Adler on Data Governance
Matching: systemic X
It starts with the definition. Systemic Risk is the risk inherent to an entire market or market segment, so says one website. From the definition, we can already see that systemic risk is primarily concerned with the prevention of risks to The System. The System in question is the global financial "system." So the goal of Systemic Risk is the prevention of loss to those involved in The System.
You might ask, "why is Adler focusing on the obvious?" Well, I don't think it is that obvious who The System is and what their interests are. There are lots of well meaning people running around trying to craft new laws and methodologies to assess and prevent Systemic Risk. Most of them will fail without first understanding the needs and interests and goals of The System.
The Goal of every System should be to serve the needs and interests of The Customer. Corruption of The System is when individuals or groups place the needs of themselves as actors in The System above the needs of The Customer. When The System is mostly serving the needs of itself, it is mostly corrupt.
The Global Financial System has had corruption for decades. In the last decade, the influence of Systemic Actors exercising the needs of themselves over the needs of The Customer has become acute. The Financial Meltdown of the past 30 months is the result of this imbalance.
So I wonder, which new brew of experts and which new conference will measure the needs of The System and compare them to the needs of The Customer to assess Risk?
I have a self-serving answer:
Last night, I was one of two panelists at a Global Association of Risk Professionals (GARP) symposium on Systemic Risk at Fordham Business School in New York. We were to be a moderator with three panelists, but one canceled at the last minute, presumably to stay home and watch the Yankees lose to the Phillies last night. The room was on the 12th floor in a mid-60's squat tower accessible from two elevators among a bank of six in the stone cold open and office-like lobby. Twelve is the top floor in the building, with a Rockefeller penthouse atmosphere. Black marble floors, mahogany paneling, subdued sixties swank.
The symposium room was longer than wide, seated classroom for one hundred in three neat blocks. We panelists were paired on a white-clothed-table with microphones we didn't need. The moderator introduced us both; the NYU Business School professor and the IBM Data Governance guy. The audience looked half-asleep, and the first question rolled out on the table, "What is Systemic Risk?" Our gracious moderator had prepared a raft of intelligent questions for us that evening, but we would only get through two in the brief hour we digested.
What is Systemic Risk? The professor told us it was the result of exogenous market conditions that created upper atmospheric bubbles in complex derivative instruments capable of devastating global economies. It could be measured in the up and down-swing of aggregate equity performance and controlled through the central banks he currently advises. He saw Systemic Risk as a macro-economic phenomena, the product of weak government regulation, greed on Wall Street, outrageous compensation packages, and unnecessary complexity in financial markets.
Before the event, I wasn't quite sure what I was going to talk about. It was a hectic Monday full of ten conference calls on twenty different topics. I left late, had traffic on the Grand Central, got lost at Lincoln Center looking for parking, and there was no coffee when I arrived. I'm not an evening person un-caffeinated, and perhaps not the best morning person in the same condition. But droll media babble passed as tenured professorial wisdom will rouse me on the sleepiest of days.
Systemic Risk is the probability of loss to a system. It is not actually a thing that can be calculated. It is a series of things that result in a loss event with causality and impact. Systemic Risk is not only about macro-economic catastrophe, because to say so is to say that we are not involved in Systemic Risk accept as victims. And that ain't true. Insofar as all of us, The People, are members of communities, parties, religions, nations, and environments we are part of a System. We are inter-related, inter-dependent, capable of causality, errors and omissions, losses and claims. Each incremental failure can cascade and result in systemic exposure.
The Credit Crisis is the result of a series of public policy mistakes from 1999 to 2006 that encouraged bad business practices at many different stages of the mortgage underwriting and securitization process. These were incremental failures that contributed to loss events that destroyed parts of the economic systems upon which markets rely. The lesson to humanity from this experience is that We The People are all members of SYSTEMS large and small that can fail as a result of incremental policy mistakes. Actuarial Science has for too long focused on the probabilities of contained loss events.
My body is a SYSTEM and Cancer is a systemic risk to me. It causes a chain of events which can result in organ failure and death. Your company is a system, and bankruptcy is a systemic loss event. If bees die, plants won't be pollinated, and that can be causality to a systemic risk to our ecoSYSTEM. The BBC Reports (http://news.bbc.co.uk/2/hi/science/nature/8338880.stm) that record numbers of plants, mammals, and amphibians are under threat of extinction. This is a systemic risk. When entire species of frogs in remote places like Tanzania become extinct in the wild, humans take note - this incremental failure is closer to your role in the food chain than you may think.
Every System has risk. Every person in every system has a role.
If we accept the gossip-press gospel that the Credit Crisis is purely the result of greed on Wall Street, and can only be fixed by wise regulators in Washington, shame on all of us for missing the opportunity to internalize the economic externalities. It is not an academic exercise to study the risk in every system large and small. Systemic Risk is a real-world imperative for all of us.
This morning, EU Regulators announced that they propose to create a Risk Board to monitor financial market performance and systemic risk indicators among the 27 member nations in the European Union. I've advocated a Council approach to risk-based decision-making since the beginning of this year and I think the EU proposal is a good idea in concept. Unfortunately, in Europe it seems decision-making takes a large number of people, becaue the European proposal would have 63 people participating on the Risk Board. A deliberative body with 63 people is not a "Board" - it is a legislature. To complicate matters, "only" 32 members of this board would have voting rights. Unfortunately, the only power they can vote on is a warning to member states that some part of their market performance contains systemic risk. How they plan to determine that threat and get everyone to agree on what it means in any reasonable amount of time is not clear. My guess is that this is a proposal to setup an intra-governmental think-tank that will study issues, write economic reports that no one reads, and only threaten to issue warnings because a vote on a warning will never happen.
Note to Obama Administration: If you want to create a Systemic Risk Regulatory Structure that is guaranteed to fail due to political indecision and lack of authority, copy the EU model.
DataGovernor 120000GKJR Tags:  senate systemic agriculture risk data bookstaber governance sec cftc 4,875 Views
Agriculture is not the first word that comes to mind when contemplating systemic risk regulation, but the Senate Agriculture, Nutrition, and Forestry Committee was the gladiatorial arena for systemic risk regulation of derivatives last week. Agricultural commodities are traded on the Chicago Mercantile Exchange and the Commodities, Futures, and Trade Commission (CFTC) regulates commodities trading, and the Senate Agriculture Committee oversees CFTC. A week ago, the Senate completed nomination hearings for Gary Gensler, the new CFTC Chairman. Gary's nomination was approved unanimously by the committee, and his participation in the hearings last week on "Regulatory Reform and the Derivatives Market" was his 8th day on the job. But judging by his testimony performance, it is easy to see why both Democrats and Republicans love him. He's smooth, diplomatic, and combines left and right positions in the same sentence. Other expert testimony came from:
Ms. Lynn Stout
UCLA School of Law
Los Angeles, CA
Mr. Mark Lenczowski
J.P. Morgan Chase & Co.
Dr. Richard Bookstaber
New York, NY
Mr. David Dines
Cargill Risk Management
Mr. Michael Masters
Masters Capital Management, LLC
St. Croix, USVI
Mr. Daniel A. Driscoll
Executive Vice President and Chief Operating Officer
National Futures Association
Lynn Stout and Michael Masters presented populist, anti-establishment, arguments for regulatory reform. Mr. Masters has impressed me in the past with his presentations on derivative markets, and in his testimony he pushed hard for notional derivative clearing and exchange trading. Mark Lenczowski and David Dines toted the bank party line on the need for choice in derivative markets, the complexity of the OTC market, and the extra costs standardization of derivatives would add to transactions. Rick Bookstaber made some reasoned and logical remarks about how easy it would be to standardize derivative trading and why it would be desireable to put it into an exchange. He said that the opacity of derivatives makes them the weapon of choice for gaming the regulatory system, that banks use them to acheive investment goals that hide leverage, skirt taxes, and obfuscate investor advantage.
The key battle positions now are:
Conservative: Leave things as they are with greater capital and margin requirements, some transactional reporting. The banks contend that exchange trading is an option in today's market but that customers should decide whether they want to buy derivatives on exchanges or via OTC. Banks already face Capital and margin requirements on derivative trading, so new limits would largely impact non-bank derivative market players. An enhanced status quo seems unlikely, and I think the banks know this and thus are taking this position as a negotiating tactic to limit the Moderate choice.
Moderate: Force derivative trading into clearing houses, require capital and margin requirements, set new position limits on holdings, and use TRACE to track market transactions. This is the essence of the Geitner proposal and Mr. Gensler espoused this position eloquently. I also believe that the banks are comfortable with this solution, because they created the clearing houses and have enormous influence there. The new capital and margin requirements would make benefit the 14 primary broker dealers and if the banks are going to give up some opacity through clearing houses they want at least to ensure a cartel status for derivative dealing. Because Gensler and Geitner are already on board with this, and bank lobbyists are behind their support, I see the moderate option the most likely.
Liberal: Force derivative trading into an open exchange in which all transactional volume, price discovery, bid/ask, etc is fully transparent. This option creates the greatest market efficiencies and allows any dealer of any size to participate in a very liquid and open derivative market. In the beginning, there would be some semantic challenges packaging bespoke derivatives into mass-customized and standardized products. But the data models and technology exists to perform these data gymnastics and the industry would, over time, become adept at provide customized derivative products in standard offerings. In an exchange, it is harder for banks to game the system, and the benefits of derivative trading are more widely shared. Thus, banks want to avoid this. Unless Obama comes out in favor of exchanges, I see the Liberal option falling to the bank cartel.
The challenge with any of these scenarios is enforcing positional limits. CFTC, and the Senators, want the regulatory power to impose position limits. This would entail positional reporting and some kind of kick-back function at the clearing house or exchange to limit registered broker/dealer transactions. But the technical solution has some complexities not obvious to the untrained senatorial eye...
A derivative position is not the same as an equity position. When I own two shares of IBM Stock, they are two units of the same instance. When I own two XYZ currency swaps with the same maturity date, they are two instances of the same unit, and they may also have other characteristics that make them different. It is not possible to add up all the derivative units at the end of the day and compare them in the same way as you might with equities. You have to record each transaction and tally up the common elements, and then you need to analyze all the composite positions to determine what they mean.
One imortant thing that all the panelists missed is the fact that it is not possible to standardize derivative products, per se. It is the components and their semantic definitions that can and must be standardized. That is, a Chevy and a Ford are both cars but they are different types of cars. Yet both have standardized components (often made by the same parts suppliers) that make them subject to classification and their functions interchaneable. We need the same kind of classification of derivative components, so that every buyer and seller can set the features they want for the financial goals they have.
By standardizing derivative components, and plugging them into a configuration engine, it will be possible for an exchange to offer customizeable derivative products to any buyer and seller in the same way as banks do today via the OTC market. The conditions may vary, but the components will be interchangeable. This is the dirty little secret banks don't want anyone to know. Because when exchanges can offer mass-customized derivative products, the huge transactional fees that banks derive from the opacity of risk will evaporate...
A few months ago, the big talk in DC, NY, and among academic circles was that the CFTC would get merged into the SEC, and that the Fed would assume responsibility as the systemic risk regulator. I think that talk is now dead.
Last week, Mr. Harkin, Chairman of the Committee, and Mr. Chambliss, the ranking republican, made many mentions and requests of Mr. Gensler on his resource requirements for regulating derivatives in CFTC. Mr. Gensler mentioned that the CFTC is woefully underfunded, with only 570 people on staff, and the commission would have to double in size at least to manage the complex derivative market. Harkin and Chambliss made it quite clear that Mr. Gensler would be getting new authorities and new funding, signaling to Treasury that CFTC will remain independent and overseen by Harkin and Chambliss in Senate Agriculture, thank you very much.
Power being what it is, the deck chairs in Washington will not be changed. Systemic Risk will be regulated in parts and pieces. I predict we have Systemic Risk Governance Councils in our future and that all the major regulators will get new authorities, new funding, and oversight from the same crusty old men and women in Congress who failed to oversee and fund them correctly prior to the crisis...