Banks, Clearing and Over the Counter Derivatives

There is a lot of pressure on banks to end their monopoly over over the counter derivatives.  The New York Times ran a piece today.  It was sort of soft, and really didn’t get into the nuts and bolts of the macro issue.  Further, it had some incorrect facts, and made some suppositions that just were not true.  However, the sentiment of the piece is correct.  The sentiment is something we have been harping on for a long time here-transparency is good.

First off, let’s correct the incorrect facts, and suppositions.  The NY Times said that coffee and cocoa were traded at the CME, they aren’t.  They are traded at the ICE.  The article also assumes that it is Republicans that are blocking the more transparent trading of OTC derivatives.  In fact, it’s both parties.  Democrats received more money from Wall Street than Republicans. To be fair, OTC derivatives are a pretty esoteric part of the business. Most in DC don’t understand them. The banks and ISDA try to keep the understanding as circumstantial as possible. There is a revolving door from Wall Street to the power alleys of the SEC, DOJ, CFTC and other agencies that regulate the industry.  The article left the impression that current CFTC chief Gary Gensler is a big time reformer.  In fact he is an ex-Goldman Sachs banker.  The reforms he has been pushing help, not hinder the big banks.  Many on the street think that he is auditioning to be the Treasury Secretary, hoping that the over matched Geithner will step down.

There are myriads of conflicts of interest in the entire investment banking, stock and option trading, regulating, listed commodity and OTC derivative trading and hedge fund industry it’s impossible to list them all. Even within this post, you might think there are contradictions. But some things you can distill and it helps one understand the landscape.

The CME and ICE compete, but their corporate cultures are very different. CME has a love/hate relationship with the investment banks of New York.  There are no investment bankers on the CME Group board, and that board has 34 people on it.  The New York bank contingent has very little control over the direction of CME’s business.  It’s a transactional relationship.  When it is symbiotic and works, they love each other.  When they compete, they hate each other.  The ICE is a complicit accomplice to the banks.  Here is all you need to read to validate that;

“So the banks responded in the fall of 2008 by pairing with ICE, one of the Chicago Mercantile Exchange’s rivals, which was setting up its own clearinghouse. The banks attached a number of conditions on that partnership, which came in the form of a merger between ICE’s clearinghouse and a nascent clearinghouse that the banks were establishing. These conditions gave the banks significant power at ICE’s clearinghouse, according to two people with knowledge of the deal. For instance, the banks insisted that ICE install the chief executive of their effort as the head of the joint effort. That executive, Dirk Pruis, left after about a year and now works at Goldman Sachs. Through a spokesman, he declined to comment.”

Previous to that, the banks put up the money so ICE could expand and become a legitimate exchange. The banks also put up the money so ICE could buy the Chicago Climate Exchange (CCX) for millions of dollars. Ironically, former VP Al Gore sat on the board of that exchange and his pockets were lined from the transaction.  No one on the street can figure out why the acquisition price ICE paid was so high when the CCX did little or no meaningful volume.

Enough of that.

Clearing is the backbone of trading. Clearing is different depending on where the trade takes place. In SEC regulated stocks and options, clearing takes at least three days.  In CFTC regulated futures, it is same day, sometimes twice a day.  In OTC derivatives, it can be cleared through the International Derivatives and Swaps Association (ISDA), or privately cleared and held in the bank that wrote the derivative contract.  In the OTC world there is no set standard.   But, since the financial crisis there has been a push to clear derivatives through a regulated clearinghouse.  Almost every exchange in the world is rushing to try and clear them.

What does clearing do?  It offers certainty to the trade.  Clearing wipes away the counter party risk associated with trading, and allows more commerce to be transacted.  It also offers price transparency since parties can look and see who traded with whom, the volume, the timing of the trade and at what price.  Clearing brings better information to markets so supply and demand can adjust more efficiently.

It’s not clear that the government and regulators should mandate clearing of every transaction that takes place though.

The investment banks of New York have created many monopolies and aggressively defend them.  The NY Times piece gently talks about OTC derivatives.  But the banks have created the same situation in Corporate Bond and Municipal Bond trading, Currency Trading, Equity Option and Equity Stock trading.  Anyplace that they can obfuscate transparency they do.  It’s all so there is an edge for them to make money off of.  They spend millions on attorney’s fees at at law firms like Sullivan and Cromwell to do their bidding for them.

The banks also will set up facades that look like competitive exchanges when in reality they just want to funnel even more business into their oligopoly.  ELX was introduced a couple of years ago to compete with CME.  Who are it’s founders?  Bank of America, Merrill Lynch, Barclays Capital, Citidel, Citigroup, Credit Suisse, Deutsch Bank, eSpeed, Getco, JP Morgan, Peak 6, and Royal Bank of Scotland.  ELX is just a way to try and get a dark pool started in the Treasury futures market.  If the banks had their way, they would rewrite CFTC regs to look like SEC regs.  Then they could fragment the market and rape and pillage the customer.  There is a tangential debate about vertical silos and clearing that banks would spend millions to win.

From the NY Times piece,

“The banks also refused to allow the deal with ICE to close until the clearinghouse’s rulebook was established, with provisions in the banks’ favor. Key among those were the membership rules, which required members to hold large amounts of capital in derivatives units, a condition that was prohibitive even for some large banks like the Bank of New York.

The banks also required ICE to provide market data exclusively to Markit, a little-known company that plays a pivotal role in derivatives. Backed by Goldman, JPMorgan and several other banks, Markit provides crucial information about derivatives, like prices.

Kevin Gould, who is the president of Markit and was involved in the clearinghouse merger, said the banks were simply being prudent and wanted rules that protected the market and themselves.”

The banks made sure they wrote the rules. That allowed them to protect their turf. They do the same thing on the regulatory front in Washington. It was the banks that wrote the Dodd-Frank law. It’s banks that are filling in the blanks to that law.  At the same time, they do need some input.  There just isn’t an organized countervailing force that can speak for the parties that are being disenfranchised.  Plus, in order to write rules there is a certain amount of familiarity and expertise that is needed to fill in the blanks correctly.

It was amazing to me how long certain transactions took to make their way through the government.  For example, when CME demutualized, the IRS took over a year to render a decision on tax consequences. When CME bought the CBOT, and the NYMEX, the DOJ dragged its feet agonizing over the transaction. But when ICE needed approval for a OTC clearing house it took weeks.

The reporter also makes a big deal about bank representatives sitting on the Clearing House Committees of exchanges. This is not a big deal or contradiction to anything previous in this post. Back when I was on the CME board, we invited all interested participants to sit on those committees. There is no strategy or back room dealing that is unearthed in those committees. It is purely a report on how the clearinghouse is doing, how it’s looking at the risk it is confronted with. The committee also allows the banks to have valuable input into the process. Exchanges cannot possibly have boots on the ground in every aspect of modern finance. If banks share their information with exchanges it makes the whole system more efficient. However, bank representatives are not involved with the making of strategy or influencing the structure of CME. They might be at ICE since they have so much money invested in them-I don’t know for sure.

Again, all these surrounding issues cloud the core issue. Is it wise to have mandated clearing on OTC derivatives?

Coase Theorem would say no. Whatever two private entities negotiate among themselves is best for the greater economy. However, supply and demand theory would say that there should be more clearing that allows for more transparency.

Perhaps there is a middle ground. Clear the trades, but have the data behind the trades anonymous. That way time, volume and price information would be available-but the parties behind the trading wouldn’t be known. Unfortunately, the business is concentrated and competitive. One bank learning another bank is exposed to a lot of risk in one particular market segment can be really damaging to business. Just ask the principles of Long Term Capital Management (LTCM) about their views on Goldman!

One thing is for sure. Virtually all the meaningful volume that is traded on the SEC regulated side of the business is done in the back offices and hallways where the public is not invited. The NYSE only does 20-30% of the volume in listed stocks. The real price is somewhere off exchange. The same is true for corporate bonds, muni bonds, and currencies. To give you some idea of how much juice there is in the market, when the CBOT listed Treasury futures in 1973, the spread went from fifteen basis points to one! That saved the government trillions when they auctioned off debt.

Dodd-Frank or any other financial regulation doesn’t contemplate transparency and competitiveness. They are designed to help the banks. If they really wanted a flat, competitive market place, they would end payment for order flow, dark pools, dual trading, internalization and all the other legal but nefarious practices that institutions use to cloud the marketplace.

The debate over clearing doesn’t begin and end here.  It is multi-faceted.  But there needs to be some core principles that we cannot waver from so the frame of reference is clear.  Competitiveness, information transparency, price transparency and ability for all parts of the market to have access equally should be bedrock that we build from.

UPDATE

for a slightly different take on this, go visit the Streetwise Professor.  He and I have sparred over this and other market structure from time to time.  But we both are in the free market/less government intervention camp.

SWP links to Felix Salmon at Reuters.  It’s a slightly different take than mine or SWP-but in the same vein.

Welcome Doug Ross readers!  Hope you take a look around.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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