Streetwise Professor

October 2, 2012

Reason Sometimes Prevails-Even With Regulators

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 12:49 pm

The Bank of Canada has decided that Canadian entities can meet their G-20 clearing obligations by clearing with international CCPs like LCH or CME.

The alternative-which was seriously considered, until fairly recently-was to require the formation of a domestic Canadian CCP through which Canadian financial institutions would be required to clear.  The Bank of Canada was leaning towards a “Canadian solution” because it believed that it could monitor such an institution more effectively, that a domestic CCP would insulate Canada from global financial shocks, and that it would be easier to provide C$ liquidity support to a domestic entity.

I co-authored a study for the Canadian Market Infrastructure Committee (CMIC) which argued that (a) these benefits were illusory because there would be C$ swaps traded by non-Canadian entities and non-Canadian entities would likely be important members of a Canadian CCP due to scale and scope economies, and (b) mandating clearing via a domestic CCP would dramatically increase collateral and liquidity costs of trading C$ swaps due to the fragmentation of netting sets (among other reasons).  As a result, I/CMIC recommended that Canadian banks, investment funds, and insurers be permitted to meet their G-20 obligations with an international clearer that could margin more efficiently.

It’s good to see that BoC acknowledged the force of these arguments, despite its initial preference for a domestic CCP.  Reason sometimes prevails.

I’m less enamored with BoC Deputy Director Timothy Lane’s argument that commodity trading firms (e.g., Cargill, Glencore, Vitol, Trafigura, Dreyfus) are systemically important.  Much more on that subject soon-it consumed much of my summer.  Hopefully he’s open to persuasion on this issue, as he was on the necessity of mandating the use of a domestic CCP for Canadian IRS.  But it would be gratuitous of me to make too much of a bother of the global commodity trading firm (“GCTF”) matter now.  So I say kudos to Mr. Lane, and the BoC, for setting priors aside; evaluating the arguments and evidence; and coming to the right choice (IMO) with respect to clearing of C$ swaps.

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  1. Somewhat off topic here, Prof., but still germane vis-a-vis regulators in general, the U.S. in particular. Here’s something my fav regulator — “Sideshow” Bart Chilton — had to say at a G-20 confab yesterday in Rome, an aptly chosen venue for a regulatory confab: “People often complain and ask why nobody went to prison for taking a wrecking ball to the economy. Well, what was done didn’t break the law. Don’t get me wrong, there were many violations of the law, but these weren’t the actions that sent economies into the gutter. That is changing, but has not changed yet.”

    He recounts how the global economy was gutted: “In 2008, the world witnessed the beginning of a serious and significant economic calamity—conditions with which we still have not recovered. It was the worst financial crisis in the U.S. since the Great Depression, but it obviously had significant global consequences. Banks melted down. Some even closed. Taxpayers were forced to bail out many of these institutions. In the U.S., that bailout accounted for more than $400 billion. Thankfully, most of that has been repaid. Worse, nine million people lost their jobs in our nation and many more globally. Millions more lost their homes. We also witnessed an astounding—and to many a dumbfounding—rise in global prices for raw commodities, and therefore, food. The results of that posed serious food security issues and the collateral issues nearly always associated with such high prices. As we know, when circumstances like these exist, they impact the least fortunate among us more than others.”

    He then goes on to explain what caused this gutting: “How did that all occur? Well, there was a lack of laws, rules and regulations. That was a major part of it. Then, of course, there was the “greed is good crowd” that took advantage of that ultra-free market environment, and created hellish havoc around the globe. While those are my words, the thrust of what I said was confirmed by the U.S. Financial Crisis Inquiry Commission (FCIC), which was created by our Congress in the wake of the 2008 crash to determine what occurred.

    “To give you a few more specifics, in the U.S., the Depression-era Glass-Steagall law had been repealed in 1999. This allowed investment banks to get into myriad businesses that they had been prohibited from being involved with for decades. In particular, they were allowed to trade for their own proprietary accounts—trading for the house, as it were. Many times, they were involved in making risky, complicated bets — sometimes against their own customers. They were allowed to speculate at will. Many times, they were over-leveraged on these bets, leading to the eventual death of firms like the 180-plus year-old firm of Bear Stearns, and the 160 year-old firm, Lehman Brothers, which was leveraged 30 to one before it was ruined.

    “The dreadful results of that policy shift — the Glass-Steagall Act repeal — are littered around the globe and reflected to varying extents in varying economies. It was a mess and something had to be done.” (Sideshow’s full remarks are here: … this is the most audacious display of ignorance I’ve come across in a long time; but, if you want to have a go and see the intellectual side of U.S. regulation, reading Sideshow Bart’s as good a place as any to start.)

    Anyway, there are a couple of things worth noting here in Sideshow Bart’s remarks: 1) the Obama administration (specifically Eric Holder and the president himself) and much of official Washington continually repeat the fiction that no laws were broken in the lead-up to the financial crisis, Chilton’s remarks being the most recent incantation. 2) It’s easy to see why this narrative is required: No one of any substance has been prosecuted or convicted; most of the folks sitting in regulatory chairs in Washington now were on watch then (so they can’t admit the most colossal regulatory failure in the history of the world occurred on their watch). This is patently false, as the FBI itself noted in Congressional testimony in 2004:

    It is telling that a gumshoe — Chris Swecker, Assistant Director, Criminal Investigative Division, Federal Bureau of Investigation — is the one who most clearly saw the implications of this fraud:

    “Market Impact: The potential impact of mortgage fraud on financial institutions and the stock market is clear. If fraudulent practices become systemic within the mortgage industry and mortgage fraud is allowed to become unrestrained, it will ultimately place financial institutions at risk and have adverse effects on the stock market. Investors may lose faith and require higher returns from mortgage backed securities. This may result in higher interest rates and fees paid by borrowers and limit the amount of investment funds available for mortgage loans.

    “Often times, mortgage loans are sold in secondary markets or are used by financial institutions as collateral for other investments. Repurchase agreements have been utilized by investors for protection against mortgage fraud. When loans sold in the secondary market default and have fraudulent or material misrepresentation, loans are repurchased by the lending financial institution based on a “repurchase agreement.” As a result, these loans become a non performing asset. In extreme fraud cases, the mortgage backed security is worthless. Mortgage fraud losses adversely affect loan loss reserves, profits, liquidity levels and capitalization ratios, ultimately affecting the soundness of the financial institution.” (p. 2)

    This FBI investigation went dark after this testimony, btw.

    So, anyway, back to my rant: Clearly laws were broken. But the regulatory edifice under Bush and Obama pretty much remained inert. As they remain today … the MF Global probe has gone dark, and, mostly likely after the election, will be buried forever.

    Chilton’s remarks are obvious misdirection — the argument being Congress changed the law and took a once-effective regulatory edifice and neutered it … there was nothing we could do — all of which are meant to obfuscate the ineptitude then and now of the agencies charged with ensuring markets are fair and orderly. What’s also interesting is hearing Obama, Holden and their surrogates make similar remarks re the legality (or the lack of illegality) of what we saw in the run-up to 2008, the MF Global collapse, Peregrine Financial Group’s collapse, the countless undetected frauds occurring daily, is the insistence there is no criminal wrongdoing. Somehow the law was insufficient to detect and prosecute criminality.

    This is laughable. Sad but laughable. Sideshow Bart’s the most clownish example of regulatory expertise in Washington at the moment, but he is nonetheless the exemplar of the current state of affairs. What these dopes fail to understand is the markets are underpinned by contracting among strangers — discussed most cogently by Schumpeter, Hayek and Friedman — and that the key to this is a judicial system that enforces those contracts freely executed in a disinterested manner. Somehow, the current discussion has morphed into a hyper-literal reading of laws and regulations which says if something is not explicitly prohibited (e.g., one cannot loot customer accounts) then variants of that behavior (e.g. plundering customer funds) are not illegal. Go figure.

    Comment by markets.aurelius — October 3, 2012 @ 7:03 am

  2. A lot to chew on there, @markets. Yes, Bart is my have too. Always good for a laugh.

    Just on my way back from London. Will read closely on the plane and reply on my return.

    One thing did catch my eye. He blames the repeal of Glass-Steagall. If I read that crock one more time I will self-detonate.

    The ProfessorComment by The Professor — October 3, 2012 @ 7:48 am

  3. I thought you’d like that G-S ref, Prof.

    Comment by markets.aurelius — October 3, 2012 @ 11:24 am

  4. @markets-it sure did. “This allowed investment banks to get into myriad businesses that they had been prohibited from being involved with for decades.”

    That is, even by Sideshow Bart standards, beyond stupid. IBs had NEVER been prohibited from these activities. Uhm, the whole idea behind G-S was to prevent commercial banks from doing those sorts of things, and to channel allegedly riskier activities like securities underwriting to IBs.

    How can you possibly expect this guy to do anything reasonable when he doesn’t understand the most basic things.

    It’s worse than that actually. He doesn’t understand the most basic things, but thinks he’s a freaking expert. Arrogant ignorance is a toxic combination.

    The ProfessorComment by The Professor — October 3, 2012 @ 6:15 pm

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