Streetwise Professor

August 2, 2011

This Sounds Very Familiar

Filed under: Clearing,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 9:57 am

John Lothian has an interview with Deutsche Boerse’s Head of Media Relations, Frank Herkenhoff.  Compare:

John Lothian: The vertical integration of your clearing house is continuously criticized by your competitors…

Frank Herkenhoff: Vertical integration between trading and clearing generates significant user benefits. Vertical integration allows maximum innovation in trading and clearing services, by aligning incentives at the trading and clearing level, as well as promoting systemic stability. Vertical integration is efficient as it reduces double marginalization and transaction costs. NYX had already initiated the move to vertical integration, independent of this transaction. The integrated business model has proven to be efficient and secure and has consequently become a role model for the industry over the past years.

And contrast:

The execution, clearing, and settlement of financial transactions are all subject to substantial scale and scope economies which make each of these complementary functions a natural monopoly.  Integration of trade, execution, and settlement in an exchange improves efficiency by economizing on transactions costs.  When scope economies in clearing are more extensive than those in execution, integration is more costly, and efficient organization involves a trade-off of scope economies and transactions costs.  A properly organized clearing cooperative can eliminate double marginalization problems and exploit scope economies, but can result in opportunism and underinvestment.  Moreover, a clearing cooperative may exercise market power.  Vertical integration and tying can foreclose entry, but foreclosure can be efficient because market power rents attract excessive entry.  Integration of trading and post-trade services is the modal form of organization in financial markets, which is consistent with the hypothesis that transactional efficiencies explain organizational arrangements in these markets.

This is the abstract from a paper about vertical integration in clearing that I wrote in 2006, and then updated in 2007: similar material will be in the monograph I’m working on now.

If you have way too much time on your hands, and delve into the paper, you’ll see that I discuss explicitly how the alignment of incentives between execution and clearing facilitates innovation, and improves coordination of responses to systemic shocks.  I go into great detail about double marginalization.  The parallels between Herkenhoff’s last sentence (integration is the role model) and the last sentence of my abstract (integration is the modal form of organization) are also pretty obvious. So Herkenhoff hits basically all the points I made in my paper.


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