| Craig Pirrong |
I’ve had several calls from reporters asking my opinion on the Lynch Amendment to Barney Frank’s derivatives-regulation bill. For some reason, Forrest Gump pops into my head every time that question is asked. You know, the part where he says “stupid is as stupid does.”
As I am sure you all know, the amendment, introduced by New Jersey representative Stephen Lynch, imposes restrictions on the ownership and control of the clearinghouses that the Frank bill will require the vast bulk of derivatives to be traded through. The amendment imposes similar restrictions on ownership of exchanges and swap execution facilities.
Specifically, the amendment defines a class of “restricted owners” that includes swap dealers and major swap participants, and limits the amount of a clearinghouse (or execution facility or exchange) that these restricted owners can own or control collectively to 20 percent. The justification for this limitation is to reduce conflicts of interest, the specific nature of which are not identified.
This represents yet another example of Congressional micromanagement of the organization and governance of financial institutions. In my view, it is incredibly wrong-headed.
Let’s focus on clearing organizations. Remember what they do. They are a mechanism for pricing (via collateral) and sharing counterparty risk. Any financial institution that agrees to participate in the sharing arrangement will reasonably expect to have control rights in the organization that oversees this sharing mechanism. No sane financial institution is going to agree to share in a large fraction of the risk borne by a clearinghouse if it is restricted to having a small share in control.
This means that restricting ownership and control rights will inevitably exert a decisive influence on the allocation of counterparty risk through a clearinghouse. If the swap dealers and other major swap market participants are limited in the amount of control they can exercise, they will limit the amount of risk they are willing to bear. So who will bear it?
The traditional clearing firm has been effectively a mutual/cooperative. Several intermediaries agree to share and manage counterparty risk. These intermediaries offer various trading services, including brokerage and market making. Counterparty risk is created as a result of the deals that they intermediate, and they find it in their mutual interest to price and share this risk collectively.
This mutual model has survival value. Even the exchange clearinghouses that Frank et al. apparently consider the ideal to be imposed on everybody are effectively mutuals governed by the major intermediaries. (Once upon a time, the Board of Trade Clearing Corporation permitted every CBOT member to become a member of the clearinghouse, and adopted a one-member, one-vote voting structure. However, over time, the organization evolved and became dominated de facto and de jure by the largest futures commission merchants.) Nor is this an anachronism reflecting merely path dependence and hysteresis. Indeed, one of the largest clearinghouses, LCH.Clearnet, has recently become a more focused mutual-type organization with increased control by large financial intermediaries; in a major reorganization completed weeks ago, LCH fended off a takeover effort launched by major market users by buying out smaller members and giving the big intermediaries a bigger stake in the organization.
This makes sense if the large intermediaries are the efficient bearers of counterparty risk. If they are the efficient bearers, they should bear it. And if they bear it, they will certainly condition their willingness to do so on their ability to control the organization.
Moreover, major market users have another reason to want to control the clearinghouse. “Trading services” is a bundle of a variety of different services, of which clearing is merely one. These services are consumed in close to fixed proportions. Moreover, there is likely to be market power in the provision of several of these services, and clearing in particular has natural monopoly characteristics. An independent clearing organization could exploit its scale economies, and exercise market power and extract rents from major intermediaries that use its services. Moreover, to the extent that there is market power in one or more parts of the trading services business, this could exacerbate double marginalization problems, leading to other pricing efficiencies.
User control of the clearing function can prevent such exercise of market power. The mutual/cooperative form allows the major users to obtain clearing services at cost. If the major users of clearinghouse services cannot control the clearinghouse, those who do control it have an incentive to extract rents from the major users by charging inefficiently high prices.
Thus, from risk bearing and pricing perspectives, user dominance of clearinghouses makes economic sense. Maybe, just maybe, that’s why users have dominated clearinghouses nearly everywhere and at all times. Could it be? What do you think about that, Rep. Lynch? Barney? (Barney is a big backer of Lynch’s amendment.) Or do you guys just know better? (We are not worthy!)
To me, what Lynch views with suspicion as a conflict of interest is actually an alignment of interest. It aligns the control rights with risk exposures. It similarly aligns the interests of those pricing the service with those who consume it.
If implemented, the Lynch amendment would make the mutual model unworkable. As a rough estimate, if big users are limited to a 20 percent stake, 80 percent of the risk would have to be borne by somebody else. Which would be who, exactly? Equity investors? Why would they provide capital? Presumably to get a return. Which would likely require the clearinghouse to be established as a for-profit venture. A venture that would have an incentive to charge supercompetitive prices for its services to extract rents from big users. And mightn’t such equity investors have an incentive to take risks, given the asymmetric nature of equity returns arising from limited liability? Isn’t that directly contrary to the whole reason for mandating clearing in the first place?
Also, does it make sense to weaken the ability and incentive of those with specialized expertise in evaluating counterparty risk to monitor and control the specialized organization established to manage this risk?
This is all so perverse. Why do Lynch and Frank want to impose a constraint that almost certainly will reduce the efficiency of the organization that they have seized on as the way to improve the operation of the derivatives markets? Or is this just a backdoor way of throttling the derivatives markets increasing the costs of using them through idiotic restrictions on the way they are organized, owned, and governed? (Make firms who trade derivatives clear them. Make clearing more expensive by preventing the implementation of efficient ownership and control structures. Voila! Fewer derivatives trades!)
There is one potentially real inefficiency that can arise through user-dominated clearing organizations. Due to the economies of scale in clearing, it is likely that only a single clearinghouse will survive in equilibrium. As I’ve shown in my work on exchanges, a cooperative organization supplying a natural monopoly service can generate rents for its members by restricting membership. It lets in just enough members so that no competing organization can survive, but due to the entry limitations reduces output and raises prices to the ultimate consumers of these services. “Non-profit” exchanges did that for a long time.
Mandating that a clearing organization permit open access would eliminate this problem, but create another. In particular, to maintain the financial stability of the clearing organization, it is likely desirable to prevent financially weak firms from joining. The hard thing is to write rules that would be sufficiently discriminating to prevent the clearing organization from using financial requirements for membership as an excuse for excluding potential members in order to enhance market power rents.
That is a real concern, but the Lynch amendment is an incredibly crude way of dealing with it. Drafts of the various derivatives regulation bills mandate that no clearing organization should implement anti-competitive policies. It would be better to leave it at that, and delegate enforcement of this provision to the antitrust authorities than attempt to handle the entry barrier problem with restrictions on organization, ownership and governance that impede efficient risk bearing and monitoring, and encourage other ways of exercising market power.