EU accuses investment banks, Markit and ISDA of CDS collusion

2 July 2013

A total of 13 global investment banks, allied with Markit and the International Swaps and Derivatives Association (ISDA), have been accused by the European Commission (EC) of colluding to prevent credit default swaps (CDS) from being traded on exchanges; thereby increasing market instability in the lead-up to - and during - the financial crisis.

The EC said that it had reached a preliminary conclusion that the banks may have violated competition rules and coordinated behaviour to prevent exchanges from entering the US$10 trillion CDS marketplace between 2006 and 2008.

A two-year investigation by the European Union (EU) has produced allegations that both Germany’s Deutsche Börse and the Chicago Mercantile Exchange (CME) attempted to set up clearing services and exchanges for CDS products, but were denied licences to crucial data by Markit and the International Swaps and Derivatives Association (ISDA).

According to the EU, the firms were acting under pressure from a group of 13 banks, which included Bank of America Merrill Lynch (BofA Merrill), Barclays, the defunct Bear Stearns, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, Royal Bank of Scotland (RBS), JP Morgan, Morgan Grenfell and UBS.

Before the bankruptcy in September 2008 of Lehman Brothers, trading proved hugely profitable for the handful of global investment banks that controlled the CDS market. Investment firm wishing to buy CDS had to do so through an investment bank and the opaque, interconnected market the banks controlled. Despite the ‘sage of Omaha’, Warren Buffett, describing CDS as “financial weapons of mass destruction”, the market flourished.

Lehman’s collapse sparked fears over how the CDS’ written on its debt would be settled and how Lehman itself would pay the instruments it had written. Insurance giant American International Group (AIG) required a massive US bailout after it emerged that its small-London based unit had also written massive volumes of CDS on US mortgage-backed securities (MBS), the value of which was plunging.

Regulators believe much of this instability could have been avoided if the instruments had not been traded over-the-counter (OTC), but instead effectively ‘on exchange’ and via central counterparty (CCP) clearinghouses - this is the new post-crash regulatory environment. Allied to centralised repositories, unwinding failed CDS trades shouldn’t be so difficult if another crash happens and monitoring the market should be simpler. Theoretically, it should also make it harder for banks, Markit, ISDA and others to game the marketplace in future.

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