[FoRK] The Wrecking Crew - A Low, Dishonest Decade

Jeff Bone jbone at place.org
Tue Jan 19 17:39:34 PST 2010

Too many good comments to reply to many of them individually;  I'll  
just make a couple of points.  Reading through them, I notice several  
instances in which folks are reading what they want to see me say into  
what I'm actually saying, and in doing so they're revealing a lack of  
understanding of the existing macro structure and function of various  
financial markets.  Not to pick on Stephen out of spite, but just as  
an example:

Stephen says (quoting me to lead give context)...

>> It's only where the "market did not have such characteristics and  
>> mechanisms that the failures really mounted to create systemic risks.
> Exactly right! Unfortunately, many crave stability and  
> predictability. Sometimes the definite loser pool (existing  
> shareholders for instance) win out over the potential (and mostly  
> unknown and unidentified) winners. This affects regulation of  
> markets and preference for gov. / commercial choices. This is  
> probably a good balancing force, however it can lead the wrong way  
> and shouldn't rule.

Unfortunately, Stephen is misunderstanding something very fundamental,  
which is the relationship between the "characteristics and mechanisms"  
mentioned, government regulation, and the impact on government  
regulation on which markets suffered the worst (and why.)

I'm glad that Stephen "agrees" with me but unfortunately his next  
statements make it clear he's not sure what he's agreeing with.  ;-)

It's not government oversight or regulatory risk limitations that  
impart predictability and stability;  it's a well-organized, well-run,  
highly credit- and risk-aware market.

This may in some cases require regulation to achieve;  but in the most  
obvious real-world case recently, it absolutely did not require  
(governmental) regulation to achieve that.

Let me give you that example in detail.

During the Bear and (particularly) Lehman events, one market that I'm  
intimately familiar with --- the global foreign exchange market ---  
suffered least of any of the various financial markets on the planet.   
During those events, not a single foreign exchange transaction (in  
net) failed to settle.  That cannot be said for *any* other financial  
market that I'm aware of;  the ripple effects of those events impacted  
counterparties and amplified counterparty risk in every other market,  
causing trade breaks, massive realization of hypothetical risks as  
netted-out positions no longer netted, and ultimately caused the  
cascading failures that sent prices reeling and destroyed value  
throughout the chain.

That didn't happen in foreign exchange.

The irony is that foreign exchange is *THE LEAST* governmentally- 
regulated financial environment on the planet.  And it's not  
particularly transparent, open, or any of those other positive  
qualities that I mentioned.  So without the "benevolent oversight" of  
governmental regulation, how did it weather the storm so well?

Well, despite an almost total lack of *governmental* regulation, it's  
one of the most tightly self-policed and self-regulated environments  
on the planet.  It's one of those dreaded "OTC" (over-the-counter)  
markets --- however, unlike some of the problematic asset classes  
(CDS / MBS) it has some appealing characteristics.  While the business  
is OTC, ultimately every transaction is directly between two parties  
according to previously-negotiated mutual credit.  So there's the  
first pillar of its stability;  these credit facilities are negotiated  
ahead of time and are more or less standardized under a standard  
template governing such transactions (the ISDA and its supporting  

Throughout the chain you've got excellent pre- and post-trade risk  
management among all of the participants in a transaction, generally  
according to the mutually negotiated and actively managed bilateral  
credit facilities put in place through these ISDA agreements and often  
mediated by credit intermediaries called "prime brokers" (whose  
purpose, among other things, is to create third-party visibility to  
and management of the utilization and administration of such credit,  
and who in doing so put their own skin in the game --- giving them  
ample motivation to risk-manage appropriately and effectively, i.e.  
eliminating a lot of moral hazard.)

Most of the business now occurs on exchange-like platforms;  while  
these aren't really exchanges --- the presence of these mutual credit  
facilities means that everybody on a given ECN sees a different book,  
and in only a few cases do you actually get to see every update to the  
overall book, every trade, etc. --- they still function as such for  
the purpose of price discovery.  Unlike the real voice-brokered and  
highly bespoke MBS and other instruments, the exchange rate between  
any two currencies at any given time is generally knowable with a high  
degree of certainty.

Finally, and most importantly, the more-central entities in the  
foreign exchange business voluntarily all participate in a non-profit  
joint venture called "CLS Bank" --- which is in effect a central  
clearer for the entire business, and almost all forex transactions  
ultimately settle within CLS, with CLS (and all its members) having  
full visibility to all the net changes in positions, netted trades,  
and credit arrangements between its members.

During the events in question, this whole system *worked perfectly.*   
Without a bit of government intervention, support, oversight, guidance  
beforehand, etc.

Now, those characteristics --- exchange-facilitated price discovery,  
bilateral / standardized / a priori credit facilities, pervasive  
credit-aware and valuation-aware risk management, and --- again, most  
importantly --- a centralized clearing facility with visibility to the  
whole thing and mutual insurance among the principals --- are all  
hallmarks of what worked, in comparison to e.g. the highly non- 
standard, decentralized, and bespoke environment of e.g. MBS.  And  
clearly it doesn't *require* government coercion to make it happen;   
this all spontaneously self-organized in the foreign exchange market  
as a way for responsible folks to manage their own risks.   
(Interestingly, CLS was created primarily just to mitigate a  
particular kind of settlement risk called Herstatt risk, which occurs  
when two parties to a transaction "settle" non-atomically due to time  
zone differences --- yet it has had a much more pervasive risk- 
mitigation impact.)

By comparison the MBS world was the Wild West, and it did *not* so  
self-organize before seeing its own near-fatal Black Swan  
materialize.  Indeed, it was the ultimate case study in mutually- 
assured destruction and engineered moral hazard:  heads we few alone  
win, tails everyone else loses --- and the governments won't allow  
that to happen.  THAT kind of behavior is not characteristic of most  
markets or asset classes, and it is THAT behavior that may  
legitimately require coercion to corral.

My endorsement of regulation is not an endorsement of what Stephen  
appears to believe regulation should attempt to achieve:  in  
particular, regulation's "affects" [sic] should not be to influence  
any particular pool of winners and losers, or to prevent losers from  
suffering the consequences, or to prevent willing participants from  
engaging in whatever transactions they desire, or to "engineer" any  
particular outcomes by levies and taxes.  Maintaining some level of  
volume, volatility, price stability, etc. is *not* a legitimate aim of  
such things, and the uninformed shouldn't play at games they don't  
understand.  Caveat emptor.

Instead, my endorsement is really merely one of well-organized markets  
--- and that doesn't *require* government intervention in all cases,  
as we see with foreign exchange as a shining existence proof and case  
study.  And indeed, quite often it's the case that politicians ---  
most of whom have no clue how any of this works --- create more damage  
than they mitigate through regulating from a position of total  

However, in markets that fail to appropriately self-organize to manage  
their own systemic risks, legal coercion and enforcement may be  
required to get the participants to adopt what should be some  
otherwise quite commonsense and mutually beneficial processes and  
mechanisms.  To figure out what those might be, we need look no  
further than those markets which *functioned well* through the recent  
(and, I would argue, ongoing) unpleasantness.

If only the policy-makers were smart enough to do so.  (And the  
armchair pundits, really, should STFU until they have a bit better  
understanding of what actually happened, much less why.  IMHO. ;-)



More information about the FoRK mailing list