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