Speaker 1: Hello, and welcome to another episode of the Odd Lots Podcast.
Speaker 1: I'm Joe and I'm Tracy Allaway. Tracy, so you know
Speaker 1: what a sort of depressing phenomenon has been lately. You're
Speaker 1: going to have to narrow that down. Job. Yeah, right there,
Speaker 1: that's that's a very broad category, very micro depressing phenomenon.
Speaker 1: Is that a lot of our recent episodes that we've done,
Speaker 1: which we sort of discussed in a very theoretical sense,
Speaker 1: have unfortunately started to become relevant extremely quickly. Yeah, you're
Speaker 1: absolutely right. One of the ones that springs to mind
Speaker 1: is the one we did with Claudia Psalm back in
Speaker 1: I think it was January or February about actually giving
Speaker 1: people money as a form of econo stimulus in order
Speaker 1: to stave offer session. And now we're sort of seeing
Speaker 1: that actually happen in the US, although obviously there are
Speaker 1: issues in a wider debate about the way that's currently
Speaker 1: being done. Yeah. Absolutely, another one, And I would say
Speaker 1: this episode that we're going to do even more than
Speaker 1: any other. On Twitter, several times a week people ask
Speaker 1: for updates of it. So there's one in particular where
Speaker 1: I'm always getting tweets. It's like, hey, what's going on
Speaker 1: with what you talked about that one episode I'm curious
Speaker 1: about you sort of have been getting the same one, Yeah,
Speaker 1: I absolutely have. I know exactly what episode you were
Speaker 1: talking about, and it was a really good one. It's
Speaker 1: Korean structured products. And not only have I been getting
Speaker 1: the same tweets with the same questions and people asking
Speaker 1: for a general update and what's going on with the
Speaker 1: structured products as well as the overall options market, but
Speaker 1: over in Asia we've also been doing a few stories
Speaker 1: on it well, and it turns out there's quite a
Speaker 1: lot that's been happening with these right. So for those
Speaker 1: who do remember, in January, we recorded an episode about
Speaker 1: these Korean structured products popular with retail investors that we're
Speaker 1: sort of premised on a there essentially, the payout was
Speaker 1: premised on a massive stock market crash not happening, and
Speaker 1: as everybody knows, we've gotten this market crash, and so
Speaker 1: everybody has been saying, what's going on with those career
Speaker 1: structured products when you're going to do a follow up?
Speaker 1: So today we're going to do a follow up. Great,
Speaker 1: I can't wait. Okay, So we are are guests back
Speaker 1: in January is the same guest we have today to
Speaker 1: do Part two is Ben Effort. He's the c i
Speaker 1: O and founder of qv R Advisors. Uh Ben, how
Speaker 1: are you doing so, Tracy? Hey, I'm doing well. Thanks.
Speaker 1: It's it's great to be back. So I'll preface this
Speaker 1: by saying that I think anyone listening to this episode
Speaker 1: should go back and listen to the first interview that
Speaker 1: we did with you back in the middle of January,
Speaker 1: so that we don't have to do a complete refresher
Speaker 1: of the Korean structured products. But well, we just sort
Speaker 1: of give us the sort of the short version of
Speaker 1: the instruments that we were discussing and how their payout
Speaker 1: was linked to essentially stability in the market. Sure. So
Speaker 1: the very brief recap is, you know, there are large
Speaker 1: global structured product businesses targeted primarily at retail and high
Speaker 1: net worth investors around the world, but very large in
Speaker 1: Korea in particular, also Japan to a somewhat lesser extent now,
Speaker 1: and the most popular types of products in the recent
Speaker 1: market environment that we've had for the last decade or
Speaker 1: so where interest rates are very low are essentially what
Speaker 1: are called reverse convertible autocollable notes, which is a lot words,
Speaker 1: but the idea is effectively, you know, the retail investors
Speaker 1: looking to generate a coupon, so a fixed income out
Speaker 1: of the equity market, and the way that you do
Speaker 1: that in this environment is you sell some kind of optionality, right,
Speaker 1: and so these notes typically the way they work is
Speaker 1: that the investor might get let's say a five percent
Speaker 1: or a seven percent annual coupon unless or until one
Speaker 1: or more of what you know, at least one of
Speaker 1: the underlying equity indices that the note is linked to
Speaker 1: is down by let's say thirty percent or at some
Speaker 1: point during the life of the note, and in that eventuality,
Speaker 1: at the point where that happens, the note is is
Speaker 1: triggered into a knockout state and the investor loses that say,
Speaker 1: thirty or of their investments. So the investor puts in
Speaker 1: a hundred dollars, they're going to get a hundred and
Speaker 1: seven back unless the markets down. But if the market
Speaker 1: at some point is down, let's say in one in
Speaker 1: let's call it the euro stocks or the knee K
Speaker 1: or the SMPH, then the investor is actually just going
Speaker 1: to take a forty percent loss at that point, and
Speaker 1: that will be crystallized, and then they'll have other features.
Speaker 1: Often they'll be callable on a on you know, a
Speaker 1: year out, so for example, if the underlying equity market
Speaker 1: is up, they'll just get their coupon, and then then
Speaker 1: note will be terminated early and probably reissued and maybe
Speaker 1: they'll do the same trade again. And so usually these
Speaker 1: notes are linked, especially these days, you know, more recently,
Speaker 1: with you know, low interest rates and low levels of
Speaker 1: equity volatility. You know, they embed all sorts of exciting optionality,
Speaker 1: like as I alluded to, being linked not just to
Speaker 1: one equity index, but like the worst performing of a
Speaker 1: basket of four or five equity industries for example. So
Speaker 1: we're talking about those knockout levels, those barrier levels, whatever
Speaker 1: you want to call them. And with the market sell
Speaker 1: off that we've just seen, it would seem that some
Speaker 1: of those have hit the point at which investors will
Speaker 1: be experiencing losses to their principal. Walk us through what
Speaker 1: you've seen in the market, give us some color how
Speaker 1: many of the structured products you know, roughly are really
Speaker 1: hitting those knockout levels at the moment. Yeah, So there's
Speaker 1: you know, there's a large stock of of these types
Speaker 1: of products globally that you know turns over over some
Speaker 1: period of time. The and you have your banks do
Speaker 1: a good job of aggregating and publishing you know, models
Speaker 1: of what the overall space looks like. So we've seen
Speaker 1: you know, a quick and quite large drawdout and inequity
Speaker 1: markets globally. Now we're a bit off of the you know,
Speaker 1: off of the lows, but the lows where let's call it,
Speaker 1: you know, thirty plus percent down from from the highs
Speaker 1: and the inequity markets. So you did see, um, you know,
Speaker 1: globally quite a lot a large stock of these notes
Speaker 1: you know, approaching those barriers where where the trigger a
Speaker 1: termination of the notes you did see you know some
Speaker 1: you know, non trivial percentage of the outstanding stock of
Speaker 1: notes you know terminate mostly not actually with respect to
Speaker 1: the SMP levels and the barriers more more on the
Speaker 1: eurostocks and some Asian industries, if you're called. So the
Speaker 1: SMP has been down quite a lot, but also the
Speaker 1: SMP in the you know, call it thirty five percent
Speaker 1: from the highs at you know a few about a
Speaker 1: couple of weeks ago. But remember the SMP had rallied
Speaker 1: very aggressively up to the highs from you know, late
Speaker 1: nineteen and the and these notes aren't linked like to
Speaker 1: the high point in the equity market. They're linked to
Speaker 1: the point at which they were issued, right, And so
Speaker 1: the smp IS is still a little bit off of
Speaker 1: off of you know, the levels of where some of
Speaker 1: the SMP barriers are. But yeah, we've seen call it
Speaker 1: some you know, low double digits percentage probably of the
Speaker 1: note stock actually knockout. And then you know, a large
Speaker 1: part of the notes stock obviously need on a probabilistic basis,
Speaker 1: become much closer to a knockout point. And as a result,
Speaker 1: of course, the investors who owned those notes, if they
Speaker 1: were to look at their stay months, uh, you know,
Speaker 1: would see a large market market loss. And of course
Speaker 1: the the risk managers you know, who managed structured product
Speaker 1: portfolios and headed them at banks face the issue that
Speaker 1: many of those notes either have terminated, therefore losing their hedging,
Speaker 1: losing their long volatility characteristics from the bank's perspective, or
Speaker 1: are nearing termination, which you know probabilistically reduces the volatility
Speaker 1: component there. So you know, large draw out in that market.
Speaker 1: So let's talk about the sort of risk management from
Speaker 1: the bank's perspective, And again people should go back and
Speaker 1: listen to the original episode because we've got a lot
Speaker 1: in the weed about how the hedging consideration of the
Speaker 1: banks changes. But as the note gets closer to the
Speaker 1: knockout or the barrier, but talk to us about sort
Speaker 1: of like what we've seen. So we've seen volatility absolutely
Speaker 1: exploding the last few weeks. It's come down a little
Speaker 1: bit lately, but it's still very elevating. Did the S
Speaker 1: and P even if it hasn't crashed as much as
Speaker 1: some indusicries, is still down quite a bit? How much
Speaker 1: does how much of a problem does this pose for
Speaker 1: the banks that have to hedge their exposure so they
Speaker 1: can either so that they're not on the hook and
Speaker 1: what have they been doing to uh to manage their risk? Yeah, absolutely,
Speaker 1: So we'll give their just really fast risk recap of
Speaker 1: the nature of this risk and then put it in
Speaker 1: the context of everything else that's going on. You know,
Speaker 1: these notes have a barrier option characteristic to them if
Speaker 1: you kind of no derivative speak. Essentially, the retail investors
Speaker 1: are selling what are called down and in knock inputs
Speaker 1: in other words, they're a put option that really only
Speaker 1: that's binary in the sense that it only matters if
Speaker 1: you actually hit the barrier, and then it just triggers
Speaker 1: a binary event, right, And so the you know, when
Speaker 1: banks issue these products, typically the first proxy hedge of
Speaker 1: the risk going to be that they sell some fairly
Speaker 1: deep out of the money, call it out of the
Speaker 1: money two or three year puts on the on the
Speaker 1: underlying indices, and that will be kind of just the
Speaker 1: first order proxy heads for the type of risk that
Speaker 1: they have. Now, as the markets start to go down,
Speaker 1: the combined hdged portfolio that a structured products book has
Speaker 1: will actually start to get somewhat longer volatility from the
Speaker 1: bank's perspective. And the reason for that gives you know,
Speaker 1: barrier options are tricky. They have they have in some
Speaker 1: sense they have a much more pronounced profile of volatility
Speaker 1: exposure to the downside than any vanilla option does. And
Speaker 1: so the vanilla options that the banks sell in some
Speaker 1: sense the convexity that the banks have is that they
Speaker 1: get longer volatility for some call it the first ten
Speaker 1: or fiftent of the move on the way down. But
Speaker 1: then as those as the market keeps falling and keeps
Speaker 1: falling down towards those barriers. Then the net position that
Speaker 1: the banks have suddenly gets shorter, very fast, and then
Speaker 1: collapses when as as you hit the notes, as you
Speaker 1: hit those trigger values, the reason being, you know, the
Speaker 1: notes themselves actually just terminate, right, and so all volatility
Speaker 1: exposure associated with the notes are gone. But the hedge
Speaker 1: was a vanilla option which still exists and still has
Speaker 1: you know, short volatility exposure from the bank's perspective. And
Speaker 1: so we're very much in that environment where where the
Speaker 1: banks have you know, have started to see you know,
Speaker 1: their hedges, you know, the volati of the vegua exposure,
Speaker 1: the volatility on exposure on their hedges now kind of
Speaker 1: falling as the market goes down much slower than than
Speaker 1: their long exposure is falling um and you know, the
Speaker 1: rally alleviated that somewhat. But you do have to put
Speaker 1: that in the broader context of of everything else that's
Speaker 1: happening in the world, in in equity, derivatives, portfolios and banks,
Speaker 1: you know, and there's and there's you know, have some
Speaker 1: insight here. Again, every bank of course is different and
Speaker 1: has different clan flows and so forth. But um, this
Speaker 1: the key thing to understand is that this crisis has
Speaker 1: developed and the equity market experienced a large draw down
Speaker 1: at an extremely fast pace. Right. So the credit crisis,
Speaker 1: of course, was you know, a a materially deeper market
Speaker 1: crisis across a variety of markets, uh, you know, in hindsight,
Speaker 1: relative to what we've seen so far. But it also
Speaker 1: was a relatively slow building crisis that took a while
Speaker 1: to manifest, where there were you know, many large legs
Speaker 1: down and in asset values over a sustained period of time,
Speaker 1: right whereas here we saw um just to truly up
Speaker 1: excel off over the course of you know, three or
Speaker 1: four weeks. And so in the broader risk portfolios of banks,
Speaker 1: you know, contrary to maybe what some folks might expect
Speaker 1: derivatives portfoli, it was a banks have generally done very
Speaker 1: well in this environment, and you know, they have not
Speaker 1: been exposed to large losses across there, across their business lines.
Speaker 1: And the reason for that is really the you know,
Speaker 1: the banking industry and investment banks are very different in
Speaker 1: a Dodd Frank world than they were back in two
Speaker 1: thousand and eight. In two thousand and eight, you know,
Speaker 1: bank in bank prop desks and bank flow book flow
Speaker 1: trading books were some of the largest risk takers in
Speaker 1: the world. They held some of the largest tail risk
Speaker 1: in the world across you know, and they were you know,
Speaker 1: they were they were the world's largest hedge funds, and
Speaker 1: they were holding you know, carry trades, and they were
Speaker 1: holding aggressive risk taking positions that lost the massive amounts
Speaker 1: of money. What we you know, what we did with
Speaker 1: Dodd Frank and steadily implemented you know, over the years,
Speaker 1: and especially combined with Basil three, we dramatically de risked
Speaker 1: the banks. We enforced dreamly type stress testing requirements on
Speaker 1: the banks with very you know, proper careful stress testing analytics,
Speaker 1: and we identified sources of tail risk in bank derivatives
Speaker 1: portfolios and told them to get rid of it. And
Speaker 1: banks have been very aggressive over the last five years
Speaker 1: developing what we call what the banks called, you know, euphemistically,
Speaker 1: alternative risk transfer programs, where they very explicitly had dedicated
Speaker 1: salespeople to go out and you know, nice slide decks
Speaker 1: going out to hedge funds and going out to asset
Speaker 1: managers and um proposing trades that those hedge funds and
Speaker 1: st managers would do you know that was associated with
Speaker 1: potentially some positive carry uh, you know, so the idea
Speaker 1: was banks shouldn't be holding this stuff, and banks were
Speaker 1: very well hedged um facing a lot of hedge funds
Speaker 1: and asset managers that have lost a tremendous amount of
Speaker 1: money during this crisis. So really those big you know,
Speaker 1: the big losses um in derivatives portfolios were on the
Speaker 1: buy side, not the south side this time, and partly
Speaker 1: as a result of how fast everything happened, you know,
Speaker 1: the on that initial shock, the banks were actually pretty
Speaker 1: well covered, even though they are auto called portfolios. We're
Speaker 1: getting pretty risky. So banks, having de risked from post
Speaker 1: financial crisis rules, are relatively well insulated from the volatility
Speaker 1: and the market sell off that we've seen. But as
Speaker 1: you point out, a lot of that tail risk has
Speaker 1: been pushed onto the bye side, onto hedge funds, other
Speaker 1: types of investors. Talk to us more about the alternative
Speaker 1: risk transfer trades. How do those actually work? And what
Speaker 1: are you observing now? Are we seeing some blow ups
Speaker 1: in those? Sure? So I'll give you a couple of examples.
Speaker 1: So and these, you know, these get a bit um
Speaker 1: a bit wonky as is as is just the nature
Speaker 1: of the business. But I'll do my best there so
Speaker 1: um so. For example, historically there have been some large
Speaker 1: sophisticated organizations that have liked to sell capped variance as
Speaker 1: a carry trade. UM. The the what there so A
Speaker 1: variant swap is a pure volatility position which pays off
Speaker 1: the difference between implied variants and realized variants over the
Speaker 1: maturity of the trade, and variance being the square of volatility.
Speaker 1: And anytime you have squared terms in you know, the
Speaker 1: p and l of something, it gets very exciting, right,
Speaker 1: So the reason that they now want a capt varian
Speaker 1: swap is um. A cap variant swap is one where
Speaker 1: you if you are said carry trade or you sell
Speaker 1: that variant swap um, but you sell its subject to
Speaker 1: a cap of two and a half times the actual
Speaker 1: level that you trade, where the most realized volatility that
Speaker 1: can possibly count in the payoff of the trade is
Speaker 1: two and a half times the initial level you sold,
Speaker 1: which is still quite high, but it gives you a
Speaker 1: finite stop loss where there is a maximum dollar amount
Speaker 1: you can lose on that trade. And you know what
Speaker 1: that number it is, right, you know? So this was
Speaker 1: if you're going to be selling variants, this is at
Speaker 1: least some somewhat of a prudent step, right. And the
Speaker 1: the type of organizations that were you know, engaged in
Speaker 1: this um you know, we're extremely large sophisticated peension funds
Speaker 1: that you know, I'm not going to get into details,
Speaker 1: but the size of those flows were quite large. Now,
Speaker 1: when banks facilitate that business, right, banks are buying capped
Speaker 1: variant swaps from these clients, and there's not really there's
Speaker 1: not a liquid inter dealer market for capped variance swaps
Speaker 1: because every you know, the caps on the variant swaps
Speaker 1: are like options on variants, and every one of them
Speaker 1: are at a different level, right, because it's two and
Speaker 1: a half times the initial you know level where the
Speaker 1: market is trading variants UM. So these are you know,
Speaker 1: somewhat funny products. So when a bank actually buys capped
Speaker 1: variants from a client and then it goes to lay
Speaker 1: off the risk, what it's going to do is it's
Speaker 1: going to sell uncapped variants in the inter dealer market
Speaker 1: or to another hedgephund. And what the bank is left
Speaker 1: with when it does that trade is a long position
Speaker 1: in capped variants and a short position and uncapped variants,
Speaker 1: which itself is just the bank being short a massively
Speaker 1: crashy piece of tail risk, right, which is just this
Speaker 1: cap so effectively, it's a call option on variants struck
Speaker 1: at you know, two and a half times the initial
Speaker 1: level of variance. And that is exactly the kind of
Speaker 1: position that you know, in two thousand and seven, the
Speaker 1: bank would have just done that and said, hey, we're
Speaker 1: just gonna, you know, keep those and we're going to
Speaker 1: get paid a lot of money and carry to keep
Speaker 1: those because and we like getting rich and getting bonuses
Speaker 1: and that's cool, um in you know, these days, the
Speaker 1: banks cannot hang onto that kind of thing because you
Speaker 1: run a proper stress test and you immediately see that
Speaker 1: if the market goes down and it's very volatile, that
Speaker 1: are going to lose an ungodly amount of money. And
Speaker 1: so what one of the earlier risk transfer trains within
Speaker 1: this alternative risk transfer universe was the bank's going out
Speaker 1: to hedge funds and esset managers and trying to find
Speaker 1: people to take exactly that position, so they would would
Speaker 1: trade you know, short term one month capped variants versus
Speaker 1: uncapped variants where the hedge funds sells the uncapped and
Speaker 1: buys the capped, and that trade and and and pockets
Speaker 1: the difference between those two variance levels, which might be
Speaker 1: you know, five years ago when this started, it might
Speaker 1: have been of all point. So it might have been
Speaker 1: you know, variant uncapped variants at sixteen and buying capped
Speaker 1: variants at fifteen. Uh, you know, by last year this
Speaker 1: is you know, very popular among hedge fund carriage traders,
Speaker 1: and it might have only been point for of all
Speaker 1: points for example. And this is the kind of trade
Speaker 1: that again, you just make money every month as long
Speaker 1: as volatility does not rise I'm more than two and
Speaker 1: a half times within the course of one month. Right.
Speaker 1: And if you look back historically, as long as you
Speaker 1: don't include, what to say is oh we'll look boss um.
Speaker 1: Even in the credit crisis, these trades didn't lose money
Speaker 1: because volatility increased a lot, and it increased you know,
Speaker 1: ten times over the course of you know, several months.
Speaker 1: But during no month did it rise more than two
Speaker 1: and a half times. Look at only you know during
Speaker 1: Lament it only rose two point four times, right, So
Speaker 1: this is what they call back test over optimization right,
Speaker 1: because you know it could have certainly just risen four
Speaker 1: times on Lehman instead of two point four times. Um,
Speaker 1: it just didn't. And this time, of course, it rose
Speaker 1: by a factor of closer to eight. And so if
Speaker 1: you so, if you were to do this trade again,
Speaker 1: that the p m l is is proportional to the
Speaker 1: square of the increase in volatility. Right, So in March,
Speaker 1: if you had sold the February you know cap uncap
Speaker 1: trade as a hedge fund engaging in alternative risk transfer,
Speaker 1: you collected you know, point four points and you ended
Speaker 1: up losing let's call it two d and fifty and
Speaker 1: the you know that, so those positions alone were enough
Speaker 1: to you know, wipe out the whole portfolio managers and
Speaker 1: hedge funds. And there, you know, that's one example, and
Speaker 1: I went into a decent amount of detail just because
Speaker 1: I wanted to make that clear. But there are there are,
Speaker 1: you know, a dozen things like that, or twenty things
Speaker 1: like that, some longer dated and more related to different
Speaker 1: kinds of you know, esoteric implied risk factors, some that
Speaker 1: are more, but a lot of them related to gap risk,
Speaker 1: to kind of the sudden appearance of very high levels
Speaker 1: of realized volatility, and that's what you know, that's what
Speaker 1: many um many folks were you know, happily engaged in
Speaker 1: because it produced, you know, just a very consistent return
Speaker 1: stream that you know, made a lot of people very
Speaker 1: rich for many years. So it's really just this extraordinary
Speaker 1: suddenness of the crash. It's not just that we had
Speaker 1: a crash. It's not just that we've had extraordinary volatility,
Speaker 1: but it's the speed of the volatility in such a
Speaker 1: short period of time that's been it's obliterated so many positions.
Speaker 1: I'm curious, sort of this might be a silly question,
Speaker 1: but you know, when we're talking about all these products,
Speaker 1: whether it's just the products sold to the retail the
Speaker 1: retail client maybe in Korea, or some of these more
Speaker 1: esoteric products that are sold by the dealers to the
Speaker 1: hedge funds or in the inter dealer market, what is
Speaker 1: the how do you track these because it doesn't seem
Speaker 1: like there's some like obvious like quote you just look
Speaker 1: up and see where they're pricing. So when you're trying
Speaker 1: to get a sense of where the overall market is,
Speaker 1: or even like a sense of where the state of
Speaker 1: Korean structured note markets or how many of them have
Speaker 1: been uh, you know knocked in. How do you like
Speaker 1: sort of get your hand around the size of this
Speaker 1: universe and the state of this universe. Sure, so let's
Speaker 1: start with the Korean autocoll market for example. So this
Speaker 1: is the kind of thing where you know, many of
Speaker 1: the large banks are heavily involved in this business. They
Speaker 1: most of them have very detailed research reports that they
Speaker 1: put out that aggregate you know, everything that they know
Speaker 1: from a lot of this data is public because these
Speaker 1: things go up for you know, the products themselves go
Speaker 1: up for you know, for OURFQ you know, out of
Speaker 1: private banks and so forth, right, and so the dealers then,
Speaker 1: you know, ingest all that data, they model the risk
Speaker 1: components of all these different products, and they'll and they'll
Speaker 1: publish that type of information. That's the kind of thing
Speaker 1: that you know, it's really that is the source of
Speaker 1: the data. It's not the kind of thing that you
Speaker 1: can like go out and you know, build your own
Speaker 1: database in some direct kind of way, because you know
Speaker 1: that you're talking about you know, many many thousands of
Speaker 1: outstanding notes with all different characteristics and so forth. On
Speaker 1: the On the the A R T side, again, it's
Speaker 1: it's very much so. The way you know where new
Speaker 1: prices are trading in that stuff, of course, is that
Speaker 1: you're you know, your your participant in these markets. Probably
Speaker 1: not you know, in our in our case, not you know,
Speaker 1: literally trading those products. But but you know, we are
Speaker 1: cover you know, large large institutional derivatives UM. You know,
Speaker 1: managers and traders are are covered by the UM, the
Speaker 1: large investment bank salesforces and speak with the traders and
Speaker 1: and track all of these things very closely. Right, So
Speaker 1: what are the you know, where are things pricing currently,
Speaker 1: what are the how much has been trading you know where?
Speaker 1: What type of accounts Because it's the kind of thing
Speaker 1: that you know, again, it's not something that I think, uh,
Speaker 1: there's only a certain subset of people who would actually
Speaker 1: be selling this stuff. But as a as a derivatives investor,
Speaker 1: you need to know where the risks are in the marketplace,
Speaker 1: and you have to understand, you know, who has these
Speaker 1: kind of positions and what the daisy chain effects could be.
Speaker 1: I have a sort of broader question, but a lot
Speaker 1: of what we're talking about here is this notion of
Speaker 1: risk having migrated from the banking system to the buy side.
Speaker 1: Is that vindication for regulators? Did they basically get this
Speaker 1: one right? Uh? Should they be satisfied with the outcome
Speaker 1: that we've seen over the past few weeks, which is
Speaker 1: banks doing reasonably well on their derivatives portfolios, but some
Speaker 1: hedge funds and maybe some other investors getting hit on
Speaker 1: variant swaps and other volatility products. Was this the desired goal?
Speaker 1: It's a great question, Tracy. Um, I think very much
Speaker 1: there are two, very much two sides to that, and
Speaker 1: the regulators will will tell you exactly this, and you
Speaker 1: can read exactly this into their their actions over the
Speaker 1: last three or four weeks. Right. So, on the one hand,
Speaker 1: from a systemic risk perspective within the banking system and
Speaker 1: resilience of the banking system to know market shocks that
Speaker 1: might come from different unpredicted angles, this was a big win,
Speaker 1: right exactly as you said, um, you know, in two
Speaker 1: thousand and eight we were talking about what the next
Speaker 1: bank to go bankrupt was. There are people who talk
Speaker 1: about that sort of thing that you know, read zero hitge.
Speaker 1: But in general, actually, um, as we talked about, the
Speaker 1: banks are doing you know, pretty pretty reasonably at least
Speaker 1: at this point, and then largely as a result of
Speaker 1: you know, being very well hedged facing the by side
Speaker 1: the and that and also not importantly not holding you know,
Speaker 1: large inventory, not trading aggressively. But the flip side of
Speaker 1: that is that the extent of the market dislocations that
Speaker 1: we have seen, you know, is certainly the catalyst has
Speaker 1: been you know, the very large and very real fundamental
Speaker 1: economic shock of the sudden stop you know, across the
Speaker 1: global economy induced by by coronavirus. Right, then that's really
Speaker 1: very real. But the severity of some of the market dislocations,
Speaker 1: the extent of you know, some of the daily moves
Speaker 1: in the witty market and in you know, higeled an
Speaker 1: investment grade credit et f s moving seven percent a day,
Speaker 1: this is not fundamental, right, This was this was the
Speaker 1: manifestation of markets under highly stressed circumstances where banks have
Speaker 1: stepped back from risk taking, right and don't help and
Speaker 1: don't hold inventories and are not facilitating and intermediating markets.
Speaker 1: And that's the flip. They be sort of the other
Speaker 1: side of the coin, right where um, we've made the
Speaker 1: banking system a lot safer from from market shocks by
Speaker 1: de risking, by taking tail risk out and by keeping
Speaker 1: inventories and and risk taking out of the banking system.
Speaker 1: But at the same time that's dramatically exacerbated the dislocations
Speaker 1: that we see. And so when you look at the many,
Speaker 1: many actions that the FED has been taking very aggressively,
Speaker 1: and not just the FED, global central banks over the
Speaker 1: last three weeks to a month, you know, there's there's
Speaker 1: traditional monetary policy, lowering interest rates and so forth, but
Speaker 1: that's not really been the interesting stuff, right. The interesting
Speaker 1: stuff has been um, you know, very aggressive expansion of
Speaker 1: of buying of different kinds of investment grade debt to
Speaker 1: try to stabilize broken markets. But then also you know,
Speaker 1: incremental steady rolling back and many of the types of
Speaker 1: capital restrictions and UH and general you know. So so
Speaker 1: for example, you know, cutting banks need to hold capital,
Speaker 1: and you know the and C car stretch ratios, doing
Speaker 1: a variety of things that look basically like rolling back
Speaker 1: many features of dot frank on a temporary basis, right.
Speaker 1: And the reason that they're doing that is UH is
Speaker 1: to get banks lending, you know, to make sure the
Speaker 1: banks keep lending to small businesses, to get banks involved
Speaker 1: taking risks and holding more inventory and stabilizing market conditions
Speaker 1: and fixing some of the crazy disruptions that we see,
Speaker 1: right And I think the recognition that you're seeing, or
Speaker 1: the what you know, what you have to read between
Speaker 1: the lines is that, you know, the regulators are realizing
Speaker 1: that many of the things that you know, some people
Speaker 1: on the buy side that have been pointing out over
Speaker 1: the last several years that the inhibiting the level of
Speaker 1: banquet was taken to the extent that we did, you know,
Speaker 1: can really cause large liquidity problems under stress. And I
Speaker 1: think we've seen that, and I think regulators are acknowledging that.
Speaker 1: So the question really over the next over the short
Speaker 1: term and then the medium term is going to be,
Speaker 1: you know, how do they find where do we end up?
Speaker 1: How do they find that happy medium right where where
Speaker 1: the regulatory framework is maintaining the right controls around system
Speaker 1: systemic risk but also allowing banks to intermediate financial markets
Speaker 1: in a meaningful way and take risk. So we obviously
Speaker 1: saw this extraordinary explosion and volatility. It's come down quite
Speaker 1: a bit um you know, the vix had gone above
Speaker 1: a d as of this most recent Friday. I get
Speaker 1: by the way, I guess this is the point of
Speaker 1: the show where I remind people what date we're recording
Speaker 1: this distinction the world has changed ranged since are you
Speaker 1: going to do the hour to job? Yeah, it is
Speaker 1: right now. It is nine am East Coast time on
Speaker 1: April five. So bear that in mind when you listen
Speaker 1: to this, because who knows what the world will look
Speaker 1: like by the time you're actually listening to this. But
Speaker 1: at the time we're recording this, the VIX is below fifty.
Speaker 1: And as you mentioned, the fan has done multiple things
Speaker 1: both in terms of the stepping into market standpoint and
Speaker 1: regulatory tweaks and so forth, without necessarily predicting the future
Speaker 1: of what the market holds. Between all these washouts and moves,
Speaker 1: is there much uh? You know, is it reasonable to
Speaker 1: think that, like we've seen the worst, not necessarily in
Speaker 1: the X levels of the economic crisis, but that the
Speaker 1: washout from a sort of pure volatility I liquidity standpoint,
Speaker 1: we saw the worst of it. Or what kind of
Speaker 1: potential triggers could there still be out there? Yeah, that's
Speaker 1: a great question. I think that within the um, especially
Speaker 1: equity volatility and probably interest rates volatility markets on the
Speaker 1: public market side, I think that's probably a fair guess
Speaker 1: is that the craziest of the of the moves is
Speaker 1: past us. The reason being all of the highly over
Speaker 1: leveraged speculative risky positioning in you know, short tail risk
Speaker 1: on the hedge fund side, um that those folks blew up,
Speaker 1: and that positioning has been largely cleaned up. There's still
Speaker 1: you know, some of it in deeper pockets, but generally speaking,
Speaker 1: generally speaking, the worst of you know, people who were
Speaker 1: short a ton of variants or short a ton of
Speaker 1: fixed calls, they've been liquidated, and so that the acceleration
Speaker 1: factor that has gone also on the on the fixed
Speaker 1: income side, you know, the FED and global central banks
Speaker 1: again are being very aggressive in terms of trying to
Speaker 1: restore basic functionality of those of those markets. You've already
Speaker 1: seen the liquidation in many of the leveraged mutual funds
Speaker 1: in the community space and and MBS space and so forth.
Speaker 1: So I think that the most disorderly market behavior on
Speaker 1: the public side is probably over um. The you know,
Speaker 1: to your point, very hard to say about, you know,
Speaker 1: index levels and so forth. You know, this is going
Speaker 1: to be a very this is a very real, very
Speaker 1: large fundamental economic shock, and it's likely to take quite
Speaker 1: a while to work through the system, and you know,
Speaker 1: it would be easy to see scenarios where you know,
Speaker 1: asset price levels are significantly lower even but I think
Speaker 1: that the place where we've probably only begun to see,
Speaker 1: you know, little inklings of the beginning is more on
Speaker 1: the private market side. Right, So just think about private credit.
Speaker 1: You know, things that aren't market to market and you
Speaker 1: know aren't don't get unwound in a messy way on
Speaker 1: the first big leg down, right. So private credit over
Speaker 1: level is private equity assets that are held probably at
Speaker 1: very inflated valuations and that are very sensitive to you know,
Speaker 1: the performance of small cat businesses that you know are
Speaker 1: seeing their you know, their revenues fall dramatically and their
Speaker 1: basic ability to uh to run their businesses, um, you know,
Speaker 1: potentially gone under quarantine. Right. And I think that you know,
Speaker 1: and it's not this is not my wheelhouse, very very directly,
Speaker 1: and so I'm not gonna make a bunch of specific
Speaker 1: predictions of any sort. But I think that if you
Speaker 1: were to look at places where the worst is probably
Speaker 1: not over, and you'll see a lot of bodies start
Speaker 1: to float to the surface, I think that's probably over
Speaker 1: the next three to six months, that's probably the place
Speaker 1: to look, right, Ben Effort, really appreciate you rejoining us.
Speaker 1: As as I mentioned, there are a lot of people
Speaker 1: are constantly asking for a sequel to your January episodes
Speaker 1: and light of everything we've seen, and so I think
Speaker 1: they'll be very excited to have listened to your perspective
Speaker 1: of now that much of what we talked about Ben
Speaker 1: is really playing out. Hey, guys, thanks for having a
Speaker 1: lot of fun than Thanks great as always, Tracy, I
Speaker 1: love talking to Ben because I feel like there's almost
Speaker 1: no one who does as good of a job taking
Speaker 1: some pretty our cane difficult to wrap your head around
Speaker 1: concepts and coming pretty close to putting them in English
Speaker 1: that even I can understand. Yeah, I definitely think sometimes
Speaker 1: you need to listen to these episodes a couple of times,
Speaker 1: but you definitely learned something from them. And to me,
Speaker 1: there are sort of two broad themes that stand out.
Speaker 1: One is that we do get these feedback loops in
Speaker 1: the market, um because of the way hedging and things
Speaker 1: like that work, where you can see moves to the
Speaker 1: downside or sometimes to the upside really exacerbated. Um because
Speaker 1: of all these things that are sort of happening in
Speaker 1: the background between dealers and investors. And the second big
Speaker 1: theme is what Ben was talking about. When it comes
Speaker 1: to de risking the banks, risk never disappears, as we know,
Speaker 1: it always moves somewhere else. In this particular case, it's
Speaker 1: moved over to the buy side, to the hedge funds
Speaker 1: some other investors. And I guess the question is whether
Speaker 1: or not that was the right thing to do, has
Speaker 1: Ben pointed out, there are some downsides again getting much
Speaker 1: bigger market moves than you might otherwise expect when banks
Speaker 1: still had the risk appetite or the ability to come
Speaker 1: in and sort of cushi in the market. Um. But
Speaker 1: on the other hand, you have financial stability. So it's
Speaker 1: a really interesting question. And sorry, I'm going to keep going.
Speaker 1: But the other thing UH to think about right now
Speaker 1: is we have seen some talk from the US about
Speaker 1: rolling back parts of Dodd Frank, things like the vocal rule,
Speaker 1: as they're trying to get banks to be more helpful
Speaker 1: to the wider economy. And I guess the question is
Speaker 1: whether we're now going to go too far when it
Speaker 1: comes to undoing all this post financial crisis regulation. Yeah,
Speaker 1: I mean, it'll be really interesting to see where they
Speaker 1: land ultimately. But I think, like, but I think, you know,
Speaker 1: I feel very anxious about saying anything like DoD Frank
Speaker 1: vindicated or the banks proved to be safe. It's like,
Speaker 1: I kind of want to wait a few months before
Speaker 1: I started saying like it all worked, because everybody is
Speaker 1: just so tense right now. But if you think about, like, Okay,
Speaker 1: what is it the core I purpose of a bank
Speaker 1: is most people know it a place to sort of
Speaker 1: hold your money. It's good on some level that where
Speaker 1: we've seen the blow ups so far, see, it seems
Speaker 1: to me it's good that on some level where we've
Speaker 1: seen the blow ups on so far have not been
Speaker 1: that Now. There's also the other factor, which is that
Speaker 1: this crisis really started as a sort of real economy
Speaker 1: shock or an exologenous shot, and it will be interesting,
Speaker 1: and it's sort of been alluded to it at the
Speaker 1: end what happens to sort of you know, at some
Speaker 1: point people just can't keep paying their bill, alright, I
Speaker 1: mean we've already seen that. I mean we started with
Speaker 1: April one, and rent and mortgage checks do because of
Speaker 1: the extraordinary sort of human told layoffs that we saw
Speaker 1: in March. What keeps happening to sort of assets that
Speaker 1: were presumed to be extremely safe as this drags on,
Speaker 1: as the health crisis continues, as the real economic crisis continues,
Speaker 1: at some point, it just sort of keeps eating deeper
Speaker 1: and deeper into assets that people thought were safe. And
Speaker 1: it's been alluded to in which I get and you know,
Speaker 1: a recent interview with Tom Barrick uh discussed this and
Speaker 1: so forth. What happens in the world of sort of
Speaker 1: private credit, private equity, other assets that are just sort
Speaker 1: of premised on the idea that you can take a lot,
Speaker 1: take on a lot of debt or any debt to
Speaker 1: own a very stable piece of the economy. When the
Speaker 1: economy comes to a halt, feels like a story that
Speaker 1: we have not yet seen the washout that we have
Speaker 1: seen in perhaps were in public u in sort of
Speaker 1: publicly traded instruments. Absolutely, we should be careful about saying
Speaker 1: that the banks are completely in the clear, and as
Speaker 1: you point out, on the safe asset side, at the
Speaker 1: same time, we have this question over what happens to
Speaker 1: those assets in what's really an unprecedented economic downturn. In
Speaker 1: many ways, we are seeing the regulators start to ease
Speaker 1: back on those capital constraints, so banks are now allowed,
Speaker 1: for instance, not to hold as much money against things
Speaker 1: like US treasure US. The regulators are doing that to
Speaker 1: try to improve liquidity in the market. But again the
Speaker 1: question is if something were to happen in the U. S.
Speaker 1: Treasury market, would that then backfire and banks might actually
Speaker 1: suffer some losses. So big questions for the economy and
Speaker 1: the financial system. Yeah, well, I think we have many
Speaker 1: more episodes. We're going to have episodes for years on this,
Speaker 1: so I think we're just getting started. Yeah, absolutely, all right,
Speaker 1: Well this has been one of those episodes. I guess
Speaker 1: I'm Tracy Ellowhit. You can follow me on Twitter at
Speaker 1: Tracy Ellowoit and I'm Joe wi Isn'tal. You can follow
Speaker 1: me on Twitter at the Stalwart. And you should definitely
Speaker 1: follow our guests on Twitter. Ben Effort really put up
Speaker 1: high value, high information stream these Ben with two ends
Speaker 1: p Effort Ben Effort. And you should follow our producer
Speaker 1: on Twitter, Laura Carlson. She's at Laura M. Carlson. Be
Speaker 1: sure to follow the Bloomberg head of Podcasts, Francesca Leavi,
Speaker 1: under the handle at Francesca Today and check out all
Speaker 1: of our podcast at Bloomberg under the handle at podcasts.
Speaker 1: Thanks for listening.