Streetwise Professor

February 20, 2012

Putin’s Arms Race

Filed under: Economics,Military,Politics,Russia — The Professor @ 11:04 am

In the immediate aftermath of the Duma election, I predicted Putin would do the following:

  1. Even more populism, with lavish promises regarding pensions, state investments, limitations on increases in utility tariffs.
  2. Nationalist appeals, complete with dark tales about foreign conspiracies to destroy Russia.
  3. Relatedly, even more truculence in foreign policy, e.g., Syria, BMD, the Near Abroad.

All is  going according to form.  Insofar as the truculence and nationalism is concerned, Putin’s promises of a lavish binge on weapons procurement fits right in.  The latest of his mind-numbingly long articles on his future plans focuses on defense.  He promises $770 billion in expenditures on weapons over the next 10 years-an increase of $120 billion over and above what had been mooted last year.

Putin gives two rationales for this binge.  The first is that the defense industry can be the catalyst for a revitalization of technologically advanced industries in Russia.  This is a common assertion, and one that has little basis in reality.

The second is that Russia is under siege:

“New regional and local wars are being sparked before our eyes,” Mr. Putin wrote. “There are attempts to provoke such conflicts in the immediate vicinity of Russia’s borders.”

Note the phrasing: “attempts to provoke conflicts.”  Only the truly dim will not understand the code and fail to identify whom Putin believes it he provocateur.

Several quick comments.

First, when Kudrin was sacked for criticizing Medvedev’s lavish defense spending plans-a mere $600 billion or so-I said that Kudrin was really attacking Putin, because Putin was the driver behind increased defense spending.  It is now clear that this was definitely the case: Kudrin’s (admittedly guarded) move to opposition provides further evidence.

Second, this plan is technologically fantastical given the actual performance in Russian weapons programs in recent years.

Third, Putin completely misdiagnoses the real source of Russia’s military weakness. It is a software problem, not a hardware problem.  Just where are all the soldiers, sailors and airmen needed to operate these new weapons going to come from?

Fourth, Putin warned defense contractors against price gouging on new contracts.  Hahahahahahahaha! What a card! Good luck with that! Especially given Putin’s own policy of consolidating Russian defense contractors into a few huge politically connected behemoths.

Fifth, this is fiscal insanity. This is especially true as there is little prospect for raising additional revenues from the energy industry.  Indeed, the opposite is likely true (h/t R):

Russia’s 12-year oil boom is nearing its peak, forcing the next president to decide whether to cut taxes and revive production or use the windfall from $100 oil to boost public spending and quell mounting unrest.

As Vladimir Putin campaigns for a second stint in the Kremlin, the nation’s existing fields are losing pressure and oil companies OAO Rosneft, OAO Lukoil and TNK-BP (BP/) say production taxes give little incentive to invest. Since Putin first became president in 2000, crude output has grown 57 percent to 10 million barrels a day, surpassing Saudi Arabia and flooding the state treasury.

“The cream has been skimmed off the top,” said Leonid Fedun, the billionaire deputy chief executive officer of Lukoil, Russia’s second-largest oil company. “Further steps require taxes based on different principles,” or production will start falling within three years, he said.

Any cuts in the oil and gas industry’s 5.64 trillion rubles ($190 billion) in taxes mean less cash to combat the biggest anti-government protests since the 1990s. Deputy Energy Minister Sergey Kudryashov said Feb. 2 the need to strike a balance between revenue and oil output levels is one of the most difficult questions facing the state.

To which I would add that future competitive threats to Gazprom will put additional pressures on revenue in the medium-to-long term.  (Note that Gazprom has already given price cuts of around 10 percent to big European and Turkish customers.  The pressure on pricing will only increase in the next several years, certainly within the 10 year defense budget horizon Putin discussed.)

Sixth, the need for revenues to pay for such outlandish promises makes the Retroactive Oligarch Tax all the more attractive.  And we can see that Putin gave a very clear hint at how Putin might propose that this tax be paid: he lavished praise on TNK and Surgutneftgas for paying  for the continued operation of a submarine base in 2002.  We can expect Putin to extract similar “contributions” from other big companies to pay for his defense splurge.  (As a too funny sidebar, Prokhorov said that the oligarchs should decide themselves how much they will pay.  Good luck with that!  And I’m pretty sure that was the real Prokhorov who said that, not @fake_prokhorov.)

Seventh, the centerpiece of Putin’s plans are the building of 400 MIRVed ICBMs.  This is occurring when the Obama administration is mulling a unilateral cut in US nuclear warheads-perhaps to as low as 300.  It will be quite interesting to see whether Putin’s announcement makes the slightest dent in these dreamy plans.  Sadly, I believe that is unlikely to be the case, given (a) Obama’s bizarre strategic views, and (b) his obsession with the Reset.

April 6, 2011

The Battle of Silo Continues*

And now on two fronts, as it were.

The battle over the “vertical silo” (i.e., vertically integrated in econspeak as opposed to bizspeak) approach to execution and clearing remains under assault in Europe:

European Union states want to extend a draft law curbing risk in privately negotiated derivatives to the whole sector, which could ultimately dent profitability of the world’s first mega bourse merger.

. . . .

But banks say the merged group should be opened up to clearing competition. Extending the law’s scope to regulating listed as well as OTC derivatives would achieve this goal.

It would make it easier for users to clear listed contracts transacted on Deutsche Boerse or Euronext’s LIFFE derivatives platform elsewhere and not be locked into the group’s clearers.

“The inclination among OTC derivatives fans like us is ‘why differentiate between one derivative and another?’,” said David Clark, chairman of the Wholesale Markets Brokers’ Association.

“The big deal in all this is the competition element with Deutsche Boerse. This move to extend the scope of the draft law has got politics written all over it,” Clark said.  [Politics?  Whoda thunk?]

. . . .

Exchanges sense integrated business models are under threat.

“Some are trying to weaken vertical structures by creating clearing links with other structures. That creates systemic risk and shifts focus away from the real issue of dealing with OTC derivatives,” an exchanges industry official said on condition of anonymity due to the sensitivity of the issue.

The battle between the “verticalists” and “horizontalists” in clearing is a decade old and has never resolved, with the same two countries pitted against each other today as back then.

“Verticalists” and “horizontalists”?  Sounds like something out of Swift.  Count me as a verticalist–or more accurately, a marketalist.  That is, that this is something best left to market processes rather than legislation and regulation.

Now a battle on vertical integration is evidently brewing in the US too.  At least in the eyes of some market analysts, ICE’s CEO Jeffrey Sprecher is worried that a horizontalist, non-marketalist US Department of Justice may condition acceptance of a NASDAQ-ICE-NYSE-EuronextLIFFE merger on opening up of the derivatives clearinghouse (from Bloomberg: no link yet):

IntercontinentalExchange Inc. may drop out of its joint bid for  NYSE Euronext if the U.S. Department of Justice raises concerns about the deal’s combined futures business, Sanford C. Bernstein & Co.’s Brad Hintz said.  ICE, the second-largest U.S. futures market, and Nasdaq OMX Group Inc. made an unsolicited offer for NYSE Euronext last week, valued at $11.3 billion, countering Deutsche Boerse AG’s February offer for $9.53 billion. In the proposal, Atlanta-based ICE would take NYSE’s Liffe futures-trading markets, expanding in Europe. New York-based Nasdaq OMX would take NYSE Euronext’s listings, equity and options units.

ICE and CME Group Inc., the world’s largest futures market, own their own clearinghouses, which may create barriers to entry and be anti-competitive, the U.S. Department of Justice said in 2008. Equity and options exchanges –such as those owned by NYSE Euronext and Nasdaq OMX–use centralized  clearinghouses like OCC that aren’t owned by any one market.

“The most important issue facing these competing offers is the possibility that the ICE/NYSE Liffe merger will resurrect DOJ concerns with vertical integration of futures execution and clearing,” Hintz, an analyst at Sanford C. Bernstein in New York, wrote in a e-mailed note today. “If this issue arises ICE will likely drop out of the bidding and the Deutsche Boerse deal moves  forward.”

Yes, be afraid.  Be very afraid.  I have the sense that the DOJ’s Antitrust Division is itching to attack vertical integration in derivatives, the economics be damned.

* This perhaps corny (perhaps?) title was inspired by my recollection that today is the 149th anniversary of the first day of the Battle of Shiloh.  Two of my great-grandmother’s brothers fought in the battle: Eli and John, who served in the 46th Ohio Volunteer Infantry.

Eli was something of what is called a “Jonah” in the Navy–a hardluck guy.  He was captured at Shiloh, and held in a prison camp in Montgomery, AL for a couple of months.  Exchanged, he returned to Ohio.  He claimed he was unable to return to his regiment because of dysentery contracted during his imprisonment.  His military record includes a note from his family doctor, believe it or not.

His efforts to stay home were unavailing, and he was ordered to report to his unit.  He returned to the 46th shortly before the Battle of Chattanooga.  He proceeded to lose his belt and cartridge box, for which he was dunned $10 pay.  He was then assigned duty as a wagon driver–probably not an endorsement of his soldierly qualities.

Maybe he straightened out, or the need for infantrymen was pressing, for he was in the ranks again for the Atlanta Campaign.  Unfortunately for him.  He was shot in the left arm close to the shoulder joint at the Battle of Dallas, GA, 28 May, 1864.  The surgical record indicates that the regimental doctor performed a resection of his left arm, removing the bone from the shoulder to the elbow.  This surgery was required because the ball struck too close to the joint to amputate.

My great-grandmother told my grandfather that “Uncle Eli had a dead arm.”  His arm dangled uselessly at his side, and my great-grandmother remembers him using his right hand to lift up his left to rest it on the dinner table.

John, on the other hand, served without incident or injury from October, 1861 to the muster out of the regiment in July, 1865.  Pretty amazing, given that the regiment fought at Shiloh, the Siege of Vicksburg, Chattanooga (the storming of Tunnel Hill, the bloodiest part of the battle), the Atlanta Campaign (including the Battle of Atlanta on 22 July, 1864), the March to the Sea, and the Battle of Bentonville.  One lucky brother, one unlucky.

December 12, 2010

Yogi Berra and the OTC Derivatives Markets

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 5:43 pm

Today’s NYT carries a breathless–and endless–expose on OTC derivatives clearing.  All of the issues it discusses have been discussed, at length, here on SWP.  I almost hesitate to say anything more, because it’s tedious to repeat myself because it’s tedious to repeat myself.  But the fact that stale arguments continue to dominate the conventional wisdom–as now officially endorsed by the New York Times–means that I must venture once more into the breach.

In a nutshell, the article repeats a familiar narrative about the OTC derivatives market.  You might call it the What’s the Frequency Kenneth Griffin Narrative.  (Indeed, Citadel and Griffin are cited throughout the article.)  An oligopoly, not to say cabal (though the NYT comes close to doing so, by referring to “a secretive elite”), of large banks operating in an opaque market earns outrageous profits.  It is now attempting to perpetuate its oligopoly through control of clearinghouses, ironically mandated by the Dodd-Frank Act.

Let’s focus on the clearing aspect for a moment.  First of all, as I’ve said repeatedly, there is definitely a double edged sword involved in clearing.  On the one hand, limiting access to clearing is a great way to exercise market power.  On the other hand, too liberal access to clearing can create systemic risks, and make the governance and management of clearinghouses far more complex and far less efficient (by increasing the heterogeneity of the membership).

Indeed, I gave a talk on clearing before the Columbia Program in the Law and Economics of Capital Markets Regulation on Thursday where I made this very point.   The audience (which consisted of a very distinguished group of law and finance scholars) was generally sympathetic to clearing, I think, and as a result there were a lot of skeptical questions.  One was right along the lines of the NYT article, suggesting that dealers were an oligopoly and that clearing would increase competition.  I responded that in fact, clearing could be a great way of cartelizing an oligopoly.  However, trying to mitigate this problem through regulating CCP admissions criteria could undermine the goal of reducing systemic risk.  As I put it in the slides for my talk, this was one of many Morton’s Forks in Dodd-Frank. (I’ll post a link to the slides and the video from my talk when they are available–probably just in time for Christmas!)

The NYT article describes the efforts of the dealer banks to exert control over CCP risk committees.  Well, duh.  It’s their capital at risk.  Which presents another problem here.  To reduce systemic risk, CCPs have to have a lot of capital backing trades.  That capital doesn’t fall from the sky.  Where is it going to come from?  Since clearing has begun, major market intermediaries have provided the capital.  And since it is their capital at risk, they have demanded and exercised control over the risks that they are taking on.  It’s not that complicated.

Attempts to regulate governance in ways that reduce the control that group X exerts means that you will simultaneously reduce the amount of capital that group X is going to supply.  So you need to get capital from someone else.  And if you don’t the CCP will be undercapitalized and then there are problems; indeed, in the event, CCPs will be the source of the very systemic risk legislators and regulators hoped that they would banish.

In other words, there are trade-offs here that are quite thorny, but the NYT–and too many other people who should know better–ignore altogether because they get in the way of a good morality play.  It is particularly ironic, and annoying, that many of those who were baying for clearing mandates are now just waking up to those trade-offs.

There are other issues in this article regarding clearing that need to be addressed.  One is ICE Trust.  The author of the piece, Louise Story, talks about the formation of the ICE Trust, which involved the combination of a dealer-run initiative Formerly Known as the Board of Trade Clearing Corporation and ICE.  As originally envisioned, and as currently operating, ICE Trust was an inter-dealer clearing system.  So who other than the dealers would you expect to dominate it?

In her attempts to make ICE Trust appear as sinister as possible, Story descends into self-parody:

The banks also refused to allow the deal with ICE to close until the clearinghouse’s rulebook was established, with provisions in the banks’ favor. Key among those were the membership rules, which required members to hold large amounts of capital in derivatives units, a condition that was prohibitive even for some large banks like the Bank of New York.

I read that to Mrs. SWP, who laughed out loud.  Mrs. SWP is an art major, but she is endowed with common sense.  Her response (post-laugh): “Like they were going to join an organization before they knew what the rules were?  And they were going to join an organization with rules that hurt them?”

More substantively, the quote makes the capital requirements seem like–and only like–a means for exclusion.  Yes, they can play that role, as I’ve written ad nauseum for years.  But high requirements can also be a crucial way of ensuring the safety of the institution, and reduced heterogeneity in the financial condition of members can make the difference between an effective organization and a dysfunctional one.

In other words, the NYT is printed in black and white, but the issues involve are anything but black and white.  Until people get real in grappling with the trade-offs, we are doomed to pointless arguments and counterproductive policies.

The other big issue in the article relates to transparency and trading, and its effect on profits.

The story begins with this tale:

This fall, many of Mr. Singer’s customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price higher.

But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives.

“At the end of the day, I don’t know if I got a fair price, or what they’re charging me,” Mr. Singer said.

It proceeds:

And the profits on most derivatives are masked. In most cases, buyers are told only what they have to pay for the derivative contract, say $25 million. That amount is more than the seller gets, but how much more — $5,000, $25,000 or $50,000 more — is unknown. That’s because the seller also is told only the amount he will receive. The difference between the two is the bank’s fee and profit. So, the bigger the difference, the better for the bank — and the worse for the customers.

It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it. Moreover, only the real estate agent — and neither buyer nor seller — would have easy access to the prices paid recently for other homes on the same block.

Ask yourself: for what product that you buy do you know the markup or the seller’s profit?  Answer: probably none.  You rely on competition, comparison shopping, etc., to discipline sellers and ensure that you get a good price.  Presumably that, and soliciting multiple offers, are exactly what Mr. Singer does when buying the physical oil he sells (the markups on which and profits made by the seller he almost certainly does not know either).  (By the way, do Mr. Singer’s customers know his costs and markups?  Just asking.)

The usual retort is that the OTC derivatives market is an oligopoly and that a lack of price transparency limits competition.  By structural measures, OTC dealing is less concentrated than most industries.  With respect to transparency, many large market participants (end users) repeatedly stress that they have access to multiple bids and offers, and are perfectly capable of shopping for good deals.

Moreover, and this cannot be stressed enough, for many products–including Mr. Singer’s heating oil–there are exchange traded markets with great transparency pre- and post-trade.  Mr. Singer and others can utilize that information to evaluate the price offers being made by the dealers on OTC trades.  Moreover, they can trade on those markets if they are so convinced that the OTC dealers are hosing them. So why don’t they?

I am also annoyed that people, including Ms. Story, accept uncritically the proposition that OTC dealing is obscenely profitable.  Maybe it is–I would definitely like to see a more definitive study on this that goes beyond the mere quoting of revenue numbers from OTC trading and how it compares to overall bank revenues.

Indeed, there’s a fundamental tension between various criticisms of OTC derivatives markets.  On the one hand, they are supposedly extremely profitable.  On the other, they supposedly pose huge risks for the banks that are the major dealers.

Think that there could be a connection?  The counterparty risks that dealers face are a contingent liability.  If OTC derivatives dealing is indeed highly risky, as is often asserted, this contingent liability could be quite large.  Which means that in a competitive market prices–notably spreads between dealer bids and offers–must be wide enough to compensate for that risk.

This further means that looking at profits in “normal” times can be misleading.  These “profits” are in part, and arguably in large part, compensation for risk.  And given the nature of risk in these markets, where things can go along swimmingly for a long time and then go non-linear, the losses for which these “profits” are compensation can be extremely concentrated in time; the contingent liability becomes a real one, and particularly a real big one, relatively infrequently. So you can look at profits over years that look fat and say that they are supercompetitive.  But they can disappear in a trice.

This is arguably analogous to the equity premium puzzle.  That puzzle states that the returns to investing in stock appear to be very high given the risks.  That conclusion is dependent on how you measure the risk, and the compensation required (based on preferences) for these risks.  Legions of finance academics and practitioners have wrestled with those issues for decades now, and there has been no definitive resolution of the puzzle.  Very little–and arguably no–comparable research has been undertaken to study the risk-return trade-off in derivatives dealing.  That problem is, moreover, arguably far more complex than the equity premium puzzle.  It is a tail risk problem, and evaluating tail risks and the appropriate compensation for them is hard.  (Tail risk could be the source of some of the equity premium too.)  With free entry and exit, to a first approximation you would estimate that the prices charged compensate for risk.  You should certainly be very reluctant to draw strong conclusions to the contrary without a much deeper analysis than has been done until now.

(This is also analogous to a peso problem.)

Until the risks of OTC derivatives dealing, and the costs of those risks, are measured far more accurately than has been the case heretofore (and the analysis usually doesn’t go much beyond the kind of stuff that’s in the NYT article), I would be chary indeed about arguing that OTC dealers make supercompetitive profits.

And I would be especially careful about arguing about the huge risks of OTC dealing out of one side of my mouth, and the huge profits of OTC dealing out of the other.

This gets at the main problem with all of these jeremiads against OTC derivatives markets.  OTC dealing is supposedly hugely profitable.  Customers are supposedly exploited.  But OTC derivatives markets expanded dramatically absolutely and relative to the transparent, anonymous exchange markets that offer products that are close substitutes on many dimensions.

Huge profitability and supercompetitive prices should have encouraged entry by other potential OTC counterparties; the entry of new trading mechanisms (including, potentially, exchange-like mechanisms with clearing as well); and the movement of trading to existing futures and options exchanges.  But the reverse happened.

In other words, criticisms like Mr. Singer’s, and Kenneth Griffen’s, and Louise Story’s remind me of what Yogi Berra said about Ruggeri’s (a restaurant on The Hill in St. Louis): “Nobody goes there anymore. It’s too crowded.”   The OTC markets are big and crowded with customers.  If they’re such a bad deal for these customers, why is that true?  Why hasn’t entry, or the movement of customers to available substitutes, constrained market power and prevented exploitation of customers?  Not to say that such an outcome is inconceivable, just that Louise Story, Kenneth Griffin, and the cast of thousands who criticize OTC derivatives markets haven’t come close to answering these questions.

I long for the day when there will be serious consideration of these issues, rather than superficial black hat-white hat narratives.  There are so many thorny, thorny issues involved in derivatives market structure.  The trade-offs are not easy.  Let’s stop pretending that they are.  And most importantly, let’s stop legislating and regulating like they are.

October 2, 2010

Collateral: No Silver Bullet

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 3:44 pm

The Hunt brothers are the poster children for the old joke: “Want to make a small fortune trading commodities?  Start with a large one!”  [Ba Dum Ching!]

Their not-so-excellent silver adventure is also an interesting object lesson in other ways.  In particular, it shows that clearing, initial margin, rigorous daily mark-to-market variation margin, and exchange trading are do not immunize the broader financial markets from contagion originating in the derivatives markets.

It is no doubt true that initial and variation margin reduce the credit exposure in a specific derivatives trade.  But that doesn’t mean that requiring collateralization of derivatives trades in a way that dramatically reduces credit exposure in a particular trade reduces the amount of leverage in the system; or reduces the likelihood of default against that borrowed money as the result of an adverse price move in the derivatives market.

This is because the creditworthy will get credit, until they aren’t.  If you deny them one channel to obtain credit (e.g., by charging hefty margins on futures trades) they can get credit through other channels.  They can use that credit to support their speculations in derivatives markets.  And if those speculations go the wrong way, it can cause the formerly creditworthy to default.  If they’ve borrowed enough, the whole system can have trouble.

That’s exactly what happened in the Hunt case.  The Hunts borrowed, from various sources, approximately $1.3 billion to support their silver market activities. That’s the equivalent of about $3.5 billion today.  They used the borrowings to pay margins and to buy physical silver.  When the price of silver fell, they couldn’t pay back their loans.  This almost led to the failure of several major brokers and banks, and could have sparked a full-scale banking crisis.  In a process not too different from that involved with the rescue of LTCM in 1998, banks restructured the Hunts debt in order to avoid a crisis: the Fed’s (and Paul Volcker’s) role in this was and is very murky, but (a) it was decidedly contrary to stated Fed policy at the time, (b) Volcker could have killed it if he had wanted, but (c) it happened.  So draw your own conclusions.

Here are the details.  After skyrocketing in late-1979, the price of silver started to drift down in 1980.  The Hunts needed cash to meet margin calls, and they borrowed money–about $233 million–from their main broker, Bache.  The loan was collateralized by silver.  Bache, in turn, rehypothecated the capital and used it to back borrowing of the money from First National Bank of Chicago.  In addition, the Hunts borrowed large sums from Swiss Bank, as did their pilot fish in this endeavor, a group of Saudi investors who were trading through the firm IMIC.  In addition, IMIC borrowed money from Merrill Lynch and commodity broker ACLI.

Most of these borrowings were used to meet margin calls.  Most of these borrowings were collateralized with physical silver.

Prices continued their downward drift, and on 17 March, 1980 the Hunts missed a margin call.  Bache covered it.  IMIC also missed margin calls on 3/25.  Broker Conti covered it.

The price decline the accelerated, and threatened to turn into a rout, when the Hunts announced an ad hoc, not to say harebrained, scheme to sell silver bonds.  This signaled to anybody paying attention that the heretofore supremely confident silver bulls were having serious cash flow issues.  The prospect of their silver hoard (and that of their IMIC shadow) being dumped on the market put prices under serious pressure.

On the 26th, the Hunts told Bache they could not meet any additional margin calls.  Bache panicked, and tried to get the CFTC and COMEX to close the silver market, and force settlement of all outstanding contracts at a price that would allow the Hunts to pay them back.  COMEX and CFTC refused.

The market therefore opened on the 27th–“Silver Thursday.”  Bache liquidated Hunt positions, and sold silver held as collateral.  It made the sales in London through a UK subsidiary, incurring losses–but Bache NY promised to cover the losses.

There were serious concerns that day that Bache would go under.  The CFTC deemed other brokers to be vulnerable, notably ACLI, Conti, Merrill, and Paine Webber .  A default by any one of these would have put the COMEX clearinghouse in jeopardy: a default by more than one, almost certainly would have.  The Fed’s (now) venerable Gerald Corrigan, openly worried about the viability of the COMEX clearinghouse.  Given the realized and potential losses, a COMEX clearing failure was a real possibility.  Again: clearing is not a panacea.

To raise cash to meet its obligations to the clearinghouse, Bache dumped stocks as well as silver.  They were not alone.  Stocks declined rapidly, the Dow losing about 5 percent, before recovering to close almost unchanged.  (Another interesting sidelight of this episode: a “Flash Crash” years before anybody even dreamed of HFT.*)

But Bache was able to scrape together enough money to meet its obligations to the clearinghouse and pay off its loans.  The owners of ACLI and Conti injected capital. Things seemed to be under control.  Disaster seemed to have been averted.

Not so fast.  When prices were sky high, silver giant Engelhard was having a difficult time meeting margin calls on its short COMEX silver futures positions.  So it had entered into exchange-for-physical (EFP) deals with the Hunts, whereby the Hunts agreed to take the Engelhard short positions (which were offset against some Hunt longs), and agreed to buy physical silver from Engelhard for delivery at the end of March, 1980.  Again–more credit, this time, extended by Engelhard to the Hunts.

When the delivery date came, based on the sales price in the EFP contracts and the prevailing price of silver, the Hunts were underwater by $335 million.  Engelhard insisted on cash.  The Hunts said sorry, ain’t got no cash.

Engelhard could have forced the Hunts into default and bankruptcy.  If that had happened, the entire Hunt debt pyramid, all $1 billion plus, would have been in default.  Several banks would have been at risk of failure–First Chicago, the nation’s 9th largest bank, most notable among them.

But Engelhard blinked–or did the country a favor, depending on how you look at it.  It accepted some Hunt oil properties in the Beaufort Sea instead of cash.

Another bullet dodged.  But the banks still realized that the Hunts were in hock to them for huge sums, and a good chunk of the brother’s wealth was still in silver that was worth a fraction of what they had paid for it.  There was still a serious risk of default, and the Hunts had a lot of bargaining leverage.  The prospect of a protracted war in bankruptcy court was hardly appetizing to the banks.

So they bit the bullet (sorry–free association at work), and renegotiated the loans with the Hunts.  The loans to the brothers were paid off by a new loan to the Hunt family oil firm, Placid Oil.  Finally, the problem was taken care of.

The role of the Fed and Chairman Volcker in this loan is shrouded in mystery. Congress pressed Volcker for answers, and he, in classical central banker fashion, obfuscated and stiffed them.  But it should be noted that the loan was starkly at odds with the Fed’s new policy of restricting credit, most especially credit for commodity speculation.  Volcker had insisted that the loan include the condition that the Hunts cease speculating in all commodities, not just silver.  Moreover, given the Fed policy and its power, if Volcker had wanted to stop the loan, there is no doubt he could have.  Thus, there is evidence of both active and tacit Fed approval of the ultimate solution.

This arrangement foreshadows the solution, 18 years later, to the LTCM problem.  Then, as in 1980, the Fed shepherded a group of private banks to finance the resolution of the victim of a derivatives blowup.

To sum up.  Here we have a market that was (a) exchange traded, (b) cleared, (c) subject to initial margins, and (d) subject to rigorous daily variation margins.  All of the things that our latter day financial reformers assert will purge derivatives-related financial contagion from the system.  Yet a derivatives-related financial contagion occurred nonetheless.

Why is that?  The reasons are pretty clear.  The real source of potential derivatives related contagion exists when (a) a large entity takes on a substantial price risk through the derivatives market (or the underlying market, e.g., silver, or both), and (b) that entity is highly leveraged.  The clearing, margining, etc., is intended to reduce the leverage extended to the entity via the derivatives transactions.  But even if it doesn’t get credit via the derivatives trade, a creditworthy entity can use its debt capacity to get credit elsewhere.  If it does so, and its speculative bet goes wrong, it may default.  If it borrow enough, the default may lead to a financial crisis.

The default may impact the clearinghouse.  Clearing members may be among the defaulter’s creditors.   The default may lead to missed margin payments.

But even if the clearinghouse survives, a crisis may occur nonetheless.  It’s the total amount leverage that matters most, far more than the form of that leverage.  If a given position is collateralized, thereby reducing the credit exposure inherent to it, but that collateral is effectively borrowed, the risk to the system isn’t any different than if the position isn’t collateralized but the entity doesn’t do any other borrowing.  All that really changes is who ends up carrying the can in the event of a default.

This is a Modigliani-Miller-like result.  It means that regulating the credit in one part of a position doesn’t really matter if the entity can obtain credit elsewhere.  If that entity has a given debt capacity, or target debt level, they’ll get the credit somewhere.  This means that you can’t really affect the systemic risk posed by big speculators by limiting their access to one channel of credit.

Which further means that requiring the clearing and collateralization of speculative positions will not substantially reduce the systemic risk posed by speculative trading.  Nor will exchange trading.  You can take risk on an exchange or off.  You can get credit through a derivatives trade, or elsewhere.  Either way, a big speculator can put together the same price risk + leverage position.  It is that risk+leverage exposure that matters, not how you get there.  Clearing and exchange trading mandates just affect the route, not the final destination.

The Hunt episode should thus serve as a cautionary tale.  Like the story of the Gold Panic of 1869, it shows that cleared, exchange traded markets pose systemic risks too.  Married with some rather straightforward economic logic, these episodes show that you should not expect that mandating how things are traded and how they are collateralized will materially affect systemic risks.  Those who assert the contrary are missing the forest for the trees, and instilling a false sense of security.

PS.  That shouldn’t cause you too much extra work, Allan:)

* Speaking of the Flash Crash, I’ve read the CFTC-SEC joint report. I will post on it tomorrow.  Teaser: the report leaves the most interesting and important questions unanswered.

July 22, 2010

Chocolate Kisses, or the FT in the Tank

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 10:34 am

I have been a close observer of manipulation since the mid-1980s, when the Japanese were squeezing the 30 year while I was devising interest rate hedging strategies for the clients of the FCM I worked for.  Since then, I have examined, intensively and forensically, manipulations in soybeans, Brent, Bunds, Treasuries, canola, copper, aluminum, propane, natural gas, WTI, and other things.  I have researched every major manipulation that I could identify, dating back to the 1860s.

I have heard all of the lame alibis, sometimes directly from the manipulators’ mouths, sometimes from the mouths of their mouthpieces.  Excuses from the likes of them are to be expected.  It is disappointing, however, to see the Financial Times regurgitate their tripe.

Yesterday the FT ran an editorial that recycled many of the tired tales that manipulators tell in defense of Anthony Ward’s actions in the cocoa market.  None of it is exculpatory, in the least.

To start with, the FT opines:

Armajaro breached no rules when, in pursuit of its view that cocoa prices would rise after a poor harvest, it snapped up contracts to purchase cocoa beans on the Liffe futures exchange. These gave it the right to take physical delivery of the beans if it chose. What stirred the controversy was that Mr Ward exercised that prerogative over 24,100 contracts. These amounted to about 7 per cent of annual world production.

Yes, the old “I had the contractual right to do what I did” defense.  But a market power manipulation involves the opportunistic use of this contractual right to distort prices and the flows of a commodity in commerce.  This action degrades the effectiveness of futures contracts as a risk shifting and price discovery mechanism, and leads to wasteful use of the commodity.  If “contractual right” trumps everything, then rules against corners are a nullity.  If that’s the way the game is played, maybe I should start The Corner Fund and go to town.  I’ll hire the FT to flack for me.  But I probably won’t even have to hire it: it seems it’s willing to do it for free!

The FT continues with another old standby: the “They had it coming to them for walking in this neighborhood alone dressed in shorts like that” story:

There is no doubt that his decision caused agony for some on the other side of the contracts. A number of cocoa traders use Liffe to hedge against falls in the prices of the stocks they hold. They suffered because they not only hedged their beans – but their holdings of cocoa powder and butter also. These were ineligible for delivery against the contracts, thus forcing the hedgers to settle contracts for cash at penal premiums or to buy sufficient beans to close the trade.

It is hard to see how Mr Ward can be blamed for this. The hedgers did not need to run a mismatch risk. They could have found other ways to insure their exposures – such as entering into a derivative with a bank. That would have been more expensive, but would also have been safer.

But the whole point of centralized markets is to concentrate liquidity, thereby permitting out-of-position hedgers to reduce risk with maximum flexibility while incurring low transactions costs.  They willingly trade basis risk for transactions costs.  That is no reason to excuse opportunistic actions that exacerbate basis risk.  The risks of being cornered induce hedgers to take costly preventative measures, such as investing collecting information about the activities of other traders that is socially wasteful because it is merely intended to reduce the risk of being the source of a wealth transfer, or using markets where transactions costs are higher.

Beating me to the punch, Tullet Prebon’s CEO T.C. Smith skewers the FT’s fatuousness–and hypocrisy:

Many commentators maintain that one lesson of the financial crisis is that all over the counter derivatives should be traded on exchanges.

I wonder how the revelation in your editorial, that the cocoa consumers who attempted to hedge their powder and butter through the imperfect mechanism of the Liffe futures in cocoa beans would have suffered much less if they had taken out OTC contracts with banks which precisely hedged their risk, fits their theory.

They can file your editorial with the reports on the as yet unexplained “Flash Crash” of May 6, in which Apple’s shares traded at one cent per share and $100,000 a share within 20 minutes.

But then, why let the facts get in the way of their theory? It will all be safer and more transparent when everything is on exchange.

Couldn’t have said it better myself.

The FT then plays three card monte and attempts to distract attention from the real issue:

It has been suggested that Mr Ward’s conduct was akin to cornering, and thus led to a disorderly market. But this is a hard case to sustain. Disorderly markets occur when two-way prices cease to be made – thus making cash settlements impossible. But the open interest on the cocoa contract fell in the weeks prior to expiry.

That is, shall we say, an idiosyncratic definition of “disorderly market.”  In fact, in many corners trading activity can reach a frenzy.  There are two-way prices, but the prices are far above where they would be in a competitive market, and the “cash settlements” are at essentially extortionary prices.  Apparently that’s hunky dory with the FT.  And even in cornered contracts open interest typically falls.  In fact, that’s almost always true.  Indeed, it often falls the most when the cornerer makes money by liquidating futures at supercompetitive prices.

The FT then suggests that the quiet word among gentlemen approach is preferable in such matters:

However, squeezes can be managed. Liffe tries to do this by directly stepping in where necessary to guide the activities of traders. This approach, which has been compared to being summoned to the “headmaster’s study for a quiet word”, effectively substitutes for a detailed rule book. The flexibility it provides can be valuable so long as the market is actively policed.

Yeah.  That works, except when it doesn’t.  And the London markets provide numerous examples of it not working.  Remember Sumitomo, and the LME’s rather, shall we say, prone, not to say accommodating, posture in dealing with Hamanaka right to the end?  Or all of the Brent shenanigans that occurred over the years?

And in that vein, a shout out to LIFFE, for validating my 1995 JLE article arguing that exchanges were unlikely to act against manipulation.  It would be hard to write a letter that does a better job at missing the elephant in the room.

Perhaps due to space limitations, the FT does manage to overlook some of the standard lines from the manipulator’s manual.  But a couple of commentors over at SeekingAlpha fill the void.

In this case, it appears that Armajaro already had customers for the cocoa delivered to it.  See!, the commentor says, there is real demand, real customers.  Well, if you know anything about manipulation, you know that the biggest danger is related to burying the corpse of the manipulation: that is, selling the massive deliveries that you take to squeeze the market.  A clever fellow bent on manipulating the market pre-arranges the funeral.  If the reports about forward sales of old crop cocoa to processors are correct, that was done in this case.  So, rather than being exculpatory, such sales are actually evidence of manipulative intent.

(I’d be interested to know who is making the deliveries.  It would be telling if any of the deliveries were made by those who had contracted to buy from Armajaro.  It would also be interesting to know more of the details of those contracts, not just the pricing terms but any other features in the contracts relating to use or marketing of the cocoa, and the delivery locations for the contracts.)

The other common excuse, again seen in my SA comments, is that the stuff that is delivered will be consumed.  Well, duh.  It’s not like the guy is going to eat it all himself, or burn it, or build houses out of cocoa beans.  It is going to be consumed.  But manipulation distorts consumption pattens–the timing and location of consumption.  The stuff is consumed, but in the wrong place at the wrong time, and too much of it is shipped around to the wrong places.  The fact that the delivered cocoa will eventually be consumed does not imply that the deliveries are efficient.

All in all, none of the arguments raised in Armajaro’s defense are even remotely exculpatory, and some are actually adverse.  A final judgment would require a full forensic and econometric evaluation of prices, pricing relationships, price-quantity relationships, and movements of cocoa.  Time permitting I hope to do some of that.  But at this juncture, there is sufficient evidence to conclude that there is a colorable case against Armajaro, and that the arguments raised in its defense are risible.

Taking huge deliveries in a large backwardation is consistent with manipulation.  This is especially true when one party takes all the deliveries.  Delivery economics are pretty straightforward, and if they work for one party they tend to work for several.  One firm taking all of the deliveries is suspect.

Moreover, the purported rationale for the trade–an expectation of a small new crop in the autumn–does not explain why the old crop price richened relative to the new crop price.  If the real motivation was a view that the market did not appreciate sufficiently the likelihood of a small crop, then the trade should have been to go long the new crop and cash in if and when that view was validated.  Taking delivery into a big backwardation, and seeing the backwardation actually increase as result of the deliveries, is not a sensible way to play an anticipated shortage in the new crop.  The backwardation across crop years screams: “don’t carry over inventory into the new crop year.”  So current inventories do nothing to alleviate future shortages (because the spreads signal that all of the cocoa should be consumed before those shortages arise).  (As an example of how the market should work in response to anticipation of a crop shortfall, during the big US drought of 1988, the old crop-new crop spreads for corn and soybeans snapped into a huge carry; indeed, the spreads exceeded full carry charges measured using official storage rates.  The warehouses in Chicago were filled to the top with grain and beans. That’s because the market realized that it was desirable to carry over old crop supplies in larger quantities than usual to alleviate the anticipated shortfall in the 1988-1989 crop.)  (Ferruzzi told the same lame betting on a new crop shortfall story during its bean manipulation in 1989.)

The rise in the London price relative to the NY price is also what you’d expect to observe in a corner.

I’m not rushing to judgment.  But neither should the FT .  Its unseemly haste to play Ward’s mouthpiece, its heaving up of tired excuses made for manipulators from time immemorial, and its complete lack of any skepticism, are not befitting a premier financial publication.

May 13, 2010

You Got a Lot of ‘Splainin’ to Do, SEC

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:07 pm

CME Group Chairman Terry Duffy’s testimony before a subcommittee of the House Financial Services Committee is quite informative and fascinating.  Of course he is defending his firm and talking his book, but he makes a very persuasive case on many issues.  What he says does not demonstrate that the May 6 market boomerang did not begin at the CME (sorry about the double negative), but he does make it pretty plain that precautions built into the CME’s Globex system worked to arrest the decline, and that the rebound probably began at CME as a result.

The Duffy testimony provides concrete evidence that stop orders were accelerating the price decline.  An EMini trade at 1062 triggered a stop for a relatively modest 150 contracts.  Execution of this order led the market down to 1058.25: that big move in response to a small order indicates how illiquid the market was (i.e., how low the depth was).  (I will dig up an article by Hasbrouck that estimates depth coefficients using Bayesian methods to see how this compares to the usual market depth.)  This triggered another 150 car stop order which led the market down to 1056.

At this point Globex’s Stop Price Logic kicked in:

Stop Logic

The Globex trading platform is programmed to prevent the continuing execution of cascading stop orders when it detects certain conditions. The Match Engine monitors if the triggering of a stop order or series of stop orders will result in matched prices that exceed the contract’s No Bust Range from the price level that matching limit orders finished matching and caused the triggering of a stop order(s) . The contract is then placed in a reserved state, during which orders may be entered, modified or cancelled but not matched.

The market went into a stop state for 5 seconds.  The decline stopped, and the rebound began as value buyers–almost certainly including some dreaded HFTs–began to buy.

Duffy’s account confirms the main elements of the scenario I sketched out a couple of days back.  The market was relatively illiquid; something triggered a relatively large price move; that triggered stops and a further decline of liquidity, which accelerated the market decline; then value buyers moved in.   Duffy’s testimony also illustrates the essential element in keeping things from going completely non-linear: stopping stop orders.  I repeat: stopping stop orders.

Things were uglier on the cash equity markets.  The price declines in individual stocks, including heavily traded broad market gauges such as the SPY were more severe than on the index futures.  As is well known, some stocks traded at a penny before bungeeing back to reasonable levels.

This reflects, in part, the evolution in the market architecture in the years following the SEC’s approval of Regulation NMS.  As I wrote in this piece in Regulation Magazine, the SEC had a choice between two alternate ways of creating a national market system: a mandated central limit order book (“CLOB”) or what I referred to as an information-and-linkages approach.  The latter means that the mandated dissemination of quote information to permit direction of orders to the best-priced markets, and the requirement that different execution venues redirect orders to other venues displaying better prices.  In Reg NMS, the SEC choose information-and-linkages.

That approach is defensible, and can work well in normal market settings.  The Boomerang illustrates, however, that this architecture has an Achilles heel during periods of extreme stress and low liquidity.  The linkages don’t work properly, the markets fragment, and prices in some venues can diverge wildly from those in others.  During the crash, several venues declared “self-help” which meant that they would not direct quotes to other markets that were not responding within a second.  In other words, every man (market) for himself, and to hell with the women and children.  The linkages broke down.

As a result of NMS, the NYSE has gone from doing about 80+ percent of listed volume to less than 30.  That’s not a big deal in normal times, as information-and-linkages works OK then.  In the stressed time, though, it was a big deal.  Especially since one of the NYSE’s circuit breakers, its Liquidity Replacement Points stopped continuous trading on that market, but didn’t affect others.  So orders ricocheted off the NYSE, bypassing whatever liquidity was there, and overwhelmed liquidity on other markets.

I should note that even centralized markets can fragment.  Back when the pits were big (e.g., T-bonds, T-notes), when trading was active there would be different prices at different points in the pit.  This happened in the ’87 Crash too.  The firm I worked for was doing some simple index arb trades during that period.  Looking at our wondrous Telerate screens, it looked like there were huge arb opportunities.  (There weren’t, because the prices coming from the NYSE were absurdly stale.)  We called down to the floor to see where we could execute the futures leg.  The guy on our floor desk said: “Somebody’s bidding P1 over here, somebody else is bidding P2 over there, and there’s a guy offering P3.  So, I don’t know what the f*cking price is.”  [I don’t remember the exact numbers, except that they were index points apart.  I do remember that last sentence.  Go figure.]  But that can’t happen in a CLOB type electronic system.  (And Globex is effectively a CLOB.)

The Boomerang almost certainly means that the SEC will have to revisit the information-and-linkages approach.  It will have to coordinate the adoption of rules and technical interfaces that prevent the fragmentation, or it will have to consider jettisoning the concept altogether.  At a minimum, the rethink on the information-and-linkages approach will require coordinated circuit breakers.

And the CME experience suggests that the most essential thing to do is to implement a coordinated stop logic analogous to the CME’s.   It is imperative to derail that positive feedback mechanism.  The whole self-help thing (i.e., the every-man-for-himself-delinkage of the information-and-linkage system) also deserves close scrutiny.

The hyperventilating about HFT continues.  Duffy defends it, and defends it well.  Again, HFT is not a homogeneous thing, so it is essential that any evaluation of it take into account the diversity of these strategies.

Also, it bears repeating that the “where did it start?” question is secondary to “why did it spread the way it did?”  and “why were some markets impacted more severely than others?” questions.  And as for those questions, I think the SEC will have a lot of ‘splainin’ to do, Lucy.

March 10, 2010

Gary Gensler’s Plan to Take Over the World

Filed under: Commodities,Derivatives,Economics,Politics — The Professor @ 10:39 pm

Gary “Jeremiah” Gensler continued his assault against CDS, this time from deep in enemy territory, at Markit’s Outlook for OTC Derivatives Markets Conference.  If it were up to Gensler, the OTC Outlook would be terminal.

In the speech, Gensler repeats several of his constant themes, and also adds some more, drafting off the cynical European outrage over sovereign CDS.  All of the tired standbys are here, including arguendo ad AIG (don’t leave home without it!)  but he also uses the shameless “derivatives used to mask Greece’s budget chicanery” argument.

I see.  We’re supposed to trust governments to regulate instruments that governments use to escape commitments they’ve undertaken.  What’s next?  Robert Downey Jr. for Drug Czar?

Gensler calls for regulation of derivatives dealers including capital and collateral requirements.  But siloed regulation of specific instruments makes little sense when these are just one element in the portfolios of complex financial institutions that engage in a wide range of risk taking activities.  A holistic approach by banking regulators is called for to ensure that risks are priced properly and consistently across all the instruments in bank portfolios.  But that wouldn’t give the CFTC a hand in the game, would it?

The CFTC chair also calls for transparency, arguing for something like the consolidated tape in equity markets.  I have no problems with that, having advocated a data hub for energy years ago, and suggesting it for OTC derivatives more broadly more recently.

But Gensler overstates the potential benefits.  He laments the fact that during the crisis there were “no reference prices for particular assets.”  Well, duh.  That’s because they didn’t trade.  And mandating that something trade on an exchange will not magically mean that it will trade at all.  Low volume instruments typically don’t trade on exchange because it’s not worth the cost of maintaining a market that is seldom used.  This isn’t Field of Dreams: just because you build a trading facility, doesn’t mean that people will come to trade everything on it.  Even with an exchange mandate and/or post-trade transparency, many instruments will still lack reference prices on a timely basis because there is no underlying demand to trade them with any frequency.

Which undermines Gensler’s next demand: that derivatives be cleared.  Sufficient trading activity is a necessary condition for clearing to be the best way of allocating default risk (though not a sufficient condition).  In addition, I note, wearily, that Gensler again invokes clearing as a deus ex machina that “guarantees obligations of both parties” and “takes trades off the books of financial institutions.”  Pray tell, where does the risk go?  Who provides the guarantee?  Is there a guarantee fairy?  Do leprechauns guarantee trades with a pot of gold at the end of a rainbow?  (Or is that needed for the Irish banks?)

In this speech, Gensler expands his criticism of CDS to take up the by now standard “no insurable interest argument” against holding “naked” CDS positions: who knew regulators were such prudes?  In a section titled “market manipulation” he regaled his audience with the story of how in the 18th century unscrupulous folk had taken out insurance on ships they didn’t own, which then seemed to have a bad habit of being lost.  This, and related schemes, led to the passage of statutes that required the purchaser of insurance to have an insurable interest.

There is an argument to be made for the efficiency of such rules in some contexts.  In particular, in the specific historical case Gensler discussed, the probability of detection was probably quite small, given the difficulty of proving that a particular vessel sank as a result of foul play (difficult if for no other reason that it was lying at the bottom of the ocean, perhaps with the bodies of its crew).  This meant that ex post deterrence of this conduct was likely very ineffective.  Moreover, there is no compelling benefit of A buying insurance on B’s property or life.

The question is whether this analogy is apt for CDS.  I think not.

First, there are potentially beneficial reasons for naked CDS.  Speculation of this sort can provide valuable information: markets that restrict short sales are typically less informationally efficient than those that don’t, and experimental evidence suggests that short sale restrictions encourage bubbles.  Moreover, market makers may sometimes take naked positions in CDS pursuant to their vital role of providing liquidity.  In addition, holding naked CDS against related positions (e.g., equity positions in the same firm, CDS positions in other firms in the same industry) can be sensible spread trading strategies that ensure that financial instruments are priced appropriately relative to one another.

Second, it is interesting that Gensler cannot point to any particular example in CDS analogous to what apparently happened to ships in the 18th century. He resorts to the “some say” dodge, stating that “some observers . . . contend” that CDS swap protection buyers “may have engaged in market activity to help undermine an underlying company’s prospects.”

Be a man Gary.  If you have evidence of this, let’s hear it.  If not, some say you should shut the hell up.  I would also note that Gensler’s argument can be applied to pretty much any financial instrument.  Owners of puts on a company have an incentive to do thing to undermine that company’s prospects.  What makes CDS special?

CFTC anti-manipulation standards require a finding that a manipulator had the ability to cause distorted prices, took actions that had the effect of causing such a distortion, and acted with the specific intent to do so.  Is Gensler arguing for a different standard for CDS?  Does he have any evidence that most CDS holders, naked or otherwise, have the ability to cause the distortions that Gensler conjectures?  Can he cite specific examples of where this ability to cause was actually exercised to cause the mayhem he describes?  Most importantly, does he seriously believe that such an action could be undertaken without being detected?   This seems an area in which ex post deterrence through enforcement action or private action is best suited, which is quite different from the shipping example that Gensler discusses.  Blanket bans against naked CDS don’t make sense in this context, as they preclude potentially valuable uses of this strategy, while (so far only hypothetically) misuses can be deterred efficiently ex post.

Gensler also trots out the empty creditor problem.  As I argued here and here, the conventional analysis of this issue (advanced most prominently by Henry Hu, and which Gensler essentially repeats) is seriously incomplete because it fails to address the latent Coase Question of what transactions costs preclude voluntary trades resulting in optimal allocation of rights.  Insofar as remedies are concerned, Gensler and I actually agree: he recommends position disclosure and voting in bankruptcy based on economic interest, just as I did last April in the first of the two posts linked above.

The CFTC chair also criticizes the Basel capital rules insofar as they apply to CDS.  I yield to no man in my disdain for these rules, and think that they were a major contributor to the financial crisis (to the extent that they incentivized banks to undertake the same trading strategy of holding large positions in AAA CDOs).  But I think that Gensler, in his Ahab-like obsession with CDS, focuses on a side issue.  Specifically, he criticizes the component of the rules that give capital relief to those who hold CDS as a hedge against other risk exposures.  He wants more restrictive capital treatment of CDS -hedged positions.  He pejoratively states that this treatment means that “a bank can essentially rent another institution’s credit rating to reduce its required capital.”

Well, yeah.  That’s what hedging is all about; an institution is laying off the risk to somebody who bears it at a lower cost. This can be done by selling the underlying instrument, or entering into a hedging transaction utilizing a related instrument.  Sometimes–a lot of the time–the latter is more efficient.   Economically, it makes perfect sense to require less capital against hedged positions.  It would be perverse indeed to do otherwise.

As to specific restrictions, Gensler suggests that “only CDS subject to collateral requirements could be allowed to provide capital relief.”  Perhaps he hasn’t read the most recent ISDA Collateral Market Review (released on March 1), which states that 97 percent of CDS positions are collateralized.

And by-the-way: AIG’s CDS contracts were subject to collateral agreements.

So, Gensler’s specific recommendations are red herrings, even in the context of arguendo ad AIG.

Would it that CDS and OTC derivatives were the only object of Gensler’s control fetish, and desire to swell the authority of the CFTC.  But no.  Not only are there position limits, but Gensler has also set his sights on the market for power firm transmission rights, setting off a turf war with FERC.

Gensler is attempting to put Rahm Emanuel’s “let no good crisis go to waste” dictum into action, exploiting the financial crisis–and importantly, more than twice told tales about the financial crisis–to advance a regulatory agenda that would concentrate tremendous power in his agency.  This agenda is built on fundamentally flawed analysis.  What’s more, the agency that he heads quite clearly has not demonstrated that it has the capability, resources, or expertise to exercise those powers effectively and judiciously.  And I am being very charitable in saying that.  (If you have any doubts, take some time and look through the reports the GAO has written about the CFTC over the years.  It does not make for happy reading.)

I have some novel suggestions, Chairman Gensler.  First, do no harm.  Second, be circumspect about anyone’s abilities–including yours–to micromanage huge, complex markets.

January 15, 2010

Unintended Consequences in Derivatives Regulation: A Flashback

I was talking to some folks at a research/policy institute at another university about regulation of carbon derivatives trading who are attempting to educate Congress (or, more precisely, Congressional staff) on the matter.  They told me that there was a widespread belief on Capitol Hill that customized, OTC derivatives offer little or no social benefit, and that as a result, their use should be highly restricted, if not eliminated altogether. The view is that these instruments create systemic risks, but confer no corresponding benefit that cannot be offered by exchange traded products.

I disagree, for reasons I set out in a Brookings paper released last fall.  But I don’t want to focus on the details of that argument here.  Instead, I just want to flash back to a historical example that demonstrates that limiting the contracting choices of commodity market participants can have extremely perverse effects, and can in fact create systemic risks.

The legislation that restructured the California electricity markets, AB1890, precluded the state’s major utilities from entering into long term contracts for power.  Instead, in order to ensure the “success” of the spot market for power, the utilities were required to buy electricity from generators through an exchange–the Power Exchange (“PX”).  The bill also capped the price that utilities could charge their customers for power.

This legislation created a huge short position for the utilities.  They were exposed to increases in prices on the PX, and could not pass on these costs to customers.  Most importantly, the bill prevented the utilities from managing their price risk by engaging in long term forward contracting.

We all know what happened.  Power prices spiked, and two utilities still subject to the constraints (SoCal Edison and PG&E) suffered huge losses.  PG&E went bankrupt.

The problem would likely have been less severe had the utilities been given the ability to hedge.  Indeed, the absence of forward contracts may have exacerbated the price spikes, because these contracts would have precommitted the generators to supply power, whereas they arguably had an incentive to restrict output on the PX when conditions became tight.

Moral of the story: limiting the ability of firms to manage risks can impose substantial dangers of financial distress on those companies.  Indeed, if they limitations are systemic (as they were in California), they create the risk of a systemic problem.

Now, the analogy should not be stretched too far.  In its infinite, tofu-fueled wisdom, California chose to favor one type of exchange trading (spot auctions on the PX) for different reasons than Congress in its infinite God-knows-what-fueled-wisdom is contemplating favoring exchange trading of carbon (and other) derivatives.  Moreover, the restrictions in California were particularly draconian, especially when combined with the retail price caps.

Nonetheless, the tale should be a cautionary one.  Firms use derivatives contracts to pass risks to others who bear them at a lower cost.  If you constrain their ability to do so, they will wear more risk than they would otherwise.  This raises the likelihood that they will suffer crippling financial losses.  The more draconian the restrictions, and the wider the scope of their application, the greater the likelihood, severity, and extent of these losses.

That is, by avoiding one risk, you create others.  Rational policy requires a prudent trade-off between these various risks.  But fixated as they are on the risk (largely chimerical, IMHO) of OTC markets, most policy makers in DC are blind to the risks they are effectively choosing.  Their ability to weigh these tradeoffs is, moreover, extremely limited due to a fundamental lack of information.  Carbon trading regulation in particular will have systemic effects: it will impact every producer and consumer of energy.  How could Congress possibly have the knowledge to evaluate the risks that they are forcing on such a vast and diverse group of companies when they restrict their ability to choose the instruments that they can use to manage that risk?  Short answer: they can’t.

I would hope that the California experience would at least make policy makers aware of the possibility that restrictions on the contracting choices available to market participants creates risks.  So far, however, the debate appears to have taken no recognition of this very real possibility.  Keeping their eyes fixed on the skies to reduce the risk of being hit by a falling object, they face the very real risk of stepping into an open manhole.

November 25, 2008

The Morgan Stanley Cascade

Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 8:47 pm

Yesterday the WSJ published a long article about Morgan Stanley’s near death experience in September.   Although the byline reads Susan Pulliam, Liz Rappaport, Aaron Lucchetti, Jenny Strasburg, and Tom McGinty, it reads like it was ghosted by Chris Cox because it raises the specter of evil speculators ganging up to destroy Morgan by buying credit protection against the bank, and short selling its stock:

Trading records reviewed by The Wall Street Journal now provide a partial answer. It turns out that some of the biggest names on Wall Street — Merrill Lynch & Co., Citigroup Inc., Deutsche Bank and UBS AG — were placing large bets against Morgan Stanley, the records indicate. They did so using complicated financial instruments called credit-default swaps, a form of insurance against losses on loans and bonds.

A close examination by the Journal of that trading also reveals that the swaps played a critical role in magnifying bearish sentiment about Morgan Stanley, in turn prompting traders to bet against the firm’s stock by selling it short. The interplay between swaps trading and short selling accelerated the firm’s downward spiral.

. . . .

Pressure also mounted on another front. There was a surge in “short sales” — bets against the price of Morgan Stanley’s stock — by large hedge funds including Third Point LLC. By day’s end, Morgan Stanley’s shares were down 24%, fanning fears among regulators that predatory investors were targeting investment banks.

. . . .

New York Attorney General Andrew Cuomo, the U.S. Attorney’s office in Manhattan and the Securities and Exchange Commission are looking into whether traders manipulated markets by intentionally disseminating false rumors in order to profit on their bets. The investigations also are examining whether traders bought swaps at high prices to spark fear about Morgan Stanley’s stability in order to profit on other trading positions, and whether trading involved bogus price quotes and sham trades, people familiar with the probes say.No evidence has emerged publicly that any firm trading in Morgan Stanley stock or credit-default swaps did anything wrong. Most of the firms say they purchased the credit-default swaps simply to protect themselves against potential losses on various types of business they were doing with Morgan Stanley. Some say their swap wagers were small, relative to all such trading that was done that day.

. . . .

But swaps were also a good way to speculate for traders who didn’t own the debt. Swap values rise on the fear of default. So traders who believed that fears about Morgan Stanley were likely to intensify could use swaps to try to turn a fast profit.

Note the use of the word “bet” (three times) in the first three quoted paragraphs.   The article also throws about terms like “financial Frankenstein” to describe credit default swaps.

I agree with Felix Salmon’s verdict:

In fact it tells a much simpler tale: Morgan Stanley’s counterparties were forced to buy CDS protection to hedge their exposure to the bank, and Morgan Stanley’s hedge-fund clients withdrew a lot of money, not in a bear-raid attempt to kill it off, but because prudence demanded that they do so, and also because they were understandably upset about John Mack’s role in getting the short-selling ban put in place. That ban devastated many hedge-fund relative-value and convertible-arbitrage strategies and caused a lot of anger in the hedge-fund community.

. . . .

So yes, it’s possible that those demonic short-sellers were responsible for the fall not only in Morgan Stanley’s share price, but also in Citi’s at the end of last week. But it’s also possible that it was just old-fashioned sellers, who weren’t selling short but were rather selling down their existing long positions. And it’s also possible that it wasn’t selling at all, but simply a lack of buyers willing to place bets on a fragile institution with a possible leadership vacuum. We simply don’t know — which is why it’s silly to assume that short-sellers were to blame.

That is, it was individually rational for the Merrills, Citigroups, Deutsche Banks, UBSs, etc., to hedge their counterparty risk.   This was especially true in the immediate aftermath of the Lehman collapse, which had demonstrated that (a) a big investment bank could collapse with stunning swiftness, and (b) there was no guarantee that the government would intervene to prevent the collapse.   Put differently, one can explain what went on without positing that malign speculators were making these trades with the specific intent of destroying the firm.

There is still an issue that deserves thought, but which is likely impossible to resolve.   That is whether this individually rational behavior was economically efficient–or collectively rational.

For instance, the activities of those hedging against (or betting on) a Morgan Stanley collapse could be consistent with an informational cascade.   The individual banks had information on Morgan Stanley’s creditworthiness, but were also drawing inferences from the actions of other potentially informed parties.   A given bank, observing others buying protection or short selling MS stock, would infer that these parties had received adverse information about Morgan’s creditworthiness.   Even if a given bank’s own information wasn’t that bearish, the inference drawn from the behavior of others could be sufficient to convince it that the firm was on the brink of failure, leading it to buy protection against an MS default.   And the next bank, seeing what that bank had just done, would likely make the same inference.   And the next bank, and the next one.   Such a “cascade” can become self-sustaining, leading everyone, regardless of their information, to join the wave of those “betting” against MS’s survival.

The literature on cascades demonstrates that these cascades can lead to the “wrong” outcome.   Specifically, if the first couple of traders act on signals that present an overly pessimistic view of Morgan’s condition, an unjustifiably bearish cascade can occur.   In such a cascade, even those with more optimistic signals will make bearish trades. Thus, the ultimate outcome of the cascade may not aggregate information accurately.   A healthy firm can be brought to its knees by a cascade.

So it is possible that Morgan Stanley’s agonies were the result of an inefficient informational cascade in which everybody was individually rational, but the result was inefficient and collectively irrational.

This raises the question: What can be done to stop such inefficient cascades?

The literature on cascades suggests that cascades are very fragile.   They can be stopped quickly by the release of accurate, credible information.   It is hard to imagine this occurring in the frenzied conditions of the market on those September days.   Who could have provided this credible, accurate information in real time?   Morgan Stanley itself was hardly a credible source of information.   Given the opaque nature of the firm’s balance sheet, moreover, it is hard to imagine that there was any credible source of information.

Perhaps some sort of circuit breaker–or, perhaps, “cascade breaker”–would have done the trick.   Stopping trading would have stemmed the cascade’s momentum.   This stoppage would have had to have been coordinated across several markets, including the CDS, stock, and options markets, in the US and abroad.   Moreover, how would the breaker be triggered?   Would it be some non-discretionary trigger based on observable market prices, e.g., a fall in a company’s stock price of X percent?   Or a discretionary action?   If discretionary, who would exercise it?   A government regulator?   There are obvious pitfalls with any of these alternatives.   (Look at the chaos in the Russian stock market in recent weeks, with myriad market closures.)

This “cascade breaker” could provide an intellectually respectable justification for a restriction on short sales.   (Not that the opponents of short sales have made such a justification, preferring instead to portray short sellers as financial Snidely Whiplashes.)

But not so fast.   Although it seems that bank runs–and what happened to Morgan Stanley is analogous to a bank run–are inherently bad, and that stopping them would be good public policy, the banking literature does not support this conclusion.   As Diamond and Rajan and others have shown, bank runs can be a valuable disciplining advice.   Absent the threat of runs, financial institutions that supply liquidity can act opportunistically towards their creditors.   This opportunistic behavior can be costlier than a run.

Thus, there is no immediately obvious policy response to the events described in the WSJ article.   The cartoonish demonization of short sellers and credit protection buyers is certainly not a reasonable basis for intervention into the markets.   The details presented in the article do not prove that speculators intent on driving Morgan Stanley out of business were responsible for the short sales and the CDS purchases; individually rational hedging behavior could have produced the same behavior.   Individual rationality does not imply efficiency because of the possibility of inefficient information cascades, but even then, the optimal policy response is not obvious.     Unless policy makers can reliably distinguish between inefficient and efficient runs/cascades, intervening to prevent all cascades through the imposition of a circuit breaker can eliminate a valuable disciplining mechanism that reduces the costs of contracting.

In the end, I imagine that one’s priors about the likelihood of inefficient cascades determines one’s policy recommendation.   Since information cascades are the result of myriad individual decisions, and the optimality of these decisions depends on private information unobservable to any investigator, it is impossible to determine ex post (let alone in real time) whether a particular run/cascade was efficient or inefficient.   Thus, there is inevitably a paucity of evidence that people can use to revise their priors.   Moreover, any policy action is likely to have large, and virtually impossible to quantify, costs.   (How does one quantify the costs arising from less efficient contracting when the elimination of disciplining runs rules out the “best” contracts?)   Thus, cascade breakers, or any policy response, are little more than shots in the dark, based on quasi-religious views about the efficiency of markets.

I know that’s not a very palatable diagnosis, but there it is.   We are ignorant, and the ignorance cannot be remedied.

April 5, 2007

I Swear I Read This Someplace Before

Filed under: Commodities,Derivatives,Exchanges — The Professor @ 8:22 am

Today from Reuters:

IntercontinentalExchange Inc.’s (ICE.N: Quote, Profile, Research) bid for the Chicago Board of Trade may have been fomented by a broker backlash against the potential power of a combined CBOT Holdings Inc. (BOT.N: Quote, Profile, Research) and original suitor Chicago Mercantile Exchange Holdings Inc. (CME.N: Quote, Profile, Research).

Atlanta-based ICE, virtually unknown in the futures business just a few years ago, stunned the industry in March with an unsolicited bid that would give CBOT shareholders a majority stake in the combined company.

Banks that are among the largest futures players have signed on to advise ICE, whose innovative proposal for CBOT has at the least created a roadblock to the consummation of a marriage between the two largest U.S. futures markets, each of which has called Chicago home for decades.

“ICE may be getting support from some some of the brokers who were critical of the CME-CBOT deal,” said Keefe, Bruyette & Woods analyst Richard Herr. “The development of ICE’s bid for CBOT speaks to a further intensification of the brokers versus exchanges.”

Last week ICE said that UBS AG (UBSN.VX: Quote, Profile, Research) and Societe Generale (SOGN.PA: Quote, Profile, Research), parent of brokerage Fimat Group, had joined Morgan Stanley (MS.N: Quote, Profile, Research) as co-advisers in its offer for CBOT, which is the parent of the No. 2 U.S. futures exchange.

Oh now I remember. I advanced this hypothesis the day the ICE deal was announced.

Although the Reuters story focuses on “brokers”–implying FCMs–it is also important to emphasize the point (raised somewhat parenthetically in the story, he said parenthetically) that these FCMs are arms of big banks that dominate the OTC derivatives market. Methinks that the OTC desks of the big banks is where the real source of the opposition lies.

The story quotes a FIMAT exec providing a rationale for the FCM/bank opposition to the merger:

“Separately, both the CBOT and CME already have virtual monopolies for most derivatives contracts they offer to the public,” wrote Fimat general counsel Gary DeWaal in a November editorial in the Financial Times.

“Naturally the new entity would have significant pricing power and … unparalleled power effectively to inhibit real competition.”

I agree completely with the first statement. The second one is highly arguable, and depends on implicit assumptions that are highly dubious. Merging two monopolies would increase pricing power only to the extent that the monopoly products are substitutes (in which case the businesses aren’t really monopolies–hence something of a contradiction in Mr. DeWaal’s reasoning). I have seen no explicit estimates of cross-elasticities of demand for CME and CBT products, but doubt they are large, and suspect they might not even be positive. That is, as I have pointed out before, it may well be the case that the products traded on the two exchanges are complements, rather than substitutes. (This would imply negative cross-elasticities). This is because the exchanges’ products are traded in spreads (e.g., Treasuries vs. Eurodollars, corn vs. live hogs). In this case, the exchanges will engage in double marginalization/markup because neither takes into account the impact of its pricing on the sales of the complementary product. Merger would actually improve the efficiency of pricing in this case. Add in the effect of cost savings, and the welfare improvement resulting from the merger could be large indeed.

In any event, its good to see that the press is finally catching onto the possibility that support for the ICE effort is not all Mom and Apple Pie, but likely reflects the very intense commercial interests of large financial players looking to protect their own turf.

« Previous Page

Powered by WordPress