JPMorgan Chase & Co.’s credit-derivatives trades that lost the biggest U.S. bank more than $2 billion were thwarted by market illiquidity, said David Kelly, director of financial engineering at Calypso Technology Inc.
Credit derivatives traders value the contracts with an assumption that if pricing relationships break down, the market is active and deep enough that hedge funds and others that seek to profit from such dislocations will drive the prices together, Kelly said. Instead, by using indexes less active than benchmark contracts and so-called tranches of the indexes that are more difficult to trade, correlation with the rest of the market deteriorated, he said.
“Lack of liquidity wasn’t fully appreciated or fully considered,” Kelly, who previously helped manage counterparty risk at JPMorgan and Citigroup Inc., said in a telephone interview. “This thing should have been making money, but the illiquidity and therefore the pricing distorted the normal behavior.”
JPMorgan Chief Executive Officer Jamie Dimon disclosed the loss in its chief investment office on a May 10 conference call, saying it stemmed from trades that had been designed to hedge the bank’s credit risk. A shift in strategy that was supposed to reduce the hedge instead turned out to be “flawed, complex, poorly reviewed, poorly executive and poorly monitored,” Dimon said on the call.
Bloomberg News first reported April 5 that Bruno Iksil, a trader for the chief investment office in London, had taken on positions that were so large he was driving price moves in the $10 trillion market for credit-default swaps indexes.
By amassing positions of as much as $100 billion in a corporate credit-default swaps index created in 2007, Iksil earned the nickname London Whale among some counterparties, according to market participants who asked not to be identified because they weren’t authorized to discuss the trades.
The benchmark, known as Series 9 of the Markit CDX North America Investment Grade Index, or IG9, had grown less active as new versions were created every six months. Iksil also used so-called tranches that take more concentrated risks on the companies in the index.
The loss underscores the difficulty banks face in hedging their risks and the ambiguity between those efforts and the kind of proprietary risks that Congress is seeking to limit for federally subsidized lenders, said Kelly, who joined Calypso in March.
San Francisco-based Calypso, founded in 1997, sells software to banks and investment firms for managing trade processing and risk in derivatives markets, according to the company’s website.
As part of an overhaul of financial regulations passed in 2010, Congress approved the so-called Volcker rule, named after former Federal Reserve Chairman Paul Volcker, to limit banks’ wagers on markets with their own capital.
When he helped manage counterparty risk at JPMorgan and Citigroup, Kelly said the desk would sometimes be given a position to hedge that couldn’t be matched perfectly. The “big basket” of loans on JPMorgan’s book would be impossible to hedge symmetrically, he said.
“You can’t possibly hedge it so you’re left with a position,” Kelly said. “You have no choice but to take some risk.”