Streetwise Professor

May 14, 2009

So, Don’t Listen to Me

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics — The Professor @ 4:59 pm

Not like they would, but anyways . . .  

The Treasury Department today released a letter on “Regulatory Reform Over-The-Counter (OTC) Derivatives” [sic–“in”? “for”? “of”?].  There are a few good ideas in it, but on balance the bad far outweighs the good.  

The centerpiece of the proposal (which has received a warm welcome from Congressional powers like Barney Frank and Collin Peterson) is to mandate clearing for “all standardized OTC derivatives.”  “Standardized” is not defined, but the letter suggests how this will be determined: If a clearinghouse offers to clear it, it’s standardized: “For example, if an OTC derivative is accepted for clearing by one or more regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.”  

On Tuesday, I gave a presentation at the Atlanta Fed conference where I reiterated my argument–which debuted here on SWP–that mandating clearing is a bad idea.  Even for standardized products (my argument nowhere depends on standardization, except to the extent that there is some correlation between standardization and the magnitude of information asymmetries), it is quite possible that information costs are higher in cleared markets than in bilateral markets.  For particular transactions, involving particular transactors, it is possible that information costs are lower in a bilateral trade.  These lower information costs can make it efficient NOT to clear such deals; for other trades, in the same or similar instruments, clearing may be more efficient.  

In a nutshell, there is no basis for the presumption that the costs of clearing are lower than the costs of bilateral trades.  Moreover, I have not seen a credible argument showing that the social benefits of clearing exceed the social costs, but the private benefits are smaller than the private costs; such a showing would be necessary to justify a mandate  for clearing.  At the Atlanta Fed conference, Ed Kane of Boston College (the moderator of my session) argued that the safety net arising from deposit insurance and the implicit promise to bail out too big to fail banks could lead to such a circumstance.  I do not see the economic basis for this conclusion.  Moreover, there have been cases in the past–namely at the CBOT in the 1920s and the LME in the aftermath of the Tin Crisis–where exchanges resisted government pressure to adopt clearing even though there was no safety net that could have caused a divergence between private and social costs/benefits.  

As I said at the Atlanta Conference, my issue is not with clearing per se.  It is with who decides what gets cleared.  Chuck Vice from ICE (no, I did not make that up;-) had chided me after my talk where I cast doubt on the virtues of clearing for some products and participants by saying “I thought you were my friend, Craig.”  I replied: “I am your friend, Chuck.  If you (i.e., ICE) build a clearing system, and market participants come–as happened in energy–more power to you.  That’s great.  What I’m worried about is the ‘We’re from the government and here to help you’ problem.”   By substituting its judgment–an ill-informed judgment IMHO–for the judgment of market participants who (a) have better information on the costs and benefits, and (b) have skin in the game, and hence an incentive to make the right decisions (though since information and incentives are imperfect, they will some times make decisions that an omniscient agent would not), the Treasury risks reducing efficiency. This is a serious risk, in my view.

I have yet to hear any indication from the Treasury, Congress, or the Fed that the issues relating to information costs, and the implications thereof for the benefits of clearing have been acknowledged, let alone addressed.  Since information costs are an essential determinant of the efficiency of any risk transfer mechanism–which is what clearing is–this is a serious omission that undermines any presumption that the proposal is based on a thorough consideration of the relevant considerations.  

Some other issues.  First, the Treasury letter is framed in a very dishonest way.  It starts by saying “[a]s the AIG situation has made clear, massive risks in derivatives markets have gone undetected . . . even if those risks had been better known, regulators lacked the proper authority to mount an effective policy response.”  As its first proposed policy response, it recommends mandatory clearing of standardized products.  But the AIG products were highly non-standardized, and it is extremely unlikely that these products would ever be clearable.  But by linking clearing with AIG, the letter suggests that the former would have prevented the latter.  Nothing in any of the proposals would have had any effect on any of the AIG deals.  This linkage is dishonest, in my view; a classic bait-and-switch.  If a firm did something like that in a securities prospectus, the SEC would nail it.  Similarly, if somebody did something similar in an infomercial, FTC would be all over them.  

Second, the standardization issue will raise no end of difficulties.  It will create an incentive for parties who recognize that the costs of clearing exceed the benefits to enter into non-standard transactions.  The letter says somebody must “ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.”  The subject of the sentence is “CCPs.”  So, are we to believe that CCPs are to investigate bilateral transactions, and make a judgment on the motives for such deals?  There is a real conflict of interest here, as the CCP has the incentive to force business its way, and look at all non-standardized deals with suspicion.  (I should also note that if the dominant CCP is a member-owned entity dominated by banks, they may influence things in the other direction.)  More likely, the regulator will be required to make such judgments.  So, CFTC (or whomever ends up being the regulator) is supposed to put itself in the heads of transactors, and decide what their motives are for a particular trade?  This is a recipe for litigation, conflict, and most importantly, legal uncertainty.  

This will raise all of the issues that created problems under the Grain Futures Act and the CEA.  Those laws required “futures” to be traded on exchange, but allowed cash market contracts to be traded bilaterally.  So, what is a future?  What is a cash market contract?  Who knows?  In part, the answer depended on the economic purposes of the transactions.  Same now with the “standardized” vs. “non-standardized” distinction.  Such distinctions are recipes for dispute, and invitations for financial engineering to circumvent the clearing requirement.  The possible implications for legal certainty are particularly disturbing.  

Third, the letter emphasizes the role for “robust margin requirements.”  There is no recognition that margining can actually contribute to systemic risks, and that the rigid types of margining that CCPs perform may be particularly susceptible to this problem.  Margin calls can induce liquidations that move prices away from equilibrium values, and set off positive feedback mechanisms that destabilize the market.  Similar problems can arise in OTC markets, but the greater flexibility in these sort of arrangements, including the ability to utilize a broader range of collateral, can mitigate the problem there.  It is by no means clear that rigid CCP-style margining reduces systemic risk; it can increase it in some circumstances.  

On the issue of margins, I was interested to hear Chuck Vice (of ICE–I just like saying/writing that;-) say that ICE Trust took an “agnostic view” of the credit risk of member firms in setting margins, and therefore would charge everyone the same margin level that would be sufficient to cover the likely loss on a particular position during an extreme market move.  Bug or feature?  Chuck thinks feature.  I think bug.  Different members pose different default risks (just look at disparities in CDS spreads among the members of ICE Trust), and this would suggest the optimality of different margins–that is done in the OTC market.  One size fits all doesn’t fit everybody when people are of different sizes.  In the OTC market, parties can customize collateral levels to reflect risks, and this has virtues.  

Back to the Treasury letter . . .  

Another pernicious proposal is that the CEA be amended “to authorize the CFTC and SEC to impose . . . . The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.”

Again, this is the GFA/CEA redux–like those laws, this proposes to force a subset of all trades onto centralized exchanges, or electronic trade execution systems that are very exchange-like.  The reason for such a mandate is not stated.  Nor do I think it exists.  What externality is being internalized?  At what cost?  What is the basis for substituting the government’s judgment as to how trades should take place for the judgment of the transactors themselves?  

This is certainly a boon for the CME, and arguably ICE.  And shazaam, their stock prices took off after the release of the letter.  Who would have thought?  

Again, as under pre-CFMA CEA/GFA, the on-exchange/off-exchange distinction will lead to dispute, litigation, and legal risk.  

One could argue that exchanges are more transparent, and that transparency is a benefit.  However, other parts of the letter–namely, the requirement that all trades (including non-standard ones) be reported to a trade repository made available to regulators, and the development of a price reporting system–address the transparency issue.  Indeed, these are better ways to address transparency concerns than either clearing or forced exchange trading.  I said just that in my FRB Atlanta presentation, and in my academic writings on the subject.  Exchange trading may be sufficient to produce price transparency, but it is not necessary.

The transparency proposals are something I support.  Indeed, I view those as something of a vindication, as I was advocating such measures in energy markets in the 2003-2004 period.  The Data Hub lives!  

One issue with post-trade price and position transparency is the effect it will have on liquidity.  JP Morgan’s Eric Beinstein raised such concerns in his talk at the Fed conference.  This was a big deal with London dealers in the stock market, who feared that premature disclosure of trades would make it more difficult for them to lay off positions that they took on from customers.  Therefore, it may be advisable that some reporting delay be permitted.  

The letter also addresses market manipulation, fraud, and other abuses: “The CEA and securities laws should be amended to ensure that the CFTC and the SEC have . . . . Clear and unimpeded authority . . . to police fraud, market manipulation, and other market abuses.”  This is a red herring.  Relatedly the letter says that “under current law [OTC markets] are largely excluded from or exempted from regulation.”  This is wrong if it is meant to refer to exemptions from the manipulation or fraud provisions of the CEA.

CFTC already has authority to police manipulation of “any commodity traded in interstate commerce” and this clearly would extend to OTC swap markets as currently constituted.  Even the much (and wrongly, in my view) maligned CFMA did not exempt any market from the anti-manipulation or anti-fraud provisions of the CEA.  So, why is this language in the proposal?  Ignorance?  

More unfortunately, the letter recommends giving regulators the ability to set position limits on OTC market positions.  As I’ve written  in my book on manipulation, and often on SWP, position limits are an inefficient way to combat manipulation and fraud.  Ex post action is a better way.   CFTC should be better able to do this with better information about positions, so position limits are not advisable.

The problem, though, is not with CFTC’s powers or information.  It is with its willingness and ability to use them.  CFTC’s record in anti-manipulation litigation is hardly glorious.  Moreover, the legal precedents–especially CFTC decisions like in re Indiana Farm Bureau and in re Cox & Frey–have seriously undermined the deterrent force of government and private ex post litigation.  Treasury and Congress would do much more to improve deterrence by writing legislation to clarify manipulation law to undo the pernicious effects of these decisions.  Without doing that, Treasury is fooling itself when it says (in Geithner’s letter to Harry Reid, linked at the bottom of the link above) that  “With CCPs, trade repositories, and other market participants providing the CFTC and SEC with a complete picture of activity in the OTC derivatives markets, they should be able to detect and deter all such market abuses [emphasis added].”

As if.

Information is NOT the binding constraint.  When a manipulation is suspected, the subpoena power is sufficient to obtain the requisite information–and it is usually the efficient way.

I repeat: The binding constraints are (a) the intellectual confusion inherent in existing manipulation precedents; (b) the intellectual confusion at CFTC and other regulatory agencies when it comes to manipulation; and (c) the vague language defining manipulation in the relevant statute, which is ultimately the source of intellectual confusions (a) and (b), and which stemmed quite clearly from Congress’s own intellectual confusion.  I have been saying this since 1994.  So, don’t listen to me.  I’m used to it.  But don’t fool yourselves into believing that you will reduce manipulation efficiently through position limits and the collection of more information that is mis-used because of a failure to understand the economics of manipulation.

The letter also recommends actions to ensure that derivatives are not marketed to unsophisticated parties.  I have not analyzed this issue in detail, but it is my sense that this is another area in which ex post litigation, including private actions (including class actions) would be a preferable way to handle the problem.  Trying to write rules to determine ex ante who is, and who isn’t, sufficiently knowledgeable to enter into derivatives trades is extremely problematic.  I also worry about the incentive this provides for people to take risks, and then attempt to back out of losing contracts by claiming that they were duped.  Maybe they were, but I think there should be a pretty high standard of proof required to support such a finding.

In sum: There are a few good ideas in the Treasury proposal.  Very few.  The biggest, most important proposals are wholly misguided, in my view.  They reflect, again in my view, (a) a shockingly incomplete analysis of the relevant economics, (b) an unjustified and unsupported presumption that regulators’ and legislators’ judgments are superior to those of private transactors, and (c) a failure to identify market failures that the proposed regulatory changes would fix.

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