As readers may recall, Gary Gensler of the CFTC has been fighting to implement Dodd Frank rules on derivatives, and not only is Obama pushing him out on an accelerated schedule, but European regulators are throwing hissy fits via Jack Lew over Gensler’s continuing
Just as not every regulator in the US has given up on doing his job, so too seems to be the case overseas. Recall that the Treasury and the FSA in the UK pushed hard for a Glass-Steagall type split between retail banking and other operations. Concerted opposition by Treasury resulted in that being watered down to mere ring-fencing.
And now, in an amusing coincidence of timing, while one cohort of European regulators is trying (with not much success) to get Gensler leashed and collared, another has launched a major attack on a big derivatives profits engine, credit default swaps. From the Financial Times:
Investment banks’ 20-year grip over credit insurance markets has come under regulatory assault as Brussels served charges against 13 banks for allegedly conspiring to block exchanges from challenging their business model.
The formal European Commission charge-sheet, running to almost 400 pages, alleges collusion to ensure the insurance-like contracts remained an “over-the-counter” (OTC) product – preserving the banks’ lucrative role as middlemen.
Investigators claim the banks from 2006-2009 protected their indispensable position in the $25tn global market through “control” of a trade body and information provider, which vetted whether new exchanges should be licensed…
Brussels alleges that the harm from blocking exchanges, such as Deutsche Börse and CME Group of the US, went beyond trapping investors in the relatively more costly OTC market.
Joaquín Almunia, the EU’s competition chief, said keeping CDS in the opaque OTC market weakened the financial system, increasing counterparty risks that were brutally exposed after the collapse of Lehman Brothers.The Wall Street Journal (hat tip skippy) provides additional tidbits:
EU authorities said Markit and ISDA—which are providers of data and licensing in the market—were at the center of the banks’ plans to prevent exchanges from getting a piece of CDS trading. The banks, the commission said, instructed ISDA and Markit to sell licenses for their data and index benchmarks only for over-the-counter trading.This case is potentially very significant. First, the EU antitrust authorities have been bloody-minded in the past. Microsoft was fined a record $689 million for tying its media player to its browser in the early 2000s. It was then fined an additional $1.4 billion (which was reduced slightly due to an error in calculating the fine) for failure to comply with the earlier antitrust decision.
EU authorities also suspect that the banks may have routed trades to one clearing house that they felt was unlikely to develop an exchange-traded CDS contract that could take business away from the banks. Clearing houses are entities that absorb losses if one of the parties to a derivative contract defaults.
Second, as we’ve written at length (both on this blog and at greater length in ECONNED), curbing CDS is critical to reducing systemic risk. CDS are tantamount to unregulated insurance and would not be viable as a product if banks had to put up adequate margin to allow for “jump to default” risk. They are also a major source of “tight coupling” or overconnectedness among firms (in layperson speak, if one fails, the others are at risk because they have so many counterparty exposures). CDS also have no real societal value (the argument that they are a way to short bonds is spurious; CDS have a ton of basis risk on the credit front alone and are a lousy hedge of only one attribute of the risks represented by a fixed income instrument. Moroever, if you don’t like a bond, sell it. No one was howling about the absence of a way to short bonds prior to the introduction of CDS. Its raison d’etre has long been for banks to game risk-based capital requirements).
The banks have wanted to keep derivatives over the counter, particularly CDS, since those prices can’t be derived readily from published indexes or actively traded markets (which is in contrast to a lot of interest rate and foreign exchange swaps). That allows the banks to mark up the price considerably over inter-dealer levels.
And from a regulatory standpoint, CDS are one of the most important products to shrink or eliminate. As long as banks can keep writing them without having to put up adequate capital or margin, they have economic incentives to pile up more risky exposures than they can handle. The fear of setting off cascading failures was the big reason Bear, an otherwise not systemically important player, was rescued (Bear was one of the three biggest prime brokers and hence writing a lot of CDS to hedge funds). And remember CDS are almost certainly booked in depositaries (recall the controversy over Bank of America moving its Merrill Lynch exposures into the deposit book of the bank). Mind you, I’d rather see the market slowly strangled out of existence (banning it outright would be very disruptive), but moving CDS onto exchanges would reduce their profit potential to bank and lead to higher margin being charged, both of which should reduce the size of the market (higher margins would make them more costly to users, and lower profits to banks means they’d devote fewer resources to selling them).
After the protracted fight with Microsoft, the European antitrust authority said it would rely more on changes in behavior (prohibitions, in other words) rather than fines. That’s like not out of a view that the initial fines were too small but that Microsoft kept a 2004 decision in legal play for another 8 years. But the fines the EU can levy represent a sword of Damocles over these banks’ heads: up to 10% of turnover, which presumably would be the notional amount of CDS sold in the relevant time frame (2006 to 2009). Given that the market’s value was $62 trillion at its peak, the EU would seem to be able to force compliance if its charges are well documented (and although I have to confess to not having read the 400 page case yet, I suspect they are).
On a mundane level, this filing is an unexpected boon for Gensler, and should make the Administration look like the bank stooges that they are for trying to stymie him.
Most of the antitrust fight will take place behind closed doors, but I’m hoping we’ll have some fun in the form of squeals of bank consternation as they are seeing their profits shorn. It’s a long overdue spectacle.
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