Streetwise Professor

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

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

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

I made a related point here. Donohue also said:

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

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

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

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

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

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

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

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

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

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

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

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

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

And from the conclusion:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The New York Times reports that the Treasury and the SEC are contemplating requiring banks to disclose publicly quotes and trades in derivatives, such as CDOs. Where have I heard that idea before? Oh yeah, I came up with it 5 years ago to address problems in the energy market.

Now, of course, I shouldn’t take entire credit for the idea, as Mike Prokopp at Amerex, Ed Bell, then of PA Consulting, and Bob Anderson at the CCRO, and some folks at Reuters were thinking along similar lines. But I think it is fair to say that I contributed as much, and perhaps more, to the development and evangelization of the concept as anybody.

In energy, the issue was that many traders falsely reported the prices at which they bought and sold natural gas to trade publications such as Gas Daily and Inside Ferc. The price reporting was purely on an “honor system,” and like everything, honor has its price–and that was a price many traders weren’t willing to pay. So the basic idea I developed was that of a “data hub.” In a nutshell, traders would report prices of actual transactions to a central repository, that would validate the submissions by matching buys against sells. The data would then be disseminated to the marketplace.

The concept is pretty straightforward, but in the energy space it attracted a lot of flak, some of which I am still picking out of my backside. Transparency is not everybody’s friend; traders feel that they give up valuable information by publicly disclosing their prices. Moreover, the price reporting incumbents–notably Platts–had a vested interest in maintaining the old system. FERC and CFTC said nice things about the idea, but the political pressure from some industry groups, individual energy firms, and Platts overwhelmed the arguments that an academic and a few industry mavericks put forth. As a result, neither regulatory agency was willing to mandate that firms report prices to a particular entity. Absent a mandate, the collective action problems of creating a viable data hub were daunting.

In May, 2004 the idea was all but dead. As a last gasp effort to revive it, my then assistant Jeff Graefe had the idea to organize a roundtable on the idea at UH. Bob Anderson, who had formed a non-profit company called Energy Data Hub (imagine that) was there, as were several representatives of energy firms. Bob was about to give up on the idea when Jim Allison from Conoco-Phillips gave the idea his strong endorsement, and suggested that the concept be extended.

The original concept behind the hub was to collect and disseminate data on simple energy products, like day ahead and month ahead gas. Allison said that it would be much more useful to collect and disseminate information on more complicated products, including longer dated swaps and options. This would help firms get better estimates of the values of their outstanding contracts, and hence allow them to manage risk and determine profitability much more effectively.

With Allison’s strong endorsement, Anderson plugged ahead with the Data Hub. It is now collecting data from several companies, and should go live later this year. Although I take pride in pioneering the concept, Bob deserves credit in persevering to make the concept a reality, and Jim deserves credit for the vision to see how the concept could be used to solve problems other than the false-reporting issue that had been the reason for its development.

It is ironic, in light of the NYT article, that at a lunch with Anderson before Christmas I mentioned that the hub concept could–and should–be extended beyond energy to deal with other opaque markets, such as credit derivatives. The idea is, as they say, scalable, and numerous segments of the derivatives marketplace could do with greater transparency.

I am not a big fan of government mandates, but theory and practical experience tell me that (a) a mandate is the only way this can be done quickly, and (b) a mandate is economically efficient. As I noted before, trading firms don’t like transparency. They operate on the motto “The One Eyed Man is King in the Land of the Blind.” A individual firm that sees some deal flow–but not all the deals–likely has something of an information advantage over other firms. If all prices are revealed to everybody, the informational playing field is level–and who can make any money when that happens? So many firms–especially the big hitters that see a big chunk of the deal flow–would rather have a relatively opaque market. Sure, they don’t know values as accurately as if all prices were disseminated publicly, but trading profitability only requires that you have better information than others. So the biggest, most influential firms have a vested interest in opposing greater transparency.

Moreover, there is a positive externality from disclosure of value information; it helps other firms manage their risk better and mark their books more accurately. Firm A doesn’t benefit if firm B can manage risk better. Though Firm A could manage risk and mark books better if it also received information from firms B, C, etc., no individual firm captures all the benefits of its disclosures. Moreover, investors in the stock of the trading firms (and investors in hedge funds trading in these opaque markets) would benefit from having more accurate valuation information. But firm A gets all the trading benefits of keeping the information to itself, but none of the benefit that disclosure confers on other firms who can use the information to manage risk and mark more accurately. Collectively firms would benefit from disclosure (as the trading part of it is close to a zero sum game but the risk management part is positive sum), but individual firms can’t capture the collective benefit through unilateral disclosure.

Thus, there is a collective action problem, similar to the common pool problem in the oil business. It is well known (as documented by Gary Libecap and Steve Wiggins) that operators of common pools typically do not resolve that problem efficiently. On a priori grounds I would predict that collective action problems would make it very difficult for individual firms to come to an efficient agreement regarding mutual disclosures of price information. Indeed, the resistance of the “front offices” (i.e., the traders) to the idea would likely overcome the influence of the “middle offices” (i.e., the risk managers) who would otherwise favor the concept. (Traders usually swing much more stick than the green eyeshade types.) My experience in the energy data hub was strongly consistent with this conjecture.

So, despite my usually libertarian/Chicago instincts, here is a situation where I believe a mandate to be warranted, and I support the Treasury/SEC initiative. It is clearly most needed in the credit derivatives market, and in the market for various structured products, but it is also defensible in other parts of the derivatives market as well.

Perhaps the SEC/Treasury action will also galvanize FERC and CFTC to revisit the issue in energy markets too. Although the Energy Data Hub lives, it is still fighting the collective action problem.

When the subprime stuff hit the fan, it was clear that the market could use better price information. It was equally clear that due to the conflicting interests and the collective action problem, market participants were unlikely to provide it absent a nudge from the feds. That nudge has come, and none too soon.

I’ve been predicting since the Whither NYMEX post almost exactly two years ago that CME would acquire NYMEX. That forecast took one major step closer to realization today, with the CME’s confirmation that it was engaged in merger talks with NYMEX. The parties have agreed to a 30 day exclusive negotiation period.

The timing of the move is very sensible. The CME just completed the integration of CBT products onto Globex. With the integration successfully completed, it is free to make its next move. The smooth segue from integration to offer suggests that this was the strategic plan all along.

As I’ve stated numerous times, the deal makes eminent sense. NYMEX already uses CME’s Globex trading system, and is contracted to do so for another 8 years. This always gave CME a leg up in any contest for NYMEX, as an alternative suitor would have to circumvent that contractual obstacle, and then migrate NYMEX business to a new platform, a costly and potentially risky endeavor. Moreover, the CME/NYMEX tie up offers far more substantial economies on the clearing side than any alternative combination–and remember, clearing is where the money is. Furthermore, NYMEX has made excellent headway in OTC energy clearing, which fits in very well with CME’s strategy of penetrating the OTC clearing business.

I don’t anticipate any antitrust issues. CME and NYMEX products are far less closely related than CME and CBT products, so if the Justice Department didn’t consider the latter a single market for antitrust purposes, they won’t consider the former to be such. Another suitor could arise–possibly NYSE-Euronext–but the economics make the CME the logical winner even if a would-be spoiler appears.

So now the question becomes: Whither ICE? I stand by my prediction that ICE will join up with NYSE-Euronext.

There is also speculation that CME will snap up the KCBOT and MGEX. That may well be, though ICE might compete for those vigorously. It has already purchased the WCE and NYBOT, so the two smaller grain exchanges would fit nicely in that portfolio. Moreover, I’ve noted before that the Chicago exchanges (now singular) always liked having Kansas City and Minneapolis around; they weren’t serious competitive threats, and their existence helped secure support from the Missouri and Minnesota congressional delegations on legislative issues of interest to the Merc and the Board. For that reason, they may be more valuable to CME as independent exchanges, but against that it must be said that it doesn’t make much economic sense for those two exchanges to survive. The cost of offering the KCBOT and MGEX contracts on CME (or ICE) is trivial compared to the cost of operating stand alone exchanges.

So, the consolidation process seems to be in its last phase. If the NYMEX deal goes through, only ICE and CBOE remain of the major independents. CBOE’s situation may become resolved fairly soon. The SEC approved a CBOE rule change that prevents CBOT members from asserting ownership rights in CBOE. This clears the way for the Delaware Chancery Court to rule on the issue. Once that is clarified, CBOE can have an IPO, and once that happens, it will probably be snapped up by somebody soon afterwards. Thus, it is likely that by the end of this year the exchange consolidation movement in the US will be complete, or nearly so. Then the main theater will shift to international alignments. More on that to come.

I was quoted in this article in the Chicago Tribune about the just announced competitor to the CME.

A couple of points. First, as I’ve pointed out in my academic research, an entrant exchange has a chance against an incumbent if it (or its owners) control enough order flow to generate sufficient liquidity to narrow the incumbent’s execution cost advantage. The owners of the CME’s new competitor do control a decent fraction of order flow in Treasuries and Eurodollars, so this exchange has a leg up as compared to earlier would-be competitors. Nonetheless, I am skeptical that this is sufficient to allow the upstart to prevail. It is a necessary condition, but not a sufficient one.

Indeed, previous attempts to compete in the US Treasury complex have failed miserably despite the direct involvement of large banks. BrokerTec Futures (BTEX) was formed in 2001 by a consortium of 14 big banks, investment banks, and brokerages (including some involved in the latest venture) . Although BrokerTec was very successful in trading cash Treasuries, it failed miserably in Treasury futures in competition with the CBOT, and the banks pulled the plug a couple of years later. BTEX was sold to Eurex US shortly before Eurex entered the US market. The major bank/owners of BTEX were given an equity stake in Eurex US, and they had incentives to direct additional order flow to Eurex US; Eurex would boost each bank’s equity stake based on how much revenue (and hence trading volume) that bank threw Eurex US’s way. That didn’t work either.

A couple of lessons: (1) Although big players do have a lot of order flow, they haven’t had enough to “tip” the Treasury futures market in their direction, and (2) the definition of insanity is doing the same thing repeatedly, and expecting a different outcome. Here we have essentially the same players implementing essentially the same business model based on the same economic theory (re control of order flow)–but we’re supposed to believe that the outcome will be different this time. If you think so.

Indeed, the CME is in a better position than CBOT was when Cantor and then BrokerTec and then Eurex made a run at the Treasuries. CBOT was still largely floor based when each of the electronic competitors entered. Thus, the entrants arguably had a technology differentiator that appealed to a large potential set of market participants (although Cantor’s setup was stupid–users couldn’t enter orders into the electronic system directly, but had to phone it in to a Cantor clerk who entered it. Gee, I wonder why that didn’t work?) Moreover, at the time its earlier competitors surfaced, CBOT was going through managerial turmoil and intense internecine conflict over strategic direction regarding the fate of the floor, and was not renowned for its managerial nimbleness and foresight; the political battling often hamstrung management. Furthermore, entrants were not at a disadvantage in attracting traders participating in other interest rate products, especially Eurodollars, and especially Treasury-Eurodollar spreaders. Spreaders, for instance, had to trade multiple platforms regardless of whether they traded the Treasury leg at the CBT or elsewhere.

In contrast, CME is fully electronic, with a robust and proven trading platform–so no technological differentiator. Moreover, CME management is very good, and CME is not beset by the political infighting that often paralyzed CBOT around the turn of the millennium. And perhaps most importantly, spreaders and others trading both Eurodollar futures and Treasuries can execute on a single platform–CME Globex. Somebody who wants to trade the Treasury leg on the CME’s new competitor still has to trade the Eurodollar leg on CME. If the entrant decides to list Eurodollar futures too in order to overcome this disadvantage, it will be faced with the task of building two liquidity pools and wresting two complexes from an incumbent. Won’t say it can’t be done. Will say it has never been done before.

Second, this is a case of back to the future–a return of exchanges to the customer-owner mutualized model. The question arises : who will benefit if this new mutual succeeds? Even if the CME is charging supercompetitive fees for its services, the entrant’s success does not mean that fee levels in the industry will become competitive. Given the tippiness of order flow, if the entrant succeeds it will likely gain a near monopoly position. In the event, the monopoly rents will just move from the CME to the new exchange–and its big bank owners.

So, this should be viewed as a battle over rents. The efficiency effects of this entry are likely to be negative because real resources will be expended in this contest in which either (a) the incumbent monopoly will survive, or (b) it will be replaced by a new monopoly. This rent dissipation is wasteful. Indeed, if the bank-backed exchange prevails, efficiency may suffer because this outcome could dampen competition in the OTC space where the CME is endeavoring to encroach on the big banks’ turf.

Aaron Lucchetti reports that J. P. Morgan Chase, Deutsche Bank, Citadel and others are planning to launch a futures exchange in competition with the CME. The article is sketchy on details. For instance, it makes no mention of the clearing arrangements for the proposed exchange. (My guess–The Clearinghouse Formerly Known As BOTCC, the Board of Trade Clearing Corporation. There is a large overlap between the identity of the firms that just acquired all the shares of The Clearing Corporation and the firms mentioned in the Lucchetti article.)

Aaron argues that this initiative arises from bank dissatisfaction with high CME fees. That’s possibly part of it, but there is another angle as well. The big Wall Street dealers also want to protect their position in the OTC swaps market. The CME is aiming to offer clearing services in that market, which represents a direct competitive threat to the swap dealers.

The prospects for the upstart exchange’s success are bleak. It is always difficult for an entrant exchange to challenge an incumbent. (Just ask Eurex or Euronext.LIFFE.) As I’ve written before (both on this blog and in some working papers) due to its liquidity advantage, the incumbent is likely to prevail unless it makes an egregious error (as LIFFE did in 1997-1998.) My prediction: a short-lived price war between the upstart and the CME (and perhaps preemptive CME price cutting) followed shortly thereafter by the upstart’s demise, followed shortly thereafter by an increase in CME fees.

One last observation. The Wall Street firms lobbied the DOJ rather intensively to oppose the CME-CBT merger, arguing (among other things) that entry was not feasible. This announcement kinda refutes that argument, eh?

Tom Fowler of the Houston Chronicle quotes me in a blog post spurred by US Asst. Attorney Belinda Beek’s mentioning during jury selection in the manipulation trial of several former El Paso traders that onions were not covered by the Commodity Exchange Act. As I noted to Tom, onion futures were banned due to intense political pressure from onion farmers after several episodes in which the price of onion futures plummeted, at times falling below the price of the sacks in which they were shipped.

Interestingly, in 1972 similar events in the potato market led to the proposal of a bill to ban potato futures. This bill failed, however, in part because a USDA study of what happened in onions after futures trading was banned; the USDA study did not find any evidence that the ban had affected pricing patterns. In a 1963 article in the Journal of Farm Economics Roger Gray found that if anything, the ban increased volatility of onion prices.

The potato contract died a somewhat unnatural death a few years later due to several spectacular manipulation attempts, but this time Congress did not commit the murder. In one of these manipulations, in 1976, both a big long and a big short were trying to manipulate the contract simultaneously, with the short trying to ship huge quantities of potatoes from Idaho to Maine (the delivery point) and the long tied up most of the railroad cars on the Bangor & Aroostook Railroad (in which delivery had to be made). There was a large default against the futures contract. The default severely damaged NYMEX’s reputation. Here is a court case that provides some of the lurid details.

Ironically, the demises of the onion and potato contracts were perhaps the best things that happened to the CME and NYMEX, respectively. The loss of these contracts forced each exchange to innovate to find replacements. CME developed meat futures (including the legendary pork belly contract, which is now fading away but was once the hottest thing in town) to replace onions. NYMEX, under the leadership of Michael Marks, developed energy futures. (Which, funnily enough, a commenter on the Fowler post says should be banned. La plus ca change.) Necessity as the mother of invention, futures exchange edition.

The common feature of potatoes and onions is perishability. Perishability makes prices inherently volatile, and also can make some manipulative strategies possible. Indeed, short manipulations are likely to be more profitable for things like onions and potatoes than other products because dumping additional supplies on the market can depress prices sharply because the perishable good must be consumed almost immediately. This allows someone short futures to profit substantially.