Back in Black (Friday)

I have long been fascinated by Black Friday, 24 September, 1869.  On that day, a massive corner in gold collapsed, throwing the American financial system into chaos.

My initial interest in the subject stemmed from my interest in corners: the opening paragraph of my book on manipulation (#2,306,956 on Amazon!  Available on Kindle!) uses the story of the collapse of the Fisk-Gould gold corner as the hook into the subject.  The episode shows how corners work; how they can fail; and interestingly, illustrates some of the game theoretic aspects of corners.  Specifically, Fisk and Gould were in a prisoners’ dilemma, and in the event, Gould ratted out on Fisk, selling when prices were driven up at the end by a surge of Fisk buying.  When Fisk stopped buying, the price collapsed, leaving Fisk with a boatload of losses, and Gould with a nice gain.  (Gould was actually selling to his erstwhile partner Fisk in some of his trades.)

But Black Friday also relates to one of my other obsessions–clearing.  Since about 1997, I’ve used the story of Black Friday to show that (a) clearinghouses can fail, and (b) that the consequences of said failure are catastrophic.

Here’s the story in a nutshell.  Gold trading started in the US in 1862, when during the Civil War the US government issued fiat currency (“greenbacks”) and made them legal tender.  Almost immediately, there was speculation on the value of gold vs. paper dollars.  The business began in the streets of New York, but soon became big enough that interested firms and individuals started a Gold Exchange and moved the business indoors.  The business boomed during the Civil War, and the price of gold ebbed and flowed with Union military victories and reverses.

Originally, deals were settled by the delivery of gold to the buyers’ offices in exchange for cash.  This, of course, resulted in robberies, sticky-fingered messengers, etc.  So the Gold Exchange adopted rules permitting delivery of bank certificates signifying ownership of gold in vaults.  That resulted in the a fraud scandal in which a trader counterfeited gold certificates (shades of the CO2 market, circa 2009-2010!).

As a result, in 1866, a Gold Exchange Bank was chartered in New York.  The Bank operated a clearing division.  Each day, traders submitted settlement statements to the Bank.  The bank calculated net pays and net owes in cash and gold.  Traders delivered their net obligation to the clearinghouse, in exchange for net payments owed them.

The Gold Exchange Bank was not a mutual organization, like a modern CCP.  But it did back trades out of its capital.  The Gold Exchange absorbed any losses attributable to the failure of any broker, and made whole those who were owed money on the daily settlements.  Thus, like a modern CCP, it insured against default risk.

The system worked like a charm from its inception in late-1866 until Black Friday.  But on that day, clearances were many times larger than usual: the usual day saw about $80 million in clearances, but (incomplete) records for the 24th indicated clearances of about $350 million.  More importantly, several important brokers–namely those who traded for Fisk–didn’t submit reports, and didn’t pay anything into the clearinghouse.

Chaos ensued.  Those owed money were clamoring for their funds.  But there was a huge whole in the Bank’s accounts.  It owed money to those who profited from the price collapse, but hadn’t received the funds from those who had lost.  It tried to finesse the situation by paying out partial settlements to those owed money.  But a trader filed an injunction stopping the Bank from doing this, and appointing a receiver to handle the settlements.  The Bank was closed for some days while the receiver unwound the tangled mess of obligations.  The Bank ended up losing close to $500,000.

The failure of the clearinghouse brought the New York financial market to a near standstill.  Liquidity dried up, as vast sums sat in the Bank’s vaults awaiting resolution of its obligations: short term money was only available at a rate of 1 percent per day.   The freeze-up of the financial markets brought foreign trade to a standstill as importers and exporters could not obtain the typical finance.

There are other interesting aspects to the story.  For instance, the Bank’s (state) regulators were overwhelmed by the situation.

In a nutshell: a big price move makes some big traders unable to meet their obligations to the clearinghouse.  The clearinghouse has insufficient capital to make up the shortfall, and shuts down.  There are serious, broader market spillovers and impacts on the real economy: that is, the clearinghouse was deeply interconnected with the broader financial markets, and consequently, with the real economy.

An old example, yes, but an illustration that clearinghouses can fail in times of market stress, and that these failures can lead to substantial market dislocations.

The episode also provides some other cautionary lessons.  For instance, collateralization–margining–was common on gold trades.  Indeed, not only was there daily variation margining, traders often posted initial margins (“independent amounts” in current OTC market parlance).  So margining was not sufficient to prevent defaults in the face of large market moves.

In the gold market of the 1860s, the clearinghouse did not collect margins: they were collected by individual traders.  This would differentiate a modern CCP from the Gold Exchange Bank.  However, the episode demonstrates that collection of margins was not sufficient to prevent default, either by deterring default-risky speculation, or by effectively eliminating the credit in any derivatives trade.  (If the net settlements paid and received by the Gold Bank took the margins already collected by the individual traders into account, the fact that the Bank did not collect the margins itself would be immaterial.  In this case, the Bank would be on the hook for default losses in excess of margins–exactly as is the case with a modern CCP.  The historical record that I have examined is not specific on this point.)

In brief: Clearing does not preclude the possibility of Black Days, with defaults and metastasizing financial chaos.

The best primary source on the episode is testimony taken by Rep. James A. Garfield’s House Committee on Banking and Currency in its Gold Panic Investigation.  That document is available on Google Books.  There’s a lot of tedious stuff, a lot of tendentious stuff, but a few (ahem) nuggets that make the read worthwhile, especially using GB’s search capabilities.

One last thing.  In conjunction with more recent events, Congress’s investigation reveals government’s love-hate relationship with clearing.  In the recent Frank-N-Dodd legislation, clearing intended to be the panacea to prevent systemic crises.  In 1925, acting under authority granted by the Grain Futures Act, the Secretary of Agriculture forced the Chicago Board of Trade to adopt clearing in order to clamp down on excess speculation.

In the Garfield investigation, in stark contrast, clearing was routinely damned by many Congressmen as the cause of excessive speculation and a systemic crisis.  As the minority report put it:

We have no doubt that the clearing-house, which is a nuisance to legitimate traffic and commerce, and the Gold Exchange Bank, which was an instrument used for the certification of fabulous amounts not represented by money (the “phantom gold,” which played so conspicuous a part in the drama,) are obnoxious to the sweeping criticisms of the majority report.  The clearing-house gave great facilities for gambling.  Seventy millions a day was its general average, and not half of it legitimate business.

“You can,” says Mr. Fisk, “make more transactions through the clearinghouse with $5,000 than with $100,000 without it.”  Men without means are by it enabled to deal in immense sums of gold, or phantom gold. . . . The gambling hells of Hamburg are Monaco are not more pernicious as temptations.  Their evils are few compared to those inflicted upon all our country and its business by this time and labor saving machine [a description given of clearing by one witness] to facilitate gold gambling.

The majority resolved to tax the clearing system out of business:

That the Committee of Ways and Means be instructed to inquire into the expediency of reporting a bill to levy such a tax on such transactions as those of the Gold Exchange and the Gold Exchange clearing-house, as, in their judgment the interests of the country shall require.

So, depending on when you ask, clearing is either: (a) the savior of the financial system and a deterrent to destabilizing speculation, or (b) a catalyst of destabilizing speculation that threatens the stability of the financial system.  Damned if you do: Damned if you don’t.

The truth is, of course, it is neither.  Which all suggests that considerable caution is warranted in believing financial morality tales spun by Congressmen in high dudgeon, the heroes and villains of which are interchangeable from episode to episode.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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