Secret Banking Derivative Cabal Redux, And Why HFT In CDS Has So Far Been A Failure

Tyler Durden's picture

Today, in a 3,500 word oeuvre, the NYT's Louise Story has done an expose on some of the key development in the CDS market. For those who may not have the patience of reading the whole thing, we provide an abridged summary...

  • The most profitable product for banks currently are derivatives (and CDS in particular)
  • As a result, the derivatives trading cabal wants to contain its members to as few as possible, and to preserve the status quo indefinitely
  • Margins on CDS can be anything as there is no central clearing or pricing mechanism; buyers and sellers rely on the broker to present an honest market
  • The trading desk spread profit on a CDS contract is 0.1% of notional ($25,000 of $25,000,000)
  • Spreads can be as wide as the banking cartel (Goldman, as most other banks just price at Goldman levels) deems them to be
  • Banks do not want to trade CDS on exchanges as that would kill margins
  • Citadel tried to make CDS trading into a HFT operation. It failed (for now)
  • Markit is a dominant industry-controlled player, and prevents transparency (and thus keeps margins high) in the market by not allowing broad dissemination of CDS pricing
  • Regulation is powerless to break the cabal's control

That pretty much covers it.

Of course, to anyone who has read Zero Hedge over the past two years none of this is a surprise. We have long claimed that:

  • Derivatives trading is and continues to be the most profitable product line for the banking cabal, but for Goldman Sachs particularly, whose FICC group would be a pale image of itself if it could not dominate CDS trading (link)
  • Goldman is a virtual monopoly in client-facing synthetic trading. Furthermore, it is a pure monopoly in cap arb situations that require the combination of cash and synthetic trades, courtesy of the elimination of the Bear fixed income trading unit (the bulk of which ended up going to Goldman) and the destruction of Lehman Brothers. And as virtually everything is now a pair trade in the basis realm of some sort, Goldman likely pockets, directly and indirectly, a few nickels of every single corporate spread trade in the world
  • Due to pricing opacity, it is not unheard of, and in fact happens quite often, that due to wide entry spreads, both sides of a given CDS trade can claim a profit at the same time, especially with banking facilitiation that "validated" End Of Day/Week/Month pricing tables. This leads LPs to believe that their fund investment is in much better shape than in reality, leading to a Madoff type event one day when reality catches up.
  • Markit, among others, has been alleged to provide above market pricing in the past (link). It will likely recur in the future, or as long as there is no transparent trading market for derivatives.
  • Donk is a joke? Really? Next up someone will tell us that the first US and European stress test were a lie...

In other words - a lot of recycling. One useful observation: contrary to claims to the contrary, High Frequency Trading in CDS is so far completely and totally DOA: Citadel's walking away with its tail between its legs proves it. To achieve that one needs a clearing market. And once HFT gets involved, margins plunge, and volume needs to make up for the margin shortfall. This means the market will need to be opened up to the general public. Zero Hedge firmly believes this will be the case... eventually. When that happens, CDS contract notionals will plunge from a minimum $1MM contract (and really $5MM) currently, down to $1K increments, and margin requirements will be impacted appropriately. Banks will be forced to open the CDS market to the greater retail fools. For that to happen, equities as an asset class will have to collapse, and the general public will want to move its trading higher in the capital structure. Which is why we are stunned that the blogosphere has not seen a broader penetration of CDS-focused sites (in addition to Zero Hedge): after all, when the enchantment with equities is over following the next major crash (and it is already well on its way followin 31 weeks of outflows), this will be the "next big thing", and the first entrant will have a tremendous advantage...