The Truth Behind the NY Times' Truth Behind Derivatives and Clearinghouses

by: Craig Pirrong

Sunday’s NYT carries a breathless–and endless–expose on OTC derivatives clearing. All of the issues it discusses have been discussed, at length, here on SWP. I almost hesitate to say anything more, because it’s tedious to repeat myself. But the fact that stale arguments continue to dominate the conventional wisdom–as now officially endorsed by the New York Times–means that I must venture once more into the breach.

In a nutshell, the article repeats a familiar narrative about the OTC derivatives market. You might call it the What’s the Frequency Kenneth Griffen Narrative (Indeed, Citadel and Griffen are cited throughout the article): An oligopoly, not to say cabal (though the NYT comes close to calling it a cabal, by referring to “a secretive elite”), of large banks operating in an opaque market that earns outrageous profits. It is now attempting to perpetuate its oligopoly through control of clearinghouses, ironically mandated by the Dodd-Frank Act.

Let’s focus on the clearing aspect for a moment. First of all, as I’ve said repeatedly, there is definitely a double edged sword involved in clearing. On the one hand, limiting access to clearing is a great way to exercise market power. On the other hand, too liberal access to clearing can create systemic risks, and make the governance and management of clearinghouses far more complex and far less efficient (by increasing the heterogeneity of the membership).

Indeed, I gave a talk on clearing before the Columbia Program in the Law and Economics of Capital Markets Regulation on Thursday where I made this very point. The audience (which consisted of a very distinguished group of law and finance scholars) was generally sympathetic to clearing, I think. As a result, there were a lot of skeptical questions.

One was right along the lines of the NYT article, suggesting that dealers were an oligopoly and that clearing would increase competition. I responded that in fact, clearing could be a great way of cartelizing an oligopoly. However, trying to mitigate this problem through regulating CCP admissions criteria could undermine the goal of reducing systemic risk. As I put it in the slides for my talk, this was one of many Morton’s Forks in Dodd-Frank. (I’ll post a link to the slides and the video from my talk when they are available–probably just in time for Christmas!)

The NYT article describes the efforts of the dealer banks to exert control over CCP risk committees. Well, duh; it’s their capital at risk. Which presents another problem here. To reduce systemic risk, CCPs have to have a lot of capital backing trades. That capital doesn’t fall from the sky. Where is it going to come from? Since clearing has begun, major market intermediaries have provided the capital. And since it is their capital at risk, they have demanded and exercised control over the risks that they are taking on. It’s not that complicated.

Attempts to regulate governance in ways that reduce the control that group X exerts means that you will simultaneously reduce the amount of capital that group X is going to supply. So you need to get capital from someone else. And if you don’t, the CCP will be undercapitalized and then there are problems; indeed, in the event, CCPs will be the source of the very systemic risk legislators and regulators hoped that they would banish.

In other words, there are trade-offs here that are quite thorny, but the NYT–and too many other people who should know better–ignore this altogether because they get in the way of a good morality play. It is particularly ironic, and annoying, that many of those who were baying for clearing mandates are now just waking up to those trade-offs.

There are other issues in this article regarding clearing that need to be addressed. One is ICE Trust. The author of the piece, Louise Story, talks about the formation of the ICE Trust, which involved the combination of a dealer-run initiative Formerly Known as the Board of Trade Clearing Corporation and ICE. As originally envisioned, and as currently operating, ICE Trust was an inter-dealer clearing system. So who other than the dealers would you expect to dominate it?

In her attempts to make ICE Trust appear as sinister as possible, Story descends into self-parody:

The banks also refused to allow the deal with ICE to close until the clearinghouse’s rulebook was established, with provisions in the banks’ favor. Key among those were the membership rules, which required members to hold large amounts of capital in derivatives units, a condition that was prohibitive even for some large banks like the Bank of New York.

I read that to Mrs. SWP, who laughed out loud. Mrs. SWP is an art major, but she is endowed with common sense. Her response (post-laugh): “Like they were going to join an organization before they knew what the rules were? And they were going to join an organization with rules that hurt them?”

More substantively, the quote makes the capital requirements seem like–and only like–a means for exclusion. Yes, they can play that role, as I’ve written ad nauseum for years. But high requirements can also be a crucial way of ensuring the safety of the institution. And reduced heterogeneity in the financial condition of members can make the difference between an effective organization and a dysfunctional one.

In other words, the NYT is printed in black and white, but the issues involve are anything but black and white. Until people get real in grappling with the trade-offs, we are doomed to pointless arguments and counterproductive policies.

The other big issue in the article relates to transparency and trading, and its effect on profits.

The story begins with this tale:

This fall, many of Mr. Singer’s customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price higher.

But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives.

“At the end of the day, I don’t know if I got a fair price, or what they’re charging me,” Mr. Singer said.

It proceeds:

And the profits on most derivatives are masked. In most cases, buyers are told only what they have to pay for the derivative contract, say $25 million. That amount is more than the seller gets, but how much more — $5,000, $25,000 or $50,000 more — is unknown. That’s because the seller also is told only the amount he will receive. The difference between the two is the bank’s fee and profit. So, the bigger the difference, the better for the bank — and the worse for the customers.

It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it. Moreover, only the real estate agent — and neither buyer nor seller — would have easy access to the prices paid recently for other homes on the same block.

Ask yourself: For what product that you buy do you know the markup or the seller’s profit? Answer: Probably none. You rely on competition, comparison shopping, etc., to discipline sellers and ensure that you get a good price. Presumably that, and soliciting multiple offers, are exactly what Mr. Singer does when buying the physical oil he sells (the markups on which and profits made by the seller he almost certainly does not know either). (By the way, do Mr. Singer’s customers know his costs and markups? Just asking.)

The usual retort is that the OTC derivatives market is an oligopoly and that a lack of price transparency limits competition. By structural measures, OTC dealing is less concentrated than most industries. With respect to transparency, many large market participants (end users) repeatedly stress that they have access to multiple bids and offers, and are perfectly capable of shopping for good deals.

Moreover, and this cannot be stressed enough, for many products–including Mr. Singer’s heating oil–there are exchange traded markets with great transparency pre- and post-trade. Mr. Singer and others can utilize that information to evaluate the price offers being made by the dealers on OTC trades. Moreover, they can trade on those markets if they are so convinced that the OTC dealers are hosing them. So why don’t they?

I am also annoyed that people, including Ms. Story, accept uncritically the proposition that OTC dealing is obscenely profitable. Maybe it is–I would definitely like to see a more definitive study on this that goes beyond the mere quoting of revenue numbers from OTC trading and how it compares to overall bank revenues.

Indeed, there’s a fundamental tension between various criticisms of OTC derivatives markets. On the one hand, they are supposedly extremely profitable. On the other, they supposedly pose huge risks for the banks that are the major dealers.

Think that there could be a connection? The counterparty risks that dealers face are a contingent liability. If OTC derivatives dealing is indeed highly risky, as is often asserted, this contingent liability could be quite large. Which means that in a competitive market prices–notably spreads between dealer bids and offers–must be wide enough to compensate for that risk.

This further means that looking at profits in “normal” times can be misleading. These “profits” are in part, and arguably in large part, compensation for risk. And given the nature of risk in these markets, where things can go along swimmingly for a long time and then go non-linear, the losses for which these “profits” are compensation can be extremely concentrated in time; the contingent liability becomes a real one, and particularly a real big one, relatively infrequently. So you can look at profits over years that look fat and say that they are supercompetitive. But they can disappear in a trice.

This is arguably analogous to the equity premium puzzle. That puzzle states that the returns to investing in stock appear to be very high given the risks. That conclusion is dependent on how you measure the risk, and the compensation required (based on preferences) for these risks. Legions of finance academics and practitioners have wrestled with those issues for decades now, and there has been no definitive resolution of the puzzle. Very little–and arguably no–comparable research has been undertaken to study the risk-return trade-off in derivatives dealing. That problem is, moreover, arguably far more complex than the equity premium puzzle. It is a tail risk problem, and evaluating tail risks and the appropriate compensation for them is hard. (Tail risk could be the source of some of the equity premium too.) With free entry and exit, to a first approximation you would estimate that the prices charged compensate for risk. You should certainly be very reluctant to draw strong conclusions to the contrary without a much deeper analysis than has been done until now.

(This is also analogous to a peso problem.)

Until the risks of OTC derivatives dealing, and the costs of those risks, are measured far more accurately than has been the case heretofore (and the analysis usually doesn’t go much beyond the kind of stuff that’s in the NYT article), I would be chary indeed about arguing that OTC dealers make supercompetitive profits.

And I would be especially careful about arguing about the huge risks of OTC dealing out of one side of my mouth, and the huge profits of OTC dealing out of the other.

This gets at the main problem with all of these jeremiads against OTC derivatives markets. OTC dealing is supposedly hugely profitable. Customers are supposedly exploited. But OTC derivatives markets expanded dramatically absolutely and relative to the transparent, anonymous exchange markets that offer products that are close substitutes on many dimensions.

Huge profitability and supercompetitive prices should have encouraged entry by other potential OTC counterparties; the entry of new trading mechanisms (including, potentially, exchange-like mechanisms with clearing as well); and the movement of trading to existing futures and options exchanges. But the reverse happened.

In other words, criticisms like Mr. Singer’s, and Kenneth Griffen’s, and Louise Story’s remind me of what Yogi Berra said about Ruggeri’s (a restaurant on The Hill in St. Louis): “Nobody goes there anymore. It’s too crowded.” The OTC markets are big and crowded with customers. If they’re such a bad deal for these customers, why is that true? Why hasn’t entry, or the movement of customers to available substitutes, constrained market power and prevented exploitation of customers? Not to say that such an outcome is inconceivable, just that Louise Story, Kenneth Griffen, and the cast of thousands who criticize OTC derivatives markets haven’t come close to answering these questions.

I long for the day when there will be serious consideration of these issues, rather than superficial black hat-white hat narratives. There are so many thorny, thorny issues involved in derivatives market structure. The trade-offs are not easy. Let’s stop pretending that they are. And most importantly, let’s stop legislating and regulating like they are.