Levine on Wall Street: Watch Out for the Gamma Trap

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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What happened on October 15?

Something weird in Treasuries, anyway: "By 9:38 a.m., 10-year Treasury yields plunged 0.34 percentage point, the most in five years." But why? This Risk Magazine article (or try this link) offers what strikes me as a pretty compelling, though messy, explanation. The building blocks are:

  • Lots of hedge funds were short Treasuries, and had been increasing that bet even as rates continued to fall.
  • Lots of hedge funds were also in other crowded trades, including being long energy stocks and betting on the AbbVie/Shire merger.
  • Bill Gross's strategy at Pimco had involved selling Treasury volatility -- writing options and swaptions -- and Pimco had become "the largest supplier of volatility to the Street."
  • Dealers bought rates volatility from Bill Gross and sold it to the mortgage market: "Summed up crudely, the market sees asset managers and hedge funds selling payer swaptions for yield enhancement on one side, and mortgage servicers and originators buying receiver swaptions to hedge pre-payment risk on the other."
  • Bill Gross had left Pimco on September 26, and "The new leadership at Pimco also reversed Gross's policy of selling volatility to enhance yield."
  • Dealers had reduced their Treasury inventories substantially.

So then oil prices dropped, the AbbVie/Shire deal fell apart, and multi-strategy hedge funds had big losses and so capitulated on their short-Treasury trades. This pushed rates down quickly, and dealers who had been left short volatility -- who had sold rates volatility to the mortgage market but who were no longer hedged by buying it from Bill Gross -- traded in a way that made the move much sharper:

Traders that find themselves in a gamma trap have to buy or sell the underlying as it moves against them. "If you're short Treasury calls and want to hedge that exposure, you have to buy Treasuries as they go up, and sell as they go down. It forces you to trade badly -- essentially buy high and sell low. This hedging action can lead to sharp V-shaped moves like the one we saw in October," says Pravit Chintawongvanich, a derivatives strategist at Macro Risk Advisors in New York, which provides risk analysis and derivatives trade structuring services to investors.

The culprit is financial technology, but it's not so much electronic market-making in Treasuries as it is regular market-making in Treasury options. "You don't get a move like that in a linear product," says one trader.

What kind of banks are there?

Here's the Quarterly Review of the Bank for International Settlements, always a fun read. Here's the full text (pdf); as usual there are some "special features" that are of particular interest. Here's one on "Bank business models":

We identify three business models: a retail-funded commercial bank, a wholesale-funded commercial bank and a capital markets-oriented bank. The first two models differ mainly in terms of banks’ funding mix, while the third category stands out primarily because of banks’ greater engagement in trading activities. On average, retail-focused commercial banks exhibit the least volatile earnings, while wholesale funded commercial banks are the most efficient. On the other hand, trading banks struggle to consistently outperform the other two business types.

So why are the trading banks still doing it? Well to some extent, they're not:

About two fifths of the banks that entered the crisis in 2007 as wholesale-funded or trading banks (ie 19 out of 50 institutions) ended up with a retail-funded business model in 2013. Meanwhile, only one bank switched from retail-funded to another business model post-crisis, confirming the relative appeal of stable income and funding sources.

I suppose there's some institutional bias for the BIS to favor stable banky banks over risky trading banks, but there you have it. Elsewhere, bond trading is recovering. But Credit Suisse is planning to shrink its prime brokerage. And consider which type of bank does this: "Banks are urging some of their largest customers in the U.S. to take their cash elsewhere or be slapped with fees, citing new regulations that make it onerous for them to hold certain deposits."

Deals deals deals.

DealBook is doing a special section on "The Deal Cycle" this week. The first entries include one about how mergers and acquisitions bankers are in the ascendant at banks, as the power of traders wanes: M&A bankers don't require capital from their bank -- "They just need a Rolodex," says one extremely old-timey lawyer -- and their work "is much more difficult to computerize" than that of traders. Also helpful for M&A bankers: M&A is back.

“This was the year of the return of the transformational deal,” said Mark Shafir, co-head of global mergers and acquisitions at Citi. “There was pent-up demand.”

Coming five years after the end of the financial crisis, the flurry of deal-making arrived later than many thought it would. It took that long, however, for executives and directors to be comfortable taking risks.

On the other hand, Bloomberg News reports that UBS "has turned to a Singapore-based technology company that uses artificial intelligence for help delivering personalized advice to the bank’s wealthy clients," so bankers shouldn't get too smug about being too hard to computerize.

Shadow banking and technology.

Here's an FT Alphaville post from Friday about how "Silicon Valley might kill banks but not banking":

In the current regulatory framework, financial innovation ultimately turns into unregulated banking. Some true p2p-lenders in the original sense still exist. But they eventually come under pressure from “banking-p2p-lenders” that manage to transform illiquid loans into inside money and, via the implicit government guarantees that come along with this business model, pass on some of the risk to society.

The authors argue that, if there's a run on various tech/peer-to-peer financial startups today, those startups will fail and people will lose money and life will go on. But if not, then "aspiring banking institutions from Silicon Valley" could "manage to create such large amounts of inside money that the prospect of their failure intimidates regulators, central banks, and governments," and would then "have morphed into just another form of banking." We've talked a little in the past about Lending Club as a shadow bank, albeit as an all-equity-funded sort of shadow bank. Of course money market funds are also all-equity-funded shadow banks, in their way. The issue is not legal characterizations of debt vs. equity, but rather historically conditioned and unspoken expectations about liquidity and moneyness and government support. Elsewhere, LendingClub updated the prospectus for its initial public offering. And here is a claim that bitcoin "will some day replace the whole global financial system," sure.

Municipal bonds are weird.

Honestly this seems like a low bar:

The city of Harvey, Ill., agreed not to sell municipal bonds for the next three years without first retaining independent counsel to tell investors the truth about what the money would be used for and how the city planned to repay its debts. In addition, Harvey agreed to hire a consultant to straighten out its troubled finances and to have an outside auditor certify that its financial statements were accurate instead of leaving investors to rely on the city comptroller’s word.

I guess the idea is that municipal governments, unlike corporations, are usually so honest and wholesome that you shouldn't have to worry about their financials being accurate. Sometimes, though, you do; Harvey seems to have had a lot of problems with honesty in its bond disclosures. And now its punishment is, it has to use audited financials to raise new money.

Things happen -- in and around Bloomberg View.

If you like this linkwrap, why not try my Bloomberg View colleague Katie Benner's tech news roundup (most recent here)? And here is an interview with my Bloomberg View colleague Michael Lewis, who talks about the lessons of finance for journalism, and who think that banks "are too big, too complicated to manage, certainly should be busted up, but I am almost at the point where I’m beyond the point of caring because it seems like a waste of energy to get too worked up about it." Also I elloed about seating arrangements. 

Things happen -- elsewhere.

"Research by Chicago Booth PhD candidate Yanping Tu suggests that the more people view a task deadline as in the present, the more likely they are to start it." "Pedro Barusco, once an obscure, third-tier executive at Petrobras, has agreed to return about $100 million in bribes related to his time at the company." "Sullivan and at least three other top executives shed their clothes, formed a rugby-like scrum and ran into the ocean, according to the complaint." "Part of Zuckerberg’s problem-solving methodology appears to be to start from the position that all problems are solvable, and moreover solvable by him. They were big numbers, but he’s comfortable with those: if he does nothing else, Zuckerberg scales." "It has emerged that a proposal to save taxpayers some money by making peers and MPs share a catering department has been rejected 'because the Lords feared that the quality of champagne would not be as good if they chose a joint service.'" "Heriot-Watt University in Scotland has developed a fabric for Harris Tweed and Johnnie Walker that promises to 'permanently give off the smell of whisky.'"

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net