During last year’s debate about the Volcker Rule, Morgan Stanley commissioned a study by the consulting firm IHS that predicted dire consequences for the U.S. economy. I called the study a hatchet job. My main complaint was that the study made the obviously unreasonable assumption that the bank commodity trading operations would be closed down and not replaced. IHS even excluded the option of having banks sell the operations.
So this story in today’s Financial Times gave me a good chuckle:
US private equity group Riverstone is leading talks on an investment of as much as $1bn in a new commodities investment venture to be run by a former Deutsche Bank executive…
Morgan Stanley is considering a sale or a joint venture for its commodities business… James Gorman, Morgan Stanley’s chief executive, last October said the bank was exploring “all form of structures” for its commodities business.
Glenn Dubin, Paul Tudor Jones and a group of other commodity hedge fund investors last year bought the energy trading business from Louis Dreyfus Group and Highbridge Capital, the hedge fund owned by JPMorgan Chase. The parties later renamed the business Castleton Commodities International.
And so, another industry funded hatchet job on the Dodd-Frank financial reform ages poorly.
Last week the OTC swaps market took a big step towards the creation of standardized interest rate swaps. Pushed by the buy-side, ISDA developed a “Market Agreed Coupon” or MAC contract with common, pre-agreed terms. From the ISDA press release:
The MAC confirmation features a range of pre-set terms in such areas as start and end dates, payment dates, fixed coupons, currencies and maturities. It is anticipated that coupons in the contract will be based on the three- or six-month forward curve and rounded to the nearest 25 basis point increments. Effective dates will be IMM dates, which are the third Wednesday of March, June, September and December. The initial currencies covered include the USD, EUR, GBP, JPY, CAD and AUD. Maturities will be 1, 2, 3, 5, 7, 10, 15, 20 and 30 years.
This is good for end-users. Dealers have long used superfluous customization as a tool to blunt competition and maintain margins. Creating a subset of contracts with standardized terms will make the interest rate swap market more efficient in many ways.
Some in the industry worry this just feeds the trend to futurization of swaps:
“It’s quite speculative to try to figure how this will turn out, but on the one hand a more standardised product is presented as more homogeneous, which is good for OTC markets, while on the other, you could argue the more a product is standardised, the less differentiated it is from futures and ultimately could lose out to straight futures activity,” says one New York-based rates trader. “I think there is a fear that this standardisation process creates a much easier path towards futurisation. You could argue this is one step closer towards promoting the success of swap future contracts.” (RISK magazine, subscr. required)
But that ship had already sailed. The G20 specifically rejected the old model of faux customization, and mandated standardization in support of improved transparency and clearing. Whether standardization happens within the OTC swaps space, or via futurization is a detail.
Does JP Morgan’s derivative portfolio hedge its other lines of business? This picture says ‘no’.
Does JP Morgan’s use derivatives to make prop trade bets on interest rates. This picture suggests ‘yes.’
Let me explain.
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Our paper on end-users and the cost of margins is now out in Morgan Stanley’s Journal of Applied Corporate Finance.
February 27, 2013 – 3:27 pm
The issue came up yesterday when Fed Chairman Ben Bernanke testified before the Senate Banking Committee. Senator Elizabeth Warren cited a Bloomberg report that put the number at $83 billion to the 10 largest U.S. banks. The Bloomberg figure is extrapolated from the finding of an IMF study that the backstop provided to banks lowers their cost of borrowing by approximately 0.8 percentage points.
Matt Levine at Dealbreaker makes the provocative claim that “The Too Big to Fail Subsidy is Negative Sixteen Billion Dollars”. This comes in the second round of Levine’s tit-for-tat with Bloomberg. His original critique started off with a reasonable and incisive drill down into the numbers.[1] Now, after an effective rejoinder by Bloomberg, he abandons the two main points from his original critique and substitutes new ones.
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January 31, 2013 – 7:49 am
Today, the CFTC is hosting a Roundtable on the “Futurization of Swaps.” More than 30 people from various parts of the industry are speaking. I’m on the first panel. Here are 3 points I’ll be making:
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January 16, 2013 – 5:54 pm
JPMorgan’s management released its Task Force Report (Report) on the trading losses at its Chief Investment Office (CIO). It’s very clearly written tick-tock and provides a good account of how various controls broke down. Taking for granted the task assigned to the traders running the CIO’s Synthetic Credit Portfolio, the report outlines where things went wrong.
As an accident of timing, the losses were first disclosed in the midst of a public debate about the Volcker Rule’s prohibition on proprietary trading at banks. So, for the public, the case became a test of whether the proposed regulations implementing the Volcker Rule had any teeth: would they prohibit the trades being done at JPMorgan’s CIO once they came into force? Management has always contended that the Synthetic Credit Portfolio was run to hedge the bank’s natural long position in credit risk, and that it was not proprietary trading and would not be prohibited under the Volcker Rule. That contention is repeated summarily in the Report when it gives an introductory overview of the Portfolio’s origin and operation. But, the contention is never actually substantiated: indeed, the Report does not purport to address the prop trading question directly.
There is much in the Report that would lead a reader to doubt management’s contention and to conclude instead that the Synthetic Credit Portfolio was a classic example of prop trading.
A key forensic test for distinguishing prop trading from hedging is the compensation criteria. A hedger’s success is not measured by his or her own profit and loss on the hedge trades. Instead, a hedger’s success is measured by how well his or her own profits and losses track and set off the losses and profits on the assets being hedged. The metrics for performance on hedging should incentivize minimizing net risk. The metrics should measure net risk reduction. When the desk reports big profits — after netting out the matched positions — that’s a bad sign, not a good one. The JPMorgan Report strongly suggests that the traders on the Synthetic Credit Portfolio expected to be rewarded on their own profit and loss, not on how successfully they hedged the bank’s natural long position. That compensation system fits prop trading, not hedging.
The Report does briefly consider the wisdom of the compensation scheme, but not from the perspective of the Volcker Rule and identifying prohibited activities. Instead, the Task Force was just concerned with the question of whether the profit and loss criterion was overvalued to the exclusion of other criteria management imposed on the unit.
So, it looks as if JPMorgan’s CIO, and its Synthetic Credit Portfolio provide a useful test case for the Volcker Rule going forward. The original regulations proposed for implementing the Rule did include an assessment of compensation criteria. Whether that will continue in a final rule is yet to be seen. And then comes the question of enforcement.
January 16, 2013 – 7:42 am
Finally, a journalist has located a real cost of futurization, as opposed to the many imagined ones.
December 13, 2012 – 11:55 am
The Capital Markets subcommittee of the House Financial Services Committee held a hearing yesterday on the derivatives portion of the Dodd-Frank Act — Title VII. The question of the futurization of swaps captured a good bit of attention.
Representative Bachus, who chairs the full Committee, said (at 14:04 in the video),
If all derivatives were supposed to be traded on an exchange, then they would all be futures. [Swaps] are differeent from exchange listed products, and imposing the listed futures or equity market model on [swaps] is not the mandate of Title VII.
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December 6, 2012 – 11:50 am
Many people underestimate the threat that futures markets pose for the OTC swaps industry because they have been suckered into thinking of swaps as carefully custom tailored instruments. It’s true that a small fraction of the OTC swaps market cannot be replicated in the futures marketplace. And it is good that the Dodd-Frank Act preserved a space for customized swaps. But the vast majority of swaps are not custom tailored, or the custom tailoring is so inconsequential that it will be an easy matter for the futures market to serve the same purpose.
Even when the swap does contain some important element of customization, that is usually not the whole story. Many customized swaps can be broken up into 2 pieces: (i) a basic, plain vanilla swap, plus (ii) a small bit of customization that adapts the plain vanilla swap around the edges. The futures market can substitute for the plain vanilla swap, and then the OTC swap market can provide the customization around the edges.
It’s like buying a suit ready-to-wear, but having the tailor adjust the hems or waistline a little bit. So long as the adjustments are small, its an economic alternative to true customization.
An illustration of how a custom swap can be broken up into two pieces appears in an article by Sean Owen, Director of Fixed Income Research and Consulting at Woodbine Associates, published in a recent special issue of the Review of Futures Markets. He breaks up an irregularly amortizing 10-year interest rate swap into (i) a 7-year bullet interest rate swap, and (ii) a customized swap that produces the irregular amortization relative to the 7-year bullet. (H/T to CFTC Commissioner Scott O’Malia for highlighting the article)
