Whales hedge their bets, giving bite to the Volcker Rule

On May 10, JP Morgan announced trading losses of US$2 billion, the resignation of the head of its Chief Investment Office and the departure of Bruno Iksil, the London-based French trader who made such large and, some say, fearless bets in synthetic credit default swaps (CDS) that he was nicknamed the “London whale”, “Voldemort” (the wizard nemesis of Harry Potter) or the “Caveman”. One recent research report guesstimated that the losses could be as large as $5 billion, but we will not know until the regulators finish poring over the numbers. 

The mystery really began in early April, when hedge fund traders complained to journalists that the London Whale was making such large trades in the CDS market that he was violating the Volcker Rule.  

The Volcker Rule is a specific section in the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010, with the draft rule released for consultation in October last year. Specifically, the Volcker Rule aims to prohibit proprietary trading by banks, but there are a whole list of exemptions such as market-making, specific hedges and proprietary trading in Treasury paper, Fannie Mae and Freddie Mac bonds, as well as municipal bonds. The banking industry has been lobbying against the Volcker Rule, and its final version has not yet been passed.

Trading in over-the-counter (OTC) CDS derivatives is so opaque that probably only specialist traders and risk managers would understand how the market operates. Thanks to a few alert journalists like Lisa Pollack in the Financial Times online post Alphaville, the mystery has been slowly unveiling, but it did not hit the major print media until JP Morgan had to announce the large losses.   

The hedge funds that may or may not have been on the other side of the bet, however, leaked to the press that the Whale’s large positions in the CDS indices could be distorting the market, which could expose JP Morgan to future losses, and maybe such trades violated the spirit of the Volcker Rule.  

Indeed, in April, the JP Morgan chief financial officer was reputed to have responded that the positions were hedges in line with the bank’s overall risk strategy. 

Hedging is, of course, a common practice to insure oneself against loss, normally by taking an opposite position in one market to offset against the risk of holding another position in a particular investment. If a bank happens to hold a portfolio of bonds, it is usual to buy CDS protection against the credit risk in those bonds or to short the bonds by selling forward. There is, of course, always a cost to the hedge.

What experienced risk managers will be aware of is that there is no such thing as a perfect hedge. Taking a hedge may reduce the risk of holding certain assets, but you assume counter-party risk. In other words, if the counter-party fails to fulfill his part of the contract, you might as well have no hedge. Moreover, there is always the danger that the hedge instrument does not behave as expected. If the value of the hedge moves in the same direction as the risk being hedged, you may end up with losses being doubled instead of losses being cancelled out by profits on the hedge.   

When does a hedge morph into a proprietary trade, defined as a trade that is undertaken by the bank using its own capital? If a bank acts as agent for any transaction, it does not assume position risk, but has a counter-party risk with the principal. But if the hedge is not working (namely losses are still being incurred), the trader can decide to undertake a hedge of the original hedge. That enters into the grey area of proprietary trading. 

There is no question that the JP Morgan hedging strategy that incurred the $2 billion losses was, in CEO Jamie Dimon’s own words, “flawed, complex, poorly reviewed, poorly executed, and poorly managed”. Given the bank’s “fortress balance sheet”, this loss is nowhere near problematic for the bank’s continuing profitability. But this incident has raised a major question: If the best of the risk managers can make these mistakes, and the best will, can the others manage? Are we not in the territory of not “Too Big to Fail”, but “Too Complex to Manage?”

Poring through the complex transactions as deciphered in blogspace by various market participants, it became obvious that the CDS markets have a small circle of players and are not always liquid. If one of them becomes too large in terms of positions, the rest either follow the momentum or if they know that the whale is caught with too many tickets that it cannot dispose of without loss, then they join in to make a killing. Very Darwinian. 

This mystery will be solved soon, once official numbers are released. But three questions remain. The first is on transparency: Should all OTC trades be made more transparent and therefore fair to all? The hedge funds are the first to want the trades to be OTC and less transparent and less regulated. They couldn’t complain to regulators to stop any whale behaviour, so they complained to the press. 

Second, as Lisa Pollack rightly asked, since most, if not all, the trades were cleared in the Depository Trust and Clearing Corporation, and available to regulators, where were they? 

Third, would the Volcker Rule have stopped such egregious behaviour? 

All we know is that the London Whale’s loss has given legislators and regulators more ammunition to tighten the Volcker Rule. If you want to know how this will play out, Paul Volcker will be in Hong Kong to give a keynote speech at the Fung Global Institute Asia Global Dialogue on May 31.  

Come and ask him yourself.  

 

Andrew Sheng is president of the Fung Global Institute.