Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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