European Union antitrust regulators announced Monday that they had reached a "preliminary conclusion" that 13 of the largest banks had violated EU antitrust regulations by colluding to prevent exchanges from entering the credit derivatives business.
The regulators tell the story like this: Back in the days before the financial crisis, the Deutsche Börse and the Chicago Mercantile Exchange wanted to enter the gigantic derivatives business by creating swaps that would trade on exchanges. This threatened the lucrative over-the-counter business of the big banks, so they got together to shut out the exchanges.
The basic complaint is that the banks (Bank of America Merrill Lynch, Barclays, Bear Stearns, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan Chase, Morgan Stanley, Royal Bank of Scotland, UBS) instructed the data service provider Markit and the International Swaps and Derivatives Association to deny Deutsche Börse and the Chicago Mercantile Exchange licenses to use their data—basically index benchmarks—to create exchange-traded products.
But they didn't seek to shut out Deutsche Börse or the CME altogether. According to the European Commission's statement, the banks said that the exchanges could have licenses to use the data for over-the-counter products. In other words, the banks were inviting the exchanges to compete on exactly the same grounds they competed with each other. That is a strange sort of anti-competitive behavior.
But why were the banks unwilling to have the exchanges compete with this new product, the exchange-traded derivative? According to the European Commission, it was because the exchange-traded versions were less expensive and less risky, which would have put pricing pressure on the over-the-counter derivatives and hurt the bottom lines of banks.
It's worth asking why exchange-traded derivatives would or might be cheaper than OTC derivatives. One reason could be standardization. Because exchange-traded derivatives don't have to be tailor-made, they require less human capital. Standardized contracts are also fungible and more easily traded. Additional liquidity may make them more attractive, although not necessarily cheaper.
But there's another reason that exchange-traded derivatives might be cheaper, one that the exchanges and regulators aren't exactly eager to promote.
Having a derivative trade on an exchange supposedly reduces counterparty risk—that is, the risk that someone on the other side of a trade will not be able to meet his obligation—because the exchange stands between sellers and buyers. Instead of worrying about assessing the credit worthiness of each counterparty to a derivatives deal, market actors can rely on the exchange's credit worthiness.
This works so long as the exchange is properly capitalized and has adequate liquidity, and the trades are properly collateralized. But without proper capitalization, liquidity and collateralization requirements, an exchange wouldn't be able to complete trades in a time of financial distress. It would go from being a risk-reducer to a risk-multiplier, with all the risk concentrated in one place.
Margin requirements and capital buffers are expensive, however, which means they cut into the savings from standardization and liquidity. What's more, it's hard for market actors to judge whether an exchange has enough liquidity, capital and collateral.
All of that would be fine if we could count on the market to work out how to price the difference between over-the-counter and exchange-traded risks. But we can't, because any exchange as important as the CME or the Deutsche Börse is almost certainly not going to be allowed to fail. This means market participants will allow them to operate with too little capital and too little liquidity, and with margin requirements that are below the level of safety.
In other words, the implicit government backing of exchanges gives them a pricing advantage over players in the OTC market.
This puts the quest by the CME and the Deutsche Börse to enter the derivatives market—and the alleged resistance of the banks—in a very different light. Instead of a cartel resisting new market entrants, we have market players defending themselves from government-backed goliath exchanges.
The banks may find it difficult to defend themselves on these grounds, of course. They were bailed out during the financial crisis. It's hard to argue that you were battling the unintended consequences of government policy when your very survival so recently turned on government support.
—By CNBC's John Carney. Follow me on Twitter @Carney