Friday's move by the European Commission marks a step up in efforts to tackle the financial contracts designed to insure against debt default, but which have been at the heart of a crisis that has engulfed weaker European countries.
It follows frustration among some countries at Europe's slow pace of reform of finance and the largely uncharted $600 trillion derivatives market, including credit default swaps (CDS), which ballooned before the global financial crisis.
"CDSs play a useful role for financial markets and for the economy," the commissioner in charge of anti-trust cases, Joaquin Almunia, said in a statement.
"Recent developments have shown, however, that the trading of this asset class suffers a number of inefficiencies that cannot be solved through regulation alone."
Lack of transparency can lead to abusive behaviour, he said, adding: "I hope our investigation will contribute to a better functioning of financial markets and, therefore, to a more sustainable recovery."
The tradeable instruments, which pay out if a company or country is not able to repay its debt, moved centre stage as Greece grappled with soaring borrowing costs. It blamed this on speculators driving up the cost of default insurance.
The European Commission, which regulates competition in the 27-state European Union, said it would investigate whether 16 investment banks including JP Morgan and Citigroup had colluded or abused a dominant market position.
The move ratchets up pressure on the banks as countries and the European parliament continue to wrangle about how best to regulate the sector.
The opaque market, where the only record of many multi-million euro deals is a fax, has frustrated politicians who have attempted to control it because there are no central records of trading.
A competition investigation could sting banks as the commission can fine companies up to 10 percent of revenues and has handed out fines as big as 1 billion euros.
"There are a small number of players in this market having a large impact on the way the world works," said Graham Bishop, an adviser to banks.
"A lot of markets are a close-knit family and the consequences of this herd behaviour have been profound but that is not to say they should be held responsible for the failings of governments like Greece."
The Commission will also investigate any involvement in collusion of financial data provider Markit which provides prices in the CDS market and is owned by banks.
Markit said it did not believe it had engaged in any inappropriate conduct and would demonstrate that to the European Commission.
"Markit has no exclusive arrangements with any data provider and makes its data and related products widely available to global market participants," it said in an emailed statement.
At the same time, the Commission said it had opened proceedings against nine of the 16 banks and ICE Clear Europe, a CDS clearing house owned by exchange operator Inter-Continental Exchange, to examine whether preferential tariffs granted by ICE to the banks had hurt competitors.
The 16 banks being examined are: JP Morgan, Bank of America Merrill Lynch, Barclays, BNP Paribas, Citigroup, Commerzbank, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, Morgan Stanley, Royal Bank of Scotland, UBS, Wells Fargo Bank/Wachovia, Credit Agricole and Societe Generale.
TWO-PRONGED INVESTIGATION
The Commission said the first investigation would focus on the financial information needed for trading CDS, which allow a creditor to hedge risk, or, if they expect a default, to take a speculative position in the market.
The Commission said it had information that the 16 banks that act as dealers in the CDS market give most of the pricing, index information and other data only to Markit, the leading financial information firm in the market.
"This could be the consequence of collusion between them or an abuse of a possible collective dominance and may have the effect of foreclosing the access to the valuable raw data by other information service providers," the Commission said.
"If proven, such behaviour would be in violation of EU anti-trust rules."
In the second investigation, the Commission said it was investigating a number of agreements between nine of the 16 dealer banks and ICE Clear Europe, a clearing house for CDSs.
It said the agreements include a number of clauses, such as preferential fees and profit sharing agreements that might create an incentive for the banks to use only ICE as their clearing house.
"The effects of these agreements could be that other clearing houses have difficulties successfully entering the market and that other CDS players have no real choice where to clear their transactions," the Commission said.
Deutsche Bank, Commerzbank, Goldman Sachs, Morgan Stanley, JP Morgan, Citigroup, HSBC, Barclays, UBS and BNP Paribas all declined to comment.
The other banks and ICE Clear Europe were not immediately available to comment. (Additional reporting by Arno Schuetze in Frankfurt and William James in London, editing by Rex Merrifield and Alexander Smith)