SEC under Schapiro after one year

Mary Schapiro took over as the Chairman of the US SEC a year ago
when the SEC’s reputation was in tatters. In a speech
yesterday, she reviewed the achievements of the past year.

First of all, she believes that the problems of the SEC were at the
top and that if the leadership at the top is changed, the rest of the
organization had the competence and attitude required to deal with its
challenges. Schapiro says: “having served as Commissioner 20
years earlier, I knew what the agency was capable of … through this
process, I witnessed firsthand the dedication and expertise that I had
long believed embodied this agency”

Schapiro believes that the new hires she has made and the new
technological initiatives that she has undertaken will be sufficient to
enable the SEC to recover its last glory. My own sense is that the
problems are not merely at the top but permeate the whole
organization. The report on the Madoff investigations revealed
problems at all levels of the SEC (see my blog
post last year).

Schapiro lists the SEC’s achievements in enforcement during the
last year and refers to the case that has been brought against State
Street Bank. She says nothing about the Bank of America case where the
judge has taken the SEC to task, and subsequently the New York
Attorney General has seized the initiative.

On the rule making agenda also, Schapiro is unable to list too much
of significance. Even the utterly misguided short sale restrictions of
the crisis is cited as an achievement. Some minor changes on proxy
rules, rating agencies and money market funds are also cited though
none of these changes went far enough to make a serious
difference.

Schapiro came to the SEC with high expectations after a succession
of lacklustre leaders. I think she needs to do a lot more to fulfill
these expectations.

 

The Volcker rule

I wrote a column
in the Financial Express today on the Volcker rule and
other proposals of President Obama.

President Obama has proposed the ‘Volcker rule’
preventing banks from running hedge funds, private equity funds or
proprietary trading operations unrelated to serving their
customers. Simultaneously, he also proposed size restrictions to
prevent the financial sector from consolidating into a few large
firms. While this might look like unwarranted government meddling in
the functioning of the financial sector, I argue that, in fact, free
market enthusiasts should welcome these proposals.

Obama has chosen to frame the proposal as a kind of morality play
in which the long-suffering public get their revenge against greedy
bankers. While that might make political sense, the reality is that
the proposals are pro free markets. To understand why this is so, we
must go back to the moral hazard roots of the global financial
crisis.

These roots go back to 1998 when the US Fed bailed out the giant
hedge fund, LTCM. The Fed orchestrated an allegedly private sector
bailout of LTCM, but more importantly, it also flooded the world with
liquidity on such a scale that it not only solved LTCM’s problems, but
also ended the Asian crisis almost overnight.

LTCM had no retail investors that needed to be protected. The
actual reason for its bailout was the same as the reason for the
bailout of AIG a decade later. Both these bailouts were in reality
bailouts of the banks that would have suffered heavily from the
chaotic bankruptcy of these entities.

Back in 1998, the large global banks themselves ran proprietary
trading books that were also short liquidity and short volatility on a
large scale like LTCM. A panic liquidation of LTCM positions would
have inflicted heavy losses on the banks and so the Fed was compelled
to intervene.

From a short-term perspective, the LTCM bailout was a huge success,
but it engendered a vast moral hazard play. The central bank had now
openly established itself as the risk absorber of last resort for the
entire financial sector. The existence of such an unwarranted safety
net made the financial markets complacent about risk and leverage and
set the stage for the global financial crisis.

Those of us who like free markets abhor moral hazard and detest
bailouts. The ideal world is one in which there is no deposit
insurance and the governments do not bail out banks and their
depositors. Since this is politically impossible, the second best
solution is to limit moral hazard as much as possible.

If banking is an island in which the laws of capitalism are
suspended, this island should be as small as possible, and the domain
of truly free markets—free of government meddling and moral
hazard—should be as large as possible. Looked at this way, the Volcker
rule is a step in the right direction. If banks are not shadow LTCMs,
then at least the LTCMs of the world can be allowed to fail.

The post-Lehman policy of extending government safety net to all
kinds of financial entities amounted to a creeping socialisation of
the entire global financial system. The Volcker rule is the first and
essential step in de-socialising the financial sector by limiting
socialism to a small walled garden of narrow banking while letting the
rest of the forest grow wild and free.

What about the second part of the Obama proposal seeking to limit
the size of individual banks? I see this as reducing oligopolies and
making banking more competitive. Much of the empirical evidence today
suggests that scale economies in banking are exhausted at levels far
below those of the largest global banks, and there is some evidence
that scale diseconomies set in at a certain level.

There is very little reason to believe that banks with assets
exceeding, say, $100 billion are the result of natural scale
economies. On the contrary, they appear to be the result of an
artificial scale economy caused by the too-big-to-fail (TBTF)
factor. The larger the bank, the more likely it is to be bailed out
when things go wrong. It is therefore rational for a customer to bank
with an insolvent mega-bank rather than with a well-run small
bank.

This creates a huge distortion in which banks seek to recklessly
grow to become eligible for the TBTF treatment. Well-run banks that
grow in a prudent manner are put at a competitive disadvantage. This
makes the entire financial sector less competitive and less
efficient.

The Obama size restrictions will reduce the distortions created by
the TBTF factor, and will make banking more competitive. One could
argue that the restrictions do not go far enough because they
legitimise the mega firms that already exist and only seek to prevent
them from becoming even bigger. Nevertheless, it is in the right
direction. It does not undo the damage that has already been done, but
prevents further damage.

 

Computational and sociological analyses of financial modeling

I have been reading a number of papers that examine financial
modeling in the context of the current crisis from a computational
complexity and sociology of knowledge point of view:

• Looking Out, Locking
  In: Financial Models and the Social Dynamics of Arbitrage
  Disasters, by Daniel Beunza and David Stark, September 2009
• Credit Models and the
  Crisis, or: How I learned to stop worrying and love the CDOs by
  Damiano Brigo, Andrea Pallavicini and Roberto Torresetti, December
  2009
• The
  Credit Crisis as a Problem in the Sociology of Knowledge, by
  Donald MacKenzie, November 2009
• Computational
  complexity and informational asymmetry in financial products, by
  Sanjeev Arora, Boaz Barak, Markus Brunnermeier and Rong Ge, October
  2009.

I liked all these papers and learned a lot from each of them which
is not the same as saying that I agree with all of them.

The paper that I liked most was Beunza and Stark which is really
about cognitive interdependence and systemic risk. Their work is based
on an ethnographic study of financial modeling carried out over a
three year period at a top-ten global investment bank. Some of their
conclusions are:

Using models in reverse, traders find out what their rivals are
collectively thinking. As they react to this knowledge, their actions
introduce a degree of interdependence …

Quantitative tools and models thus give back with one hand the
interdependence that they took away with the other. They hide
individual identities, but let traders know what the consensus
is. Arbitrageurs are thus not embedded in personal ties, but neither
are they disentangled from each other.

Scopic markets are fundamentally different from traditional social
settings in that the tool, not the network, is the central
coordinating device.

Instead of ascribing crises to excessive risk-taking, misuse of the
models, or irreflexive imitation, our notion of reflexive modeling
offers an account of crises in which problems unfold in spite of
repeated reassurances, early warnings, and an appreciation for
independent thinking.

Implicit in the behavioral accounts of systemic risk is an emphasis
on the individual biases and limitations of the investors. At the
extreme, investors are portrayed as reckless gamblers, mindless
lemmings, or foolish users of models they do not understand. By
contrast, our detailed examination of the tools of arbitrage offers a
theory of crisis that does not call for any such bias. The reflexive
risks that we identified befall on arbitrageurs that are smart,
creative, and reflexive about their own limitations.

Though the paper is written in a sociological language, what it
most reminded me of was Aumann’s paper more than 30 years ago on
“Agreeing to disagree” (The Annals of
Statistics, 1976). What Beunza and Stark describe as
reflexivity is closely related to Aumann’s celebrated theorem:
“If two people have the same priors, and their posteriors for a
given event A are common knowledge, then these posteriors must
be equal.”

The Brigo et al paper is mathematically demanding as they
take “an extensive technical path, starting with static copulas
and ending up with dynamic loss models.” But it is very useful
in explaining why the Gaussian copula model is still used in its base
correlation formulation though its limitations have been known for
several years. My complaint about the paper is that it focuses too
much on the difficulties in fitting the Gaussian copula to observed
market prices and too little on the difficulties of using it to
estimate the impact of plausible stress events.

MacKenzie focuses on “evaluation cultures” which are
broader than just models. They are “pockets of local consensus
on how financial instruments should be valued.” He argues that
“‘Greed’ – the egocentrically-rational pursuit
of profits and bonuses – matters, but the calculations that the
greedy have to make are made within evaluation
cultures”. MacKanzie highlights “the peculiar status of
the ABS CDO as what one might call an epistemic orphan –
cognitively peripheral to both its parent cultures, corporate CDOs and
ABSs.”

The Arora et al paper is probably the most mathematical of
the lot. It essentially shows that an originator can put bad loans
into CDOs in such a way that it is computationally infeasible for the
investors to figure this out even ex post.

However, for a real-life buyer who is computationally bounded, this
enumeration is infeasible. In fact, the problem of detecting such a
tampering is equivalent to the so-called hidden dense subgraph
problem, which computer scientists believe to be intractable
… Moreover, under seemingly reasonable assumptions, there is a way
for the seller to ‘plant’ a set S of such over-represented
assets in a way that the resulting pooling will be computationally
indistinguishable from a random pooling.”

Furthermore, we can show that for suitable parameter choices the
tampering is undetectable by the buyer even ex post. The buyer
realizes at the end that the financial products had a higher default
rate than expected, but would be unable to prove that this was due to
the seller’s tampering.

The derivatives that Arora et al discuss are weird binary
CDOs and my interpretation of this result is that in a rational
market, these kinds of exotic derivatives would never be created or
traded. Nevertheless, this is an important way of looking at how
computational complexity can reinforce information asymmetry under
certain conditions.

 

More on OTC derivatives

I have several comments by email on my blog post
yesterday on OTC derivatives. This post responds to some of them and
adds some more material on the subject.

One of the papers that I did not refer to in yesterday’s post
was a paper by Riva and White on the evolution of the clearing house
model for account period settlement at the Paris Bourse during the
nineteenth century. Streetwise Professor linked to a conference
paper version of this in his post while Ajay Shah
pointed me to an NBER version
of the same paper.

The account period settlement at the Paris Bourse was similar to the
‘badla’ system that prevailed in India until the beginning of this
century. All trades during a month were settled at the end of the
month so that the stock market at the beginning of the month was
actually a one month forward market. At the end of the month, the
settlement could be postponed for another month on paying the price
difference and a market determined backwardation or contango charge.
In fact, this system for trading individual stocks continued even
after the introduction of stock index futures (CAC 40) in the Paris
market. Crouhy and Galai, “The settlement day effect in the
French Bourse,” (Journal of Financial Services
Research, 1992) provide a good description of this market and
explore the working of the cost of carry model in this market.

Coming back to Riva and White, they document the emergence of a
clearing house model in which the Paris Bourse guaranteed all trades
on the exchange. The bourse not only guaranteed settlement of trades
between two brokers but also repaid the losses suffered by the
defaulting broker’s clients (except during a period from 1882 to
1895). This clearing house guarantee was supported by a capital
requirement for all brokers and by a guarantee fund, but not by any
margins. The entire process seems to have been driven by the
government and the central bank.

By contrast, the US futures exchanges introduced initial and
variation margins well before they introduced the clearinghouse in
1883 as documented in the Kroszner paper that I mentioned in my post
yesterday. The existence of margins eliminates most of the moral
hazard problems that plagued the clearing house in Paris and required
state intervention of some form or the other. The US thus saw a
private ordering emerging without any involvement of the state.

India ran the ‘badla’ system in the nineteenth and
through most of the twentieth century without any margins and without
any clearinghouse guarantee. While France solved the risk problem in
its usual dirigiste style and the US solved it using private ordering,
India seems to be a case of state failure and market failure until the
last decade of the twentieth century. In fact, the problem was solved
only a few years before the abolition of ‘badla’
itself.

Now I turn to some other papers relevant to the regulation of OTC
derivatives.

Viral Acharya and several coauthors have written extensively on the
regulation of OTC derivatives, and I will mention two. Acharya and
Engle have a nice paper that
explains the key issues in the context of the proposed US
legislation.

Acharya and Binsin have a conference
paper explaining how an exchange is able to price counterparty
risk better than the OTC market because it is able to see the entire
portfolio of the counterparty. Streetwise Professor
criticizes this on the ground that exchanges charge the same price to
everybody and do not discriminate. I think this criticism is incorrect
– exchanges do not discriminate in the sense that they apply the
same risk model to everybody, but the standard SPAN type model is a
portfolio model where the margin is not on an individual position but
on a portfolio. The incremental margin requirement for any position
thus depends on what else is there in the portfolio. Thus the risk is
priced differentially.

The Acharya and Binsin paper must be read in conjunction with a paper by Duffie and Zhu
who show that the efficiency gain from central clearing is best
realized when there is a single clearing house for all derivatives and
the gains may disappear if there are separate clearing houses for
different products and even more so when there are competing clearing
houses for the same product. This in my view is only an efficiency
issue and does not detract from the reduction of systemic risk from
the use of central clearing.

For those interested in data about the magnitudes involved in these
markets in terms of risk and collateral requirements, a good source is
an IMF
Working Paper on “Counterparty Risk, Impact on Collateral
Flows, and Role for Central Counterparties.” For more detailed
information about the CDS market, there is an ECB
paper on “Credit default swaps and counterparty risk”

 

Regulation of OTC Derivatives

Last month, the UK Financial Services Authority (FSA) and the
Treasury put out a document
entitled “Reforming OTC Derivative Markets: A UK
perspective.” My one line summary of this document is that the
UK does not wish to make any significant changes to the regulations of
the OTC markets. A cynic would say that this is explained by the fact
that London dominates the OTC derivative markets globally.

This month there was a nice paper
by Darrell Duffie and two co-authors for the New York Fed advocating
not just central clearing, but also encouraging the use of exchanges
and electronic trading platforms, as well as post-trade price
transparency. I like this report though the Streetwise Professor
thinks that this is tantamount to socialist planning.

Streetwise Professor has been arguing in a series of posts on his
blog that OTC markets have evolved naturally and must therefore
represent an efficient outcome absent demonstrable externalities. This
argument deserves serious consideration and is one to which I am
sympathetic.

One of the early and clear enunciations of the private ordering
argument is a paper over ten years ago by Randall Kroszner (“Can
the Financial Markets Privately Regulate Risk?,” Journal of
Money, Credit & Banking, 1999) which describes the historical
evolution of exchange clearing in the last century and compares it to
the development of the OTC markets. As I re-read this paper, I was
struck by two statements in the paper.

• Kroszner argues that the large derivative dealer
  “effectively creates its own ‘mini’ derivatives
  exchange, with its own netting, clearing, and settlement
  system.” with the International Swap Dealers Association (ISDA)
  providing partial standardization of contractual terms.
• Kroszner also points out that: “Credit rating agencies are
  the effective regulators in setting standards for capital, collateral,
  and conduct, much like clearinghouses and government regulators, but
  do not have a direct financial stake in the transactions.”

This analysis provides one perspective on what went wrong during
the crisis. First, the “regulation” provided by the rating
agencies was an absolute disaster and the “mini derivatives
exchange” run by the large derivative dealers turned out to be
far less robust than the derivative exchanges.

At the same time, private parties have no incentive to move from
the failed model to the robust model because the failed model now
comes with the wrapper of a “Too Lehman-like To Fail”
guarantee from the government. In the absence of this government
guarantee, private ordering might have been relied on to do the right
thing, but in its presence, things are different.

 

Currency in circulation

The Chief Cashier of the Bank of England, Andrew Bailey, gave a
fascinating speech last month on
various aspects of currency in circulation in the UK. The key point is
that while cheques have been in terminal decline in the UK (see this
blog
post), cash has in recent years been growing not only in notional
value, but even as a percentage of GDP.

Bailey thinks that people are increasingly using cash as a store of
value (and not just as a medium of exchange) partly because of a lack
of confidence in the banking system and partly because at near zero
interest rates, the opportunity cost of holding cash is negligible. If
people are indeed stuffing cash under their mattresses, it tells us
how harsh the global financial crisis has been.

Another interesting point is about the quality of notes. In India,
ATMs typically give out better notes than the bank branches do, but
Bailey tells us that in the UK, it is the reverse. The new generation
of ATM machines can dispense notes so soiled that a human teller would
regard them as unfit to be dispensed. One almost hopes that India
remains stuck in the old generation of easily jammed ATMs that give
out relatively clean notes.

The most important point that Bailey makes is that “banknotes
are central-bank money in a form that can be held by the public, in
other words the retail equivalent of reserve accounts at the central
bank.” I would like to push this point further – if
technology allows electronic accounts to be maintained at near zero
cost, should not the central banks provide electronic reserve accounts
to all citizens? As India moves toward issuing a unique identity
number to every citizen, would it not be nice for each such number to
be linked to a no frills account at the RBI?

Why in other words should only the rich and powerful institutions
have access to central bank money? When a variety of tax laws and
money laundering laws attempt to prevent the use of central bank money
in the form of cash, should they not then facilitate the use of
central bank money in the form of electronic reserve accounts at the
central bank?

The shocking thing in finance is that financial markets settlements
do not reach the highest standards of DVP (delivery versus payment)
– simultaneous and irrevocable payment in central bank money. If
you go to a grocery shop, pay for your purchases in cash and walk out
with your goods, the transaction conforms to the highest standards of
DVP because cash is central bank money. In most financial markets on
the other hand, we do not get this level of DVP because the settlement
systems do not settle in central bank money. This is a shame.

 

Foreign Investment: Direct versus Portfolio

Ever since the Asian crisis, there has been a sort of consensus
that foreign direct investment (FDI) is the best and most stable form
of capital inflows while foreign portfolio flows (FII in Indian
parlance) are more volatile and therefore less desirable.

Ever since the global crisis began, I have been reading a lot of
financial history (starting with the last 500 years and slowly going
further back). It now appears to me that the aversion to the
volatility induced by portfolio flows is extremely short sighted.

In the long run, the volatility gets washed out and what counts is
the average growth rate of the economy. The short term (high
frequency) is all noise (volatility) while the signal (mean) is
apparent only in long time series (low frequency). Lessons drawn from
short time series of data are probably wrong.

Looking back at some of the major emerging markets of the
nineteenth century (US, Canada, Australia and Argentina) puts things
in a totally different perspective. I particularly enjoyed the
discussion about nineteenth century US in Chapters 7 and 8 of Atack
and Neal, (The Origin and Development of Financial Markets and
Institutions; From the Seventeenth Century to the Present,
Cambridge University Press, 2009).

Of all the big emerging markets of the nineteenth century, the US
relied most on portfolio flows and Argentina relied the most on
foreign direct investment. By 1890, the results of the different
trajectories were quite apparent.

In the long run, the volatility of the growth rate is largely
irrelevant; it is the average that counts. Despite frequent financial
crises and corporate bankruptcies, the US grew faster. More
importantly, it was also able (despite the damage inflicted by
populist politicians like Andrew Jackson) to build a domestic
financial system that ultimately made it less dependent on foreign
markets and institutions.

Applying that historical lesson would suggest that India should
remain friendly to foreign portfolio flows while developing domestic
financial markets. We must simply learn to live with the volatility
and occasional crises that come in their wake.

 

Indian coupling with global risk aversion in 2009

I wrote a column
in the Financial Express today about why Indian markets
were swayed by global developments in 2009.

Indian markets in 2009 appeared to dance almost completely to the tune
of global developments, reminding us of how strongly integrated we are
with world financial markets.

Unlike China, the Indian economy does not depend so much on exports
for its growth. Collapse of global trade in 2008 and early 2009 did
impact sectors like textiles, diamonds and software services, but
collapsing exports did not crush the whole economy because many other
sectors thrived on domestic demand.

India’s tight coupling with global markets was not due to trade
linkages, but to its dependence on foreign portfolio flows for risk
capital. Over the last few years, more and more Indian investors have
sold their shares in Indian companies largely to foreign investors
(but also partly to Indian promoter groups seeking to increase their
stakes).

Foreigners might have bought because they are more bullish about our
country than we are, or because their global diversification makes
them less concerned about India-specific risks. What is important is
that Indian asset prices are now increasingly determined by foreign
investors.

This dependence has three implications. First, when foreign portfolio
flows reversed, as in late 2008 and early 2009, risk capital
disappeared completely. A few companies with strong balance sheets
were able to raise modest amounts of debt locally, but those with
weaker balance sheets found that they could not raise money at all.

When the corporate sector talked about a liquidity crunch in early
2009, it was really bemoaning the lack of risk capital. Banking system
liquidity was probably adequate by early 2009, but this liquidity was
not risk capital that could meet the needs of cash-strapped
businesses. It was the return of foreign risk capital in mid-2009 that
saved the day for these companies.

The second implication of India’s dependence on foreign risk capital
is that asset prices in India depend on global risk aversion as much
or even more than on domestic sentiment. Capital inflows can ignite
asset-price bubbles and outflows can prick the bubbles.

Many of us worried about asset-price bubbles in India in 2007,
particularly in the stock markets and in real estate. This view can be
debated, but if it is accepted, some of the air went out of these
bubbles in 2008 and early 2009, and the bubbles might have been
inflated again in the second half of 2009. They could deflate again if
global risk appetite reverses in 2010.

The third implication of reliance on foreign risk capital is that
equity portfolio flows have a strong effect on the exchange
rate. Reserve accumulation by the central bank dampens currency
appreciation but does not eliminate it completely. A regime of managed
exchange rates creates difficulties for the conduct of monetary
policy.

Despite all these problems, foreign risk capital (unlike debt capital
inflows) brings huge benefits to the economy. Even in the extreme
scenario where all inflows are sterilised in the form of reserves,
capital inflows provide dramatic risk reduction for the economy as a
whole.

This benefit was clearly visible in late 2008 and early 2009 when
foreign investors sold shares at prices well below what they had paid
only months earlier and converted the rupee proceeds into dollars at
exchange rates much higher than the rate at which they had bought
rupees when they came in.

Whenever foreign investors sell cheap after buying dear, they make a
loss and India as a nation makes a profit. More importantly, we as a
country make a profit precisely when the economy is not doing too
well. This is a wonderful risk hedge that is worth all the costs that
come with it.

Looking forward to 2010, it is quite likely that the ups and downs of
global markets will be felt in India as well. Major downside risks
remain in the global economy and the question is how well positioned
we are to cope with their impact on India.

The Indian corporate sector has used the recovery of 2009 to repair
balance sheets in a variety of ways. A lot of the rebuilding of
balance sheets has been made possible by foreign risk capital.

Some companies have raised new equity in 2009 largely in the form of
private placements and sales to strategic investors. Many companies
that found themselves struggling to roll over short-term debt in 2008
have taken advantage of benign conditions in 2009 to refinance
short-term debt with longer-term debt.

A few companies have also addressed the problem of busted
convertibles. The recovery of 2009 enabled them to successfully
exchange old convertibles that had uncomfortably high conversion
prices for more viable instruments. The re-emergence of mergers and
acquisitions activity also allowed some companies to carry out asset
sales to rebuild their balance sheet strength.

As a result of all this, the Indian corporate sector is better
positioned to face new challenges in 2010.

 

Letting large banks fail

I wrote a column
in the Financial Express today about the reform
legislation winding its way through the US Congress. I argue that the
regulatory goal of making large banks failure proof will not be
realized and that it is better to have a policy of letting even large
banks fail.

Towards the end of 2008, US policymakers halted the panic phase of the
global financial crisis with three simple words: “No more
Lehmans.” In the short run, this statement could mean that there
would be no more bankruptcies like Lehman – any large financial
entity on the verge of failure would be simply bailed out. AIG was the
first beneficiary of the new policy.

However, in the long run, the ‘No more Lehmans’ policy can
only mean that there would be no more failures like Lehman. Either
financial entities should be unimportant enough to be safely left to
the bankruptcy courts when they fail, or they should be robust enough
to make their failure extremely unlikely.

In this context, the US House of Representatives has passed a
comprehensive 1,279-page Financial Reform Bill, but the Bill could
change significantly before it is passed by the Senate and becomes
law. How effective would this law be in eliminating Lehman-like
failures?

First, the new US provisions (as well as the recent Basel proposals at
the global level) impose higher capital requirements on financial
institutions. While higher capital would reduce the chances of
failure, it would not make failures so unlikely that governments can
safely promise to bail out any large bank that slips through the
cracks. Other elements of the new legislation are, therefore, designed
to make it easier to let large institutions fail.

A second key part of the legislation extends the existing resolution
mechanism for failed banks to systemically important non-banks and
bank holding companies. Under the old law, Lehman could not have been
resolved in this manner and while the banking part of Citigroup could
have been resolved, the holding company itself (which owned many of
the foreign subsidiaries) could not have been.

The new resolution mechanism makes it easier for the regulator to
contemplate the failure of a large entity because the messy bankruptcy
is replaced by a more orderly resolution process. There is also a
provision for a bailout fund (Systemic Dissolution Fund) to facilitate
the resolution process, but this fund is to be financed by
contributions from the financial industry itself.

The problem with this proposal is that while it avoids bailing out
shareholders of a large entity, it actually formalises the bail-out of
their creditors through the systemic dissolution fund. It would,
therefore, have the perverse effect of encouraging banks to become
even larger to exploit this implicit guarantee from the government.

A third key element in the legislation is the reform of the OTC
(over-the-counter) derivatives market. Lehman was not spectacularly
large in terms of assets and liabilities. The systemic importance of
Lehman (and even more so of AIG) came from OTC derivatives.

Lehman was a large dealer in OTC derivatives and AIG was a large
counterparty for subprime-related credit default swaps. They were not
too large to fail, but were described as too interconnected to
fail. Reform of OTC derivatives is intended to prevent this kind of a
situation from arising.

The straightforward solution to the OTC derivative problem is to move
these derivatives to the exchanges where a central counterparty (the
clearing house) collects margins from all participants and assumes
responsibility for all trades. Lehman did have a portfolio of 66,000
contracts totalling $9 trillion of interest rate swaps cleared by
LCH.Clearnet in London. LCH not only resolved the Lehman default
without any loss, but also returned a large part of the margins that
it had collected from Lehman.

To understand the difference with the OTC market, suppose that Lehman
had sold $100 billion of a certain OTC swap to some parties and bought
$90 billion of the same OTC swap from others. Its failure would force
all its counterparties to terminate their $190 billion of Lehman deals
and establish new contracts with other counterparties. When all these
trades are done through an exchange, the clearing house would have to
liquidate only the net position of $10 billion, and this is easier
because of the margins that the clearing house has collected.

The US law tries to mandate clearing of standardised OTC derivatives,
but the proposals are riddled with loopholes that threaten to make
them ineffective. First, it does not mandate exchange trading; it only
mandates clearing and that too if a clearing house accepts the
concerned derivative for clearing. Second, many OTC derivatives lack
price transparency and are therefore illiquid. Without a push towards
transparency, many derivatives will simply be unacceptable for
clearing. Third, minor changes in terms may make a derivative
non-standardised and therefore not subject to clearing.

All in all, the 1,000-odd pages of complex provisions riddled with
loopholes in this legislation will not make Lehmans sufficiently
unlikely in future. I would suggest that ‘No more Lehmans’
is not the correct policy after all. True capitalism is about letting
insolvent banks fail, however painful that might be.

 

How broken are the OTC markets?

The SEC has filed a complaint
against the world’s largest inter dealer broker ICAP which
dominates trading in US government securities and many other OTC
markets. ICAP has settled the charges for $25 million and an
undertaking to implement remedial action to be suggested by an
independent consultant.

The charges are very serious:

• ICAP displayed thousands of fictitious trades designed to mislead
  other traders about the true state of the market; and
• ICAP brokers executed thousands of trades to liquidate
  ICAP’s positions against customer orders in violation of the
  stated workup protocol.

It is depressing that charges of such seriousness are settled
without an admission of guilt. The alleged actions shake the very
foundations of market integrity and make one wonder whether OTC
markets can be trusted at all.

Around the same time that I was reading this complaint, Rortybomb
alerted me to a Bloomberg
story of a few months ago about an investigation against
Markit. The charges here are of a very different nature but they are
disturbing in their own way. It is alleged that Markit agreed to
provide price information to a clearinghouse only if the latter agreed
to clear only trades that involved a dealer.

The question in my mind now is how badly broken are the OTC
markets. Whenever, people describe the stock exchanges as casinos, my
response is that even if many of the participants are only gambling,
the stock exchange still performs the socially useful purpose of price
discovery. OTC markets that do not provide transparent price discovery
do not perform this function and are much closer to pure
casinos. Those that distort the price discovery are worse than
casinos.