The US Department of Justice’s Antitrust Division hardly covered itself in glory the last time it weighed in on derivatives market structure when it criticized vertical integration of trading systems and clearinghouses in 2007 (if memory serves), in the aftermath of its (apparently grudging) approval of the CME-NYMEX merger. I excoriated that “analysis” on SWP, and I have been told that the posts I wrote made the rounds on Capitol Hill, causing (in the words of somebody in a position to know) one senator’s “head to explode” in anger (at the DOJ, not me) when he read them.
Well, the Antitrust Division is at it again. They submitted a comment letter in response to the CFTC’s proposed rulemaking on conflicts of interest at exchanges, SEFs, and clearinghouses. It is slightly better than the Parthian shot fired at the CME in 2007, but that is praise only in the “you don’t sweat much for a fat girl” variety, for the economic analysis in the comment is weak on the issues it discusses, and completely ignores salient economic considerations.
In brief, the DOJ recommends that the CFTC adopt a tougher rule that imposes “an aggregate ownership cap on major derivative dealers” because it fears that the absence of such a cap would “[preserve] the opportunity for these powerful entities to achieve majority ownership in DCMs/SEFs” thereby jeopardizing competition.
The Department argues that “limiting aggregate ownership and imposing stringent governance requirements . . . may prevent the emergence of a dominant trading platform controlled by major dealers to the detriment of other market participants.”
Let’s unpack that particular set of claims. Is it the “emergence of a dominant trading platform” that bothers the DOJ, or the fact that it might be “controlled by major dealers”? It is quite possible–and indeed, I would claim likely–that the nature of liquidity (specifically, its network aspects) strongly–strongly–favors the “emergence of dominant trading platforms.” If market power is the concern, who controls the dominant platform is of secondary or tertiary importance, at best. Does the DOJ believe that multiple platforms that compete aggressively are likely to emerge if dealers are precluded from controlling them? What is the basis in economics for this claim? I’m not aware of any. I would argue that the tendency for a single entity to emerge is driven by liquidity, and technological scale and scope effects (e.g., the ability to trade multiple instruments on a single platform).
There is, in fact, a stark example of this phenomenon staring the DOJ in the face: the very same CME that exercised the DOJ so mightily in 2007. The CME is not dealer dominated, but it has emerged as the dominant exchange in the US in the past decade.
This means that the Division’s belief “that an aggregate ownership cap on Enumerated Entities may facilitate competition by encouraging the creation of new DCMs/SEFs” is seriously misguided. What is going to drive market structure is the economics of liquidity (which could, in fact, be affected by CFTC SEF regulations, with exchange-like limit order book systems more susceptible to natural monopoly) and the economics of scale and scope driven by technology.
The Division anticipates this argument by saying that “[i]t could be argued that economies of scale in trading are so pronounced that derivatives markets will best be served by a single trading platform.” It then rejects this by saying “[t]his claim would seem to be inconsistent with developments in other financial markets–for example, cash equities–where multiple trading platforms have flourished.”
Two responses. First, that claim is not inconsistent with developments in most derivatives markets in the US and overseas, which are the markets of interest. Those markets are almost universally dominated by a single large exchange. (With respect to options, (a) index options are still dominated by single exchanges, and (b) in the US, for options on individual stocks, order handling rules effectively socialize order flows in a way that eliminates tipping that creates a dominant exchange).
Second, in equity markets, many of the trading platforms (e.g., dark pools) are means by which demonstrably uninformed traders reduce trading costs. As I’ve written before, it is price discovery that is the natural monopoly: dark pools and other mechanisms (e.g., internalization) that don’t contribute to price discovery aren’t subject to network effect driven economies of scale. Moreover, those mechanisms have not, heretofore, developed in derivatives markets, likely because the information intensity of trading is not as acute. Moreover, Reg NMS in US equities essentially socialized order flows and created a network of interconnected platforms, where the interconnection is mandated and regulated; prior to RegNMS, a single exchange dominated equity trading in the US, and single exchanges dominate equity trading in most other markets (that lack a RegNMS-type rule). Without a similar regulation in derivatives trading, the tipping tendency will prevail, leading to the dominance of one or a small number of platforms, ownership restrictions or no.
The kind of “competition for monopoly” story that DOJ tells (p. 6) is a more reasonable one, but ownership and governance restrictions are not going to effect one whit whether such competition occurs. Regardless of who owns a dominant exchange, there is a lot of money to be made displacing it, giving an incentive for somebody–anybody–to attempt to displace it. All that takes is money and technology, which is pretty widely available.
I also consider it ironic in the extreme that DOJ holds up BrokerTec as an example of an entity that spurred technological innovation through a competition for the CBT’s monopoly on Treasury futures. It’s ironic because BrokerTec was a dealer initiative. Similarly, the most recent competitor for the CME (which is not dealer owned or dominated) is a dealer dominated ELX, and CME’s strongest competitor in energy is the dealer-dominated ICE. And dealer dominated Turquoise has tried to oust non-dealer dominated LSE in British equities. So, if anything, dealer ownership limits would have hamstrung these competitors to dominant exchanges.
The focus on control of a dominant entity by dealers seems to reflect politics, rather than economics. The Antitrust Division’s concern should be about competition and market power generally, not about who collects market power rents. It has definitely not made the case–nor do I think it is possible to make the case–that restrictions on ownerhsip will have a material effect the magnitude of market power rents.
That said, (a) I’m not advocating intrusive regulation of competition in derivatives trading, and (b) I’m not advocating RegNMS-like rules for derivatives. I’m just saying that if your desire is to create multiple competitive platforms, something like RegNMS is necessary, and governance and ownership restrictions are superfluous at best, and counterproductive at worst.
The DOJ’s discussion of joint ventures (p. 6) suggests they just don’t understand the economics of exchanges and financial trading. They are concerned about a joint venture between dealers that admits too many members! The concern should be quite the opposite. As shown in my 2002 JLEO paper, exchanges can exercise market power by (a) admitting enough members that allow them to achieve scale economies that make them immune to competitive entry, but (b) which have fewer members than optimal. This is a consequence of the liquidity network effect. DOJ should be concerned about limits on membership, not that membership is too inclusive. The analogy between exchanges and airline alliances is completely off point.
With respect to clearing, the DOJ’s concern that restricting access to CCPs could serve to reduce competition is well-grounded; indeed, that’s exactly the kind of point I just made in the previous paragraph. I made that argument long before they did. But what is missing from its analysis is any consideration of the effects on ownership and governance regulations on (a) the willingness of institutions to commit the capital necessary to ensure that CCPs have the financial wherewithal to absorb large defaults, thereby mitigating systemic risk, and (b) CCP decisions on margins and capital levels that also impact their financial soundness and ability to withstand large price, volatility and liquidity shocks. As I’ve argued over and over, it is difficult to balance these considerations. But given that the whole purpose of clearing mandates is to reduce systemic risk, you’d think that these considerations should predominate. What’s more, it’s just inexcusable to ignore the financial safety/systemic risk issue altogether. Trade offs are hard, but ignoring them is unpardonable.
Indeed, the DOJ treats this issue dismissively: “[t]hese actions against potential new clearing members could be explained away, for example, by expressing risk management-related concerns.” Yeah, sure, somebody is likely to make that argument, and it deserves consideration rather than dismissal because these concerns are of first-order importance. Not that you’d learn that from reading the DOJ comment.
This is a very important issue, one that deserves careful, honest, and balanced analysis, none of which the DOJ provides.
With respect to governance recommendations, the DOJ comment is similarly incomplete and superficial. It focuses on conflicts of interest, but says nothing about ensuring that ownership structures align the incentives of those bearing the risk and those making the decisions. Misalignment would court disaster. To overlook this issue completely is quite disgraceful.
All in all, this is a fundamentally flawed analysis of the economics of derivatives trading and clearing, competition in those markets, and the benefits of restrictions on ownership and governance. Despite its crowing about its expertise in these markets, DOJ exhibits glaring deficiencies in its understanding of the economics of competition in trading and in clearing. As a result, if the CFTC has any sense, it will dismiss DOJ’s recommendations out of hand.
Yeah. I know.