Streetwise Professor

December 5, 2006

I Can See Clearly Now

Filed under: Derivatives,Exchanges — The Professor @ 12:35 pm

There is an old expression in the military: “Amateurs talk tactics. Professionals talk logistics.” There is a clear parallel in the financial markets; although the logistics of derivatives markets–clearing–attract little popular attention, they are matters of prime importance to market professionals.

The CBT-CME merger is bringing clearing into the public eye, however. This previously arcane issue has taken center stage in the debate over the the desirability of the merger. Former SEC chief economist (and academic) Larry Harris has opined that the CME’s ownership and control of clearing impedes competition in derivatives markets. He is seconded by PHLX president Meyer Frucher in his jeremiad against the merger. Moreover, (per a report in Crain’s Chicago Business) the Department of Justice is allegedly focusing its attention on the CME’s clearing operations.

The battle cry of Harris, Frucher, et al is “Fungibility!” (Not quite “Remember the Alamo!”) In essence, they argue that the clearinghouse is an essential facility, and by restricting access to the essential facility CME impedes competition for its futures contracts. If CME were to open access to its clearinghouse, it would allow other exchanges to offer contracts that were perfect substitutes for CME contracts, that is, were fungible with CME contracts. This would allow competition in futures trading, and in Harris’s phrase, “break the futures monopoly.”

There are several problems with this analysis. First, it implicitly presumes that the market for futures execution would be highly competitive, but for restricted access to the clearinghouse. However, due to the network effects of liquidity, this assertion is problematic. (I return to this issue later.)

Second, this argument is very retro. BC–Before Chicago (School)–in fact. It is a re-hash of the monopoly leveraging argument demolished by Chicago economists and legal scholars in the 1960s and 1970s. If the monopoly bottleneck is at the clearing level, the clearing operator would actually like to encourage competition in execution. This would increase the demand for clearing services by reducing the costs of execution services that are complementary to clearing. This would allow the clearing monopoly to charge a higher price for its services. Put differently, if clearing is a natural monopoly (as the essential facility/bottleneck arguments implicitly assume–and for which there is a reasonable basis), the operator of the clearing facility can extract the entire monopoly rent by pricing clearing services appropriately, and has no incentive to force a putatively inefficient organization of complementary activities, such as execution. If there are no scale economies in execution, or if there are scale diseconomies, integrating into execution actually reduces the clearing monopolist’s rents.

As the Chicago School scholars noted long ago, this reasoning leads to a presumption that there is an efficiency rationale for the vertical integration of clearing and execution. I set out the sources of efficiency in my Silos post from the summer. In a nutshell, integration eliminates double marginalization problems, and reduces transactions costs.

So what can be done? Merely requiring the CME to allow other exchanges to access its clearinghouse would not change things even if the merger’s critics are correct. The exchange can merely charge the monopoly price for clearing services. Thus, it would be necessary to regulate clearing prices and terms of access very intrusively in order to reduce the exchange’s market power. For anyone who doubts who messy this can be, just take a look at the experience of the regulation of access pricing and terms in telecommunications. This is an invitation to rent seeking and litigation (and rent seeking litigation), and will likely discourage innovation by the clearing operator. (I doubt that the DoJ has the power to impose such price and access regulations in any event.)

Similarly, attempts to increase competition in clearing by forcing the CME to eliminate its rule requiring contracts traded on the exchange to be cleared through the CME clearinghouse would be unlikely to have much of an effect. Due to the strong scale and scope effects in clearing, this function is (as argued by the fu(ngibility) fighters) a natural monopoly. Moreover, due to the specific assets and sunk costs associated with clearing, and the costs of coordinating a simultaneous defection of sufficient numbers of clearing customers to generate network economies, it is not likely to be a contestable one. Thus, the incumbent clearer would likely prevail over any entrant. And in the unlikely event that the entrant did prevail, users would be flung from the frying pan into the fire–from one monopoly to another. Moreover, this would entail additional costs–double marginalization and higher transactions costs.

So what about a more radical alternative? For instance, forcing the CME to divest its clearinghouse as a condition of the merger? In order to improve welfare, somehow it would be necessary to organize the (monopoly) independent clearing entity so that it would not exercise market power. One possibility is to organize the clearer as a user-owned cooperative that rebates revenues in excess of costs to its users. (The OCC and NSCC work this way). In theory, the cooperative could price its services at marginal cost, and fund its fixed costs through fixed assessments on its members. Alternatively, non-linear price schedules with inframarginal prices in excess of marginal costs and marginal cost pricing for the marginal unit would be efficient and cover fixed costs. Either alternative would lead to competitive pricing of clearing services.

Nirvana? Not so fast, chief. Two big problems.

First, the non-profit clearer could still exercise market power. How? By restricting access. My 1999 Journal of Financial Markets and 2002 Journal of Law, Economics, and Organization papers showed how non-profit cooperatives can exercise market power by restricting membership. In a nutshell, the big clearing brokers (e.g., the big banks and investment banks) could form a clearing utility, and impose unnecessarily burdensome financial requirements on membership. This would restrict entry into clearing services, and raise the price of these services above the efficient level. To the extent that the execution entity also has market power, this would result in double markups. Moreover, it would raise transactions costs (in the relationship between the clearing and execution firms.) Therefore, it would be necessary to pay close regulatory attention to the access and membership admission policies of this clearing entity. This is not a trivial task, by any means. Given the systemic implications of clearing for the stability of the financial system, financial standards for members are obviously desirable. Who is to evaluate the trade off between the effects of tighter/looser standards on financial stability vs. the pricing of clearing services? Any volunteers? Any confidence that the evaluation will be the right one? Not by me, that’s for sure.

Second, due to the network effects in trading I alluded to earlier (and which I have analyzed in great detail in my 2002 JLEO piece and several working papers) make it almost certain that even an exchange shorn of its clearing function can exercise market power. That is, the centripetal force of liquidity induces trading to concentrate on a single exchange. This confers market power on the incumbent exchange; it is very costly to coordinate a simultaneous defection of order flow sufficient to overcome the liquidity incumbent’s advantage.

This means that even if, through some miracle of economic organization, the clearing cooperative charged marginal cost prices and admitted the “right” number of members of the “right” kind, the exchange would still likely be a monopoly, and earn all the monopoly rent. That is, the clearing integration issue is a red herring. The CME is not a combination of a natural monopoly clearer with an execution facility that would be a near perfect competitor if shorn of its clearinghouse; it is a natural monopoly clearer merged with a natural monopoly execution facility. Indeed, as I argued in Silos, that is exactly WHY they are integrated. Integration addresses the problems posed by bilateral monopoly.

For evidence that an execution-only exchange with no clearing function can exercise market power, look at the London Stock Exchange. LSE has no clearing or settlement function. It gets clearing services through LCH.Clearnet. LSE has faced competition in the past–like Tradepoint–that failed miserably. It maintains a dominant market share in the trading of the stocks it lists. Despite all the flack that Deutsche Borse gets over its integrated clearing and trading, guess who has the bigger margins–LSE. It has the highest fees of any of the major world equity exchanges, and has higher margins (66 percent) than Euronext (60 percent) or DB (58 percent).

In sum, disintegrating clearing and trade execution is no silver bullet that will make futures markets perfectly competitive. As Posner, and Bork, and other Chicagoans who wrote on antitrust long ago noted, vertical integration should not be a focus of antitrust concerns. Vertical integration is almost always a way to economize on transactions costs or double markups. In my view, this is true in futures markets (and equity markets, for that matter). Vertical integration has long been the dominant form of relationship in futures execution and clearing, for exchanges large and small. This reflects transactional efficiencies, not monopoly leveraging.

If competition is imperfect in futures (and equities) markets, this imperfection arises from the strong scale, scope, and network economies in trading and clearing. At best, disintegrating clearing and execution will just allow the execution entity to capture the rents that arise from the imperfect competition. At worst, disintegration will increase transactions costs and the fees that participants pay (due to double markups). What market forces have joined together, let no man put asunder–without a compelling economic case for doing so. So far, the fungilistas have not done so. Indeed, in my view the compelling arguments are all on the other side.

December 3, 2006

An Inconvenient Truth?

Filed under: Climate Change — The Professor @ 12:08 pm

Recent research shows that the ocean’s heat content declined substantially in 2003-2005, losing in these two years 20 percent of the heat that built up in the 1955-2003 period. This is embarrassing, to say the least, to advocates of the anthropogenic global warming hypothesis (especially NASA’s James Hansen, who has argued that “missing” atmospheric warming he’s been predicting for nigh on to 20 years is due to the ocean soaking up huge quantities of heat.) So, NASA has to spin mightily to explain away these results:

The average temperature of the water near the top of the Earth’s oceans has cooled significantly since 2003. The new research suggests that global warming trends are not always steady in their effects on ocean temperatures. (Click NOAA image for larger view of Sea Surface Temperatures for the Western Hemisphere for Sept. 20, 2006, taken at 10:59 a.m. EDT. Click here for high resolution version. Please credit “NOAA.”)

Although the average temperature of the upper oceans has cooled significantly since 2003, the decline is a fraction of the total ocean warming seen over the previous 48 years.

“This research suggests global warming isn’t always steady but happens with occasional ‘speed bumps’,” said Josh Willis, a co-author of the study at NASA’s Jet Propulsion Laboratory, Pasadena, Calif. “This cooling is probably natural climate variability. The oceans today are still warmer than they were during the 1980s, and most scientists expect the oceans will eventually continue to warm in response to human-induced climate change.”

Note the assertion that the cooling is due to natural climate variability–but the previous warming is (implicitly) assumed to be man-made. And it is only an assertion on top of an assumption. Where is the evidence that rejects the null hypothesis that the 1955-2003 warming was due to natural climate variability, in favor of the alternative that it was anthropogenic in origin? If the impact of anthropogenic greenhouse gases is so dominant relative to the natural variability of the climate, how could the latter overwhelm the former? This is a lame rationalization of results that contradict the dominant paradigm–something that should be familiar to anyone who has read Kuhn.

I also note the different standards applied to evidence that contradicts the AGW paradigm and the evidence that supports it. I have read in major media sources reports of numerous studies which document very short-lived trends, such as increases in temperatures or decreases ice over two or three year periods, that are trumpeted as evidence of global warming. They are never explained away as naturally-occurring “speed bumps.”

One last point. In his book Stochastic Climate Theory, Russian scientist S. G. Dobrovolski notes that many climate variables that are averaged over large geographic areas (like ocean heat content) are indistinguishable from random walks. That is, they are integrated time series. Equivalently, they have unit roots. This means that these series tend to exhibit large swings that appear trend-like. They increase for many years, and then may decrease for many years. (It is sometimes said that integrated time series exhibit “stochastic trends.”) That is, long periods of increases in one of these time series may merely reflect their natural time series dynamics, and may not be due to human forcing.

Carbon dioxide has been trending up for years. So has ocean heat content. Both series are essentially integrated. Regressing one on the other will almost certainly result in a highly statistically significant relationship between the two variables–but this regression is spurious. It says nothing about causation.

I recognize the virtues of using ocean heat content as a measure of global climate. As Roger Pielke, Sr. has noted, it is not contaminated by the effect of land use changes or urban heat islands or other factors that can distort temperature readings from land-based weather stations. However, as a globally averaged variable that per Dobrovolski is likely to be integrated, it is also very difficult to use as a measure of the impact of greenhouse gases on climate trends.

Easier Said Than Done

Filed under: Exchanges — The Professor @ 10:58 am

Two weeks ago seven major banks announced their plans to form an electronic stock trading platform to compete with LSE, Euronext, and Deutsche Borse. The seven, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS, have launched Project Turquoise, and will hold shares in the venture. Other reports indicate that the Swiss SWX exchange is willing to provide the technology platform for the venture, and that Swiss group SIS has offered clearing services, although the banks have not had “concrete” talks with either party.

Previous attempts to challenge incumbent European equity exchanges have failed ignominously. Neither Tradepoint in the 1990s nor the LSE’s Dutch equity endeavor generated appreciable volumes. The experience has been similar in derivatives markets, with Eurex’s success in the Bund the exception that proves the rule. The combination of technological differentiation, Eurex’s owners’ control of substantial order flow, and LIFFE’s playing the role of the hare in the exchange adaptation of Aesop’s Tortise and the Hare, allowed Eurex to prevail.

That said, Turquoise has a decent shot at success. Most importantly, the participating banks are responsible for a substantial fraction (an estimated 50 percent) of European equity trading, and hence have control over large order flows. As I argued in my papers “Bund for Glory” and “Upstairs, Downstairs,” the ability to coordinate the movement of order flow to a competing trading venue is necessary (though probably not sufficient) to unseat an incumbent exchange.

LSE, Euronext, and Deutsche Borse shares all fell substantially on the release of the news about the new venture. I expect a period of fierce price competition following Turquoise’s launch. Indeed, to avoid repeating LIFFE’s error of failing to respond to Eurex’s price cuts, it is likely that the incumbent exchanges will cut fees preemptively. This will cost them considerable revenue–hence the stock price declines. In the end, however, I predict that the incumbents will prevail unless they make a serious strategic mistake. Moreover, I predict that exchange fees will rebound when Turquoise exits, just as occurred in the US when Eurex and Euronext.LIFFE surrendered in their challenges to the CBT and CME, respectively.

One further thing of interest in the Turquoise venture: it is essentially a mutual/cooperative, like traditional exchanges that were owned by the brokers and market makers that traded on them, and in contrast to the modern for-profit, investor owned exchanges. Moreover, the participating banks are relatively homogeneous. The cooperative form is a traditional way for homogeneous groups of consumers to circumvent market power; farmer elevator, seed, fuel and fertilizer cooperatives were formed largely to undercut incumbents’ market power in these goods and services. There is a key difference, however. If Turquoise succeeds, due to the nature of liquidity it will supplant one or more of the incumbent exchanges as the (near) monopolist in some segments of the European equity trade. The member banks will capture the monopoly rents from the incumbent’s owners. The successful farmer cooperatives increased competition and undercut existing monopolies, but did not create monopolies of their own. In the event, Turquoise’s entry may actually reduce welfare; the entry will likely not reduce deadweight losses over the longer term (as one monopoly supplants another), but it will utilize real resources in the attempt to capture the monopoly rent. Given the fat margins that exchanges reap, it is a fair bet to spend a substantial amount to create a competing trading platform even if the odds of successfully supplanting the incumbents is fairly small.

December 2, 2006

Russian Roundup

Filed under: Commodities,Politics,Russia — The Professor @ 10:50 am

So much Russia-related news, so little time. At the top of the list, of course, is the Litvinenko story. I can do no better than Russian commentator Leonid Radzikhovskiy:

In the case of Litvinenko, there are so many things that are absolutely incomprehensible – especially from the sidelines – that to try and play the role of a self-styled Dr Watson would be absurd. And I wouldn’t dare to try my hand at Sherlock Holmes.

There are many theories, but few facts. [NB. The morning after I posted this, Edward Lucas said that the Russian phrase “Nyet faktov, tolko versii”–no facts, only theories–fits the situation perfectly. Here, here–great minds!] To extend the Holmes analogy, these are akin to the story of Holmes, Dr. Moriarty and the London-Dover-Canterbury train. Putin had him killed. No, somebody had him killed to make Putin look bad. No, Putin had him killed to make it look like somebody was trying to make Putin look bad. And on and on. I think people should chill until more facts are in evidence.

Regardless of which of these theories–or some even wilder possibility that no one has yet thought of–is correct, one thing is certain: Russia is not a normal country where powerful people play by even slightly civilized rules. Pick your poison: murder by the security forces at the Kremlin’s behest; murder by a rogue element in the security forces; murder by an oligarch; some dangerous plot that backfired on its perpetrator. Every alternative is depressing, and makes one despair for Russia and for everyone who intersects Russian interests in any way.

And much news about Gazprom. The excellent Edward Lucas notes that Gazprom is terribly inefficient, and that as a result Russia faces a gas shortage–which would make it highly unreliable as a supplier to Europe and Asia. Leon Aron of AEI similarly notes the stagnation (at best) of Russian energy output in the aftermath of the Kremlin’s de-privatization of the energy sector. The combination of subsidized domestic gas prices, a Kremlin push to encourage substitution of gas for other fuels (both of which encourage domestic consumption), a decaying infrastructure, and niggardly investment in new capacity all threaten to constrain sharply the amount of gas available for export. There was some talk of raising domestic prices, but that plan has supposedly gone by the board.

Moreover, Russia is supposedly attempting to form a cartel of gas exporting nations. Although Kremlin spokesmen deny this, their denials are risible. They prattle about the “interdependence” of producers and consumers, and say that only a “madman” would do anything to harm its customers. Err, monopolists and cartels exist to harm customers by forcing them to pay excessively high prices. Interdependence my eye. Gazprom’s strategy is to increase European dependence on Russian gas by constraining output of alternative suppliers, or denying the access of these suppliers to the European market (by buying up strategic pieces of the European gas infrastructure).

The Russians repeatedly present the image of symmetry between demanders and suppliers (“mutual interdependence,” “security of demand and security of supply are equally important”) but there is no symmetry here. A fragmented consumer and industrial side with myriad relatively small demanders is in no way symmetric to a highly concentrated supply side. The Orwellian phrase “security of demand” so often repeated by Putin and the Gazpromniks really means: we want no competition; we want to ensure that there are no substitutes for what we sell; we want to make sure that you have to deal with us on our terms.

There are certainly circumstances where a buyer and a seller are locked into a bilateral relationship due to their investment in specific assets, and where there is a symmetric threat of opportunistic holdup. This is not the case here. There are many competing buyers of gas who cannot individually holdup Gazprom. There is one Gazprom that can holdup its customers.

The lack of Gazprom investment in upstream production noted by Lucas, Aron, and this Washington Post article likely arises from a variety of factors. First, a firm with market power restricts output. Not investing in capacity is a credible way of constraining production. Second, as a majority state owned company Gazprom is largely free from capital market discipline. Third, and relatedly, it faces the free cash flow problem from hell. The company throws off huge amounts of cash, which permits its managers to do pretty much what they damn well please without having to satisfy investors. Hence, according to the WaPo article, the company spent $18 billion on non-gas acquisitions, or about 6 times what it spent on investments in gas.

Moreover, I surmise that management’s discount rate is very high. In an environment as volatile–and deadly–as Russia is today for both the ordinary man or the very powerful, planning for the distant future is probably not a high priority. Get what you can today, and let the very tenuous tomorrows take care of themselves. Such circumstances are not exactly conducive to taking the long investment view–and there are few industries where the long view is more relevant than energy given the size of the projects, and the length of the exploration and development process.

The WaPo article also mentions that Gazprom’s pipeline construction costs are two to three times industry norms. To me this suggests a Credit Mobilier-Union Pacific type situation, where inflated prices for materials and equipment flow into the pockets of companies owned by Gazprom managers. Just thinkin’.

Before leaving this Gazprom rant, I have to mention the hilarious statement of Gazprom Vice Chairman Alexander Medvedev: “We are not an instrument of policy because it cannot comply with our commercial structure.” Stop it, Alex, you’re killing me! (That’s a figure of speech there, Alex old buddy. Don’t get any ideas. Can’t be too careful.)

I guess I have time for one more Russia story–there are many more that will just have to wait for another day. Peter Hambro Mining’s (subscription required) share price fell 14 percent after the Russian government threatened to revoke some of its licenses to mine and produce gold. The head of the natural resource ministry’s environmental regulator, Rosprirodnadzor, cited two (somewhat contradictory) explanations for this action: environmental law violations, and a failure to develop projects rapidly enough. As if revoking the licenses is going to expedite the development of these properties.

Another day, another holdup. Rent seeking run amok. Another short sighted decision that will further erode confidence in the security of investments in Russia–another manifestation of the truncation of time horizons in a land where life is too often brutish and short.

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