Monday, July 22, 2013

An example of "Trying to pierce a Wall Street fog"

In her NY Times column, Gretchen Morgenson looks at the credit default swap market and finds that because of opacity the market is not acting in a competitive manner and Wall Street's informational advantage enables it to extract a much higher profit margin.

Regular readers are not surprised by this finding.  As Yves Smith said, nobody on Wall Street is compensated for developing low margin, transparent products.  Credit default swaps are an example of a high margin, opaque product.
BACK in 2009, the Justice Department said it was investigating the large Wall Street banks for possible collusion in the huge and opaque credit default swaps market. The question was whether the big financial institutions had worked to keep transactions in these insurance-like instruments closed to competitors and more profitable for themselves....
On July 1, the antitrust division of the European Commission announced that its investigators had come to a “preliminary conclusion” that the banks and two entities controlled by them had infringed European antitrust rules. These entities colluded, the commission said, “to prevent exchanges from entering the credit derivatives business between 2006 and 2009.” 
Credit default swaps were at the center of the financial crisis. These instruments allow holders of bonds or other debt to hedge their risks in those positions. But the swaps also let speculators bet on a debt issuer’s default. ... 
But the market for these swaps has been conducted in the shadows. Trades were made over-the-counter — between private parties and not on an exchange. This meant that participants’ positions were not disclosed to regulators. 
Wall Street likes the fog of over-the-counter markets because the profits generated by executing customers’ trades in them are far greater than in more transparent arenas. 
Think of the way you might shop for a mortgage: if mortgage rates were not publicly available, it would be hard to know whether the rate one banker offered was competitive. Customers that dealt with only one banker on their credit default swaps almost certainly did not get the best prices. 
The 13 banks under the microscope on credit default swaps include Bank of America Merrill Lynch, Goldman Sachs, JPMorgan Chase, Morgan Stanley and UBS. Two associated entities controlled by the big banks are also being scrutinized — the International Swaps and Derivatives Association, a lobbying organization, and Markit, a data service provider....
“There was no question the banks did not want the C.M.E. to make the market more liquid and transparent,” said one person briefed on the banks’ internal discussions who asked for anonymity because he was not authorized to speak publicly. “This was their cash cow, and they didn’t want to give it up.”...

The banks have pushed to keep the market for credit default swaps in the dark. 
Three years ago, the Dodd-Frank legislation aimed to bring more competition by pushing trading onto exchanges and swap execution facilities. Wall Street tried to beat back regulators’ efforts to write tough rules after the legislation’s lead. They won some and they lost some. For instance, dealers now have to report swap transactions to regulators. 
There was a reason for the banks’ pushback: money. The Deloitte study cited a 2010 analysis by Citigroup showing that the big banks’ trading in over-the-counter derivatives generated revenue of $55 billion, or 37 percent of the total at these institutions. Such profits will fall as more swaps trade on swap execution facilities under the new rules.... 
“When you have markets that are .... opaque and where market players don’t have access to the same information, the markets are not functioning in a competitive fashion. Those that have the information can take advantage of that fact and extract anticompetitive leverage over those that lack the information.”
Please re-read the highlighted text as it nicely summarizes why transparency needs to be brought back to all the opaque corners of the financial system.