June 28, 2011 Leave a comment
No real surprises, but sparks some interesting discussion of correlation trading from ‘Janet Tavakoli, a Chicago-based derivatives consultant’, whatever that is:
…said many bank managements did not fully appreciate the illusory nature of the trading profits being generated from derivatives correlation desks before the financial crisis. She said those profits often disappeared and turned into losses when the underlying assets turned south. “The thing about correlation desks is that it will appear you are making a lot money from trades, but it is all money at risk,” said Tavakoli. “I call this kind of trading an invisible hedge fund.”
My only real dispute with this statement is that it appears to single out correlation trading as if it alone, among derivatives trading, is somehow unique in this regard. All derivatives (as opposed to, say, simply crossing bonds i.e. the pure Platonic ideal of what broker-dealers supposedly could or should confine themselves to doing) put money at risk. All derivatives by definition come onto the book with a valuation that would ‘disappear and turn into losses when the underlying assets turned south’ (for appropriate definitions of ‘south’). If they didn’t, they wouldn’t be derivatives.
They can go south, that is, unless those derivatives are properly and perfectly (!) hedged with liquid hedging instruments. Of course, as a general matter, except for very simple cases, derivatives won’t and can’t be hedged perfectly, hedging instruments won’t always be liquid, putting on the hedges won’t be costless, etc. Although some derivatives (say, equity options) are probably easier to hedge accurately and with little bid-offer cost than others (say, ABS correlation trades). Such things lie on a continuum. So the truth in her statement is that correlation trades had a far greater likelihood for the hedging to slip/fail and the resulting net valuation to lead to losses than would probably be the case for, say, an equity options book. Yes, that is almost certainly true. But this doesn’t make this ‘illusory trading profits’/'it is all money at risk’ thing some sort of unique property of correlation trading alone. Again, please let’s stop with the artificially treating a continuum like an on-off switch.
Besides, is it even true that other derivatives, e.g. equity options, are so perfectly hedgeable that they don’t have the ‘illusory profits’ time-bomb potential? What happened in 1987 exactly? What exactly is supposed to be the perfectly-hedgeable, ‘nice’ derivatives trade? How about an interest-rate swaps book. Surely those never lose money because all their PnL is clean and riskless and they never take positions. Um…no. FX options? Equity index futures? Surely those derivatives have no potential for illusory gains, hidden time bombs, stealth prop trading, or huge losses. Hmmm. Well, I’ll have to get back to you….
The article proceeds directly to an ominous-sounding, yet non sequitur discussion of VaR:
In an early 2010 regulatory filing, Deutsche attributed some of the rise in the bank’s value-at-risk, or VAR, at the end of 2009 to a “recalibration of parameters in the Group’s credit correlation business.”
On Wall Street, VAR is one metric used by a bank to estimate how much money it could conceivably lose in a day if all of its trading bets and hedges went awry. It’s an imperfect measurement, but one followed by most industry analysts.
As I have written before, VaR is nonsense. It is a single number calculated by an army of well-paid Master’s and PhD’s about which the one definitive statement we can make is that it is wrong.
But this article also puts the cart before the horse, treating the ‘rise in VaR’ as if it is an interesting event in and of itself. It isn’t. VaR is a model number that has no effect on anything by itself. What did DB really do at the end of 2009? ‘Made VaR higher’ is just not an interesting answer. Even to say they ‘recalibrated parameters’ isn’t interesting by itself; parameters are just a means to an end (the mark). Marks are what count. Did they mark their book up or did they mark it down? Sure, any model change calls into question the prior model – but clearly some changes are more ominous than others, i.e. remarkings that bring marks in line with the market vs. those that move them away from the market. Which was this? We just don’t know, presumably because the reporter doesn’t ask the ‘derivatives consultant’ or anyone else a question of real importance.
Obviously there is plenty of genuine and deserved embarrassment for DB to be had in this article but what is frustrating is how a true-enough fact pattern can be so grossly misread. The premise of the article is clearly that [such-and-such kind of trading] is a Bad Kind Of Trading, and this bank was guilty of it, and now they’re embarrassed and trying to get out of it, because of the Volcker Rule, because it’s hedge-fundy, or some such thing. My dispute is not with the embarrassments listed. My dispute is with the conceit that one can single out this kind of trading as the Bad Kind Of Trading, and somehow distinguish and then firewall it off from all the Good Kind Of Trading that banks do that (supposedly) isn’t risky, or dependent on opaque valuation methods, or hedge-fundy, or whatever bogeyman we are supposed to blame for The Financial Crisis.
Maybe I’m dumber or denser than regulators and Congressmen and ‘derivatives consultants’ and Reuters reporters, but I just don’t really see the two easily-distinguished kinds of trading that everyone else seems to. I don’t see these banks’ activities as separating neatly and cleanly into the (bad, nasty, tainted) “prop”/hedge fundy activity and the Nice, Sweet, Organic, Free-Range Trading that supposedly are the banks’ bread and butter, and that they could somehow get back to with clever enough regulations.
Although I obviously see and acknowledge differences lying along a continuum, I really only see one kind of trading, not two. You can artificially rope off the one and ban it, while keeping the other, but I don’t know what you think you’ll be accomplishing other than to incentivize banks (& the shadow banking system), as staffed by even more highly-paid personnel, to proceed to explore the boundaries you’ve just artificially drawn and patted yourself on the back for doing so.
As such, I have grown well good and tired of the ‘let’s identify and purify our village of the Bad Kind Of Trade‘ subgenre of financial criticism. To paraphrase (and improve upon) Ben Stiller’s frustrated (and incorrect) little soliloquy to Darryl Zero in Zero Effect, there aren’t evil kinds of trades and innocent kinds of trades. It’s just… It’s just… It’s just a bunch of… trades.