How the ‘London Whale’ trade could have been stopped
March 26, 2013 4 Comments
Hey, it’s probably been at least like 9 hours since I’ve written about the ‘London Whale’. You’re probably worried about me & wondering whether I’m ok. Well yes, since you asked, I was briefly hospitalized (involuntarily). I asked for access to a padded laptop of some sort so that I could blog more about the ‘London Whale’ but the doctors just looked at me funny, put me inside a big cylindrical machine, and then gave me a lot of pills. Anyway, I feel much better now.
If you’re still reading Serious Financial Journalists about the incident one thing you’ll have noticed is that for all the huffing and puffing no one seems to have figured out how to stop that trade other than brilliant ideas like (a) magically close all possible loopholes in the Volcker Rule i.e. just don’t let banks do anything that ends up losing money later, (b) (relatedly) actually finish writing the Volcker Rule, (c) bring back Glass-Steagall because I read in a blog comments section somewhere that Glass-Steagall used to be awesome or something and stop all bad things, (d) um don’t let anyone use spreadsheets?
These ideas, the less said the better. Suffice to say they do not help. Here’s what would have helped, in case you’re actually curious: a liquidity provision.
If JP had had a policy of requiring any reasonable liquidity provision on said trading, that desk would never have built up that position. Liquidity provision means: ‘the more illiquid the stuff you’re trading, the more rainy-day buffer we’re going to withhold from your P&L’. And since one way a thing becomes illiquid is ‘you’re dominating the market already’, you inevitably make it nonlinear, like a progressive income tax: No (extra) liquidity provision on the first (say) 100mm you own, half a point on the next (say) 400mm, a point on the next 500mm, 2 points on the next 1000mm, etc etc. (specific #s depend on the product**). Problem solved. In fact, it’s genuinely weird and dumb if they didn’t have such a thing.
The London Whale’s problem (one of them) was that he traded so much of a particular thing that he basically became the market in it. That means among other things that even if on paper “The Price” of what he owned was X there would have been no way for him to sell the position for X. A liquidity provision is a rough and dirty way of acknowledging this fact.
It wouldn’t have to be ‘accurate’ or ‘correct’. It would, essentially, be a made-up rule like I just outlined above. Oh, I’m sure there is some advanced research about markets and auction/pricing theory that would allow the development of some beautiful, perfect ‘liquidity’ measurement. Doesn’t matter. In practice the calculation and updating of this provision would just be handed to the same JUNIOR RISK GUY we have already met, or similar. He would run and update daily a – possibly – spreadsheet (gasp) and tell the desk their current provision. They’d withhold it from their P&L. They’d become, therefore, intimately familiar with the fact that for every marginal $100mm they add to that position, even if traded at mids, they would show an immediate day-1 loss of $2mm (or whatever the rule is). Which would not be pleasant. (They like money.)
Why would this have helped? Given how much they lost, $6bln, on (basically) just being squeezed by Headlines, I guesstimate that any reasonable liquidity provision calc would have already been withholding, say, $1-3bln from their books. But that is a lot. The traders, liking money and (relatedly) not liking sitting around with giant provisions in their books, would not have chosen to build such a position in the first place. They would have diversified, explored their best options within the framework of the provision, etc. And yes, they would have meanwhile continually screamed bloody murder about how ‘stupid’ the provision is, sought ways to ‘revisit’ it and loosen it, because the dummy gnome quants who put it in place just don’t understand the product or the markets, etc. But as long as some blunt provision were still being applied, it’s safe to say the incentives would have pushed them away from their apparent strategy (?) of exiting a short by going so long something else that they dominated the market in some illiquid derivative they’d never ever exit at the mark.
There are genuine serious issues surrounding the ‘London Whale’. I guess they withheld info from regulators. I guess they mismarked (although, if you understand the issue described above, you also understand there’s no possible way not to mismark such a position). Perhaps those things do indeed need addressing by the government, and that will play itself out. I’ll get bored by all that and hopefully will have moved onto some other obsession by then. But those are after-the-fact, coverup-not-the-crime types of issues. The one simple measure that would have stopped such a trading ‘strategy’ [sic] from the get-go – if that’s what you care about – is one that could have, and probably should have, just been implemented by JPM unilaterally. And, if they haven’t done so already, by all means they should put a liquidity provision policy in place ASAP.
I’ll be invoicing them $1.5mm for my Risk Consulting Fee in the next couple days.
**Of course, if you’re cynical – as I am – you see a loophole here. Any given ‘liquidity provision’ rule will withhold X from some products and Y from other products. Maybe the ratios between all those X’s and Y’s are magically Perfect. But, probably not. That means that a ‘clever’ desk could reverse-engineer the provision and figure out the ‘best’ product to trade for their needs, the one being under-measured by the provision rule. But that’s kinda ok. It would distort those relative incentives and prices, but at least the basic incentive of Do Not Become The Market In An Illiquid Derivative would still be in place.
UPDATE (3/28): I’m grateful to commenter DK for sharing some useful & informed perspective:
Their synthetic credit portfolio had offsetting positions between HY and IG (and likely tenor, payoff structure, and so on), and I am guessing these positions were aggregated for the purpose of measuring risks (e.g. VaR & liquidity reserve).
That is probably right. What he’s saying is that if one is long $10bln IG, but also short something very very IG-ish, a typical liquidity reserve method might treat them as ‘you have about 0 net-net, so you don’t need any reserve’. If you’re long 10 and short 9, you take a reserve only on the remainder 10-9=1. If you’re long 10 and short 2 of tranches whose net effective delta is 4, you are seen as having an overhang of 10-4*2 = 2 so that’s what you reserve against. And so on.
But if the short is only 33% IG-ish (whatever that means), maybe there is some factor; maybe you only get 33%*9 = 3 ‘credit’ for the hedge and so you have to take a reserve on the remaining 10-3 = 7. Or whatever. (Again, any instance of this methodology will get pretty made-up.)
In the CIO case, let’s imagine DK is right that this is why they (apparently) had little such reserve. If so, we then infer that the reserve calculation must have been giving them a lot of ‘credit’ for the IG long as offsetting the HY short. (And similar for tranches, etc.) Maybe they were counted as 50% correlated when really it should be more like 10%. But of course that would be the locus of the weakness in the policy then; IG vs HY is a basis, not a correlated position. IG tranches vs IG is a correlation position. Etc.
Incidentally, for the anti-prop-trading puritans, this (having an effective liquidity provision policy) also would have made it pretty easy to identify that position as a ‘prop trade’: does the book have giant liquidity provisions sitting in it or doesn’t it? Either what they were doing in an IG space was an effective ‘macro portfolio hedge’ to their HY or it wasn’t. That HY short, in turn, was either an effective hedge to the whatever-bond-portfolio or it wasn’t. If these things weren’t good correlated hedges via simple/straightforward logic understandable to RISK GUY’S SPREADSHEET (and it’s pretty apparent that they weren’t) then such a liquidity provision, with appropriately conservative offsetting rules (i.e. no, sorry, IG doesn’t really offset HY), would have been very large – so large as to dissuade the strategy from the get-go. Evidently it wasn’t though, so there you go.
Please note I am not advocating that the regulators go all medieval on all the banks writing 50-page docs describing the liquidity provision method they must put in place. 1) As DK says, they all pretty much already have something in place. 2) I don’t trust regulators to police this or prescribe the Perfect Liquidity Provision Algorithm in a top-down manner. 3) There probably are already regulations about it anyway. What I will say is that that’s what you should want JPM to have if you are, like, a JPM stockholder. And (similarly) that’s what I would urge JPM to work on improving – assuming prompt payment, of course, of my $1.5mm Risk Consulting Fee.
UPDATE #2: Matt Levine has (unlike me) done some legwork of actually trying to address what GAAP says about such adjustments, and related SEC questions in the JP context, since I obviously have no idea of either. The upshot seems to be there can be a fundamental iffiness to taking such a provision, and you may find yourself having to answer regulator questions like ‘tell us how you calced this’, and no one’s gonna wanna say ‘well we basically made up some factors and handed them to RISK GUY to do a sumproduct’. The fact remains though that there are always such slop provisions floating around in that kind of book (they may be called something else – often the tussle with regulators/accountants is over what they are called). My point is that, in some ideal sense, evidently JPM’s weren’t as punitive as they probably should have been. But I guess GAAP-savvy accountant types might actually disagree.