The public reaction on what, if anything, should be done by regulators with respect to JPM’s $2 billion dollar loss Â (or potentially even more?) has been mixed. However, to constructively answer the question more needs to be learned about the conditions under which these trades took place. A critical issue is whether the involved tradesÂ were supposed to have been done for hedging purposes or simply for proprietary trading.Â Is it possible to distinguish these? A recent insightful interview by Professor Andrew Lo (MIT Sloan School of Management) provides interesting insights into this question:
Yes, we can tell the difference [between hedging and trading]….There is one very simple question that you can ask ” which has a definitive answer ” about the small number of individuals who were responsible for managing this group at JP Morgan and putting on the specific trades that lost these large amounts of money. That question is: How were they compensated on an annual basis? Were they paid a salary and a bonus, and was the bonus a function of the profitability of the group, or was the bonus a function of the hedging ability of the group? If you can answer this question ” and it definitely has an answer to it; it’s not a metaphysical question ” you will have your answer as to whether it was proprietary trading or hedging. I don’t know the answer, but I know the answer exists, and I know that certainly the government can get that answer with a single phone call.
And on whether new regulations should be imposed as a response to this loss, Professor Lo adds that:
I think there’s a lot more we need to learn about what happened, for a couple of reasons. I’m a firm believer in the need for financial regulation, so I’m not in the camp that says, Let markets run wild. But it’s tremendously costly to implement any new regulation, never mind the existing ones, so before we propose new rules, we really want to make sure we know what we’re doing.
The whole interview is well-worth reading; it’s available at http://web.mit.edu/newsoffice/2012/3-questions-andrew-lo-on-jp-morgans-multibillion-dollar-trading-loss-0530.htm.l