Once upon a time in 2001, I was trading Extreme Networks (EXTR) at the CBOE. My DPM, I and the small pit had bought a bunch of March “at the money” options, mostly puts at 135% Volatility. Now, it was one big player who was pounding this March volatility day after day, then WE MOVED. The trade was killing him. He decided to get out, “puke”. So, the broker comes for a quote, and we decided, …..” well if he wants out, he is going to PAY.” We offered 150% size up….We felt on top of the world. This was going to be the a BIG winner. Next thing we know, 5000K contracts trade “away” on the PCE. Whoa……wait a minute. They just did the trade at 140%. “Hey, get that broker back here….” Now luckily we were able to hedge in the front month, but now our position risk had doubled.
What happened……one word LIQUIDITY.
Back to JPM. Now JPM has a position on (that some know) but I would guess they sold some form of CDS on the OTC market. First, if you sell CDS (an option) your risk is unlimited to a certain extent. Well here comes the problem. Because of current regulation, CDS and OTC derivatives are unregulated. This means they are not traded on exchanges, are not cleared, and are not marked with collateral every night. Most important, the OTC market is basically illiquid. This means there are not many traders who trade the product. So……JPM is at the mercy of the firm on the other side of this huge trade.
Dodd-Frank is a mess. 2000 pages. Who really knows what is in it. But, I believe that it would be in JPM’s best interest to push regulation and FAST. Why? How if OTC markets went onto exchanges? I know, I know……the products are too complex. That’s crap. I guarantee that many GREAT options traders all over the world (many in Chicago) who could figure out risk/reward on the stupid CDS. Now, if that happens, guess what! LIQUIDITY!!!! Now JPM could find someone, because the pool of traders is HUGE now to take the other side of trade. This would tighten the market, allow for fair price discovery, and make the firm on the other side unable to be the only player. Like my example above, JPM could just find a counter-party, “go away” with the trade, and liquidate the position. They still might lose money, but they wouldn’t be forced into a corner (like they are now).
This should happen, but won’t. What will probably happen is JPM will lobby for less OTC regulation in order to keep B/O spreads wide for potential profit. They will hope, hope some more, and mark their position to a theoretical model that allows them not to lose a lot of money.
This is a dangerous game JPM is playing. They have been beneficiaries of this shadow OTC theoretical model land for many years. This is all well and good until it is NOT. Well it seems it is NOT, now.
Obviously, Jamie Dimon is smart. It would be prudent for him to lobby for regulation involving OTC derivatives.
If this DID happen. Well, banks wouldn’t need to fight about some Volker Rule. They would have to mark positions to market daily through a clearing operation. This would LOWER RISK AND ADD LIQUIDITY Isn’t that what EVERYONE wants? We’ll see…….