Friday, June 29, 2012

Interviewing Darrell Duffie on Financial Economics

The June 2012 issue of the Region, from the Federal Reserve Bank of Minneapolis, has an insightful interview of Darrell Duffie by Douglas Clement. It's worth reading the whole thing, but here are a few of the highlights that caught my eye. Except where noted, all quotations are from Duffie.


Developing a theory of inattentive investors and market volatility

"In the ideal world, we’d all be sitting at our terminals watching for every possible price distortion caused by demands for immediacy. We’d all jump in like piranhas to grab that, we’d drive out those price distortions and we’d have very efficient markets. But in the real world, you know, we all have other things to do, whether it’s teaching or interviewing economists or whatever, and we’re not paying attention.

"So we do rely on providers of immediacy, and we should expect that prices are going to be inefficient in the short run and more volatile than they would be in a perfectly efficient market, but in a natural way. I have been studying markets displaying that kind of price behavior to determine in part how much inattention there is or how much search is necessary to find a suitable counterparty for your trade."

As a vivid example of how even professional investors aren't always attentive, a footnote to the interview relates one of Duffie's anecdotes on this subject: "In his American Finance Association presidential address, Duffie refers to a Wall Street Journal article (Feb. 19, 2010) that reported, “Investors took time out from trading to watch [Tiger] Woods apologize for his marital infidelity. ...New York Stock Exchange  volume fell to about 1 million shares, the lowest level of the day at the time in the minute Woods began a televised speech. ...Trading shot to about 6 million when the speech ended.”


Reducing the need for future government guarantees on investments at money market mutual funds

In September 2008, one of the events that created panic in financial markets was when a money market, the Reserve Primary Fund, seemed likely to announce that it had lost money. Investors pulled $300-$400 billion out of money market funds in two weeks, until the government guaranteed the value of your principal in these funds. What might be enacted so that money market mutual funds don't face runs in the future? Duffie explains:

"One of those proposals is to put some backing behind the money market funds so that a claim to a one-dollar share isn’t backed only by one dollar’s worth of assets; it’s backed by a dollar and a few pennies per share, or something like that. So, if those assets were to decline in value, there would still be a cushion, and there wouldn’t be such a rush to redeem shares because it would be unlikely that cushion would be depleted. That’s one way to treat this problem.

"A second way to reduce this problem is to stop using a book accounting valuation of the fund assets that allows these shares to trade at one dollar apiece even if the market value of the assets is less than that. ...  That’s called a variable net asset value approach, which has gotten additional support recently. Some participants in the industry who had previously said that a variable net asset value is a complete nonstarter have now said we could deal with that. ... 

"A third proposal, which has since come to the fore, is a redemption gate: If you have $100 million invested in a money market fund, you may take out only, say, $95 million at one go. There will be a holdback. If you have redeemed shares during a period of days before there are losses to the fund’s assets, the losses could be taken out of your holdback. That would give you some pause before trying to be the first out of the gate. In any case, it would make it harder for the money market fund to crash and fail from a liquidity run. ...

"The SEC has a serious issue about which of these, if any, to adopt. And it’s getting some push-back not only from the industry, but even from some commissioners of the SEC. They are concerned—and I agree with them—that these measures might make money market funds sufficiently unattractive to investors that those investors would stop using them and use something else. That alternative might be better or might be worse; we don’t know. It’s an experiment that some are concerned we should not run. ...  I feel sympathy for the  SEC. It has a tough decision to make."

Addressing instability in the repo market with a public utility for tri-party clearing

The market for repurchase agreements ("the repo market") was one of the financial markets that seized up during the financial crisis in late 2008 and early 2009. Repo agreements are very short-term borrowing, often overnight. But as a result, those using such agreements often want to borrow during the day, as well. The financing for intraday trading is done by "tri-party clearing banks," and essentially all of the tri-party deals in the U.S. are handled by two banks: JPMorgan Chase and Bank of New York Mellon.

"JPMorgan Chase and Bank of New York Mellon handle essentially all U.S. tri-party deals. As part of this, they provide the credit to the dealer banks during the day. Toward the end of the day, a game of musical chairs would take place over which securities would be allocated as collateral to new repurchase agreements for the next day. All of those collateral allocations would get set up and then, at the end of the day, the switch would be hit and we’d have a new set of overnight repurchase agreements. The next day, the process would repeat.

This was not satisfactory, as revealed during the financial crisis when two of the large dealer banks, Bear Stearns and Lehman, were having difficulty convincing cash investors to line up and lend more money each successive day. The clearing banks became more risk averse about offering intraday credit. ...  [T]he amounts of these intraday loans from the clearing banks at that time exceeded $200 billion apiece for some of these dealers. Now they’re still over $100 billion apiece. That’s a lot of money. ..."

"The tri-party clearing banks are highly connected, and we simply could not survive the failure of probably either of those two large clearing banks without an extreme dislocation in financial markets, with consequential macroeconomic losses. So if you take, for example, the Bank of New York Mellon, it really is too interconnected to fail, at the moment. And that’s not a good situation. We should try to arrange for these tri-party clearing services to be provided by a dedicated utility, a regulated monopoly, with a regulated rate of return that’s high enough to allow them to invest in the automation that I described earlier."

What financial plumbing should we be working on now, so that the chance of a future financial crisis is reduced?

"And there has been a lot of progress made, but I do feel that we’re looking at years of work to improve the plumbing, the infrastructure. And what I mean by that are institutional features of how our financial markets work that can’t be adjusted in the short run by discretionary behavior. They’re just there or they’re not. It’s a pipe that exists or it’s a pipe that’s not there. And if those pipes are too small or too fragile and therefore break, the ability of the financial system to serve its function in the macroeconomy—to provide ultimate borrowers with cash from ultimate lenders, to transfer risk through the financial system from those least equipped to bear it to those most equipped to bear it, to get capital to corporations—those basic functions which allow and promote economic growth could be harmed if that plumbing is broken.

"If not well designed, the plumbing can get broken in any kind of financial crisis if the shocks are big enough. It doesn’t matter if it’s a subprime mortgage crisis or a eurozone sovereign debt crisis. If you get a big pulse of risk that has to go through the financial system and it can’t make it through one of these pipes or valves without breaking it, then the financial system will no longer function as it’s supposed to and we’ll have recession or possibly worse."

Some of the preventive financial plumbing that Duffie emphasizes would include (in the words of the interviewer): "broadening access to liquidity in emergencies to lender-of-last-resort facilities," "engaging in a deep forensic analysis of prime brokerage weakness during the Lehman collapse, "
"tri-party repo markets," "wholesale lenders that might gain prominence if money market funds are reformed and therefore shrink," "cross-jurisdictional supervision of CCPs [central clearing parties]," and "including foreign exchange derivatives in swap requirements."

Bringing the plumbing up to code in an older house is no fun at all, and bringing the economy's financial plumbing up to code is not much fun, either. But having the plumbing break under when stressful but predictable events occur is even less fun.