Category Archives: speculation

CSI: prop trading investigation squad.

April 21, 2013 – 8:57 pm

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.’

 

Piazzesi et al.

Let me explain.

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By John Parsons | Also posted in Dodd-Frank, hedging, measuring risk, regulation | Comments (4)

Dynamic Hedging or Futile Speculation?

April 3, 2013 – 10:28 am

chesapeake

Chesapeake still thinks it can time the market.

On Tuesday management held its Conference Call to update to investors and stock analysts. Steve Dixon, the acting CEO, said “We’ve also taken advantage of the recent surge in natural gas prices to lock in additional price protection in 2013, and we have begun to hedge natural gas production in 2014 at prices well above $4, a level the market has not seen for some time.”

The company has had problems in the past from its foolish attempts to time natural gas prices. Last time prices were falling and the company took off its hedges. This time prices are rising and its putting on hedges. But the mindset is the same.

Behind this dynamic hedging strategy is a common misunderstanding about mean reversion in natural gas prices. The same misunderstanding applies to other commodities as well.

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By John Parsons | Also posted in commodities, dynamic risks, hedging | Comments (1)

Prop Trading at JP Morgan

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.

 

 

By John Parsons | Also posted in Dodd-Frank, hedging, measuring risk, regulation | Comments (0)

Prop-Flow stands convicted, too.

November 21, 2012 – 10:30 am

The trial of UBS trader Kweku Adoboli ended yesterday with his conviction on two counts of fraud and the dismissal of the accounting allegations. Some news accounts have noted that testimony at the trial also exposed embarrassingly shoddy risk management at UBS. Prop-flow also stands convicted.

Prop-flow is one of those wonderful neologisms of the investment banking world. UBS’s Delta One desk, where Kweku Adoboli was employed, is a classic example of the prop-flow trading model. Ostensibly, a Delta One desk is serving customers, manufacturing risk exposures that the clients want, and earning revenue for providing that service. But the testimony at Adoboli’s trial leaves no doubt that his assignment was proprietary trading, pure and simple. He wasn’t convicted because he did prop trading, but because of how he did his prop trading. The testimony leaves no doubt that his UBS managers always expected him to be placing proprietary trading bets. The only dispute was about how those bets were managed and recorded, and the scale of the bets along the way.

How much tolerance bank Boards of Directors and bank regulators have for neologisms like prop-flow will be an important question in the coming years as the Volcker Rule and similar prohibitions come into force.

By John Parsons | Also posted in Dodd-Frank, hedging, regulation | Comments (0)

SEC Staff examines copper ETFs with blinders on

November 20, 2012 – 2:39 pm

The SEC is currently considering whether to allow JP Morgan and Blackrock to list new copper ETF’s on the NYSE Arca. Some copper industry players oppose the listing, as does U.S. Senator Carl Levin and the advocacy group Americans for Financial Reform. Comment letters can be found here. Earlier this month, SEC Staff in the Division of Risk, Strategy, and Financial Innovation filed a memo reporting its empirical analysis that downplays any potential problem. That memo is a testament to how America’s financial regulators too often fail in their duty to protect the sound functioning of US financial markets.

The SEC staff asks two narrow questions.

First, is there a simple and enduring mechanical link between the flow of money into a commodity ETF and the price of copper. They answer, ‘no.’

Second, is there a simple linear relationship between copper inventories and copper prices. Again, they answer, ‘no.’

The Staff’s analysis is faulty in many ways. Both industry players and the advocacy group Americans for Financial Reform filed careful, detailed critiques of the econometrics and reasoning. These are well worth reading, and thoroughly impugn the soundness of the Staff’s conclusions.

What alarms me most is the narrow scope of the questions that the Staff posed, even had they bothered to do a thorough analysis of those questions. A proper regulator needs to assure that the market functions well. There are any number of ways in which its operation can be disrupted. We have a long, long history of commodity markets in the US, and that means we have a long history with market manipulation and other price distortions. We have a long, long history with financial markets in the US, and that means we have many experiences with asset bubbles, especially in the recent past with the dotcom and housing bubbles, as well as the oil price bubble. Neither of the two empirical tests the SEC Staff examined touches in any way on the issues one would want to examine in order to assure the sound functioning of the copper market and the healthy contribution that financial trading could make to the market. The mechanical link the Staff searched for would not show up in a market rife with manipulation. Nor is that mechanical link necessarily symptomatic of an asset price bubble. So failing to find such a link provides no assurances that this market will function properly. And it is alarming that the SEC Staff does not explore any of these other important issues that must be settled. Just as the SEC Staff did in the Madoff case, it carefully asks the wrong questions and thereby comes to easy answers.

Personally, I’m confident that financial markets have a valuable contribution to make in extending the efficiency and productivity of the real economy. I believe that’s true for all commodity markets as well, copper included. But making that happen requires active engagement by US regulators, and not a ‘see no evil’, hands off, laissez faire approach. That way lies market disruption and an undermining of the productivity of the economy.

The SEC can do better. It must. American industry depends on it.

By John Parsons | Also posted in commodities, financial innovation, markets, regulation | Comments (3)

Was Ina Drew a Hedger or a Speculator?

October 9, 2012 – 4:45 pm

This Sunday’s New York Times Magazine included a piece by Susan Dominus about Ina Drew, the former Chief Investment Officer (CIO) at JP Morgan who resigned following the outsized trading loss in her unit. The focus of the piece is on the rough and tumble of a woman trying “to succeed as an interloper in the Wall Street boys’ club. But buried within the piece is a repeated confusion of hedging with proprietary trading. Dominus repeatedly describes Drew as responsible for hedging this or that risk facing the bank, but immediately afterwards Dominus lauds Drew’s uncanny ability to predict where the market was heading and so to be a profit center. Since the question of whether JP Morgan’s CIO was or was not hedging is at the heart of the public policy dispute surrounding JP Morgan and the Volcker Rule (see here and here), it is worthwhile addressing the confusion in Dominus’ piece.

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By John Parsons | Also posted in exposure, governance, hedging | Comments (0)

Chesapeake’s Two Natures

June 12, 2012 – 9:19 am

In yesterday’s post I said that Chesapeake’s management was speculating on natural gas and oil prices. But Chesapeake claims that it is a hedger. Speculating and hedging are different things, so is Chesapeake a hedger or a speculator?

In representations to regulators, Chesapeake’s Vice President for Finance and Assistant Treasurer, Elliot Chambers, has stated categorically that “we never speculate.” Is that true? Is his definition of a speculator the same as mine?

Chesapeake is a hedger. It uses exchange traded futures and options, OTC swaps, and a specialized financing vehicle called Volumetric Production Payments, among other things, to mitigate the price risk on its production and “predict with greater certainty the effective prices we will receive for our hedged production.” (10K for FY2011 p. 72)

But Chesapeake is also a speculator. The company is straightforward in its SEC filings that it tries to profit off of price swings: “We intend to use this volatility to our benefit by taking advantage of prices when they reach levels that management believes are either unsustainable for the long term or provide unusually high rates of return on our invested capital.” (10K for FY2011 p. 6) “Depending on changes in natural gas and oil futures markets and management’s view of underlying natural gas and oil supply and demand trends, we may increase or decrease our current derivative positions.” (10K for FY2011 p. 59) “Our general strategy for attempting to mitigate exposure to adverse natural gas and oil price changes is to hedge into strengthening natural gas and oil futures markets when prices allow us to generate higher cash margins and when we view prices to be in the upper range of our predicted future price range. Information we consider in forming an opinion about future prices includes general economic conditions, industrial output levels and expectations, producer breakeven cost structures, liquefied natural gas trends, natural gas and oil storage inventory levels, industry decline rates for base production and weather trends.” (10K for FY2011 p. 87) As I related in yesterday’s post, Chesapeake’s decision last fall to remove its natural gas hedge was based on its prediction that prices were temporarily low and would recover, allowing it to replace the hedges and capturing a profit on the short-run volatility. This is all speculation.

A company can be both a hedger and a speculator.

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By John Parsons | Also posted in commodities, governance, hedging | Comments (0)

Chesapeake takes its eye off the ball

June 11, 2012 – 5:28 am

Chesapeake Energy has been going through a shake-up of late, most recently at Friday’s shareholder meeting. The low, low price of natural gas is contributing to a cash squeeze. This has made all the more vital the many debates about corporate governance and the company’s investment strategy. To the list of items needing review, I would add the management’s short-term speculations on natural gas and oil prices.

Here’s a slide from a deck distributed in advance of last week’s meeting:

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By John Parsons | Also posted in commodities, hedging | Comments (2)

Show me, per Dodd-Frank

May 22, 2012 – 11:30 am

The finance lawyer who blogs at Economics of Contempt has a very nice summary of what is required for JP Morgan to claim that the trades at the CIO unit are allowed under the Volcker Rule because they were “portfolio hedging”. It is a more comprehensive and textual version of our requirement that JP Morgan “show me”.

By John Parsons | Also posted in accounting, Dodd-Frank, hedging, measuring risk, regulation | Comments (1)

Show me

May 14, 2012 – 5:24 am

JP Morgan’s $2 billion loss on credit derivatives traded by its Chief Investment Office (CIO) has moved the debate over implementation of the Volcker Rule to the front page. Many claim that these trades are a clear example of the type of speculative, proprietary trading banned by the Volcker Rule. JP Morgan CEO Jamie Dimon insists otherwise, claiming the trades were intended as a hedge, which is clearly permitted under the Volcker Rule. Public discussion on the matter is confused, in part because many people are unclear about what defines a hedge and what defines a speculation. Who can blame the public when the premier vehicles for speculative trading are known as hedge funds?

Moreover, the current battle over financial reform and the Volcker Rule gives bankers an incentive to escalate the confusion. They want to continue their speculative trading, and that can only be done by labeling it either hedging or market making. Clarity is not their ally. When regulators, legislators and pundits advocate bright line tests for hedging, these bankers ridicule them as simpletons, accusing them of applying a dangerously unsophisticated understanding of financial markets drawn from a bygone era. These simpletons, they complain, fail to grasp the complexity of the modern world that bankers are tasked with mastering in order to serve the needs of society.

So, in order to try to make some progress and gain some insight from the JP Morgan case, let us first step back from the details of the current trades and losses, and from the debate over the Volcker Rule, and instead gain some clarity on the concept of hedging. Then we can double back and analyze the JP Morgan case in light of a sensible notion of hedging.

Two points about hedging…

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By John Parsons & Antonio Mello | Also posted in accounting, Dodd-Frank, hedging, measuring risk, regulation | Comments (2)
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