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from Felix Salmon:

How Bruno Iksil lost $2 billion

In February 2009, Deutsche Bank announced that its Credit Trading desk had managed to lose €3.4 billion in the fourth quarter of 2008, with €1 billion of those losses directly attributable to the bank's prop desk.

The losses in the Credit Proprietary Trading business were mainly driven by losses on long positions in the U.S. Automotive sector and by falling corporate and convertible bond prices and basis widening versus the Credit Default Swaps (CDS) established to hedge them.

In English, Deutsche Bank had put on a basis trade: it owned credit instruments, like bonds, and it also owned credit default swaps designed to hedge against those loans. And then the trade blew up.

The Deutsche trader responsible for the monster losses was Boaz Weinstein, who eventually left the bank to start his own hedge fund, Saba Capital. His first job, obviously, was to make sure he didn't blow up a second time. But his second job, it seems, was to use his experience at Deutsche to be able to notice when someone else was about to blow up on a massive basis trade. In this case, JP Morgan.

Go back to early February, long before the articles about the "London Whale" came out in Bloomberg and the WSJ, and you'll find Weinstein revealing his biggest trade at the Harbor Investment Conference:

The derivatives trader and legendary hedge fund manager said his trade idea is to buy Investment Grade Series 9 10-Year Index CDS (maturing on 12/20/2017).

"They are very attractive," he explained adding that they can be bought at a "very good discount."

At the time, Weinstein didn't know -- or necessarily even suspect -- that his big trade would involve a zero-sum bet with one of the biggest hedge funds in the world, JP Morgan's Chief Investment Office. But over time, as he bought more and more protection but the price stubbornly refused to rise, he began to learn just how big the other size of the trade was. Whale big.

from Felix Salmon:

How dumb rules can mitigate model risk

We're still not much the wiser on exactly how the London Whale managed to lose $2 billion this quarter, but I think Matt Levine has the smartest take. (This is why the blogosphere is so great: it's full of people who used to do this kind of thing for a living, rather than just people who write about people who do this for a living.)

The key thing to note here is that while the monster hit to the P&L is what got all the headlines, the real problem here lay with JP Morgan's risk models. A hint of far out of whack they are is given in the difference between the bank's earnings release, which showed $67 million of value-at-risk in the Whale's division in the first quarter, and the new SEC filing, which showed that number as actually being $129 million. Here's Levine:

This was attributed to modeling changes made over the last year, and someone asked on the call “why did you change the VaR model?,” but I’m not convinced that’s exactly the right question. This, I suspect, is not an issue of a thing called a “VaR model” that sits in a central location and spits out numbers for regulators and 10-Qs; rather, this looks like the CIO’s trading desk modelling the actual P&L and risks of the trade wildly wrong. That seems to me like the simplest way to lose a billion dollars without noticing it.

I'd put this another way. JP Morgan's Bruno Iksil, it seems, managed to find an incredibly profitable way of hedging the bank's positions. Like any other economically rational actor, when he saw a lot of dollar bills lying on the sidewalk, he decided to pick them up. But in Iksil's highly-complex world, a dollar bill isn't really a dollar bill. Instead, it's the output of a model. And if a trader can't trust his model, he's flying blind.

The problem is that pretty much by definition, it's impossible to model model risk. We now know that Iksil's model was deeply flawed. And indeed the minute that the rest of the world found out about his positions, they didn't really pass the smell test: it's very hard to see how writing an enormous amount of protection on an off-the-run CDX index would hedge anything much.

This is where grown-ups like Jamie Dimon are meant to step in. If they see billions of dollars in super-senior mortgage exposure, or in off-the-run CDX exposure, they're meant to say "I know that your highfalutin' models say that these exposures are risk free, but I don't understand how this isn't risky, so go unwind this trade". Dimon has historically been very good at that -- very good at refusing to simply trust that superstar traders earning eight-figure bonuses are doing nothing that might blow up in their faces. In this case, however, for some reason, he had blind faith in Iksil -- and in Iksil's models, which proved to be very faulty.

A modern trading desk is a bit like a high-tech airplane: nearly all of the time, you're better off trusting your instruments than trusting your gut. But at the same time, if your instruments are broken, then trusting them can lead you to fly straight into the ocean.

from Breakingviews:

Botched BATS IPO at least good test of markets

By Antoy Currie The author is a Reuters Breakingviews columnist. The opinions expressed are his own. The botched BATS initial public offering could be disastrous for the upstart electronic exchange. It scrapped its market debut on Friday after shares crashed from their $16 opening to just 2 cents after a “serious technical failure.” It’s a potential killer for the company, which is already the focus of investigations into high-frequency trading. The good news is that the stumble didn’t catalyze a broader market meltdown.

That at least offers some reassurance that the infrastructure of U.S. equity markets is far more robust than it was at the time of the so-called Flash Crash of May 2010. Markets tanked 9 percent in seconds then, after a few random trades kicked off a tailspin across the many electronic trading platforms and exchanges handling U.S stocks.

Friday’s flop had the latent power to create a similar fiasco. BATS accounts for some 11 percent of U.S. equity trading volume, much of it from firms using supercomputers moving in milliseconds. Instead, the damage was limited. There was the hit to Apple, the $600 billion powerhouse, whose shares were briefly halted after dipping 9 percent. The erroneous trades were swiftly nullified before the iPad maker’s stock was back up and running.

It’s a welcome sign that improved circuit breakers installed after the Flash Crash appear to be working well. That won’t, however, comfort BATS employees or investors, including the IPO’s underwriters Morgan Stanley, Citigroup and Credit Suisse.

Wall Street traders, however, can be pretty agnostic about where to send their orders. And BATS is hardly the first exchange to have technological issues - though greater scrutiny of, or even restrictions to, high-frequency trading may harm BATS more than others.

from Breakingviews:

JPMorgan offers peek into trading magic circle

By Antony Currie The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Jes Staley is not going to be popular in Wall Street’s trading brotherhood. The head of JPMorgan’s investment bank has broken a code of silence by revealing how much the firm rakes in as a market-maker.

Shareholders will consider that a smart move. The new disclosures at the bank’s investor day on Tuesday gave them needed insight into the trading tricks investment banks typically keep under wraps. Banks usually bundle their 25 or more fixed income, currency and commodity products into just one revenue number, perhaps adding a little data-light color during earnings calls. Aside from that, all investors have to go on is trading desk gossip.

Goldman Sachs revealed a sliver more last year by divulging the pre-tax margin for its trading unit as well as for its other major businesses. But Staley has, as he put it, “opened the kimono” much further by breaking out the average revenue per trade the bank earned last year in 11 major FICC products and four equities ones.

Interest-rate swaps came top at $12,000 a pop. Trading loans or asset-backed bonds brought in $10,000 a time. These amounts reflect illiquidity or the fact the trades are tailor-made for clients, in both cases leaving the middleman with extra risk. Foreign exchange spot and forward trades were the least profitable per transaction at just $70. But they’re also the most popular, at five million trades a quarter, and mostly done electronically at low cost.

This gives investors useful extra information to include in their models. JPMorgan, which may only want to release the data once a year, is taking the risk that analysts and shareholders will push for more frequent updates, and for more detail.

But the bank, headed by Jamie Dimon, is also sending a message to regulators and lawmakers by offering a peek inside the trading magic circle. All the data points reflect deals with clients, not other banks. And they represent 70 percent of trading revenue, with the rest coming from net interest income, prime brokerage and other client businesses. In other words, Staley is trying to show a skeptical audience that banks - well, JPMorgan at least - provide valuable services rather than indulging in trading for their own account.

from Breakingviews:

Hildebrand shows stark exposure of central bankers

By Peter Thal Larsen The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Philipp Hildebrand’s downfall is a warning to the world’s central bankers. The Swiss National Bank chief has been forced out after his wife engaged in ill-advised currency trades. In less turbulent times, he might have escaped with a slap on the wrist. But central bankers’ controversial policies have made them political targets.

At best, Kashya Hildebrand’s decision to swap 400,000 Swiss francs for U.S. dollars three weeks before the SNB intervened to push down the overvalued currency was stunningly naïve. Her husband’s failure to immediately reverse the transaction, when he found out the next day, was equally mistaken. The SNB also handled the situation badly. It did not commission an external investigation until December, and did not publish the report - and details of its ethical code - until early January.

Other central bankers may think they would have avoided these mistakes. They may also feel they have little in common with Hildebrand, who worked for a hedge fund before entering public life, and whose 2010 income of 861,000 Swiss francs ($900,000) made him one of the world’s best-paid central bank chiefs. Besides, central bankers are hardly prone to scandal: Rupert Pennant-Rea, who resigned as deputy governor of the Bank of England in 1995 following an extramarital affair, is one of the few whose personal behaviour cost him his job.

Nevertheless, the financial crisis has turned central bankers from faceless technocrats into divisive figures. Hildebrand angered Switzerland’s largest banks by pushing for them to hold more capital. He also attracted political criticism for his efforts, initially unsuccessful, to stem the Swiss franc’s rise - though subsequent pegging of the currency to the euro was seen as far more of a success.

Other central bankers are no strangers to political controversy. Ben Bernanke’s pursuit of quantitative easing at the U.S. Federal Reserve has made him a target for some Republican presidential nominees. Mario Draghi is bound to make political enemies whether or not the European Central Bank president intervenes to ease the euro zone’s sovereign debt crisis. In such positions, the slightest slip could prove fatal. In order to retain their independence, central bankers will have to make sure they are whiter than white.

from Unstructured Finance:

SAC Capital: a look back in time

By Matthew Goldstein

The full year numbers aren't in, but it appears Steve Cohen's SAC Capital had a pretty good year--especially compared to most other long/short equity hedge funds which lost money. But how does this year's 8% gain stack-up against other strong years posted by the Stamford, Conn. hedge fund?

As we reported previously on UF, a good chunk of SAC Capital's trading prowess in 2011 is being credited by sources to a single team led by Gabe Plotkin. His $1.2 billion book is one of the largest at SAC Capital and has generated between $150 million and $200 million in profits.

Indeed, only Cohen's own 2 billion book--called the "big book,'' the "Cohen account," or simply "COHE"--is believed to manage more money at the $14 billion fund.

But SAC Capital's projected 8% return got me thinking about 2007, another year when Cohen's fund posted pretty good numbers even as some hedge funds (notably the Bear Stearns funds) either stumbled or crashed burned on the way to the start of the financial crisis.

A while ago, I got my hands on some old performance stats for SAC Capital's long/short book for 2007. And while it's hard to draw too many conclusions from the numbers, they do offer a glimpse into some of the muscle behind Cohen's 900-employee trading empire.

In 2007, the firm recorded 251 trading days and during that period its long/short book had a gross market exposure of $34 billion. (GMV includes the total value of all long and short positions). In 2007, assets under management at SAC Capital ended the year at about $16 billion. So yes, the fund was generally operating under a higher leverage ratio than now.

from Financial Regulatory Forum:

Banking on Volcker: Big Crisis, Big Rule

By Thomson Reuters Accelus staff

NEW YORK, Oct. 19 (Business Law Currents) - Banking lawyers should be forgiven if they’re not returning calls right away: they’re busy trying to digest the Volcker Rule (or “the rule”). The proposed rule’s 298-page doorstop represents the collective efforts of the Treasury Department, Fed, FDIC and SEC to implement §619 of the Dodd-Frank Act, which itself added a new §13 to the Bank Holding Company Act of 1956 (the BHC Act). The intent of the Volcker Rule is to “generally prohibit any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund (“covered fund”), subject to certain exemptions."

So does the Volcker Rule satisfy its mandate? To paraphrase ‘The Simpsons’: yes with an “if,” no with an “unless.” The rule carves out significant exemptions from the proscription against proprietary trading, but each of these exceptions has a number of criteria required to take advantage of the exemption. Moreover, a number of the rule’s measures provide for rebuttable presumptions of non-compliance for certain types of trading activity.

The Volcker Rule carves out significant exemptions in the following areas: underwriting and market-making related activities; risk-mitigating hedging; and “exemptions for trading in certain government obligations, trading on behalf of customers, trading by a regulated insurance company, and trading by certain foreign banking entities outside the United States.” In addition, the rule imposes reporting and record-keeping requirements, and addresses some narrower applications in the context of specific transactions with covered funds.

KEY DEFINITIONS

Cobbling together definitions of key terms, the rule borrows liberally from the BHC Act. Beginning with the baseline for the Volcker Rule’s application, the rule provides:

Proprietary trading means engaging as principal for the trading account of the covered banking entity in any purchase or sale of one or more covered financial positions. Proprietary trading does not include acting solely as agent, broker, or custodian for an unaffiliated third party.

from Reuters Money:

Beat high-frequency trading machines by not playing their game

The days of you trying to make a buck actively trading in the stock market are over.

Individuals don't stand a chance anymore because they are largely competing against rational machines often guided by herd-like irrational forces. The robots can rule in the blink of an eye.

I'm not spouting lines from an Isaac Asimov novel, but citing reality. The machines and people who program and profit from them have won -- for now.

I knew it was over for human traders when I heard that high-frequency trading firms were hooking up their data lines directly to exchange computers to gain an extra hundredth of a second in execution time.

High-speed programs are designed to move millions of shares in a fraction of a second to take advantage of small movements in securities prices. These algorithms are ideal Wall Street workers. They don't need health insurance and you don't have to pay them bonuses to help finance their Lamborghinis or homes in the Hamptons.

There's no way to beat the machines, unless of course, you have a faster machine, better programs or the ability to predict the future. Your odds are better in Vegas, which never had great odds for a palooka pulling a one-armed bandit.

Who are you trading against when you take on the machines? Any entity from a boutique investment firm with a handful of "quants" -- math majors who flocked to Wall Street for the big bucks -- to a mega-bank or hedge fund. Some 60 percent of the volume of the New York Stock Exchange is attributed to high-speed trading, maybe more.

from Reuters Money:

A mad day trader’s diary of market turmoil

The following is a guest post written by Marianne Paskowski, who was vice president of Reed Business Information’s Television Group. Today she manages her extended family’s portfolios from Cape Cod.The opinions expressed are her own.

Some of my pals, with unvarnished disdain, call me a day trader. They lost a lot of money in the 2008 crash. I stayed the course and finally made money. So I prefer the handle "active investor."

Last week, though, the up-and-down market got me thinking about what I actually do to manage investments, so I kept a diary of my days, tallying up what I did or didn’t do. My conclusion: I’m definitely not an investor, but a trader in this market, and that’s because I feel far worse about what is going on now in the global economy that I did three years ago.

And I don't see any good news on the short term horizon so I'm trying to keep my powder clean. It's killing me,  because I'm used to more action. But I'm not crazy and don't like to be in the path of falling knives.

So let’s revisit last week in what I can only call a bad trip through a carnival house of mirrors --  full of distorting, confusing images. I didn't have a great week and I don't know anyone who did. I actually hit the bottle of Tums today. Not a good omen.

Monday Not too shabby at all. The Dow was up 213 points and I had a lot of realized income come my way via dividends and interest from earlier trades. I actually got out to the gym, ever so briefly, ran a lot of errands, but couldn’t stop thinking about the market.

So I bought 500 shares of BMO, set a strike point and sold some covered calls.  I’ve been in and out of Bank of Montreal and always made money. Last go round, I only stayed in for two weeks. I bought it back for $5 a share less than when I sold it earlier this summer. It kicks off a great dividend, so why sit in so much cash? Weeks earlier I grabbed just about every profit off the table, so there wasn't a lot to do. Very frustrating.

from Reuters Money:

Video sheds light on high-frequency trading

The following is a guest post by Brad Allen, personal finance journalist and founder of RiskRewardNews.com. The opinions expressed are his own.

Wall Street’s computer-powered, high-frequency traders are getting renewed scrutiny in the current volatile market with some media reports suggesting they are not just profiting from the wild market swings, but making them worse. There's a new report that the U.S. Securities regulator has subpoenaed high-frequency trading firms in relation to last year's "flash crash" probe.

This lightening fast micro-second trading buys and sells a few shares of stock thousands of times a second, generating huge profits by capturing just a couple of pennies on each trade – over and over again.

Despite the criticisms, nobody can accuse high-frequency traders of not making every second count.  And to illustrate the point, an investor in Portland, Oregon stretched the thousands of trades occurring in one second out over a one-minute video.

Architect Brian White, a self-described active individual investor, read about high frequency trading on financial blogs.  Fascinated by the lightening-speed trades occurring thousands of times a second, he began to observe trading activity on different websites, watching as the bid/ask trading data flashed across his screen.

“Initially, I was purely interested in the graphics,” he said. The shifting patterns inspired design elements, such as carpets, in his architectural and design work for clients.

White and his associate Dan Arico, “my graphics guy,” then set out to create a video of the constantly changing bid/ask screen. “It became a challenge to graphically show how quickly these things are spinning,” he said. While the trading details were incomprehensible, White realized "your eyes could probably comprehend” the action by following the changing patterns without having to think about it. Their solution:  stretching one second’s worth of trading data into a minute of video.