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What Would You Do to Earn $5 in Seven Days?

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If you are like most people, you would not want to do too much heavy lifting if you were trying to earn those five crummy dollars.

Would you risk your job?
Would you risk your house?
Would you risk your company?

Most people would not. 

However if you are sitting on an overnight lending/repo desk, that is was you are being asked to do every single evening before the close of business. Because at current short term rates in the US, you earn roughly $5 for every $1mm at risk. This sounds like an innocuous trade - what could go wrong with US debt in one week? But 6 months ago, European repo traders were probably thinking the same thing. "I need to make my bonus. Greece is paying 10x the going LIBOR rate. F@#k it. I'm in for $500mm." This is a seemingly small bet for a large money center bank. 

However risk tends to cluster in homogeneous groups (e.g. traders). Recently a junior trader was asked his position, "Short yen". Why? "My boss is short". The inquisitor went up the chain, all the way to the head of risk, getting the same answer. The head of risk's response? "We heard a large macro hedge fund is short". And that's it. That's how a bank can find itself concentrated in a single trade, dozens of people grabbing at the same nickel on the ground before the steamroller gets them. This is also the risk facing banks when they develop mono-culture in their risk taking. All traders coming from Ivy league schools, etc. 

It is no surprise that banks are finding themselves owning a lot more of Greece than they thought. It is no surprise that MF Global was more at risk than probably Corzine imagined ("Hey John is long, so I am too!"). When faced with the prospect of making $5 for a $1mm bet, you will start looking at ANYTHING to make bottom line look better, especially if it appeases your boss.

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Guest Monday, 25 May 2020