Streetwise Professor

May 31, 2011

LCH.Clearnet and the Exchanges: It’s the Transactions Costs, *Not* the Scope Economies

Filed under: Clearing,Economics,Exchanges,Regulation — The Professor @ 3:28 pm

LCH.Clearnet has announced that three exchanges have expressed an interest in buying the heretofore independent CCP.  Why does stuff like this happen on my vacation?  I’ll just make a brief comment, and leave more for later.

Jeremy Grant posits that LCH is in play because of cross margining efficiencies.  This conjecture is understandable, but fundamentally flawed.  Yes, there are definitely cross margining efficiencies.  More generally, there are economies of scope due to diversification effects that make it less costly to consolidate clearing for multiple asset classes in a single CCP.  But this does not explain why exchanges would want to vertically integrate clearing and execution.  Ownership is not necessary to exploit scope economies.  Indeed, the two things are often in tension–and are in this instance.

Scope economies do not explain integration.  Indeed, things cut the other way.  To the extent that there are more scope economies in clearing than execution (which is quite plausible), in the absence of transactions costs the most efficient way to organize the business would be to form a single clearinghouse, with which multiple execution exchanges would contract to obtain clearing services.  In fact, one of the costs of integration is that it often entails the sacrifice of scope economies in clearing.

Put differently, scope economies do not explain the pattern of ownership: the relevant question is why do exchanges find it optimal to own their own clearing facilities, rather than obtaining clearing services by contract.  That would be the way to optimize cross margining, netting, and diversification economies.   Such economies would be exploited maximally by having, say, LCH, clear just about everything, and sell its clearing services to myriad exchanges that offer execution services in different product classes.  But that’s not the way the market is moving.

Thus, the fact that many exchanges are already integrated, and why more exchanges are seeking to integrate, must arise from some other economic force than scope economies.  The most plausible explanation–and one that I advanced more than 5 years ago–is transactions costs.  Due to double marginalization problems and the transactions costs that arise when complementary activities are supplied by single firms (or by a small number of firms that do not compete vigorously), it is often efficient to integrate these complementary activities.  That is a basic lesson of Williamsonian Transactions Cost Economics (TCE).

In my view, that’s why exchanges like CME and DB have integrated, and why other exchanges have or are in the process of doing the same thing.  This drives regulators and legislators nuts: they see such integration as a nefarious scheme to leverage monopoly.  That’s bad economics–and it’s been known to be bad economics for going on 50 years.  Instead, it is all about transactions cost economization.  Regulators can try and fight it, and they will.  If they succeed in their quest, however, they will only succeed at raising costs and reducing efficiency.

Insofar as the potential LCH deals with exchanges are concerned, SwapClear is presumably a major target in any deal, but also a major obstacle.  I can’t see the banks that dominate SwapClear going along with a merger of LCH into NYSE-EuroNext or NASDAQ or LSE.  Or if that happens, I would expect them to leave SwapClear and set up their own CCP, perhaps through ICE Trust or through a new, freestanding interest rate swap and repo CCP.  (Going through ICETrust would exploit scale economies, so that would be a likely approach.)

I have more to say on this, and probably will.  But it’s been a long day in the sun, so it will just have to wait.

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  1. Another explanation is that by owning LCH the potential bidders can impede other Execution venues from using the clearing facility, especially if the Germans succeed in removing the “fair & open” access provisions around CCPs & exchanges in EMIR. This would allow a successful bidder to ensure that execution business is instead routed onto their own venue, coupled with the near-monopoly rents from clearing available. Moreover, it would further allow a successful bidder to offer cross-product margining on an uncontested basis given that neither in the US, nor it seems in the EU, will listed vertical silos have to open up for competition, thus ensuring that as incumbent listed product exchanges+CCPs only they will be able to integrate with OTC CCPs [the reverse option not being available to competing OTC-only CCPs].

    As you rightly point-out, the ability to retain the Swapclear business will be a major issue for any bidder and that is not a given. Of course, any collective action by the banks in that regard though could elicit further scrutiny from the EU anti-trust authorities on top of their existing ICE Clear investigation, something that the potential bidders may be counting upon to thwart the banks impeding any deal.

    Comment by John Wilson — June 1, 2011 @ 2:52 pm

  2. @John–We’re just not going to agree on your other explanation. Leveraging monopoly stories are suspect. As I’ve noted before, clever theorists have constructed clever little toy models in which that works, but even they admit the models are the exception that proves the rule that monopoly leveraging is almost always self-defeating and profit destroying. The conditions that drive the results in the cute models, moreover, bear no relation to real conditions in clearing and execution.

    I do agree the anti-trust authorities are likely to make trouble if the banks act collectively. That’s what they do–make trouble, and usually without any economic wisdom. I stand agape at the impending conflict between anti-trust and financial regulators over clearing issues. A train wreck in the offing.

    The ProfessorComment by The Professor — June 2, 2011 @ 12:53 am

  3. @Theprofessor. Allow me to cite a recent example of the impact of vertical silos in action. Looking at the launch of Eurodollar futures contracts by NYSE, the FT notes that

    “NYSE Liffe in February launched eurodollar trading in competition with the CME, but has so far captured only 3 per cent market share.” Is this because the NYSE Execution service is inferior or are traders not switching to it simply because they can’t access the existing “open interest” at the incumbent clearing house, CME, which happens to operate the competing execution venue.

    This lock-in of existing liquidity within a vertical silo is a huge barrier to entry for new/competing execution venues and thus a prize worthy of a fight. I genuinely believe that greater than 3% of execution might have switched to NYSE had such trades be cleared with the existing open interest – at the very least there would have been competition between the venues on fees/service to the benefit of users.

    Eurex US also fought to gain access to CME clearing facilities when it launched in the US over four years ago in direct competition with the CME, in the knowledge it would fail unless it could access existing open interest in the CCP on comparable terms. And fail it did, hence Eurex’s determined effort with respect to EMIR via the German authorities to remove the “fair and open access” provisions that were introduced by the Hungarian Presidency in January in the EU Council text, in order that Eurex may protect its’ own vertical silo.

    Are these really only “clever little toy models”, because they certainly seem of extreme importance to the parties negotiating the regulatory texts and lobbying on their outcome.

    Comment by John Wilson — June 3, 2011 @ 3:28 pm

  4. John–there is a lock in due to liquidity effects alone. The model in my earlier paper to which I referred you before explicitly incorporates network effects of liquidity and clearing with scope economies.

    The ProfessorComment by The Professor — June 3, 2011 @ 3:37 pm

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