None of our commenters took us up on last week’s wager for when Jefferies would release its next statement, and a good thing too — Monday was our guess, and here we go:
Jefferies announced today that its trading positions in the sovereign securities of the nations of Portugal, Italy, Ireland, Greece, and Spain have been reduced by an aggregate of approximately $1.1 billion long and $1.1 billion short. This represents a 49.5% reduction in Jefferies’ gross holdings of these securities since the close of business Friday and resulted in no meaningful profit or loss on today’s trading activity or our remaining positions, which continue to be substantially matched by country and maturity. Jefferies’ current net exposure to these sovereign securities is currently $59 million, or 1.7% of shareholder equity, with negligible market or credit risk.
Have a look at the Jefferies periphery positions posted on Friday before the exposure reduction and you’ll see that the single biggest figures were the neatly matched long and short positions (each about $1.5bn) of Italian 2012 debt.
Simple maths obviously means a chunk of the reduction had to have been from that position, though we don’t have more details and therefore no way of knowing the extent to which this could have affected the recent deep moves in Italian bonds. The long and short unwinds were unlikely to have been completely offsetting — especially if the long position was cash and the short was partially bolstered with futures. If that was the case the unwinding could have hit the curve differently, though to what extent we just don’t know.
According to Jefferies there was “no meaningful profit or loss” resulting from the unwind.
But as before it’s the so-called DV01 exposure, which measures the delta sensitivity of the positions with respect to interest rate changes, which is really of interest. But even here Jefferies states that there is no meaningful exposure.
We’d be curious to know, as ever, who took the other side of those trades and exactly how the unwind was done, if only for what it would tell us about the issues we raised last week. But as far as Jefferies are concerned, they seem to be saying, “Hey, we dropped this exposure to show that we could; we’re market makers, now leave us be.” Which has been the consistent message from the first statement on.
Here’s the rest of the statement from Monday:
“We undertook this reduction in our holdings solely to demonstrate the liquid nature of this market-making trading book,” said Richard Handler, Chairman and CEO, and Brian Friedman, Chairman of the Executive Committee of Jefferies, in a joint statement. “We will now resume our normal market-making activities and serve our clients around the world.”
Whatever “normal” is, these days.
Of course, it’s worth reminding readers that market-making by definition carries principal risk if flows cannot be offset immediately. It is usually the responsibility of the market maker to hedge themselves effectively to manage that risk as a result.
In normal circumstances market-makers only act as middlemen to their clients. They buy low and sell high. Their longs are the result of offering to buy from the market at a particular cost (usually a discount to the real market rate they themselves can sell for). Their shorts, meanwhile, are the result of offering to sell to the market for a premium. Thus, if you have bonds to dump, a market maker will buy from you provided you make it worth their while. If you are short, they will provide you with the bonds you need to cover your position, but again at a price that makes sense for them. Calculating this spread on a daily basis is a market maker’s bread and butter, and the spread should always account for liquidity and flow bias.
In an ideal world what they take on will be immediately offloaded to cover the short covering needs of their clients. As a result, it’s only a residual position (which cannot be offset) which would be hedged elsewhere. A sensible market-maker would usually look to do so as cheaply as possible.
How they determine the actual residual exposure is very much up to them. In fact it’s usually the secret sauce of many a market-making operation. In some cases it can be a function of their own view of where markets will go, but most of the time it will be a reflection of what they feel is correlated and what isn’t. In bond markets, the biggest skill comes in matching duration, interest-rate risks and funding costs alongside underlying bond positions.
If flows suddenly get skewed so that it becomes disadvantageous to carry long positions, this could theoretically impact a market maker’s ability to run the short side of the trade profitably. The extent to which that is the case, however, will depend on the nature, terms and conditions of the legacy shorts — and also to what degree they were providing funding.
– by Izabella Kaminska and Cardiff Garcia