Streetwise Professor

April 21, 2010

The Next Derivatives Disaster

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 9:06 pm

Is the legislation currently working its way through Congress.  According to The Hill, Harry Reid wants the Lincoln derivatives bill incorporated into the Dodd legislation (replacing the “place-holder” derivatives title of the Dodd bill).  Great.

There are many bad features in the Lincoln bill.  Arguably the worst (though the competition is stiff!) is the proscription on any “Federal assistance”, including Fed lending, to financial institutions that trade derivatives, including clearinghouses.  Especially when combined with the mandated expansion of clearing, this is extremely dangerous.

Clearinghouses can blow up.  It has happened historically, and it almost happened with disastrous effects during the ’87 crash.  Arguably the only thing that prevented that from happening was the intervention of the Fed.  I strongly suggest that Lincoln, or her staff, read the Brady report on the Crash to get some understanding of that.  Or better yet, read Bernanke’s “Clearing and Settlement During the Crash” (3 Rev. Financial Stud. 1990 at 133).  A few telling excerpts:

Let us put aside the possibility of government intervention for the moment. Then there seems to be a potential structural problem with the clearinghouse arrangement. The problem is not that some traders who thought they had a guaranteed contract would end up not being paid off; as we have said, perfect insurance against systemwide shocks is not possible. Rather, the problem is that a shock large enough to exhaust the clearinghouse’s capital and assessment powers would have a serious prospective effect on the ability of the clearinghouse and thus of the futures market itself to function. Presumably, over a period of time reorganization and recapitalization would occur. But in the shorter run the poor functioning or shutdown of the futures market might exacerbate the adverse conditions that precipitated the problem in the first place.

That is, the potential for failure of a clearinghouse–just the potential–can lead to a positive feedback mechanism that worsens the crisis.

Bernanke discusses the essential role of the Fed on 19-20 October:

The malfunctioning of the banking side of the clearing and settlements systems during this period is indisputable. [Emphasis added.]

. . . .

The official reports and other observers generally agree that the Federal Reserve’s attempts to alleviate the crisis were very constructive. On Tuesday morning, October 20, the Fed issued a brief statement: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the financial and economic system.” This statement was backed up by three types of actions: First, the Fed reversed its tight monetary stance of the previous weeks and flooded the system with liquidity. Second, the Fed “persuaded” the banks, particularly the big New York banks, to lend freely, promising whatever support was necessary. (The 10 largest New York banks nearly doubled their lending to securities firms during the week of October 19.) Finally, the Fed monitored the situation and took some direct actions where necessary, notably in the case of First Options of Chicago. When that large clearing firm was in danger of defaulting, Fed Chairman Greenspan acted quickly to enable its parent firm, Continental Illinois, to inject funds into its subsidiary; according to some observers, this action may have helped avoid the closing of the options exchange.

. . . .

In retrospect we may ask, what really were the dangers to the integrity of the financial markets posed by the crash? And what were
the benefits of the Federal Reserve’s actions? The technological problems of communications and information availability that plagued the system, while serious, did not in and of themselves threaten to bring down the markets. For the most part, information availability was a critical issue during the crash only in the sense that illiquidity is essentially a problem of imperfect information. (Clearly, though, improvements in these technologies should be made.)

It was the financial problems-the possibility of insolvency by major players-that were potentially the more serious. As we have emphasized, financial problems impaired the market’s functioning in at least two ways. First, concerns about solvency impeded the operation of the payments and clearing systems, contributing to financial “gridlock.” Second, the fear that major brokers, FCMs, or clearinghouses might default created uncertainty about the contract performance guarantee. Both aspects reduced market liquidity and disrupted trading. Conceivably these problems could have forced a market shutdown.

In response to this situation, the Federal Reserve, in its lender-of- last-resort capacity, performed an important protective function. The Fed’s key action was to induce the banks (by suasion and by the supply of liquidity) to make loans, on customary terms, despite chaotic conditions and the possibility of severe adverse selection of borrowers. In expectation, making these loans must have been a money-losing strategy from the point of view of the banks (and the Fed); otherwise, Fed persuasion would not have been needed. But lending was a good strategy for the preservation of the system as a whole.

The principal effect of the loans was to transfer some trader default risk from the clearinghouses and their members to money-center
banks. Under the presumption that the money-center banks were well capitalized, and that in any event their solvency would be guaranteed by the government, this transfer of risk reduced the overall hreat of insolvencies in the system. This allowed the payments process to begin to normalize; it also restored confidence in the clear- inghouse’s guarantee of futures contract performance. The resulting stabilization of the markets served the interest of the banks and the Fed in a wider sense, by avoiding any potential costs that a market breakdown might have imposed on the banking system and the general economy.

In performing its lender-of-last-resort function, the Fed redistributed risks in the system in a socially beneficial way. Conceptually, it
is as if the Fed had provided ex post insurance to the clearinghouse against a shock that it seemed possible would exhaust the insurance capability of the clearinghouse itself. Thus the Fed became the “insurer of last resort.”

What, pray tell, would have happened absent the Fed supplying liquidity to the system?  A disaster.

Note that Bernanke’s analysis recognizes that a clearinghouse’s financial resources are limited.  Would it that those flogging the clearinghouse cure would recognize this, and grapple with its implications in a serious way (as Bernanke did), rather than ignoring this brute fact as they do routinely: no, reflexively.

A dramatic expansion of clearing will increase, in a commensurately dramatic way, the potential for operational and financial failures in the clearing and payment system (like those observed in ’87) during a large price move.  Any policy of mandates MUST acknowledge this, and make sure that mechanisms are in place to address this reality.  By cutting out derivatives, and clearinghouses, from the lender of last resort mechanism, but providing no replacement, the Lincoln bill is courting financial Armageddon.

(Perhaps the Fed would be able to intervene indirectly, by supporting banks and inducing them to support the clearinghouses financially, but constraining the means by which the Fed can supply liquidity to the clearing system increases the likelihood of a failure.)

Bernanke argued in his 1990 article that the Fed has a role in ensuring the integrated banking, clearing, and settlement systems can survive a shock like a stock market crash.  (Again–it is integrated: interconnected.)  Although the Lincoln bill attempts to hive off the derivatives markets from the broader financial system, this is an impossibility.  No, it is worse: it is an absurdity.  The banking and derivatives trading systems are inextricably linked.  Policy must be predicated on that fact.

Maybe the Fed is a flawed institution, but it’s the institution we have.  If Lincoln gets her way, and constrains the ability of the Fed to perform its LOLR function in support of a vastly expanded clearing system, without providing any alternative, she is indeed “reforming” derivatives markets in the worst way.

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9 Comments »

  1. […] – The next derivatives disaster. […]

    Pingback by FT Alphaville » Further reading — April 22, 2010 @ 2:00 am

  2. […] Craig Pirrong makes a strong case that this will greatly increase risk to the system. […]

    Pingback by Ignore Obama’s Big Wall Street Scolding Today, Here’s The One Real Regulatory Battle To Watch — April 22, 2010 @ 7:22 am

  3. […] This post was mentioned on Twitter by Mike McCartney. Mike McCartney said: Streetwise Professor » The Next Derivatives Disaster https://streetwiseprofessor.com/?p=3687 […]

    Pingback by Tweets that mention Streetwise Professor » The Next Derivatives Disaster -- Topsy.com — April 22, 2010 @ 9:35 am

  4. ‘Thus the Fed became the “insurer of last resort.”’ Does that magic money come out of thin air? The rest of your article looks like it was written by Gubm’t Sachs.

    http://finance.yahoo.com/news/Wholesale-prices-rise-in-apf-299827519.html/print?x=0

    Comment by Mr. X — April 22, 2010 @ 9:48 am

  5. When I gave evidence to the UK Treasury Select Committee I advocated a different approach, and that is the mandatory transaction registration via membership of a market user group/ International Trade Association (ITA).

    Firstly, this creates a new tool available for access by regulators.

    Secondly, this creates a database of data available for dissemination/broadcast ‘at cost’ by market service providers.

    Thirdly, the ability to suspend or terminate membership -and hence the right to register transactions – gives pretty sharp, and globally applicable, regulatory teeth in respect of the enforcement of agreed ITA market standards.

    As for clearing, I agree with you that to concentrate OTC risk with intermediaries in a ‘single point of failure’ is pretty dumb, and the key reason why the Internet came about in the first place was DARPA’s attempt to avoid just this risk.

    I prefer a ‘Clearing Union’ approach, whereby all market participants (ie the ITA members above) provide a guarantee – as shipping firms do in a ‘P & I Club’ insuring hulls – and the risk is managed by a service provider again with suitable collateral/margin etc.

    Within such a ‘framework of trust’ it would then be possible to use software such as Ripple to generate settlement chains to net out the gross open bilateral positions, in the same way that Brent/BFOE ‘daisy chains’ come about on expiry of that vanilla forward contract and give rise to ‘book-outs’ and cash settlements.

    Comment by Chris Cook — April 23, 2010 @ 11:44 am

  6. […] Craig Pirrong makes a strong case that this will greatly increase risk to the system. […]

    Comment by Jeff — April 26, 2010 @ 10:44 pm

  7. […] Craig Pirrong makes a strong case that this will greatly increase risk to the system. […]

    Comment by Simon — April 27, 2010 @ 9:34 pm

  8. When I gave evidence to the UK Treasury Select Committee I advocated a different approach, and that is the mandatory transaction registration via membership of a market user group/ International Trade Association (ITA).

    Firstly, this creates a new tool available for access by regulators.

    Secondly, this creates a database of data available for dissemination/broadcast ‘at cost’ by market service providers.

    Thirdly, the ability to suspend or terminate membership -and hence the right to register transactions – gives pretty sharp, and globally applicable, regulatory teeth in respect of the enforcement of agreed ITA market standards.

    As for clearing, I agree with you that to concentrate OTC risk with intermediaries in a ‘single point of failure’ is pretty dumb, and the key reason why the Internet came about in the first place was DARPA’s attempt to avoid just this risk.

    I prefer a ‘Clearing Union’ approach, whereby all market participants (ie the ITA members above) provide a guarantee – as shipping firms do in a ‘P & I Club’ insuring hulls – and the risk is managed by a service provider again with suitable collateral/margin etc.

    Within such a ‘framework of trust’ it would then be possible to use software such as Ripple to generate settlement chains to net out the gross open bilateral positions, in the same way that Brent/BFOE ‘daisy chains’ come about on expiry of that vanilla forward contract and give rise to ‘book-outs’ and cash settlements.

    Comment by Simon — April 28, 2010 @ 1:47 am

  9. Well, to me, the idea of a clearinghouse and of mark-to-market sounds like a much safer bet than the current over-the-counter situation.

    Now, about bankruptcy. Remember, that any over-the-counter, private contract can’t be negative to the system as a whole: whatever one party loses on this contract, the other party wins. Thus, when AIG is in the red for, say, $20 bln, it means somebody else – mostly Goldman Sachs, probably – is in the black for $20 bln.

    Thus, in such situations no government financial bail-out of Wall Street is needed. Let Wall Street companies decide among themselves who should pay to whom and how much. If AIG owes $20 bln to Goldman Sachs but can’t pay, why should the taxpayers help AIG pay (other than the obvious fact that our Fed and Treasury execs are Goldman alumni)? If AIG can pay $20 bln to Goldman – let it pay. If it can’t – let Goldman get from AIG whatever it can. And if it ain’t much – well, Goldman just won’t make as much profit as they hopped.

    Look, if Goldman wants to continue with these private contracts – let them be responsible for them. These OTC derivatives are highly risky bets. When Goldman entered into these contracts, it knew that the market and the counter-party risks were working in the opposite directions. Goldman knew perfectly well that AIG had been entering into ruinous deals left and right. So, Goldman knew that AIG would soon go belly up. And yet, Goldman chose to enter into these deals with AIG anyway, knowing full well that if the market goes Goldman’s way on these contracts, AIG would default and wouldn’t be able to pay anyway. So, why did Goldman take this idiotic-looking counter-party risk? Because they knew that the US taxpayers will pay them the profits when AIG goes belly up.

    Here is a perfect way for two Wall Street firms – say, Goldman and AIG – to become enormously rich: enter into the following contract:

    If by December 31, 2010, Dow-Jones is above 12,000 – AIG owes Goldman $10 trillion. Otherwise – Goldman owes $10 trillion to AIG.

    In either case, one of the parties won’t be able to pay the full $10 trillion. So, the taxpayers will.

    That way, both Goldman and AIG have received (for free!!) binary options (a call and a put with strike 12,000) worth $10 trillion.

    If Dow-Jones is above 12,000 – AIG execs will be able to pay themselves $10 trillion in bonuses, while Goldman won’t lose a dime. Otherwise – Goldman execs will be able to pay themselves $10 trillion in bonuses, while AIG won’t lose a dime.

    But in either case, with probability 1, the US taxpayers will end up paying $10 trillion to Wall Street execs. What a beautiful riskless way to rob average Americans!

    Comment by Vlad Rutenburg — May 2, 2010 @ 5:11 am

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