Fifteen of the biggest players in the $14 trillion market for credit insurance are also the referees.
Firms such as JPMorgan Chase & Co. and Goldman Sachs wrote the rules, are the dominant buyers and sellers and, ultimately, help decide winners and losers.
Has a country such as Argentina paid what it owes? Has a company like Caesars Entertainment Corp. kept up with its bills? When the question comes up, the 15 firms meet on a conference call to decide whether a default has triggered a payout of the bond insurance, called a credit-default swap. Investors use CDS to protect themselves from missed debt payments or profit from them.
Once the 15 firms decide that a default has taken place, they effectively determine how much money will change hands.
And now, seven years after the financial crisis first brought CDS to widespread attention, pressure is growing inside and outside what's called the determinations committee to tackle conflicts of interest, according to interviews with three dozen people with direct knowledge of the panel's functioning who asked that their names not be used. Scandals that exposed how bank traders rigged key interest rates and fixed currency values have given ammunition to those who say CDS may also be susceptible to collusion or, worse, outright manipulation.
The trade group that oversees the process, the International Swaps & Derivatives Association, is now proposing rule changes that it says will reform the determinations committee. The proposals include limiting the people who can be involved in decision-making and prohibiting panel members from discussing decisions outside meetings, according to a document obtained by Bloomberg News.
For skeptics, the question is whether the changes would go far enough. Because only the biggest CDS traders are seated on the panel, conflicts are not only tolerated but unavoidable.
"You've got a self-regulatory body that has handed the authority over an entire market to those folks who have the greatest self-interest and have no prohibition for putting their interests ahead of the broader market," said Joshua Rosner, managing director of the financial research firm Graham Fisher & Co., who wrote a report on the shortcomings of the determinations committee earlier this year.
ISDA says its system is transparent. "Regulators have full transparency on the trades and positions held by all market participants," according to ISDA spokesman Nick Sawyer. On its website, ISDA says conflicts are mitigated by having both buyers and sellers on the panel.
"I think we have a robust and transparent process," said Scott O'Malia, ISDA's chief executive officer. "But like all robust processes, there needs to be continual analysis, feedback and improvement. We will continue to review policies and procedures as market practices adapt."
Rarely, if ever, does the wider world learn how or why the committee's decisions are made. Though final tallies and how each firm voted are posted online, discussions among panel members are not.
None of the 15 committee members, nor the firms they represent, would comment for this story. An executive at one of the firms said, without being specific, that there were potentially severe repercussions for discussing the panel's internal matters.
CDS on corporate and sovereign debt, which are subject to the panel's decision-making, have bubbled into prominence lately. The plummeting price of oil and other commodities has caused some corporations and governments to struggle to keep current with creditors. For instance, CDS prices are showing that traders have priced in 95 percent odds that Venezuela will default within five years, according to S&P Capital IQ CDS data released Tuesday.
The stakes go far beyond a few hedge funds and banks. Although the market for credit insurance on individual companies and countries has shrunk by 59 percent since 2008, more money is now invested in benchmark CDS indexes than at any time since the committee's creation in 2009, according to the Depository Trust & Clearing Corp. Mutual funds increasingly use CDS because they're having trouble finding bonds to trade. That means the determinations committee is increasingly affecting the $3.5 trillion of bond mutual funds, a staple of U.S. retirement savings.
Though the determinations committee has rendered more than 1,000 judgments in the last six years, no records of its discussions have ever been made public -- nor is ISDA proposing they be.
"The problem is there's no ability for an independent body to determine whether or not the process is fair, which ISDA says it is," said Dennis Kelleher, CEO of Better Markets Inc., a Washington-based nonprofit watchdog group.
How conflicts of interest are handled became apparent last year during a call involving the perilous finances of Argentina.
Had the country defaulted on its debt? The question was submitted to the determinations committee on July 31.
If the panel voted yes, as much as $532 million would flow to CDS buyers. Those buyers included Paul Singer's hedge fund, Elliott Management Corp. -- also a member of the determinations committee.
Elliott had a history with Argentina. The firm was a creditor during the country's debt default in the 1990s and had refused to accept a reduced payment for some of its bonds. To get its money back, Elliott's tactics included trying to seize an Argentine ship docked in Ghana and suing Elon Musk's Space Exploration Technologies in a bid to take over the rights to two of Argentina's satellite-launch contracts.
On Aug. 1, the committee voted yes. Argentina had defaulted. According to ISDA, the committee voted the same way it did in almost all its decisions: unanimously.
Only it wasn't quite that simple.
Elliott's representative -- Mary Kuan, a partner at New York law firm Kleinberg, Kaplan, Wolff & Cohen -- did something that no member had ever done before, according to people with direct knowledge of the matter. She asked that Elliott be recused from voting.
The rules don't allow recusals. And if a member firm abstains for any reason twice during its term, it gets booted from the panel.
If everyone with a conflict were recused, there might be no one left to make the decisions, people at the firms said on condition of anonymity. There are conflicts on almost every vote, they said.
Michael O'Looney, an Elliott spokesman, declined to comment on behalf of Kuan and the hedge fund.
Elliott ended up joining the yes vote.
Determining whether a company or government has formally defaulted might sound easy, but bonds are often freighted with covenants and structures that are virtually indecipherable to anyone but lawyers and traders.
Before the determinations committee was created, CDS sellers facing payouts on the insurance might insist a "default event" hadn't been triggered.
After the collapse of Lehman Brothers Holdings Inc. in September 2008 exposed the complexity of the CDS market, Timothy Geithner, then president of the Federal Reserve Bank of New York, decided it needed an overhaul -- and fast. At his bidding, executives of the largest CDS dealers and money management firms met at Goldman Sachs's headquarters in Lower Manhattan. Working with markers on paper white boards, the group drew up a new system for improving the settlement of CDS obligations.
Their solution: Let us decide.
ISDA, created in 1985, would oversee the determinations committee and everyone would abide by its decisions. If a vote fell short of a required 12-member supermajority, the committee would appoint a three-person external review panel -- something that has happened only twice in six years.
Creating the committee "was part of a series of measures to ensure greater standardization and transparency," Sawyer, the ISDA spokesman, said. Its decisions can only be based on publicly available information, such as media reports and regulatory filings. The committee is guided by definitions of default "meant to ensure the process is objective and predictable," Sawyer said.
The executives and regulators who established the determinations committee were less concerned about members' conflicts of interest than they were in setting up the panel quickly for an avalanche of decisions as the world economy was faltering at the time, according to a person who was there.
"We did consider the issue of conflicts when we designed the process, but the most important thing was to have people with knowledge of the product running the process," said Athanassios Diplas of Diplas Advisors, who helped create the committee when he was chief risk officer at Deutsche Bank AG's credit business.
To some, the process, whatever its shortcomings, is the best approach and helps manage the conflicts that are built into the system.
"By having those invested in the outcomes at the table -- those on both buy and sell sides -- you get the spectrum and difference of opinion needed in complex situations," said Jordan S. Terry, founder and managing director of Stone Street Advisors in New York. Geithner, through a spokesman at his current employer, Warburg Pincus, declined to comment.
But at least one former panelist said they've raised concerns with ISDA about the potential for unwanted attention from regulators, citing parallels with the recent interest-rate and currency scandals.
Sometimes, decisions that are reported on ISDA's website as unanimous don't start out that way. Before members vote, an ISDA official often takes an informal poll to see where everyone stands, according to people with direct knowledge of the committee's deliberations.
The set-up allows members to assess how the panel is leaning, align their interests and thus avoid having the three- person review panel decide, people with knowledge of the matter said.
The determinations committee also sets the parameters under which CDS holders get paid in the event of a default. It picks which bonds will be included in an auction to set the price of the CDS payout.
Argentina represented a rare case where the public record shows dissent within the committee on that point. In that instance, members disagreed about using yen-denominated bonds that were trading at relatively low prices to help determine the CDS payout -- a step that would effectively require sellers of the insurance to pay more.
The only firm to vote against that plan was Pacific Investment Management Co., according to ISDA's website. Pimco's $95.5 billion Total Return Fund had sold CDS to other investors who had bet on a decline in a bond index that included Argentina, according to a regulatory filing. If Argentina's situation worsened, the index would fall more, meaning Pimco would owe more. Pimco declined to comment.
Representatives of more than half the committee members said the process could be improved, which is what ISDA says it's now trying to do. Three Wall Street derivatives executives who helped create the determinations committee said a firm should have the option of recusing itself without penalty. ISDA's proposed new rules don't address recusals. Other representatives recommend changing the rules so that the three-person panel makes more decisions.
Rosner would go even further. The best way to fix the process is to ask members to disclose potential conflicts and the rationale for their votes, he says.
"If you want people to feel confident in the fact that the committee works for the best interests of the market then you have to have that transparency," he said.