Friday, April 6, 2012

JP Morgan trader's position in credit default swap market makes case for ultra transparency

Both Bloomberg and the Wall Street Journal have written articles (see here and here) on the activities of one JP Morgan trader in the Credit Default Swap market.  Apparently, the trader has taken such a large position that it is distorting pricing in the market.

According to Bloomberg,

JPMorgan Chase & Co. (JPM) trader of derivatives linked to the financial health of corporations has amassed positions so large that he’s driving price moves in the multi-trillion-dollar market, according to traders outside the firm. 
The trader ... specializes in credit-derivative indexes, an off-exchange market that during the past decade has overtaken corporate bonds to become the biggest forum for investors betting on the likelihood of company defaults. 
Investors complain that [the] trades may be distorting prices, affecting bondholders who use the instruments to hedge hundreds of billions of dollars of fixed-income holdings....
Speculation about his positions intensified yesterday after the newest and most-active index of investment-grade credit, the Markit CDX North America Investment Grade Index of credit- default swaps Series 18 climbed 4.4 basis points to a mid-price of 97 basis points at 5:13 p.m. in New York, the biggest increase in almost four months, according to Markit Group Ltd.... 
In some cases, [the trader] is believed to have “broken” the index -- Wall Street lingo for the market dysfunction that occurs when a price gap opens up between the index and its underlying constituents, the people said.
At first blush, this look like exactly the type of proprietary trading that the Volcker Rule is suppose to prevent banks from engaging in.

However, according to the Wall Street Journal

[The trader], who works primarily out of London, has earned around $100 million a year for the bank's Chief Investment Office, or CIO, in recent years, according to people familiar with the matter. 
There is no suggestion the bank or the trader acted improperly....

J.P. Morgan said the CIO unit is "focused on managing the long-term structural assets and liabilities of the firm and is not focused on short-term profits." 
The bank added, "Our CIO activities hedge structural risks and invest to bring the company's asset and liabilities into better alignment."... 
[The] trades are partially hedged, or protected by some offsetting trades, according to people close to the matter. Mr. Dimon is regularly briefed on details of some of the group's positions..
One person familiar with the matter said the bank has run tests that show [the trader's] positions likely will be profitable in any economic or market downturn. 
Potentially, the trader is legitimately hedging a risk faced by the bank.

At a minimum, the fact that the hedge has to be so big that it distorts the market suggests that JP Morgan needs to be shrunk in size so that hedges can be done without distorting the market.

The Wall Street Journal article continues
Some analysts who follow J.P. Morgan Chase, the biggest U.S. bank by assets, said they weren't aware of the group's trading. "They've talked about their investment strategies and procedures and risk controls but haven't highlighted this division," said Gerard Cassidy, a banking analyst at RBC Capital Market. 
J.P. Morgan said the CIO unit's "results are disclosed in our quarterly earnings reports and are fully transparent to our regulators."
It is this gap between what market participants know because bank disclosures leave the bank resembling 'black boxes' and what the regulators know that needs to be closed.

The only way to close this gap is by requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

If JP Morgan did this, market participants could see if the activities of the trader were actually hedging a legitimate business risk or were in fact simply proprietary trading.

If the former, there would still be the issue that the bank is probably too large if hedging its risk requires distorting market pricing.

If the latter, this is a classic case where market participants could help the regulators by identifying a proprietary trade and the regulators could require JP Morgan to close its position under the Volcker Rule.

Regardless of whether it is legitimate hedging or proprietary trading, this trade makes the case for why banks need to be required to provide ultra transparency.

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