Streetwise Professor

According to Bloomberg’s Matt Leising (story not yet online), the CME’s would be competitor ELX is in discussions with The Clearing Corporation (the clearinghouse formerly known as BOTCC) to obtain clearing services. Immediately following the announcement of the formation of the new exchange in December, I surmised that the then-unnamed CME competitor would clear through the Clearing Corp due to the fact that several of the nascent exchange’s founders had just bought stakes in the once and former BOTCC. Although the Options Clearing Corp and ICE Clear have submitted proposals to ELX, I predict that at the end of the day Clearing Corp will prevail.

Although this will not be formally a vertical relationship, as ELX and CC are formally separate organizations, given the overlaps in ownership it will functionally integrate execution and clearing. Indeed, that is almost certainly one of the virtues of the arrangement to ELX, although I imagine they will not be too vocal about this as that would contradict their criticism of CME’s ownership of its clearinghouse.

This would also represent another move in the direction of more integration in clearing. The trend is clear (no pun intended): SWX, ICE, and LIFFE have already moved decisively in this direction, and LSE has also mooted the possibility. Regulators on both sides of the Atlantic view this with alarm, due to their fixations on the purportedly anti-competitive effects of integration (a fixation derived from bad economics), and their steadfast refusal even to contemplate the potential efficiency benefits of integration. You’d think that such a trend would spark at least a little doubt and reflection among European regulators and USDOJ, but you’d be wrong.

Treasury Secretary Paulson made a big splash with his announcement of a “plan” to reform US financial markets. In fact, it is much sound and fury signifying nothing, with virtually no chance of being implemented. Moreover, it is completely non-responsive to the current travails in the credit markets.

The biggest headline was that the recommendation for the merger of the SEC and the CFTC. This puts in me in mind of two quotes. The first is by Churchill: “A fanatic is one who can’t change his mind and won’t change the subject.” Whenever anything happens in the financial markets, the cry immediately goes up to merge the SEC and the CFTC. Many people are apparently fanatical, because they never change about their minds about the desirability of the merger, and the subject always seems to return to it.

The second quote is by somebody slightly–well, a lot actually–less famous; that would be me. In a 2001 Regulation Magazine piece on the Clinton regulatory legacy, I wrote that the SEC-CFTC combination was a solution in search of a problem.

I am always somewhat mystified by the substance of the arguments for the merger. The most commonly mentioned benefit is a harmonization of margins between stocks and stock index futures. What, it’s not possible to harmonize without going merging the two bodies? Moreover, given the myriad other more important issues facing the two agencies, this seems like a very thin reed on which to rest a major reshaping of the regulatory structure.

In reality, there is very little overlap between the regulatory responsibilities of the two agencies. What’s more, there are huge swathes of the trading landscape that fall outside the jurisdiction of either agency. So merger will hardly reduce that much duplicative or contradictory regulation, and will not fill any regulatory gaps. So what’s the point?

Indeed, there are many sources of potential danger in a merger. One, very underappreciated in my view, is that it sacrifices the advantages of specialization. There are issues unique to securities markets and derivatives markets. Specialized agencies can develop the expertise needed for each market space. Of course the staff at a merged agency could specialize, but major policy, rulemaking, and interpretive decisions are made at the commissioner level. Right now SEC commissioners, for example, need to deal with arcane issues of accounting, disclosure, securities intermediation, and securities trading practices in stock, option, and fixed income markets. This is an already daunting task. Adding new areas of responsibility involving different markets and different instruments with different issues will further tax the already limited expertise of the commissioners of the merged agency.

The inevitable outcome of this dilution of expertise and specialization will be to enhance the power of staff, and degrade the quality of commission decision making. Neither outcome is desirable.

Indeed, I would argue that the SEC is already underspecialized. The agency operates subject to three statutes, the Securities Act of 1933, the Exchange Act of 1934, which focus on primary and secondary markets for securities, respectively; and the Investment Company Act of 1940, which focuses on mutual funds and the like. The agency has responsibility over the issuers of securities, and the markets and intermediaries that trade securities. There is little overlap between these areas. Issues of disclosure and accounting can be conceptually and operationally distinguished from issues of market structure and organization.

A second area of concern is that a unified agency will provide a mechanism to reduce and distort competition between different sectors of the financial markets. There are many on Wall Street that would love to throttle the futures exchanges in order to reduce competition for the securities business. (The margin issue is a perfect example of this. The securities firms would love to force an increase in margins on futures to drive some business from the futures exchanges to the stock market.) The regulatory autonomy of the CFTC has largely precluded such an outcome. The SEC has indeed tried in the past to impede the development and introduction of futures products that compete closely with securities markets but has largely failed in these endeavors because it does not have the necessary authority or jurisdiction.

Now, of course, a merger would change agency politics. Under the current framework, the SEC is largely responsive to securities firms and exchanges, and the CFTC is responsive to the futures exchanges and the FCMs. A merged entity would be responsive to the interests of all of these parties. But that is not necessarily a good thing, as one very likely outcome is that the merged entity would implement regulations that would reduce competition between the varying constituencies.

A more sensible, but still problematic, regulatory reorganization would involve (1) stripping out the primary market, accounting, and disclosure responsibilities from the SEC and putting them in a separate agency focusing on these corporate finance issues, and (2) creating a separate agency responsible for trading and market structure issues in securities and derivatives markets. This second agency, call it the “Commission for Financial Trading and Markets” (“CFTM”) would focus on issues relating to manipulation; fraud; the financial adequacy of intermediaries (securities and derivatives brokerages); and facilitating competitive market structures in financial markets. Arguably the manipulation, fraud and competition responsibilities should give the CFTM some authority in the OTC markets.

This approach would be far preferable to mashing together two disparate agencies with very different histories and cultures in the hope that something beneficial will come out of the unnatural coupling. It would permit the development of some specialization, and many issues of fraud, manipulation, and market structure are common across securities and derivatives markets, so the specialization could be applied to a variety of related markets. This alternative is still problematic, however, because the CFTM could easily become a mechanism for stifling competition between different methods of allocating risks and discovering prices.

All that said, there is little likelihood that the merger (or the creation of a CFTM) will come to pass in any event. The idea has been around for decades, and has never even come close to implementation. This is no surprise. There are powerful political forces in the way. Most notably, the futures exchanges, their members, and the FCMs have fought the SEC’s loving embrace vociferously, and found vocal support in Congress. Moreover, whereas the SEC falls under the congressional banking committees (e.g., the Senate Banking Committee and the Securities, Insurance and Investment Subcomittee), the CFTC is under the ag committees. Neither is about to readily cede jurisdiction over a large, well-heeled, and generous industry.

There is another strange aspect of the Paulson initiative. The ostensible reason for the urgency of financial reform is to address systemic risks. The most recent event stoking this urgency is the near failure of an investment bank and the resulting bailout (call it what you will, but by any other name it would still stink.) But what financial institutions are almost wholly absent from Paulson’s “blueprint”?–well, investment banks. Now, presumably, they would be subject to the Fed’s “supercop” authority if they posed a threat to financial stability, but what is striking is that the specificity of the proposals for commercial banks, insurance companies, the SEC, the CFTC, and mortgage intermediaries is not matched by specific proposals for changes in the regulation of investment banks.

Don’t get me wrong, I am not advocating expansive new regulations of IBs. I just find the contrast somewhat jarring.

I also think that the blueprint shockingly fails to mention, let alone address, a major source of the current ongoing tumult in the credit markets, and what could be the source of worse problems in the future: the lack of transparency in the valuation of many products in bank and investment bank portfolios.

One reason for Bear-Stearn’s liquidity crisis was that potential lenders and counterparties had no way of ascertaining the value of the complex products in its portfolio. Even if Bear had opened the kimono (as the phrase goes) and told everybody what was in its portfolio, nobody would have been able to put a value on it. The complexity of many of the products, and the lack of pricing data make the task of valuation impossible.

I wish I could say I had a canned answer to this last problem. I don’t. Neither does anybody else. However, Treasury and the SEC have already made tentative moves to engage the NYSE in launching a pricing service. There are some existing precedents, albeit dealing with simpler tasks–the Municipal Securities Rulemaking Board and NASD have created price reporting services for municipal and corporate bonds, respectively, for example. Getting accurate valuations of much more complex structured products will be far more daunting, but before this difficult problem can be tackled, it must be raised. Paulson did not do so.

In my view, all of the things that Paulson actually addressed are small beer compared to the thing he left out–improving price discovery, valuation accuracy, and transparency in the vast markets for structured credit and mortgage products. These products are the source of the current problems in the credit markets, and are the most likely source of future problems. The lack of good information about the valuation of these products is what makes the credit markets most vulnerable to seizing up; who will finance intermediaries when nobody knows what they are really worth?

As I said, this is a hard problem. But it is a problem of first order importance–something which cannot be said of other things in the Paulson initiative, the SEC-CFTC merger most notably. it would be far better had the Treasury secretary identified this problem as a priority, and at least outlined a proposal to tackle it.

According to the FT, the UK’s Office of Fair Trading (the British antitrust authority) has apparently caught a case of the stupids from the USDOJ:

In the row over the ICE, which is planning to move clearing in-house and away from LCH, the matter is under review by the UK Office of Fair Trading. There are signs that the OFT, which has long been troubled by the competition issues raised by exchanges owning clearers, is studying the application closely. Two weeks ago, it sent out questionnaires to market participants querying the level of competition for the mostly widely traded ICE contracts in London.

If ICE forces customers to use only its own clearer, bankers say they will press the Commission to block the deal. Last week, in a separate initiative, Nymex launched a suite of products in direct competition with ICE that will clear through LCH.

Meanwhile, customers are also threatening to bring LCH to the attention of European authorities over a deal it tentatively struck with Liffe last week that would see the exchange take some of its clearing in-house but stop short of forming its own in-house operation and ending its relationship with LCH.

It would be nice, if just once, somebody, somewhere in some antitrust authority would actually step back and do a thorough analysis of economics of vertical integration in clearing and execution. The monomaniacal focus on (likely chimerical) anti-competitive effects, to the complete exclusion of any consideration of the possibility that vertical integration, might, just might, have some efficiency rationales will inevitably lead to bad policy. As I have said before, this is throwback antitrust analysis–BC, as in before Chicago.

One simple question for the OFT: if exchange control of clearing is the big obstacle to competition in execution, why hasn’t LIFFE faced competition in its products? And for that matter, why hasn’t LSE? (Okay, that’s two questions.) And who owns a big chunk of LCH? (Okay–three.) It wouldn’t happen to be the banks that are complaining about LIFFE moving clearing in-house, would it? (I know.)

On that last point, before one canonizes the poor, martyred banks who suffer at the hands of those cursed exchanges, consider the following story by the excellent Natasha (may I call you dahlink) de Terán:

LCH.Clearnet has operated SwapClear, a much used and admired swap clearing service, for nearly a decade. SwapClear has its critics and limitations but the one that could prove to be most damaging is its membership criterion.

A self-qualifying circle of dealers, OTCDerivNet, guard SwapClear’s gates. The buyside and other smaller dealer firms are kept outside. LCH.Clearnet might have wanted to roll out a similar service to that of the CME. But it has been hamstrung by OTCDerivNet.

Imagine that, a cooperative that restricts entry! Never heard of that before. (Yeah, well, except for the NYSE and pretty much every traditional US derivatives exchange and many overseas exchanges.) Think that such entry restrictions might well enhance the profitability of the members that are on the inside looking out? That certainly was the case with exchanges, as my 1999 J. Financial Markets paper showed.

Thus, perhaps the European Commission and OFT should take a break from obsessing about exchange vertical integration, and take a gander at some other possible competition issues in clearing. As I wrote in my clearing paper, disintegration combined with the formation of a cooperative clearing venture is no guarantee that a thousand competitive flowers will bloom. Execution venues that discover prices are likely to remain monopolies after disintegration; even cooperative clearers can exercise market power by restricting entry or supercompetitive pricing (and don’t be fooled by big rebates to members–that can be perfectly consistent with the exercise of market power); and the parallel operation of an exchange and a clearer both with market power can lead to inefficiencies in the form of double marginalization and higher transactions costs.

In my earlier posts on the DOJ’s jeremiad on clearing, I questioned whether its analysis of US options markets was apposite. I have finally had a little time to research the issue, and the answer is a resounding “NO!”

In my original post pointed out a couple of possible important issues–intermarket linkages and payment for order flow–that could mean that the survival of multiple options exchanges does not imply that network effects are immaterial in financial trading. Indeed, as several SEC studies document, both features are very relevant in US options markets.

As part of the exchanges’ antitrust settlement with the government, the exchanges adopted an intermarket linkage plan and agreed to adhere to order handling rules. Though not as streamlined as those eventually adopted for the equity markets under RegNMS, these measures provided considerable linkage between the different option markets. That is, though they did not go as far as creating a central limit order book (“CLOB”), the rules did go a long way towards creating a central price discovery venue. That is, options exchanges are not competing price discovery venues; they are competing portals to a central price discovery mechanism. Linkages and order handling rules sharply reduce the centripetal forces that would otherwise induce trading to “tip” to one exchange

Moreover, the SEC studies report that a very large fraction of order flow served by the options exchanges is purchased. As I have written in my academic work, purchased order flow is typically uninformed order flow that does not contribute to price discovery. Moreover, as I have also shown in that work, multiple “cream skimming” venues servicing uninformed order flow can coexist. That is, segmented uninformed order flow does not tip. The survival of multiple exchanges servicing uninformed traders via payment-for-order-flow and internalization arrangements in no way contradicts the tipping/natural monopoly of price discovery framework.

Thus, the survival of multiple exchanges in options is not attributable solely to the fact that the industry operates a cooperative clearing “utility” as the DOJ claims. Rather, this survival reflects the facts that (a) linkage and order handling rules have effectively socialized order flow and created a central price discovery venue, and (b) much of the uninformed order flow is “skimmed” and segmented, and thus not susceptible to tipping.

This implies that creation of a clearing cooperative is NOT sufficient to lead to competition in execution, and the survival of multiple, competing price discovery venues as the DOJ letter asserts. Much more radical steps are required. Specifically, no execution venue can be allowed to own and control its order flow. Absent any obligation to redirect order flow to another market offering a better price, and the creation of technological linkages that make this redirection quick and efficient, trading activity will tip to the market that offers the best expected terms of trade. This becomes a self-fulfilling process, resulting in the survival of a single market.

Now, there is an argument to be made that such rules and linkages are efficient; in fact, I’ve made it in my JLEO article “Security Market Macrostructure.” But the DOJ does not make that argument–or even provide any inkling that it even understands the issue. It merrily suggests that cutting the baby in half–splitting execution and clearing–alone will allow the proliferation of many competing execution venues. Wrong. Wrong. Wrong. Look at the history of equity trading 1975-2005 for abundant proof of that. If the formation of a clearing cooperative was sufficient to create competition in execution, why did the SEC feel it necessary to push ahead with RegNMS and its socialization of order flow decades after the creation of a securities clearing cooperative?

Indeed, if followed, the DOJ’s prescription could be very damaging, leading to no improvement in competition in exchanges, but resulting in reductions in efficiency due to double marginalization, and higher transactions costs. Without measures to break the network effect–to socialize order flow through mandated market linkages and order handling rules, or the creation of a CLOB–shearing clearinghouses from exchanges will do nothing–zip, nada, zero–to increase in competition in execution, but it will lead to wasteful “friction” at the interface between the independent clearer and exchange. All pain. No gain.

It is also interesting to note something that the DOJ ignores altogether. Not only is exchange ownership of futures clearinghouses the standard worldwide, it is actually increasing in importance. ICE has brought its clearing in-house in the US, and is endeavoring to do so in the UK, though that is running into some obstacles–regulatory and in implementation. As another example, LIFFE, which had historically secured clearing from LCH (and subsequently LCH.Clearnet) is now moving to integrate clearing. This is quite consistent with the transactions costs arguments I have advanced.

There are two stark choices: either keep the status quo, or undertake a thorough remaking of the regulatory structure in futures markets along the lines of what has been done in equity (and latterly options) markets in the past 30 plus years. The DOJ’s nostrum either goes too far, or not far enough. Since there has been absolutely no debate regarding the organization and regulation of futures markets along the lines of that which has roiled the securities markets for decades, it is highly unlikely that the more radical alternative is in prospect any time soon. I only fear that the pressure to do “something” leads Congress and the regulators to take the DOJ’s middle ground–to the detriment of the markets and their users.

No, another Craig–Craig Donohue, CEO of the CME. In fact, though, in his speech today, that Craig–Craig D.–echoed some things that this Craig–Craig P.–has written in several working papers on clearing.

In his full-throated defense of integrated clearing, Donohue said:

[T]here has not been sufficient discussion of the potential problems associated with an investment bank-owned/controlled CCP. While one can reasonably argue that some exchange-owned CCPs may seek to extract monopoly rents, one must also be willing to acknowledge that investment bank-owned CCPs may limit CCP activities in some markets in order to maximize trading and dealing profits for their owners at the expense of smaller members of the CCP and true end-users.

I made a related point here. Donohue also said:

These problems exist in large part because investment banks traditionally have resisted a more centralised, transparent execution system for these products, preferring to maintain their dealer franchises and proprietary trading profits. And they have tended to oppose central counterparty clearing services in these markets, worried that a mutualised risk structure will dissipate their credit and balance sheet advantages.

I made a similar point in a 1999 working paper (cited here by current Fed Governor Randy Kroszner) that morphed into this paper.

Relatedly, the Federal Trade Commission Report on the Grain Trade of 1921/1922 reported that concerns that central clearing would level the credit playing field was a source of opposition to the adoption of the clearinghouse at the CBOT in the ‘teens and twenties.

Stepping back a bit, it is important in this context to remember Coase’s point that it is necessary to compare real world alternatives, not a real world situation to the Nirvana alternative. Too much of the debate on clearing has compared the existing clearing arrangements to a pie-in-the-sky alternative (with crucial implementation details conveniently left out.) Donohue makes appropriate comparisons. He acknowledges that a central clearer may exercise market power, but draws attention to the point that alternative clearing arrangements may also result in the exercise of market power.

That’s a major theme of my most recent paper on clearing silos. There I show that seemingly innocuous differences–such as, whether a cooperative clearer owned by banks rather than an exchange rebates fees proportionally to output, or instead rebates fees to owners proportional to fixed ownership shares–can have a major impact on market power, with the latter arrangement essentially allowing the “cooperative” clearer to operate as a perfect cartel. Moreover, as I have pointed out in other articles (namely, my JLEO and JFM papers on exchange organization) a “not-for-profit” firm (be it an exchange or a clearer) can effectively exercise market power by restricting membership; in this case, the market power rents are not earned by the firm itself, but by the members.

So, let the debate continue–but when considering alternatives to exchange-owned clearing, let’s focus on how those institutions might work in practice.

Catching up with several 2007 SWP posts, the G-7 finance ministers have called for China, Indonesia, and India to end price controls on oil (and the associated subsidies) because these encourage inefficiently high consumption. According to the linked Economic Times (India) article, Indonesia spends $11.5 billion to subsidize fuel; India $2.8 billion; and China $2 billion.

The article does not state whether the G-7 or any commentators have provided estimates on the additional consumption of oil that has resulted from these policies, or the impact on the world oil price. Nor have I been able to track down (via Google) any other articles or statements containing this information. Given the magnitude of the subsidies, and the inelasticity of oil supply, the quantity and price effects are unlikely to be trivial.

It’s good to see that this issue is finally getting some visibility, and that decision makers in the G-7 countries understand the world wide effects of these price controls. I wish I could be more sanguine that things will change, but I seriously doubt they will.

Apparently having confronted the Beltway equivalent of catapulted cows or killer rabbits, the DOJ has beat a hasty retreat from its bold condemnation of exchange control of clearing in financial futures. (Dunno if any armor was soiled.)

As would befit Eric Idle’s Robin of Loxley, DOJ denies that they were ever itching for a fight. Oh no. They were just calling for a study:

The U.S. Department of Justice said its opinion this week that financial futures exchanges are anti-competitive took no stand on how the issue should be addressed.

The division’s comments did not take a position on what action, if any, that should result from such a study and contemplated that Treasury would take into account a range of consideration, the department said.

Sure, Brave Sir Robin. Here are the first couple of paragraphs from the DOJ Comments:

[T]he department believes that certain regulatory policies governing financial futures may have inhibited competition among financial futures exhanges, potentially discouraging innovation and perpetuating high prices for exchange services.

More specifically, the Department believes that the control exercised by futures exchanges over clearing services . . . has made it difficult for exchanges to enter and compete in the trading of financial futures contracts. If greater head-to-head competition for the exchange of futures contracts could develop, we would expect it to result in greater innovation in exchange systems, lower trading fees, reduced tick size, and tighter spreads, leading to increased trading volume.

And from the conclusion:

The Department believes that current rules and policies related to clearing futures contracts may be unnecessarily inhibiting competition among futures exchanges . . . to the detriment of the economy and consumers. Unnecessary restraints on competition threaten the viability of the US financial markets to adapt to changing dynamics . . . .

The Department believes that significant benefits might be achieved if regulatory policy were changed so as to foster exchange competition by, inter alia, ending exchange control of clearing.

Now, although the DOJ “recommends that Treasury undertake a careful and objective review of exchange controlled clearing of financial futures” the quoted language makes it abundantly clear that it is extremely disingenuous to say that the Department “took no stand on how the issue should be addressed.” Justice obviously cannot tell Treasury what to do, but it is crystal clear–even given the Loxleyesque “mights” and “mays”– that DOJ was taking a very clear stand on what it thought Treasury (or was Congress the real audience?) should do. So, rather than stand by the courage of its convictions (flawed though they are) that clearing be wrested from exchange control, as expressed in 22 single spaced pages, DOJ hid behind the the two sentences in the Comments calling on Treasury to study the issue.

Who you gonna believe, the DOJ press release, or your lyin’ eyes?

One other curious, curious thing. Dennis Carlton, former Deputy Assistant Attorney General for Economic Analysis, the individual who oversees the Competition Policy Section, rejoined Lexecon on 30 January, 2008. The Comments were dated 31 January, 2008. Assistant Attorney General (and head of the Antitrust Division) Thomas Barnett has stated that the Comment was not something prepared hastily, but was instead the product of long study and work, as evidenced by its 22 page length. As I noted two days ago, moreover, the Comment was submitted two months late. Dennis did not sign the Comment.

I don’t know exactly when Dennis resigned from DOJ, but it is possible that his resignation was effective on or about 30 January, 2008 given that FTI Lexecon announced his return to the firm on that date. If this is the case, the comment was written while Dennis was still at DOJ. It is my understanding that Dennis recused himself from the CME-CBT case because Lexecon was working for CME on the case. Therefore, perhaps Dennis did not sign the letter because of the same perceived conflict.

But that is hard to square with the Comment’s release the very day after Dennis rejoined Lexecon. Another possibility that is more compatible with the timeline–and this is clearly just speculation on my part–is that Dennis did not agree with the substance of the analysis, and that as a result its release was delayed until after his departure from the Antitrust Division and his return to Lexecon. This would explain the otherwise inexplicable submission of the Comment two months after the deadline had passed. Moreover, I would be greatly surprised if Dennis agreed/agrees with the substance of the Comment. Regardless, the credibility of the Comment would have been enhanced if an economist of Dennis’s stature had signed it–if they could find one who would do so.

So let me get this straight. The DOJ submitted its comments to Treasury two months after the end of the public comment deadline. Moreover, the Treasury disclaims any interest whatsoever in antitrust issues in futures markets (from Bloomberg):

Treasury officials preparing an overhaul of U.S. financial regulations haven’t discussed antitrust issues involving financial futures exchanges, Treasury Undersecretary Robert Steel said, two days after the Justice Department said the companies may inhibit competition. “Our issue is the overall structure” of markets and not antitrust matters, Steel said today in an interview.

How clearinghouses are structured “really hasn’t been part of our discussion,” Steel said. “The issue of antitrust is not something Treasury is involved with.” Steel said such matters were under the authority of the DOJ.

Now, what is the probability that DOJ didn’t know that Treasury couldn’t care less about clearing market structure? Zero would be a good guess–and my only one.

So, let’s put it together. Well after the deadline for public comment DOJ submits a tendentious comment letter on an issue of no interest to the recipient thereof. The comment therefore did not serve its ostensible purpose of illuminating Treasury about a matter of concern to it, and the DOJ surely knew this was the case. So, what was the motive for doing this?

I don’t want to go all Soviet over this, and turn every question of fact into question of motive, but the objective reality is that there is an agenda at work here. Exactly what it is I don’t know. But the situation bears the hallmarks of a disgruntled staff getting some payback, or attempting to achieve a desired policy outcome (the derailing of the CME-NYMEX tie up?) that it could not achieve through established procedures (e.g., a merger review). Did DOJ feel pressured by Illinois’ formidable Congressional delegation into waving through a CME-CBOT merger that it really wanted to oppose? Just guessing here, but the extraordinary circumstances (timing, disconnect between the comments and the DOJ announcement on its closing of the investigation of CBT-CME merger, the fact that the comments were completely off point to the issue about which comments were solicited) raise very serious questions. I have tried–really I have–to discern a benign or favorable interpretation of these facts, but have failed miserably.

This is serious business. These gratuitous, unsolicited comments cost investors billions of dollars. They created tremendous uncertainty. DOJ better have a very good reason for its actions, but I’ll be damned if I can think of one. Somebody got some ‘splainin to do, Lucy.

The politics/motive are interesting and important, but the most important thing is to focus on the substance of the comments. As I blogged yesterday, the substance is an embarrassment. The suspicious circumstances surrounding the release only gild the lily.

The DOJ comment refers to “appropriate regulation” of a separate clearing entity, but never specifies just what that “appropriate regulation” would entail. In football, that’s called a punt. It reminds me of the old Steve Martin routine “How to Make a Million Dollars Without Paying Taxes.” First, make a million dollars . . .

The devil is in the details, and “appropriate regulation” doesn’t appear at the wave of a magic wand. Indeed, after the political sausage is ground, all too often we end up with inappropriate regulation. It takes a market structure to beat a market structure, and merely assuming an “appropriate” alternative doesn’t cut it. If DOJ is really serious, it would spell out a model market structure, and how to transition from the current structure to its proposed alternative so that the tradeoffs can be evaluated. Otherwise, we’re just rocking with Nirvana–the Nirvana Fallacy, that is.

The Antitrust Division of the US Department of Justice just lobbed a grenade at US futures exchanges, most notably the CME. In comments submitted to the US Treasury’s review of the Regulatory Structure Associated With Financial Institutions (try fitting that on a business card), the DOJ stated that it “believes that control exercised by futures exchanges over clearing services . . . has made it difficult for exchanges to enter and compete in the trading of financial futures contracts.” The DOJ also opined that

current rules and policies related to clearing futures contracts may be unnecessarily inhibiting competition among futures exchanges . . . the detriment of the economy and consumers. . . . The Department believes that significant benefits might be achieved if regulatory policy were changed so as to foster exchange competition by . . . ending exchange control of clearing (in conjunction with appropriate regulation to ensure that clearinghouses could not in turn exercise market power.

The grenade has caused casualties upon impact. Futures exchange stocks cratered today, with billions of dollars of market cap disappearing after the DOJ blast.

Unfortunately, the DOJ letter is an appalling combination of bad economics and a selective reading of history. It is also almost impossible to reconcile the letter with the DOJ’s decision to permit the CBT-CME merger. This raises questions about the motives underlying the comments.

The fundamental problem with the economic “analysis” in the comments, such as it is, is that the DOJ does not seriously analyze why futures exchanges typically vertically integrate clearing and execution. (And note this is not a uniquely American phenomenon. As I have documented in an academic paper on the subject, integration is the rule worldwide, and separation the clear exception.) The implicit story in the DOJ comment is that (a) execution is inherently competitive, (b) exchanges that control clearing impede competition in execution by withholding access to clearing, and (c) economies of scale in clearing make it impossible (or at least, extremely difficult) for an entrant to compete against the incumbent clearinghouse.

But, as I have pointed out ad nauseum before, if clearing is actually a natural monopoly (part (c) of the argument), why wouldn’t the incumbent clearer just extract the monopoly rent by charging a supercompetitive price for clearing, and not give a whit where execution takes place? Indeed, the DOJ comment makes this very point:

If exchanges did not control clearing, an appropriately regulated clearinghouse could treat contracts with identical terms from different exchanges as interchangeable, i.e., fungible. The incentives of such a clearinghouse would be to maximize its own profits, and thus likely would treat identical contracts as fungible. In a world of fungible financial futures contracts, multiple exchanges could simultaneously attract liquidity in the same of similar futures contract, facilitating sustained head-to-head competition.

But, this argument also implies that a profit maximizing exchange that offers both clearing and execution would also have an incentive to maximize its own profits by making contracts fungible. An exchange with a monopoly clearinghouse would be cutting off its nose to spite its face by tying execution and clearing if execution were indeed competitive. By so doing, it reduces the derived demand for its services–and hence its profits–by forcing traders to execute trades on a higher cost platform. Thus, the DOJ’s assertion that exchanges integrate into clearing to deter competition in execution doesn’t make sense. An integrated, profit maximizing clearer has no incentive to force traders to execute on its platform if execution is indeed competitive.

This immediately raises the question: then why does integration occur? If integration doesn’t make sense as a strategy to deter entry, it must have some other rationale. The most plausible rationale is that it somehow enhances efficiency, by economizing on transactions costs, or mitigating multiple supercompetitive markups, for example. The DOJ doesn’t even raise this possibility, let alone address it in a serious way. Its analysis of justifications for integration in section III.D is pathetically weak, and completely untethered to any serious analysis of the economics of vertical integration and vertical restrictions.

Now, one could argue that clearing is a natural monopoly, and hence it must be regulated to prevent the clearer from exercising market power. (This is implicit in the DOJ’s call for “appropriate regulation to ensure that clearinghouses could not in turn exercise market power.”) But if clearing is a monopoly, then there is no need for the incumbent, unregulated clearer to tie execution. Thus, the DOJ’s call for “ending exchange control of clearing” in “conjunction with” regulation of a clearing monopoly makes no sense. In this case, the “exchange control of clearing” is a red herring. The ability of a clearing monopoly, integrated or no, to charge supercompetitive prices, is the central issue. By linking these two issues, DOJ betrays economic ignorance/confusion.

Now, I have shown that if execution is not competitive due to network effects, an exchange with a clearinghouse may have an incentive to tie (i.e., not make its contracts fungible) to deter entry. But, this is not consistent with DOJ’s (implicit) assertion that execution is competitive. Moreover, I have also shown that if execution is not competitive, entry may be inefficient, and in this case a tie that deters entry may actually enhance welfare. Again, no serious analysis of these issues from the DOJ.

In brief, the DOJ opinion represents a return to a long-discredited antitrust law and economics view of vertical integration and vertical restrictions, a suspicious, hostile view that deems vertical restrictions and integration as anticompetitive, rather than efficiency enhancing.

Insofar as the history is concerned, DOJ examines several instances in which entrants failed to survive in competition with incumbent exchanges. DOJ asserts–but in no way proves–that these failures were due to exchange control of clearing. DOJ says “[e]fforts over the last decade by exchanges to enter the U.S. financial futures markets . . . all of which failed, show the effect of exchange-controlled clearing.” Er, no, they don’t. These failures could have also been due to the liquidity network effect in execution. Just because entry against integrated exchanges failed doesn’t imply that the entry would have succeeded if the incumbent hadn’t been integrated into clearing. DOJ does not seriously investigate the possibility that in these instances clearing was not the crucial barrier to entry, or that the network effect of liquidity in execution was sufficient to make entry fail.

One piece of DOJ’s historical analysis is extremely dubious. It attributes Euronext.Liffe’s failure to dent the CME’s hold on Eurodollars to CME’s adoption of a rule preventing the transfer of positions from CME to LIFFE. Importantly, this occurred after several large block trades that “amounted of a large scale transfer of open interest in Eurodollar contracts from CME to LCH[which was LIFFE’s clearer].” But note well; LIFFE offered clearing (via LCH), and apparently it was economical for some traders to use LCH clearing. Thus, CME clearing was not an “essential facility” that LIFFE needed to access to compete against CME on execution. Implicit in DOJ’s argument is the assumption that integrated entry is infeasible, and no entrant can succeed without access to an existing clearing facility. DOJ’s argument would actually be stronger if no open interest had moved, as this would suggest that there was no economical alternative to clearing via the CME. The fact that (a) LIFFE offered both execution and clearing (via contract with LCH), and (b) some market participants found it economical to use LCH clearing undercuts the DOJ argument that the incumbent exchange’s control of clearing deters entry.

DOJ also points to the history of clearing in equities to suggest that clearing is the crucial bottleneck that precludes competition in execution. The DOJ comment notes that the formation of a cross-exchange clearing platform occurred in the 1970s. What the DOJ does not tell the Treasury is that the NYSE nonetheless maintained a dominant position in the execution of its listed stocks until the last couple of years. NYSE market share was on the order of 80 percent throughout this period, and most of the off-exchange volume was of the “cream skimming” variety, rather than head-to-head competition among price discovery venues. Only with (a) the socialization of order flow through the imposition of RegNMS, and (b) the NYSE’s delay in embracing electronic trading has NYSE market share declined appreciably. Moreover, a lot of the off-exchange trading (in dark pools, particularly) is execution of uninformed orders. That is, contrary to the DOJ’s assertions, the case of the equity market shows that removal of exchange control of clearing is not sufficient to ensure rigorous competition in execution. This is consistent with the view that liquidity network effects make execution relatively uncompetitive–but if this is true, the DOJ’s prescription of disintegration of execution and clearing (perhaps combined with price regulation of clearing) makes no sense.

The options market is the strongest evidence for the DOJ view. Superficially, the fact that multiple exchanges compete in the options market is inconsistent with the network effects-driven “tipping” story. But I am not sure that this superficial contradiction would survive a more detailed analysis.

For one thing, as I have shown in my JLEO paper and several working papers, multiple trading venues can co-exist when there is “cream skimming” of uninformed order flow. There is payment for order flow in options markets, and this is often associated with cream skimming. The tipping story basically implies that price discovery is a natural monopoly, and other markets can free ride off of that price discovery.

There is considerable evidence that off-NYSE trading in listed stocks (block trades, NASD trades, etc.) prior to RegNMS was uninformed, and that these execution venues were cream skimming. I am aware of no such analysis of options trades. Thus, the options market case may not provide evidence of the simultaneous existence of multiple price discovery execution venues.

For another thing, aggregate statistics on options volume are uninformative. As an extreme example, if 100 percent of options on stock X are transacted on one exchange, and 100 percent of options on another are transacted on another, it would be misleading to say that this is evidence against tipping. I know the example is extreme, and not reflective of reality, but it would be more informative to see exchange market shares for individual equity options. And even if one finds some spreading of volume in a particular option across exchanges, it would be essential to know whether one of these exchanges is the locus of price discovery, and the others are satellite, cream skimming markets.

For yet another thing, as the DOJ acknowledges, “multiple listing was followed by regulatory changes that have furthered competition in options trading, included rules that have linked option markets.” This linkage is extremely important. Linkage can socialize order flow (this is what RegNMS has done), thereby preventing any single exchange from taking advantage of the liquidity network effect.

Thus, it may well be the linkages, rather than fungibility in clearing, that are truly important in facilitating competition in execution in options. This is the lesson from the equity market. If so, mere disintegration of clearing and execution will not be sufficient to generate similar outcomes in futures markets. As I said in an editorial over a year ago, the survival of multiple execution venues may require much more far-reaching structural changes, such as the creation of a central limit order book or other mechanism that effectively creates a cross-exchange liquidity pool–that is, requires the socialization of order flow, not just clearing.

In sum, the DOJ comment makes a very weak case for its assertion that a separation of clearing (with price regulation) and execution is the magic bullet that will dramatically improve the competitiveness of futures markets. Moreover, its own analysis implies that exchanges do NOT integrate to impede competition, which in turn implies that they do it for some other reasons–reasons that DOJ does not explore in any serious way. If exchanges do not control clearing to deter entry in execution, the DOJ’s conclusions do not follow. This in turn suggests that implementing the DOJ’s recommendations could well lead to efficiency losses (as integration economizes on transactions costs.)

I am not arguing that financial market structure in general, or futures market structure in particular, is efficient. Indeed, my academic work emphasizes that network effects in execution and clearing impede competition in the trading of financial instruments. If one agrees with this assessment, simple nostrums like separating clearing and execution are not going to mitigate these problems. Instead, far more reaching measures–such as forced linkage of execution venues (socialization of order flow) or the creation of a central open entry order book and regulation of clearing fees or clearing firm structure–are necessary. But as I have also noted, these measures pose their own difficulties.

So, the DOJ either goes too far, or not far enough. It certainly does not get it right. It is disappointing that decades after the Chicago critique of traditional antitrust analysis of vertical structure that DOJ repeats the analytical errors the Chicago economists pointed out so long ago. The shoddiness of the work, its inconsistency with the decision in the CBT-CME merger, and the timing of the release all raise questions about why DOJ did this. I have my suspicions, but they are just that.

One last thing. Oddly, in footnote 1, the DOJ states “[o]ur comments are directed solely at competitive issues raised by financial futures markets. Markets for commodities futures, such as energy futures markets, are outside the scope of this comment.” Huh? Why should commodities be any different? Does DOJ believe that commodities are different? (In which case, I might add, the CME purchase of a pure commodity exchange like NYMEX and maintaining an integrated clearinghouse would not be problem.) If it believes that they are the same, why explicitly disclaim any opinion regarding commodity markets? (Does this suggest a political calculation? I don’t know, but its difficult to divine a rational, economically grounded, intellectually rigorous explanation for this separate treatment of financial and commodity futures.)