In the wake of JPMorgan’s $2 billion trading loss, there’s been lots of talk about whether “portfolio hedging” is allowed under the Volcker Rule, and whether that should be changed. As I wrote in my previous post, the statutory language of the Volcker Rule very clearly allows portfolio hedging, and anyone who claims otherwise is lying to you. That’s just an objective fact, inconvenient though it may be for some people.

But the focus on portfolio hedging in the wake of JPMorgan’s trading loss is entirely misplaced. Portfolio hedging is only one of the seven criteria that a bank must meet in order to rely on the hedging exemption in the proposed Volcker Rule, and far from the most important. Commentators and certain politicians seem to believe that if JPMorgan’s trades met the definition of a “portfolio hedge,” then they would necessarily be allowed under the proposed Volcker Rule. That’s simply not true. Even if JPMorgan’s failed trades qualified as portfolio hedges, they would still have to meet other, more stringent requirements in order to qualify for the Volcker Rule’s hedging exemption.

What are the other criteria that a bank must meet in order to qualify for the proposed Volcker Rule’s hedging exemption? The first two have to do with the “programmatic compliance regime” that banks are required to establish under the Volcker Rule, so we can skip those for now. The third criterion deals with portfolio hedging — the trade has to mitigate specific risks, which can be done on a portfolio basis.

The fourth criterion is the most important, and it requires that the hedge “be reasonably correlated, based upon the facts and circumstances of the underlying and hedging positions ... to the risk or risks the transaction is intended to hedge or otherwise mitigate.”

Would JPMorgan’s trades have satisfied the requirement that they be “reasonably correlated” to the underlying risks being hedged? Maybe, maybe not. JPMorgan’s failed hedging strategy has been described several different ways in the press, so it’s impossible to say at this point. A lot depends on what specifically JPMorgan was trying to hedge in the first (original) leg of the hedging strategy, and what exposures the second leg of the strategy was intended to hedge. At first, the press was reporting that JPMorgan had been worried about weakness in the European economy, which led it — for whatever reason — to buy protection on the CDX.NA.IG.9 index. Now, I haven’t run the numbers, but I would question whether an index of investment-grade corporate credits is “reasonably correlated” to the European economy. So if those press reports are to true, then JPMorgan’s trade might have failed to qualify for the hedging exemption right there. But again, a lot of this depends on what JPMorgan was actually trying to hedge.

The fifth criterion, which is also crucially important, requires that the hedge “not give rise, at the inception of the hedge, to significant exposures that are not themselves hedged in a contemporaneous transaction.” JPMorgan’s trades could have failed to satisfy this requirement in two ways: first, when it initially bought protection on the IG.9; and second, when it later sold short-dated protection on the same index to hedge its original hedge. Why did JPMorgan have to hedge its original hedge? Was it because of changes in the economic outlook, or was it because they bought too much CDS protection initially? If it was the latter, then JPMorgan’s initial hedge may not have qualified for the Volcker Rule’s hedging exemption in the first place. The same analysis also applies to the second leg of the hedging strategy, in which JPMorgan reportedly ended up selling far too much CDS protection on the IG.9 index. If JPMorgan significantly over-hedged by selling too much CDS protection, then those trades also would not have been allowed under the Volcker Rule.

The sixth criterion requires that the hedge “be subject to continuing review, monitoring and management after the hedge position is established.” Jamie Dimon has all but admitted that the trades wouldn’t have satisfied this requirement.

Finally, the seventh criterion requires that “the compensation arrangements of persons performing the risk-mitigating hedging activities are designed not to reward proprietary risk-taking.” Now, I don’t know what Bruno Iksil and Achilles Macris’s compensation arrangements were, but I would actually be very surprised if their compensation arrangements didn’t reward proprietary risk-taking. Mostly this is because the Chief Investment Office (CIO) had something of a dual mandate — the CIO not only hedged the bank’s risks, but it also invested excess deposits, which is a risk-taking role. So I would suspect that compensation arrangements in the CIO accounted for their risk-taking mandate. If so, then the trades may have failed to qualify for the Volcker Rule’s hedging exemption for yet another reason.

The point of all this is that the debate over “portfolio hedging” is a complete sideshow — portfolio hedging is definitely allowed under the statutory language of the Volcker Rule, but this in no way means that the proposed hedging exemption is too weak, or has been “gutted.” JPMorgan’s trades may have qualified as “portfolio hedges,” but still may have failed to qualify for the Volcker Rule’s hedging exemption on at least four other grounds. The “reasonable correlation” and “no new exposures” requirements are far more important than whether portfolio hedging is allowed.

Commentators and journalists would do well to remember this.

245 comments:

Jesse said...

Here is a reasonably good discussion of this.

http://www.nytimes.com/2012/05/12/business/jpmorgan-chase-fought-rule-on-risky-trading.html?pagewanted=all

Donald Pretari said...

"The sixth criterion requires that the hedge “be subject to continuing review, monitoring and management after the hedge position is established.” Jamie Dimon has all but admitted that the trades wouldn’t have satisfied this requirement."

I can't believe you need a Law to require this. But then, I'm wrong.

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I saw a post somewhere - it may have been on the American magazine Atlantic Monthly - saying that these kinds of losses are just part of the complexity of the modern financial system and will always occur on a regular basis. It argued that even if regular banks were completely hived off and separated from trading arms, these kinds of things would still be happening. It almost seems like the financial system itself has become a kind of systemic Frankenstein.

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