Friday, 5 July 2013

Usual Suspects: The Credit Default Swap Investigation

This article first appeared on the CCH Law Chat website on 4 July 2013

On 1 July 2013, the European Commission (EC) issued a statement of objections to thirteen of the world's largest investment banks concerning alleged anti-competitive conduct in relation to credit default swaps.[1]  In its statement of objection the EC alleged that these investment banks may have engaged in a “serious breach” of Article 101 of the Treaty on the Functioning of the European Union (TFEU). While it is still very early days and details of the alleged illegal behaviour remain quite sketchy, if the EC’s investigation is successful, a number of the world's largest investment banks may be liable to pay billions of dollars worth of fines.

What are credit default swaps?
The EC’s investigation relates to a financial derivative product called a Credit Default Swap or a CDS.

A credit default swap is a form of insurance against possible default in the payment on an underlying debt.  A company sells its credit risk to a buyer for a fee.  In return, the buyer agrees to indemnify the seller against its losses if the borrower fails to meet its obligations under the loan.

Satyajit Das in his book, Traders, Guns and Money: Knowns and Unknows in the Dazzling World of Derivatives[2] explains why companies choose to enter into a CDS contract:

The basic idea of a CDS is simple.  Assume that a bank has made a loan to a client. The bank now wants to sell the risk on the loan; it has too much exposure to the client, industry or country.  This is “concentration risk’, the opposite of diversification.  Alternatively, the bank is worried – it knows something that makes it worry about whether it will get its money back. The reason doesn’t matter, the bank just wants to sell the credit risk on the loan.

The bank finds someone who wants the risk. They like the company; they have little exposure to the company, industry or country; they don’t think the company will default; they are unaware of the risks. Whatever the reason, the investor is happy to take on the risk. The two parties enter into the CDS.

Das goes on to explain the main advantages of using CDS’s to sell risk.  The first advantage is that it is, for all practical purposes, “insurance” without being considered “insurance” in a legal sense. This means that the various investment banks which trade in CDS’s do not have to obtain an insurance licence to trade CDS’s.  The consequence of this is that the trade of CDS’s is not subject to any form of government regulation, including compliance with any mandatory disclosure rules.

Das goes on to list the other main advantages of using CDS’s to sell risk:[3]

It has many advantages: you don't have to do anything with the loan; you don't have to tell the borrower or get their consent; you don't have to exactly match the terms the loan. You can also fiddle the pricing. You keep the loan on your books. You get rid of the risk.

The CDS allows you to short credit easily, which allows you to profit from the decline in the fortunes of the company. Before the CDS, this was hard. As the CDS is a derivative contract, it is also off-balance-sheet. It can be leveraged, infinitely. It is the killer derivative.

The other significant characteristic of CDS’s is that they are traded “over-the-counter” (OTC), rather than being traded through exchanges. 

OTC trading involves private and bilateral negotiation between buyers and sellers of CDS’s, with the investment bank acting as the intermediary.  The investment banks charge both the buyer and seller fees for organising the swap.

How big is the CDS market?
According to the EC the CDS market is worth €10 trillion with almost 2 million active CDS contracts world wide.   This is the value of the amount of credit risk covered by the CDS contracts, but not the value of the actual CDS transactions.

The actual payment flows from CDS contracts are is considerably less in terms of the fees which sellers pay to buyers for entering into a CDS, as well as the payments made by buyers to sellers in event that a borrower defaults on their loan.[4]

What has the EC alleged?
The EC has alleged that between 2006 and 2009 thirteen investment banks colluded to prevent International Swaps and Derivatives Association, Inc (ISDA) and Markit Group Limited (Markit) from issuing licences for data and index benchmarks to exchanges that proposed to enter the CDS market.[5]

In order to participate in the CDS market, new entrants must first obtain a licence from ISDA and Markit for data and index benchmarks. 

The EC claimed that the thirteen investment banks were able to collude in directing ISDA and Markit not to issue licences to both Deutsche Borse and Chicago Mercantile Exchange through their ownership and control of those two organisations.

The thirteen investment banks which have been named in the EC investigation are:

·       Merrill Lynch;
·       Barclays;
·       Bear Stearns (now part of JP Morgan);
·       BNP Paribas;
·       Citigroup;
·       Credit Suisse;
·       Deutsche Bank;
·       Goldman Sachs;
·       HSBC;
·       JP Morgan;
·       Morgan Stanley;
·       UBS; and
·       Royal Bank of Scotland.

The EC has also sent a statement of objections to ISDA and Markit.

On issuing the statement of objections, Joaquin Alumina, the Vice President of the EC Responsible for Competition Policy also released a press statement about the CDS investigation. In particular, Mr Alumina stated that:

To launch these exchange traded credit derivatives, these exchanges needed licences for data and index benchmarks. But ISDA and Markit refused to provide these licences because – according to our findings at this stage of the investigation – the banks had instructed them not to do so. In addition, several investment banks sought to shut out the exchanges in other ways, for example by coordinating amongst themselves the choice of their preferred clearing house. In the end, neither Deutsche Borse or CME managed to enter the market. [6]

Alumina went on to explain the EC's theory as to why the investment banks had decided to engage in this alleged illegal conduct:

In sum, exchange-trading of credit derivatives improves transparency and market stability. But the banks acted collectively to prevent this from happening. They delayed the emergence of exchange trading of the financial products because they feared that it would reduce their revenues. This, at least, is our preliminary conclusion. If confirmed, such behaviour would constitute a serious breach of our competition rules.[7]

In other words, the EC has alleged that the investment banks, colluded to preserve the OTC trading system for CDS’s, in order to maintain their high profit margins. These high profit margins came about because of the lack of price transparency which results from the OTC trading of CDS’s.

The EC believes that trading CDS’s on an exchange will result in much greater price transparency both in terms of the fees paid by the seller to the buyer for taking on the credit risk, as well as in terms of the fees paid by the parties to the intermediary investment banks for arranging the CDS.

The EC’s has also suggested that the investment banks conduct was motivated by a desire to prevent a significant amount of the current CDS trade (which consists of over 2 million CDS contracts) moving out of the OTC trading environment and into exchanges. If this happened, buyers and sellers would no longer have to use intermediary investment banks to arrange CDS’s, but rather could choose to purchase or sell a CDS directly through the exchanges. Such a move would have resulted in the investment banks losing a significant amount of the fees which they currently derive from the sale of CDS’s. 

A related benefit of CDS’s being sold on exchanges, as suggested by the EC, is that exchanges are safer and more stable than OTC trading.  This greater safety and stability would have provided both buyers and sellers with significant transaction cost benefits, as well as improving the efficiency and liquidity of the CDS market.

What happens next?
The thirteen investment banks, ISDA and Markit now have an opportunity to provide the EC with an explanation of their conduct in order to avoid the imposition of sanctions. 

While it is not clear what explanations or justifications the merchant banks will seek to provide to the EC in relation to their alleged illegal conduct, one issue that they will be very mindful of, are the sanctions which the EC could impose for what appears to be a “serious breach of competition rules”.  Any finding of an infringement of EU competition rules, such as Article 101 of the TFEU, could lead to the imposition of fines of up to 10% of the annual worldwide turnover of each of the thirteen investment banks. 

The EC’s current investigation of the CDS market appears to be yet another example of very serious and blatant illegal anticompetitive conduct being engaged in by the world’s leading investment banks. In addition to this particular investigation, the EC is continuing its major investigation into allegations that many of these very same investment banks also colluded in an attempt to manipulate the LIBOR.  The EC has recently announced that it is expecting to conclude its investigations into the alleged LIBOR manipulation by the beginning in 2014.

While it is difficult to predict the outcome of the EC's investigations, it would seem likely that if the EC’s CDS and LIBOR investigations are successful, the combined penalties which may be imposed by the EC against these investment banks will total many billions of dollars.  What is also certain about these investigations is that no criminal charges will ever be laid by the EC against any bank or any bank officer or employee for the simple reason that the EC does not have criminal jurisdiction in relation to breaches of competition laws.

It is hoped that the announcement of the EC’s CDS statement of objections, following so soon after the announcement of the EC’s LIBOR investigation, will provide the stimulus for a renewed debate on the need for the EC to introduce criminal sanctions for breaches of competition laws. The fact that the EC cannot seek criminal sanctions for serious contraventions of competition laws is a serious shortcoming. This is becoming particularly evident as the EC pursues yet another investigation against the usual suspects, namely the world’s major investment banks, for what appears to be a serious, blatant and highly damaging contravention of competition laws.

[1] Antitrust: Commission sends statement of objections to 13 investment banks, ISDA and Markit in credit default swaps investigation at

[2] Satyajit Das, Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives, Prentice Hall – Financial Times, 2005, p. 271.
[3] Ibid., p. 273.

[4] Antitrust: Commission sends statement of objections to 13 investment banks, ISDA and Markit in credit default swaps investigation – Frequently Asked Questions at

[5] Footnote 1, above.

[6] Statement on CDS (credit default swaps) investigation at

[7] Ibid.