The five largest banks have a stranglehold on trading in credit default swaps, a type of security that was at the center of the financial crisis, and those banks will be able to foil congressional reform plans unless the government takes antitrust action, according to a new report.
Citicorp, Bank of America, JPMorgan Chase, Goldman Sachs and Wells Fargo together control virtually all trading in these swaps and apparently dominate the only private companies with access to pricing and trading information, according to an investigation by Robert Litan, vice president of research and policy at the Kauffman Foundation. In a report published today by the Brookings Institution, Litan -- a former antitrust official in the Clinton administration -- lays out an agenda of legislation and regulatory reforms that he said will be needed to make trading in credit default swaps competitive and transparent. Without such reforms, he said, there could be a repeat of the banking system's meltdown in 2008.
In an interview, Litan said he is surprised that no one in government has focused on the antitrust problems in credit default swaps and other financial derivatives, which are privately traded contracts that effectively bet on future events -- in this case, whether particular corporations will fall into financial difficulty. These antitrust problems will make it impossible to set up fully functioning exchanges for trading these securities, as envisioned by House and Senate legislation on financial reform that is expected to get a final vote in the coming weeks. Gary Gensler, chairman of the Commodity Futures Trading Commission, has informally offered his opinion that the top five banks are a major impediment to derivatives reform, Litan noted, but Gensler hasn't offered a plan to address that roadblock.
Litan's report is another knock to the financial reform legislation, which critics say doesn't do enough to reduce the risk of another financial crisis.
The top five banks form a "Derivatives Dealers Club," according to Litan, a kind of cartel that controls all the trading and information on these securities. In addition to participating on one side or the other in virtually all of these contracts, the report says, the banks control the two private companies that have access to pricing and trading information: Markit, "the only company that has direct and broad-based access to CDS transactions data;" and ICE Trust, the private company that now has a monopoly on "clearing" these trades, or verifying that they are taking place.
The pending legislation calls for some derivatives to be traded at clearing houses, leaving ICE Trust poised to extend its monopoly, Litan said. "Perhaps most important, the current legislation would leave untouched, through their apparent significant ownership interests in Markit, the dealers' control over [CDS] pricing data."
Litan said that the authors of the financial reform legislation envision swaps being traded like stocks and bonds. But imagine for a moment if access to all that information were controlled by a tiny cabal of companies, he said -- that is the situation with credit default swaps.
Litan's proposed solution is a combination of legislation and regulation by the CFTC and the Securities and Exchange Commission to raise capital requirements and require independent ownership of the companies that will conduct derivatives trading and publish data. If necessary, the Justice Department should use antitrust law to ensure that the five top banks allow these reforms to move forward.
The stakes are huge, said Litan, who noted that it was a breakdown in trading for credit default swaps that forced the government to commit $180 billion to rescuing American International Group, which had trillions of dollars in CDS contracts with the five major banks. The market value of credit default swaps is thought to total more than $3 trillion, representing liabilities of more than $30 trillion if the market shuts down again. A collapse of the market, such as the one averted in 2008, could cause pervasive bankruptcies and a shutdown of bank lending around the world, banking experts have warned.