Streetwise Professor

I was quoted in this WSJ/Dow Jones article about why sovereign CDS are not being cleared.  I think that legal risk has something to do with it.  But upon further consideration, I think the problem with sovereign CDS is far deeper than that.

The problem is not exclusively with clearing vs. bank intermediated-bilateral.  The problem is with wrong way risk which makes it very dangerous to have a bank as the counterparty selling protection in a sovereign CDS.  Clearing sovereign CDS through a bank-dominated CCP means that banks are the ultimate counterparty, and if the protection seller defaults there is a possibility that banks will be on the hook to pay out on the defaulted contracts precisely when they are in financial distress.

The recent crisis in Europe demonstrates that with current monetary arrangements, the default of any sovereign name of any size can trigger a financial crisis that threatens banks.  Note that bank CDS spreads tend to blow out whenever one of the PIIGS looks shaky. I don’t have the data at hand, but I would wager there is a very high correlation between Greek, or Portugese, or Spanish, or Italian CDS spreads and bank CDS spreads.  Which means that there is a substantially elevated risk that a bank or bank-backstopped counterparty (i.e., a CCP) won’t be there if a sovereign defaults.

There are structural reasons for correlation.  Banks tend to hold large amounts of sov debt in their portfolios.  A surge in sovereign default risk tends to lead to funding problems for banks–especially those with large sovereign exposures.  Thus, sovereign debt crises are associated with substantially elevated risk of bank failure.

This is actually a firmer basis for governments and regulators to be skeptical about–and perhaps even hostile to– sovereign CDS than their usual kill-the-messenger bleats about evil speculators.  Sovereign CDS are potentially beset with wrong way risk, and they pose a real systemic threat to banks if the banks sell protection: in contrast, banks buying protection makes good sense as a hedge if the counterparty is likely to be able to perform in a sovereign debt crisis.  The risk is right-way when banks are protection buyers.

The issue with clearing sovereign CDS is that clearing makes banks contingent protection sellers, and the contingency kicks in right when banks are least able to afford it.  But even a bank running a balanced book would still pose problems because if a counterparty from whom it bought protection defaults, it would be obligated to dip into its capital to pay off the parties to whom it had sold protection, and again precisely when it is least able to afford it.

This suggests that there are acute systematic risks inherent in sovereign CDS under both bilateral and cleared approaches.  Since we have seen that the potential default of any European sovereign name, even those of middling size, can precipitate financial panic, sovereign CDS are arguably the most problematic derivatives out there from a counterparty risk/systemic risk perspective.  They are likely beneficial as long as banks are not major protection sellers under any contingency.  That’s impossible to achieve with clearing, and likely very difficult to achieve in a bilateral market.

What this suggests to me is that (a) it is unwise in the extreme to clear sovereign CDS, and (b) banks should be subject to a hefty capital charge on their gross sales of sovereign protection.  Gross, not net, because the gross drives their contingent exposure.  Low capital charges on a positive net position in protection purchases would be defensible as that risk is right way and net protection purchases gives banks an incentive to lay off sovereign debt risk on those who can bear it at a lower cost than they can.

Looking at the issue of sovereign debt risk more broadly, this analysis again raises serious alarms about the wisdom of mandating or incentivizing banks to hold large sovereign debt positions, where the incentivizing comes in the form of liquidity requirements that must be met by sovereign debt holdings and favorable capital charges, and the mandating comes in the form of margin and clearing requirements.  But the financial repression pressures driven by the pressing need of governments to get somebody to hold their bonds is driving us in that direction.

Which suggests to me that the systemic risk of the future–and the systemic risk from hell–is the prospect for chronic fiscal crises around the world.

And on that cheery note . . . back to work.

Betting the Business has a recent post that is a paean to central clearing.  I have some major problems with it.

The problems start with the title: “Central clearing lowers end-user costs.”  That short, unqualified, declaration begs major questions.  Most importantly: If clearing is more efficient, why did cleared markets lose market share to the putatively less efficient alternative, bilateral uncleared OTC trades?

I’m not suggesting that such inefficient outcomes are possible, but I take it as a rebuttable presumption that competitive processes tend to result in the displacement of the inefficient by the efficient.  So I’d like to see a convincing story at least, backed by some anecdotes at least, that would represent a plausible rebuttal.  That’s a low bar: it would be preferable, of course, to have a rigorous model supported by empirical evidence.  But I’ve yet to see anyone clear even that low bar: indeed, very few have tried.  To be honest, BTB don’t in this piece.

And by “convincing,” I don’t mean stories that rely on bankers’ Svengali-like hold on their customers, or customers suffering from some variant of battered spouse syndrome.  These stories are facially implausible, and indeed, counterfactual during the period during which OTC derivatives markets grew dramatically, the 1980s and 1990s.  This was a period in which banks were suffering “disintermediation”: they were losing business and customers to capital markets that customers found more efficient sources of capital.  So, the Svengali thing wasn’t working so good when it came to traditional loan business.  Ironically, many of the big loan customers that banks lost simultaneously began trading OTC derivatives with them.  Also ironically, one of the major reasons that the CDS market began was that banks were losing their traditional loan business.  JP Morgan in particular made a strategic decision to develop CDS business aggressively because it was facing more intense competition from capital markets in making traditional loans.  Which all means that customers–especially big ones–have the ability to adopt more efficient ways of financing and managing risk.

My other big problem with the BTB piece relates to netting:

Central clearing, if managed appropriately, helps to reduce the volume of credit risk by cancelling out many offsetting positions, disappearing some credit risk and leaving us with a smaller, residual credit risk from derivatives trading. One of the problems with OTC markets is that brokers wanting to closely guard their clients don’t have an incentive to cancel out offsetting exposures to counterparties. Critics of the clearing system keep overlooking the fact that risk can in fact disappear. The derivatives market system, depending upon how it is structured and operated, can have more or less total credit risk.

The notion that multilateral netting necessarily reduces risk is incorrect regardless of whether one focuses on credit risks in derivatives alone, or takes the proper perspective of looking at credit risk in toto.

With respect to credit risk in derivatives taken in isolation, clearing some products and not clearing others–which is inevitable given the unsuitability of some products for clearing, and indeed, the refusal of CCPs to clear them–may exploit some scale economies from multilateral netting in a particular product, but can destroy cross-product scope economies.  For instance, clearing a credit index but not all the names in the index destroys the scope economies that a bank can realize by holding positions with customers in both the index and the components.  Or if an interest rate swap is cleared but an interest rate swaption is not, netting economies across these products are lost.  These are simple examples, but they could be multiplied ad infinitum.

Indeed, these cross-product netting opportunities are one very plausible explanation as to why clearing lost ground to bilateral markets dominated by dealers.  Dealers trading multiple products can exploit cross-product netting economies and thereby offer their customers lower costs.

What’s more, when we consider clearing-as-it-will-be-in-this-messy-world, as opposed to the Platonic ideal of clearing, even within a single product clearing mandates may reduce netting economies.  Jurisdictionalism is likely to result in the creation of multiple CCPs for a given product type.  For instance, it is likely that regulators in the US and Europe insist that CCPs for particular products be established in their jurisdictions, and that financial institutions subject to their jurisdiction will use these “home” CCPs.  That creates operational headaches and reduces the netting benefits of clearing.

A proper, systemic approach also demonstrates that the disappearance of risk, like a magician’s trick, is often an illusion that works because the audience’s eyes are fixed in one place, and therefore they miss where the real action is.  As I pointed out several years ago, taking derivatives positions and the capital structures of market participants as given, netting redistributes risk from derivatives counterparties to other holders of liabilities on these derivatives market participants.  Yes, multilateral netting (and bilateral netting supported by collateral, rights of offset, etc., for OTC deals under bankruptcy laws) reduces the credit risk in derivatives trades, but the risk doesn’t disappear down the magician-CCP’s hat: it is reallocated to those who have lent money to the firms that hold positions in the netted derivatives.  Netting puts derivatives counterparties closer to the front of the line of creditors in bankruptcy.

Now the issue of the proper priority of derivatives is a sticky one, and I don’t claim to have the answer.  Giving derivatives counterparties priority tends to reduce their incentive to run, but it can increase the incentive of other creditors to run.  And in equilibrium, capital structures will depend on priority rules.  So it may be the case that clearing reduces the risk of runs on derivatives dealers by their derivatives counterparties, but increases the risk of runs by their repo counterparties, or the buyers of their corporate paper. It’s unclear how that cuts.  (No pun intended.)

Though I don’t have the answer as to the optimal priority rules, I do realize that netting does affect priority–and that this means that statements about netting “making risk disappear” are not generally true, and are typically wrong, because these statements are based on only a portion of the total risks.  The risk no more disappears due to a change of priorities achieved through netting than the rabbit really disappears into the magician’s hat.

It should be noted, moreover, that this issue of netting and priority has long been understood in other contexts, notably in payment systems.  Work in the 1990s and early 2000s (by Charlie Kahn, among others) emphasizes that netting systems and real time gross settlement have different affect the priority of payment system participants relative to other creditors of those systems.

There are some other problems with the BTB analysis, but I’ll just mention them in passing.  They say:

Margins are paid by those who use the system. In the OTC markets, banks either correctly price risk, or trade with clients by granting these subsidies from the taxpayer, or from wealth transfers by their bond holders. Clearing and margining is a potent dissuader of free riding on the system by negligent brokers, and also helps to mitigate agency conflicts between bonus motivated bankers and the bank’s stakeholders, which, we have learned, includes the taxpayers/citizens of each country.

I can’t say that I fully track that paragraph, but I will say that I am struck by the free riding analysis.  It suggests a sort of transubstantiation, where bankers are agency-conflicted, or perversely incentivized due to too big to fail subsidies when acting individually, but somehow become less conflicted and better incentivized when they act collectively through a CCP (and most CCPs will be bank dominated).  It’s not obvious how that works.  Indeed, collective action problems and multi-task/multi-principal agency problems usually result in weaker, not stronger incentives.

In this regard, it should also be noted that the homogenization of credit risk in a CCP creates problems.  CCPs make all trades by all members fungible, even if those members bring differing amounts of credit risk to the system.  This tends to reallocate trading activity away from the more creditworthy to the less creditworthy.

I also consider this unrealistic:

And to protect the public, it is necessary for regulators to see and be able to manage the true volume of credit supporting derivatives trading. Clearing is part of making that possible.

Given the fungibility of credit, you will never unambiguously know how much credit is used to support derivatives trades, even in a cleared system.

I have other issues (I can just imagine you exclaiming: “I’ll say!”), but I’ll leave it at that.  Suffice it to say that there are major holes in this clearing paean, and that it certainly does not provide a firm basis for mandating the adoption of central clearing.

Zero Hedge provides a reminder of the approaching automatic triggering of an increased haircut on Spanish and Italian government bonds in RepoClear.  Earlier this year LCH indicated that it would increase margins on Irish bonds when the spread hit 450 bp, and Italian and Spanish debt is reaching that level.

This is the kind of action that is individually rational for a clearer to take, but which can be destabilizing, pace my earlier posts on the hike in silver margins earlier in the year.

The haircut spiral plays a central role in a recent paper by BOE Financial Stability Executive Director Andrew Haldane and two co-authors.  The paper is nicely done, and the use of numerical methods to study the highly non-linear dynamics of complicated financial networks is the right way to go.

I am not persuaded that the paper focuses on the real sources of financial crises, however.  The reason is directly related to my post earlier in the week on clearing and systematic risk.  Haldane et al study how an idiosyncratic shock to the bank-specific haircut of a particular bank can propagate through a complex, densely connected network.  In some cases, such a shock can lead to a systemic crisis resulting from a cascade of banks deciding to hoard liquidity.  Not surprisingly, they find that the likelihood and intensity of such a contagion depends on the connectedness of the network, the skewness of the sizes of firms in the network, and the size and connectedness of the bank hit by the shock.

But I remained unconvinced as an empirical matter that major financial crises, at least in recent years, have developed in this fashion.  For this story to work, a single bank–and in the Haldane et al results, that bank would likely have to be a very big, highly connected one–is hit by an idiosyncratic shock that results in it having to pay higher haircuts on its secured lending.  In the real world, this could happen as the result of a rogue trader risk or some other major operational failing.

Perhaps the canonical example of such an episode would be the Kervial debacle at SocGen.  But even though that occurred when the markets were already stressed (in January, 2008), it didn’t lead to contagion.  I would be interested to hear of other examples, but I can’t think of any that have led to the cascade of failures like that that plays the central role in the Haldane et al analysis.

Instead, the major financial crises, most notably that of 2007-2008, the one that may be impending,  1998, etc., have been marked by an adverse shock hitting virtually all major financial institutions due to the similarity of their balance sheets.  European banks today are on the brink because they are all–all–heavily exposed to Eurozone government debt, and in particular to PIIGS debt.  This is a system-wide shock–a systematic shock, not a diversifiable, idiosyncratic one that is magnified through the web of interconnections among banks.  Such interconnections, margin spirals, liquidity hoarding, and so is a real possibility and could exacerbate the effects of the shock, but the point is that what is going on now, and what went on in 2007-2008, and what went on in 1998 is very different than the mechanism studied in the Haldane et al paper.

Perhaps many of the recommendations that Haldane and his coauthors make based on their analysis of the propagation of an idiosyncratic shock carry over to the case of a common shock hitting virtually all banks.  For instance, bigger liquidity cushions might be stabilizing in this situation as they are in the Haldane et al setup.

But maybe not.  Especially when one considers that for a variety of reasons–financial repression among them–sovereign debt is, and likely will remain a major component of any liquidity buffer.

That doesn’t work so well when the collapse of the creditworthiness of the governments issuing the debt is the root of the crisis, as is the case today.

I recommend the Haldane paper, but I think that it,  and many other papers that are based on tracing out the implications of idiosyncratic shocks to individual banks in a dense network, aim well wide of the mark.  I would like to see empirical work–hell, a case study, or even an anecdote–showing this mechanism working in practice.  If it is instead the case, as I am highly confident that it is, that financial crises are typically the result of an economy-wide, non-idiosyncratic, shock, the mechanism will be different and the policy implications will almost certainly be different.

A conjecture: in such a world, the greatest crisis accelerant is the similarity of balance sheets across major financial institutions.  To some degree, this cannot be avoided.  But there is no doubt in my mind that uniform regulations–and the Basel standards and other coordinated risk-based capital requirements–encourage even greater similarities in balance sheets.  This is a real danger, and if my conjecture is correct, many of the efforts currently underway to harmonize capital and liquidity requirements could make crises more rather than less likely . Basel Faulty and all that

The self-interested role of governments in cramming down more of their burgeoning debt will only exacerbate this problem, as regulators have an incentive to tilt capital and liquidity requirements in favor of holding government debt.  As dodgy as that debt is these days, it’s hard to imagine a better way to create the next crisis.

Central counterparties work on the principle of mutualization.  CCP default funds are a mechanism for mutualizing–sharing–counterparty loss risk, where the CCP-insurer has some protection in the form of a “deductible” that consists of the defaulter’s margin plus default fund contribution.

Insurance works when risks are diversifiable.  So, to the extent that the risks of default exhibit relatively little correlation across clearing members (CMs), mutualization through a CCP can improve the allocation of risk: through diversification, the variability of the average default loss across all CCP members is smaller than the variability of any CM’s default loss profile.

It should be noted that these diversification effects work in OTC markets too: market participants who deal with multiple counterparties diversify exposure to counterparty losses.  Moreover, in OTC markets, it is often possible to hedge counterparty risk through the CDS market.  [Which raises a question: how do you hedge CCP credit risk?  It is highly unlikely that CDS will be traded on CCPs.  Perhaps using a portfolio of CDS on CMs?  But who clears those CDS?  Sounds like the wrong way risk from hell.]

CCPs have been sold as a means of reducing systemic risk.  The basic story is that in bilateral OTC markets, the failure of one entity can cause the failure of other entities in falling-domino-like fashion.  In this telling, a CCP reduces interconnectivity of the financial market, and thereby reduces the likelihood of that the failure of one firm–even a big one–will cause the failure of others.  Put differently,  in this view default/counterparty risk is insurable because it is diversifiable, and therefore mutualization can improve the allocation of risk.

But is the domino-model really a good description of systemic risk?  Is the system really threatened by the isolated, idiosyncratic failure of one firm, even a big one?

Here’s an alternative story, in which a big, system-wide shock hitting many institutions simultaneously is the source of systemic crisis.  Some examples: Black Monday in 1987, the Asian and Russian crises in 1998, and the subprime meltdown of 2007-2008.

In such episodes, there are large price moves across asset classes.  These price moves often blow through margins–and by a lot.  During the subprime crisis, for instance, even well-before the Lehman episode, some prices moved by huge amounts.  In August, 2007–more than a year before Fannie-Freddie, Lehman, and AIG–David Viniar of Goldman lamented that there had been several 25 standard deviation moves in multiple markets.  In a “normal” (Gaussian) world, 25 sd moves don’t occur.  Period.  People don’t set margins based on the possibility of 25 sigma moves.  So when such moves occur–and they occur in the real, non-normal world–margins get blown through.  Meaning that if someone defaults, they’re well into the default fund, and the protection of the “deductible” is gone.

Moreover, such earth-shaking episodes are typically associated with adverse shocks to bank (CM) balance sheets.  What’s more, such events raise serious doubts about the solvency of banks/CMs: adverse selection problems can run rampant, causing markets to freeze.  This tends to cause funding and liquidity to dry up.  Due to actual insolvency, and illiquidity driven by widespread fears of potential insolvency, those facing big margin calls may face substantial difficulty in meeting them.   Thus, they are more likely to default.  This is what happened to AIG and Lehman.

Since the shock hits all financial institutions simultaneously, and since the shock is big, this risk of default is not idiosyncratic; it is highly correlated across firms.  Given such a shock, if one firm defaults, others are at elevated risk of default too.

If defaults that breach margins occur, the surviving CMs who contribute to the default fund must absorb the loss, and take a hit to their capitals.  But this hit occurs exactly when capital is very valuable/costly for them.  That is, hits to the default fund are likely to come at the absolute worst times–during adverse moves in the overall market.

It is possible that a CCP’s default exposure in such a circumstance could crater the clearinghouse.  But even if the CCP survives, its surviving members suffer a loss (via to their exposure to the default fund) when they can afford it least.

This has some interesting implications.  In particular, it means that the systematic risk of default fund capital is very high, which in turn means that default fund capital is extremely expensive.  The default fund is like a deep out of the money short put on the market.  Such puts are essentially bets on systematic risk, and hence are very expensive.

The expense of such capital means that CMs are likely to want to minimize the amount they post.  They have every incentive to try to construct risk measures that make CCPs look safe, with very low risk of default, in order to reduce their exposure to the default fund.

Think that this can’t be done?  Think again: that was essentially the entire game in CDOs.  As Coval-Jurek-Stafford show in an AER paper, “super senior” CDOs were claims that had low probabilities of default, but that defaults would occur precisely during periods of crisis–analogous to the foregoing characterization of the risk profile of default funds.  C-J-S present empirical evidence that these CDOs–which were AAA rated–were grossly underpriced, meaning that those who were buying these securities didn’t fully appreciate how heavily they loaded on systematic risk because analysis–and ratings–were framed almost exclusively in terms of unconditional default probabilities, and the rating agencies and many investors and regulators ignored the fact that defaults would occur when the value of capital was very high.  I can see the same thing happening with CCPs–who will reflect the interests of their members–focusing on default probabilities to justify their capitalization to regulators.

Another interesting implication is for what instruments should be cleared.  Instruments that have big losses during big systematic shocks–those that load heavily on systematic risk–are exceptionally dangerous for CCPs.  This means that clearing things like senior or supersenior tranches (or derivatives on them) is exceptionally dangerous.

This has a corollary: anybody that uses AIG to justify clearing mandates doesn’t know what the hell they’re talking about.  AIG’s positions in derivatives on supersenior tranches were, as C-J-S show, systematic risk time bombs.  Clearing those things would dramatically increase the systematic risk of default funds, because they would expose default funds to losses precisely during systemic crises.

Some people know this.  Jon Gregory, for instance.  When discussing “market coverage of a CCP”, he states:

Finally, CDO tranches (especially supersenior) would be expected to have serious correlation [i.e., systematic risk] impact since in a scenario where there are losses on these tranches it is likely that many CCP counterparties [and CMs] are in a distressed state.

The above analysis is to some degree subjective but one general point–probably beyond argument–is that the most important trades products to be traded through CCPs are arguably the most risky from the point of view of the stability of the CCP.  There has been much recent interest to trade all CDS index products and single-name products through CCPs. . . . The general point is that the products that market participants will most want and need to trade through a CCP will be the precise products that are most difficult to handle in this way (pp. 381-382).

In sum, the belief that CCPs can reduce systemic risk is predicated on a particular narrative of  the likely source of a future crisis.  This view is that the failure of a single institution, arising from some shock idiosyncratic to it (a bad trading decision, an operational risk such as a rogue trader) can lead to the failures of other institutions via a contagion mechanism.

But, in my view, that isn’t an accurate characterization of the actual crises that have occurred over the years.  These have been associated with broad-based shocks that hit large numbers of institutions simultaneously.  Again: Black Monday, Asia/Russia, subprime.

There have been multiple examples of large, one-off collapses of highly interconnected and leveraged institutions that have not resulted in a cascade of failures that led to a systemic crisis.  To name several off the top of my head: MG (1992), Barings (1995), Amaranth (2006). For a while, it looked like the Hunt collapse in 1980 could have broader, systemic consequences, but that fear evaporated rather quickly.

The contrast between the effects of the collapse of Amaranth in 2006 and the crisis surrounding the problems of LTCM in 1998 is particularly instructive.  Amaranth was actually bigger than LTCM (though it should be noted that the markets were bigger too), and had large OTC positions.  The difference was that Amaranth’s collapse was not caused by a systematic shock, whereas LTCM’s was.  LTCM engaged in strategies that blew up because of major shocks arising in Asia and Russia.  It was thus on the verge of failure precisely when liquidity had dried up, and its (big bank) counterparties were in bad financial shape because of the crisis.

The Amaranth collapse was effectively a diversifiable risk, and potentially clearing improved the allocation of that risk (many of Amaranth’s positions were cleared).  But the bilateral markets could have likely handled it quite well too.  In contrast, LTCM’s risk was not diversifiable.  Clearing would have still passed the risk of its failure onto stressed financial institutions, and likely resulted in some similar emergency measure to mitigate the impact of its huge losses.  (I’ve long argued that the same would have been the case with AIG.)

Along these lines, FTAlphaville has a very interesting post describing some forthcoming research which shows that incorporating “common jumps” into models of index option prices go a long way towards explaining the volatility skew, and reconciling the skews of index components and the skew of the index:

According to a technical paper published on Risk.net by Alex Langnau, global head of analytics at Allianz Investment Management and Daniel Cangemi, head of FICC trading at EFG Financial Products, Wall Street’s next top (risk) model is actually a copula that attempts to explicitly link correlation skew to systemic risk so as to improve tail risk management of large portfolios.

The basic premise lies in the idea that the downside risk of a portfolio of assets is generally substantially higher than the downside risk of its components — because assets tend to correlate more strongly in times of crisis.

. . . .

As the authors conclude this could become extremely useful for trying to figure out the additional risk attached to asset portfolios:

We have presented a generalisation of the Merton jump option formula to multi-assets as well as diffusive skews and found that common jumps are an appropriate and intuitive way to define copulas that describe the systemic risk of a portfolio.

Financial institutions should start treating systemic risk as market data across asset classes and start to mark, risk-manage and price these effects in a systematic way.

This suggests that these common jumps are of first order importance.  And these common jumps aren’t diversifiable.  What I argue above is that the major risk that CCPs face arises from such system-wide, common shocks.  And in the event, mutualization is all but irrelevant.  Except, perhaps, to the extent that CMs attempt to limit their exposure to this risk via the default fund by undercapitalizing CCPs, thereby threatening the ability of these vital–and soon to be even more vital–pieces of market infrastructure to survive a systematic shock.  In which case, mutualization makes things worse because if some CCPs don’t survive, the knock-on effects from the original shock will be even more catastrophic.

In some respects, the issues I’ve discussed here reflect an older literature on bank runs.  One view of bank runs is that they are idiosyncratic in origin (i.e., a bad shock–perhaps even a sunspot–hits a single bank, leading to a run), but have systemic effects due the interconnectedness of the financial system.  In this view, widespread panics spread like a wildfire from a single, isolated spark.

An alternative view, associated most strongly with the work of Calomiris and Gorton, is that runs occur when depositors receive adverse information about the aggregate economy, which raises concerns about the viability of all banks.  In this view, panics involving runs at many financial institutions reflects the fact that all banks are exposed to a common risk.

The Calomiris-Gorton view, and the evidence they amassed to support it is persuasive.  In more recent times, major periods of crisis have been associated with a common shock hitting many financial institutions, rather than from the contagion of an idiosyncratic shock to one big institution laying low otherwise healthy institutions.  In these types of events, mutualization of risk isn’t of much help, and can actually make things worse.  Meaning that clearing mandates were sold largely on the basis of a misleading portrayal of, or misunderstanding of, the real dynamics of financial crises.

One takeaway from this is that there should be a very hard look at CCP capitalization, and at measuring the cost of default fund capital.  The exposure that default funds face to systematic risk affects the cost of capital–and hence the cost of clearing.  That cost should be taken into consideration when deciding the scope of clearing mandates–that is, when deciding what should be cleared.   For the analysis suggests that clearing can be very expensive, and that a major source of cost has been largely overlooked.  Forcing too much to be cleared can create costs with no corresponding benefit.

John Lothian has an interview with Deutsche Boerse’s Head of Media Relations, Frank Herkenhoff.  Compare:

John Lothian: The vertical integration of your clearing house is continuously criticized by your competitors…

Frank Herkenhoff: Vertical integration between trading and clearing generates significant user benefits. Vertical integration allows maximum innovation in trading and clearing services, by aligning incentives at the trading and clearing level, as well as promoting systemic stability. Vertical integration is efficient as it reduces double marginalization and transaction costs. NYX had already initiated the move to vertical integration, independent of this transaction. The integrated business model has proven to be efficient and secure and has consequently become a role model for the industry over the past years.

And contrast:

The execution, clearing, and settlement of financial transactions are all subject to substantial scale and scope economies which make each of these complementary functions a natural monopoly.  Integration of trade, execution, and settlement in an exchange improves efficiency by economizing on transactions costs.  When scope economies in clearing are more extensive than those in execution, integration is more costly, and efficient organization involves a trade-off of scope economies and transactions costs.  A properly organized clearing cooperative can eliminate double marginalization problems and exploit scope economies, but can result in opportunism and underinvestment.  Moreover, a clearing cooperative may exercise market power.  Vertical integration and tying can foreclose entry, but foreclosure can be efficient because market power rents attract excessive entry.  Integration of trading and post-trade services is the modal form of organization in financial markets, which is consistent with the hypothesis that transactional efficiencies explain organizational arrangements in these markets.

This is the abstract from a paper about vertical integration in clearing that I wrote in 2006, and then updated in 2007: similar material will be in the monograph I’m working on now.

If you have way too much time on your hands, and delve into the paper, you’ll see that I discuss explicitly how the alignment of incentives between execution and clearing facilitates innovation, and improves coordination of responses to systemic shocks.  I go into great detail about double marginalization.  The parallels between Herkenhoff’s last sentence (integration is the role model) and the last sentence of my abstract (integration is the modal form of organization) are also pretty obvious. So Herkenhoff hits basically all the points I made in my paper.

Coincidence?

This morning’s recon mission for derivatives-related stories turned up bumper crop of realizations that should have been painfully obvious, but were not made when it could have made a difference–meaning that the real pain is to come.

First, from the FT:

Quite simply, the regulators succumbed to the sheer volume of rulemakings and an avalanche of comments from the industry. There was not enough time to meet the deadline, and it became clear that implementing Dodd Frank was going to be far more complicated than initially thought.

Thought by whom, exactly?  We need to know, because anybody who admits to not foreseeing a train wreck should be disqualified from further comment or participation in these matters, (a) for not foreseeing the obvious, and (b) for copping to such cluelessness.

Next, from Financial News.  In response to the rhetorical question “Are clearing houses ‘too big to fail'”, Ben Wright writes (heh):

It is a real concern that not enough people have asked this question before now and even more worrying that no one has provide a satisfactory answer.  [The answer is almost certainly yes, though I guess that is unsatisfactory substantively.]  As the possibility of some form of huge sovereign credit event grows ever-more imminent, a solution need to be found, and fast.

It’s a little late to start thinking about packing a parachute when you’re already 30,000 feet up. But that’s Frank-n-Dodd in a nutshell (with an emphasis on the “nuts”).

Wright also recalls a speech by the BoE’s Paul Tucker (which I blogged about in June), in which this worthy

said clearing houses had to think of themselves as system risk managers and start behaving as such.  Clearing houses should, therefore, steer clear of procyclical margin practices, monitor the soundness of their members, and plan for their disappearance.

No disagreements here, except that it is insane to think that CCPs will think of themselves as “system risk managers.”  Because they aren’t “the system”, but only part of it.  They will act in their interest and the interest of their members.  That is quite different from–and often contrary to–acting in the interest of “the system.”  Clearing does not internalize most of the key externalities that create systemic risk, and all the wishing and should-ing in the world won’t change that fact.

And from Dow Jones:

Dealers and clearing experts have urged regulators to introduce so-called living wills for clearing houses, warning that a “credible” plan for unwinding critical pieces of market infrastructure is “vital to financial stability”. The comments come amid growing fears that the US government’s inability to raise its debt ceiling could prompt a global credit event.

. . . .

Roger Barton, founder and managing director at Financial Reform Consultancy, said: “It is arguable that the whole issue of clearing house resolution should have been addressed earlier.”

“Arguable”?  Go out on a limb there, Roger.

I wonder if it’s possible to fashion a parachute from the seat covers and a few stray blankets in the overhead bins.

Then there’s this article on portability in Risk.  It’s long (and gated), but the moral of the story is easily stated: this is a major issue, with systemic implications, but which is totally up in the air.  (Lot of company up there.)  There’s one on portability in the FT, coming to pretty much the same conclusion.

What, never heard of portability?  Apparently the Sorcerer’s Apprentices hadn’t either.

I could go on.  In recent days there have been numerous articles about myriad issues in clearing–collateral, margining, capital requirements, and on and on–all of which are (a) unresolved, and (b) of first order systemic importance.  All the important details were left to the end–most likely because those that demanded the system remade it, and wrote legislation demanding its remaking didn’t even know what the relevant details are.

An entire system that evolved organically with all of the complexity and interconnectedness that implies is being re-engineered on the fly.  Anyone even marginally cognizant of the complexity of the system would have been too humble to even contemplate remaking it root and branch.

But unfortunately, the marginally cognizant weren’t in charge.  The imperious, overconfident, ignorant, and foolish were–some were all of the above.

That never works out well.

Yes, today marks the one year anniversary of the day when The Monster slouched off of Capitol Hill (aka Frank-n-Dodd Castle) to begin its rampage of error and terror in the countryside.

Believe it or not, I’m not grateful, despite the never-ending source of material that it has provided in the past 12 months.

It is hard to pick the Worst of Frank-n-Dodd.  There is much to choose from, and the competition is intense.  There is one element, though, that is particularly indefensible, and which happens to be in the news now, so it will get special billing in this Special Anniversary Post: The Swaps Execution Facility (SEF) mandate.

It is indefensible for a variety of reasons.  For one thing, the ostensible purpose of Frank-n-Dodd is to reduce systemic risk, and it is very difficult to make a case that requiring trading of swaps on exchange-like platforms has anything to do with systemic risk.  It is particularly interesting to note that the Europeans, who are on board with the Dodd-Frank stuff that at least is related to systemic risk (like clearing and margining of derivatives) are deeply skeptical, not to say contemptuous, of the SEF requirement.  They show no signs of adopting anything even like it.

Moreover, the SEF requirement seems to reflect some extremely childish understanding of markets.  Exchanges– transparent and good.  OTC markets–dark and scary.

This cartoonish view of markets completely fails to recognize the tremendous diversity of transactors and instruments in the market place.  It is sensible that this diversity has given rise to a diversity of trading mechanisms adapted to the traders and instruments.  Shoving everything into a one-size-fits-all framework with intense pre-trade and post-trade transparency–and transactor anonymity–presumes that all traders and all traded instruments are effectively alike.

Wrong.  Gary Gensler regales everyone with tales of how the improved transparency is going to reduce transactions costs for the buy side and end-users, and these benefits will more than offset the other, uhm, inconveniences arising from Frank-n-Dodd.  Which is kind of weird, because the buy side and end-users have been largely critical of the SEF mandate, and comfortable with the current way of doing business.  As I’ve said before, Gensler’s Fairy Tale presumes that the supposed beneficiaries of the SEF mandate are suffering from some sort of battered spouse syndrome, and love and protect their bankers despite the abuse that the latter allegedly dish out on a daily basis.

It’s also weird because the OTC markets grew absolutely and relative to exchanges–by a large margin–pre-crisis.  Given the choice, the buy side and end-users more often than not chose to trade OTC. Absent mass ignorance of self-interest, this very strongly suggests that it was cheaper for the buy side and end users to trade on these markets.

Has Gensler, or any of the other SEF evangelists, provided a convincing explanation of these facts?

No,they haven’t.  They haven’t even tried.

A non-cartoonish analysis of transactions and transactors makes it perfectly clear why the OTC markets have flourished.  A big part of that is the very basic fact that for many traders exchanges with pre- and post-trade transparency but trader anonymity are more costly places to trade.  Uninformed traders (e.g., big hedgers or pension funds) trading in size typically trade more cheaply in face-to-face markets with negotiated prices, rather than in anonymous auction markets where their orders get lumped with the trades of the informed, and hence get filled at worse prices.  This is why dark markets, block markets, etc., have always been with us, and why OTC markets are frequently the venue of choice for big buy side and commercial traders.

The SEF mandate is bad enough, but as hard as it is to believe, the CFTC proposals are even worse.  Gensler and Chilton in particular clearly want to make OTC markets as exchange-like as possible, and are pushing SEF rules that would sharply constrain the diversity of execution platforms.  The CFTC is taking an even more extreme approach to this than is the SEC.

Which is why it is encouraging to see that this is one part of Frank-n-Dodd that is the target of a legislative effort for overhaul.  Representative Scott Garrett (R-NJ) has sponsored a bill that would sharply limit the kinds of requirements the CFTC or the SEC could impose on SEFS:

H.R. 2586 prohibits the CFTC and the SEC from interpreting the SEF definition to: 1.) require a minimum number of participants to receive or respond to quote requests, 2.) require a SEF to display or delay quotes for any specific period of time, 3.) limit the means of interstate commerce that market participants can use to execute swap transactions, or 4.) require one trading system (i.e. RFQ) to interact with another trading system (i.e. Limit Order Book) on the same SEF.  These prohibitions are necessary to preserve investor choice of execution, promote transparent price discovery for market participants, and decrease the costs of hedging for American businesses, farmers, and retirement plans, all of which contribute to economic growth and job creation.

I’d prefer no SEF requirement at all, but at least this bill would give market participants a lot more lee-way to develop systems that accommodate the diversity of trades and traders.

As to its prospects–I have no idea.  But hopefully this is a harbinger of efforts to chain The Monster and bring some relief from its depredations.  That would be a good thing–despite anything Timmy! says.

Laurie Carver of Risk passed along this BIS/Basel Committee on Banking Supervision Consultation Paper that proposes a methodology for measuring whether a bank is a “global systemically important bank” or G-SIB.  Laurie perceptively points out that a bank’s OTC derivatives exposure is included as one of the factors in the proposed index that will be used to determine systemic significance, but that cleared derivatives exposure is not. Since capital charges will depend, under the proposal, on the index score, this means that OTC derivatives exposures will affect capital requirements, but cleared exposures will not.

This is a major mistake.  A bank’s exposure to CCPs, and perhaps more importantly, CCP exposures to banks, are of major systemic importance.  The failure of a large bank with a large book of cleared derivatives, both proprietary and client, would pose a substantial risk to the CCP, the other banks that are members of the CCP, and to the broader financial system.  Moreover, via the liquidity channel, large cleared exposures can also be destabilizing, as when a big bank needs large sums of cash in a hurry to meet margin calls on cleared trades.  Indeed, due to the rigid timing deadlines of CCP margin payments, it is my belief that cleared exposures put more stress on the liquidity channel than OTC deals.

Put differently, CCPs are a channel of contagion, and a potential source of shocks that create contagion.  What’s more, they don’t internalize all the externalities that the BIS cites to justify stricter regulation of big banks.  Indeed, as I’ve argued repeatedly, CCPs actually create some perverse incentives (in particular, moral hazards) that can increase systemic risks.

It is particularly disappointing to see this glaring oversight at this late date.  Although the proper time to debate the clearing issue was over a year ago (the Frank-n-Dodd anniversary just passed), it did seem that serious people were coming to recognize that the idea that CCPs were a panacea for derivatives-driven systemic risk was an unrealistic dream, and were therefore thinking far more seriously about how to deal with the systemic risks arising from CCPs.  Even the Basel Committee had genuflected to this understanding, and incorporated a capital charge for cleared exposures into the Basel III proposal.  Hence, the Consultation Paper seems to be a retrograde step back to the unrealistically optimistic view of CCPs as safe.

This attitude is very dangerous.  The longer it persists, and the more widespread it remains, the higher the likelihood that cleared derivatives will play a major role in creating or exacerbating some future financial crisis.

Update: Laurie kindly pointed out that my description of the implications of the G-SIB index score was misleading.  The G-SIB score affects only the systemic risk capital surcharge; cleared derivatives are included in the standard capital calculations.  Bad drafting aside, the basic point stands: the proposal implicitly assumes that cleared derivatives do not contribute to systemic risk.  Danger, Will Robinson!

Betting the Business (i.e., John Parsons and Antonio Mello) notes that the Coalition of Derivatives End Users has backed off its more extreme claims about the effects of clearing and margin mandates.  John and Antonio have been correct to point out that Frank-n-Dodd requirements may just result in the credit implicitly bundled in derivatives deals being unbundled, by the extension of a loan or a credit line.  (This is something that I also pointed out in my Cato piece last year).  But they have not explicitly addressed an implication that I pointed out, and specifically asked them to analyze.  Specifically, if margin requirements merely result in making implicit credit explicit, how do these requirements affect the aggregate amount of credit in the system?   This is the crucial question because the amount of leverage in the system is the first-order driver of systemic risk.

The End User Coalition’s letter makes this point:

Margin lending facilities offered by banks (and especially if offered by [Swap Dealers] or [Major Swap Participants] [as will almost surely be the case], would merely re-allocate and re-label risk, but not materially reduce it.  What was formerly a derivatives exposure risk would be converted to a lending facility risk.  A counterparty default from a derivatives obligation would have the same impact on a bank as a default on a margin lending facility obligation.  In other words, changing the form of the risk does not eliminate the risk (p. 10).  [Emphasis in original.]

. . . .

Some have suggested that end-users that traditionally pledge non-cash collateral cold continue their operations by using a secured financing facility.  Like the margin lending facility discussed earlier in Section II.B.3., a secured financing facility does little or nothing to remove risks from the system.  Instead, it simply changes the name of the risk from derivatives exposure to financing facility exposure (pp. 11-12).

Exactly.  And exactly as I’ve pointed out for well over a year.

Revealed preference suggests that implicit and explicit credit are not perfect substitutes.  Indeed, the End User Coalition letter points out (on p. 12) why a secured lending facility may be an imperfect substitute for using non-cash collateral in a derivatives deal.   Thus, the imposition of the constraint will be costly for firms, and will lead to less hedging.

But the Parsons-Mello main point–and the important implication–remains unchanged: substitutions of one form of credit for another will limit, and perhaps sharply so, the effects of margin and clearing and capital mandates on the amount of leverage in the system.  Since leverage is the source of systemic risk–what’s the point?

I also think that P-M are too dismissive of contentions that the regulations as written will result in deadweight losses.  This is because the amount of margin required can be so large as to require firms to alter drastically their capital structures, and such alterations are costly and can result in some of the inefficiencies the Coalition laments.  As the Coalition letter points out, for non-cleared swaps, the margin requirement is quite onerous: the margin must be sufficient to cover 99 percent of 10 day price moves.  That’s a lot.  This will likely require firms to (a) hold far larger amounts of their assets in liquid instruments, and hence less in more productive assets, (b) reduce their derivatives usage, or (c) most likely, both.

Margins and liquidity are costly.  That’s why firms strive to manage liquidity tightly, and are quite sensitive to margin: the amount of collateral and the form in which it must be held are definitely not matters of indifference to them.  A big margin requirement, and a requirement that the margin be posted in liquid assets, will definitely be a binding constraint, and its shadow price will be non-trivial. I don’t know what it is, but I know it’s not zero–primarily because firms optimize with respect to margin costs.

All this means that, at best, the margin requirement and capital requirement rules on end users will merely lead to a relabeling of credit and will not alter the economic substance of end user’s balance sheets.  (Similar arguments hold for financial institutions too.)  At worst, the constraints will result in costly changes to these balance sheets: excessive holding of liquid assets (can you say financial repression?), deficient investments in higher returning illiquid assets (i.e., the productive assets that enhance productivity), and too little hedging.  I read M-P to mean that the margin requirements on end users will merely lead to a relabeling, and that the requirements will not alter balance sheets.  I think that is far too sanguine.

And for what, exactly?  Under the best circumstances (i.e., no change in the economic substance of balance sheets), systemic risk doesn’t change a whit.  Under the worst circumstances, capital is misallocted, risks are misallocated, and there is no reduction in systemic risk (because end users do not contribute to it in a material way).  So, in the best of outcomes: no gain and no pain; in the worse ones, all pain and no gain.

Such a deal.

One final quibble with Betting the Business.  They state:

But of course an implicit credit line embedded in the bid-ask spread has great advantages to dealer banks. It is hidden, bundled with the derivative contract sold and therefore difficult to figure out by client end-users, who never really know how much they are paying for the amount of credit extended. Welcome to the opaque world of OTC markets.

Who cares how the cost components of a derivatives deal break out?  The end user cares only about the all-in cost, and the bid or offer is sufficient for end users to figure that out.  They can solicit quotes from multiple dealers and choose the most favorable one.  They can compare the quotes to the prices of related, exchange traded instruments to evaluate the reasonableness of the prices they are quoted.

Do you really care how the cost of a gallon of gasoline breaks down between the price of the crude, refining margins, transportation, retailing margin, etc?  No: you care about what it costs you to fill up.  If one station quotes $4.60 and another $4.65 for gasoline of equivalent quality, do you care why?  Or, to use the famous example of a pencil: do you really care about what each step of the process of putting a pencil in your hands cost?  No: you care about the price of the pencil.

That’s the information economizing role of prices at work.  It works in OTC markets as it does in pencils and gasoline.

Back in the late-90s and early-00s I often remarked that it was interesting how exchanges had drawn so little anti-trust scrutiny, despite the fact that may were effectively monopolies.  I also predicted that they would get more scrutiny when they became for-profit, and more like conventional firms.

That prediction is being borne out today, and how.  Exchanges, particularly merging exchanges, are the subject of considerable attention from anti-trust authorities.  ICE CEO Jeffrey Sprecher–who ironically had hoped that anti-trust objections to the CME-CBT deal would open the door for an ICE-CBT merger–has seen the writing on the wall:

Exchanges will have to “rethink their global strategies” because of unexpectedly strong scrutiny of proposed bourse tie-ups from antitrust regulators, according to IntercontinentalExchange (ICE), one of the world’s biggest exchanges.

A string of proposed mergers has come unstuck in recent months, either through nationalist opposition in the home market of exchanges perceived as the targets of takeovers, or as antitrust authorities have moved to stymie combinations amid concerns they could reduce competition.

. . . .

Jeff Sprecher, ICE chief executive, said: “There’s been a marked change in the way regulators look at exchanges generally. The good news is that they are looking to exchanges to provide more transparency to prevent another meltdown.

“The bad news is that they want to ensure a lot more exchanges to ensure competition. So the impediments are now higher than they were a few years ago and I think it’s going to cause everyone to rethink their global strategies,” he told the Financial Times.

A major sticking point for anti-trust regulators has been vertical integration between execution and clearing.  The USDOJ Anti-trust Division’s Parthian shot at the CME from early-08 is one example of this.  Battles currently going on in Europe are another.

But the vertical silo wars have now gone beyond execution and clearing to encompass other vertical restrictions, including exclusive arrangements for use of data centers.  Last week, Swedish competition authorities raided the country’s stock exchange as part of an investigation of its deal with Verizon over exclusive access to a data center.

This area is fraught with potential for policy error, because as Sam Peltzman notes in his chapter on Aaron Director in Cohen and Wright’s Pioneers of Law and Economics, and as Posner notes in his Antitrust Law, anti-trust policy over vertical restrictions and vertical integration has long been a mess.

The brief against integration, particularly between execution and clearing venues, is that clearing is a natural monopoly, and that the operator of a clearing monopoly can thwart competition in execution by creating a vertical silo, and providing clearing services exclusively to its integrated execution arm. That is, that the clearing monopolist can leverage his market power into execution, which would otherwise be competitive.

As Peltzman notes, and as Director argued well over a half-century ago, this fear of leveraging one monopoly into two is commonsensical–and more often than not, wrong.   The essence of the Chicago critique is that the monopolist (in this case, the operator of the clearing service) can extract all of the monopoly rent by choosing the monopoly price for his product.  Keeping out potentially more efficient suppliers of complementary services (e.g., execution, which is highly complementary to clearing) just reduces the profit the monopolist could extract.  The monopolist wants complements sold for the lowest price possible, in order to push out the demand curve for the monopoly good as far as possible.  Thus, keeping out a more efficient supplier of the complementary good, or reducing competition in the sale of the complementary good, is counterproductive.

Chicagoans starting with Director explained vertical restrictions as a form of price discrimination (which has ambiguous welfare consequences) or as a means of addressing free rider problems (as in Telser’s model of resale price maintenance) or as a way to eliminate double-marginalization problems.  Transaction costs economists devised other efficiency-related explanations for vertical integration.

But the suspicion of vertical integration and ties and exclusive dealing and other vertical restraints lives on.  Hence the fighting over silos in the exchange space.

Post-Chicago, there have been several attempts to produce models which lead to anti-Chicago implications, i.e., to show that monopoly leveraging is possible.  In this post I will discuss those models, and show that they don’t apply to the facts of the exchange case.  In a future post, I will discuss the efficiency rationales for integration and exclusivity.

The most prominent post-Chicago leveraging model is by Whinston.  In his model, there is a monopoly good M.  Some customers want to consume that good along with another good C that could be produced by competitive firms.  But some customers don’t want to buy M.  They wish to consume C alone.

In Whinston’s model, the M monopolist may want to tie or vertically integrate into C (and not sell to other producers of C) if entry into C production requires payment of a fixed cost.  By tying/integrating, those who want to buy M have to buy C from the M producer too.  Thus, potential entrants into the C market can sell only to those who want to buy C alone.  If there are too few of those customers, or fixed costs are too high, it will be unprofitable to enter into the production of C.  Then the monopolist can sell C to the stand-alone customers at a monopoly price.

This model clearly doesn’t fit the facts in the clearing-execution case.  Those products are highly complementary.  Indeed, they are consumed in nearly fixed proportions–if you want to trade, you need to clear, and if you clear, you need to trade.  The whole point of the Whinston model is about monopolization of a product some customers do not find complementary to M. The monopolist uses his power over the customers who have strong complementarity to gain a monopoly over customers who do not experience any complementarity with M.   This is clearly at odds with the assertions of those who assert that clearing monopolies use their power to achieve execution monopolies, because those assertions rely heavily on the notion that clearing is an essential service–i.e., highly complementary to execution, and a service that all traders consume.  That’s completely at odds with the Whinston story, so it is of no help to the anti-silo crowd.

Carlton and Waldman have an interesting model that embeds complementarity, but arrives at similar conclusions to Whinston’s model.  But whereas Whinston argues that ties/integration can be used to extend a monopoly to a non-complementary good, Carlton-Waldman devise a model in which a monopolist ties a complementary good to protect his M monopoly.

C-W present a two-period model.  A firm has a monopoly over M.  It is guaranteed this monopoly for 1 period, but in the second period, a competitor can enter.  The M monopolist can also produce a good C, and a firm that can enter the M market in the second period can produce C in the first period.

In one model, the rival incurs a fixed cost to enter the C market.  By tying the complementary good in the first period, the M monopolist deprives the entrant of any sales in the first period.  The profits from producing C and M in the second period may not be sufficient to cover entry costs, meaning that with the tie entry may not occur in either market, thereby preserving the M monopoly.  In contrast, without a tie, the entrant can produce C in the first period, and make a profit that contributes towards covering fixed costs: he can make a profit because his C good is superior to that of the monopoly producer of M.  The profit from entering C production in the first period may cover fixed costs of entering the C market.  Then, in the second period, it may be profitable to enter the M market as well.  In this case, tying protects the M monopoly.

In the second model, there is customer lock in due to network effects.  By tying in the first period, the monopolist of M locks in a lot of consumers of C, and deprives the entrant of any sales in the first period.  The customer lock-in reduces the profitability of entry into M and C production in the second period, likely by enough to make such entry unprofitable.  Again, the tie protects the M monopoly.

These models work best to explain ties in highly technologically dynamic industries where monopolies are likely to be short-lived in any event.  That doesn’t seem to fit the exchange-clearing case.  Moreover, there is no legal or economic bar on entry into clearing and execution simultaneously: the necessity of sequential entry is the key driver of the C-W results.  Indeed, integrated exchanges have entered in competition with incumbents, and execution platforms have secured clearing services by contract, so simultaneous entry has occurred.

A third type of model relies on contracting externalities to explain how exclusive dealing and integration can impair competition.  One example of this is a model by Hart and Moore.  In H-M, an upstream monopolist can sell to multiple downstream retailers.  In the exchange case, the upstream firm would be the clearing monopoly, and the retailers execution venues.

In the H-M model, the upstream monopolist negotiates with the downstream firms individually and secretly.  Moreover, they negotiate over output–the quantity sold: this is a key assumption.  H-M show that under these conditions, the monopolist cannot credibly commit to sell the monopoly output Q_m.  For instance, if he sells .5Q_m to one firm, he has an incentive to sell more than .5Q_m to the other: he cannot credibly commit to selling .5Q_m to the second firm once he has sold that amount to the first firm.  Thus, total output exceeds the monopoly output and the monopolist’s profit is smaller.  Indeed, he can only achieve the Cournot duopoly profit.  If he sells to N retailers, he can get only the N-firm Cournot profit.

By integrating, or selling to only a single retailer, the monopolist effectively commits to the monopoly output.  This may come at a cost.  For example, there may be diseconomies of scale in retailing, or retailers may be differentiated and service different customer clienteles.  But the gains from eliminating the commitment problem may exceed the costs arising from diseconomies of scale or underproduction of variety/customization.

The monopolist obviously has incentives to avoid the commitment problem that drives the exclusionary result.  For instance, he could charge the monopoly price, post that price publicly, and let the downstream firms buy as much as they want–which would be .5Q_m.  This would require the avoidance of secret price discounts.  Reputation may ensure this in a repeated game.  The retailers could monitor competitors’ sales to see if the monopolist were cheating.

Moreover, this doesn’t seem to match up well with the mechanics of the exchange case.  “Output” is not the choice variable; prices are.  And trading volumes are readily observable, making it possible to detect whether a clearing monopolist were offering secret price cuts.

A similar model is one in which a downstream monopolist buys from two upstream suppliers who compete in an input market in which the supply curve for the input slopes up.  Similar commitment problems preclude achievement of the monopsony outcome in the input market.  This model has the same choice variable problem as the H-M model, and what’s more, it is difficult to imagine what the relevant input with the upward-sloping supply would be.  Computer programmers?  Servers?  Again, it doesn’t fit the exchange case well at all.

Another model of anti-competitive integration is by Ordover, Saloner, and Salop.  In that model, two downstream firms D1 and D2 compete, as do two upstream firms U1 and U2.  If D1 and U1 integrate, and the integrated firm refuses to sell to D2, D2 now has to buy an input from a monopoly supplier U1.  D2 pays a higher price for the input, which makes it a less formidable competitor for the integrated firm, which therefore becomes more profitable.

This model is quite fragile.  What’s more, an example in a related paper by Riordan and Salop makes it hard for me to take the theory seriously.  Their example of how this could work is that the purchase of Autolite–a spark plug maker–by Ford could raise the price of spark plugs to GM and Chrysler, thereby allowing Ford to raise the price of cars.  Really.  They couldn’t come up with a better example.  (Posner snarkily dismisses the applicability of this theory by pointing out the complete absence of credible examples.)

Moreover, it doesn’t fit at all the arguments of the anti-silo advocates.  Their premise is that clearing is a natural monopoly.  But the OSS model depends crucially on integration reducing competition upstream (i.e., in clearing).  That can’t happen if clearing is already a monopoly.  OSS is not a theory of monopoly leveraging.

In brief, there are a variety of rather special models that arrive at anti-Chicago conclusions, and which suggest that vertical restrictions and vertical integration can be anti-competitive.  None of these models, however, fit the facts of securities or derivatives trading.  Moreover, many are completely at odds with the arguments made by those who claim that integration between clearing and execution is monopoly leveraging.

Which means that the anti-silo forces are on very shaky intellectual ground.  There is no existing, rigorous, logically consistent theory that is (a) consistent with the facts of the exchange case, and (b) rationalizes their conclusion that integration is anti-competitive monopoly leveraging.

In his industrial Organization text, Tirole warns:

Few topics in industrial organization are as controversial as market foreclosure.  . . . Though market foreclosure is a “hot” issue among those concerned with anti-trust proceedings and with regulation, economists still have a very incomplete understanding of its motivation and effects.  Nor can they always explain successfully why a particular tool is employed to achieve foreclosure.  (Tirole, The Theory of Industrial Organization, p. 193).

True, that.  And given that Tirole is hardly a wild-eyed libertarian, those convinced that vertical silos in exchanges are anti-competitive foreclosure should take his words as cautionary.

Posner once upon a time was more of a libertarian than Tirole, but his words are also worth considering:

The general prohibition in section 2 of the Sherman Act against monopolizing is adequate to deal with the rare case in which a firm imposes a tie-in with the purpose or likely effect of monopolizing the market for the tied (or for that matte the tying) product.  A special tie-in doctrine, inevitably with a life of its own, is unnecessary and inappropriate.  (Antitrust Law, 2d. Ed., p. 207). [Emphasis added.]

Whinston recognizes that many of the models of vertical exclusion are quite special cases, limited primarily to “triangular” situations (i.e., two upstream firms and one downstream, or two downstream firms and one upstream).  Thus, like Tirole, he cautions against drawing strong conclusions on the basis of special models.

In his “Should Antitrust Be Modernized” (J. Econ. Perspectives, 2007), Dennis Carlton cautions that rules intended to identify anti-competitive exclusive acts “could potentially challenge a wide array of core competitive behaviors” and hence become “dangerous” (p. 170).   Peltzman, in the chapter on Director I alluded to earlier, takes a more benign view of the effects of errors in precluding certain types of vertical restrictions.  Sam explains courts’ hostility to vertical restrictions by a monopolist to the belief that it is unlikely that outlawing such restrictions is unlikely to have a serious detrimental impact on competition, that any benefits of the restriction are likely to be indirect, and that courts typically discount any such indirect effects.  Transaction costs economics suggest that these benefits may be large, however, so such discounting is problematic at best.

In sum, the existing models that demonstrate that vertical restrictions can leverage monopoly don’t fit the facts of the clearing-execution case and are so highly stylized that even their developers caution against taking them too seriously in practical situation.  Moreover, thoughtful analysts of anti-trust discount their applicability.

Based on this, antitrust authorities–and those who criticize integration between clearing and execution, or between exchanges and data centers, for that matter–should be much more circumspect in their attacks on silos: the cases in which integration or vertical restrictions are anti-competitive are the exception, rather than the rule.  This circumspection should be all the greater because there are compelling efficiency rationales for vertical integration and other vertical restrictions involving clearing and execution.  I’ve laid out some of those rationales in working papers, and will devote a future post to the subject.