Reuters | April 29, 2011
By John O'Donnell and Luke Baker

BRUSSELS (Reuters) - The $28 trillion credit default swaps market came under investigation on Friday by the European Union, adding to official pressures bearing down on a huge and opaque business that is widely blamed for aggravating the recent banking and euro zone debt crises.

The European Commission, the EU's executive body, said it is probing whether major investment banks, including Goldman Sachs and JP Morgan, colluded in their operations in a market that is already under scrutiny by U.S. authorities and being subjected to broad, new regulations.

Credit default swaps, or CDS, are derivatives that let a buyer transfer loan default risk to a seller, making them a kind of insurance against default. CDS can also be bought by speculators without direct interest in the debts involved.

CDS played a central role in the near collapse of AIG in 2008, which led to a massive U.S. taxpayer bailout of the former insurance giant. The contracts have also been at the heart of the debt crisis engulfing some weaker EU states.

The EU probe comes as the 27-nation bloc struggles, along with the United States, to complete a government crackdown under way for months now on the broad, $600 trillion off-exchange derivatives markets, including CDS.

"CDS play a useful role for financial markets and for the economy," said the EU's anti-trust commissioner, Joaquin Almunia, in a statement announcing the two-track inquiry.

"Recent developments have shown, however, that the trading of this asset class suffers a number of inefficiencies that cannot be solved through regulation alone," he said.

Almunia added that a lack of transparency could lead to abusive behavior and that he hoped the probe would improve financial markets and aid economic recovery.

The U.S. Justice Department in 2009 launched an inquiry into anti-competitive practices in the trading, clearing and pricing of CDS in the United States. A spokeswoman for the U.S. Justice Department declined to comment on the EU move.

Unlike other derivatives, such as grain or metal futures, credit derivatives are risk transfers. "It's a banking function that's been converted by this small group of banks into a trading instrument," said Karen Shaw-Petrou, managing director at consulting firm Federal Financial Analytics.

"The problem is no one knows what anything is worth unless or until the entity against which the CDS is placed defaults ... That's what makes it very opaque," she said.

GREEK CRISIS

In Europe, CDS moved to center stage last year as Greece grappled with higher borrowing costs, blaming the move on speculators raising default insurance costs.

The European Commission, which regulates competition in the EU, said it would investigate whether 16 investment banks had colluded or abused a dominant market position.

The opaque CDS market, where industry players say the only record of some multimillion-euro deals is just a fax, has frustrated politicians who have struggled to understand it because there are few central records of trading.

"It is not a transparent market," said Shaw-Petrou. "It's a liquid market ... but there's no real proof of value other than moment-to-moment exchanges that are then impossible to verify because it's not a public exchange."

The probe could hit banks' bottom lines as the EU can fine companies up to 10 percent of revenues and has handed out penalties as big as 1 billion euros ($1.5 billion).

Analysts said CDS trading was too concentrated. "Eighty percent of derivatives transactions on both sides of the Atlantic are done by about eight banks," said Karel Lannoo of the Center for European Policy Studies, a think tank.

EU countries and the region's parliament are trying to agree how to revamp derivatives market rules, with some lawmakers calling for outright bans on speculative CDS trading. Such calls were heard two years ago in the United States, but major CDS dealers were able to silence them.

Instead, the 2010 Dodd-Frank reforms of financial regulation mandated the first comprehensive U.S. regulation of off-exchange derivatives, including CDS. The legislation is now being implemented by regulatory agencies.

The reforms mandate standardization and increased trading on exchanges or electronic platforms of derivatives. For instruments ill-suited to this, more use of central clearinghouses and disclosure of transactions is required.

A comparable level of detail has yet to emerge from EU debates about derivatives oversight, leading to some concern among regulators that momentum behind global reforms could slow amid divergent regional regulatory approaches and stiff resistance from banks defending their business models.

MARKIT EYED

The European Commission said it will also investigate any collusion by Markit, which provides prices and whose shareholders are the 16 banks. Markit denied any inappropriate conduct.

"Markit has no exclusive arrangements with any data provider and makes its data and related products widely available to global market participants," it said in a statement.

The EU said it would investigate nine of the 16 banks and ICE Clear Europe, a CDS clearinghouse owned by exchange operator InterContinental Exchange, to see if preferential tariffs given to the banks hurt competitors.

The 16 banks being examined are: JP Morgan, Bank of America Merrill Lynch, Barclays, BNP Paribas, Citigroup, Commerzbank, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, Morgan Stanley, Royal Bank of Scotland, UBS, Wells Fargo Bank/Wachovia, Credit Agricole and Societe Generale.

The banks named either declined to comment or were not immediately available.

(Additional reporting by Arno Schuetze in Frankfurt, Emma Thomasson in Zurich, Kevin Drawbaugh, Sarah Lynch and Diane Bartz in Washington and William James in London; editing by Rex Merrifield and Alexander Smith, Gary Hill)