A Secretive Banking Elite Rules Trading in Derivatives
AN ELECTRONIC EXCHANGE?
An Electronic Exchange?
Two years ago, Kenneth C. Griffin, owner of the giant hedge fund Citadel Group, which is based in Chicago, proposed open pricing for commonly traded derivatives, by quoting their prices electronically. Citadel oversees $11 billion in assets, so saving even a few percentage points in costs on each trade could add up to tens or even hundreds of millions of dollars a year.
But Mr. Griffin’s proposal for an electronic exchange quickly ran into opposition, and what happened is a window into how banks have fiercely fought competition and open pricing. To get a transparent exchange going, Citadel offered the use of its technological prowess for a joint venture with the Chicago Mercantile Exchange, which is best-known as a trading outpost for contracts on commodities like coffee and cotton. The goal was to set up a clearinghouse as well as an electronic trading system that would display prices for credit default swaps.
Big banks that handle most derivatives trades, including Citadel’s, didn’t like Citadel’s idea. Electronic trading might connect customers directly with each other, cutting out the banks as middlemen.
So the banks responded in the fall of 2008 by pairing with ICE, one of the Chicago Mercantile Exchange’s rivals, which was setting up its own clearinghouse. The banks attached a number of conditions on that partnership, which came in the form of a merger between ICE’s clearinghouse and a nascent clearinghouse that the banks were establishing. These conditions gave the banks significant power at ICE’s clearinghouse, according to two people with knowledge of the deal. For instance, the banks insisted that ICE install the chief executive of their effort as the head of the joint effort. That executive, Dirk Pruis, left after about a year and now works at Goldman Sachs . Through a spokesman, he declined to comment.
The banks also refused to allow the deal with ICE to close until the clearinghouse’s rulebook was established, with provisions in the banks’ favor. Key among those were the membership rules, which required members to hold large amounts of capital in derivatives units, a condition that was prohibitive even for some large banks like the Bank of New York.
The banks also required ICE to provide market data exclusively to Markit, a little-known company that plays a pivotal role in derivatives. Backed by Goldman, JPMorgan and several other banks, Markit provides crucial information about derivatives, like prices.
Kevin Gould, who is the president ofMarkit and was involved in the clearinghouse merger, said the banks were simply being prudent and wanted rules that protected the market and themselves.
“The one thing I know the banks are concerned about is their risk capital,” he said. “You really are going to get some comfort that the way the entity operates isn’t going to put you at undue risk.”
Even though the banks were working with ICE, Citadel and the C.M.E. continued to move forward with their exchange. They, too, needed to work with Markit, because it owns the rights to certain derivatives indexes. But Markit put them in a tough spot by basically insisting that every trade involve at least one bank, since the banks are the main parties that have licenses with Markit.
This demand from Markit effectively secured a permanent role for the big derivatives banks since Citadel and the C.M.E. could not move forward without Markit’s agreement. And so, essentially boxed in, they agreed to the terms, according to the two people with knowledge of the matter. (A spokesman for C.M.E. said last week that the exchange did not cave to Markit’s terms.)
Still, even after that deal was complete, the Chicago Mercantile Exchange soon had second thoughts about working with Citadel and about introducing electronic screens at all. The C.M.E. backed out of the deal in mid-2009, ending Mr. Griffin’s dream of a new, electronic trading system.
With Citadel out of the picture, the banks agreed to join the Chicago Mercantile Exchange’s clearinghouse effort. The exchange set up a risk committee that, like ICE’s committee, was mainly populated by bankers.
It remains unclear why the C.M.E. ended its electronic trading initiative. Two people with knowledge of the Chicago Mercantile Exchange’s clearinghouse said the banks refused to get involved unless the exchange dropped Citadel and the entire plan for electronic trading.
Kim Taylor, the president of Chicago Mercantile Exchange’s clearing division, said “the market” simply wasn’t interested in Mr. Griffin’s idea.
Critics now say the banks have an edge because they have had early control of the new clearinghouses’ risk committees. Ms. Taylor at the Chicago Mercantile Exchange said the people on those committees are supposed to look out for the interest of the broad market, rather than their own narrow interests. She likened the banks’ role to that of Washington lawmakers who look out for the interests of the nation, not just their constituencies.
“It’s not like the sort of representation where if I’m elected to be the representative from the state of Illinois, I go there to represent the state of Illinois,” Ms. Taylor said in an interview.
Officials at ICE, meantime, said they solicit views from customers through a committee that is separate from the bank-dominated risk committee.
“We spent and we still continue to spend a lot of time on thinking about governance,” said Peter Barsoom, the chief operating officer of ICE Trust. “We want to be sure that we have all the right stakeholders appropriately represented.”
Mr. Griffin said last week that customers have so far paid the price for not yet having electronic trading. He puts the toll, by a rough estimate, in the tens of billions of dollars, saying that electronic trading would remove much of this “economic rent the dealers enjoy from a market that is so opaque.”
“It’s a stunning amount of money,” Mr. Griffin said. “The key players today in the derivatives market are very apprehensive about whether or not they will be winners or losers as we move towards more transparent, fairer markets, and since they’re not sure if they’ll be winners or losers, their basic instinct is to resist change.”
IN, OUT AND AROUND THE HENHOUSE
In, Out and Around Henhouse
The result of the maneuvering of the past couple years is that big banks dominate the risk committees of not one, but two of the most prominent new clearinghouses in the United States.
That puts them in a pivotal position to determine how derivatives are traded.
Under the Dodd-Frank bill, the clearinghouses were given broad authority. The risk committees there will help decide what prices will be charged for clearing trades, on top of fees banks collect for matching buyers and sellers, and how much money customers must put up as collateral to cover potential losses.
Perhaps more important, the risk committees will recommend which derivatives should be handled through clearinghouses, and which should be exempt.
Regulators will have the final say. But banks, which lobbied heavily to limit derivatives regulation in the Dodd-Frank bill, are likely to argue that few types of derivatives should have to go through clearinghouses. Critics contend that the bankers will try to keep many types of derivatives away from the clearinghouses, since clearinghouses represent a step towards broad electronic trading that could decimate profits.
The banks already have a head start. Even a newly proposed rule to limit the banks’ influence over clearing allows them to retain majorities on risk committees. It remains unclear whether regulators creating the new rules — on topics like transparency and possible electronic trading — will drastically change derivatives trading, or leave the bankers with great control.
One former regulator warned against deferring to the banks. Theo Lubke, who until this fall oversaw the derivatives reforms at the Federal Reserve Bank of New York, said banks do not always think of the market as a whole as they help write rules.
“Fundamentally, the banks are not good at self-regulation,” Mr. Lubke said in a panellast March at Columbia University. “That’s not their expertise, that’s not their primary interest.”