The Commodity Futures Trading Commission has settled its case against JPMorgan Chase, the nation’s largest bank, over the latter’s alleged attempt to manipulate a financial-derivatives market amid massive trading losses at one its units.
The background is that, from 2007 to 2011, the bank amassed a net $51 billion portfolio of credit-default swaps, a type of derivative that is like an insurance contract used to hedge against, or just plain bet on, the risks of default in the bond markets.
Here’s how it works. The buyer of the credit-default swap (or CDS) pays the seller for the contract sort of like the way we pay insurance premiums. In return, the seller guarantees the credit risk by agreeing to pay off the debt in the event of a default. If the underlying debt performs, the seller profits, but if there’s a default, the buyer is protected.
As one can imagine, the value of these contracts can rise precipitously if there’s a wave of defaults in a given market. In 2006, for example, one money manager, John Paulson, began buying CDS contracts tied to the mortgage-backed-securities market. In effect, he began shorting, or betting against, the U.S. housing market. When he started, most of Wall Street was still bullish on housing, and these contracts weren’t worth much. But before long, as the risk of default began rising, and as banks and investors scrambled to buy protection, their prices went up. And how. In 2007, Paulson made nearly $4 billion from these investments. That’s right: $4 billion in one year. His move has been dubbed, “the greatest trade ever.”
In the JPMorgan case, the bank’s $51 billion portfolio began suffering heavy losses in January 2012. As daily losses grew into February, the trading unit acted to defend its position. Specifically, because the portfolio stood to benefit from a drop in the price of one particular type of CDS, traders began unloading that CDS copiously, including by selling it to another branch of the bank. On one day, for example, the bank sold over $7 billion worth of the CDS, an amount which dwarfed the average daily trading volume of the bank and other market participants. According to the CFTC, this constituted a “manipulative device” employed in reckless disregard of its consequences to legitimate market forces.
The case was a test of the Dodd-Frank law’s new prohibition against manipulative market practices. Whereas the law previously required proof that a trader have “intended” to manipulate the market and was actually successful in doing so, the Dodd-Frank amendments enable the Commission to prosecute the use of any manipulative device under a “recklessness” standard of liability. See the Commodity Exchange Act, 7 U.S.C. § 9, and the Commission’s Regulation 180.1, which is codified at 17 C.F.R. § 180.1.
JPMorgan admitted the factual findings set out in the Commission’s order, including that its traders acted recklessly, and agreed to pay a $100 million civil monetary penalty. Although the bank admitted certain findings of fact, it did not consent to the use of the settlement order against it in other civil lawsuits. In the meantime, separate investigations by the U.S. Justice Department and the Massachusetts Securities Division will continue.
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