Streetwise Professor

September 15, 2011

The Road to SEFdom

This week marks the beginning of a whirlwind couple of months in which I give talks or participate in conferences on either clearing or Frank-n-Dodd (there of course being a big overlap there).  Tuesday I moderated a panel at the ISDA Annual New York Conference, and yesterday I participated in a panel on Frank-n-Dodd at a Futures Industry Association event in New York.

First, the FIA event.  What came through loud and clear was the widespread belief that the SEF mandate in Frank-n-Dodd is wholly wrongheaded.  The consensus is that it is an attempt to jam a one-size-fits-all model on an inherently heterogeneous and non-standardized business–the business of executing OTC derivatives transactions.  That heterogeneity reflects the inherent heterogeneity of particular transactions, and the firms that want to execute them.  The market has evolved to accommodate heterogeneity, and the SEF mandate will impose uniformity.  Everybody better fit a 42-regular sportcoat, because that is what Frank-n-Dodd is going to force everybody to wear.

Of course there are dissidents from the consensus: most prominently those who do, or want to, operate SEFs.  Big surprise.  The NYT recently ran an article describing the efforts of these firms to influence policy.  The point you should take away from that article is that the idea of SEFS is not new, that SEFs have tried to gain traction in the market for some time (they are not “Johnny-come-latelys” in the words of one exec quoted in the article), but they have not made a big dent in the marketplace.

The failure to this point of SEFs to transform execution in the swap market, the way electronic trading did for listed derivatives, is a crucial fact.  It is not dispositive proof that the SEF mandate is misguided, but it does raise serious questions about it.  Before remaking the world, it is a pretty good idea to understand why the world is the way it is and why it isn’t the way you want to remake it.  Competition is never perfect, but competitive forces usually work inexorably towards the adoption of more efficient practices.  The rebuttable presumption should be that competition has pretty much gotten it right, and that policy prescriptions that are wildly at odds with existing practice are likely based on ignorance.  Those advocating a wholesale re-engineering of the results of market processes should be required to advance a coherent justification, based on rigorous logic and empirical evidence.

This the SEFocrats have not done.  Not even close.  And no, invoking the magic word “transparency” or advancing theories that presume that half the market is suffering from something akin to battered spouse syndrome don’t cut it.

The SEF rules are a particularly prominent example of the deficiency in cost-benefit analysis in CFTC rulemaking.  I have it on good authority that some analysis will soon be forthcoming that demonstrates that the cost of these rules will be immense.  As for benefits, the six members of the FIA panel couldn’t name one–even when pressed to do so.  We, collectively, couldn’t even come up with a “well you don’t sweat too much for a fat girl” compliment.  (If you don’t like that remark, direct your complaints to Ty Cobb:  I stole it from him.)  So, insofar as cost-benefit analysis is concerned–you should be able to do the math pretty easily.

The title for the post, by the way, is a joint product.  Tom LaSalla of CME Group coined “SEFdom” to describe what Frank-n-Dodd will soon bring on us.  I added the Hayekian allusion.  (Go figure.) I think the comparison is apt.

Insofar as the ISDA panel on clearing is concerned, I walked away from it thinking what I do after hearing any informed discussions of this subject: that it is the most devilishly complex issue you can possibly imagine.  It is one of the world’s biggest onions, and neither I nor anyone who has spent considerable time and effort thinking about it or actually doing it has gotten through even a small fraction of its layers.  The number of serious issues, their complexity, and their interconnectedness, is hard to exaggerate.

Which further demonstrates the frivolity of legislators and regulators around the world,who seized upon it as a panacea and imposed it without due consideration of these complexities.  The idea was hatched out of superficial understanding by panicked people who then proceeded to let others deal with the brain-twisting realities.

One hopes (though I do not expect) that regulators will be sufficiently patient and flexible to permit people who actually know something accommodate these complexities, and make the hard trade-offs that are necessarily involved.  New ideas on ways to perform the same functions as CCPs are still being developed: ISDA chief Conrad Volstad mooted a promising approach that would achieve the purposes of the clearing mandate, but at far lower cost.  These approaches deserve analysis and development before another one-size-fits-all approach is locked in.

I don’t like clearing mandates, but think that clearing has its virtues if it is done right, and in a way that reflects its comparative benefits and costs.  In this way it differs from the SEF mandate, which is why I gave the latter my Worst of Frank-n-Dodd Anniversary Award.  But rigid and superficial conceptions about how the mandate should work (and you know whom I am talking about) raise the very serious possibility that the potential benefits of clearing will be swamped by the unintended costs of imposing it where it is inappropriate, or in a way that is not adapted to its strengths and weaknesses.

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  1. It is amusing to see the helpless flailing of some Democrats as they try to impede the process of the American people falling into debt bondage to Us, and We greatly appreciate your ridicule of them, Professor.

    Well done!

    Little do they know that Our assiduous servants George and Barack have already decisively undermined their efforts, so that all the recent gains of productivity growth accrue to capital, and then some, where they belong. Our servants, such as your good self, have been so effective in their work that profits are at record levels while the level of median wages has declined to the level of 1997 and poverty is at levels not seen in the fifty years that such trivial statistics have been kept.

    Again, well done!

    Comment by a — September 16, 2011 @ 3:49 am

  2. @a. Leave sarcasm to the pros. Re your economic analysis, such as it is, the massive regulatory burden and uncertainty about what regulations are to come, combined with additional uncertainty re the financial system, readily explain the statistics you cite. Note that although returns to capital-in-place are high (the profit numbers you cite), investment is very, very low. Why would high returns to capital be associated with low rates of investment? That is most likely to happen in a highly uncertain environment; something similar happened in the 1930s. The greater the uncertainty, the greater the return required to justify more investment. This fits in well with my earlier real options analysis of regime uncertainty. Since political volatility and huge policy uncertainty is contributing to that, you should be joining me in criticizing the global outbreak of political/regulatory insanity.

    The ProfessorComment by The Professor — September 16, 2011 @ 12:18 pm

  3. Professor, speaking of sarcasm: what do you think of Paul Krugman’s remarks about “confidence fairy” at Colbert Report the other night? Should academics be required to have run a hot dog stand to get a feel about what’s real and what’s fairy tale?

    Comment by Ivan — September 16, 2011 @ 4:05 pm

  4. My good professor,

    Please support your supposition,with data, that insane regulation in the 1930s suppressed growth rates. I certainly share your contempt for regulation attempting to restrain Us in the exercise of our maxims, but We have never been able to overcome the data showing very rapid rates of economic growth after 1933.

    We would be grateful for your kind assistance.

    Comment by a — September 16, 2011 @ 4:44 pm

  5. @Ivan–I don’t pay much attention to Krugman, except when he just begs for a mocking. I do consider it ironic, though, that someone who claims to be a die-hard old school Keynesian for whom the General Theory is a bible, would heap scorn on the importance of confidence. After all, Keynes’s theory of cycles depended crucially on the idea of “animal spirits”–booms and busts in investor optimism. The whole confidence idea is fundamentally important to Keynes qua Keynes. Now maybe Krugman would argue that confidence is important, but that austerity is not the way to get there. But really, I don’t care, because the guy is so out to lunch IMO that I really don’t have time to worry about how he tries to square his circles.

    The ProfessorComment by The Professor — September 16, 2011 @ 7:01 pm

  6. Our servant George W Bush achieved a feat similar tothat achieved by Our servant Barack. Economic growth resumed in mid-2001, but private sector job losses continued for another two full years. The number of private sector jobs did not recover its January 2001 level until the middle of 2005. Wages were thoroughly suppressed by this. Yes, just like Our servant Barack, Our servant George ensured that the gains from productivity growth accrued to capital, not labor.

    Comment by a — September 16, 2011 @ 7:29 pm

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