Bloomberg (my underline):
Revenue at JPMorgan Chase & Co., the second-largest U.S. bank, may drop by as much as $3 billion should most derivatives trades be moved to exchanges, a Sanford C. Bernstein & Co. analyst said…
Derivatives traders profit from the so-called bid-ask spread, the gap between what they charge customers and what they pay to hedge the trades. They can charge more on derivatives that aren’t actively traded, are customized or considered riskier. The more actively traded the contracts become and the more transparent prices get, the narrower the spread.
“You’re able to drive more bid-ask income through because of the fact that you have a certain financing relationship,” Yelvington said in an interview today. “If the product moves to an exchange, your financing flexibility is hampered.”
Of the giant over-the-counter derivatives market For all U.S. Commercial Banks dealing with OTC derivatives contracts, 97% of the notional amount of contracts is handled by 5 dealers, 4 of whom were TARP recipients (1. JPMorgan Chase, 2. Goldman Sachs, 3. Bank of America, 4. Citibank, 5. HSBC.) I’m going to keep repeating this statistic, since I think it clearly illustrates part of the problem in this market. The firms handling this market certainly look like they have market power to get larger spreads than they would normally (Bloomberg more or less says as such there). And part of the reason they can justify these spreads is because prices aren’t transparent, and they have an implicit Too Big To Fail guarantee on the counterparty risks now.
The presence of malign market power gets a boost when you consider statements like: “Trading in some of the over-the-counter derivatives widely blamed for aggravating the financial crisis is likely to surge if legislators press ahead as expected with proposed reforms, according to Icap, the world’s largest interdealer broker.” Icap isn’t a neutral agent, and they are talking about clearing and I’m talking about clearing+exchanges, but I think the analysis holds – prices will decline, and volume will increase. Economics 101 fans will remember the problem with an oligopoly is that too little is produced, and it costs too much.
Going back to the price mechanism, the reform of having an exchange for as many instruments as possible will get the price mechanism out to as many people as possible. Certainly, with influence and cash there are ways for connected people to get large amounts of this information – but the greater the transparency, the easier it is for more people to make informed decisions. I think this price transparency is key for an educated general audience who may not know the ins and outs of finance. Keeping prices opaque, and not transparent, is a selling point of the current market structure. Let’s contrast two opinions. Vince Lanci (my underline):
What OTC Venues Offer…But the OTC execution model offers value despite the outcries of its detractors….minimal information leakage…the longer a large order rests in the market, the more potential for competitors to move the price away from the clients order price. Good OTC brokers use discretion and one-price liquidity to minimize this problem.
Interesting, because last time I checked, that ‘information leakage’ was one of the major selling points of a market economy. Here’s Friedrich Hayek, The Use of Knowledge in Society:
The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity—or rather that local prices are connected in a manner determined by the cost of transport, etc.—brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process….The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.
There are ways that certain types of exchange orders get nailed (especially in the days of HFT), but the solution isn’t just to keep prices hidden within the books of the largest firms, and not doing their job for the larger market.
So there’s a choice in this market structure in how we’ll set it up. We can set up structures that emphasize transparency versus opaqueness, and structures that emphasize many firms competing, versus a few large market participants where each firm is a giant internal market, with mechanisms of counterparty risks and prices unable to be seen by the public at large. Keep these in mind as I do my best to walk you through OTC Reform 101 next week at this blog.