Another Fine Mess

Article, Legal WeekOctober 2013

Insurance / Legal / Disputes

RGL Economist Tom Robinson discusses factors that suggest an ability to pursue damages following a European Commission finding of exclusionary conduct in the market for credit default swaps (CDS).

At the risk of sounding like a master of understatement, it is fair to say that people's trust in banks has been rather tested of late. The financial crisis, followed by the well-publicised LIBOR fixing scandal has seen to this. So it is probably not surprising that more allegations of misdemeanour have come to light. 

The latest behaviour has received a somewhat quieter response in the press when compared to LIBOR fixing and revolves around a European Commission finding, published during the summer, of competition law infringement in the market for credit default swaps ("CDS"). In particular, thirteen investment banks have been accused of exclusionary conduct in this market – having ostensibly colluded in attempts to stop the introduction of exchange based trading from being introduced between 2006 and 2009 .

In July, the European Commission issued a statement of objections to the parties involved, which, in addition to thirteen investment banks, included the International Swaps and Derivatives Association ("ISDA") and the data service provider Markit. It was preliminarily concluded that Deutsche Bbrse Group and the Chicago Mercantile Exchange were blocked by ISDA and Markit in their attempts to obtain the necessary licenses for them to operate in these markets as "the banks controlling these bodies instructed them to license only for "over-the-counter" ("OTC") trading purposes and not for exchange trading." With the market for CDS being so large, the propensity for anticompetitive agreements in this area to attract damages is significant. Indeed, in this regard, class action law suits have already been initiated in the USA to pursue such damages.

The alleged conduct could have affected a wide variety of operators in the CDS market. Most obviously, the exchange companies who were apparently excluded from the market will have experienced damages equal to the additional profits that they would have achieved had they been allowed to operate in a competitive environment. However, the damages could have a far wider impact than this.

This wider impact is largely formed by the structural differences between OTC markets and exchange based markets. The banks behaviour, by inhibiting the introduction of an exchange based CDS market, was likely beneficial in terms of their maintenance of joint dominance in this market and the profitability of the deals which they facilitated . But how might maintaining the status quo of an OTC market structure actually benefit them?

There are fundamental differences in the way in which OTC markets and exchange based markets operate and these differences can have a significant impact upon the stability and structure of markets and the cost of transactions. To briefly explain the difference between the two, OTC trading is a bilateral agreement between a dealer and a customer (or a dealer and a dealer) in which only two parties observe the quotes and the execution of the trade. Conversely exchange trading is undertaken in a 'market place' where the communication of bid and offer prices is centralised and communicated to all market participants. Exchanges also benefit from centralised clearing which reduces counterparty risk on any transaction and helps ensure stability.

The benefits of exchanges do not end with stability though - they are also broadly thought to bring cost benefits. One study by Deutsch Börse Group (which, considering their interest in promoting exchange based trading, may have to be taken with a pinch of salt), states that, in Europe, total transaction costs for the exchange segments are around eight times less expensive to customers than the OTC segment (€7 per €1m notional, compared to €55 per €1m notional).

If one puts aside the possible tangible benefits of exchanges, this case boils down to one of competition and information asymmetry. The dealer banks' alleged joint dominance in the dealer market for CDS, coupled with the inherent opaqueness in exclusively OTC markets, implies that customers were neither able to go elsewhere to satisfy their demand nor establish easily whether they were being 'taken for a ride'. Indeed, the introduction of transparency, as has been shown in regulated utilities through the widespread publishing of regulatory financial statements, is always of benefit to competition and, ultimately consumers.

So, who has been damaged by the alleged conduct and by how much?

Well, if one considers the counterfactual that, on average, it was more expensive to enter into a CDS contract under a jointly dominated OTC model than under a standardised, highly diversified and collateralised exchange, one could argue that all buy-side customers may have incurred damage. Proving that this was the case, and the quantum of any such excess earnings, will hinge on the evidence of such a counterfactual. As such, we can expect to see parallels drawn between other markets that have gone through identical/similar transitions (from OTC only to exchange based trading) to prove that improved transparency (amongst other benefits) lead to lower transaction costs. In a normal situation, this is something that, in my view, carries a great deal of logic. Indeed, the introduction of transparency in the bond market and its subsequent reductive effect upon costs has already been raised in the USA.

However, this takes a look into the murky future of what would have been - especially difficult in the period in question for which the adjective tumultuous could be described as an understatement. Careful and comprehensive forensic analysis of this matter is needed but three points should be remembered: 1) the organisations accused would not have undertaken this collusion in the absence of a significant financial upside, 2) where someone wins from anticompetitive behaviour, someone loses out, and 3) sympathy for banks is likely to be somewhat thin on the ground .

Assuming that the EC's preliminary findings persist in their decision, these three ingredients comprise a strong recipe for follow on damages.


About the author - Tom Robinson MSc (Econ), Economist at RGL Forensics

Tom Robinson is an economist specialising in the field of competition economics and finance. He has detailed knowledge of both macro and micro economics and has particular interest in the financial services sector. Within this sector, his focus is on the convoluted world of financial derivatives and the way in which they are priced and valued.

About RGL Forensics

RGL is a global firm of forensic accountants and consultants who assist lawyers around the globe create defensible financial analyses. Specialising in investigating and evaluating damages and economic losses, and determining business value across a broad range of industries, our experts provide services in dispute resolution, including mediation, arbitration and litigation.


As appeared in Legal Week, 18 October 2013.


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