The Blurred View of Risk

JP Morgan's losses will be partly offset by the sale of other financial assets, bringing the bill down to $800 million.

JP Morgan’s trading losses and SEF regulation round off a busy week.

When I was at university, we used to have stock market nights at one of our campus bars on a regular basis. The premise was simple; a rudimentary index would be consistently running on screens above the pumps, listing the prices of various drinks. As demand increased for a particular drink, the price would go up, while the least popular ones, invariably the ales, would shrink in cost to sub-pound levels. What this meant, of course, was that you'd see rush squads of people clamouring to order the cheapest drink possible ─ we were students, after all ─ which would suddenly drive the price up. You might order a pint of Brains at 80 pence, but by the time it was put in front of you and the price rung up on the till, which was linked to the pseudo-exchange, it would be three quid.

Plus ça change, plus c'est la même chose, as our Gallic colleagues say.

Eventually, a group of us decided to get clever. We'd counter order for each other, purposefully front running the orders to maintain optimal price levels for the next wave of our group, who would benefit from the drop we precipitated. The cycle would reverse for the next round. Perhaps inevitably, we devised a rudimentary form of derivatives construction from this ─ the components in a snakebite are lager, cider, and blackcurrant, for instance, so affecting the individual prices of these underlying drinks, we learned, would have a direct ramification on the overall price of the component product, hedged by bolstering prices for other ones.

Needless to say, it became a mess rather quickly. Can you see where this is going? JP Morgan's announcement of its $2 billion trading loss (before offsetting income from asset sales), which seems to be down to disorganized or unlucky hedging using complex derivatives is something of a told tale. How such massive positions can be amassed and not alert internal surveillance and risk engines, particularly when it takes part in a risk-related area of the office, is unknown. But it does emphasize the need to have effective controls and proper oversight, technologically as well as in terms of human eyes, over all areas of an enterprise. For us, at the Aberystwyth student union, the only things that we lost were our dignity and the ability to eat anything other than cold beans for a week after. For large investment banks, as we've seen over the past few years, the stakes are much higher.

Extensions and Implementations
On the subject of derivatives, the US Commodity Futures Trading Commission (CFTC) announced yesterday that it would be extending its deadline for swap execution facility (SEF) regulation, under Article VII of the Dodd-Frank Act. Originally scheduled for July, there's not a great deal of surprise that this has been prolonged.

The CFTC also noted that it was nearing completion for what it will consider a swap dealer, and security-based swap dealer, two key components of the regulation. The effective date is now 31 December 2012. For more information on SEFs, see my colleague Timothy Murray's excellent and in-depth feature here.

Outside of regulation, derivatives and alcohol, it's also worth bringing to your attention that the Waters rankings are still open for voting. The period to submit your choices closes at midnight on 25 May, so please do get involved in what should be a great event.

If anyone would like to talk SEFs, JP Morgan, or the particular idiosyncrasies of Aberystwyth University ─ I know there are a few of you out there ─ please do feel free to give me a call on +44207 316 9811, or send an e-mail to [email protected].

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