Tuesday, April 20, 2010

Other Than That, How’s the Bill, Mizz Lincoln?

Original posted on the Streetwise Professor by Craig Pirrong:

Very bad. Problem one is obviously the ban on “Federal assistance” to any “swaps entity” where “Federal assistance” includes a Fed loan. It is ironic, and disturbing, that (a) the bill mandates extensive clearing, and thereby makes swaps clearinghouses a central pillar of the financial system, but (b) denies these entities the ability to access liquidity via the Fed. This goes against the recommendations of Duffie et al in their policy piece for the FRBNY, the European Commission, and now the IMF:

Hence, those [CCPs] deemed to be systemically important should have access to emergency central bank liquidity. However, any such emergency lending should be collateralized by the same high-quality liquid securities as those typically posted against monetary policy operations. Also, it should not be done in any way that might compromise the central bank’s monetary policy or foreign exchange policy operations. [IMF, Making the OTC Derivatives Markets Safer (April, 2010), p. 20.]

In short, Lincoln’s bill goes against the advice of virtually all those who have analyzed the implications of clearing mandates–including strong supporters of these mandates.

During periods of market stress, and ESPECIALLY in cleared markets, the demand for liquidity increases dramatically. Firms need liquidity to meet margin calls in response to big price moves. CCPs that can borrow on behalf of their members can facilitate this process. Denying these entities access to central bank liquidity facilities is a major mistake, and will in effect make the markets like they were prior to the formation of the Fed in 1913. Can you say “Panic of 1907″? I knew you could.

And even allowing CCPs to access liquidity facilities, while denying swap dealers from the same option–effectively requiring banks to hive off derivatives dealing activities–will cause problems. If the idea is to reduce systemic risks arising from counterparty risk, it is desirable to ensure that market participants, including derivatives market participants, have access to liquidity during periods of market stress. A firm experiencing a liquidity shock, due, for instance, to a big collateral call, but which is solvent, would be forced by this provision into fire sales or defaults that would exacerbate systemic risks. It would do so by threatening to transform liquidity shocks into crises.

Lincoln’s bill evidently mistakes a bailout for the exercise of lender of last resort functions. The latter, if Bagehot’s basic framework is followed, eases liquidity crises by lending freely against good collateral. (The Fed’s promise to do so in October, 1987 almost surely saved the CME and CBT clearinghouses during the crash). A bailout transfers wealth from taxpayers to the claimants of an insolvent firm. Lincoln’s provision threatens to turn liquidity shocks into full-blown crises.

In some respects, Lincoln’s confusion is understandable. After all, the Bernanke Fed has clearly blurred the line between Bagehot-esque lender of last resort activities and bailouts. That’s a serious issue, that should be addressed. But Lincoln’s approach would be a very bad way of doing that.

The bill’s end user exemption is extremely, extremely limited. That’s also a problem, for reasons I’ve discussed before. What’s particularly amazing is that the end user exemption is basically limited to commodity producers and consumers (although firms like J. Aron or Morgan Stanley that handle physical commodities are expressly excluded from the exemption). That means that a firm, say IBM or Merck that uses currency or interest rate swaps would not be eligible for the exemption.


The bill also extends position limits to the OTC market. More pain, without gain.

The proposal requires trading on either exchanges or swap execution facilities, and precludes voice brokerage. It mandates pre-trade price transparency, and “real time” price reporting. I’ve commented extensively on these ideas in the past, and find them no more reasonable now than I have before.

About to jump on a plane, so I will add more later. One last thing. The bill envisions a massive expansion of responsibilities for the CFTC. To be honest, the CFTC does not have the capabilities to handle its current responsibilities, let alone the new and extremely complex ones it would have under the bill. This is a setup for future regulatory failure, in a situation where the regulation is much more pervasive–and systemic. Regulators failed before. They will fail again. The likelihood of failure will be higher, and the consequences of failure more catastrophic, when regulatory responsibilities are expanded greatly and foisted onto an agency that is ill prepared to handle them. Even if the CFTC is funded much more generously, it will face daunting challenges in scaling up, and obtaining the expertise it needs to do a much expanded job. This is a train wreck ready to happen.

OK. Time for one more thing, something that the bill doesn’t do. Manipulation is a potential problem in derivatives markets, and existing law and regulation has proved problematic (at best) in deterring it. I’ve advocated for years that a statutory fix is required, and this bill (or the Frank bill, or the Dodd bill) would present opportunities to do that, but they don’t. So we have a bill (bills, actually) that does many things it shouldn’t and doesn’t do something it can and should. Great.

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