The European Commission has adopted a decision that renders legally binding commitments to licence inputs for credit default swaps, offered separately by the International Swaps and Derivatives Association Inc. (ISDA) and information service provider Markit.
The Commission had competition concerns relating to the licensing of intellectual property that is needed to offer trading services on the market for credit default swaps (CDS). These concerns related to the “final price”, which is used to value CDS if there is a default, and to the licensing of specific CDS indices. The commitments address these concerns as they will make it easier to trade CDS on exchanges, while improving transparency. The increased efficiency and stability in the market for credit derivatives will benefit investors such as mutual funds, pension funds and insurers.
Commissioner in charge of competition policy, Margrethe Vestager said: “Today’s decisions ensure that all trading venues can benefit from fair, reasonable and non-discriminatory access to data and intellectual property owned by ISDA and Markit. This will translate into more choice and lower transaction costs for investors and will also increase market stability.”
The credit default swaps market
A CDS is a contract designed to transfer the credit risk, or risk of default, linked to a debt obligation, such as government or corporate bonds. Neither the buyer nor the seller needs to own any of the debt obligations to which their CDS contract refers to.
CDS are used by investors both to hedge risks and as investments. As a hedge, a CDS provides protection against the credit risk arising from holding debt instruments. As an investment, CDS can be used to take a view on the future development of the debt issuer’s creditworthiness, and earn a profit if the view is correct.
Today, the global amount of outstanding CDS contracts, which is the value of underlying assets specified in the contracts, is about USD 12 trillion.
CDS can be traded”over the counter“, i.e. privately and through market makers (“CDS dealers”) who charge fees for every trade (“bid-ask spread”). Or, they can be traded on an exchange where supply and demand is matched anonymously and directly between investors on an electronic trading platform.
Currently the vast majority of CDS trading still takes place over the counter, where price formation lacks transparency and transaction costs are high, partly because investors must pay high bid-ask spreads.
Over the counter trading of CDS also has a higher market stability risk as compared to exchange trading, since two thirds of this market is still not cleared with a central counterparty. Central counterparties clear the transactions between two parties, managing the risk if one party defaults on its payments. Financial markets become more stable and less risky by having credit derivatives such as CDS cleared through central counterparties. Exchange trading always includes central clearing.
Exchange trading platforms wishing to offer trading for CDS to investors need access to specific intellectual property:
- the ‘Final Price’: i.e. the price which is used, following the default of a debt obligation, to determine the payments between buyers and sellers of CDS contracts linked to that debt obligation. ISDA claims proprietary rights over the “Final Price”.
- CDS indices: Markit owns the iTraxx and CDX index families which are the most liquid and most commonly referenced baskets of CDS contracts. They are market benchmarks and new exchange products could not generate sufficient liquidity without reproducing the main characteristics of trading and clearing of these indices. For these reasons, licences for these indices are essential to support new exchange products.
The Commission’s competition concerns
In July 2013, the Commission raised concerns that ISDA, Markit and some of its member investment banks breached EU antitrust rules by:
- refusing to license the Final Price for exchange trading,
- subjecting the Final Price to a Use Agreement which contains restrictions for its use for exchange-traded products or transactions and
- refusing to licence the CDX and iTraxx indices for exchange trading.
This may have blocked or delayed the emergence of an effective, safer and cheaper market for exchange traded credit derivatives, which would have reduced the bid-ask spreads imposed by CDS dealers and thus the costs of trading.
To address the Commission’s concerns, ISDA and Markit have each offered a set of commitments aimed at facilitating access to their respective intellectual property and data for exchange trading purposes. In April 2016 the Commission market tested the draft commitments and the outcome was positive. In light of the results of the market test, Markit proposed minor modifications and clarifications to the initial commitments.
The main elements of the commitments are:
- both ISDA and Markit will exclude CDS dealers from taking individual licensing decisions and prevent them from influencing such decisions.
- ISDA will license its rights in the Final Price for the exchange trading on fair, reasonable and non-discriminatory (FRAND) terms.
- Markit will license its rights in the iTraxx and CDX indices on FRAND terms for exchange traded financial products based on the indices it owns.
The commitments will apply for ten years, during which ISDA and Markit’s compliance will be monitored by independent trustees. In addition, both sets of commitments are subject to third-party arbitration in case of dispute. The commitments will facilitate access to essential price data and indices for CDS exchanges and exchange products. It will also facilitate access for investors whose statutes may oblige them to trade on regulated venues only.
The Commission found that the commitments address the identified competition concerns and has made them binding on ISDA and Markit.
The International Swaps and Derivatives Association Inc. (ISDA) is a trade organisation representing over 850 financial institutions. Markit Ltd. is a global provider of financial information services.
The Commission opened antitrust proceedings into the CDS market in March 2011 and extended the scope of the investigation to ISDA in March 2013. In December 2015 the Commission closed proceedings against the banks but continued the investigation of ISDA and Markit.
Article 9 of the EU’s Antitrust Regulation (Regulation 1/2003) allows the Commission to conclude antitrust proceedings by making commitments offered by a company legally binding. Such a decision does not reach a conclusion on whether EU antitrust rules have been infringed but legally binds the company to respect the commitments. If Markit or ISDA were to breach the commitments, the Commission could impose a fine of up to 10% of the companies’ total annual turnover, without having to find a violation of the EU competition rules. A policy brief on commitment decisions under Article 9 is available here.
Today’s commitment decisions complement regulatory initiatives to make financial markets more efficient, resilient and transparent. The newDirective on markets in financial instruments (‘MiFID 2’) and the Regulation on markets in financial instruments (‘MiFIR’) will apply from January 2018, and address the vital role of exchanges in strengthening the safety and integrity of financial markets. They aim to move trading of derivatives onto regulated venues and give non-discriminatory access to trading services for derivatives traded on exchanges.
More information is available on the Commission’s competition website in the public case register under the case number 39745.
Compliments of the European Commission