Central Clearing and Systemic Risk

This guest post is by Ilya Podolyako, member of the Yale Law School Class of 2009 and a friend of mine. Ilya led the Progressive Economic Policy reading group with me and served as an adjunct professor of law at DePaul University this past spring.

One of the key provisions of the Dodd-Frank Act is Title VII, which requires all non-exempt derivatives transactions to go through a central clearinghouse (this report provides a good summary). As James and Simon have explained, the Dodd-Frank Act uses the term “swap” as a big basket that captures most financial products that we would normally call derivatives: options, repos, credit default swaps, currency swaps, interest rate swaps, etc.

Prior to the passage of the Act, most of these products were sold over-the-counter by certain large institutions. That is, in form, a transaction where you wanted to buy a credit default swap triggered by some event (say, the bankruptcy of Ford Automotive) resembled a trip to the car dealership. The dealer had inventory on the lot; this inventory was split into several different models / types of product; individual instances of a given model were relatively homogenous and varied mostly by color and minor adornments (spoilers, leather seats, etc.). If you were looking for a car of a given make and model that had certain extra features, a dealer might be able to get one custom-built for you at the factory, but you’d have to wait for the item and pay extra. Of course, the salesperson would not be able to accommodate all requests – if you show up to your average Chevy dealership and ask to buy a jet-powered car, you are likely to leave empty-handed no matter how much money you have, even though a few other individuals have been able to procure said exotic item.

From a structural perspective, an important characteristic of the new car market and other OTC markets is the absence of publicly available information about other transactions. Thus, when you show up to the dealership, you see only the sticker price, which is unlikely to be what prior customers actually paid to take drive the car off the lot. A related and notable feature of OTC markets is the ad hoc nature of customer-retailer pairings within them. That is, such markets usually have multiple parties independently striking their own deals for the same product; the coupling depends on chance, networks, and amenability to agreement. Predictably, in this environment, the final terms could differ quite drastically from one transaction to the other – prices could vary, some parties could be excused from performance in circumstances where others aren’t, warranties may apply to some sales but not others, etc.

By contrast, a centralized exchange pairs buyers with sellers on terms visible to everyone and pursuant to some fixed queuing algorithm. To switch metaphors for a bit, exchanges are like a reality TV show about a match-making service – a bossy central character sets everyone up while the cameras are rolling and even nonparticipants can witness the results. In this frame of reference, an OTC market is like a college bar – transactions are happening between some parties based on pre-existing relationships, between others who don’t know each other based on clearly indicated mutual interest, and between others still based on mutual acquaintance with an intermediary. The point is that an observer sitting in the corner of the bar might be able to figure out who has successfully negotiated a deal and who hasn’t based on secondary indicators like changes in the number of buyers and sellers remaining on the floor, but won’t have any clue as to the specifics of a given transaction or even the average negotiation.

Dodd-Frank does not mandate that private OTC swap markets convert to exchanges (such a requirement may exceed Congress’s Commerce Clause powers and would be unprecedented in the securities arena). Instead, it uses a more subtle measure to centralize and standardize derivatives trading by requiring most such transactions to go through a clearinghouse. A clearinghouse is sort of like an exchange in that both facilitate trusting interaction between buyers and sellers, but the two types of entities go about their mission in different ways. An exchange makes traders more confident they are getting the best possible price by making the market more transparent. A clearinghouse, on the other hand, makes traders more certain that the seemingly excellent price that their counterparty just agreed to pay is actually the amount of money they will receive when the transaction ends. In an OTC market, that can be far from certain, especially for a longer-term product, like a credit default swap covering a five-year period. In that time, even a CDS seller that was solvent at the time the deal was originally struck could become financially unsound (perhaps, because like AIG, it spent years handing out CDS’s for pennies to anyone who would ask) and be unable to meet its contractual obligations. If the buyer of the CDS found such an irresponsible seller on his own in the OTC jungle, the buyer would have no recourse to anyone else. He could sue the seller or try to extract the money in some other way, but if this money had already leaked out by the time the triggering default event occurred, the buyer would be left holding nothing by a worthless contract in his hands.

A clearinghouse ameliorates such risk by standing behind every transaction and ensuring that it goes through. More specifically, pursuant to previously accumulated legal authority, the clearinghouse takes contracts setting out each deal, “splits” them into two – one setting out a sale and the other setting out the countervailing purchase – and substitutes its name for the counterparty in each half of the transaction. This process, known as novation, ensures that the clearinghouse becomes the seller for every buyer and the buyer for every seller. In doing so, it absorbs all of the counterparty risk from the market, but keeps a posture that is indifferent to changes in the price of the underlying asset because all of its long positions (obligations to buy an asset) match up with short positions (obligations to sell an asset).

The business of a clearinghouse thus closely resembles that of a specialized (monoline) insurer. The clearinghouse makes money in a similar way too – by charging a fee for every transaction it processes. Clearinghouses are usually mutually owned by the members / clients whose transactions it will stand behind. These may include banks, hedge funds, large broker-dealers, and exchanges (who own two of the largest existing American derivatives clearinghouses, CME Clearing and the OCC). These members are responsible for contributing money to an emergency rescue fund in rough proportion to their trading activity, maintaining capital accounts that satisfy a performance margin , and, in some situations, usage fees (though capital contributed free of charge and not subject to an interest rate obviously counts as an implicit fee). Clearinghouses may also call on their members to contribute additional capital or absorb the positions of a member that cannot meet its obligations at any time. Their business model is thus subject to significant network externalities, because a clearinghouse that includes only a few small companies will process exponentially fewer transactions than one that includes all of the major market participants. Moreover, the smaller clearinghouse may attract less financially stable participants and thus carry more counterparty risk on any transaction than a large one. These parameters explain why the existing private-sector clearinghouses enjoy a near-monopoly in their markets.

Clearinghouses aren’t unique to the derivatives arena. They serve as key intermediaries for the stock market and electronic fund transfers. The Federal Reserve is a clearinghouse of sorts, in that it facilitates transfers of assets from one bank to another. Indeed, in the era prior to the existence of the Federal Reserve, banks formed their own regional clearinghouses as a means of assuring investors that an individual bank failure would not jeopardize their savings. These structures proved popular but not particularly effective.

Herein lies the problem. A clearinghouse is a private business that puts its own money on the line. It works by ensuring that its members are actually well-capitalized institutions capable of paying for bets they made, and thus closely scrutinizes the risk profile of each participant’s portfolio on an ongoing basis. This access permits a clearinghouse to observe otherwise opaque OTC markets with great precision and provide valuable data on concentration, exposure, and capitalization to regulators. Meanwhile, under normal circumstances, the clearinghouse can neither borrow from the Federal Reserve nor receive government backing for its capital. So what could go wrong with using these organizations to grab control over derivatives?

Well, while in theory the model sounds good, history has demonstrated that private sector risk aggregators routinely underprice systemic, correlated risk. AIG provides the most startling example of this behavior. From 2005 to 2008, its Financial Products group essentially acted like a clearinghouse gone mad, willing to become the counterparty to nearly every bet by writing billions of dollars (in then-notional, subsequently real value) worth of credit default swaps without holding on to capital or hedging its reference product risk. A similar tendency to charge too little for catastrophic risk undermined the finances of MBIA (initially formed by a consortium of principal insurance companies in a structure reminiscent of the OCC) and AMBAC, the main monoline insurers, whose credit ratings were rapidly cut during the credit crisis. Fannie and Freddie are even better examples, because government housing policy exacerbated their natural tendency to underestimate the likelihood of fat-tail events and charge too little for their guarantees of conforming RMBSs.

Now that clearinghouses have become ingrained into our official market framework, they are likely to become susceptible to the same business pressures that led other too-big-to-fail institutions to dance while the music is playing and not worry about what happens after. In the absence of mandatory clawback requirements, the people who own CME Clearing, OCC, and any other entity that can successfully break into the oligopoly will be able to benefit enormously by charging nonrefundable fees to process every transaction that the DF Act shoves onto their platforms from the previously scattered OTC markets. Realistically, they will continue to carefully monitor their members to avoid costly liquidation of individual portfolios, which cost real dollars from proprietary emergency funds and may decrease trade volume (and revenue) by frightening relatively cautious investors. But the possibility that these sophisticated, logical actors will overlook the fact that Congress has just anointed them as systemically critical parts of the U.S. economy (on whom farmers, power plants, and steel mills will depend to provide a backbone to their trades)* seems slim. I need not belabor the dangers of such awareness on this site.

Of course, social absorption of losses may be a fair price to pay for transparency, stability, and liquidity, at least in some circumstances. For example, the FDIC does just that, and it is widely recognized as a drastic improvement over earlier approaches to the banking system. On the other hand, a lack of centrally cleared derivatives did not cause the economic crisis; lax or nonexistent capital requirements for portfolios of these derivatives did. Clearinghouses can and do impose a version of these, but for the reasons stated above, their requirements are not likely to adequate. The Dodd-Frank Act is still a step in the right direction because it allows the government to survey the derivatives market in real time and stage precise rescue operations when necessary, but in this arena, as in many others, the reforms carry a significant cost.

*Most of these institutions should be able to avail themselves of the End-User exception in Section 723(h)(7)(A) of the Act, but their counterparties are likely to be large financial conglomerates who rely on clearinghouses to manage, clear, and hedge their exposure to any given farm or steel mill.

59 responses to “Central Clearing and Systemic Risk

  1. The Clearinghouses have at least one stabilizing factor that individual firms like AIG lack. Each member is a significant shareholder. It is presumed that more oversight by interested shareholders will provide an additional measure of stability.

    In addition, the members/shareholders have even greater incentives (as well as opportunity) to keep an eye on the other members.

  2. I’m disappointed James. Usually the quality of the commentary from the authors and guests on this site is far greater. This reads like an high school AP term paper finished the night before it was due. I can still smell the starbucks coffee on this post.

  3. AIG wasn’t effectively a clearinghouse in that it was acting as a counterparty and a warehouse. A clearinghouse would have had transparent ongoing margin requirements publicly stated so that counterparties would have had to deposit the requisite balances and also would have seen the lack of proper risk understanding.

    AIG was effectively bearing risk without proper offsets acting as game-keeper and poacher in the false clearinghouse model mentioned above. Clearinghouses rarely would have such concentration risk or could effectively limit concentration risk by putting caps on participants exposures.

    The most Basic models would have shown the effective vertical increases in Delta, Gamma and concentration risks AIG was bearing relative to the non-existent capital base and single counterparty (AIG) itself. At a bare minimum the diversity of opinions in the traded sphere about the “clearinghouse’s” risk requirements would have raised both debate and suspicion.

    My guess is that had AIG been a clearing house, trade volumes would have shrunk as participants would become nervous about counterparty risk, inadequate margins etc. This itself would have been an early signaling mechanism that something was seriously wrong.

  4. The two major “takeaways” (I absolutely hate that word) from my viewpoint here:
    In the absence of mandatory clawback requirements, the people who own CME Clearing, OCC, and any other entity that can successfully break into the oligopoly will be able to benefit enormously by charging nonrefundable fees to process every transaction that the DF Act shoves onto their platforms from the previously scattered OTC markets.”
    and
    “On the other hand, a lack of centrally cleared derivatives did not cause the economic crisis; lax or nonexistent capital requirements for portfolios of these derivatives did.”

    The Dodd-Frank Act is an improvement. The question is, an improvement over what??? What exactly was the standard before??? (I ask rhetorically ) It still puts way way too much proportional risk on the public sector (the taxpayers carrying the investment bankers’ risks) and way too much proportional rewards for the Hedge fund or CDS trader to scoop up huge short-term gains and run off to Paris and say “Sayonara Suckers!!!!” when the bill comes due.

    Dodd and Frank have prescribed a small band-aid for major internal hemorrhaging. Dick Shelby should go throw a party with his buddies at the ABA (American Bankers Association) as we speak.

  5. Can’t the Fed bypass all these middle-men and buy home mortgages at zero percent, maybe homeowners can pay that.

  6. Why don’t you specify your problem with the post??? A 3 sentence comment that doesn’t specify the criticism. Nice.

  7. Guest post wrote:

    “Of course, social absorption of losses may be a fair price to pay for transparency, stability, and liquidity, at least in some circumstances.”

    We’re halfway there.

  8. It essentially does, since 80% of home mortgages are underwritten by Treasury. Unfortunately, many home-dwellers could not even maintain regular payments of principal on their original loan amount (now much higher than the value of the home).

  9. Credit Is Finally Available, But No One Wants It

    August 30, 2010: 2:45 PM ET – CNN

    http://money.cnn.com/2010/08/30/news/economy/debt_fears.fortune/index.htm

  10. Thing is, that shouldn’t have become a problem to begin with. If all that happened was that they were upside down with a stagnant wage and payments they could cover, there wouldn’t be a problem. It’s the fact that they got in to too much house to begin with. Even WITHOUT being upside down, they still couldn’t afford the payments.

    Being upside down doesn’t matter if you a) didn’t get in to too much house and b) weren’t trying to flip the thing. Too bad all the madness of the “hot” market had tons of people doing one or both of those.

  11. I have had no problem getting credit throughout the burst of the bubble. Helped a couple very close friends build credit by co-signing, one buying a car, the other a motorcycle. Bought myself a brand-spanking-new motorcycle as well at a decent rate (though I was paying it down at a grand a month, even though my payment was just over a hundred bucks).

    Credit’s been there all along for responsible people. It’s only the folks that were living paycheck to paycheck with zip left over each month after making all the payments that were hurting. Or the small businesses playing the game of trying to float NET 30 on stuff they shouldn’t so they could pretend they’re bigger than they are. They shouldn’t have had credit to begin with. Perhaps they learned their lesson and are doing everything through cash now if they aren’t bankrupt and stuck with a 7 year black mark.

  12. Perhaps the real effect of a clearinghouse is to standardize products. That wouldn’t be a bad thing.

    If the business needs to be sold through a clearinghouse, unusually structured swaps and derivatives may not generate sufficient interest to justify the cost of developing and maintaining the products.

    Instead, we might end up with a limited number of standardized products that everyone understands and that can be better controlled.

  13. Many small, responsible, profitable businesses couldn’t get credit since the crisis. Credit is more than a card. Besides, much has been written about how those with jobs are doing more or less ok, even if their income has taken a hit. It’s not really the point.

  14. Bayard Waterbury

    Ilya, thanks for the post. I’m somewhat of a novice when it comes to the details of how clearinghouses work, and so I appreciate the enlightenment. Of course, even without your description of the potential perils, I intuitively knew that whatever our legislators designed would be flawed. We, as humans, have a major failing. We tend to overtrust institutions. This is, I believe, an admission that we don’t wish to take the time and trouble to analyse them carefully enough, and so incipient errors plague their formation and operation. This trust in institutions, and the fact that so many have acceded to such incredible power, is why we currently find ourselves in such a bind socially. Sadly, this is a global problem of interconnectedness, insider information, and malicious institutionally planned corruption. But, then, ever since humanity formed itself into large complex societies the trend has been negative in many ways. Oh, yes, we’ve had a few “golden” eras, but, even during those, we barely made it positive, only to sink back into the mire of ignorance, apathy, greeed, and lust for power and theoretical control.

    Keep writing, and, next time, suggest how the present system and/or legislation may be productively modified to protect us from the potential toxicity within the institutional environment about which you write. Thanks, as far as it goes!!!

  15. I have a real hard time buying in to the part where it’s ever responsible to do things in a business on credit outside of leasing/purchasing an office and necessary outfitting for start up. Yes there’s the whole liquidity argument, but after getting a taste of using credit personally… I plan to pay it off and stay out of debt for anything other than maybe a house or car purchase in the future. I’ve not gotten in any real trouble, I just don’t see advantages to it.

    Yes yes, I know that people will claim business is different from personal finance, but is it really? I mean at its very basic level, you’re essentially a business of one to however many are in your family person(s). You want to take it more than you pay out in order to grow your family and/or increase the quality of your life style. The difference is only one of scale.

    Credit is only necessary for very major purchases that you can’t necessarily put off until you have the money, or emergencies if you’ve failed to save properly for them. I just fail to make the logical leap where using credit daily really isn’t all that responsible for the individual (it simply adds cost to every transaction, with the bank acting as a middle man), but suddenly it is responsible when you’re using it for business expenses. Really? Is it? Is it that impossible to run a business strictly on cash day-to-day?

    It’s an honest question, since I’m debating starting my own company. I can see that not using credit means I have to delay growth until I can actually afford to pay for it, but is that really such a bad thing?

  16. As a side note, I realize credit is more than a credit card. The article focused pretty heavily on consumers, hence the reason I focused on them in my comment.

  17. I found this very informative. Thank you, Ilya.

  18. …Exactly, and this should stand as a reminder that businesses that profit from engaging in such systemically sensitive activities are never likely to willingly embrace or consistently comply with clearinghouse participation requirements. They will never value the systemic (aka non-private) benefits that such institutions create sufficiently (except perhaps for brief moments immediately after a crash) for anyone to assume that provisions for eternal vigilance and active enforcement, when required, will not be necessary. The history of the pre-Fed, “Free Banking” moments in the US, Western Europe, and Scandinavia suggest that in the end, industry-friendly private clearinghouses fare no better (e.g., in terms of industry goodwill, voluntary compliance, appreciation of systemic benefits, or longevity between collapses) than their notionally sovereign-backed counterparts.

    Now that technology has made it possible to “rationalize” unbounded/infinite leverage (at least on paper), the price of stability is going to be eternal vigilance (or alternately, the creation/maintenance of radical transparency), forever.

  19. Will the Dodd-Frank Act take on any of these things?

    http://americaspeaksink.com/2010/08/the-many-faces-of-tyranny/

  20. These ARE NOT GLEN BECK LYRICS!!!! Cause I can’t spell those.

    Play Are the Good Times Really Over for Good
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    I wish a buck was still silver.
    It was back when the country was strong.
    Back before Elvis; before the Vietnam war came along.
    Before The Beatles and “Yesterday”,
    When a man could still work, and still would.
    Is the best of the free life behind us now?
    Are the good times really over for good?
    Are we rolling down hill like a snowball headed for hell?
    With no kind of chance for the Flag or the Liberty bell.
    Wish a Ford and a Chevy,
    Could still last ten years, like they should.
    Is the best of the free life behind us now?
    Are the good times really over for good?

    I wish coke was still cola,
    And a joint was a bad place to be.
    And it was back before Nixon lied to us all on TV.
    Before microwave ovens,
    When a girl could still cook and still would.
    Is the best of the free life behind us now?
    Are the good times really over for good?

    Are we rolling down hill like a snowball headed for hell?
    With no kind of chance for the Flag or the Liberty bell.
    Wish a Ford and a Chevy,
    Could still last ten years, like they should.
    Is the best of the free life behind us now?
    Are the good times really over for good?

    Stop rolling down hill like a snowball headed for hell.
    Stand up for the Flag and let’s all ring the Liberty bell.
    Let’s make a Ford and a Chevy,
    Still last ten years, like they should.
    The best of the free life is still yet to come,
    The good times ain’t over for good.

    James is Asian, but I know James “GOT” this. Love you James Kwak

  21. These CAN BE</b the best times of America. When we answered the challenge. I believe it. Will you????

    I saw similar things in my time as a truck driver, some odd years ago………….http://www.youtube.com/watch?v=YleF5tJuQ64

    BELIEVE IT, I SAW IT

  22. Mr. Gogerty – good comments.

    I believe AIG was closer to a conversion account – long stock, short call, long put or short stock, long call, short put (easier to see with vector analysis but blog tech will not support graphics). Prior to the CBOE, OTC put-and-call dealers used to hedge settlement risk with conversion account operators in a manner similar to a bookie approaching kickoff.

    Like AIG, these conversion account operator and the contra-party arrangements were contract or trade specific (vs. clearinghouse continuous net settlement). Like the bookie, the conversion account operator’s profit was determined by spread management as one trade would initiate multiple related trades.

    Mr. Podolyako makes a good attempt at addressing a complicated and not widely understood piece to the subprime puzzle. But the Series 27 principal (Financial and back office) test is much more difficult than the Series 24 principal (managing principal) for a good reason; the Series 27 manages his firm’s and contra party capital exposure. It is one thing to reverse a trade, it is quite another to try to recapitalize an illiquid firm. I never again want to reconcile another stock break before the opening.

    Further, much of the financial services industry, especially the back office, suffers from jargon. But to know the industry, you unfortunately have to know the jargon. And to that point, I believe a couple of comments are needed to amplify the discussion.

    The OTC market with competing market-makers is a quote-driven market (multiple quotes explain why there are multiple prices to match differing needs—consumer choice for investments that are sold) whereas an exchange market with a single specialist is an order-driven market (determinate transactions that are bought to meet known needs). The relative efficiencies have been debated for ever. Both OTC and exchange markets can and have cleared through clearinghouses such as the Depository Trust Corp.

    Thus, I believe that “transparency” is not so much the type of market platform as it is standardization of contract and enforcement of trade reporting relative to determinate and indeterminate underlying economic environments as I have previously argued.

  23. whatever……………

  24. Here it is clearance text…….

  25. All the kings horses and all the kings men, cannot put this predatorclass machination together again. If the rules are systemically thwarted, or skirted, or ignored – then in practical reality – there are no rules. And in a world where there are no rules – there are no rules for anyone predatorclass biiiiiaaatches!!!

    The predatorclass obdurately imagines they will escape their crimes and abuses, – but they are sorely mistaken. There will be a reckoning and a balancing and there will be blood.

  26. Okay, Tony, stop with the “blood” – pick up the taser and zap ‘em, or even one big piece of fly trap paper on Wall Street…don’t increase health care costs with “blood”…

    You can’t go for “blood” until you produce a Declaration of Independence 2010 (Just War doctrine)

    and until there are massive LABOR strikes – not just teachers, and peace officers, and infrastructure people

    but LAWYERS, IT, RESEARCHERS, MEDIA, etc – everyone NOT in a union…and a separate section for “small business” people…

    I’ll agree that we are in a free-fall because the Middle Class’s version of LAW and ORDER (FAIR that people get to keep the fruits of their labor)

    was replaced by hooligans referencing Patriot Act….it IS very bad on the Law and Order side but DO NOT throw the first punch! Push every psychological button to get them to do it – and they WILL make something up – stage violence – soon enough…

  27. Lots of businesses use credit to pay for raw materials and labour for confirmed orders. If I’m a limousine maker and get 20 orders totaling 50 cars I’ll need some working capital (i.e. credit) to buy the unmodified cars, modification materials, and labour before I can complete the orders and get paid.

    This is but one of many reasons small businesses need credit; if borrowed money can be used to turn a profit businesses will borrow and use it to turn a profit. If there’s no credit available, they won’t borrow when it makes economic sense to and unemployment will go up.

  28. Stephen A. Boyko

    @ Anon
    @ Per Kurowski
    @ Bruce E Woych

    But the cost of one-size-fits-all deterministic regulation falls disproportionately on small business. That is why EntEX was created different overhead scale for SMEs, different underlying economic randomness for governance.

    “Small is Beautiful”, The National Interest, No. 77 – Fall 2004.

    http://www.findarticles.com/p/articles/mi_m2751/is_77/ai_n6353167/print

  29. The implication of you argument (here and in your TNI article and your 2005 CFO Magazine interview) seems to be that (a) risk-loving microcap investors are averse to transparency, and (b) SMEs require microcap financing to grow and employ people, ergo (c) transparency is, if not useless or downright harmful, a luxury that we cannot afford. While I’m sure that microcap-scale SMEs (i.e., those in the $5-30m market cap range) appreciate your concern, I suspect that the harm that they have lately suffered from the lack of market transparency — and which they will be at perpetual risk of suffering again and again forever absent some major changes — vastly outweighs any marginal advantages that they enjoy by catering to investors who favor obscurity and secrecy over all other market virtues.

    And even if I’m wrong about the obscurity preference/dependence of SMEs, their interests certainly don’t trump those of every other segment of the economy. In fact, the preferences of any such SMEs would be net contrary to the interests of the overwhelming majority of individual worker-consumers — even those who might forego some marginal consumption or employment opportunities. I suspect that people tend to be much less motivated to work or to consume when they are constantly aware that the system is literally “rigged” (in both senses), and could “go off” without warning at any time.

  30. Stephen A. Boyko

    @ Anon
    @ Per Kurowski
    @ Bruce E Woych

    Anonymous said “The implication of you argument (here and in your TNI article and your 2005 CFO Magazine interview) seems to be that (a) risk-loving microcap investors are averse to transparency, and (b) SMEs require microcap financing to grow and employ people, ergo (c) transparency is, if not useless or downright harmful, a luxury that we cannot afford.”

    Nothing could be further removed from anything that I have written relative to the error of conflation of risk and uncertainty, or, the burden of disproportionate regulation such as SOX upon SMEs result in unintended consequences (http://www.viddler.com/explore/ceivideo/videos/125/).

    The conflation of “risk” and “uncertainty” exacerbates capital market structural problems thus accelerating the troubling trend of larger and more frequent economic dislocations. The preferred reform strategy is to fix the market by segmenting the legacy, one-size-fits-all, deterministic governance. Why? There is more precise information correlation to limit prospective bailouts from systemically institutionalizing what was though to be credit risk and not uncertainty. You make my point in that “risk-loving microcap investors’” underlying economic condition is “uncertain—lacking positive cash flow and/or mark-to-market valuation. I argue that this material differentiation should be a disclosable item.

    Investor rights (governance commands) have to be proportionate to investor responsibilities (due diligence). Either you have proportionate regulation for efficient domestic market transparency or disproportionate regulation will incur the cost of gray market (offshore and underground) opacity. As stated in Small is Beautiful “De-listings can lead to decreased transparency for shareholders of such companies. This is the reverse of what the historic legislation was meant to accomplish.”

    Why do people support Dr. Johnson’s blog acknowledging that the system for capital market governance is broken in need of fundamental reform only to support the old regime? Markets are adaptive complex systems. If there is complexity, there is uncertainty. If the system could “go off” without warning at any time;” in the name of transparency, why would you not segment the deterministic, one-size-fits-all regime to disclose this underlying economic of environment of uncertainty?

  31. Re: Stephan Boyko’s rebuttal of September 2, 2010 5:24pm

    I agree wholeheartedly with your characterization of the economy as a dynamic CAS, and also agree that attempts to monitor and when necessary regulate the behavior of sophisticated agents based on to their membership in rigid ex ante classifications is almost certain to be a futile undertaking.

    Unfortunately, the latter prediction also applies when the classes happen to be “SME as steady revenue generator” or “SME as transient target of investment opportunity.” One cannot ignore the fact that every giant firm and stable revenue generator starts out as an SME. Given that fact it’s not clear how one could expect firms, investors, and the economy to benefit from greater SME opacity while simultaneously believing that all of the same parties will continue to benefit from the more transparent practices that firms will naturally/automatically embrace once they reach a certain size. Being a truly dynamic CAS, many firms would simply adopt superficial decentralization strategies to preserve their ability to grow without sacrificing any control or becoming subject to the big-league transparency requirements.

    Embrace that kind of regulatory philosophy instead one that emphasizes a more generalized transparency and clear, enforceable fiduciary obligation to disclose and the frequency and severity of future crashes won’t be any better (and might be quite a bit worse) than what we’ve come to expect today — with the only real difference being that the mechanism of financial destruction probably won’t be TBTF institutions, but rather the equivalent of distributed financial botnet armies.

  32. Stephen A. Boyko

    We push on

    Anonymous: “benefit from greater SME opacity”

    SAB: Where was this statement made? A discussion of transparency should begin with an accurate representation of the facts. Disclosing the underlying economic environment as predictable, probable, or uncertain provides context from which to analyze independent financial facts. Ergo, greater transparency.

    Anonymous: Embrace that kind of regulatory philosophy instead one that emphasizes a more generalized transparency and clear, enforceable fiduciary obligation to disclose and the frequency and severity of future crashes won’t be any better (and might be quite a bit worse) than what we’ve come to expect today

    Nice apple-pie testimonial but how does this happen by conflating “risk” and “uncertainty?” Were you against the Surgeon General’s warning on tobacco products? Or, since gum and tobacco were both impulse purchases they could be sold at the cash register without warning.

    Regulatory enforcement is a function of pricing and practice (the complainant alleges that he was either over-charged or misled). In both pricing and practices SMEs differ from the S&P 500.

    When you conflate two separate items and treat them as though they were the same, error is likely. No money down, liar loans gave property rights to renters who later defaulted because they had no skin in the game.

  33. Re: skin in the game, once again we are in agreement. But, adopting your preferred explanatory trope* by way of illustration, which side of the mortgage lending transaction was actually more uncertain* vs. more unpredictable* during the boom times? Which of the transacting parties possessed the greater means and experience in ascertaining the material and technical details of relevance to the lending decision (e.g., borrowers income, assets, and propensity to suddenly reinterpret terms and/or change behavior, vs. same for the lenders)? In the end which really had less “skin in the game” — the irresponsible mortgage applicant who willingly risks personal bankruptcy in the pursuit of a home that is beyond their means, or the irresponsible mortgage supply chain participant who willingly contributes to the incremental degradation of whole monetary and financial system in pursuit of an income that is actually beyond their grasp in a more honest (and/or more transparent) economy?

  34. uh, this guy…?

    “the irresponsible mortgage supply chain participant who willingly contributes to the incremental degradation of whole monetary and financial system in pursuit of an income that is actually beyond their grasp in a more honest (and/or more transparent) economy?”

    I betcha it can be proven that the un-natural unemployment numbers were always a part of the plan for “income beyond their grasp” – there WAS criminal intent at genesis.

  35. Well, intent to profit certainly is not criminal — in the presence of sufficient external bounding conditions like transparency and competition, or alternately endogenous checks on behavior (e.g., “conscience,” an appreciation for other things that are incompatible with the monomaniacal, unbounded pursuit of profit), it’s one of the key catalysts that produces change/novelty and sustains diversity (and often if not always “progress”) at the individual, group, and macro- levels.

    Unfortunately, there are clearly circumstances under which both kinds of checks tend to fail simultaneously with unusual frequency. It is equally clear that such situations can become self-reinforcing (i.e., if the compulsive profit-seekers reinvest some of their earnings to further undermine external checks on their profit-seeking behavior). While many such activities could not be characterized as “criminal”/illegal now, that distinction doesn’t make them any less unwise, unsustainable, or simply bad.

  36. There is a LIMIT to how much NUMERICAL profit you can extract from any other system that also uses math to keep track of itself.

    How come no one acknowledges that profit-taking has a LIMIT? Cancer cells suck up so many resources that a vital organ gives way and you die.

    And an acknowledgement of what “profit” IS besides numerical mumbo jumbo is also a good intellectual idea since one must be careful of the BIG SACRED COW of the religion of authority that calls itself “the economy”.

    My idea of “profit” is a civilization that provides sustainability and security.

    Why not start generating some math formulas for the “intangible” profits like “life, liberty and the pursuit of happiness”?

    It is neither a debate nor a problem solving strategy to continue to defend the “activity” that has already been identified – that being that the amount of “profit” people made playing THIS virtual game has no basis in reality – meaning if it wasn’t a video game, then they could have never walked away with so much $$$. Even if they pay $100 million per organ transplant, they still have billions to spend on themselves and the stairway to heaven.

  37. Re: @ anonymous___Very well said…and may I add a famous exegesis quote that sums up your thesis in the endogenous/exogenous domain mired in this symbiotic abstract – where does the radius begin during a nearly timeless prodigy?____{“going as far back as the first century BC in a tiny kingdom called “Phrygia” – a philosopher named “Epictetus” said, – “Appearances are of four kinds: things either are as they appear to be; or they neither are nor appear to be; or they are but do not appear to be; or they are not and yet appear to be.”} PS This is pure “Logic” – the master of thought begot by thought!

  38. The metaphor with OTC derivatives and the new car market is not accurate. The new car is near perfect market with more information available for the consumer than most others. For instance, the invoice price is readily available online along with holdback amounts, floorplan costs, etc. You would be hardpressed to find that information posted by other retail good like plasma TVs etc. A better metaphor would have been the hidden costs associated with smart phones and the accompanying service plans.

  39. Stephen A. Boyko

    Agreed. Furthermore, AIG was closer to a conversion account – long stock, short call, long put or short stock, long call, short put (easier to see with vector analysis but blog tech will not support graphics). Prior to the CBOE, OTC put-and-call dealers used to hedge settlement risk with conversion account operators in a manner similar to a bookie approaching kickoff. See my response to Gerty above.

  40. Stephen A. Boyko

    Typo Mr. Gogerty

  41. It is obvious from this latest economic debacle that the “rules of the game” were not sufficient…..even taking into account of so-called “free markets” etc…blather.
    The capitalist “game” is just that; a game of participants…one of the major problems of the latest transgressions is that they were measurably predictable….with the de-constructive regulatory processes over the past 30 or so years….culminating in the destruction of the “firewall” between proprietary banking/trading and the public’s money. All the arguments for the deconstruction pointed to the necessity of innovative financial “progress” for financial firms competing maniacally against each other here and globally…all for “market share”…as that market share dwindled it became obviously predictable that somewhere along the transaction line “….somebody was going to be in a world of hurt”. And, that became the social cost to the ordinary person…..whether by deception, outright fraud, it degenerated into a game of “greed”.
    Greed won this time because we had almost no restraint left in the system….the cry of “Oh no, not more regulation!” to the slashing and burning of the “rules of the game”.
    One commenter above seemed to believe that small business didn’t need to rely on credit….well, if that individual understood the construction business which was hugely responsible for the fueling of the housing bubble, an exceptional amount of small construction builders and small contributing contractors “lived and died” on 24/7 credit…….you may agree with the concept or not, but that’s how thousands of small business/contractor’s operate/ed.
    Any society that depends on the capitalist system as it’s core engine of business “desperately” needs a “firewall” between the maniacal, free flowing (and now global) ravages of capital and the true needs (not merely “desires”) of a solid, progressive society…one that must not depend entirely on those flows of capital….Even Adam Smith preached the need to restrain those torrid flows from destroying any hope for the basic needs of society.
    Our roads and freeways have white lines separating the flow of traffic; we have rules and regulations to try to restrain the more basic human dark sides of individual actions; we have environmental regulation to try to guarantee clean water, air, food, etc….
    So why not have good, transparent rules to at least give all individual investors THE SAME LEVEL PLAYING FIELD?
    What’s wrong with that concept?
    We won’t get this from any present and immediate incoming legislators because they all participate in the same semi-corrupt system….whatever knowledge I have that gives me the “comparative advantage” over the next fool in the transaction gives me the advantage to make more $$$$.
    The “markets” operate on the, “Greater Fool Theory” where there must be a greater fool to purchase what I’m “willing” to sell……and the more I can keep that “greater fool” in the dark the more to my “comparative advantage”.
    We need better rules to the game and better, more educated “referees”.

  42. Stephen A. Boyko

    @ sierra

    Why not have good, transparent rules to at least give all individual investors
    THE SAME LEVEL PLAYING FIELD?
    What’s wrong with that concept?

    The participants are not equal. That is why I argue for regulatory segmentation to make the groupings of participants more homogeneous (not necessarily less regulation but more appropriate and applicable) for their underlying economic condition of predictable, probable, and uncertain. The rationale is similar to having elementary, junior high, and high school governance for education.

  43. Stephen A. Boyko

    @ Sierra: Follow-on to above

    “Our roads and freeways have white lines separating the flow of traffic; we have rules and regulations to try to restrain the more basic human dark sides of individual actions”

    Agreed with one major exception, we qulify drivers for cars, cabs, and 18-wheelers etc. We similarly need to do the same for capital market participants investors, issuers, and intermediaries.

  44. …and the analogy to school governance that you suggest perfectly illustrates why, although this might sound plausible in theory, it is grossly naive in conception and would be hopeless in practice.

    The only way that this could work is if the students (aka regulated entities) were absolutely and perpetually incapable of exerting any positive or negative influence of any kind on the teachers or administrators (regulators), and both parties understood and accepted that status quo.

    Now consider what schools would look like if your analogy were applied in a more realistic context, in which the vast majority of elementary school students made far more money than the teachers, and with every step forward the resulting wealth/financial power gap expanded even further. In relative terms, the burden of expectations, workload and discipline in real schools tends to fall more lightly on the youngest students, but ratchet up gradually (with big jumps at the start of middle school and high school). Many students grumble about this when it happens, but the vast majority get over it, because they have no viable alternative. But what would happen if the older students could leverage their increasingly overwhelming financial advantage over school officials to advance their own vision of good school governance?

    I think you may have just suggested the storyline for next smash hit TV sitcom — the comical plot possibilities are endless. One episode could feature seniors lobbying to annex the teacher’s lounge and parking lot, because the benefits of maximizing their convenience would surely trickle down to the rest of the student body. Another could feature protests by middle schoolers (backbone of the secondary education population) that prohibiting gum chewing and restricting bathroom breaks to between classes represents an unreasonable imposition on their personal liberty, or a barrier to their advancement. No Taking of candy, cigarettes, and other contraband from students would be permitted unless the student can be promptly compensated on fair market terms.

    I’m calling my agent!

  45. Stephen A. Boyko

    But what would happen if the older students could leverage their increasingly overwhelming financial advantage over school officials to advance their own vision of good school governance?

    You can call the sitcom “Regulatory Capture” …

  46. An excellent suggestion, although I don’t think it would appeal much to the critical 17-25 demographic.

    Perhaps we started with entirely orthogonal premises (?). To recap (and close), I think that regulatory capture is a major problem, if not THE major problem. If it were possible to suddenly erase that condition, and also eliminate any possibility of its return in the future — e.g., through public funding of elections plus the universal application of some kind of effective transparency mechanism, and/or the elimination of limited liability — then adopting some kind of (more) explicit scale-sensitive approach to financial regulation might make sense. I have some doubts about the applicability of categorical distinctions like “uncertain” vs. “unpredictable” to current/past phenomena, esp. when the act of classification itself is likely to alter the subsequent behavior of relevant agents in ways that could directly affect the validity of those classifications. Perhaps the market would overcome this challenge challenge, e.g., a new industry of “probability/frequency rating agencies” would emerge to keep the rest of us properly updated as to individual company status — but then I imagine that’s not the sort of arrangement that you had in mind (?).

    In any case, unless/until the aforementioned fact of (and risk of yet worse) regulatory capture can be solved, embracing a regulatory strategy that actively sets up every growing SME to view the regulatory environment as an arbitrary imposition and a direct threat seems like a major undertaking with no significant upside.

  47. Stephen A. Boyko

    @ anonymous

    Regulatory capture is a serious problem, but after the fact. In essence, you are grabbing the bull by the tail. Regulation is a negatively defined business, “thou shall not, except for.” The present system is loaded with regulatory exceptions and exemptive “no action” letters. When exceptions to the rule become the rule, you need a new rule.

    The “shadow law” to which you default judgment reduces compliance to a random event because of legal obeisance to the legacy deterministic one-size-fits-and-fails-all regime. At least the Maginot Line was a solid structure, as compared with a labyrinth of legal loopholes that we now have—try Fannie Mae’s SOX compliance.

  48. A casual observer

    “such a requirement [that private OTC swap markets convert to exchanges] may exceed Congress’s Commerce Clause powers…”

    Seriously? In what universe? The statement was admittedly introduced as a discarded straw man distinguishing such a proposal from the lesser regulation that actually happened, but it’s still an unseemly assertion. How the heck could it? Perhaps the good professor could explain. A Commerce Clause power that reaches home-grown wheat (or weed) and individual insurance purchasing can surely reach the raw commerce that is the sale of a financial instrument. Is there some obtuse case law in this area already, excepting this genteel commerce of securities from the coarse agrarian commerce of the common man? Absent that, what is a “progressive” graduate of arguably the most prestigious law school in the US doing asserting that the Commerce Clause can’t reach OTC swaps?

  49. This post takes the banksters’ side in the argument over whether it is a good idea to require CDS,, CDOs, and other creative products to be listed on exchanges. If they are, the banksters may have to value,or worse yet sell, the nearly worthless junk on their books at market prices some day. The current bid/ask spread on this business is huge, and there is no transparent competitiion. The hedging buyer is at the mercy of the seller. The investment banks making markets in these products make huge $$$ as a result of the asymmetry of information.

  50. Ilya,
    I do not understand your statement: “Dodd-Frank does not mandate that private OTC swap markets convert to exchanges (such a requirement may exceed Congress’s Commerce Clause powers and would be unprecedented in the securities arena).”
    Just how would regulation of private OTC swaps exceed the Commerce Clause powers? just because these are “private” transactions? a private trade in nuclear or toxic material would be within the reach of Congress.
    look at these financial instruments referred to as swaps: “options, repos, credit default swaps, currency swaps, interest rate swaps, etc.” in each case the underlying financial instruments are interstate in nature: stocks, bonds, national currencies, interest rates set by central banks, etc. a court would not even need to go through a “Wickard v. Filburn” analysis to aggregate the local effects of these swaps to find a direct effect on interstate commerce. no need to aggregate because the underlying transactions are inherently interstate in nature.

  51. Re: @ antony___Excellent anaysis… eg.”Wickard v. Filburn” :-))

  52. Stephen A. Boyko

    @ mrrunangun

    @ antony

    I will try to connect the dots of the following to statements from an economic market perspective and let the lawyers address the Commerce Clause implications.

    “Dodd-Frank does not mandate that private OTC swap markets convert to exchanges …

    and

    The current bid/ask spread on this business is huge, and there is no transparent competition.”

    A swap aggregator such as AIG was closer to a conversion account – long stock, short call, long put or short stock, long call, short put (easier to see with vector analysis but blog tech will not support graphics). Prior to the CBOE, OTC put-and-call dealers used to hedge settlement risk with conversion account operators in a manner similar to a bookie approaching kickoff. A conversion account operator and the contra-party arrangements were contract or trade specific (vs. clearinghouse continuous net settlement). Like the bookie, the conversion account operator’s profit was determined by spread management as one trade would initiate multiple related trades.

    The nature of the markets, OTC and Exchange, differ greatly depending on the characteristics of the transaction to be conducted. The OTC market with competing market-makers is a quote-driven market (multiple quotes explain why there are multiple prices to match differing needs—consumer choice for investments that are sold) whereas an exchange market with a single specialist is an order-driven market (determinate transactions that are bought to meet known needs). The relative efficiencies have been debated for ever and both OTC and exchange markets can and have cleared through clearinghouses such as the Depository Trust Corp.

    The width of the spread suggests the lack of liquidity and the related “uncertainty” (lack of instrument cash flow and market comparable) of the investment to be transacted.

  53. It’s hard to imagine a response from Ilya Podolyako on the Commerce Clause issue because his assertion is baseless (and yes, quite embarrassing to come from a leader of a progressive economic policy reading group and graduate of Yale Law School).
    Regarding Stephen Boyko’s contribution, it doesn’t much matter whether we’re talking about a conversion account/OTC approach or an exchange, whether it’s quote-driven or order-driven, the result is the same for purposes of any Commerce Clause analysis. This is not even a close call.
    If mandating private OTC swap markets to convert to exchanges would be unprecedented in the securities area, that’s simply because the big banks have managed to keep the field shielded from regulation through the Commodity Futures Modernization Act of 2000. But to jump from the fact of deregulation to a conclusion that Congress lacks the constitutional authority to regulate is completely unfounded.
    There are conservatives who would like to push the clock back to pre-Wickard v. Filburn. Ilya Podolyako goes even further since one does not need to aggregate local effects of swaps to find interstate commerce. Swaps are inherently interstate by nature. So perhaps Ilya believes the Commerce Clause, which covers interstate commerce, does not cover swaps (which are interstate by their very nature) simply because it would be “unprecedented” (i.e., Congress has thus far failed to do so). If this is his view, he should expressly acknowledge that. If he misspoke, he should step back from his flawed analysis right away.

  54. Regulatory capture is a serious problem, but after the fact. In essence, you are grabbing the bull by the tail. Regulation is a negatively defined business, “thou shall not, except for.” The present system is loaded with regulatory exceptions and exemptive “no action” letters. When exceptions to the rule become the rule, you need a new rule.

    The “shadow law” to which you default judgment reduces compliance to a random event because of legal obeisance to the legacy deterministic one-size-fits-and-fails-all regime. At least the Maginot Line was a solid structure, as compared with a labyrinth of legal loopholes that we now have—try Fannie Mae’s SOX compliance.

    Re: “The ‘shadow law’ to which you default judgment reduces compliance to a random event because of legal obeisance to the legacy [[Boyko-preferred pejorative characterization]] regime.”

    Setting aside for a moment your oft-mentioned theories about risk/uncertainty and regulation, I cannot argue with the main point you make here. But it’s a banal point. At every point in time, the actual level of compliance of any/every economic agent with any/every norm, rule, convention, or law that they happen to find distasteful for any reason ultimately reduces to a “random event,” the odds of which are determined by a variety of subjective considerations that are, at best, imperfectly responsive to objective changes in external conditions — legal/regulatory, economic, or otherwise.

    In other words, the relevance of your observation is not limited to the prospective behavioral responses of financial intermediaries to changing regulations (and no matter what form they might take, many/most affected parties are going to passionately object and pro-actively resist). It is equally relevant to the probability that everyone else will continue performing the customary “legal obeisance” to the cumulative results of our “legacy deterministic one-size-fits-and-fails-all” property rights regime. By pushing too hard/long/far for various narrow forms of “enhanced assurance” that are at best relevant only to a small, privileged subset of economic agents (and that might in fact be positively harmful to others), champions of perpetual financial deregulation risk undermining the much broader and vastly more important “basic assurance” mechanisms that the we all rely on every day — the ones that make the modern economy possible. Perhaps we don’t need no revolution, but then almost everyone tends to think that way all the time… and yet sometimes it happens anyway.

  55. Stephen A. Boyko

    @Anonymous de minimus

    “I cannot argue with the main point you make here.”

    Then why comment?

    “But it’s a banal point.”

    A contradiction of above or a self-characterization?

  56. Stephen A. Boyko

    @ Anonymous

    Why do markets segment?

    Answer – efficiency of information that begets tansparency.

    I argue that governance must similarly do so, otherwise it falls victim to the problem of non-corellative information that is regulatorily toxic

  57. Re: Stephen A. Boyko’s reasoning about “Why do markets segment?”

    Boyko’s Answer: “efficiency of information”… / / …”that begets transparency.”

    The first part of your answer is conventional enough to stand. Information, including about matters of common/inter-subjective interest, is never uniformly distributed across individuals, and market segmentation is one dynamic/emergent response to shifting individual-level differences in “information endowments.” [Needless to say this is neither the only reason that markets “segment,” nor the only possible or observed adaptation to information asymmetries.]

    That said, I cannot understand how you make the leap from the fact of asymmetrical private information to the expectation of “transparency,” which in this context denotes a sufficiently high level of open *non-private* information about especially critical matters of inter-subjective interest to permit demand-driven, ad hoc “third-party scrutiny.” To preempt unnecessary quibbling, I’ll stipulate that the latent potential that such a condition might emerge through pure market forces at some indefinite point in the hypothetical future is not sufficient grounds to make sensible claims about this or anything else. Birth begets nirvana, early bird begets worm, tree begets eleven-legged stool, asymmetrical private information begets sufficient open/public information — all equally (in)valid arguments without some relevant, valid connective logic.

    Given ever-increasing levels of complexity/specialization in almost all domains of significance, any oversight/coordination/”regulatory” model that depends exclusively on increasingly narrow/specialized proxies would likely be a perpetual losing strategy in an eternal race. I suspect that this fact, as much as perverse incentive structures, contributed significantly to the recent abject failure — and to the future non-viability — of the CRAs as a public or private assurance mechanism.

  58. Stephen A. Boyko

    @ Anonymous

    Sorry for the tardy response, I have been travelling.

    We are talking at cross purposes.

    Asymmetrical—unequal access to either private information or non-private information is different from the uncertainty—the absence of knowledge. Uncertainty is different from, rather than a higher degree of, risk. This distinction was made famous by economist Frank H. Knight in his seminal book, “Risk, Uncertainty, and Profit” (1921). Risk refers to situations in which the outcome of an event is unknown, but the decision maker knows the range of possible outcomes and the probabilities of each. Uncertainty, by contrast, characterizes situations in which the range of possible outcomes, let alone the relevant probabilities, is unknown.

    Accordingly, I frame capital market randomness with three questions.

    1. Does uncertainty exist in the capital market to a material degree?
    2. If so, can it be regulated by one-size-fits-all deterministic governance?
    3. What metric(s) demarcate risk from uncertainty in the capital market?

    For example, software iteration 2.1 was written because of unforeseen circumstances experienced with version 2.0. As there are innate complexities in the capital markets, the element of uncertainty always will be a part of complex adaptive systems.

    Difficulties arise when risk is conflated with uncertainty under deterministic, one-size-fits-all governance metrics that frustrate the market’s price discovery function. We can insure (put options) and hedge (Ford and Exxon) risk. We can insure (natural disaster insurance) uncertainty, but we cannot hedge (Ford and pork bellies) uncertainty. If we cannot hedge, we cannot cross-regulate risk and uncertainty in a one-size-fits-all regime due to non-correlative information.

    See “Dodd-Frank: A fine alphabet soup appetizer, but where’s the beef? http://readingthemarkets.blogspot.com/2010/07/dodd-frank-fine-alphabet-soup-appetizer.html: and,

    Mr. Volcker is wrong! http://www.yorktownpatriot.com/article_659.shtml