Wednesday, February 13, 2008

Improving competition in the exchange industry

One of the many clever things that were done in the equity market reforms of the 1990s was a pro-competitive framework for depositories. The depositories legislation explicitly plans for multiple competing depositories. Further, there is an elegant decoupling between the decision of a customer about which exchange to use vs. which depository to use. E.g. it's perfectly feasible for a customer of NSE to use BSE's depository (or vice versa).

I believe competition policy is a very important element of sound government in the area of finance, and such thinking is essential to reshaping the competitive landscape. All too often, such care is not exercised in the formative phase, and we endup being stuck with a monopoly and/or conflicts of interest.

Jayanth Varma alerts us to a proposal of the US Department of Justice which has major implications for competition between exchanges. The document written by DOJ is of top quality - I really admire the human capital they are able to bring into these things - and is well worth reading.

At the essence, it is a proposal to unbundle an exchange business from a clearing corporation business. This would yield orthogonality (as above) where the choice of a exchange and the choice of clearing corporation are made independently. As he points out, this must surely be a good idea for competition, for the CME stock price dropped by 15%:

(Click on the picture to see it more clearly, or click here to see current data from Yahoo Finance.)

The logic here runs well beyond the simple idea of ensuring competitive conditions hold in both sub-industries. The DOJ's reasoning is essentially this:

If exchanges did not control clearing, an appropriately regulated clearinghouse could treat contracts with identical terms from different exchanges as interchangeable, i.e., fungible. The incentives of such a clearinghouse would be to maximize its own profits, and it thus likely would treat identical contracts as fungible. In a world of fungible financial futures contracts, multiple exchanges could simultaneously attract liquidity in the same or similar futures contract, facilitating sustained head-to-head competition. A trader could open a position on one exchange and close it on another. In such a world, a trader could execute against the best price wherever offered without fear of being unable to exit the position because there is insufficient trading interest (or of being forced to exit at a poor price) on the new entrant trading venue when a trader chooses to exit.

In addition, if exchanges did not control clearing, an appropriately regulated clearinghouse could reduce member margin obligations by recognizing offsetting positions in correlated financial futures contracts traded on different exchanges. The ability to offset correlated positions in a futures clearinghouse can significantly reduce the capital required to trade.

Here is a response from CME.

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