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Neal Wolkoff

Wolkoff Consulting Services, LLC

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Neal Wolkoff

21 February 2013

DTCC vs. CME: A Battle Between Competition and Regulation?

In determining whether the CME can use the ‘closed access’ model of the futures markets for swaps trades, the CFTC seemingly must weigh the benefits of competition against the need to protect investors. Unfortunately for DTCC’s position, the anti-competitive issues that it raises have little, if any, bearing on the well-being of customers in the derivatives markets.

Two financial industry heavyweights -- the CME Group and the Depository Trust & Clearing Corp. -- are in a war over the seemingly mundane topic of derivatives data storage. While the subject matter sounds unremarkable, the fight shows the difficulty the CFTC faces in bringing competition to the swaps markets when a less competitive model from the listed futures world offers a better regulatory tool. The collision between the Dodd-Frank model of “open access” swaps markets and “closed access” futures markets presents a stark choice for regulators: Enhance market competition or regulate the derivatives markets in the best way possible.

Although Title VII of Dodd-Frank specifically directs that the trading and clearing of swaps be done in an “open access,” or fully competitive model, Congress and the CFTC have also chosen time and again to retain a “closed access” model for listed futures, and they have done so with a complete understanding of the limits their choices place on competition. Dodd-Frank did not specifically extend the “open access” provisions to Swaps Data Repository (SDR) services, and it did not condition or limit a “closed access” market participant from using its futures-related assets to build a successful “open access” market to trade or clear swaps. As such, CME is assertively seeking to take advantage of the benefits its traditional marketplace can bring to its success in the swaps markets.

DTCC characterizes that assertiveness as impermissible anticompetitive behavior, in effect imprinting the “closed” practices from the futures world onto the new “open access” market structure for swaps. DTCC, in its letter to the CFTC opposing the CME’s proposed Rule 1001 -- which ties the choice of using CME’s Swaps Data Repository to the decision to use CME’s clearinghouse for a swaps trade -- dramatically describes its position as protecting “the integrity of the Dodd-Frank Wall Street Reform and Consumer Protection Act’s (‘Dodd-Frank Act’) primary objectives.”

[Related:Behind the Lines of the Dodd-Frank Reporting Wars”]

The dispute over data storage raises a number of questions about whether non-competitive practices long associated with the futures industry can also become a feature of the OTC derivatives space as well. The answer seems to be yes, as traditional restrictions on anti-competitive business practices meet a complex new market structure. Given a wide-ranging statutory scheme such as Title VII of Dodd-Frank, which is enforced by a fully empowered regulator -- the CFTC -- the regulator will decide competition issues in light of how they impact the regulation of the markets and the safety of the investing public. Competition concerns will not stand on their own in a black-and-white determination of whether a new practice will be allowed in the absence of a statutory mandate.

In the interest rate space, CME will likely clear the large majority of swaps due to the benefits its customers will receive from margining their swaps alongside CME’s pool of listed futures. Language in the proposed rule, which requires approval by the CFTC, gives a customer discretion to ask the CME to forward the same proprietary swap information to another SDR; but the rule is silent about whether a customer that requests its data be moved will incur extra costs in doing so, and thus be deterred from asking.

In the murky waters around competition in the derivatives space, the CFTC faces two questions in deciding on Rule 1001: (1) Can the CFTC better regulate the markets where most data -- at least for interest rate futures and swaps -- is retained by a single entity, in this case the CME? And (2), can CME’s cost structure be designed to protect users of its clearing services from being disadvantaged by using the data sharing arrangement called for by Rule 1001?

Competition among SDRs is subordinated in Dodd-Frank to regulatory interests. In the case of SDR regulation, Dodd-Frank empowers the CFTC to fashion rules as it sees fit to meet its regulatory burden. The statute even empowers the Commission to force any or all SDRs to report their data into a centralized SDR, should that help it better regulate the markets (7 USC §24a(a)(c)(4)(a)). It is almost inconceivable that the Commission would not be better off in fulfilling its regulatory duties with a more concentrated deposit of swaps data than a more dispersed one, especially given the weak customer concerns in maintaining robust competition in data storage.

Unfortunately for DTCC’s position, the anti-competitive issues that it raises are not particularly strong in the SDR context. DTCC’s argument over data storage is a fight between competitors and their allies over issues that have little, if any, bearing on the well-being of customers in the derivatives markets. Derivative customers have no commercial interest in where their data is stored for review by the CFTC, other than how much storage will cost at any particular SDR. In contrast, customers have strong interests in choosing one SEF over another, or one DCO over another, because execution and clearing services are integral components of what makes a trade successful or not.

As to the issue of cost -- which is the only customer interest at stake in this decision -- the CFTC could easily mitigate such concerns in order to obtain a better regulatory result by conditioning Rule 1001 on the CME waiving any fee it charges for SDR services, including transfer of data, to a customer requesting a transfer. (To glimpse the type of power that regulators have in controlling fees to maintain a “fair and orderly” market, consider the SEC’s imposition of a fee cap of 30¢ on exchange fees in securities markets.)

DTCC has direct experience from its recent past in a conflict between competitive concerns and regulatory interests. In the situation in mind, DTCC (through its subsidiary FICC) received SEC approval to partner exclusively with a single exchange to offer collateral reductions for that exchange’s futures contracts when offset by U.S. Treasury Securities held in DTCC’s utility clearing business. The SEC allowed DTCC to move forward because it saw a regulatory benefit, notwithstanding the anticompetitive issues. (ELX, of which I was then CEO, vigorously opposed DTCC’s proposed rules in that venture). Regulatory interests -- even when not compelling -- can overcome competitive concerns where markets are subject to a regulatory agency’s oversight under broad statutory powers, as is the case with swaps regulation. The CFTC, like the SEC,has the same opportunity to evaluate this case on the merits of what is best for the market -- more aggregation of data in fewer SDRs, or more fragmented availability of data in more SDRs.

In its role as the market regulator, the CFTC’s main focus will be on whether Rule 1001 will enhance its ability to act upon trade and position information for the benefit of the public.DTCC’s anti-competitive concerns are indeed substantive, but they will not be evaluated in a vacuum. Rather, they will be decided, and likely disposed of, in light of regulatory interests, the relative lack of customer harm, as well as moving the pace of Dodd-Frank regulation forward in a sensible and effective way.

Neal L. Wolkoff was formerly the Chairman and CEO of the American Stock Exchange, COO of the New York Mercantile Exchange, and CEO of ELX Futures, L.P. He is currently an independent consultant and Of Counsel with the law firm Richardson & Patel.

Spotlight-white-trans For more stories in the OTC Derivatives Reform Spotlight Series click here.

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5 Comments to "DTCC vs. CME: A Battle Between Competition and Regulation?":
  • Anon_avatar
    Anonymous

    22 February 2013

    Interesting analysis Neal.

    Do you see any difference between the DTCC use of its "utility clearing" pool to support a single exchange where that exchange was a new entrant (hence trying to bring increased competition) vs. the CME seeking to defend/extend an existing incumbent position?

    Also, should CFTC/others be obliged to consider , having established a new regulatory mandate such as the use of STRs, whether they have a responsibility to avoid such mandates leading to the entrenchment/extension of an incumbent's position?

  • Missing
    Neal L. Wolkoff

    22 February 2013

    Those are excellent questions.  Regarding the approval of DTCC's role with NYPC, had the regulator providing the approval been the CFTC then futures opening the market to greater competition might have been a worthy interest.  But the approval was given by the SEC, and while the SEC would not want to discourage one of its registrants from entering a new business, it does not have as its mandate increasing competition in the futures markets, so I am not sure he motivation was to further a new futures market entrant.  

    The second question about acting to avoid entrenching an existing market participant raises a very good and interesting consideration.  First, the CME's competitive strength in swaps rests on its position as the clearinghouse for the vast majority of the open interest in (interest rate) futures.  I question whether SDR services adds much to its position in being the clearer of choice.  Nonetheless, as you say, the CFTC may take competition into account in making its decision.  However, the CFTC may also give secondary consideration to competition issues if it finds that it's regulatory interests are furthered by a different decision.  

    Thank you for your comment.  I think the competition issues inform many of the regulatory issues in Dodd Frank, and your comment indeed shows a strong understanding of the tensions by having a mix of open and closed access derivatives markets.

  • Missing
    John Harris

    22 February 2013

    Good article, Mr. Wolkoff - thank you. You shed helpful light on an untenable conflict - that between "regulatory" and competitive interests. To the extent CFTC or SEC operate as if they have regulatory interests apart from competitive interests, they act as masters, not servants. Their sole interest should be to promote competition, while protecting market participants against fraud, theft, and trespass.

    I do not mean to suggest that these agencies should intervene in the natural course of the market. If the market prefers to have a single provider of a given good or service, be it clearing, order matching, or what you have you, so be it. As Steve Wunsch argues so effectively, monopolies may arise naturally from the desire by consumers to enjoy network economies. These are good monopolies and should be left alone - even they are not permanent and will some day yield to other arrangements that better satisfy consumers.

    But by regulatory interests you really mean "agency convenience," and, sorry, that is not a fit standard for agency intervention in the marketplace. Were we to consider solely agency convenience, then regulators would foment monopolies and impede innovation to the detriment of the very people they supposedly exist to serve. After all, what could be more convenient for a regulator to regulate than a single firm lacking any incentive to change?

  • Comment_reg_pritchard_rights_management_associates_limited
    reg_pritchard

    22 February 2013

    Potential conflict between competitive concerns and "regulatory interests" can also be seen in Europe where the latest MiFIR draft proposes that the EU Commission procure a “single commercial solution” (i.e. government-spnsored monopoly) for the provision of a Consolidated Tape that “will not prevent others from providing market data services“. As I understand it, the EU competition and securities regulators report to a different Commissioner.  Making this proposal work could keep them busy for a long time. Mr Harris's comments could not be more relevant.

  • Missing
    Neal L. Wolkoff

    22 February 2013

    I think Mr. Harris makes an excellent point about needing to make sure that regulatory decisions are not made for the sake of "convenience" but for a real public benefit, and that regulator's decide matters because their decision results in the greatest public benefit.  Thank you for that comment - I think it is an important point you make.

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