01 July 2013

FT: Europe steps up regulatory assault on CDS

The charge sheet against banks 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, generating big revenue streams.

Investment banks’ lucrative role as the middlemen of derivatives markets has 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. 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 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.

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 cooperation, 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.

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. Last year the DoJ widened its investigation to include Tradeweb and the Clearing Corp.

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