The Sausage Making Begins. I’m Sure It Will Turn Out Swell.
I’ve been writing for some time that Frank-N-Dodd will open a battle over derivatives market structure. This battle will be waged in the markets, and in the political and regulatory arenas. In particular, clearing mandates will lead to a protracted conflict. The nature of the clearing business, with its strong scale and scope economies and the myriad competitive implications of alternative configurations of the clearing business will make this battle particularly intense. And the stakes will be particularly high given the importance of clearing in the new financial architecture.
In an article forthcoming in the Journal of Applied Corporate Finance, I put it this way (link to follow when it’s available):
It is well known that the effects of central clearing on the costs of bearing counterparty risk and on systemic risk depend crucially on the equilibrium configuration of the clearing industry. For instance, netting benefits are maximized when clearing is concentrated into a small number of multi-product clearinghouses—and arguably into a single CCP. But the failure of an immense CCP would have disastrous consequences for the stability of the financial system, and could set off a daisy chain of failures of other CCPs, with further damaging effects. Moreover, the scale and scope of CCPs are almost certain to affect incentives, governance costs, and the effectiveness and accuracy of risk pricing. So it is by no means obvious what is the structure of the clearing market that optimally trades off these competing considerations.
It is equally unknown what clearing market structure will evolve, and how close this structure will come to approximating the ideal structure. In this regard, it is essential to keep in mind two facts.
First, the extensive scale and scope economies associated with clearing make it likely that the clearing industry will be highly oligopolistic, and that strategic considerations will influence decisively the way that the industry develops. Moreover, scope economies across trade execution and clearing (Pirrong, 2010b) will also affect the strategic and efficiency forces that will shape industry structure. Strategic considerations will almost certainly drive a wedge between what is optimal for the individual decision makers, and what is optimal for the economy. This is particularly true inasmuch as there is no market mechanism evident that would induce CCPs to internalize the systemic externalities associated with their failure.
Relatedly, governance and organizational form will matter. For instance, for profit and not-for-profit mutual CCPs are likely to act differently. Which choice is preferable? What will determine CCP choices of organizational form? CCPs are effectively cooperatives: how will collective action problems affect their incentives and actions? What regulations are required to address the governance problems that might arise under each form? These are not easy questions to answer, but those answers will have an important effect on how clearing works in practice.
Second, industry evolution will inevitably be a highly politicized process. Dodd-Frank gives regulators enormous discretionary authority over the operation of CCPs. Interested parties will influence the regulatory process for their private benefit. Political tradeoffs, rather than efficiency considerations, also threaten to cause serious divergences between the structure that evolves in practice, and the one that would optimize the relevant economic tradeoffs. The effects of politics are particularly pronounced in this context because finance is a truly international industry, and hence jurisdictional issues and competition between jurisdictions will play a decisive role in determining the industry’s ultimate configuration. For instance, governments in major financial centers (e.g., the US, London, the EU, and individual countries in the EU, Japan, Singapore, and Hong Kong) have all expressed a strong interest in domiciling CCPs, for both economic and political reasons. But accommodating these interests would fragment clearing, reducing netting benefits and raising serious concerns about coordination during a crisis. Moreover, regulatory competition between jurisdictions to favor their local CCPs could compromise financial market stability.
I’ve written elsewhere–long before the crisis, in fact–that there is a fundamental tension in clearing organization. Risk control and moral hazard considerations provide a strong rationale to limit participation in CCPs, and/or to impose substantial capital requirements on participants. But limiting membership to CCPs can also be a way of cartelizing the industry: given the strong scale and scope economies, a CCP that has fewer than optimal members can still be large enough to make it impossible for any other competing CCP to achieve the scale economies to compete with it.
What’s the right trade off? Barney? Chris? Gary?
The politicized process is underway. Bloomberg’s Matt Leising (article not online, it appears) and the WSJ describe how the battle lines began to form at a recent CFTC-SEC public workshop. The competition-risk trade-off is a main axis of conflict. First Matt Leising, describing the arguments of those who favor opening up CCPs to encourage competition:
Financial firms should be allowed to become members of over-the-counter derivatives clearinghouses even if they don’t meet current minimum capital requirements, according to an industry group. The Commodity Futures Trading Commission and Securities and Exchange Commission should allow smaller firms that don’t meet clearinghouse guidelines to become members, said Jason Kastner, vice chairman of the Swaps and Derivatives Markets Association.
Kastner spoke at a roundtable discussion today on OTC derivatives clearing at CFTC headquarters in Washington. Clearinghouse operators Intercontinental Exchange Inc., CM Group Inc. and LCH.Clearnet Ltd. in the $615 trillion privately negotiated derivatives markets enforce capital requirements and trading rules intended to bolster the ability of their organizations to withstand losses. Those requirements prevent all but the world’s largest banks, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Barclays Plc, from sending trades to the clearinghouses, the SDMA told the Federal Reserve in June.
“It’s not just about capital,” Kastner said today, referring to rules such as Intercontinental’s that members of its credit-default swaps clearinghouse have a minimum net worth of $5 billion. Regulators should create and enforce rules so that smaller firms can become members so “that it’s somehow proportional.”
But then Matt notes that some argue that Dodd-Frank is about reducing systemic risk, and has nothing to do with competition:
The main purpose of the financial-reform law, named after its principal authors, Connecticut Senator Christopher Dodd and Massachusetts Representative Barney Frank, was to make the financial system stronger by increasing risk-management standards, said Jonathan Short, a senior vice president at Intercontinental.
“It all sounds great on paper to say ‘let a thousand flowers bloom,’” he said. “I’ve never heard the Dodd-Frank Act
described as something that was done to promote competition among firms.”
[It should be noted that Dodd-Frank does include provisions encouraging competition and enjoining CCPs not to violate anti-trust rules. How to reconcile that with the injunctions to reduce systemic risk? Who knows? Not Dodd and Frank’s problem. They just wave their wands and presume the broomsticks will take care of it.]
This all makes some people nervous:
Ananda Radhakrishnan, director of the CFTC’s Division of Clearing & Intermediary Oversight, said he would hesitate before telling clearinghouses to lower their capital standards for members.
“As someone in charge of clearing, I’m reluctant to tell someone ‘you should lower the level of capital,’” he said. [In charge of clearing? Think much of yourself, Al Haig Radhakrishnan?]
The WSJ article notes that people have picked up on the tension inherent in the issue:
James Hill, a global credit-derivatives officer at Morgan Stanley, warned that if companies without proper risk management expertise were allowed into the clearinghouses, “they will become the next “too big to fail,” and we don’t want to do that.”
After J.P. Morgan Chase & Co. managing director Jeremy Barnum said regulators would have to weigh “very complicated tensions” in determining how to write the rules, Mr. Kastner shot back that “it’s not credible to say it’s complicated.”
Not credible, indeed.
So, barely weeks after the passage of Dodd-Frank, we are seeing the sausage making process begin. Efficiency and rent seeking and competitive considerations are all going into the hopper. Who the hell knows what will come out the other end? The potential for a colossal mistake–or mistakes–is great. And these mistakes will be systemic in the effect. For as I also say in the JACF piece:
This change is fraught with potential unintended consequences. It is predicated on a belief that market participants systematically chose the wrong ways to trade derivatives and allocate the default risks inherent in them, but there strong reasons to believe that in fact many of the institutions adopted prior to the crisis had a strong economic rationale. This means that forcing the implementation of a particular market infrastructure via legislative fiat runs the serious risk of reducing the efficiency of the financial markets. In particular, although it is intended to reduce systemic risk, the mandating of expanded clearing carries its own systemic risks. Moreover, the future evolution of market structure is highly uncertain, especially given the cost characteristics of clearing and the fact that this evolution will occur in a highly regulated environment in which political—and rent seeking—influences will play an important role. Very bad evolutionary paths are certainly possible. In brief, the effects of Dodd-Frank on the efficiency and stability of the financial markets are highly uncertain at best, and highly unfavorable outcomes wholly unintended by the authors are quite possible, and indeed, likely.
One final thought about systemic risk. It is worth remembering that the imposition of a single, one-size-fits-all infrastructure is inherently systemic in its effects. Any flaw or failure in that standard structure will have systemic consequences. A mandate that is ill-adapted to the fundamental economic conditions in the derivatives markets creates a systemic risk because (a) ill-adaption makes failure more likely, and (b) the sweeping breadth of the mandate means that the effects of such a failure will be system wide in scope.
But have no worries, Gary Gensler tells us: “U.S. regulators won’t succumb to Wall Street efforts to weaken financial-market oversight as they implement the biggest rules overhaul since the Great Depression.”
Just how is this supposed to happen? Yes, interested parties–and not just the big banks–have an incentive to shape the rules to benefit them. But interested parties also have the best information and the greatest knowledge. Are Genlser and the other regulators to shut their eyes and ears to what industry participants tell them? That would mean ignoring the good advice, as well as the bad, self-interested kind. If not, how are they to distinguish between the good and the bad? Mistakes are inevitable.
This information problem is inherent in regulation, especially when involving something as incredibly complex, dynamic, reflexive/responsive, and interconnected as the financial markets. Painting this as a morality play between the good government types (the “Goo goos” in Boston Mayor James Curley’s trenchant phrase) and the malign self-interested banks is insultingly simplistic.
Congress and Obama have given regulatory agencies the authority to lead the industry, but no map to show them where to go. The blunder potential is huge. The cacaphony of voices, reflecting differences in information, interest, and motivation, will make it difficult to avoid such blunders. Last week’s meeting gives just an inkling of the conflicts to come.
But I’m sure it will all turn out well. It always does, doesn’t it?
You don’t have to answer that.
[…] The Sausage Making Begins. I’m Sure It Will Turn Out Swell. Streetwise Professor. A really good piece on what a disaster the derivatives clearing house is likely to be. […]
Pingback by Links 8/22/10 « naked capitalism — August 22, 2010 @ 3:37 am
Nearly impossible to read against background picture…
Comment by Helpful Friend — August 22, 2010 @ 4:20 am
Excellent as always. Just a couple of points: More competition (competition being defined as diversity of strategies) aids system resilience rather than hurting it – and in order to have a diverse pool of clearinghouse participants, preserving easy entry of new firms is essential. To quote from my favourite ignored economist on this topic, Burton Klein in “Prices, Wages and Business Cycles: A Dynamic Theory” said: “Because of new entries, a relatively concentrated industry can remain highly dynamic. But, when entry is absent for some years, and expectations are premised on the future absence of entry, a relatively concentrated industry is likely to evolve into a tight oligopoly. In particular, when entry is long absent, managers are likely to be more and more narrowly selected; and they will probably engage in such parallel behaviour with respect to products and prices that it might seem that the entire industry is commanded by a single general!” Just speaking from my experience in the OTC derivatives business, that observation is spot on.
In this respect, the suggestion that such high levels of minimum net worth are necessary is just an unashamed way to preserve the “dealers’ club” – not surprising given that the lion’s share of profits for the big banks right now comes from the OTC business. As one of my old professors puts it here http://www.financialexpress.com/printer/news/659463/ on the topic of bank regulation in India: “Equating money with seriousness is a misconception unique to the financial elite…financial regulators in India and elsewhere have an abiding belief in the ennobling power of money.” The cynic in me suggests that this “misconception” is fuelled in no small measure by bank lobbying to preserve the status quo.
Comment by Ashwin — August 22, 2010 @ 4:50 am
Anyone who does not understand why we have not gotten one iota closer to getting rid of the regulatory interference that created this financial mess has no right to call himself “streetwise”, since he obviously never left his desk.
http://subprimeregulations.blogspot.com/2010/08/what-do-financial-regulations-say-about.html
Comment by Per Kurowski — August 22, 2010 @ 7:40 am
I agree to large extent on what you are saying, but I think you over egg the pudding in a couple of instances:
“…serious risk of reducing the efficiency of the financial markets”
A lot of engineering is devoted to *not* having as efficient complex systems due to the risk of contagion propagating quickly and with unforeseen consequences. Can anybody spell ‘flash crash’? Having some friction between the systems can help attenuate this.
“But interested parties also have the best information and the greatest knowledge”
Some of these same folks got bailed out by the taxpayer when their best information and the greatest knowledge went awry. I don’t think anybody would say that their ‘knowledge’ should by default usurp other points of view.
Comment by Mac — August 22, 2010 @ 2:04 pm
[…] Derivatives & Clearing Houses: The Sausage Making Begins. I’m Sure It Will Turn Out Swell – via Streetwise professor – I’ve been writing for some time that Frank-N-Dodd will open a battle over derivatives market structure. This battle will be waged in the markets, and in the political and regulatory arenas. In particular, clearing mandates will lead to a protracted conflict. The nature of the clearing business, with its strong scale and scope economies and the myriad competitive implications of alternative configurations of the clearing business will make this battle particularly intense. And the stakes will be particularly high given the importance of clearing in the new financial architecture. […]
Pingback by Simoleon Sense » Blog Archive » Weekly Wisdom Roundup 92: A Linkfest For The Smartest People On The Web — August 22, 2010 @ 3:37 pm
@Per–really not good form to dis somebody who agrees with you about the hopelessness of regulators. Presumably you just stumbled across this blog, but if you’ve been following it for any length of time you would know that regulators are routine whipping boys and girls of mine. My routine smackdowns of Gary Gensler and Bart Chilton, to name two, are well known around the financial blogosphere. Indeed, the whole point of this post is that the inherent limitations of regulators make blunders inevitable, and regulatory blunders have effects that are systemic in scope. That’s a recurring theme here.
Moreover, I have been particularly critical of their dreamy reliance on capital requirements as the means of preventing crises when the experience of the last one demonstrates that badly designed capital requirements (but I repeat myself) are a primary cause of said crises.
And I get away from my desk a lot. Again, if you did some research before shooting off your mouth you’d have known that.
In a nutshell: before going off half-cocked, do a little research on your target. I am sure we agree far more than disagree.
@Mac–I didn’t say by default it should usurp other points of view. Quite the contrary. I explicitly recognize that much of the advice that affected parties give is defective. But some of it isn’t. This is the essence of the regulatory conundrum which is the focus of the end of the post. Blunders are inevitable because regulators get bad information and often overlook good information. The problem is they can’t tell which from which.
Re “efficiency”–seems like a semantic difference. I don’t think that Flash Crashes are efficient, nor is rapid propagation of contagion. You are misunderstanding what I mean when I say “efficiency.”
@Ashwin–I agree that competition is important. Indeed, one of my most fundamental objections to the whole Dodd-Frank scheme, and much of the rest of the Obama regulatory agenda, is that it does not recognize role of competitive forces, and that by imposing market architectures by fiat, it actually short-circuits competition.
At the same time, I recognize that competition in financial markets is often quite problematic due to the pervasive scale and scope economies in all parts of the business. This has been a focus of a good deal of my academic research. These factors make entry to compete with incumbents very difficult.
The fact that competition is often far from perfect is no justification for reducing it further, as D-F do by imposing market structures.
My basic point is that it will be very hard for regulators to determine what restrictions on membership of CCPs are justified as means to ensure the security of said institutions, and what are just efforts to cartelize the business. The knowledge problem is acute.
Tying this all together. The knowledge problem means that I am extremely skeptical of legislative and regulatory efforts to dictate market structure and prescribe conduct. Indeed, I believe it is a recipe for disaster. Anybody who has read this blog for any time at all would recognize that extreme skepticism. I would prefer to rely on market processes to grope towards finding better structures. This requires more competition, not less. That said, we should recognize that the nature of financial markets means that there can be substantial impediments to competition.
@Helpful Friend. Sorry you have a hard time reading it. If you have a Mac, hit the rss icon (the orange one) and the posts will appear on a plain white background. Alternatively, if you subscribe to SWP using an rss feed like Google Reader, you can read the posts on it with just a plain vanilla background.
The real problem is that exotic derivatives need to be banned. NO ONE understands them. This absurd, farcical tinkering(how many angels on the head of a pin? how to organize all the buddhist saints) is heaven for technocrats, but all the sophisticated, completely phony mathematics and micro-economic analysis in the world does not alter the fact that the exotic derivatives DID NOT WORK, DO NOT WORK, AND WILL NOT WORK in their stated goal: to reduce risk.
The sheer craziness of the whole effort is very similar to the so-called War on Drugs, although I’d be hard-pressed to say which one surpasses the other in absurdity.
And to parody the author, “one final thought on systemic risk”:
Systemic risk IS NOT MEASURABLE OR QUANTIFIABLE, it’s very, very misquided to think that it can be measured at all. Very foolish, indeed.
Comment by Deja-Vu — August 22, 2010 @ 9:03 pm
There are Clearing House in Chicago (CME) that have worked since 1848 and is the only choice that can enjoy universal acceptance. Going elsewhere is going away.
Comment by ToNYC — August 23, 2010 @ 5:58 am
@ToNYC–I suggest that you research your history a little bit more thoroughly.
@Deja-Vu–Who said systemic risk is measurable? Not me. But it exists, and you can think through the implications of various policies for it.
You wrote in your article forthcoming in the Journal of Applied Corporate Finance:
“…the effectiveness and accuracy of risk pricing.”
So, maybe you’re not trying to quantify systemic risk, but this certainly sounds like you’re trying to price or assign a number to some kind of risk(individual securities?), not sure.
I agree that systemic risk exists, but it can’t be talked about in any useful way, especially when economists and policymakers are making the mistake of not banning exotic derivatives and instead thinking they can design markets that somehow contain the “risk” involved in their use.
This policy discussion is similar in its absurdity to cage designers in a zoo trying to design a cage for lions that people can walk through safely(low systemic risk) and therefore they have to pick species of lions that have a low probablity of attacking humans. And also for good measure, they’ll put two species of lions in this same cage that will be more pre-occupied with each other than with attacking the humans that are walking through their cage. Therefore this cage will have a low systemic risk of danger for zoo goers.
That is the level of craziness we’re talking about here.
Anyway, why would you not be against banning exotic derivatives? They clearly did not work and almost brought down the world economy. Agree, Disagree?
Comment by Deja-Vu — August 23, 2010 @ 8:45 am
@Deja-Vu. Risk pricing is what banks and other intermediaries do all the time. It is their economic function. The question I have been addressing in my research going back into the 1990s is what institutions have the comparative advantage (in respect to information and incentives) in performing this risk pricing and the associated risk bearing, and how this might vary across instruments, counterparties, markets, etc.
Systemic risk, for the concept to be meaningful, involves some sort of externality, which by definition private agents cannot price. I am extremely skeptical that the government/regulators have appropriate information & incentives to do this pricing.
Re exotic derivatives—to have a reasonable discussion, please define.
I’m mostly channeling Robert Skidelsky and Nassim Taleb here(with a dash of Wittgenstein).
Systemic risk, involves some sort of externality, true but if markets are efficient, then the mispricing of risk shouldn’t really happen, should it? But I don’t know if you believe in the efficient markets hypothesis or not.
Private agents may not be aware of externalities, and may not price “risk” correctly but on aggregate, markets should, according to the EMH? Again, I don’t know if you subscribe to the EMH.
Obviously, markets failed catastrophically in pricing the risk of a housing crisis, but even more critically, exotic derivatives failed in their function to contain the damage from falling prices in the housing market. Therefore, I contend that NO ONE understands exotic derivatives, they can’t be priced even now 3 years into the crisis, and most importantly they failed in their most important function, the dispersal of “risk” throughout the financial system so as to minimize it. Therefore the rational response, in my opinion, is to ban them outright.
And by exotic derivatives I mean CDSs, MBSs, the securitization of financial instruments; NOT standard futures, options, etc.
Comment by Deja-Vu — August 23, 2010 @ 10:52 am
As Robert Skidelsky has said in regard to the Chicago School of economics:
‘When John Lucas of Univ. of Chicago said, ‘We’re all Keynesians in the foxholes’, this was a sign of intellectual surrender on the part of mainstream, academic economics.’
You got your doctorate from the U. of Chicago business school, any comment?
Comment by Deja-Vu — August 24, 2010 @ 11:10 am
@Deja vu. “Chicago economics” is a very broad and diverse classification. To many, Skidelski most prominent among them, “Chicago economics” is a bogeyman, and one that he seems to perceive in caricature, rather than the reality.
Lucas is the avatar of the New Classical school. He, and the NCE school generally, are responsible for some devastating, and still cogent criticisms of Keynesianism which even modern economists that call themselves Keynesian acknowledge. For instance, New Keynesian macro models incorporate rational expectations. That said, I think that NCE is reductionist. I have written on the blog how when I took Lucas’s macro course in the early-80s, he stated explicitly that based on the work of the NBER in documenting business cycles, he was convinced that all business cycles are alike, and all recessions/depressions can be traced to a single cause. I thought at the time that was not logically rigorous.
Recent events, IMO, have demonstrated that mono-causal interpretations of aggregate fluctuations are fundamentally flawed. Like Tolstoy’s families, all recessions are unhappy in their own way. A recession traceable to the collapse of a bubble is something different than one arising from an attempt to shock inflation out of the system.
But in their mania to generalize, theorists are loath to recognize this. It makes economics too much like history, and makes broad conclusions and recommendations pointless.
I am not a practicing macroeconomist. I would say now that my views are quasi-Austrian, and in terms of policy, are heavily influenced by an appreciation of the importance of Ricardian equivalence, especially in current conditions. But these are, at best, semi-professional observations. Though I should say that the distance that comes from not being a member of any macro tribe gives me some perspective that those fighting their tribal wars to the knife lack.
Insofar as micro is concerned–and I am a microeconomist–Chicago’s tradition is incredibly diverse. Coase and Stigler were very different, and Friedman different still. But I think that the fundamental Chicago contributions to microeconomics and particularly to the economics of regulation, anti-trust, and industrial organization, have stood the test of time.
One last general comment. In the Knight-Simons-Viner era, Chicago was outspoken in its refusal to join the conventional wisdom that the Great Depression was a failure of capitalism, rather than government policy. That critique is, I think, still cogent. And Chicago and Chicago-influenced people–including yours truly–are similarly skeptical of the current wisdom that the Continuing Crisis is just another failure of capitalism. The policy failures were many and serious, and were first-order causes of the Crisis. Moreover, those like myself, and people at Chicago (e.g., Murphy, Cochrane) who were skeptical of the efficacy of the fiscal stimulus as a response to a balance sheet recession, have also been vindicated to some degree by the continuing economic malaise in the US (in contrast to the experience in other countries that were less spendthrift for as long).
PS: I’d also like to see the Lucas quote in context.
@Deja-vu. And BTW it’s “Robert Lucas” (or “Bob Lucas”). I have no clue who “John Lucas” is.
@Actually, you say “John Lucas” and I think of the famous (or infamous) point guard, a major force at the collegiate level (U Maryland, where he was All-American in both basketball and tennis), and at times a star NBA player. He was a noted drug casualty in the cocaine era. He was never the same after rehab. He later coached in the NBA, including stints has a head coach. And Maurice Lucas was a major stud as a power forward in the 1970s, esp. on the ’76 Trailblazers team that won the NBA Championship .
@TheProfessor,
Unfortunately, I don’t have the time to engage in a discussion with you(classes are starting in a week and a half). Also, it’s probably pointless, as our “conceptual intuitions” are so far apart we would never come to an agreement on anything.
But, briefly…I don’t see how you can separate government policy from capitalism, as if the two were completely different. You’re free to do so, but don’t you have to define your terms first? That is, what is capitalism? Since no one knows the answer to that question beyond commonplaces and there is no one generally agreed upon definition, then what you’re saying is unclear on its face. The only thing you might be saying is that government intervention in markets is BAD, but since the crisis was caused by deregulation of finance(the absence of goverment), under Clinton particularly, I don’t really see how you can say this.
To be very blunt, did the Chicago school predict the crisis that began in 2007? NO, it did not. Skidelsky thinks the Chicago School could NOT predict a crisis partly because it rules out the very possiblity of one.
So how much intellectual credibility can the Chicago school have? or economics in general?
I noticed you haven’t responded to the question about the failure of exotic derivatives to contain the damage of the decline in housing prices.
You might want to email Robert Skidelsky, I’m sure he could dispatch your arguments with alacrity(and with much less effort than myself).
But you write well, I’ll give you that.
Sincerely,
DV
Comment by Deja-Vu — August 25, 2010 @ 10:49 pm