STOCK MARKET WATCH -- Monday, 23 July 2012

[Demeter]

12. (CREDIT DEFAULT) Swap Market, Like Libor, Is Vulnerable to Manipulation

http://dealbook.nytimes.com/2012/07/18/behind-credit-default-swaps-market-a-cartel-left-open-to-collusion/



The rate-manipulation scandal has demonstrated that banks will collude with one another for their own benefit. Banks didn't report the rate at which they were borrowing from other institutions. They could report a made-up rate that, not surprisingly, turned out to serve their economic interests at the time. So, it might come as a worry that there is another, multitrillion-dollar market - the credit-default swap market - that operates under a similar principle. Credit-default swaps are insurance-like derivatives, or side bets, that protect investors from bad events like a company going bankrupt or a country failing to pay its debts.

Whether a company has defaulted on its debt might seem unambiguous to some naïve souls out there. But that's hardly the case, especially when there are lawyers involved and billions of dollars at stake. Because credit-default swap contracts can be worthless when they expire, the timing of insolvencies can make the difference between making and losing a great deal of money. Decisions about when a swap pays out are made by a trade group called the determinations committee of the International Swaps and Derivatives Association. The mere fact that a determinations committee exists is evidence that "insolvency" is not simple to define. Sure, credit-default swaps are products for grown-ups. Sophisticated investors play in this market. Foster children and the infirm are not putting their life savings into this market directly.

But they matter to corporations and countries. When Europe tried to bail out Greece, an enormous debate sprang up about whether the restructuring of Greece's debt was technically considered a "default." Initially, the committee said it wasn't. Then, after some details shifted, the committee ruled it was. A proper market would want an organization that was impartial, regulated, transparent and open to appeal. No such luck. The determinations committee has 15 members, 10 of which are the major dealers in credit-default swaps, the giant banks that are effectively permanent members. One criterion for dealer members is that they trade a certain amount of derivatives. After the 2008 financial crisis, there are fewer such firms, and they have consolidated their influence and power over our capital markets. The committee operates as a quasi-Star Chamber. It makes decisions without having to publish its reasoning and almost never has. There isn't any appeal process. The committee itself says it isn't bound by precedent....The biggest concern is that there's no prohibition against committee members deciding cases in which they may well have an economic interest. There is no recusal process. Indeed, it is almost impossible for the major dealers to not have a stake in the outcomes, since they are the major dealers.

A spokesman for the association contended that "there are safeguards built into the process which work to support integrity of process." The voting, if not the reasoning behind it, is publicly disclosed. The committee requires a supermajority for decisions, 12 of the 15 votes, so the dealers can't gang up on the other members. And it's entirely possible that banks might be on different sides of a trade, with some banks having sold protection and some having bought it. The hope would be that the conflicts of interest cancel each other out.

To the market's credit, there is no evidence that the process has become corrupted by big banks. Given the evidence of collusion in the rate-manipulation case, however, trusting it to remain that way doesn't seem like a good plan...

I SAY GIVE IT A WEEK.