Monthly Archives: December 2011

Eyes on the prize in financial reform #1: the Volcker Rule

The Financial Times’ Tracy Alloway has a nice piece that crystallizes concerns circulating among many observers regarding reforms to the banking system. New rules designed to increase the safety of the banking system are forcing banks to get smaller in a number of ways. But are these reforms just pushing the same risks off into the shadow banking system?

The public discussion is muddled in a couple of ways. A few useful distinctions can help to separate sensible concerns from baseless anxiety. A good place to start is the Volcker Rule. Alloway writes that “Some proprietary trading businesses that are no longer allowed at deposit-taking US banks under the Volcker rule have morphed into newly minted hedge funds.”

This is exactly what is supposed to happen. It does not reflect a worrisome expansion of the shadow banking system.

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Duality and Uncertainty: Lessons from the carbon market

The Great Recession has hit the European carbon market hard. With output down, the demand for allowances is down, and so is the price. As recently as the start of this year, emissions allowances were trading at €14/t CO2. But last week the price was below €7. This is gloomy news for those who want the carbon price to incentivize innovation in low carbon technology. For example, David Hone, Climate Change Advisor for Shell, is one of many who have been advocating that the Union set aside a number of allowances in order to support the price. Earlier this week that proposal moved a step closer to becoming a reality with a favorable vote by the European Parliament’s Environment Committee. The price of carbon subsequently jumped up by 30% on Tuesday on the news.

I bring up this news because I think it highlights a weakness in the economic debate about the best means to the end of pricing emissions. The argument revolves around whether or not the government should set the price of emissions, and let companies choose the quantity of emissions, or whether the government should set the quantity of emissions it will allow, and let the market set the price. The former is a carbon tax, the latter is a cap-and-trade system. In a world of certainty, where the cost of abatement by companies is well known, the two are equivalent. When the government sets the price (tax level), it knows the quantity of emissions that companies will choose. Alternatively, when the government sets the cap, it knows the price that will emerge in the market. That’s duality.

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The growing return on cash in the bank

Phil Izzo at the Wall Street Journal‘s Real Time Economics blog is focused on how the danger of contagion from the European debt crisis is raising the return on those cash hoards US companies have been stockpiling.

Is that a fat tail I see?

One side effect of the financial crisis is a much wider familiarity with the wonky lexicon of risk management, which is generally a good thing. But it has its drawbacks. Once a person has learned to spot a black swan, it seems there are black swans everywhere. Of course, the very ubiquity means one isn’t really talking about black swans. Overuse of the term threatens to rob it of its special meaning.

Javier Blass reports in the Financial Times that

One buzzword – “tail risk” – is dominating oil markets and could have big implications for prices for 2012. If this year was marked by relative stability in crude prices, with oil trading in a narrow band between $100 and $120 a barrel in spite of turmoil in the Middle East, next year may be very different. Oil traders and investors are bracing themselves for a rougher ride. In the trading rooms of London, New York and Geneva the talk is of tail risks, low probability events that have an outsize impact on prices. The problem, says Daniel Jaeggi, head of trading at Mercuria, the Geneva-based oil trading house, is that these tails are “currently inordinately fat”. On the one hand are intensifying fears over the eurozone crisis, a bearish factor. On the other, the continuing political turmoil in the Middle East could be bullish. “This means that the [price] outcomes could be substantially altered from the base case if anyone of a number of low probability events materialises,” he says.

So, the probability of prices far above and below the base case is higher than usual. That’s risk alright, but it’s not necessarily a fat tail. It could just be a plain vanilla increase in variance. If the percent change in price is a normally distributed random variable, and the variance goes up, that gives a higher probability of prices far above and below the base case. A fat tail is something more. The normal distribution does not have fat tails, no matter how high the variance.

Maybe the tails are fat. Or maybe it’s just a plain vanilla increase in risk. Not everyone is as punctilious as a pedant on such fine points.

The lesson from MF Global for the management of a prop trading unit.

Much has been said about MF Global, the US brokerage and clearing group that filed for bankruptcy in late October. In March 2010, when Jon Corzine was brought in as the CEO, MF Global’s franchise in brokerage and clearing operations was strong, but had tallied a string of losses. Corzine was tasked with cutting expenses and returning those operations to profitability. But that wasn’t good enough for him. He wanted to transform the firm into a major league investment bank, expanding into market making in fixed income instruments as well as adding asset management, advisory and capital market services. Corzine also sought to transform proprietary trading into a major source of profit for the firm.

Proprietary trading was something more to Jon Corzine than simply another line of business. He personally stepped in to make an outsized bet on the Eurozone sovereign debt crisis. The firm took a long position in bonds of financially stretched European countries with loans secured by the bonds themselves. To avoid the risk of refinancing, MF Global arranged the trade to be funded until the maturity of the bonds. If everything went according to plan, for a ten percent haircut on the collateral, the spread between the EU high bond yields and the overnight rate would generate €400-€500 million in profit for the company.

As Aaron Lucchetti and Julie Steinberg, of the Wall Street Journal report, MF Global’s Chief Risk Officer, Michael Roseman, warned of the dangers of the trade: he “contended MF Global didn’t have enough spare cash to withstand the risks of its position in bonds of Italy, Spain, Portugal, Ireland and Belgium. He also presented gloomy hypothetical scenarios of what could happen if MF Global’s credit rating was downgraded because of the exposure.” Nevertheless, Corzine held firm and the Board did not restrain him.

MF Global’s lenders grew worried over the summer as the collateral lost a good deal of value. They demanded the company post additional margin, and when the company was unable to do so, they called the loans. With no additional credit available to the firm, MF Global had no choice but to liquidate the portfolio at very disadvantageous prices, for the market for bonds of highly indebted European countries is very illiquid. Ultimately, the bad bet forced the company into bankruptcy.

There are many lessons that can be drawn from the collapse of MF Global. One that we would like to highlight has to do with the proper place of prop trading in a larger business. We see no problem with standalone prop trading units – hedge funds, as they are sometimes called. When the prop traders are gambling using their own balance sheet, they are forced to fully bear any risk of failure. But when the prop traders share a balance sheet with other lines of business – like MF Global’s brokerage and clearing operations – the danger arises that they are gambling using the capital of other units without paying for it. When MF Global’s bet went bad, it lost more than the price of that bet. It wiped out the long-term health of the brokerage and clearing franchise. That is a dead weight cost produced by having the two operations share a balance sheet.

Was that potential cost factored in when taking the original bet? We doubt it. Measuring the capital at risk from proprietary trading is a difficult task. Traders habitually underestimate the risks of their trades and the capital required to run their operation. MF Global structured it’s repo-to-maturity deal to seemingly hedge out key risks, thereby benefitting from an accounting trick that kept its bet off of its balance sheet and out of sight of the market. But that accounting treatment ignored the huge liquidity risk created by the need to hold onto the position to maturity. That liquidity risk put the entire balance sheet of the firm on the line. Ultimately, one of MF Global’s regulators, FINRA, flagged the risk and demanded more capital, forcing more disclosure.

One way to discipline traders is to give them their own balance sheet. With no one to blame but their operation, the tradeoff between risk and return is more carefully scrutinized. A stand alone balance sheet isn’t the only tool for disciplining traders, but it is certainly the most reliable. Companies that decide, for whatever reason, to put the proprietary trading unit onto the same balance sheet with other activities, had better have superior disciplinary tools at their disposal than what MF Global had.


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