By John Kemp
LONDON May 17 JP Morgan's reported loss on a "hedge" highlights the way the concept has been stretched in the last two decades to cover a broader range of transactions than before, many of which have little to do with the traditional concept of offsetting underlying price risks with like-for-like derivative positions.
It should stiffen the resolve of regulators to define hedging more narrowly in future when deciding whether positions should qualify for special relief under banking and derivatives laws -- and ignore special pleading from banks, lobbyists and derivatives lawyers to continue stretching the term to give privileged treatment to an ever-wider range of transactions.
If institutions wish to continue portfolio hedging for commercial reasons, they should remain free to do so, but without any special favours from the regulatory system.
In general, U.S. law treats derivatives positions established for hedging more favourably than those which are speculative in character. Preferential treatment for hedging transactions has been evident in every major piece of derivatives legislation from the original 1922 Grain Futures Act to the 2010 Dodd-Frank Act.
Hedges get more favourable treatment on everything from position limits to margining, capital requirements and position reporting. Underlying this separate and unequal treatment is an assumption that hedges are more socially useful than purely speculative positions.
U.S. law explicitly encourages hedging. For example, Title 7 of the U.S. Code contains "Special procedures to encourage and facilitate bona fide hedging by agricultural producers" (7 USC 6q).
But legislators have taken a more sceptical approach to other positions, especially anything that might lead to "excessive speculation," which Congress has defined as speculation that "causes sudden and unreasonable fluctuations or unwarranted changes in the price" and constitutes "an undue and unnecessary burden on interstate commerce" (7 USC 6a(a)(1)).
WHAT IS A HEDGE?
Hedging is variously defined in the law as a derivative position to "mitigate commercial risk" (7 USC 2(h)(7)(A)(ii)) or as a transaction to "permit producers, purchasers, sellers, middlemen and users ... to hedge their legitimate anticipated business needs" (7 USC 6a(c)(1)).
But the most comprehensive and basic definition is set out in the provisions regarding hedging exemptions to the position limits that apply to everyone else (7 USC 6a(c)(2)).
Here a bona fide hedging transaction is defined as one which "represents a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel" and it "is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise".
It arises from any potential change in the value of "assets that a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising; liabilities that a person owns or anticipates incurring; or services that a person provides, purchases or anticipates providing or purchasing".
In addition, banks and other swap dealers may claim a hedging exemption when they enter into swaps with a counterparty which is itself hedging underlying price risks.
In other words, when a bank enters into a swap transaction with an airline, and then offsets that price exposure with a futures contract or an option, it can claim to be hedging even though its exposure to the underlying commodity is purely financial rather than physical.
The definitions mostly apply to physical commodities, but the same ideas lie behind hedging of financial risks. Behind all these complicated definitions is the idea that hedging transactions offset and reduce existing risks in the business, while speculative transactions increase them or take on new ones in the hope of making a profit.
In reality the distinction is often less clear cut. Some institutions use derivatives to hedge and speculate at the same time. For example, an oil company or a bank may use derivatives to hedge its operational inventories (a physical hedge), offset other swap deals it has done with customers (a financial hedge) and bet on the direction of oil prices or refining margins (pure speculation).
In principle these different transactions can be analysed and regulated separately. In practice, institutions often treat all these positions as part of a single "book" and then try to claim favourable hedging treatment for the whole lot, arguing that it is impossible to identify the different components.
BASIS AND CORRELATION
The bigger problem arises when firms try to hedge their exposure to one commodity or financial instrument by establishing a derivative position in a similar but not quite identical one.
So-called dirty hedges or correlation trades are in fact very common. For example, a copper fabricator might hedge the value of its work in progress and stock of unsold items with a position in copper futures which specifies delivery of copper cathodes.
A cocoa processor might hedge stocks of cocoa butter and powder with a position in cocoa futures specifying delivery of beans. Or an oil refiner might hedge purchases of Libyan Es Sider crude in the Mediterranean with a position in Brent crude futures priced in the North Sea.
More ambitiously, airlines often hedge their jet fuel requirements in the more liquid crude market.
Differences in the stage of processing, location, timing, or quality/grade between what the physical leg of the hedge and the material deliverable or referenced in a derivative contract leave the hedger with residual "basis risk".
Basis risk is inevitable in the public futures and options markets, where contract terms are highly standardised to maximise liquidity. Over-the-counter swap transactions can be structured and customised to eliminate or substantially reduce basis risk, but only at the cost of a loss of liquidity and transparency.
Basis risk is a familiar and accepted feature of futures markets, though it causes periodic blow ups and squeezes, for example when a cocoa processor finds itself unable to deliver its physical stocks of powder and butter against a short position in cocoa futures.
The need to strike a balance between hedgers and speculators, so basis risk and the threat of squeezes does not undermine the usefulness of futures contracts and cause them to disappear altogether, is one reason for position limits and other rules against squeezes and corners in futures markets.
In the last two decades, banks and other large financial institutions have stretched the concept of hedging further by arguing they should be able to hedge the aggregated/net risk position of the institution as a whole rather than on a trade by trade or position by position basis.
Rather than hedge each transaction separately, institutions want to total up (and net out) all the risks of one particular type in their portfolio and put on a single hedging transaction (or set of transactions) to offset them. The theory is sound but the practice can occasionally be disastrous.
Even assuming risks can be aggregated correctly, the resulting portfolio-wide exposures may be very large and rather imprecise. In most cases it is hard to find an exact or even an approximate hedge, especially one with the sort of size and liquidity that a major financial institution or energy company would need to be able to put the hedge on and lift it safely.
Portfolio hedges therefore often involve much more basis or mismatch risk than transaction by transaction hedges and instead rely heavily on correlations. The problem with correlations, as Long-Term Capital Management and now JP Morgan have discovered, is that they can prove unstable, particularly when they are needed most. At that point a transaction originally conceived as a hedge can morph into a speculative directional bet.
Moreover, once broad correlation hedges are permitted to receive special treatment by regulators, almost any transaction can be counted as a hedge. Regulations designed to safeguard derivative markets and the safety and soundness of the financial system become ineffective, as the exemption swallows up the rule.
Indeed there is a suspicion this is why banks and their lawyers have pushed so hard for the broadest possible definition of hedging to circumvent tough new rules on position limits, margining, capital requirements and proprietary trading.
If the law is going to create a distinction between hedging and speculation, and treat hedges more favourably, it is essential regulators adopt and enforce a restrictive definition of what constitutes a hedge. Regulators should employ the narrowest possible definition of hedging, not the broadest.