Streetwise Professor

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

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

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

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

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

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

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

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

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

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

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

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