Ever since the news hit this week that the Department of Justice (DOJ) is investigating the derivatives market, I've been trying to figure out why. That resulted in my need to better understand the over-the-counter (OTC) derivatives market. Lucky for me, multiple sources came forward to help out. In fact, anyone who does not have intimate knowledge of the derivatives market, but is interested in learning more, would be well-served to read this piece appearing on Atlantic Business yesterday. Through what I've learned this week, I have finally wrapped my mind around what's going on. DOJ is likely concerned with either price control or market share in the OTC derivatives market, or both.

The DOJ's probe focuses on a firm called Markit. It collects derivatives market data, including pricing information, and is owned by a handful of big banks. At this point, the DOJ is still not showing its hand, but it has revealed that the inquiry is antitrust related. The specific anti-competitive practices it's concerned with are open to speculation. But since the owners of Markit create a kind of oligopoly, the common problems with a few businesses having control over a market might shed some light on the mystery.

Price Control

Before understanding the derivatives market, I couldn't imagine how price control could possibly be involved. Markets set the prices for derivatives. How could a few companies with greater control over the creation of those derivatives control price? Ultimately investors and traders will decide what they're worth.

That's true, but it isn't the prices of the derivatives that likely attracted the DOJ's attention: it's the price banks charge buyers as a fee for their services. This is also known as the spread they charge investors. The banks set those spreads and investors have to pay them.

I know what you're thinking: but isn't that true of all bank fees? Other entrants enter markets and can drive those prices down through competition. For example, the fees banks charge for merger advisory are subject to what their competitors, such a boutique investment banks, might be willing to charge.

In the OTC derivatives market, it's a little different. Not everybody has the liquidity to be a player. That's why the creation of derivatives is so dominated by the big banks. Liquidity creates a high barrier to entry for firms wanting to join in the fun. That keeps competitors out, and possibly spreads higher than they otherwise would be.

Market Share

As I just mentioned, it's hard for potential competitors to enter the market for creating derivatives -- and that's fine with the current market makers. After all, that way they can preserve their market share. The question then becomes whether they have taken action to purposefully keep potential competitors out of the market.

For example, what if a hedge fund wanted to create derivatives? Well, it would need to find another market participant to take the other side of the coin. Each derivative created has a winner and a loser. What if the big banks refuse to answer when hedge funds come knocking?

That's where Markit comes in. Through its services, big banks can know when the risk the derivatives they create can be "netted out" by one of the other big players in the market. Markit keeps track of it. But if you aren't in the club, you can't really play.

So what legitimate reason could banks have to keep others out of the market -- other than wanting to maintain their market share? They could complain that hedge funds and others don't have the capital base to absorb losses that might occur if the derivatives they create go bad. Counterparty risk is quite relevant with derivatives. Even if you win a bet, if the person you bet with doesn't have the money to pay up, you lose.

Could the DOJ be concerned with both of these issues? Sure. After all, if the market had more competitors, then the fees charged would also be more competitive. As the government inquiry unfolds, it will be interesting to see if it finds impropriety in the OTC derivatives market. And if so, how it intends to fix it.

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