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Derivatives Reforms: Breaking Another Market

It's time to wonder if the decades long war by the government that has allegedly been waged in favor of making financial products and services more competitive might have been a mistake.

Time after time the government has intervened in practices that it has deemed anti-competitive. This happened in the 1970s, when the government effectively got the New York Stock Exchange to abolish fixed trading commissions. It happened in the 1990s, when the government cracked down on NASDAQ market makers. In 2002, corporate bond trading went onto "screens" on the TRACE system after years of pressure from securities regulators.

The buyers and sellers, especially ordinary investors and institutional investors such as pension and endowment funds, were supposed to benefit from these government initiated changes.

Each transformation had large and unintended consequences. As a result of the loss of fixed commissions, Wall Street consolidated and several firms went public. Fixed income trading became far more important than it had been. The crackdown on NASDAQ market makers was followed by the dot com boom and bust. The push into TRACE incentivized credit traders to emphasize less transparent derivatives.

It's far from clear that the gains from these government interventions outweigh the costs.

Now that the attention is being focused on derivatives trading, I have to ask: are we making the same mistakes again?

When you make trading of financial instruments open and competitive, it becomes less profitable for dealers and banks. This happened in 1975 with stock broking and in 2002 with corporate bond trading, and in both cases broker-dealers lost billions of dollars as aggressive price cutters entered the market and commissions shrunk. It was good news for buyers and sellers, but bad news for banks.

So what about derivatives trading, the biggest and most profitable market by far on Wall Street? You will be un-surprised to learn that big banks have never been keen on the prospect of putting derivatives trading into a clearinghouse and requiring that prices be made public. They much prefer the current system, in which a small number of banks control the entire market and neither buyers nor sellers have any idea exactly what commissions they're paying when they purchase derivative contracts.

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