Streetwise Professor

September 29, 2014

McNamara on Pirrong & Clearing: Serious, Fair, But Ultimately Unpersuasive

Stephen Lubben passed along this paper on central clearing mandates to me. It would only be a modest overstatement to say that it is primarily a rebuttal to me. At the very least, I am the representative agent of the anti-clearing mandate crowd (and a very small crowd it is!) in Steven McNamara’s critique of opposition to clearing mandates.

McNamara’s arguments are fair, and respectfully presented. He criticizes my work, but in an oddly complimentary way.

I consider it something of a victory that he feels that it’s necessary to go outside of economics, and to appeal to Rawlsian Political Theory and Rawls’s Theory of Justice to counter my criticisms of clearing mandates.

There are actually some points of commonality between McNamara and me, which he fairly acknowledges. Specifically, we both emphasize the incredible complexity of the financial markets generally, and the derivatives markets in particular. Despite this commonality, we reach diametrically opposed conclusions.

Where I think McNamara is off-base is that he thinks I don’t pay adequate attention to the costs of financial crises and systemic risk. I firmly disagree. I definitely am very cognizant of these costs, and support measures to control them. My position is that CCPs do not necessarily reduce systemic risk, and may increase it. I’ve written several papers on that very issue. The fact that I believe that freely chosen clearing arrangements are more efficient than mandated ones in “peacetime” (i.e., normal, non-crisis periods) (something McNamara focuses on) only strengthens my doubts about the prudence of mandates.

McNamara addresses some of the arguments I make about systemic risk  in his paper, but it does not cite my most recent article that sets them out in a more comprehensive way.  (Here’s an ungated working paper version: the final version is only slightly different.) Consequently, he does not address some of my arguments, and gets some wrong: at least, in my opinion, he doesn’t come close to rebutting them.

Consider, for instance, my argument about multilateral netting. Netting gives derivatives priority in bankruptcy. This means that derivatives counterparties are less likely to run and thereby bring down a major financial institution. McNamara emphasizes this, and claims that this is actually a point in favor of mandating clearing (and the consequent multilateral netting). My take is far more equivocal: the reordering of priorities makes other claimants more likely to run, and on balance, it’s not clear whether multilateral netting  reduces systemic risk. I point to the example of money market funds that invested in Lehman corporate paper. There were runs on MMFs when they broke the buck. Multilateral netting of derivatives would make such runs more likely by reducing the value of this corporate paper (due to its lower position in the bankruptcy queue). Not at all clear how this cuts.

McNamara mentions my concerns about collateral transformation services, and gives them some credence, but not quite enough in my view.

He views mutualization of risk as a good thing, and doesn’t address my mutualization is like CDO trenching point (which means that default funds load up on systemic/systematic risk). Given his emphasis on the risks associated with interconnections, I don’t think he pays sufficient concern to the fact that default funds are a source of interconnection, especially during times of crisis.

Most importantly, although he does discuss some of my analysis of margins, he doesn’t address my biggest systemic risk concern: the tight coupling and liquidity strains that variation margining creates during crises. This is also an important source of interconnection in financial markets.

I have long acknowledged-and McNamara acknowledges my acknowledgement-that we can’t have any great certainty about how whether clearing mandates will increase or reduce systemic risk. I have argued that the arguments that it will reduce it are unpersuasive, and often flatly wrong, but are made confidently nonetheless: hence the “bill of goods” title of my clearing and systemic risk paper (which the editor of JFMI found provocative/tendentious, but which I insisted on retaining).

From this “radical” uncertainty, arguing in a Rawlsian vein, McNamara argues that regulation is the right approach, given the huge costs of a systemic crisis, and especially their devastating impact on the least among us. But this presumes that the clearing mandate will have its intended effect of reducing this risk. My point is that this presumption is wholly unfounded, and that on balance, systemic risks are likely to increase as the result of a mandate, especially (and perhaps paradoxically) given the widespread confidence among regulators that clearing will reduce it.

McNamara identifies me has a hard core utilitarian, but that’s not quite right. Yes, I think I have decent formal economics chops, but I bring a Hayekian eye to this problem. Specifically, I believe that in a complex, emergent system like the financial markets (and derivatives are just a piece of that complex emergent system), top down, engineered, one-size-fits-all solutions are the true sources of system risk. (In fairness, I have made this argument most frequently here on the blog, rather than my more formal writings, so I understand if McNamara isn’t aware of it.) Attempts to design such systems usually result in major unintended consequences, many of them quite nasty. In some of my first remarks on clearing mandates at a public forum (a Columbia Law School event in 2009), I quoted Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

I’ve used the analogy of the Sorcerer’s Apprentice to make this point before, and I think it is apt. Those intending to “fix” something can unleash forces they don’t understand, with devastating consequences.

At the end of his piece, McNamara makes another Rawlsian argument, a political one. Derivatives dealer banks are too big, to politically influential, corrupt the regulatory process, and exacerbate income inequality. Anything that reduces their size and influence is therefore beneficial. As McNamara puts it: clearing mandates are “therefore a roundabout way to achieve a reduction in their status as ‘Too Big to Fail,’ and also their economic and political influence.”

But as I’ve written often on the blog, this hope is chimerical. Regulation tends to create large fixed costs, which tends to increase scale economies and therefore lead to greater concentration. That clearly appears to be the case with clearing members, and post-Frankendodd there’s little evidence that the regulations have reduced the dominance of big banks and TBTF. Moreover, more expansive regulation actually increases the incentive to exercise political influence, so color me skeptical that Dodd-Frank will contribute anything to the cleaning of the Augean Stables of the American political system. I would bet the exact opposite, actually.

So to sum up, I am flattered but unpersuaded by Steven McNamara’s serious, evenhanded, and thorough effort to rebut my arguments against clearing mandates, and to justify them on the merits. Whether it is on “utilitarian” (i.e., economic) or Rawlsian grounds, I continue to believe that arguments and evidence weigh heavily against clearing mandates as prudent policy.  But I am game to continue the debate, and Steve McNamara has proved himself to be a worthy opponent, and a gentleman to boot.

Print Friendly, PDF & Email


  1. Bang on prof. Especially the last point about barriers to entry. Forcing OTC mandates is actually squeezing out smaller traditional FCMs as the big boys bundle Derivatives Clearing (futures and OTC). The increased costs of being an FCM did for BoNY and RBS.

    How many private equity firms are setting up as an FCM? Kind of shows that the competition the regulators seek is not there and will not come any time soon.

    I do welcome a more reasoned argument though as frankly Gensler was disingenuous with his sound bite rationale.

    The clearing mandates and other restrictions (Basel 3 capital and leverage ratio) are going to impact the derivatives trading side of the big dealers. I am more optimistic of competition in the trading arena. There are still high barriers to entry from a reg and compliance point of view as well as the traditional trading and technology costs.

    Interesting times…

    Comment by Greenwichmeantiger — September 30, 2014 @ 2:01 am

  2. The clearing mandates are an enormous cost: the piping required to the clearing groups is not something one wants to look at after eating.

    Comment by sotos — September 30, 2014 @ 7:23 am

  3. @sotos. Truly. But the piping always works, right?, and can’t create any systemic risks, surely. Operational risk is a figment of our imaginations, and connections always work best in times of stress.

    I remember vividly how the Fed Wire went down twice on 10/19/1987. Good times. Good times.

    The obligation to make clearing commitments in real time is a disaster waiting to happen. This greatly increases the tightness of the coupling in the system, and it is these couplings that create systemic risks. Did any of the geniuses (yeah, I’m looking at you, GiGi) who inflicted this upon us think about how that would work, or more importantly, how it could break, during a systemic event?

    The ProfessorComment by The Professor — September 30, 2014 @ 10:59 am

  4. SWP:

    Where indeed IS Turbot Tax little Timmy Geithner when one needs his insight?

    Help us Barack Hussein Obi-Wan! You’re our ONLY hope.

    VP VP

    Comment by Vlad — September 30, 2014 @ 5:35 pm

  5. Craig, hello from Beirut…. I’ve actually been coming to your blog more for geopolitical/Obama/Putin discussion than finance recently seeing as Syria is burning and it’s very unclear how the situation there resolves. At least 6 or 7 outside powers have only modestly overlapping ideas about what they want to have happen there. And then there are the Syrians, who are hopelessly divided now into supporters of the regime and opponents. I don’t think it can be put back together. Also, while there is the possibility of “blowback” I think most people in the Levant are glad that Obama and a few others are bombing ISIS.

    Thanks for your analysis of my paper–your positions aren’t unexpected of course. In addition to reading your papers, some other financial economists have given me feedback, making similar points, probably the most important of which is that whether the CCP is a good thing or not is ultimately an empirical question. So, one of my challenges is that even in an argument from a non-cost benefit perspective (ie, a non-utilitarian one), if the CCP ultimately greatly increases risk in the financial system, that ruins my argument. And that’s an empirical question.

    A few points, maybe you could share your thoughts:

    1. I come to this project as a lawyer, not a financial economist. So I tend to see financial regulation as the political system’s way of responding to crises in the economy. Certainly the history of the ’33 and ’34 Acts, and SOX, illustrate this. And these sets of laws, which form the basis of American securities regulation, were at least reasonably successful in curing the problems they set out to cure. SOX put an end to the Enron, Tyco-style accounting frauds. The ’33 and ’34 Acts and their regulations largely put an end to the types of abuses occurring in the securities markets in the 10’s and 20’s. There is a legitimate debate to be had about the costs of those laws, and I know with SOX in particular many have thought the costs would outweigh the benefits (e.g., Roberta Romano at Yale law school). But I would argue that with the ’33 and ’34 Acts the benefits have certainly outweighed the costs. Federal securities regulation became the scaffolding for the American corporate finance system that fueled the economy from 1945 to 2008. So why can’t Dodd-Frank have a similar long-term effect? I know it’s very complex (and that’s just the law, not the regulations which are still being written), but it is meant to control systemic risk. If the argument is solely an empirical one about whether it will do so, that’s fine. But if you read what was being said in the 30’s by the opponents of the federal securities legislation (for example, Joel Seligman, The Transformation of Wall Street on this) it sounds very similar to what opponents of Dodd-Frank have said. And then I go back to my overall point: the ’33 and ’34 Acts should be looked at as scaffolding that in large part enabled the post-war boom. Obviously regulation isn’t the (sole) “cause” of that growth, but it is a factor enabling a great deal of financing which in turn gives rise to economic activity. Living in the Middle East makes one appreciate how much trust Americans, Europeans, Canadians, and East Asians have in the financial system, which is by comparison lacking in societies where there is little rule of law.

    2. Following from this: with Hayek in particular, aside from the insights about how prices work in an economy and other more technical insights, I tend to see his political beliefs as a justifiable reaction to his time and place. If Stalin and Hitler were your main examples of big government, you would be sceptical of the claims of politicians and bureaucrats. Our situation I would argue is much different. Since the late 1970s, and especially the 80s, the American regulatory state has been in a defensive posture, and the forces of deregulation (such as the Commodities Futures Modernization Act of 2000, and other securities laws) have predominated. Of course there is a tremendous amount of “regulation” going on, but the system has also become far more complex, and subject to far more complex intellectual/computer technology, than in previous decades. So it seems to me that after the crisis of 2008 the reconsideration of the mood that has prevailed over the past 30 years is appropriate. The release of the FOMC minutes from 2008 shows that the crisis took the economists at the Fed largely by surprise; this is also true of academic economists with a few exceptions. Ironically, a higher proportion of people on Wall St saw it coming. I am fundamentally skeptical of people (think of Peter Wallison, or Charles Calomiris) who see the crisis of 2008 as a crisis of over-regulation. I think it had to do with over-complexity in the financial system, specifically in structured finance, and under-regulation.

    3. The use of Rawls to talk about these things comes from my frustration with the limits of economics. As I say in my article, the concept of “social welfare” in standard economic argumentation seems limited to tangible factors, typically expressed in terms of the efficiency of a given economic system. I understand that economics wants to be a “science” and limiting itself to a narrow set of items to evaluate helps move it in this direction, but that means a lot of what concerns the general public about the economy doesn’t really enter into economists’ discussions. Also relevant here is uncertainty. As we both agree, there is a lot of uncertainty about causes and effects in the financial system. The appeal to Rawls is a way to try to connect what was happening in the fall of 2008, and even later when Dodd-Frank was being hashed out, with his “maximin” solution, where one has to make a decision about social welfare under conditions of extreme uncertainty. I realize that the desirability of a CCP mandate is ultimately an empirical question, but this was a way to talk about the problem of financial crises in a framework different from that of the usual cost-benefit analyses in public policy discussions, which are often very equivocal in my opinion.

    4. One thing I wanted to try with this paper was to make the pro-regulation case in a reasonably thorough way. You, and Mark Roe, and a few others had written against CCPs. On the other side a lot of people were for Title VII of Dodd-Frank, but there was really no one making more thorough technical arguments for it. One thing I looked for but could not find was any deeper discussion by Gary Gensler or the people pushing the CCP mandate in Congress. I don’t know if there are more technical defenses of the mandate but the paper is an attempt to give one.

    that’s it for now–all best, Steve

    Comment by Steve — October 1, 2014 @ 7:27 am

  6. Thanks for your extended reply, Steve. Sorry for the delayed response. I’ve been traveling.

    A few quick reactions:

    1. I am not persuaded by the Rawlsian approach because it does not confront the real problem with radical uncertainty. Maximin is an objective function. It says nothing about the mapping between policies and outcomes. Without knowing that mapping, we can’t figure out how clearing mandates affect the least among us. That’s the issue here: how does clearing affect the likelihood of crises? The radical uncertainty makes it difficult to determine that.

    2. I wish it were an empirical issue. It is experiential, but that’s something different. Empirical research involves identifying regularities in data. That’s problematic with things like crises, which tend to be unique and contingent: we really won’t know the strengths and weaknesses of a particular system until we try it. Crises are like what Tolstoy said about unhappy families: they are unhappy in their own ways. What I’ve tried to do in my work is to show that the confident arguments advanced by Gensler and others that mandated clearing would reduce the odds of crises are fundamentally flawed, and that there are plausible scenarios in which clearing can bring on or exacerbate crises.

    3. I think you do Hayek an injustice. His criticism of “constructivist” approaches is more subtle and deep than you suggest, and applies even in the absence of a Hitler or Stalin. Scientific work on complex systems and emergent orders owes a great deal to Hayek. Merton’s work on unintended consequences, and Scott’s Seeing Like a State also influenced my thinking on this. The hubris of legislators is a scary thing, especially when they are also driven by political economy considerations.

    4. As for the 33 and 34 acts being the “scaffolding” for the prosperity of the post-war years, that smacks of post hoc ergo propter hoc. Recent scholarship has shown that many of the problems that the acts were intended to correct were non-existent (e.g., investment banks sticking customers with bad securities that they underwrote). As for trust in the financial system, I definitely think that’s important, but I’m skeptical that has much to do with those pieces of legislation, and the regulation they gave birth to. IMO it’s more attributable to the fact that Anglo-Saxon countries are higher trust societies overall, in large part due to the rule of law and a relatively fair and uncorrupted judicial system. In many ways, arbitrary regulations can undermine predictability and trust.

    I’d also note that the US grew very rapidly even when the financial markets were virtually unregulated, and were often the equivalent of the Wild West.

    5. The 33 and 34 Acts (and the CEA in futures) bore in them the seeds of their own demise. A good deal of the complexity and innovation in the 70s and 80s was aimed at circumventing the constraints imposed by the acts and other financial regulations adopted in the post-war period. Money market funds are one example. The CFMA, which you criticize, was a direct response to the incredible complexity of regulation and markets that occurred in the 80s and 90s. Market responses to regulatory constraints challenged the regulatory order, and regulators responded in ad hoc ways through interpretive releases, no action letters, and the like. The result was incredible uncertainty which posed systemic risks. For instance, what would have happened had someone challenged the legality/enforceability of swaps on the grounds that they were illegal, off-exchange futures contracts? This was a real concern, and IMO CFMA got a bad rap.

    We can already see the ad hoc regulatory responses to lacunae and inconsistencies and absurdities and impossibilities in DFA. These responses will lead to market responses which will lead to regulatory reactions and on and on. I predict that within 10 years we will see something analogous to the CFMA for the exact same reasons.

    This brings to mind Andy Haldane’s appeal for simplicity in regulation. If only it were that easy. The regulatory/market dialectic inevitably produces complexity out of intended simplicity.

    In other words, the complexity of the system that you lament (with some justice) is at least partly attributable to regulation. Just how much-who knows? That’s another example of radical uncertainty.

    6. Yes, economists at the Fed and elsewhere were surprised by the crisis, but this hardly gives me confidence in the ability of anyone to design a system that will be immune to crisis, or even less vulnerable. If you are unable to predict a crisis in a known system conditional on current, observable conditions, how can you be confident in your ability to predict the likelihood of a crisis in an untried system under unknown future conditions, especially since some of those conditions are endogenous (but unpredictable) consequences of that system?

    7. I very much appreciate your efforts to mount a more technical defense of clearing mandates. Somebody needed to. Certainly looking for a deep discussion by Gensler or Geithner was a snipe hunt, and I can understand your frustration coming up empty handed. I was scathing about them here on the blog precisely because their justifications were superficial and often flatly nonsensical, which did not prevent them from delivering them with utter confidence, and condescension towards those who disagreed. (True fact: Gensler ordered that I was not to be allowed in the CFTC building. So much for his confidence in his ability to counter criticism.)

    That’s enough for now. Let’s continue the conversation.

    The ProfessorComment by The Professor — October 4, 2014 @ 7:40 pm

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress