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FAQ: Credit default swaps – investigation proceedings

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What is a Credit Default Swap (CDS)?

A credit default swap (“CDS”) is a derivative contract designed to transfer the credit risk (i.e. the risk of default), linked to a debt obligation referenced in the contract. CDS are used by investors for hedging and investing. As a hedge a CDS provides protection against the credit risk arising from holding debt instruments. As an investment vehicle CDS can be used to express a view on the future development of the debt issuer’s creditworthiness and earn a profit if the view is correct. CDS are by far the most important type of credit derivatives. Other less frequently used credit derivatives are options and forwards.

What is the size of the Credit Default Swaps market?

In 2013, there were almost 2 million active CDS contracts world-wide, with more than € 10 trillion gross notional amount (source: DTCC). The notional amount is the amount of debt the CDS contract is written on. The actual payment flows from CDS contracts are considerably smaller than the notional amounts. The payments for offering or obtaining credit protection are expressed as a percentage of the notional amount and usually quoted in basis points, i.e. in one-hundredths of a percentage point.

Why was the alleged anti-competitive behaviour of the banks to block exchanges from entering the credit derivatives business potentially harmful?

In the period under investigation (2006-2009) exchange-trading of credit derivatives could have made the trading of standard credit derivatives contracts cheaper and increased its availability to different types of investors. In addition, exchange-trading of credit derivatives could have improved transparency and market stability. Indeed, unlike trading “over the counter” (OTC), exchange trading is automatically combined with central clearing. Central clearing eliminates “counterparty risk”, that is to say the risk that the contractual partner of a derivatives contract will not honour its obligations towards the other trading partner. A “central counterparty” steps in between the trading partners and guarantees the performance of the contract towards the other trading partner. Through various means (collateralisation, guarantee fund) the clearinghouse continues to service the contract even if one of the trading partners later defaults, and thus isolates other market participants from the effect of this default.

Before the 2008 financial crisis, in the absence of central clearing, credit derivatives trading involved considerable counterparty risks. Risk management practices to mitigate such risks were inadequate and increased the fragility of large investment banks. As the example of Lehman Brothers showed, the failure of one large dealer bank only can set off a chain reaction that destabilises an entire financial market. This is why after the financial crisis of 2008, the G20 leaders required the introduction of central clearing of OTC derivatives.

How could the migration of OTC derivatives to exchange market impact the revenues of the dealers?

The emergence of exchange trading could drive the trade flow away from dealers to exchanges. Even if dealers participate in exchange trading as liquidity providers, due to the safe, transparent and competitive trading model that exchanges use their profits could have been reduced. Further, exchange trading allows investors to trade directly with one-another without any dealer intermediation and thus raises the risk of the complete elimination of the dealers’ intermediary role.

Will the legislative developments in the US and the EU not solve the problems linked to OTC derivatives? Why does the Commission need to investigate?

The Commission has reached the preliminary conclusion that the banks, ISDA and Markit have engaged into anticompetitive behaviour. Such behaviour is prohibited by Article 101 of the Treaty on the Functioning of the European Union (TFEU). The enforcement of EU antitrust rules by the Commission aims to sanction any such behaviour if confirmed as well as deter the companies from repeating it – whether in the market concerned or in other markets, for example in neighbouring derivatives markets. The Commission can also impose remedies to end the continuing effects of an anti-competitive conduct.

Antitrust enforcement can therefore complement the regulatory efforts of the European Union in the field of OTC derivatives. The European Market Infrastructure Regulation (“EMIR”) requires the central clearing of standardised OTC derivatives and imposes capital requirements on the trading of non-cleared derivatives.

The on-going review of the Markets in Financial Instruments Directive 2004/39/EC (“MiFID”) will require that standardised and liquid derivatives be traded on transparent and organised trading platforms. It will also increase price transparency in respect of derivatives that continue to be traded outside these trading platforms.

While these regulatory reforms will fundamentally improve the existing OTC market structure, obstacles which are due to the collective behaviour of some individual market participants should also be addressed. If the preliminary conclusions are confirmed and if the anticompetitive behaviour had continuing effects (for instance, through on-going licence agreements concluded during the period under investigation), the Commission could impose remedies on the addressees of the statement of objections to remove such obstacles.

Will the companies that received this statement of objections have to pay fines?

Any finding of infringement of EU antitrust rules may lead to the imposition of fines up to 10% of a company’s annual worldwide turnover, if the Commission considers it appropriate. Before the Commission takes any decision in this investigation, the addressees of the statement of objections will be able to exercise their rights of defence and the Commission will carefully examine their arguments.

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