Streetwise Professor

Today from Reuters:

IntercontinentalExchange Inc.’s (ICE.N: Quote, Profile, Research) bid for the Chicago Board of Trade may have been fomented by a broker backlash against the potential power of a combined CBOT Holdings Inc. (BOT.N: Quote, Profile, Research) and original suitor Chicago Mercantile Exchange Holdings Inc. (CME.N: Quote, Profile, Research).

Atlanta-based ICE, virtually unknown in the futures business just a few years ago, stunned the industry in March with an unsolicited bid that would give CBOT shareholders a majority stake in the combined company.

Banks that are among the largest futures players have signed on to advise ICE, whose innovative proposal for CBOT has at the least created a roadblock to the consummation of a marriage between the two largest U.S. futures markets, each of which has called Chicago home for decades.

“ICE may be getting support from some some of the brokers who were critical of the CME-CBOT deal,” said Keefe, Bruyette & Woods analyst Richard Herr. “The development of ICE’s bid for CBOT speaks to a further intensification of the brokers versus exchanges.”

Last week ICE said that UBS AG (UBSN.VX: Quote, Profile, Research) and Societe Generale (SOGN.PA: Quote, Profile, Research), parent of brokerage Fimat Group, had joined Morgan Stanley (MS.N: Quote, Profile, Research) as co-advisers in its offer for CBOT, which is the parent of the No. 2 U.S. futures exchange.

Oh now I remember. I advanced this hypothesis the day the ICE deal was announced.

Although the Reuters story focuses on “brokers”–implying FCMs–it is also important to emphasize the point (raised somewhat parenthetically in the story, he said parenthetically) that these FCMs are arms of big banks that dominate the OTC derivatives market. Methinks that the OTC desks of the big banks is where the real source of the opposition lies.

The story quotes a FIMAT exec providing a rationale for the FCM/bank opposition to the merger:

“Separately, both the CBOT and CME already have virtual monopolies for most derivatives contracts they offer to the public,” wrote Fimat general counsel Gary DeWaal in a November editorial in the Financial Times.

“Naturally the new entity would have significant pricing power and … unparalleled power effectively to inhibit real competition.”

I agree completely with the first statement. The second one is highly arguable, and depends on implicit assumptions that are highly dubious. Merging two monopolies would increase pricing power only to the extent that the monopoly products are substitutes (in which case the businesses aren’t really monopolies–hence something of a contradiction in Mr. DeWaal’s reasoning). I have seen no explicit estimates of cross-elasticities of demand for CME and CBT products, but doubt they are large, and suspect they might not even be positive. That is, as I have pointed out before, it may well be the case that the products traded on the two exchanges are complements, rather than substitutes. (This would imply negative cross-elasticities). This is because the exchanges’ products are traded in spreads (e.g., Treasuries vs. Eurodollars, corn vs. live hogs). In this case, the exchanges will engage in double marginalization/markup because neither takes into account the impact of its pricing on the sales of the complementary product. Merger would actually improve the efficiency of pricing in this case. Add in the effect of cost savings, and the welfare improvement resulting from the merger could be large indeed.

In any event, its good to see that the press is finally catching onto the possibility that support for the ICE effort is not all Mom and Apple Pie, but likely reflects the very intense commercial interests of large financial players looking to protect their own turf.

One article about the ICE initiative suggests the possibility of a three way–CME+CBT+ICE. This is an intriguing possibility. As I noted in the previous post, the benefits of an ICE-CBT combination are underwhelming, but adding ICE to the CME-CBT combo would add additional savings to the already large benefits of the latter combination.

If this does happen, NYMEX would be in a very tenuous situation. I have been somewhat skeptical of NYMEX’s strategic situation. In particular, NYMEX does not own its technology. Pushed by ICE, it ran into the arms of the CME. The move to Globex turned out to be a win-win for the two Mercs. But if the CME combines with ICE, NYMEX is in a world of hurt. I doubt it would be feasible (especially given its technology track record) to build a credible electronic platform on the fly, and would have to partner up with another exchange (e.g., Eurex or EuroNext), and right quick too. Its negotiating position would be pretty weak, although it could potentially play Eurex off against EuroNext/NYSE.

It’s hard to figure out what the market thinks of this possibility. Even before this all hit, I thought NYMEX was overvalued, but its stock went up 8 percent on the ICE announcement, and has held onto most of that gain. In contrast, ICE stock jumped up on the news, and then went down by almost the same amount by the end of the day. Indeed, it is now trading below the pre-announcement price. (CBT stock is above the pre-announcement level, but off its high.) I conclude that the market’s collective judgment is either that an ICE-CME tie up is unlikely, or that if successful this would make NYMEX a takeover candidate. Expanding on the first alternative, NYMEX’s strong stock price performance could suggest a market view that however things work out, the ICE endeavor divert its management’s attention and resources away from energy, thereby taking some of the heat off NYMEX. It is ironic, however, that the stock of a seeming bystander has done so well as a result of ICE’s move.

Little did I expect upon going to sleep last night in Boca Raton after participating in a CME-sponsored panel on the CME-CBT merger that I would awake to a reporter’s call this morning with the news of ICE’s unsolicited offer for the CBT.

Here are my initial thoughts on the situation.

First, the economics of a CME-CBT tie up are considerably more compelling than those of an ICE-CBT merger. Far more participants trade far more volume of some combination of Treasuries, Eurodollars, S&Ps and Dow than trade Treasuries (or grains/oilseeds) and coffee, sugar, cocoa, cotton, OJ or Brent Crude (ICE Futures key products).

From an operational perspective, this means that whereas a CME-CBT combination would allow many traders to use one screen, one system, one connection, and one point of contact, with ICE-CBT most traders will continue to have to deal with two systems, two screens, two connections, and two points of contact—just as they do today. Indeed, operationally things will be more complex as they will have to deal more extensively with two clearers, rather than just one.

From a clearing perspective, the potential margining and risk management benefits from joint clearing of CME and CBT products are self-evidently superior to those that could be realized from a CBT-ICE tie up. This is because the CME markets are bigger; the spreading between CME and CBT products more prevalent; and the pool of traders who participate in both markets larger. I don’t recall the industry clamoring for years for joint clearing of CBT and CSCE or NYCE products (CSCE and NYCE being NYBOT/ICE Futures predecessors); they were clamoring for a CME-CBT clearing link that was eventually established after years of back and forth. There was a good reason for that. The savings from the CME-CBT clearing link were—and are—clearly much larger than a CBT-anybody else clearing link. Moreover, CME has a real chance of making inroads into OTC clearing, which would create other scope economies and increase competition in that market. I don’t think ICE has any realistic chance at doing the same.

Moreover, from a systemic risk perspective, CME’s clearinghouse is financially stronger than NYBOT’s, has experience in operating at immense scale—scale that dwarfs what NYBOT handles—and sees a bigger part of the market than a ICE-CBT clearing operation would, meaning that a CME-CBT clearing operation would have a better picture of overall risk exposures.

Second, ICE is already undertaking an integration process with NYBOT. Near simultaneous integration of another, far larger, exchange, is problematic. See my earlier post re the LCH-Clearnet integration fiasco if you need reminding how integration issues can bedevil seemingly sensible deals. Since CME already clears CBT, a good part of the integration battle is already completed there. Moreover, Globex is a proven, scalable platform already used by most CBT participants, so migrating CBT contracts to Globex should be less difficult than migrating them to ICE.

Third, with respect to competition: As I noted in my October 2006 post on the merger, how one views the competitive impact of the CME-CBT deal depends on how one defines the market. If one defines the market as “futures” the CME-CBT merger leads to a substantial increase in concentration—far greater than a ICE-CBT combination. However, I think this is the least defensible market definition. Under a narrower definition—i.e., by product line, such as Treasuries or STIRs—the merger doesn’t increase concentration, as the respective exchanges already essentially have monopolies in these products. Moreover, if you are going to define the market as “futures” there is no reason whatsoever to stop there—you should expand the definition to include OTC derivatives (e.g., vanilla swaps). Indeed, in the case of the CBT, cash Treasuries should also be considered; one can create forward positions that are close substitutes for a futures contract through repo transactions. Nor should you just define the market as the US, as the futures business is increasingly global and with electronic trading location doesn’t really matter that much any more.

Many that I spoke to at Boca believe that a combined CME-CBT entity would have far more pricing power than the two exchanges do separately. Again, I am highly—emphasize highly—skeptical. Each exchange already has a dominant position in its own products, and is pricing its services accordingly. Moreover, as the Euronext and Eurex entry attempts demonstrated, the Chicago exchanges know how to defend their turf against new competitors. Entry leads to initial price cutting, but the eventual success of one exchange. Knowing this, potential entrants are likely to remain merely potential, and incumbents will continue to charge high fees unless and until some brave soul decides to trust to hope rather than experience. And the survivor will raise fees again when the loser (most likely the entrant) exits.

[Random thought: why is ICE trying to buy one dominant exchange, rather than competing with it head-to-head? What does that say about the feasibility of competitive entry?]

In my view, CME is not pricing its services now to deter a CBT threat in Eurodollars, nor is CBT pricing to deter a CME threat in Treasuries. Nor where they doing that before Terry Duffy and Charlie Carey met for dinner at Gene & Georgetti’s that fateful October night. They will cut prices when there is a real competitor to ward off, and not before. (The economics/industrial organization/game theory literatures have long recognized that potential competition is likely to have little effect on prices, except under special and arguably unrealistic assumptions about ability to adjust prices like those made in the contestability literature.)

It should also be noted that if—as has been suggested—the integration of execution and clearing in a single exchange is the impediment to competition (again something I dispute), the ICE deal is no different than the CME deal, as each involves an integrated clearing and trading operation.

Managing market structure through merger policy will not appreciably impact the competitiveness of the execution business in futures markets. Only something that radically socializes order flow—as the just implemented RegNMS does in securities—will have this effect. (Perhaps saying “mandating a centralized open access liquidity pool” is a less provocative phrase than “socializing order flow,” but they amount to the same thing.)

Absent the creation of an open access central limit order book for futures, or its near equivalent (a la RegNMS), the tippiness of order flow, and the difficulty of coordinating the simultaneous movement of order flow to a new exchange, give the incumbent execution venue decisive advantages. (An earlier post suggests that algorithmic trading may virtually link markets and socialize order flow, but this is still a possibility not a reality). Only stupidity (e.g., LIFFE c. 1998) or a refusal to adopt new trading technologies (e.g, LIFFE again, and almost NYMEX last year) gives an entrant a fighting chance.

Put differently, anti-trust policy generally, and merger policy in particular, are extremely blunt tools that, in my view, are not suited for improving competitiveness in derivatives markets, but may well impede the realization of important efficiencies. Thus, in my opinion, derailing a CME-CBT merger would not appreciably improve competition in the futures markets, but could deprive the marketplace of important operational, credit, and systemic efficiencies. For those who want to improve competition in futures in the worst way–well, scotching the CME-CBT deal would be it.

For historical reasons, derivatives markets have not experienced the same disputes over market structure that have raged for decades (three and counting) in the securities markets. Only a dramatic change in regulatory policy carried out under authority granted to the SEC by Congress, and implemented only after years of controversy, has begun to reshape the competitive landscape in securities—and even there, it is still to early to determine whether these changes will dramatically improve competition. If futures market participants are really concerned about competition, they had better be prepared for far more drastic measures than preventing this merger or allowing that one. DOJ is incapable of doing the heavy lifting with the tools at its disposal.

I hate to say I told you so, but, well, I can’t resist. At the start of the demutualization wave in the late-1990s and 2000-2001 I opined (in writing, and at conferences like one sponsored by the Chicago Fed in 2001 or early 2002, I forget which) that by becoming more like ordinary firms, futures exchanges would become subject to the same antitrust scrutiny as ordinary firms in other industries. I don’t think this message resonated then. Regardless of what DOJ does now, however, it will soon become conventional wisdom.

I should also note that I believe that the uncertainty surrounding what DOJ will do, and the recent stories to the effect that DOJ was moving to challenge the CME-CBT deal is what precipitated ICE’s move five months after the initial merger announcement. ICE is essentially long a call on what the DOJ does—if DOJ blesses the CME-CBT merger, the call will almost certainly end up out of the money because CME will win any bidding war. But if DOJ challenges the merger, or imposes unpalatable conditions (especially involving clearing) the call will be in the money. I’d put the option at the money now—and at the money calls are acutely sensitive to volatility. Uncertainty about DOJ is creating the volatility, making this a canny move by ICE. It is buying vega (or lambda, for you Greek purists) on the cheap.

A couple of final thoughts.

Both ICE and CME are impressive exchanges that are technically progressive. ICE was a technology leader from the get go, by design. CME has also been a technological leader (especially by comparison with other traditional exchanges), but only after demutualization did it fully unleash its technological prowess. Hence, from an innovation prospective, the market would do well regardless of whether CME or ICE ends up owning the CBT at the end of the day.

And lastly something more provocative—and completely conjectural/speculative. We know that the main opponents to the CME-CBT merger are the major bank/investment bank/FCMs. We also know that a couple of same are major investors in ICE. Could it be . . . ? Just sayin’. No concrete evidence, but some interesting conjectures pop into my Machiavellian mind.

There is an old expression in the military: “Amateurs talk tactics. Professionals talk logistics.” There is a clear parallel in the financial markets; although the logistics of derivatives markets–clearing–attract little popular attention, they are matters of prime importance to market professionals.

The CBT-CME merger is bringing clearing into the public eye, however. This previously arcane issue has taken center stage in the debate over the the desirability of the merger. Former SEC chief economist (and academic) Larry Harris has opined that the CME’s ownership and control of clearing impedes competition in derivatives markets. He is seconded by PHLX president Meyer Frucher in his jeremiad against the merger. Moreover, (per a report in Crain’s Chicago Business) the Department of Justice is allegedly focusing its attention on the CME’s clearing operations.

The battle cry of Harris, Frucher, et al is “Fungibility!” (Not quite “Remember the Alamo!”) In essence, they argue that the clearinghouse is an essential facility, and by restricting access to the essential facility CME impedes competition for its futures contracts. If CME were to open access to its clearinghouse, it would allow other exchanges to offer contracts that were perfect substitutes for CME contracts, that is, were fungible with CME contracts. This would allow competition in futures trading, and in Harris’s phrase, “break the futures monopoly.”

There are several problems with this analysis. First, it implicitly presumes that the market for futures execution would be highly competitive, but for restricted access to the clearinghouse. However, due to the network effects of liquidity, this assertion is problematic. (I return to this issue later.)

Second, this argument is very retro. BC–Before Chicago (School)–in fact. It is a re-hash of the monopoly leveraging argument demolished by Chicago economists and legal scholars in the 1960s and 1970s. If the monopoly bottleneck is at the clearing level, the clearing operator would actually like to encourage competition in execution. This would increase the demand for clearing services by reducing the costs of execution services that are complementary to clearing. This would allow the clearing monopoly to charge a higher price for its services. Put differently, if clearing is a natural monopoly (as the essential facility/bottleneck arguments implicitly assume–and for which there is a reasonable basis), the operator of the clearing facility can extract the entire monopoly rent by pricing clearing services appropriately, and has no incentive to force a putatively inefficient organization of complementary activities, such as execution. If there are no scale economies in execution, or if there are scale diseconomies, integrating into execution actually reduces the clearing monopolist’s rents.

As the Chicago School scholars noted long ago, this reasoning leads to a presumption that there is an efficiency rationale for the vertical integration of clearing and execution. I set out the sources of efficiency in my Silos post from the summer. In a nutshell, integration eliminates double marginalization problems, and reduces transactions costs.

So what can be done? Merely requiring the CME to allow other exchanges to access its clearinghouse would not change things even if the merger’s critics are correct. The exchange can merely charge the monopoly price for clearing services. Thus, it would be necessary to regulate clearing prices and terms of access very intrusively in order to reduce the exchange’s market power. For anyone who doubts who messy this can be, just take a look at the experience of the regulation of access pricing and terms in telecommunications. This is an invitation to rent seeking and litigation (and rent seeking litigation), and will likely discourage innovation by the clearing operator. (I doubt that the DoJ has the power to impose such price and access regulations in any event.)

Similarly, attempts to increase competition in clearing by forcing the CME to eliminate its rule requiring contracts traded on the exchange to be cleared through the CME clearinghouse would be unlikely to have much of an effect. Due to the strong scale and scope effects in clearing, this function is (as argued by the fu(ngibility) fighters) a natural monopoly. Moreover, due to the specific assets and sunk costs associated with clearing, and the costs of coordinating a simultaneous defection of sufficient numbers of clearing customers to generate network economies, it is not likely to be a contestable one. Thus, the incumbent clearer would likely prevail over any entrant. And in the unlikely event that the entrant did prevail, users would be flung from the frying pan into the fire–from one monopoly to another. Moreover, this would entail additional costs–double marginalization and higher transactions costs.

So what about a more radical alternative? For instance, forcing the CME to divest its clearinghouse as a condition of the merger? In order to improve welfare, somehow it would be necessary to organize the (monopoly) independent clearing entity so that it would not exercise market power. One possibility is to organize the clearer as a user-owned cooperative that rebates revenues in excess of costs to its users. (The OCC and NSCC work this way). In theory, the cooperative could price its services at marginal cost, and fund its fixed costs through fixed assessments on its members. Alternatively, non-linear price schedules with inframarginal prices in excess of marginal costs and marginal cost pricing for the marginal unit would be efficient and cover fixed costs. Either alternative would lead to competitive pricing of clearing services.

Nirvana? Not so fast, chief. Two big problems.

First, the non-profit clearer could still exercise market power. How? By restricting access. My 1999 Journal of Financial Markets and 2002 Journal of Law, Economics, and Organization papers showed how non-profit cooperatives can exercise market power by restricting membership. In a nutshell, the big clearing brokers (e.g., the big banks and investment banks) could form a clearing utility, and impose unnecessarily burdensome financial requirements on membership. This would restrict entry into clearing services, and raise the price of these services above the efficient level. To the extent that the execution entity also has market power, this would result in double markups. Moreover, it would raise transactions costs (in the relationship between the clearing and execution firms.) Therefore, it would be necessary to pay close regulatory attention to the access and membership admission policies of this clearing entity. This is not a trivial task, by any means. Given the systemic implications of clearing for the stability of the financial system, financial standards for members are obviously desirable. Who is to evaluate the trade off between the effects of tighter/looser standards on financial stability vs. the pricing of clearing services? Any volunteers? Any confidence that the evaluation will be the right one? Not by me, that’s for sure.

Second, due to the network effects in trading I alluded to earlier (and which I have analyzed in great detail in my 2002 JLEO piece and several working papers) make it almost certain that even an exchange shorn of its clearing function can exercise market power. That is, the centripetal force of liquidity induces trading to concentrate on a single exchange. This confers market power on the incumbent exchange; it is very costly to coordinate a simultaneous defection of order flow sufficient to overcome the liquidity incumbent’s advantage.

This means that even if, through some miracle of economic organization, the clearing cooperative charged marginal cost prices and admitted the “right” number of members of the “right” kind, the exchange would still likely be a monopoly, and earn all the monopoly rent. That is, the clearing integration issue is a red herring. The CME is not a combination of a natural monopoly clearer with an execution facility that would be a near perfect competitor if shorn of its clearinghouse; it is a natural monopoly clearer merged with a natural monopoly execution facility. Indeed, as I argued in Silos, that is exactly WHY they are integrated. Integration addresses the problems posed by bilateral monopoly.

For evidence that an execution-only exchange with no clearing function can exercise market power, look at the London Stock Exchange. LSE has no clearing or settlement function. It gets clearing services through LCH.Clearnet. LSE has faced competition in the past–like Tradepoint–that failed miserably. It maintains a dominant market share in the trading of the stocks it lists. Despite all the flack that Deutsche Borse gets over its integrated clearing and trading, guess who has the bigger margins–LSE. It has the highest fees of any of the major world equity exchanges, and has higher margins (66 percent) than Euronext (60 percent) or DB (58 percent).

In sum, disintegrating clearing and trade execution is no silver bullet that will make futures markets perfectly competitive. As Posner, and Bork, and other Chicagoans who wrote on antitrust long ago noted, vertical integration should not be a focus of antitrust concerns. Vertical integration is almost always a way to economize on transactions costs or double markups. In my view, this is true in futures markets (and equity markets, for that matter). Vertical integration has long been the dominant form of relationship in futures execution and clearing, for exchanges large and small. This reflects transactional efficiencies, not monopoly leveraging.

If competition is imperfect in futures (and equities) markets, this imperfection arises from the strong scale, scope, and network economies in trading and clearing. At best, disintegrating clearing and execution will just allow the execution entity to capture the rents that arise from the imperfect competition. At worst, disintegration will increase transactions costs and the fees that participants pay (due to double markups). What market forces have joined together, let no man put asunder–without a compelling economic case for doing so. So far, the fungilistas have not done so. Indeed, in my view the compelling arguments are all on the other side.

Well, it finally happened. The CME and CBOT have announced their intention to merge. On the one hand, it’s not a surprise–this tie up has been mused about for years, and there were talks of a combination in the runup to the CBOT’s IPO not long ago. On the other hand, the timing of the deal was a surprise. There was no serious uptick in rumors or conjectures about an impending deal in the days leading to the announcement.

The economics of the deal are perfectly sensible–as they have been for years. When each exchange was a membership organization, however, politics and rent seeking stood in the way of the combination. As I noted in my 2000 JLE piece on exchanges, the members of exchanges are heterogeneous, and there is considerable disparity in the rents accruing to different members. Thus, any major policy change–including a major merger–is likely to have important distributive effects that raise the cost of implementing this change even if it enhances total member wealth. Indeed, the infamously Byzantine nature of member-owned exchange governance structures is a sensible way to control rent seeking–even though it slows decision making and impedes major strategic moves.

Electronic trading eroded the rents that exchange members–notably the locals and floor brokers who dominated exchange governance–earned from their special skills. As I predicted in my JLE article, the move to electronic trading completely undermined the rationale for the not-for-profit form and member ownership. In the early 2000s, the CME and the CBOT went for profit, and had IPOs. Distributive considerations were muted as a result. The exchange owners became much more homogenous–they were all essentially residual claimants to the stream of rents thrown off by the electronic trading system. All had a common interest in maximizing the share price. This reduced the political opposition to any deal, and made the CME and CBOT owners interested in maximizing the size of the pie, rather than fighting over the division of the pieces. Under these circumstances, the compelling economics of the combination finally prevailed.

What’s next? The exchanges are publicly confident that anti-trust review will not cause problems. Perhaps that’s the case, but I would expect the deal to get some attention from DoJ. It’s a big deal, and those tend to attract attention. Moreover, exchanges have attracted little anti-trust scrutiny in the past, but with sea change in the industry, the tendency towards concentration in trading, and the prospect for further consolidation, that may change. DoJ will recognize that this deal will establish a precedent for future mergers in derivatives, equities, and options, and will likely want to make sure that it is comfortable with it.

The key will be market definition. If it’s an individual futures contract market (e.g., Treasury futures), then there’s no problem–the deal won’t increase concentration as the exchanges don’t compete head-to-head in any contract. If it’s the derivatives markets (including the OTC derivatives market), no problem–because the futures markets are small relative to the overall derivatives markets. If it’s the futures markets (i.e., not individual futures markets, but something like “interest rate futures”)–then there could be a problem.

Economically, I think that the first two are more economically sensible than the third. The third market definition presumes that different futures are close substitutes for one another. This is problematic. Different futures–even relatively related futures such as Eurodollars and Treasuries–are not very good substitutes for hedgers. They may be substitutes for some speculators, but I am doubtful that the relevant cross-elasticities are very high. Moreover, some pairs of contracts are actually complements for some speculators. For instance, traders who spread Eurodollars and Treasury note futures, or corn and live hog futures, consider these contract pairs complements. Thus, there is not a strong prima facie case that “futures” is the appropriate market definition.

The deal also sparks additional speculation about what will happen with other exchanges. As I’ve said before, it makes sense to combine NYMEX and CME. Indeed, NYMEX has some of the same attributes–and weakenesses–as the CBOT. NYMEX has a strong slate of contracts, but like the Board, does not own its trading technology. Moreover, there is another benefit to adding NYMEX to the mix–the economies of scope in clearing. Clearing NYMEX, CME, and CBOT contracts together would be cheaper, and economize substantially on margin, relative to clearing NYMEX separately from CME/CBOT.

Beyond that? CBOE+CME+CBOT? There is already cross margining on index options and index futures, so that limits the potential margin savings. Also, CBOE clears through OCC, and there will remain advantages to clearing options on individual stocks that are traded on multiple exchanges through OCC. CME+CBOT+NASDAQ? That is intriguing, and I’ll give it some further thought.

In the meantime, as a Chicagoan, and a student of exchange history, the merger is somewhat bittersweet. The CBOT has been around since 1848, and has been a world leader in futures trading since the Civil War. There aren’t a lot of American business institutions that have been around for 150+ years, let alone world leaders for over 140. The Board was the scene of many important economic events, the birthplace of many important financial innovations, and the stomping grounds for many colorful, illustrious, and sometimes infamous, characters. The CME is also a storied institution with a distinguished past, but it only came into its own in the 1960s, and particularly the 1970s and 1980s. Indeed, the CME almost died when Congress outlawed trading of onion futures–the exchange’s leading contract–in the 1950s. Thus, this represents the passing of an age, and the passing of the torch from a venerable pioneer to a relative newcomer.

Fortunately, the combined entity will utilize the CBOT’s beautiful and historic building at LaSalle and Jackson (depicted in the background wallpaper of this site), so there will be visible and enduring evidence of the Board’s contribution to the city, and a reminder of the exchange’s glorious past. Moreover, the combination will ensure that Chicago will remain the dominant force in derivatives trading for years to come. So though the name “Chicago Board of Trade” will no longer live on, its legacy will. Modern futures trading was born in Chicago. In the last 20 years the futures industry has grown dramatically around the world, but for the foreseeable “future” its home address will continue to be 141 West Jackson Boulevard, Chicago, Illinois, 60604.

A few thoughts regarding the Amaranth matter.

First, the good. A large hedge fund blows up, losing $6 billion in a matter of days, and the market just chugs along with no problems. Quite a contrast to the tumult that accompanied the demise of LTCM 8 years (to the month) earlier.

Now, that said, we shouldn’t get too complacent about this. For one thing, although the dollar value of Amaranth’s loss dwarfs that of LTCM (which lost about $2 billion in equity), the market is just much bigger today. It remains to be seen whether a fund with the same relative size as LTCM could implode without wider fallout. For another, LTCM’s problems occurred during a time of—indeed were caused by—a general financial crisis sparked by a de facto Russian default. This caused a rush for liquidity, and since LTCM was long illiquid instruments and short liquid ones, it was devastated. Its losses, combined with the fact that it was counterparty to most major financial institutions, threatened to make a bad situation worse. In contrast, Amaranth’s travails occurred during relatively quiescent times in the broader financial markets—although natural gas markets were indeed highly volatile and unsettled. It still remains to be seen whether a major hedge fund collapse in the midst of a financial crisis could touch off an acute systemic problem.

Second, the bad. The Amaranth episode proves again, as if further proof was needed, the danger of the “superstar trader” complex. Gas trader Brian Hunter reportedly made Amaranth $800 million in 2005. Whereas historically the fund had kept a close watch on its traders, requiring them to operate out of its Greenwich, CT offices, Amaranth let Hunter set up his own little empire in Calgary. Moreover, it is plausible that Hunter’s past success made the fund’s management loath to question his judgment in putting on the massive spread trade that apparently brought down the house. For you slow learners out there: big winners need more supervision and oversight, not less.

Third, the ugly. Not that we should be surprised, but the usual suspects in DC immediately leapt into action to use the Amaranth situation to justify yet again (yet again . . . ) their tiresome claim that the OTC energy markets are a threat, and that additional regulation is required. One failproof way to identify quackery is if the doctor always prescribes the same “cure” (nostrum is more like it) regardless of the patient’s symptoms. If anything even remotely untoward happens in the OTC energy markets, Drs. Feinstein, Levin, and Coleman (see, it’s not a purely partisan game) always prescribe greater oversight of electronic OTC trading platforms (read ICE) and the mandatory reporting of large OTC energy derivative positions. Possible manipulation—position reporting. Large investor loss—position reporting. Energy prices go up—position reporting. Energy prices go down—position reporting.

What, pray tell, would the CFTC have done with additional information in the Amaranth case? Since Amaranth’s positions posed no plausible manipulative threat in the immediate term (as they were 2007 gas positions) the CFTC could not have used the information to facilitate a manipulation investigation. Nor was fraud a remotely likely problem. Furthermore, CFTC is not in business to keep adults from losing money by speculating the wrong way. Perhaps the agency might have directed inquiries to Amaranth’s FCMs to determine whether the positions posed a threat to the financial viability of these firms and their other customers. Since there have been no reports that any FCM was seriously injured by Amaranth’s difficulties, however, it is unlikely that such inquiries would have led to any CFTC action that would have had the slightest effect on developments.

Even with regard to matters clearly within the CFTC’s ambit—notably, the prevention of manipulation and fraud—it is highly unlikely that position reporting is all that helpful. Position reporting might—and I emphasize might—facilitate early intervention to prevent a manipulation. As I’ve written in the past, notably in my book on manipulation (now #1,565,885 on Amazon after reaching the low-500,000s in late-August!), however, prevention is inefficient as compared to ex post deterrence. As Judge Easterbrook put it, an undetected manipulation is an unsuccessful manipulation. Highly anomalous price movements are the hallmark of manipulation. Transparent exchange prices, and prices on transparent electronic OTC platforms like ICE, provide the most reliable information regarding manipulation. Anomalous price movements—and the complaints of traders harmed by them—can trigger further inquiry to determine whether a manipulation has plausibly occurred, or is in process. Position information can be requested and obtained at that time. Why incur the cost of routinely collecting and analyzing masses of information about positions, most of which is almost completely irrelevant to detecting, deterring, or preventing manipulation? Put differently, a large position may be a necessary condition for manipulation, but it is clearly not a sufficient one. It is more efficient to utilize scarce enforcement resources to examine circumstances in which the primary indicia of manipulation—anomalous prices—are present, than to scrutinize big positions even when price distortions are not evident.

Ironically, raising the cost of doing business on transparent electronic platforms would likely force business into less transparent ways of transacting. This would reduce the availability of reliable price data that is of essence in any manipulation case.

To those who might say: “well, by the time that prices become distorted it’s too late—we need to catch these things ahead of time” I reply: just how, exactly? All manipulations are associated with big positions, but many big positions are not associated with manipulation in any way. One needs to worry about both type I and type II errors, false positives and false negatives. Raising the costs of accumulating large positions may reduce the frequency of manipulation—but it can also constrain the accumulation of large positions for legitimate business purposes. This is costly. A rifle shot approach directed at particular markets where the signs of manipulation are manifest is more efficient than a shotgun approach like that advocated by Sens. Feinstein, et al.

So I venture a daring prediction: the next time the energy market catches a cold, the flu, colitis, or any other ailment known to man or beast, the Capitol Hill Medicine Show will prescribe its Sure-Fire Senatorial Position Reporting Cure.

Any time that commodity prices reach highs or lows, speculators are invariably the culprits. Today’s energy market is no exception. Many commodity market commentators have been quite upfront in their assertions that current high energy prices (and metals prices too) are due to speculative excess, rather than supply and demand conditions. Now the Senate Permanent Subcommittee on Investigations has endorsed these views (and given them substantial credibility) in a just released a report claiming that fundamental supply and demand conditions cannot explain current high oil prices, and asserting that speculative activity is to blame instead. The report breathlessly repeats claims that speculation in energy markets has inflated oil prices by as much as $25 per barrel.

Where to begin? The report is a farrago of facts, factoids, and falsehoods stitched together to arrive at a conclusion that is miles beyond what the evidence actually supports. Moreover, although I concur that manipulation is a potential problem in energy markets–as it is in all commodity and even financial markets–the report does not even make the effort to show that current price levels are the effect of manipulation. Nonetheless, it sternly recommends a variety of new regulatory initiatives to combat manipulation, suggesting (by implication) that manipulation is the cause of high oil prices. This is a flagrant example of bait-and-switch of a variety that I imagine that the Subcommittee members would vigorously condemn if committed by your local used car salesman.

The report (and most of the other criticisms of speculation) fails on only two points: logic and evidence. Other than these shortcomings, it’s great.

With respect to logic, the report documents (to the extent available–reliable evidence being hard to come by) the growth of speculative activity in energy markets. It draws particular attention to “long only” speculators such as pension funds and other traditional investment vehicles that historically have not participated in the commodity markets to any great extent, but which have increased their exposure to commodity prices in recent years as a way of diversifying their portfolios. These funds typically invest in the commodity market through investment vehicles tied to commodity indices, such as the Goldman Sachs Commodity Index (“GSCI”), which parenthetically have a very high exposure to the energy market. Moreover, the report alleges that these funds typically are index buyers rather than sellers. (NB. This is itself something curious, as the diversification benefits could be obtained by shorting the index too.)

According to the report:

As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the futures contract by a refiner or other user of petroleum (p. 16).

The large purchases of crude oil futures by speculators, have, in effect, created an additional demand for oil, driving up the price of oil for future delivery in the same manner that additional demand for contracts for the delivery of a physical barrel of oil today drives up the price for oil on the spot market.

Well, not exactly. Note that most speculators–and most particularly the long commodity indexed investors–offset their positions prior to delivery. For instance, the GSCI is rolled according to a fixed schedule, meaning that to replicate the index, the nearby futures contract is purchased sometime prior to the expiration month and then sold some days before that contract moves to delivery. Thus, the “rolling” speculator, even if continuously long, does not contribute any additional demand for physical oil. The supply and demand for spot oil determines the spot price, and the long speculator–and indeed, virtually all speculators–do not participate in this physical market.

If anything, the entry of speculators affects the price of energy price risk. That is, it impacts the “drift” in a futures price to an expected future spot price that is based on expectations regarding supply and demand conditions at contract expiration, rather than affecting the price of physical oil. Put differently, derivatives markets are primarily for buying and selling price risks rather than for buying and selling the commodities themselves. The delivery process ensures that futures prices converge to physical spot prices, but the amount of activity in contracts with payoffs tied to a commodity price need bear no relationship to the amount of the physical commodity available, and if speculators (and others) act competitively, the physical spot price will be driven by supply and demand fundamentals regardless of the magnitude of the “side bets” on commodity price risk.

I wish that this was an original analysis that I could take credit for, but it’s actually quite old. That’s because the arguments against speculation like those contained in the Senate report are themselves quite old, and spurred cogent refutations long ago. For instance, back in the day when the concern was about short speculators driving down farm prices rather than long speculators driving up energy prices, a 1901 report from the United States Industrial Commission on “The Distribution of Food Products” stated:

As we have attempted to show, it is a mistake to represent speculation in futures as an organized attempt to depress prices to the producers.

First. Because every short seller must become a buyer before he carries out his contract.

Second. Because, so far as spot prices are concerned, the short seller appears as a buyer not a seller, and therefore, against his own will is instrumental in raising prices. (p. 233).

These arguments apply with equal force to analyses of long speculation, as to the short speculation that was the concern of the report.

Insofar as evidence is concerned, the report points to the the current contango in the energy market and the co-existence of historically high prices and high inventories as a smoking gun that proves that energy prices have become unmoored from fundamentals, and are instead driven by speculation. (NB. “Contango” means that prices for more distant delivery–such as for delivery in a year–exceed the spot price. The opposite situation is “backwardation.”)

It is indeed true that historically, high levels of inventory are associated with low prices, and since contango is associated with high inventories, contango is also typically found in energy markets when prices are low. Current conditions are therefore anomalous (by historical standards) and require some explanation.

In this regard, it is important to understand just what inventories are for. Commodity stocks are a buffer against future adverse supply and demand shocks. Typically it is desirable to accumulate inventories when demand is low (or supply is high) relative to future expected supply and demand. Thus, during a recession, demand is low, and is expected to rise at some future date. Therefore, it is often economically rational to accumulate inventories during a recession. Conversely, during a demand boom, it is typically economically rational to draw down on stocks in anticipation of a fall in demand, or perhaps more likely, the entry of new production capacity. The market often moves to backwardation under these circumstances. Thus, all else equal, inventories are typically high when prices are low, but it is important to remember that the price and quantity are determined simultaneously.

It is also possible to identify circumstances in which inventories may be high during periods when prices are at historically high levels. In particular, this can occur if: demand is already high relative to productive capacity, demand is not expected to dampen soon, entry of new productive capacity takes a considerable period of time and no new large sources of supply are in prospect, and there major risks of future supply disruptions. The current high demand causes current prices to be high. The dim prospect for demand declines or augmentation of supply means that if current inventories are consumed they will not be available to meet expected future demand or offset future production disruptions, nor will they be readily replaced through the entry of new production capacity. Moreover, the possibility of major supply disruption in the future means that even though things are tight today, they could get even tighter in the future–which in turn means that consuming a unit from inventory today may be very costly in the future when that unit is not available in the event of a supply disruption.

In my opinion, these conditions are present in the current energy market. The current demand-supply balance is tight. There are no major supply enhancements on the horizon. Indeed, some major investments in new capacity, most notably Canadian oil sands, will come on line much later than originally anticipated due to bottlenecks in getting labor and materials in place. The world is rife with unrest in major oil producing regions–the Middle East, Venezuela, Nigeria, even Indonesia and Russia. Rightly or wrongly, in light of the devastating effects of Rita and Katrina (and Ivan the year before), concerns about increased frequency and intensity of hurricanes in the major US production region has raised sensitivity about the vulnerability of US output to future weather-related disruption.

In brief, as tight as things are today, there is a very real prospect that they could get significantly tighter in the future. Under these circumstances, holding inventories in the face of high prices makes sense, and certainly these conditions make it very difficult to have a high degree of confidence that market participants are holding too much inventory.

The evidence–most notably comparisons across markets–also casts serious doubt on the validity of the hypothesis that speculation is causing excessive inventory accumulation and high prices in energy.

First note that most indexed money (e.g., funds that are tracking the GSCI) have positions concentrated in the nearby contracts. The GSCI tracks front month contracts. Therefore, per the speculative excess theory, the presence of new speculative longs should lead to less contango, not more.

Furthermore, note that speculators are active in many commodity markets, not just oil. Many participants in industrial metals markets have also argued that speculation, including speculation from funds, has distorted those markets. Prices are indeed high in these markets (notably copper and nickel), but the inventory and term structure patterns are very different. Base metal stocks (again esp. copper and nickel) are at very low levels and these markets are backwardated. This either suggests that speculators are behaving very differently in energy and metals markets (which would be peculiar, as many of the speculators, especially indexed money are in both markets and trade the same way in both) or that there are different fundamentals driving prices in these markets and that speculation is not the overriding determinant of price and inventory action.

(As an aside, I read a brokerage study which claimed that speculators were driving all the price action in metals, and the producers were notably absent. This begs the question: if speculators had driven prices to unreasonably high levels, why haven’t producers sold into the rally in a big way? )

There are other markets that also attract significant speculative action, including participation by indexed money that trades almost exactly the same way in all markets, that are at relatively low price levels. For instance, wheat, corn and soybean prices are currently at relatively low levels. If mindless long speculation driven by commodity-indexed money is the main driver of commodity prices, why are grain prices low when energy prices are high?

Of course these comparisons cannot by themselves rule out the possibility that speculation has some impact on prices. However, they do speak to the broad claims that speculation is the 800 pound gorilla that is moving commodity prices far away from their fundamental values. The Senate report argues that oil prices are perhaps 30 percent too high as a result of speculation. That’s a huge impact. Given that the “story” in the Senate report holds true for industrial metals and grains (and other commodities too) such a huge impact should be manifest in prices and inventories for other commodities. Most importantly, since especially indexed money trades all markets in the indices the same way, we should see high prices, contangos, and high inventories in all these markets if this type of speculation is exerting such a decisive influence on commodity prices.

All these markets exhibit very different patterns, however. Therefore, the burden should be on the advocates of the speculative distortion theory to provide an explanation for this diverse behavior in response to an activity–speculation, especially by indexed money–that is common to all markets.

The arguments over the impact of speculation have gone on for a very long time–in Wealth of Nations Adam Smith wrote about laws against “engrossing” passed in the late-Middle Ages. These arguments have cropped up periodically in the years since, and are made with particular force when commodity prices are low or high by historical standards. These arguments are so durable because they are so superficially appealing, and because they are hard to disprove. After all, nobody knows what the “right” price should be given supply and demand fundamentals, because these fundamentals are unobserved. That is, no direct test of the speculative-excess hypothesis is feasible. However, if it is widely apparent that commodity prices are substantially different from fundamentals, other speculators would see a profit opportunity and tend to act in a way that would mitigate, and perhaps eliminate, the observed deviation. This mechanism is not perfect (for reasons set out by DeLong-Schelifer-Summers-Waldman, among others) but in a world where hedge funds and others can go long or short at will, and where these vast pools of speculative capital have a strong economic incentive to take advantage of price distortions, one must posit very strange behavior on speculators’ parts in order to rationalize long, speculatively-driven departures of prices from fundamentals.

Long as it is (no pun intended), this post only scratches the surface of the economic issues related to speculation. The “real” impact of speculation–on investment, production, and inventory decisions–is of crucial importance, but altogether neglected here. I look to remedy this in future posts. Specifically, I am working on some dynamic programming models that will make predictions about the impact of speculation on price levels, stock levels, and price volatility in a storage economy. This should be directly relevant to the current debate over the stock-price relationship that is the source of so much controversy in the energy market.

Reduced IT/systems costs is one of the major economies that has been advanced to motivate/explain/rationalize exchange mergers. It is quite risky to bet the farm on realizing these economies, however. Integrating IT systems is always a tricky endeavor given their complexity and idiosyncracies. Much of the information regarding systems lives in the heads of individuals who can leave the merging firm (and since cutting IT headcount is one of the sources of “savings” many are indeed destined to leave). Moreover, fixes of past problems, or implementations of various systems, are imperfectly remembered even by those that remain.

Case in point–LCH.Clearnet. The whole “story” behind the merger was that the merger would allow the creation of a single, efficient clearing IT system to replace the legacy systems of the merger partners, LCH and Clearnet. Three years and many millions of pounds sterling later, the merged entity has not realized these benefits. LCH.Clearnet’s chairman resigned in May, and just recently the CEO David Hardy resigned. His resignation was directly attributable to the difficulties in the IT implementation. A ComputerWeekly article provides a detailed account of the problems, delays, and cost overruns.

To me, this suggests that an exchange merger makes sense if the products of one exchange can be migrated to the existing system of the other partner to the merger. For instance, moving NYMEX products to CME’s Globex, or NYBOT products to CBT’s electronic system (or ICE, as rumor now has it) would not face the type s of challenges that have heretofore stymied LCH.Clearnet. Conversely, mergers involving major systems integration (which seems to be the case for NYSE-Euronext) are much riskier. Indeed, as it is rare (unprecedented?) to read of systems integrations that went more smoothly than anticipated, all of the risk seems to be on the downside.

So a word to the wise would-be empire building exchange CEO. Building empires can be fun–if it doesn’t cost you your head. If the economic case for a merger is predicated on realizing IT savings, that is a very real risk indeed.

Growing up in the Midwest during the Cold War, the word “silo” evoked images of blue A.O. Smith grain silos, or Minuteman missile facilities. Now the word has come to mean “vertical integration” in MBA-speak.

The “vertical silo” issue is front and center in debates over the structure of European financial markets. Deutsche Borse owns both a trading platform and a clearing system. Trading is pretty well understood, but clearing is part of the essential “plumbing” of the financial system that most don’t understand. Clearing is the process of confirming and matching transactions, establishing obligations to complete trades, and in some cases, putting a central counterparty in between ultimate buyer and seller in order to reduce performance risk.

The DB silo has been criticized as an impediment to competition in the trading for German stocks. It has been alleged that by denying other exchanges to its clearing platform, DB protects its market dominance in trading. The recent merger discussions between DB and EuroNext stalled in part over DB’s refusal to shed its clearing operation. The proposed EuroNext-NYSE combination will supposedly eschew the silo model.

So who’s right? As a dyed-in-the-wool Chicago School guy, I look askance at anti-competitive explanations of vertical restrictions and vertical integration–it’s in my DNA. Nonetheless, I do recognize that there are circumstances in which vertical restraints can be used to impede competition. (Note that quintessential Chicago guy Les Telser’s famous article on resale price maintenance considered both pro- and anti-competitive explanations of this vertical restriction.) Hence, rather than respond reflexively, I think I should provide some analysis of the issue.

This analysis must be predicated on a recognition of the importance of network effects in both trading and clearing. It is well known that the nature of liquidity creates a network effect in trading of financial instruments; see my 2002 JLEO paper, or an earlier paper by Pagano for a formal analysis. This network effect exerts a centripetal force that tends to induce all trading to tip to a single venue. In my JLEO piece, I show that alternative trading venues (e.g., the block market, the third market) can survive only by limiting participation to the verifiably uninformed. The predictions of these models are largely supported by the data. Most trading does tend to concentrate on a single market, and off-exchange trading tends to have much less information content than on-exchange trading. Attempts of entrants to compete with incumbents, e.g., LSE’s attempt to wrest the Dutch equities trade from EuroNext, Eurex v. CBOT in Treasuries, or EuroNext.Liffe v. CME in Eurodollars, almost always end in failure.

Although it has not been analyzed as extensively, there are strong sources of network economies in clearing too. The number of matches between buyers and sellers is maximized when all trades are submitted to one clearer. If there are several clearers, and the buyer and seller direct orders to different ones, no match occurs, or the clearers must take the additional step of contacting each other to complete the trade. This is duplicative, and increases the possibility for costly errors or delays in trade processing.

The use of netting to economize on the flows of cash and securities also creates network effects. Netting economizes on liquidity needs; traders who both buy and sell in a given settlement cycle need only the cash necessary to pay for their net transactions. Netting possibilities are maximized when all orders are directed to a single clearer. [N.B. The term “liquidity” used in this context is somewhat different than its use in the trading context. In the clearing/settlement context it refers to to the amount of liquid assets (cash, readily marketable securities) needed to support/finance the clearing and settlement process.]

Network effects create a centripetal force which induces tipping to a single venue. Therefore, if clearing and trading in a particular instrument are separate, one would expect tipping to lead to the survival of a single trading platform and a single clearer. This creates the real possibility of a bilateral monopoly problem. This has two potentially adverse consequences. First, it leads to double marginalization. An exchange that possesses market power due to the network effect in trading will markup the above marginal cost clearing cost that a clearer that also possesses market power due to the network effect in clearing. Second, it raises the possibility of holdup and opportunism as the monopoly exchange and the monopoly clearer attempt to capture the quasi rents that arise due to specialized investments in clearing and trading infrastructures. (There will be an additional source of inefficiency if clearing services and trading services are not consumed in fixed proportions, i.e., they are not perfect complements. In this case, production may be inefficient due to distortions in the mix of clearing and trading inputs. However, it seems that fixed proportions is a reasonable assumption so I focus on double marginalization and opportunism.)

Integration is a well-known–and usually efficient–way to mitigate both double marginalization and holdup. Therefore, one expects to observe integration between trading and clearing. This is typically, though not always the case. Most US futures exchanges own their clearing arms. The US stock exchanges jointly own their clearing entity, the NSCC, just as US options exchanges own the Options Clearing Corporation. As already noted, DB is integrated into clearing. EuroNext is something of a hybrid. It owns a 25 percent stake in its clearing provider, LCH.Clearnet.

There are exceptions, of course. The LSE secures its clearing services in an arms length transaction with LCH.Clearnet. The LCH has long provided clearing services for numerous (and relatively small) UK futures exchanges. Nonetheless, there is considerable integration between clearing and trading functions, which is not surprising given the bilateral monopoly issues.

So what are the efficiency implications of integration, and how would mandatory dis-integration of clearing and trading affect efficiency? I am putting the finishing touches on some models that address these issues. In the basic model, there are network effects in both trading and clearing. Moreover, neither stage is contestible. These effects lead to tipping at each level. That is, competition between clearers leads to the market tipping to a single clearer, and competition between exchanges leads the market to tip to a single trading platform. If clearing and trading are separate, double marginalization impairs efficiency, and creates an incentive to integrate clearing and trading. Similarly, any holdup costs also reduce efficiency. Therefore, integration is the efficient outcome in this case even though it is not first best because there is market power due to network effects.

Therefore, when the realities of network effects are considered, the case for dis-integration, well, disintegrates. Since network effects lead to considerable market power–and arguably natural monopoly in certain segments of the market for trading–dis-integration can create serious double marginalization inefficiencies since it is highly unlikely that an independent clearer–which will likely be a monopoly or at the very least a firm with considerable market power due to network induced tipping–will sell its services at marginal cost. Moreover, dis-integration will likely raise holdup costs. If there is considerable market power in trading as one would expect due to tipping (though regulations such as RegNMS can mitigate this power), dis-integration will not appreciably reduce exchange market power, but will raise double marginalization and holdup inefficiencies. This is a lose-lose proposition.

Therefore, any case for dis-integration must be based on the presumption that trading in and of itself is reasonably competitive. I am working on other models which attempt to derive conditions in which dis-integration can enhance efficiency. In these models, there is tipping in clearing due to network effects (so the clearer is a natural monopoly) but Cournot competition among N>1 exchanges at the trading level. If (a) the monopoly clearer in independent, and for some reason sells at marginal cost, and (b) there are sufficiently high fixed costs of operating a clearinghouse (which obviously makes assumption (a) problematic unless there is some two part pricing scheme), then foreclosure and a loss of efficiency can occur. One of the Cournot competitors can buy the clearer, and the other Cournot competitor(s) find it better to go out of business rather than incur the fixed costs of establishing their own (inefficiently small) clearing operation. In this case, output and welfare go down. Welfare is higher if the clearer is separate–and is constrained in its ability to exercise market power.

Back here on earth, we should doubt that a monopoly clearer will provide services at cost (more on this below). If the monopoly clearer charges a super-marginal cost price, double marginalization arises with Cournot competition at the trading level. In this case, integration of clearing and trading into a single monopoly firm actually results in larger output and welfare, even though deadweight monopoly losses persist; integration doesn’t increase the amount of monopoly power, which the clearer possessed in any event, but does reduce the double marginalization inefficiency.

This “foreclosure” outcome can be an equilibrium if the fixed cost of operating a clearing function is sufficiently high. If fixed costs are sufficiently high, one exchange and the clearer merge, and the other exchange loses money if it creates its own integrated clearing operations (because of the fixed costs and the fact that these integrated operations are inefficiently small since they cannot exploit all the network effects). If fixed costs are sufficiently small, the model predicts that one may observe competing integrated exchanges, each with its own suboptimally small clearing operation. I have not yet pinned down the welfare comparison here, as there are offsetting effects–redundant fixed costs and suboptimally small clearing networks on the one hand and greater competition on the other. My intuition is that there is no unambiguous welfare ranking in this model.

Regardless, I don’t find this model very plausible. The Cournot model banishes network effects from trading, which is unrealistic. Moreover, it’s hard to have a great deal of confidence that a separate, monopoly clearer will charge marginal cost prices. In this case, double marginalization inefficiencies likely overwhelm the competitive implications of foreclosure; barring integration doesn’t reduce market power (because the monopoly power arises at the clearing level) but it does raise double marginalization costs. Moreover, the multiple-integrated-exchange outcome that is possible in the model is not widely observed. Indeed, it is hardly if ever observed. Thus, although there are conditions in which dis-integration is welfare enhancing, it is highly doubtful that one would observe these conditions in practice.

Standing back and reviewing the argument makes it clear that a necessary–but not sufficient–condition for forced dis-integration to make sense is that the natural monopoly clearer sell its services at marginal cost. Is this realistic? Color me skeptical.

In essence, this requires either (a) contestibility in clearing or (b) regulation of clearing prices. Don’t even get me started on the latter possibility, so let’s focus on contestibility. On a priori grounds, there is some reason to be skeptical about the complete contestibility of the clearing market. There are likely large costs to switching clearers, especially inasmuch as system users must invest in an IT infrastructure specific to a given clearer in order to connect to it. Switching clearers requires investment in a whole new infrastructure. Given the sums of money involved in the clearing process, and therefore the high costs associated with errors, technical problems, lack of connectivity, etc., this investment is not likely to be small. This clearly creates switching costs, and thereby impedes contestibility.

That said, it must be noted that there are exceptions to vertical integration that suggest some degree of contestibility at the contract renewal stage. Recall that LSE is not integrated with its clearinghouse. Moreover, when its clearing contract with LCH neared expiration, LSE let the contract out for tender. There was competition for the business, which LCH retained, but at a 25 percent savings according to LSE officials. The interesting–and unanswered question–is how the contract price compared to cost. As George Stigler said, data is not the plural of anecdote, but this episode does suggest the possibility that there is a degree of contestibility in the clearing business. On the other side of the ledger, this may be the exception that proves the rule–integration or exclusive contract is the norm, and the LSE episode is the exception.

LSE is also attempting to encourage competition between LCH.Clearnet and a Swiss clearing firm x-clear. Specifically, LSE has signed an agreement whereby x-clear can provide member firms with the ability to choose where to clear. x-clear has a “sub-CCP” account with LCH.Clearnet. If the buyer and seller in a trade both choose x-clear to clear the trade, that entity serves as the CCP. Conversely if one chooses x-clear and the other LCH.Clearnet, x-clear serves as the equivalent of a clearing member of LCH.

It is evident that there are trade-offs in this arrangement. On the one hand, it may increase competition–at least for awhile. On the other, it almost certainly will result in cost duplication and failure to exploit all netting economies. This trade-0ff raises questions. If the arrangement does not result in a relatively seamless merger of the two clearing pools, does the increase in competition more than outweigh the inefficiency that results from the simultaneous existence of two suboptimally scaled clearers that do not exploit all network effects? Will the two actually survive, or will the market tip? That is, will the increase in competition endure, or will it prove evanescent? Do customers need links with both clearing houses? How much additional cost does this involve? The experiment is new, and deserves watching.

In sum, dis-integration is not a magic spell that will make European securities markets more efficient. Indeed, it is plausible that it would make these markets even less efficient. In essence, it is necessary to acknowledge the implications of network effects in trading and clearing. These are the sources of market power and inefficiency, and dis-integration will not fix them. In my view, it is plausible that not only will dis-integration not fix these inefficiencies, it will introduce other inefficiencies (double marginalization and holdup). Therefore, dis-integration in and of itself is not equivalent to cutting some Gordian knot that constrains competition in securities markets.

Instead, improving efficiency will require separate responses to facilitate competition in both clearing and trading. Measures like RegNMS in the US–which effectively weakens the order flow/liquidity externality by opening access to the total liquidity pool–can improve competition in trading. Clearing seems to be a bit more nettlesome.

In brief, don’t expect any easy solutions. Network industries always pose competitive challenges, and virtually every conceivable regulatory scheme to address these challenges is problematic, at best.

Interestingly, integration has attracted little regulatory or legislative attention in the US futures industry. It will be interesting to see whether US futures bourses will be able to fly under the radar on this issue forever. Even if US regulators don’t express concern, the growing internationalization of the futures business might spark foreign (esp. European) regulatory/anti-trust scrutiny. Note that the EU is engaged in a long raging anti-trust battle against Microsoft. Note too that there is considerable opposition to the vertically integrated clearing model in the EU. Putting two-and-two together, this suggests that EU regulators might put CME or CBT or NYMEX in their crosshairs as the globalization of the futures business proceeds apace. This may be particularly true if a US exchange attempts an acquisition in the EU. Just speculatin’, but it should be an issue that US futures exchange executives give some thought to.

The Chicago Trib’s Susan Diesenhouse interviews several people on the implications of the incipient NYSE-Euronext tie up for the Chicago derivatives exchanges. Columbia’s John Coffee opines: “”This is going to put a burden on the CME and CBOT to make their own bids to become multiproduct exchanges because the NYSE has engaged in a market-extending merger.”

Pardonez mon francais, but that makes no freakin’ sense whatsoever. NYSE’s Thain made it clear that he wanted to get into derivatives–as he has done by merging with Euronext and its LIFFE derivatives exchange–primarily because they offered higher growth potential, higher margins, and less competition than NYSE’s core equity business. So the king of the high margin, high growth, low competition derivatives space–the CME–is supposed to respond to the NYSE effort by acquiring a low margin, low growth, high competition equity business so that it can be a multiproduct exchange just like the NYSE? Huh?

I’ve heard it said that imitation is the sincerest form of flattery, but in this instance, for the CME to imitate the NYSE would be the sincerest form of stupidity. If anything, the NYSE’s move shows that the CME–and to a considerable extent, the CBT–are in the cat bird seat. The NYSE believes that it has to get where the CME and CBT already are–and feels compelled to buy rather than build its way into the derivatives space. Why should the Chicago exchanges dissipate their resources by moving into an already highly competitive equity market?–an equity market that in the US is becoming more competitive all the time due in large part to RegNMS.

Chicago shouldn’t feel threatened by the NYSE action–it should feel honored. Just keep on doing what you do so well on LaSalle St. and Wacker Drive and let the others play catch up. Chicago rules! Except for the Cubs.