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"Streetwise Professor" Craig Pirrong Critiques the Options Clearing Corporation's New Capital Plan (with Lofchie Comment)

In a blog post titled, "BATS in the OCC's Belfry? or The Perils of Natural Monopoly Regulation, CCP Edition," University of Houston finance professor Craig Pirrong discussed the dispute surrounding the Options Clearing Corporation ("OCC") new capital plan.

Pirrong states that BATS, other non-owner exchanges and market users are concerned that the capital plan "allows OCC's owners to 'monetize' the rents accruing to its status as the monopoly clearer for options transactions in the U.S." He explained that non-owner exchanges and market users believe that OCC will pay for dividends received from preferred stock by charging fees that will impair competition among exchanges and will burden market users.

Mr. Pirrong suggested that the situation would not likely be resolved in the near term because: (i) financial market utility pricing and governance is "inherently messy and controversial," and (ii) when it comes to capitalizing, allocating, and pricing the systemic risks that central clearing counterparties bear, the problem becomes even more complicated.

Lofchie Comment: Professor Pirrong's article focuses on the economics of the OCC. His observations have broad applicability to an increasing number of areas of financial services, particularly as Dodd-Frank imposes government-mandated structures on the provision of financial services. For example, Dodd-Frank mandates the central clearing of certain swaps. As to most (perhaps all) of the types of swaps that are centrally cleared, there will be a monopoly or near-monopoly clearing house (or at best a cartel) through which anyone wishing to trade in the relevant swap must transact.

Given the network benefits of trading through a clearing house with established volume, a monopoly power will be nearly impossible to challenge. Once a monopoly clearing house is established, a competitor will not be able to come in and win business on the basis of offering lower costs or better services. As a result, the clearing house, left to its own unregulated devices, would have the ability to: (i) charge high fees and (ii) undercapitalize itself from a risk standpoint. An important downside to mandated central clearing is that decisions of profitability and risk will be left in the hands of the government. It is ironic that the outcome of years of CFTC action intended to enhance competition in the swaps market may be simply to replace a dealer cartel with a clearing house cartel.

One cannot overlook the probability that such monopoly or cartel power may be extended to ancillary services such as trade reporting on swap data repositories (which are also mandated by Dodd-Frank). Clearing houses insist that such reporting be done through their captive SDRs and the CFTC has blessed this approach.

See: "BATS in the OCC's Belfry? or The Perils of Natural Monopoly Regulation, CCP Edition," by Craig Pirrong.

Body of Law: