Streetwise Professor

May 3, 2012

Sorry, GiGi, But Systemic Risk Lipstick Won’t Make the SEF Mandate Pig Beautiful

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 7:35 pm

On the anniversary of the passage of Frankendodd, I named the swaps execution facility mandate as the Worst of Frankendodd.  There was intense competition for the honor, to be sure, but I stand by that conclusion.

Gary Gensler sortied into enemy territory at the ISDA AGM in Chicago to do his best to defend the worst.  My verdict (based on press coverage): #Fail.

Interestingly, although Gensler used to focus (wrongheadedly) on the supposed competitive benefits of a SEF mandate, in Chicago he tried to portray it as a bulwark against systemic risk:

“Transparency to the public lowers the risk [for] clearinghouses,” he told the conference.

“Clearinghouses can only survive if they have reliable pricing feeds on a daily basis to mark to market their positions, and also have reliable, liquid markets in default scenarios,” Gensler said.

“There is far less risk in a clearinghouse if you have both pre-trade transparency and post-trade transparency.”

Dealers have criticised the move to electronic execution of OTC derivatives, complaining the large size and small volume of trades means such rules are inappropriate for the market.

This is clearly-no pun intended-incorrect, particularly when viewed in the context of Gensler’s desire for extensive pre-trade transparency and near real time reporting of trades.

CCPs will obtain the prices of deals cleared through them, that they can use to determine marks on a periodic basis.  Moreover, they have access to information from member firms that will permit marking deals to market.

Pre-trade transparency is particularly irrelevant in this context.

And Gensler is positively delusional if he thinks that the pre- and post-trade transparency is going to ensure “reliable and liquid markets” in default scenarios-especially if those scenarios involve the default of a systemically important clearing member.   Note that even for normally listed, exchange traded products CME used an auction procedure, rather than normal trading protocols, to handle the Lehman default.  Also note that LCH was able to handle the Lehman IRS portfolio default in a pretty effective and orderly way even without mandated centralized trading.

Gensler appears to believe that OTC derivatives markets, even for cleared products, will be like exchange trade futures.  Hardly.  One size does not fit all.  The nature of the transactions, the transactors, and the products is very different.  That’s why there are different markets and different market structures: the different structures are discriminating ways of accommodating the diversity of trades and traders. Market structures are endogenous, and reflect the characteristics of trades and traders, a point that is lost on Gensler and all too many others.

Indeed, the biggest problem that CCPs will not be obtaining price information on fairly active products, even if those products trade without pre-trade or post-trade transparency: even without SEFs, it will be relatively easy to mark 10 year USD IRS or active credit indices to market.  The problem will be obtaining information on the value of the products that don’t trade.  Gensler apparently believes in the Field of Dreams Theory: if you build a SEF, the trades-and bids and offers-will come, for everything.

No, actually.  Many products traded OTC do not trade frequently.  That’s a major reason why a dealer market structure rather than a centralized auction market structure, predominates there.  Moreover, the life cycle of trading activity in OTC and listed products is quite different.  Exchange traded products start out illiquid, and if they become liquid at all, become progressively more liquid as their maturity/time to expiry declines.  With OTC products, the cycle is the reverse.  Five year and 10 year swaps are quite active and liquid, and a lot of deals are done.  Those deals live on, and the 10 year swap becomes a 9 year swap and then an 8 year swap, and so on, and these products are far less liquid than the benchmark maturities.  You can have all the SEFs in the world, and 3.35 year swaps ain’t going to be trading, and won’t even be bid or offered.  Meaning that it SEFs will matter exactly bupkus for such products.

What’s more, mandated pre- and post-trade disclosure has costs  (mainly in the form of lower liquidity as disclosure of trades and price information raises risks to liquidity suppliers, inducing them to supply less), and these costs will vary by product.  Again, one-size-fits-all is misguided in the extreme.  Gensler dismisses these costs, and pays even less attention to the heterogeneity of products and transactions.

ISDA has pretty much acquiesced to most of the clearing-related rules, but is still fighting hard against the SEF mandate:

A theme of the ISDA conference, which includes large dealers as well as users of derivatives, is that while central clearing reduces systemic risk, regulators should not impose new rules on how derivatives trade, because it could disrupt those established markets and reduce trading volumes.

“Listed and over-the-counter markets are completely different, and it’s important that lawmakers and regulators keep this in mind,” said [ISDA Chairman and Morgan Stanley’s head of Global OTC Clearing Stephen] O’Connor,

He added that the industry was open to more public reporting, but with restrictions such as not revealing the size of very large trades or delaying trade reporting. “We’re not anti-public reporting,” he said.

I agree with O’Connor, but you might say “but he’s biased and protecting the dealers’ gravy train.”  Fine.  But interestingly, a supposed beneficiary of what Gensler wants so badly, isn’t sold on the idea:

Michael Davie, head of LCH.Clearnet’s SwapClear platform, agreed that regulators, clearers and market participants must know what is going on, but public reporting isn’t essential.

As I’ve argued ad nauseum, regulators will know what is going (in terms of positions and trades) due to swap data repositories.  As Davie says, public trade reporting-particularly in near real time-isn’t important for CCPs to do what they need to do.  And as I state above, public reporting of trades won’t help CCPs at all if there are no trades.

No, Gary.  SEF mandates are still the Worst of Dodd-Frank.  And slathering on the systemic risk lipstick won’t make that pig any more attractive.

A quick comment about the ISDA AGM.  A perusal of the press coverage is fascinating.  Virtually every issue-every damn one-that is the subject of intense debate at the AGM was raised here on SWP, or in my academic writing years ago.  Going back to 2008-2009, and sometimes to the late-90s (obviously pre-SWP, but not pre-Pirrong clearing research).  That old Cassandra feeling is particularly powerful right now.  I was invited to participate in the meetings, but had to decline due to another commitment, which alas did not materialize due to the vagaries of court scheduling.  (No! I am not on trial!  Sorry to disappoint some of you.) It would have been a fascinating experience.

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  1. […] – Risk lipstick and the SEF mandate pig: a regulatory fairytale. […]

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    Pingback by SDPs prepare to offer SEF liquidity aggregation/routing for clients « — May 4, 2012 @ 5:31 am

  3. This is a major subset of the whole “market price” conundrum: how do you determine a market price for something in which there is no real market. I have blathered about this before as a designer and implementer of pricing systems, so will keep it brief: in any such market such as IRS where there are ON the run trades and old not on the run trades, the pricing is based on a guesstimate of how much they need to be backed off, and / or some arbitrage calculation to determine values. At times of systemic pressure, the guesstimate becomes massive ( and illusory, and the arb breaks down because no one is answering the phone – i.e. nobody believes ‘nuttin and the dealers are hiding under their desks if they still have one.

    Comment by sotos — May 4, 2012 @ 2:26 pm

  4. @Sotos. Exactly. Tell it to Gensler. Good luck with that. He believes the transparency fairy will fix everything.

    The ProfessorComment by The Professor — May 4, 2012 @ 3:23 pm

  5. Too bad you couldn’t be there. As the country song says, you should’a seen it in color.

    Comment by DrD — May 6, 2012 @ 10:43 am

  6. In the case of the 3.35 year swap atleast the problem isn’t that bad. We just interpolate from 2yr and 3yr points 🙂 Swaps are unwound all the time and the dealers use some reasonable interpolation and things work out not too bad in practice. It is entire a different story if we want to mark swaption vols in the South African rate markets for instance. It will be particularly interesting if the various dealer quotes are averaged (or medianed) to come up with the “market” price. The spreads are widest in such sparsely traded products and plenty of money to be made by those who are smart 😉

    Comment by Surya — May 6, 2012 @ 7:52 pm

  7. The point is that the swaps or any other instruments can be unwound as long as they can be unwound – it is during points of very high stress that things break down and you cannot (or should not) do an interpolation. Classic failed arbs include the spectacular 1987 S&P future to cash during the crash – the complete collapse of the ABCP market in 2007 – where the market consisted of dealers buying and only trading in their own proprietary deals, funded by the FED open window, etc. At times like this the “market” becomes an administered fiction.

    The market works until it doesn’t.

    Comment by sotos — May 7, 2012 @ 10:05 am

  8. […] Craig Pirrong, the “Streetwise Professor.” Professor Pirrong disagrees that pre-trade transparency helps to reduce systemic risk: “CCPs will obtain the prices of deals cleared through them, that they can use to determine marks […]

    Pingback by What Price Transparency? | ISDA media.comment — May 11, 2012 @ 9:54 am

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