Competition policy in the exchange industry
The globalization of the securities and derivatives industries, and their attendant client bases, has spawned a wave of reviews of exchange structure and regulation, notably in the United States and the European Union.
The evolving policy framework has focused on two main components: the harmonization of international rules governing exchange operations; and the structure of exchanges, notably whether the clearing business can be embedded within exchanges, or separated into independent or user-owned operations to protect and promote competition.
The creation of the first crossborder exchanges, notably NYSE Euronext, saw a tacit admission from regulators that oversight has failed to keep pace with industry development, leading to renewed efforts to improve harmonization and spawning initiatives such as the EU-US Coalition on Financial Regulation.
The focus of the structural debate has been on vertically-integrated exchanges such as Deutsche Börse - which has been targeted by a variety of European regulators and politicians - and the CME Group, with the US justice department proposing a review of clearing house ownership in early 2008.
Policy developments in the U.S. futures industry
Competition policy in the U.S. futures industry stems from the introduction of the Commodity Futures Modernization Act of 2000, which specifically provided the Commodity Futures Trading Commission with an anti-trust remit for the first time, while also expressing the wish of Congress to maintain the international competitiveness of the U.S. industry.
The first test of the policy came in the wake of the 2003 application from Eurex to establish the first overseas-controlled U.S. exchange, USFE, later known as Eurex US. The application was approved by the CFTC in February 2004 after substantial debate, and won support from the US Federal Trade Commission.
However, the failure of Eurex US to capture significant volumes spawned a lawsuit from the venture against the Chicago Mercantile Exchange and the Chicago Board of Trade, which formed a common clearing link and reacted against the competitive threat by cutting fees, spurred by another initiative from Euronext.Liffe to introduce competing currency contracts. Euronext.Liffe also filed suit against the CME.
The emergence of Eurex US also coincided with the creation of a common clearing link between the two exchanges, a move whose approval by regulators set the stage for both M&A policy and the reigniting debate over clearing.
M&A policy and ownership of clearinghouses
The first test of mergers and acquisitions policy in the U.S. futures sector arrived with the bid in October 2006 by the Chicago Mercantile Exchange for the Chicago Board of Trade. Though the Department of Justice ultimately cleared the deal in June 2007, a comment letter sent to the U.S. Treasury on January 31, 2008, signed by anti-trust chief Thomas Barnett, called for a review of the current market structure and questioned whether clearing services should be owned by exchanges.
The DoJ submission focuses on interest-rate contracts, and its timing and contents prompted a firm call from the CME - the dominant U.S. futures clearer - to retain the status quo. Other regulators, notably CFTC commissioner Bart Chilton have raised questions over the objectives and timing of the DoJ move, which has also spawned criticism from academics.
The DoJ subsequently insisted it was only seeking a review of the regulatory structure, rather than pushing for a separation of trading and clearing.
The DoJ submission came despite its approval of the agreed CME offer for the CBOT following a two-stage probe into the impact on pricing, product innovation and barriers to market entry.
The Chicago exchanges argued the deal would not impact competition, and maintained that their common clearing link provided market efficiencies and cost savings for clients. However, some users and critics – including the Futures Industry Association - said control of more than 90 percent of exchange-traded futures in the U.S. provided the enlarged exchange with pricing power which could be detrimental to competition. The Intercontinental Exchange, which launched a rival offer for the CBOT, also argued during an ultimately unsuccessful bid that its proposal contained fewer antitrust concerns.
The DoJ approved the deal on June 11, 2007 without any conditions, saying neither the deal nor an existing clearing joint venture was likely to "reduce competition substantially", or impact innovation or barriers to entry.
However, the DoJ subsequently insisted its clearance and the issue of industry structure were separate.
Policy developments in the EU
The policy debate in Europe is more advanced than in the U.S., with attacks on the ownership of clearinghouses by some exchanges – such as Deutsche Börse and Borsa Italiana - fuelling calls for an end to the vertically-integrated model for securities and derivatives trading.
After more than two years of debate, the European Commission introduced a voluntary code of conduct in July 2007, monitoring the exchanges with the proviso that it will revisit the issue if it finds competition policy is being breached by silo operators.
The Commission started its review of “vertical silo” ownership of trading, clearing and settlement by exchanges in July 2005.
The move ran parallel to the consideration of Deutsche Börse's prospective bid for the London Stock Exchange conducted by the UK Competition Commission, which ruled in July 2006 that its approval was contingent on the sale of clearinghouses, or opening its platform to other clearers.
The issue continued to bubble, with industry groups calling in January 2006 for the break up of silos . It continued during Deutsche Börse’s unsuccessful bid for Euronext in May 2006 when Thierry Breton, then the French finance minister, said vertically-integrated exchanges were "not appropriate at the European level".
In July 2007, Charles McCreevy, the competition commissioner, stopped short of ordering any break-up of exchanges and launched a code of conduct, with a monitoring group consisting of officials from various Commission departments, the European Central Bank and the Committee of European Securities Regulators. In August 2007, LCH.Clearnet launched the first test of the code when it formally requested that Deutsche Börse and Borsa Italiana provide it with an electronic link letting it clear share trades executed on their platforms".
Mifid, the new EU directive governing the financial services sector, does not as yet apply to the derivatives business.
The CFTC and the UK Financial Services Authority signed a Memorandum Of Understanding in November 2006 concerning consultation, cooperation and the exchange of information related to market oversight.
Other international developments
The smaller scale and fragmentation of securities and derivatives markets outside Europe and the US has seen consolidation and, in some cases, the creation of "national champions" prevail over any lingering concerns about vertical integration.
This process now sees the vast majority of derivatives exchanges owning or controlling their own clearing operations, and the trend towards vertical integration saw the bank-owned SWX Swiss Exchange merge with the bank-controlled SIS clearing operation in early 2008.
Japan is one of the few jurisdictions where derivatives clearing has been structured as a utility. The Japan Securities Clearing Corporation clears transactions for the Tokyo Stock Exchange - which holds a 86.3 percent stake - and five other exchanges.
- DoJ statement approving CME-CBOT combination
- DoJ Comment Letter - Review of the Regulatory Structure Associated With Financial Institutions
- Response to DoJ letter from Sen. Dick Durbin and Rep. Rahm Emmanuel
- Commodity Exchanges and Antitrust by Andrew N. Kleit and James M. Falvey
- Common Clearing Revisited by John P. Davidson III
- Regulating Price Discovery and Conflicts of Interest in a Multi-Operator Financial Market Australian Securities Exchange
- Transatlantic regulatory harmony in the air. Financial Times.
- Approval letter. CFTC.
- Press release. FTC.
- DoJ challenges ownership of clearinghouses. Financial Times.
- Press release. CME.
- Blog. Craig Pirrong, University of Houston.
- US: No new CME scrutiny. Chicago Tribune.
- CME-CBOT deal faces increased scrutiny. Financial Times.
- Opponents of all-Chicago deal find case has backfired. Financial Times.
- CME_CBOT deal gets anti-trust approval. Financial Times.
- Press release. DoJ.
- Europe to investigate silo trades. Financial Times.
- Call for end to European silos. Financial Times.
- Call for end to European silos. Financial Times.
- Euronext and Deutsche Börse clash over silos. Financial Times.
- Brussels optimistic over code of conduct. Financial Times.
- LCH.Clearnet launches appeal for bourses. Financial Times.
- Press release. CFTC.