Three quotes and an apology May 2, 2014 at 9:39 am

The resumption didn’t happen: sorry. I just didn’t feel like writing. Even the Michael Lewis/HFT thing couldn’t rouse me from my stupor, mostly because it is so obvious what you need to do to fix these issues*.

There is a three day weekend ahead. I don’t anticipate writing much any time soon, but let me at least leave you with three quotes that have amused me recently:

Happy worker’s day: I hope you get to go to the Fair.

Frozen rain

*National auctions every second or so using orders in all the markets so that reg NMS is obeyed by construction; reporting of the results of those auctions delayed at least ten seconds to stop quote fishing; minimum fees for quote submission and no rebates; dramatic simplification of order types; a small FTT.

Sorry folks March 26, 2014 at 10:18 pm

I’m horrendously busy, and unlikely to be blogging for some weeks. Normal service might be resumed by mid-April, but more likely there will be fewer but hopefully longer posts. Happy Easter

Practising Stalinism and the Regulatory Paradigm March 16, 2014 at 6:17 pm

No, this isn’t a ‘call it Stalinist when you want to trash it’ post. Rather, it’s about thoughts stimulated by reading Sheila Fitzpatrick’s review of J. Arch Getty’s Practising Stalinism: Bolsheviks, Boyars and the Persistence of Tradition in the LRB.

Fitzpatrick gives us an insight into Getty’s view of how Russians in the 70s and 80s

organised their lives, using personal contacts to get things done, enmeshed in a network of reciprocal favours, contemptuous of state bureaucracy and skilled at evading its demands

That description reminded me of Italy a decade later, by the way. It suggests a state that

was nothing more than a mirage, and ‘official institutions … just collections of people whose public façade was better than most at convincing people to obey them’. Observing his friends, [Getty] concluded that ‘few people trusted or even believed in institutions; they believed in people. Everything was personal … Was the modern [Russian] state, as in Pierre Bourdieu’s suspicion, creating itself through my reading of it?’

One could suggest that there is a spectrum ranging from states where governmental (Federal) power is, predominantly, obeyed (Switzerland, the UK, perhaps much of the US?) to ones were it is systematically evaded (Italy, Russia). Note that issue here isn’t subsidiarity – a lot of power is held at the Cantonal level in Switzerland, and at the State and local level in the US – but rather what happens when the Federal (for want of a better word) government tries to do something: are they obeyed?

A number of legal theorists and political scientists are starting to view regulatory structures using the same tools they use to analyze states, prominently Julia Black at LSE and Kevin Young now at Amherst. (See also Meredith Wilf at Princeton.) One of the things these folks point out is that a totalizing narrative of regulatory power does not explain the facts: things are not just agreed by the powerful then passed down and implemented, but instead power is contested and polycentric. Policy may be agreed internationally, but it is always subject to renegotiation, diverse implementation, and interaction with the facts on the ground. Financial regulation, then, is not completely at the ‘obey’ end of the spectrum.

A particularly interesting example of this is US insurance regulation. Before the crisis, insurance in the US was state regulated, with each state having an insurance commissioner: these commissioners then collaborate through the National Association of Insurance Commissioners. The Dodd-Frank Act mandated the creation of the Federal Insurance Office to review the actions of the commissioners rather than replace them.

Needless to say there is a good deal of friction between the state commissioners and the FIO: a recent article in Risk outlining the views of Thomas Leonardi, head insurance regulator for Connecticut, is a good example. To say that Leonardi is not enamored of Federal intervention in insurance regulation is, perhaps, to under-state the case.

For these purposes at least I don’t want to take a position on whether the FIO is right or not. What’s interesting, rather, is how contested its authority is. Yes, Dodd Frank says that it has certain powers and responsibilities. No, it is not being allowed to exercise them without considerable push-back, not just from the regulated, but other regulators. Indeed, the latter seem rather more vocal than the former. It’s very much, for the moment anyway, at the Russian end of the spectrum.

One final thought. The Bourdieu point is important. As he said with the characteristic lucidity of the twentieth century French philosopher:

Official language, particularly the system of concepts by means of which the members of a given group provide themselves with a representation of their social relations … sanctions and imposes what it states, tacitly laying down the dividing line between the thinkable and the unthinkable, thereby contributing towards the maintenance of the symbolic order from which it draws its authority.

Think of that the next time you start to read the text of a new regulation…

News of the day March 14, 2014 at 12:31 am

Copper is limit down in Shanghai, Ukraine is getting hotter again, and investment bank profits are thought to be tumbling, so of course I am writing about baked goods. The important update is that I tried a crothingy this morning and really, as Bill hinted in his comment to my earlier post, they are not worth it. A St. John egg custard donut, yes; a cro, no. On the basis of this one data point I declare baked goods officially in bubble territory and demand macro-prudential intervention including but not limited to cocoa percentage floors, minimum custard-to-value ratios, and bans on little bits of pistachio that look good but taste of grit.

Strange days indicator March 13, 2014 at 5:48 am

According to Reuters, Mexico has begun marketing a new 100-year benchmark bond denominated in sterling. Yes, I had to read it twice too.

Orderly failure vs. no failure March 12, 2014 at 3:00 pm

Quoth SEC Commissioner Daniel Gallagher:

In the banking sector, which features leveraged institutions operating in a principal capacity, capital requirements are designed with the goal of enhancing safety and soundness, both for individual banks and for the banking system as a whole. Bank capital requirements serve as an important cushion against unexpected losses. They incentivize banks to operate in a prudent manner by placing the bank owners’ equity at risk in the event of a failure. They serve, in short, to reduce risk and protect against failure, and they reduce the potential that taxpayers will be required to backstop the bank in a time of stress.

Capital requirements for broker-dealers, however, serve a different purpose, one that, to be fair, can be somewhat counterintuitive. The capital markets within which broker-dealers operate are premised on risk-taking – ideally, informed risks freely chosen in pursuit of a greater return on investments. In the capital markets, there is no opportunity without risk – and that means real risk, with a real potential for losses. Whereas bank capital requirements are based on the reduction of risk and the avoidance of failure, broker-dealer capital requirements are designed to manage risk – and the corresponding potential for failure – by providing enough of a cushion to ensure that a failed broker-dealer can liquidate in an orderly manner, allowing for the transfer of customer assets to another broker-dealer.

As I said, it’s counterintuitive, but the possibility – and the reality – of failure is part of our capital markets. Indeed, our capital markets are too big – as well as vibrant, fluid, and resilient – not to allow for failure.

If it doesn’t work as a hedge fund strategy, try making policy with it March 7, 2014 at 12:24 pm

Capital structure ‘arbitrage’ is largely discredited as a hedge fund strategy for the rather good reason that a lot of people lost a lot of money on it. An arbitrage, remember, is supposed to involve a risk-free profit. But using the Merton model or its variants to ‘arbitrage’ between different parts of the same companies’ capital structure didn’t work very well — or, at least, it worked well until it didn’t. One of the problems (aside from various liquidity premiums embedded in prices) is that the first generation of these models assumed that the value of a firm’s assets follow a random walk with fixed volatility: which they don’t. In fact it has been known for over two decades that the PDs backed out from Merton models are far too high, something that KMV try to fix with some success at the cost of what might kindly be termed ‘pragmatic adjustments’. Now there may well be capital structure arbitrage models which don’t have these first generation problems and don’t involve arbitrary adjustments, but they are not well known (not least because if you had one that worked, you would want to use it to trade rather than to burnish your academic credibility).

There is an exercise by the US Government Accountability Office to determine how much lower big bank borrowing costs are due to expectations of government bailouts. Stefan Nagel suggests on Bloomberg that there is a risk that, by using a simple Merton-type model, the GAO will “underestimate both the banks’ proper borrowing costs and the implicit subsidy they receive from taxpayers”. True, there is. But there is also the risk that they will overestimate it, not least because as we noted above, models like this are flawed, and they tend to overestimate PDs. I absolutely think that taxpayers deserve to know what the implicit subsidy they are providing to big banks is worth – but by the same token, I think they deserve to know the model risk in those estimates. Scaremongering to suggest that the estimate will necessarily be too low is not helpful here.

Tony Lomas says March 5, 2014 at 4:38 pm

There’s something about doubly bisyllabic names. Jackie Wilson. Tony Lomas. They draw you in. Anyway, Tony has a corker re the liquidation of LBIE, the Lehman London broker/dealer: it turns out that it wasn’t a balance sheet insolvency that collapsed this entity, but [rather] a problem of liquidity, and Lomas expects there will be a £5B surplus at the end of the liquidation. LBIE started with £15B of capital, so that isn’t bad. The markets are discounting a distribution of this surplus, with LBIE receivables trading at 140. Honey chilli, you make my day indeed.

Ontogeny recapitulates phylogeny March 4, 2014 at 12:50 pm

Ontogeny recapitulates phylogeny, or ORP, was a hypothesis in evolutionary biology whereby it was conjectured that an organism’s development (ontogeny) will take it through each of the adult stages of its evolutionary history (phylogeny). The word `recapitulates’ is important: this isn’t a strict repeat, and it can include secondary development, variation, even omission (think Beethoven Op. 31 No 2 or the Brahms Piano Quintet). Thus we are not saying that from egg to chicken we get a fish, a lizard-like reptile and an ancestral bird; merely that there may be echoes of one or more of these in a chick.

Noahpinion recently pointed out that ORP is more common in model building than in infant development. He was talking about macro, but it’s a sensible strategy in finance too: you start off with a correlated random walk model, for instance, then change the copula or add stochastic volatility or something. That made me think about the design risk of this process: if you want to hack up a Heston model in a hurry, starting from a quanto model probably isn’t a bad idea; but if you want to do something more novel, then it can lead you down a blind alley. There’s also the efficiency issue: something designed from scratch is likely to be much more efficient than code that has been modified from an earlier application.

When model building, then, think before you modify. Evolution has dead ends too, and you don’t want a model that is the equivalent of a bird with teeth.

Advertising their concentration March 3, 2014 at 11:59 am

I’m feeling under the weather, and hence watching more TV than usual. There’s a new TSB ad that strikes me as odd. The punchline is “Every penny our customers deposit with us stays right here in Britain, supporting mortgages and loans for other TSB customers.” So what they are telling us is that their loan book is completely concentrated in one country and thus not nearly as well diversified as it could be. It’s the first `please consider giving us a pillar 2 add-on for concentration risk in the loan book’ advertisement I’ve seen on national TV*. That said, it isn’t as bad as the paypal ad. I really hope I feel well enough to read instead of watch TV tomorrow…

*OK, TSB is part of Lloyds, and Lloyds is better diversified – or at least they don’t advertise that they are not – so it is probably fine, but still, this kind of flag-waving is kinda odd.

OK winter, time’s up, get out of here March 1, 2014 at 5:42 pm

Frozen rain

Is that a ‘screw you’ I hear?

How much is too much? February 26, 2014 at 8:27 am

Marco Onado at Vox EU makes a couple of good points:

  • European Banks’ gross and net profitability are at a historical low level, so
  • They have an incentive to remain on the present levels of leverage to obtain a ‘reasonable’ return on equity and
  • the rate of increase of capital allowed by retained earnings is modest.

To this I would add:

  • Credit in Europe will remain rationed and expensive until capital and leverage standards are reduced, or banks’ earnings increase.

I think Prof. Onado implies that this situation isn’t sustainable for much longer: to agree one only needs to think that a fix that requires a decade or more of austerity isn’t politically tenable.

At last a Republican policy I can get behind February 25, 2014 at 8:26 pm

Bloomberg tells us of a lovely policy idea that I really hope comes to pass:

The biggest U.S. banks and insurance companies would have to pay a quarterly 3.5 basis-point tax on assets exceeding $500 billion under a plan to be unveiled this week by Congress’s top Republican tax writer.

Done right (i.e. without a powerful incentive to move assets to the shadow banking system), this could be a big shove towards ending too big to fail.

The great London cronut crawl February 22, 2014 at 4:23 pm

Ever since the cronut was popularised by a Manhatten bakery, it was clear that London needed its own croissant-donut hybrid, and several bakeries stepped up to fill the breach. Which, though, is best? I have no idea, but it does occur to me that with contestants from Nunhead to Paddington and from the Northern borders of Islington to Brockley, a London cronut crawl is going to be strenuous. Worst, the Nunhead entrant apparently sells out early so if you aren’t on the road by 6am, you lose.

Frozen rain

There is a reasonable walk either Paddington to Whitechapel or the reverse, but what if the best croissant-donut is made on the periphery? At least cycling to Nunhead might consume a pastry’s worth of calories…

Interest(ing) February 19, 2014 at 10:43 pm

Do not charge your fellow man interest, whether on money or food or anything else that may earn interest.

This passage, and its paraphrase in Hamlet, comes to mind reading Bloomberg’s account of the IMF’s new thinking on sovereign loans. Perhaps one way to interpret the ancient text is as pointing out that debt – obligations that must be repaid on time – is inherently dangerous for both borrower and lender in that the former might not be able to pay promptly, and that can sometimes cause problems for the latter. Naively one might think that deferrable or bail-in’able instruments – like much bank debt these days – are better. Investors are compensated for deferral risk via the coupon, as well as plain default risk (which of course is now much lower as there would often be no need to default). Instead of railing against the IMF’s thinking, as Bloomberg does, perhaps they could consider the stability benefits if all sovereign debt was deferrable?

Collateral crises February 18, 2014 at 12:22 pm

From the abstract of Collateral Crises, by Gary Gorton and Guillermo Ordoñez:

Short-term collateralized debt, private money, is efficient if agents are willing to lend without producing costly information about the collateral backing the debt. When the economy relies on such informationally insensitive debt, firms with low quality collateral can borrow, generating a credit boom and an increase in output. Financial fragility is endogenous; it builds up over time as information about counterparties decays. A crisis occurs when a (possibly small) shock causes agents to suddenly have incentives to produce information, leading to a decline in output. A social planner would produce more information than private agents but would not always want to eliminate fragility.

Personally I think this approach is interesting but insufficiently epistemic. It’s easier to explicitly model lender’s beliefs about borrowers, and about collateral. Still, it’s nice to see a formal model of the run on repo insights.

Eurovision and redenomination risk February 17, 2014 at 10:14 pm

Coming quickly behind the news that Scotland can’t have the pound, nor join the EU, should it pick independence, comes an even bigger worry for the Yes campaign:

Scotland’s bid to join Eurovision would be opposed by countries where people can hear, it has been claimed.

As so often, the Daily Mash is your source here. Still, at least all those lawyers trying to figure out what to do with thirty year inflation swaps sold to Scottish pension funds and now referencing an irrelevant inflation rate and settling in the wrong currency can listen to the radio without the risk of hearing bagpipes.

A selective boost February 16, 2014 at 10:56 am

I am all in favour of Keynesian stimulation when the economy is in the doldrums, but £28m for a public toilet is… perhaps inefficient? Still, as anyone caught short in many UK towns knows, we do need more public conveniences. At least this approach could provide a massive boost to would-be-edgy architects, plate glass manufacturers, and young people with art history degrees and an over-developed sense of fashion.

A trillion dollars less February 15, 2014 at 10:32 am

From the New York FED’s latest Update on Tri-Party Repo Infrastructure Reform:

[Due to reforms] the two clearing banks are providing over a trillion dollars less in intraday credit to market participants on a daily basis today than in February 2012.

(Emphasis mine.)

The best of… February 14, 2014 at 11:33 pm


If we’d go again / All the way from the start / I would try to change / The things that killed our love.

Also sprach Analyst
I prefer our finances to be independent to prevent moral hazard

Malcolm Crocker
I love it when you address your structural deficits

I will always be there for you. Unless there is inflationary pressure.