Streetwise Professor

April 3, 2015

BATS in the OCC’s Belfry?, or The Perils of Natural Monopoly Regulation, CCP Edition

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 11:13 am

The Options Clearing Corporation (“OCC”) and the exchanges that own it (Chicago Board Options Exchange, Incorporated, International Securities Exchange, LLC, NASDAQ OMX PHLX LLC, NYSE MKT LLC, and NYSE Arca) are embroiled in a dispute with virtually everyone else in the options business regarding its new capital plan. Pursuant to its designation as a “Systemically Important Financial Market Utility” (“SIFMU”) under Frankendodd, OCC was required to boost capital from $25 million to nearly $250 million. Part of this will be obtained through retained earnings, with an additional $150 million via a capital injection from the four owner-exchanges. In addition, CBOE et al promise to inject up to $117 million in the event of “unexpected losses”, which would be most likely to occur during a financial crisis.

In return, the owner-exchanges receive in essence preferred stock, which pays a dividend in perpetuity. The exact amount of the dividend is not known publicly, but those objecting to the plan (including BATS and KCG) claim that it could be as much as 16-19 pct, at least in the first few years of the plan’s operation.

Non-owner exchanges like BATS and market users like KCG are furious, claiming that the the capital plan allows OCC’s owners to “monetize” the rents accruing to its status as the monopoly clearer for options transactions in the US. They believe that OCC will pay for the dividend by charging super competitive fees that will impair competition among exchanges (advantaging the owner exchanges over the non-owners) and will burden market users.

This is a difficult issue, the nature of OCC. Here are some thoughts:

1. OCC is a regulated monopoly, and arguably a natural monopoly.This creates the traditional conflict between the owners of the utility and its customers, which include other exchanges that aren’t owners (like BATS) and clearing firms and market users (like KCG). This is in many ways very similar to a dispute between a traditional electric utility and its ratepayers heard before a state utility commission, with the exception that this is before the SEC.

2. Like a traditional are case involving a regulated utility, the dispute here is over what is a fair rate of return on capital. BATS and KCG are objecting to the rate of return the 4 exchange owners of OCC are being promised for their capital contribution, and the process by which the SEC approved this rate of return.

3. It is particularly challenging to determine a “fair” rate of return on this capital because of the unique risks that the OCC exchanges are assuming. This capital is at risk of taking a big hit, and the owner-exchanges are potentially obligated to make additional capital contributions, during periods of financial crisis (the “dire circumstances”) referred to in BATS’s letter to the SEC. This tends to make this capital very expensive, and it should therefore earn a relatively high rate of return (high dividend). Capital that has bad returns when the market is doing poorly overall-“high beta”, if you will-is expensive capital. The type of capital being provided is fraught with wrong-way risk: it is likely to take a hit precisely when the capital suppliers are least able to afford it. Determining how much of a risk premium is warranted is a challenge, because of the exceptional nature of the risk. In essence, the exchanges are assuming tail risk, i.e., the risk of exceptional events, and it is inherently difficult to evaluate and price these risks.

4. The other exchanges and firms like KCG benefit from the risk bearing capital supplied by the owner exchanges. Otherwise, they would have to bear the risk. But of course they would like to underpay for this benefit, just as the owner exchanges might want to overcharge for it.

5. In other words, this situation is tailor made for disputes. Monopoly rate setting to determine fair rates and a fair rate of return on capital with very unusual and hard to evaluate risks.

6. The fears about the effects of pricing on inter-exchange competition in execution service are misdirected. Yes, it is possible that the owner exchanges will capture monopoly rents accruing to the OCC’s dominant position, but traditional “one monopoly rent” analysis implies that they don’t have an incentive to use OCC pricing power to advantage their competitive position in execution services. Indeed, the opposite is true.

This also highlights some organization, ownership and governance issues that I addressed in my research on exchanges that culminated in my 2000 JLE piece. Exchanges (and clearinghouses) have market power, and serve disparate and heterogeneous interests. They can use pricing to redistribute rents (which accrue in part due to market power) from one group of intermediaries to another. Not-for-profit status and mutual ownership (having the exchange or CCP operate as a non-profit “utility” serving disparate intermediary-owners is a way of reducing rent seeking and mitigating the use of pricing to redistribute rents.

But non-profit, mutual organization comes at a cost. It requires highly participative, committee-heavy governance that slows decision making and often creates gridlock that makes it difficult for the exchanges/CCPs to respond to technology, regulatory, or market shocks. (Look at the CBT in the 1990s and early-2000s if you want an example.) If everybody has a voice and a vote, it is very difficult to get things done.

In sum, “financial market utility” pricing and governance is inherently messy and controversial.  It has all of the problems associated with public utility regulation, and then some. The problems are particularly daunting when it comes to capitalizing, allocating and pricing the systemic and wrong way risks that CCPs bear. Given these complexities, I won’t venture an opinion here, except to say that (a) I can see both sides of the argument here, and (b) this ain’t going away anytime soon.

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  1. Hello Craig, nothing new under the sun of regulated monopolies agency. During fiscal year 2014, CFTC collected more than $3 billion in fines that are not retained by the CFTC but, instead, go into the Treasury Department’s coffers to be used as it sees fit.

    We just come out of an unprecedented period where Government bailed-out all kind of institutions, It would against the current to not inject capital into the OCC to preserve the clearing system from a major credit default or period of volatility, it is a Beast.

    Comment by Simon Jacques — April 3, 2015 @ 12:00 pm

  2. I agree that it is unfair to the exchanges that own equity to be required to contribute capital and place it at risk potentially for non-owners’ actions without an adequate return on capital. Assessing what a fair rate of return on that capital is quite difficult, as you point out, which inevitably will leave non-owner exchanges guessing about how they and their customers might be disadvantaged by such a regulated rate of return. One possible area to explore is to open the ownership of OCC to non-owner exchanges (ISE, for example was admitted as a non-original owner, so there is precedent) for a basic cost, perhaps even book value, provided they are willing to make an equivalent capital contribution along with the other owners. Unlike most corporations, the owners of OCC have an extremely limited voice in governance and business matters – the board is largely controlled by large non-exchange firms who do not own stock. It is also highly unlikely that the SEC would allow OCC to become a for-profit public company given its status as a regulated monopoly. Thus, the value of the OCC’s equity is circumscribed by a unique set of factors and valuation should not become a high hurdle to ownership by new, targeted shareholders. Existing shareholders can hardly have a view that equity in such an unusual entity will become highly valuable in a closed and regulated marketplace like OCC. In other words, dilution is not the significant issue it would be with a public company. Although he clearinghouse doesn’t compete against other clearinghouses, the exchange owners and members compete vigorously against each other for customers, which would preclude any monopoly pricing ultimately affecting the marketplace. Of course, determining a value for OCC’s equity, and limiting the purchase only to option exchanges but not clients, are more than minor details to be worked out. However, expanding ownership to non-owner options exchanges can be a positive step to creating a more transparent and equitable clearinghouse with a uniform cost structure across all exchanges, provided they purchase equity and contribute capital.

    Comment by Neal Wolkoff — April 5, 2015 @ 5:02 pm

  3. It’s curious the antitrust implications are not discussed more. I recall from a law school course that this was an issue the department of justice opined on rather forcefully a few years ago:

    Comment by Gary S — May 7, 2016 @ 3:32 pm

  4. @Gary S. Yes, it was. I wrote about it several times. I’ll dig up the links to those posts.

    The ProfessorComment by The Professor — May 7, 2016 @ 8:48 pm

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