EMAIL DETAILS

December 11, 2010
A Secretive Banking Elite Rules Trading in Derivatives
By LOUISE STORY
On the third Wednesday of every month, the nine members of an elite
Wall Street society gather in Midtown Manhattan.

The men share a common goal: to protect the interests of big banks in
the vast market for derivatives, one of the most profitable — and
controversial — fields in finance. They also share a common secret:
The details of their meetings, even their identities, have been
strictly confidential.

Drawn from giants like JPMorgan Chase, Goldman Sachs and Morgan
Stanley, the bankers form a powerful committee that helps oversee
trading in derivatives, instruments which, like insurance, are used to
hedge risk.

In theory, this group exists to safeguard the integrity of the
multitrillion-dollar market. In practice, it also defends the
dominance of the big banks.

The banks in this group, which is affiliated with a new derivatives
clearinghouse, have fought to block other banks from entering the
market, and they are also trying to thwart efforts to make full
information on prices and fees freely available.

Banks’ influence over this market, and over clearinghouses like the
one this select group advises, has costly implications for businesses
large and small, like Dan Singer’s home heating-oil company in
Westchester County, north of New York City.

This fall, many of Mr. Singer’s customers purchased fixed-rate plans
to lock in winter heating oil at around $3 a gallon. While that price
was above the prevailing $2.80 a gallon then, the contracts will
protect homeowners if bitterly cold weather pushes the price higher.

But Mr. Singer wonders if his company, Robison Oil, should be getting
a better deal. He uses derivatives like swaps and options to create
his fixed plans. But he has no idea how much lower his prices — and
his customers’ prices — could be, he says, because banks don’t
disclose fees associated with the derivatives.

“At the end of the day, I don’t know if I got a fair price, or what
they’re charging me,” Mr. Singer said.

Derivatives shift risk from one party to another, and they offer many
benefits, like enabling Mr. Singer to sell his fixed plans without
having to bear all the risk that oil prices could suddenly rise.
Derivatives are also big business on Wall Street. Banks collect many
billions of dollars annually in undisclosed fees associated with these
instruments — an amount that almost certainly would be lower if there
were more competition and transparent prices.

Just how much derivatives trading costs ordinary Americans is
uncertain. The size and reach of this market has grown rapidly over
the past two decades. Pension funds today use derivatives to hedge
investments. States and cities use them to try to hold down borrowing
costs. Airlines use them to secure steady fuel prices. Food companies
use them to lock in prices of commodities like wheat or beef.

The marketplace as it functions now “adds up to higher costs to all
Americans,” said Gary Gensler, the chairman of the Commodity Futures
Trading Commission, which regulates most derivatives. More oversight
of the banks in this market is needed, he said.

But big banks influence the rules governing derivatives through a
variety of industry groups. The banks’ latest point of influence are
clearinghouses like ICE Trust, which holds the monthly meetings with
the nine bankers in New York.

Under the Dodd-Frank financial overhaul, many derivatives will be
traded via such clearinghouses. Mr. Gensler wants to lessen banks’
control over these new institutions. But Republican lawmakers, many of
whom received large campaign contributions from bankers who want to
influence how the derivatives rules are written, say they plan to push
back against much of the coming reform. On Thursday, the commission
canceled a vote over a proposal to make prices more transparent,
raising speculation that Mr. Gensler did not have enough support from
his fellow commissioners.

The Department of Justice is looking into derivatives, too. The
department’s antitrust unit is actively investigating “the possibility
of anticompetitive practices in the credit derivatives clearing,
trading and information services industries,” according to a
department spokeswoman.

Indeed, the derivatives market today reminds some experts of the
Nasdaq stock market in the 1990s. Back then, the Justice Department
discovered that Nasdaq market makers were secretly colluding to
protect their own profits. Following that scandal, reforms and
electronic trading systems cut Nasdaq stock trading costs to 1/20th of
their former level — an enormous savings for investors.

“When you limit participation in the governance of an entity to a few
like-minded institutions or individuals who have an interest in
keeping competitors out, you have the potential for bad things to
happen. It’s antitrust 101,” said Robert E. Litan, who helped oversee
the Justice Department’s Nasdaq investigation as deputy assistant
attorney general and is now a fellow at the Kauffman Foundation. “The
history of derivatives trading is it has grown up as a very
concentrated industry, and old habits are hard to break.”

Representatives from the nine banks that dominate the market declined
to comment on the Department of Justice investigation.

Clearing involves keeping track of trades and providing a central
repository for money backing those wagers. A spokeswoman for Deutsche
Bank, which is among the most influential of the group, said this
system will reduce the risks in the market. She said that Deutsche is
focused on ensuring this process is put in place without disrupting
the marketplace.

The Deutsche spokeswoman also said the banks’ role in this process has
been a success, saying in a statement that the effort “is one of the
best examples of public-private partnerships.”

Established, But Can’t Get In

The Bank of New York Mellon’s origins go back to 1784, when it was
founded by Alexander Hamilton. Today, it provides administrative
services on more than $23 trillion of institutional money.

Recently, the bank has been seeking to enter the inner circle of the
derivatives market, but so far, it has been rebuffed.

Bank of New York officials say they have been thwarted by competitors
who control important committees at the new clearinghouses, which were
set up in the wake of the financial crisis.

Bank of New York Mellon has been trying to become a so-called clearing
member since early this year. But three of the four main
clearinghouses told the bank that its derivatives operation has too
little capital, and thus potentially poses too much risk to the
overall market.

The bank dismisses that explanation as absurd. “We are not a nobody,”
said Sanjay Kannambadi, chief executive of BNY Mellon Clearing, a
subsidiary created to get into the business. “But we don’t qualify. We
certainly think that’s kind of crazy.”

The real reason the bank is being shut out, he said, is that rivals
want to preserve their profit margins, and they are the ones who
helped write the membership rules.

Mr. Kannambadi said Bank of New York’s clients asked it to enter the
derivatives business because they believe they are being charged too
much by big banks. Its entry could lower fees. Others that have yet to
gain full entry to the derivatives trading club are the State Street
Corporation, and small brokerage firms like MF Global and Newedge.

The criteria seem arbitrary, said Marcus Katz, a senior vice president
at Newedge, which is owned by two big French banks.

“It appears that the membership criteria were set so that a certain
group of market participants could meet that, and everyone else would
have to jump through hoops,” Mr. Katz said.

The one new derivatives clearinghouse that has welcomed Newedge, Bank
of New York and the others — Nasdaq — has been avoided by the big
derivatives banks.

Only the Insiders Know

How did big banks come to have such influence that they can decide who
can compete with them?

Ironically, this development grew in part out of worries during the
height of the financial crisis in 2008. A major concern during the
meltdown was that no one — not even government regulators — fully
understood the size and interconnections of the derivatives market,
especially the market in credit default swaps, which insure against
defaults of companies or mortgages bonds. The panic led to the need to
bail out the American International Group, for instance, which had
C.D.S. contracts with many large banks.

In the midst of the turmoil, regulators ordered banks to speed up
plans — long in the making — to set up a clearinghouse to handle
derivatives trading. The intent was to reduce risk and increase
stability in the market.

Two established exchanges that trade commodities and futures, the
InterContinentalExchange, or ICE, and the Chicago Mercantile Exchange,
set up clearinghouses, and, so did Nasdaq.

Each of these new clearinghouses had to persuade big banks to join
their efforts, and they doled out membership on their risk committees,
which is where trading rules are written, as an incentive.

None of the three clearinghouses would divulge the members of their
risk committees when asked by a reporter. But two people with direct
knowledge of ICE’s committee said the bank members are: Thomas J.
Benison of JPMorgan Chase & Company; James J. Hill of Morgan Stanley;
Athanassios Diplas of Deutsche Bank; Paul Hamill of UBS; Paul
Mitrokostas of Barclays; Andy Hubbard of Credit Suisse; Oliver Frankel
of Goldman Sachs; Ali Balali of Bank of America; and Biswarup
Chatterjee of Citigroup.

Through representatives, these bankers declined to discuss the
committee or the derivatives market. Some of the spokesmen noted that
the bankers have expertise that helps the clearinghouse.

Many of these same people hold influential positions at other
clearinghouses, or on committees at the powerful International Swaps
and Derivatives Association, which helps govern the market.

Critics have called these banks the “derivatives dealers club,” and
they warn that the club is unlikely to give up ground easily.

“The revenue these dealers make on derivatives is very large and so
the incentive they have to protect those revenues is extremely large,”
said Darrell Duffie, a professor at the Graduate School of Business at
Stanford University, who studied the derivatives market earlier this
year with Federal Reserve researchers. “It will be hard for the
dealers to keep their market share if everybody who can prove their
creditworthiness is allowed into the clearinghouses. So they are
making arguments that others shouldn’t be allowed in.”

Perhaps no business in finance is as profitable today as derivatives.
Not making loans. Not offering credit cards. Not advising on mergers
and acquisitions. Not managing money for the wealthy.

The precise amount that banks make trading derivatives isn’t known,
but there is anecdotal evidence of their profitability. Former bank
traders who spoke on condition of anonymity because of confidentiality
agreements with their former employers said their banks typically
earned $25,000 for providing $25 million of insurance against the risk
that a corporation might default on its debt via the swaps market.
These traders turn over millions of dollars in these trades every day,
and credit default swaps are just one of many kinds of derivatives.

The secrecy surrounding derivatives trading is a key factor enabling
banks to make such large profits.

If an investor trades shares of Google or Coca-Cola or any other
company on a stock exchange, the price — and the commission, or fee —
are known. Electronic trading has made this information available to
anyone with a computer, while also increasing competition — and
sharply lowering the cost of trading. Even corporate bonds have become
more transparent recently. Trading costs dropped there almost
immediately after prices became more visible in 2002.

Not so with derivatives. For many, there is no central exchange, like
the New York Stock Exchange or Nasdaq, where the prices of derivatives
are listed. Instead, when a company or an investor wants to buy a
derivative contract for, say, oil or wheat or securitized mortgages,
an order is placed with a trader at a bank. The trader matches that
order with someone selling the same type of derivative.

Banks explain that many derivatives trades have to work this way
because they are often customized, unlike shares of stock. One share
of Google is the same as any other. But the terms of an oil
derivatives contract can vary greatly.

And the profits on most derivatives are masked. In most cases, buyers
are told only what they have to pay for the derivative contract, say
$25 million. That amount is more than the seller gets, but how much
more — $5,000, $25,000 or $50,000 more — is unknown. That’s because
the seller also is told only the amount he will receive. The
difference between the two is the bank’s fee and profit. So, the
bigger the difference, the better for the bank — and the worse for the
customers.

It would be like a real estate agent selling a house, but the buyer
knowing only what he paid and the seller knowing only what he
received. The agent would pocket the difference as his fee, rather
than disclose it. Moreover, only the real estate agent — and neither
buyer nor seller — would have easy access to the prices paid recently
for other homes on the same block.

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 of Markit 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 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 panel last March at Columbia University. “That’s not their
expertise, that’s not their primary interest.”