Are We Able to Manage a Whale of a Risk?
While everyone in the East has been mesmerised by China’s Bo Xilai saga, another drama has been playing out in the West. On May 10, JPMorgan Chase simultaneously announced trading losses of US$2 billion, the resignation of the head of its chief investment office and the departure of Bruno Iksil, a London-based French trader who made such large and apparently fearless bets in synthetic credit default swaps (CDS) that the market variously nicknamed him “the London Whale”, Voldemort (the wizard nemesis of Harry Potter) and “the Caveman”. One recent research report guesstimated that JPMorgan Chase’s actual losses could be as large as $5 billion.
The tale began in early April, when hedge-fund traders complained to journalists that “the London Whale” was making huge CDS trades that, it some said, violated the Volcker Rule. The Volcker Rule, named after former chairman of the US Federal Reserve Paul Volcker, who proposed it, is a section in the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010 by the US Congress. Specifically, the Volcker Rule aims to prohibit proprietary trading by banks, but there are a host 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 yet to be passed.
Trading in over-the-counter (OTC) CDS derivatives is so opaque that only specialist traders and risk managers probably understand how the market operates. Thanks to a few alert journalists like Lisa Pollack of the Financial Times online post Alphaville, “the London Whale’s” trades have been slowly unveiled, but the story did not hit major print media until JPMorgan Chase announced the massive 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 London Whale’s” large positions in CDS indices could be distorting the market, which could expose JPMorgan Chase to future losses. What is more, such trades may have violated the spirit of the Volcker Rule.
JPMorgan Chase’s chief financial officer was reported to have said 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 holding a 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. There is, however, always a cost to hedging.
Experienced risk managers are aware that 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 hedging 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 doubling the losses instead of cancelling them out.
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 an agent for any transaction, it does not assume a position risk but has a counterparty risk with the principal. But if the hedge is not working (that is, losses are still being incurred), the trader can decide to undertake a hedge of the original hedge. This is entering into the grey area of proprietary trading.
There is no question that the JPMorgan Chase hedging strategy which incurred the $2 billion in 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 the blogosphere by various market participants, it becomes 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 someone is caught with too many of these instruments that he cannot dispose of without a loss, they will join in to make a killing. Very Darwinian.
The full story of “the London Whale’s” trades will be known once official numbers are released. But three questions remain. The first is 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 over-the-counter and less transparent and less regulated. This is why, when they could not complain to regulators to stop any “Whale”-like behaviour, they complained to the press. Second, as the FT’s Pollack rightly asked, since most if not all the trades were cleared by the Depository Trust and Clearing Corporation, and available for regulators’scrutiny, where were they? Third, would the Volcker Rule have stopped such egregious behaviour?
All we know is that “the London Whale’s” losses have given legislators and regulators more ammunition to adopt a tighter Volcker Rule. If you want to know how all this will play out, Paul Volcker will be in Hong Kong to give keynote remarks at the Fung Global Institute's Asia-Global Dialogue, on May 31.
Come and ask him yourself.