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Collusion in Credit Derivatives?

Tuesday May 3rd 2011

In addition to the note below we have attached a simple handbook (Please click here),  to explain how the credit derivative structures work. 

In an increasingly complex market dominated by sophisticated structures aimed to mitigate risk and the rise of ever faster, or "flash" trading practices it would be helpful to believe that all participants were able to operate on a level playing field.

Let's be grown up about this as that has never been the case. For even in a simple world of "plain vanilla" investments larger players have had had better access to market knowledge than market minnows. However, when one starts to hear that markets are not simply skewed because of relative size between players, but may actually be manipulated by blatant collusion then it is only right and proper that regulatory authorities get involved. Maybe we should be asking, what has taken the regulators so long?

In the past few days the European Commission (EC) have opened an antitrust investigation on the behaviour of several market heavyweights within the credit default swap (CDS) market.

Let's start with a definition:

A CDS is often referred to as an insurance policy that protects a lender if a borrower of capital, i.e. a taker of credit, defaults on an interest payment or redemptionof a  loan. When a market participant purchases a CDS the precise event that the CDS covers is pre-defined and the liability of the loan becomes a credit that may be swapped for cash upon the loan defaulting.  It is actually too simplistic to say it is like general auto or fire insurance as the CDS can be acquired by anyone.  One does not have to have a direct interest in the appropiate repayments being made. The CDS is an investment vehicle available to all and any market participants. It can, liquidity allowing, be freely traded.

So what is the investigation looking at?

The EC are holding 2 seperate investigations. In the first they are seeking clarity as to whether or not the British company, Markit colluded with 16 banks to dominate the market as they provided the finacial information required to allow the trading of CDS. If so, did they seek to edge out, unfairly, key market competitors such as Bloomberg and Thomson Reuters? 

The second investigation is focused on ICE Clear Europe, a division of the Atlanta based Intercontinental Exchange. Was there an arrangement within which beneficial tariff charges were offered in league alongside profit sharing arrangements with 9 banks. If so did such an arrangement effectively bar access to the market for other clearing houses? No one could accuse ICE Clear Europe of having made an immediate financial killing as whilst it cleared CDS contracts in both Europe and the US that carried a nominal value of $17.5Tn it only made a profit of $15m from the activity. However, one could say this is just the begining as it has firmly cemented its relationships with the 9 banks.

Not all of us have heard of Markit or ICE Clear Europe, however, some of the bank names involved are more than familiar: Bank of America, Barclay's, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Morgan Stanley and UBS. Markit has said hat it does not believe it has been involved in any unethical practices.

This is not simply a case of a bureaucratic European body trying to muddy the markets waters. The EC investigation follows on from a similar probe undertaken in the US during 2010. In this case if the EC really are seeking to bring about fairness and transparency, then I for one am in full and wholehearted support. 

Such fiancial innovations as CDS are not bad. They are not, when used fairly and by competent market professionals financial weapons of mass destruction. They can actually play a useful role in enhancing liquidity and immunising a portfolio against unexpected risk. If I may use the insurance analogy as a fig leaf for the idea...one does not have auto insurance because one intends to crash the car one is driving. It is purchased in case there is an accident. In the same way one may have a negative view on a particular company...maybe looking at the fiscal balances of certain national economies the same could be said for nations, so rather than run the wroth of the politicians and bureaucrats one could buy a CDS as against running a naked short on the debt and so express concern that way. It is a simple fact that used correctly, CDS is an asset class that can afford strong portfolio protetcion.

The reasons why such financial instruments have received such a pasting in recent years is because many of the managers using them did not understand their mechanics, nor did they run a risk profile that had any connection with feet on the ground reality.

One clear difficulty springs up from the second invesigation to be conducted by the EC is that regulators had strived to have over the counter (OTC) derivative products settled through international clearing houses. If ...let me stress that word again..."IF"...it is the case that ICE Clear Europe looked to gain an advantage over rival clearers then the  drive to achieve market dominance may open the path to lightweight due diligence and so allow unhealthy exposures between counterparties to accumulate.

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