Streetwise Professor

May 1, 2011

The Shape of Things to Come

Filed under: Clearing,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 7:23 pm

I’ve written over the years that I expect that financial markets will receive more anti-trust scrutiny than has traditionally been the case.  Liquidity effects impede competition in execution.  A variety factors relating to risk, notably diversification and the fact that an option on a portfolio is less costly than a portfolio of options, create strong natural monopoly elements in clearing.  The transactions costs that arise when concentrated upstream and downstream industries interact make vertical integration efficient.  All of these features give rise to potential anti-trust concerns.

Last year the USDOJ was investigating the data provider Markit and ICE Trust CDS clearing for potential anti-trust violations.  Friday it was announced that the European Union is picking up the cudgels, and also investigating Market and ICE Trust:

Lack of transparency in markets can lead to abusive behavior and facilitate violations of competition rules,” Joaquin Almunia, the EU’s competition commissioner, said in an e-mailed statement. “I hope our investigation will contribute to a better functioning of financial markets.

. . . .

“What we are looking at is whether the main players in the market have behaved badly, have entered into anti-competitive agreements or abused a possible dominant position,” Amelia Torres, a commission spokeswoman, told reporters in Brussels today.

ICE in Atlanta didn’t return a phone call and an e-mail seeking comment. ICE’s U.S. clearing arm is owned by dealers including JPMorgan, Goldman Sachs and UBS.

Goldman Sachs declined to comment on today’s probe, said Michael Duvally, a spokesman for the bank in London.

Deutsche Bank

Deutsche Bank, Commerzbank, JPMorgan, Bank of America, BNP Paribas, Morgan Stanley, Barclays, UBS, Credit Suisse, RBS, Societe Generale, HSBC, Wells Fargo and Citigroup also declined to comment.

The agreements with ICE have clauses on preferential fees and profit sharing arrangements “which might create an incentive for the banks to use only ICE as a clearinghouse,” the EU said. That may block other clearinghouses from starting up and limit choice for CDS dealers, it said. [Emphasis added.]

The investigation will also cover fee structures used by ICE to check if they give “an unfair advantage to the nine banks by discriminating against other CDS dealers.”

The italicized portion suggests that the EU has a lot to learn about clearing.  As noted above, and as I’ve written about numerous times here and elsewhere, there are strong efficiency reasons for concentrating trade clearing in a single CCP.  Concentrating clearing maximizes netting possibilities.  It economizes on the use of capital by permitting more efficient margining. Due to diversification and the option-like nature of counterparty risk, the more positions that are cleared through a single CCP, the smaller the capital required to ensure a given probability of CCP default.

This all means that dealers have a very strong incentive absent any fee and profit sharing arrangements to use a single clearinghouse.  Moreover, informational considerations make it desirable for firms to use a single CCP: that way, the CCP has a more complete picture of each firm’s risk, whereas if a dealer clears through multiple CCPs none of them will have a good understanding of the dealer’s true riskiness.  Thus, dealers have a good motive to provide dealers with an incentive to bring all their business to the common CCP, all the better to keep an eye on one another.

This all also means that the market for clearing is almost certainly unlikely to be highly competitive.  That it is delusional to think that there will be robust competition between CCPs in the long run: maybe multiple CCPs will start up and compete for the market, but eventually, the economies of scale and scope that characterize clearing will result in one winner taking all.  CDS dealers, or dealers in any derivative, are unlikely ever to have much choice in clearing–or to want it.

Since dealers are the main users of CCP services, and since a single CCP is likely to dominate any market, it is also the case that dealers are going to control and/or own CCPs in order to limit their vulnerability to the dominant CCP’s market power.  Indeed, this integration also contributes to efficiency by reducing markups over marginal cost and also reducing transactions costs.  Dealer control is also necessary to align risks and control; if dealers are the residual risk bearers in a CCP, it is efficient to have them control the CCP to prevent excessive risk taking.

But as I’ve written ad nauseum over the years, the economies of scale and scope that make clearing a natural monopoly, or close to one, can be exploited to exercise market power.

There are no easy resolutions to these issues.  Clearing–and execution as well–are like other network industries.  And every network industry–every one–has posed similar thorny difficulties.  For the most part, financial exchanges and clearing have escaped the regulatory and anti-trust scrutiny that industries like electricity transmission, gas pipelines, and telecoms have received.  But that’s changing.  The EU investigation is a harbinger of that.  And if the initial announcement is any indication, the EU has not progressed very far down the learning curve on the issues related to clearing.  Until they do, the potential for ham-handed, counterproductive anti-trust and regulatory intervention is quite high.

This also demonstrates one of the potential consequences of force feeding clearing.  Not only is force feeding problematic from a systemic risk perspective, it will also create competitive issues.  And the tension between desires to increase competition and desires to ensure the safety and soundness of CCPs are likely to result in regulatory mistakes–serious regulatory mistakes–in the future.

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1 Comment »

  1. […] The Streetwise Professor has added his thoughts to the EU probe here […]

    Pingback by EU has opened two antitrust probes into transparancy in CDS market « SerenDiPity — May 2, 2011 @ 1:28 am

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