Y’all Should Have Thought About This Ahead of Time: I Did

Matt Leising and Shannon Harrington report that smaller firms are accusing the big dealers of blocking access to clearinghouses:

Rules intended to lessen the risk of a systemwide failure are “working to restrict access to only the incumbent dealers,” the Swaps and Derivatives Market Association said in a statement sent today to Theo Lubke, senior vice president at the Federal Reserve Bank of New York. The group of more than 20 brokers including Jefferies & Co., Imperial Capital LLC and Newedge USA LLC formed in February to lobby Congress and regulators for access to derivatives clearing.

Intercontinental Exchange Inc., CME Group Inc. and other companies that operate clearinghouses for the $615 trillion privately negotiated derivatives markets enforce capital requirements and trading rules intended to bolster the ability of the clearinghouses to withstand losses. Those requirements, though, prevent all but the world’s largest banks, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Barclays Plc, from sending trades to the clearinghouses, according to the statement by the brokers group.

“The effort to protect clearing, however, is actually a proxy war to limit competition to the incumbent dealers’ $100 billion in profits for derivatives execution,” the brokers group said. Mike Hisler, a spokesman for the association, and Ray Zorovich, the group’s policy assistant, are listed as contacts on the statement. Hisler also is a partner at New York- based Hexagon Securities LLC, a member of the association.

This was only a matter of time.  I’ve written academic articles dating back well into the 1990s that in the presence of large scale economies in a particular service (e.g., trading), including scale economies arising from network effects, a suboptimally small coalition of suppliers can form a cooperative firm that offers this service (see, for instance, my 1999 J. of Financial Markets and 2002 J. of Law, Econ., and Org. articles).  The cooperative is smaller than optimal, but just big enough that no competing coalition can form because it cannot achieve the same scale economies.  Because it is suboptimally small, and faces no competition, the members of the dominant coalition/cooperative firm earn rents.

I applied this argument to clearing in the early-2000s, and again in a couple of papers done in 2007 and 2008.  So, what Matt and Shannon report is no surprise to me.  None whatsoever.  It was a direct implication of the work I’ve done for going on 15 years.

Indeed, when many asked me whether dealer opposition to clearing was motivated by their desire to limit competition, I would often reply that forming a clearinghouse that limited entry was perhaps the best way to cartelize the industry, and make even more profits.

But that’s not the end of the story.  I’ve also written that there are good economic reasons to limit entry into a clearinghouse.  In particular, rigorous financial requirements are necessary to ensure the safety and soundness of the CCP.  Moreover, I’ve also written that the transaction costs/organizational costs of operating a clearinghouse will be greater, the more heterogeneous the membership: this provides further justification for limiting membership to a relatively homogeneous group of firms.  Setting margin, capital levels, etc. is more difficult, and the process more rancorous, the more heterogeneous the membership.  (The effects of heterogeneity on governance was the focus of my 2000 JLE piece on exchange organization.)

In brief: just as is the case in virtually all trading services, market structure issues in clearing are extremely, extremely knotty because of the pervasive scale and scope economies.  The pronounced scope and scale economies create opportunities for the exercise of market power, most notably by the formation of cooperative firms that restrict entry and face no competition.  This is the way that exchanges earned rents for their members for years, and years, and years.  At the same, time, open entry is particularly problematic for CCPs given the effects of heterogeneity on governance costs, and the extreme importance of financial stability.

Battles over market structure in securities have been raging for decades, due in large part to similar considerations.  Ditto recently in futures markets.  (Note the battles that raged over the CME-CBT and CME-NYMEX mergers.)

Note that this battle over entry is going to create serious legislative and regulatory conflicts because, as I have pointed out ad nauseum (including in a forthcoming Policy Paper for Cato) there is a fundamental tension between enhancing competition and reducing systemic risk in CCPs.  Conventional political economy considerations are going to play out here.  The pressure of the SDMA and other firms will inevitably lead to regulatory interventions that will open up entry and access, and thereby threaten to compromise the financial soundness of CCPs.

The irony is almost too much to take.

There are no free lunches.  None.  Only very difficult trade-offs.

Is their any evidence that any legislator or regulator has given serious consideration to this problem?  Not that I’ve seen.  But now, with clearing mandates on the horizon, there will be years of knock down-drag out fights over CCP rules, membership requirements, etc.  At every turn, there will be a tension between the systemic risk issues and the competition issues.  The results will not be pretty: they will be driven by the political economy considerations that dominate all such issues.  Economic efficiency and the soundness of the financial system will take a back seat, a distant back seat, to rent seeking.  We know how that usually works out.

No regulator or legislator can say that s/he wasn’t warned.  They just weren’t paying attention, or thinking seriously about the subject.  Oh yes, they said: just mandate clearing and we can go live on the big rock candy mountain.  As if.

For some reason Mark 6:4 just popped into my head.

I think I’ve made the analogy before on SWP, but it bears repeating.  There’s an old story about the Indian village that is beset by mice, and brings in cats to get rid of them.  The village is soon overrun by the cats, so they bring in dogs to scare off the cats, but then the dogs become a plague, so they bring in the elephants . . . and then realize that mice weren’t such a bad problem after all, so they bring back the mice to scare off the elephants.  The moral: short sighted “solutions” to a problem adopted without consideration of all of the consequences can lead to worse problems than you started with.

The criticism of CCP membership problems is just a harbinger of things to come: after too long, the mice might look pretty good by comparison.

About Craig Pirrong 223 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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