How NPR Mangled Geithner’s Plan For OTC Derivatives

Also published on the Atlantic Monthly’s Business Channel.

Timothy Geithner has released his proposal on how to regulate the OTC derivatives market. The proposal is broad in its scope and the regulations proposed would have a profound impact on market practice if implemented. Despite this, the sleuths at NPR claim to have discovered a “huge loophole” in the plan. I’ve also been studying both Geithner’s proposal and the NPR article on the subject, and the only holes that I found were in NPR’s understanding of the OTC market. In order to fully understand the earthly implications of Geithner’s policies and the gargantuan errors made on Planet Money, we should probably understand what the OTC derivatives market is. So, let’s begin with a brief overview of what the OTC market is and what it isn’t.

What Is An OTC Derivative?

A derivative is a contract that derives its value by reference to “something else.” That something else can be pretty much anything that can be objectively observed and measured. That said, when people talk about derivatives, the “something else” is usually an index, rate, or security. For example, an option to purchase common stock is a fairly well-known and ubiquitous derivative. So are futures for commodities such as pork belly and oil. However, these are not the kind of derivatives that Geithner is talking about. Geithner is talking about OTC derivatives, or “over the counter” derivatives. This category of derivatives includes the much maligned “credit default swap” market, as well as other larger but apparently less notorious markets, such as the interest rate and foreign exchange derivatives markets. The key defining characteristic of an OTC derivative is that it is entered into directly between the parties. This is in contrast to exchange-traded derivatives, such as options to purchase common stock. Highly bespoke OTC derivatives are often negotiated at length between the parties and involve a great deal of collaboration between bankers, lawyers, and other consultants. For other, more standardized OTC contracts, commonly referred to as “plain vanilla trades”, contracts can be entered into on a much more rapid and informal basis, e.g., via email.

For the limited purpose of wrapping your head around the world of derivatives, think of all derivatives as being in one of three broad categories: (1) exchange-traded derivatives (e.g., options on common stock and futures on pork belly); (2) standardized OTC contracts (e.g., your basic credit default swap); and (3) bespoke OTC contracts (transaction specific, often more complex instruments).

The “Huge Loophole”

NPR claims that Geithner’s proposal has a “huge loophole”, which they uncover through the following summary:

- Banks and other players have to tell the government when they buy and sell these derivatives. That means the government can know how many are out there and who has them.

- If banks and others are buying and selling standardized derivatives, they must trade them on an exchange, sort of like how stocks are traded on an exchange. That way it’s more transparent and the prices should more accurately reflect the market sentiment.

- But — and here’s the big but — banks and others are perfectly free to continue trading custom-made derivatives as private transactions between two parties.

In case you didn’t catch it, that last part was supposed to be the clincher. But before we can appreciate why it’s not a clincher, we need to do a bit more homework on the OTC market. In Geithner’s proposal, there’s a lot of talk about CCPs, or “central counterparties.” These are often incorrectly equated with exchanges. CCPs are not exchanges. They are exactly what their name suggests: a central counterparty for swaps of a particular type. After two parties enter into an OTC trade together, they novate, or more colloquially, move their trades to the CCP. So unlike trades executed on an exchange, CCP trades are entered into directly between the two parties, but later shifted over to the CCP. There are a lot of reasons why this is done, and they’re beyond the scope of this article. But if you’re interested in reading more about CCPs, go here. The key take-away is that CCPs are not exchanges, but more like risk repository/management systems where trades get moved to after they’re executed.

So, NPR believes that because OTC market participants are not forced to trade on exchanges, their trades will continue to be unnoticed and unregulated. This is completely false for two reasons: first, trades that are capable of being moved to a CCP would be required to be moved to a CCP under Geithner’s plan; second, even if they weren’t, Geithner’s plan calls for all OTC trades, including those in the third bespoke category, to be recorded in what are known as “trade repositories,” such as DTCC’s Deriv/SERV. Here is the relevant language from Geithner’s proposal:

[I]f an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.

[A]ll trades not cleared by CCPs [are] to be reported to a regulated trade repository.

This is in contrast to NPR’s second point above, which asserts that all such trades would be traded on an exchange. That is wrong. What this says is: all trades that can be moved to a CCP (not an exchange) should be, and it will be assumed that this is required; and if they’re not moved to a CCP, they have to be recorded in a trade repository. So, by definition, this proposal would make regulators aware of every single trade in the OTC market since every trade is either on a CCP, in which case the CCP will record its existence, or not on a CCP, in which case the trade repository will record its existence. But how do we explain NPR’s blunder in their third point? That blunder comes from yet another equivocation between a CCP and an exchange. The relevant language from Geithner’s proposal is as follows:

[Relevant laws should be amended to impose] the encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.

NPR hones in on the “encourage” language, taking this to mean that market participants will have a choice between using an exchange or being unregulated financial pirates. Of course, those swashbuckling financiers will choose the latter. As I’m sure you’re starting to see, this is a false dilemma. What Geithner is suggesting here is that regulated institutions avoid the OTC market altogether, and make use of derivatives from the first category above (the exchange traded ones). Of course, such a policy should be suggestive and not prescriptive, because contrary to popular belief, OTC products serve legitimate needs that exchange traded products don’t meet, at least not yet.

Customized Misinformation

No finance bashing story is complete without a kooky conspiracy theory, and so in order to fulfil the meme, NPR offers us an explanation as to why those crazy credit default swaps are so darn complex:

It seems reasonable to expect that every single sales team on Wall Street will work very hard to convince their customers that they have Very Special, One-Of-A-Kind Credit Derivatives that are far better than the boring old ones traded on the exchange.

Unfortunately for NPR, this is complete nonsense. The vast majority of credit default swaps are completely standardized and have been for a while. Recent changes to how CDS are priced has increased fungibility even further. In fact, one of NPR’s commenters actually pointed this out. The NPR commenter writes:

Virtually ALL CDS contracts are standardized. Which is to say that I can open a position with Goldman Sachs and unwind that position at Citigroup. These instruments will be covered under the Obama proposal and are well suited to being exchange traded. Are there bespoke products available in the derivative market place? Absolutely. But they account for a minuscule portion of the overall business.

But NPR doesn’t stop there. Acknowledging the possibility (fact) that they are wrong about standardized CDS, they go on to claim that:

[Even assuming the commenter] is right (he probably is) and most currently-traded CDS would qualify for a new exchange or clearinghouse; it seems fair to guess that lots of CDS operations will be looking for ways to avoid that clearinghouse and all the extra regulation and transparency and lowered commissions it brings with it.

Yet again, unfortunately for NPR, that is more nonsense. The major swap dealers have already set up a CCP on their own, before regulators required them to do so, and are currently moving trades to it. Swap dealers do not make money by over-complicating products and duping trillions of dollars worth of capital. They make money by creating a market. That is, they buy and sell swaps, creating a market, and pocket the difference between the prices at which they buy and sell. If you want to use jargon, you would say they create “liquidity” for swaps. That’s their business. Making complicated products that aren’t fungible does not advance that business model. Even more importantly, as we noted above, Geithner’s proposal wouldn’t let them off the hook simply because they used bespoke products. If the trade is accepted on a CCP, it is presumed to be required to go there. And even if it’s not, it gets reported anyway.

Clearly Planet Money doesn’t think it’s a very good proposal. But in my humble opinion, it’s at least a reasonable proposal for the residents of planet Earth.

Boring Banking Will Not Save You

Also published on the Atlantic Monthly’s Business Channel.

Paul Krugman wants us to believe that by making banking boring again, we can prevent another crisis from occurring in the future. Although Krugman doesn’t provide any clear definition of what it means to make banking boring again, the context suggests that he is pushing for a return to a simpler and smaller banking sector. As such, Krugman offers up a very comforting theory, since the benefits of making banking boring are twofold: ridding us of devastating downturns while simultaneously smiting those greedy bankers. So in addition to fitting nicely into the fashionable banker-bashing meme, Krugman’s argument provides comfort in that it suggests the problem has already been identified and has a simple fix. Unfortunately, making banking boring again would probably have a devastating affect on the availability of credit, particularly at the consumer level, and won’t do a thing to stop asset bubbles from occurring in the future.

Krugman paints the recent history of banking with broad strokes – in contrast to James Surowiecki’s reasonably detailed article on the subject – drawing primarily on what is little more than the coincidence of boring banking and economic stability. In essence, he claims that we did our best when banking was boring. Presumably, we are to infer that this coincidence compels us to accept that boring banking is indeed the cause of economic stability. Answering such a complex question with such a simple and obviously flawed form of argumentation would normally smack of idiocy. But in Krugman’s case, it smacks of paternalism. Krugman is undoubtedly smart enough to know that abstracting from historical coincidences is an unacceptable method of discovering theories of causation, even for an economist. So, with this, I invite Mr. Krugman to explain why boring banking is superior to interesting banking. In the meantime, here are some things to consider before smashing banking back into the Stone Age.

Securitization And The Capital Markets

Securitization takes money from the capital markets and funnels it into the consumer credit market by bundling individual loans, lines of credit, and mortgages that would otherwise be unattractive to investors on a piecemeal basis. Tremendous sums of money are funneled to consumers using this process, particularly in the mortgage space. If the boring banking regime precludes securitization, we can expect this capital to either sit idle or go elsewhere, thereby depriving consumers of credit and spending power.

Bubbles Are Nothing New

Markets experienced bubbles long before credit default swaps and securitization were even a glimmer in a greedy banker’s eye. And so stripping bankers of the tools and techniques of modern finance will do nothing to stop them from occurring again. Whether it’s tulips, internet stocks, or spec houses, humans create investment fads that skew prices upwards and create value out of thin our. Then, once the jig is up, prices tank, and those still dancing are left holding the bag. And so, every asset bubble will create a class of losers: those who bought during the boom and held on past the bust. In my humble opinion, the severity of this bust will turn on who’s in that class of losers. If that class of losers turns out to be a group of individuals or businesses that perform a vital function in the economy, e.g., lending, we should expect the effects of the bust to be pretty severe. At this juncture, a boring banking argument could be made. That is, we don’t want banks to be heavily exposed to asset bubbles popping, whether it’s through lending or direct ownership. But this is no different than saying that we don’t want banks to make too many risky investments, since systemic bank failures have severe consequences. So even in the context of bubbles, it’s not the complexity or sophistication of banking that is at issue, but rather the accuracy of valuations and the adequacy of the capital that banks set aside in anticipation of losses.

The Suggestion Box

I realize that many of you have questions about the financial markets that I probably have yet to answer. As such, I’m taking requests. So please leave a comment below and let me know what you’d like me to write about. If there are any topics that prove to be of common interest, I will write something about them. Depending on the level of feedback, this might be something I’ll do again.

Regards,

Charles

Rethinking Central CDS Counterparties

Also published on Cluster Stock

Regulators have been largely supportive of the credit default swap market’s efforts to move all standard CDS (a.k.a. “vanilla” CDS) contracts onto a central counterparty (CCP). Within a relatively short amount of time, the CDS market garnered the support of both the SEC and the Federal Reserve, setup shop, and executed CDS transactions totaling $71 billion in notional amount on ICE Trust LLC (ICE), the first of what could be a handful of CCPs. Given that the CDS market is still serving time on the pillory, this kind regulatory largess seems to imply that a CCP must undoubtedly be a good thing. However, not everyone is convinced. In a recent paper, Darrell Duffie and Haoxiang Zhu of Standford University described the state of affairs with and without a CCP in mathematical terms, proposed a measure of efficiency which they use as a proxy for counterparty risk, applied this measure to each state of affairs, and came to conclusions that are surprising, but not counterintuitive once you take a moment to consider the trade-offs between a distributed dealer system and a CCP.

There are two central points in their paper: (1) the benefits of having a CCP compared to not having a CCP (the distributed dealer system) is a function of the number of dealers (i.e., the more dealers, the more the system benefits from having a CCP) and that the current number of CDS dealers might be too small to realize any benefits from a CCP; and (2) even if having a single CCP is more efficient than not having one, having more than one CCP is never more efficient than having none at all. The assumption underlying these two points is that having a CCP as opposed to not having a CCP is in essence a choice between (i) multilateral netting across a single asset class and (ii) bilateral netting across multiple asset classes. After a bit of back and forth with Duffie, I agree that this is the case, but only in the short term. That is, there is nothing about a CCP that precludes netting across asset classes, even if the current model doesn’t facilitate it. I also disagree with the two central conclusions, mostly due to shortcomings of the model that the authors acknowledge in their paper. Specifically, they acknowledge that their model doesn’t deal with so called “knock-on effects,” or simply put, how one dealer default can lead to another. I also disagree with how Duffie and Zhu measure the benefits of netting, but we’ll spare our brains the heavy lifting and focus on the more practical issues. In this article, I’ll focus on explaining why a CCP does not preclude netting across asset classes. In a follow up article, I’ll explain how a CCP mitigates counterparty risk by facilitating trade compression.

What Is A Central Counterparty?

Rather than provide a one line, academic definition, I’ll proceed gradually, and by way of example. For starters, a CCP is not an exchange. Even with a CCP, inter-dealer trades will still be entered into between dealers, and price discovery will still take place across dealers. That is, dealers will still trade with each other, at least initially. After two dealers enter into a CDS trade, they will transfer, or “novate” their positions to the CCP. For example, in the prototypical CCP transaction, if Dealer A sells protection to Dealer B, each dealer would then novate its position to the CCP. After the novation, the state of affairs is such that A sells protection to the CCP and the CCP sells protection to B. When payments are made on the CDS, they get made to the CCP and then passed on to the parties.

At first blush, it might seem like all we’ve done is throw an extraneous and useless 3rd party into the transaction that does little more than operate as a conduit. However, this is not the case. The CCP is a distinct entity that has an interest in its own survival, and since the CCP is now liable to both dealers, it has an interest in being well-capitalized. While individual dealers also have an interest in being well-capitalized, they are unable to determine whether the CDS market as a whole is well-capitalized. And even if they were able to determine whether or not that is the case, each individual dealer has no power to convince others to increase the capital allocated to their positions. By centralizing all of the trade information into one entity and giving that entity control over the levels of collateral that dealers must post, we have created a method through which we can better ensure the adequate capitalization of the entire CDS market. For example, if one dealer is unable to fully collateralize its positions, the CCP can draw on its own capital and the capital of the other dealers to make up for the shortage. Without a CCP, that shortage of collateral would probably trigger events of default, which could “knock-on,” or cascade through the market. But as always, there’s no free lunch, and despite all of this upside, we have also concentrated the risk of counterparty failure.

Payment Netting And Payment Settlement

As Duffie and Zhu note, dealers net their payments and collateral across different types of vanilla swaps. So, for example, if Dealer A owed Dealer B $5 under a vanilla interest rate swap on some payment date, while Dealer B owed Dealer A $3 under a vanilla CDS, A would simply pay B $2. This type of bilateral netting across asset classes reduces the risk that dealers will default when compared to not having such netting because it reduces the total amount of cash that is needed to meet payment obligations. Duffie and Zhu argue that because CCPs segregate vanilla CDS trades from all other types of vanilla swaps, we miss the opportunity to net across asset classes. This is not necessarily the case.

First, we need to distinguish between the entities that are liable for the trades (i.e., the dealers and the CCP) and the entities that actually process the trade information and payments. In the case of ICE, trade information is processed by DTCC. After that trade information gets processed, DTCC submits payment instructions to CLS Bank, which actually handles the payments. So, the CCP itself is not able to net payments across various asset classes, since it only handles CDS trades and moreover doesn’t actually settle the payments. However, DTCC will submit payment instructions to a settlement agent, CLS Bank, that actually handles the cash payments. CLS Bank could also receive payment instructions for other asset classes from the dealers (i.e., payment instructions on interest rate swaps, etc.) and net the payment instructions from the DTCC against the payment instructions from the dealers’ other activities. In fact, CLS Bank is also a leading settlement agent in the FX market.

In short, netting CDS contracts first does not preclude you from netting against other swaps later, especially since trading and settlement are handled by distinct entities.

The Sorry State Of The Dismal Science

Also published on the Atlantic Monthly’s Business Channel.

John Authers’ recent interview with University of Chicago professor Richard Thaler is a fine example of what I hope are broader trends in economic thought. To some, it might seem like just another interview. But Authers undoubtedly recognizes its significance. Thaler is a professor at the University of Chicago, which is the birth place of the Efficient Market Hypothesis, and Authers is a well-respected columnist for the Financial Times, which is arguably the voice of the free market in the press. And yet, there they are, casting doubt upon the very theories underpinning a generation of thought that have made the University of Chicago the epicenter of free market ideology. In the language of soda-pop-economics, this interview is a “black swan.”

It seems Authers is leaning ever closer towards a world view informed by behavioral economics. While I haven’t done any empirical research into Authers’ work, I do read his column, The Short View, religiously (personally, I recommend you do the same). And as the recent downturn developed, I noticed several articles that suggest he’s come to question at least some of the assumptions underlying the old free market dogmas, particularly the Efficient Market Hypothesis. In my opinion, this is a welcomed development. And I sincerely hope it is part of a broader trend away from grandiose theories about how humans make decisions and towards precise theories which are supported by real-world observations.

Those that have toiled through my writing in the past know that I am a big fan of free markets. Yet, I am not a big fan of the EMH. And in general, I find a lot of economic theory, particularly macroeconomic theory, to be little more than hand-waving. There’s an almost priestly air about it that makes me deeply suspicious of its validity. In gentler terms, Economics lacks a rigorous epistemological theory. That is, economists have no robust system of determining which statements about economics are true, and which are not. This is in stark contrast to say, mathematics. A statement about an alleged mathematical truth is verifiable (putting Gödel and Turing aside for the moment). If you tell me that you have discovered a new mathematical truth, you can sit down and in a finite number of words, provide a logical path from assumptions we both agree are true to your new found conclusions that I must accept as true, else I reject either the assumptions or logic itself. Now, I understand that economics can never be a purely deductive sport, since it is complicated by the nuance and uncertainty of, well, reality. But that doesn’t mean we can’t do better than simply assuming away all of human ridiculousness.

The economics that assumes rational behavior on the part of humanity is, in my opinion, dead. It is simply at odds with everyday experience. It’s arguable that the desire for wealth is itself an inherently irrational impulse for most of the developed world, given that our needs would likely be satisfied on public assistance. That said, those who are able to control their behavior and act rationally do a much better job at generating and accumulating wealth. But once they get the money, they go and do something absurd with it, like buy a fleet of planes. So while reason and deferred consumption might be the means by which we accumulate wealth, the end goal of accumulating wealth seems to be driven by a need to express dominance, or at least an antisocial impulse to be free of society’s constraints. This view finds support in popular culture, which often equates wealth with conspicuous consumption, sexuality, and control. All of this suggests that somewhere buried under all of those pinstripes is a real brute.

If I am correct, and there is a sea change taking place in how economists view human behavior and the markets humans create, then there may be a lot of quackery in the short term. That is, during the intellectual power vacuum that will follow the demise of the old Chicago School, a few crackpots might temporarily seize power as we trace our way from the four humors to phlogiston. But when we finally get our Lavoisier, this time let’s remember to keep his head on, despite our penchant for the irrational.

Cluster Stock

I’ve written an article for Cluster Stock on the benefits of central counterparties for credit default swaps. I might write for them in the future, so be sure to check them out.

Regards,

Charles