Derivatives are financial instruments used to shift risks, such as fluctuations in interest rates or foreign exchange rates or changes in the value of assets such as stocks, bonds, metals, or agricultural or energy products. At first glance, entering into a derivative may appear to involve little more than contract drafting, negotiation, and execution. After all, each derivative amounts to an agreement providing for contingent payments between the counterparties, which are based on some referenced variable. In reality, however, entering into a derivative generally involves sophisticated financial market intermediaries that provide services subject to commercial considerations, regulation, market practice, and other constraints shaping the terms of transactions. Derivatives can be classified as either cleared or non-cleared, with the distinction relating to the intermediaries imposing collateral obligations and other credit-risk mitigants. This post presents the high levels of concentration in key areas of the derivatives industry, while a second post will explore a novel explanation for this level of concentration.
Cleared Derivatives
Clearing refers to a quasi-legal technology that addresses counterparty credit risk through use of a central counterparty, i.e., a clearinghouse. When a transaction is cleared, it is extinguished, and two new transactions — each identical to the first — are created. One of them is between the first party to the trade and a clearinghouse, and the second is between the clearinghouse and the second counterparty. As a result, parties to a cleared transaction pay amounts due under the transaction to the clearinghouse rather than each other. Irrespective of whether the clearinghouse receives payment due under a cleared trade from one counterparty, the clearinghouse must make an identical payment to the other counterparty. Thus the clearinghouse insulates counterparties to the initial trade from each other’s default risk.
In the U.S., the major clearinghouses are affiliated with major exchanges. Federal law requires that exchange-traded derivatives generally have to be cleared. This requirement covers all futures, most options, and a significant portion of swaps – the three types of derivatives. Federal law also makes it illegal to execute many derivatives contracts except through a regulated exchange; this mandate applies to all futures, many options, and a subset of swaps that are subject to the clearing requirement.
The alternative to executing a financial transaction through an exchange is turning to the over-the-counter (OTC) market. Without an exchange to aggregate supply and demand for a financial product, a party wishing to obtain a position in the relevant product would need to locate a source of liquidity. That requires identifying a market participant willing to enter into the desired contract on acceptable terms (including price). The primary OTC derivatives market is in swaps, which developed relatively recently and over 100 years after the futures market. The OTC market is discussed in the subsequent section.
Decades of commodity futures regulation was built on the centrality of exchanges and clearinghouses to derivatives transactions, and as an aside, it was this model that was imported to regulate swaps under the Dodd-Frank Act. Through regulatory fiat, exchanges serve as the providers of liquidity in these instruments. And clearinghouses serve to standardize credit risk, enabling fungibility as well as assuaging concerns related to default. Exchanges, clearinghouses, and a few other intermediaries serve as pressure points for regulation – formal gatekeepers tasked with regulating the stability and integrity of markets.
There are three dominant clearinghouses in the U.S. for derivatives trading on commodities: ICE, CME and LCH. ICE and CME are headquartered in the U.S., while LCH is based in London and primarily offers interest-rate swap clearing to U.S. customers.[1] All three offer clearing services, but some products are only cleared by one or two of the three.[2] All three have been designated as critical market infrastructure, and it is well understood that their failure could jeopardize our financial system and paralyze segments of our economy.
Clearinghouses are robustly regulated and take a number of measures to assure payments are made on the derivatives they clear. One of these measures is limiting clearing privileges to “clearing members” that satisfy eligibility criteria at admission and over the lifetime of their membership. These criteria are subject to minimum regulatory requirements. Notwithstanding screening and monitoring of clearing members, there are additional requirements imposed to assure payment on members’ cleared transactions. These include posting of margin (i.e., reliable collateral) to secure members’ obligations to the clearinghouse.
Limiting clearing (and thus trading) to those that meet clearing membership criteria raises the question as to how non-members enter into derivatives transactions that must be cleared – including all exchange executed transactions. The answer lies in the role of esoterically named “futures commission merchants,” which are clearing members that are authorized to clear on behalf of non-member clients.
A futures commission merchant (FCM) is a distinct type of derivatives market participant that stands between a clearinghouse and its customers. Customers use an FCM to clear their derivatives transactions; in other words, the FCM enters into cleared trades on behalf of its customers whose performance the FCM effectively guarantees. FCMs are subject to capital requirements and other extensive regulation. This regulation is primarily aimed at protecting clearinghouses from FCM failure and customers from FCM misconduct (e.g., misuse of collateral or customer information). A number of measures are used to assure FCMs do not default on obligations arising from their customers’ cleared trades. In addition to capital, a key measure is margin. FCMs must collect margin from their customers. And FCMs must post margin to the clearinghouse(s) where their customers’ trades are cleared. Figure 1 below illustrates an archetypal relationship between market participants, A and B, which seek to take opposing positions in a futures transaction executed through an exchange.
Figure 1: Execution and Clearing
As illustrated, clearing a derivative may create four (rather than just two) financial relationships: (i) obligations between Counterparty A and FCM 1, (ii) obligations between FCM 1 and the clearinghouse, (iii) obligations between the clearinghouse and FCM 2, and (iv) obligations between FCM 2 and Counterparty B.
As noted above, there are only three significant clearinghouses active in the U.S. and, for some products, fewer than that. There are benefits to concentration among clearinghouses, including efficiencies of scope and scale as well as regulatory advantages. But concentration of clearing also poses several potential concerns. First, ceteris paribus, the more derivatives flow through one clearinghouse, the greater the systemic risk from failure at that clearinghouse. Second, concentration enables coordination and monopoly pricing. Finally, lack of competition promotes quasi-corrupt relationships between clearinghouses and regulators (e.g., legislators and agencies). Political patronage is left uncontested where there are effectively two national champions, which moreover do not overlap in some of their product offerings. This is likely to contribute to deference on the part of the CFTC to the clearinghouses as organs of market regulation. Dependence on the major clearinghouses may lead to inefficient rules (e.g., excessive mandates to clear products to help clearinghouses grow revenue), supervision (e.g., reluctance on the part of CFTC personnel to advocate for changes in clearinghouse operations), or enforcement (e.g., failures to promptly bring public actions in response to suspected violations). While clearinghouse concentration is not necessarily adverse and its ill effects may be managed without introducing new entrants, understanding the factors that contribute to concentration is of interest.
Concentration is not just an issue among clearinghouses. Consolidation is also taking place among FCMs. As introduced above, a party to a cleared transaction must enter into a clearing arrangement with an FCM unless that party is itself a member of the relevant clearinghouse. Becoming and remaining an FCM is onerous, and the overwhelming majority of traders in derivatives markets clear through an FCM rather than themselves become clearing members. The number of FCMs in the U.S. has been steadily declining, as reflected in Figure 2 below.[3]
Figure 2 Registered FCMs 2002-2023
The decline in FCMs has prompted bipartisan concern. Like the lack of choices among clearinghouses, the erosion of FCM alternatives theoretically poses both systemic risk and ordinary consumer-interest concerns. CFTC Commissioner Berkovitz identified the reduction in the number of FCMs as limiting options for commercial hedgers. Additionally, if there are fewer FCMs and those that operate are larger, the failure of one FCM may be more difficult to absorb. That is because at the time of a clearing member’s failure, a larger portfolio of cleared trades will have to be transferred to other clearing members.
Finance and business school scholars have noted the decline and the level of consolidation;[4] the top eight FCMs hold over 70 percent of the posted futures margin, suggesting they service the vast majority of customer activity at least in futures. My recent article adds to the analysis. As will be covered in a subsequent post, I propose a new explanation for the high level of concentration among derivatives intermediaries. I explain not only the level of concentration, but also document and explain the lack of new entry. Through comprehensively analyzing data on FCM registrations, capital and margin levels, I find that there have been 63 new entities that began operating as FCMs since 2002. Of the 63 new entrants that began to clear customer trades, 40 crossed into the top 50 percent of FCMs based on relative futures customer margin (including in the denominator those with zero customer margin). To emphasize, these rankings are ordinal and not cardinal; in other words they do not account for how much more collateral firms at the top end of the range hold than those lower down. Being in the top 50 percent of firms based on customer margin is not that great of an achievement both because a large number of firms have zero customer collateral and because a handful or two of firms at the top end clear the great majority of transactions. Thus the analysis is conservative, overstating the success of new entrants. Of all new entrants, the only ones to enter the top 20 percent are entities formed by large financial institutions that already had an FCM.[5] Primarily these were major non-U.S. financial institutions reorganizing or expanding their U.S. based business. For over two decades – during a time of extraordinary technological innovation – there have been no examples of starting a commodity futures clearing business from scratch and attracting substantial customer interest.
Non-Cleared Derivatives
While all futures transactions and most options within the U.S. are executed on regulated exchanges and cleared, a range of swaps may be executed OTC. A core part of the Dodd Frank Act forced the clearing of interest rate and index credit default swaps. Of these, a subset are required to be executed through exchanges. However, some swaps are not subject to clearing requirements and, even for categories of swaps subject to clearing requirements, exemptions exist such as for commercial hedging. For these transactions, the credit risk of the counterparty is relevant to the trade. And furthermore, non-cleared transactions are — by their form — ineligible for anonymous exchange trading. This is because the price and other terms of an uncleared transaction will depend on the credit risk the counterparty poses – a risk that is impossible to determine when trading anonymously through an exchange order book.
Rather than sourcing liquidity from an exchange, a party wishing to enter into an uncleared swap will turn to a swap dealer. Swap dealers are critical intermediaries for the OTC market, filling in for exchanges and, with respect to uncleared swaps, clearinghouses. Many swap dealers are affiliates of large banks and thus subject to the myriad prudential regulations imposed on bank holding-company affiliates. The CFTC independently regulates swap dealers, including with respect to margin and capital if the swap dealer is not subject to banking regulation in these regards.
Like the FCM industry, the swap dealer industry is concentrated. The CFTC publishes a list of all registered swap dealers, and there are 106 registered swap dealers in the U.S.[6] However, many of the registered dealers are affiliates of one another, with large financial institutions having multiple affiliates registered as swap dealers. There are no more than about 70 distinct institutions providing swap dealing services. As with FCMs, many represent major financial institutions from outside the U.S. that are important inter-jurisdictional links for offering access to financial products. Because some of the dealers are registered to serve limited product or customer needs, the number of registrants overstates competition within specific product markets. This is similar to the observations made with respect to clearinghouses and FCMs above: The number of intermediaries may understate concentration due to specialization in certain products but not others. Moreover, although registered swap dealers tend to be parts of major financial institutions, just a handful tend to control most major markets. For example, Office of the Comptroller of the Currency data show that over 90 percent of U.S. swaps entered into by a financial institution that has a bank affiliate include JPMorgan Chase, Goldman Sachs, Citibank, or Bank of America as a counterparty.[7]
Again, concentration has identifiable benefits, including efficiency benefits that may be passed on to swap-dealers’ customers as well as the creation of discrete, manageable nodes for regulation. But concentration among swap dealers also poses concerns similar to concentration among FCMs. First, there are issues as to the quality and pricing of services. Swap dealers in particular have been implicated in a series of price fixing scandals, showing that small sets of financial institutions not only can but do collude.[8] In developing rules governing swap dealers, the CFTC has been conscious of the risk of driving smaller swap dealers out of the market to the detriment of customers that have niche or less frequent trading demands. In addition to the traditional antitrust focus on consumer protection, swap dealers implicate concerns with systemic risk. Swap markets are highly interconnected, with swap dealers entering into offsetting transactions to avoid warehousing risk. And swap dealers tend to be parts of massive financial institutions. As a result, the failure of a swap dealer may go beyond its customers and other counterparties, undermining financial stability.
Conclusion
Derivatives are unlike stocks, bonds, loans, and other common financial instruments. The market risk related to a derivative contract is unrelated to its credit risk because the underlying variable tends to be unrelated to the counterparties. For example, while a corporation issuing a share is also the source of risk related to the share, parties to a futures contract tracking corn price or interest rate fluctuations are unrelated to that market risk. This follows naturally from some instruments being used to raise capital, while derivatives are generally used to manage risk. There are additional distinctions between derivatives and most other financial instruments. It takes vastly longer to settle a derivatives contract than a transaction in shares, bonds, loans, etc. because a derivative can stay outstanding for months or years, whereas the latter settle in a couple of days. And finally, either party to a derivative can be the payor or payee – whereas with a share, bond, loan, etc., only the capital recipient will be the payor. Because of these unique features, credit support as well as related market infrastructure differ in important ways for derivative transactions and tend to be far more sophisticated. This post follows the two approaches to credit support used in derivatives markets – trading on a cleared and uncleared basis – to present key intermediaries and levels of concentration among them. The next post will examine a novel explanation for that concentration, which emerges from the intersection of legal regimes and statistical properties governing portfolios of derivatives.
ENDNOTES
[1] There are a handful of other notable clearinghouses that serve non-U.S. markets. Additionally, there is the Options Clearing Corporation. However, because the OCC services a relatively narrow range of securities-based products for which it generally does not compete with LCH, CME, or ICE, OCC does not affect this discussion.
[2] For example, only ICE clears credit default swaps, only CME and LCH clear interest rate swaps, and only CME and ICE clear futures.
[3] This graph collects publicly available data on FCMs that the CFTC has published monthly since 2002 and expanded over the years. The data are available from me upon request, and the data can be independently obtained here: https://www.cftc.gov/MarketReports/financialfcmdata/index.htm.
[4] Ekaterina E. Emm, Gerald D. Gay and Mo Shen, Futures Commission Merchants, Customer Funds and Capital Requirements: An Organizational Analysis of the Futures Industry, 18 J. Commodity Mkts. 1 (June 2020).
[5] The only FCMs to cross into the top 20 percent of FCMs by futures or options activity, as measured by volume, were created by the following well known financial institutions in order from relatively least to relatively most succesful: (1) BNP Paribas; (2) Enskilda; (3) Abbey National; (4) Macquarie; (5) Bank of America; (6) Prudential; and (7) Societe Generale.
[6] https://www.cftc.gov/LawRegulation/DoddFrankAct/registerswapdealer.html
[7] Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities at 33 (December 2023).
[8] See Gregory Scopino, Expanding the Reach of the Commodity Exchange Act’s Antitrust Considerations, 45 Hofstra L. Rev. 573 (2016).
This post comes to us from Professor Ilya Beylin at Seton Hall Law School. It is based on his recent paper, “How Portfolio Netting Deters Diversification and Competition in the Derivatives Industry,” forthcoming in the University of Pennsylvania Journal of Business Law and available here.