‘Cartel Profits’: Wall Street Giants Gamed Final Auction Prices for Credit Default Swaps, Antitrust Class Action Claims

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The biggest names in banking have for years engaged in a conspiracy to manipulate the final auction price for credit default swaps (CDS), reaping billions in “cartel profits” at the expense of non-dealer market participants, a proposed class action alleges. 

Filed on June 30 by the New Mexico State Investment Council, the 133-page antitrust complaint alleges a number of CDS “dealers,” major Wall Street banks including the likes of Bank of America/Merrill Lynch, Barclays, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan and Morgan Stanley, have since 2005 manipulated the benchmark price used to value all CDS contracts market-wide at settlement (i.e., the final auction price) through a bid-rigging and price-fixing process that ultimately produces a supra-competitively low final auction price. An artificially low final auction price increases the amount that must be paid by CDS protection sellers to CDS protection buyers when their contracts settle, thereby generating an “anticompetitive windfall” for some of the CDS dealers. 

The dealer defendants, listed in full at the bottom of this post, have been aided in the alleged conspiracy by three entities over whom they yield “significant power and influence”—Creditex, ISDA and Markit, per the suit. The antitrust action summarizes that the big-name finance defendants, i.e., “dealers,” armed with disproportionate control over CDS auctions and “inside-information advantages that they bestowed upon themselves as exclusive gatekeepers to the auctions,” have manipulated the final auction price—the benchmark that they “created and forced upon the market,” per the case. 

“They have achieved this manipulation 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—typically downward,” the complaint alleges. 

According to the lawsuit, a CDS is akin to a type of insurance in that a “protection seller” agrees to pay the “protection buyer” for losses the buyer might suffer if its underlying investment, such as an investment in corporate or sovereign bonds, which are central to the plaintiff’s case, fails. In exchange, the protection buyer shells out what essentially amount to “premiums” to the seller over the life of a CDS contract, the suit says.

The suit states, however, that a credit default swap is unlike insurance in that the buyer can “purchase CDS on bonds that it does not actually own,” a maneuver known as a “naked” swap, the case informs. Per the lawsuit, naked swaps “provide an opportunity for CDS market participants to speculate about the creditworthiness of a bond issuer.” When a bond suffers a “credit event,” which typically involve bankruptcy or missing a coupon payment on the bond, the CDS is “triggered” and “the protection seller’s promise of compensation is activated,” according to the complaint. 

Credit default swaps have historically been settled “physically,” meaning the protection buyer would give impaired bonds over to the protection seller, with the seller then paying the buyer the face amount of the CDS contract. As they’ve become more popular and naked swaps have gained prevalence, however, CDSs have come to be more frequently settled with cash, the lawsuit relays. With a cash settlement, the protection buyer and protection seller agree on the value of the underlying impaired bonds, the case says. The seller then pays the buyer “the face amount of the CDS minus the value of the underlying, impaired bonds,” per the suit.

Before 2005, protection sellers and buyers engaged in different methods of determining how much a bond is worth, including by negotiating its value after impairment, which would then determine the amount of money to be paid to the protection buyer, the case says. In 2005, a group of dealers working with Creditex came up with a new way to calculate the value of post-impairment bonds: a two-stage auction process that is still in use today, the lawsuit states. 

“The first stage happens in the morning. The second stage takes place in the afternoon. The Dealers are the only direct participants in the auctions. A representative from each Dealer—typically, a trader on the CDS market making desk—will participate in each auction on behalf of the Dealer.” 

The complaint alleges the dealer defendants convinced – and may have even forced – non-dealer market participants to adopt this auction process to settle and value impaired bonds, but ultimately, the banks manipulated the process in their own favor. Many non-dealer participants accepted the banks’ terms that they would resolve their CDS contracts using the dealer-controlled final auction prices, the case says, adding that the dealer defendants took another step toward making the final auction price the universal benchmark for valuating and settling CDS contracts when they decided in 2008 to incorporate the auction process into the standardized contracts used to trade credit default swaps.

In practice, the dealer defendants’ imposition of the final auction price as the universal CDS benchmark served only themselves, the plaintiff claims: 

“The reality was much different. The Dealers formed a Dealer-only ‘working group’ whose only members were representatives of each of the Dealers and a representative from the dealer-dominated trader association ISDA. The Dealer-only working group had no formal name. Its existence was not publicized.”

Per the case, the dealer-only working group was helmed informally by representatives from Goldman Sachs, Deutsche Bank and JPMorgan. At the dealer-only working group meetings, the entities reached “several agreements to exclude and constrain non-dealer participation in the auctions,” the case says. 

Among the dealer-friendly rules imposed by the defendants on CDS auctions was the caveat that only dealers would be allowed to be direct participants, and they held the right to vote on those who could also directly participate, the lawsuit alleges. Moreover, only dealers would be allowed to submit the initial markets used to determine the initial market midpoint (IMM), essentially placing “a cap or floor on the final auction price,” the case claims. In addition, non-dealers could only participate in the auctions through the dealers themselves, the case explains.  

“When a non-dealer wants to submit a limit order or a physical settlement request into an auction, it needs to disclose that trading information to at least one Dealer, providing that Dealer with advance, insider knowledge of the non-dealer client’s identity, the price at which it wants to trade, the quantity that it is looking to trade, the types of bonds it wants to trade, and its timing for the trade…” 

All of this, the lawsuit stresses, is competitively and commercially sensitive information that the Dealers have exploited through “illegal market manipulation tactics, including front-running.” 

“The intent of these agreements was to make the Dealers the exclusive gatekeepers to the auction. The effect of making the Dealers the exclusive gatekeepers to the auction was to bestow upon each Dealer various inside-information advantages that enable it to reap anti-competitive trading profits at the expense of unknowing non-dealer market participants—and to enable the dealers to manipulate the benchmark final auction price.” 

Overall, the dealer defendants’ gaming of the CDS auction process to yield supra-competitively low final auction prices cheats more protection dollars out of the pockets of non-dealer counterparties such as the plaintiff and putative class members. 

The lawsuit looks to represent a proposed class of all persons or entities, who, from June 1, 2005 through the present, settled a credit default swap in the United States or its territories by reference to the ISDA credit default swap auction protocol (or the auction process that became the ISDA credit default swap auction process.) Per the complaint, a “credit default swap” includes single-name CDSs, index CDSs and swaptions. 

Named as defendants in the antitrust action are Bank of America Corporation; Bank of America, N.A.; BofA Securities, Inc.; Barclays PLC; Barclays Bank PLC; Barclays Capital Inc.; BNP Paribas S.A.; BNP Paribas Securities Corp.; Citigroup, Inc.; Citibank N.A.; Citigroup Global Markets Inc.; Citigroup Global Markets Limited; Credit Suisse Group AG; Credit Suisse AG; Credit Suisse Securities (USA) LLC; Credit Suisse Capital LLC; Credit Suisse International; Deutsche Bank AG; Deutsche Bank Securities Inc.; Goldman Sachs Group, Inc.; Goldman Sachs & Co. LLC; Goldman Sachs International; J.P. Morgan Chase & Co.; J.P. Morgan Chase Bank, N.A.; J.P. Morgan Securities LLC; Morgan Stanley; Morgan Stanley & Co., LLC; Morgan Stanley & Co. International PLC; Morgan Stanley Capital Services, LLC; NatWest Group PLC; NatWest Markets PLC; NatWest Markets Securities, Inc.; The International Swaps and Derivatives Association, Inc.; Creditex Group Inc.; and IHS Market, LTD. 

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