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Another Reason to Break Up Giant Banks: Regardless of the Law, Mega-Banks Will Continue to Game Derivatives Market and Destabilize the Economy

Many of us have pointed out that the economy will not stabilize until the too big to fails are broken up.

We have also pointed out that derivatives are still very dangerous for the economy, that the derivatives “reform” legislation previously passed has probably actually weakened existing regulations, and the legislation was “probably written by JP Morgan and Goldman Sachs“.

As I noted earlier this month:

Harold Bradley – who oversees almost $2 billion in assets as chief investment officer at the Kauffman Foundation – told the Reuters Global Exchanges and Trading Summit in New York that a cabal is preventing swap derivatives from being forced onto clearing exchanges:

There is no incentive from the moneyed interests in either Washington or New York to change it…

I believe we are in a cabal. There are five or six players only who are engaged and dominant in this marketplace and apparently they own the regulatory apparatus. Everybody is afraid to regulate them.

That’s bad enough.

But last week, Bob Litan of the Brookings Institute wrote a paper (here’s a summary) showing that – even if real derivatives legislation is ever passed – the 5 big derivatives players will still prevent any real change. James Kwak notes that Litan is no radical, but has previously written in defense in financial “innovation”.

Here’s a good summary from Rortybomb, showing that this is yet another reason to break up the too big to fails:

Litan is worried about the “Dealer”s Club” of the major derivatives players. I particularly like this paper as the best introduction to the current oligarchy that takes place in the very profitable over-the-counter derivatives trading market and credit default swap market. [Litton says]:

I have written this essay primarily to call attention to the main impediments to meaningful reform: the private actors who now control the trading of derivatives and all key elements of the infrastructure of derivatives trading, the major dealer banks. The importance of this “Derivatives Dealers” Club” cannot be overstated. All end-users who want derivatives products, CDS in particular, must transact with dealer banks…I will argue that the major dealer banks have strong financial incentives and the ability to delay or impede changes from the status quo — even if the legislative reforms that are now being widely discussed are adopted — that would make the CDS and eventually other derivatives markets safer and more transparent for all concerned…

Here, of course, I refer to the major derivatives dealers – the top 5 dealer-banks that control virtually all of the dealer-to-dealer trades in CDS, together with a few others that participate with the top 5 in other institutions important to the derivatives market. Collectively, these institutions have the ability and incentive, if not counteracted by policy intervention, to delay, distort or impede clearing, exchange trading and transparency

Market-makers make the most profit, however, as long as they can operate as much in the dark as is possible – so that customers don”t know the true going prices, only the dealers do. This opacity allows the dealers to keep spreads high…

In combination, these various market institutions – relating to standardization, clearing and pricing – have incentives not to rock the boat, and not to accelerate the kinds of changes that would make the derivatives market safer and more transparent. The common element among all of these institutions is strong participation, if not significant ownership, by the major dealers.

So Bob Litan is waving a giant red flag that the top dealer-banks that control the CDS market can more or less, through a variety of means he lays out convincingly in the paper, derail or significantly slow down CDS reform after the fact if it passes.

***

If you thought we”d at least get our arms around credit default swap reform from a financial reform bill, you should read this report from Litan as a giant warning flag. In case you weren”t sure if you”ve heard anyone directly lay out the case on how the market and political concentration in the United States banking sector hurts consumers and increases systemic risk through both political pressures and anticompetitive levels of control of the institutions of the market, now you have. It”s not Matt Taibbi, but it”s much further away from a “everything is actually fine and the Treasury is in control of reform” reassurance. Which should scare you, and give you yet another good reason for size caps for the major banks.

View the original article at Washingtons Blog

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