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E-MailDan Awrey is Professor of Law at Cornell Law School, and Joshua C. Macey is Assistant Professor of Law at University of Chicago Law School. This post is based on their recent paper.
In markets with significant scale economies and network effects, scholars and policymakers often tout open access and interoperability requirements as superior to both regulated monopoly and the break-up of dominant firms. In theory, by compelling firms to coordinate to develop common infrastructure, regulators can use these requirements to replicate scale and network economies without leaving markets vulnerable to monopoly power. Examples of successful coordination include the provision of electricity, intermodal transportation, and credit card networks.
This paper analyzes the history of U.S. securities clearinghouses and depositories in order to offer a significant qualification to this received wisdom. This history demonstrates that open access and interoperability requirements can actually serve as instruments by which dominant firms obtain and entrench their monopoly power. Specifically, by imposing high fixed costs to connect to common infrastructure, allowing dominant firms to dictate the direction and pace of innovation and investment, and reducing the scope for product differentiation, these requirements can prevent smaller firms from competing with their larger rivals. In these ways, open access and interoperability can actually exacerbate the very problems that they were designed to address.
Fifty years ago, American securities markets were supported by a number of regional clearinghouses and depositories, each connected to a regional stock exchange. Today, a single firm—the National Securities Clearing Corporation (NSCC)—is the only remaining clearinghouse, while another—the Depository Trust Corporation (DTC)—is the only remaining depository. DTCC owns both NSCC and DTC.
So what happened? Intuitively, we might expect the answer to be grounded in the economies of scale and network effects associated with securities clearing and settlement. However, while this is undoubtedly an important piece of the puzzle, the answer also stems from a series of 1975 amendments to the Securities Exchange Act of 1934 that, ironically, were designed to enhance competition with the U.S. securities clearing and depository markets. These amendments prohibited the Securities and Exchange Commission (SEC) from granting NSCC and DTC monopolies over their respective industries. Instead, Congress ordered the SEC “to facilitate the establishment of linked or coordinated facilities for clearance and settlement of transactions in securities.” In turn, the SEC ordered NSCC, DTC, and other clearing agencies to “establish full interfaces or appropriate links with the clearing agencies of designated regional exchanges.” These requirements were intended to prevent NSCC and DTC from becoming monopolists.
Yet less than thirty years later, NSCC and DTC were the last firms standing. Rather than promoting greater competition, the SEC’s open access and interoperability requirements became an instrument by which large incumbent firms obtained, consolidated, and entrenched their dominant market positions. This concentration occurred for three reasons. First, these coordination requirements did not eliminate the need for each regional clearinghouse and depository to build and maintain the technological and operational linkages that allowed them to connect to the new SEC-mandated market infrastructure. The high fixed costs of building these linkages placed a disproportionate burden on smaller firms, putting them at a competitive disadvantage.
Second, the SEC’s coordination requirements enabled larger firms like NSCC and DTC to dictate the direction and pace of their rivals’ technological innovation. Whenever NSCC and DTC introduced technological improvements to their clearing and depository systems, the SEC’s coordination requirements forced their regional competitors to make enormous infrastructure investments to ensure the technological compatibility of their own products and services. This, in turn, contributed to market consolidation, since whenever NSCC and DTC adopted new products and services, they forced the regional firms to do so as well—and to bear the substantial costs of building better, faster, and more resilient clearing and depository systems.
Lastly, coordination requirements prevented firms from differentiating their products and services from those of their competitors. Open access and interoperability quickly morphed into a form of outsourcing that resulted in firms offering virtually identical products and services. Specifically, because the interoperable interfaces mandated by the SEC made it possible for brokerage firms to process trades that involved more than one clearinghouse or depository, each clearinghouse and depository was effectively forced to rely on the systems developed by their competitors. In practice, this meant that the regional clearinghouses and depositories had no choice but to rely on NSCC and DTC. Ultimately, this undercut the ability of smaller regional players to compete with NSCC and DTC, because their only path to profitability was to layer additional processes—and costs—on top of those already built by their larger rivals.
The SEC’s open access and interoperability requirements were not the only driver behind the consolidation of the U.S. securities clearing and depository industries. The competitive dynamics described in this paper played out in parallel with other seismic changes within the U.S. securities industry, including the elimination of fixed brokerage commissions, the introduction of the National Market System, the changing ownership structure and governance of U.S. stock exchange groups, and a technological revolution in trade execution. Nevertheless, the consolidation of the U.S. securities clearing and depository industries and the rise of the DTCC—against the backdrop of the SEC’s open access and interoperability requirements—represents an important and previously untold chapter within this broader story.
And this chapter has significant implications beyond the world of financial market infrastructure. The first is for financial regulation. As a threshold matter, our analysis helps explain how and why two of the most critical components of our financial market infrastructure became too-big-to-fail. Granted, securities clearinghouses and depositories would have likely been systemically important regardless of the prevailing level of industry consolidation. However, the exit of the regional clearinghouses and depositories left U.S. securities markets without any competitors that could theoretically absorb the business of NSCC or DTC. Thus, the SEC’s open access and interoperability requirements contributed to a lack of substitutability and left regulators with few options other than public ownership or a taxpayer-funded bailout should NSCC and DTC ever find themselves on the brink of failure.
The second implication relates to the design, governance, and limits of open access and interoperability requirements as an alternative to traditional antitrust remedies. In theory, the benefits of interoperability stem from the coordinated redistribution of the otherwise high and potentially duplicative costs of developing and maintaining infrastructure among multiple competing firms. However, our analysis suggests that where these costs are not readily divisible, not actually divided, or where the division of costs places a disproportionate burden on smaller firms, then interoperability is unlikely to forestall monopoly control.
Finally, our analysis also suggests a qualified defense of open access and interoperability requirements even where they fail to forestall monopoly control. Specifically, where there is uncertainty about whether a particular market is a natural monopoly, interoperability may offer a means of determining the optimal market structure. By compelling securities clearinghouses and depositories to coordinate with each other, policymakers were able to avoid dictating the optimal market structure by regulatory fiat and instead allow the market to determine, over time, whether securities clearing and depository markets should be controlled by a single firm. Moreover, while interoperability failed to prevent NSCC and DTC from obtaining a monopoly, it left clearing and depository markets vulnerable to new entry. This, in turn, has continued to spur investment and innovation and reduce—although not eliminate—monopoly rents.
The complete paper is available for download here.
