Streetwise Professor

May 4, 2011

Another Quickie: The Regulatory Dialectic

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 3:25 pm

The LME has announced that it is considering severing its clearing relationship with LCH.Clearnet (a relationship that goes back to the Tin Crisis of the 1980s) and setting up its own clearinghouse.  This is a perfect illustration of the disconnect between market participants on the one hand, and regulators on the other.  Regulators are extremely suspicious of the “vertical silo” model, but exchanges are migrating in that direction: recently, ICE, EuronextLIFFE, and LSE have set up or moved to set up integrated clearing operations.

As I wrote years ago, both on the blog and in some academic work, vertical integration makes sense for exchanges on transaction costs grounds, even though it involves the sacrifice of some margining and netting economies, especially for relatively narrow exchanges like the LME or ICE (less so for multi-asset class exchanges like CME or Deutsche Borse).  Regulators seem a little slow on the uptake about this point, being instead haunted by hobgloblins screeching that integrated CCPs are anti-competitive (and thereby ignoring well-understood economics).

Moreover, this brings home a point I made in some things I’ve written over the past couple of years about the uncertainties of the evolution of market structure in the aftermath of Dodd-Frank and EMIR.  For instance, in the Journal of Applied Corporate Finance I wrote that “strategic considerations will influence decisively the way that the industry develops.”  By that I meant exactly that transactions-cost driven decisions regarding CCP ownership would play an important role in the industry evolution.  What’s more, these decisions will have implications for the costs and benefits of clearing, and the systemic risk effects of clearing mandates.

The financial markets are an extremely complex system.  Market participants will make decisions regarding things like clearing arrangements based on private costs and benefits, even though those will have systemic effects not internalized by the decision makers.  Legislators and regulators overlooked this almost entirely when deciding that clearing was the magic solution to counterparty risk.  As a result, they have unleashed a process that will have unintended consequences that will in turn spark regulatory and legislative responses.

This process has just begun.  It’s already complicated, and will get more complicated in very short order as dreamy regulators and legislators butt up against commercial reality.

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1 Comment »

  1. http://www.zerohedge.com/article/lucas-van-praag-dont-blame-goldman-food-crisis-blame-middle-class

    What say you, Professor? Is the Giant Vampire Squid jacking up food prices?

    Comment by pahoben lite — May 4, 2011 @ 7:23 pm

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