Some Further Thoughts on the NYT and Derivatives

Dec.13.10 | About: The Bank (BK)

One of the sob stories in yesterday’s New York Times piece is that the incumbent dealers froze Bank of New York Mellon (NYSE:BK) out from membership in ICE Trust, a CCP for CDS. The CEO of BNY Mellon Clearing is quoted as saying, “We are not a nobody.”

Which raises the question: Given BNY Mellon’s non-nobodiness status, if OTC derivatives trading is so obscenely profitable, why didn’t that bank (and others) endeavor to get a bigger piece of those profits and increase the scope of its business in competition with the major dealers? What was the entry barrier that prevented that? I’m not saying there wasn’t one, just that nobody has come up with a credible answer as to what it is or was.

To put things in perspective, BNYM is seventh among US banks (that’s just US banks) in overall derivatives positions. It is dwarfed by the big five; in terms of overall notional, in billions, per OCC data, the rankings are: JP Morgan (NYSE:JPM) ($75253); Bank of America (NYSE:BAC) ($48520); Citi (NYSE:C) ($45991); Goldman (NYSE:GS) ($42087); HSBC (HBC) ($3683); Wells Fargo (NYSE:WFC) ($3612); BNY Mellon ($1457). In terms of CDS, which is really what is relevant in any discussion of ICE Trust, the numbers are (in the same order): $5355; $4694; $2397; $499; $759; $126; $0.7. Yes, $0.7 for BNY.

And even this comparison is misleading, because (a) it covers only U.S. banks; (b) not all of the U.S. derivatives dealers do all their business through a bank; and (c) there are other firms in CDS that rank above BNY Mellon, including: PNC (NYSE:PNC), Suntrust (NYSE:STI), US Bank NA, Keybank, Fifth Third (NASDAQ:FITB), RBS Citizens, Morgan Stanley Bank, Deutsche Bank Americas, and Huntington Bank.

That disparity speaks volumes. As I’ve said before, and as has been noted in other contexts in the economic literature, cooperative organizations work better and can be governed more efficiently when the members are homogeneous. BNY Mellon is a very different animal than the members of ICE Trust. Moreover, is it really credible that the major dealers were so afraid of competition from the bank with the 17th largest CDS book among U.S. banks, with an outstanding position that was rounding error as compared to the other ICE Trust members, that anti-competitive exclusion was the true motive for keeping out Bank of New York Mellon?

Note to Times reporter Louise Story: Data is our friend. Further note to Louise Story (forwarded from George Stigler’s ghost): the plural of “anecdote” is not “data.”

Next thought. There is a tension between the dominant narratives involving OTC derivatives. The one narrative is that there is an evil cabal of bankers that exercises market power and keeps prices (spreads) at supercompetitive levels; this would suppress output. In this narrative, regulators should take measures that increase competition, and thereby increase output. The other narrative is that OTC derivatives markets are too big, thereby posing a systemic risk, and that output should shrink.

This sounds like Alice in Wonderland. One pill makes you too big. The other pill makes you too small. Which is it? Are the markets too big or too small? Which pill did they take?

If you really think that the OTC derivatives markets are too big because of systemic risks, on second-best grounds you should favor reducing competition and enhancing market power. You should rejoice that a dealer cabal restricts output. (You should rejoice on other grounds too; high profits lead to higher capital -- to the extent it isn’t paid out in bonuses and dividends -- and hence less systemic risk.)

So: Pick your poison (or your pill, as you like).