Wider and Direct Access to Financial Market Infrastructure Is the Next Step for a More Competitive Financial Market

The potential impact of Europe’s revised Payment Services Directive, known as PSD2, should not be underestimated, as banks adapt to a flatter and more competitive landscape.

 

 

 

The EU’s PSD2 is a major development in payments and financial market infrastructure, a once-sleepy “back-office” function that is now alive and kicking. The essence of PSD2 is to encourage competition and reduce the information advantages of incumbent banks. Likewise, the Bank of England announced in July 2017 that non-bank payment service providers can become direct settlement participants in the UK’s payment system, as long as certain requirements are met.

 

Access to financial market infrastructure such as payment systems has important implications for market competition. The study of industrial organization shows that competition is reduced by vertical integration. A vertically integrated incumbent that produces both “upstream” and “downstream” goods can effectively reduce competition in the downstream market if its stand-alone competitors rely on the incumbent for providing the upstream good.2)See, for example, Rey and Tirole (2007), A Primer on Foreclosure, Handbook of Industrial Organization, edited by M. Armstrong and R. Porter, Volume 3, Chapter 33, Pages 2145-2220. Financial market infrastructure is the ultimate upstream good for almost all economic activities. Privileged access to market infrastructure makes banks “special” and, in some situations, may encourage anticompetitive behavior. Good examples to keep in mind include two antitrust class lawsuits in over-the-counter derivatives markets in which investors accused dealer banks of, among other things, using their unique positions as clearing members in OTC derivatives to shut off new entrants that aim to compete with dealer banks in the transaction of these derivatives.3)As of this writing, the credit default swap class litigation is closed and case documentations are no longer available online. For news coverage, see, for example. See also Chang (2016), Second-Generation Monopolization: Parallel Exclusion in Derivatives Markets, Columbia Business Law Review, Number 3, Pages 657-739. For the interest rate swap class litigation, see. One of these lawsuits has been settled, with dealer banks paying $1.86 billion.

 

While privileged access to market infrastructure is valuable and probably incurred banks substantial costs to “acquire” in the first place, banks also realize that a certain degree of disintermediation is inevitable, especially if they face a comparable or even higher cost of capital on certain activities than their customers do. One example of this is clearinghouses, another central piece of financial market infrastructure that safeguards much of the $540 trillion OTC derivatives market.4)See Bank for International Settlements, Semiannual OTC derivatives statistics. Basel III banking regulation has made it costlier for banks to provide clearing services to customers in derivatives because clients’ cash margin—funds that are posted as collateral to cover expected losses if default happens—is counted toward the leverage ratio of banks that clear the trades for customers, increasing capital costs.

 

While in the past banks acted as intermediaries standing between customers and clearinghouses, in today’s regulatory environment it often makes more economic sense for certain types of customers to directly access clearinghouses, reducing reliance on banks’ balance sheets that have become more expensive. Indeed, various types of direct clearing arrangements are already set up (Eurex and LCH) or proposed (CME).5)See herehere, and here.

 

A common concern of direct access to market infrastructure is that new players like fintech firms, hedge funds, or asset managers may default and lead to systemic risk. But these risks exist even if they are intermediated by large banks, which are already systemic in their own right. Another concern is that “excessive” disintermediation of banks can reduce banks’ profitability. However, if low profitability of banks in certain businesses is due to regulatory constraint such as Basel III, nonbanks may well be the more efficient providers. Examples include clearing, repo, and market-making in low-risk securities—all of them are particularly constrained by the Basel III leverage rule, if done by banks. But this raises yet another question: Does the migration of financial activities away from regulated banks increase systemic risk? Not if regulators stay on top of the developments. For example, clearinghouses, repo and security financing, and high-frequency traders are all subject to increased oversight. The Financial Stability Board is also conducting a study on how the clearing mandate in OTC derivatives affects incentives and market outcomes.6)See here.

 

On the other hand, cybersecurity and operational risk have become more important as more players gain access to market infrastructure. This challenge needs to be addressed by sound risk management and solid technology. In fact, this concern may well lead to further unbundling of financial services, with certain firms specializing in providing the technology, perhaps expanding the set of institutions with access to operational and technological risk mitigants.

 

As PSD2 comes into effect in Europe, payments and financial market infrastructure will continue to witness significant changes in 2018, as they did in the past few years. It will be interesting to watch how banks adapt to the flatter and more competitive landscape—and how the landscape evolves itself.

 

Disclaimer: The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.  

References   [ + ]

1. See here for a timeline of this regulation.
2. See, for example, Rey and Tirole (2007), A Primer on Foreclosure, Handbook of Industrial Organization, edited by M. Armstrong and R. Porter, Volume 3, Chapter 33, Pages 2145-2220.
3. As of this writing, the credit default swap class litigation is closed and case documentations are no longer available online. For news coverage, see, for example. See also Chang (2016), Second-Generation Monopolization: Parallel Exclusion in Derivatives Markets, Columbia Business Law Review, Number 3, Pages 657-739. For the interest rate swap class litigation, see.
4. See Bank for International Settlements, Semiannual OTC derivatives statistics.
5. See herehere, and here.
6. See here.

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