Streetwise Professor

August 18, 2010

EFF-ing Up

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics — The Professor @ 9:52 pm

There was a kerfuffle earlier this week when the CFTC said that Exchange of Futures for Futures transactions–EFFs–were legal, despite the CME’s claim that they were banned wash trades.  There has been some breathless commentary that this is a grave competitive threat to CME, and raises the specter of “fungibility,” meaning that clearing and execution would effectively be unbundled.  A trade could be traded on one exchange, and then cleared elsewhere.  This would, supposedly, increase the competition that the CME would face.

I rolled this rock up the hill too many times pre-crisis, when fungibility was a headline issue before it was overshadowed by the crisis and its effects.   For instance, this was a big issue in the DOJ’s infamous passive-aggressive letter in the winter of ’08.

So, let me say it yet again.  As the Chicago School of Antitrust Economics pointed out long ago, if clearing is the source of the CME’s market power (as the advocates of fungibility claim), the CME could maximize the profits it earns by charging the appropriate price for clearing services.  It would have no incentive to tie execution and clearing.  Indeed, it would have an incentive to encourage competition in execution in order to maximize the derived demand for its (monopoly) clearing services.

So, the argument that tying execution and clearing is anti-competitive is fundamentally flawed.  There is another purpose for it.

I should also note that even with fungibility, the CME competitor ELX will face daunting obstacles in challenging CME in execution.  That’s because clearing is not the only source of scale economies in providing trading services.  Due to the effects of liquidity, there are huge scale economies in execution as well.  Price impact costs are far smaller in bigger, more liquid markets.

Indeed, it is the existence of large scale economies in clearing and execution which, in my view, drive the integration/bundling of the two services.  Integrating back-to-back monopolies economizes on transactions costs.

But integration does not require bundling of the services.  So why does CME insist on doing so?  (I.E. why do you have to trade on the CME to clear on the CME?)  The most likely explanation is that it wants control over access to the clearinghouse for risk management and control reasons.  The CME wants control over whose risk it takes and whose risk it guarantees.  EFFs could call that into question.  But if that’s the case, the CME would be advised to make it straight up, rather than relying on the wash trade argument.

I called this a kerfuffle because I don’t think EFFs will catapult ELX into contention in head-to-head competition with CME.  The CME’s liquidity advantages are too great.  This will get ELX some headlines, but not much business.

Update (1145 CT, 8/19/10). Last night, after posting this, I read something from the CME that was sent to me before I’d written the post.  It makes the “clearinghouse control” argument “straight up.”  Responding to a Consultative Paper issued by Center of European Securities Regulators, CME CEO Craig Donohue wrote:

[F]ungibility (i.e., one contract could be substituted for another contract) is not necessary or desirable.  Fungibility for OTC derivatives contracts across multiple exchanges or trading venues serves only to provide linkages, or interoperability, among various clearing houses providing clearing services for the exchanges or trading venues listing such contracts.  Interoperability among clearinghouses increases systemic risk to each clearing house and the financial system as a whole.  Indeed, when one side of a matched trade is transferred, the original clearing house automatically becomes exposed to the risk of the other clearing house.  As transfers build and links between clearing houses increase, the ability to contain a single failure decreases and the risk throughout the system increases.

So, CME is making the risk control argument in a straightforward way.

This is a good response to Bill’s question in his comment.  The key issue is one-sided transfers.  Before an EFF, trader A’s counterparty is the CCP of the original exchange (CCP1).  CCP1 has an offsetting position with A’s original trading party, B say.  If A executes an EFF with an exchange using CCP2, since both CCP1 and CCP2 have to have zero net positions, and the EFF doesn’t change CCP1’s position with B, the chain of contracts is now:  A has a position with CCP1; CCP1 has an offsetting exposure with CCP2; and CCP2 has its original exposure with B.  Thus, giving A the unilateral right to EFF into CCP1 allows him to create an inter-CCP exposure without CCP1’s consent.  CCP1 may not want to be exposed to CCP2, for both risk and operational reasons.  From a systemic risk perspective, too, this creates the dread interconnections that clearing is intended (by the ignorant, admittedly) to eliminate.

Hope that helps, Bill and BwO.

As an aside, the Donohue letter does go on to say that the CME endorses “open access” to CCPs.  The distinction is that open access as the CME uses the term means that end users can choose their clearinghouse when doing a cleared OTC deal, and if they enter into offsetting trades with different dealers, direct the trade to the original CCP in order to liquidate a position.

In response to BwO’s comment.  The argument in a nutshell is that monopoly leveraging is generally unprofitable.  Assume that product M is monopolized, and product C is competitive.  Can the monopolist increase profits by requiring that anybody who buys M also buy C from it?  Except under special conditions, the answer is no.  This is because consumers may not like the monopolist’s variety of C.  They are willing to pay less for the M+C bundle provided by the monopolist than they are for a bundle of M and their preferred variety of C.  This means that bundling reduces the demand for M, reducing the price that the monopolist can charge.  The demand for his product–and his profit–is greatest when he lets customers choose their preferred variety of C, and he charges the monopoly price corresponding to this higher demand curve.  (A similar argument holds with respect to the case where the M monopolist is not the low cost producer of C).

So, except under highly unusual circumstances (which I discuss next) it is absolutely NOT the case that “tying is anti-competitive bundling that parlays one monopoly into another monopoly.”  This has been widely understood in economics and anti-trust since the 1960s.  So yes I can argue that, and it has been argued since Bork, Posner, Director and others first addressed the issue, and virtually every model on the subject implies this result except if you build in some special (and usually contrived) conditions.  Even Whinston, who made his name on these alternative models, admits that there aren’t good practical examples of the factors he identifies leading to the anti-competitive result.

There are some counterexamples in the literature.  Hart and Tirole (1990) have one.  Whinston (1990) has several.  None of these models is remotely applicable to the case of clearing.

Carlton and Waldman (2002) have a very nice model specifically designed to address the Microsoft bundling issue in a two period model.  The key assumptions in their model is that the tied products are durable goods, and that any entrant cannot produce the monopoly product in the first period, but can produce the competitive one.  They show that under some conditions–not all–anti-competitive bundling might work here.  Neither of these assumptions is relevant in the clearing/execution context: these are not durable goods, and simultaneous entry by an integrated competitor is possible.  Nor is their assumption that one good is competitive and produced subject to constant returns to scale: in trading, both clearing and execution are subject to strong scale economies.  In this working paper I modify the Carlton-Waldman model, and show that in conditions that are most plausible in the clearing/execution setting, anti-competitive bundling is not likely to be a profit increasing strategy for the clearing monopolist.  That paper discusses the literature in some detail, and examines other transactions-cost based reasons for integration of clearing and execution.

Thanks for the comments.

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  1. […] This post was mentioned on Twitter by Craig pirrong, Craig pirrong and Craig pirrong, Craig pirrong. Craig pirrong said: Updated my SWP blog post: Effing Up ( ) […]

    Pingback by Tweets that mention Streetwise Professor » EFF-ing Up -- — August 18, 2010 @ 11:33 pm

  2. I’m no expert but, how is CME’s controlling risk an issue? Most EFF’s will be used to offset (close) positions. Any EFFs that add to positions are backed by the broker and margined as per each clearing house’s requirements anyway. What am I missing for risk?

    Comment by Bill — August 19, 2010 @ 4:50 am

  3. […] EFF-ing Up Streetwise Professor […]

    Pingback by Links 8/19/10 « naked capitalism — August 19, 2010 @ 6:15 am

  4. I don’t understand the argument here. I’m not familiar with what the Chicago School of Antitrust Economics pointed out long ago, but it sounds like they concluded that CME could maximize profits by just owning the clearing house and letting someone else do the execution. I assume this argument relies on the lower execution costs driving profitable volume at the clearing house. While I’m sure that one can invent a model to that effect, I think there are lots of examples of how monopolies do not, in fact, behave the way that the School might like them to. When MSFT bundled word and explorer with Windows, they apparently didn’t understand that they could best exploit their Windows monopoly by opening these things up.

    So, correct me if I’ve misunderstood, but you CANNOT be saying that tying execution and clearing is NOT anti-competitive. In fact, that tying is clearly anti-competitive bundling that parlays one monopoly into another monopoly. Instead, the argument is that such bundling does not maximize profits to CME. And if this does not maximize profits to CME, then they will not do it. Ergo, if CME behaves as a pure profit maximizer in the model, and they do, in actual fact, seem to be fighting pretty hard to maintain their bundling, said bundling must have a different reason.

    The proposed alternate reason is risk control. I side with Bill’s comment in not understanding how this applies. Some guy opens a position on an EFF and comes to the clearing house looking to settle. He either shows up with the required collateral or he does not. What more do you need to know about him if you are the unique clearing house for the product?

    Have I understood the argument correctly? If so, I would like to go into business picking up the hundred dollars bills you are convinced cannot be real. Or, to adapt the analogy to the present case, I would be happy to pick up the easy fifty dollar bills today despite your theory assuring me that restraint will ultimately net me one hundred somewhere down the road.

    Comment by BwO — August 19, 2010 @ 8:52 am

  5. Thanks for the helpful update.

    Comment by BwO — August 19, 2010 @ 3:43 pm

  6. @BwO–no problem. Thanks for your helpful question.

    The ProfessorComment by The Professor — August 19, 2010 @ 3:51 pm

  7. Craig,
    The EFF does not create the kind of blind exposures you claim. There is no interoperability: an EFF is a bilateral trade involving two off-exchange trades that close out a position on one market (clearinghouse) and open the same position on another market (clearinghouse). There’s no hanging risk – the risk angle is a red-herring.
    For more detail see:
    Best wishes,
    Neal Wolkoff

    Comment by Neal Wolkoff — August 19, 2010 @ 4:07 pm

  8. In fact I was wrong. It sounds like every EFF involves the closing of a position and not “most” like I had said. Always closing in one spot and opening in another.

    While Donahue says, “the original clearing house automatically becomes exposed to the risk of the other clearing house” I guess I agree but if the correct CME margin requirement is put up and overseen by the clearing broker doesn’t this mean the risk he is talking about is the same as if they’d traded on CME? Sounds like virtually the same risk to me.

    I guess if I’m right that stuff about the single failure etc…sounds a bit like bs.

    Comment by Bill — August 19, 2010 @ 8:52 pm

  9. Has prof read teh undergrad thesis everyone was talkin about?

    Comment by Surya — August 20, 2010 @ 3:35 pm

  10. The argument that bundling almost never benefits a monopolist didn’t make sense to me. Doesn’t that depend entirely on how easily customers for product C can make do without any of product M?

    If the monopoly product is indispensable for customers buying the product in which there is healthy producer competition, then absolutely the monopolist rakes it in by refusing to sell its monopoly product unless customers also buy its offering in the competitive market.

    Comment by Karen — August 20, 2010 @ 5:23 pm

  11. @Karen–Not really, because the monopolist can extract all of the surplus from consumers by pricing of the monopoly product.

    Simple example. Let’s say that consumers are willing to pay 1000 for M, and 100 for C: the big difference in willingness to pay captures the “indispensable” nature of M (you can make this number as high as you want–analysis goes through exactly the same). C is produced by efficient firms at a constant marginal cost of 0 (just to make the arithmetic a little simpler). The monopolist is an inefficient producer of C: it costs him 100 per unit to produce. It costs the monopolist 0 per unit to produce M.

    The most the monopolist can charge for M without bundling is 1000. The profit per unit is therefore 1000.

    Now consider the bundled product. The most the monopolist can charge for the bundled product is 1000. Let’s say that he tries to charge 1100. If consumers buy the bundle, they get zero surplus. If they buy just C, they get a surplus of 100 because the competitive price of C is 0 (the marginal cost). So the monopolist gets 0 sales of the bundle. You can repeat the same logic for any price of the bundle greater than 1000.

    So say the monopolist charges 1000 for the bundle. Well, his profits are lower because he is an inefficient producer of C. It costs him 100, leaving him with a profit on the bundle of 900. This is smaller than the profit by selling M alone, which is 1000.

    You can construct a similar argument in which the consumers consider monopolist’s variety of C inferior.

    The point is that the monopolist can extract the value of the “indispensibility” of M by charging a high price for M. Imposing an additional constraint on the consumers only reduces the amount that they are willing to pay for the monopoly good. The monopolist makes less money by imposing a constraint on consumers because that limits his ability to extract the value consumers get from M.

    @Bill–I think the issue is encapsulated in your phrase “correct margin.” Margins are the first line of defense, but even with margins the CCP is exposed to the credit of its counterparties. So in addition to caring about the margin level, CCPs care about who their counterparties are, and limit their dealings accordingly. In actuality, CCPs deal directly only with clearing member firms, and not just anybody can become a clearing member. That is, CCPs control counterparty risk not just by charging margins, but by choosing who the acceptable counterparties are and imposing requirements on becoming a direct CCP counterparty. The Donohue characterization of EFFs (which Neal Wolkoff disputes per his comment) is that they prevent the CME CH from choosing its counterparties, and the exposure to those counterparties. This is an anathema to CCPs.

    Parenthetically, something related is going to become a big issue as the clearing mandates are implemented. (I blogged about this in June.) Specifically, who can become a member of a CCP is going to be an extremely contentious issue. Extremely. There were articles in Bloomberg and the WSJ in the last two days about small firms claiming that they should be allowed to become members of OTC CCPs. I’ll try to write about this tonight or tomorrow.

    Just another thing the brilliant Solons on Capitol Hill didn’t manage to think about when deciding to remake the world.

    @Neal. Thanks for your comment. CME, what say you?

    The ProfessorComment by The Professor — August 21, 2010 @ 8:08 am

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