29 May 12 When ‘Whales’ trade…

JP Morgan reported US$2billion trading loss when its trader Bruno Iksil’s (nicknamed London Whale for his big ticket trades) shorting of credit derivatives (synthetic credit default swaps) reversed as the Euro zone problems resurfaced last month. Looking at it from the other side, JP Morgan’s loss made some other aggressive risk taking traders (read ‘Whales’) who made the contrary bet gain handsomely. (Refer to the NY Times article)

While the incident is of significant consequence, especially from a regulatory perspective (it has called for stricter oversight), it reminds me of the proposal by US treasury Secretary Timothy Geithner in 2009 of not allowing financial institutions to become too big to fail. Mr. Geithner had called for the government intervention to restrict growth of these institutions to ensure they do not grow so big that their failure can adversely affect the entire economy. I think a similar restriction is required on traders or teams of traders within an institution on the size of their trading bets.

Why should a single trader (‘Whale’) or a team of traders be allowed to take such massive speculative bets through proprietary desks or otherwise? That too on securities that are opaque and complex and values of which are far from related to that of the original underlying. At the first place should these trader ‘Whales’ be allowed to exist at the first place?

When used just as a risk mitigation tool, credit derivatives are handy for banks. In fact credit derivatives can aid lenders and financial institutions in better capital risk management. In the Indian context, the relative underdevelopment of credit derivatives market (on the back of a weak corporate debt market) and its delayed introduction could be seen as a blessing in disguise. The Reserve Bank of India cleared the introduction of credit derivatives in November 2011 after much discussion and caution. The good part is that purely speculative bets are not allowed.

The recent incident shows how we have not learnt from history – recent or distant. While the well capitalized JP Morgan can absorb the losses without denting its financial performance, the incident will surely help strengthen the case for implementation of the Volcker rule that limits risk-taking by banks on propriety trading. But then again, increasing oversight and restrictions will only be from a compliance perspective – ticking the boxes till another crisis occurs.

Whether ‘Whales’ trade or a ‘Stout infantfish’ makes trading bets, regulations can restrict recurrences of irregularities in financial markets only to a certain extent. ‘Greed may be legal’, but self discipline and moral restraint are the only true saviours.

Ribhu Ranjan Baruah

Ribhu was a project manager at ValueNotes, managing a team that met the research needs of a global investment management firm. He has since moved on to pursue opportunities in impact investing.

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