The Antitrust Division of the US Department of Justice just lobbed a grenade at US futures exchanges, most notably the CME. In comments submitted to the US Treasury’s review of the Regulatory Structure Associated With Financial Institutions (try fitting that on a business card), the DOJ stated that it “believes that control exercised by futures exchanges over clearing services . . . has made it difficult for exchanges to enter and compete in the trading of financial futures contracts.” The DOJ also opined that
current rules and policies related to clearing futures contracts may be unnecessarily inhibiting competition among futures exchanges . . . the detriment of the economy and consumers. . . . The Department believes that significant benefits might be achieved if regulatory policy were changed so as to foster exchange competition by . . . ending exchange control of clearing (in conjunction with appropriate regulation to ensure that clearinghouses could not in turn exercise market power.
The grenade has caused casualties upon impact. Futures exchange stocks cratered today, with billions of dollars of market cap disappearing after the DOJ blast.
Unfortunately, the DOJ letter is an appalling combination of bad economics and a selective reading of history. It is also almost impossible to reconcile the letter with the DOJ’s decision to permit the CBT-CME merger. This raises questions about the motives underlying the comments.
The fundamental problem with the economic “analysis” in the comments, such as it is, is that the DOJ does not seriously analyze why futures exchanges typically vertically integrate clearing and execution. (And note this is not a uniquely American phenomenon. As I have documented in an academic paper on the subject, integration is the rule worldwide, and separation the clear exception.) The implicit story in the DOJ comment is that (a) execution is inherently competitive, (b) exchanges that control clearing impede competition in execution by withholding access to clearing, and (c) economies of scale in clearing make it impossible (or at least, extremely difficult) for an entrant to compete against the incumbent clearinghouse.
But, as I have pointed out ad nauseum before, if clearing is actually a natural monopoly (part (c) of the argument), why wouldn’t the incumbent clearer just extract the monopoly rent by charging a supercompetitive price for clearing, and not give a whit where execution takes place? Indeed, the DOJ comment makes this very point:
If exchanges did not control clearing, an appropriately regulated clearinghouse could treat contracts with identical terms from different exchanges as interchangeable, i.e., fungible. The incentives of such a clearinghouse would be to maximize its own profits, and thus likely would treat identical contracts as fungible. In a world of fungible financial futures contracts, multiple exchanges could simultaneously attract liquidity in the same of similar futures contract, facilitating sustained head-to-head competition.
But, this argument also implies that a profit maximizing exchange that offers both clearing and execution would also have an incentive to maximize its own profits by making contracts fungible. An exchange with a monopoly clearinghouse would be cutting off its nose to spite its face by tying execution and clearing if execution were indeed competitive. By so doing, it reduces the derived demand for its services–and hence its profits–by forcing traders to execute trades on a higher cost platform. Thus, the DOJ’s assertion that exchanges integrate into clearing to deter competition in execution doesn’t make sense. An integrated, profit maximizing clearer has no incentive to force traders to execute on its platform if execution is indeed competitive.
This immediately raises the question: then why does integration occur? If integration doesn’t make sense as a strategy to deter entry, it must have some other rationale. The most plausible rationale is that it somehow enhances efficiency, by economizing on transactions costs, or mitigating multiple supercompetitive markups, for example. The DOJ doesn’t even raise this possibility, let alone address it in a serious way. Its analysis of justifications for integration in section III.D is pathetically weak, and completely untethered to any serious analysis of the economics of vertical integration and vertical restrictions.
Now, one could argue that clearing is a natural monopoly, and hence it must be regulated to prevent the clearer from exercising market power. (This is implicit in the DOJ’s call for “appropriate regulation to ensure that clearinghouses could not in turn exercise market power.”) But if clearing is a monopoly, then there is no need for the incumbent, unregulated clearer to tie execution. Thus, the DOJ’s call for “ending exchange control of clearing” in “conjunction with” regulation of a clearing monopoly makes no sense. In this case, the “exchange control of clearing” is a red herring. The ability of a clearing monopoly, integrated or no, to charge supercompetitive prices, is the central issue. By linking these two issues, DOJ betrays economic ignorance/confusion.
Now, I have shown that if execution is not competitive due to network effects, an exchange with a clearinghouse may have an incentive to tie (i.e., not make its contracts fungible) to deter entry. But, this is not consistent with DOJ’s (implicit) assertion that execution is competitive. Moreover, I have also shown that if execution is not competitive, entry may be inefficient, and in this case a tie that deters entry may actually enhance welfare. Again, no serious analysis of these issues from the DOJ.
In brief, the DOJ opinion represents a return to a long-discredited antitrust law and economics view of vertical integration and vertical restrictions, a suspicious, hostile view that deems vertical restrictions and integration as anticompetitive, rather than efficiency enhancing.
Insofar as the history is concerned, DOJ examines several instances in which entrants failed to survive in competition with incumbent exchanges. DOJ asserts–but in no way proves–that these failures were due to exchange control of clearing. DOJ says “[e]fforts over the last decade by exchanges to enter the U.S. financial futures markets . . . all of which failed, show the effect of exchange-controlled clearing.” Er, no, they don’t. These failures could have also been due to the liquidity network effect in execution. Just because entry against integrated exchanges failed doesn’t imply that the entry would have succeeded if the incumbent hadn’t been integrated into clearing. DOJ does not seriously investigate the possibility that in these instances clearing was not the crucial barrier to entry, or that the network effect of liquidity in execution was sufficient to make entry fail.
One piece of DOJ’s historical analysis is extremely dubious. It attributes Euronext.Liffe’s failure to dent the CME’s hold on Eurodollars to CME’s adoption of a rule preventing the transfer of positions from CME to LIFFE. Importantly, this occurred after several large block trades that “amounted of a large scale transfer of open interest in Eurodollar contracts from CME to LCH[which was LIFFE’s clearer].” But note well; LIFFE offered clearing (via LCH), and apparently it was economical for some traders to use LCH clearing. Thus, CME clearing was not an “essential facility” that LIFFE needed to access to compete against CME on execution. Implicit in DOJ’s argument is the assumption that integrated entry is infeasible, and no entrant can succeed without access to an existing clearing facility. DOJ’s argument would actually be stronger if no open interest had moved, as this would suggest that there was no economical alternative to clearing via the CME. The fact that (a) LIFFE offered both execution and clearing (via contract with LCH), and (b) some market participants found it economical to use LCH clearing undercuts the DOJ argument that the incumbent exchange’s control of clearing deters entry.
DOJ also points to the history of clearing in equities to suggest that clearing is the crucial bottleneck that precludes competition in execution. The DOJ comment notes that the formation of a cross-exchange clearing platform occurred in the 1970s. What the DOJ does not tell the Treasury is that the NYSE nonetheless maintained a dominant position in the execution of its listed stocks until the last couple of years. NYSE market share was on the order of 80 percent throughout this period, and most of the off-exchange volume was of the “cream skimming” variety, rather than head-to-head competition among price discovery venues. Only with (a) the socialization of order flow through the imposition of RegNMS, and (b) the NYSE’s delay in embracing electronic trading has NYSE market share declined appreciably. Moreover, a lot of the off-exchange trading (in dark pools, particularly) is execution of uninformed orders. That is, contrary to the DOJ’s assertions, the case of the equity market shows that removal of exchange control of clearing is not sufficient to ensure rigorous competition in execution. This is consistent with the view that liquidity network effects make execution relatively uncompetitive–but if this is true, the DOJ’s prescription of disintegration of execution and clearing (perhaps combined with price regulation of clearing) makes no sense.
The options market is the strongest evidence for the DOJ view. Superficially, the fact that multiple exchanges compete in the options market is inconsistent with the network effects-driven “tipping” story. But I am not sure that this superficial contradiction would survive a more detailed analysis.
For one thing, as I have shown in my JLEO paper and several working papers, multiple trading venues can co-exist when there is “cream skimming” of uninformed order flow. There is payment for order flow in options markets, and this is often associated with cream skimming. The tipping story basically implies that price discovery is a natural monopoly, and other markets can free ride off of that price discovery.
There is considerable evidence that off-NYSE trading in listed stocks (block trades, NASD trades, etc.) prior to RegNMS was uninformed, and that these execution venues were cream skimming. I am aware of no such analysis of options trades. Thus, the options market case may not provide evidence of the simultaneous existence of multiple price discovery execution venues.
For another thing, aggregate statistics on options volume are uninformative. As an extreme example, if 100 percent of options on stock X are transacted on one exchange, and 100 percent of options on another are transacted on another, it would be misleading to say that this is evidence against tipping. I know the example is extreme, and not reflective of reality, but it would be more informative to see exchange market shares for individual equity options. And even if one finds some spreading of volume in a particular option across exchanges, it would be essential to know whether one of these exchanges is the locus of price discovery, and the others are satellite, cream skimming markets.
For yet another thing, as the DOJ acknowledges, “multiple listing was followed by regulatory changes that have furthered competition in options trading, included rules that have linked option markets.” This linkage is extremely important. Linkage can socialize order flow (this is what RegNMS has done), thereby preventing any single exchange from taking advantage of the liquidity network effect.
Thus, it may well be the linkages, rather than fungibility in clearing, that are truly important in facilitating competition in execution in options. This is the lesson from the equity market. If so, mere disintegration of clearing and execution will not be sufficient to generate similar outcomes in futures markets. As I said in an editorial over a year ago, the survival of multiple execution venues may require much more far-reaching structural changes, such as the creation of a central limit order book or other mechanism that effectively creates a cross-exchange liquidity pool–that is, requires the socialization of order flow, not just clearing.
In sum, the DOJ comment makes a very weak case for its assertion that a separation of clearing (with price regulation) and execution is the magic bullet that will dramatically improve the competitiveness of futures markets. Moreover, its own analysis implies that exchanges do NOT integrate to impede competition, which in turn implies that they do it for some other reasons–reasons that DOJ does not explore in any serious way. If exchanges do not control clearing to deter entry in execution, the DOJ’s conclusions do not follow. This in turn suggests that implementing the DOJ’s recommendations could well lead to efficiency losses (as integration economizes on transactions costs.)
I am not arguing that financial market structure in general, or futures market structure in particular, is efficient. Indeed, my academic work emphasizes that network effects in execution and clearing impede competition in the trading of financial instruments. If one agrees with this assessment, simple nostrums like separating clearing and execution are not going to mitigate these problems. Instead, far more reaching measures–such as forced linkage of execution venues (socialization of order flow) or the creation of a central open entry order book and regulation of clearing fees or clearing firm structure–are necessary. But as I have also noted, these measures pose their own difficulties.
So, the DOJ either goes too far, or not far enough. It certainly does not get it right. It is disappointing that decades after the Chicago critique of traditional antitrust analysis of vertical structure that DOJ repeats the analytical errors the Chicago economists pointed out so long ago. The shoddiness of the work, its inconsistency with the decision in the CBT-CME merger, and the timing of the release all raise questions about why DOJ did this. I have my suspicions, but they are just that.
One last thing. Oddly, in footnote 1, the DOJ states “[o]ur comments are directed solely at competitive issues raised by financial futures markets. Markets for commodities futures, such as energy futures markets, are outside the scope of this comment.” Huh? Why should commodities be any different? Does DOJ believe that commodities are different? (In which case, I might add, the CME purchase of a pure commodity exchange like NYMEX and maintaining an integrated clearinghouse would not be problem.) If it believes that they are the same, why explicitly disclaim any opinion regarding commodity markets? (Does this suggest a political calculation? I don’t know, but its difficult to divine a rational, economically grounded, intellectually rigorous explanation for this separate treatment of financial and commodity futures.)