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.
Indeed, the derivatives market today reminds some experts of the Nasdaq stock market in the 1990s. Back then, the Justice Department discovered that Nasdaq market makers were secretly colluding to protect their own profits. Following that scandal, reforms and electronic trading systems cut Nasdaq stock trading costs to 1/20th of their former level — an enormous savings for investors.
Representatives from the nine banks that dominate the market declined to comment on the Department of Justice investigation.
Clearing involves keeping track of trades and providing a central repository for money backing those wagers. A spokeswoman for Deutsche Bank , which is among the most influential of the group, said this system will reduce the risks in the market. She said that Deutsche is focused on ensuring this process is put in place without disrupting the marketplace.
The Bank of New York Mellon’s origins go back to 1784, when it was founded by Alexander Hamilton. Today, it provides administrative services on more than $23 trillion of institutional money.
Recently, the bank has been seeking to enter the inner circle of the derivatives market, but so far, it has been rebuffed.
Bank of New York officials say they have been thwarted by competitors who control important committees at the new clearinghouses, which were set up in the wake of the financial crisis.
Bank of New York Mellon has been trying to become a so-called clearing member since early this year. But three of the four main clearinghouses told the bank that its derivatives operation has too little capital, and thus potentially poses too much risk to the overall market.
The real reason the bank is being shut out, he said, is that rivals want to preserve their profit margins, and they are the ones who helped write the membership rules.
Mr. Kannambadi said Bank of New York’s clients asked it to enter the derivatives business because they believe they are being charged too much by big banks. Its entry could lower fees. Others that have yet to gain full entry to the derivatives trading club are the State Street Corporation , and small brokerage firms like MF Global and Newedge.
The criteria seem arbitrary, said Marcus Katz, a senior vice president at Newedge, which is owned by two big French banks.
“It appears that the membership criteria were set so that a certain group of market participants could meet that, and everyone else would have to jump through hoops,” Mr. Katz said.
The one new derivatives clearinghouse that has welcomed Newedge, Bank of New York and the others — Nasdaq — has been avoided by the big derivatives banks.
How did big banks come to have such influence that they can decide who can compete with them?
Ironically, this development grew in part out of worries during the height of the financial crisis in 2008. A major concern during the meltdown was that no one — not even government regulators — fully understood the size and interconnections of the derivatives market, especially the market in credit default swaps, which insure against defaults of companies or mortgages bonds. The panic led to the need to bail out the American International Group, for instance, which had C.D.S. contracts with many large banks.
None of the three clearinghouses would divulge the members of their risk committees when asked by a reporter. But two people with direct knowledge of ICE’s committee said the bank members are: Thomas J. Benison of JPMorgan Chase & Company; James J. Hill of Morgan Stanley; Athanassios Diplas of Deutsche Bank; Paul Hamill of UBS ; Paul Mitrokostas of Barclays ; Andy Hubbard of Credit Suisse; Oliver Frankel of Goldman Sachs; Ali Balali of Bank of America; and Biswarup Chatterjee of Citigroup.
The secrecy surrounding derivatives trading is a key factor enabling banks to make such large profits.
If an investor trades shares of Google or Coca-Cola or any other company on a stock exchange, the price — and the commission, or fee — are known. Electronic trading has made this information available to anyone with a computer, while also increasing competition — and sharply lowering the cost of trading. Even corporate bonds have become more transparent recently. Trading costs dropped there almost immediately after prices became more visible in 2002.
Not so with derivatives. For many, there is no central exchange, like the New York Stock Exchange or Nasdaq, where the prices of derivatives are listed. Instead, when a company or an investor wants to buy a derivative contract for, say, oil or wheat or securitized mortgages, an order is placed with a trader at a bank. The trader matches that order with someone selling the same type of derivative.
So the banks responded in the fall of 2008 by pairing with ICE, one of the Chicago Mercantile Exchange’s rivals, which was setting up its own clearinghouse. The banks attached a number of conditions on that partnership, which came in the form of a merger between ICE’s clearinghouse and a nascent clearinghouse that the banks were establishing. These conditions gave the banks significant power at ICE’s clearinghouse, according to two people with knowledge of the deal. For instance, the banks insisted that ICE install the chief executive of their effort as the head of the joint effort. That executive, Dirk Pruis, left after about a year and now works at Goldman Sachs . Through a spokesman, he declined to comment.
The banks also refused to allow the deal with ICE to close until the clearinghouse’s rulebook was established, with provisions in the banks’ favor. Key among those were the membership rules, which required members to hold large amounts of capital in derivatives units, a condition that was prohibitive even for some large banks like the Bank of New York.
The banks also required ICE to provide market data exclusively to Markit, a little-known company that plays a pivotal role in derivatives. Backed by Goldman, JPMorgan and several other banks, Markit provides crucial information about derivatives, like prices.
Kevin Gould, who is the president of Markit and was involved in the clearinghouse merger, said the banks were simply being prudent and wanted rules that protected the market and themselves.
Still, even after that deal was complete, the Chicago Mercantile Exchange soon had second thoughts about working with Citadel and about introducing electronic screens at all. The C.M.E. backed out of the deal in mid-2009, ending Mr. Griffin’s dream of a new, electronic trading system.
With Citadel out of the picture, the banks agreed to join the Chicago Mercantile Exchange’s clearinghouse effort. The exchange set up a risk committee that, like ICE’s committee, was mainly populated by bankers.
It remains unclear why the C.M.E. ended its electronic trading initiative. Two people with knowledge of the Chicago Mercantile Exchange’s clearinghouse said the banks refused to get involved unless the exchange dropped Citadel and the entire plan for electronic trading.
Kim Taylor, the president of Chicago Mercantile Exchange’s clearing division, said “the market” simply wasn’t interested in Mr. Griffin’s idea.
“It’s not like the sort of representation where if I’m elected to be the representative from the state of Illinois, I go there to represent the state of Illinois,” Ms. Taylor said in an interview.
Officials at ICE, meantime, said they solicit views from customers through a committee that is separate from the bank-dominated risk committee.
The result of the maneuvering of the past couple years is that big banks dominate the risk committees of not one, but two of the most prominent new clearinghouses in the United States.
That puts them in a pivotal position to determine how derivatives are traded.
Under the Dodd-Frank bill, the clearinghouses were given broad authority. The risk committees there will help decide what prices will be charged for clearing trades, on top of fees banks collect for matching buyers and sellers, and how much money customers must put up as collateral to cover potential losses.
Perhaps more important, the risk committees will recommend which derivatives should be handled through clearinghouses, and which should be exempt.
Regulators will have the final say. But banks, which lobbied heavily to limit derivatives regulation in the Dodd-Frank bill, are likely to argue that few types of derivatives should have to go through clearinghouses. Critics contend that the bankers will try to keep many types of derivatives away from the clearinghouses, since clearinghouses represent a step towards broad electronic trading that could decimate profits.
The banks already have a head start. Even a newly proposed rule to limit the banks’ influence over clearing allows them to retain majorities on risk committees. It remains unclear whether regulators creating the new rules — on topics like transparency and possible electronic trading — will drastically change derivatives trading, or leave the bankers with great control.
One former regulator warned against deferring to the banks. Theo Lubke, who until this fall oversaw the derivatives reforms at the Federal Reserve Bank of New York, said banks do not always think of the market as a whole as they help write rules.