Clearing Up Misconceptions on Clearing: Vertical Integration of Clearing and Execution May Produce Considerable Efficiency Benefits
Pirrong, Craig, Regulation
Clearing--a centralized mechanism for confirming and guaranteeing trades in securities and derivatives markets--is often likened to the plumbing of the financial system: it is ignored when it works, and can cause serious problems when it doesn't. Market insiders have always understood the importance of this arcane aspect of the financial system, however, and recently it has received far more attention on both sides of the Atlantic. In particular, in both the United States and Europe, fierce debates are raging over how clearing should be organized and who should own the clearing function. For the most part, the battle pits exchanges on one hand and large banks and regulators on the other, but even then some exchanges and some regulators take different views than most of their peers.
In a nutshell, the debate centers on whether exchanges should own the clearing entity or whether exchange ownership of the clearing function impedes competition for the execution of financial transactions. Opponents of vertical integration in clearing assert that clearing is effectively a natural monopoly function and that exchange control over this function makes it effectively impossible for new exchanges to compete against incumbents. Proponents of the "vertical silo" model, including the world's largest derivatives exchanges, Deutsche B6rse and the Chicago Mercantile Exchange, respond that exchange ownership of clearing is not an insuperable obstacle to competition, and what is more, is an efficient way to organize financial transactions. Opponents of vertical integration prefer a user- (read "large bank and brokerage") owned nonprofit clearing cooperative, which they argue will achieve efficiencies in clearing, mitigate market power in clearing, and also encourage competition in the execution of financial transactions. Most exchanges believe that those benefits are chimerical and that such an institution will merely transfer power to large banks, to the detriment of the broader financial system.
This article goes back to basics in an attempt to sort out the competing claims. Based on an analysis of the fundamental economic features of the businesses of executing and clearing trades in financial instruments--the most notable feature being the presence of strong scale and network economies--I conclude that the competitive benefits of "opening up" or "dis-integrating" the clearing function are illusory and that integration can economize on transactions costs. Thus, the economic case for the forced disintegration of the clearing and execution of financial transactions is very weak. Indeed, in my view, such a measure would actually be counterproductive, leading to greater costs than benefits.
THE ECONOMICS OF EXECUTING AND CLEARING
Completion of a financial transaction, such as the purchase of a stock or the sale of a futures contract, involves several complementary steps. Consider a transaction in a standardized futures contract, such as a Treasury bond contract traded on the Chicago Mercantile Exchange. The buyer and seller must first interact to establish a price at which they are willing to trade. The process of negotiating the price and quantity terms of the transaction is the process of "executing" a trade. Historically, and still today to some extent, execution took place in "open outcry" auctions on the floor of an exchange. During an open outcry auction, buyers and sellers (or their broker-agents) shouted out the prices at which they wanted to transact in the trading pit or ring of an exchange, reaching agreements via the face-to-face bargaining process. Today, most futures, options, and stock transactions are executed via computers. Buyers submit bids and sellers submit offers to an exchange computer. If the highest price any buyer submits equals or exceeds the lowest price offered by any seller, the exchange computer matches the high bid and low offer, resulting in the execution of a trade.
Once a buyer's and seller's orders are matched, the putative deal is submitted for clearing. …