I’m back to working on this blog starting this month.
This is what I’ve been up to
The months of February and March were crazy with the coronavirus and its impact on the market. I was busy most of the time in these months trading, documenting, programming, and continuing the improve and refine my trading processes.
2018 (with emphasis on the last three months of the year) was extremely rough for me. I fought the Fed multiple times on trades and I lost. I was actually looking for jobs in January and February because I wasn’t sure I’d be able to continue trading.
That changed, fast
Volatility in the market took off. I held short positions that profited insanely. Negative gamma had proven to be my ally. Convexity won out.
This extended my runway another 4-6 months at a minimum. It’s been a scary ride but I’m loving every minute of it.
What’s to come
Anything that I’m interested in. I’m currently interested in the following things, in no particular order.
Understanding gamma exposure deeper
Other options greeks and their effects on markets
Higher order options greeks (vanna and volma)
Game theory
Kelly criterion and position sizing
The rise of the carry trade
Federal Reserve operations
The current state of the economy
The current state of politics in the world
Python programming
Calculating gamma exposure from easy to obtain information
Building trading dashboards
That’s just a few I can think of off the top of my head.
There are two sides to every deal. The repo markets are no different.
On one side of the deal, there are banks sitting on a large supply of cash. On the other side of the deal, there are the hedge funds that are sitting on a large supply of Treasuries.
Banks lend cash to hedge funds and hedge funds place Treasuries as collateral to banks. Hedge funds are able lever up trades they make on Treasuries.
How do they do it?
One increasingly popular hedge fund strategy involves buying US Treasuries while selling equivalent derivatives contracts such as interest rate futures, and then pocketing the difference. This is an arbitrage strategy that hedge funds use that would generally yield small profits.
The trade is not profitable on its own, given the close relationship and price between the two sides of the trade. Hedge funds use leverage via the repo markets to increase returns.
In some cases, hedge funds take those Treasury securities they own, and place it as collateral in the repo market for cash. Those hedge funds then use that cash to increase the size of their trade and buy more Treasuries, and place it as collateral in repo market for cash once again. This process can be repeated over and over to leverage off the potential returns of this trade.
The arbitrage strategy above was once popular amongst dealer banks themselves. However, higher capital charges have led to their displacement by hedge funds, due to hedge funds greater ability to take on the risk of this trade.
There has been a growing clout of hedge funds in repo market, including Millennium, Citadel, and Point 42, which are very active in repo market and are also the most highly leveraged multi-strategy funds in the world.
So what really happened in September 2019 in the repo market?
This brings us to the market on September 16, 2019. The secure overnight funding rate (SOFR) more than doubled in the intraday range jumped about 700 basis points (repo rates typically fluctuate in an intraday range of 10 to 20 basis points).
The repo rate reached as high as 10% that day.
Some have speculated that end of quarter pressures put on banks to meet those regulatory guidelines caused the repo spike.
However, you have to consider that these overnight funding Market issues arose in mid-September. Not at the end of September when you would expect banks to hoard more cash.
What happened in August and September that could have caused issues in the repo Market that rippled through hedge funds?
We turn our attention to Treasuries and their performance in August and September.
From July 31st 2019 to August 15th 2019 TLT (20+ year Treasury Bond ETF) increased almost 13%. This was following the Fed’s first-rate cut after the tightening cycle that we saw ultimately in December 2018.
The Fed cut the rate 25 basis points and the Treasury market responded with an outsized move on Long-Term Treasuries in anticipation more easy money Fed policies becoming a mainstay. The Fed reiterated that the rate-cut was a “mid-cycle adjustment”, but that didn’t stop Long-Term Treasury prices from surging.
From September 5th to September 13th the same Long-Term Treasury bond prices dropped 7%. This could be due to the fact that investors realized they over adjusted the price of long-term treasuries and were now adjusting prices down to reflect new expectations.
I believe much of the volatility in the overnight repo markets has to do with these large moves in Treasuries, which increased volatility in any trade related to Treasuries, which in turn would have an effect on leveraged trades made by hedge funds on Treasuries. Banks may have recognized this, and grew reluctant to provide cash funding to this market for this and other regulator reasons.
There is still a lot of research and learning I need to do on this, but these are my thoughts on the repo markets as of January 20, 2020. Please share your insights in the comments below.
One potential solution is to lend cash directly to smaller banks, securities dealers and hedge funds through the repo market’s clearinghouse, the Fixed Income Clearing Corp., or FICC.
Hedge funds currently borrow through a process called sponsored repo, in which they ask a large bank to act as a middleman, pairing their government bonds with money-market funds willing to lend cash. The bank then guarantees that the parties will fulfill their obligations—repaying the cash or returning the securities. Firms trading through the FICC contribute to a fund that would cover a borrower’s default. Critics of the new plan say if the Fed lends cash directly through the clearinghouse, it could end up contributing to a hedge-fund bailout.
The Fed’s aim, according to analysts, is to step back from temporary efforts to quell repo-market volatility and increase financial reserves. After September’s volatility, officials succeeded in suppressing year-end swings with temporary measures, such as offering short-term repo loans and buying Treasury bills.
With the Fed acting as a backstop to hedge funds, is this admitting failure in the repo market with repo operations? Maybe failure is a strong word. Let’s say that repo operations have been less effective at diffusing money market issues than they Fed anticipated?
Did the Fed believe these funding issues would go away after year-end, only to discover these issues aren’t going anywhere anytime soon?
This is an interesting development that I post about more in the days to come.
Back on December 31, 2018 (before our September 2019 repo blowup) the rate on “general collateral” overnight repurchase agreements (repo rate) went from from 2.56 per cent to 6.125 per cent. This was the highest repo rate observed since 2001 and was the single largest percentage jump since at least 1998.
Some (including JP Morgan Chief Jaime Dimon) believe that various regulatory measures introduced in the wake of the Lehman crisis designed to make the financial system safer ends up putting stress on banks at quarter-end and moreso at year-end.
What regulations are said to cause stress in the repo markets?
The Basel III regulatory framework, calculates a tiered capital surcharge on global systemically important banks (GSIB) and is based on factors like their geographical sprawl, complexity and absolute size.
These charges are calculated from a snapshot at the end of the year which means that the world’s biggest banks (JPMorgan Chase, Citigroup and Bank of America) are motivated to deflate the size of their overall balance sheet and trading book ahead of the end of every year, and then reflate them again afterwards.
This allows banks to essentially operate with less capital, boosting returns to shareholders in the form of stock buybacks and dividends.
Some believed that the spike in repo rates in December 2018 suggests that big banks were wary of playing their usual role in facilitating markets this year feeding the turbulence in the repo markets,
In mid-December 2018, the Basel Committee on Banking Supervision opened up a consultation on whether it should revise its quarterly assessment of balance sheets, noting that “heightened volatility in various segments of money markets and derivatives markets around key reference dates (eg quarter-end dates) has alerted the Basel Committee to potential regulatory arbitrage by banks”.
Some argued that regulators could also easily tweak the impact by calculating daily averages rather than using a snapshot, and move to a smoother sliding scale of capital ratios as opposed to the current tiered approach that encourages gaming.
Changes have not been made to these regulations however, and the repo market continues to wreak havoc on Fed policy as of January 2020.
Repo is a generic name for repurchase transactions.
In a repo transaction, one party sells an asset (such as Treasury Bonds) to another party at a set price. The seller commits to repurchase the same assets from the same party at some future date. If the seller defaults, the buyer is free to sell that asset to a third party to offset their loss.
Repos are a way for borrowers to raise short-term funding by agreeing to buy and sell securities over very short timeframes. In practice they function much like a collateralized or secured deposit, and are a vital part of the financial system.
Banks had become increasingly active in the repo market in recent years, lending out some of the surplus money they hold at the Federal Reserve to earn a little extra return in a safe and liquid way.
How is repo rate determined?
The difference between the price paid by the buyer at the start of the repo and the price received at the end is effectively the lending rate on the repo. This is known as the repo rate or repo interest.
Why are repos used?
Repo agreements can serve four primary functions to different institutions:
They are a safe investment for those with extra cash laying around.
Borrowing costs are cheap.
Yields can be enhanced for institutions holding safe assets and by increase their leverage.
They provide a means for short-selling and short-covering.
It’s safe because the cash is secured by collateral, which is generally safe assets. It also makes it easy for seller of repo to make money back by selling those secured assets if the buyer does default on their payments.
Yields are enhanced because a party could lend out a high demand asset to the market, and in return they receive cash for cheap which can be used for funding or reinvesting profits.
What is repo with an example?
When an institution or bank needs immediate cash but doesn’t want to sell their securities, they can enter into a repurchase agreement to supply their immediate cash needs.
A repurchase agreement is similar to a loan, and you are using securities as a collateral.
For example, say XYZ Bank Corp. needs to raise cash in order to meet some reserve requirement level. They have plenty of securities on hand, but not enough cash.
In this situation, XYZ Bank Corp. decided to enter into a repurchase agreement with ABC Bank Group.
ABC Bank Group will take on XYZ Bank Corp’s securities and will lend them cash overnight to ensure they are meeting those reserve requirements.
Once the term is up, XYZ Bank Corp will “repurchase” their securities from ABC Bank Group and their debts will consider to be settled.
Repo operations (within the context of the Federal Reserve) are Repurchase agreements and are conducted only with primary dealers.
The Fed purchases Treasury, agency debt, or agency mortgage-backed securities from a counterparty, subject to an agreement to resell the securities at a later time.
It’s similar to having a loan that is collateralized with assets. These assets from the banks have a higher value than the loan to protect the Fed against market and credit risk.
Repo transaction temporarily increase the quantity of reserves in the banking system.
The New York Fed began conducting repo operations in September 2019 to ensure supply of reserves is ample and to mitigate risks of money market pressures near year-end that could affect policy implementation of interest rates.
What is a repo?
Repo is a generic name for repurchase transactions (which can include buying or selling). It is a transaction in which one party sells an asset (such as Treasury Bonds) to another party at a set price and commits to repurchase the same assets from the same party at some future date.
If the seller defaults, the buyer is free to sell that asset to a third party to offset their loss. This is what makes a repo very similar to a collateralized or secured deposit.
How is repo rate determined?
The difference between the price paid by the buyer at the start of the repo and the price received at the end is effectively the lending rate on the repo. This is known as the repo rate or repo interest.
Why are repurchase agreements (repos) used?
Repurchase agreements can serve four different functions for various market participants:
They are a safe investment
Borrowing costs on repos are very cheap
Yields can be enhanced for those holding a large amount of safer assets
They provides a means for short-selling and short-covering
It’s safe because the cash is secured by collateral, which is generally safe assets. Makes it easy for seller of repo to make money back by selling those secured assets.
Yields are enhanced because a party could lend out a high demand asset to the market, and in return they receive cash for cheap which can be used for funding or reinvesting profits.
Why do banks use repos?
Banks will use repurchase agreements (repos) for short-term borrowing. They do this to raise short-term capital and generally use agreements which are very short-term, generally overnight or 48 hours.
The implicit interest rates on these agreements is known as the repo rate, and is a proxy for the overnight risk-free rate.
Repo can be used for many purposes. One such purpose would be as an efficient source of short-term funding
It also allows institutional investors to meet liquidity requirements without having to liquidate long-term investments. The repo market has become an important source of cash for non-banks to meet Basel regulatory requirements.
Two months ago Ray Dalio wrote an article on how the world has gone mad with regards to monetary policy. Here is my short summary of Mr. Dalio’s article:
We are currently “pushing on a string”, a phase which Ray says we have never seen during our lifetimes. This is the situation where investors are flush with cash, and would rather invest it, not spend it.
The prices of financial assets have gone up as interest rates have plummeted. Low expected returns aren’t just driving up the prices bonds, but also equities, private equity, venture capital, etc.
Startups don’t have clear paths to profits, so they rely on selling dreams (Adam Neumann WeWork is a prime example) to get people to invest in their ideas. Investment managers are sitting on large hordes of cash and are looking for any place to park their funds, hence the overblown valuations of companies.
Government deficits are large and continue to grow. As a result, governments must sell more debt that nobody is interested in buying because the interest rates on these debts are so low. Central banks end up buying this debt by printing new money. (But don’t say they are monetizing the debt).
Down the road, as pension and healthcare liability payments come due, those obligated to make these payments will be unable to do so. How does this happen? Those institutions have expected returns of 7%, much greater than expected returns in the market in the coming years.
As these institutions are unable to make payments, unfunded liabilities will balloon as a result of suppressed growth. Teachers and governmental employees are those most exposed to this risk.
In sum, money is basically free (because of low to negative interest rates) for those who have money and creditworthiness. Money is unavailable for those without money or creditworthiness.
This contributes further to the wealth gaps we see today. Technological innovations are creating a way for companies to cut jobs further as well. The effects of low interest rate monetary policies are no longer “trickling down” to workers as a result. Thus explains how to we got where we are today.
Primary dealers are trading counterparties of the New York Fed in the implementation of monetary policy. The make markets for the NY Fed as needed, and bid on a pro-rate basis in all Treasury auctions at reasonably competitive prices.
There are 24 banks designated as primary dealers. Well known banks that are primary dealers include JP Morgan, Wells Fargo, Bank of America, Citi Group, Deutsche Bank, just to name a few.
Why do we have primary dealers?
Primary dealers are counterparties who buy government securities and resell them to the overall market. These are banks that have an inside track to buy US Treasuries.
Primary dealers purchase the vast majority of the U.S. Treasury securities (T-bills, T-notes, and T-bonds) sold at auction. They will then resell those securities to the public. Their activities extend well beyond the Treasury market.
Arguably, this group’s members are the most influential and powerful non-governmental institutions in global financial markets.
Where are primary dealers located?
Many dealers are in the US. There are also dealers across the globe, including Japan and Europe that distribute US Treasuries to those geographical areas of the world.
What are the requirements for primary dealers?
Firms must meet specific capital requirements before it can become a primary dealer.
The capital requirements for broker-dealers that are not affiliated with a bank is $50 million. Banks acting as primary dealers need to have $1 billion of Tier 1 capital (equity capital and disclosed reserves).
Prospective primary dealers need to show they made markets consistently in Treasuries for at least a year before their application.
I used to believe that risks to the market get priced into the market.
This is based off the efficient markets hypothesis. Once information is known it immediately gets priced into the market.
However, risks don’t always get priced in (right away) for one reason or another. Perhaps those risks are further off the horizon than believed. Perhaps those risks are going to dissipate soon. Perhaps those risks are not as significant as I believed they were.
Whatever the case may be, the market doesn’t always price in risks to the market right away.
Lesson learned
In October, I saw numerous risks to the market and strongly believed we would move down another leg lower in the S&P 500. I placed my bets accordingly, and it did not work out at all.
What risks did I see? A hiccup in the overnight repo market, beginning in mid-September. Hong Kong protests taking place every weekend, and U.S. Government officials denouncing China and supporting Hong Kong protestors. No signs of a real trade deal of significance. Slowing economic growth across the globe. A collaterialized loan market that’s looking more and more frothy.
I saw all of the risks, and here we are with the S&P 500 up 8.8% since October 8th, when the Fed made it known they would begin expanding their balance sheet with the purchase of Treasury Bills.
Markets are not efficient
Information can be priced in right away. Information can be ignored for days, weeks, months, or even years.
Risks can be priced in one week, and completely ignored the next week.
Markets are manipulated. No doubt about it.
But blaming my poor performance this month on market manipulation is irresponsible and definitely not a recipe for success.
I must learn how to trade around uncertainty and market manipulation caused by institutions and central banks across the world.
Trade the market you have, not the market you want.
On October 11, 2019, the Federal Reserve announced they would begin buying Treasury Bills in an effort to ensure there are “ample reserves” in the banking system through the end of the year.
On October 11, 2019, the Volatility Index (VIX) sat at 17.4. Today on November 26, 2019 the VIX has recently closed at 11.5. As you can see from below, it appears as though this not-QE program that is “organically” growing the Federal Reserve’s balance sheet has effectively killed the long VIX trade.
The case made that supports this idea is that investors are engaging in more risk on behavior, because they are basing their decisions based on the Federal Reserve’s prior balance sheet expansion programs (QE 1-3).
Because the Fed is purchasing T-bills, they have eased some of the money market pressures. Liquidity in the market has proven to be a positive catalyst to the market.
Why do I believe this?
It can’t be the trade deal.
That’s the only other source that has been moving the markets higher according to many daily stock market new reporters. And I don’t believe these markets are pushing higher on hopes of a trade deal.
I think the Fed’s easy money policies have once again eased tensions. For now.
A lesson to me
This whole scenario has taught me a valuable lesson about position sizing. I’ve learned to not be so overconfident in my predictions.
Every trade made is a small bet. Each bet will abide by the Kelly criterion.
Never go all in.
Grow your money slowly and strategically.
Live to trade another day.
Read
Barton_options on Twitter has been a great resource for me to learn more about the Federal Reserve operations and how it relates to the Treasury and the overall economy.
He recently wrote about this in a newsletter you can read here.
Enlightenment Investing 
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