The Shadow Derivatives Market Lives On

Tomorrow, the public interest will take a loss and the largest banks will chalk up a win.

The shadow market for derivatives was at the heart of the financial crisis. By far, the largest component of this market was the $60 trillion per year swaps market, with more than $700 trillion of swaps outstanding. Compare that with the 2012 U.S. GDP of about $15 trillion. These markets influence interest rates, currency values, credit costs, share values, and commodities, including food, fuel and precious and base metals. The shadow market was oligopolistic and became a goldmine for the big banks. Almost all swaps have a bank on one side. And the Office of the Comptroller of the currency has consistently found that four banks hold well over 90 percent of all derivatives.

As would be expected in such a large oligopolistic market, bank profits have been staggering. Financier Bertrand de Pallieres has estimated that two-thirds of all trading revenues come from derivatives. This has syphoned massive value from the economy, like a tax that transfers wealth from the American public to the financial sector. It also puts the economy at risk of a new financial crisis at a time when we no longer have the resources to buy our way out of it.

In order to bring this massive market out of the shadows, the Dodd-Frank Act forced the Commodity Futures Trading Commission to implement rules moving a large swath of the market onto “Swap Execution Facilities” or “SEFs.” It is plain from the Act and from the Congressional debate that a transparent market in which multiple buyers and multiple buyers interact competitively to transact so that prices are fair and reliable, devoid of under the table deals and trickery.

For four-and-a half years, the financial sector has relentlessly pounded on the CFTC to gut this law. As reported here, Congress has pitched in by threatening the meager budget of the CFTC and proposing bills to restrict its authority over derivatives. Progressive opposition has been valiant, but massively under-resourced compared with the financial sector. Many Democrats have been unable to resist the flood of lobbyists and have joined with Republicans on several measures.

The investment of hundreds of millions of dollars by the financial sector will pay off tomorrow. Instead of an open and broadly competitive market, SEFs will be permitted to allow an investor to contact as few as two specific banks to “request quotes” to transact. The proposed rule had already been compromised to allow "requests for quotes," but required at least five recipients, preserving at least a semblance of the “many-to-many” requirement of the law. Five was not an arbitrary number. The swaps markets are highly balkanized and many are dominated by one or two banks.

Imagine this—an institutional investor or corporation gets favors from a bank to cultivate a relationship and in return enters into a special deal on a big swap transaction. They can transact on the SEF by putting out the "request for quotes" to one other party. It is easy enough to frustrate the law by picking the second request recipient tactically. The swaps markets are balkanized and each tends to be dominated by one or two banks.

But even worse, it is an obvious invitation for collusion between the two recipients of the request to assure the outcome. This kind of collusion has been rampant on Wall Street for decades. But we need go no further back in history than the recent disclosure on rigging LIBOR, the interest rate that underpins $350 trillion of derivatives contracts and even more conventional financial transactions. If the banks can rig LIBOR, rigging SEF transactions is child’s play.

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