Is it true that customers always get a better price for their trades when executions take place on a regulated exchange? That seems to be the premise underlying a putative class action suit filed in federal court last November in the Southern District of New York. Next week, on July 19th, the court and litigants will be developing the pretrial schedule, including discovery and deadlines for naming experts, in what may well be a landmark case for competition in financial services.
That action, described here, seeks damages for presumed losses suffered by public pension funds and other customers of dealers in the interest rate swaps market. Plaintiffs, led by the Chicago Public School Teachers’ Pension Fund, argue that swap dealers conspired to prevent a major over-the-counter swaps market evolve into a more efficient exchange-based market. The dealers’ goal, argue the plaintiffs, is to protect their monopolistic profits.
This is a case about competition and fair pricing of financial services. The nature of interest rate swaps is secondary to the main issues.
The intuition that exchanges offer better execution seems reasonable on the surface. Ostensibly, there’s more transparency, competition, oversight, capital and so on. Yet is that argument persuasive in its fundamentals?
Let’s consider a rebuttal argument:
- Pricing on an exchange is anonymous and based solely on supply, demand and friction. Dealers often consider relationship factors, so it’s quite possible that customers who have multiple services with a dealer could receive better prices.
- Organized exchanges have membership requirements. So, not every potential trader can join an exchange. Therefore, competition may not be as widespread as in the OTC markets.
- Just as membership is restricted, so also is the practical range of traded instruments. Listing requirements usually limit the scope and nature of available issues, as well as their liquidity. As a result, not every swap may be available.
Given just these considerations – and there are many more – it seems somewhat uncertain whether the underlying premise of better execution will hold in the case of swaps. And, that’s just from an economic perspective.
Defense attorneys may well point out the lack of a regulatory requirement to provide best execution for derivatives transactions. One way or the other, it’s likely that the action will find a vigorous response from the defense.