Streetwise Professor

February 14, 2008

Craig Says . . .

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 9:39 am

No, another Craig–Craig Donohue, CEO of the CME. In fact, though, in his speech today, that Craig–Craig D.–echoed some things that this Craig–Craig P.–has written in several working papers on clearing.

In his full-throated defense of integrated clearing, Donohue said:

[T]here has not been sufficient discussion of the potential problems associated with an investment bank-owned/controlled CCP. While one can reasonably argue that some exchange-owned CCPs may seek to extract monopoly rents, one must also be willing to acknowledge that investment bank-owned CCPs may limit CCP activities in some markets in order to maximize trading and dealing profits for their owners at the expense of smaller members of the CCP and true end-users.

I made a related point here. Donohue also said:

These problems exist in large part because investment banks traditionally have resisted a more centralised, transparent execution system for these products, preferring to maintain their dealer franchises and proprietary trading profits. And they have tended to oppose central counterparty clearing services in these markets, worried that a mutualised risk structure will dissipate their credit and balance sheet advantages.

I made a similar point in a 1999 working paper (cited here by current Fed Governor Randy Kroszner) that morphed into this paper.

Relatedly, the Federal Trade Commission Report on the Grain Trade of 1921/1922 reported that concerns that central clearing would level the credit playing field was a source of opposition to the adoption of the clearinghouse at the CBOT in the ‘teens and twenties.

Stepping back a bit, it is important in this context to remember Coase’s point that it is necessary to compare real world alternatives, not a real world situation to the Nirvana alternative. Too much of the debate on clearing has compared the existing clearing arrangements to a pie-in-the-sky alternative (with crucial implementation details conveniently left out.) Donohue makes appropriate comparisons. He acknowledges that a central clearer may exercise market power, but draws attention to the point that alternative clearing arrangements may also result in the exercise of market power.

That’s a major theme of my most recent paper on clearing silos. There I show that seemingly innocuous differences–such as, whether a cooperative clearer owned by banks rather than an exchange rebates fees proportionally to output, or instead rebates fees to owners proportional to fixed ownership shares–can have a major impact on market power, with the latter arrangement essentially allowing the “cooperative” clearer to operate as a perfect cartel. Moreover, as I have pointed out in other articles (namely, my JLEO and JFM papers on exchange organization) a “not-for-profit” firm (be it an exchange or a clearer) can effectively exercise market power by restricting membership; in this case, the market power rents are not earned by the firm itself, but by the members.

So, let the debate continue–but when considering alternatives to exchange-owned clearing, let’s focus on how those institutions might work in practice.

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