Sometimes Goldman Loses Money

When oh when will the Volcker Rule be finalized so we banks can stop losing money in their trading businesses?

The first thing to notice about today's story on Goldman Sachs losing a billion dollars in currency trading is that it is two different stories. The Wall Street Journal tells us that "a complex options trade tied to the U.S. dollar and Japanese yen had contributed to the decline," while Reuters thinks that "Goldman's currency-trading problems came from the way the bank had positioned itself in emerging markets," which do not as far as I know include Japan. There's nothing necessarily inconsistent about that -- there are lots of ways to get to losing a billion dollars in a quarter, and most of them involve multiple bad trades. 1

I guess the next thing to think about is the business, as in, "is this a harbinger of something, or just, like, sometimes trades go wrong?" Goldman CFO Harvey Schwartz gets the last word in the Journal article, saying "It's just a quarter," which is a good thing to remember about volatile trading businesses. On the other hand one could usefully wonder if the Big Changes Afoot in FICC businesses -- lower inventories and increased electronic trading and efficiency and so forth -- will push banks to search for higher margins into riskier trades. Once you can't make money in FX by just manipulating benchmarks you gotta go do riskier options trades to make up the revenue, maybe.

The last thing to think about is of course the Volcker Rule, which is supposed to ensure that banks don't go around losing money by betting their own money in trading businesses, which I guess this is. A couple of points are worth making about that.

First, from public reports this seems to be a perfectly legitimate market-making trade that would be allowed under the intent of the Volcker Rule. "Goldman's FICC arm tends to rely more heavily than other rivals on business from hedge funds and other large investors that seek out more complex trades," says the Journal, and these trades that lost money for Goldman seem to have been the sort of complex trades that their clients wanted.

Second, those complex client trades are often sold, not bought. (The Journal says that, after weak results last quarter, "senior securities executives urged traders to reach out to clients more frequently to drum up business," which is telling.) Exotic options traders don't sit around waiting for the phone to ring. The way you run a derivatives market-making business is that you build a thing that both you and your clients want. You need to know your clients' needs so you can build a thing that gives them an exposure that they want. But you also need to know your own book, and have your own views, to make sure the thing gives you an exposure that you want.

I was going to say "gives you an exposure that you want or that you can hedge efficiently," but I stopped myself. Doing any sort of non-trivial trade leaves you with some residual exposure; there are no perfect hedges. If you do "a complex options trade" you can hedge by doing some math and buying the appropriate offsetting number of dollars or yen or whatever, but that math changes over time and you still run the risk that the volatility will be more or less than you expected. (You can perhaps hedge the volatility, too, but if the trades are complicated enough then there's third-order effects that can still move against you.)

The only way to perfectly offset all your risks is to do a precisely opposite trade with someone else, and if you're doing that then what is the point of your business? 2 Hedge funds come to Goldman to do trades that don't otherwise exist in nature; if Goldman could go lay off its risk in perfectly symmetrical ways then it would not be providing any useful service.

You have to be positioned somehow, so you might as well be positioned the way you want. Your position could be "the dollar will strengthen against the yen" or "dollar/yen volatility will increase" or "the curvature of the dollar/yen volatility smile will increase" or some further-dimensional variant on that, but in any case it is always possible you will be wrong and if you are wrong you will lose money, that is the nature of things.

The discussion around the Volcker Rule is largely driven by suspicion of everything that banks do, which I suppose is natural enough, but sometimes you gotta pick your suspicion. You can be suspicious of market making for clients, because market making is a good way to take on positions that can lose a lot of money -- as Goldman seems to have done here.

The way to fix that is I suppose to require banks to hedge those positions, but that is a complicated job. (What do you have to hedge? Delta? Gamma? Vega? How close to flat do you have to get, and on what measures?) And of course you can be suspicious of hedging, especially complicated hedging, because complicated hedging is a good way to take on positions that can lose a lot of money -- as JPMorgan did with the London Whale.

There are not a lot of obvious solutions, beyond the trivial ones of "just hope banks are good at their jobs" and "just hope regulators are good at banks' jobs." (Or the non-Volckery ones of capital and ring-fencing and so forth.) The Volcker Rule is complicated because finance is complicated. Preventing banks from losing money is a good idea but it is also an idea that people have thought of before. They actually try pretty hard not to lose money. Sometimes it doesn't work.

[Update: Goldman has pointed out that in fact they don't lose money. Specifically they issued a statement saying "Goldman Sachs did not suffer a loss in our currencies business in the third quarter of 2013." Rather the $1.3 billion losses on currencies reported in the 10Q seems to include losses on hedges of other instruments with exposure to foreign currencies. So yeah: You gotta pick your suspicions. You can lose money on currency market making -- presumably Goldman did lose money on some yen and emerging market trades, but its money-making currencies trades more than made up for that -- but here the main culprit seems to have been hedging.]

1 The stories are consistent insofar as they suggest that Goldman was positioned for a strengthening dollar -- in the Journal story, "The yen has fallen against the dollar over the past year. This past summer, though, the yen's decline stalled," while Reuters says "the bank was anticipating that the Federal Reserve would begin winding down its monetary-easing programs" and "absolutely got annihilated" when it didn't.

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  1. And the counterparty to each of those bad trades has some incentive to talk to the press about it, mostly because it is fun to publicize that you beat Goldman Sachs, but also sometimes because publicizing Goldman's losing positions can force Goldman out of them at a further loss, as happened to JPMorgan's whale once he was spotted.

  2. Even there, there's counterparty risk.

    Disclosure: I used to work at Goldman Sachs, I have some restricted stock subject to transfer restrictions, and a portion of those transfer restrictions expire in January, at which point I will sell some stock. (Nothing against Goldman, I'm just not a single-stock sort of guy.) So I have every incentive to see the stock price go up in the next couple of months. Goldman is great! Buy Goldman stock! It makes a great Hanukkah present!

To contact the author on this story:
Matthew S Levine at

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