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The SEC Demanded That JPMorgan Provide More Disclosure About Goldman Sachs's Prop Trading

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I enjoyed Bloomberg's story about how the SEC was pestering JPMorgan to better disclose its proprietary trading activities well in advance of the London Whale fiasco. If you just read the headline you'd be all "oh look how prescient the SEC was," but if you read the actual letters, not so much. Here is my favorite exchange:

SEC: Identify the trading desks and other related business units that participate in activities you believe meet the definition of proprietary trading. Identify where these activities are located in terms of your segment breakdowns. Quantify the gross revenues and operating margin from each of these units. We note your disclosure on page 59 of your Form 10-K for the year ended December 31, 2010 that you have liquidated your positions within Principal Strategies in your former Equities operating segment. It is not clear if this was the extent of your proprietary trading business. Please clarify if there are other proprietary trading businesses. If there are, please clearly identify the extent to which such activities or business units have been terminated or disposed of as well as the steps you plan to take to terminate or dispose of the rest of these components.

JPMorgan:1 ... The Firm believes that the Staff’s comment regarding the disclosure on page 59 relates to the Form 10-K filed by a registrant other than JPMorgan Chase.

Hahahahaha true, it's Goldman Sachs.

The more interesting question in this, um, poorly edited form letter that the SEC sent JPMorgan is:

Revise your future filings to clearly identify aspects of your business that are similar to but excluded from your definition of “proprietary trading” for these purposes. Clearly disclose how you differentiate such activities. Tell us the extent to which you believe it is possible that such activities will be scoped into the final regulatory definition of proprietary trading.

I mean, you tell us, SEC! This is really a head-scratcher of a question, is it not? "Tell us what things that you think aren't prop trading you also think will be prop trading. Also tell us what rules you think we will make." I guess everyone wants Jamie Dimon's opinion about everything.

JPMorgan continues to answer in the spirit of "this is dumb but what can you do," giving a good crisp defense of why (1) market making and (2) structural-hedging-with-a-possibility-of-going-horribly-awry are not "proprietary trading" under the Volcker Rule, followed by a polite form of "but you dopes can do whatever you want so we'll warn our investors that you might make the wrong decision."2 It does not, however, make much effort to quantify the revenues in its market-making and Whale-hedging businesses that are at risk if the SEC decides to make a more draconian Volcker Rule. And from subsequent letters it seems like the SEC dropped the issue.

Which is kind of a shame, no? I'm not a big believer in the idea that you can sharply or sensibly delineate bad "proprietary trading" from good ... good whatever, "market making" or "hedging" or "long-term financial intermediation like, y'know, lending." Banks get money and then invest it in stuff; the stuff that they invest in is not rendered more or less risky by calling it "proprietary" or something else. If the Whale wasn't losing money on CDX curve trades, somebody at JPMorgan would be losing it on mortgage modifications or lending to Greece or whatever.

But the Volcker Rule is happening, probably, so somebody's gotta do that delineating. And it might be nice to get JPMorgan's sensitivity table, as it were, about the costs and benefits of bans on various forms of prop-trading-adjacent activity. How much revenue would it cost if, for instance, any mark-to-market profits on market-making were verboten? How much revenue would it cost if Whale-hedging were not allowed? Or, as it turns out, how much revenue would that save?

JPMorgan Pressed by SEC on Prop Trading Before Whale Loss [Bloomberg]
July 1, 2011 from JPMorgan Chase & Co. to SEC [EDGAR]

1.Delightfully this response is in a footnote. In the body of the letter they actually answered the SEC's question as it applied to JPMorgan, providing a table (unfortunately redacted) of JPMorgan's prop trading revenues.

ALSO: You're the SEC, man. This correspondence happened over a year ago and is just being made public now. Wouldn't you come to an understanding with JPMorgan about editing out this bit of the letter?

2.I mean, you can just read the letter, but here's the relevant bit:

The Firm does not believe that its client-driven market-making and risk management activities constitute proprietary trading. However, for completeness, we discuss below these activities, which have some features that are somewhat similar to proprietary trading activities, but remain distinguishable based on several important characteristics.

The Firm’s Investment Bank line of business is active in markets for all major financial products in the course of its client market-making and other client-driven activities and actively manages its exposures to credit, interest rate, and other financial risks arising from such activities. While some of these activities require that the Firm take principal positions that, superficially, appear to be similar to proprietary trading positions, they are distinguishable from proprietary trading positions based upon their basic objectives, which are to provide market liquidity and assist clients in achieving their investment and risk management objectives and to manage the resulting risk to the Firm. The Firm’s client market-making and risk management activities are defined by their business mandates and limits, which, together with the risk profiles and other characteristics of the businesses in question (including, for example, the employment of significant numbers of sales staff in the Firm’s client-driven businesses), distinguish these activities from proprietary trading desks.

In addition, the Firm’s Chief Investment Office manages the Firm’s structural risks such as interest rate and foreign exchange risk arising from the assets and liabilities created by its operating businesses. These asset and liability management activities, including securities and loan investment strategies and risk management activities using derivative instruments, are designed to mitigate the Firm’s structural risk exposure and preserve the Firm’s longer-term capital value through economic cycles and, as such, are clearly distinguishable from proprietary trading activity.

The final determination of what is, and what is not, considered proprietary trading for the purposes of the Volcker Rule is heavily dependent on the final content of the Implementing Rules. Certain of the activities that the Firm currently expects to be permitted under the Volcker Rule could be scoped into the definition of prohibited proprietary trading under the final Implementing Rules. However, it is too early to identify definitively activities that may be scoped into the definition of prohibited proprietary trading. Accordingly, in future filings the Firm will include appropriate disclosure of this uncertainty through the inclusion of additional Risk Factor disclosure as further outlined in the Firm’s response to Question 2 of this letter.


You Say "Voldemort" Like That's A Bad Thing

Do you think that Bruno Iksil, when he woke up in Paris on Friday looking forward to trading from home in his black jeans, expected to become an international celebrity? The evidence suggests not. You may remember Iksil - possibly under other names like "Voldemort" or "the London Whaleâ„¢" as the JPMorgan chief investment office trader who has sold protection on $100bn of notional of a CDX investment grade index to ... hedge ... JPMorgan's massive short position in credit ... or ... something?* Anyway a lot of people are mad at him because that's just too much protection to sell on that index and so they are complaining to Bloomberg and the Journal about how he is manipulating the market and also taking huge proprietary risks with JPMorgan capital that should obvs be regulated out of existence. This is weird in a lot of ways but one of them is that you can distill a lot of the Volcker-Rule complaints into "my God, you're telling me that JPMorgan is exposed to $100bn of credit risk on investment-grade debt issued by a diverse mix of 121 U.S. companies!?" No! JPMorgan is exposed to something like $750bn of credit risk on debt issued by a diverse mix of companies. Some of it's non-US. Some of it's not even investment grade. And that's just in its loan book.** Is writing $100bn of protection on the CDX.IG.NA.9 a terrible risk to take with investor and depositor and government-backstop money? Well, define "terrible risk." It's certainly less risky than operating the rest of JPMorgan.***