By Paul Amery
The credit markets have been a boom area for much of this decade. But now, in the aftermath of the bubble, politicians and regulators are taking a closer look at the market’s infrastructure. What does the Department of Justice’s recently announced investigation into credit derivatives mean for index investors?
Last week the US Department of Justice confirmed in a public statement that its antitrust division is investigating the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries. The statement followed earlier press reports that the DoJ had sent civil investigative notices to several investment bank shareholders of data and index provider Markit requesting the disclosure of various details of their trading activities.
Markit, which has grown from a small start-up operation earlier this decade to become the key pricing and data source for the credit markets, has responded with a promise to cooperate with the investigation and a reminder that it “strives to enhance transparency and efficiency…by making all our independent data products commercially available to all market participants.”
The firm plays a significant role in the ETF market as the compiler of the iBoxx and iTraxx indices, which underlie a large number of bond and credit ETFs, respectively. Markit also calculates a number of key benchmarks for the structured credit markets (notably the ABX and CMBX indices), which became highly popular with certain specialist investors such as hedge funds and banks’ proprietary trading desks during and after the peak of the credit bubble in 2007.
There are still no details regarding the precise nature of the alleged anticompetitive practices that the DoJ is investigating. The three areas of investigation which the DoJ’s statement refers to – information on market prices, trading and clearing – cover all the major functions that a financial marketplace or exchange might be expected to fulfil.
The credit derivatives market – in common with large parts of the bonds market and the foreign exchange market – has grown up as an unregulated, over-the-counter trading network between consenting banks and other financial institutions. For that reason the way in which the DoJ’s investigation and other, competing regulatory initiatives proceed will be a crucial test of how policymakers intend to redesign the financial system following the credit crunch.
There are very significant interests at stake. Trading in credit instruments continues to contribute a significant portion of the income of many banks – three quarters of JP Morgan’s (JPM) 2008 profits according to one observer, and a large part of Goldman Sachs’s (GS) recent record quarterly revenues. And individual investments linked to Markit’s credit derivatives indices have also been record breakers. Goldman’s proprietary traders reportedly made over US$4 billion in 2007 from short positions in the ABX index as the US sub-prime market imploded, while hedge funds run by New York’s Paulson and Co. earned over 600% in the same year from similar trades.
One potential area of investigation is the pricing procedures Markit uses when calculating credit market indices. The firm collates its prices from quotes provided by the middle offices of the major bank dealers in the credit derivatives market – and these same banks also represent a significant portion of Markit’s own shareholder base. Critics argue that this presents a conflict of interest. A government ruling on this issue could have broader implications for the index fund and ETF industry given that the credit markets are far from the only sector in which banks trading in the underlying assets have significant involvement in index calculation.
Competing methodologies for calculating the main Markit benchmark indices already exist. For example, credit information specialist CMA calculates its own real-time versions of the iTraxx and ABX indices, using trade-based data from more than thirty buy-side investing institutions. Other data providers such as Bloomberg and BestQuotes provide their own credit market price feeds. A leading London-based bank credit trader told IndexUniverse.eu that his firm calculates the index itself rather than relying on external price feeds.
For its part, Markit argues that it uses a robust pricing procedure when calculating index levels, starting with independent price sources and removing outliers and inconsistent data, allowing for breadth and depth of credit market coverage.
However, concerns over pricing may also reflect fundamental illiquidity in large chunks of the market. Satyajit Das, credit derivatives expert and author of several books on the subject, said in an interview with IndexUniverse.eu that of the 600-800 corporate names typically quoted in the global credit default swap market, only 50 or so trade daily with consistent liquidity, another 100 or so with some regularity, the next 150 once or twice a week, and the remainder only “by appointment”. Das argues that the result is an inevitable “smoothing” of price and index levels by data compilers as many CDS quotes are subjective and open to interpretation.
Das believes that attempts to achieve pricing transparency could be hindered by the recent relaxation of mark-to-market rules by the US Financial Accounting Standards Board and similar proposals from the International Accounting Standards Board. These would allow banks to split their assets into an “accruals book”, which would not be marked to market, and a “trading book”, which would. “Isn’t this what got us into trouble in the first place?” asked Das.
Gary Jenkins, head of fixed income research at Evolution Securities in London, also points to the market dislocation of the last 12 months as a reason for pricing difficulties. He says that investors frequently find that credit market prices at which they can actually trade are different from those which index levels might suggest, something he sees as an unfortunate but inevitable consequence of the credit crisis.
The problems faced by index compilers as a result of infrequent trading in the underlying securities or derivatives extend beyond the credit markets. James Rieger, vice president of fixed income indices at Standard and Poor’s in New York, argues that trade price transparency in fixed income has not evolved as rapidly as in other areas of the securities markets. As a result, when building indices S&P distinguishes between the broad benchmarks used for performance measurement and attribution and indices that are designed specifically for passive investing or trading. For the latter, the availability of good mark-to-market price information is key.
It is not only the DoJ’s examination of market price information that could have consequences. Its investigation in other specified areas – trading and clearing – could also have direct implications for investors in credit indices, both past and present.
Yves Smith, author of the Naked Capitalism blog, questioned last week whether any insider trading charges could be levelled at banks operating in the credit market in view of its unregulated status, and whether the DoJ would have jurisdiction in an area normally considered the responsibility of the SEC. Nevertheless, some commentators have argued that investment banks operated under multiple conflicts of interest in the asset-backed securities which underlie Markit’s ABX index, and that this should be a major focus of the DoJ’s investigation.
Janet Tavakoli, president of Tavakoli Structured Finance and author of two reference books on credit derivatives and structured finance, points to widespread fraud in the mortgage-backed securities market in recent years and what she terms “predatory securitisations”, many of which became ABX index components. “Credit derivatives linked to these phoney securitisations were key drivers in the financial market meltdown,” said Tavakoli.
Several observers have highlighted the importance of the credit derivatives market’s clearing mechanism as a motivation for the DoJ’s probe. Financial market regulators have been pushing for centralised clearing of credit derivatives as a way of reducing the potentially catastrophic consequences of a bank failure, and several competing ventures are seeking to occupy the role of the major central clearing counterparty (CCP) in the credit derivatives market.
In a recent email reported by Reuters, Samuel Cole, COO of BlueMountain hedge fund, alleged that the banks which dominate credit derivatives market trading are seeking to retain an oligopoly over the market by blocking alternative clearing mechanisms. The banks favour the Intercontinental Exchange’s clearing arm, Cole argued, because they receive 50 percent of its revenues.
The DoJ’s credit derivatives investigation must be seen in the context of a host of competing regulatory initiatives, including some proposals by US politicians to ban CDS trading outright. Its outcome, however, could have major implications for the way financial markets are structured and for index investors in some of the more opaque areas of the market. As ETFs venture into new areas of the investment universe, this is a story well worth following.