The dismantling of the economy’s legal infrastructure III: Derivatives [Updated]

Derivatives are financial contracts that do not involve direct investment in productive activity, as stocks and bonds do, but instead reference such contracts (or other phenomena including stock market indexes and even the weather). In short, they are called derivatives, because their value is derivative from that of other assets. While derivatives contracts take many forms, for the purposes of this post it is enough to understand a specific derivative, a futures contact. A futures contract is a standardized contract to purchase/sell a specific amount of a specific asset at a specific price on a specific future date.

Consider an example, in which I agree in December 2018 to sell 100 shares of Apple stock at a price of $150 a share (the current market price) on May 15, 2019. I will call the person who takes the other side of this agreement, my counterparty. Whether the market price of Apple is $140 or $158 on May 15 does not affect the price at which our contract will settle, because the whole point of a futures contract is to fix the price of the contract on the future date. For the purposes of discussion let’s assume that the price on May 15 turns out to be $158. Since I sell my shares at $150, I have $800 less, that is $8 less per share, than I would have if I had simply waited to sell my shares. Similarly, my counterparty has $800 more than she would have if she had simply waited to buy the shares.

Why would I have chosen to enter into this contract? If I owned Apple shares maybe I knew in December that I would need the money on May 15, but didn’t want to sell in December for tax purposes and was worried that the price would fall in the meanwhile. Alternatively, maybe I don’t own Apple shares, but have reason to believe that the price is going to fall over the next six months and want to have the opportunity to sell shares that I will be able to purchase at low price (as I expect to be the case in May) while selling at high price. In the first case, I am protecting myself against risk of loss – or hedging, and in the second case I am speculating on the price of the shares.

Why would my counterparty have chosen to enter into this contract? Perhaps, she expects the price of Apple shares to go up over the next six months, but doesn’t have the money to buy them now and wants to lock in today’s price on a contract that can be paid for when her funds are available. In other words, she is speculating on the price of the shares, since she could simply wait and buy the shares when her funds are available. (A retail investor would not be hedging, since that would imply some kind of an obligation to possess shares in May that aren’t owned in December. By contrast, a financial professional might have such an obligation and be using such a position to hedge an exposure.)

Thus, a crucial aspect of a derivatives contract is that the same contract can be used either to hedge an exposure – i.e. to insure against an existing risk – or it can be used to speculate on a change in prices. The derivatives contract itself will not give any indication how it is being used. If the owner of shares enters into a contract to sell them in the future, that is a means of protecting the owner against the risk of loss, and it would not be considered a wagering contract under the traditional law governing derivatives. Traditional gambling law applied only to derivatives where no contract participant was hedging, but instead both were speculating (in opposite directions) on a price movement.

With this introduction let’s get into some details.

Britain’s Gaming Act of 1845 laid a cornerstone of Anglo-American securities regulation: wagers, including derivatives that could be characterized as wagers, were void and could not be enforced as contracts. The reasoning behind this approach was cost-benefit analysis. Because a wager, by definition, involved two parties who did not have a real economic interest or productive purpose at stake, the benefit of enforcement was necessarily small and deemed not to be worthy of the costly expense of judicial resources (H.C. 1844: v-vi; see also testimony of Daniel Whittle Harvey, Esq., Commissioner of the City Police Force, Honorable Mr. Justice Patteson, and John Bush, Esq., Attorney and Solicitor).

In Britain, as in the US, the real world implications of a law are often determined only after the courts have interpreted the text of the law and developed a legal test that will be used to apply the law. In 1851, Grizewood v. Blane, 138 Eng Rep 578, 584 (C.B.), interpreted the 1845 Act, establishing a seminal precedent that would undergird Anglo-American securities law for the better part of a century: if one of the parties genuinely intended to deliver/receive the underlying asset (typically a question of fact for the jury), the transaction was not a wager, but instead a valid contract. Over the next 50 years many US state legislatures adopted similar gaming laws and many US courts cited Grizewood v. Blane on the interpretation of such statutes with respect to financial transactions. The Supreme Court affirmed this interpretation in Irwin v. Williar, 110 US 499 (1884).[1]

Let us apply this legal test to the example given in the introductory paragraphs. If I am hedging my need to sell 100 shares of Apple in May, then the whole point of the transaction is that I expect to sell (and deliver) my shares. On the other hand, if I am speculating, then I don’t have any shares to sell, and it’s easiest to just pay the difference between the contract price and the actual price in May. In this example, I pay my counterparty $800 without a transfer of shares. The fact that I own shares and need to sell them in May would be strong evidence of my intent to deliver, and therefore that the contract is not a wager. By contrast, the absence of any such evidence together with the presence of a pattern of entering into futures contracts and settling differences without ever taking ownership of shares is likely to be viewed as evidence that I am speculating. If the same is also true of my counterparty, then the derivative is a wager. As noted, in practice the evidence on each party’s intent was typically submitted to the jury so the jury could make the factual determination with respect to each party.

During this period derivatives contracts, particularly those that were typically settled by paying price differences, were at risk of being deemed unenforceable in court. Because settling by paying price difference was common on the Exchanges, they had to develop their own mechanism by which they could enforce the claims of parties to these contracts.[2] That mechanism was margin, which is a synonym for collateral.[3] Upon entering into a derivatives contract a trader was asked to post to the exchange margin that would cover a portion of the value that the trader might end up owing on it. And on a regular basis the exchange would reevaluate the contract and change the amount of margin that must be posted to reflect how the contract had changed value over time. In this way, if the trader went bankrupt the exchange had the means to make sure payment was still made on the contract.

In short, the system of margining derivatives contracts was designed for an environment where legal enforcement of contracts was not likely to be available to traders. This alternate system for ensuring payment on derivatives conflicted with the bankruptcy code which sought to catalog all of a bankrupt’s assets and distribute them fairly across creditors. The Supreme Court in 1876 created a carve-out for exchanges, allowing them to process transactions according to their rules and indeed even allowing them to use the proceeds from the sale of the bankrupt’s seat on the exchange to settle any remaining debts on the exchange – all outside the reach of the bankruptcy court (Hyde v. Woods, 94 US 523, 1876). This special status was preserved for commodities exchanges when the Bankruptcy Code was revised in 1978 by allowing commodities brokers to foreclose on margin despite a bankruptcy. In 1982 the contractual rights set forth by the rules of securities exchanges were also exempted from bankruptcy (Pub. L. No. 97-222).

In the early 20th c. the invention of the telegraph posed an existential crisis for the Exchanges as their prices were instantly transmitted for off-exchange trading, threatening not just members’ income, but the price discovery process itself (Levy 2006). This led in 1905 to a Supreme Court determination that exchange-traded contracts were a special category due to the important role they play in setting prices for the business world, CBOT v. Christie Grain, 198 US 236 (1905). This decision distinguished exchange-traded contracts from off-exchange contracts and deemed only the former legally enforceable. The wagering laws that had been enacted at the state level continued to apply to derivatives contracts that were not traded on an exchange.

The Commodities Exchange Act of 1936 was therefore building on existing law when it prohibited trade in derivatives referencing commodities with two exceptions: exchange-traded contracts and contracts where the intent was to deliver the underlying.[4] In 1974 when the CFTC was created and tasked with enforcing the Act, the definition of a commodity was deliberately amended to cover not just virtually all goods, but also “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in … .” In short, the CFTC was granted jurisdiction over derivatives referencing virtually anything, except for categories that would be explicitly excluded, including currencies, government bonds and mortgages that were considered the domain of banks, and options on securities that were removed to the sole jurisdiction of the SEC.[5]

As a result, during the 1980s there were two tiers of regulation governing derivatives. At the Federal level the CFTC Act made derivatives presumptively illegal, unless they were traded on an exchange, the intent was to deliver the underlying, or they were explicitly excluded from the CFTC’s jurisdiction. And at the state level derivatives contracts were void unless they either served to insure one party from an existing risk or the intent was to deliver the underlying.[6]

At the same time, subsequent to the Savings and Loan crisis there were growing markets in new categories of derivatives, interest rates swaps which reference Treasuries, and foreign exchange swaps. The 1974 Treasury Amendment’s exemption of commercial banking activities excluded some such derivatives from the CFTC’s jurisdiction. By 1985, however, products outside the exemption were being developed, and US investment banks were prominent dealers in this market alongside three major commercial banks. These dealers formed the International Swaps Dealers Association (ISDA) with the explicit goals of standardizing the unregulated contracts to facilitate trade, and addressing accounting and regulatory issues. Effectively the ISDA was acting as a Self-Regulatory Organization (SRO) like the National Association of Securities Dealers, but without any supervising regulator. The market grew rapidly and increased tenfold from 1986 to 1990. (Sissoko 2017).

In 1990 at the request of the ISDA the Bankruptcy Code was amended to exempt interest rate and currency swaps as well as “any other similar agreement” from provisions of the Code (Pub. L. No. 101-311). Observe that, whereas the original Bankruptcy Code exemptions had only been granted to the contractual rights created by the rules of the regulated Exchanges (and related SROs), in 1990 these exemptions were granted to unregulated financial contracts and to contractual rights founded in common law; in short, this new exemption was much broader than the 1982 exemption. Having opened this breach in the financial regulatory structure, industry lobbyists spent the next decade and half forcing the gap open as wide as possible.

A 1992 law granted the CFTC the power to exempt any contract from its oversight and by doing so to preempt the application to the exempt contract “of any State or local law that prohibits or regulates gaming or the operation of ‘bucket shops’” (Futures Trading Practices Act, Pub. L. No. 102-546). The structure of this exemption power was unwise, and set a dangerous precedent. In order for the CFTC to exempt a contract from its own oversight, it also had to exempt the contract from one aspect of the traditional State law regulating securities contracts. In short, instead of treating the law that had supported economic activity for more than a century as valuable infrastructure, the 1992 law treated it as disposable. As a result, even the subject experts who staffed the CFTC were not given the choice of exempting a contract from CFTC oversight while at the same time leaving in place traditional state-based restrictions on wagering-type contracts.

In 1993 the CFTC exempted interest rate and currency swaps as well as “any other similar agreement” with the qualifications that they could not be standardized, fungible contracts and that they not be traded through a multilateral execution facility (58 FR 5587 at 5589 (Jan. 22, 1993)). By 1998 the swaps market had evolved such that it was no longer evident that the contracts complied with the qualifications on the exemption, and scandals that had led to litigation indicated that unwitting participants had in some cases been defrauded. When the CFTC proposed to revisit the question of regulating of the swaps market, stating explicitly that any such regulation would only be prospective (63 FR 26, May 12, 1998), industry lobbyists has sufficient influence at the Federal Reserve and Treasury to successfully pressure Congress to enact a six-month moratorium on the CFTC release (Greenberger 2018: 21-23).

The final outcome of the full-bore industry response to the CFTC’s proposal to evaluate the need for regulation of swaps was the enactment of the Commodities Futures Modernization Act of 2000 (CFMA; Pub. L. No. 106-554), which excluded not just interest rate and currency swaps, but financial derivatives more generally from the Commodity Exchange Act – as long as they were traded by “eligible contract participants,” roughly speaking entities with more than $10 million in assets. By excluding these derivatives from the Act itself, they were not just removed from the jurisdiction of the CFTC, but also from the CEA’s anti-fraud and anti-manipulation provisions. Furthermore, when it came to the application of State law excluded contracts were treated like contracts that had been exempted as per the 1992 FTPA; in other words, the CFMA explicitly preempted any application of state gambling law to excluded contracts (Greenberger 2018: 27-28).[7]

Pause for a moment to consider the hubris embedded in the CFMA. At least the 1992 FTPA had left the discretion to the subject experts at the CFTC to determine whether or not to exempt contracts from both oversight and state law. In the CFMA Congress assumed that it had the ability to judge not just whether the excluded contracts should be subject to the CFTC’s oversight but also whether they should be exempt from the State law and common law that had served the economy well for more than a century. And this decision was taken without even commissioning a study of the reasoning behind the use of the traditional wagering law to restrain securities markets. (One is reminded of Chesterton’s fence: “If you don’t see the use of something. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.”)

Although the CFMA established over-the-counter derivatives as an entirely unregulated market and allowed to the ISDA to organize that market unsupervised and without the constraints on anti-competitive practices that had been adopted throughout the financial system in the 1930s, this was not, however, enough.

The margining system that had been developed to enable the earliest exchanges to enforce their contracts without relying on the legal system could be used to create leverage that was invisible to the Federal Reserve, which was still using theoretic frameworks appropriate to unsecured interbank lending, and had not yet mastered the implications of the growing use of margin by the biggest financial participants. With the Fed blind not just to the risks of the derivatives margining system but also to the extent of its growth, commercial and investment banks could take on an unregulated form of leverage.

It seems unlikely that many of the financial industry lobbyists saw the big picture of what they were doing when they lobbied for the 2005 bankruptcy act. Most likely they simply saw an opportunity to shift the rules in a way that would be profitable for them and went for it, without a thought for the broader economy at all.

The outcome was legal reform of the Bankruptcy Code as it affected financial institutions that was just as stunning in its implications as the CFMA had been with respect to derivatives regulation: In an early paper I dubbed this legislation “The No Derivative Left Behind Act of 2005” (Sissoko 2010). The goal of the reform was to make it possible for the broker-dealer banks to manage collateral, not contract by contract, but in a way that would make the collateral as mobile as possible. The banks wanted to be able to aggregate all the margin posted by a certain counterparty on all of its contracts and deal with it as a whole. Since the broker-dealers (but for the most part not their clients) could reuse – or rehypothecate – the margin that was posted to them, the ability to aggregate collateral positions would free up more collateral for the broker-dealers to reuse. Reusing margin is a way for a bank to leverage its balance sheet.

The ability to aggregate collateral positions was created by, first, granting exemption from the Bankruptcy Code to master agreements that were designed to bring a wide variety of different contracts under a single netting agreement, and, second, by revising the specific terms of the bankruptcy exemptions granted to the different types of contract so that they would be uniform – and thus amenable to aggregation. Unsurprisingly the way the various terms were made uniform was by taking the broadest grant of exemption from the Bankruptcy Code and applying it to the various contracts (Sissoko 2010).

For example, exemption from the Bankruptcy Code for options on securities had been limited as was noted above to contractual rights established by the rules of a securities exchange. This was expanded to include the terms that applied to swaps and thus to the more general contractual rights that exist under common law. This was a vast change in the applicability of the Bankruptcy Code exemptions.

Other revisions in the 2005 Act also broadened its reach: to allow for new products to be developed, each type of exempt contract was defined to include similar contracts. One practitioner’s comment on the new definition of a swap was: “Read literally this language cedes the content of the definition to the players in the market.” Kettering (2008: 1712). In addition, before the 2005 Act exempt repurchase agreements had been limited for the most part to those referencing Treasuries and Agencies. After the Act, repurchase agreements on securities and mortgages had been included in the definition of securities, and were therefore exempt.

Like the CFMA, the hubris implied by this law boggles the mind. The bankruptcy exemptions had been created to facilitate the operation of Exchanges because they could not rely on the courts to enforce their speculative contracts. The whole logic of this financial structure was turned on its head by applying the exemptions to off-exchange contracts, that had already been exempted from the state and common law governing speculative contracts. Not only this, but this brand-new, ill-considered financial structure was not applied to some very narrow set of contracts, but it was applied to a vast range of contracts and was designed to make it easy for the interested parties who had lobbied for the law to expand the range of contracts at will.

Just three years after the law was passed, the implications of establishing a vast unregulated financial market with extraordinary privileges under the Bankruptcy Code were realized. The repurchase agreement market which was a core part of the margining system for this unregulated market experienced a massive run and came close to bringing down the financial system entirely. The margining system was saved only by the Federal Reserve’s unprecedented measures.

With the Dodd-Frank Act supervision has been extended over these instruments, and many have been forced to trade on exchanges. The basic incoherence of this new financial structure remains, however. Off-exchange contracts are still exempt from provisions of the Bankruptcy Code and from state wagering laws. The central banks are struggling to develop a theoretic framework that can allow them to manage the new system of margin-based interbank lending successfully. It remains to be seen if the growth rates achieved under the old system can be attained under the new one.

[1] Note that Kreitner (2000)’s discussion of the intersection between securities regulation and wagering law starts with Williar, and this case apparently does not offer the best explanation of the logic underlying this form of securities regulation. Kreitner (2000) argues that moral rather than economic considerations drove this form of securities regulation.

[2] As Levy (2006) observes, while there are many cases arguing that exchange-traded contracts were void as wagers in the late 19th century, not one of them is brought by a member of the exchange. That is, they are all brought by the clients of exchange members.

[3] In 1865 the Chicago Board of Trade introduced the first standardized futures contract together with the requirement that a “performance bond,” which serves the same function as margin, be posted by futures traders.

[4] Derivatives were covered by the term “contracts for future delivery,” but the law was careful to state that “The term ‘future delivery’ does not include any sale of any cash commodity for deferred shipment or delivery,” thus creating what was known as the “forward contract exclusion.” (as currently encoded, 7 U.S.C. 1(a)(27))

[5] The bank contracts were exempted in the 1974 Treasury Amendment to the CEA and securities with the 1982 enactment of the Shad Johnson Accord (GAO 2000).

[6] Because the era of federal common law had ended in 1938, the exchange trading exemption to state wagering laws was unsettled.

[7] In current law this exclusion is found in 7 USC s. 16(e)(2).

Note: Updated January 14 2019 to add more explanatory text regarding derivatives.

Advertisements

Collateralized shadow banking: still at risk of fire sales

A few basic points about shadow banking ten years after the crisis:

“What shadow banking is” isn’t very complicated if banking is defined as “borrowing short to lend long”

What makes banks unstable is that their liabilities are on demand (i.e. they borrow short) while their assets pay out only over the course of years (i.e. they lend long). A principle reason that we are worried about “shadow” banks is that they have the same instability as banks, but lack the protections in the form of a strict regulatory regime and a lender of last resort. When shadow banks have this instability it is because they borrow short to lend long.

This approach makes it easy to understand the world of shadow banking, because there are only a limited number of financial instruments that are used to borrow on a short-term basis. Thus, for the most part shadow banks have to finance themselves on the commercial paper market (unsecured financing) or on the repo market (secured financing) or, especially for investment banks, via derivatives collateral (e.g. that is posted by prime brokerage clients). These are the major sources of wholesale short-term funding.

So typically when a financial product is subject to losses due to a run-prone (and therefore classified as a shadow bank), it’s because of the product’s relationship to the commercial paper market, to the repo market, and/or to the derivatives market.* The latter two, which comprise the collateralized segment of shadow banking, are the most complicated, because the run can come from many different directions: that is, lenders may stop lending (e.g. Lehman Bros), borrowers who post collateral may stop posting collateral (e.g. novation at Bear Stearns), and for derivatives contracts conditions may shift so that suddenly collateral posting requirements increase (e.g. AIG).

Collateralized shadow banking is governed by ISDA protocols and contracts, not the traditional law governing debt

While repos have been around for centuries, a “repo market” in which anyone can participate and where collateral other than government debt is posted is a relatively new phenomenon. Similarly derivatives contracts have been subject to margin requirements for more than a century, but in the past these contracts were exchange-traded and exchanges set the rules both for margin and for eligibility to trade on the exchange.

Thus, what made repo and derivatives financially innovative in the 1980s and 1990s was that suddenly there were unregulated over the counter (OTC) markets in them. What “unregulated” really meant, however, was that the big banks wrote the rules for this market themselves in the form of International Swaps and Derivatives Association (ISDA) protocols and contracts.

In the early days of repo and derivatives it was far from clear that they wouldn’t fall under the existing regulatory regime as securities (regulated by the SEC), or as commodities and/or futures (regulated by the CFTC). (The legal definitions of the SEC’s and the CFTC’s jurisdiction was deliberately made very broad in the implementing legislation, so an intuitive understanding of these terms will not coincide with their legal definitions.) Similarly, it was far from clear that the collateral posted in these OTC contracts would not be subject to the standard terms in the bankruptcy code governing collateralized debt. (Kettering who describes repos in this era as too big to fail products is great on this.)

Thus, one of the ISDA’s first projects was lobbying in the US for exceptions to the existing regulatory regime. Progress was incremental, but a long series of legislative amendments to the financial regulatory regime starting in 1982 and culminating in the bankruptcy reform act of 2005 effectively placed the whole system of repo and margin collateral outside the financial regulatory regime that had been set up in the 1930s and 1940s (for details see here, or ungated). These reforms also exempted these contracts from the bankruptcy code’s protections for debtors (see here or ungated).

Where the US led others followed. Gabor (2016) documents how Germany and Britain came to adopt the US model of collateralized lending, despite the central banks’ serious reservations about the system’s implications for financial stability. The world economy entered into 2008 with repo and derivatives markets effectively subject only to the private “regulation” of ISDA protocols and contracts.

Despite reforms, the instability at the heart of the collateralized shadow banking system has yet to be addressed

We saw in 2008 how the collateralized shadow banking system relies extremely heavily on the central bank for stability. (Federal Reserve programs to support the repo market included the TSLF and the PDCF.  Data released by the Fed indicates that at the peak of the crisis it accepted substantial amounts of very risky collateral.)

Indeed the International Capital Markets Association has put it quite bluntly that it considers the systemic risk associated with fire sales in repo and derivatives markets to be a problem that “the authorities” are expected to step in and address.

“The question is how to mitigate such systemic liquidity risk. We believe that systemic risks require systemic responses. In this case, the authorities can be expected to intervene as lenders of last resort to ensure the liquidity of the system as a whole. For their part, market users should be expected to remain creditworthy and to have liquidity buffers sufficient to sustain themselves until official intervention restores sufficient liquidity to obviate the need for fire sales.”

In short, the collateralized shadow banking system is constructed on the expectation of a “Fed put”. Instead of attempting to build a robust infrastructure of debt, shadow banking embraces the risk of fire sales and expects the governments that don’t make the shadow banking rules to bail it out.

The only sure-fire way to eliminate the risk of fire sales is to reduce the financial system’s reliance on repo- and margin-type contracts that allow a decline in the value of collateral to be a trigger for demanding additional funds. Based on financial market history this would almost certainly require an increase in the use of unsecured interbank debt markets. However, not much progress has been made on this front, especially since the EU’s proposed Financial Transactions Tax stalled in 2015.

On the other hand, significant reforms have been made since 2008 (Please let me know if I’ve left out anything important.) :

  • Collateral has shifted mostly to sovereign debt. This helps stabilize the market, but perhaps only temporarily as a broad range of collateral is still officially acceptable (so deterioration of the quality of collateral can creep in).
  • Approximately 50% of derivatives now are held with central counterparties. (The estimate is based on a 2015 BIS report.) This reduces the risk that the failure of a small market participant sets off a chain of failures that results in a fire sale. There is some concern however that fire sale risk has been transformed into the risk of a failure of a central counterparty.
  • Derivatives are now officially regulated by either the CFTC or the SEC and and there has been an effort to harmonize OTC margining requirements internationally.
  • Under pressure from regulators a voluntary stay protocol has been developed by the ISDA that is designed to work with the regulators’ special resolution regimes and to limit the right to terminate a contract due the default of a related entity. In the US systemically important banks are required to include this protocol in their OTC derivatives contracts.
  • Bank liquidity regulations have been adopted that limit the degree to which regulated banks are exposed to significant risk in these markets.

Notice that these new regulations embrace the basic framework of collateralized shadow banking: much of the focus is on making sure that enough collateral is being used. Special rules are designed to protect the largest banks and the banking system more generally. But aside from protecting the banks, it’s not clear that significant measures have been taken to eliminate the risk of fire sales that originate outside the banking system. Assuming that these regulations are effective at protecting the banks, this raises the question: Who bears the fire sale risk in this new environment?

Thanks to @kiffmeister for requesting that I write up this blogpost.

* While one can usually figure this out after the run has occurred, current regulation does not necessarily make the relevant information available before a run has occurred. Mutual funds are a case in point: the vast majority of them have so little exposure to repo and derivatives markets that it can be ignored, but the few that take on significant risk may have disclosures that are hard to distinguish ex ante from the ones that don’t (e.g. Oppenheimer Core Bond Fund in 2008).

How the 2005 bankruptcy reforms guarantee unfair returns to derivatives counterparties (and our largest banks)

The effects of the derivatives safe harbors in bankruptcy that protect financially sophisticated creditors at the expense of the bankrupt company’s other creditors (and were greatly expanded by the no-derivative-left-behind act of 2005 — a.k.a. BAPCPA) are demonstrated by this Lehman Brothers lawsuit.

The former purpose of the bankruptcy process was to guarantee that all creditors receive no more than they are due under the law given that the bankrupt debtor is unable to meet all of its obligations.  The modern bankruptcy process allows derivative and repo counterparties to foreclose on any collateral posted to them. While theoretically they must demonstrate that the collateral they have taken was no more than was owed to them, the imprecision inherent in the process of marking complex assets to market clearly gives these counterparties the upper hand. In the event that discussion fails to result in the return of improperly seized collateral, the bankrupt debtor must sue the counterparty to get what is due the other creditors, as the Lehman lawsuit aptly illustrates.

It is a trivial matter to show using economic analysis that the costs to the bankrupt debtor of suing will guarantee that the vast majority of derivative and repo counterparties will be able to keep more collateral than they are due (unless they were undercollateralized at the date of default). In short the bankruptcy process now favors financially sophisticated creditors over trade creditors and debt-holders, not only because the financially sophisticated are able to negotiate more favorable contracts before bankruptcy, but also because they are able to take more than they are due under the law once a company enters bankruptcy.

Update 5-8-13: Matt Levine has done the yeoman’s job of reading some Lehman-related legal complaints and appears to reach similar conclusions.

Update 5-15-13: This article leaves the impression that that best targets for a lawsuit regarding the closing of a derivative contract are those who can’t afford expensive legal advice.

The role of derivatives in the 2008 crisis

“More generally, the 2008 credit crunch was never related to worries over traded derivatives; it was — like all credit crunches — related to much more general worries over bank solvency and the quality of banks’ balance sheets.”  Felix Salmon

The claim that the 2008 crises were not related to worries over traded derivatives is simply wrong.  And I write this post to present some of the considerable evidence against this claim.  (That said, I agree with Felix Salmon’s critique of this article that the Greek default is not a good example of CDS-generated systemic risk.)

First, William Dudley the President of the New York Federal Reserve Bank has stated publicly that:  “The novation of OTC derivatives was an important factor behind the liquidity crises at both Bear Stearns and Lehman Brothers.”

Novation takes place when, for example, a hedge fund decides that it doesn’t want to face Bear Stearns as a counterparty and therefore transfers the contract from Bear Stearns in order to face JP Morgan Chase.  In the process any collateral the hedge fund has posted to Bear Stearns must be transferred to JP Morgan Chase.

Second, the OCC derivatives reports (that include derivatives held by regulated commercial banks, but not by the investment banks) indicate that credit derivatives experienced much greater changes in values than other derivatives over the course of 2008.  Specifically credit derivatives comprised 20% of the fair value (summing positive fair value with negative fair value) of derivative portfolios in the first quarter of 2008.  (See Table 6 here.)    And by the third quarter had jumped to 32% of the fair value.  (here)  Thus, it reasonable to conclude that a minimum of 20% to 30% of the novations that played an important role in the collapse of both Bear and Lehman were due to credit derivatives.

It is entirely possible that significantly more of these novations were due to credit derivatives.  Since the aggregate fair value of bank derivative portfolios actually fell from Q1 to Q3 2008 by 6% or $250 billion, the increase in fair value of credit derivatives reflected a move from approximately $1 trillion to $1.3 trillion.  In other words, as one might predict, the value of credit derivatives moved much more dramatically during the “credit crunch” than the value of other derivatives.  Under the circumstances of these dramatic price changes, it seems safe to assume OTC derivative related collateral calls between Q1 and Q3 2008 were more likely to involve credit derivatives than other derivatives.  And I would posit that such collateral calls can trigger demands for novation.  Attibuting 30% of the novations in the credit crises of 2008 to credit derivatives is therefore probably a low estimate.

[Update 3-2-10:  The ISDA Margin Survey 2009, Table 4.2, indicates that from 2007 through 2009 66% of credit derivative exposures were collateralized.  Thus when the fair value of credit derivatives held by regulated banks increased by $300 billion from March 31, 2008 to September 30, 2008, it’s fair to assume that this had the direct result of increasing the demand for collateral over this period by $200 billion.  And this number excludes the increased demand in collateral created by the investment banks’ credit derivatives portfolios.]

Finally, we have the fact that New York Fed jumped on the CDS market after the Bear Stearns bailout – and didn’t allow Lehman to fail until after “centralized settlement among major dealers” for credit derivatives was implemented.  Previous industry commitments with respect to credit derivatives were focused on back office infrastructure issues and had a leisurely timeframe.  (This September 2006 press release indicates that significant advances for the industry included an end to novation without consent, an 80% reduction in the number of confirmations outstanding for more than 30 days, and a significant increase in the confirmation of trades on an electronic platform.)

In March 2008, by contrast, the industry agreed to automated novations processing by the end of 2008, and full implementation of centralized settlement among major dealers by September 2008.  The latter commitment was confirmed by the dealers in July 2008.  (page 3 here.)  In other words, the regulators moved from jawboning to a demand for commitments from the credit derivatives dealers for major changes in the clearing process that included very close deadlines, due to concerns over “the resiliency of the OTC derivatives market.”

While Felix Salmon may argue that this sudden seriousness about reform of the credit derivatives market was pure coincidence, most would conclude that it reflected regulators’ concern about the market after the failure of Bear Stearns in March 2008.

Overall, the claim that “2008 credit crunch was never related to worries over traded derivatives” is contradicted by the facts.  Insiders have acknowledged that novation of OTC derivatives played an important role in the crisis.  And I think Felix Salmon would have difficulty finding a member of the industry who is willing to assure him that the credit derivatives market would have handled the failure of Lehman effectively, if it had still been working with the market infrastructure of March 2008. Given this situation, the evidence points pretty clearly to likelihood fact that the CDS market was one of the reasons the Federal Reserve was unwilling to let Bear Stearns fail the way it let Lehman fail.

An additional note.  Felix Salmon writes, comparing bilateral clearing to a clearinghouse:

“If a bank has written so much credit protection that it becomes insolvent, then there’s significant systemic counterparty risk regardless of how its derivatives trades are cleared.”

Huh? The whole point is that the bank default to the clearinghouse is born jointly by the banks that guarantee the clearinghouse, instead of being born by individual counterparties – who are naturally more likely to be bankrupted by the bank’s failure to pay, then if they share the losses and thus divide them by 3 or 5 or some such number.

The point of a clearinghouse is not to prevent bad banks from facing a credit-crunch.  Obviously from an efficient markets point of view the sooner that happens, the better.  The point is that clearinghouse should help prevent the credit crunch/failure of a bad bank from taking down other banks that could potentially be made insolvent by excessive exposure to the bad bank — and thus to prevent the bad bank from setting off the chain of failures that defines a systemic crisis.  Of course, if the banks are willing to rely on collateral and choose not to limit credit to bad banks, then we’re in big trouble in either system.

The End of Equity?

Barry Ritholtz is blaming the falling value of bank stocks on the decision not to require mark-to-market accounting.  I’m wondering whether the fall isn’t a delayed reaction to the implementation of broad safe harbors for derivatives in the bankruptcy code (which was completed in 2005).

After all, Lehman Bros. made clear that anyone who holds equity in a financial institution can expect to get nothing when the company is wound up — in fact, it looks like the unsecured creditors will get 20 cents on the dollar.  What happened to the $640 billion in assets and $26 billion in shareholders’ equity that was reported for May 2008?  You can be sure that a large chunk of it ended up being posted as collateral on derivative obligations and thus removed from the control of the bankruptcy estate.

Why after this experience would anyone own the shares of a financial institution that could possibly go bankrupt or be resolved?

Another concern is what will happen when some large real economy firm ends up with such big derivatives exposures that its shareholders get treated the same way as Lehman’s.  Will one-time equity investors decide that, after the recent changes to the bankruptcy code, being a shareholder of a listed stock is just an option on nothing at all?

Unintended consequences, indeed.

Update 10-8-11:  In case it wasn’t clear, the issue that is created by the new bankruptcy code is that is that in the months leading up to a bankruptcy (or resolution) the claims on the firm’s assets are likely to change dramatically with the result that the accounting statements don’t reflect the relevant information.  So the underlying problem is that equity investors are asked to invest blindly.  While this problem is worse for financial firms, it’s far from clear that the problem is limited to them.

Price movements are the point of “real-time transparency”

Pers Sjoberg and Susan Hinko of TriOptima argued in Financial Times this week that OTC derivative markets aren’t liquid enough to be subject to real-time transparency requirements.  But what does liquidity have to do with the social benefits of price transparency?

The correct comparison is not futures or option markets, but other illiquid markets like the corporate bond market.  And it’s far from clear that real-time transparency has been detrimental to the corporate bond market — in fact, the most recent news has been that the corporate bond market is thriving.

The authors argue:

[In] highly-liquid, standardised markets, real-time reporting and price transparency are meaningful concepts. When these concepts are applied to the OTC markets, adjustments should be made, especially given the fact that many of these low-frequency transactions have large notionals and need to be hedged discreetly to minimise hedging costs.

 

The whole goal of price transparency is that it should be impossible for anybody to “hedge discreetly.”  That’s the point.  Every transaction shows up in the market price.  If I do a bond transaction sequentially for two different accounts, I’m likely to see a price movement from one transaction to the next — and I trade in very small quantities.  But this is simply the inherent nature of trading on a functional market where my earlier purchase (which was completely unpredictable before I sent it in) shows up as having a price effect after it has been made public.  Price movements, like this, are the very purpose of transparent markets.

The authors continue:

However it is important for the new rules to reflect the realities of the market so regulators and the public have access to meaningful information. Intra-day reporting will place systems and cost burdens on institutions already restructuring to meet the demands of new legislation and regulation, and will not yield significant results to the public.

I don’t understand why purchases like my first purchase of an illiquid bond are classified by the authors as not “meaningful information.”  That’s a decision that the dealers on the market make when they post their bids and offers.  If a transaction is not meaningful to them, it will not shift the price, and, if it is meaningful to them, it will.

We can all understand that it is more beneficial to financial institutions for them to be able to trade with more information than the rest of us, but  it is far from clear that protecting their intra-day information is in the public’s interests.  If the only costs are structural, because financial institutions will have to set up real-time reporting systems, it seems to me to be in the public’s interest to create a standard that says that such systems should be set up for just about everything that financial institutions trade.  Thus, when regulators want real-time reporting of a new product, it should take the financial institutions days, not weeks, months or years to provide.

We live in a society where every pack of gum is bar-coded and consumers can do cross-store price checks on their phones.  Why has the financial industry chosen to maintain back office procedures that are practically medieval — even as they trade in multi-million dollar products?

If economists ruled the financial world

The negative reaction by many in the financial industry to this New York Times article critiquing the structure of over the counter derivative markets motivates me to make a very simple point:  Economic theory makes it clear that there is no reason to believe that trading activity will be socially beneficial when the market structure is as described in the article.

Elementary economics tell us that in order for the invisible hand of the market to work, pricing (including bids and offers) must be transparent.  That is, economics is explicit that it is only where there is public information about prices that self-interested behavior is socially beneficial or that the ability to make money on the market is an indicator that a valuable service is being provided to the economy.  [Ask any economist to explain a competitive equilibrium to you and you will find that good price information is a necessary condition for “first-best” social welfare to be achieved.]

Because transparent pricing is a pre-requisite to market trade having positive implications for society as a whole, if economists ruled the financial world these would be the foundational principles of the marketplace:

1.   [Enforceability of pricing regulations]  In general contracts that are not traded on SEC or CFTC regulated trading forums are unenforceable.  (Note that this is a revitalization of the reforms enacted during the Depression by the passage of the Securities Exchange Act and the Commodities Exchange Act.  Note also that I recognize the need for limited exceptions to this rule.)

2.  [Price transparency pre-trade]  Best bid and offer prices posted by market makers and other traders on all trading forums are publicly available in real time.  Market depth information is also publicly available in real time.  The cost of providing this data to the public is covered by a fee proportional to trade on the market (e.g. a penny per $100 traded).

3.  [Price transparency post-trade]  All completed trade data (item, time, price and quantity) on all trading forums is publicly available.

4.  [Meaningful prices]  All bids and offers have a minimum duration of one minute.