CDS market wrestles to throw off Libor’s shadow

September 15, 2015

By Dominic Elliott and Neil Unmack

The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

The credit default swap market is the latest bank activity to encounter Libor-style market abuse shame. Twelve banks on Sept. 11 agreed a $1.9 billion settlement following investor allegations they abused their market-making position in CDS, which insure investors against losses. Even so, the market is mending itself.

CDS market abuse is not like the London interbank offered rate or foreign exchange scandals. There, price-setting mechanisms were rigged; here, the entire market structure was alleged to be tilted towards the banks. A group of investors and hedge funds argued that banks extracted excessive profits by exploiting their dominant position to charge high trading fees. Pricing in over-the-counter sectors like CDS is more opaque than on transparent exchanges, and banks – investors alleged – resisted attempts to change the status quo.

The settlement, while not proof of guilt, could bring further pain. The European Commission has been trying for years to pin similar charges on the banks. Although European civil lawsuits will have to wait until Brussels finishes its probe, those working on the former will be encouraged, particularly if they think banks are keen to avoid publicity.

Still, the market is moving on. Post-crisis regulation like Dodd-Frank shift a lot of trading through clearing houses and onto electronic platforms, meaning less risk and more transparency. Recent data from the International Swaps and Derivatives Association shows that in the year to date 78 percent of CDS were cleared, and 60 percent were matched through venues dubbed swap execution facilities.

The transition remains a work in progress. Most of the trading that has moved onto SEFs and clearing houses is the commonly traded indexes, not those tied to individual companies. And some investors argue that the modern trading venues still give banks an edge – investors still have to disclose more and rely more on the banks for pricing than in many other markets.

The delays aren’t all the fault of the banks – regulators have been slow and uneven over clearing and transparency, and not all investors are yet convinced of the benefits of an exchange model for a product like single-name swaps, which may be less easy to trade. But the shift towards clearing houses and electronic venues should bring in more market participants and reduce the role of the banks. That should make future lawsuits less likely.

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