Bruno Iksil: he rules from the shadows.
So for those who haven’t been following, the recent story shaking the Bloomberg Buzzworld is that of the JPMorgan credit derivatives trader with enough capital to break indices. Other traders are upset and calling him names. Names like “He Who Must Not Be Named” and “the London Whale”. And probably more conventional ones like “bastard” and “that irritating mother-f***er with the mother-f**k of a capital base”.
As a non-investor in credit-derivative indices, I get to use names like “Hero” and “Legend”. But out of envy and a little disdain, I’m going to keep using “Voldemort”. Partly because Voldemort was a big bully with some panache, but mostly because his large amounts of inbuilt power were the result of (ma)genetics and the size of his wand. If you have the entire resources of the internal capital base of JPMorgan at your disposal, you get to be the big boy on a small playground when you start throwing your weight around.
To be upfront, I’m letting everyone know that I’m going to engage in a little rinse-and-repeat from some of my earlier news posts.
So what is breaking an index?
Well most people have some memory of George Soros breaking the British Pound. And what that meant is that George Soros’ Fund had enough capital to break the fixed exchange rate regime at the time. A fixed exchange rate regime combined with no capital controls effectively meant that the Bank of England was willing to sell and buy as much currency as sought by any counter-party, all at the same rate. However, the fundamentals at the time had Britain sitting with low interest rates and high inflation, while still attempting to maintain its fixed rate under the European ERM (Exchange Rate Mechanism). Fundamental fail, is what is.
Enough capital to buy such vast quantities of pounds that when he eventually dumped them on the market, the BoE couldn’t meet the other side of the transaction and was forced to float the currency. Followed immediately by a sudden and dramatic devaluation (the so-called breaking of the pound).
Indeed, capital controls at Reserve Banks in many (if not all) developing countries are there to prevent exactly that.
And the theoretical principle with Mr Iksil is nearly the same. Enough purchasing power that when he makes a trade move, things happen.
And what is a broken credit index? Well – the credit index is meant to represent a basket of investments in credit default swaps held over various companies. In theory, we could replicate the index by buying those underlying CDS instruments. And this is quite a useful tool. Because if we price the underlying investments, and we see that they are not equal to the index: we would then sell the more highly priced option and buy the cheap one, bidding up the price of the undervalued side of the transaction, and lowering the price on the overvalued side by increasing its supply on the market. In other words, under efficient market conditions, this temporary mis-pricing self-regulates as investors trade under the expectation of price reversion.
However, when a trader can dramatically change the price of the index just by trading it, the index stops replicating its underlying investments indefinitely. Why? As the story goes: because Iksil can take such large positions, and is not liquidating them, there is not enough supply for the reversion to take place.
And the Volker Rule?
The reason that this is such a fun topic at the moment is the much controversy around the Volker Rule (which sounds like the joke name from a Ben Stiller movie about meeting the parents). The Volker Rule is the part of the Dodd-Frank Act that everybank is protesting. The key points:
- The Volker Rule is going to regulate the risks that a bank can take with its own money (ie. its capital).
- The reason for the rule is the merging of Commercial and Investment Banking activities since the repeal of the Glass-Steagal Act.
- The merging of the two arms of banking means that the “traditional” banks of loan and deposit are exposed to the much riskier activities of Investment Banks.
- This puts the layman’s money at risk. Scratch that. This puts your average American voter’s money at risk. At least – that’s the theory and the political party-line.
- More likely: after the subprime mortgage crisis and the big bail-outs of the banks, there was pressure on the legislators to do something. And the Dodd-Frank Act was that something. And then someone noticed the incentive mis-alignment between the two types of banking and said “let’s regulate that and we’ll name it after Mr Volker”.
- But sadly, however much weight is thrown around in the area of Iranian sanctions, America can only really regulate the capital activities of American Banks.
- The foreign banks based in London and Switzerland and Germany and Tokyo and Shanghai and such are just going to calmly continue as they did before. Which makes the Goldman and the JPM throw around terms like “internationally competitive” and “we need to be”.
- So now the legislators are confused as to what they want. But the bank lobbyists – they are not.
And then along comes this kind of scandal, where JPM is playing around with its own money and breaking things. This incites the liberals and makes for bad press. Or is it good press? There are a couple of theories floating around out there as to where this story is coming from:
- The jealous hedge fund managers: who are upset and embittered because the markets are not working the way they expected when they made their trades; or
- JPMorgan itself: showing the world that it can and will do what it wants with its own money, through its London Chief Investment Office (I’m not sure if I entirely understand the theory of this point, but I refer to my favourite blogger, M. Levine, who wants to know why we say Voldemort like it’s a bad thing).
Either way, the point of the Chief Investment Office is to hedge risk and invest excess cash. I think everyone is concerned because the firm’s investments are around $350 billion, and wagers on this particular index are sitting at around $145 billion. According to Bloomberg, who have this figure according to market participants, who have this figure according to their observations of trade patterns and such, Iksil has built up a position that may be as large as $100 billion. In a single index: the Markit CDX North America Investment Grade Series 9 (IBOXUG09).
The trade involves selling long-term default protection (ie. expiring in 2017) and buying short-term default protection (expiring in the next 8 months). Basically, the strategy implies a bet on defaults happening sooner rather than later. JPMorgan then earns the difference in spread (around 47 basis points as of early April). There is some controversy around whether that even makes sense – after taking into account transaction costs and such. Again, refer to Mr Levine’s article (link above).
However you look at it though, the reality is probably more complex than “this serves as a great example of why the Volker rule is needed” or “this serves as a great example of why the Volker rule is irrelevant”.
Because let’s be honest – no one really knows what’s going on. There’s lots of hype and speculation and great name-calling. Politicians have reacted by making many statements punctuated with “effects on the US Economy” and “effects on the US taxpayer”.
And poor Bruno is sitting in his London office going “WTF, dude? I was all getting-my-morning-starbucks and missing-my-girlfriend when *wham* – my sh*t hit the Bloomberg fans”.
Anonymous April 12, 2012 at 17:40
Please excuse my ignorance. But how does the trade of such a large nature make money for the investor. I understand that it looses the link to the real world but how does the investor gain income buy this massive move.
Also if George Soros sold pounds and this guy at JP Morgan held onto his investments how are they the same?Reply
Jayson Coomer April 12, 2012 at 18:23
The theory here is that the investor gains income by earning the spread. So in this case, the longer-term default protection is more expensive than the shorter term protection. If you buy the cheaper protection at, say, 250bps on the underlying, and sell the longer term protection at, say, 297bps, then you get to keep the difference. But the spread is minimal – here we're talking about 47 basis points (Bloomberg's actual figure), so 0.47% of the value of the underlying trade. If I did this with $1000 worth of trades, I'd only earn 47 cents. However, if I did it with $100 billion – then I'd earn $47 million off the trade – for every year that I held the position.
And from a risk perspective, you're hedged against overall movements in the index: because as the overall risk of default goes up, so you gain on the one side of the trade (the protection bought), and lose on the other side (the protection sold). It leaves your capital position relatively unchanged, but you're continuing to earn spread.
But I think that you're right. Earning the spread seems like a small pay-off for the amount of capital at play, even if the capital is technically hedged against big movements in the underlying. I guess that's why some of the bloggers out there are calling the math suspect.
The other option here is that JPM has actually lent money to the companies over whom protection is being sold, and JPM is just hedging their exposure to those companies going into default. Like I said – the size of the trades is speculative (not the trades themselves – although they could be as well).
And your second point:
Agreed, George and Bruno are different fish. The one sold pounds, the other is making the index illiquid by maintaining his position. I was going to try and argue that Mr Soros made the foreign currency market in the UK illiquid by maintaining the forex position he'd just acquired; but I'm going to rather say that they both caused a market mechanism to malfunction purely by the size of their trade positions.
Does that make some sense?
Disclaimer: I haven't actually done the math on the trades, or checked that Bloomberg's figures are accurate. This is just the way that I read the articles. 🙂Reply