Interesting speculation from econoblogger Felix Salmon at RGE, here and (later on) here, drawing on our earlier post about the CDS market. He suggests that the reason the long/short equity funds are getting into the CDS market is that they are putting on CDS carry trades - shorting the stock and selling default protection on the debt.

This trade has got a few attractive features: as long as CDS yields stay higher than repo rates, you will make money, and if the underlying name hits trouble, the money you lose on the protection you've sold will be recouped through the equity short.

It's similar to the EDS/CDS carry trade, (pdf, and a technical pdf at that) where you sell equity default swaps and buy credit default swaps on the same underlying name; if everything goes smoothly, you will profit - if there's a credit default, you're hedged. The problem comes if an equity default isn't accompanied by a credit default - which could happen if, say, you were coming into a general market slump, and shares fell enough to trigger the EDS without any credit events.

Salmon's commenters point out that there are problems with the CDS carry trade too. First among them, what happens in an LBO? An LBO means lots more debt, so CDS spreads go up; but it also means the stock rises, so you lose money on your equity short too.

Of course, we don't know if anyone is actually doing these trades - yet. But we're digging deeper on this one...

Any thoughts? Take them to the Risk Forum.

Writing in Forbes, author and academic Larry Harris calls for the US regulators to crack open the futures market which will otherwise become a virtual monopoly with the merger of the Chicago Mercantile Exchange and the Chicago Board of Trade. (The link comes from Alea.)

Unlike other financial products like equities and options, US futures are tied to the exchange where you bought them - which makes no intuitive sense at all, and allows the exchange to keep fees high, because they don't have to worry about people setting up rival exchanges or just trading off-board. The CME/CBOT merger means that they will lock up this market for good, almost monopolising the futures business, Harris warns. And he concludes:

"When exchanges were not-for-profit organizations controlled by their member traders, the members acted in their self-interest to keep fees reasonable. This self-interest helped keep exchanges from exploiting the power in their unique positions.

"Now that exchanges are for-profit corporations, they no longer face the same restraints on their fees. The failure to address the off-board trading restriction problem will ultimately ensure that only exchange shareholders and exchange managements will benefit from the cost savings that consolidation and new electronic technologies are bringing to the exchange services arena."

Here are our reports on the merger. Note that cost savings are predicted, but not necessarily reductions in fees...

Discuss exchange consolidation on the Risk Forum.

A couple of pieces come in about the risks involved in the currently-worsening credit environment. First (via Felix Salmon) the FT's Lex column highlights how constant proportion debt obligations could produce huge losses in the event of a downturn. Briefly, they depend on heavily leveraged sales of credit default swaps - returns are leveraged up to 4% from 0.25% but the potential losses, of course, are also larger. In fact, they're amplified by the structure, which reduces leverage as the returns accumulate (if everything's going well) but increase it if things go badly.

"Even the clever structuring behind CPDOs will not shield their owners from the pain of a turn in the credit cycle", Lex concludes.

Felix Salmon points out with some asperity that this is rather an unremarkable conclusion to reach - obviously if you sell a lot of credit default swaps you will be in the hole if companies start defaulting.

"Um, duh? If you buy spread product and the credit markets turn against you, you're likely to lose money. Why is this a problem?"

The second document, addressing not the same issue but a closely-related one, comes from Hennessee Group in New York.

The Financial Services Authority is worrying, very publicly, about the rise of private equity companies. In a long discussion paper (pdf) released this week, it outlines the problems.

First, increased use of credit derivatives means that when one or more private equity firms default - which, incidentally, the FSA reckons will inevitably happen pretty soon - the result will be an almighty tangle of assigned, repackaged, structured debt which will take ages to sort out. If, indeed, it can be sorted out.

Second, a lot of private equity companies have been borrowing more heavily than they should - "this lending may not, in some circumstances, be entirely prudent", the FSA says, which is, like Jeeves raising one eyebrow and murmuring "Most disturbing, sir", about as emotional as they get. This has meant that, conceivably, the financial stability of the UK could be affected. (Excuse the italics.)

After that sort of bombshell, the other effects seem fairly mild - reduced capital market efficiency (which ties into our post yesterday on the effects of exchange modernisation) and a growing risk of market abuse. This worry, incidentally, is shared by the European High Yield Association, whose commissioned research found that 90% of investors are worried about shady dealings in the CDS, leveraged loan and high yield bond markets.

Despite these rather worrying suggestions, the FSA reckons it has the situation under control: "our current regulatory architecture is effective, proportionate and adequately resourced." But it will be expanding its hedge fund oversight branch to cover private equity as well - makes sense, as both are exposed to many of the same risk factors - and is thinking about closer supervision of leveraged lending levels.

The point is that there may not be very much time - the credit cycle is turning. If the FSA is confident that it can handle the risk of a major private equity default, it could do a better job of reassuring the rest of us.

Are we overreacting? Discuss this post in the Risk Forum.

The FT today picks up on the idea of banks competing with stock exchanges, which was discussed here last month - Morgan Stanley is the latest bank to start matching orders internally before sending them on to the exchanges. "Dark pools of liquidity" provide an apparently attractive alternative to the expense and hassle of trading on a regulated exchange. The link comes via Sean Park, who, once he has got the inevitable Star Wars reference off his chest, makes the point that it's not impossible that other, apparently non-financial companies (Amazon and eBay) might get into this market too.

It's difficult not to find the prospect disturbing - stock exchanges dwindling to be replaced by private markets. And it feels like a retrograde step, too; as though we were heading back to the age of sitting in a corner of some 'Change Alley coffee house whispering to equally-bewigged investors about getting the best price on our South Sea Company shares. Surely the advantages of having a single, transparent pool of liquidity outweigh the fees that the exchanges charge?

The key is going to be keeping in touch with all these different pools of liquidity as they multiply (and shrink). Here's a discussion (pdf) from September which touches on the subject - ISE head Andrew Brenner and Credit Suisse CTO Andy Brown reckon that the next three to five years will see a lot of bet-hedging while the new market place works itself out.

UPDATE: Risk looked at algo trading and the problems of internal markets in May. Read the article here.

Discuss the future of the exchanges on the Risk Forum.

... is the disturbing conclusion of Chris Jeffery's cover story in this month's Risk. There are concerns over liquidity - much of the apparent depth in the market is the result of structured trades by a small number of participants - and traders expect it could take ten years before a consensus model of correlation emerges.

Read the whole thing - here - and then comment on the Risk Forum.

By the way, the latest issue of Risk is now online at www.risk.net. Subscribers can read the entire magazine - and there's free content for non-subscribers too - Gareth Gore's piece on contracts for difference (which I mentioned before) looks at the possibility of a regulatory clampdown in the UK; and Joe Morgan looks at the danger that Mifid could open investment firms to the risk of being sued by investors who lose money on retail structured products.

(This article also appears in the November issue of Risk)

Locusts, predators, highwaymen ... as the financial markets' favourite bogeyman, hedge funds have become used to name-calling. But the $6 billion losses at Greenwich-based hedge fund Amaranth Advisors in September might just lead to sticks and stones replacing the verbal attacks. With the US Securities and Exchange Commission (SEC) looking at how it can tweak its rules requiring the registration of hedge funds - thrown out by the US Court of Appeal in June - the latest failure has given renewed impetus to those campaigning for tighter regulation of the sector.

There appears to be no shortage of critics. In the past month, politicians on both sides of the Atlantic have queued up to attack hedge funds for their lack of transparency, the danger they pose to investors, and the potential systemic risk they create in the financial markets, with some calling for even tighter regulation than the rules originally proposed by the SEC.

Let's just pause a minute.

It's a little disturbing when a senior banker tells you that he only joined the bank to get a little financial experience, in order to improve his CV when he started looking for a real job. But then you consider that, since he's stayed there for the last 27 years, his thinking has probably changed.
Morten Friis, chief risk officer at the Royal Bank of Canada, is the subject of the latest back page profile, appearing in the next issue of Risk. Read the whole article for his thoughts on the problems of running a bank's loan portfolio and the biggest new source of risk.

As of now, Over the Counter has comments on each post - just click on the "comments" link at the bottom right of each post to leave your thoughts. The Forum will still operate, but for more general topics of discussion. Let us know what you think...

An interesting piece on Dow Jones today raises the point that previous generations of traders have learned their, er, trade on the floor, moving up the ranks from runner to trader to manager. Now, with electronic trading superseding open-outcry, some brokers worry that new traders won't get the same training.

For many who have been around the exchanges for years, the demise of the floors represents not only the end of the traditional way of doing things but also the loss of a critical training tool.

"Part of the learning in the pit in the old days was not only understanding markets but understanding people," says Luke Morretti, a broker for Cytrade Financial LLC. "The people aspect of it is gone now."

This may sound naive, but surely if you don't learn "the people aspect" while trading electronically, it's a sign that you don't need to know it? I'm sure that bankers' handwriting is far worse now they don't all start as ledger clerks in the counting house, too...

On a more serious note, the article says that banks are shifting to online training courses for their traders - an opportunity for net-smart universities and business schools, and also another aspect of the levelling taking place between New York and foreign exchanges. After all, if the University of Chicago can train a dealer online for the CBOT, it can train one online for any other exchange.

Discuss electronic markets or the decline of New York in the Risk Forum.

Plenty of stories over the last few days warning of the coming decline of New York as the world's leading financial centre. (Gibbon would no doubt have made some crack about "the triumph of regulation and paranoia"). The Economist and the FT join in.

Opinions differ on the cause. The Economist blames regulation - specifically the Sarbanes-Oxley act, which it says has "tangled the markets up in red tape" - and tort law. This basic anti-regulation stance is (surprise surprise) quite popular among US financiers, and (again, surprise surprise) rejected by people like Eliot Spitzer, who said: "We're failing in competitiveness because of failed business models and the lack of smart investment in technology. General Motors is not failing because of regulations but because it hasn't produced good products."

The FT's John Gapper says that New York is just going to have to get used to it. In the past, listing in New York gave access to the deepest capital pool and the most innovative financiers in the world. Now, he says, there is plenty of capital elsewhere - east Asia and Europe - and New York isn't any more innovative than London.

New York is also a lot less welcoming to foreigners, says Clay Risen in The New Republic - not only does AIM do far better than Nasdaq at attracting the new listings, but the worldwide reputation of the terrifying US immigration and homeland security authorities has done much to discourage foreign companies from coming anywhere near the country.

Incidentally, far from attracting the bulk of IPOs, the New York markets are seeing the reverse - companies being taken private. This could be the product of Sarbanes-Oxley making life hard for listed companies - or a temporary result of the vast amounts of cheap debt available. On the other hand, US academic (and former Labor Secretary) Robert Reich, writing in the US political magazine The American Prospect, believes that it simply represents a huge outbreak of greed and underhand dealing by chief executives, who make vast sums when the company inevitably goes public again a few years later.

There are two ways out: it's possible, as Risen suggests, that London, and Hong Kong as well, have been too lax, and a wave of corporate scandals among Aim-listed foreign companies will redress the balance. But it's more likely that New York will gently adapt to being no longer first in the world, but merely first among equals.

Discuss the decline of New York in the Risk Forum.

The FT this morning took a look at the longevity market - how insurance companies and pension providers are dealing, in their different ways, with the increase in human life expectancy. It's an increase that a lot of them may have underestimated, Risk reported earlier this month.

(And, the FT adds, London will be the heart of the longevity market, which could be bigger than credit derivatives...)

Longevity bonds, with a coupon linked to survival rates, haven't been a great success: but, as Gareth Gore writes in the next issue of Risk, the need is still there, and the next generation of complex structured mortality products will be able to meet it.

But dealers now predict a revolution in longevity risk management. Talk at half a dozen investment banks is brewing of using collateralised debt obligation (CDO) technology to provide tailored solutions to pension and insurance schemes in a way that makes distribution of that risk quick, cheap and easy.

Read the full article in Risk, or online at Risk.net, when it is published next month. In the meantime, discuss longevity risk in the Risk Forum.

Point Carbon (via Alea) predicts that the EU emissions market will pass the billion-tonne mark this week.

Coming after the news of a shift in Australian policy on climate change, this looks good for the carbon market. But, as Risk pointed out in July, overallocation in the second phase of the EU trading scheme could still ruin everything by swamping the market with too many credits. The European Commission's now looking at rules for a possible third phase, to kick off in 2013.

OTC looked at the carbon market back in October. Discuss it on the Risk Forum.

The Economist (via CFO Magazine) has picked up on a worrying finding of interest to every resident of the business class lounge - travelling east can kill you. Everyone who's flown long-haul knows that westbound flights - London to New York, say - are relatively easy to get over, as moving to a timezone five hours behind just involves staying awake and operational until four o'clock in the morning on your own personal body clock (11 pm local). Going the other way, from London to Singapore, is harder work because it involves forcing oneself to go to bed at, say, six in the evening (midnight local) and getting up again at one in the morning.

The researchers, Gene Block and Alec Davidson at the University of Virginia, subjected mice to the equivalent of one long-haul flight a week for eight weeks by changing the timing of light and dark in their cages, either moving it six hours back (a "westbound flight") or forward (for "eastbound").

Young (or "associate") mice survived the "flights" fairly well, whether east or westbound. But the older (or "senior partner") mice suffered; eight weeks of effectively flying to Singapore every seven days killed more than half of them.

VIX, the Chicago Board Options Exchange's measure of expected volatility, is at a near-record low; it closed on Friday at 10.05, and hasn't gone below that since 1994. Reuters describes this as "record complacency" and quotes an options researcher as saying "This shows that investors are not inclined to seek options protection for their portfolios."

Well, maybe. They're certainly seeking VIX options - now trading at tens of thousands of contracts a day on most days, well up from their launch in March. And according to the BIS, equity derivatives notionals are still growing at about 17% in six months (though this is a slight deceleration, and in any case we can't tell how much of that represents hedging rather than speculation).

According to this opinion piece, a low VIX doesn't tell us much of anything anyway. Phrases like "record complacency", with their strong undertone of "you poor fools" might be a little unfair. On the other hand, from a low, Merrill Lynch's David Bowers reckons, the only way is up.

How will a more volatile equity market affect the derivatives markets? Discuss it in the Risk Forum.

Like climate change, the subject of pension fund deficits is something not all governments are ready to tackle. While the pension issue is creeping up the agenda, the magnitude of the problem is intimidating. With life expectancy expected to rise, soon more than one-third of the European population will be over 60 years old, compounding the global pension problem.
Lars Rohde, chief executive at Denmark’s state pension plan ATP, who was speaking at Risk USA this week, has taken his fund through a change and shared his experiences.
“There is no easy escape,” said Rohde. “We have to find a way to address pension shortfalls. Aging populations are going to stretch societies around the world.”
Denmark’s approach to its pension issues is what Rohde calls the third way: a collective insurance-based defined contribution scheme. ATP runs two portfolios: a hedge portfolio which mirrors its liabilities using interest rate swaps and investment portfolio focused on generating returns to grow the fund’s assets.
Only 31% of Americans believe that the social security system will still be operating when they retire. (This compares with 70% who expect aliens to have contacted humanity by that point.) The truth here is that the majority of pension schemes are still ticking along without aggressively attacking deficit problems. Maybe by the time Nasa launches its first mission to Mars around 2020, pension deficits will be solved. Either that or we will prepare for the aliens.

Discuss the pensions crisis on the Risk Forum.

Everyone’s talking about alpha and a lot of hedge funds claim they generate it. While hedge fund strategies are usually not transparent, their fee structures are—typically 2% investment fee and a 20% performance fee. But are hedge funds really generating alpha thus justifying these hefty fees?
Not always, says Laurence Siegel, director, policy research at the Ford Foundation: “Hedge funds say they are absolute return investors. What people are really investing is a mix of alpha and beta.”
Some managers have above-average skills, generate alpha and deserve the fees. But these managers are a rare breed. “I’ve been interviewing managers for so long that it’s getting boring unless they’ve taught me something new,” said Siegel.
The Ford Foundation invests in carefully selected super funds that Siegel believes are the best alpha generators in the world. What’s their due diligence process? Sitting around a table and arguing.

Discuss the hedge fund business in Risk Forum.

Last month I wrote about predictions that stock exchanges would soon face competition from banks. It's therefore quite pleasant to see it starting already.
Seven banks - Citi, Credit Suisse, Deutsche, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS - are setting up a European joint venture stock trading floor, ready to undercut the existing bourses as soon as MiFID implementation allows them. (Coverage from the BBC here).
Points to ponder: obviously the selling point is lower transaction costs, but how much lower can they get? Presumably the banks will transfer some of their own trading to the new exchange - but how much? (They won't say.) Is this the first of many? Are other banks going to join, or start their own?

Comment on exchange consolidation on the Risk Forum.

Few large financial institutions have maximised risk capital to create shareholder value. This was one of the provocative statements offered up by Peter Hancock, president of Integrated Finance in his keynote address to delegates at Risk USA. Hancock, who led JP Morgan’s derivatives efforts in the 1990s, expounded on the need for banks to develop a holistic picture of their risks and allocate risk budgets differently to add more value for shareholders.

“Shareholders reward firms that choose to allocate more capital to more idiosyncratic risks,” said Hancock. “Management has the responsibility to allocate risk capital to areas of outperformance.”

The way firms look at risk now is focused on refining the definitions of risks already identified. What they should be doing is looking for risks they haven’t already thought of, emphasised Hancock. Getting a complete picture of risk should be a policy priority.

Risk should be contributing more to how firms communicate to shareholders about performance. “Analysts are increasingly irrelevant thanks to [Elliot] Spitzer,” said Hancock. “Firms should replace earnings guidance with risk guidance and value guidance.” And increasingly chief executives should be talking directly to investors instead of allowing analysts to have that dialogue, he added.

Risk management is not limited to earthly pursuits. Jeevan Perera, risk manager at Nasa's Johnson Space Centre, is heading the risk management of the Orion project, which is developing a replacement for the space shuttle. Since the Columbia space shuttle disaster Nasa has been weighing up its options for developing a safer vehicle that will be able to go to the moon and beyond.

In the past 18 months, the Orion project has got underway and Lockheed Martin has just been handed the mandate to develop the new spacecraft. This craft will replace the shuttle and make its first mission around 2010. The plan is to fly to the moon in around 2020 and establish a permanent habitation there, and then, toward the end of the 2020s, make the first manned mission to Mars.

This is quite a demanding task, but Perera has experience managing tough projects. His last post was overseeing risk management for the construction of the international space station.

Perera explained to Risk USA delegates some of the lessons learned at Nasa about effective risk management:

- Risk management must be supported by management

- Formally documented processes that are not overly complex are key

- There must be a continuous and iterative assessment of risk management programmes

- Risk management must be integrated with projects

- There must be continuous improvement

Finally, Perera noted that risk management must be implemented at the enterprise level and said that Nasa is trying to move away from a siloed approach to risk to a holistic one.

BNP Paribas and Deutsche Bank are reportedly having a crack at the mortality market, by issuing mortality derivatives for pension funds.

I'm trying to get more details on the products. The last ones suggested have been bonds with a coupon that pays out depending on longevity, such as this from EIB. But the big problems are still: what index do you base it on; and, more importantly, there are plenty of people who want to hedge against mortality risk, but who do you get to take the other side of the trade? That is to say - it sounds rather macabre - who stands to profit from people living longer lives? One suggestion is pharmaceutical companies; the idea is that longevity means people spend longer as pensioners, who consume large quantities of pharmaceuticals. Not sure if this is true.

Anyway, I'll post answers to these questions as soon as I get them.

Longevity bonds haven't had a great history: a year after it was announced, the EIB bond (also arranged by BNP Paribas) still hadn't been launched. Our sister publication Life & Pensions looked at the reasons why. (pdf)

Credit Suisse launched a US longevity index at the start of this year - but it hasn't had anyone use it as the base for a successful launch yet, as far as I know.

Meanwhile, here (via Alea) is a report from earlier this year on Axa's Extreme Mortality Bond.

Can there be a successful market in longevity? Discuss it in the Risk Forum.

Risk's senior staff writer, Rachel Wolcott, is even as I write en route for New York, where she will be attending the Risk USA conference and blogging about it for Over the Counter. So, if you're not going to be at the Hilton next week, keep an eye on OTC for the latest news, opinion and gossip from the conference...

...writes Steve Waldman at Interfluidity, who goes on to call for an end to leveraged investment!

He's spurred to do this by a piece in New York magazine by the investment market reporter James Cramer. In the aftermath of the Amaranth business Cramer's calling for severe restrictions on who can invest in hedge funds, and blaming pension fund managers and consultants for missing the risks involved. But he's against more regulation:

The only government regulation we need is a prophylactic one: If you aren’t rich or your clients aren’t rich (as defined by a simple suitability rule—do they have more than, say, a million dollars?), they shouldn’t be in hedge funds. That’s how the law was for years. It was changed under Clinton because of heavy lobbying—and giving—by hedge funds, and that’s how Amaranth happened. The other way to regulate hedge funds is to say that you can’t borrow more than, say, 50 percent of the money you have under management to leverage up, if you are running pension money.

And Waldman picks up on Cramer's second point and says: "Why should hedge funds be leveraged at all?"

The argument is that hedge fund investors are supposed to be rich and risk-hungry - they should leverage themselves, and then invest, rather than effectively insulating themselves by sharing a lot of the risk with the hedge fund's creditors.

Over the Counter now has a RSS feed. Left-hand column, right down at the bottom.

RSS - Real Simple Syndication - is basically a way for you to hear every time a new entry goes up, so you don't have to keep checking back to look for new blog posts. If you find yourself spending a lot of time looking at various blogs or news sites, checking for new content, then an RSS reader is what you need - it collects all the new posts as soon as they go up on your favourite sites, and puts them all together on the same screen.

Click on the button (or go here) and follow the instructions - if you already use RSS to keep up with other websites, you'll know the drill. If not, it's fairly straightforward (also free...) Let us know if you have any problems - or any comments about the website in general - on this Forum thread.