Big banks could lose a sizable source of revenue, while exchange operators could stand to benefit from the burgeoning efforts to create a public, transparent marketplace for unregulated derivates. The multitrillion dollar market for credit default swaps is facing intense scrutiny from legislators and regulators over its role in contributing to the current economic crisis. While Senate Agriculture Committee Chairman Tom Harkin (D., Iowa), has threatened to ban the products altogether, it is unclear how much support there would be for such a move. A less radical way of getting control over the market would involve moving trading to exchanges. That would be a revenue killer for banks like Goldman Sachs ( GS), Morgan Stanley ( MS), JPMorgan Chase ( JPM), Deutsche Bank ( DB), Citigroup ( C), Bank of America ( BAC), UBS ( UBS) and Merrill Lynch ( MER), which are major dealers in this market. They benefit from the lack of price transparency, because it allows them to trade with parties that have less information. On the other hand, it is a potential bonanza for the exchange industry -- especially IntercontinentalExchange ( ICE) and CME Group ( CME) -- which had been eyeing the CDS market long before it became a priority for Washington. The market is 10 times the size of the U.S. corporate bond market and 40% larger than the open interest on CME futures contracts, according to a recent Credit Suisse report. While several exchanges, including NYSE Euronext ( NYX) and Nasdaq OMX Group ( NDAQ), may eventually try to get into the game, CME Group and ICE are already off and running. They have partnered up with major market participants and are working with the Federal Reserve to establish central clearing facilities -- a critical back-office function that would provide many of the benefits of exchange trading, such as ensuring the financial soundness of the participants and preventing manipulation.
The banks mentioned above have been working for 14 months with ICE and the Clearing Corp., which had provided clearing services for the Chicago Board of Trade before the exchange merged with the Chicago Mercantile Exchange in 2006 to form CME Group. The banks are also shareholders in the Clearing Corp. This arrangement makes ICE and the Clearing Corp. front-runners to dominate the credit default swaps trading and clearing businesses, argues Justin Schack, an analyst at Rosenblatt Securities. However, if regulators require CDS to be traded on an exchange, that could favor CME Group and its partner, giant Chicago hedge fund Citadel Group, Schack says. That is because they have a stronger clearinghouse and closer ties to the Commodity Futures Trading Commission, which regulates future exchanges. CME and Citadel also appear to have time on their side. Officials at the Federal Reserve want a solution as soon as possible, and Clearing Corp. says it won't be operational until the end of the year. A Rosenblatt Securities report notes that Clearing Corp. missed its initial target of September. "It has been without a permanent chief executive for some time, and may be experiencing some of the operational inefficiencies that can plague industry consortia," the report says. But Jamie Cawley, CEO of interdealer broker IDX Capital, says it is impossible to predict who will come out on top among the exchanges, as history has shown that new markets never evolve in an orderly fashion. "The prize is huge, and the only thing that's certain is that whoever you pick as a winner is going to be the wrong guy," Cawley says. "Look at what happened with the personal computer. At the time of Wang and Commodore 64, nobody could have envisioned Dell ( DELL) or Gateway."
One thing that is certain is that banks will lose out as the market moves out of the shadows and pricing is easier to determine. How much it contributes to the earnings of any specific bank is hard to know because investment banks guard such secrets closely. One measure of the importance of the market to the banks is staffing levels. One trader at a large bank estimates that the top five CDS dealers have an average of 400 employees globally dedicated to the CDS business, including traders, lawyers and back office employees. But even if the regulators were not breathing down the banks' necks, Sandler O'Neill analyst Jeff Harte believes the days of CDS as a great profit machine were already numbered. Competitive pressures would probably have opened up the market anyway. "That's the natural flow of things in the investment banking business and has been for decades," he says "When a product comes out and it's not fully understood or fully standardized it's a much higher margin product, but once it gets to the point where its actively used enough that it can be cleared through an exchange or traded entirely electronically, that's the direction it goes."