Do dealers have a chokehold on CDS markets?

By Cate Long
March 28, 2013

European competition regulators are examining the coordinated activities of the big dealer banks in the credit derivatives space – a pretty dark part of financial markets. Supposedly, the dealer banks are thwarting competition for these products by using groups like Markit and ISDA (a trade association) to block access for other venues to conduct trading in credit default swaps. Markit’s board of directors includes employees of Bank of America, BNP Paribas, Commerzbank AG, Goldman Sachs, HSBC, JP Morgan and Morgan Stanley, and it has been under investigation by the U.S. Department of Justice since 2009. Bloomberg reports:

Regulators found ‘indications that ISDA may have been involved in a coordinated effort of investment banks to delay or prevent exchanges from entering the credit derivatives business,’ the European Commission said in a statement today. The EU started a probe in April 2011 into whether 16 lenders, including Citigroup Inc. and Deutsche Bank AG, colluded by giving pricing information to data provider Markit Group Ltd.

The EU’s probes add to separate antitrust investigations into whether banks colluded to manipulate benchmark lending rates, including the London interbank offered rate. The U.S. Justice Department is also probing the credit derivatives clearing, trading and information services industries.

I don’t have any particular knowledge of those facts, but I did write last year about how ISDA and Markit were working together to push the use of credit default swaps in the municipal space. From MuniLand last April:

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.

A study conducted by Kamakura Corporation showed less than one non-dealer trade per day for California (page 2 of study), which was the most active muni CDS. Unlike corporate and sovereign CDS markets, which are actively traded, muni CDS is a dud.

To get control of FIX, the standard for electronic trading of fixed income and CDS, the big dealers formed a new group and hired a consulting firm, staffed with former employees of JP Morgan, Nomura and Goldman Sachs, to control the rules for electronic trading. When this happened in June of 2011, John Harris of BondMart Technologies, a 12-year member of FIX, objected. In this exchange posted on the FIX website, Harris questions what the legal relationship is between these banks who are taking over the standard. FIX message board w/ John Harris of BondMart Technologies:

What is the legal nature of the relationship among these firms? Have they formed a corporate body of some sort? If so, what is its name and where is it domiciled? If not, are they operating under a memorandum of understanding or similarly-styled agreement?

When you say that your ‘consultancy has been retained by this group of banks to facilitate their initiative,’ do you mean they engaged you severally or jointly, through a corporate body?

In your press release you draw a distinction between the ‘Working Group’ as a whole and a smaller body representing ‘[a] majority of the Working Group members…also sponsoring the development of an enhanced FIX specification and domain model that is intended to form the basis of an updated open industry standard for fixed income.’

Who are the members of this smaller group and why have they diverged in their efforts from the larger group?

What is the meaning of the term ‘domain model?’

Your press release states that ‘[t]he Working Group will also liaise with industry and standards organisations in order to migrate the governance for the new specifications to the appropriate standards bodies as quickly as possible.’

I infer from this statement that these new specifications are being developed outside of either (a) existing standards bodies or (b) a new standards body that will ultimately hold them – otherwise, there would be no need for migration. Is my inference correct? If not, would you please clarify the forum in which these new standards are being developed?

Who owns them?

You can click through the message board to see more, but in my mind it was, once again, the major banks seizing control of the rules. This instance is for how electronic trading would occur between sell-side, buy-side and trading platforms. It can be dressed up in a lot of pretty ways, but, in essence, the dealer banks seized control of the rule book.

A big question is whether the U.S. Department Justice will make a RICO case or other charges against the big banks for stifling competition. If not, and the big banks are allowed to keep their chokehold on pricing and trading in the CDS markets, then much of Dodd-Frank will be diluted. But waiting for the DOJ to prosecute seems like waiting for Godot: endless and in vain. Hopefully the Europeans have better luck.

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