40-Times-Leveraged Short Volatility Trade Goes Horrifically Wrong For Everyone Involved

…or, Managing and Mitigating the 2014 CNH FX TARF blowup

(Author’s note: I wrote this a year or so back for a few friends on Finance Twitter who wanted to know what FX TARFs were and what effect the huge vol overhang from USDCNH TARFs would have on the spot market. I figured that the shenanigans in USDCNY yesterday made it an appropriate time to dig this up and republish it for a wider audience. Onward…)

In 1985, it was CHF-denominated loans to Aussie farmers. In 1998, it was USDIDR cross-currency swaps with Indonesian noodle makers. In 2008, it was USDKRW KIKO options to Korean corporates and PRDCs to Japanese investors. In 2014, the FX blowup du jour is USDCNH European-knock-in target redemption forwards (EKI TARFs): SME and wealth management clients across Asia made gargantuan, leveraged, unfunded bets that the PBOC would continue to manage the CNY for a slow appreciation, and were caught long-and-wrong when the trend turned in February of this year.

Your instinctive reaction might be “if the customers are losing, the exotics books on the other side must be having a good time” – but you’d be mostly wrong. When TARFs go wrong, they can go wrong in all sorts of unexpected ways: imperfect hedging; counterparty risk; and collateral risk among them 1; and most of those are bad news for both the bank’s exotics book and any smaller banks that might have back-to-backed the trade along the way.

The trades in question are strips of leveraged knock-in forwards with an autocall feature 2. The typical pitch runs something like this: Continue reading

  1. Also there’s the risk that the regulators will storm in and fine you and shut your lucrative TARF business down, which has happened to four banks in Taiwan as I write this.
  2.  They’re also not a million miles from the “5/30 swap” 17×-leveraged-shortdate-low-delta-spread-option trades that blew up P&G back in 1995. If everything else from the 90s is coming back, I’m thinking it’s time for some opportunistic distressed-asset trades in flannel shirts and X-Files VHS tapes.
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What’s mine is yours; what’s yours is mined

(I was going to turn this into a tweetstorm, but it’s a bit over the line for what would be a reasonable-length tweetstorm and also I am an old fart who thinks tweetstorming is unwieldy. Am I the only one who thinks tweetstorms are kind of annoying? Apparently I am.)

The big news in bitcoin-land today is the nine-figure-USD evaporation of the Mycoin exchange in Hong Kong (the SCMP article is paywalled but also worth a read) which turned out to have been a ponzi scheme. Mycoin ran a small BTC exchange, but their main business was selling bitcoin mining contracts: buy HKD 400,000 worth of mining capacity, the pitch ran, and you’d make HKD 1 million within a few months as the miners threw off bitcoin. When you pitch it like that, it’s pretty obviously a ponzi. 

But the idea of “mining contracts” is very well established in bitcoin-land. Googling “bitcoin mining contracts” gets you a lot of perfectly reputable-looking businesses offering “invest now; get a stream of cash later”. And the idea is somewhat sensible on the face of it: you pay $x upfront, in return for a stream of cash valued at $y (and hopefully y > x), and at the end of the contract you have a thing with residual value $z ≈ 0. 

That’s not the most insane thing in the world; it’s not a million miles from an industrial leasing business. But with an industrial leasing business, you have actual cars and heavy vehicles and machines and such, with actual measurable depreciation. With a Bitcoin mining contract, you just have a black box: BTC goes in, BTC comes out a few weeks later, and the stream of BTC tapers off as the difficulty increases. There are a lot of places an unscrupulous “mining contract” operator could either siphon cash out, or just fail to mine entirely and just pay users back out of their principal… until the principal runs out.

The question, then, is how (or even if) you can verify that there’s actual mining being done behind a given mining contract. Photos of rack-mount servers with an arrow pointing to them saying “this one is yours” are useless, obviously. A ticker on the company’s website saying “this many hashes per second!” doesn’t have to be real data. Even the bitcoin payouts don’t make it real. 

And really, if these bitcoin miners existed and were NPV-profitable, they wouldn’t be being leased out; they’d be kept by the owners and milked until it wasn’t economical to run them any more. You don’t see Hertz offering to sub-lease its rental-car fleet to people  and let them keep the profits.

Maybe it’s time for “bitcoin mining contract” to be filed next to “high-yield investment plan” in the “synonyms for ponzi scheme” file… along with a whole lot of other bitcoin lexicon.

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A staggering failure of Economics 101

It’s not often that you find out about developments in the Aussie housing market from Canadian ex-finance-ministers, but Garth Turner ran an interesting piece yesterday about Senator Nick Xenophon’s proposals to make housing “more affordable”. In short, he says “we tried that and it backfired”: 

I confess. Once I thought like you. I even supported realtors years ago when they cooked up this scheme to allow kids to dip into their retirement funds to buy a first home. At the time we were in a steep recession with real estate plunging and the economy in a funk. So, I voted in our Parliament for a temporary program to create the Home Buyer’s Plan in order to stabilize the market and try to revitalize the home-building business. It worked, kinda. Then subsequent governments (a) made the plan permanent and (b) doubled the amount people can suck out of their registered savings.

Now, Nick, we’re reaping the bitter harvest sown when that dumbass legislation passed. Allowing first-time buyers to remove tax-free money to buy a modest home they could not otherwise afford, then restore it to their long-term retirement savings makes perfect sense in theory. In practice and experience, just the opposite.

Meanwhile in San Francisco, the Board of Supervisors is proposing a Singapore-style flipper tax on people who sell houses within four years of buying them. The tax would range from 24% on sales within one year to 14% for sales between four and five years after the purchase. 

And back in Australia, people are fighting tooth and nail to preserve the generous “negative gearing” tax breaks that allow homeowners to tax-deduct the entirety of any losses on their investment properties (interest expenses over rental income). The negative gearing laws have been around since the mid-eighties; they’re a major reason why housing is such a popular investment in Australia; and they’re widely considered a third rail in Aussie politics.

There’s something about the housing market that makes people forget everything they learned in Econ 101. 

On first principles, if you want to reduce the price of a thing, you either need to decrease demand for the thing or increase supply of the thing. All three policy measures up the top of this post would do the exact opposite, no matter how well-intentioned they are. 

First: letting people tap their retirement funds to pay for a house. This typically gets dressed up as a “benefit for first homeowners”, but here’s what happens: if all first home buyers can tap their retirement funds, all of them will. And they won’t just tap the funds; they’ll use them as part of their 20% deposit, letting them leverage up the money four times. 

End result: the demand for houses increases (because people can pay more for them), but the supply doesn’t change. So prices go up, and homebuyers end up in more debt than they would have had without the policy change. (First-home-buyers’ grants, occasionally nicknamed “first-home-sellers’ grants”, have the same end result.) 

Second: flipper taxes. Again, the legislators have forgotten that if you want to bring house prices down, you need to encourage sellers. Flipper taxes do the opposite: they motivate potential sellers to keep their houses off the market until they reach the five-year mark, but they don’t do anything to stop buyers. 

Singapore’s experience with a flipper tax is worth examining. They introduced the “ABSD” tax in 2011, and jacked up the rate in January 2013. Since 2011, residential house prices have gone up, not down; and industrial property prices skyrocketed because the flip tax only covered residential property. 

Third: negative gearing and other tax incentives for homeowners. By now, you can probably figure this out yourself: tax incentives encourage people to buy; and more people buying means prices go up. 

Home ownership is not necessarily a bad thing. But policy-makers across the world seem to have a blind spot when it comes to house price policy, and they love implementing policies that are dressed up as “keeping houses affordable” but end up making houses unaffordable. Someone with an Econ 101-grade education should probably step in at some point and explain the unintended consequences of these policies. 

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Blast you Chris Hayes why must you be so reasonable

When I found out Chris Hayes was interviewing Michael Lewis on his show tonight, and they were going to talk about Lewis’s controversial new book Flash Boys, I was jazzed – I was ready to unleash hell on them for peddling alarmist rubbish and scaring people away from equity markets. (It’s a slow Wednesday night, what else am I going to do?)

But no. The interview was sensible (though can we stop using the word “rigging”?). They even managed to agree that the real target of HFT is large investors – mutual funds, hedge funds, pension funds – rather than “the guy in his underpants e-trading”. If you’re the guy in your underpants e-trading, you’re probably being net helped by HFT, as Felix Salmon explains, and also please put pants on.

Lewis took exception to Felix Salmon’s claim that he “queered the narrative”, creating heroes and villains – but if you think the heroes and villains of HFT are as clear-cut as Lewis makes them out to be, go read Matt Levine’s alternate take on the Flash Boys story (and then come back). 

There was only one part of the interview that really struck me as overtly wrong:

Scalping – trying to jump in front of big flows to get ahead of them, or in front of small orders to preferentially trade with them – has been around since financial markets were a bunch of dudes punting rice futures in 18th-century Osaka. (Here it is back in the day-trading days of 1995.)

For that matter, so has proximity arbitrage. Open-outcry futures traders fight for positions closer to the top step of the pit, where they can see more activity and be closer to the top step where the big brokers traditionally stand; HFT firms colocating their servers next to the exchange’s matching engines is the electronic equivalent of standing on the second-top step in the futures pit. If you bar the exchanges from offering colo space in their datacenters, the HFT firms will just bid up space in the datacenters next door instead. 

Flash Boys is a great read, an exciting story of plucky outsiders bringing down the old regime (like The New New Thing, like Moneyball, like The Blind Side, like The Big Short, you might notice a pattern here). But it seems to have turned into a policy paper for financial regulators, and if we ran the government by who can write the most interesting narrative then we’d have David Simon running the justice system and Teju Cole or Chimamanda Ngozi Adichie running immigration policy wait that might not actually be so bad. 

Here’s the video. It’s worth a watch. 

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Trading while insolvent is apparently fine if you’re a bitcoin exchange

Amid the fiasco of MtGox’s apparent collapse last night (acquisition? rebranding? god knows), some kind person leaked MtGox’s “Crisis Strategy Draft”. It’s an internal Powerpoint that appears to describe a plan for shutting down MtGox and relaunching it as “Gox” – a new, trustworthy Bitcoin exchange from the people who brought you this. And this.

And there is so much icky stuff in there.

On page 2, there’s the admission that they’ve been robbed of nearly 750,000 BTC – call it  $400 million and you’re not far off.

There’s also a couple of paragraphs arguing that if MtGox fails, it’ll destroy the public perception of Bitcoin’s worth. This seems like a tenuous argument at best, and you can come up with any number of good arguments against it – not least the fact that everyone already knows that MtGox is up the spout – but the MtGox crew seems to take it as gospel, and that leads them to a very icky strategy to revive the exchange.

The first step in their strategy – “Immediately reduce liabilities as much as possible with partners” – seems to involve making money by arbitraging the MtGox discount that they created. The rest of it is basically “shut down, rebrand, and relaunch in a month” with a low-cost platform that people will want to use… or, to put it another way, “trade our way out of insolvency”.

The Financial Assets and Liabilities slide, if it’s even remotely close to reality, should be enough reason to shut down MtGox (and maybe send the management out in handcuffs?).

The first thing I like on this slide is that they value the bitcoin deficit using the cheaper MtGox price ($160), not the broad-market price ($500-ish). The only way that valuation would be legit is if they can buy enough BTC to cover the deficit at the MtGox price – again, exploiting the discount that MtGox created through its own incompetence. (Arbing your customers – it’s the Bitcoin way!)

The exchange’s assets exceed its liabilities by somewhere around $21.5 million of actual cash. Even if you leave out the 742,000 BTC bitcoin deficit, that sounds a lot like an admission of insolvency. Is trading while insolvent as illegal in Japan as it is in the UK or Australia?

Update: a kind Redditor named pyalot has unredacted the blacked-out financials slide, and it is comedy gold. Despite some fairly enthusiastic growth assumptions, the revised gox.com would only be making $40 million a year by 2016 – so it’d still take somewhere close to ten years to dig itself out of its half-billion-dollar hole and refund all those missing bitcoins.

MtGox doesn’t deserve to be acquired, bailed out, or saved. It’s a disaster. It needs to be liquidated.

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Bad Ideas: “Be A Stockbroker!”, Sez SGX

The SGX wants Singaporeans to quit their jobs and become stockbrokers

Singapore Exchange (SGX) is partnering NTUC’s e2i (Employment and Employability Institute) to draw more Singaporeans to the stockbroking profession and equip new joiners with the necessary skills.

“A career as a licensed broker offers Singaporeans the opportunity to be an entrepreneur, a financial professional and a front-liner in the exciting world of markets and investments.” … said Lynn Gaspar, Senior Vice President of SGX who oversees SGX Academy.

Never mind that stockbroking as a career is slowly being destroyed by online discount brokers (on the execution side) and independent financial advisors or RIAs (on the advice side). 

Nobody in their right mind would pay 30 or 40 bps to trade Singaporean stocks through some dude on the other end of a phone line when they can pay 18bps at Standard Chartered or 8bps at Interactive Brokers. (Or is that just me? Do people actually do this? Has Singapore not had its Stratton Oakmont to sour people on cold-calling brokers yet?)

You can excuse the NTUC for not knowing this, but the SGX should know this. 

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JRE Sells Out: Snugg iPad Mini Retina Case

So the fine folks at TheSnugg.com emailed me and asked me if I’d like to review one of their iPad Mini cases. I said yes; they sent me a fetching one of these – the iPad mini Retina Leather Case – and I wore it around on my iPad for a week. 

If you’re the sort of person who wants to wear a case on your iPad, the Snugg cases are pretty great. They’re rock-solid, stitched nicely, made of decent leather and fabric both inside and out. They’re built rock-solid, and the elastic hand-strap makes it easier to hold the cased iPad up while you’re reading. 

It’s got all the usual bells and whistles an iPad case should have – the flat-on-the-desk or propped-up-for-TV configurations, magnetic sleep/wake when you close or open the case and cutouts for the speakers and microphones (including the new dual noise-cancelling microphones in the Retina mini – watch out if you’ve bought yourself a Retina mini and use a case that’s not designed for it). 

One thing I particularly like is their height when they’re in “desk mode”. The iPad Smart Cover (my usual cover of choice) leaves the iPad almost flat against the desk, and leaves you hunched over it while you’re typing;  the Snugg case lifts it up a little higher, making it easier to type on and a bit less of a strain to use. Heavy iPad typists will probably like this case a lot. 

If you’re a light typist, or you only use your iPad for reading, though, you’ll probably be wondering why you need a case at all – and not unjustifiably. Any case – even the slimline Apple cases – is going to make your svelte iPad significantly thicker and heavier, making it harder to hold up to read, heavier to tote around in your backpack, and generally a lot less practical than it was designed to be. 

So that’s the tradeoff you make with any case. But honestly, if you’re going to make that tradeoff – and if you’re a heavy iPad user, and your use skews toward writing instead of reading – you’re probably going to like the Snugg case. (Plus, at $25 – it’s on sale right now! – it’s cheaper than Apple’s cases and sturdier than the no-name off-brand cases you find littering the iAccessories market.)

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Tiny Robot is Disappointed by Wall Street

Jeez, it’s been quiet around here lately, hasn’t it?

Here’s some Tiny Robot for you, to break the monotony. Tiny Robot heard about a place called Wall Street, deep in Bryce Canyon National Park. This Wall Street is a deep slot canyon between two huge sandstone massifs… but there’s nobody there to help Tiny Robot with the IPO of Tiny Robot Industries.

Tiny Robot was disappointed.

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This is what we call idiosyncratic risk

So despite having been away from Disneyland-with-the-death-penalty for more than a year, I can’t resist keeping up with the news from Singapore’s spectacularly dodgy S-chip stocks – the Chinese small-caps that infest the lower reaches of the SGX because it’s the only exchange that will take their listing fees. 

And one of them – an abalone-farming firm named Oceanus Group – dropped an absolute humdinger of an announcement a few days ago. It requested a trading halt on August 5th, but waited until August 11th to explain the reason for the halt (at the same time as it asked for a suspension from listing, leaving shareholders in the lurch): 

The board of directors (the “Board” or “Directors”) of the Company hereby would like to further request for a trading suspension of the shares of the Company and provide clarifications on the same matter. The Company previously announced that, at the Company’s [AGM], one of the resolutions tabled at the AGM to re-elect Mr Wu Yong Shou (“Mr Wu”) as a Director of the Company was defeated by a 95.51% majority of the shareholders of the Company (“Shareholders”) present and voting at the AGM. […]

As a result of the AGM, Mr Wu retired at the conclusion of the AGM and has consequently ceased as the Executive Director of the Company. […]

While Mr Wu remains as the General Manager in charge of the Company’s China operations and production in the interim of the Board re-composition, he became increasingly un-cooperative towards the re-constituted Board ever since he was not re-elected as a Director of the Company at the AGM. The Company was notified on 02 August 2013 and again on 05 August 2013 by the Head of Production of the occurrence of substantial and abnormal mortalities of abalones at the Company’s China farms within a very short span of time immediately following the AGM.

There are two broad categories of risk in investing. There’s systematic risk: risk that affects all companies in an industry (for example, the risk that yield curve flattening will dent the profits of the banking sector). And then there’s idiosyncratic risk: risk that only affects one company… for example, the risk that a disgruntled board member will take revenge for his sacking by poisoning all your abalone.

(And was there a sudden 10% selloff on higher-than-normal volume two days before the trading halt? Was there ever!)

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Prior Art

An eagle-eyed colleague recently pointed me to the case of CLS Bank v Alice, where Alice Corporation is trying to enforce a set of patents against CLS Bank, the little-known (but systematically vital) central settlement point for interbank FX trades. 

The judgment itself is interesting because it tries to rule on the patentability of computer-implemented inventions (that is, business methods implemented “on a computer” instead of “in real life”). Alice’s patents specifically refer to computer-based implementations of certain processes, rather than the processes themselves, and the Federal Court was asked to rule whether the computer-based implementation might be patentable even when the business process itself isn’t. 

The end result was a hung bench – five people saying that computer-based implementations are patentable, and therefore Alice has a case; five people saying they’re not. The end result is that they’re apparently not, though there’s a lot of talk that Alice will appeal to the Supremes. (…never mind.)

I’m going to leave the “they were wrong! they were right!” arguments over jurisprudence to the people who know better. But it seems to me that Alice’s patents – even if you look at them purely as computer-based implementations, not as claims on the underlying processes – might have problems with prior art. That is, the patents aren’t valid because someone else already did it. 

Have a look at the patents linked off the PatentDocs article (the very first link in this post). Here’s the abstract of 5,970,479:

Methods and apparatus which deal with the management of risk relating to specified, yet unknown, future events are disclosed. `Sponsor` stakeholders specify a particular product relating to an event or phenomenon for which there is a range of possible future outcomes. `Ordering` stakeholders then offer contracts relating to the predetermined phenomenon and corresponding range of outcomes. The offered contracts specify an entitlement or (pay-off) at the future time of maturity for each outcome, and a consideration (or premium) payable, in exchange, to a `counter-party` stakeholder.

Independently of the offered contracts, the `counter-party` stakeholders input data as to their view of the likelihood of occurrence of each outcome in the predetermined range into the future, or specifically at the predetermined date of maturity. Each offered contract is priced by calculating counter-party premiums from the registered data, and a match attempted by a comparison of the offered premium with the calculated premiums. Matched contracts can be further traded until maturity, and at-maturity processing handles the exchange of entitlement as between the matched parties to the contract.

Here’s a decoder ring: “ordering stakeholder” = “market maker”; “probability” = “delta”; “premium” = “premium”. The claimant is describing an options exchange. Or, specifically, he’s describing an electronic implementation of an options exchange. (Have a read further down in the Claims section if you’re suffering from insomnia, it’s gold.)

All well and good. But the patent’s dated 1992… and CBOE implemented an electronic options limit order book in 1978.

Another patent – the one at issue in CLS Bank – is 6,912,510:

A method of exchanging an obligation between parties where the exchange is administered by a supervisory institution that ensures real-time settling of obligations between parties by updating shadow records in real-time and instructing one or more exchange institutions to effect, from time to time, the exchange of obligations in accounts maintained external to the supervisory institution. Updates to the exchange institution accounts may reflect the net obligations of parties over a nominated period of time. The role of the supervisory institution is to ensure that obligations are only settled where parties have sufficient balance in their shadow records to complete the transaction.

Obligations that can be exchanged include, but are not limited to: shares in financial or physical assets, participation rights in wagers, national or synthetic currencies, exchange settlement account deposits, taxation account deposits, and deposits of financial instruments or precious metals.

The decoder ring again: “shadow balances” = “bank accounts”; “exchange institutions” = “banks” (and credit card companies, but you get the idea). The claim describes real-time gross settlement systems. (Claim 58 reads to me like they’re trying to claim nostro accounts as part of the patent, which seems remarkably ambitious.)

And again, the patent’s dated 1992. But CHIPS – a privately-run American settlement system that competes with Fedwire – has been doing electronic RTGS settlement since the 1970s, and Fedwire itself seems to have been doing the same thing long before CHIPS appeared

I’m not sure where I stand on the issue of software patents. I mean, I have no problem with patenting an innovative business process. But I think saying “we’re patenting this already-existing process… on a computer!” is a bit of a stretch. And attempting to patent something that’s already been in existence for twenty years is a real stretch – and I think that’s what Alice has done, at least in these two cases. 

Have I misread these patents? Or is there a possible serious issue of prior art here? 

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