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"Streetwise Professor" Craig Pirrong Discusses Developments in Clearing Business (with Lofchie Comment)

In a blog post titled "Hit the Road, State Street," University of Houston finance professor Craig Pirrong discussed the recent exit of smaller firms from the swaps clearing business and argued that the industry has become "highly concentrated and dominated by major dealers."

Professor Pirrong commented that State Street's announcement that it is exiting the swaps clearing business to "focus on trading other types of derivatives, particularly more traditional exchange-traded futures, that have not been subject to broad new regulations," is not surprising. Professor Pirrong had predicted that the Dodd-Frank-imposed regulations in the swap clearing business would increase scale economies, making the business so concentrated and connected that "only the truly huge can survive."

Professor Pirrong also asserted that the derivatives marketplace is now dominated by a small number of central clearing counterparties ("CCPs"), each of which is dominated by a small number of large bank-clearing members who are members of all of the major CCPs. He concluded that those who implemented Dodd-Frank did not understand "the economics of clearing, clearing firm scale and scope economies, and how the complicated regulatory structure the CFTC put in place exacerbated these scale economies."

Lofchie Comment: Ironically, under Dodd Frank, legislators who decried "too big to fail" have mandated a system that exacerbates the problem in two ways.

First, the central clearinghouses themselves are too big to fail, since the legislation forced a tremendous share of the derivatives business done in the United States (and potentially the world) through a few U.S. clearing corporations. Given that the government forced clearing in a manner in which there is no way for the U.S. markets to trade around the risk of the central clearing systems, and consequently, created a situation in which complete chaos would result in the financial markets if the clearing corporation failed, the clearing corporations can be assumed to be too big to fail.

The second problem, as pointed out by Professor Pirrong, is that not only are the clearing corporations too big to fail, but the clearing members that intermediate between the market and the clearing corporations also are too big to fail because of their massive scale. This scale results not from any wrongdoing on the part of the clearing members, but from the structure established by the regulators. That is, the regulators created a structure that (i) has massive fixed costs (a function of direct regulation and the technology required to comply with those regulations) and (ii) essentially is a "generic" service, meaning that there is no basis on which clearing parties can compete other than pricing. (To put this another way, a smaller competitor is not going to be able to beat a larger competitor by providing better or more personalized services at a price sufficiently high to compensate for its inability to achieve economies of scale. Even if the smaller competitor had the chance to win, making the attempt would be too risky.)

In short, before Dodd-Frank, we had an economic market in which there were many swap dealers trading on a bilateral basis with each other and with numerous other customers. We are moving toward a market in which there are likely to be far fewer swap dealers that will be required to clear through an even smaller number of clearing counterparties, which counterparties will funnel all of the United States' (and a good part of the world's) swap transactions into a handful of clearing corporations.

See: "Hit the Road, State Street," by Craig Pirrong.


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