Streetwise Professor

The clearing debate is getting more complicated, with major brokerages/FCMs clamoring to be admitted to OTC derivatives clearinghouses:

MF Global Holdings Ltd., Hexagon Securities LLC and at least 19 other financial firms are pressing regulators to force swaps clearinghouses to lower entry barriers in order to improve competition in a $605 trillion derivatives market dominated by the world’s biggest banks.

Brokers formed an association last month that hired a Washington-based law firm to pursue the issue with lawmakers and regulators, said Mike Hisler, a partner at New York-based Hexagon. They also seek tougher conflict-of-interest laws to ensure that a bank’s derivatives desk doesn’t influence clearinghouse decisions that could shut out new competitors.

There are numerous issues here that cut in different ways, and make policymaking treacherous.  Indeed, these are issues that I have raised in some of my academic work.

One issue is market power.  I’ve shown that in the presence of substantial scale and scope economies (which definitely exist in clearing), a coalition of intermediaries can form a cooperative firm to provide these services that is (a) smaller than optimal, and (b) immune to competitive entry.  The basic idea is that by adding just enough members to ensure that any other competing effort does not have the scale or scope to compete, this decisive coalition (which consists of the most efficient suppliers, e.g., the big dealers) can reap market power rents even if the cooperative itself charges marginal cost prices.  So, it is potentially problematic to permit a clearing cooperative firm to limit membership.

But there is another issue.  The whole idea behind a clearinghouse is to mutualize risk and, hopefully, to reduce systemic risk.  Admitting anybody willy-nilly is contrary to these goals.  Permitting less financially solid, not to say dodgy, entities imposes costs on the more solid ones, unless those risks can be priced effectively.  But, as I’ve argued extensively, clearinghouses typically do not have the information or the incentive to price the balance sheet risks of members properly.  Moreover, since the price setting process will inevitably be political in such an organization, it is likely (for reasons similar to what Peltzman described in his famous JLE ’75 article on regulation) that the prices will transfer wealth from the efficient to the inefficient (i.e., from the low risk to the high risk).  (A median voter-style analysis leads to a similar result.) Thus, open entry is a recipe for moral hazard–and systemic risk.  And hence, more financially solid firms have an incentive to bridle at the prospect of being required to share risk with other entities.

Allowing anybody in also increases the heterogeneity of the membership, which makes governance more costly and cumbersome.

This is just another example of the dilemmas posed by the network-nature of financial markets generally, and clearing in particular.  Scale and scope economies make competition difficult, if not impossible; efficiently scaled-entities are very large relative to the total market, and arguably natural monopolies.  These scale and scope economies can be exploited to exercise market power by limiting entry.  But permitting open entry creates its own difficulties, especially in clearing, because member heterogeneity that is inevitable with open entry, and member heterogeneity can be expected to lead to cross subsidies.  In this context, that means that some risks are underpriced, and riskier firms can expand and the expense of less risky ones.  That hardly comports with the putative objective of forcing more things onto clearinghouses.

In their rush to find a “solution” and the resulting embrace of clearing, regulators and legislators have largely ignored these very real challenges.  Mandating an expansion of clearing, and micromanaging the organization and governance of clearinghouses (as Gensler has advocated, and as the Lynch Amendment does), will involve unintended consequences.  These consequences will almost certainly undermine the ostensible objectives of these initiatives.

Again: Fools rush in.