Owning the Banking System
Senator Carl Levin relentlessly questioned Goldman Sachs executives regarding conflicts of interest in the mortgaged backed securities markets. This is a story of conflicts that are far more pervasive and dangerous than those which drew the ire of the Senator.
The banks have always dominated the derivatives trading markets by taking risks and making markets for other trading firms. Historically, the amount of risk taken on and the profits have been staggeringly large.
There came a time (roughly coinciding with de-regulation) when the banks discovered a way to enhance profits from dominating trading activity. They discovered the immense advantage of owning the infrastructure of the markets. The value of investments in infrastructure could be assured if banks used their market power to direct trading volume through the structures they owned. Non-bank traders would have no choice. They had to use the infrastructure which the banks preferred and a flow of business would be captured.
Perhaps more importantly, banks could influence the evolution of the marketplaces. The market structures would suit their trading businesses. The scope of the markets and prevailing practices would serve their strategies. These influences are less obvious than pumping up value of investments, and are more of a concern for that reason.
The events of 2008 have made clear to the public that these markets are not merely a playground for banks to trade esoteric investments with each other and large businesses. The derivatives markets impact the supply and cost of energy, food, essential manufactured products and money itself. It has never been more important to secure the independence of market infrastructure from the banks. With regulatory reform in place, the ability to avoid its intended purpose by influencing the mechanisms of the market to enlarge gaps in regulation will be a central goal of the financial institutions. They must be told that the infrastructure is not theirs to use to avoid regulatory control.
Robert E. Litan, writing for the Brookings Institute, referred to a “Derivatives Dealer Club” of the top 5 bank dealers. There is no doubt that he has identified the group which, in various combinations, exerts tremendous control over market infrastructure.
It is important to note Goldman Sachs’ interest in market structures with particular interest. When Goldman is an investor in a structure, its influence is disproportionate to that of other investors. Its strategy is to deploy greater expertise to the role of investor, advising management and sometimes seconding executives to fill key roles. Goldman also represents large volumes of business that can be directed to the structures. This increases both the value of the investment as well as Goldman’s influence over the structures on themselves. Goldman is by no means the only firm to pursue this strategy - it just seems to be the best at it.
In 2000, the Intercontinental Exchange (”ICE”) was founded with an initial investor group of Goldman, Morgan Stanley, BP, Total, Deutsche Bank, Shell and Societie Generale. ICE was originally an electronic platform that was intended to displace brokers in the over-the-counter energy markets. The investors would to profit from the fees (including those paid by the investors) which would otherwise go to brokers and would shape the marketplace to meet their needs.
ICE evolved and its scope expanded. Cutting out the brokers was small potatoes compared with cutting out the exchanges and clearinghouses. ICE added a clearing function and the electronic trade matching was adapted to compete with the exchanges. ICE took on NYMEX and other exchanges as its product list grew.
Trade volume was critical to ICE as a source of fee income and the owners did their best to accommodate by directing trade flow to the platform. If major institutions sent trades to ICE, lesser players in the market had to follow if they wanted to transact with them.
An incentive plan was also created. Stock warrants, very valuable if there was an IPO, were awarded to customers based on volume. Sure enough, some customers (not Goldman) undertook “round trip trades.” In short, A will buy from B if B agrees to subsequently buy the same thing from A, all at an agreed price. This inflated volume and earned warrants. The other reason for the round trip trades was to establish artificial prices, also problematic. The regulators discovered this activity and took appropriate action.
In 2005, ICE shares were very successfully offered to the public. This IPO (Morgan Stanley and Goldman were senior underwriters) was quite unusual. Relatively little capital was raised by ICE. The vast majority of the offering consisted of the shares of the original investors. They cashed out. But that did not end their influence. The original investors, and predominantly Goldman Sachs, retained great influence not only because of relationships and corporate DNA, but because of the market volume they controlled. Remember, volume is the life blood of ICE. Much of the evolution of the energy market was driven by ICE.
The credit default swap market developed with dealer bank influence in parallel with energy. The CDS market was exclusively transacted over-the-counter and un-cleared. There were three significant market structure providers: Depository Trust Clearing Corporation (”DTCC”), Markit and CreditEX.
DTCC has a long history as an institution created to serve the dealer banks by providing data and other services that they can share. Of the 18 board members, 12 are representatives of financial institutions. DTCC is the primary repository of information on CDS transactions. It is widely known that DTCC serves the interests of the banks and would be loath to act against those interests.
Markit managed information, creating price indices for various derivatives and provided other processes. Goldman Sachs and other dealers were owners since its early days in 2003. CreditEx provided an electronic environment in which OTC traders could meet up and transact. Goldman was not an owner of CreditEx, but other banks were. Goldman’s influence was soon to be felt by CreditEx, however.
Markit and CreditEx were partners in a number of initiatives. One such strategic partnership changed the CDS market dramatically, facilitating explosive growth. In 2005, Markit and CreditEx developed a Credit Event Fixing product. It provided standard methods for determining valuations and procedures in the event of default for CDS. It also provided an environment for effecting transactions conforming to these processes and procedures. The success of this joint venture led to the absorption in 2007 of two competing credit index providers by Markit, each of which was partially owned by Goldman Sachs - CDS Index Co. and International Index Co.
To complete the circle, and with an eye on the coming storms in the CDS market, ICE acquired CreditEx in 2008.
After the financial crisis, it became apparent that clearing of CDS was not only politically essential but a good business opportunity. There were two US-based initiatives that raced to provide the service, one effort sponsored by ICE and the other by the Chicago Mercantile Exchange.
ICE chose to separate clearing from its energy and other clearing businesses. It set up ICE Trust which could receive swaps transacted in the OTC markets in the past and contemporaneously. Its structure was very friendly to the banks. In fact, 50% of ICE Trust profits go to Goldman, JP Morgan, Morgan Stanley, Bank of America and Citigroup. The banks sit on the ICE Trust risk committee, allowing the great influence over what is offered for clearing. The bank own profit shares, not equity investments; perhaps ownership would have been impolitic under the circumstances. However, the profit share clearly aligns the interests of the big banks and the clearing entity. Bank influence on ICE Trust was immense.
CME took another route. The swaps were to be cleared through its main clearing operation. CME proposed an electronic front-end trade matching function, mimicking an exchange. This would, of course, be an aid to price transparency.
ICE Trust was successful in attracting volume. CME was not successful. It attempted to modify its product to please the dealer banks, in part by abandoning the front-end system. CME volume continues to lag ICE Trust’s substantially.
The financial reform legislation promises to inspire a new set of structures to markets subject to real regulation. If the new structures are subject to the undue influence of the primary targets of regulation, the results may not be what Congress and most of the American public hoped to achieve. Control and influence over the companies which provide new structures is worthy of careful scrutiny.
Mr. Litan suggests that the scrutiny should include consideration of the applicability of anti-trust laws to their ownership positions. If that route is pursued, there are several practices which emerged in the years of operation of the murky OTC derivatives markets which might also warrant anti-trust examination.
Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.
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