Streetwise Professor

May 19, 2011

What’s the Frequency, Luigi?

Chicago finance prof Luigi Zingales has written a short oped on OTC derivatives markets.  Considering the source, it is very disappointing, not to say embarrassing.

Indeed, it seems that Luigi is on the same frequency as Kenneth Griffin of Citadel: their arguments, such as they are, are virtually indistinguishable.

Zingales’s basic argument is that the OTC derivatives market is oligopolistic, and that all sorts of bad things flow from that structure:

Indeed, today the market for derivatives is oligopolistic, with a few banks running huge profit margins. And, regardless of whatever political motivations might lie behind the latest investigations, this market concentration is a real problem. According to a 2009 study by the European Central Bank, the five largest CDS dealers were party to almost half of the total outstanding notional amounts, while the 10 largest CDS dealers accounted for 72% of the trades. The markets for other derivatives are not much better.

As is usual in assertions of dealer oligopoly, there is seldom any comparison to other markets.  The concentration figures Zingales cites are hardly exceptional when compared to other industries, and I daresay to the markets for groceries or gasoline in Chicago.

But worse, Luigi’s argument is very anti-Chicago.  Long, long ago, dating back to the 1960s and 1970s, Chicago eviscerated the structure-conduct-performance paradigm associated with Harvard (and Joe Bain in particular).  Folks like Harold Demsetz and Sam Peltzman pointed out that market structure is endogenous, that concentration can result from the exploitation of cost advantages, that prices can be close to marginal cost even in concentrated markets, and that large profits in such markets are not prima facie evidence of weak or absent competition.

This means that rather than taking the concentration data (as benign as they are by comparison with other industries) and making the leap that this concentration indicates a lack of competition, Zingales should ask why the structure is what it is, what forces generated it, and whether concentration is actually symptomatic of an inefficient, non-competitive market structure.  Put differently, concentration is neither sufficient nor necessary condition for a non-competitive outcome. Regurgitating concentration statistics and proclaiming “QED” is bad economics.

That’s all bad enough, but then he really goes off the rails:

A high degree of concentration distorts the market in several ways. First, when they transact among themselves, large players do not insist on an adequate amount of collateral, relying on the counterparty’s generic creditworthiness (and on the implicit guarantees that governments provided to large firms). Not only does this severely undermine the ability of small firms to compete, but it also contributes to systemic instability of the type that we experienced in 2008, thus increasing the likelihood that taxpayers will have to step in. Market concentration renders mostly illusory the beneficent risk-spreading role that is claimed for derivatives, because the bulk of the risk is borne by very few players.

The point about implicit guarantees is fine–but that’s a policy error that can’t be fixed by jiggering with the market structure.  But the criticism that banks don’t collateralize trades but rely on generalized creditworthiness is wide of the mark for many reasons.  For one, under standard credit support annexes, dealers don’t post independent amounts with one another, but do collateralize via variation margins on a daily basis.  Hence, inter-dealer credit is limited to one-day moves.

For another, Zingales is overlooking the fungibility of credit: initial margins/independent amounts could be funded by borrowing–and banks kind of have access to a lot of borrowing channels.  And since dealers typically rehypothecate collateral, what’s the point of interdealer independent amounts anyways?: with hypothecation A can give collateral to B who can effectively turn around and give it back to A; the actual money flows are a little more complicated, but rehypothecation effectively allows banks to lend each other the collateral that they post with one another.  What’s the point of that?

For yet another, regarding the “undermining the ability of small firms to compete”–can he be serious?  Because of the borrowing point I just made, no doubt if independent amounts on all inter-dealer trades were somehow mandated, who do you think would have the lower cost of funding these margins, the big incumbent banks, or small firms?  I would wager that mandated collateralization would actually favor bigger, more creditworthy firms.

Moreover, Zingales also overlooks other potential scale and scope advantages in derivatives dealing: yes, some of these may be artificial because they arise from TBTF subsidies, but again, that is a problem that needs to be tackled directly.

Zingales then trots out the conventional arguments regarding opacity:

Over-the-counter trading also contributes to the opacity of derivatives markets, further reducing competition and increasing the margin enjoyed by the traders – and the prices that final users (mostly industrial firms) must pay. The combined profits of the key players in this market total $80 billion, which represents a massive tax on the real economy.

To fix this problem, we need to move the bulk of derivative trading onto organized exchanges, where daily collateral requirements would guarantee systemic stability, and price transparency would force competition, reduce margins, and increase the market’s depth. In the United States, the Dodd-Frank Act moves some of the way in this direction, and similar efforts are underway in Europe.

I’ve been over this ground so many times, so I’ll try to keep it brief (for me, anyways).  Zingales presents no evidence that margins are excessive.  End users have choices, including very close exchange-traded substitutes for many OTC derivatives, but they choose to trade OTC instead: like others who have made similar criticisms, Zingales apparently believes that end users are suffering from Stockholm Syndrome or Battered Spouse Syndrome.  When touting exchanges as an alternative, he also overlooks the very real possibility that face-to-face OTC dealings reduce adverse selection costs that end users incur, but would incur on anonymous exchanges.

Moreover, apropos the earlier point about anti-Chicago, if margins are so wide and profits are so fat, why doesn’t entry occur?  Why doesn’t competition work to erode margins and profits here, like in other markets?  Perhaps there’s a story, but Luigi sure doesn’t tell one–and he is far from alone in this.  The statement about profits being a tax is so embarrassing I will pass over it in silence.  The profit number itself is completely contextless; his statements about profits based on absolute magnitude (“boy, that’s big”) remind me of the periodic attacks on oil industry profits that are similarly without any context, or attempt to control for capital deployed, risk, etc.  Given that he alludes to the concentrated riskiness of derivatives positions, perhaps he should at least entertain the possibility that the profits are in fact compensation for risk:  indeed, large profits in “normal” times interspersed with periods of big losses is characteristic of the risk-reward profile associated with tail risk.

As for his proposed “solution,” I can only stand and wonder.  The hook for the entire piece is the EC’s antitrust investigation of the OTC market:

the existence of political motivations does not undermine the legitimacy of the new EU investigations, which will be conducted alongside an ongoing inquiry by the United States Justice Department into anti-competitive practices in the trading, clearing, and pricing of CDS in the US

He starts out his critique of the OTC market by focusing on concentration in the OTC market, and concludes that high concentration is symptomatic of a lack of competition.

Uhm, has he looked at concentration in the exchange space? Is he aware that virtually every major exchange-traded derivatives contract is a monopoly?  Has he looked at concentration trends in exchanges?  Has he noticed the major consolidation wave that has been going on in exchanges since about 2005, and which as picked up again after tailing off during the crisis?

To go on: Is he aware that OTC markets also engage in “daily collateralization”, particularly among dealers?  Is he aware that such daily collateralization is not necessarily stability enhancing, as he asserts? Is he aware that “price transparency” already exists, though in a different form, on OTC markets?  Is he aware that the price transparency on exchanges is accompanied by counterparty opacity that can actually increase trading costs for the uninformed end user due to adverse selection?  And again: if the advantages of exchange trading are so great for end users, why haven’t exchanges made greater inroads in attracting their business, and why have end users in fact gravitated more towards OTC markets where he claims they are getting shafted?

Luigi is a very accomplished economist.  He can do much better than uncritically recycling stale and unpersuasive conventional wisdom.

Please, Luigi: adjust the frequency on your receiver.

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  1. Professor Z’s point about inter-dealer collateral is contradicted by the data: According to the 2011 ISDA Margin Survey, 89% of large dealer exposure to other banks is covered by collateral. And as clearing becomes standard for inter-dealer trades, this number will certainly rise. In addition, some earlier studies that focused on large dealers showed that dealers have routinely collaterized their largest inter-dealer exposures down to exceedingly small amounts.

    What’s happened to Chicago?

    Comment by DrD — May 19, 2011 @ 3:16 pm

  2. Huh…come again.

    Holy cow, with analyses like these I now have some insight into Strauss-Kahn’s hotel behavior-just surprised he wasn’t arrested sooner. Dominique may need to cast this in more of a hip hop style before he teaches the Economics class at Attica. 🙂

    Comment by pahoben — May 19, 2011 @ 5:16 pm

  3. @DrD–re “what happened to Chicago?” Don’t even get me started.

    The ProfessorComment by The Professor — May 20, 2011 @ 8:19 am

  4. “why doesn’t entry occur?”

    Seriously? That is exactly what a CCH facilitates…not just facilitates…..OTC entry would/does take years even if spreads were wide enough to drive through

    Comment by se — May 23, 2011 @ 6:29 pm

  5. I think the analysis of OTC markets with regard to concentration is tough. There just aren’t a lot of players in these markets to avoid concentration. However, if you take his analysis to the cash equities markets-there is a problem with structure.

    I think instead of looking at the number of players, look at the hierarchy of market structure. Is there a clearly defined distribution system? Flatter, horizontal structures should be more competitive.

    Comment by Jeff — May 24, 2011 @ 5:48 am

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