On 10 May 2012, JP Morgan, the largest US bank by assets, announced that poorly designed and executed hedging strategies had caused more than $2 billion in derivatives trading losses from transactions in London. Even more worrying is the fact that some regulators, including the US Commodity Futures Trading Commission (CFTC) and the US Securities Exchange Commission (SEC), have argued that since they do not yet monitor JP Morgan as a swap dealer, they became aware of the trading losses after JP Morgan’s announcement despite earlier media reports at the beginning of April that raised red flags over the London Whale’s $100 billion notional exposure in one credit index. Even the regulators, the US Office of the Comptroller of the Currency (OCC) and Federal Reserve Bank, failed to detect the risk posed by the massive hedging strategy, despite having more than 100 of their own staff embedded at JP Morgan, up until April, around the same time that Bloomberg and Wall Street news reports suggested that the UK-based trader at the bank was playing a dominant role in certain markets and distorting prices.
Regulators might argue that it is not their responsibility to flag risks posed by some hedging strategy but it is important to note that JP Morgan is identified by the OCC as one of the top five systemically important financial institutions, which collectively accounted for more than 50 percent of the $700 trillion OTC derivatives in total notional value at the end of 2011. JP Morgan exposure alone exceeds $70 trillion, which implies a leverage of one to 31 times, given JP Morgan total assets $2.26 trillion, according to the OCC report.
Given the prominence of the company in derivatives trading (estimated to account for over 10% in notional value of OTC derivatives trading in late-2011), this raises important questions about regulatory oversight, the pace and extent of financial reform and ultimately (even though energy markets were not directly involved) the functioning of energy derivatives markets.
The Trades in Question
According to news reports, JP Morgan trades can be classified as directional bets, although some might argue that it is a complex hedging strategy to cover overall portfolio risk. In the simplest terms, the company initially purchased credit default swaps (CDS) on high yield bonds to hedge their loan book. Money could have been made if the economy deteriorated. In the event, as the US economy showed some improvement, this strategy did not perform well in terms of making money although it is the appropriate strategy in terms of risk management. In the second stage, JP Morgan sold substantial amounts of under-priced swaps on a basket of investment-grade corporate bonds, a traded index of credit default swaps, on the expectation that the economy would further improve.
It is especially this portion of the trades that are being questioned, and whether this constituted a hedge or a proprietary trade. Some have argued that this was a hedge against future obligations for which the firm is naturally short. Others argued that this is actually proprietary trading, which would have been prohibited under the Volcker rule. The company’s large position eventually created a material gap between the index price and the sum of the prices on the underlying CDS in such a way that buying protection on the index was cheaper than buying protection via individual company CDS. Instead of unwinding their position in the index, JP Morgan further took the opposite position to hedge their exposures in the index by buying CDS on the investment-grade bonds of individual companies, which led to further losses for the company.
We expect that debates surrounding these trades will have important implications for at least three contentious issues; namely the Volcker rule, the Lincoln swaps push-out rule, and the cross-border application of the Dodd‑Frank Act.
Implications for the Volcker Rule
As explained in the February OMR, the proposed Volcker rule prohibits proprietary trading while allowing transactions related to underwriting, market-making, risk mitigating hedging, trading in certain US government obligations, and trading on behalf of customers. For example, the proposed rule allows for banking entities’ risk-mitigating activities for their portfolio. The statute defines proprietary trading as engaging in the purchase or sale of certain financial assets as a principal for the trading account of a covered banking entity. The rule further provides guidance on what banking entities must do to prove that they are not undertaking proprietary trading but engaging in permitted activities, such as hedging, market-making or trading on behalf of customers. Finally, the proposed rule provides detailed limitations on the permitted activities. For instance, if their permitted activity would endanger the safety or soundness of the banking entity or the financial stability of the United States, then it is considered proprietary trading and it is prohibited.
The determination of what constitutes proprietary trading and what constitutes legitimate trading activity, such as hedging or market-making, remains under debate, although the final rule will now likely narrow hedging exemptions. Some suggest that portfolio hedging should not be considered as a legitimate hedging activity, and therefore should not be permitted. Also, regulators might interpret market-making activity more narrowly than the proposed rules. While recent events might boost popular support for more restrictive rules, they do not remove the need for thorough cost-benefit analysis on measures which might reduce liquidity in the market, adversely affecting price discovery and the transfer of risk functions of derivatives markets.
Implications for the Lincoln Swaps Push-Out Rule
The Lincoln rule specifically requires federally insured banking entities to move their risky trades, such as swap trading in uncleared credit-default swaps and energy and metal swaps, among others, from a banking unit into separately capitalised affiliates, while allowing exemptions for certain traditional bank derivatives activities, such as hedging and trades in interest-rate swaps. The rule is expected to be in effect starting on 16 July 2013. Banks lobbied against this rule and the US House Committee on Financial Services amended the Lincoln rule on 11 May to allow a wider range of swaps to stay in-house. However, due to the recent JP Morgan losses, the US House Committee on Agriculture granted an extension for further consideration, ending not later than 16 July 2012. It will be interesting to see whether and how recent events trigger a major regulatory rethink in the US Congress.
Implications for Cross-Border Application of the Dodd-Frank Act
The extent to which the Dodd-Frank Act will govern cross-border activities is an important issue in light of the global nature of the swap market. The Dodd-Frank Act gives broad authority to the CFTC over the global swaps markets by Section 722. Section 722 provides that the CFTC’s jurisdiction shall not apply to activities outside of the US unless they have a direct and significant connection with activities in, or effect on, commerce of the US.
The CFTC is yet to vote on interpretive guidance extending the Dodd-Frank Act to some overseas swap trading, but the Commission is likely to release its guidance in late June 2012. The US banking sector has argued that broader oversight of cross-border derivatives activities will diminish their competitiveness in global swaps markets with their foreign-based competitors. Others suggest that JP Morgan’s losses are a reminder of how trades overseas by subsidiaries and branches of US firms can quickly affect domestic banking units.
Although we still need to see the actual guidelines, CFTC Chairman Gensler provided some of the key elements in the interpretive guidelines on 22 May 2012, which include:
- requirement for entities to register under the CFTC’s swap dealer registration rules if a foreign entity transacts in more than a de minimis level of U.S. facing swap dealing activity.
- addressing what it means to be a U.S. facing transaction, which will include transactions not only with persons or entities operating in the United States, but also with their overseas branches.
- a tiered approach for requirements for overseas swap dealers that could include entity level requirements, such as capital, risk management and record-keeping as well as transaction-level requirements, such as clearing, margin, real-time public reporting, trade execution and sales practices.
- use of entity-level requirements to all registered swap dealers, but in certain circumstances, overseas swap dealers could comply with these requirements through substituted compliance.
- use of transaction-level requirements for all U.S. facing transactions, but for certain transactions between an overseas swap dealer (including a foreign swap dealer that is an affiliate of a U.S. person) and counterparties not guaranteed by or operating as conduits for U.S. entities, Dodd-Frank may not apply.
Implications for Energy Derivatives Markets
Although JP Morgan losses were not related to energy derivatives trading, the implications of any resultant new interpretation of the Volcker, Lincoln and cross-border application of the Dodd-Frank Acts will certainly affect energy markets, where banking institutions have been the biggest liquidity providers through their hedging, market-making and speculative activities. Commercial traders have raised their concerns on the impact of the Volcker rule and other rules on market liquidity and their unintended consequences of higher trading costs. They were already lobbying for more exemptions from commercial banks’ trading bans ahead of the events surrounding JP Morgan, but might struggle now to win their case, not least if a narrower interpretation of hedging and market-making activities gains momentum. Cross-border application of the Dodd-Frank Act might complicate the international harmonisation of regulation if the CFTC’s guidance goes beyond its own jurisdiction. Genuinely increasing transparency and reducing systemic risks in the global swaps market will need such harmonised rules, and moreover rules that have been subject to proper cost-benefit analysis.
IEA Oil Market Report, June 2012
IEA Oil Market Report, June 2012