Debating the Lynch Amendment

by: Rortybomb

Economics of Contempt has a post up where he called the Lynch Amendment, an amendment which would limit the ownership of clearinghouses and exchange for major swap dealers at 20%, and which I wrote in favor of in this post, “Bizarre and Confused”:

Why on earth would we want to discourage the dealer banks—who, for better or worse, are the only ones capable of being market-makers in OTC derivatives—from mutualizing losses? That’s what the Lynch amendment would do. The clearing members are the ones who are ultimately on the hook for a default in a clearinghouse model, so of course they’re going to want to have a say in the kinds of contracts the clearinghouse accepts, and in the clearinghouse’s risk management practices. A dealer is unlikely to trade through a clearinghouse if it’s prohibited by law from having a say in the kinds of contracts that it—as a clearing member—is being put on the hook for. Clearing members should have a say in those kinds of matters—it’s exactly the kind of aligning of economic interests that we’re looking for!

Take a second and read that quote. It’s saying that of course we want the largest swap dealers having a say in what kind of trades go through a clearinghouse and what kind of trades will be pushed back onto the OTC market. It’s an excellent alignment of economic interests, what could possible go wrong?

Po-po

Well, here’s one thing. Bloomberg, Aug 3rd (my underline):

Markit Group Ltd., the data provider majority-owned by Wall Street’s largest banks, is under Justice Department scrutiny for potential anticompetitive practices ranging from requiring customers to buy bundled services to restricting which trades can be cleared in the $26 trillion credit-default swap market.

Markit told a swaps clearinghouse customer to purchase a pricing service as a condition for granting use of its benchmark indexes, said a person with knowledge of the transactions. Markit permitted use of its indexes by another clearinghouse only if every swap guaranteed by the company included a dealer, such as one of its owners, said other people familiar with those negotiations.

“That’s a legitimate area of inquiry,” said Evan Stewart, a partner at Zuckerman Spaeder LLP in New York who has practiced antitrust law for more than 30 years and isn’t involved in the case. “If you want to get into the market with Markit with access to real-time prices, this is where you have to play,” he said. “You don’t have a supermarket of other choices.”

Right now the Department of Justice is investigating the largest players in the derivatives market for anticompetitive practices, one of which is manipulating which types of instruments can clear in a clearinghouse.

To put it a different way, opponents of full financial reform are saying that the a few concentrated market players can be trusted to not manipulate the clearinghouses at exactly the same moment as a few concentrated market players are being investigated by the Department of Justice for manipulating the clearinghouses. Change we can believe in!

I know what the retort is. “Mike, you know that po-po is always fucking with a working man who is just trying to hustle some (financial) product on the corner to feed his kids.” I’m sympathetic to critiques of “po-po” myself. But this was the point of the recent Slate piece on the Lynch Amendment; giving the largest players a legal ability to sit together in the same room and make rules for trading and clearing swaps at the same exact moment they are being investigated for a conspiracy to do that is a terrible idea.

More generally, EoC has very little use for exchanges or swap execution facilities. He believes that if 7-8 major players sit down and report a price that takes place if a trade takes place is enough price discovery. I think having prices at which multiple parties would be willing to trade at a moment in time is far more important. With technology and financial innovation, this will cut into lucrative spreads enjoyed by the biggest banks, hence their completely rational interest in not seeing it go through. I wrote out my arguments for why exchanges and swap execution facilities are better than simply clearing in the previous entry.

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