November saw a mini-drama involving the CME, CFTC, and DTCC about the issue of SDRs. (Acronym overload!) SDRs being Swap Data Repositories, a spawn of Frankendodd-arguably the only good thing in the Title VII litter.
CME had filed to become an SDR, and wanted to require anyone who cleared swaps through CME to report the trade to its SDR. The CFTC didn’t like the idea of tying clearing and reporting, and held things up: it had stated that the choice of SDR should be up to the customer. So CME sued. DTCC-which has its own SDR and would benefit if some CME swap deals were reported to it-filed as an intervenor in the suit.
Lo and behold, the CFTC approved the CME application, including the provision that tied clearing and reporting. CME dropped its suit, and DTCC is stomping its little feet:
“The Commission’s action late yesterday was an unexplained and an abrupt reversal of course,” the DTCC, which runs a rival swaps data repository, said in a statement.
“This action is inconsistent with the Commission’s previous actions, and will cause market participants to question the finality of any Commission rule or interpretation.”
First, issues of tying and vertical integration are cropping up all over in trading and exchanges. I just presented a paper at a conference honoring Oliver Williamson that looks at vertical integration between execution and clearing and settlement. But the issues are also present in things like data centers and reporting and likely will be present in any service exchanges offer. Regulators are hostile to these sorts of arrangements. The lesson of my paper is that there can be-and in my view, typically are-good, transactions cost economics-based reasons for these sorts of vertical arrangements. Regulators should take a deep dive into TCE and learn something about the potential benefits of vertical restrictions or vertical integration rather than continuing to indulge in their reflexive hostility to it. What’s the transaction at issue? What are the potential contractual hazards? Are the contracting and governance methods chosen to implement the transaction well-adapted to the contracting hazards?
IOW, as if (40 plus years after Coase made an observation on the subject) it is rather astounding that regulators look at every vertical restriction with a jaundiced eye.
Second, in some respects this is like Groundhog Day for me. I’ve seen this before. I came across a similar controversy in my failed attempt to create a predecessor to SDRs-an “energy data hub”-back in 2003. It was obvious then, and is obvious now, that there are substantial scale and scope economies in creating and operating an SDR, and that an SDR is a natural, multi-product monopoly. It is highly likely that the efficient form of organization would be an industry utility/cooperative, likely a non-profit.
But as I experienced in ’03, industry players see this as a great commercial opportunity, and there is intense competition to establish for-profit data hubs and regulators will not mandate the creation of a single hub or pick a winner. Hence, it is likely that in the end, in each jurisdiction there will be one dominant hub that could be quite lucrative. Hence the intense competition to be the winner in a winner-take-all contest. This competition is typically dissipative. Moreover, if multiple SDRs do survive (because, for instance, the firms play some sort of oligopoly pricing game), there will be excessive costs due to incomplete exploitation of scale and scope economies (i.e., fragmentation is costly).
Which all means that although mandatory reporting to a data hub/SDR is a good idea, as a result of political economy considerations it will be implemented in a highly inefficient way.