The Devil Is in the Details

Mike Konczal at Rortybomb disagrees with Economics of Contempt's recent post in these pages about the proper regulatory structure for derivatives trading:

To put it a different way, opponents of full financial reform are saying that the a few concentrated market players can be trusted to not manipulate the clearinghouses at exactly the same moment as a few concentrated market players are being investigated by the Department of Justice for manipulating the clearinghouses. Change we can believe in!

I know what the retort is. “Mike, you know that po-po is always fucking with a working man who is just trying to hustle some (financial) product on the corner to feed his kids.” I’m sympathetic to critiques of “po-po” myself. But this was the point of the recent Slate piece on the Lynch Amendment; giving the largest players a legal ability to sit together in the same room and make rules for trading and clearing swaps at the same exact moment they are being investigated for a conspiracy to do that is a terrible idea.

Even better, Mike is not content just to hurl brickbats and criticism. He explains in an accompanying post exactly what it is he is looking for in derivatives trading reform:

Let’s define some terms. Many people are comfortable forcing OTC derivatives to be forced into clearing (though I don’t think the author above does). I like that, but I and others worried about financial reform want to see more. Let’s talk about exchanges versus clearing. Now as opposed to the FT article, I’m not saying everything needs to be forced onto an exchange proper. There are plenty of great innovations going on in the swap execution facility (SEF) world. What I am worried about is that the swap execution facility will move away from a formal “trading facility” definition towards a vague nebulous definition of whatever people can get away with.

So what are the features that I want to see? I want to see pre-trade price transparency. I want a facility where multiple parties can see and execute on offers from other parties. A facility that collects the prices at which multiple parties would be willing to trade a a moment in time, and update those prices as time passes.

“Wake Up, Gentlemen”

[This post originally appeared at The Baseline Scenario on December 15, 2009. It is reproduced here in its entirety with the kind permission of the author.]

The guiding myth underpinning the reconstruction of our dangerous banking system is: Financial innovation as-we-know-it is valuable and must be preserved. Anyone opposed to this approach is a populist, with or without a pitchfork.

Single-handedly, Paul Volcker has exploded this myth. Responding to a Wall Street insiders‘ Future of Finance “report“, he was quoted in the WSJ yesterday as saying: “Wake up gentlemen. I can only say that your response is inadequate.”

Volcker has three main points, with which we whole-heartedly agree:

1. “[Financial engineering] moves around the rents in the financial system, but not only this, as it seems to have vastly increased them.”
2. “I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy”

and most important:

3. “I am probably going to win in the end”.

Volcker wants tough constraints on banks and their activities, separating the payments system – which must be protected and therefore tightly regulated – from other “extraneous” functions, which includes trading and managing money.

This is entirely reasonable – although we can surely argue about details, including whether a very large “regulated” bank would be able to escape the limits placed on its behavior and whether a very large “trading” bank could (without running the payments system) still cause massive damage.

But how can Mr. Volcker possibly prevail? Even President Obama was reduced, yesterday, to asking the banks nicely to lend more to small business – against which Jamie Dimon will presumably respond that such firms either (a) are not creditworthy (so give us a subsidy if you want such loans) or (b) don’t want to borrow (so give them a subsidy). (Some of the bankers, it seems, didn’t even try hard to attend – they just called it in.)

The reason for Volcker’s confidence in his victory is simple - he is moving the consensus. It’s not radicals against reasonable bankers. It’s the dean of American banking, with a bigger and better reputation than any other economic policymaker alive – and with a lot of people at his back – saying, very simply: Enough.

He says it plainly, he increasingly says it publicly, and he now says it often. He waited, on the sidelines, for his moment. And this is it.

Paul Volcker wants to stop the financial system before it blows up again. And when he persuades you – and people like you – he will win. You can help – tell everyone you know to read what Paul Volcker is saying and to pass it on.

By Simon Johnson

The Lynch Amendment: Bizarre and Confused

[This post originally appeared at Economics of Contempt on December 15, 2009. It is reproduced here in its entirety with the kind permission of the author.]

The Lynch amendment has to be one of the most bizarre pieces of legislation relating to derivatives I've ever seen—and that's saying something. Really, the amendment is just illogical. Introduced by Rep. Stephen Lynch, the amendment prohibits swap dealers and "major swap participants" from owning more than 20%, collectively, of a derivatives clearinghouse. Here's how Rep. Lynch justified his amendment on the House floor:

[T]he problem is—and in my view, this is a huge problem with the bill—the bill would allow these same big banks to purchase the clearinghouses that are being created to police the big banks in their derivatives trading. The big banks would be allowed to own and control the clearinghouses and to set the rules for how their own derivatives deals are handled. My amendment would prevent those big banks and major swap participants, like AIG, from taking over the police station—these new clearinghouses.

This makes absolutely no sense. Rep. Lynch appears to be deeply confused about both clearinghouses and the derivatives market. Unfortunately, the Lynch amendment has been cheered on by the blogosphere, which now reliably swoons at any mention of hurting "Wall Street," seemingly without regard for the merits of the proposal.

Honestly, what do supporters of the Lynch amendment think clearinghouses are? The purpose of a clearinghouse is risk mutualization. If one clearing member defaults on a cleared contract, the other members—via the clearinghouse—will pick up the tab. That's why the clearinghouse, as the central counterparty (CCP), interposes itself between counterparties to contracts cleared through the clearinghouse, serving as the buyer to every seller and the seller to every buyer. The whole purpose of this set-up is to put all the clearing members on the hook for one clearing member's default. (If after applying a defaulting member's margin account, the money the other clearing members have contributed to the clearinghouse's guaranty fund still isn't sufficient to cover the losses from a member's default, the clearinghouse can generally force the other clearing members to make one-time contributions to cover the remaining losses.)

Build It, and They Will Come

Mike Konczal over at Rortybomb¹ has weighed in this morning on my reformist manifesto. For the most part, he does not seem to have disagreed with me overmuch, which is either a sign that I am on the right track or that Mike is too much of a gentleman to reveal to the world that I am a hopeless idiot. I prefer to believe the former, despite all evidence to the contrary.

Anyway, he specifically comments on a handful of my proposals. While I do not disagree with the substance of his remarks, I thought it would be useful to respond in this forum with a few clarifications and comments of my own. He repeats my proposals in bold and comments below:

2) Narrow and focus the role of the Federal Reserve…3) Render Fed actions and deliberations transparent.

To me this is an either/or. If the Fed wants to be the systematic risk regulator and use its 13 (3) privileges in an expansive manner going forward, there needs to be a change in the way they are monitored. I understand 13 (3) goes back 70 years, but given that the Fed will use these privileges more aggressively in the future then they need to be monitored in an equally aggressive manner. Removing these regulation powers to outside the Fed (as the Dodd Bill currently proposes), means that there isn’t quite the same need for transparency (though the way appointments are made could stand to be reformed either way).

I think we really agree here. My proposal is to narrow the Fed's mandate to its core responsibility for monetary policy and price stability but add "responsibility for monitoring, controlling, and managing systemic financial risk." If we commission the Fed to act as our overall systemic regulator, as I suggest, of course we should increase legislative oversight of it. It is exactly the sort of non-monetary policy decisions like the Fed made in the case of AIG and others recently that must be examined in retrospect under a clear and searching light. Just reassign the Fed's other responsibilities for consumer protection etc., which it has sadly neglected, to other parties. Monetary policy, as far as I am concerned, can remain largely unexamined and protected from political interference in the deep dark hole where it has resided for decades.

A Reformist Manifesto

[This post originally appeared at The Epicurean Dealmaker on December 3, 2009. It is reproduced here in its entirety.]

The Communists disdain to conceal their views and aims. They openly declare that their ends can be attained only by the forcible overthrow of all existing social conditions. Let the ruling classes tremble at a Communistic revolution. The proletarians have nothing to lose but their chains. They have a world to win.

Working Men of All Countries, Unite!

— Karl Marx and Friedrich Engels, Manifesto of the Communist Party

It has not escaped my notice, O Estimable and Valued Readers, that you have displayed remarkable patience with Your Dedicated Correspondent over the last many moons of the ongoing financial crisis and its aftermath. I have ranted, I have railed, and I have hopped up and down spluttering like a one-legged kangaroo rat on a hotplate over the many failures of our present regulatory system to have avoided or even anticipated the financial tsunami which rolled over us. "Sure," I have seen you mutter to yourself, "TED has fulminated rather spectacularly about what went wrong, and how idiots, nincompoops, and boobs of every stripe screwed the pooch, but what does he suggest? Does he have any ideas, or is he merely content to take potshots at financiers, regulators, and politicians and leave it at that?"

This is a fair question, and I think you deserve an definitive answer. Being none other than who I am, however, you can rightly expect that I will give it to you with both barrels. Subtlety and nuance be damned.