After UBS, who could be next: The shit waiting in the derivatives market

"The few who understand the system, will either be so interested from its profits or so dependent on its favors, that there will be no opposition from that class." - Mayer Amschel Bauer Rothschild

According to the Office of the Comptroller of the Currency (OCC) in its quarterly report on Bank Trading and Derivatives Activities for the fourth quarter of 2008,

• The notional value of derivatives held by U.S commercial banks increased $24.5 trillion in the 4^th quarter of 2008, or 14% to US 200.4 trillion due to the migration of investment bank derivatives business into the commercial banking system.
• US commercial banks lost $9.2 billion trading in cash and derivatives instruments in the 4^th quarter of 2008 and for the year they reported tgrsding losses of US 836 million The poor results in 2008 reflect continued turmoil in financial markets, particularly in credit instruments.
• Net current credit exposure increased 84% from the 3rd quarter to a record $800 billion and much of the decline is due to the sharp decline of interest rates in the fourth quarter
• Derivatives contracts remain concentrated in interest rate products, which comprise 82% of total derivatives notional value. The notional value of credit derivatives decreased contracts by 2% during the quarter to $15.9 billion. Credit default swaps are 98% of total credit derivatives.

Who 'owns' the derivatives market

The $200 trillion notional amount of derivatives contracts held by U.S banks is summarized in the following table,

Rank Bank Name Total Derivatives held (in $millions)

1 JPMorgan $87,362,672

2 Bank of America $38,304,564

3 Citibank $31,887,869

4 Goldman Sachs $30,229,614

5. HSBC $ 3,713,075

6 Other Banks $ 8,515,786

So, it can be deduced that the top 5 banks in the US held about 94% of the total derivatives, while the rest of the more than 1,000 banks held less than 6%.

The most popular

The following table shows the type of derivatives that make up the $200 trillions.

Type of Derivatives In ($Billons)

Interest Rate Swaps 164,404

Foreign Exchange 16,824

Equities 2,207

Commodities 1,050

Credit Derivatives 15,897

Total 200,382

The interest-rate swap

The table shows that the majority (about 82%) of the derivatives are interest rate-based. Interest rate swaps are basically a type of financial instrument where two parties agree to exchange interest rate cash flows from a fixed to floating rate and vice versa.

It can be used as a hedging or speculative device depending on how you utilize it.

Say if you think that in the next 5 years down the road, the economy will be doing well and hence the authorities may increase the interest rate so as to slow down the rate of inflation. In such a case, if you are having a floating interest rate exposure, you may wish to reduce your risk by swapping your interest rate to a fixed rate. The amount to be swap will not change, only the duration or whether you want a fixed or floating rate will be changed during the swap.

Interest rate swaps can also be used by hedge funds or any investor for speculative purposes. Due to the differential in the interest rates, they can take advantage of the arbitrage opportunities that are available to make a profit. There are risks involved when you are speculating IRS, such as market and credit risk. Market risk is due to the fluctuating interest rates during the duration of the swap, while credit risk may be caused by a default in any of the parties involved

Another point to note is that the derivatives held by the US banks increased by $24.5 trillion to $200.4 trillion or 14% in the fourth quarter.

Instead of unwinding their speculative positions, they are adding more bets to the derivatives market. What could be the cause for the increase in derivatives held by US banks?

Doubling up!

Firstly, it may be due to some previous bets that may have gone wrong. In order to recover their losses quickly, the traders may indulge in ‘Doubling the BETS’. It’s a strategy whereby traders will double their bets each time they lose because they believe eventually if one of the bets win, then they will recover all their previous losses in one go. However, when they keep doubling their bets, it will reach a point where their losses are so large that they can’t pay it off and no one wants to have anything to do with it.

To illustrate how this strategy works, say initially you lose $2 betting on even numbers in a blackjack table. In order to recover your $2 in your next bet, you will wager $4. This will go on exponentially and by the time you have your 15^th loss, you will need to place a bet of $65,536 in the next round in order to win back your original $2. I have personally seen people losing 15 times straight in a blackjack table. Talk about risky business, the risk/reward ratio is just way too high. I believe this is one of the reasons why most of contracts or trades are not able to unwind and instead they just keep increasing.

Bonuses

Secondly, it's all about bonuses. Bonuses are of course directly related to a company’s profit. The higher the profit the bigger the bonus. It is a normal practice in the Risk Control Departments at investment banks ‘To look the Other Way’ for some of their so-called ‘Star Performer’ traders.

These traders can get away with the risk control departments guidelines for safe trading. They are able to get away with larger than stipulated daily losses and trade way above their daily trading limits. And this is why they have the incentive of doing what brings the bonus money in. At the end of the day when the trader wins big, everyone gets a bigger bonus and when he looses, the trader will be the scapegoat.

What happened at UBS

This is what actually happened in the UBS recent $2.5 billion loss. The trader, Kweku Adoboli, trades from the Delta One trading desk and as you know Delta One trading desk only handles quite low risk financial instruments like forwards, futures, swaps, equities and ETFs because most of them are hedged. Delta One remains one of the most profitable divisions in most investment banks.

According to UBS version of its investigation, it is caused by the failure of four risk control mechanism in its risk control department. In order to accumulate such a big loss in such a short period, the trader might have done the following:

a) having a huge position

b) the instrument traded must be very liquid

c) no supervision from the Risk control department

d) trading some very risky products (most probably CHR/EUR or other cross currency trades) because the day they reported the loss coincided with the day the Swiss authorities pegged its Swiss Franc to the Euro at 1.20.

e) the Risk Manager is not doing his job because at the end of the day there will be a report of ALL TRADES available at the desk of the Risk Manager

f) collusion between the trader and someone above so that losses go unreported.

g) he might be engaged in trading ‘naked CDS’. Naked is Wall Street lingo for uncovered trades meaning there is no hedging for those bets and its only one way.

As for me, I would say all of the above are the reasons for the UBS loss.

In the day to day operations, banks control the market risk in trading operations by establishing daily trading losses. Banks normally use the VaR or (Value at Risk) to specify the maximum loss at a given time horizon (normally one day) and also the confidence level at that particular time to control risk.

A VaR of $100 million and a confidence level of 99% on a trading day indicates that a bank’s portfolio should only lose $100 million more than once in every 100 trading days in normal conditions.

The following table shows the VaR of the three largest US banks.

In ($millions) JPMorgan Citigroup Bank Of America

Average VaR 2008 $196 $292 $111

Equity Capita $166,844 $150,599 $177,052

Var/Equity 0.12% 0.19% 0.06%

So, as you can see the VaR/Equity ratio is actually very small. If they followed guidelines and best practises, then most of them would not end up in the situation as they are now.

According to the Bank of International Settlements, total global derivatives are estimated to be more than $600 trillion as of December 2008.

Heck, if just 10% of this amount of derivatives, be it CDS,CDO,MBS and et al, were to go bust, it would be enough to wipe out at least half of the world’s GDP. This would likely cause a major meltdown in the global financial system and would be much more lethal than the one we had in 2008.

Malaysia Chronicle