Unbundling derivatives clearing from trading

The US Department of Justice has put out a very well argued and cogent paper arguing that unbundling derivatives clearing from trading would lead to greater competition in derivative trading with attendant benefits in terms of greater innovation and lower costs for the users of derivatives.

The DOJ’s theoretical reasoning is quite sound:

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.

This theoretical reasoning is backed up by some excellent discussion about the attempted entry of Eurex into US Treasury futures as well as of other competitive battles in the derivative industry.

But the most important confirmation came from the stock market: the share price of the CME Group that runs the largest derivative exchange in the US dropped by 18% after these comments were released and rose again after subsequent news reports suggested that the proposed changes were unlikely to happen anytime soon.

Posted at 5:00 pm IST on Tue, 12 Feb 2008         permanent link

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