Remarks to the New York State Bar Association
Futures and Derivatives Law Committee
New York, New York
Commissioner Sharon Brown-Hruska
Commodity Futures Trading Commission
May 20, 2003
Good morning. I am pleased with the opportunity to speak with many of you here today, see familiar faces, and provide remarks on issues of importance to the futures and derivatives industry.
Of course, as I am certain each of you will appreciate, I must note that the thoughts and views I share do not necessarily represent the official position of the Commodity Futures Trading Commission (CFTC), but rather are those of one Commissioner, with a perspective that draws upon my background and experience as an academician. As an economist and former professor at Tulane and George Mason University, I tend to evaluate issues and problems using an analytical approach that employs basic paradigms from the discipline of economics, historical evidence, and the experiences observed in similar or related markets. So, if you will indulge me today, I would like to offer my perspective as a regulator who views things through the lens of a professor seeking to objectively evaluate challenging issues of concern to the financial and legal communities, as well as many of your clients.
As regulators, we are frequently asked to intervene in circumstances potentially impacting competition in the marketplace, often from a market structure or policy perspective. Some of the most difficult issues include the mechanisms, ownership, and governance of clearing operations, the entry of foreign and electronic competitors in products and markets, and transparency and disclosure in the markets. In order to understand the proper role for government with respect to these issues, it is important to understand the economic principles underlying them.
Regulators should have a valid theoretical basis for the actions they take. Economics provides just such a useful framework for analyzing competitive issues in financial markets, dealing with issues related to investor protection, and promoting innovation in our markets. Issues as disparate as deceptive advertising and price transparency, for example, are informed by what is known as the “economics of information.” And while I will only be able to skim the surface of the concepts involved (and let me caution you that they should not to be construed as legal currency), I would like to provide some observations based on my work in the area of the market for information.
When I started my term as Commissioner, the Roundtable on Derivatives Clearing Organizations had just convened and the clearing members of our exchanges, represented by the Futures Industry Association (FIA), had raised concerns about the level of clearing fees and the governance of the clearing function within the exchanges. Indeed, in my prior research on market data, I had found that clearing and market data services were significant sources of revenue for exchanges, lending support to the assertion of the FIA and the Futures Commission Merchant (FCM) community that clearing fees may be unreasonably high.
As a technical matter, since trade information emanates from the clearing and settlement function, they are closely wedded activities. Typically, the technology used to register and verify price and trade data creates the raw material – information – that is used to determine collateral requirements, manage credit and other risks, and even assist us in the regulatory functions of surveillance and enforcement. It has been the exchanges’ contention that efficiencies in many of these related processes would be compromised if any one component, such as trade clearing, were separated from the other activities.
The question of concern to the Commission is whether this organizational structure, a vertically integrated model in which all features of trade execution and processing are housed in the exchange, constitutes an anti-competitive burden on trading. While I am not going to try to discuss the legal aspects of that question, nor will I espouse a policy, I would like to share with you my observations, again from the economist’s view, about exchange organization and how these markets compete for and retain order flow.
Markets compete on the basis of the cost and quality of trade executions. Costs include transaction fees associated with execution, clearing and settlement, and most importantly, the liquidity costs associated with doing a trade. Thus, when we think in terms of the cost of trading in these markets, we should think of it in terms of an equation where the total cost can be broken down into these individual component costs.
Liquidity costs can be measured in various ways. Most commonly we use some measure of the difference between what we can buy and sell something for at one instant in time. This difference, commonly referred to as the “bid-ask spread”, is an important component of the cost of a transaction, since it tells us the implicit profit margin that market professionals earn when they buy and sell an asset. As a result, spreads are a key facet of how we measure the cost of liquidity. If spreads are wide, liquidity is costly. The greater the spread, the more one pays for liquidity.
To the extent that execution prices are uncertain, (e.g. if the price moves while executing the trade as a result of illiquidity or delay in order execution) execution quality is diminished and therefore considered to be a cost. Either way, brokers, dealers, and end-users evaluate these costs when deciding to trade. If costs are too high, or are cheaper elsewhere, then they will either forgo trading or go elsewhere if such an option is available.
In this context, the tough question raised by industry participants, including organizations like the FIA, is whether there are viable options for trading elsewhere, or whether by virtue of the current market environment, there exists only one place to trade. More precisely, does a “de-facto monopoly” exist? From my perspective, the determination of whether an organization is behaving like a monopoly is an empirical one; that is, I would want to know if there are barriers to entry and whether the entity is engaging in discriminatory pricing practices. Although I have always believed that such questions warrant serious investigation and study—lacking that—let me provide my view based on anecdotal observations and an understanding of market dynamics.
In the futures markets, economies of scale in liquidity provision, what economists sometime refer to as “network externalities,” result in significant concentration of order flow in one market. Basically, order flow will migrate to the market with the smallest spreads and the greatest liquidity. Order flow attracts more order flow since, as more trading interest is attracted to a market, costs tend to fall as greater competition ensues to get the trading business. Thus, liquidity is a self-reinforcing proposition, and once a market has it, we have generally seen that it is “winner-take-all.”
However, market domination is necessary, but not sufficient, to establish the existence of a monopoly. A proper analysis would also consider barriers to entry, discriminatory pricing practices, and existing or potential competition. The fact that liquidity pulls order flow to one market demonstrates that market participants are seeking to attain the lowest cost transaction, with liquidity cost being the preeminent component of the cost equation.
The principle of cost minimization, and the drive to attain it, is at work here, and the FIA and its members continue to voice the ongoing competitive drive to minimize the total cost of trading. They point to the activity of exchange clearing, suggesting that clearing fees, said to make up 75% of exchange revenue, are too high. But this is only part of the equation. Since execution costs are often bundled into one execution fee, a lack of transparency in the way the resulting revenues are distributed has contributed to the concern that exchanges are taxing one member type, clearing members, in order to subsidize another member type, floor traders.
Up until now, it appears that economies of scale in liquidity provision have been sufficient to offset the costs of cross-subsidies common in a vertically integrated exchange model. In more concrete terms, traditional exchanges like the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX) use clearing and market data revenue to subsidize activities such as new contract development and marketing, improvements to the floor, technology upgrades, etc. The higher fees for clearing have not been so high as to outweigh the benefits of liquid, low cost executions and to make it feasible for market participants to take their business elsewhere.
I would add, though, that the paradigm of competition—that volume will go to the best-priced, lowest transaction cost market—is constantly being tested. And even if a new competitor is unable to oust an established exchange, the test nonetheless will have an effect on the market. BrokerTec was a test. It tested the Chicago Board of Trade’s (CBOT) ability to compete against an electronic market offering the same interest rate complex at lower explicit transactions costs. I would suggest that the CBOT has prevailed up until now because it still offers the best price and the lowest implicit spreads across the board for all sizes of transactions. When it does not, and a competing market does, traders will go elsewhere, as they did in attendant proportion to BrokerTec.
There is information in the BrokerTec example. The CBOT, clearing through the Board of Trade Clearing Corporation (BOTCC) and an integrated electronic and open outcry market, is the liquid, low cost choice. But change the numbers and you are not going to need the ridiculous amount of math that economists have to endure to figure out that the choice will change, too.
Eurex is coming, and the total costs in the equation that they will bring to the market will determine where volume goes. Eurex will test, among other things, whether the CME, with its clearing model, and component fees and open outcry trading in Eurodollars, can retain the edge. With the characteristic pull of liquidity pools, the exchanges would not be wise to sit on their hands and cling to less efficient market structures that elevate their costs and make “jumping ship” even more compelling.
For these reasons, the views of the FIA and the FCM community have already helped the US futures markets recognize the competition they face from potential electronic and foreign competitors. The view that FCMs are trying to compete with the exchanges so they can get the revenue for themselves does not comport with my observation of the way they must do business. FCMs face their own competitive pressures. If FCMs can reduce their costs, and the costs of their customers, it will be good for their business and the industry. If the industry can attract more business because of lower costs, then it is good for everyone. Hence, I believe that the incentives of the exchanges and the clearing members are aligned, and I would encourage the exchanges to listen and try to solve the issues and problems they have identified.
Finally, I would like to comment briefly on the role that the CFTC is expected to play under the Commodity Exchange Act to assure that our markets are competitive. Section 3(b) of the Act says that one of the purposes of the act is to “promote responsible innovation and fair competition among boards of trade, other markets and market participants.” This language, added by the Commodity Futures Modernization Act, which was passed in December 2000, shows that Congress recognized the importance of competition in our markets. I share that appreciation and would add that, when we think about competition, the first thing that we should be wary of is simply counting the number of competitors operating in the marketplace.
The fact that we do not observe more than one exchange offering the very same product does not mean they are not actively competing. From time to time, we do see attempts at direct competition with exchanges introducing new contracts that directly compete with ones already being traded by another exchange. The CBOT, for example, once threatened to wrest precious metals trading from Commodity Exchange, Inc. (COMEX) when that exchange experienced difficulties with their contracts. While ultimately the CBOT’s efforts did not prove successful, the threat to COMEX was real and showed that an exchange cannot “rest on its laurels”, but must instead vigorously protect its products by offering a superior product mix and cost structure.
Likewise, we can observe the beneficial effects of potential competition. In our markets today, we observe BrokerTec, and potentially Eurex, attempting to move in on another exchange. They are only the latest examples of possible new entries. But they will certainly not be the last. Whether BrokerTec and Eurex are ultimately successful is less the point than the fact that they attempt to do so. Indeed, the theory of potential competition, which has become one of the mainstays of modern antitrust law, holds that existing firms will keep their prices down (or enhance other aspects of their offerings, such as product quality) in an attempt to deter the entry of the potential competitor. That is, the threat of entry forces incumbent firms to behave in a manner that we associate with markets that are fully competitive.
My main caution is that we, as regulators, not try to micromanage competition, and that we be circumspect not to tinker with market design or market structure decisions that are best considered as business decisions. In the area of clearing, the real question is whether the exchanges will respond to intermediary concerns. Up until a few weeks ago, the answer was probably not. But with the announcement that the CBOT would move its clearing to the CME clearinghouse, we see an exchange effort to try to achieve efficiencies in preparation for potential competition. In this regard, and in other markets, it is my hope that we will see real movement toward addressing some of the issues that have been raised regarding collateral management, risk and position offsets, and portfolio margining.
As I have discussed here today, I believe robust competition takes place between and within markets, though in ways that may not always be obvious to the uninformed eye. Moreover, the greater threat to the markets, in my view, would be for us, as regulators, to step in and dictate a market structure based upon an unsophisticated notion of competition. Very simply, the best solutions are arrived upon by deference to the needs and desires of the users of the marketplace.