Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Wed, 29 Jun 2005

FSA Fine on Citigroup is total nonsense

The order that the Financial Services Authority (FSA) of the UK has passed against Citigroup Global Markets Limited (CGML) in the Euro MTS case imposing a fine of $25 million is total nonsense. Clearly, the FSA lacked either the evidence or the courage to say that Citigroup had manipulated the markets. At the same time, the FSA was unwilling to let them off without any penalty. What they have done therefore is to impose a penalty under regulations that have no bearing on the case at all. This means a penalty is imposed without having to prove any serious charges against Citigroup.

The event that led to the fine was quite simple. On 2 August 2004, Citigroup “executed a trading strategy on the European government bond markets which involved the building up and rapid exit from very substantial long positions. The centrepiece of the strategy was the simultaneous execution of a large number of trades on the MTS platform using specially configured technology.”

FSA claims that in executing these trades, Citigroup contravened the following two Principles of Business of the FSA:

On the face of it, it is difficult to see how Citigroup's trading violated either of these principles. On the contrary, it would appear that its actions demonstrated a high degree of skill and sound risk containment systems.

FSA however believes that due skill and care were lacking because Citigroup did not consider the likely consequences of the execution of the trading strategy could have for the efficient and orderly operation of the MTS platform. This statement is absolute nonsense. The whole strategy was predicated on a clear understanding of these consequences which were highly beneficial to Citigroup. More importantly, Citigroup's understanding of these consequences was quite correct.

FSA also believes that there were

This would be a perfectly valid argument provided the FSA had first established that the trading strategy itself violated the rules of market conduct. The FSA does not however want to assert that the trading strategy was manipulative. If it does not do so, then it is difficult to see why a trade, even if it is very large, needs clearance from senior management.

I think the FSA has simply taken the easy route out. Perhaps, for Citigroup too, paying a $25 million fine is an easy solution to its problems.

Posted at 12:56 on Wed, 29 Jun 2005     View/Post Comments (0)     permanent link

Thu, 23 Jun 2005

Credit derivatives versus cash markets

In a recent paper (Packer, F.and Wooldridge, P. D. (2005), “Overview: repricing in credit markets”, BIS Quarterly Review, June 2005), the BIS compares the resilience of the credit derivative markets and the cash markets during the turbulence of May 2005 after the GM and Ford downgrades. They write:

“ the downgrade of the auto makers had the potential to cause dislocation in credit markets. In the event, cash markets appeared to adjust in an orderly way to the downgrade. Credit derivatives markets were more adversely affected, with CDS spreads ‘gapping’ higher on several days in the first half of May and lower in the second half ... Yet spillovers from credit derivatives markets to other markets were limited.”

They also contrast the lack of contagion to other markets in May 2005 with the massive contagion from the Russian default and the collapse of LTCM in 1998.

While the statements are factually correct, the implicit suggestions that the credit derivative market is less resilient and less important is misleading. As the paper itself points out, the major trigger for the turmoil of May 2005 was a sharp fall in default correlations. Since contagion is by definition a sharp rise in correlations, it is not surprising that a fall in default correlations is not accompanied by contagion. Similarly, it is correlated defaults that cause the greatest stress on the cash bond markets. Uncorrelated defaults are quite benign in their impact. It is only in the credit derivative markets - n‘th to default credit swaps and the lower tranches of a CDO - that a fall in default correlations can cause havoc. It is precisely in these markets that players lost a lot of money.

The relative resilience of the cash market and the credit derivative market can be truly tested when there is a credit event which is more symmetric in their impact on the two markets.

Posted at 18:39 on Thu, 23 Jun 2005     View/Post Comments (1)     permanent link