As reported in Financial News and the WSJ, people are starting to talk more about the potential counterparty risk problems with the credit default swap (CDS) market. It often gets reported how large the CDS market has become, from $180 million more than 10 years ago, to over $62 trillion now. Of course, the $62 trillion in notional value is somewhat misleading given that the CDS market is a "closed system" or zero-sum game such that the losses of one party are offset by the gains of another. When looked at like normal insurance, and protection against specific assets, the cost to replace contracts and provide protection is being reported by the WSJ to be more like $2 trillion.

The real issue is the counterparty risk from an investment bank not meeting their obligations. Beyond affecting just one specific type of corporate debt, failure of an investment bank could affect the entire CDS market and the underlying securities (i.e., corporate bonds) upon which the swaps are valued. This effect was seen last March at the height of the credit crisis as Bear Stearns was being bailed out (sorry, purchased), causing CDS cost to rise. A similar increase in cost is now occurring with Lehman Brothers and Merrill Lynch. It is yet to be seen if this is a short-term blip. Nonetheless, you can expect that the Federal Reserve is keeping an eye on this market and be ready to take future action to protect the bond and equity markets, and potential international market contagion.

As mentioned in recent WSJ and Bloomberg articles, the Commodity Futures Trading Commission is conducting an investigation into potential crude oil price manipulation. What is interesting about the story is not only how the CFTC is initiating an investigation, but that they are making a formal announcement of what they are doing, an indirect indication that they are also aware of the public and political outrage given higher energy costs. The CFTC commissioner said it best:

"It's important that people who are paying high gas prices understand the CFTC is on the case and that we're closely monitoring and in this instance deeply investigating any potential abuse in this important energy market"

I guess we will have to wait and see if the investigation uncovers anything of interest, or if it is simply being used to keep regulators and Congress at bay until energy prices hopefully retreat to more "normal" levels (or the public gets used to current prices, which is doubtful).

In addition to reporting about the investigation, the WSJ article does highlight some potential abuses, including using the Platts price-reporting system to manipulate prices. Essentially, traders could issue numerous orders during the window of time that Platts uses for setting the prices that it reports to subscribers. This artificially high or low price could then be used to profit in other markets by taking an opposite position based on the move in reported prices. Another potential manipulation includes spreading false information about oil tankers being either empty or full, sending the wrong impression about supply, and thereby affecting price. Whether either of these potential abuses (if true) could be classified as wide-spread speculation, and thereby causing a larger scale lasting move toward higher energy prices, is yet to be determined.

When considering potential abuses it is important to remember that a company can actually take advantage of insider information regarding its own production and demand when it makes trades, either for hedging or for increasing/decreasing its own position. Since insider information is not technically illegal in the same way it is with equities, this forces regulators to work a little harder to prove that traders were intentionally trying to create an artificial price in order to profit from speculation. Something tells me that this aspect will either be ignored or put into question as some look for validation of out-of-control speculation abuses.

Libor rose 0.03% to 2.68% after a recent Wall Street Journal article that once again questioned the validity of the key rate (update article). While 3 bps does not seem like a large move, it is the largest move in the last two weeks. The British Bankers' Association, which oversees and sets Libor, has been reviewing the system and is expected to report its finding on Friday. Potential changes include shaking-up the 16 member bank panel that provide quotes of borrowing costs to the association, as well as examining quote reporting and the Libor methodology. Given that nearly everything, including mortgages, corporate debt, and numerous financial derivatives are pegged in some degree to Libor, the ramification could be tremendous, and should probably be something investors are paying more attention to. No doubt that banks and financial institutions are considering the effects on capital and hedged positions. The effects on investors will be both obvious (mortgages) and not so obvious (derivatives) as the rate continues to come under scrutiny, and potentially rises to meet other benchmarks.

Update: The BBA met today and basically decided to do nothing, other than say they would get tough with offending members that misquote rates. They did mention that they will strengthen the oversight of BBA Libor, with details "published in due course."

There has been a recent resurgence in interest in dark pools of liquidity. No, this is not some Star Wars reference (at least I don't think so), but does refer to a procedure and method of trading that is once again causing some concern on Wall Street. For years, crossing networks have been matching buy and sell orders "off-exchange" in what have been referred to as dark pools of liquidity. The advantage of these pools it that they should make the execution of a large order safe, and allow the two market participants to execute the large order without moving price, while maintaining some privacy. While the amount of dark pool transactions is estimated to be a little over 10% (but including more than 20% of all trades in NYSE-listed stocks), it is continuing to grow as hedge funds look for less transparent ways to sell large positions, and brokerage firms look for more ways to generate trading income and possibly tap into the increase in trading revenue streams that the exchanges have been enjoying over the last few years.

Unfortunately, some are worried that gaming is allowing others to profit from the transaction, and of course potentially leaving one side of the dark pool transaction a little worse off. The problem has gotten significant enough that some are considering no longer using the dark pools, with 60% showing some hesitation. As recently highlighted in a Finanial News article, steps are being taken to tackle the problem, such as putting anti-gaming measures in place at both large and small firms. Steps being used and/or considered include physically monitoring patterns of trade abuse using a human element, using computer algorithms to spot trends, developing fair pricing models, and using anti-gaming logic.

While it is true that it may not always be known exactly what is occurring within the dark pools, it appears as if their operations are simply more organized ways to perform crossing of block trades, with a print of the tape after the transaction is complete. Nonetheless, it is still surprising to me how in the current financial environment that the SEC, other regulators, and some of the exchanges themselves have not spoken more about dark pools, their transparency (or lack of transparency), and the affect this has on price discovery. In fact, it seems to me that given current credit issues, this might not be a something the industry wants to advertise. Yet, this is apparently not stopping some.

As recently reported at the Deal Breaker blog, Goldman Sachs, Morgan Stanley and UBS have agreed to share their dark pools, such that each will allow for the secretive trading to take place between their clients. The dark pools include Goldman Sach's Sigma X, Morgan Stanley's MS POOL, and UBS's PIN ATS. The union further threatens to take business from the exchanges and furthers current consolidation of the brokerage industry. Right now exchanges are at a disadvantage when they try to compete with the dark pools since they are being regulated by the SEC, with new rules being put in place over the last year forcing them to share even more information and route trades to the exchange offering the best price and fastest execution. Dark pools have in many instances been able to avoid regulation by keeping trading volumes under a set threshold.

But again, while this is probably a good move for the financial institutions with regard to generating new business, lowering costs, and helping to tap into the monopolies of the exchanges, it is probably not the most public relations friendly move in the current credit environment. As is often unfortunately the case, this will surely cause some in Congress to start talking of new regulation, especially if someone goes way out on a limb and attempts to tie the practice to home foreclosures or high energy cost - adding a new level of regulation with the usual unintended consequences. If this happens, we may end up wishing that a dark pool of liquidity was truly just a Star War reference.

As reported in a New York Times article, liquefied natural gas (LNG) terminals built in Louisiana are becoming a home to empty supertankers that were expected to be importing LNG from around the world. Shipments of LNG to the U.S. are falling, with the LNG instead going to Spain and Japan, further depleting U.S. stockpiles. Unlike crude oil, natural gas is more of a regional commodity, although its price is connected somewhat to crude oil prices. Historically, crude oil has traded at about a 6-8 multiple to natural gas (or natural gas has traded at a 6-8 times discount to crude oil). Recently, natural gas has not kept up as crude oil continues to climb in price.

Given that competition is increasing for LNG, and since others are willing to pay more for the commodity, the U.S. will continue to get shut out unless changes are made. Due to reduced imports, it is estimated that the U.S. will only have 3.1 trillion cubic feet of natural gas in storage at the end of October, a figure that is almost 1 trillion cubic feet below what is considered full storage. Until the pricing structure in the U.S. becomes competitive with the rest of the world, it is unlikely that storage levels will increase, although the same cannot necessarily be said for natural gas prices. Historically, demand is usually lower in the spring, only to start increasing again in the fall as we enter the winter heating season. This year, natural gas prices have continued to rise through the spring as its price moves with oil, even if not at the same historical multiple. If supply constraints continue we may begin to see natural gas prices continue to rise, even if crude oil prices stay flat or even slightly decrease, as prices move to and stay within historical multiples.

A few months ago there was a discussion regarding the problems with Libor, in particular, how many banks may have been under-reporting their actual cost of borrowing. At the time there was speculation that a new way was necessary to insure that the rates quoted actually represented the true cost of borrowing. A recent article in the Financial News discusses how swap traders are once again beginning to show interest in alternatives to Libor.

Potential alternatives include the Sonia (Sterling overnight index average) and Eonia (Euro overnight index average). While Libor is calculated each day as an average of what banks state (think) are their borrowing costs, the Sonia and Eonia are effective rates computed as a weighted average of overnight unsecured lending in the interbank market. The Eonia is one of the benchmarks for the euro zone money and capital markets and is the standard interest rate for Euro currency deposits. The European Central Bank calculates the Eonia daily.

Most interest rate swaps have short maturities under two years, but more than one day. Swaps pegged against an overnight fixing are known as an Overnight Indexed Swap (OIS). This overnight market is a small part of the overall interest rate market, but interest in the market is increasing as traders look for alternatives to Libor. Numerous traders, from FX traders, hedge funds, mortgage lenders, and asset swap traders are showing interest for two curves, one against Libor for longer-term swaps, and one for overnight fixings.

Even with its problems, it is probably too early to write-off the Libor rate, as highlighted in a recent Reuters article (posted on Forbes.com). Many feel that the Libor system is not broken, but that recent volatility can be blamed on the reluctance among member banks to lend to each other as a result of the on-going credit crunch. The number of assets pegged to Libor is too large to make a quick transition. It is more likely that further steps will be taken instead to insure that banks are reporting the correct borrowing rates.

As reported in an LA Times article, the country of Bolivia is opening up a 40 billion ton deposit of iron ore for mining - the world's largest concentration of iron ore at a single site. The Indian company Jindal Steel and Power has been granted a 40 year concession to mine the ore at El Mutun, extending over 23 square miles. The rush to secure iron ore has increased as the demand for steel continues to climb.

In order to run the operation, it is expected that natural gas will be used as the energy source to power the necessary machinery. Bolivia has been one of South America's poorest nation despite a number of natural resources, such as natural gas, tin, zinc, silver and gold. Nonetheless, environmental and political issues have kept the resources in the ground. High commodity prices have a way of changing perspective. It is expected that revenue from the iron ore deposits will supply about 5% of the annual revenue of the Bolivian government. In addition to India, companies from China and Europe have been bidding on projects in the area.

As reported in a Financial Times article, banks are reporting a 65% increase in the practice of supply chain financing (SCF). This practice essentially involves using a company's unpaid invoices, or receivables, to secure financing. In some cases the company can also receive a lower borrowing rate. As reported:

"SCF involves companies and their suppliers agreeing to extend the payment period to the supplier, who still obtains early payment from the buyer’s bank. The buyer gets the benefit of longer payment times, the supplier lowers its working capital costs, which it can then pass back to the buyer in lower prices. The bank in the middle has the invoices to secure its lending and earns a margin on the loan."

The technique is essentially an alternative to the traditional asset-backed commercial paper market, where banks have also used receivables as the assets to back the paper. When the commercial paper market froze up, many started considering using supply chain financing. While SCF is an alternative source of financing for companies having difficulty obtaining traditional credit, it is also giving some banks a more efficient use of their balance sheet capital.

Looks pretty similar to me. Financial innovation never sleeps ......... or do ways for finding new sources of funding.

As reported in a recent Barron's article, how much money investors get back from auction-rate securities depends on who originally issued the securities. Auction-rate securities are debt that matures in 30 year or more, sometimes in perpetuity. The recent increase in the number sellers compared to buyers has caused some problems in the market, with some issuers running for the door. How the security was initially issued, and for what purpose, may impact how fast you are able to redeem the security.

The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will also likely receive their money, but may have to wait a little longer. Not surprisingly, the investors that purchased auction-rate securities sold by a CDO or student-loan trust will not get their money back for some time, up to many years. Many auction-rate security holders have no idea what the CDOs own since the information is not disclosed. Estimates have about $20 billion of CDO auction-rate securities that are failing to be sold in auction and therefore illiquid. Many of these securities will not be redeemed, and will essentially stay outstanding until the CDO either collapses, or the investment within the CDO mature - in some cases, many years out.

For student loans, many loans are financed by selling them into a trust, and the trust then sells medium and long-term debt, some of which are auction-rate securities. For the trust, there are not many refinancing options given that student-loan financing costs have gone up quickly. Initial rates from some failed auctions were 10% or higher. To prevent problems, some trust have a mechanism that prevents the average rate from going high enough so as to push a trust into default. Some student-loan based auction-rate securities are therefore offering 0% rates to investors, with average rates of 3%. With such low rates, this doesn't encourage student-loan trusts to fix the liquidity problems anytime soon.

Unfortunately, auction-rate securities are probably just one example of what is no doubt becoming a much larger problem. As investment companies continue to deal with their own credit issues, expect more of the fixes, and consequences, to roll down hill.

Below are the weekly link summaries for the usual groups: commodities, derivatives, hedge funds, private equity, quantitative finance and financial engineering, and trading. As usual, hopefully you find some articles that you may have passed over, but might be interested in reading. Enjoy the long holiday weekend.

Commodities

Oil's tense trading scene may sway a move to Dubai
Myra Saefong - MarketWatch.com
* The Dubai Gold and Commodities Exchange will begin trading crude-oil futures on Tuesday. This planned commodity trade is turning out to be a timely move given the talk from Congress and elsewhere about the regulation of speculators in the commodity markets. As with many actions in Congress, there are unintended consequences. The movement of trading off-shore may be one such consequence. Without really affecting the overall problem, the move may just end up taking the control of the issue out of our hands - to the extent it can even be controlled. Liquidity and volume are low in comparison, but in a few years the Dubai exchange could see an increase in volume as traders look for a friendly environment.

Derivatives

Citigroup Says Swaps Mania in Muniland Is Finished: Joe Mysak
Joe Mysak - Bloomberg
* Sales of synthetic fixed-rate munis, used to help the municipal market hedge their bond issue interest rate risk, are being scaled back, in part due to counterparty risk, but mainly due to inexperience. Many local municipalities are realizing that they don't have the experience and knowledge to understand the risk involved, the money to hire professionals, or the ability to know if the professionals (if hired) are taking advantage of them. As a result, they are eliminating one type of risk, but are in some instances now leaving themselves without a hedged position.

World Watches EU's Carbon Trading Scheme
Leigh Phillips - BusinessWeek
* Another article about the law of unintended consequences. This time with carbon trading. When Europe first implemented carbon trading, the scheme resulted in windfall profits for energy companies, drops in the price for carbon credits (due to over-allocation), and a disincentive for the industry to increase expenditures on clean energy infrastructure and efficiency measures. The result were higher consumer prices, higher energy company profits, and higher carbon emissions. Hopefully the EU experiment will provide lessons. They are currently taking measures to correct mistakes.

Derivatives Market Grows to $596 Trillion on Hedging
Abigail Moses - Bloomberg
* Data shows that derivatives on debt, currencies, commodities, stocks, and interest rates has increased 44% compared to last year, to $596 trillion. Amazing numbers indeed. CDS protection doubled during this time to $58 trillion of debt. Interest rate derivatives were up 35%, foreign exchange derivatives were up 40%, equity derivatives were up 14%, and commodity derivatives were up 26.5%.

OTC platform to offer iron ore access
Javier Blas - FT.com
* Both Credit Suisse and Deutsche Bank are teaming together to create an off-exchange over-the-counter (OTC) market to trade iron ore swaps. The swaps will have initial maturities out to December 2009 and be cash settled on a monthly basis against an iron ore index published by the Metal Bulletin. Iron ore was one of the largest commodities without a market, and given the rising demand and prices for steel, it makes sense that a new hedging (and speculation) contract would be offered.

Hedge Funds

Global Hedge Funds Rose in April as Worldwide Stocks Gained
Tomoko Yamazaki - Bloomberg
* Overview of global hedge fund performance. Of interest is how hedge funds worldwide were up in April as global stock markets recovered. In particular, managers of long-short equity fund were the best performers.

Age is key to hedge funds
Anuj Gangahar - FT.com
* A recent study finds that hedge funds that are less than two years old produced higher returns on average than older funds (11.7% per year to 10.2% per year), but that older funds tended to have returns that were more steady. In a sense, as managers get older, return is given up for risk management. It was not mentioned in the article, but this may results from the manager having so much of their wealth in the fund the he or she starts to get a little more conservative.

Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults
David Evans - Bloomberg
* Interesting article on the problems with trading in swaps in the current market. This is a longer article, but well worth the read. In part, it discusses how given that the swap markets are basically unregulated, counterparty risk is not only present, but it is difficult to quantify. But this is not stopping the swap market, which has doubled every year since 2000, and is currently larger in dollar value than the entire NYSE. As of now, 40% of credit default swap protection sold worldwide is on companies or securities that are rated below investment grade. Estimates have hedge funds selling about 31% of all CDS protection, yet many have not been asked to post adequate collateral to back up their positions, and no set regulations are in place. Many hedge funds do not have the necessary funds in place if a problem does develops.

Ex-Amaranth Trader Hunter Helps Deliver 17% Gain for Peak Ridge
Saijel Kishan - Bloomberg
* Well, if you are wondering why anyone would hire Brian Hunter, the hedge fund trader that helped bring down Amaranth Advisors in 2006, this is why: His new fund returned 17% last month using a similar strategy as that employed at Amaranth. The fund is using option spreading strategies on natural gas prices, nearly the same strategy to that was used at Amaranth. The quote of the day comes from energy analyst Kent Bayzaitoglu: "To have lost that amount of money and get back into the market with a similar-type trade takes a lot of confidence, if not arrogance."

Private Equity

Mideast Private Equity Looks to India
Saikat Das - BusinessWeek
* Middle East sovereign wealth funds are beginning to focus on the country of India as a result of believing that the country’s long-term growth prospects are good and that the country is decoupled from the United States. Areas of interest include real estate, health care, retail, and education. The number of private equity deals in India for the first four months of year were 156 ($4.94 billion) compared with 136 deals ($3.42 billion) over the same four months in 2007.

The year of the vulture
Allan Sloan and Katie Benner - Fortune
* Article on private equity, discussing how those that will profit are most likely to be the firms that profit from other's misfortunes. In particular, firms are "double cropping," or in other words, making a second profit from the buyouts already done by offering capital to the institutions that financed the original deals and now need help. In a sense, they are buying their own debt back from the banks at reduced cost, given that the banks were unable to unload it after the credit crunch, not only eliminating the extra commissions and fees, but also now exposing themselves to credit risk. Ah, the old golden rule - those with the gold make the rules, and in this case, profit from the misfortunes in the market. Those with capital truly can buy when things look the worst, and not just pray on others, but also help them out of difficult positions.

Quantitative Finance and Financial Engineering

Quantitative funds aim to retool models
Mark Copley and Ben Wright - WSJ
* Interesting article on how quant funds suffered as the credit crisis unfolded, causing many of their models to breakdown. One aspect that has the quant managers worried is how many of the quant strategies that are being used seemed to be affected in the same way at the same time for certain market conditions, suggesting that the models were using the same techniques - a kind of quantitative herd mentality. It is believed that one of the problems is that they tend to use the same type of academic research, and be trained by the same set of researchers. Many are now trying to considering non-traditional public information (at least non-traditional for quants), such as short interest, quality of R&D, and insider buying.

Quant to Double Assets This Year After Beating Hedge Fund Peers
Netty Ismail - Bloomberg
* The rise of the quants from the ashes. Well, not exactly, but the QAM Asian Equities fund, a small Singapore-based quant hedge fund is doing well by betting against stock index futures. The QAM global fund rose 44.5%, while the Asian portfolio gained 66.2% in 2007. Not bad in the current market, especially for a fund not concentrated totally in energy. The fund has only $150 million in total assets under management, but is growing at 30% per year. The fund manager has a Masters in computer engineering, among other graduate degrees.

Trading

The Most Promising ETF's? Russia and Coal
Dash of Insight Blog
* A discussion of various ETFs, with an emphasis on an ETF from Russia and a Coal EFT. A sector ETF report is also provided by Dash of Insight. Of interest, not surprisingly, are that energy and international EFTs continue to rise to the top of the list.

Straddle Strangle Swaps
Condor Options Blog
* A nice overview of the straddle strangle swap, which is a specific type of double diagonal that involves selling a front month straddle and buying a back month strangle. Too much detail (see the article) without reprinting everything in the article, but the position has a number of positive attributes. In particular, it has a larger width (more profit opportunity) and positive vega, but only half the theta of a swap (for the example given). It can also be entered for a credit rather than a debit. Nonetheless, it does require more commissions.