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.
Experienced risk managers know there is no such thing as a perfect hedge. Taking a hedge may reduce the risk of holding certain assets, but you assume counterparty risk. In other words, if the counterparty fails to fulfil 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 being cancelled out.
When does a hedge morph into a proprietary trade, which is 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 counterparty 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. And that puts it in the grey area of proprietary trading.
There is no question that the hedging strategy that lost JPMorgan US$2billion was, in chief executive Jamie Dimon's own words, 'flawed, complex, poorly reviewed, poorly executed, and poorly monitored'. Given the bank's 'fortress balance sheet', this loss is nowhere near problematic for its continuing profitability. But this incidence has raised a major question: if the best of the risk managers can make these mistakes, and the best will, can the others manage? Aren't we in the territory of 'too complex to manage', rather than 'too big to fail'?
It's becoming clear 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, they join in to make a killing. Very Darwinian.
This mystery will be solved once official numbers are released. But three questions remain. The first is transparency: should all over-the-counter trades be made more transparent and therefore fair to all? The hedge funds are the first to want the trades to be less transparent and less regulated. They couldn't complain to regulators to stop any whale behaviour, so they complained to the press.
Second, as Pollack rightly asked, since most if not all the trades were cleared by the Depository Trust and Clearing Corporation, and available to regulators, where were they?
Third, would the Volcker rule have stopped such egregious behaviour?
The whale of a loss has certainly given 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's Asia-Global Dialogue next Thursday. Come and ask him yourself.
Andrew Sheng is president of the Fung Global Institute