December 16, 2015    5 minute read

The European Commission’s Interesting Decision on CDS

   December 16, 2015    5 minute read

The European Commission’s Interesting Decision on CDS

Recently the European Commission (EC) published a press release announcing the closure of antitrust proceedings under art. 101 of the Treaty for the Functioning of the European Union (TFEU) against 13 investment banks involved into its investigations on the restriction of competition in the credit default swap (CDS) market.

On the 1st of July 2013 the Commission sent a Statement of Objections to Bank of America Merrill Lynch, Barclays, Bear Stearns, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, Royal Bank of Scotland and UBS, as well as Markit – a data service provider – and the International Swaps and Derivatives Association (ISDA) – the trade organisation of the participants to the market of over-the-counter derivatives. They were accused of impeding entry into the CDS business.

Between 2006 and 2009, Chicago Mercantile Exchange and Deutsche Börse tried to get into the sector but they were refused both full authorisation by ISDA and the access to all the necessary information by Markit. As a consequence, the exchanges were able to get license only for “over-the-counter” (OTC) trading purposes and not for exchange trading. According to Brussels, the banks controlling these two organisations instructed them to limit access to the market to possible competitors – they feared that exchange trading would have cut down their revenues from acting as intermediaries in the OTC market. However, on the 4th of December the EC dismissed all the charges against the 13 financial institutions saying that

“the evidence was not sufficiently conclusive to confirm the Commission’s concerns with regards to the 13 investment banks. This closure does not prejudge the outcome of the Commission’s investigation regarding Markit and ISDA, which is on going.”

What is an antitrust proceeding?

“[Art. 101 TFEU prohibits] all agreements between undertakings, decisions by associations of undertakings and concerted practices which may affect the trade between Member States and which have as their object or effect the prevention, restriction or distortion of competition within the internal market […]”.

A Statement of Objections (SO) is the formal document throughout which the EC informs the parties of the antitrust proceedings brought against them.  The subjects implicated can examine the documents in the Commission’s investigation file, reply in writing and request an oral hearing to expose their comments and opinions. If, after the parties have exercised their rights of defence, the Commission concludes that there is sufficient evidence of an infringement, it can pronounce a decision prohibiting the conduct and impose a fine of up to 10% of a company’s annual worldwide turnover.

What are CDS?

Credit default swaps are financial instruments used to transfer the risk of credit exposure of a fixed income product between two or more parties. They are utilized either as hedges or as investments. As hedges, CDSs are conceived as a sort of insurance: the buyer of the swap makes payments to the seller up to the maturation of the contract; in return the latter agrees that in case of default of the debt issuer he will pay the security’s premium as well as the interest that would have been paid between that moment and the security’s maturity date.

On the other hand, CDSs are utilised as an investment to predict the future development of a debt-issuer’s creditworthiness, earning profits in case of correct forecasts. According to the Commission:

in the period under investigation (2006-2009) CDS were traded over-the-counter (OTC), that is to say, they were privately and bilaterally negotiated. In OTC trading an investment bank typically acts as intermediary between supply and demand in the market for credit derivatives by promising to be a seller to every buyer and to be a buyer to every seller. Exchange trading, on the contrary, matches supply and demand on an exchange’s trading platform. In respect of standardised and liquid credit derivatives exchange trading is less costly and safer than OTC trading. In June 2013, ICE has launched credit futures on its exchange. Whether this entry attempt will succeed is currently uncertain. The suspected anticompetitive behaviour investigated by the Commission occurred in the past and may have delayed exchange trading of derivatives.”

What did the Commission decide?

Despite the issuing of a Statement of Objections, the Commission can also decide to drop the charges if it does not find any convincing arguments. Although it is a quite rare event, this is exactly what happened last week. The Commission decided to stop the proceedings against the investment banks, maintaining the procedures against Markit and ISDA.

So, is the glass half full or half empty?

On the one hand, financial institutions have been cleared of all accusations, escaping multi-million (sometime even billion) fines. On the other, the Commission can still find ISDA guilty, imposing financial penalties. In this last case, according to the rules the members of the trade organisation would be called to pay. So, it means that the same banks that have been acquitted today might be indirectly condemned tomorrow.

The next round of financial fines may not be so far away…

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