WEBVTT - Here’s What’s Happening With Those Korean Structured Notes That Bet Against Market Volatility 0:00:10.680 --> 0:00:14.560 Hello, and welcome to another episode of the Odd Lots Podcast. 0:00:14.600 --> 0:00:19.840 I'm Joe and I'm Tracy Allaway. Tracy, so you know 0:00:19.880 --> 0:00:23.480 what a sort of depressing phenomenon has been lately. You're 0:00:23.480 --> 0:00:28.440 going to have to narrow that down. Job. Yeah, right there, 0:00:29.000 --> 0:00:34.880 that's that's a very broad category, very micro depressing phenomenon. 0:00:36.080 --> 0:00:39.280 Is that a lot of our recent episodes that we've done, 0:00:39.720 --> 0:00:42.840 which we sort of discussed in a very theoretical sense, 0:00:43.240 --> 0:00:48.279 have unfortunately started to become relevant extremely quickly. Yeah, you're 0:00:48.320 --> 0:00:51.320 absolutely right. One of the ones that springs to mind 0:00:51.560 --> 0:00:54.400 is the one we did with Claudia Psalm back in 0:00:54.640 --> 0:00:58.160 I think it was January or February about actually giving 0:00:58.160 --> 0:01:01.240 people money as a form of econo stimulus in order 0:01:01.280 --> 0:01:04.039 to stave offer session. And now we're sort of seeing 0:01:04.040 --> 0:01:07.440 that actually happen in the US, although obviously there are 0:01:07.880 --> 0:01:11.280 issues in a wider debate about the way that's currently 0:01:11.280 --> 0:01:15.960 being done. Yeah. Absolutely, another one, And I would say 0:01:16.000 --> 0:01:19.520 this episode that we're going to do even more than 0:01:19.600 --> 0:01:24.080 any other. On Twitter, several times a week people ask 0:01:24.240 --> 0:01:27.839 for updates of it. So there's one in particular where 0:01:28.040 --> 0:01:30.600 I'm always getting tweets. It's like, hey, what's going on 0:01:30.680 --> 0:01:32.760 with what you talked about that one episode I'm curious 0:01:32.760 --> 0:01:36.560 about you sort of have been getting the same one, Yeah, 0:01:36.680 --> 0:01:39.840 I absolutely have. I know exactly what episode you were 0:01:39.840 --> 0:01:42.360 talking about, and it was a really good one. It's 0:01:42.440 --> 0:01:46.119 Korean structured products. And not only have I been getting 0:01:46.120 --> 0:01:49.600 the same tweets with the same questions and people asking 0:01:49.640 --> 0:01:52.320 for a general update and what's going on with the 0:01:52.320 --> 0:01:56.240 structured products as well as the overall options market, but 0:01:56.320 --> 0:01:59.480 over in Asia we've also been doing a few stories 0:01:59.520 --> 0:02:02.880 on it well, and it turns out there's quite a 0:02:02.920 --> 0:02:05.560 lot that's been happening with these right. So for those 0:02:05.560 --> 0:02:10.160 who do remember, in January, we recorded an episode about 0:02:10.240 --> 0:02:15.120 these Korean structured products popular with retail investors that we're 0:02:15.160 --> 0:02:19.040 sort of premised on a there essentially, the payout was 0:02:19.080 --> 0:02:23.680 premised on a massive stock market crash not happening, and 0:02:23.840 --> 0:02:26.840 as everybody knows, we've gotten this market crash, and so 0:02:26.960 --> 0:02:29.320 everybody has been saying, what's going on with those career 0:02:29.320 --> 0:02:31.240 structured products when you're going to do a follow up? 0:02:31.600 --> 0:02:34.120 So today we're going to do a follow up. Great, 0:02:34.360 --> 0:02:37.360 I can't wait. Okay, So we are are guests back 0:02:37.400 --> 0:02:40.320 in January is the same guest we have today to 0:02:40.760 --> 0:02:43.880 do Part two is Ben Effort. He's the c i 0:02:43.960 --> 0:02:49.840 O and founder of qv R Advisors. Uh Ben, how 0:02:49.840 --> 0:02:52.880 are you doing so, Tracy? Hey, I'm doing well. Thanks. 0:02:52.919 --> 0:02:57.120 It's it's great to be back. So I'll preface this 0:02:57.200 --> 0:02:59.959 by saying that I think anyone listening to this episode 0:03:00.400 --> 0:03:03.920 should go back and listen to the first interview that 0:03:03.960 --> 0:03:06.680 we did with you back in the middle of January, 0:03:06.720 --> 0:03:09.560 so that we don't have to do a complete refresher 0:03:09.800 --> 0:03:13.840 of the Korean structured products. But well, we just sort 0:03:13.840 --> 0:03:17.640 of give us the sort of the short version of 0:03:17.840 --> 0:03:22.440 the instruments that we were discussing and how their payout 0:03:22.639 --> 0:03:28.840 was linked to essentially stability in the market. Sure. So 0:03:28.919 --> 0:03:32.120 the very brief recap is, you know, there are large 0:03:32.160 --> 0:03:36.560 global structured product businesses targeted primarily at retail and high 0:03:36.640 --> 0:03:40.280 net worth investors around the world, but very large in 0:03:40.680 --> 0:03:44.240 Korea in particular, also Japan to a somewhat lesser extent now, 0:03:44.840 --> 0:03:48.920 and the most popular types of products in the recent 0:03:48.960 --> 0:03:51.400 market environment that we've had for the last decade or 0:03:51.400 --> 0:03:55.200 so where interest rates are very low are essentially what 0:03:55.280 --> 0:04:00.760 are called reverse convertible autocollable notes, which is a lot words, 0:04:00.800 --> 0:04:04.720 but the idea is effectively, you know, the retail investors 0:04:04.800 --> 0:04:08.480 looking to generate a coupon, so a fixed income out 0:04:08.480 --> 0:04:11.280 of the equity market, and the way that you do 0:04:11.360 --> 0:04:15.320 that in this environment is you sell some kind of optionality, right, 0:04:15.360 --> 0:04:18.839 and so these notes typically the way they work is 0:04:18.880 --> 0:04:21.520 that the investor might get let's say a five percent 0:04:21.640 --> 0:04:26.600 or a seven percent annual coupon unless or until one 0:04:26.800 --> 0:04:29.080 or more of what you know, at least one of 0:04:29.120 --> 0:04:31.680 the underlying equity indices that the note is linked to 0:04:32.480 --> 0:04:36.920 is down by let's say thirty percent or at some 0:04:37.000 --> 0:04:40.320 point during the life of the note, and in that eventuality, 0:04:40.360 --> 0:04:42.400 at the point where that happens, the note is is 0:04:42.440 --> 0:04:46.200 triggered into a knockout state and the investor loses that say, 0:04:46.240 --> 0:04:49.839 thirty or of their investments. So the investor puts in 0:04:49.839 --> 0:04:52.159 a hundred dollars, they're going to get a hundred and 0:04:52.200 --> 0:04:55.640 seven back unless the markets down. But if the market 0:04:55.720 --> 0:04:58.520 at some point is down, let's say in one in 0:04:58.640 --> 0:05:00.440 let's call it the euro stocks or the knee K 0:05:00.920 --> 0:05:03.760 or the SMPH, then the investor is actually just going 0:05:03.839 --> 0:05:06.560 to take a forty percent loss at that point, and 0:05:06.600 --> 0:05:09.400 that will be crystallized, and then they'll have other features. 0:05:09.440 --> 0:05:12.279 Often they'll be callable on a on you know, a 0:05:12.360 --> 0:05:14.960 year out, so for example, if the underlying equity market 0:05:15.040 --> 0:05:18.080 is up, they'll just get their coupon, and then then 0:05:18.120 --> 0:05:20.839 note will be terminated early and probably reissued and maybe 0:05:20.839 --> 0:05:23.280 they'll do the same trade again. And so usually these 0:05:23.320 --> 0:05:26.840 notes are linked, especially these days, you know, more recently, 0:05:26.920 --> 0:05:29.719 with you know, low interest rates and low levels of 0:05:29.760 --> 0:05:33.839 equity volatility. You know, they embed all sorts of exciting optionality, 0:05:33.960 --> 0:05:36.200 like as I alluded to, being linked not just to 0:05:36.320 --> 0:05:39.159 one equity index, but like the worst performing of a 0:05:39.240 --> 0:05:42.799 basket of four or five equity industries for example. So 0:05:43.200 --> 0:05:47.200 we're talking about those knockout levels, those barrier levels, whatever 0:05:47.240 --> 0:05:49.440 you want to call them. And with the market sell 0:05:49.480 --> 0:05:53.080 off that we've just seen, it would seem that some 0:05:53.160 --> 0:05:56.520 of those have hit the point at which investors will 0:05:56.640 --> 0:06:02.600 be experiencing losses to their principal. Walk us through what 0:06:02.640 --> 0:06:05.000 you've seen in the market, give us some color how 0:06:05.080 --> 0:06:08.560 many of the structured products you know, roughly are really 0:06:08.640 --> 0:06:11.799 hitting those knockout levels at the moment. Yeah, So there's 0:06:11.920 --> 0:06:15.039 you know, there's a large stock of of these types 0:06:15.040 --> 0:06:18.040 of products globally that you know turns over over some 0:06:18.120 --> 0:06:22.480 period of time. The and you have your banks do 0:06:22.520 --> 0:06:26.039 a good job of aggregating and publishing you know, models 0:06:26.120 --> 0:06:29.400 of what the overall space looks like. So we've seen 0:06:29.520 --> 0:06:32.760 you know, a quick and quite large drawdout and inequity 0:06:32.800 --> 0:06:35.479 markets globally. Now we're a bit off of the you know, 0:06:35.560 --> 0:06:37.920 off of the lows, but the lows where let's call it, 0:06:38.320 --> 0:06:41.200 you know, thirty plus percent down from from the highs 0:06:41.200 --> 0:06:44.240 and the inequity markets. So you did see, um, you know, 0:06:44.360 --> 0:06:47.479 globally quite a lot a large stock of these notes 0:06:47.520 --> 0:06:52.560 you know, approaching those barriers where where the trigger a 0:06:52.680 --> 0:06:55.160 termination of the notes you did see you know some 0:06:55.640 --> 0:06:59.120 you know, non trivial percentage of the outstanding stock of 0:06:59.240 --> 0:07:03.640 notes you know terminate mostly not actually with respect to 0:07:03.720 --> 0:07:07.200 the SMP levels and the barriers more more on the 0:07:07.520 --> 0:07:10.760 eurostocks and some Asian industries, if you're called. So the 0:07:10.840 --> 0:07:13.440 SMP has been down quite a lot, but also the 0:07:13.600 --> 0:07:17.400 SMP in the you know, call it thirty five percent 0:07:17.520 --> 0:07:20.400 from the highs at you know a few about a 0:07:20.440 --> 0:07:22.800 couple of weeks ago. But remember the SMP had rallied 0:07:22.880 --> 0:07:25.880 very aggressively up to the highs from you know, late 0:07:26.440 --> 0:07:30.240 nineteen and the and these notes aren't linked like to 0:07:30.320 --> 0:07:32.120 the high point in the equity market. They're linked to 0:07:32.160 --> 0:07:34.320 the point at which they were issued, right, And so 0:07:34.360 --> 0:07:37.040 the smp IS is still a little bit off of 0:07:37.040 --> 0:07:39.600 off of you know, the levels of where some of 0:07:39.640 --> 0:07:42.200 the SMP barriers are. But yeah, we've seen call it 0:07:42.320 --> 0:07:46.040 some you know, low double digits percentage probably of the 0:07:46.080 --> 0:07:49.000 note stock actually knockout. And then you know, a large 0:07:49.040 --> 0:07:52.920 part of the notes stock obviously need on a probabilistic basis, 0:07:52.960 --> 0:07:57.200 become much closer to a knockout point. And as a result, 0:07:57.240 --> 0:07:59.040 of course, the investors who owned those notes, if they 0:07:59.040 --> 0:08:01.280 were to look at their stay months, uh, you know, 0:08:01.320 --> 0:08:04.080 would see a large market market loss. And of course 0:08:04.160 --> 0:08:07.520 the the risk managers you know, who managed structured product 0:08:07.520 --> 0:08:11.760 portfolios and headed them at banks face the issue that 0:08:12.240 --> 0:08:16.560 many of those notes either have terminated, therefore losing their hedging, 0:08:17.040 --> 0:08:20.840 losing their long volatility characteristics from the bank's perspective, or 0:08:20.920 --> 0:08:26.160 are nearing termination, which you know probabilistically reduces the volatility 0:08:26.200 --> 0:08:29.040 component there. So you know, large draw out in that market. 0:08:29.600 --> 0:08:33.240 So let's talk about the sort of risk management from 0:08:33.600 --> 0:08:37.800 the bank's perspective, And again people should go back and 0:08:37.840 --> 0:08:41.040 listen to the original episode because we've got a lot 0:08:41.080 --> 0:08:44.720 in the weed about how the hedging consideration of the 0:08:44.760 --> 0:08:49.200 banks changes. But as the note gets closer to the 0:08:49.240 --> 0:08:52.520 knockout or the barrier, but talk to us about sort 0:08:52.520 --> 0:08:55.240 of like what we've seen. So we've seen volatility absolutely 0:08:55.280 --> 0:08:57.640 exploding the last few weeks. It's come down a little 0:08:57.640 --> 0:09:00.920 bit lately, but it's still very elevating. Did the S 0:09:01.000 --> 0:09:03.640 and P even if it hasn't crashed as much as 0:09:03.679 --> 0:09:07.200 some indusicries, is still down quite a bit? How much 0:09:07.280 --> 0:09:10.680 does how much of a problem does this pose for 0:09:10.800 --> 0:09:13.720 the banks that have to hedge their exposure so they 0:09:13.760 --> 0:09:15.880 can either so that they're not on the hook and 0:09:15.920 --> 0:09:21.000 what have they been doing to uh to manage their risk? Yeah, absolutely, 0:09:21.040 --> 0:09:24.560 So we'll give their just really fast risk recap of 0:09:24.600 --> 0:09:26.520 the nature of this risk and then put it in 0:09:26.559 --> 0:09:29.480 the context of everything else that's going on. You know, 0:09:29.520 --> 0:09:33.800 these notes have a barrier option characteristic to them if 0:09:33.800 --> 0:09:37.720 you kind of no derivative speak. Essentially, the retail investors 0:09:37.720 --> 0:09:40.760 are selling what are called down and in knock inputs 0:09:41.280 --> 0:09:44.240 in other words, they're a put option that really only 0:09:44.600 --> 0:09:47.760 that's binary in the sense that it only matters if 0:09:47.760 --> 0:09:50.920 you actually hit the barrier, and then it just triggers 0:09:50.920 --> 0:09:54.600 a binary event, right, And so the you know, when 0:09:54.720 --> 0:09:59.400 banks issue these products, typically the first proxy hedge of 0:09:59.440 --> 0:10:02.320 the risk going to be that they sell some fairly 0:10:02.360 --> 0:10:04.480 deep out of the money, call it out of the 0:10:04.520 --> 0:10:06.800 money two or three year puts on the on the 0:10:06.880 --> 0:10:09.360 underlying indices, and that will be kind of just the 0:10:09.440 --> 0:10:13.000 first order proxy heads for the type of risk that 0:10:13.040 --> 0:10:16.319 they have. Now, as the markets start to go down, 0:10:17.559 --> 0:10:21.360 the combined hdged portfolio that a structured products book has 0:10:22.040 --> 0:10:25.920 will actually start to get somewhat longer volatility from the 0:10:25.960 --> 0:10:30.080 bank's perspective. And the reason for that gives you know, 0:10:30.200 --> 0:10:34.040 barrier options are tricky. They have they have in some 0:10:34.160 --> 0:10:39.240 sense they have a much more pronounced profile of volatility 0:10:39.240 --> 0:10:43.000 exposure to the downside than any vanilla option does. And 0:10:43.120 --> 0:10:47.439 so the vanilla options that the banks sell in some 0:10:47.520 --> 0:10:50.679 sense the convexity that the banks have is that they 0:10:50.720 --> 0:10:54.080 get longer volatility for some call it the first ten 0:10:54.160 --> 0:10:56.960 or fiftent of the move on the way down. But 0:10:57.120 --> 0:10:59.720 then as those as the market keeps falling and keeps 0:10:59.720 --> 0:11:02.719 falling down towards those barriers. Then the net position that 0:11:02.800 --> 0:11:06.720 the banks have suddenly gets shorter, very fast, and then 0:11:06.800 --> 0:11:10.120 collapses when as as you hit the notes, as you 0:11:10.200 --> 0:11:12.880 hit those trigger values, the reason being, you know, the 0:11:13.280 --> 0:11:16.520 notes themselves actually just terminate, right, and so all volatility 0:11:16.520 --> 0:11:19.240 exposure associated with the notes are gone. But the hedge 0:11:19.320 --> 0:11:21.880 was a vanilla option which still exists and still has 0:11:22.040 --> 0:11:25.360 you know, short volatility exposure from the bank's perspective. And 0:11:25.440 --> 0:11:28.880 so we're very much in that environment where where the 0:11:28.920 --> 0:11:32.920 banks have you know, have started to see you know, 0:11:33.280 --> 0:11:36.640 their hedges, you know, the volati of the vegua exposure, 0:11:36.679 --> 0:11:39.760 the volatility on exposure on their hedges now kind of 0:11:39.800 --> 0:11:42.360 falling as the market goes down much slower than than 0:11:42.400 --> 0:11:46.000 their long exposure is falling um and you know, the 0:11:46.120 --> 0:11:49.760 rally alleviated that somewhat. But you do have to put 0:11:49.800 --> 0:11:53.520 that in the broader context of of everything else that's 0:11:53.559 --> 0:11:57.920 happening in the world, in in equity, derivatives, portfolios and banks, 0:11:58.280 --> 0:12:01.360 you know, and there's and there's you know, have some 0:12:01.440 --> 0:12:03.760 insight here. Again, every bank of course is different and 0:12:03.960 --> 0:12:07.840 has different clan flows and so forth. But um, this 0:12:08.240 --> 0:12:12.080 the key thing to understand is that this crisis has 0:12:12.200 --> 0:12:16.560 developed and the equity market experienced a large draw down 0:12:16.880 --> 0:12:20.480 at an extremely fast pace. Right. So the credit crisis, 0:12:20.520 --> 0:12:25.560 of course, was you know, a a materially deeper market 0:12:25.640 --> 0:12:29.520 crisis across a variety of markets, uh, you know, in hindsight, 0:12:29.600 --> 0:12:32.760 relative to what we've seen so far. But it also 0:12:32.920 --> 0:12:36.120 was a relatively slow building crisis that took a while 0:12:36.200 --> 0:12:39.120 to manifest, where there were you know, many large legs 0:12:39.160 --> 0:12:42.120 down and in asset values over a sustained period of time, 0:12:43.160 --> 0:12:46.440 right whereas here we saw um just to truly up 0:12:46.440 --> 0:12:48.240 excel off over the course of you know, three or 0:12:48.240 --> 0:12:53.640 four weeks. And so in the broader risk portfolios of banks, 0:12:54.440 --> 0:12:58.080 you know, contrary to maybe what some folks might expect 0:12:59.120 --> 0:13:02.440 derivatives portfoli, it was a banks have generally done very 0:13:02.440 --> 0:13:05.360 well in this environment, and you know, they have not 0:13:05.440 --> 0:13:09.200 been exposed to large losses across there, across their business lines. 0:13:10.000 --> 0:13:13.240 And the reason for that is really the you know, 0:13:14.559 --> 0:13:17.480 the banking industry and investment banks are very different in 0:13:17.559 --> 0:13:22.439 a Dodd Frank world than they were back in two 0:13:22.480 --> 0:13:25.120 thousand and eight. In two thousand and eight, you know, 0:13:25.200 --> 0:13:29.600 bank in bank prop desks and bank flow book flow 0:13:29.600 --> 0:13:32.520 trading books were some of the largest risk takers in 0:13:32.559 --> 0:13:36.000 the world. They held some of the largest tail risk 0:13:36.080 --> 0:13:38.600 in the world across you know, and they were you know, 0:13:38.640 --> 0:13:40.960 they were they were the world's largest hedge funds, and 0:13:41.040 --> 0:13:43.360 they were holding you know, carry trades, and they were 0:13:43.400 --> 0:13:46.600 holding aggressive risk taking positions that lost the massive amounts 0:13:46.640 --> 0:13:49.280 of money. What we you know, what we did with 0:13:49.360 --> 0:13:53.120 Dodd Frank and steadily implemented you know, over the years, 0:13:53.200 --> 0:13:57.560 and especially combined with Basil three, we dramatically de risked 0:13:57.640 --> 0:14:02.320 the banks. We enforced dreamly type stress testing requirements on 0:14:02.400 --> 0:14:06.480 the banks with very you know, proper careful stress testing analytics, 0:14:07.520 --> 0:14:11.280 and we identified sources of tail risk in bank derivatives 0:14:11.280 --> 0:14:15.480 portfolios and told them to get rid of it. And 0:14:15.760 --> 0:14:19.360 banks have been very aggressive over the last five years 0:14:19.960 --> 0:14:24.080 developing what we call what the banks called, you know, euphemistically, 0:14:24.160 --> 0:14:28.120 alternative risk transfer programs, where they very explicitly had dedicated 0:14:28.160 --> 0:14:30.880 salespeople to go out and you know, nice slide decks 0:14:30.920 --> 0:14:32.880 going out to hedge funds and going out to asset 0:14:32.880 --> 0:14:37.120 managers and um proposing trades that those hedge funds and 0:14:37.200 --> 0:14:39.960 st managers would do you know that was associated with 0:14:40.000 --> 0:14:44.280 potentially some positive carry uh, you know, so the idea 0:14:44.400 --> 0:14:46.680 was banks shouldn't be holding this stuff, and banks were 0:14:46.760 --> 0:14:49.560 very well hedged um facing a lot of hedge funds 0:14:49.560 --> 0:14:51.560 and asset managers that have lost a tremendous amount of 0:14:51.560 --> 0:14:54.320 money during this crisis. So really those big you know, 0:14:54.440 --> 0:14:58.160 the big losses um in derivatives portfolios were on the 0:14:58.200 --> 0:15:01.320 buy side, not the south side this time, and partly 0:15:01.360 --> 0:15:04.200 as a result of how fast everything happened, you know, 0:15:04.240 --> 0:15:07.040 the on that initial shock, the banks were actually pretty 0:15:07.080 --> 0:15:09.840 well covered, even though they are auto called portfolios. We're 0:15:09.840 --> 0:15:27.840 getting pretty risky. So banks, having de risked from post 0:15:27.960 --> 0:15:32.960 financial crisis rules, are relatively well insulated from the volatility 0:15:32.960 --> 0:15:35.560 and the market sell off that we've seen. But as 0:15:35.680 --> 0:15:37.840 you point out, a lot of that tail risk has 0:15:37.840 --> 0:15:41.120 been pushed onto the bye side, onto hedge funds, other 0:15:41.200 --> 0:15:45.000 types of investors. Talk to us more about the alternative 0:15:45.320 --> 0:15:49.440 risk transfer trades. How do those actually work? And what 0:15:49.560 --> 0:15:52.480 are you observing now? Are we seeing some blow ups 0:15:52.480 --> 0:15:56.040 in those? Sure? So I'll give you a couple of examples. 0:15:57.200 --> 0:16:00.280 So and these, you know, these get a bit um 0:16:00.360 --> 0:16:02.760 a bit wonky as is as is just the nature 0:16:02.800 --> 0:16:05.600 of the business. But I'll do my best there so 0:16:06.600 --> 0:16:11.240 um so. For example, historically there have been some large 0:16:11.440 --> 0:16:17.440 sophisticated organizations that have liked to sell capped variance as 0:16:17.440 --> 0:16:22.000 a carry trade. UM. The the what there so A 0:16:22.080 --> 0:16:28.200 variant swap is a pure volatility position which pays off 0:16:28.320 --> 0:16:32.080 the difference between implied variants and realized variants over the 0:16:32.120 --> 0:16:36.000 maturity of the trade, and variance being the square of volatility. 0:16:36.120 --> 0:16:38.720 And anytime you have squared terms in you know, the 0:16:38.720 --> 0:16:41.280 p and l of something, it gets very exciting, right, 0:16:41.720 --> 0:16:44.320 So the reason that they now want a capt varian 0:16:44.360 --> 0:16:47.360 swap is um. A cap variant swap is one where 0:16:47.360 --> 0:16:50.080 you if you are said carry trade or you sell 0:16:50.120 --> 0:16:53.600 that variant swap um, but you sell its subject to 0:16:53.760 --> 0:16:57.400 a cap of two and a half times the actual 0:16:57.520 --> 0:17:01.240 level that you trade, where the most realized volatility that 0:17:01.280 --> 0:17:03.680 can possibly count in the payoff of the trade is 0:17:03.720 --> 0:17:05.760 two and a half times the initial level you sold, 0:17:06.280 --> 0:17:08.119 which is still quite high, but it gives you a 0:17:08.240 --> 0:17:11.840 finite stop loss where there is a maximum dollar amount 0:17:11.880 --> 0:17:13.199 you can lose on that trade. And you know what 0:17:13.240 --> 0:17:16.040 that number it is, right, you know? So this was 0:17:16.440 --> 0:17:18.520 if you're going to be selling variants, this is at 0:17:18.600 --> 0:17:21.920 least some somewhat of a prudent step, right. And the 0:17:21.920 --> 0:17:24.840 the type of organizations that were you know, engaged in 0:17:24.840 --> 0:17:30.600 this um you know, we're extremely large sophisticated peension funds 0:17:30.600 --> 0:17:32.840 that you know, I'm not going to get into details, 0:17:32.880 --> 0:17:35.640 but the size of those flows were quite large. Now, 0:17:36.040 --> 0:17:39.520 when banks facilitate that business, right, banks are buying capped 0:17:39.560 --> 0:17:44.320 variant swaps from these clients, and there's not really there's 0:17:44.359 --> 0:17:48.160 not a liquid inter dealer market for capped variance swaps 0:17:48.200 --> 0:17:50.520 because every you know, the caps on the variant swaps 0:17:50.520 --> 0:17:52.840 are like options on variants, and every one of them 0:17:52.880 --> 0:17:54.639 are at a different level, right, because it's two and 0:17:54.640 --> 0:17:57.800 a half times the initial you know level where the 0:17:57.800 --> 0:18:01.119 market is trading variants UM. So these are you know, 0:18:01.200 --> 0:18:04.800 somewhat funny products. So when a bank actually buys capped 0:18:04.880 --> 0:18:06.760 variants from a client and then it goes to lay 0:18:06.800 --> 0:18:08.360 off the risk, what it's going to do is it's 0:18:08.359 --> 0:18:11.080 going to sell uncapped variants in the inter dealer market 0:18:11.359 --> 0:18:14.320 or to another hedgephund. And what the bank is left 0:18:14.359 --> 0:18:18.280 with when it does that trade is a long position 0:18:18.359 --> 0:18:21.160 in capped variants and a short position and uncapped variants, 0:18:21.680 --> 0:18:26.360 which itself is just the bank being short a massively 0:18:26.440 --> 0:18:29.000 crashy piece of tail risk, right, which is just this 0:18:29.160 --> 0:18:32.080 cap so effectively, it's a call option on variants struck 0:18:32.119 --> 0:18:33.919 at you know, two and a half times the initial 0:18:34.000 --> 0:18:37.159 level of variance. And that is exactly the kind of 0:18:37.160 --> 0:18:39.159 position that you know, in two thousand and seven, the 0:18:39.160 --> 0:18:41.680 bank would have just done that and said, hey, we're 0:18:41.720 --> 0:18:43.720 just gonna, you know, keep those and we're going to 0:18:43.800 --> 0:18:45.760 get paid a lot of money and carry to keep 0:18:45.760 --> 0:18:48.240 those because and we like getting rich and getting bonuses 0:18:48.280 --> 0:18:52.639 and that's cool, um in you know, these days, the 0:18:52.680 --> 0:18:54.920 banks cannot hang onto that kind of thing because you 0:18:55.000 --> 0:18:57.080 run a proper stress test and you immediately see that 0:18:57.119 --> 0:18:59.879 if the market goes down and it's very volatile, that 0:19:00.000 --> 0:19:03.360 are going to lose an ungodly amount of money. And 0:19:03.440 --> 0:19:07.160 so what one of the earlier risk transfer trains within 0:19:07.200 --> 0:19:10.760 this alternative risk transfer universe was the bank's going out 0:19:10.800 --> 0:19:13.040 to hedge funds and esset managers and trying to find 0:19:13.080 --> 0:19:17.080 people to take exactly that position, so they would would 0:19:17.160 --> 0:19:21.840 trade you know, short term one month capped variants versus 0:19:21.920 --> 0:19:24.919 uncapped variants where the hedge funds sells the uncapped and 0:19:24.960 --> 0:19:29.480 buys the capped, and that trade and and and pockets 0:19:30.080 --> 0:19:33.600 the difference between those two variance levels, which might be 0:19:34.320 --> 0:19:36.359 you know, five years ago when this started, it might 0:19:36.400 --> 0:19:38.280 have been of all point. So it might have been 0:19:38.359 --> 0:19:41.280 you know, variant uncapped variants at sixteen and buying capped 0:19:41.320 --> 0:19:44.439 variants at fifteen. Uh, you know, by last year this 0:19:44.520 --> 0:19:48.200 is you know, very popular among hedge fund carriage traders, 0:19:48.200 --> 0:19:50.320 and it might have only been point for of all 0:19:50.359 --> 0:19:53.040 points for example. And this is the kind of trade 0:19:53.040 --> 0:19:57.440 that again, you just make money every month as long 0:19:57.480 --> 0:20:00.919 as volatility does not rise I'm more than two and 0:20:00.920 --> 0:20:04.960 a half times within the course of one month. Right. 0:20:05.040 --> 0:20:08.320 And if you look back historically, as long as you 0:20:08.359 --> 0:20:13.400 don't include, what to say is oh we'll look boss um. 0:20:13.440 --> 0:20:16.280 Even in the credit crisis, these trades didn't lose money 0:20:16.320 --> 0:20:19.960 because volatility increased a lot, and it increased you know, 0:20:20.040 --> 0:20:22.960 ten times over the course of you know, several months. 0:20:23.000 --> 0:20:25.680 But during no month did it rise more than two 0:20:25.680 --> 0:20:27.760 and a half times. Look at only you know during 0:20:27.800 --> 0:20:31.280 Lament it only rose two point four times, right, So 0:20:31.600 --> 0:20:35.440 this is what they call back test over optimization right, 0:20:36.080 --> 0:20:38.600 because you know it could have certainly just risen four 0:20:38.640 --> 0:20:41.320 times on Lehman instead of two point four times. Um, 0:20:41.359 --> 0:20:44.240 it just didn't. And this time, of course, it rose 0:20:44.720 --> 0:20:48.480 by a factor of closer to eight. And so if 0:20:48.520 --> 0:20:50.480 you so, if you were to do this trade again, 0:20:50.480 --> 0:20:52.479 that the p m l is is proportional to the 0:20:52.520 --> 0:20:56.560 square of the increase in volatility. Right, So in March, 0:20:56.800 --> 0:20:59.679 if you had sold the February you know cap uncap 0:20:59.720 --> 0:21:03.560 trade as a hedge fund engaging in alternative risk transfer, 0:21:04.400 --> 0:21:07.640 you collected you know, point four points and you ended 0:21:07.680 --> 0:21:12.240 up losing let's call it two d and fifty and 0:21:12.760 --> 0:21:16.560 the you know that, so those positions alone were enough 0:21:16.680 --> 0:21:20.119 to you know, wipe out the whole portfolio managers and 0:21:20.160 --> 0:21:24.320 hedge funds. And there, you know, that's one example, and 0:21:24.359 --> 0:21:26.160 I went into a decent amount of detail just because 0:21:26.160 --> 0:21:28.760 I wanted to make that clear. But there are there are, 0:21:29.080 --> 0:21:31.440 you know, a dozen things like that, or twenty things 0:21:31.520 --> 0:21:35.520 like that, some longer dated and more related to different 0:21:35.600 --> 0:21:39.199 kinds of you know, esoteric implied risk factors, some that 0:21:39.240 --> 0:21:41.680 are more, but a lot of them related to gap risk, 0:21:41.840 --> 0:21:45.639 to kind of the sudden appearance of very high levels 0:21:45.680 --> 0:21:49.080 of realized volatility, and that's what you know, that's what 0:21:49.280 --> 0:21:52.800 many um many folks were you know, happily engaged in 0:21:52.920 --> 0:21:56.080 because it produced, you know, just a very consistent return 0:21:56.119 --> 0:21:58.479 stream that you know, made a lot of people very 0:21:58.560 --> 0:22:03.000 rich for many years. So it's really just this extraordinary 0:22:03.040 --> 0:22:07.479 suddenness of the crash. It's not just that we had 0:22:07.520 --> 0:22:10.280 a crash. It's not just that we've had extraordinary volatility, 0:22:10.359 --> 0:22:12.840 but it's the speed of the volatility in such a 0:22:12.840 --> 0:22:16.760 short period of time that's been it's obliterated so many positions. 0:22:17.080 --> 0:22:21.119 I'm curious, sort of this might be a silly question, 0:22:21.200 --> 0:22:23.560 but you know, when we're talking about all these products, 0:22:23.560 --> 0:22:27.359 whether it's just the products sold to the retail the 0:22:27.400 --> 0:22:31.560 retail client maybe in Korea, or some of these more 0:22:32.119 --> 0:22:34.760 esoteric products that are sold by the dealers to the 0:22:34.800 --> 0:22:37.560 hedge funds or in the inter dealer market, what is 0:22:37.880 --> 0:22:40.800 the how do you track these because it doesn't seem 0:22:40.800 --> 0:22:43.040 like there's some like obvious like quote you just look 0:22:43.119 --> 0:22:45.240 up and see where they're pricing. So when you're trying 0:22:45.240 --> 0:22:47.600 to get a sense of where the overall market is, 0:22:47.720 --> 0:22:49.760 or even like a sense of where the state of 0:22:49.840 --> 0:22:52.600 Korean structured note markets or how many of them have 0:22:52.720 --> 0:22:55.359 been uh, you know knocked in. How do you like 0:22:55.440 --> 0:22:58.000 sort of get your hand around the size of this 0:22:58.200 --> 0:23:01.480 universe and the state of this universe. Sure, so let's 0:23:01.480 --> 0:23:04.560 start with the Korean autocoll market for example. So this 0:23:04.640 --> 0:23:07.280 is the kind of thing where you know, many of 0:23:07.320 --> 0:23:11.480 the large banks are heavily involved in this business. They 0:23:11.520 --> 0:23:14.520 most of them have very detailed research reports that they 0:23:14.560 --> 0:23:17.520