Banks face EC inquiry into crisis-linked derivatives

Competition investigation will focus on the market for credit default swaps

Business Editor,David Prosser
Saturday 30 April 2011 00:00

Some of the biggest names in global investment banking face a European Commission competition probe into their role in the market for a derivative that played a crucial role in the credit crunch and has also been blamed for the eurozone's sovereign debt crisis.

The Commission said yesterday that it is to investigate 16 banks, including Goldman Sachs and Britain's Barclays, HSBC and Royal Bank of Scotland, amid its suspicion they "may hold and abuse a dominant position" in the credit default swap (CDS) market.

CDSs are contracts that were originally invented to enable investors to insure themselves against a counter-party defaulting on a financial obligation – such as a company or a country failing to repay a bond, for example. In recent times, however, they have been used as speculative investments, with hundreds of billions of pounds' worth of the contracts being written, mostly in one-to-one transactions, rather than on an exchange, making the deals difficult for regulators to monitor.

The contracts were at the root of the collapse of several Wall Street banks during the financial crisis and also brought AIG, the US insurer, to its knees. More recently, European officials have accused investors of using the CDS market to bet on countries such as Greece and Portugal being unable to repay their debts, increasing the likelihood of a full-blown sovereign debt crisis in the eurozone.

However, the EC's inquiry is focused not on the derivatives themselves, but the way in which a small number of banks have come to dominate the market after regulators tried to take control of it following the crisis.

"CDSs play a useful role for financial markets and for the economy," said Joaquin Almunia, the European Union's competition commissioner. "Recent developments have shown, however, that the trading of this asset class suffers a number of inefficiencies that cannot be solved through regulation alone."

In their haste to get to grips with the CDS sector, securities regulators forced investors to use a financial clearing house when trading the derivatives. The intention was to ensure transactions became more visible to watchdogs, but the Commission is now concerned the reform led to the banks grabbing all of the market. It is also investigating IntercontinentalExchange, the clearing house through which most CDSs pass, and Markit, a British firm that provides crucial financial data on the derivatives. Both have denied any wrongdoing.

Graham Bishop, an economist who advises banks on regulation issues, said: "There are a small number of players in this market having a large impact on the way the world works."

Karel Lannoo of the Centre forEuropean Policy Studies added: "80 per cent of derivatives transactions on both sides of the Atlantic are done by about eight banks."

The Commission believes the small number of players may have enabled leading banks to deprive potential rivals of the sort of market data they would need to compete.

In theory, the investigation could pose a serious threat to the banks in question because the Commission has the power to issue draconian fines in cases where it finds breaches of European competition law, which it has used on them in the past. Penalties can be as high as 10 per cent of a company's global turnover, which would potentially see fines of several billion pounds in the case of the banks.

All of the banks involved in the case will contest any suggestion of wrongdoing, but the case will pit powerful interests against each other.

While the Commission is investigating competition matters, the probe is likely to prompt fresh calls for a ban in Europe on "naked" selling of CDSs, where investors trade the derivatives even though they do not actually own the underlying securities against which the swaps provide insurance. It is this form of speculative investment that has most upset eurozone officials.

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