The Dearth of Clearing Kills Innovation

It’s really hard for people to grasp basic finance much less the nuance of regulation.  Our nation’s financial system is bifurcated among a lot of different regulators.  When it comes to capital marketplaces, there are two that hold sway; the SEC and CFTC.

They look at things very differently.  Yesterday at the Fintank Blockchain event, panelists Richard Sandor and Dennis Chookasian made that exact point.  The way the regulators look at things shapes the competitive environment in each of their domains.

For example, on the SEC side there is a terrific amount of fragmentation.  Pay for order flow is allowed.  Dark pools are allowed.  Clearing the trades is a commodity.  But, existing clearing operations extract a lot of second and third degree pricing to realize some producer surplus.  At the same time, there is nothing driving the SEC clearinghouses to innovate.  At the FIA show in Chicago I stopped by the Depository Trust Clearing Corporation booth and asked if they had an executive tasked with bringing innovation into the DTCC.  They looked at me like I was from Mars and as if they never heard the word “innovation” before.

The innovation on the SEC side is in how orders get to market and how they are matched in pools. That’s where it’s hyper-competitive.  Competition breeds innovation which is why capitalism is so much better for society than socialism or even a heavy handed government regulated market.

On the CFTC side it’s far different.  Because exchanges hold their clearinghouses captive, competition drives them to innovate. However, because the exchanges own their own clearing, it’s really hard to establish new exchanges or new ways to trade.  Without a clearinghouse you don’t have a marketplace and on the CFTC side of the business there are only four clearing operations in the US.

For example, if CME decides to match orders a certain way they only really have to worry about an extremely small group of competitors that might challenge them.  Because they can leverage their clearinghouse across all product groups, they can crush competition with pricing.  But, it makes all market participants beholden to CME if they trade CME products.  Same goes for any commodity exchange-I am not picking on CME.

That”s a huge stumbling block to potential innovation that would make the entire sector more competitive driving a lot of consumer surplus to users of markets and away from producers.  Do they have a monopoly?  It all depends on where you draw the lines.  If you draw the lines narrowly you could conclude that they do.  If you draw them more broadly and look at international competition, and the full compliment of every derivative product known then they almost certainly do not have a monopoly.

Here is the problem.  Suppose you wanted to start a new clearinghouse today on the CFTC side of the market.  Initial startup cost is $100MM.  That’s out the door.  Mind you, you are building this on the come because there are exactly zero customers waiting to use your service.  Once it’s built, they will develop but that will take time as well.

It goes without saying that it will take lots of time for your new clearing operation to get through all the regulatory hurdles.  Figure at least one year if not more.

If we agree that our goal is to provide a free market system to more places so that people can get access to goods and services at a cheaper price with more production, then we need to find a way to increase competition in all areas of financial services.  Increased competition has to be balanced with ensuring that the marketplace remains stable and totally transparent.  There are 14,000 exchanges trading cryptocurrency and I can pretty much guarantee that their marketplaces wouldn’t meet the stable/transparent test.

I don’t favor forcing the four existing clearing operations to open up their clearinghouses SEC style to the market.  I do favor figuring out how to decrease the startup costs and eliminate the regulatory hurdles to opening up new clearinghouses.  I think that would be good for markets, good for citizens and great for innovation in finance.