Streetwise Professor

Today is Frankendodd’s fifth birthday. Hardly time for celebration. It is probably more appropriate to say that this is the fifth year in the Frankendodd life sentence.

So where do we stand?

The clearing mandate is in force, and a large fraction of derivatives, especially interest rate and credit index derivatives are cleared. This was intended to reduce systemic risk, and as I’ve written since before the law was passed and signed, this was a chimerical goal. Indeed, in my view the systemic risk effects of the mandate are at best a push (merely shifting around the source of systemic risk), and at worse the net effects of the mandate are negative.

Belatedly regulators are coming around to the recognition of the risks posed by CCPs. They understand that CCPs have concentrated risk, and hence the failure of one of these entities would be catastrophic. So there is a frenzy of activity to try to make CCPs less likely to fail, and to ensure their rapid recovery in the event of problems. Janet Yellen has spoken on the subject, as has the head of the Office of Financial Research, Robert Dudley of the NY Fed, and numerous European regulators. Efforts are underway in the US, Europe, and Asia to increase CCP resources, and craft recovery and resolution procedures.

This is an improvement, I guess, over the KoolAid quaffing enthusiasm for the curative effects of CCPs that virtually all regulators indulged in post-crisis. But it distinctly reminds me of people madly sewing parachutes after the rather dodgy plane has taken off.

Further, these efforts miss a very major point. The main source of systemic risk from the clearing mandate derives from the huge liquidity strains that clearing (notably variation margin on a rigid time schedule) will create when the market is stressed. There has been some attention to ensuring CCPs have access to liquidity in the event of a default, but that’s not the real issue either. The real issue is funding large margin calls during a crisis.

Moreover, as I’ve also discussed, efforts to make CCPs more resilient can increase pressures elsewhere in the financial system (the “levee effect.”) Relatedly, regulators have not fully come to grips with the redistributive aspects of clearing–including in particular how netting, which they adore, can just relocate systemic risks.

I therefore stand by my prediction that a regulation-inflated clearing system will the source of the next systemic crisis.

Moving on, I called the SEF mandate the worst of Dodd-Frank. In the US, the majority of swap trades are done on SEFs, though mainly through RFQs rather than the central limit order books that Barney and Co. dreamed about in 2010.

There was never a remotely plausible systemic risk reducing rationale for the SEF mandate. Hence, if SEFs are inefficient ways to execute transactions, the mandate is all pain, no gain. As an indication of that this is indeed the case, note that virtually all European banks and end users stopped trading Euro-denominated swaps with US counterparties exactly when the mandate kicked in. The swaps mandate was too onerous, and anyone who could escape it did.

In a piece in Risk, I referred to the Made Available to Trade part of the SEF mandate the worst of the worst of Dodd-Frank. It made no sense to force all market participants to trade a particular kind of swap on SEFs just because one SEF decided to list it. Apparently that realization is slowly sinking in. The CFTC recently held a meeting on the MAT issue, and it seems as if there is a good chance that the CFTC will eventually determine what has to be traded on SEFs.

It is an indication of my loathing for MAT as it currently exists that I consider that an improvement.

Still moving on, Frankendodd was intended to reduce concentration and interconnectedness in the financial system. The actual result cannot really be called a mere unintended consequence: it was the exact opposite of the intended effect. Completely predictably (and predicted) the huge regulatory overhead increased concentration rather than reduced it. This is particularly true with respect to clearing. Gary Gensler’s dream of letting a thousand clearing firms bloom has turned into a nightmare, in which the clearing business is concentrated in a handful of big financial institutions, exacerbating too big to fail problems. And clearing has turned out to be the Mother of All Interconnections, because every big financial institution is connected to all big CCPs, and because pretty much everyone has to funnel the bulk of their derivatives trades through clearinghouses.

I could go on. Let me just re-iterate another risk of Frankendodd: standardization–the regulators’ fetish–is  a major source of systemic risk. Monocultures are particularly vulnerable to catastrophic failure, and the international regulatory standardization that was birthed in Pittsburg in 2009, and enacted in Frankendodd and MiFID and Emir, has created a regulatory monoculture. Some are grasping the implications of this. But too few, and not the right people.

I’ve focused here on the sins of commission. But there are also the sins of omission. Frankendodd did nothing about the Fannie and Freddie monster, which is coming back from the dead. F&F was a real systemic risk, but the same political dynamic that fed it in the 1990s and pre-2008 is at work again. Get ready for a repeat.

Frankendodd should have just focused on raising capital requirements for banks and other financial institutions with liquidity and maturity mismatches, and driven a stake through Fannie and Freddie. Instead, it sought to impose a detailed engineered solution on an emergent order. This inevitably ends badly.

So maybe it would be more accurate to say that we’re in our fifth year on death row. Someday the warden will come knocking.