Who are them?
Many option traders and stock traders ask, who is buying from me when I am selling and who is selling to me when I am buying? What happens when nobody wants to buy a stock or stock option which I am selling? In a normal, liquid market, there are usually someone queuing to sell a stock or stock option when you are buying and someone queuing to buy when you are selling. However, there are times when nobody is queuing to sell when you are buyng and times when nobody is queuing to buy when you are selling, so, how is it that you are still able to buy or sell your stocks or stock options smoothly? This is where Market Makers come in.
A "Market Maker" can be an individual or representatives of a firm whose function is to aid in the making of a market, by making bids and offers for his account in the absence of public buy or sell orders in order to ensure market transactions are as smooth and continuous as possible. When an option trader places an order to buy a stock option which nobody is queuing to sell, market makers sell that stock option to that option trader from their own portfolio or reserve of that particular stock option. When an option trader places an order to sell a stock option which nobody is queuing to buy, market makers buy that stock option from that option trader and adds it to their own portfolio and reserve. In doing so, market orders are continuously moving, eradicating sudden surges and ditches due to buying and selling imbalance.
You'll most often hear about market makers in the context of the NASDAQ or other "over the counter" (OTC) markets. In contrast to the "Specialist" system that the NYSE employs, NASDAQ has no individuals through which a stock's transaction must pass. Instead, all transactions pass from one market maker to another. In the market maker system, market makers compete with one another to buy or sell stocks & options to investors by displaying quotes and are obligated to buy and sell at their displayed bids and offers. An investor may be dealing with several market makers at once if that investor is placing a very large order which cannot be filled by the inventory of one market maker. An option trader may also deal directly with individual, specific market makers through Level II Quotes.
In reality, Market Makers make up the actual "market". When a stock or option trader places an order with a broker, that broker fills that order by buying or selling with the Market Makers.
Another way of understanding what Market Makers do is that Market Makers are like the book makers in Las Vegas who set the odds and then accommodate individual gamblers who select which side of the bet they want. A Market Maker supplies a bid and ask price and then let the public decide whether to buy or sell at those prices. As an options trader, Market Makers are master position traders who aims to establish and profit from every low risk and risk free opportunities.
Advantage Of The Market Maker System
In NYSE, there is one official employee of the exchange to act as market maker for each security. In the Market Maker System, many market makers are assigned to every security. As every Market Maker effectively acts as a "Specialist" like in NYSE, there are effectively many specialists for each stock. This creates a decentralised market place where liquidity and volatility varies. This improves overall liquity and makes market manipulation much more difficult.
What Happens If There Are No Market Makers?
Market makers have given option traders quite a negative impression as people who buys at very low prices and sells at very high prices just when an option trader is desperate to buy or sell a position. Let's see what happens when we remove market makers from the markets.
XYZ stock is an extremely bullish stock who has just announced fantastic earnings. You want to buy XYZ stocks but investors who are already holding XYZ stocks are not selling. In order to attract a seller, you begin to bid higher and higher for XYZ stock until at last, a seller is moved to selling the stock. This price could already be extremely high.
Consider again a sudden bad news released from XYZ company, creating a rush to sell XYZ stocks. You are queing to sell but nobody is buying. In order to attract a buyer, you start to push the price lower and lower until at last, the price bottoms out worthless.
As we have seen, in an imbalanced buying and selling situation, market makers play an extremely important role of creating liquidity for prices in between in order to eradicate huge gap ups and downs and to ensure a liquid market for all.
How Does Market Makers Make A Profit?
Market Makers are not paid commissions to buy and sell stock options, so how do they make a profit? Well, most institutional market makers simply earns a salary from the marker maker firm that they represent. Market Maker firms like Goldman Sachs and Morgan Stanley, commit their own capital to maintain an inventory of stocks and options and represent customer orders. On the trading floor, Market Makers make money by maintaining a difference between the price he would buy and the price he would sell a particular stock or stock option. This difference in price is known as the Bid-Ask Spread. A bid-ask spread ensures that if an order to buy and an order to sell arrives simulataneously, the Market Maker makes the difference in Bid-Ask Spread as profit.
Example : XYZ May30Call option has a bid price of $1.10 and an ask price of $1.30. Market Maker John recieves simulataneously an order to buy and an order to sell. Market Maker John buys that May30Call option from the seller for $1.10 and then sells that same May30Call option to the buyer for $1.30, thus making $0.20 in profit completely risk-free.
However, when a Market Maker is not confident that a stock or stock option can be so quickly bought and sold, due to the fact that there are only very few option traders or stock traders trading that security, then there is a risk that a stock or stock option which that Market Maker buys can only be sold when the market price is lower than the prevailing price, therefore resulting in a loss. In order to protect against such a risk, Market Makers, widen the bid-ask spread so that the transaction remains risk free to him over a larger price range.
Conversely, when Market Makers are selling highly active option contracts, they frequently raise the price of the option through increasing the implied volatility of that particular option contract. That results in the Volatility Smile or Volatility Skew.
Apart from market making, market makers also make profits from options arbitrage. An arbitrage opportunity presents itself when a severe deviation from Put Call Parity occurs leading to options pricing discrepancies which can be locked in completely risk-free using options trading strategies such as the Box Spread and the Conversion & Reversal Arbitrage. As any possible profits from arbitrage is extremely low, only Market Makers who need not pay a broker commission can actually make any money out of it.
How Does Market Makers Protect From Risk?
As you can see by now, Market Makers are like you and me, buying and selling stocks and stock options. Doesn't that expose them to certain directional risks? Yes, even though market makers endeavour to be able to buy and sell simultaneously in order to benefit risk-free from bid-ask spread, such ideal situation rarely exist in stocks or stock options which are not extremely liquid. Most of the time, Market Makers end up owning stocks or stock options and that exposed them to directional risk.
Example : Market Maker John buys XYZ May30Call option from a seller for $0.80. If XYZ stock falls before Market Maker John manages to find a buyer for it, Market Maker John stands to lose money as the call option decreases in price.
Market Makers protect themselves from directional risks through "Hedging" and flexible use of synthetic positions. A Market Maker hedges his inventory through buying or selling additional stocks or stock options in order to achieve a position whereby stocks and options falls as much as the other rises in order to maintain the overall value of the account. This is what we call a "Delta-Neutral" position. A Market Maker's positioning strategy, especially in making markets for stock options, is extremely complex and requires to the second calculation and execution. It is because of this complexity in balancing all kinds of risks that some new Market Makers actually lose money to the market despite all the privileges of being a Market Maker.
Risks That Market Makers Face
Market Makers for stock options trading faces 6 forms of risks which, in fact, all option traders face :
1. Directional Risk / Delta Risk
Directional or Delta risk is the risk that a stock option price will turn against the market maker as the underlying stock value changes. A Market Maker consistent attempts to hedge this risk by going "Delta-Neutral".
2. Gamma Risk
Gamma risk is the risk that the delta value of a stock option may change over time. This consistently threatens to tip a Market Maker's sensitive Delta-Neutral position to become of positive or negative delta, thereby exposing a Market Maker to directional risk. Gamma risk can be overcome by taking Gamma Neutral Positions.
3. Volatility Risk
An increase in implied volatility in the market increases the premium value of stock options while a decrease in implied volatility decreases the premium value of stock options due. This is known as the Vega risk. Market Makers who hold an inventory of stock options could sustain a loss if implied volatility decreases.
4. Time Decay Risk
Time Decay or Theta risk is when stock option premium reduces as expiration date draws nearer even if the underlying stock does not move. A Market Maker with an inventory of long stock options can sustain a loss over time even if the underlying stock does not move.
5. Interest Rate Risk
Stock options, especially long term ones, are affected slightly by changes in interest rates. This change, although insignificant to most option traders, is significant to Market Makers who hold very large inventory of stock options. This risk is represented by the Options Rho.
6. Dividend Risk
Dividends declared reduces call option value as holder of the call option do not recieve the dividends. Such risks are usually hedged by Market Makers by buying the underlying stock ahead of it's dividend declaration. The dividends recieved then hedge against the decline in call option value.
Unlike independant option traders, Market Makers cannot sell off their inventory of stock options simply because they know these stock options are going to go down in value due to any of the above risks, that is why hedging is such an important skill to Market Makers.
How Does One Become A Market Maker?
One can only become a Market Maker by joining one of the Market Maker firms like Goldman Sachs or through a clearing agency or brokerage firm which is a member of NASDAQ. Most firms provide on the job training and requires applicants to have at least the following criteria :
1. A Bachelor's Degree
2. Excellent numeracy and analytical skills.
Most firms also have entry examinations in order to ensure that applicants have the required numeracy and analytical skills.
Another way of becoming a Market Maker is by owning a trading pit in NASDAQ or LSE itself... something that is out of reach for most individuals.
Thursday, August 21, 2008
Sunday, August 17, 2008
The Money Masters - How International Bankers Gained Control of America
"The powers of financial capitalism had a far-reaching plan, nothing less than to create a world system of financial control in private hands able to dominate the political system of each country and the economy of the world as a whole...Their secret is that they have annexed from governments, monarchies, and republics the power to create the world's money..."
THE MONEY MASTERS is a 3 1/2 hour non-fiction, historical documentary that traces the origins of the political power structure that rules our nation and the world today. The modern political power structure has its roots in the hidden manipulation and accumulation of gold and other forms of money. The development of fractional reserve banking practices in the 17th century brought to a cunning sophistication the secret techniques initially used by goldsmiths fraudulently to accumulate wealth. With the formation of the privately-owned Bank of England in 1694, the yoke of economic slavery to a privately-owned "central" bank was first forced upon the backs of an entire nation, not removed but only made heavier with the passing of the three centuries to our day. Nation after nation, including America, has fallen prey to this cabal of international central bankers.
THE MONEY MASTERS is a 3 1/2 hour non-fiction, historical documentary that traces the origins of the political power structure that rules our nation and the world today. The modern political power structure has its roots in the hidden manipulation and accumulation of gold and other forms of money. The development of fractional reserve banking practices in the 17th century brought to a cunning sophistication the secret techniques initially used by goldsmiths fraudulently to accumulate wealth. With the formation of the privately-owned Bank of England in 1694, the yoke of economic slavery to a privately-owned "central" bank was first forced upon the backs of an entire nation, not removed but only made heavier with the passing of the three centuries to our day. Nation after nation, including America, has fallen prey to this cabal of international central bankers.
SemGroup, the US physical oil trader, on Tuesday filed for bankruptcy as it acknowledged trading losses of more than $3.2bn in different energy markets after betting this year that crude oil prices would fall. Its collapse came as oil prices plunged to their lowest levels since early June. West Texas Intermediate crude oil fell to an intraday low of $125.63 a barrel, down $5 on the day. Traders sold oil futures as news emerged that tropical storm Dolly was set to miss oil and natural gas installations in the US Gulf of Mexico. Oil traders said SemGroup could have exacerbated the spike in oil prices this month, when the market experienced unprecedented swings of more than $10 a barrel, as the company was buying back some previous bets on lower prices. The bankruptcy of SemGroup, which describes itself as the fourteenth largest US private held company, affects approximately $3.1bn of debt, according to court filings. Oil company BP is the largest creditor, with almost $160m.
SemGroup took a $2.4 billion loss on July 16 after it transferred its New York Mercantile Exchange oil futures trading account to Barclays Plc, converting what they called "loss contingencies" into an actual loss. Included in the NYMEX loss was $290 million owed to SemGroup by a trading company owned by co-founder and former chief executive Thomas Kivisto, who was placed on administrative leave on July 17. Securities legislation limits publicly traded company executives from extensive dealings with their firms, but experts said privately held companies have more flexibility. . . . SemGroup, ranked the No. 12 private U.S. company by Forbes.com in a 2007 article, also took $850 million in losses on July 17 when its over-the-counter hedging program was marked to market. It listed liabilities of $7.53 billion in its bankruptcy filing, including $3.1 billion of total debt $2 billion of secured debt and $594 million in unsecured notes. SemGroup's financial difficulties were disclosed by its publicly traded affiliate SemGroup Energy Partners LP last week, when it warned that a liquidity crisis at its parent could lead to bankruptcy.
There are many factors that affect oil prices. Fundamental factors such as global supply and demand and dollar moves are often cited. But many also say that traders play a big role in affecting oil prices fluctuations. No doubt, fundamentals are behind oil's long-term uptrend. And it is the dollar's weakness of the past few years that has supported the trend. But short term? Could traders' short covering be the reason behind oil's recent run-up to nearly $150 a barrel?
Perhaps, but that's behind us. Oil prices have retreated more than $20 dollars since. What caused that? Have the fundamentals changed? Some say global demand is bound to slow as the global economy weakens, but others say supply concerns due to geopolitical unrest are also growing. Has the dollar strengthened? A little, but then it declined right back Thursday after a housing report showed recovery is still far off. And what about traders?
Well, here's where The Wall Street Journal as well as Reuters bring an interesting theory. They say that the rise and fall in oil prices coincided with energy company SemGroup L.P.'s (mis)fortunes. SemGroup is a little known private company that transports, stores and distributes crude oil and refined products. It is also the parent of pipeline operator SemGroup Energy Partners L.P. (NADSAQ: SGLP). SemGroup L.P. filed for Chapter 11 bankruptcy protection Tuesday. According to the Journal, "Changes in its hedging strategies coincided with big moves in oil recently."
SemGroup's losses from oil trading amounted to $3.2 billion. How can a company lose so much in oil-trading when prices of oil just kept increasing, you ask? By covering short positions, of course. The company said the losses were incurred as part of a failed hedging strategy designed to protect its main physical oil trading business, but the loss seemed too great . Now new information reveals the company may have engaged in trading for profit, which is not in its mandate. Creditors have claimed fraud and unauthorized trading and have already filed a class action suit. The SEC is inquiring too. With $290 million losses caused by SemGroup's own former CEO, it is no wonder people are questioning what happened.
Regardless of how things progressed later, according to Reuters, "SemGroup was forced to take a $2.4 billion loss on July 16 after it transferred its NYMEX trading account to Barclays Plc." Given the time frame, the WSJ says some on the Street claim SemGroup's demise may have been partially responsible for the big drop in oil prices. In fact, SemGroup may have been first responsible also for the big oil rally, since as its long positions grew, so did oil prices. Then, during the transition of its portfolio to Barclays, oil prices plunged. Coincidence? At the very least, "SemGroup's rapid exit from the market removed a force for upward momentum."
Others claim that since it's unclear what Barclays did with the positions, the linkage isn't certain, especially since oil started dropping on Bernanke's comments July 15 and then on the inventories report the following day.
Either way, this whole story shines a bright light on how traders can affect oil prices and perhaps better explains why regulators have recently put short trading constraints on some banks. Meanwhile, the Commodity Futures Trading Commission continues its probe into price manipulation in the oil futures market and has recently charged a Dutch trading fund, Optiver Holding BV, with manipulating the price of crude, gasoline and heating-oil futures.
I have no doubt that more regulation is needed to help limit such manipulations. Of course, there will always be fraudsters and crooks, but I'd like to believe most traders are there to make an honest buck, not cause financial havoc. While bear markets are always a fertile ground for shorts and options traders, with clearer regulations and rules, we may be able to at least avoid some of the insane fluctuations and volatility we've witnessed in the market lately.
Whether SemGroup's forced cover is the catalyst for one of the biggest recent corrections in crude oil can be debated. But the fact that this correction started literally hours after SemGroup were forced to cover (July 16/17) seems to be more than mere coincidence.
SemGroup took a $2.4 billion loss on July 16 after it transferred its New York Mercantile Exchange oil futures trading account to Barclays Plc, converting what they called "loss contingencies" into an actual loss. Included in the NYMEX loss was $290 million owed to SemGroup by a trading company owned by co-founder and former chief executive Thomas Kivisto, who was placed on administrative leave on July 17. Securities legislation limits publicly traded company executives from extensive dealings with their firms, but experts said privately held companies have more flexibility. . . . SemGroup, ranked the No. 12 private U.S. company by Forbes.com in a 2007 article, also took $850 million in losses on July 17 when its over-the-counter hedging program was marked to market. It listed liabilities of $7.53 billion in its bankruptcy filing, including $3.1 billion of total debt $2 billion of secured debt and $594 million in unsecured notes. SemGroup's financial difficulties were disclosed by its publicly traded affiliate SemGroup Energy Partners LP last week, when it warned that a liquidity crisis at its parent could lead to bankruptcy.
There are many factors that affect oil prices. Fundamental factors such as global supply and demand and dollar moves are often cited. But many also say that traders play a big role in affecting oil prices fluctuations. No doubt, fundamentals are behind oil's long-term uptrend. And it is the dollar's weakness of the past few years that has supported the trend. But short term? Could traders' short covering be the reason behind oil's recent run-up to nearly $150 a barrel?
Perhaps, but that's behind us. Oil prices have retreated more than $20 dollars since. What caused that? Have the fundamentals changed? Some say global demand is bound to slow as the global economy weakens, but others say supply concerns due to geopolitical unrest are also growing. Has the dollar strengthened? A little, but then it declined right back Thursday after a housing report showed recovery is still far off. And what about traders?
Well, here's where The Wall Street Journal as well as Reuters bring an interesting theory. They say that the rise and fall in oil prices coincided with energy company SemGroup L.P.'s (mis)fortunes. SemGroup is a little known private company that transports, stores and distributes crude oil and refined products. It is also the parent of pipeline operator SemGroup Energy Partners L.P. (NADSAQ: SGLP). SemGroup L.P. filed for Chapter 11 bankruptcy protection Tuesday. According to the Journal, "Changes in its hedging strategies coincided with big moves in oil recently."
SemGroup's losses from oil trading amounted to $3.2 billion. How can a company lose so much in oil-trading when prices of oil just kept increasing, you ask? By covering short positions, of course. The company said the losses were incurred as part of a failed hedging strategy designed to protect its main physical oil trading business, but the loss seemed too great . Now new information reveals the company may have engaged in trading for profit, which is not in its mandate. Creditors have claimed fraud and unauthorized trading and have already filed a class action suit. The SEC is inquiring too. With $290 million losses caused by SemGroup's own former CEO, it is no wonder people are questioning what happened.
Regardless of how things progressed later, according to Reuters, "SemGroup was forced to take a $2.4 billion loss on July 16 after it transferred its NYMEX trading account to Barclays Plc." Given the time frame, the WSJ says some on the Street claim SemGroup's demise may have been partially responsible for the big drop in oil prices. In fact, SemGroup may have been first responsible also for the big oil rally, since as its long positions grew, so did oil prices. Then, during the transition of its portfolio to Barclays, oil prices plunged. Coincidence? At the very least, "SemGroup's rapid exit from the market removed a force for upward momentum."
Others claim that since it's unclear what Barclays did with the positions, the linkage isn't certain, especially since oil started dropping on Bernanke's comments July 15 and then on the inventories report the following day.
Either way, this whole story shines a bright light on how traders can affect oil prices and perhaps better explains why regulators have recently put short trading constraints on some banks. Meanwhile, the Commodity Futures Trading Commission continues its probe into price manipulation in the oil futures market and has recently charged a Dutch trading fund, Optiver Holding BV, with manipulating the price of crude, gasoline and heating-oil futures.
I have no doubt that more regulation is needed to help limit such manipulations. Of course, there will always be fraudsters and crooks, but I'd like to believe most traders are there to make an honest buck, not cause financial havoc. While bear markets are always a fertile ground for shorts and options traders, with clearer regulations and rules, we may be able to at least avoid some of the insane fluctuations and volatility we've witnessed in the market lately.
Whether SemGroup's forced cover is the catalyst for one of the biggest recent corrections in crude oil can be debated. But the fact that this correction started literally hours after SemGroup were forced to cover (July 16/17) seems to be more than mere coincidence.
Monday, May 12, 2008
The Up-Coming U.S. Financial Crisis
Next up - the credit default swap crisis
While attention has been focused on the relatively tiny US subprime home mortgage default crisis as the center of the current financial and credit crisis impacting the Anglo-Saxon banking world, a far larger problem is now coming into focus.
Subprime, or high-risk collateralized mortgage obligations (CMOs), are only the tip of a colossal iceberg of dodgy credits that are beginning to go sour. The next crisis is already beginning in the US$62 trillion market for credit default swaps (CDS).
The credit default swap was invented a few years ago by a young Cambridge University mathematics graduate, Blythe Masters, hired by JP Morgan Chase Bank in New York and who, fresh from university, convinced her new bosses to develop the revolutionary new risk product.
A CDS is a credit derivative or agreement between two counterparties in which one makes periodic payments to the other and gets a promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the "buyer". The second party gives credit protection and is called the "seller". The third party, the one that might go bankrupt or default, is known as the "reference entity". CDSs became staggeringly popular as credit risks exploded during the past seven years in the United States. Banks argued that with CDS they could spread risk around the globe.
Credit default swaps resemble an insurance policy as they can be used by debt owners to hedge, or insure against, a default on a debt. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes.
Warren Buffett once described derivatives bought speculatively as "financial weapons of mass destruction". In his Berkshire Hathaway annual report to shareholders he said:
Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties. In the meantime, though, before a contract is settled, the counterparties record profits and losses - often huge in amount - in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).
A typical CDO is for a five-year term. Like many exotic financial products that are extremely complex and profitable in times of easy credit, when markets reverse, as has been the case since August 2007, in addition to spreading risk, credit derivatives, in this case, also amplify risk considerably.
Now the other shoe is about to drop in the $62 trillion CDS market due to rising junk bond defaults by US corporations as the recession deepens. That market has long been a disaster in the making. An estimated $1.2 trillion could be at risk of the nominal $62 trillion in CDOs outstanding, making it far larger than the subprime market.
No regulation
A chain reaction of failures in the CDS market could trigger the next global financial crisis. The market is entirely unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb. The US Federal Reserve under the former ultra-permissive chairman, Alan Greenspan, and the US government's financial regulators allowed the CDS market to develop entirely without supervision. Greenspan repeatedly testified to skeptical congressmen that banks are better risk regulators than government bureaucrats.
The Fed bailout of Bear Stearns on March 17 this year was motivated, in part, by a desire to keep the unknown risks of that bank's credit default swaps from setting off a global chain reaction that might have brought the financial system down. The Fed's fear was that because it didn't adequately monitor counterparty risk in credit-default swaps, it had no idea what might happen. Thank Greenspan for that. Those counterparties include JPMorgan Chase, the largest seller and buyer of CDSs.
The Fed does not have supervision to regulate the CDS exposure of investment banks or hedge funds, both of which are significant CDS issuers. Hedge funds, for instance, are estimated to have written 31% in CDS protection.
The credit-default-swap market has been mainly untested until now. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7%, according to Moody's Investors Service. But Fitch Ratings reported in July 2007 that 40% of CDS protection sold worldwide was on companies or securities that are rated below investment grade, up from 8% in 2002.
A surge in corporate defaults will now leave swap buyers trying to collect hundreds of billions of dollars from their counterparties. This will serve to complicate the financial crisis, triggering numerous disputes and lawsuits, as buyers battle sellers over the technical definition of default - this requires proving which bond or loan holders weren't paid - and the amount of payments due. Some fear that could in turn freeze up the financial system.
Experts inside the CDS market now believe that the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $150 billion in defaults. Banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. That will not work as many of the funds won't have the cash to meet the banks' demands for more collateral.
Sellers of protection aren't required by law to set aside reserves in the CDS market. While banks ask protection sellers to put up some money when making the trade, there are no industry standards. It would be the equivalent of a licensed insurance company selling insurance protection against hurricane damage with no reserves against potential claims.
Basle BIS worried
The Basle Bank for International Settlements, the supervisory organization of the world's major central banks, is alarmed at the dangers. The Joint Forum of the Basel Committee on Banking Supervision, an international group of banking, insurance and securities regulators, wrote in April that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world.
"It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred," the report said. "It can be difficult even to quantify the amount of risk that has been transferred."
Counterparty risk can become complicated in a hurry. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle. That has created a huge concentration of risk. As one leading derivatives trader expressed the process:
The risk keeps spinning around and around in this daisy chain like a vortex. There are only six to 10 dealers who sit in the middle of all this. I don't think the regulators have the information that they need to work that out.
Traders, and even the banks that serve as dealers, don't always know exactly what is covered by a credit-default-swap contract. There are numerous types of CDSs, some far more complex than others. More than half of all CDSs cover indexes of companies and debt securities, such as asset-backed securities, the Basel committee says. The rest include coverage of a single company's debt or collateralized debt obligations.
Banks usually send hedge funds, insurance companies and other institutional investors e-mails throughout the day with bid and offer prices, as there is no regulated exchange to price the market or to insure against loss. To find the price of a swap on Ford Motor Co debt, for example, even sophisticated investors might have to search through all of their daily e-mails.
Banks want secrecy
Banks have a vested interest in keeping the swaps market opaque, because as dealers, the banks have a high volume of transactions, giving them an edge over other buyers and sellers. Since customers don't necessarily know where the market is, you can charge them much wider profit margins.
Banks try to balance the protection they've sold with credit-default swaps they purchase from others, either on the same companies or indexes. They can also create synthetic CDOs, which are packages of credit-default swaps the banks sell to investors to get themselves protection.
The idea for the banks is to make a profit on each trade and avoid taking on the swap's risk. As one CDO dealer puts it, "Dealers are just like bookies. Bookies don't want to bet on games. Bookies just want to balance their books. That's why they're called bookies."
Now as the economy contracts and bankruptcies spread across the United States and beyond, there's a high probability that many who bought swap protection will wind up in court trying to get their payouts. If things are collapsing left and right, people will use any trick they can.
Last year, the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDSs. So far, it hasn't worked. It's been boycotted by banks, which prefer to continue their trading privately.
While attention has been focused on the relatively tiny US subprime home mortgage default crisis as the center of the current financial and credit crisis impacting the Anglo-Saxon banking world, a far larger problem is now coming into focus.
Subprime, or high-risk collateralized mortgage obligations (CMOs), are only the tip of a colossal iceberg of dodgy credits that are beginning to go sour. The next crisis is already beginning in the US$62 trillion market for credit default swaps (CDS).
The credit default swap was invented a few years ago by a young Cambridge University mathematics graduate, Blythe Masters, hired by JP Morgan Chase Bank in New York and who, fresh from university, convinced her new bosses to develop the revolutionary new risk product.
A CDS is a credit derivative or agreement between two counterparties in which one makes periodic payments to the other and gets a promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the "buyer". The second party gives credit protection and is called the "seller". The third party, the one that might go bankrupt or default, is known as the "reference entity". CDSs became staggeringly popular as credit risks exploded during the past seven years in the United States. Banks argued that with CDS they could spread risk around the globe.
Credit default swaps resemble an insurance policy as they can be used by debt owners to hedge, or insure against, a default on a debt. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes.
Warren Buffett once described derivatives bought speculatively as "financial weapons of mass destruction". In his Berkshire Hathaway annual report to shareholders he said:
Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties. In the meantime, though, before a contract is settled, the counterparties record profits and losses - often huge in amount - in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).
A typical CDO is for a five-year term. Like many exotic financial products that are extremely complex and profitable in times of easy credit, when markets reverse, as has been the case since August 2007, in addition to spreading risk, credit derivatives, in this case, also amplify risk considerably.
Now the other shoe is about to drop in the $62 trillion CDS market due to rising junk bond defaults by US corporations as the recession deepens. That market has long been a disaster in the making. An estimated $1.2 trillion could be at risk of the nominal $62 trillion in CDOs outstanding, making it far larger than the subprime market.
No regulation
A chain reaction of failures in the CDS market could trigger the next global financial crisis. The market is entirely unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb. The US Federal Reserve under the former ultra-permissive chairman, Alan Greenspan, and the US government's financial regulators allowed the CDS market to develop entirely without supervision. Greenspan repeatedly testified to skeptical congressmen that banks are better risk regulators than government bureaucrats.
The Fed bailout of Bear Stearns on March 17 this year was motivated, in part, by a desire to keep the unknown risks of that bank's credit default swaps from setting off a global chain reaction that might have brought the financial system down. The Fed's fear was that because it didn't adequately monitor counterparty risk in credit-default swaps, it had no idea what might happen. Thank Greenspan for that. Those counterparties include JPMorgan Chase, the largest seller and buyer of CDSs.
The Fed does not have supervision to regulate the CDS exposure of investment banks or hedge funds, both of which are significant CDS issuers. Hedge funds, for instance, are estimated to have written 31% in CDS protection.
The credit-default-swap market has been mainly untested until now. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7%, according to Moody's Investors Service. But Fitch Ratings reported in July 2007 that 40% of CDS protection sold worldwide was on companies or securities that are rated below investment grade, up from 8% in 2002.
A surge in corporate defaults will now leave swap buyers trying to collect hundreds of billions of dollars from their counterparties. This will serve to complicate the financial crisis, triggering numerous disputes and lawsuits, as buyers battle sellers over the technical definition of default - this requires proving which bond or loan holders weren't paid - and the amount of payments due. Some fear that could in turn freeze up the financial system.
Experts inside the CDS market now believe that the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $150 billion in defaults. Banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. That will not work as many of the funds won't have the cash to meet the banks' demands for more collateral.
Sellers of protection aren't required by law to set aside reserves in the CDS market. While banks ask protection sellers to put up some money when making the trade, there are no industry standards. It would be the equivalent of a licensed insurance company selling insurance protection against hurricane damage with no reserves against potential claims.
Basle BIS worried
The Basle Bank for International Settlements, the supervisory organization of the world's major central banks, is alarmed at the dangers. The Joint Forum of the Basel Committee on Banking Supervision, an international group of banking, insurance and securities regulators, wrote in April that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world.
"It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred," the report said. "It can be difficult even to quantify the amount of risk that has been transferred."
Counterparty risk can become complicated in a hurry. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle. That has created a huge concentration of risk. As one leading derivatives trader expressed the process:
The risk keeps spinning around and around in this daisy chain like a vortex. There are only six to 10 dealers who sit in the middle of all this. I don't think the regulators have the information that they need to work that out.
Traders, and even the banks that serve as dealers, don't always know exactly what is covered by a credit-default-swap contract. There are numerous types of CDSs, some far more complex than others. More than half of all CDSs cover indexes of companies and debt securities, such as asset-backed securities, the Basel committee says. The rest include coverage of a single company's debt or collateralized debt obligations.
Banks usually send hedge funds, insurance companies and other institutional investors e-mails throughout the day with bid and offer prices, as there is no regulated exchange to price the market or to insure against loss. To find the price of a swap on Ford Motor Co debt, for example, even sophisticated investors might have to search through all of their daily e-mails.
Banks want secrecy
Banks have a vested interest in keeping the swaps market opaque, because as dealers, the banks have a high volume of transactions, giving them an edge over other buyers and sellers. Since customers don't necessarily know where the market is, you can charge them much wider profit margins.
Banks try to balance the protection they've sold with credit-default swaps they purchase from others, either on the same companies or indexes. They can also create synthetic CDOs, which are packages of credit-default swaps the banks sell to investors to get themselves protection.
The idea for the banks is to make a profit on each trade and avoid taking on the swap's risk. As one CDO dealer puts it, "Dealers are just like bookies. Bookies don't want to bet on games. Bookies just want to balance their books. That's why they're called bookies."
Now as the economy contracts and bankruptcies spread across the United States and beyond, there's a high probability that many who bought swap protection will wind up in court trying to get their payouts. If things are collapsing left and right, people will use any trick they can.
Last year, the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDSs. So far, it hasn't worked. It's been boycotted by banks, which prefer to continue their trading privately.
Thursday, May 1, 2008
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