People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public.Adam Smith warned the world about collusion more than two centuries ago. More recently, shady, inside, nontransparent dealing in derivatives contributed to a financial meltdown and the deepest recession since the 1930s. And yet, we continue to allow the too-big-to-fail banks to collude in the derivatives market.
Adam Smith, The Wealth of Nations, 1776
The New York Times reports
On the third Wednesday of every month, the nine members of an elite Wall Street society gather in Midtown Manhattan.To be clear, the issue isn't derivatives themselves. When traded fairly, derivatives serve an important function in financial markets, allowing firms and investors to diversify and hedge risks. Rather, the problem is how the market is operated.
The men share a common goal: to protect the interests of big banks in the vast market for derivatives, one of the most profitable — and controversial — fields in finance. They also share a common secret: The details of their meetings, even their identities, have been strictly confidential.
Drawn from giants like JPMorgan Chase, Goldman Sachs and Morgan Stanley, the bankers form a powerful committee that helps oversee trading in derivatives, instruments which, like insurance, are used to hedge risk.
In theory, this group exists to safeguard the integrity of the multitrillion-dollar market. In practice, it also defends the dominance of the big banks.
The banks in this group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market, and they are also trying to thwart efforts to make full information on prices and fees freely available.
At a minimum, the lack of transparency and lack of competition lead fees to be higher than they need to be. In essence, it's hard to get a good deal because buyers can't see the other deals that are out there. As the article explains
It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it. Moreover, only the real estate agent — and neither buyer nor seller — would have easy access to the prices paid recently for other homes on the same block.
The profits of the colluding banksters soar but at the expense of firms and investors who buy the products.
The clearing house also gives the participating banks a tremendous and unfair information advantage. Banks start with an information advantage from assembling the derivatives. The same way that a used-car salesman has inside information about a lemon he may be trying to offload; the banks often have inside information about the securities that make up the derivative (Goldman Sachs' scandalous participation in the ABACUS CDO is but one example).
And there are other information advantages. The clearinghouse allows participating banks to see how the overall market is trending, while investors are left largely in the dark.
If banks were always neutral market makers, these information asymmetries might matter less, but the investment banks are also often parties to these transactions, trading from their own accounts or using derivatives to offload their own risks.
The clearinghouses should, in principle, be advantageous by increasing the information in the market. However, these advantages only obtain if the clearinghouses are open to all qualified institutions and if the resulting information is shared with all market participants.