Earlier today we noted that, as every last trace of the 2008 global financial crisis (and the 2007 credit bubble peak preceding it) is coming back with a vengeance thanks to a world that is drowning in liquidity as central banks begin the final lap in the race to terminal currency debasement, HELOC-based bonds are making a triumphal comeback.
And just to make sure that there are plenty of weapons of derivative-based mass destruction, JPM is also doing everything in its power to bring back the BFG of the financial crisis which allegedly was the catalyst that nearly brought down most Wall Street firms: the synthetic CDO.
According to IFRE’s Chris Whittall, the biggest US bank which is set to report another quarter of disappointing trading revenues, “is stepping up efforts to get more clients trading credit derivatives, including synthetic CDOs, through a platform that makes it easier for investors to take leveraged bets on corporate debt markets.”
According to the report, the gateway to spread these weapons of mass destruction to as many pathological gamblers as possible is JPM’s Credit Nexus platform which was launched earlier this year, and is designed to simplify the “cumbersome process investors usually face to trade derivatives, including credit-default swaps, CDS options and synthetic collateralised debt obligations, according to a client presentation obtained by IFR.”
In short, retail investors will soon be able to trade CDS and CDOs (both cash and synthetic). What can possibly go wrong…
Some more details from the report:
Rather than taking direct exposure to such instruments, users of the platform can instead buy certificates packaging together a range of credit derivatives as well as corporate bonds, FX forwards and interest-rate swaps. The presentation highlights how the certificates enable clients to lever up their investments several times over, while lessening much of the operational and market risks typically associated with trading derivatives.
“It’s a huge effort to negotiate ISDAs,” said one credit investor, referring to the International Swaps and Derivatives Association’s standard legal document governing derivatives trades. By contrast, the investor called JP Morgan’s platform “ISDA-lite”.
JP Morgan’s 22-page client presentation, which says it is for “professional and eligible” investors only and not retail, notes there are a number of “operational hurdles” to trade derivatives. Those include, the presentation says, having legal documentation in place as well as booking and monitoring the risk of trades.
Derivatives users must also comply with rules regulators introduced following the financial crisis to reduce risk in the US$544trn over-the-counter market, such as reporting trades and funnelling them through clearing houses.
The presentation says JP Morgan’s platform is “designed to streamline these requirements” by effectively removing them for clients, as certificates do not need to be cleared or reported. In short, JPM will onboard much if not all of the legal, financial and regulatory requirements, and let any Tom, Dick and Harry, allegedly institutional but in these days of home offices galore, certainly retail as well.
Ironically, JPM may be too late to get even more people “involved” in this diffusion of balance sheet risk to as great a population as possible. As IFRE notes, derivatives volumes are already surging in many of these products in recent months. This may be the result of the need for ever greater trading leverage at a time when government bond yields have tumbled across the world, narrowing the pool of high-yielding investments on offer for fund managers, while also forcing investors to magnify modest moves by applying layers of leverage.
And sure enough, trading volumes in synthetic CDOs linked to credit indexes were up 40% this year after topping US$200bn in 2018, according to IFRE. Trading in swaptions, or options on CDS indexes – until recently all but dead – now stands at US$20bn–$25bn a day, analysts say, which is higher than trading of US high-grade corporate bonds.
Banks including Citigroup and Goldman Sachs have been looking to take advantage of growing client interest in these products. That, for some bizarre reason includes the controversial, crisis-era synthetic CDO, which has been revamped to focus solely on whether corporate defaults will rise.
And this is where JPM comes in: it Credit Nexus platform allows investors to get exposure to synthetic CDOs linked to credit indexes. The bank’s client presentation suggests such investments are suitable for asset managers, hedge funds, insurance companies and pension funds to use as “hedging overlays” among other things.
Which brings us to the punchline: why the sudden surge of interest – and trading – in derivatives and CDOs? The answer, as noted above, is simple: leverage (upon leverage, upon leverage).
In its presentation, JP Morgan devotes several pages to highlight and explain one of the main advantages of getting exposure to derivatives through the platform: leverage, and the same reason why back in 2005-2008 nobody traded cash bonds and everyone traded CDS.
Unlike when buying a bond, investors do not have to stump up all the cash needed to match the full size of their positions when trading a derivative. Instead, they only need to post a fraction of that total amount in margin. In this way, investors can make bigger bets on credit markets than they could ordinarily, leading to potentially outsized gains – or losses.
“This [certificate] is designed to replicate the economics of trading derivatives in an OTC format,” the presentation says. “Investors do not need to post [US$100m] of cash to trade [US$100m] of CDS.”
Of course, this is all great when the trade goes your way, the problem is when it doesn’t, and suddenly one – or usually thousands of investors – are called to post margin on their trades, either at the end of day trading, or – in a nightmare scenario – during the day. Such margin calls usually lead to, well, disaster as the trader holding the products rarely if ever has the required cash to post margin and a waterfall liquidation ensues, which in the case of 2008 did not end until the entire financial system had to be bailed out.
One final ironic twist is that not only is JPM giving its clients just the right weapons to blow up both themselves and the system once again, it is charging them for it, to wit: “JP Morgan charges running costs for its platform, which are higher for riskier products. There are also higher fees if the client chooses to use banks other than JP Morgan to execute the trades underlying the certificate.”