Fragged
In my recent piece on clearing in the Journal of Applied Corporate Finance, I wrote:
It is equally unknown what clearing market structure will evolve, and how close this structure will come to approximating the ideal structure. In this regard, it is essential to keep in mind two facts.
First, the extensive scale and scope economies associated with clearing make it likely that the clearing industry will be highly oligopolistic, and that strategic considerations will influence decisively the way that the industry develops. Moreover, scope economies across trade execution and clearing (Pirrong, 2010b) will also affect the strategic and efficiency forces that will shape industry structure. Strategic considerations will almost certainly drive a wedge between what is optimal for the individual decision makers, and what is optimal for the economy. This is particularly true inasmuch as there is no market mechanism evident that would induce CCPs to internalize the systemic externalities associated with their failure.
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Second, industry evolution will inevitably be a highly politicized process. Dodd-Frank gives regulators enormous discretionary authority over the operation of CCPs. Interested parties will influence the regulatory process for their private benefit. Political tradeoffs, rather than efficiency considerations, also threaten to cause serious divergences between the structure that evolves in practice, and the one that would optimize the relevant economic tradeoffs. The effects of politics are particularly pronounced in this context because finance is a truly international industry, and hence jurisdictional issues and competition between jurisdictions will play a decisive role in determining the industry’s ultimate configuration. For instance, governments in major financial centers (e.g., the US, London, the EU, and individual countries in the EU, Japan, Singapore, and Hong Kong) have all expressed a strong interest in domiciling CCPs, for both economic and political reasons. But accommodating these interests would fragment clearing, reducing netting benefits and raising serious concerns about coordination during a crisis. Moreover, regulatory competition between jurisdictions to favor their local CCPs could compromise financial market stability.
There is another mandate in Frank-n-Dodd, this one for reporting all swaps transactions to trade respositories. The scale and scope economy issues, and the jurisdictional and political issues are also present for repositories, and a recent article in eFinancial News demonstrates that the problems in the likely evolution of clearing market structure that I identified above, with the associated inefficiencies, are coming to pass with the repositories:
However, repositories are not a cure all. While the concept of a trade repository is not controversial, there are issues to address. Most notably, the sudden explosion of repository providers is leading to fragmentation, a problem familiar in other areas of the market, such as the clearing landscape.
Market participants are concerned that fragmentation would undermine the purpose of repositories to provide a single integrated view of derivative risk. The DTCC’s Douglas said: “The problem with trade repositories is that if everyone wants to build their own, how can regulators be sure that they are seeing the whole picture?”
l;”>The market has also raised concerns that multiple repositories may lead to double-reporting, while others highlight the implicit problem of dividing repositories along asset-class lines.
Richard Metcalfe, head of global policy at the International Swaps and Derivatives Association, which supports repositories in principle, warns that this approach does not show the trade data in its fullest context. He said: “You are looking at derivatives in isolation from positions that dealers might be hedging or adding to.”
This problem may be partially addressed by developing interconnectivity between the different trade repository providers. Interconnectivity would help build a full regulatory picture but would still afford dealers a choice of reporting venue, according to Philip Brown, head of client relations for Europe and the Americas at Clearstream.
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“>But the legislation is not yet finalised and the industry will have to move fast before the proliferation of repositories in both US and Europe renders the task of standardisation slow, tedious, and painful.
Metcalfe said: “I think the key issue is can we ensure that supervisors work together internationally to ensure that the information can be aggregated.”
It’s easier to create repositories than CCPs. That’s why the process of creating them is further along than for CCPs. But you can expect that all of these problems will occur in spades as development of clearinghouses proceeds in the coming months and years.
It’s also important to remember that repositories just consolidate data, not risk, so the consequences of getting it wrong are not as severe, by far, with repositories as compared to CCPs. Fragmentation seriously impairs the allocation of risk, by reducing netting possibilities, reducing diversification, and limiting cross margining. It also will create the potential for serious coordination problems in the event of a crisis; poor coordination across CCPs could greatly exacerbate the effects of a crisis.
Which all means that when you see the difficulties already becoming manifest in trade repositories, you should be very concerned about the effects of a clearing mandate. Frank-n-Dodd, and what the EC is doing, can mandate clearing, but they can’t mandate market structure. That is going to evolve in a messy way, driven by the nature of indivisibilities and politics–as the repository experience is showing. And a messy evolution in clearing is a very sobering prospect, given that our legislative and regulatory betters have decided it wise to put all our eggs in that basket.
This was unintended, but not unpredictable. At least it shouldn’t have been. But one hopes that even for the dreamers and the slow learners, that what is happening in trade repositories is a cautionary tale that will open their eyes to what is likely to transpire in clearing.
