Out the tragedy... fun

It is interesting how a tragedy impresses itself upon the human collective conscience, how it is transformed, in rather unexpected ways. From the holocaust we have books, films, plays. From the financial crisis and its various extensions of financial meltdown we have gotten a Margin Call, a movie with a rather loose grip on reality  (as is the case with most movies) and, I now find, a game called Market Meltdown.

What is it?

The game appears to be based on the antics of a number of rogue traders. In Market Meltdown the players are traders who must make ever bigger bets (as the money they owe increases) in order to stay afloat. The losers are those who go bust first.

Just some fun

It is likely the board game is just good fun, amoral. That is what it is intended to be. It is hard to tell if the game will succeed, whether perhaps people will find it distasteful. But if kids can play computer games pretending to be evil overlords, why not have families play games pretending to be reckless traders. It could be used as an exercise in moral instruction – don’t do this in real life.

But in our hearts

The fact is that there is something about these rogue traders that captures our hearts. Sure, we’re angry with them for being heartless human beings, extensions of a merciless financial sector. But it’s not our money they lost. What a thrill it must be to place such huge bets, to waver between being ignominious Kweku Adoboli or glorious George Soros. (Admittedly Soros was no rogue trader, but his bets were massive and if he were wrong his ignominy would have been as great, if not necessarily prosecutable).

Social commentary

In some sense, the game, with its simplified rules, its exaggerated nature, is a kind of mockery. What were they thinking? We give them, those rogue traders, immortality, not by their reputation, but by frequently reliving their defeat, and laughing at it. Perhaps that, too, is a kind of punishment.

Out of sight

Despite the financial crisis’s impact on people, it being discussed everywhere. Despite the fate of Greece and the entire Eurozone hanging in the balance, I do not think that it is a ripe source of creative inspiration. There are a number of other games inspired by the crisis. Still, I would not imagine that many books of fiction will be written about these times once they are past, that many more films will be made (though there will undoubtedly be some). The halls of finance are just too hard for people to imagine, the dealing and wheedling too obscure, the language too foreign, with certain obvious exceptions, it’s just not exciting enough (although I may be wrong).

It is a pity. Perhaps if we could bring the world of finance to the hearts of people, we could place some heart in finance.

Some references

The game:

• Clarendon Games, 2012a. Market Meltdown. Available at: http://www.clarendongames.com/product.php?xProd=19 [Accessed December 29, 2012]. Clarendon Games, 2012b. 
• Market Meltdown Intro. Available at: http://www.youtube.com/watch?v=lq_AdyyiQx4 [Accessed December 29, 2012]. 

The Economist's take:

• The Economist, 2012. Financial board games: Playing the markets. The Economist. Available at: http://www.economist.com/blogs/prospero/2012/12/financial-board-games [Accessed December 29, 2012]. 

George Soros: 

• Wikipedia, 2012a. George Soros. Wikipedia. Available at: http://en.wikipedia.org/wiki/Soros [Accessed December 29, 2012]. 

Rogue trader Kweku Adoboli (he is just the most recent):

•  Wikipedia, 2012b. Kweku Adoboli - Wikipedia, the free encyclopedia. Wikipedia. Available at: http://en.wikipedia.org/wiki/Kweku_Adoboli [Accessed December 29, 2012].

Backtest blindness

Suppose you have to find a “brilliant” strategy for making money in the markets. You come up with a strategy you think will work. How do you “know” that it will work? One way is to perform backtests. This means you take past investment data, notably share prices, and pretend that you could use your strategy in the past and then see how much money you make.

So let’s suppose your strategy makes a lot of money. In fact, it seems to always make money. What could possibly go wrong? In this post, I will look at a few things that common sense dictate one should consider. A more academic investigation of backtesting will need to wait until a later post.

The curse of finite data

One problem is that you have only tested your strategy on a finite amount of past data. You only “know” it makes money if the future is exactly like this past. How likely is that?

A momentum strategy (involving buying companies whose shares have gone up and selling those whose shares have gone down) is one strategy that seems to perform very well over a very long time period. For instance if you were a quant at a trading desk in 2008 and you backtested such a strategy as far back as say 1940, you might have concluded you had a money-printing machine.

If, however, you had gone as far back as 1930 you would have seen this strategy could wipe out nearly all your capital in just a two month period. And had you implemented the strategy you would have experienced just that in 2009.

The lesson of this is not that you should have backtested all the way to 1930 (although you probably should have). You can only conceivably backtest about that far in any case – we simply do not have data going back much further. Of course a longer backtest is good, but you still have only a finite amount of data.

Markets can and do change

Markets do change, and sometimes quite abruptly. The by-now well-documented implied volatility smile observed in prices did not exist before 1987. Backtesting options strategies on pre-1987 data may not be very useful. The big crash in October seems to have permanently changed the way the market views options. But it could change again.

The problem with “successful” strategies

There is a lot of backtesting going on in financial institutions, I am quite certain. Lots of strategies will never see the light of day because they don’t produce high retrospective returns (they fail the backtest). However, the only strategies you are likely to come across as a potential investor are the ones that succeeded. These strategies have, by process of elimination, been optimised to produce excellent results in past conditions. This is collective data-mining.

These are the most misleading strategies. They are the most likely to disappoint because the past will not repeat itself exactly. This is much like trying to fit a curve to a number of data points – you can fit a curve that matches the data perfectly if you want, but it will have absolutely no predictive power.

Calibration

Calibrating a strategy can be a very dangerous thing to do. If your strategy has a few parameters and you try to find the ones that result in the most profit, you run into exactly the data-mining problem described above. The more parameters the more dangerous this becomes. It helps if you calibrate on one part of the data and test on a separate part. But this does not eliminate the problem – try enough strategies and you will find one that works both in and out of sample and completely fails in real life.

The problem with theories

You may think that if you come up with some brilliant idea, some model of market behaviour, that leads to a great strategy, all will be well. Not necessarily. The problem is that your idea is probably based on working with and observing markets and market data over a period. You are probably more likely to come up with a strategy that works well on past data merely because you know the past data better – even if only intuitively. This does not mean you have found a fundamental market law (perhaps the only fundamental market law is that any trading strategy will fail).

Strategies for which backtests do not work

You cannot backtest everything. Backtests assume you can take the past market prices as given and that you can trade at those prices. This only holds if the amounts you wish to trade are small compared to the volumes traded in the market. Thus backtesting will not work very well in illiquid markets and it will not work if you need buy or sell a large amount of stock that could potentially influence the market price. It is probably good practice to compare the volumes you wish to trade against the volumes actually traded in the past (noting that this changes from day to day).

How to keep the windscreen clear

One way to avoid at least some of the nasties of backtest blindness is to just conceive of a scenario in which your strategy would not make money (or better yet, in which it would lose a lot of money). It does not matter if it’s never happened. It doesn’t matter if it seems unlikely – you are bound to underestimate the probability of it occurring. Prepare for it anyway.

It is useful if whatever strategy you want to implement is based on some underlying theory – a theory that is likely to remain valid even if markets change. For instance, human behaviour is unlikely to change. If your strategy exploits fear and greed, it is more likely to succeed. However, this is no panacea. How do you know you’re actually exploiting human behaviour?

It helps if a strategy works in many markets – it is far more likely you are exploiting some fundamental human behaviour. However, more data is problematic if it gives you false confidence. More data is useful, but it does not negate the problems mentioned.

I admit I am not certain how to avoid all the pitfalls I mentioned above, at least not yet. But being aware of them is much better than not and that is a start.

Some references

• Barroso, P. & Santa-clara, P., 2012. Managing the Risk of Momentum. Business, (April), pp.1–26. Available at: http://ssrn.com/paper=2041429. Investing Answers, 2012. 

• Backtesting. Investing Answers . Available at: http://www.investinganswers.com/financial-dictionary/stock-market/backtesting-865 [Accessed November 17, 2012]. 

• Investopedia, 2012. Backtesting Definition. Investopedia. Available at: http://www.investopedia.com/terms/b/backtesting.asp#axzz2CNdPITKg [Accessed November 17, 2012]. 

• Wikipedia, 2012. Backtesting. Wikipedia. Available at: http://en.wikipedia.org/wiki/Backtesting [Accessed November 16, 2012]. (not a very good Wikipedia article)

Review: The Big Short

The Big Short by Michael Lewis is a very good book, thoroughly entertaining. The language is simple, but all the concepts are sufficiently explained to make sense to non-financial readers, without leaving out too much. It also cleared up some issues I have been unable to get a grip on despite reading sporadically about the crisis for years. I do recommend that you read this book. But if you do, beware of a couple of things.

It’s a story

The books reads like a story, which is what makes it so entertaining. But it is also exactly there that its danger lies. It is centred on a handful of individuals that made money from the subprime crisis, who, in essence, predicted it and took investment positions to profit from it.  It contains many personal elements of the lives of these people, explaining how they moved through life and how they decided to place their bets against the system.  Their lives are very interesting, at least Lewis manages to make them appear so.

Don’t trust a story

Storytelling, though useful, is dangerous. It makes you forget how messy life really is. Everything is put into plots and subplots, everything heads toward the ending, in this case, a financial collapse. It has the illusion of inevitability. Never believe that.  As smart as these people were, as thorough as their research was, nothing about their success was inevitable. They were lucky. I do not mean to say the odds were not in their favour – they looked at information most others ignored, they saw things others did not see. But they could (or rather, should not) have been certain. A difference in timing, a slight change in the economy, stimulus here or not there, and we could have seen a different set of winners or losers.

There is a survivorship bias in the book. (This is also a problem with stories – usually they focus on the people who succeed, sometimes on the ones who fail horribly, never the ones in-between). We hear only from the people who made it. How they happened to make their fortune. We don’t hear about the people in similar situations with similar intellects who did not. We are to presume they did not exist.

As I read and I felt the suspense of the coming crash (and voyeuristic  exhilaration at the heaps and heaps of money the protagonists would make) I too felt, perhaps I can make money too, perhaps I could also be a great investor. Of course these people were not really investors, they were speculators betting on the crash of a system (albeit, probably with the odds in their favour).  They were right, at least partly because they were lucky enough to stumble on the right information at the right time.

Disclaimers

Perhaps, if there is anything to learn from the crisis and from the book, it is that you are far more likely to be the sucker who misunderstands everything (in this case almost all of Wall Street) than anything else. Humility is your ally.

I do not mean to say there is anything wrong with the book. It has its uses and its limitations. But perhaps it should contain a disclaimer about the danger of stories.

Knight in soiled armour

Last week the markets experienced another little jolt, similar to the flash crash in 2010. A computer glitch at Knight Capital caused its systems to send out incorrect orders, causing huge price swings in stocks and driving the company nearly to bankruptcy.

Bugs

There is now talk of changing regulations (again) and everyone wonders what Knight Capital did wrong. They had a bug. I cannot be certain, but my guess is that whatever software they were using had been tested. But with sophisticated systems bugs always slip through (it’s inevitable). Unluckily for Knight their particular bug caused a lot of trouble and damaged the company’s reputation, possibly irreparably.

It’s (almost) all in the mind

What is interesting is that the company is set to survive. Knight was bailed out not by government, but by a handful of its competitors – perhaps they know this could just as easily have happened to them. They were not just being helpful, though. They saw an opportunity to buy a large stake of a good business (potentially good, in any case) very cheaply. The major obstacles to Knight’s continued survival were a lack of capital and loss of confidence. Both were addressed by the bailout. The very fact that these companies were willing to fund Knight will give the market assurance that the business was worth saving.

Reputations

This bailout comes at a price to current shareholders (who are the ones who should pay – not taxpayers and not clients) whose holdings are diluted. Perhaps, slowly, clients will return. The key reason to think this may happen is the reputation of Knight’s CEO, Thomas Joyce, which seems to have been both battered and uplifted in the debacle. Unlike Bob Diamond, CEO of Barclays and other banks’ top brass, Joyce’s integrity is not in question. He has been called a hero for managing to get hold of the much needed financing. Knight also, it seems, absorbed most of the losses – shielding their clients.

What is in question is Knight’s risk management and software testing. And after an incident like this, I think this is liable to become too strict rather than too relaxed. They cannot afford another incident – that would almost certainly end them, if not through a direct loss, then due to a loss of confidence.

Operational risk 

Knight’s problems highlight, once again, that the major risk in business, any business, is operational. It is unpredictable, its costs can be little or gigantic. Even with good risk management procedures (which are a must – and there is no reason to believe Knight’s were not adequate) mistakes will be made. The regulatory reactions to this will (probably) be firstly to increase the amount of capital that companies need to hold so they can absorb operational losses, secondly to mandate more stringent risk management, and thirdly to demand more detailed reports to the regulator (in this case the SEC). All of these things have their costs.

People will, of course, be very interested in knowing what exactly caused the software malfunction and how. And what Knight will be doing to prevent it from happening again. But what the error was hardly matters – it was random. Next time it will be something else. Hopefully responses will focus less on the specific nature of the problem that arose and more on the general nature of operational risk, which has a tendency to pop up in unexpected places.

References

• Kisling, W., & Mehta, N. (2012). Joyce Puts Knight Survival Over Shares in Rescue Deal. Bloomberg. Retrieved August 7, 2012, from http://www.bloomberg.com/news/2012-08-06/joyce-puts-knight-survival-over-shares-forging-400-million-deal.html
• Pratley, N. (2012). Knight Capital’s computer “glitch” shows dangers of desire for faster trading. The Guardian. Retrieved August 7, 2012, from http://www.guardian.co.uk/business/nils-pratley-on-finance/2012/aug/06/knight-capital-computer-glitch-trading?newsfeed=true
• Reuters. (2012). Knight Capital handed $400m lifeline after trading debacle. The Guardian. Retrieved August 7, 2012, from http://www.guardian.co.uk/business/2012/aug/06/knight-capital-400m-lifeline
• Sapa-AP. (2012). Knight Capital’s $440m computer glitch. Times Live. Retrieved August 7, 2012, from http://www.timeslive.co.za/scitech/2012/08/03/knight-capital-s-440m-computer-glitch
• The Economist. (2012). Desperate times. The Economist. Retrieved August 7, 2012, from http://www.economist.com/blogs/schumpeter/2012/08/knight-capital?fsrc=scn/fb/wl/bl/desperatetimes
• Touryalai, H. (2012). Knight Capital: The Ideal Way To Screw Up On Wall Street. Forbes. Retrieved August 7, 2012, from http://www.forbes.com/sites/halahtouryalai/2012/08/06/knight-capital-the-ideal-way-to-screw-up-on-wall-street/

When to give back the Bacon

My last two posts both were both very critical of ethics in the markets. Today I would like to give some praise. Louis Bacon, manager of a very large fund ($8Bn) of assets has decided to give back a quarter to investors. It is, in essence, admitting defeat. And that is something investment professionals seem to be very loathe to do.

Hedge funds do not like to give back money to investors, even when the investors themselves request it. More assets under management (AUM) means reduced management fees and less prestige. Giving back money also immediately says that you are unable to make money, that you are stumped, that the money is better invested elsewhere. Mr Bacon is giving up about $60m a year (but don’t praise him too much; he is worth over a billion. He is not giving up anything he cannot do without).

Mr Bacon, after recent poor returns, does admit that he just can’t make money in the current environment, not with such a large pool of assets. His fund seems to focus on macro-economic strategies, meaning it makes bets on macro-economic factors affecting countries as whole. Most notably, in this environment, that includes everything affecting the sovereign debt crisis. With all the government intervention and decisions by Ms Merkel (prime minister of Germany) and Mr Draghi (head of the European Central Bank) sending markets up and down, but with no decisive actions being taken, Mr Bacon feels he cannot make a bet on the market movements. He needs to bet something big will happen. And it just won’t happen. Probably Mr Bacon feels he cannot figure out what’s going to happen next, but he hasn’t gone quite as far as admitting that.

A large fund is not as agile as a smaller fund. With a smaller fund Mr Bacon will be able to take smaller positions that have a larger impact on the overall performance of the fund and be able to move in and out of positions more quickly. Hedge funds normally charge a performance fee – if the increase in performance is high enough it may offset the loss of the management fee mentioned earlier.

 Mr Bacon cares for his image. That is why he’d rather try to make a decent return on a smaller fund than poor returns on a larger fund. However, admitting his inability to profit from current market conditions is quite laudable for a man who made his fortune placing bets on other international events equally as murky. He also seems to take his responsibility as a custodian of other people’s money seriously. He cannot give the performance expected and so he has his investors put their money elsewhere. Unfortunately, for many, admitting the limits of their abilities does not seem to come as easily.

References 

• Chung, J. (2012). Louis Bacon to Return $2 Billion to Investors. Wall Street Journal. Retrieved August 3, 2012, from http://blogs.wsj.com/deals/2012/08/01/louis-bacon-to-return-2-billion-to-investors/ Herbst-Bayliss, S. (2012).
• Big hedge funds seen unlikely to diet after Bacon slims down. Reuters. Retrieved August 3, 2012, from http://www.reuters.com/article/2012/08/02/us-hedgefunds-idUSBRE8711VN20120802 Thomas Jr., L. (2012).
• Too Big to Profit, a Hedge Fund Plans to Get Smaller. Dealbook. Retrieved August 3, 2012, from http://dealbook.nytimes.com/2012/08/01/hedge-fund-titan-plans-to-return-2-billion-to-investors/

Li(e)bor

In my last post I lamented the apparently non-existent moral foundations of banks. I hardly thought the next scandal would be so soon after. Last month it transpired that Barclays had been manipulating the Libor rate. However, everybody else was doing it too, it seems. This is a betrayal of public trust egregious enough, in my opinion (and many others’), to warrant some jail sentences.

But everybody’s doing it

Bankers never seem to do anything alone. Everybody has to have their piece of the pie. No one is willing to stand out, even for the sake of such things as moral principles, ethics, right and wrong. After Barclays was fined a paltry amount it became clear that they were not the only ones involved. A large list of banks is now under investigation. Were they colluding? Probably, but not necessarily. I will discuss this further below. First, let us get a grip on what this mysterious Libor is.

What is the Libor?

Libor, actually LIBOR , is an acronym for London Interbank Offered Rate. It seems to be an interest rate. Actually, it is not, which is part of the problem. It should, however, in principle at least, be related to actual interest rates. The interest rates referred to are the rates banks charge each other when they lend money to each other. It is a common occurrence for a bank to lend money to another bank, for instance if the latter bank needs liquidity in the short term. The Libor is calculated more or less as follows. A number of banks (16, it seems) are asked to give an estimate of the rate at which they could borrow money from the inter-bank market. The top and bottom quarter of these estimates are thrown out and an average taken of the ones that remain. This is the Libor. The problem with the above process is that it is open to manipulation. It is subjective, which makes it easier (and more tempting) to lie. This, then is what Barclays did. What many banks did.

Why does it matter if Libor is wrong?

Libor might not be an actual interest rate, but many (very many) actual interest rates are based directly on Libor, from mortgage rates to rates on derivatives known as swaps. If Libor is low it means those with mortgages related to Libor pay lower amounts. They win. However, people invested in instruments that pay rates related to Libor lose out as they get less. These may not even out. The impact of a single basis point difference in Libor is a huge redistribution of wealth. Libor matters not only because of instruments it affects directly. It has become a global benchmark interest rate. It is taken into account in many decisions. It could affect many other rates charged, advice given, corporate actions taken. The Libor is also an indicator of the health of the banking system. When it is high, it indicates banks have little faith in the ability of their peers to repay their money. An artificially low Libor rate is, in effect, a collective denial of the fragility of the banking system. It is serious if such a globally significant figure is a lie.

Why try to manipulate Libor?

1. In order to look better. For a time Barclays’ submitted Libor figures were higher than the rest of the market. This, seemingly, indicated that Barclays was in relatively poor health. Lowering its Libor estimates alleviated these fears.
2. Because everybody else is doing it. Why were the other banks’ Libor estimates so low? Possibly because they were underreporting them. Barclays may not have been the first to do so. The more banks that underreport their Libor the more pressure there is on other banks to do the same in order not to seem weak. In addition, if everybody else is doing it, it is far easier to delude yourself into thinking it is acceptable. You can defend yourself by pointing fingers. 
3. Profit. Profit. Profit. Emails between those responsible for the submission of Libor and traders show agreements to attempt to manipulate Libor in order to favour the traders’ positions. For instance, suppose Barclays held a swap contract in which they agreed to pay a the Libor rate to another party and, in return, received a fixed rate¹. If the Libor rate falls, the bank’s position becomes more valuable as it is now paying out a smaller amount, but still receiving the same fixed amount.

What does it matter if Barclay’s Libor is wrong?

Barclays is only one bank. Does it really matter if its Libor submission is wrong? Well, yes and no. If Barclays submission is too high or too low it does not influence the calculated result at all. However, every bank’s submission influences every other banks’ submission. None of the banks would want to seem too weak compared to the others. This can lead to seemingly co-ordinated underreporting of Libor even if the banks are not colluding explicitly. This, however, is really only relevant for reasons 1 and 2 above. To profit from Libor rigging, Barclays would need to be able to move the rate on its own, unless it colluded with other banks which had similar positions.

Let us suppose Barclays’ estimate is not thrown out, so it is one of the eight estimates that do get averaged. What is the effect of Barclays’ estimate? Suppose the average of the other 7 banks is x and the Barclays estimate b (in per cent), then the average of all 8 is 7/8x + b/8. How much lower than the average of the other banks would Barclay’s estimate need to be in order to lower the Libor by 1 basis point, that is by 0.01? Solving a simple linear equation gives that Barclays’ estimate should be 8 basis points lower. Conversely, to push up Libor by one basis point, Barclays’ estimate needed to be 8 basis points higher. To give a little more perspective: In 2005/6 Libor was around 5% at times. If Barclays’ wanted to lower the Libor to 4.99, it needed to submit an estimate of 4.92. It might not have needed to manipulate it any more than that to profit. Now, I am no expert on Libor rates or their spreads. It may be that the spread in Libor estimates was high enough to allow Barclays’ estimate to be included in the average. In any case, presumably those submitting the rates would know more or less, from experience, what kind of range of values are usually submitted and adjust the submission accordingly. So, it seems that it was possible for Barclays’ to manipulate Libor, albeit in a somewhat limited fashion. It also appears that traders did in fact collude so that several banks altered their submissions simultaneously. This would have a far greater influence on the Libor estimate.

Should bankers go to jail?

Yes. This is an example of fraud (albeit committed by almost an entire industry). I hope to see several people behind bars for this. However, whether that will happen, given the widespread nature of the fraud and the possible difficulty in assigning culpability, I do not know. What is clear is that the fines imposed for this kind of behaviour are ineffective. They do not even make a dent in the Banks’ balance sheets. Lawsuits against Barclays may do more damage, though.

Are regulators also to blame?

It seems that regulators knew Libor was incorrect for quite some time. And did nothing. In the midst of the financial crisis they probably thought there were more pressing concerns. Perhaps they just did not want to believe that what they were told was true, and so they didn’t. Bernanke apparently knew of the troubles with Libor and told the British regulators, who did not take it seriously. So the British regulators are clearly at fault. However, morally, Bernanke is too. Here is one of the greatest financial scams in history, affecting millions of people, and you keep silent, you don’t make a public statement, you don’t force a resolution. You say in the gentlemen’s club. Something similar can be said of Tim Geithner, president of the New York Fed at the time the rigging occurred.

What to do?

Of course, Libor is now useless. I think the best thing to do would be to replace it with a similar rate, but based on actual transactions. This has been suggested by others. Of course, everyone is calling for tougher regulation. Probably, the entire structure of regulating bodies will need to be changed. It’s no use for there to be good regulation if it is not enforced. The relationship between regulators and the industry is clearly not working. Perhaps we should all start putting our money in Triodos. At least these bankers seem to have a conscience. Or perhaps we should just mutualise all the banks. No more shareholders and banks owned by depositors. Less profit motive. Perhaps the incentives would be less perverse, but honestly, I am not sure. Ideally, people would grow spines, come to believe in a higher power, or just start caring about other people, but that won’t happen.

Post-apocalypse

We have not, it seems, heard the last of this particular scandal. The investigation of other banks is going to take a while and will, hopefully, unearth some corpses. A good article says the following:

The unpalatable message of the crisis and Diamond's actions – or inaction – is that financial institutions can't be trusted to not act foolishly in pursuit of their own self interest, and that the only question is how frequently they do so and how grave the consequences prove to be either for their shareholders or for the financial system as a whole.

Banks have demonstrated time and again that they are devoid of moral rectitude, that they act selfishly and (economists would rejoice) rationally in the face of temptation. And why should they not? We always let them off the hook. As one article puts it “there’s something rotten in banking.”

References

News 

• Barr, R. (2012). Former Barclays exec admits false LIBOR submission. Newsday. Retrieved July 18, 2012, from http://newyork.newsday.com/news/region-state/former-barclays-exec-admits-false-libor-submission-1.3840836 
• Barrow, B., & Davies, R. (2012). Bob Diamond DID give orders to cut Libor, claims Barclays executive . Mail Online. Retrieved July 18, 2012, from http://www.dailymail.co.uk/news/article-2174614/Bob-Diamond-DID-orders-cut-Libor-claims-Barclays-executive.html 
• Bloomberg. (2012). There’s Something Rotten in Banking . Bloomberg View. Retrieved July 18, 2012, from http://www.bloomberg.com/news/2012-07-02/barclays-case-shows-something-s-rotten-in-banking-culture.html 
• Bloomberg News. (2012). NY among states probing interest-rate fixing. Newsday. Retrieved July 18, 2012, from http://newyork.newsday.com/news/region-state/ny-among-states-probing-interest-rate-fixing-1.3843206 
• Crutsinger, M. (2012). Bernanke: Fed had no power to change LIBOR. Newsday. Retrieved July 18, 2012, from http://newyork.newsday.com/news/region-state/bernanke-fed-had-no-power-to-change-libor-1.3843208 
• DuBois, S. (2012). The Barclays school of crisis management. CNN Money. Retrieved July 18, 2012, from http://management.fortune.cnn.com/2012/07/03/the-barclays-school-of-crisis-management/?iid=SF_F_River 
• Farrell, M. (2012). Barclays: Don’t just blame us! CNN Money. Retrieved July 18, 2012, from http://buzz.money.cnn.com/2012/07/03/barclays-libor-investigation/?iid=EL 
• McGee, S. (2012). The Big Questions Raised by the Barclays Scandal. The Fiscal Times. Retrieved July 18, 2012, from http://www.thefiscaltimes.com/Columns/2012/07/05/The-Big-Questions-Raised-by-the-Barclays-Scandal.aspx#page1 
• Morris, N. (2012). Other banks face bigger fines on rate fixing, warn Barclays directors. The Independent. Retrieved July 18, 2012, from http://www.independent.co.uk/news/business/news/other-banks-face-bigger-fines-on-rate-fixing-warn-barclays-directors-7945444.html 
• O’Toole, J. (2012). Explaining the Libor interest rate mess. CNN Money. Retrieved July 18, 2012, from http://money.cnn.com/2012/07/03/investing/libor-interest-rate-faq/index.htm 
• Reuters. (2012). RBS set for fine as Barclays boss remains defiant. The Fiscal Times. Retrieved July 18, 2012, from http://latestnews.thefiscaltimes.com/2012/06/28/uk-banks-face-new-scandal-barclays-boss-in-peril/ 
• Reuters. (2012). Barclays takes rate fixing scandal hit. Business Report. Retrieved July 18, 2012, from http://www.iol.co.za/business/international/barclays-takes-rate-fixing-scandal-hit-1.1341163 
• Rosenberg, Y. (2012). Libor-gate Explained: Why Barclays’ Scandal Matters. The Fiscal Times. Retrieved July 18, 2012, from http://www.thefiscaltimes.com/Articles/2012/07/06/Libor-gate-Explained-Why-Barclays-Scandal-Matters.aspx#page1 
• Sky News. (2012). Barclays Was “In Denial” Over Rate-Fixing. Sky News HD. Retrieved July 18, 2012, from http://news.sky.com/story/961370/barclays-was-in-denial-over-rate-fixing

An interesting blogger

• Doyle, L. (2012). Barclays Libor Scandal: Reports Regulators Knew; Time for Independent Investigation and Eliot Spitzer. Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-reports-regulators-knew-time-for-independent-investigation-and-eliot-spitzer/ 
• Doyle, L. (2012). Barclays Libor Scandal: When Did Manipulation Start? Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-when-did-manipulation-start/
• Doyle, L. (2012). Barclays Libor Scandal: Who’s Really to Blame? Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-whos-really-to-blame/ Doyle, L. (2012). Barclays Libor Scandal: “Diamond Lied.” Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-diamond-lied-to-the-committee/ 
• Doyle, L. (2012). Barclays Libor Scandal: Holding Regulators to Account. Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-holding-regulators-to-account/ 
• Doyle, L. (2012). Barclays Libor Scandal: The Precedent. Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-the-precedent/#more-30091
• Doyle, L. (2012). Barclays scandal: How big will this get? CNN Money. Retrieved July 18, 2012, from http://finance.fortune.cnn.com/2012/07/03/barclays-libor-scandal/?iid=EL 

Some graphs 

• FedPrimeRate.com. (2012). LIBOR rates: Historical Charts. FedPrimeRate.com. Retrieved July 18, 2012, from http://www.fedprimerate.com/libor/libor_rates_history-chart-graph.htm 

Wikipedia

• Wikipedia. (2012). Libor scandal. Wikipedia. Retrieved July 18, 2012, from http://en.wikipedia.org/wiki/Libor_scandal

1 This is a common arrangement. An organization may for instance have a variable rate loan which it needs to repay with a floating interest rate. In order to make its costs more certain, it can enter a swap contract with a bank, pay a fixed amount every month and in return the bank will pay the interest on the loan.

Another day, another embarrassment

It seems that Wall Street never misses an opportunity to embarrass itself. The most recent scandal is a multi-billion (read milliard in strictly correct British English) dollar trading loss at JP Morgan. The exact value of this trade (or rather collection of trades) will only become known when it is finally unwound. Details of what happened are sketchy and likely to remain so.


Why don't we know what happened?

At least partially we don't know because JP Morgan won't tell us. In fact the market probably already knows far more than JP Morgan would like. As long as the trade is not completely wound down, it is bad for the bank if others know exactly what it has been up to, because then they can more easily trade against it. In fact the market has already done so, magnifying the loss. More fundamentally, however, we don't know because nobody knows, perhaps not even the trader, known as the “London Whale” who initiated the trades. It is somewhat frightening to think that such things can happen without the CEO knowing, but one man can only know so much and there is just too much too know in an organisation so large. Ironically, JP Morgan ended up betting against itself – one unit of the company took the opposite position to the loss-making trade, offsetting part of the losses.


The department of mysteries

The unit of JP Morgan where this loss took place, the Chief Investment Office, appears to be a bit of a mystery. It has been described as being "charged with managing the bank’s idle cash to earn a profit while minimizing risk". Well, if it really were doing that, it should not have taken such huge bets, not under any circumstances. Other reports say it was meant to hedge risk. This means it was supposed to enter into trades that would minimize possible losses on other positions. From what little is known of the trades involved, though, they seemed more like pure speculation (although some of the losses were offset by other positions in the company). I can imagine that the trades were in a kind of gray area – hedge-like enough to put through as legitimate and too profitable (at least momentarily) to really question. What is clear, though is that the operations in the CIO and its links with other departments failed and they failed horribly. This was not really a trading loss. It was an operational loss, caused by the failure of proper risk management, proper oversight and proper communication.


Whose fault is it?

A lot of blame has been dished out. The trader involved has taken a lot of blame. It does not, however, appear that he was a rogue trader. He was making ill-advised bets, yes, but his trades were signed off, it seems. He may even have thought he really was hedging risk (rather than creating it). The person at the head of the CIO, of course should (and has) taken much blame. And so has Jamie Dimon, JP Morgan's CEO. He deserves blame, not for not being aware of these trades (he cannot know what every individual trader is doing), but for ignoring reports about these trades when they surfaced before the loss became evident.


The problem with complexity

A part of the problem, perhaps, lies in complexity. The trades that caused this huge loss were, it seems, very complex and interconnected. Built up over a number of years, they could have grown in complexity to the point where even their progenitor did not fully understand them. JP Morgan itself is a frighteningly complex institution (I admit I looked at its wiki page and did not even try to unravel its intricacies). Human minds cannot handle such complexity. We need to cordon off specific elements, simple enough to comprehend, to specific people and groups. The people at the top must handle the big picture, which can be made simple enough, but they cannot know all the details. In such an environment things get lost, things are forgotten, and errors are made. Ultimately accountability is hard to assign because no one (or two, or even three people) knew enough to have done something. This, of course, plays right into the "too big to fail" debate because bigger institutions are more complex. However, it is not clear to me that forcing these institutions to split into smaller ones would help (they became this big for a reason, so being big does have advantages).

Is it really a problem?

On the one hand this loss represents an egregious failure within JP Morgan. On the other hand, we should expect such losses (operational and otherwise) to occur from time to time. If you invest in stocks you don't always expect them to go up. If you have a large institution you don't expect everything to always go like clockwork. What regulators have attempted to do is to ensure that banks have enough capital to absorb these losses. At least, in this case, the loss was easily covered and only made a little dent in the bank's balance sheet. The instinctive response of more and stricter regulation may not be the right one, not if it increases complexity even further.


The final curtain

The details of the trade and the loss, perhaps, are not all that important. The point is that yet another financial institution has (for not the first time in its history) proven that it cannot be trusted. JP Morgan was in the thick of the speculation in 1930s and now we have this loss. I imagine it was not blameless in the raging financial crisis either. I plan to work in the financial sector. I hope I do not one day have to say "We know we were sloppy. We know we were stupid."

Some references

• Campbell, D., 2012. JPMorgan Faces $4.2 Billion Trading Loss. Huff Post Business. Available at: http://www.huffingtonpost.com/2012/06/05/jpmorgan-chases-trading-l_n_1570578.html [Accessed June 11, 2012]. 
• Campbell, D., 2012. JPMorgan Faces $4.2 Billion Trading Loss, ISI Forecasts - Bloomberg. Bloomberg. Available at: http://www.bloomberg.com/news/2012-06-04/jpmorgan-faces-4-2-billion-trading-loss-isi-forecasts.html [Accessed June 11, 2012]. 
• LaCapra, L.T., 2012. JPMorgan trading loss shows danger in bank size -Volcker. Reuters. Available at: http://uk.reuters.com/article/2012/06/07/uk-jpmorgan-volcker-idUKBRE85615720120607 [Accessed June 11, 2012]. 
• Macke, J., 2012. JP Morgan Trading Loss: Still More Questions Than Answers. Yahoo! Finance. Available at: http://finance.yahoo.com/blogs/breakout/jp-morgan-trading-loss-still-more-questions-answers-154010320.html [Accessed June 11, 2012]. 
• Schwartz, N.D. & Silver-Greenberg, J., 2012. JPMorgan’s Trading Loss Is Said to Rise at Least 50%. New York Times. Available at: http://dealbook.nytimes.com/2012/05/16/jpmorgans-trading-loss-is-said-to-rise-at-least-50/ [Accessed June 11, 2012]. 
• Smith, A. & Thomasch, P., 2012. JPMorgan $2 billion loss hits shares, dents image. Reuters. Available at: http://www.reuters.com/article/2012/05/11/us-jpmorgan-trading-idUSBRE8491H020120511 [Accessed June 11, 2012]. 
• Wikipedia, 2012. 2012 JPMorgan Chase trading loss. Wikipedia. Available at: http://en.wikipedia.org/wiki/2012_JPMorgan_Chase_trading_loss. 
• Zuckerman, G. & Burne, K., 2012. “London Whale” Rattles Debt Market. Wall Street Journal. Available at: http://online.wsj.com/article/SB10001424052702303299604577326031119412436.html [Accessed June 11, 2012].