaction costs rather than lower ones, transaction costs that will be passed on to the customer and ultimately to the shareholder

Hear, hear.

The CFTC’s Gensler, of course, is as bad–or worse–an offender as Schapiro when it comes to overselling the virtues of transparency and trading on centralized markets.  Who can forget his apple metaphor?  (Believe me–I’ve tried.)  (Though it is interesting to note that Gensler has deigned to consider the possibility that voice brokering “may be OK” on block trades, although he’s still all hot for real time reporting and transparency.)

Both Mar’ and Gar’ are regulatory versions of Procrustes, trying to jam all trading of all types of instruments for all types of counterparties into a single model: centralized markets with extensive pre- and post-trade transparency.

It is sort of amazing–scary, but amazing–to try to reverse engineer their mental models of the financial markets.  The markets as we know them have evolved a variety of trading mechanisms.  These mechanisms vary pretty systematically by instrument, and the kind of firms that trade them.  Equity markets are different from FX are different from corporate bonds.  There are even differences within categories: there is a diversity of order execution mechanisms in equity, for instance.

How do Mr. and Mrs. Procrustes explain these variations?  Is it all just random to them?  How can that be?  Have they ever tried to test their randomness hypothesis?  Have they considered alternatives, like, oh, I don’t know, maybe that under the pressures of competition and the drive to reduce costs and improve the utility of market users, relatively efficient structures adapted to the nature of transactions and transactors have evolved?  Even if they take the view that cabals of interested parties design markets for their own selfish ends, how do they explain why different markets have different trading mechanisms and protocols?  If centralized exchange trading with lots of price transparency is so great, why has that prevailed only in some segments of the equity and derivative markets?

The arrogance, and the narrowness, of their view of the world is truly quite staggering.  In their minds, quite clearly, the financial markets are one big market failure, with a few exceptions–exchange traded equities and derivatives.  And they know better.  They know how things should trade.

This mindset, at root, denies the roles of competition, innovation, creative destruction, and survival of the efficient in determining/selecting market institutions and structures.  It is a command-and-control, we-know-better mindset.  It is a truly pessimistic mindset, too, for it effectively denies the ability of dispersed individual decision makers to make economically efficient choices.

I believe in contrast that one should try to explain and understand how market structures are what they are, and change the way that they have, before dictating sweeping changes to them.  A useful starting point for any theory is to assume that market institutions economize on costs, and that market participants operate in reasonably competitive environments, to derive the implications of these assumptions for instruments/goods with different characteristics, and then test these implications against the observed structures.  Then identify the anomalies–the things the theory can’t explain–and try to understand them better.

Believe it or not, this exercise is not Panglossian.  You won’t always conclude that we are in the best of all worlds.  In my own work, I’ve shown how various frictions can lead to less than first best outcomes.  But I’ve also shown that many seemingly curious institutions and organizational choices–such as not-for-profit, mutual organization of exchanges, or vertical integration between execution and clearing–make economic sense.

But this approach leads to a much more nuanced understanding of complex institutions and practices, and a much more practical way of identifying possible ways to improve the way the markets work.

In contrast, the you’ll-fit-in-this-bed-and-like-it approach epitomized by Schapiro and Gensler is simpleminded, ignorant, and arrogant.

Stretching or crushing markets to fit a standard template will dramatically reduce the efficiency, effectiveness, and adaptiveness of our financial markets.  But that’s what Mary and Gary Procrustes have in mind.

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