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July 1, 2013 5:53 pm
Investment banks’ lucrative role as the middlemen of derivatives markets have long been under regulatory attack. But Brussels is not only rewriting rules for future trading and clearing; it could now punish banks for their past dominance.
On Monday the European Commission accused 13 of the world’s top investment banks of illegally sustaining their grip over the credit default swap market by muscling out rival exchanges which threatened their indispensable and highly profitable position as dealers.
The almost 400-page charge sheet is the latest front in a transatlantic regulatory assault against “over-the-counter” derivatives markets such as CDS, where banks build customised insurance-like products for clients, doing deals privately away from exchanges and generating big revenue streams.
The allegations from 2006-2009 are not yet proven. But Brussels alleges that collusion did more than simply inflate costs or reduce choice for investors in CDS. It also potentially left the world’s financial system more vulnerable to shocks and amplified the fallout from the collapse of Lehman Brothers.
“Exchange-trading of credit derivatives improves transparency and market stability,” says Joaquín Almunia, the EU’s competition chief. “But the banks acted collectively to prevent this from happening. They delayed the emergence of exchange trading of these financial products because they feared that it would reduce their revenues.”
All 15 groups receiving the “statement of objections” on Monday have a right of defence before Mr Almunia takes a decision and potentially imposes hefty penalties. Their case will rest on picking apart the evidence of illegal co-operation, while showing there were many other reasons preventing the rise of credit trading on exchanges. At stake are hundreds of millions of euros in potential fines.
Underlying the commission’s case is an assumption that without interference CDS trading would naturally progress – as contracts became more standard and volumes increased – from the opaque, bespoke world of dealers to cheaper, more open exchanges, where trades are cleared.
This trend would also benefit market stability as counterparty risk is more strictly managed through clearing houses, the commission argues. A clearing house stands between two parties in a trade, ensuring a deal is completed in the event of a default.
Regulators have moved to force this transition on to exchanges through law on both sides of the Atlantic. But for now CDS remain the purview of banks. The first credit futures traded on exchange were launched just a fortnight ago – via IntercontinentalExchange – while clearing of OTC trades remains the exception. Around $2.5tn of transactions had been cleared by December 2012, compared to the notional outstanding for the CDS market of $25tn.
The Commission’s two-year probe homed in on two ways that investment banks are alleged to have joined forces to safeguard this profitable business.
The first is what Mr Almunia describes as “control” of Markit, the main information provider for the CDS market, and Isda, the trade body that issues licences that would be essential for trading credit on exchanges to emerge.
Both bodies – on the advice of banks sitting on their internal committees – included explicit restrictions in licences that made it impossible for Deutsche Börse and CME Group to enter the credit trading business, according to the commission’s preliminary conclusions.
Investigators found that all 13 banks at some point were involved in or aware of these crucial recommendations. Some of those restrictions remained in place until recently, but the commission case has been narrowed to a three-year period up to 2009, where its evidence is strongest.
The antitrust division of the US Department of Justice has been probing the CDS market since the crisis, focusing on the role of Markit and its ownership by big investment banks including Goldman Sachs, JPMorgan and Credit Suisse.*
According to Brussels, a smaller group of investment banks also allegedly sought to preserve their role through a second means: co-ordinating their choice of clearing house.
As banks began to clear some off-exchange CDS trades from 2009, US derivatives exchange ICE quickly built up a dominant position. This was in spite of an earlier concerted effort to break into credit trading by CME, the world’s largest futures market operator.
Rather than just offer CDS clearing like ICE, CME launched hybrid credit futures trading in 2006, which in theory challenged the banks’ OTC business. The Chicago group’s efforts failed to make headway, in part because the banks favoured the approach taken by its rival.
*This article has been amended to remove a sentence stating that Tradeweb and the Clearing Corp were part of the DoJ’s investigation.
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