How a bank's hedge became a US$2b loss, and why it can happen again
While everyone in the East has been mesmerised by the Bo Xilai mystery, another enigma has been unravelling out West, involving a London whale. JPMorgan Chase this month announced trading losses of US$2 billion and the resignation of the head of its chief investment office. Also expected to be leaving is Bruno Iksil, the London-based French trader who made such large, and some say fearless, bets in synthetic credit default swaps that he was variously nicknamed the London whale, Voldemort (the wizard nemesis of Harry Potter) and the Caveman.
One recent research report guesstimated that the losses could be as large as US$5 billion, but we will not know until 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 so-called Volcker rule.
This is a specific section in the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010. A draft rule was released for consultation in October last year. Specifically, the rule aims to prohibit proprietary trading by banks, but there is 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 rule and its final version has yet to be passed.
Trading in over-the-counter CDS derivatives is so opaque that probably only specialist traders and risk managers understand how the market operates. Thanks to a few alert journalists, such as Lisa Pollack from the Financial Times' online news service, FT Alphaville, the mystery was being slowly unveiled, but it did not hit the major print media until JPMorgan announced the losses.
The hedge funds that may or may not have been on the other side of the bet have leaked to the press that the whale's large positions in CDS indices could be distorting the market, and the trades may have violated the spirit of the Volcker rule.
In April, JPMorgan's chief financial officer was said 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 the risk of an 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, a cost to the hedge.