What’s the Justice Department’s angle on derivatives?

July 14, 2009

Lots of posts and articles are circulating about the Department of Justice’s investigation into the derivatives market and specifically the dealers that own Markit – the administrator of popular credit default swaps indexes and aggregator of CDS prices.

Yet, I must say I’m not sure what the investigation hopes to turn up. Instead, it looks more like the Obama Administration flexing its muscle to let banks know that it’s serious about derivatives regulation just in case they didn’t get the point when the government released its white paper on regulatory overhaul last month.

From the Bloomberg article:

Justice Department investigators want to know if Markit’s bank shareholders received advantages as owners and providers of prices and trading patterns for credit-default swaps, said two of the people. The data from the market’s largest users is provided to more than 300 financial firms to set prices of the contracts in their portfolios, according to Markit’s Web site.

The notices ask recipients to give the Justice Department details on the amount of their trading, how much they have at risk in the market, the monthly value of their credit swaps and other information, said a person who read parts of the letter to Bloomberg News.

But it’s the dealers themselves that provide Markit with the data, not the other way around. So how much advantage could they actually get from using Markit data before everyone else?

Naked Capitalism also seems puzzled and points out that even if they did have privileged information, that’s not necessarily illegal.

As much as I would love to see the credit default swaps market reined in, or better yet, shut down, this move is puzzling. CDS are unregulated. Therefore there is no such thing (legally) as insider trading. Even in regulated commodities markets, there is no such thing as insider trading, since no one in theory had the advantaged position relative to the market in a commodity that corporate insiders do relative to a business.

So what legal theory is the DOJ operating on? Insider trading and front-running are SEC notions, and SEC regulations don’t extend to CDS, save any registered securities that had embedded CDS. The letter came from the antitrust division, so the theory may be abuse of monopoly position (as in, relative to those contracts). But Markit is headquartered in London, which also raises jurisdictional issues.

Hmmm. If I were a betting woman, I’d say this isn’t going to go very far.

For those curious about which banks are the biggest Markit shareholders, Bloomberg has the breakdown. Conspiracy theorists get ready to be disappointed. Goldman Sachs isn’t number one.

JPMorgan is Markit’s largest shareholder, with at least 1.67 million ordinary voting shares out of a total of 14.38 million, according to filings at U.K. Companies House. Bank of America Corp. is the second-largest, with more than 1.52 million shares held through its own units and those acquired in its purchase of Merrill Lynch & Co. last year. Royal Bank of Scotland Group Plc owns at least 1.35 million shares after its purchase of ABN Amro Holdings NV, while Goldman Sachs Group Inc. has about 1.11 million shares, the filings show.

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