Streetwise Professor

January 28, 2014

Were the Biggest Banks Playing Brer Rabbit on the Clearing Mandate, and Was Gensler Brer Fox?

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 10:25 pm

One interesting part of the Cœuré speech was his warning that the clearing business was coming to be dominated by a few large banks, that are members of multiple CCPs:

Moreover, it appears that for many banks, indirect access is their preferred way to get access to clearing services so as to comply with the clearing obligation. Client clearing seems thus to be dominated by a few large global intermediaries. A factor contributing to this concentration may be higher compliance burdens, where only the very largest of firms are capable of taking on cross-border activity. This concentration creates a higher degree of dependency on this small group of firms.

There are also concerns about client access to this limited number of firms offering client clearing services. For example, there is some evidence of clearing firms “cherry picking” clients, while other end-users are commercially unattractive customers and hence unable to access centrally cleared markets.

These are all developments that I believe the international regulatory community may wish to carefully monitor and act on as and when needed.

And wouldn’t you know.  He supports a longstanding SWP theme: That Frankendodd and EMIR and Basel create a huge regulatory burden that is essentially a fixed cost.  This increase in fixed costs raises scale economies, and this inevitably leads to an increase in concentration-and arguably a reduction in competition, in the provision of clearing services.

It now seems rather quaint that there was a debate over whether CCPs should be required to lower the minimum capital threshold for membership to $50 million.  That’s not the barrier to entry/participation.  It’s the regulatory overhead.

It’s actually an old story.  I remember a Maloney and McCormick paper from the 80s-hell, maybe even the late 70s-about the effects of the regulation of particulates in textile factories (if I recall).  The cost of complying with the regulation was essentially fixed, and the law essentially favored big firms and they profited from it.  It raised the costs of their smaller rivals, led to their exit, and resulted in higher prices and the big firms profited.  Similarly, I recall that  several papers by the late Peter Pashigian (a member of my PhD committee) found that environmental regulations favored large firms.

The Cœuré speech suggests this may be happening here: note the part about client access to a “limited number of clearing firms.”

And it’s not just pipsqueaks that are exiting the clearing business.  The largest custodian bank-BNY Mellon-is closing up shop:

More banks are expected to follow BNY Mellon’s lead and pull out of client clearing, as flows have concentrated among half a dozen major players following the roll-out of mandatory clearing in the US last year.

The decision of the world’s largest custodian bank to shutter its US clearing unit was the first real indication of how much institutions are struggling with spiralling costs and complexity associated with clearing clients’ swaps trades – a business once viewed as the cash cow of the new regulatory regime.

You might recall that BNY Mellon was one of the firms that complained loudest about the high capital requirements of becoming a member of ICE Trust and LCH.  Again: it’s not the CCP capital requirements that are the issue.  It’s the other substantial cost of providing client clearing services, and regulatory/compliance costs are a big part of that.

Ah yes, another Gensler argument down in flames.  Remember how he constantly told us-lectured us, actually-that Frankendodd would dramatically increase competition in derivatives?  That it would break the dealer hammerlock on the OTC market?

Remember how I called bull?

Whose call looks better now?  Sometimes I wonder if JP Morgan, Goldman, Barclays, etc., weren’t playing the role of Brer Rabbit, and Gensler was playing Brer Fox. For he done trown dem into dat brer patch, sure ’nuff.

Though it must be said that this was not Gensler’s biggest contribution to reducing competition in derivatives markets in the name of increasing competition.  His insane extraterritoriality decisions have fragmented the OTC derivatives markets, with Europeans reluctant to trade with Americans.  The fragmentation of the markets reduces counterparty choice in both Europe and the US, thereby limiting competition.

This is not just a matter of competition.  There are systemic issues involved as well, and these also make a mockery of the Frankendodd evangelists.  They assured the world that Frankendodd and clearing mandates would reduce reliance on a few large, highly interconnected intermediaries in the derivatives markets. That is proving to be another lie, on the order of “if you like your health plan, you can keep your health plan.”  The old system relied on a baker’s dozen or so large, highly interconnected dealers.  The new system will rely on probably a handful or two large, highly interconnected clearing firms.

The most important elements in the clearing system are a small number of major banks that are clearing members at several global CCPs.  The failure or financial distress of any one of these would wreak havoc in the derivatives markets and the clearing mechanism, just as the failure of a major dealer firm would shake the bilateral OTC markets to the core.

Just think about one issue: portability.  If there are only a small number of huge clearing firms, is it really feasible to port the clients of one of them to the few remaining CMs, especially during times of market stress when these might not have the capital to take on a large number of new clients?

What happens then?

I don’t want to think about it: there’s only so much I can handle.

But Cœuré assures us the regulators are on top of it.  Or at least they are thinking about getting on top of it: “the international regulatory community may wish to carefully monitor and act on as and when needed.”  “May wish to act as needed.”  Sure. Take your time! What’s the hurry? What’s the worry?

I won’t dwell on the  irony of those who advocated the measures that got us into this situation pulling their chins and telling us this might be a matter of concern, especially since they were deaf to warnings made back when they could have avoided leading us down the path that led us to this oh-so-predictable destination.

Print Friendly, PDF & Email


  1. I fervently believe no piece of legislation should be passed without a sunset provision that would necessitate it being re-enacted or allowed to die after a period of time. Legislators need to acknowledge certain pieces of legislation are effective and others are not. Political retribution such as Dodd-Frank has its place in our system of government, but at some time, we have to get back to the original goal of governmental regulation of financial markets, which was to promote fair and efficient markets. We have to build safeguards into the system, in the form of sunset provisions, that allow for reasoned thought to replace misguided politically driven legislation.

    Comment by Charles — January 29, 2014 @ 9:40 am

  2. @Charles:

    Bravo!I would go one step, or several steps further: constitutionally state that any law passed must be affirmed in Congress every X number of years, or be considered fallen into desuetude.
    Further any Regulation derived form a Power delegated to a Regulatory Body must be affirmed by positive vote within X period before becoming effective, and subject tot he same rules of desuetude as above.

    I know this will lead to mass voting to affirm existing legislation, BUT it removes the idea that we or Congress are helpless in the face of the growing Bureaucratic, gangster state. Our Politicians would be forced to legitimatize things that are intolerable, and justify it.

    This would take a fair amount of time – excellent: less time for them to think up new mischief!

    Comment by Sotos — January 31, 2014 @ 10:41 am

  3. SWP- it’s been known at the “sharp end” that there was always going to be just a few few, relatively stronger, banks who could play in the OTC Clearing arena since 2010. In the US you can really only count 3 substantial domestic counterparties, 1 aspirant (with no international presence),1 for former “bulge bracket” firm (who’s CDS spread rocketed north of 1000bps in the last crisis), and 1 extremely selective and exclusive provider of IB services. The non-US firms are having to re-trench because of leverage issues (both local and global), bank separation / “ring-fencing” and other regulation. In Europe the same issues prevail. Bottom line – these are not “unforeseen consequences” but highly predictable ones, certainly by practitioners in the market. I’m not sure I’d blame the US regulators on even the EU ones alone for this – the Banks came up with the arguments and predicted the outcomes, and indeed enlisted the buy-side to articulate the rationale at many points. The industry (buy and sell side) was not listened to; and to an extent that is understandable as the faith and trust was lost by the industry in the broadest sense. We move on….

    Comment by JCmoves — February 6, 2014 @ 1:56 pm

  4. @JCmoves. I predicted these consequences back then. It’s pretty basic economics. But that’s lost on these people.

    The ProfessorComment by The Professor — February 6, 2014 @ 5:31 pm

  5. Writing a paper concernings ISDA’s suit against the CFTC over the cross-border rule. I find your articles very helpful and really appreciate your insight.

    I’ve skimmed through some brief submitted by both sides in the case, and the CFTC seems to be hanging its hat on the fact that this is a ‘guidance’ and not a ‘rule,’ therefore they pretty much didnt need to follow any procedures when enacting the ‘guidance.’

    From my limited understanding, if that’s the best arrow in the CFTC’s quiver I think there’s a good chance the D.C. Circuit court will strike down the cross-border guidance.

    Do you think ISDA will win this suit, and could you see the ‘substituted compliance’ caveat playing a larger role in the future?


    Comment by Tony — April 5, 2014 @ 12:12 pm

  6. @Tony-thanks. I am not the best person to opine on the legal merits of this case, though I have to say that reading the various comments of Steven Lofchie at Cadwalader on the case I get the sense that ISDA is likely to prevail. But Lofchie also makes the point that even if CFTC prevails, the victory would likely be a Pyrrhic one because “guidance” doesn’t have any real legal force.

    Given the impossibility of getting common rules across jurisdictions, and the massive costs (due, for instance, to Balkanization of the markets) that would result if the US tries to assert expansive jurisdiction, I think substituted compliance will inevitably play a larger role, and that CFTC, and the authorities in other jurisdictions (UK, EU, Asia) will be more liberal in their standards regarding whether entities in other jurisdictions are acceptable.

    The ProfessorComment by The Professor — April 5, 2014 @ 1:46 pm

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress