Introduction
Scandals and abuse
Trading and risk
Trading activities
Policy
Global Financial Systems
Chapter 9
Trading and Speculation
Jon Danielsson
London School of Economics
© 2013
To accompany
Global Financial Systems: Stability and Risk
http://www.globalfinancialsystems.org/
Published by Pearson 2013
Global Financial Systems © 2013 Jon Danielsson, page 1 of 48
Introduction
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Book and slides
• The tables and graphs are
the same as in the book
• See the book for
references to original data
sources
• Updated versions of the
slides can be downloaded
from the book web page
www.globalfinancialsystems.org
Global Financial Systems © 2013 Jon Danielsson, page 2 of 48
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Introduction
Global Financial Systems © 2013 Jon Danielsson, page 3 of 48
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Speculation
Force for good and force for bad
• Speculators help farmers to plan production
• And traders to threaten the financial system
• There is no clear definition of the term “speculation”
• But generally investment is long–term, speculation
short–term (buy and hold vs. buy and sell)
• It is often impossible to distinguish between “legitimate”
and “illegitimate” speculation
• Speculation cannot be eliminated, even though many
political leaders have expressed the desire to do so
Global Financial Systems © 2013 Jon Danielsson, page 4 of 48
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Terminology (Appendix)
• Party and counterparty
• Orders, clearing (clearing house), settlement
• Exchange vs. over–the–counter (OTC)
• Market maker (quotes both sides)
• Broker arranges transaction and charges commission
• Netting
• Central counterparty (CCP)
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Scandals and Abuse
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London whale and JP Morgan
• Chief investment office at JP Morgan lost over $6 billion
in London
• Part of adjustment to Basel III, thought to lower
risk–weighted assets
• But became a speculative bet on the shape of the yield
curve
“flawed, complex, poorly reviewed, poorly executed, and
poorly monitored. The portfolio has proven to be riskier, more
volatile and less effective as a hedge than we thought,”
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LIBOR scandal
• LIBOR/EURIBOR benchmark interest rate (average
reported rate)
• Very costly because many contracts (e.g. derivatives and
mortgages) have the rates set by LIBOR ($800 billion)
• Some banks manipulated it, have been investigated and
paid fines
• For Barclays it happened before/after crisis, e.g.
manipulation of reported borrowing costs
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Ponzi scheme
• An entity promises very high returns, collects money, pays
handsome returns to early investors, which attracts more
investors, in a pyramid scheme
• Named after Charles Ponzi in 1920 in US
• Best known recent case is Bernie Madoff ($18 billion
paper losses)
• Happens all the time
Global Financial Systems © 2013 Jon Danielsson, page 9 of 48
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Rogue traders
• A bank employee manipulates the system to take very
high risk
• Nick Leeson and Barings (£824 million)
• Jérôme Kerviel’s liberal interpretation of “low–risk
arbitrage” causing a e4.91 billion loss to his employer,
Société Générale (world record)
• (Kerviel did not really get bonuses)
• Happens frequently
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Trading and Risk
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Market participants
• General term referring to those who engage in trading
• Proprietary trading (prop trading) buying and selling for a
financial institution’s own account, in order to make
speculative profits
• this is the target of the Volcker rule, UK Independent
Commission on Banking (Vickers report), EU Liikannen
report
• Institutionalization, outsource investment decisions,
perhaps using a benchmark to evaluate performance
• plenty of scope for abuse (e.g. underperformance and
fraud)
• hence highly regulated (micro–prudential regulations)
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Hedge funds (HFs)
Lightly but not unregulated
• Lightly regulated funds that only sell to sophisticated and
•
•
•
•
•
•
wealthy investors (accredited)
Who consequentially should be able to take care of
themselves (no need for micro–prudential protection)
Still subject to securities laws and deal with regulated
parts of the financial system
Prime brokers
Difficult to classify (except by absence of regulations)
Before 2007 thought to be the main source of financial
instability (echoes of 1998 and LTCM)
It is a typical example of the successful general syndrome
Global Financial Systems © 2013 Jon Danielsson, page 13 of 48
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Financial innovation
• Create new types of financial instruments
• Viewed favorably until 2007
• Perhaps because only proponents understood it
• We look at CDS, CDO, SIV, conduits, etc. later
“the most important financial innovation that I have seen in
the past 20 years is the automatic teller machine”
Financial innovation “moves around the rents in the financial
system”, benefiting the inventor, not the clients.
Paul Volcker 2009
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Trading Activities
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Trading strategies
• Rules used by traders when deciding what to buy and sell
• Can be highly formalized and automated (like HFTs)
• Or a vague preference for low–risk or safe investments
• Often are unconscious
• We have seen several examples, especially in the
endogenous risk chapter
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Value investing
• Find companies trading below their inherent worth
• Stocks with strong fundamentals like earnings, dividends,
book value, cash flow
• The strategy of Warren Buffett
• One example of a mean reversion trade
Seeking yield is maximizing risk
Warren Buffett
Global Financial Systems © 2013 Jon Danielsson, page 17 of 48
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Carry trades
• Exploiting differences in yields
• We focus on foreign exchange carry trades
• Borrow money in a country with low interest rates,
exchange it for a currency with high interest rates
• Profit from interest differential and the resulting
foreign–exchange appreciation
• Very controversial because leads to excessive inflows of
hot money and inability to manage exchange rates (we
discuss this in detail later)
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Yen–Dollar 1998
145
135
125
115
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
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Endogenous risk feedback in unwinding
up by the escalator and down by the elevator (lift)
Dollar
weakens
Unwind carry
trade
Global Financial Systems © 2013 Jon Danielsson, page 20 of 48
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Carry trades as a source of contagion
Hedge fund
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Carry trades as a source of contagion
Hungary
New Zealand
Hedge fund
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Carry trades as a source of contagion
Hungary
New Zealand
Crisis
Hedge fund
Global Financial Systems © 2013 Jon Danielsson, page 23 of 48
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Carry trades as a source of contagion
Hungary
New Zealand
n
rgi
Ma
ll
ca
Crisis
Hedge fund
Global Financial Systems © 2013 Jon Danielsson, page 24 of 48
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Carry trades as a source of contagion
Hungary
n
rgi
Ma
ll
ca
Crisis
Sel
lN
ZD
New Zealand
Hedge fund
Global Financial Systems © 2013 Jon Danielsson, page 25 of 48
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Carry trades as a source of contagion
Contagion
n
rgi
Ma
ll
ca
Crisis
New Zealand
Sel
lN
ZD
Hungary
Hedge fund
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Technical trading
• Forecasting prices with quantitative methods
• Often successful with statistical arbitrage and HFT
• Less likely to work at lower frequencies
• Many studies proclaiming it works
• A problem with data mining. Forecasting in–sample not a
proof of success
• Most public studies have methodological problems
• However, if someone is successful they will not really talk
about it in any detail
Global Financial Systems © 2013 Jon Danielsson, page 27 of 48
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Momentum — trend following
• Buying assets that have seen recent price increases and
•
•
•
•
selingl those that have fallen in price
Can endogenously affect prices (self–validating in the
short run)
In the long run may cause bubbles and crashes
May be conscious, but perhaps more likely done
subconsciously
For example, we only engage with successful managers
Global Financial Systems © 2013 Jon Danielsson, page 28 of 48
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High–frequency trading (HFT)
• Using technology to beat everybody else
• Famous example Nathan Rothschild, pigeons and
Napoleon’s defeat in Waterloo in 1815
• Now done with high–speed computers, data networks and
algorithmic trading
• Main fears crystallized in the flash crash of May 2010
Global Financial Systems © 2013 Jon Danielsson, page 29 of 48
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Flash Crash, May 6, 2010. DJIA
10800
10600
10400
10200
10000
10:00
11:00
12:00
13:00
14:00
15:00
16:00
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Accenture transaction prices
40
30
20
10
0
14:45
14:50
14:55
15:00
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Sothebys transaction prices
105
104
103
102
14:45
14:50
14:55
15:00
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Impact
• The Flash Crash had little impact
• It happened intra day, and by closing time the market had
recovered
• So did not impact on margins, mark–to–market, daily
risk, etc.
• Hid the danger of HFT
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Short selling
• Selling assets one does not own — borrow with the
intention of buying back later
• In many cases a legitimate hedging activity
• But can be used to make directional speculative bets
• Difficulties in sorting out economic vs. political or moral
arguments
Global Financial Systems © 2013 Jon Danielsson, page 34 of 48
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Naked short selling
Two different activities
A. A short speculative position, rather than hedging
B. Short selling an asset without borrowing it
Global Financial Systems © 2013 Jon Danielsson, page 35 of 48
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Issues
• Profits from falling markets
• But is it any different from just selling assets one owns?
• Hard to see an economic distinction
• Hence the political/moral dimension of profiting from a
crisis, or causing prices to fall
• Frequently banned
• However little empirical evidence indicating damage from
short–selling or effectiveness of banning
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Policy
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CCPs
• The problem of asymmetric information
• And OTC instruments
• Makes it hard to net out positions, get a clear overview of
size of market/positions, and can create enough
uncertainty to cause an institution to fail, and even a
crisis
• This is the problem a CCP aims to solve (see next slide)
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CCPs
Bank B
Bank C
Bank A
Bank D
Global Financial Systems © 2013 Jon Danielsson, page 39 of 48
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CCPs
Bank B
Bank C
Bank B
Bank A
Bank D
Bank C
CCP
Bank A
Bank D
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How many CCPs
• Ideally only one in the world
• But this concentrates vulnerability
• And everybody wants to host it
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Vulnerabilities
• The CCP cannot be allowed to fail — that would be a
•
•
•
•
systemic crisis
Hence is a candidate for a government bailout — Hong
Kong bailed its CCP out in 1987
Therefore, a CCP may practice self preservation to the
extreme
And therefore trigger vicious endogenous feedbacks
Alternatively, it may take risk knowing it gets bailed out
— moral hazard
Global Financial Systems © 2013 Jon Danielsson, page 42 of 48
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Universal and narrow banking
• Should we restrict banking by activities?
• Glass–Steagall
• Investment banking and commercial banking
• Volcker rule, UK Independent Commission on Banking
(Vickers report), EU Liikannen report
Global Financial Systems © 2013 Jon Danielsson, page 43 of 48
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The rest of these slides relate
to compensation and FTT as
discussed in Chapter 9. The
same discussion, but with
updated content is in Chapter
21.
Global Financial Systems © 2013 Jon Danielsson, page 44 of 48
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Bonuses
• Some bank employees get performance bonuses
• Presumably incentivizes them to take more risk than
society likes
• Like creating a portfolio that delivers steady profits 99.9%
of the time, but blows up the bank (and even the
financial system) 0.1% of the time
• can be very easy to create such portfolios
• can be very difficult to identify
Global Financial Systems © 2013 Jon Danielsson, page 45 of 48
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So does limiting bonuses reduce systemic
risk?
• No evidence exists either way
• The biggest banking crisis in recent history involved no
bonuses — Japan
• In the 19th century bonuses were absent
• And we still get crises and bank failures without bonuses
• It is unclear if bonuses make this worse
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Policy options on bonuses
• Limit bonuses
• Will the rainmakers leave?
• EU now has a Directive limiting bonuses (discussed later)
• Banks say activity will migrate out the EU
• But no evidence suggests that would happen on a large
scale
• And proponents say “good riddance”
Global Financial Systems © 2013 Jon Danielsson, page 47 of 48
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Financial transaction tax (FTT)
• Impose a low tax on financial transactions
• Tobin tax
• Originally an anti–complexity device
• And has considerable merits as such
• However, sold as a way to fund governments
• does not make much sense,
• trading would sharply fall
• and the very same banks that are receiving massive
bailouts would have to pay the tax
• We return to the EU FTT later
Global Financial Systems © 2013 Jon Danielsson, page 48 of 48