China Reading List

Some time ago, I put together a condensed reading list of things that have most shaped my understanding of China. My hope is that this can help others who are similarly interested, or are just setting out in understanding the language, trajectory, systems, and culture of China. Help me add to it in Google, and read my additional thoughts (some of which may be dated) after the jump:

News: 
Sinocism 
zgbriefs 
Tea Leaf Nation 
Chinese Media Project 
Danwei 
Chinafile 
Truth About China 
China Digital Times 
South China Morning Post 
Haohao Report History & Politics: Patrick Chovanec - Primer on China's Leadership Transition*** Congressional Research Service - Understanding China's Political System*** Jonathan Spence - The Search for Modern China Fox Butterfield - Alive in a Bitter Sea Richard McGregor - The Party James Fallows - Postcards from Tomorrow Square Peter Hessler - River Town, Oracle Bones, Country Driving Leslie Chang - Factory Girls (Hessler’s wife, also very good writer) Jung Chang - Wild Swans Evan Osnos - The New Yorker Nicholas Kristof - China Wakes (NYT correspondent, 1980s) Dan Harris - China Law Blog Carl Walter - Red Capitalism Henry Kissinger - On China Seeing Red in China Geopolitics & Security: The Diplomat Department of Defense - Military and Security Developments Involving the People’s Republic of China Foreign Policy Foreign Affairs Center for Strategic & International Studies Strategic Studies Institute Council on Foreign Relations European Council on Foreign Relations ... this section needs some work (more experts and specific works) Economics & Finance: Michael Pettis - Peking University*** Patrick Chovanec - Tsinghua University Richard Wong - University of Hong Kong Nicholas Lardy - Peterson Institute for International Economics Minxin Pei - Carnegie Endowment for International Peace Cheng Li - Brookings Institution Andy Xie - Caixin Matt Dale - Mao Money Mao Problems Greg Canavan - Daily Reckoning Also Sprach Analyst*** Stephen Green - Standard Chartered Global Research Zhang Zhiwei - Nomura Global Research Stephen King - HSBC Global Research
Charlene Chu - Fitch Ratings (formerly) Pranab Bardhan - Awakening Giants, Feet of Clay Netizen Sentiment: Chinasmack Shanghaiist Beijing Cream Language: Skritter MDBG NCIKU Pleco ICIBA

Some basic thoughts (a snapshot of present-day China): Economics & Finance:

• National accounting identities and how they explain the China and Asian growth model and its need to re-balance, as well as why growth will inevitably slow to a much more reasonable pace.
• Low interest rates --> favor (subsidize) manufacturers and infrastructure as a driver of the economy through easy borrowing, but penalize (tax) households through low wages.
• Easy borrowing (= low interest rates) --> leads to massive hidden debt, non-performing loans in the banking sector, and fraud in investment.
• Easy borrowing + lack of retail investment options (closed capital account) --> lead to makings of a real estate bubble --> as well as a huge shadow banking sector.
• Tax on households --> leads to low consumption and an economy that heavily leans upon investment, rather than consumption --> as well as leads to financial repression
• Undervalued currency --> favors exporters as a driver of the economy.
• Balance of payments surplus --> extra capital exported abroad to fund foreign debt --> enables persistent foreign fiscal deficits.
• Domestic stability above all else, and the importance of employment (and thus the economic growth model) in safeguarding that goal.
• The internationalization of the RMB, and how the mechanics (e.g. the need for capital account reform and governance) dictate the likelihood and desirability of that happening (bilateral agreements, etc).
• The degree of accounting irregularities, misrepresentations, scandals, and fraud (also read point 3 in this article) in China that accompany its overabundance of credit.
• The influence China exerts on global commodity markets and commodity-rich nations because of its major contributions to global demand (i.e. growth, building, etc. must be fed by raw materials), and the impact rebalancing will have upon these relationships (e.g. Australia).
• The relatively cash-rich position of Chinese companies and the Chinese sovereign wealth fund, how it has lead them to seek increasing amounts of foreign acquisitions in recent years, and the political resistance they have met.
• The old story about intellectual property theft, forced technology transfers, etc. What’s ironic is that IP theft is just as much an obstacle to domestic Chinese entrepreneurs as it is to Western corporations.:
• As for innovation, I do believe there is talent here but the local governments are the biggest obstacles. I've heard from and seen too many entrepreneurs complaining about IP theft from entities controlled by local governments. If you are doing a startup and have good tech, there is a 75% chance you will somehow have a competitor that's more well-financed from the local banks and have almost the identical IP in six months. It's a tale that's told again and again. So you have this disconnect: the central government wants China to stop being the world's workshop and become an innovator, thus giving all these tax breaks and incentives; but when a local guy or an overseas returnee builds up a credible product/service, it'll be stolen from right under them by the local government. What, then, is the incentive for innovation for the little guys? -- Lloyd
• The lack of a good social safety net, which generates incentives to save, rather than to consume, further exacerbating the imbalanced economy
• China and India's linked stories on their path to economic power, and the vastly contrasting models they use to get there.
• The role of Taiwanese companies and employers in China, and the importance of China-Taiwan economic integration, especially to Taiwan.
• China's urbanization, differently tiered cities, and special economic zones.
• Poor performance of Chinese capital markets linked to a general lack of profitability

Politics & Society:

• The domestic political landscape: the obstacle that the existing landed interests, stakeholders, and lobby represent to future reform (i.e. manufacturers, exporters, owners, and those who benefited from its 1979-current growth policies).
• The influence of the Guangdong vs Chongqing development models and how they have traditionally vied with each other within Chinese policy circles (also, how the Bo Xilai incident changed the balance of power).
• China's relative attractiveness and cultural influence (soft power), or lack thereof, and how various factors conspire to send a flight of capital and emigration abroad.
• The state of education, and how it prioritizes test-taking skills, rather than inspiring innovation.
• The state of pollution
• The Party's fixation upon stability above all else, and the ways it protects that interest.
• Factors that affect the Party’s stability
• The use of employment*, as previously mentioned.
• The potential for inflation to unite key constituencies
• The party’s procedures for reporting corruption and removal of officials
• China's views towards religious freedom, and its toleration of Christianity only insofar as it counters other religions (i.e. Buddhism, Falungong).
• China's fourth estate and censorship.
• Instability in China's western provinces, and growing inequality in spite of a growing middle class.
• The tension in policymaking between the central government and local government; how incentives at the local government level causes them to constantly frustrate central government objectives
• Local government debt
• Entrepreneurial incentives (central gov’t gives tax breaks and subsidies to foster innovation, but local governments steal startup ideas)
• Housing market (central gov’t wants to curb housing prices, but local governments have a monopoly on land)
• How interwoven corruption is into the status quo (e.g. Xi Jinping's assets, the Immortal 8 families, and the Bo Xilai corruption scandal).

Geopolitics & Security (hard power):

• Japanese aggression and Chinese concessions to Western nations in the past 200 years, and their importance to understanding the aggressiveness of Chinese security policy.
• String of Pearls strategy: China's energy security concerns, and how it informs their actions and diplomacy across ASEAN, and Africa. aligning the islands, etc against or with U.S.
• The importance of the Malacca strait in establishing energy security and independence.
• Strategic investments in Africa infrastructure:
• Korean Peninsula issue: the South Korea-North Korea-China-U.S.-Japan-Russia configuration.
• Indo-Pakistani nuclear issue: the China-India-Pakistan-U.S. relationship.
• Sino-Indian relations: the Sino-Indian war over contested territory near the McMahon Line and the Himalayas.
• U.S. pivot issue: U.S. → Japan, Korea, Taiwan, Australia, ASEAN (Philippines, Vietnam, Brunei, Malaysia, Singapore, Thailand, Indonesia) somewhere in between → China; or is it not that simple?
• Island issues: the source of island conflicts in energy exploration rights
• Korea-Japan-China-Taiwan: Senkaku/Diaoyu, etc (e.g. natural gas)
• Philippines-Vietnam--Malaysia-Taiwan-China - Spratlys and Paracels
• Indian Ocean and South China Sea disputes, legal bases, and the future importance of international arbitration.
• ASEAN issues: U.S.-Australia, island alignments, Taiwan, etc.
• China's increased role in providing global security and patrolling shipping lanes.
• Comparative military strength:
• China-Japan: Shinzo Abe and the expansion of the JDF; the Japanese Navy and submarine fleet as a relative strength compared to China's; and how its demographics subtract from the effectiveness of its Army, and any potential projection of power on land.
• China-U.S.: China's (now) two aircraft carriers, development of anti-carrier missiles, its own drone technology.
• China-India: mutual assured destruction as a stabilizing factor to the region?
• China as an originator of cyber attacks, espionage, and intellectual property theft; and Western corporations encountering failed joint ventures, and forced technology transfers (e.g. Huawei and ZTE)
• China's Taiwan strategy, which involves militarily deterring the U.S., and gradual economic integration with Taiwan. The CPC is patient.

California's Biggest Issues

California Pension Funds

One of the greatest challenges is that some of California’s pension funds are structurally underfunded and short millions of dollars per year, based upon their current set of assumptions (e.g., the number of workers and retirees, average retirement age, life span, rate of wage growth, and the investment returns offered to employees).  What this shortfall means is that California’s pension systems have promised retirees more than what they are currently able to pay. 

If the California pensions funding gap does not work mathematically, how can it be resolved?  Will the promise of employee pensions simply disappear?  After all, even if total contributions increase (from employers and employees), funds would still be severely underfunded.  One possible change, lowering assumptions from 7 ¼ to 6 ¼ percent, would conceivably bring contributions up over a 10 year horizon.  In the end, whatever the State takes to fund the teachers' pension funds, for example, will likely have to come out of the classroom—specifically, teachers’ take home pay. 

Demographics and State Politics

One of the broader underlying issues is the aging population.  The growing pool of retirees and shrinking work force at national and state levels means lessening revenues and increasing fiscal burdens for governments, which provide services to retirees.  This strain on the system means that immigration, particularly of young people, will likely play an important role in California’s future.  

If a public servant wishes to be elected in California today, she is confronted with the demographic reality that the real decision makers in the state are minorities from Latin America and Asia.  Minority groups are equipped to determine their future for themselves. 

As a result, the political power struggle between certain groups (e.g., Latinos and African Americans) occurs at the lowest levels, such as school systems, often determining who gets what.  Furthermore, California’s union membership has increased in part because Latino leaders see unions (not the mayor or governorship) as their bases of power, just as African Americans did twenty years ago. 

Education

Perhaps the single biggest issue in California, related to both the pension and political demography issues mentioned above, is the school problem.  If graduation rates do not improve, L.A. risks becoming a less attractive place to live and raise a family. 

Charter schools have been a great source of improvement.  For example, half of the schools in Washington D.C. are now public charter schools.  One charter school in California implements double math and English into its 9^th grade curriculum in order to bring students, who are often three years behind at that point, up to speed.  However, they alone are not enough.

Charter schools also have untold effects on communities.  Magnet and charter school bussing often means children don’t go to school with peers from their own neighborhood anymore.  This depresses real estate prices in those areas, whereas places with their own school systems have stronger pricing, forcing parents to decide whether to send their children to charter schools, or to stay and fight.

Though other occupations are more sheltered, teachers are often the closest to the ground.  In a sense, schools feel society and determine what society is, so fixing the schools means fixing society.  The family must be the unit that sees the value in education.  If not, then there is little the government can do about it.  

Credit Ratings vs. CDS Spreads, and Which Measure is More Responsive

During the past decade, the United States suffered the worst financial crisis and the most severe recession since the Great Depression.  In response to this dire situation, the federal government took action in October 2008 to inject capital into some of the biggest financial institutions in the country.  Some individuals believe that credit rating agencies failed to adequately assess the creditworthiness of many of these institutions in a timely manner.  In short, the contention is that ratings were kept too high for too long.  As a result, investors may have relied too heavily on the ratings, and thereby suffered losses before the large institutions were downgraded.

To assess this belief, I look at the credit ratings that Fitch assigned to eight of our largest financial institutions prior to the government bailout in October 2008.  Specifically, I compare the credit ratings assigned to these institutions in 2004, 2005, and 2007, a period before the full emergence of the financial crisis and before the Great Recession.  This will enable us to determine the extent to which the each of the institutions was downgraded, depending upon the degree to which each was leveraged (i.e., the total assets per each dollar of equity capital).  Clearly, the more leveraged an institution, the greater the likelihood an institution will become insolvent for any given amount of losses.  One would therefore expect the credit ratings to decline with substantial increases in leverage.

Chart 1 shows the relationship between credit ratings and leverage for our sample of eight institutions.  Over the period examined, only two institutions were downgraded, Citigroup and Merrill Lynch, three institutions received the same rating, Bear Stearns, Goldman Sachs, and Morgan Stanley, and three institutions were upgraded, Bank of America, JPMorgan Chase, and Lehman Brothers.  In the case of the two institutions that were downgraded, Citigroup was downgraded from AA+ to AA and Merrill Lynch from AA to A+, which still were investment grade ratings.  And the other cases, all the ratings were A+ or higher.  As we eventually learned, however, Lehman Brothers failed despite its upgrade in rating after 2005, and Bear Stearns with its investment grade rating was acquired by JPMorgan Chase.

Chart 1

Source: Bloomberg.

In contrast to credit ratings, there is other information about the financial condition of big financial institutions.  In particular, credit default swap premiums (i.e., the price one pays to essentially insure against losses on investments) provide indications of the financial condition of institutions.  The higher the credit default swap premium, the greater the cost of protecting one’s investment against losses.  Chart 2 shows the average credit default swap premiums along with the leverage ratios for the same eight large financial isntitutions shown in Chart 1.  In contrast to the lack of any significant relationship between credit ratings and leverage, there is a significant positive relationship between CDS premiums and leverage.  Specifically, the CDS premiums increased to a high of nearly 80 (indicating investors would have had to pay, on average, $80,000 a year to insure $10 million against losses) from a low of just under 20 basis points (indicating investors would have had to pay, on average, $20,000 a year to insure $10 million against losses), a roughly four fold increase over the period.  Notice that the CDS premiums for both Bear Stearns and Lehman Brothers increased the most, and they were among the most highly leveraged institutions, and, as already noted, one of which failed and the other acquired by another large institution.

Chart 2

Source: Bloomberg.


The bottom line is that the CDS premiums were a much better indicator of the financial condition of big financial institutions insofar as there is a significant positive relationship between the premiums and the degree of leverage.  And it was the highly leveraged institutions that suffered the most as a result of the recent financial crisis and severe recession, with most bailed out by the government and only one institution allowed to fail.  To this extent, credit default premiums, if not a replacement for ratings, should surely be used in addition to such ratings when assessing the financial condition of large financial institutions.  The benefit of also using publicly available CDS premiums is that they are market-based measures, unlike publicly available, but yet based upon proprietary information, credit ratings.  

Collateral is the Linchpin of Modern Finance, Part I: The Shift from Retail Banking to Wholesale Banking

Over the last forty years, the banking industry has dramatically changed the way it funds itself.  At one time, banks relied almost entirely upon retail deposit funding. Under this traditional funding model, banks offer deposits to customers in exchange for interest rate payments. Banks then turn around and use the deposits to extend loans to businesses and consumers, earning profits by charging them higher interest rates than what they pay depositors.

However, this model’s weakness was its susceptibility to “bank runs” on deposits.  Whenever depositors believed that banks were in deep trouble, they would panic and “run” to the banks to withdraw their deposits.  The runs would often even affect healthy institutions, resulting in cascades of insolvencies, as banks sold assets at “fire sale” prices to meet the deposit withdrawals.  This problem was largely resolved by the establishment of the Federal Deposit Insurance Company (FDIC) in 1933.  Should banks fail, depositors are now insured against losses by the FDIC up to $250,000 per account.

Beginning in the 1970s, banks began to modify their traditional funding model by expanding their funding sources to include the wholesale markets, as shown in Figure 1.  More specifically, banks began relying more heavily on issuing short and long-term debt to other financial institutions.  This enabled banks to grow larger without relying as heavily on retail deposits. Furthermore, it enabled banks to leverage to a greater degree, and thereby potentially increase their return on equity.

Wholesale funding instruments, also known as non-core or non-deposit liabilities, include repurchase agreements, foreign currency debt, commercial paper, large-denomination certificates of deposits (CDs), federal funds, and brokered deposits.  The purchasers of such instruments are large institutions such as hedge funds, private equity firms, insurance companies, ultra-high net worth individuals, and corporations.

Figure 1 & 2

Source: Federal Deposit Insurance Corporation. 

Since wholesale funds in the form of debt are generally not insured like retail deposits, large institutions in the wholesale market attempt to achieve a comparable degree of security and safety by putting their money into high-quality collateral, such as mortgage-backed securities and government treasuries.

A problem that arises with this newer funding model is that to the extent a bank cannot roll over its short-term debt, it may have to sell off assets if it cannot obtain additional deposits or issue additional equity.  In short, if purchasers of short-term debt believe that banks are in deep trouble or collateral is impaired, they may decide to “run” away from such debt, which creates a problem somewhat similar to that which existed before the establishment of the FDIC’s deposit insurance scheme.

Ironically, this means that the modern banking system still faces runs, but no longer on just retail deposits.  Instead, as shown in the financial crisis that fully emerged in September 2008, banks are now vulnerable to runs by participants in the wholesale funding market.  In 2008, the world watched as the wholesale market seized up, and banks could not rely upon this market funding.  Banks’ ability to roll over their debt and uninsured liabilities disappeared overnight along with their ability to use repurchase agreements. As a result, the government created the Troubled Asset Relief Program (TARP) to provide funding to banks, and the Federal Reserve engaged in three quantitative easing programs.

In the course of the evolution of the banking system, the government solved one problem early on, but a new one arose in its place.  Since the modern banking model is now more dependent upon wholesale funding, high-quality collateral will likely be instrumental to finding a solution that both emulates the earlier solution provided by a federal deposit insurance system, and helps prevent runs on the wholesale market. Whatever steps regulators take next will have landmark consequences for preventing or reducing the severity of future financial crises, just as the FDIC’s introduction of retail deposit insurance did.

How the Korea Exchange Vaulted to Top, a Case Study

How did the Korea Exchange come to be amongst the world's largest derivatives exchanges?  The main factors in its strong growth were 1) the strength of its equity derivatives market, 2) the role domestic retail investors played during its early years, 3) the lifting of the cap on investment for foreign investors in 1992, and 4) the more recent rise of institutional investors.

Korea Exchange's rise to the top is due disproportionately to domestic retail (and later, foreign investor and institutional) participation in its equity derivatives market (specifically, its Kospi 200 options, which were until recently the most actively traded derivatives contract in the world), rather than due to any outstanding strength in its exchange-traded T-bond, currency, or commodity derivative markets.

In 2011, the Korea Exchange was at the top of the rankings in contract volume, with 3.748 billion, 93% of which was equity index options.  In 2012, the Korea Exchange fell a little in the rankings, but still fully 86% of the 1.835 billion in volume that year was equity index options.  Of those equity index options, roughly 28% could be attributed to retail traders, while 42.3% could be attributed to foreign entities, and 29.7% to institutional investors (as of April, 2012; 27% retail and 43% foreign in 2011).

• As a developing country, Korea initially lacked institutional investors (hedging demand), but developed strong retail (speculative) demand.  Developing markets often lack natural hedging demand, as they do not yet have enough institutional investors who can make long-term investments and manage their risk.  Retail investors originally comprised 2/3 of the equity derivatives market, driving its growth and making Korea stand out (along with India and Taiwan) from most other developing markets, which have weak equity derivative markets.  Since then, institutional players have steadily increased their presence in the derivatives market.

• Until recently, it was relatively cheap for retail investors to buy options on the index, making the equity options index key to the exchange’s rise, and key to its recent dip.  The index multiplier was low ever since the contract launched in 1997, making it cheap for retail speculative investors to trade.  The main reason the Korea Exchange recently dropped in the rankings is because regulators quintupled the nominal size of their Kospi equity index contracts, making them more expensive and damping excessive retail speculation.  Korean exchange-traded derivatives also tend to be concentrated in short-term contracts.  Long-term contracts are not even listed, meaning it is difficult to manage risk and hedge in the long-term. 

• Furthermore, widely available internet (94% of people have high-speed connections) made it easier and cheaper for retail investors to participate in the markets.  Combine that with online broker competition, low transaction costs and commission fees, the proliferation of market research sites, and a cultural enthusiasm for trading like that in Japan, and you have the makings for very active retail investor participation (and in seeking opportunities for arbitrage or speculation).

• Capital control liberalization also lifted the investment ceiling for foreign investors, enabling them to be the contributors to Korea’s capital markets that they are today.

• Fourth, consolidation and partnerships played a role in Korea Exchange’s growth, as it often does in the wider industry.  As a product of the Korean Stock and Futures Exchange Act, three markets merged to form the Korea Exchange in 2005, accelerating the growth of Korean capital markets.  Then, in 2009, Korea Exchange partnered with Eurex, enabling its contracts to be traded in Europe and the U.S., when the Korean market is closed. 

• The growth in Korea’s economic fundamentals, its integration into the global community, and value as a high beta investment play has been an underlying driver for its capital markets. 

Credit Rating Reform, Part II: Forging a Hybrid Model

Regulators tasked with reforming the credit rating industry have been hesitant to rock the ship, taking great pains to explore every possible option.  Furthermore, the fact that structured products are the main target of scrutiny, yet have been the most profitable line of business for credit rating agencies presents a considerable headwind for reforms.  As a result, talks have slipped beneath the waters, floundering along in slow motion.

Recently, we discussed a prominent “rating clearinghouse” proposal that has raised industry objections.  For a brief review of the options before regulators up to this point, please see Table 1.

Table 1: Fixing the Credit Rating Industry

Source: SEC.

The debates of the last few years have put a spotlight on the weaknesses of a range of proposals.  With that in mind, the challenge for the SEC will be to construct a model that effectively erases the conflict of interest problem, yet avoids regulatory overreach.  It must further be operationally feasible and affordable to implement.  By identifying the vulnerabilities shared by the various reform proposals, regulators may forge a more effective model from their midst.  Whatever the eventual model, it should take heed of those design constraints. 

First, it needs to effectively prevent conflicts of interest and “rating shopping,” in which issuers seek out the agency that offers the most favorable appraisal.  In order to do that, it must actually be utilized, unlike the inert Rule 17g-5 program, an early effort which failed to motivate agencies and investors to participate.  Also, solving one conflict of interest could create new ones if incentives are not managed carefully.  The investor-owned models run this risk, as investors have an interest in seeing certain rating results, just as issuers do.  One important distinction to make, when designing a solution, is whether the conflict of interest stems more from the payment mechanism (i.e., who pays the agency), or from the selection mechanism (i.e., who selects the agency).  

In the process, it should take care to avoid regulatory overreach.  As is often the case with legislation and regulation, policies can be too ambitious or aggressive, and have unintended consequences.  In this case, investors’ traditionally free access to ratings should be preserved, competition within the industry should not be undermined, and issuers should not be overly burdened. 

Third, it should be operationally feasible.  The complexity of rating deals under the new regime should not overwhelm regulators’ capacity or an assigned agency’s expertise.  Without the requisite experience, a central clearing party, or assigned agency in any one deal could cause delays, and the quality of service could decline.  Therefore, whatever system is put in place must speedily and efficiently handle the deal type and flow, and adequately compensate the rating agencies.  Preferably, it wouldn’t require legislation to enumerate new powers in order for it to work.  Questions of cost and feasibility have tended to plague the section 15E(w) program, as well as the stand-alone and designation models.    

Last, it should be affordable to implement.  Overly prohibitive costs could include the extensive resources required to form a new oversight body, or even a serious loss in market efficiency.  Even increasing the size of a regulatory agency may be undesirable at a time when government is generally trying to do the opposite.  

One approach that could effectively marshal these lessons is a hybrid model, in which issuers and investors are both stakeholders of a fund that is only responsible for collecting fees from new issuances (from issuers) and secondary transactions (from investors), and for disbursing payments to selected agencies.  Unlike the clearinghouse model, the fund would have no active role in selecting the agencies.  Rather, agencies would simply initially be placed in a continuous queue to receive rating assignments, unless they were unable to rate a particular issue.  

Along with randomization, an agency’s capacity for rating complex structured transactions would be built into the process and determined at the time of NRSRO eligibility, rather than decided later by a centralized body.  In the future, assignments would be ruled by performance.  

Chart 1: Severing the Links that Create Conflict of Interest

This solution would cover quite a few of the constraints listed above, and takes a step towards satisfying the question of feasibility.  It separates many of the links between issuer, agency, payment, and selection that typically generate conflicts of interest; and by bringing together issuers and investors as stakeholders, it balances the various conflicts of interest between raters, issuers, and investors. 

 Although it might tradeoff deal speed and volume because it would be blind to individual NRSRO competencies, it also avoids the burden of having to create a new government oversight board or clearinghouse responsible for determining assignments.  Queuing up agencies that are pre-qualified to rate structured deals would still achieve the random assignment effect.  

Though imperfect, such a hybrid model would be a step forward in a dormant effort, with strengths that reformers can build upon.

Credit Rating Reform, Part I: The State of Credit Rating Reform

Since the Dodd-Frank Wall Street reform bill became law in 2010, government efforts to cure what ails the credit rating industry have completely stalled in some areas, while inching ahead in others. In recent months, the Department of Justice initiated a lawsuit against Standard & Poor’s, accusing it of inflating its ratings and misleading investors, and the SEC convened a roundtable to contemplate the industry’s future. Yet aside from these events, the silence of the last three years has been deafening.

The core issue remains conflicts of interest.  This refers to the incentives generated by the industry’s pay structure, in which issuers compensate the agencies to rate their securities. Multiple agencies may submit ratings, but in the end, issuers select – and pay -- only one firm to grade their deals. Consequently, agencies have a huge incentive to relax their standards and submit favorable ratings to gain business, especially during a fight for market share. During the boom years leading up the 2008 financial crisis, issuers would frequently pressure the rating firms to influence outcomes.

“It would be like a figure skater bribing the judges, and they’re all giving 10s,” said Sen. Al Franken, Democrat of Minnesota.

Franken’s clearinghouse model, which is the main alternative to this way of doing business, involves creating an independent supervisory board to randomly assign and rotate work among agencies. Over time, however, performance and accuracy would determine which agencies received more work in the future.  That idea got a very cool reception at the roundtable, where some participants, including regulators and financial executives, were reticent to overhaul the system and failed to reach consensus on the pay structure question. Critics argued that a clearinghouse would run counter to the government’s objective of reducing investors’ reliance on credit ratings, and that random assignments would overlook the contours of each deal as well as each firm’s area of expertise. The view that it would infringe on the agencies’ First Amendment rights was also aired.

The lone area of regulatory progress seems to be the SEC’s effort to dismantle institutional reliance on rating agencies such as S&P, Moody’s, and Fitch (e.g. formally known as nationally recognized statistical rating organizations, or NRSROs). In the 1930s, and again in the 1970s, regulators shaped the industry’s landscape for decades to come by mandating that institutional investors must rely on the NRSROs’ ratings. Now, removing references to credit ratings from the regulatory infrastructure is intended to weaken that linkage and encourage investors to conduct additional, independent due diligence and credit analysis.

Although Franken’s proposal has become mired in a web of indecision, efforts in this area continue to plod ahead. And the SEC has not been alone in its undertaking: The Federal Reserve, the Treasury Department, and the Federal Housing Finance Agency have all proposed and adopted rules to remove references to NRSROs. This takes rulings on the industry full circle – regulators are now trying to transform what they created long ago.

One factor limiting the SEC’s ability to implement Dodd-Frank, a complex and comprehensive law, has been its chronic understaffing at all levels. Reformers also doubt the ability of recently appointed SEC Chairwoman Mary Jo White, a former Wall Street defender, to lead the process forward. The SEC “embraced the classic D.C. strategy of kicking the can down the road,” law professor Jeffrey Manns of George Washington University said about the slow progress. “The concern would be that the longer the SEC takes, the less political will there would be to see this through. The sense of urgency is not as pronounced as it has been.”

Although the SEC sometimes uses this tactic to delay rules that it considers poorly designed, the clearinghouse model deserves timely consideration. The conflict of interest issue, which Franken’s plan is designed to address, is fundamental, inescapable, and relatively self-evident compared to other problems in the financial industry, so working around its edges is a strategy that falls short. Other ideas, such as improving NRSRO governance, paring back reliance on ratings, increasing disclosure, and lowering the industry’s barriers to entry, are relevant but secondary. The longer regulators chase those half-measures, the more they risk missing the issue that truly matters.

As Sheila Bair, the former FDIC chairman, remarked during the Dodd-Frank approval process: "This stuff doesn't get any better with time.  The longer you wait to finalize the rules, the more they get watered down, the more exceptions that get built in, people's memories about the crisis start to fade, and the pressure isn't there."

Comparing the Benefits of OTC and Exchange-Traded Derivatives

Price discovery and transparency mechanisms are typically better in exchange-traded markets than in OTC markets.  This is to be expected, as electronic communication networks (ECNs) in exchange-traded markets allow for complete and immediate transactions and pre-trade price data.  Despite the presence of active brokers in OTC markets, electronic media (e.g. Reuters, Bloomberg, Markit), post-trade price reporting through TRACE, and dealer runs, OTC markets are relatively opaque.  For not only do buyers and sellers in OTC markets privately negotiate terms in relative isolation from the prices and trades occurring elsewhere in the market, but also dealers prefer at least some market opacity.  Too much price transparency would increase competition and put pressure on bid-offer spreads to a point where dealers are discouraged from intermediating.  It has been suggested that due to their undisclosed nature, dark pools may detract from heightened price transparency in exchange-traded markets.
Which market allows for more effective risk management is actually two separate matters: which is better at managing counterparty risk, and which has better at hedging risk (e.g. cash flow, fair value, or net investment risk).

It is unclear which market has the edge in terms of reducing counterparty risk.  It is crucial to understand that clearinghouses and exchanges are not the same thing—that it is a clearinghouse that allows better counterparty risk mitigation by mutualizing losses from failures, netting trades, requiring parties to post collateral, and centralizing trade reporting.  Central clearing also reduces the need for trade participants to formulate complex in-house models to manage counterparty risk.  Many large U.S. derivatives exchanges also have their own clearinghouses, so it just happens that most exchange-traded derivatives are also cleared through the exchange’s clearinghouse.  Now that regulators are enforcing central clearing in OTC markets, the balance is less clear.  It used to be that the inherent opacity of OTC derivatives and limited post-trading infrastructure hampered risk management.  Because of the private nature of OTC markets, it was difficult to assess how different institutions were interlinked and how risk exposures were distributed.

It should be noted that having central counterparties does not completely eliminate systemic risk, as the risk is simply shifted to the clearinghouse.

In terms of hedging power, it could be said that OTC markets offer greater flexibility to meet individual buyers and sellers’ risk management needs.  Due to the lack of a standardization authority, parties have greater flexibility in the terms of the trade, latitude to negotiate, customizability, and ability to use non-standard products.  OTC markets are also better testing grounds for customized products before they are standardized.

Transaction costs in exchange-traded markets are competitive with, if not lower than those in OTC markets.  This is because regulations have pushed up OTC derivative trading costs, and the greater transparency in exchange-traded markets supports more competitive pricing.  Certain listed products have huge trading volumes (economies of scale), trades are fully automated (technology), and greater trade uniformity.  In the past, OTC derivatives had a clear cost advantage over exchange-traded derivatives, due to lower fees and taxes, and the lack of margin requirements.  It was often more costly to do business on an exchange rather than off-exchange, because of the substantial margin/collateral (in the range of 5-15% of the total notional value of the transaction) requirements for clearing or trading on exchanges.