Tommaso Padoa-Schioppa

English

Research Papers in Economics

42 4Q/2006, Economic Perspectives
Central counterparties: The role of multilateralism  
and monopoly
Tommaso Padoa-Schioppa
It is a great pleasure for me to speak tonight at this 
joint conference of the European Central Bank (ECB) 
and the Federal Reserve Bank of Chicago (Chicago 
Fed) on central counterparty (CCP) issues. Central 
counterparties were the topic of the very first work-
shop in the field of payment and settlement issues 
that I organized as a member of the Executive Board 
of the ECB. I am also happy to attend a conference 
co-organized by the ECB and the Chicago Fed, since 
it represents an example of multilateral cooperation 
between monopolistic institutions!
Multilateralism and monopoly are indeed the two 
issues I would like to deal with tonight. These two is-
sues are essential in order to understand central banks’ 
concerns in the field of central counterparty issues; they 
are also very general issues, going well beyond pay-
ment and settlement issues and even beyond econom-
ics. Their wide spectrum makes them suitable for a 
dinner speech, where the topic should be both related 
to the specific occasion and of a general nature. I will 
take multilateralism and natural monopoly one by one, 
then show how they are interrelated, and finally argue 
that it is because of their presence in clearing and set-
tlement that the involvement of public authorities is 
indispensable if the “hot” issue of integrating the in-
frastructure is to be properly addressed.
Multilateralism
Multilateralism is a method or an approach that 
involves a relationship between two parties with a 
third party coming into play. This third party is the 
collectivity itself, the group, the universe of all par-
ties. As a result, it incorporates some notion of “pub-
lic good” to the extent that breaching a multilateral 
agreement implies not only “private” and “individu-
al” but also “social” and welfare costs. Indeed, it con-
stitutes the very essence of money as it is the element 
that makes a difference between a barter economy 
and a monetary economy.
This article is a reprint of a speech by Tommaso Padoa-
Schioppa, Minister of Economic Affairs and Finance of Italy 
and former member of the Executive Board of the European 
Central Bank, on April 3, 2006, at “Issues Related to Central 
Counterparty Clearing,” a joint conference of the Federal 
Reserve Bank of Chicago and the European Central Bank, 
held in Frankfurt, Germany, April 3–4, 2006. The confer-
ence agenda and presentations are available at www.ecb.
int/events/conferences/html/ccp.en.html.
Multilateralism is thus an essential feature of a 
payment system, that is, the set of arrangements where-
by money performs its function as a medium of ex-
change. Defined as “a group of independent but 
interrelated elements that compose a unified whole,” 
the notion of system is thus tantamount to the notion 
of “multilateralism.” Indeed, a malfunction in a pay-
ment system has the potential to affect all the partici-
pants in the system. Clearly, central counterparties are 
multilateral entities, since they replace a multiplicity 
of bilateral relations between sellers and buyers and 
become the single counterparty of each and every 
transaction, just as the money is the single counter-
part of every exchange in a nonbarter economy.
It is interesting to note that the concept of multi-
lateralism or its converse antonym (unilateralism and/
or bilateralism) exist also in fields remote from the one 
you are debating at this conference. In medicine/biol-
ogy, the terms unilateral and bilateral indicate a con-
dition or disease that occurs respectively on only one 
or both sides of the body. As multilateral does not identi-
fy any kind of disease, we are tempted to conclude 
that a multilateral body is healthier than a unilateral 
or bilateral one! In political history, multilateralism 
refers to multiple countries working in concert. In 
this respect, the first modern experiment in multilater-
alism occurred in Europe after the Napoleonic Wars, 
when the great powers redrew the map of Europe at 
the Congress of Vienna and established the Concert 
of Europe, as it became known, the practice whereby 43 Federal Reserve Bank of Chicago
great and lesser powers would meet to resolve issues 
peacefully. So multilateralism becomes rightly, I 
think, synonymous with peace! In sociology or politi-
cal science, the term multilateral has been used as an 
adjective to describe the noun institution. What dis-
tinguishes the multilateral form from others is that it 
coordinates behaviors on the basis of generalized 
principles of conduct.
The economic literature shows that in a world  
of interdependent economies a number of externali-
ties cut across the individual/national players, requir-
ing commonly agreed solutions. Of course, policies 
themselves have spillovers and hence naturally raise 
the possibility of inefficiencies: policymakers or mar-
ket players who pursue an individual objective and 
ignore the externalities they impose on others. The 
literature also tells us that there are two types of ex-
ternality: spillover externality, in which each of the 
two players is affected by the behavior of the other, 
irrespective of his/her own behavior, and network  
externality, in which damage only materializes if  
the two players act differently.
A network externality is typically described by 
the tale of the “battle of the sexes.” As the story goes, 
a recently married couple discusses whether to go 
shopping or to a football match. In my version of this 
story—one which does not affect the reasoning—the 
wife prefers that they both go to the football match, 
while the husband prefers that they both go shopping. 
If they separately go to different places, however, 
they both are worse off than joining their partner in 
their least preferred activity. It is intuitive that this 
tale captures the collective incentives arising from a 
network externality.
In the field of payment systems the foremost  
example of network externalities is standardization.  
If two systems adopt different and incompatible  
proprietary networks, participants will be penalized, 
since they cannot reach each other. If only one  
standard is adopted, everyone will benefit from the 
possibility of increasing the number of the potential 
counterparties. However, the costs of adopting the 
new common solution are unequal. The case of the 
CCP provides another example. Imagine market par-
ticipants who are members of more than one CCP. 
Going to one CCP only can be beneficial for these 
participants. However, the criteria for selecting the 
CCP are not obvious, since the costs for the various 
participants to join one or the other are unequal.
Let’s move to the second type of externality, a 
spillover externality, which occurs irrespective of the 
behavior of the player experiencing it. The parable here 
is the well-known one of the prisoner’s dilemma.1 
Two individuals, who jointly committed a crime, are 
separately offered the following deal: Defect, give 
evidence, and implicate your accomplice. If both re-
fuse, neither gets any time in jail. If both defect and 
implicate the other, both go to jail for a short period 
of time. If one turns in the other but is not implicated, 
he gets off while the one implicated goes to jail for a 
long period of time.
The prisoner’s dilemma also applies to payment 
and settlement systems; for instance, in the two cases 
of standards setting and cross-margin requirements. 
When new standards are introduced, if the central 
bank decides to adopt them but market participants 
do not, the latter will de facto be excluded by monetary 
policy operations, unless central banks agree to deal 
with old and new standards at the same time. Manag-
ing two sets of standards is obviously quite inefficient. 
And it is equally obvious that only multilateral coor-
dination would lead to a common set of standards. 
Moving from standards to margin, consider now the 
case where participants in two CCPs would like to 
stipulate cross-border arrangements in order to reduce 
the costs associated with margin requirements. The 
benefits of cross-margins could be maximized if both 
CCPs decide to change one of their operational rules. 
If one CCP makes the change, the general benefits for 
its participants will be much lower. If both refuse 
(thinking that by doing so they will penalize the com-
petitor) the arrangement will not be possible. Now, in 
practice, it is likely that neither CCP will change pro-
cedures, fearing that the other won’t do so. The only 
(Nash) equilibrium would thus be the least favorable 
for the users.
Natural monopoly
Let me now turn to the second topic, natural mo-
nopoly. The concept of natural monopoly has been 
used and abused in the current European Union (EU) 
debate on the need for a single CCP. Economic theory 
helps in identifying natural monopolies but not in un-
derstanding why concrete implementation of monop-
olistic solutions is so difficult. 
Economics teaches us that natural monopolies re-
sult from the presence of market failures: externalities, 
public goods, asymmetric information, and increasing 
returns to scale or decreasing average costs. The con-
cept of natural monopoly generally covers activities 
requiring a high level of fixed investment to develop 
the infrastructure. When giving examples of a natural 
monopoly, reference is often made to the case of net-
work industries, such as telecommunications, trans-
portation (rail and air), and energy markets.44 4Q/2006, Economic Perspectives
The clearing and settlement industry is a network 
industry that presents several aspects of a natural mo-
nopoly. However, so far, market forces have in practice 
established a monopolistic infrastructure for reasons 
that are not clearly explained by economic theory.
The first element involves EU and U.S. experience 
in the field of securities systems, which seems to dem-
onstrate that the only existing examples of a natural 
monopoly in this field are those imposed by law!  
A more in-depth look at the EU and U.S. experience, 
however, shows that the inability of market forces to 
establish monopolistic solutions depends on the exis-
tence of regulatory barriers limiting competition, and 
indeed competition is the vehicle leading to a monopoly. 
For instance, in the euro area, a study by the London 
School of Economics for the European Commission 
reported two elements limiting competition in the field 
of clearing and settlement, namely: 1) legal require-
ments indicating the clearing and settlement providers 
to be used, and 2) trading and clearing membership 
rules imposing the use of a specific service provider.
The second element is the “bundling” between 
entities providing different services. Integration in the 
production and provision of complementary services 
is not undesirable. However, standard economic theory 
suggests that two (for-profit) entities that offer com-
plementary services should merge, provided that both 
entities are monopolistic firms.2
However, in reality the complementary services 
are provided by vertically integrated entities that are 
not in a monopolistic position in the provision of both 
services. In this situation, a vertically integrated struc-
ture has the potential to undermine the possibility for 
the investors to freely choose the services they want 
to use. As a consequence, the incentive for the institu-
tions to provide services as efficient as those offered 
under competitive conditions would decrease.
The third element concerns the geographical scope 
of the natural monopoly. Economic literature seems 
to refer to a stylized situation of one country, one cur-
rency, one stylized product, and one market. Reality 
confronts us with situations where multicurrency  
systems are in operation in a single country. Monetary 
unions have created situations where one currency 
exists in more than one country. In the European Union’s 
very special situation, you have a single market with 
13 currencies and a single economic integrated area 
with 18 currencies. European experience shows that 
CCPs for derivatives have expanded their business so 
as to cover cash products as well, unlike in the U.S. 
This seems like advocating a “genetically modified” 
natural monopoly!
Last but not least, technological developments 
have a strong impact on the definition of the scope  
of the monopoly. Technology may create the need to 
remove existing regulations or to create new ones. It 
affects the scale and scope of economies; allows for 
the further removal of geographical barriers, making 
irrelevant location of the parties; and reintroduces 
contestability in the market.
Conclusions
Let’s now briefly draw some conclusions. The 
first conclusion is that we should note there is a com-
mon element in multilateralism and natural monopoly. 
This seems to be based on the fact that both embody 
a “public good” element. Thus, the existence of an al-
most natural monopoly is one of the situations calling 
for cooperation, in particular when the geographical 
scope of the monopoly is hard to define. The emergence 
of a monopoly can be the result of a competitive pro-
cess (war) or of multilateral cooperation between 
competitors (peace). Needless to say, the latter is the 
less painful.
The second conclusion is that the presence of  
elements of a natural monopoly and the failure of 
market forces to achieve spontaneously multilateral 
cooperation make it necessary for the authorities  
(by this I mean institutions mandated to pursue the 
public interest) to intervene in the process with a 
view to facilitating the development of cooperative 
solutions. The history of payment systems provides 
innumerable examples. With the exception of the  
case of the Society for Worldwide Interbank Finan-
cial Telecommunication (SWIFT), which represents  
a very remarkable case of multilateral cooperation 
leading to the creation of a monopolistic solution by 
market forces, the establishment of national and inter-
national infrastructures has been only possible thanks 
to the intervention of the authorities: Let me just 
quote the case of CLS (Continuous Linked Settlement) 
and the Depository Trust and Clearing Corporation 
(DTCC). The recent Single Euro Payments Area 
(SEPA) project of the Eurosystem is another example 
of the catalyst role played by the authorities in foster-
ing market agents’ cooperation.
This takes me to my third and final conclusion, 
which concerns the role of the authorities. A persistent 
lack of cooperation can rightly be interpreted as a 
lack of government. There are many ways the author-
ities can intervene. They can create conditions for co-
operation through regulation or by acting as a catalyst, 
as well as by being an “enabler,” but not a “constrainer.” 
Or, they can provide integrated facilities (when the 45 Federal Reserve Bank of Chicago
elements of natural monopoly and the financial stabil-
ity concerns are particularly strong). For example,  
almost all central banks provide real-time gross set-
tlement (RTGS) facilities and most of them provide 
central security depository (CSD) services for gov-
ernment securities. Third, they can regulate/oversee 
the monopolistic solution in order to prevent potential 
abuses by the monopolist.
1The prisoner’s dilemma, devised by Merrill Flood and Melvin 
Dresher in 1950, is the cornerstone of a vast theoretical literature 
on cooperation in fields as different as evolutionary biology and in-
ternational relations.
2The underlying assumption is that all customers either buy both 
services or neither of them, and therefore they only consider the 
sum of both prices, but not each price individually. If the sum of 
the two prices is low, then the demand for both services is high. 
The best situation for one entity is a high own price and a low price 
of the other entity. As a result, both tend to set high prices, which 
are bad for the customers. If the two firms merge, this upward price 
pressure disappears and lower prices are more likely.
George Bernard Shaw said that democracy is a 
device that ensures we shall be governed no better 
than we deserve. I would say that cooperation is a de-
vice that ensures that we will be governed better than 
we deserve. That’s why I would like to conclude by 
inviting the authorities to foster multilateral coopera-
tion: It is the best way to obtain the best solutions for 
the most difficult problems.
NOTES

Central counterparties: the role of multilateralism and monopoly

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Central counterparties: the role of multilateralism and monopoly

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