Department of Justice: Potential Headache for CDS Dealers

Jul.16.09 | About: SPDR S&P (KBE)

According to Matt Leising and Justin Blum at Bloomberg, the Justice Department investigation of the CDS markets includes clearing:

A U.S. antitrust probe of the credit-default swaps market includes efforts to guarantee contracts through clearinghouses, according to a Justice Department spokeswoman.

“The Antitrust Division is investigating the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,” Laura Sweeney, a Justice Department spokeswoman in Washington, said today in an e-mail.

Just what would the anticompetitive practices in CDS clearing be? Here are some theories the DOJ might be considering and investigating:

  • If a subset of big dealers form a clearinghouse, and exclude other market participants from membership, they could reduce competition. That is, as I’ve shown in my academic work, a cooperative organization that is subject to strong scale and/or scope economies can serve to cartelize an industry. A smaller than optimal set of members creates a CCP. It is just big enough such that no other organization can achieve the scale or scope to compete with it, but smaller than optimal, thereby ensuring that its members can charge supercompetitive prices. What’s more, through the pricing of its services, and the rules for sharing revenue, the members can coordinate pricing, and in some cases, achieve a monopoly pricing outcome.
  • The DOJ may actually be more interested in the resistance of the CDS dealers to clearing. Here the idea would be that the CDS market currently behaves like an oligopoly that is very profitable. The dealers don’t have to worry that much about competitive entry, because there are few other firms that have the scale to compete effectively. Clearing would make it easier for other firms to enter in competition with the big dealers, as these competitors would essentially be able to take advantage of the clearinghouse’s scale. This would undermine a competitive advantage of the big dealers–so if they kneecap or slow walk clearing, they could protect their oligopoly. Similar arguments would apply to anticompetitive practices in trading.
  • The big banks are impeding competition by refusing to deal with potential competitor clearinghouses, such as the CME’s or the just euthanized NYSE-EuronextLIFFE venture.

I don’t know which, if any, of these theories is in DOJ’s mind. But the antitrust scrutiny of the entire gamut of OTC trading practices is quite interesting, and bears close watching going forward.