Banks Preferred Profitable CDS Business Over Less Profitable One

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The thing about antitrust law is that it's so understandable. Not in the sense that a human can easily understand antitrust law, particularly, just that it's easy to understand where the people who violate it are coming from.1 This EU antitrust case against 13 banks for "colluding to prevent the lucrative global business of trading credit derivatives from moving onto regulated exchanges and away from markets controlled by the banks themselves," for instance. Like, here you are in 2006 or whatever, and you're a big bank, and you've built yourself a nice little business buying and selling credit default swaps. This generates information and that information is useful; it's even more useful if you share it with your other CDS-trading friends. So you and your big-bank friends and your ISDA and your Markit get together to share trade data, just like those guys did under that buttonwood tree that one time. Once you've got trade data, for instance, you can make an index, and so you can trade index CDS, which means you can move from having a weird niche product to a macro credit product, and it is good. Also you can gouge customers because, y'know, it's OTC and stuff.

Anyway one day an exchange comes to you and says "we'd like to take all your data and use it to massively undercut you on price and drive you out of this lucrative little business you got here, whaddaya say?" And so obviously you say no. The EU thinks that's an antitrust violation and I guess it is but you can see where they were coming from? Like, that's pretty harsh: you build a business and just when it's successful, not only does someone come along to cannibalize it, but you have to help them do it. "Here, take our data, put us out of business, really, we don't mind."2

While the banks' resistance to change is understandable it also seems a little hopeless. Because there's antitrust law, for one thing, but also, like, come on. Financial products move over time toward transparency, standardization, tradeability. Now you can buy CDS futures. In any particular day or month or year people are pretty conservative about what new things they'll do, what venues they'll trade on, and what products they'll use as substitutes for other products, but eventually faster and better and cheaper really should beat high-priced non-transparent monopolistic voice trading.3 Maybe even for bonds, who knows.

In general you'd expect this to play out in the form of low-grade bickering between the banks and exchanges, not a big EU investigation, but of course the banks' delaying tactics took place just before a global financial crisis in which bilateral OTC credit derivatives played a starring role, so, bad timing.4 "If, after the parties have exercised their rights of defence, the Commission concludes that there is sufficient evidence of an infringement, it can issue a decision prohibiting the conduct and impose a fine of up to 10% of a company's annual worldwide turnover," though you could imagine that paying 10% of one year's revenue for a, like, five-year delay in credit derivatives' move to exchange-type business might actually be an attractive proposition even in hindsight. Depending on how you did on your credit derivatives in '07-'08. Not attractive for Lehman obviously.

Incidentally if you're building yourself a derivatives business in the shadow of increasing electronification and exchangification and antitrust enforcement, how do you, like, moat it up? Well, popular products that are useful to a lot of customers in a lot of situations seem like the ones most likely to move to exchanges. Those tend to be products that solve economic problems: hedging macro credit risk and stuff. Contracts built to solve regulatory problems, on the other hand, are more likely to be one-off. And customized. And the sort of thing that the client isn't really looking to publicize. You won't see Renaissance's basket option contract listed on the CME any time soon. Which makes it a good business. Though I guess it's illegal too.

Antitrust: Commission sends statement of objections to 13 investment banks, ISDA and Markit in credit default swaps investigation [EU]
EU Charges Banks Over Derivatives Trading [WSJ]

1.I mean, I guess you can understand why people, like, steal a briefcase full of $100 bills from an airplane too, but you know what I mean.

2.Obvs I'm being melodramatic, banks don't go out of business when an OTC product moves on to an exchange. Actually there's anecdotal evidence that they sometimes do better - what they lose on margins they make up in volume. Still.

3.Also I'll just never understand indices, and the licensing of indices. Like, CME or Deutsche Börse: set up your CDS market. Don't license data feeds from Markit. Let people trade. If there's an arb between OTC and exchange, someone will arb it. Your prices will be fine. Once your prices are fine, set up your own index from your own data. I know this wouldn't really work but it sort of bothers me that it wouldn't. WHERE ARE YOUR EFFICIENT MARKETS?

Also, obviously there's the irony of the CME suing to stop other exchanges from using its licensed index data to trade products that compete with it, while also being the antitrust whiner here because it couldn't use the banks' index data to trade products that competed with the banks, but, whatever, I can't really hold it against them. You say "hypocrisy," I'll say "smart business practices."


The Lehman bankruptcy "has shown how this mechanism of over-the-counter negotiations of derivatives, and in particular credit default swaps, is capable of destabilizing the entire financial system," EU antitrust chief Joaquín Almunia said Monday.

"[The banks] delayed the emergence of exchange trading of these financial products because they feared it would reduce their revenues," Mr. Almunia said.


So Maybe Greek CDS Won't Be Fine, Who Knows, I Give Up

ISDA decided today that there has been no credit event for purposes of Greek CDS. Obvs! And by "obvs!" I mean what I said the other day, which is that with 100% certainty there's been no credit event yet, but with 100% certainty there will be, so everyone should just chill out. Except that it seems like that last part may be wrong. So go ahead and panic. I used to make convertible bonds and some of my time was spent answering questions about what happened to things upon Events. The most popular was: what happens after a merger? If you have a convertible that converts into 10 shares of XYZ stock, but now XYZ is being acquired and each share of XYZ is being acquired for $30 in cash and 4.5 shares of PQR stock and a pony - what happens to the convertible? And the answer I would give usually started with "don't trouble your pretty little head about it." Like, it's fine: you have a convertible that converts into 10 Things, and before the merger each Thing was an XYZ share, and after each Thing is exactly what an XYZ share transformed into, so you convert into $300 and 45 PQR shares and 10 ponies. It just works because it has to work. Economic interests follow without interruption from changes in form; derivative securities poof into derivatives of things that the underlying poofs into. There is no arbitrage! That assumption is central to doing any sort of derivative work, and it spoiled me a bit. Sometimes people would come up with more complicated scenarios involving dividends, multiple-step transactions, weird splits and spinoffs and sales, etc. etc. And I would generally start from the bias "it has to work, so I am sure the document written in the way that works." Where "works" means "the economics and intent of the trade are preserved after the change in form." But of course the document was written by humans, often specifically me, and those humans, often including me, are fallible. So there may well be documents from my former line of work that don't "work" in the sense that an issuer could do some structural tricks that would screw holders out of their economics - where the derivative doesn't follow the underlying everywhere it might go. These tricks are unlikely enough that I don't lose sleep over them. You can't predict everything. I sort of assumed that Greek CDS also had to just work but here is Felix Salmon at Reuters saying no. Lisa Pollack at FT Alphaville said something similar a week ago but I could not fathom that she meant it so I read it to mean something else. But she means it, and Felix does too. Go read it but the basic gist of this theory is:

So Maybe Greek CDS Will Be More Than Fine?

Gaaaaaaaaaaaaaaaah Greece. Okay so all systems appear to be go on the Greek debt exchange, which means its time to decide What This Means, and, I just. Really. Greece. Come on. All I want is to talk about 13D reporting requirements, and now I have to pay attention to Portugal? No. Just no.* Still here is arguably a fun factoid: On Wednesday, Swiss bank UBS AG started quoting a "gray market" in new Greek sovereign bonds ... using as a guide details of the debt swap Greece has put on the table for private investors to accept until Thursday evening. The "bid" price for a batch of future Greek bonds due in 2042, or the highest price the dealer was willing to pay, was around 15 cents on the dollar; the "offer" price, or the most the dealer was willing to sell at, was 17 cents on the dollar, the first person said. ... The prices quoted by UBS imply that losses private creditors to Greece will take are more like 79% of face value, not the original haircut of 70-75% many had expected. Yeah but. If you believe this horrible CDS mechanics stuff that various people including me have been yammering about for weeks - here is the best explanation - that means that if for some reason you had the foresight to be long Greek bonds and hold CDS against them you'd end up with a package worth (1) 21 on the bonds and (2) 83 on the CDS (assuming that the 17 offer for the 2042 bonds represents a real price for the cheapest-to-deliver new bond in the Greek auction) for (3) 104 total which is (4) more than par, so you win this particular game, yay. Which you were at risk of losing - a week ago one of our fearless commenters spotted the longest new bonds at 25ish vs. 24ish for the old-bond-y package, for a total of 99 for the hedged holder - losing 1 point versus par.**

Banks Were Asked If They Would Prefer To Make More Money Or Less Money, Chose More Money

One kind of obvious thing about financial markets is that you can't just call everyone into a room and tell them, "look, guys, just be honest about the price that you would pay / receive for Thing X." This is because financial industry traders are degenerate lying scumbags. No, wait, that's not right. This is because if everyone just told each other their reserve prices then it would be really hard for them to make any money trading and so we, like, wouldn't have a financial system. So you have things like anonymous execution on stock exchanges and dark pools and, um, lying scumbag traders. And that allows you to have profitable trading. Of course you have to put some limits on the lying scumbaggery: you can't tell people you're investing their money while really blowing it on hookers, and I guess now you can't sell someone synthetic CDOs without telling them who was on the other side. But a little fudging around the edges about the price you're willing to pay or receive - or the price you could pay or receive elsewhere - is kind of at the heart of what trading is. So in a sense the amazing thing about the Libor scandal is that people are amazed by it. A quick recap:

One Last Greek CDS Post Before It All Goes Poof

One of the side benefits of Greece taking whatever somewhat irreversible steps it is now taking is that something will happen to CDS written on existing Greek debt and that will mean that we can stop talking about what will happen to CDS written on existing Greek debt and start talking about more interesting things like quasi-CDS written by the EFSF on shaky Eurozone government debt. For now, though, we've got at least a few more weeks of surprisingly and unsurprisingly ill-informed fretting that triggering the $4bn of Greek CDS will Bring Down The Entire Global Financial System. That seems sort of silly because notionals aren't that big, mark-to-market collateral is mostly being posted, and at this point the marks are pretty close to what you'll get from Greece so it doesn't look like there's tons of unknown unrecognized losses lurking out there. On the other hand, we're mostly through with the speculation that not triggering Greek CDS will Prove That CDS Is Worthless and thereby Bring Down The Entire Global Financial System, so that's nice. The reason that's mostly over is that it sure looks like Greek CDS will in fact trigger, as Athens has moved to adopt a collective action clause that will flip the Greek restructuring from "voluntary, heh heh heh" to "involuntary" and thus trigger the ISDA restructuring event definition. You can argue that the mechanics of the cash settlement auction will mildly screw CDS holders but I'm not so sure, and in any case this is pretty solidly in the category of derivatives nerdery rather than Bring Down The etc.