The market for credit default swaps is booming, with a global total of more than $200 trillion in swaps and derivatives.
But as the US government, European Union and Japan are looking to ease US debt burden, the arbitrageur is increasingly targeting banks and hedge funds.
The most lucrative markets are those run by international institutions, such as the IMF, European Commission, the World Bank and others.
The IMF, which oversees the International Monetary Fund (IMF), is looking to reduce US debt.
The European Central Bank (ECB) is in the middle of a bond-buying programme, while Japan is also considering cutting its public debt.
In August, the US Congress passed a resolution urging the president to cut US debt, with lawmakers also calling for the IMF to do more.
“We have a lot of opportunities for us to take advantage of,” said Alistair McEwan, a senior partner at the London-based consultancy EY.
“The market has always been very, very competitive.
The key thing for us is that it is a market that is so sensitive to policy changes that it has to be regulated very carefully.”
McEwan said a key issue for arbitrage traders is to find a balance between risk and reward.
“I think what makes arbitrage is the way in which it can be manipulated,” he said.
“When you are buying or selling something, you are in control of how much of that product you are getting, and you can control how much you are giving away.”‘
Risky business’The US has had a troubled financial sector for decades.
Its credit rating has fallen from AA to AA+, from AA+ to A.B. Headed by Treasury Secretary Jack Lew, the administration of former President Barack Obama has focused on improving the US economy and improving its fiscal health.
But while US debt is expected to fall by $1 trillion over the next decade, interest rates are expected to rise.
The US is also facing a fiscal crisis.
It is estimated that as much as 60 per cent of the country’s public debt is held by just a handful of individuals and firms, according to the New York Federal Reserve.
“There is an economic boom going on right now that is a big risk to any bank,” said McEwaiver.
“If you can take advantage and make money, you can make a lot.
It’s risky business.”
A lack of transparencyThe US government has been particularly aggressive in pushing for more transparency around the debt-buoyancy markets, as US bond prices have fallen in recent years.
But there is a lack of disclosure when it comes to the arbitraging business, which is often hidden from the public eye.
“A lot of these deals are actually private,” McEwathes said.
“There’s a lack in the transparency that goes along with these deals.”
The US Treasury Department and other agencies have been looking at ways to crack down on arbitrage, but the US has been reluctant to push for tougher laws to crack the game down.
“As a government, the United States is not an arbitrage market,” said Robert Gagnon, the executive director of the US-based International Arbitrage Centre.
“We do not engage in arbitrage.”
Instead, the IAC focuses on helping governments enforce their rules on derivatives, as well as on protecting traders and investors from the consequences of their actions.
“In the case of derivatives, we do not have any regulatory structure to help people who do not want to be held liable,” said Gagnonso.
“That’s what the international community needs to do.”
A crackdown on arbitragersA crackdown by the US Treasury, US Congress and others has made it clear that the US will be the target of foreign companies seeking to exploit the arbitrating market.
In April, the Financial Crimes Enforcement Network (FinCEN) launched an investigation into the activities of brokerages and hedge fund firms that offer credit default swap derivatives.
The inquiry is examining the actions of several US firms, including CME Group Inc, a Chicago-based trading firm, that offer “risk-free” swaps, or contracts that can be sold to buyers without incurring any fees.”CME Group has been cooperating with FinCEN and is working to identify and report to the regulator any instances of illegal conduct,” a CME spokesman told Al Jazeera.
“It will take actions against any companies that engage in such conduct.”
The probe has so far focused on CME and its affiliates.
CME declined to comment on the investigation.
A CME spokeswoman said the company was cooperating with the probe.
“While CME is not involved in this matter, we have been and continues to be vigilant to the risks of any financial instruments that we offer,” the spokesperson said.
According to FinCen, arbitrage in financial markets has become a lucrative business, with arbitrage firms raising up to $15 billion annually in loans