Streetwise Professor

September 6, 2011

Son of Frank-n-Dodd?

There are news reports providing some glimpses into draft regulations regarding the regulation of derivatives and securities markets in Europe.  It looks like it is taking some of the worst of Frank-n-Dodd, and adding some dumb flourishes of its own.

Insofar as the worst of Frank-n-Dodd is concerned, despite initial indications to the contrary, it looks like the proposal is going to incorporate something like a SEF requirement.  You might recall that on The Monster’s first birthday, I named the SEF requirement as its worst feature.  Well, the Euros (don’t they have bigger problems right now? Just asking.) don’t look to be avoiding the US’s mistake:

Widely traded derivatives would have to be transacted on an electronic platform to improve transparency and safety, draft European Union rules showed on Monday.

The bloc is overhauling its markets in financial instruments directive (MiFID) to catch up with technological advances, apply lessons from the financial crisis and deal with problems such as price fragmentation raised by the original rules.

“The main aim of the proposal is to ensure that all organised trading is conducted on regulated venues and is fully transparent,” the draft, seen by Reuters, said.

More specifically, world leaders agreed in 2009 that derivatives, largely traded bilaterally between banks in an opaque $600 trillion sector, should be traded electronically.

This will give supervisors the full picture of who is affected when a counterparty gets into trouble, which they lacked when Lehman Brothers bank collapsed three years ago.

“The proposed revision will shift trading of the suitably developed derivatives to such platforms,” a draft of the MiFID reform, now circulating widely in Brussels, said.

“This obligation will be imposed on both financial and non financial counterparties,” the draft added.

Another unfortunate imitation is the adoption of restrictions on commodity speculation, including position limits:

The European Securities and Markets Authority should have the power to impose position limits on traders in crisis situations when “the stability of the whole or part of the financial system” is threatened or “delivery arrangements for physical commodities” could break down, the document says.

The Euro flourishes are clearing-related, although here I have to say that the reporting is not too clear.  As I’ve written in the past, European regulators are obsessed with the vertical integration of execution and clearing–the silo issue.  Various reports (including the two linked above) and this one suggest that the regulators will force CCPs to be open access.  The reporting also states that integrated exchanges will have to share data streams, including calculations of indexes that are the basis for traded products.

Insofar as open access is concerned, the FT article quotes language stating that CCPs will be required to accept trades for clearing “on a non-discriminatory and transparent basis, regardless of the trading venue on which the transaction is executed.”

The idea here is to facilitate competition between CCPs, apparently.  But it is fraught with difficulties.

For one, there is the question of why a dominant CCP, including one that is integrated with an execution venue, would turn away business.  Even if it is a monopoly, it could sell clearing services at the monopoly price.  If, as the anti-silo crowd commonly argues, the execution of transactions is potentially highly competitive, absent some cost, the monopoly CCP would maximize profits by selling its services at the monopoly price.  It wouldn’t be necessary to mandate open access.  The CCP would gladly offer access–for a price.

It is therefore necessary to understand why an integrated CCP wouldn’t sell clearing services to others on an open access basis.

One possible reason is that the dominant CCP believes that open access rules will eventually result in the regulation of the prices it can charge for its services.

I think a more important reason relates to a fundamental misunderstanding  among the Europeans of the way competition is likely to work.  There are two possibilities.

One possibility is that there remains a single clearer–given the cost conditions in clearing, that’s not unlikely, although it seems that the Europeans think that they are constructing rules that will reduce the likelihood of this outcome.  Note that particularly now, financial trading is highly technological.  There will thus be the necessity of coordinating technologies and changes in systems between the execution venues and the clearer.  This can be very difficult to achieve across firm boundaries; this is one of the factors that I identified as justifying integration well over 5 years ago.  It should also be noted that this is precisely the reason given for many recent exchange decisions to integrate into clearing; the LSE is the most recent and prominent example of this.

The other possibility is that there are multiple CCPs offering to clear a particular instrument.  There are myriad challenges to this, but I’ll focus on just one.  In particular, assume a transaction in a particular instrument is cleared at CCP A and CCP B.  A trade is executed on venue X.  If the parties to the trade can choose independently where to clear, the buyer may submit the trade to A and the seller to B.  In this case, A and B must be interoperable.  Interoperability is extremely challenging.  It is likely to increase collateral costs (as A and B are going to require collateral from each other).  Moreover, A and B may find it difficult to negotiate an interoperability arrangement because of (a) competitive pressures (the model the Europeans seem to have in mind involves a unique balance of competition and cooperation), and (b) distrust of each other’s risk management, arising from the difficulties of monitoring.  Moreover, the technology/system coordination issues are now multiplied, as X has to coordinate with both A and B.  And if there are multiple execution venues (Y and Z, say) as the Euros presumably hope and expect, these difficulties are multiplied accordingly.

Having an exclusive arrangement with an execution venue avoids this problem.  Those trading on X could be required to clear on A, for instance.  But that just raises the same kinds of problems as if there is only a single clearer.

In brief, it is hard to see how robust competition between CCPs is possible.  Once that is admitted, the whole basis of the regulation collapses.

The whole evolution of the exchange space–most notably in Europe–in the past 5 years is exactly contrary to the thrust of the proposed regulation.  And maybe that’s the point: the Euroregulators are clearly bugged by this trend.  But maybe they should try to understand it first; it’s pretty evident that they don’t now.

Case in point: LCH.Clearnet’s difficulties–its loss of exchange clearing business (EuronextLIFFE, ICE, and almost certainly LSE)–suggests that integration is not primarily driven by anticompetitive impulses.  Instead, in my view it reflects the difficulties of coordinating complementary activities across firm boundaries in a highly technologically dynamic industry.*  At the very least, the Euros should consider that possibility, and take it seriously, before attempting to micromanage the structure of a dynamic industry with strong network characteristics.

Instead, it seems that the regulations are based on an intellectual framework that would be suspect in any industry (as I’ve written about before), and which does not seem to take into account that unique characteristics of financial trading: network effects, scale  and scope economies, technological dynamism, and information asymmetries with respect to performance risk.

So, if the European endeavor is truly the son of Frank-n-Dodd, it may well be the ugly bastard child.  It has the defects of F-n-D, and adds some more–as if more were needed.

Perhaps this is Brussels’ negotiating position.  There is considerable opposition (particularly in Germany–go figure) to some of these initiatives, and maybe the EU is proposing a more radical change in the knowledge that it will have to be watered down.   One can only hope that it drowns.

* I spoke at an FIA panel that touched on this issue in March, 2007.  I made the coordination point.  Charlie Carey, then head of the CBT (which had already agreed to sell out to the CME–this was the day before ICE made its surprise offer) was sitting next to me.  After I made this point, he handed me a note that said that was an extremely important, but insufficiently appreciated, fact.

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