Streetwise Professor

James Hamilton is a great econometrician, and has written importan tpapers on the relation between oil and the economy. He blogs periodically on the oil market. Yesterday he posted this piece on backwardation. Like my piece, he discusses Ann Davis’s WSJ piece. Overall, I think Hamilton’s take is reasonable, although he does engage in one of my pet peeves, by attributing the increase in storage to the contango in the market. As I noted yesterday, prices and inventories are both endogenous, and determined simultaneously. As the Welfare Theorems show, in a competitive market prices adjust to induce agents to take the first best actions. Therefore, saying that “storage increased because the market moved into contango” is an incomplete analysis. One must push the analysis back one step to understand what economic forces made it optimal to increase the amount of oil in inventory. When talking about forward curves, the key forces are market tightness today relative to expected future tightness.

Hamilton’s post reproduces the graph of oil forward curves (from last week and a year prior) that ran in the WSJ. The interesting thing about the graph is that when the market was in contango a year ago, distant dated forward prices were substantially lower than they are today when the market is backwardated. This illustrates an important point; it is not the level of market tightness per se that drives backwardation or contango. It is tightness today relative to what is expected in the future.

In “Care to Dance the Contango?” I analyzed in some detail the movement of the oil into contango–where prices for future delivery are above nearby “spot” prices. Consistent with the theory of storage, the move to contango coincided with massive increases in the amount of oil in storage.

Now, the market for oil has moved into backwardation–the typical state of the market since the birth of crude futures trading in the early-1980s. And, surprise, surprise, inventories of oil have fallen. The theory of storage strikes again.

This movement in oil inventories and prices was discussed in a recent WSJ article (subscription only). There are glimpses of economic sense in the article, but there is a lot of nonsense too. I doubt that the lay reader could make heads or tails on why inventories have fallen. One problem is that prices and quantities are determined simultaneously, but author Ann Davis makes statements about price structures causing inventory levels. Most importantly, the article Rounds Up the Usual Suspects–speculators–and attributes the movements between contango and backwardation to their whims.

Speculators participate in the market, and big financial firms such as Morgan Stanley have staked out big positions in the physical oil business. But speculators are responding to fundamental economic conditions, not dictating prices to move contrary to levels and structures justified by fundamentals.

As I noted in “Care to Dance,” the move to contango was a rational response to fundamental market conditions. The oil forward curve goes into contango when the current supply is abundant relative to expected future supply (or, put differently, when the current supply/demand balance is less tight than anticipated supply/demand balance.) Given the widespread anticipation in late-2005 of repeated hurricane-caused supply interruptions in the Gulf of Mexico; geopolitical unrest in the Middle East, Nigeria, and Venezuela in 2005-2006; and expectations of robust world growth in the future, as tight as supply conditions were in fall 2005, it was reasonable to believe that supply conditions would become even tighter in the future. Under these conditions, holding higher precautionary inventories was economically efficient; inventories rose accordingly; and the market moved into contango.

In recent months, the most acute fears of future supply disruptions due to hurricanes, political unrest, etc., have dissipated, and the subprime crisis has reduced expectations for future economic growth. Under these conditions, precautionary stocks needn’t be as large. Hence, we’ve seen the drawdown in stocks and the concomitant move of the forward curve into backwardation.

Speculators are an important part of this process. It is their job to assess market conditions and take positions accordingly. They are essentially conveyor belts that transform diffuse information about current and future supply and demand fundamentals into real economic decisions that affect prices and quantities. They are not always right of course, when viewed retrospectively, but that’s because the world is an unpredictable place and the best information today only imperfectly forecasts the future. But speculators are responding to market conditions, and the market is a harsh taskmaster. There are rich rewards to being right, and harsh punishments for being wrong. So, rather than lazily attributing any movement in prices and quantities to the deus ex machina of speculators, it would be far better if journalists and other analysts would think a little more thoroughly about the fundamental economic forces that really drive markets–and speculators.

This WSJ article (subscription required) warns about Russia’s creation of an oil exchange that will “shift energy business away from existing global financial centers.” St. Petersburg’s historic Greek Revival Bourse building is being restored to house it. Author Judy Shelton says that this is just one effort among many by Putin to challenge America’s (and to a lesser degree Europe’s) global financial primacy.

My fearless prediction: within months of its opening, you will hear crickets chirping on the trading floor. I base my prediction on two factors, one common to all attempts to start new exchanges, one specific to Russia and other nations that do not respect property rights and which are dominated by lawless governments.

The universal problem is liquidity. It is notoriously difficult to start a new market, or to launch a new contract, especially in competition with existing markets. This is due to the difficulty of attracting liquidity. As a result of the Catch-22 nature of liquidity, nobody wants to enter a market where no one else is trading. Potential traders are like Alphonse and Gaston, each waiting for the other to go first.

There is an excellent example of this right now in the very oil market that Russia hopes to enter. The world’s oil supply is increasingly sour and heavy, but both major pricing benchmarks—Brent and WTI—are sweet and light. Thus, oil traders, producers, consumers, and marketers have been seeking a viable sour/heavy price benchmark and hedging vehicle. Both ICE and the Dubai Commodity Exchange (“DCE”) launched Middle East crude contracts (tied to Omani crude) that would meet these needs. After the typical initial flurry of activity, volume in both contracts has declined dramatically, and ICE has pulled its contract. These problems follow the pattern of earlier failed attempts to launch a heavy/sour contract (NYMEX tried back in the 1990s.)

Both ICE and DCE are excellent exchanges operating under secure legal and contractual regimes. Both have spent a lot of money designing, developing, and marketing their contracts. Despite these efforts, both contracts have withered, and I have little faith that this trend will be reversed.

The specifically Russian problem? That should be problems, plural. Futures and commodity markets are markets for promises. If there is even a modicum of doubt that contractual promises will be honored, a futures market cannot develop. Russia’s lack of a rule of law, and its recent flouting of laws and contracts, creates a something well beyond a modicum of doubt regarding the sanctity of contractual commitments.

One can easily imagine scenarios in which contracts are abrogated or undermined. Let’s say that a politically connected individual or firm (a member of the siloviki, for instance, or Rosneft or Gazprom) takes a big position that loses a lot of money. The loser raises a hue and cry that the market has been manipulated, and a sympathetic government (which may include people with a direct financial interest in the losing company, or who can be “persuaded” with a well-placed gratuity) brings its investigative and police powers to bear. It finds manipulation, and either explicitly abrogates the contracts, or exerts pressure that leads to a “negotiated” settlement that makes the loser whole—and maybe even more than whole. This outcome is particularly likely if the party on the right side of the market happens to be a foreigner.

If you think this is far-fetched, you obviously haven’t been paying attention to the way that Putinworld works, cf. Yukos, Rusoil, Ukrainian gas, Sakhalin II, BP/TNK, maybe Sakhalin I, etc.

And speaking of manipulation, let’s turn the example on its head. A playah—a Rosneft or a Gazprom—has incredible leverage through its control of physical assets to manipulate prices. Consider this very real possibility: Remember that pipeline that is the source of deliveries against the futures contract? Well, it just sprung a leak, and darn it, we really don’t know how long it will take to fix. So deliverable supply has just gone to zero. And wouldn’t you know it, we just happen to be long. Sorry about that, suckers . . . we mean shorts. Better luck next time. Or a connected a firm can just run the tried-and-true squeeze play.

In either instance, is there any reason to believe—any at all—that the Russian authorities would intervene, or impose penalties on the connected malefactor?

As a quick example, I read some months ago how Gazprom was using its market power to hammer the Russian electricity behemoth EES. (I also read another article that specifically discussed a gas auction which resulted in EES paying much higher prices. There were allegations that Gazprom withheld output from the auction. It’s in my clip files–I’ll try to dig it out.) Were there consequences? Surely you jest.

Moreover, although the Russian government is no doubt happy now that oil markets are establishing high prices, but will it be so happy if (and I should actually say “when”) the worm turns, and prices move lower? The government’s temptation to interfere with the market, or to shut it down, will be very great. Shooting the messenger is not unknown in Russia (and unfortunately, the shooting is arguably not just metaphorical.) The government may like the market’s message now, but will not like it nearly so much in the event of a price decline, and in my view it is highly likely to act aggressively in that event. This is another major political risk that will impede the development of an open oil trading market in Russia.

Vertical integration is another obstacle to a successful Russian energy futures market. Vertical integration impedes the development of a viable futures market. There are fewer arms-length transactions that need to be priced and hedged in a highly integrated chain, as opposed to a dis-integrated one. Energy trading is all about identifying and pricing transformations in space, time, and product. These transformations are internalized in an integrated structure, and hence there are fewer trading opportunities.

The Russian energy infrastructure is already highly integrated, and becoming even more so as the result of conscious political decisions, rather than economic forces. The “power vertical” in the energy industry means that vertical integration is the dominant form of organization in Russian energy. Indeed, Russia is trying to integrate extensively into marketing, distribution, transportation, and refining outside of Russia. This integration will impede the development of a Russian energy exchange.

Information asymmetry is another impediment to the development of a liquid market. The notorious lack of transparency in Russia aggravates information asymmetries. And there is incredible opacity obscuring the kinds of information that are particularly important in Russia—such as political information and operational information relating to the Russian energy infrastructure. Energy has been identified as a primary pillar of Russian state security, and the aggressive use of state secrecy and espionage laws that has characterized Russia in recent years strongly suggests that these laws could readily be directed against those attempting to ferret out price-relevant information in the energy market. Indeed, since information advantages would tend to redound to the politically connected in Russia, there is a direct economic incentive to use the state’s powers to preserve those information advantages.

In sum, launching a new exchange is hard enough in a country subject to the rule of law, with independent enforcers and a tort system available to crack down on manipulators, a culture of transparency, and a relatively unintegrated market structure. The fundamental defects of Russia’s political, regulatory, and economic structure make the prospects for an energy exchange dim indeed. Inside a cave at midnight dim. And this is true in spades for Iran, another country that has made noises about starting an oil bourse to undermine American economic hegemony.

So, it’s nice and all that a historic building with ties to Russia’s financial past is being refurbished. It is a nice symbol of the demise of communism, and of the fact that Russia is at least paying lip service to markets. But don’t expect much of consequence beyond the architectural preservation/revitalization. A la the military posing I analyzed in an earlier post, this seems just another Potemkin moment. Viable markets need the appropriate institutional and legal infrastructure, and those are woefully underdeveloped in modern Russia–when, indeed, they are not actively undermined by the actions of the state and politically connected companies.

It’s a bummer (grew up in the 70s? who? me?) to have to read about the approval of the CBT-CME merger from distant China, where I am teaching until mid-July. But it’s good news nonetheless. Things played out pretty well as I forecast, with CME bumping its bid at the last minute, and ICE folding because it just couldn’t afford to overcome the CME’s efficiency advantages. Congratulations to the managements of both exchanges, and to their owner-members.

Although this brings down the curtain on the longest running act in the derivatives business (at least as an independent venture) it is a smart move. Due to mis-steps in the 90s (born out of a futile hope that they could stave off the electronic era by failing to create a viable electronic system and building a huge new trading floor–sorry guys, but Econ 1o1 says sunk costs are sunk), the CBT has been living on borrowed time for years. It never owned its clearing operation, and due to its failure to create and own its own technology, it was inevitable that it would be snapped up post-demutualization by somebody who owned both. And who better than the CME, with a first class clearing operation and arguably the best trading system in the business. The CBT-CME combination was clearly the most efficient way to go.

As I noted in an earlier post, things will develop quickly, and the remaining independent exchanges will soon cease to be such. NYMEX and ICE will soon be the next to go–and for quite handsome prices, thank you. The FT surmises that NYSE-EuroNext will try to snap up NYMEX to break up the CME-NYMEX strategic partnership. I doubt it. That partnership has worked very well, so why should NYMEX migrate to a new platform only months after moving to Globex? Moreover, the clearing efficiencies would be large. As I have said for well over a year, I expect NYMEX to end up in the CME Group ASAP. The natural thing is for NYSE-EuroNext to buy ICE.

That pretty much leaves CBOE, and various small fry, at least in the US. (LSE is another matter altogether). One could see a rationale for CBOE combining with CME, but I think that (a) the CME’s reluctance to suffer any more SEC oversight than it has to, and (b) the lingering rancor over the CBT-CBOE trading rights will make that a difficult deal to do. (Although a marriage might be one way of dealing with that troublesome issue.) So I see CBOE going with NYSE too, although that’s going to have to wait resolution of the trading rights issue.

But those are tomorrow’s stories. Now it is appropriate to reflect on the glorious and colorful–though often contentious–history of the Chicago Board of Trade. Truly a pioneer, the derivatives business as we know it would not exist if it hadn’t blazed the trail for almost a century and a half. In some respects, however, that very historical legacy–the traditions and habits and interests that grow like barnacles on venerable institutions–impaired its ability to lead the industry in the 21st century. Its management made the wise choice of partnering with a younger, more dynamic, and lately more innovative exchange. I fully expect that this partnership will blaze yet more trails, and thereby enhance the efficiency of the financial markets in the 21st century and beyond.

CME CEO Craig Donahue sent on some thoughtful remarks on the evolution of financial market structure that he gave at an International Monetary Conference that merit some comment.

A crucial point he makes is how demutualization has changed the nature of the relationship between exchanges and intermediaries, notably the large FCMs. Whereas the FCMs were once exchange members, and hence owners, and exchange efforts were devoted in part to enhancing their profits, now exchanges are focused on maximizing returns to shareholders. This, as Donahue puts it, creates a tension between “value chain players” with exchanges and intermediaries both chasing dollars from ultimate customers. Although this is not a zero sum game, exchanges can profit at intermediaries’ expense, and vice versa. Exchanges and intermediaries provide complementary services, and each is striving to get the biggest piece of what customers are willing to pay to execute and clear a trade.

This is not to say that these conflicts never existed. Donahue notes that non-profit exchanges were “inefficient member-run utilities.” In large part, that inefficiency was a feature, not a bug. Inefficient, committee-dominated, deliberative decision processes were in large part a way of managing tensions and conflicts and rent seeking between different types of exchange members, such as FCMs, floor brokers, and locals, all of whom were “value chain players,” and each of whom had an incentive to seek rents from other parts of the value chain. Thus, the tensions between exchanges and intermediaries are just now more out in the open. They used to be all in the exchange member family, as it were, but we all know that intra-family disputes can sometimes be very intense indeed. (I saw some of these battles up close when I worked with the Chicago Board of Trade to redesign its grain futures contracts, first in the early 1990s, then in 1997. I saw short hedgers pitted against long hedgers, Locals pitted against brokers, etc. Committee gridlock was intended in part to ensure that nobody could do anything to drastically change the status quo, and hence reallocate profits from one group of members to another.)

Donahue also notes that in the demutualized world, exchanges are venturing into the intermediaries’ space (e.g., the CME FXMarket Space and Swapstream) and intermediaries are striving to execute trades, either through internalization or the creation of execution platforms. He pays particular attention to the issue of “dark pools,” a subject that Clara Furse has been quite outspoken on as well.

Dark pools are off-exchange execution vehicles. Importantly, they typically do NOT contribute to price discovery, instead allowing large traders to execute orders at prices derived from those established on the exchanges where price discovery does occur.

Donahue (and Furse as well) raise concerns about the impact of this fragmentation on price discovery and the liquidity of exchange markets. The basic idea–which has been understood for quite awhile–is that dark pools (once called “third markets”) siphon off uninformed traders who provide liquidity from exchanges. This exacerbates the adverse selection problem on the central exchange market, leading to wider spreads and lower depth. The dark pools free ride off of exchange price discovery, and actually impair the quality of that price discovery by reducing the amount of trading activity that occurs on exchanges where the price discovery actually takes place.

It is quite correct that fragmentation impairs liquidity on central exchanges where price discovery occurs. It may be going to far, however, to conclude that this is inefficient, at least relative to the alternative of discouraging the formation of dark pools/third markets. Third markets may be second best, as I argued in a paper with a similar title, and in an article published in JLEO in 2002.

The argument is that central exchanges are likely to possess market power due to the network effects of liquidity. The existence of exchange market power means that we are not in a first best world, and hence the theory of the second best implies that an externality (such as free riding off of exchange prices) does not necessarily reduce welfare relative to what it would be if the externality was eliminated. (If absent the externality the exchange would supply the optimal level of output, the externality would reduce surplus.)

In the formal model in these papers the dark pools/third markets actually increase total surplus because they result in increased trading activity–trading activity that would be too small in the absence of the third market due to the output-restricting policies of exchanges with market power. The defection of some traders to third markets indeed reduces liquidity on the central locus of price discovery, making the traders on the central exchange worse off, but in the model the defecting traders reduce their trading costs (price impact costs) by an amount that is larger than the increase in trading costs on the exchange.

Thus, theoretical models do not support a blanket conclusion that fragmentation and free riding on exchange price discovery is a bad thing. I acknowledge that these results are dependent on the assumptions underlying the model, and that different results might obtain with different assumptions. The models do serve to caution us, however, that fragmentation is not necessarily a bad thing if competition between exchanges is imperfect, as is almost certainly the case due to the centripetal force of liquidity that tends to make price discovery a natural monopoly.

In my view, the dizzying pace of change in market structure in derivatives and securities trading is a very complex phenomenon. Moreover, it is very difficult to draw hard and fast conclusions about the desirability of various alternative arrangements because network effects and the information-intensive nature of trading mean that the “perfect competition” benchmark of textbook economics is not achievable in financial markets. All alternatives involve trade offs, and arguments over which arrangement is second best, third best, fourth best . . . . The devil is truly in the details, and it is very important to understand the microfoundations of trading. Different formulations of those microfoundations can lead to very different conclusions. The formulation of the microfoundations in my models leads to one conclusion–other formulations might lead to opposite implications.

In such an environment, it is important to have vigorous–and thoughtful–debate so that the relevant issues and trade-offs can be identified and evaluated. Craig Donahue’s speech is a fine example of such a thoughtful contribution, and I encourage anyone interested in the evolution of financial markets to read it when it is published (as I understand it will be soon.) In the meantime, it has reinvigorated my interest in these issues, and I will devote some effort to pushing the theoretical envelope to help gain a better understanding of how fragmentation affects welfare under alternative assumptions about microfoundations. My earlier work was inspired by mutualized exchanges that exercised market power by limiting membership rather than by charging supercompetitive prices for their services. Things may be different in a demutualized world where exchanges have an incentive to encourage entry of liquidity suppliers, and exercise market power by charging higher prices rather than by limiting access. The key thing will be to come up with models of such exchanges that predict that dark pools will form in equilibrium (as is clearly the case), and then to see how trading costs and trader surplus depends on policies affecting the operations of third markets. So many interesting problems, so little time!

Former FRBNY President Gerald Corrigan made a call for cash settlement of credit derivatives in the event of a default. This WSJ article doesn’t state whether one of Corrigan’s rationales was that cash settlement would make credit derivatives less vulnerable to manipulation. (Nor did any of the other press coverage that I found via Google.) I hope not, as I blogged last year this is NOT a reason to adopt cash settlement. A cash settled contract is as vulnerable, and perhaps more vulnerable, to a market power manipulation as a delivery settled one. I would also note that cash settlement is viable only to the extent that there is a reliable, independent price discovery mechanism that can be used to determine the settlement price. An auction of defaulted securities, combined with cash settlement, will provide the price discovery mechanism, but will not reduce the frequency or severity of manipulation (of the corner/squeeze variety) of these instruments.

The FT comes out foursquare for “fungibility” in futures clearing. [Is it just me, or do you get a sense of deja vu when reading that article? Is it just me, or do you get a sense of deja vu when reading that article? FT must be really impressed with its reasoning, as it repeats it word for word three times.]

In a nutshell, the FT believes that open access into clearing is a sufficient condition for competition in trade execution. Its case is a weak one. It asserts that there is “cutthroat competition” in US equities, and attributes that to the industry’s clearing cooperative, the DTCC. Well after the creation of the DTCC, competition in listed equities was very weak. The NYSE was dominant. Most of the off-exchange execution was of the cream-skimming variety. That’s better than no competition at all, but it’s hardly cutthroat. The NYSE members earned substantial rents as a result. In Europe, clearing fungibility didn’t allow the LSE to gain any headway in its foray into Dutch equities. In US futures, Eurex and EuronextLIFFE offered both execution and clearing when they attempted to go after CBOT and CME, respectively, and both failed miserably.

Competition is arguably heating up in US equities, but that is attributable to RegNMS, which effectively socializes order flow and undermines the liquidity network effect that gives a dominant exchange considerable shelter from entry. Although open access clearing probably facilitates competition in this environment, it is not a sufficient condition; additional measures are necessary to reduce market power in execution.

The strongest evidence for the FT case is US options, where the OCC operates a fungible clearing mechanism, and trading in individual options is split among several exchanges; tipping has yet to occur. This example needs further study to prove whether it is the exception that proves the rule that competition in execution is highly imperfect, or whether it shows that execution in fact can be highly competitive.

A key issue here is payment for order flow. Option exchanges pay for order flow. This may reflect underlying factors that make the US options market unrepresentative of what might happen if clearing fungibility is extended to futures.

Payment for order flow can arise from excessive tick sizes. Too large a tick can impede competition for liquidity. It can serve as a price floor that supports more trading venues than would exist in its absence. That is, it can dull the tipping effect. The move to pennies will provide an interesting test of this hypothesis.

Payment for order flow can also arise when some order flow is uninformed. Payment for order flow can serve as a cream skimming mechanism; market makers rationally pay for order flow that is verifiably uninformed Basic microstructure theory shows that multiple cream skimming trading venues can exist. Thus, although theory suggests that order flow that is not verifiably uninformed will tip to one trading venue, verifiably uninformed order flow will not tip, and may be served by multiple venues.

There needs to be more detailed study of the US options example before it is used as the basis of regulatory and anti-trust intervention into the organization of futures trading.

There is one major reason to doubt that competition in futures execution is likely to be cutthroat even given open access to clearing. If clearing is truly a natural monopoly (as the FT argument implicitly assumes), then a dominant clearinghouse (such as the CME) would like to encourage competition in execution, not discourage it–this would allow it to make more money from its monopoly clearing operation. Clearing and execution are complements. The derived demand for the putative clearing monopolist is higher, the lower the cost of execution. Competition and entry in execution reduce execution costs, so the clearing monopoly would encourage it. However, if execution is not highly competitive, integration between the clearing and execution venue can improve efficiency. Thus, if the FT is correct, the CME would have no incentive to tie clearing and execution–but the CME is a diehard defender of tying. Either the CME is stupid, or the FT is wrong. Any guesses where I place my bet?

This is the old Chicago School argument that vertical restrictions are likely to have an efficiency rationale, rather than an anticompetitive one. I still have not seen a convincing refutation of the relevance of this argument to futures trading.

I should also note that although “non-profit cooperatives” sound like wonderful things, they can often be an effective way of exercising market power. After all, the NYSE was a non-profit cooperative for years–and ran a restricted entry cartel. My working paper on clearing shows that a user-owned clearing cooperative can be efficiency enhancing, or it can be an incredibly effective way of cartelizing the brokerage business. Moreover, even if the clearing cooperative avoids the dark side, and prices services at cost, if my surmise is correct that competition in execution is highly imperfect, all this will do is transfer rents to the dominant execution venue. The LSE–which gets clearing services from a user-owned entity, but which has the highest margins of any equity exchange in the world–is a great example of that.

So, all in all, I am less than persuaded by the FT’s argument–no matter how many times they repeat it. The case for remaking the futures business with the blunt tool of antitrust is far from made.

In FI magazine, Galen Burghardt makes a good point:

This may be a good time to reflect on the influence that the electronic revolution has had on the costs of trading, and consider asking the exchanges to make drastic reductions in their minimum tick sizes. Now that the locals have been taken out of the equation of exchange decision-making, all major stakeholders— traders, hedgers, exchange shareholders, and brokers—would stand to gain enormously from such reductions. It would be a win/win/win situation.

It is indeed something of a puzzle that demutalized exchanges have not reduced tick size. As I have noted before, the demand for exchange services is a derived demand. The higher the price/cost of complementary services, such as liquidity supply, the lower the demand curve for exchange services–and hence the lower the fee that the exchange can charge. By reducing tick size, an exchange will reduce the price that liquidity suppliers charge; if the tick size is currently binding, the marginal cost of liquidity provision equals the tick size, and competition between potential liquidity suppliers dissipates any profit they could earn by resulting in queuing of orders and a commensurately lower probability of execution of a limit order. By reducing the tick size, the exchange reduces the marginal cost of liquidity, and raises the derived demand for its services. It can profit from this by raising its fee.

Thus, it is not quite the win-win-win Burghardt suggests; any decline in liquidity costs that results from a reduction in tick size will be offset in part by an increase in exchange fees. There is also a cost issue–lower tick size is likely to lead to more message traffic as more orders are entered and canceled. So exchanges will have to bulk up capacity to deal with a lowered tick.

Given the pressure on exchanges to generate earnings, it is surprising that they have not been more aggressive in exploiting this strategy. Perhaps the penny tick experiment in equity options will convince futures exchanges to take the plunge and reduce tick size. Message traffic has not overwhelmed the options exchanges, and the penny experiment seems to be generating a big uptick (no pun intended) in volume.

Holman Jenkins wrote a blistering article (subscription required) on the all-too-typical inanities of market definition in anti-trust. He didn’t mention CME-CBT, but as I wrote on the day the merger was announced, market definition will be the key issue. I know with near metaphysical certainty which market definition is the wrong one–the one that is most often cited by opponents of the deal, namely “US futures.” One can only hope that Jenkins’s cynical view of the antitrust authorities (namely, that they rig the definition of markets in order to permit them to file cases so as to justify their existence) isn’t confirmed by the Justice Department in the exchange merger case. There is virtually no economic rationale for the US futures definition, but it is the only one under which it is possible to challenge the merger. If Justice uses that definition, it will go a long way to validating Jenkins’s cynicism.

The debate over exchange competition and mergers–and the CME/CBT merger in particular–continues to percolate. I’ve commented on several aspects of this debate, but other remarks are in order.

Further my previous musings on elasticities of substitution between CBT and CME products. I’ve opined that they might be negative (due to spreading). I’ve also opined that even things like Treasury futures and Eurodollar futures are unlikely to be close substitutes due to the non-negligible basis risks. But upon further reflection, I believe there is another even more important factor.

Specifically, the demand for an exchange’s services is a derived demand. That is, futures traders demand a bundle of services–liquidity, brokerage, clearing, execution, etc. Of this bundle, liquidity costs (e.g., price impact costs) are probably by far the biggest. Exchange fees represent a relatively small fraction of the total cost of a trade.

This is exactly what gives exchanges pricing power. If the exchange’s fees represent say 5 percent of the total cost of executing a transaction, if an exchange doubles its fee, the cost of trading goes up by 5 percent. Thus, the demand for an exchange’s services is very own price inelastic. Hence the ability of exchanges to earn such nice margins–this inelasticity gives them considerable pricing power.

This also has important implications for cross price elasticities. For instance, if the CBT halved its trading fee on Treasuries in an attempt to attract business from the CME, the cost of trading Treasuries would fall by about 2.5 percent (again assuming that fees represent about 5 percent of the cost of a trade.) Thus, in this example, the cross price elasticity for CBT/CME services is about 2.5 percent of the cross price elasticity (taking ALL costs into account) between Treasuries and Eurodollars. Thus, if I am correct that the “gross” cross price elasticity (taking all costs into account) is small to begin with due to basis risks and spread trading, the cross price elasticity relevant for evaluating the competitive effects of a CME-CBT merger is far smaller. Even if the gross price elasticity is somewhat larger than I conjecture (and positive), the effect of the fact that exchange fees represent a relatively small fraction of total trading costs tends to make the relevant cross price elasticity small nonetheless. Small cross price elasticities drastically attenuates the “static” competitive effects of the merger of exchanges trading non-overlapping product sets.

There is one case where exchange fee cutting did appear to be decisive–Eurex vs. LIFFE in 1998. A couple of points. First, this involved competition in identical products–no basis risk or spreading considerations. This is not relevant in evaluating the CME-CBT merger. Second, LIFFE made key strategic errors that are unlikely to be repeated in the future. In particular, it did not respond to the Eurex price cuts, whereas such inaction is unlikely in the future. Anticipating a quick response to price cuts, an exchange is unlikely to initiate a round of price cutting. Third, due to the rough parity in other trading costs, the Eurex price cut was sufficient to induce tipping, meaning that the effect of the price cut was exaggerated. This is not likely to happen in competition between different products. For instance, a CBT price cut is not going to cause all volume to leave Eurodollars.

Thus, in my view, cross price elasticities between CBT and CME products are likely to be quite small, meaning that the “static” competitive implications of the merger are likely to be quite benign.

Now consider the impact of the merger on innovation. John Lothian opines that the merger would reduce competition to innovate. This is a complicated issue, but I respectfully disagree that innovation will suffer, or that if efforts to innovate do in fact decline, that this is necessarily inefficient.

I should note that there is little agreement among economists about the effect of market structure on innovation. Profitability is what provides the incentive to innovate. Reduction of competition through merger does not attenuate this incentive, and may strengthen it.

I don’t believe that a CME that absorbs the CBT will rest on its laurels, and feel no need to innovate. Indeed, the high CME stock price clearly capitalizes the stock market’s expectation of high cash flow growth. This growth is unlikely to result from volume growth in existing products alone, as healthy as this growth has been. Pleasing the god of the street will require growth from other sources–new products. The CME is like a pharmaceutical company that needs to keep its pipeline full. The stock market will punish the CME if it fails to do so. This will tend to concentrate management’s minds and keep them on the hunt for new products.

Moreover, even if one believes that more competitive market structures are more conducive to innovation, in the modern electronic trading era, in which foreign exchanges (absent regulatory barriers) can offer products in US markets (and vice versa), and in which global financial firms trade on exchanges around the world, the relevant market is the world market. Looking at the US market share of a combined CME-CBT entity is inappropriate in this regard. From a world-wide perspective, the increase in market share (or the Herfindahl index) resulting from the merger would not typically present anti-trust concerns.

It must also be remembered that the winner-take-all nature of exchange competition can mean that competition to create new products can be inefficient. The winner of the competition earns a rent. As in patent races or land rushes, competition to earn the rent can dissipate it, creating a social cost of approximately the same magnitude as the rent. Thus, competing firms can spend too much on innovation. (More innovation, or more expenses spent on innovation, are not always better. There can be too much innovation, or too much spent on trying to develop new products.) Perhaps counterintuitively (to most folks) softening competition can actually improve welfare.

Against this is a good point that Lothian raises. Specifically, nobody knows exactly what the right design for any futures product should be. Everybody agrees that credit derivatives are the Next Big Thing for exchanges. But nobody agrees on what the “right” credit derivative product design should be. Having more exchanges experimenting with different designs increases the likelihood that one of them will be close to optimal. Losing a “laboratory” through merger may reduce the odds of finding the Goldilocks design. Note, however, that exchanges can revise their contracts if they don’t appear well-suited to market needs. Also, at the risk of being repetitive, due to the rent at the end of the rainbow for the winning exchange, exchanges may spend excessively to find the product that is Just Right.

All in all, I am skeptical that the CME-CBT merger will appreciably reduce innovation. Moreover, given the nature of liquidity (and the consequent winner-take-all nature of exchange vs. exchange battles for market share in a given product type), dissipative (“excessive”) rent seeking competition between exchanges is a real concern. Given these circumstances, I do not believe that concerns about the impact of the merger on innovation can provide a firm basis for blocking it.