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07/02/2021 | Articles and TV
Big Banks Are Accused Of CDS Market Manipulation Scheme
Published in: Law360
Major Wall Street banks have taken part in a more than decadelong, multibillion-dollar scheme to manipulate the benchmark prices used to value credit default swap contracts at settlement, New Mexico's State Investment Council has alleged in a new proposed antitrust class action.
In a complaint filed Wednesday in Albuquerque federal court, the state's investment panel accused Bank of America, Citigroup, Deutsche Bank and other leading CDS dealers of exploiting their market power and informational advantages to rig the auctions that determine payouts when credit default swaps are settled.
In the process, these dealers have managed to rake in billions of dollars in illegal, anti-competitive profits for themselves at the expense of others in the CDS market, according to the suit.
"Because of the regulatory patchwork that governs the credit default swap market, no regulator has unearthed the defendants' conspiracy," the SIC said.
Named as defendants in Wednesday's 128-page complaint were parents and subsidiaries of 10 big-bank corporate families as well as two companies involved with running CDS auctions and the derivatives industry's main trade organization, which is alleged in the suit to have functioned as a "front organization" for the dealer banks.
According to the complaint, their alleged conspiracy dates back to the 2005 introduction of the auction process for settling credit default swaps, a type of derivative that investors can use to speculate on credit risk and hedge against investment losses from a credit event like a bond issuer's bankruptcy.
After such a credit event, a CDS buyer can collect a payout from the CDS seller to compensate for lost value on the asset underlying the CDS contract. Rather than have sellers and buyers negotiate this new discounted price individually, the auction process yields a single, market-wide price based on two rounds of submissions from dealer banks, which can be both CDS sellers and buyers.
The SIC, which is being represented in part by the New Mexico Attorney General's Office, alleged that the dealer banks strong-armed the rest of the market into adopting this auction process and colluded to lord over the auctions as "exclusive gatekeepers" through a working group formed in 2008.
"The dealer-only working group had no formal name. Its existence was not publicized," the SIC said in its complaint. "At the dealer-only working group meetings, the dealers reached several agreements to exclude and constrain non-dealer participation in the auctions."
The dealer banks have then used their control over the auction process to benefit themselves "by sharing competitively and commercially sensitive pricing information with each other, and then coordinating their auction submissions to drive the final auction price in the direction that suits their respective CDS positions," the SIC alleged.
According to the complaint, evidence of secret coordination and information-sharing turns up in econometric analyses of publicly available CDS auction and bond pricing data.
And while the complaint did not cite any allegedly damning trader chat room transcripts the way some other market manipulation cases against major banks have, the SIC alleged that the dealer banks' traders do share proprietary trade and pricing information among themselves through channels like text messages, WhatsApp and Bloomberg terminal chats.
The SIC also alleged that a "secret loophole" in the Bloomberg system has for years allowed traders at different dealer banks to check key pricing information from their competitors that is supposed to be off-limits.
Combined with the inside information that they gain from handling their own clients' auction submissions, the dealer banks then steer the auction toward a "supra-competitive" final price, according to the complaint.
The SIC said this price is most often skewed downward because the dealer banks are generally net buyers of CDS protection on assets at auctions, meaning they stand to make more money when the final price is lower.
"Even minor deviations in the final auction price cause a sea change in the amount of money that changes hand for CDS settlement purposes marketwide, netting the dealers billions of dollars in additional CDS protection payments over time," the SIC said in its complaint.
The complaint has asserted claims under the Sherman Act and Commodity Exchange Act, as well as for unjust enrichment, on behalf of a proposed class that includes investors who have settled a CDS contract since June 2005 based on the auction process.
The SIC has asked for the court to award unspecified treble damages with interest, attorney fees and other relief.
Spokespeople for Bank of America, Citi and Deutsche Bank declined to comment on Friday. Representatives for the New Mexico Attorney General's Office did not immediately return a request for comment.
The SIC is represented by P. Cholla Khoury of the Office of the New Mexico Attorney General and by David E. Kovel and Thomas Popejoy of Kirby McInerney LLP.
Counsel information for the defendants was not immediately available.
The case is New Mexico State Investment Council v. Bank of America Corp. et al., case number 1:21-cv-00606, in the U.S. District Court for the District of New Mexico.
In a complaint filed Wednesday in Albuquerque federal court, the state's investment panel accused Bank of America, Citigroup, Deutsche Bank and other leading CDS dealers of exploiting their market power and informational advantages to rig the auctions that determine payouts when credit default swaps are settled.
In the process, these dealers have managed to rake in billions of dollars in illegal, anti-competitive profits for themselves at the expense of others in the CDS market, according to the suit.
"Because of the regulatory patchwork that governs the credit default swap market, no regulator has unearthed the defendants' conspiracy," the SIC said.
Named as defendants in Wednesday's 128-page complaint were parents and subsidiaries of 10 big-bank corporate families as well as two companies involved with running CDS auctions and the derivatives industry's main trade organization, which is alleged in the suit to have functioned as a "front organization" for the dealer banks.
According to the complaint, their alleged conspiracy dates back to the 2005 introduction of the auction process for settling credit default swaps, a type of derivative that investors can use to speculate on credit risk and hedge against investment losses from a credit event like a bond issuer's bankruptcy.
After such a credit event, a CDS buyer can collect a payout from the CDS seller to compensate for lost value on the asset underlying the CDS contract. Rather than have sellers and buyers negotiate this new discounted price individually, the auction process yields a single, market-wide price based on two rounds of submissions from dealer banks, which can be both CDS sellers and buyers.
The SIC, which is being represented in part by the New Mexico Attorney General's Office, alleged that the dealer banks strong-armed the rest of the market into adopting this auction process and colluded to lord over the auctions as "exclusive gatekeepers" through a working group formed in 2008.
"The dealer-only working group had no formal name. Its existence was not publicized," the SIC said in its complaint. "At the dealer-only working group meetings, the dealers reached several agreements to exclude and constrain non-dealer participation in the auctions."
The dealer banks have then used their control over the auction process to benefit themselves "by sharing competitively and commercially sensitive pricing information with each other, and then coordinating their auction submissions to drive the final auction price in the direction that suits their respective CDS positions," the SIC alleged.
According to the complaint, evidence of secret coordination and information-sharing turns up in econometric analyses of publicly available CDS auction and bond pricing data.
And while the complaint did not cite any allegedly damning trader chat room transcripts the way some other market manipulation cases against major banks have, the SIC alleged that the dealer banks' traders do share proprietary trade and pricing information among themselves through channels like text messages, WhatsApp and Bloomberg terminal chats.
The SIC also alleged that a "secret loophole" in the Bloomberg system has for years allowed traders at different dealer banks to check key pricing information from their competitors that is supposed to be off-limits.
Combined with the inside information that they gain from handling their own clients' auction submissions, the dealer banks then steer the auction toward a "supra-competitive" final price, according to the complaint.
The SIC said this price is most often skewed downward because the dealer banks are generally net buyers of CDS protection on assets at auctions, meaning they stand to make more money when the final price is lower.
"Even minor deviations in the final auction price cause a sea change in the amount of money that changes hand for CDS settlement purposes marketwide, netting the dealers billions of dollars in additional CDS protection payments over time," the SIC said in its complaint.
The complaint has asserted claims under the Sherman Act and Commodity Exchange Act, as well as for unjust enrichment, on behalf of a proposed class that includes investors who have settled a CDS contract since June 2005 based on the auction process.
The SIC has asked for the court to award unspecified treble damages with interest, attorney fees and other relief.
Spokespeople for Bank of America, Citi and Deutsche Bank declined to comment on Friday. Representatives for the New Mexico Attorney General's Office did not immediately return a request for comment.
The SIC is represented by P. Cholla Khoury of the Office of the New Mexico Attorney General and by David E. Kovel and Thomas Popejoy of Kirby McInerney LLP.
Counsel information for the defendants was not immediately available.
The case is New Mexico State Investment Council v. Bank of America Corp. et al., case number 1:21-cv-00606, in the U.S. District Court for the District of New Mexico.
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