On Hedging, Speculation and Financial Instability

Over on the Aleph Blog, David Merkel has promised a "long set of irregular posts" about what he calls "the rules." Here's an extract from the second in this series:

On to tonight’s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.

This rule is pretty simple.  There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.  In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.  There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.

The trouble occurs when the speculator can’t make good on his obligations.  As with many speculators, he overcommits.  He is short of funds because many trades are going against him at the same time.  It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.

That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.  The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.

There are really two separate points here: (i) hedging is generally possible only if speculation also occurs, and (ii) if speculators do not have adequate capital reserves, then the stability of the system is at risk.

The first point is worth keeping in mind when thinking about the regulation of derivatives. For every bondholder who purchased credit default swaps as protection, there was a counterparty betting against default. Hedging by the former would not have been possible without speculation by the latter. This kind of transaction involves the transfer of credit risk from one party to another at a price that is agreeable to both. If such transactions were not possible, then those who have the capital to buy the underlying bonds would be forced also to bear the credit risk, possibly resulting in a thinner market and increased costs of borrowing. This is the usual economic argument against curtailing the use of such instruments.

In thinking about the costs and benefits of speculation, however, it is equally important to keep in mind that the converse of David's rule does not hold: it is clearly not the case that someone must hedge in order to allow you to speculate. Two parties can enter a contract in which they are both making directional bets. Naked credit default swaps (where the buyer does not hold the underlying bond) are contracts with this character, as are put options purchased (or call options written) without ownership of the underlying stock. 

Hence, while some degree of speculation is necessary to make hedging possible, there is essentially no limit on the volume of purely speculative transactions that can be sustained by any given quantity of underlying assets. The fact that the sum total of such side bets must net to zero does not mean that the scale of this activity has no effect on prices, volatility, or financial instability. Richard Portes (via Mark Thoma) explains why:

Naked CDS, as a speculative instrument, may be a key link in a vicious chain. Buy CDS low, push down the underlying (e.g., short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity – it normally cannot issue at a rate that won’t cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this. The probability of default is not independent of the cost of borrowing – hence there may be multiple equilibria, with self-fulfilling expectations, as Daniel Cohen and I have argued.

In addition to the multiple equilibrium issue (previously discussed on this blog here and here), there is the problem of counterparty risk:

The mechanism of CDS is like that of reinsurance. The fees are received up front, the risks are long-term, with fat tails. There are chains of risk transfer – a CDS seller will then hedge its position by buying CDS. So the net is much less than the gross, but the chain is based on the view that each party can and will make good on its contract. If there is a failure, the rest of the chain is exposed, and fears of counterparty risk can cause a drying up of liquidity. The long chains may create large and obscure concentration risks as well as volatility, since uncertainty about any firm echoes through the system.

Naked CDS increase leverage to the default of the reference entity. They can thereby substantially increase the losses that come from defaults. And the leverage comes at low cost – nothing equivalent to capital requirements, no reserve requirement of the kind insurers must satisfy.

This brings us full circle to the second part of David's rule: the dangers of undercapitalized speculation. AIG was able to sell credit default swaps without posting collateral as long as it maintained its AAA credit rating. When the Lehman bankruptcy simultaneously triggered both higher CDS spreads and a downgrade of AIGs rating, the company faced major collateral calls that it could not meet. Had it not been for an $85 billion line of credit from the Federal Reserve (acting in concert with the Treasury) AIG would have entered bankruptcy and its counterparties, despite having correctly predicted the movement in CDS spreads, would themselves have taken major losses. They either failed to fully appreciate this risk, or anticipated (correctly as it turned out) that the government would not allow a failure on this scale.

That $85 billion investment has now swollen to more than $180 billion and there is a great deal of public outrage and incomprehension concerning the need for taxpayer funded payouts on privately negotiated speculative bets. William Dudley, in a speech at Columbia University last December, defended the actions taken by his employer but acknowledged that the situation was "unfair on its face... galling in an environment in which the unemployment rate is 10 percent and many people are struggling to make ends meet... deeply offensive to Americans" and "counter to basic notions of justice and fairness."

These decisions were made under enormous pressure with little time for reflection, and mistakes made in such circumstances would ordinarily be forgivable. But Dudley, as well as Bernanke and Geithner in their congressional testimony, continue to insist that the best available course of action was taken, and that any alternative would have had devastating economic costs. Even if they are correct on this point (and I have my doubts), the fact that it came to this surely reflects one of the most staggering failures of regulatory oversight in recent history.