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Investment banks’ hold over the derivatives market has come under regulatory scrutiny as European Commission – the European Union’s (EU) anti-trust body – accused 13 large global banks of colluding against stock exchanges. The EU charged the banks for preventing the exchanges from entering the lucrative derivatives market during 2006–2009.

The banks indicted by the EU include – Bank of America Corporation (BAC - Analyst Report), Barclays PLC (BCS - Analyst Report), JPMorgan Chase & Co. (JPM - Analyst Report) along with the Bear Stearns Co. business that it purchased, BNP Paribas SA, Citigroup Inc. (C - Analyst Report), Credit Suisse AG (CS - Snapshot Report), Deutsche Bank AG (DB - Analyst Report), The Goldman Sachs Group, Inc. (GS - Analyst Report), HSBC Holdings PLC (HBC), Morgan Stanley (MS - Analyst Report), Royal Bank of Scotland Group PLC (RBS - Snapshot Report) and UBS AG (UBS - Analyst Report). Concurrently, International Swaps and Derivatives Association (ISDA) and Markit – a financial data provider – was also charged by the EU.

After conducting preliminary investigation, the EU concluded that banks, aided by ISDA and Markit prevented Deutsche Boerse Group and CME Group Inc.’s (CME - Analyst Report) Chicago Mercantile Exchange from entering the credit default swaps (CDS) business during 2006–2009. Nevertheless, IntercontinentalExchange, Inc. (ICE - Analyst Report) has started offering credit futures on its exchange from this year.

CDS permits an investor to place a bet on whether a company or country will default on its bonds within a fixed time period. CDS were initially traded over-the-counter (OTC). Gradually, given the regulatory efforts to improve transparency, CDS have been shifting to exchanges.

The EU alleged that the banks were against the CDS move from OTC to the exchanges, as their bottom lines would have suffered, since exchange-traded CDS are less expensive. Hence, the banks instructed ISDA and Markit to refuse the stock exchanges licenses to use their data for creating exchange traded CDS. They were only given licenses to using data for OTC products.

Further, OTC trading of CDS lacked transparency and regulatory oversight, thereby weakening the financial markets. This was all the more exposed when Lehman Brothers Inc. collapsed in 2008. Since then, efforts from regulators across the globe continue in an attempt make derivatives trading more transparent.

The banks charged by the EU for their alleged involvement in such contentious practices are expected to be severely penalized. Moreover, the U.S. anti-trust authorities have started their own investigation with respect to similar allegations.

For banks, these charges and investigations pose huge risks. These are likely to increase legal expenses and tarnish the company’s reputation to some extent as well.

However, for financial markets as a whole, these initiatives will help in countering economic crisis in the future. Notably, this could ultimately result in less involvement of taxpayers’ money in the bailout of troubled financial institutions.

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