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The Credit Default Swap Trap

Sep. 01, 2017 8:30 AM ETBAC, C, DB, GS, JPM, NOBGY11 Comments
Kurt Dew profile picture
Kurt Dew


  • Every significant OTC derivatives market is megabank-dominated.
  • Each of these markets unnecessarily imposes oligopoly costs on the rest of the economy.
  • But compared to the credit default swap market, the other OTC markets are apparent models of efficiency.
  • Here is an example of one fun CDS game: collecting big on seemingly risky companies covertly protected by major governments.

Chains, my baby's got me locked up in chains, And they ain't the kind that you can see…

- Carole King

The worst of the megabank-controlled market traps is the credit default swap (CDS) market. Unlike the interest rate swap market, where 90% of the sell-side of the American market is in the hands of four megabanks (over 90% by notional amount) - Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), and JPMorgan Chase (JPM) - the CDS market is dominated by only three megabanks (over 96% by notional amount; Goldman Sachs drops off the list) according to the Comptroller of the Currency Derivatives Report (first quarter, 2017).

There are multiple sins associated with this market:

  • Extreme sell-side market concentration.
  • Events of default that result in buyer payoff determined by a committee that represents the dominant sell-side of the market. Most of the buys are sell-side positions, despite almost all the sells being theirs, interestingly.
  • The underlying product (credit) that determines settlement values, is also dominated by the sell-side.
  • The hedge funds that participate on the buy-side of the market are over-collateralized. Hedge funds provide margin collateral triple the asset value of their positions.
  • The CDS market was the casino where AIG lost a multibillion-dollar bet to Goldman Sachs at the apogee of the Crisis.

This article argues that this market is so fraught that - unlike other markets I cover, such as interest rate swaps, securities lending, and foreign exchange - there is no way to provide this market with integrity. When three parties control the sell-side of the market, dominate the buy-side of the market, charge triple collateral to the second-largest group of participants (the hedge funds) at governmental behest, and comprise the committee that decides whether buyers or sellers are paid on every trade, what business do the rest of us have participating at all?

This article was written by

Kurt Dew profile picture
My primary interest is financial market structure. I write about market platforms, index instruments, and exchange management firms primarily. I was a member of the team that introduced index trading at the CME. Later, I pioneered the secondary market trading of OTC interest rate swaps.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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