Streetwise Professor

January 12, 2011

The CFTC Does Net Neutrality? Or, The Blob Grows Some More

Filed under: Uncategorized — The Professor @ 2:15 pm

The CFTC’s Proposed Rule on Core Principles for Designated Contract Markets (DCMs) contains something that has escaped comment (but not the sharp eyes of Jerry, who brought it to my attention).

Specifically, it states:

A DCM can satisfy the requirement that membership and participation criteria are impartial, transparent, and non-discriminatory by establishing clear and impartial guidelines and procedures for granting access  to its facilities and publishing such guidelines and procedures on its Web site. Such requirements may  establish different categories of market participants, but may not discriminate within a particular category. Fee structures may differ among categories if such fee structures are reasonably related to the cost of providing access or services to a particular category. For example, if a certain category requires greater information technology or administrative expenses on the part of the DCM, then a DCM may recoup those costs in establishing fees for that category of member or market participant (p. 80579, emphasis added).

So, it appears the CFTC is adopting its own version of net neutrality for DCMs (exchanges, in everyday, non-legalese parlance).  Specifically, it is asserting regulatory authority over the pricing of exchange services.  Just like the FCC’s net neutrality rule (as proposed) would regulate the terms on which the operators of internet services can offer and price access to their systems, the CFTC’s access principle (Core Principle Two) imposes constraints on the terms on which operators of exchanges can offer access to their trading facilities.

The principle is that (a) within a category of users, all must be offered access on the same terms at the same prices, and (b) across categories, access fees can differ on a cost basis.

On an intellectual level, this demonstrates yet again a point I’ve harped about for years: financial markets, especially electronic ones, raise many of the same issues that have been staples of analysis, argument, and regulation for years in what are traditionally considered network industries, such as telecoms and electricity transmission.  (A point that will be one of the themes in my next book, tentatively titled Market Macrostructure: The Organization of Securities and Derivatives Markets.)   Financial regulators are just waking up to that fact, but unfortunately all too often it appears that they are reinventing the wheel, and not taking advantage of all the work that has been done on network industry pricing and regulation.

On a practical level, this is yet another troubling example of the expansion of the CFTC’s authority.  It is becoming the new regulatory Blob*.  Its capacity and competence are already challenged by its existing responsibilities.  Dodd-Frank added massive new ones, and here the agency is claiming even more.

The experience in network industries is that regulating access prices is beset by conceptual difficulties, impeded by the lack of data to quantify cost differences, and mired in politics and rent seeking.  Some regulatory agencies, notably the FCC and FERC, have developed vast apparatuses to deal with these complications.  In contrast, CFTC has no real experience in this area.  It is miles away from its normal bailiwick.  There is no reason whatsoever to believe that it has the competence to regulate the pricing of access services.  Yes, it allows cost based differences, but pray tell what expertise does the agency have to measure these cost differences?  And with the proliferation of SEFs, which will almost certainly be subject to similar constraints at some future date, just think of all the disputes that could arise.

Even beyond the issue of competence and resources, the proposed rule poses conceptual difficulties.  Any system of categorizing users will result in heterogeneity within categories.  Due to this heterogeneity, some customers within a category will be costlier to serve than others in the same category.  The proposed rule would suppress any price differences across entities in a particular category.  Which will mean that those subject to the regulation will attempt to create more, narrower categories.  Which will mean that these decisions will likely be subject to legal challenge.

On the other hand, lawyers will be happy.

One other quick comment on the Core Principles rulemaking.  To show that a derivatives contract that can be settled by delivery is not subject to manipulation, the Commission requires a DCM to ensure the deliverable supply for the contract is adequate.  This makes sense as a means of reducing the frequency of market power manipulation.  In contrast, the criteria that the Commission uses to determine whether cash-settled contracts are subject to manipulation does not impose any requirements relating to deliverable supply.

You might say: of course not!  Because there’s no delivery, you don’t need to worry about a delivery squeeze.  But you’d be wrong.  As I show in my 2000 JOB piece on manipulation of cash-settled derivatives contracts, one can manipulate a cash-settled derivatives contract by buying or selling large quantities of the physical in the cash market.  Indeed, the very same factors that determine the susceptibility of a delivery settled contract to a squeeze or corner determine the susceptibility of a cash-settled contract on that commodity to manipulation by buying or selling large quantities of the physical commodities used to determine the settlement price.  Thus, the size of the cash market, deliverable supply if you will, is relevant for these contracts as well.

Appendix C of the Proposed Rule does mention the “size and liquidity of the cash market” and “the volume of cash
market transactions and/or the number of participants contacted in determining the cash-settlement price” but these don’t get at the kind of manipulation I discuss in the JOB piece.  Particularly, the volume of cash market transactions doesn’t correspond even remotely to the relevant measure of the size of the deliverable supply.  I would also note that whereas CFTC goes into great detail prescribing what DCOs must do to document that the deliverable supply for a delivery-settled contract is adequate, it imposes no comparable requirement for cash-settled ones.

Instead, the appendix focuses on manipulations that could arise from false reports, or settlement indices based on a small number of cash market transactions.  These are relevant to the susceptibility of a cash-settled contract to one kind of manipulation, but are irrelevant to determining its susceptibility to market power manipulation, where the market power is exercised in the cash market.

A small point, perhaps.  But given that manipulation is an offense that has been under the CFTC’s jurisdiction, or that of its predecessor agencies since 1922, and which has in fact been its primary responsibility since that date, it does raise questions about the agency’s qualifications to regulate new, arcane, and inherently complex areas, such as the pricing of access.

Beware the Blob.

* Steve McQueen is one of my favorites.  A hero to sinewy blond guys everywhere.  I also like this:

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