Muni CDS goes ‘bang’

April 4, 2012

The use of credit default swaps in muniland is poised to take off, a project that’s being called the “U.S. Municipal CDS Bang.” Starting Apr. 3, the terms and conditions of new muni CDS have been standardized with the stated intent of creating a useful risk-hedging product. This project is being driven not by regulators but by Markit, a private market-data vendor, and the International Swaps and Derivatives Association, a global consortium of Wall Street banks. But it’s not so clear that this is what the market needs at this time.

Although the muni CDS market is unregulated, the SEC is set to implement new rules (§§763 and 766) in the second half of 2012, according to the schedule posted at the agency. Even that may be optimistic, as a lot of the SEC’s deadlines for Dodd-Frank rule-writing have slipped. Nevertheless, it’s curious that these changes to muni CDS contracts are being introduced ahead of the SEC’s rules. In most instances, banks and dealers wait until the regulatory framework has been established before rolling out new products, which is what happened with the Volcker Rule.

Municipal CDS do not trade publicly, nor do they have publicly available pre-trade or post-trade information. All available pricing information for muni CDS comes from Markit, the privately held market-data firm in London. When I asked for details about the firm’s ownership, Markit was unable to provide them. Instead, the firm referred me to Companies House, the UK equivalent of the SEC’s Edgar filing service. From their required filings at Companies House, I discovered that the banks that provide the pricing information for muni CDS are mostly the same banks that sit on the Markit Board of Directors and the Determinations Committee of ISDA, the organization that decides if an event that occurs in the underlying reference bond should trigger a payout of the CDS.

In other words, the handful of banks that control the pricing of muni CDS are the same banks that seem to control the firm that collects these quotes (see table below for listing of banks). Moreover, these same banks seem to decide whether these products pay out in a credit event. Coincidentally, the banks – Bank of America-Merrill Lynch, Citibank, Goldman Sachs, JPMorgan and Morgan Stanley – are the same ones that dominate the cash market in municipal bonds.

These financial institutions, operating through Markit, will exert even more influence on the municipal debt markets and could potentially affect the borrowing costs of cities and states. Given the volatility that muniland went through with Meredith Whitney’s unsubstantiated predictions of massive defaults, it’s not clear why regulators will allow this product to launch without more transparency.

Muniland has recently suffered from a few massive bid-rigging schemes. Markit itself was investigated in 2009 by the Department of Justice, which sought to determine if the banks that owned Markit had unfair access to price information. The spokeswoman for Markit said that as far as the firm understands, the DOJ is continuing a broad review of the credit derivatives and related markets and Markit continues to cooperate and assist the DOJ.

Markit’s opaque business practices will roll back the gains in transparency that the municipal bond market has achieved over the last five years with the expansion of EMMA and the public availability of trade data. Everything about the expansion of municipal CDS goes in the opposite direction of these trends and obscures yet another part of the securities markets.

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