The more I learn about the implementation costs and burdens of Frank-n-Dodd, the more monstrous the thing appears. These burdens will be immense, and affect virtually every company that touches derivatives, regardless of the extent of their involvement. IT. Compliance. Reporting. And on and on and on.
But Frank-n-Dodd’s chief evangelist, Gary Gensler, has often said not to worry. The greater transparency created by the law, via the mandating of swap execution facilities and clearing, will drive down execution costs for derivatives. The savings will offset the burdens of the regulation. Transparency will make the market more competitive, to the benefit of end users.
I think that the core of Dodd-Frank is to bring the benefits of transparency and risk reduction to this marketplace, which has existed for 150 years.Right now, when you enter into bilateral swap transactions, probably most of you have a handful, at most 10, counterparties that you go to. And it might be three or four. And they’re the largest financial institutions.
And I think that openness and competition will come into this marketplace because of transparency, and because for most of the market, it will have to be centrally cleared.
But later he becomes extremely equivocal about these benefits:
MR. FINK:Offstage you mentioned profits of $30 billion that Wall Street makes on derivatives. You figure that would decline to $27 billion?
MR. GENSLER: No, I don’t know what it will decline to. It might go up. What we know is that the derivatives marketplace today is concentrated among large financial institutions.
Dodd-Frank modestly shifts the needle on information because Congress thought that markets are safer and more efficient with that transparency. After the transaction, you will be able to get real-time reporting of transactions in various ways. That’s the new law, called post-trade transparency. Some portion of the market also will have some pretrade transparency, where buyers and sellers meet in platforms.
Those two forms of transparency will modestly shift some of the information advantage. When you do that, you democratize the markets a bit more. The smaller banks might compete for business with some of the larger banks, and so forth.
“[Dealer profits] might go up.” “Modestly shifts the needle on information.” “Modestly shift some of the information advantage.” “Democratize the markets a bit more.” “The smaller banks might compete for business with some of the larger banks.” Hardly stirring stuff there. Pretty limp justification of the competitive benefits of Frank-n-Dodd. Not exactly the kind of thing that suggests these transparency benefits will offset all of the other massive costs arising from the law.
The title to the WSJ article is “Keep on Hedging.” Gensler is apparently taking that advice to heart, as he is quite strikingly hedging his advocacy of the cost-reducing effects of improved transparency.
And even these benefits are likely oversold, and perhaps chimerical. Here’s just a list of some of the reasons to doubt that Dodd-Frank will actually increase competition in a way that reduces end user transaction costs, let alone by enough to overcome the huge regulatory overhead the law creates:
- Post-trade transparency–especially real time post-trade transparency, which the Commission is advocating–need not improve liquidity. Indeed, it can have the opposite effect. Liquidity suppliers will be reluctant to trade in size when their trades are exposed immediately after they are made. This will widen spreads and reduce depth.
- It is not plausible that end users are at a substantial information disadvantage for vanilla products traded in volume, such as vanilla interest rate swaps in major currencies. They have access to quotes from multiple sources, and can compare quotes for OTC trades to contemporaneous prices for closely related exchange traded products, like Eurodollar futures (for interest rate swaps) or NYMEX futures (for NYMEX lookalike swaps–go figure).
- Spreads on vanilla OTC products are very small. Margins on these products are razor thin.
- It is well known that institutional traders in many markets prefer to trade on dark markets rather than transparent ones. This is because their execution costs are lower on these markets. And “dark market” is a misleading term: as I’ve noted before, there are different kinds of transparency. Exchange trading, or SEF trading, has pre-trade and post-trade price transparency, but counterparty opacity: the prices are lit, but the counterparties are in the dark. OTC dealings, or dealings in dark markets, or dealings in block markets, have less price transparency, but more counterparty transparency. The latter works to the benefit of those who are known to be unlikely to be trading for information-driven reasons. Forcing trading onto anonymous platforms, especially order driven platforms, raises the trading costs of the verifiably uninformed, which includes many hedgers and end users. It is categorically false to say that price transparency and counterparty opacity–exchange trading–lowers the trading costs of all liquidity demanders. Some are made worse off: that’s why they choose to trade off exchange.
- This helps explain why many, many end users oppose the various mandates. It raises their costs. They aren’t stupid. They aren’t victims of battered spouse syndrome. When they oppose the mandates, they are talking their books.
- Gensler talks like 10 big counterparties is a small number. Not too many other industries with 10 major competitors.
- And if you believe those 10 firms are colluding, or would like to collude, tacitly on spreads, forcing them to trade through markets with pre-trade transparency is a great way to facilitate such collusion. Collusion is harder to sustain when buyers and seller strike deals in private. The colluders can chisel on the agreement through secret price cuts without being caught. Harder to do when prices are posted publicly: you can see when cheating occurs. When cheating can be detected, it can be punished, meaning that price transparency can facilitate collusion. Cf. NASDAQ antitrust case, Stigler’s seminal articles on collusion, the fact that the Justice Department looks with deep suspicion at price sharing arrangements, the fact that public auctions are more susceptible to collusion, etc.
- Order driven markets are prone to tipping to a single dominant platform, which can exercise market power and charge supercompetitive prices. Surely Genlser is aware that virtually every single futures and futures option contract in the US is dominated by a single exchange. Mandating exchange-like, order driven markets for vanilla OTC derivatives is likely to result in the same tipping process, and with the charging of supercompetitive trading fees by the winner-takes-all platforms.
- It is almost certain that any benefits arising from compressed spreads–to the extent that they exist, which the foregoing suggests may well not happen–will be distributed very differently from the cost burdens of Dodd-Frank. As I noted earlier, any firm that is at all involved in derivatives will have to incur substantial costs to comply with the law. These include IT expenses associated with record keeping, reporting (including the reporting of trades and positions to data repositories), regulatory compliance, oversight, etc. With regards to regulatory compliance, to achieve any relief from position limits it will be necessary to show that every transaction is a hedge, as opposed to showing that trades are “normally” used to offset price risks. Similar record keeping burdens will be necessary to demonstrate whether a company is a swap dealer or major swap market participant or not. It will be necessary to perform all these tasks, and invest in the people and IT overhead needed to perform them, if you trade modest amounts of derivatives or large amounts. Those who trade smallish amounts will not generate sufficient benefits in terms of lower trading costs–even if those costs materialize, which I doubt–to offset the regulatory overhead. Some will choose to stay away from derivatives altogether–which may be easier said than done.
In brief: (a) even Gensler is much more guarded in his predictions about the cost-reducing effects of transparency, and (b) for many market participants, transparency and mandated exchange-like trading will actually increase their trading costs. What’s more, the regulatory burden–you know, the costs that the CFTC adamantly refuses to estimate despite the requirement that it perform a cost-benefit analysis of its rules–is very likely to be crushing: you talk to people in industry, and you realize that they are afraid. Very afraid.
So remind me again why all this stuff that isn’t remotely related to systemic risk is a good idea. And only non-masochists may answer, please.