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Global Financial Systems

Chapter 9
Trading and Speculation
Jon Danielsson
London School of Economics
2013
To accompany
Global Financial Systems: Stability and Risk
http://www.globalfinancialsystems.org/
Published by Pearson 2013
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Book and slides

The tables and graphs are

the same as in the book

See the book for
references to original data
sources
Updated versions of the
slides can be downloaded
from the book web page
www.globalfinancialsystems.org

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Introduction

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Speculation
Force for good and force for bad

Speculators help farmers to plan production

And traders to threaten the financial system
There is no clear definition of the term speculation
But generally investment is longterm, speculation

shortterm (buy and hold vs. buy and sell)

It is often impossible to distinguish between legitimate
and illegitimate speculation
Speculation cannot be eliminated, even though many
political leaders have expressed the desire to do so

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Terminology (Appendix)

Party and counterparty

Orders, clearing (clearing house), settlement
Exchange vs. overthecounter (OTC)
Market maker (quotes both sides)
Broker arranges transaction and charges commission
Netting
Central counterparty (CCP)

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London whale and JP Morgan

Chief investment office at JP Morgan lost over $6 billion

in London
Part of adjustment to Basel III, thought to lower
riskweighted assets
But became a speculative bet on the shape of the yield
curve
flawed, complex, poorly reviewed, poorly executed, and
poorly monitored. The portfolio has proven to be riskier, more
volatile and less effective as a hedge than we thought,

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LIBOR scandal

LIBOR/EURIBOR benchmark interest rate (average

reported rate)
Very costly because many contracts (e.g. derivatives and
mortgages) have the rates set by LIBOR ($800 billion)
Some banks manipulated it, have been investigated and
paid fines
For Barclays it happened before/after crisis, e.g.
manipulation of reported borrowing costs

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Ponzi scheme

An entity promises very high returns, collects money, pays

handsome returns to early investors, which attracts more

investors, in a pyramid scheme
Named after Charles Ponzi in 1920 in US
Best known recent case is Bernie Madoff ($18 billion
paper losses)
Happens all the time

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Rogue traders

A bank employee manipulates the system to take very

high risk
Nick Leeson and Barings (824 million)
J
erome Kerviels liberal interpretation of lowrisk
arbitrage causing a e4.91 billion loss to his employer,
Societe Generale (world record)
(Kerviel did not really get bonuses)

Happens frequently

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Trading and Risk

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Market participants
General term referring to those who engage in trading
Proprietary trading (prop trading) buying and selling for a

financial institutions own account, in order to make

speculative profits
this is the target of the Volcker rule, UK Independent

Commission on Banking (Vickers report), EU Liikannen

report
Institutionalization, outsource investment decisions,

perhaps using a benchmark to evaluate performance

plenty of scope for abuse (e.g. underperformance and

fraud)
hence highly regulated (microprudential regulations)

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Hedge funds (HFs)

Lightly but not unregulated

Lightly regulated funds that only sell to sophisticated and

wealthy investors (accredited)

Who consequentially should be able to take care of
themselves (no need for microprudential protection)
Still subject to securities laws and deal with regulated
parts of the financial system
Prime brokers
Difficult to classify (except by absence of regulations)
Before 2007 thought to be the main source of financial
instability (echoes of 1998 and LTCM)
It is a typical example of the successful general syndrome
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Financial innovation
Create new types of financial instruments
Viewed favorably until 2007
Perhaps because only proponents understood it
We look at CDS, CDO, SIV, conduits, etc. later

the most important financial innovation that I have seen in

the past 20 years is the automatic teller machine
Financial innovation moves around the rents in the financial
system, benefiting the inventor, not the clients.
Paul Volcker 2009
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Trading Activities

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Trading strategies

Rules used by traders when deciding what to buy and sell

Can be highly formalized and automated (like HFTs)
Or a vague preference for lowrisk or safe investments
Often are unconscious
We have seen several examples, especially in the

endogenous risk chapter

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Value investing
Find companies trading below their inherent worth
Stocks with strong fundamentals like earnings, dividends,

book value, cash flow

The strategy of Warren Buffett
One example of a mean reversion trade
Seeking yield is maximizing risk
Warren Buffett

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Carry trades
Exploiting differences in yields
We focus on foreign exchange carry trades
Borrow money in a country with low interest rates,

exchange it for a currency with high interest rates

Profit from interest differential and the resulting
foreignexchange appreciation
Very controversial because leads to excessive inflows of
hot money and inability to manage exchange rates (we
discuss this in detail later)

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YenDollar 1998
145

135

125

115
Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

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Endogenous risk feedback in unwinding

up by the escalator and down by the elevator (lift)

Dollar
weakens

Unwind carry
trade

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Carry trades as a source of contagion

Hedge fund

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Carry trades as a source of contagion

Hungary

New Zealand

Hedge fund

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Carry trades as a source of contagion

Hungary

New Zealand

Crisis
Hedge fund

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Carry trades as a source of contagion

Hungary

New Zealand
n
rgi
Ma
ll
ca

Crisis

Hedge fund

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Carry trades as a source of contagion

Hungary
n
rgi
Ma
ll
ca

Crisis

Sel
lN
ZD

New Zealand

Hedge fund

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Carry trades as a source of contagion

Contagion
n
rgi
Ma
ll
ca

Crisis

New Zealand

Sel
lN
ZD

Hungary

Hedge fund

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Technical trading
Forecasting prices with quantitative methods
Often successful with statistical arbitrage and HFT
Less likely to work at lower frequencies
Many studies proclaiming it works
A problem with data mining. Forecasting insample not a

proof of success
Most public studies have methodological problems
However, if someone is successful they will not really talk
about it in any detail

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Momentum trend following

Buying assets that have seen recent price increases and

selingl those that have fallen in price

Can endogenously affect prices (selfvalidating in the
short run)
In the long run may cause bubbles and crashes
May be conscious, but perhaps more likely done
subconsciously
For example, we only engage with successful managers

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Highfrequency trading (HFT)

Using technology to beat everybody else

Famous example Nathan Rothschild, pigeons and

Napoleons defeat in Waterloo in 1815

Now done with highspeed computers, data networks and
algorithmic trading
Main fears crystallized in the flash crash of May 2010

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Flash Crash, May 6, 2010. DJIA

10800
10600
10400
10200
10000

10:00

11:00

12:00

13:00

14:00

15:00

16:00

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Accenture transaction prices

40

30

20

10

0
14:45

14:50

14:55

15:00

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Sothebys transaction prices

105

104

103

102

14:45

14:50

14:55

15:00

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Impact

The Flash Crash had little impact

It happened intra day, and by closing time the market had

recovered
So did not impact on margins, marktomarket, daily
risk, etc.
Hid the danger of HFT

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Short selling

Selling assets one does not own borrow with the

intention of buying back later

In many cases a legitimate hedging activity
But can be used to make directional speculative bets
Difficulties in sorting out economic vs. political or moral
arguments

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Naked short selling

Two different activities

A. A short speculative position, rather than hedging

B. Short selling an asset without borrowing it

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Issues
Profits from falling markets
But is it any different from just selling assets one owns?
Hard to see an economic distinction
Hence the political/moral dimension of profiting from a

crisis, or causing prices to fall

Frequently banned
However little empirical evidence indicating damage from
shortselling or effectiveness of banning

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CCPs

The problem of asymmetric information

And OTC instruments
Makes it hard to net out positions, get a clear overview of

size of market/positions, and can create enough

uncertainty to cause an institution to fail, and even a
crisis
This is the problem a CCP aims to solve (see next slide)

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CCPs

Bank B

Bank C

Bank A

Bank D

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CCPs
Bank B

Bank C

Bank B
Bank A

Bank D

Bank C

CCP

Bank A

Bank D

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How many CCPs

Ideally only one in the world

But this concentrates vulnerability
And everybody wants to host it

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Vulnerabilities
The CCP cannot be allowed to fail that would be a

systemic crisis
Hence is a candidate for a government bailout Hong
Kong bailed its CCP out in 1987
Therefore, a CCP may practice self preservation to the
extreme
And therefore trigger vicious endogenous feedbacks
Alternatively, it may take risk knowing it gets bailed out
moral hazard

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Universal and narrow banking

Should we restrict banking by activities?

GlassSteagall
Investment banking and commercial banking
Volcker rule, UK Independent Commission on Banking

(Vickers report), EU Liikannen report

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The rest of these slides relate

to compensation and FTT as
discussed in Chapter 9. The
same discussion, but with
updated content is in Chapter
21.

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Bonuses

Some bank employees get performance bonuses

Presumably incentivizes them to take more risk than

society likes
Like creating a portfolio that delivers steady profits 99.9%
of the time, but blows up the bank (and even the
financial system) 0.1% of the time
can be very easy to create such portfolios
can be very difficult to identify

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So does limiting bonuses reduce systemic

risk?

No evidence exists either way

The biggest banking crisis in recent history involved no

bonuses Japan
In the 19th century bonuses were absent
And we still get crises and bank failures without bonuses
It is unclear if bonuses make this worse

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Policy options on bonuses

Limit bonuses
Will the rainmakers leave?
EU now has a Directive limiting bonuses (discussed later)
Banks say activity will migrate out the EU
But no evidence suggests that would happen on a large

scale
And proponents say good riddance

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Financial transaction tax (FTT)

Impose a low tax on financial transactions
Tobin tax
Originally an anticomplexity device
And has considerable merits as such
However, sold as a way to fund governments
does not make much sense,
trading would sharply fall
and the very same banks that are receiving massive
bailouts would have to pay the tax
We return to the EU FTT later

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