On Friday I attended a conference on OTC clearing sponsored by the Chicago Fed. The conference was excellent, and organizers Ed Nosal and Robert Steigerwald of the Fed, and Darrell Duffie of Stanford, did an excellent job of assembling a stellar group of speakers. I had the privilege of moderating (Me? A moderator?) one of the panels.
The speakers represented all of the major constituencies; sell side/dealers, buy side, end users, exchanges, CCPs, regulators. Perhaps not surprisingly, there was little consensus on important issues relating to governance, organization, capital requirements, collateral, the number or size of CCPs, or any of the important matters that still remain to be decided. It is evident that the coming months and years will be fraught with uncertainty as the industry gropes towards equilibrium in the Brave New World of Dodd-Frank.
The lunchtime speaker was Citadel founder Kenneth Griffin. Griffin gave a paean to central clearing, and to Dodd-Frank more generally. Clearing is cheaper operationally and administratively. It reduces risk. It economizes on capital. It is the cure for all that ails the financial markets.
So if it is so wonderful, what stands in the way of its adoption? Per Griffin: a small, self-interested cabal of dealers who reap billions and billions of profits at the expense of end users, and who will lose their ill-gotten gains in a cleared world.
This narrative is a familiar one, the stock theme of the advocates of central clearing. And as I’ve said on numerous occasions, this story begs far more questions than it answers. Most importantly, if the efficiencies of clearing are so manifest, and the market power losses so large, why don’t basic competitive forces undermine dealer dominance? An inefficient business, with high monopoly markups on top of that, is a juicy target for entry by more efficient suppliers. You would expect such a business to suffer erosion in market share; quite rapid erosion, in fact. But the reverse has happened to dealers in recent years, as OTC markets have grown absolutely and relatively.
Maybe competition doesn’t work, or works differently, in OTC derivatives markets. If so, it would be nice to have a convincing model, backed by empirical evidence, to explain such an anomalous outcome, so different from the received understanding in economics, and from the experience in many other industries. Needless to say, Griffin didn’t provide either model or evidence.
He didn’t help himself by quoting OCC data about concentration in US OTC markets. This is akin to the drunk looking for his wallet under the lamppost. The OCC data are readily available and easy to use, but they are incomplete because they only cover US banks. More comprehensive surveys indicate that there are currently 10 or 11 major international dealer firms; there were 14 prior to the crisis. I’d be interested to hear Mr. Griffin identify other industries with 10-14 major competitors, and argue that they are similarly uncompetitive.
Moreover, it is well known that concentration figures can be very misleading measures of competitiveness. They do not measure the effects of potential competition. Moreover, concentration ratios are endogenous. As Demsetz showed long ago, industries can become concentrated and profitable as efficient producers gain market share at the expense of less efficient rivals.
It’s not just me, folks. After Griffin’s talk, I chatted with an economist, a former colleague with a very responsible non-academic policy and research-oriented job who was unpersuaded by Griffin’s jeremiad. This individual said: “He ignores the IO [industrial organization] questions.” Exactly. Why is the industry organized this way? Why doesn’t competition erode market power and market power rents? Why don’t putatively more efficient organizations and institutions (clearing, in Griffin’s view) displace less efficient ones? Why do the inefficient survive?
He brought up energy, in which clearing has made strong inroads in the past 8 years, to bolster his point. The problem is that the case of energy suggests quite the opposite. Clearing grew in energy naturally, organically, without a push from Dodd, or Frank, or the Fed or anybody else. If this can happen in energy, and this is efficient, why can’t it happen in other sectors of the OTC market?
Inquiring minds, open to persuasion, want to know. Griffin didn’t deliver. What he did deliver was a sermon, complete with saints and devils.
Moreover, the Citadel commander’s argument presumes that end users–who, as he properly notes, must be the ultimate source of any dealer market power profits–are the victims of some sort of battered spouse syndrome. For end users are among the most vociferous opponents of clearing mandates. FMC Treasurer Thomas Deas was quote outspoken on this score at the session immediately prior to Griffin’s speech. Why are end users the most ardent defenders of a system that is supposedly rigged against them, and robs them blind?
Griffin also failed to analyze seriously the trade-offs of alternative ways of allocating and pricing counterparty risk. No suggestion of any comprehension of issues relating to the information and incentives to price and manage counterparty risk. No mention of moral hazard or adverse selection. No discussion of how the industry will evolve and how this will affect the ability of clearing to realize its full potential. Most importantly, no mention of the potential systemic risks in clearing–a point mentioned prominently in the opening remarks at the conference delivered by Chicago Fed President Charles Evans.
He did acknowledge objections to clearing mandates–but in an incomplete way, and in caricature.
If the substance was, to me, unpersuasive, the delivery and tone were off-putting in the extreme. ”Supercilious” hardly does it justice.
The serious people who spoke on all sides of the clearing issue during the conference proper raised many interesting arguments and issues. They made it plain that the way forward will be complex, and that it is by no means evident that the way mapped out by Frank-n-Dodd will improve the efficiency, stability, and safety of the financial markets. Griffin’s talk was, in contrast,unserious, one-sided, and ultimately unconstructive. Manichean sermons, delivered in sneering and belligerent tones, are like that.