By Luigi Zingales
CHICAGO: The launch of two European antitrust investigations into the market for credit default swaps (CDS) might appear to be no more than a political vendetta against one of the alleged culprits behind the 2010 European sovereign-debt crisis. The negative perception that most people (especially in Europe) have of CDS has certainly played a role here. After all, foreigners and politically weak companies are often the favorite targets of law enforcement.
Consider, for example, that the first insider-trading case tried in Russia after the fall of communism was against an American firm. Likewise, the European Union’s antitrust authorities have been tougher with Microsoft than with many European firms.
That said, the existence of political motivations does not undermine the legitimacy of the new EU investigations, which will be conducted alongside an ongoing inquiry by the United States Justice Department into anti-competitive practices in the trading, clearing, and pricing of CDS in the US. In fact, the ideological bias of Europeans against CDS might be beneficial in the long term for the development of a better market for CDS, and for derivatives in general.
Indeed, today the market for derivatives is oligopolistic, with a few banks running huge profit margins. And, regardless of whatever political motivations might lie behind the latest investigations, this market concentration is a real problem. According to a 2009 study by the European Central Bank, the five largest CDS dealers were party to almost half of the total outstanding notional amounts, while the 10 largest CDS dealers accounted for 72 percent of the trades. The markets for other derivatives are not much better.
A high degree of concentration distorts the market in several ways. First, when they transact among themselves, large players do not insist on an adequate amount of collateral, relying on the counterparty’s generic creditworthiness (and on the implicit guarantees that governments provided to large firms). Not only does this severely undermine the ability of small firms to compete, but it also contributes to systemic instability of the type that we experienced in 2008, thus increasing the likelihood that taxpayers will have to step in. Market concentration renders mostly illusory the beneficent risk-spreading role that is claimed for derivatives, because the bulk of the risk is borne by very few players.
Over-the-counter trading also contributes to the opacity of derivatives markets, further reducing competition and increasing the margin enjoyed by the traders — and the prices that final users (mostly industrial firms) must pay. The combined profits of the key players in this market total $80 billion, which represents a massive tax on the real economy.
To fix this problem, we need to move the bulk of derivative trading onto organized exchanges, where daily collateral requirements would guarantee systemic stability, and price transparency would force competition, reduce margins, and increase the market’s depth. In the United States, the Dodd-Frank Act moves some of the way in this direction, and similar efforts are underway in Europe.
Nevertheless, the journey is still a long one. The major investment banks are fully aware that every day that they delay appropriate market regulation, they earn millions of dollars for their managers’ bonus funds. It is no surprise that the reform process is taking so long.
According to European Commission spokeswoman Amelia Torres, the latest efforts at antitrust enforcement can be seen as complementing pending derivatives regulation. To overcome the enormous lobbying power of investment banks — and thus help to ensure global financial stability — any tool is helpful, even if it comes wrapped in a package of European ideological bias.
Luigi Zingales is Professor of Entrepreneurship and Finance at University of Chicago Graduate School of Business and co-author, with Raghuram G. Rajan, of Saving Capitalism from the Capitalists. This commentary is published by Daily News Egypt in collaboration with Project Syndicate, www.project-syndicate.org.
