Belgium: EU Competition Investigation Into Credit Default Swaps: The End In Sight?

In what could be the last step before closing its investigation into credit default swaps (CDS), the European Commission has announced that it is market testing commitments offered by the International Swaps and Derivatives Association Inc. (ISDA) and Markit to address preliminary competition concerns.  The commitments were published on 29 April 2016 in the Official Journal. 

If the results of the market test are positive, the European Commission could make the commitments legally binding by decision under Article 9 of Regulation 1/2003.  This would result in the closing of the investigation, without the European Commission concluding to - nor the parties recognizing- an infringement of EU competition rules.  Article 9 decisions have become by far the preferred route (instead of prohibition decisions) for closing investigations where non-cartel competition concerns under Articles 101 or 102 TFEU have been identified. 

Background and facts

Credit default swaps are derivative instruments which were originally created to protect against the risk of default of a corporate or government bond.  They are also used for speculation.  During the period under investigation (2006-2009), CDS were traded over the counter through dealers and allegations were made that the market was not transparent and exchanges were being prevented from accessing this market. 

The CDS market has been under investigation by the European Commission since 2011.  In fact two antitrust investigations were opened in 2011: one concerning the CDS information market; the other concerning agreements between CDS dealers and ICE Clear for the clearing of CDS instruments.  The investigation into CDS clearing was closed on 4 December 2015 due to an apparent lack of evidence.  The European Commission had expressed concern that banks coordinated on the choice of ICE Clear as their preferred central counterparty for clearing CDS trades.  On the other hand, the investigation into CDS information market which originally concerned investment banks and Markit was extended to ISDA in 2013 and then narrowed down to only ISDA and Markit after the European Commission announced on 4 December 2015 that it was closing proceedings against all 13 investment banks.  In this latter investigation, the European Commission expressed concern that ISDA and Markit refused to license to Deutsche Börse and the Chicago Mercantile Exchange access to data and indices necessary for on-exchange trading of CDS instruments.

ISDA is a trade association which represents the financial derivatives industry.  It claims ownership rights over the 'Final Price' which consists in the price resulting from a credit auction used to determine the settlement price of a credit derivatives trade following default.  Although challenged by ISDA, access to 'Final Price' data is considered necessary by exchanges for settling exchange traded credit derivatives.  Markit is a financial information and services company.  It collects data on credit derivatives and in particular, it owns all rights for the iTraxx and CDX indices.  These indices –or also referred to as benchmarks - are baskets of the most commonly traded CDS on the market.   As these indices are highly liquid, access to this data is also viewed as important references for CDS trades or other exchange traded instruments and to attract liquidity.  Both ISDA and Markit refused to license their rights over the Final Price and indices to Deutsche Börse and the Chicago Mercantile Exchange.

The commitments

The commitments published last week were made separately by each of ISDA and Markit.   They consist in behavioural commitments and organisational commitments. 

ISDA commits for a ten-year period to:

• grant licenses on fair, reasonable and non-discriminatory (FRAND) terms within a period of 120 days (with a possible agreed 30-day extension) to use the Final Price for the purpose of exchange trading to any applicant. Exceptionally the license may be terminated under specifically defined conditions, including where there is proven credit auction manipulation.  ISDA had expressed concern regarding the risk of manipulation of the credit event auction results by bidders to benefit from exchanged-traded open contracts.  A mechanism is provided for the resolution of disputes: by arbitration (failing which, by court adjudication) as regards the commercial terms of the licence agreement; through the monitoring trustee as regards a concrete auction manipulation concern; and
• change its internal procedures to exclude CDS dealers from ISDA's licensing decisions regarding the Final Price.  As a result, licensing requests will be decided upon by ISDA's CEO alone.  To date, these decisions were taken by the ISDA Board of Directors, or a sub-committee, on which CDS dealers could sit. 

Markit commits for a period of ten years to:

• grant licenses on FRAND terms within 3 months (with possibility to extend to 6 months under certain circumstances but only for a transitional period) to applicants to create exchanged-traded financial products based on an iTraxx or CDX index.  Markit may refuse to grant a license under defined circumstances, namely where "significant legal or regulatory risks or very significant reputational risks for Markit and/or for the Indices" exist or where "the trading venue has insufficient experience and resources to develop and launch the proposed exchange-traded product."  Markit may also grant preferential terms for an initial two-year period without being in breach of its FRAND commitment.  Exclusivity periods may not be granted, save that existing licenses containing an exclusivity period which is incompatible with the commitments are allowed to run before Markit's licensing commitment kick in.   A mechanism is provided for the resolution of disputes by arbitration within nine months, failing which the matter may be brought before the courts of England and Wales; and
• enlarge membership of its two remaining CDS Index Advisory Committees to include a range of market participants other than CDS dealers.  These include non-dealer buy-side firms, market makers, trading platform exchanges and clearing houses.  Membership will be rotating, terms limited in time and at least 50% will change after the first year.  In addition the terms of reference of Markit's committees will focus only on "technical, operational and administrative matters"; discussions on the following will be banned: licensing decisions; "terms, commercial aspects or revenue generation proposals relating to CDX and iTraxx indices or the merits of any new exchange or similar platform designed financial products referencing such indices".  A Markit lawyer will attend each meeting/conference call and take written minutes to be retained for 5 years.

Commentary

The commitments offered by ISDA and Markit could lead to the closing of an investigation which has been wrought with difficulties.  Initially opened in 2011 under the Almunia administration, the investigations into the CDS market were narrowed down considerably after Mrs Vestager took over as Commissioner for Competition, first by closing the investigation into CDS clearing and second by excluding the banks from the CDS information market investigation as the evidence against them 'was not sufficiently conclusive". 

The statement of objections issued by the European Commission in 2013 focused considerably on the alleged collusion amongst banks to prevent exchanges from accessing the CDS market, thereby preserving their stronghold as intermediaries in OTC trading of CDS instruments.   With the commitments offered, the focus has shifted to the owners of the rights over the data used for trading in CDS instruments, namely ISDA and Markit, and ensuring that access to data is granted to applicants on FRAND terms.  Nevertheless, and although the proceedings against the banks have been closed, the commitments also indirectly address some of the underlying concerns expressed by the Commission earlier on in the proceedings regarding the potentially concerted role played by banks in preventing the licensing of data and indices to exchanges.  Indeed, the organisational changes to be made to the structure of ISDA and Markit aim to ensure that the banks active on the CDS market are no longer involved in licensing decisions made by ISDA and Markit.   These organisational commitments are far-reaching and will introduce internal structural changes to ISDA and Markit akin to Chinese walls.  A significant amount of oversight is likely to be required from the monitoring trustees to ensure compliance not only with the licensing obligations but also to monitor that internal technical discussions do not overflow into licensing decisions. 

The progress made in this investigation has been aided also by parallel regulatory advances made with the adoption in 2014 of a financial services legislative package, namely the MIFIDII Directive and MIFIR Regulation.  This package - due to enter into force in January 2018 – is aimed at introducing more transparency, orderly trading and a level playing field for the trading of financial services instruments, with its biggest impact being on derivatives such as CDS.  In particular, the rules will require a significant proportion of derivatives (including CDS products) to be moved from OTC trading to trading venues; owners of benchmarks (including owners of CDS indices) will be required to provide non-discriminatory access to trading venues and central counterparties to price and data feeds relating to the benchmarks; trading venues and central counterparties will be required to provide non-discriminatory and transparent access to each other.  The EU Benchmark Regulation -which was approved last week by the European Parliament - will also impose, on owners of benchmarks, requirements inter alia on internal governance, in particular to avoid any conflict of interest and risk of undue influence in the provision of a benchmark.  Although strongly debated within the financial services industry, these legislative rules are expected to add further transparency, competition and ease of access to the CDS market.  The commitments offered by ISDA and Markit should therefore be viewed against this background. 

The European Commission is not the only antitrust regulator to have looked recently into the CDS market.  In the US, the Department of Justice (DoJ) carried out from 2011 a four-year investigation into allegations of collusion by banks and Markit to keep information on the CDS market opaque and prevent access to exchanges.  Ultimately no charges were brought by the DoJ given the lack of sufficient evidence against the banks and Markit.  However, although the DoJ did not find evidence of an antitrust infringement, banks nevertheless ended up paying USD 1.87 billion as settlement in 2015 in a US civil law suit to address allegations from investors of a conspiracy to limit competition in the CDS market, including closing off access to price and trade information to the detriment of investors and preventing on exchange trading.     

In accordance with the European Commission's procedure, interested parties should submit their comments on the commitments offered by ISDA and Markit by 28 May 2016.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.