Streetwise Professor

May 13, 2011

Almost as Pitiful, Only in a Different Way

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 5:55 pm

It’s hard to know whether to laugh or cry when reading day after day the expression of newly recognized concerns about the possible consequences of clearing mandates and other efforts to re-engineer the very complex derivatives markets.  All around the world, it is dawning on this Sorcerer’s Apprentice or that one that gee, a wave of the legislative or regulatory wand may just unleash forces that they did not intend with results they may not like.  Newly recognized by some, that is.

For instance, for quite a while now I’ve pointed out that the economies of scale and scope in clearing mean that it will be highly unlikely that this sector is going to be highly competitive.  There are strong natural monopoly elements.  This is an inherent part of the economics of risk and clearing.

One Apprentice awakes to this realization:

Over-the-counter (OTC) derivatives into clearing houses must not reinforce monopolies in the clearing business, otherwise the wider economy will suffer, a British government minister has warned.

. . . .

Mr Hoban said: “But we must not allow new standards for CCPs, combined with a legal obligation to clear derivative products, to embed monopolies in clearing that will result in costs passing back to the wider economy.”

But then he proceeds to bugger up the economics completely (sorry about the language, but he is a Brit):

The comments, by Mark Hoban, financial secretary to the Treasury, are a sign of growing unease in London over a trend gathering pace globally for exchanges to have their own clearing houses in a so-called vertical silo.

. . . .

“To prevent this, our view is that, while linked structures – so called vertical silos – can be effective, they must be subject to fair and open access requirements,” he told a conference organised by Markit, a derivatives data company.

Proponents of vertical silos, which include Deutsche Börse and CME Group, the US exchange operator, say that vertical silos are efficient and that derivatives traders like the fact that they offer a single pool of liquidity in key derivatives contracts, offering more opportunities to get deals done at keener prices.

In the latest draft of Emir, circulating among EU member states, a clearing house that has been authorised to clear [OTC] derivative contracts “shall accept clearing such contracts on a non-discriminatory, and transparent, basis, regardless of the venue of execution”.

Mr Hoban said: “Market participants should be offered a meaningful choice of using all or part of a vertical structure.”

This is getting tiresome.  Again: the very fact that there are strong natural monopoly elements in both execution and clearing is exactly why vertical integration–the dreaded silo–is so common, and in fact is becoming more so (e.g., LME’s recent mooting of setting up its own clearinghouse, following similar efforts by ICE and EuroNextLIFFE).  Straightforward transactions costs economics and even some straightforward neoclassical economics (double marginalization) provide a strong rationale for integration of execution and clearing venues.

Scope economies are the only thing that really push against this.  To the extent that there are greater scope economies in clearing than in execution, vertical integration can be more costly as it means that scope economies are not fully exploited.

But the fact remains that scale and scope economies and transactions costs and double marginalization effects are going to lead to industry structures that are likely to involve a lot of concentration and a lot of integration (in part because there’s a lot of concentration).  Forcing greater use of clearing and exchange-like execution venues is only going to intensify these effects.

Bloviating about mandating “meaningful choice” doesn’t change the fundamental economic drivers.  People who regulate and legislate in blissful disregard of these drivers, and then express Shock!, Shock! that the results they engender are not what they desired are annoying beyond belief. Annoying and pathetic.

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  1. It’s rare that I find cause to disagree with this blog but whilst clearing in a product might concentrate in a particular CCP for various reasons, most particularly the network effect which naturally creates a monopoly, it does not follow that an optimal solution entails Execution Venues/Exchanges obliging their users to have to clear through the in-house CCP. Neither does it follow that CCPs should have the ability to exclude trade feeds from Venues that may compete with their own Exchange as a means of eliminating trading competition.

    Hoban is reasonably arguing that whilst users may elect to congregate around particular venues/CCPs, they should be free to choose which ones with a choice made at each layer of the trade process.

    It is easily foreseeable that Dodd-Frank [and the future MIFID2 in the EU] will create an explosion in the number of execution venues. If CCPs are able to stifle competition with their own venue by denying competitors access to their clearing facility, this will not be to the benefit of the market. Likewise, a venue that becomes dominant could similarly provide trade feeds to only one CCP thereby causing a huge distortion. In each case, the “favoured” party is not necessarily the one that would have captured top slot.

    Separately, Hoban is further arguing that regulation has to apply to all derivatives and not just OTC. Firstly it is ludicrous to differently regulate the parts of a CCP covering listed products from those looking after OTC, given they are performing identical functions. Secondly and equally importantly, the increasing convergence of such products in terms of economic exposure and risk offset [cross product margining], means to permit vertical silos in Listed products as Eurex/Germany advocate would have serious consequences for the OTC market competition. This is because only a Listed silo would have the ability to offer cross product margining, as they would have unfettered access to OTC products but which is non-reciprocal to listed, thereby denying the opportunity for OTC operators to the same service.

    Comment by John Wilson — May 17, 2011 @ 4:20 am

  2. […] on OTC clearing mandates.  The sentiment to get OTC into a clearing house is a good one.  The way they are strong […]

    Pingback by Breakfast Links | Points and Figures — May 17, 2011 @ 4:26 am

  3. @John–We can’t agree on everything, and I disagree with your disagreement:) Re optimal solution, integration (a silo) is not logically necessary, but there are strong economic considerations driving that result. Have you seen my paper (it’s several years old) on vertical integration in clearing and execution? It pre-dates the crisis, but the economic arguments carry through to the current environment. I can provide a link if you’d like. I have a shorter article in Regulation that summarizes the results.

    To put it as straightforwardly as possible (even if that makes it sound a little harsh, which is not intended), Hoban’s economic arguments against integration, and by extension yours, were discredited long ago. In particular, it has long been known that in typical situations, it is actually value-destroying to try to extend monopoly through vertical integration or tying. If, in fact, clearing is the natural monopoly element, the clearing monopoly would strongly prefer vigorous competition in complementary functions like execution. This competition increases derived demand for the monopoly service–and hence increases profit.

    This argument is a staple of the Chicago antitrust critique, and although the Chicago antitrust critique in general has been the subject of many assaults over the years (largely unsuccessful, IMO, but perhaps I’m biased), this particular argument has proven extremely robust. There have been some cute theoretical papers that identify conditions under which the basic conclusion doesn’t hold, but these primarily provide the exceptions that prove the rule. Even one of the cutest modelers, Michael Whinston, is quite modest about the models, saying that they are “possibility results” of limited practical relevance. What’s more, if you look at the specific models, they do not apply to the clearing-execution link. The closest one is a paper by Carlton and Waldman, but as I show in my paper, a suitable modification of that model does not show that vertical integration between clearing and execution is problematic.

    So, if you are right and Frank-n-Dood and MIFID II do lead to a proliferation of execution venues (which I am skeptical will happen), clearers with market power should rejoice at this and shouldn’t do anything to try to stifle it, and certainly wouldn’t want to turn away potential customers whom they could charge supercompetitive prices. This would be cutting off their noses to spite their faces.

    Which means that there’s another economic explanation for integration–one not based on monopoly leveraging. If my skepticism is correct, and network effects lead to considerable consolidation in execution too, the forces leading to integration are particularly strong.

    In brief–as if I ever am–integration is a red herring. If you are worried about economic forces making competition in clearing problematic, focus on that issue, and don’t get diverted by dodgy arguments about leveraging clearing market power into execution market power.

    The ProfessorComment by The Professor — May 17, 2011 @ 3:50 pm

  4. @The Professor I think you have misunderstood the position advanced in that whilst integration may be optimal, to mandate it via protectionist measures [or passive measures that allow anti-competitive behaviour] is wrong unless one believes that central planning models were successful. Moreover, in suggesting clearers will rejoice at a proliferation of many execution venues ignores several matters that I have witnessed first hand as a person that has been closely involved in setting up OTC CCPs.

    Firstly, there is considerable financial and resource cost to integrating with other platforms and CCPs would thus prefer to only connect with a few “winners”. Of course, they can publish an API and insist everyone conforms to their standard but that is not the only work involved in linkages. Hence, the CCP can select who it will work with and as such bestow its favours on a few if permitted. It is not necessarily the case that they will pick those which “natural” selection would have chosen via competition and will have an automatic bias to including their in-house venue.

    Secondly, CCPs will favour their in-house venues because it will create incremental revenue for the Group they belong to – they will get the clearing revenues regardless of venue used but the execution revenue is incremental if it can be channelled internally. We see CCPs deliberate stiffle execution platforms as was demonstrated when Eurex US sought to access CME CCPs but was denied given it would be competing with CME’s own platform. It is this experience that Hoban together with many others with practical experience like myself are arguing needs regulation to protect against.

    To quote another, “To put it as straightforwardly as possible” if vertical silos win out on merit so be it, but lets not rig the rules to allow for ineffective structures to prevail just because it coincides with academic studies/theory.

    As for your scepticism on the proliferation of SEFs, I guess time will prove one of us wrong. But then as my own Economics Professor would remind us on making bold assertions, it rather depends on the time frame over which we are to measure things – I think the first few years will indeed see many SEFs launch and then fail, before we see consolidation around a small number of platforms per asset/instrument class.

    For transparency, as a banking practitioner I have been intimately involved in both the development of the regulations especially in the EU, as well as in the development of over 28 OTC CCP services currently in-flight around the globe. Hence, I hope you will excuse me for sharing with you battlefield experiences and warning against the possible distortions some are seeking to implement and exploit in this area, let alone in the area of national champions and extra-territoriality.

    Comment by John Wilson — May 21, 2011 @ 1:45 am

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