Editor's note: The "London Whale" incident triggered a discussion on regulatory rules and internal control system, and showed the difficulties faced by financial regulators, including the trading dilemma of systemically important institutions, the self-expansion trend of derivatives market and the speculative impulse of investment banks. In view of these problems, the analysis of the "London Whale" incident in this paper shows that the supervision of large financial institutions must be moderate, and the monopoly of derivatives market needs to be broken, and the supervision of risk hedging behavior that is traditionally thought to reduce risks should be strengthened.

It seems that some "stories" are always repeated in the financial market, following Nick of Bahrain Bank. Allison, Kuiku from UBS Group AG? After Adoboli, "London Whale" Bruno? Michelle? Ixil was born, and caused huge losses in JPMorgan Chase, which is known for its steadiness. On May 1th, 212, JPMorgan Chase announced that it had lost $2 billion in credit derivatives trading. But the problem didn't stop there. Before the huge losses were announced, in April, JPMorgan Chase was accused of illegally disposing of Lehman clients' funds in the bankruptcy case of Lehman Brothers, and was fined $2 million. On May 3th, JPMorgan Chase was investigated by the Japanese financial supervision department for alleged insider trading related to the Japanese Banyanzi rights offering plan (Japan Banyanzi Co., Ltd. is a Japanese glass manufacturer-editor's note). These events show that even for financial institutions with a good history of internal control, speculative impulse is inevitable, especially in the complex derivatives market, financial institutions will inevitably expand their business and risks greatly.

Three key words of the "London Whale" incident

The details of the transaction that caused huge losses in JPMorgan Chase have not been disclosed. At present, it is only known that JPMorgan Chase traders, known as "London Whale", made huge transactions in the credit default swap market, which led to the continuous distortion of some credit default swap market prices and brought huge risk exposure to JPMorgan Chase. All the other detailed discussions about the "London Whale" incident are still confined to speculation. However, in the analysis and debate of the "London Whale" incident, three key words are repeatedly mentioned, which is also the core conflict of the "London Whale" incident.

The Volcker Rule

The "London Whale" incident made people pay attention to the risk isolation of financial institutions again. With the passage of the Financial Services Modernization Act of 1999, the American financial industry officially returned to the era of mixed operation. However, the subprime mortgage crisis made people see the systematic risks brought by high-risk derivatives transactions, and tried to isolate the high-risk business of financial institutions in the financial supervision system. As the embodiment of this idea, Volcker rule was put forward.

the so-called Volcker rule refers to article 619 of Dodd-Frank Act. This article stipulates that: unless otherwise stipulated, banking institutions cannot engage in self-operated business, obtain or hold any common stock, partnership or other forms of owner's rights and interests, nor can they initiate hedge funds or private equity funds. Non-bank institutions under the supervision of the Federal Reserve should also have additional capital requirements and scale restrictions when engaging in the above business. This rule tries to separate high-risk self-operated business from low-risk traditional business, but it is opposed by most financial institutions. Because most financial institutions in the United States have proprietary business, and proprietary business has become an important source of profits, the Volcker rule has seriously affected the profitability of financial institutions. Under the lobbying of financial institutions, the implementation of the Volcker rule was postponed. On April 19, 212, the Federal Reserve, the Futures Trading Commission, the Federal Deposit Insurance Corporation, the Monetary Authority and the Securities and Exchange Commission jointly issued the Notice on the Adaptation Period of the Volcker Rule, announcing that financial institutions applying the Volcker Rule can postpone the time to fully meet the requirements of the Volcker Rule until July 21, 214, and it is likely to be further postponed until 217.

JPMorgan Chase's huge losses have pushed the Volcker rule to the forefront again. The transaction in the "London Whale" incident is no longer a loss problem of financial institutions caused by financial derivatives trading, but a market manipulation problem caused by financial derivatives trading out of control. This is quite similar to the "327 national debt incident" in China. It is the almost infinite trading position of the empty side that leads to the failure of the market price to return to the theoretical value, which in turn leads to the deterioration of the whole market.

There are still two views on the discussion of Volcker rule. Supporters believe that it is JPMorgan Chase's huge trading in credit risk derivatives that forces JPMorgan Chase or its counterparties to accumulate a large number of positions, thus bringing systemic risks to the market. If the Volcker rule is strictly implemented, the huge trading will be restricted, which will neither seriously distort the operation of the credit derivatives market nor bring huge losses to both parties. Opponents believe that the Volcker rule lacks enforceability. On the one hand, JPMorgan Chase's derivatives trading is characterized by hedging risks, while the existing version of the Volcker rule puts forward some exemptions from the ban on proprietary trading, such as making markets for customers and hedging the risks related to customer transactions, but does not completely prohibit banks from hedging transactions; On the other hand, the Volcker rule will further restrict the liquidity of the assets of banking financial institutions that are already in a difficult situation due to the disintermediation of the banking industry and the financial crisis, making them at a disadvantage when competing with other companies. At present, the debate between the two sides on the Volcker rule is still going on.

Value at Risk

The "London Whale" incident also made people pay attention to the risk internal control of financial institutions. As the most important risk control tool in JPMorgan Chase, Value at Risk (VaR) has been repeatedly mentioned.

first of all, the question to be answered is whether the value at risk hinders the disclosure of risk information. As early as during the Southeast Asian financial crisis, the problem that the value at risk is not helpful to manage small probability and huge losses was widely recognized, and it was gradually supplemented by risk analysis tools such as stress testing. However, the "London Whale" incident further shows that the value at risk will also bring about the selective disclosure of risk information. Risk analysis tools such as stress testing can be used as a supplement to the value at risk, but these tools can't be calculated day by day and easily decomposed like the value at risk, thus providing an optional "blank area" for the disclosure of risk information of financial institutions, enabling managers of financial enterprises to conceal potential small probability and huge losses within a certain period of time and providing space for insider trading. Therefore, the U.S. Department of Justice, the Federal Bureau of Investigation and the Securities and Exchange Commission investigated JPMorgan Chase's executives to find out whether they concealed the real risks of the transaction.

Secondly, the calculation model of value at risk is also controversial. To calculate the value at risk, it is necessary to determine the distribution characteristics of the value of financial products in a specific period of time in the future. In the original value at risk model, the value of financial products obeys normal distribution or lognormal distribution. However, historical data show that the actual value distribution of financial products has a higher peak and a thicker tail than the normal distribution, which is called "peak fat tail" characteristics. In order to be closer to the real value at risk, the calculation of value at risk can adopt historical simulation method, Monte Carlo simulation method, pressure test method and fractal distribution method. Considering that the value at risk ignores the risk exceeding the confidence interval, this paper puts forward the Conditional Value at Risk (CVaR) on the basis of the value at risk, that is, the average value of the losses exceeding VaR. Various calculation methods of value at risk and derived risk indicators have their own advantages and disadvantages, which leads people to discuss whether the loss is caused by the wrong model. JPMorgan Chase changed the method of calculating the risk value of the Chief Investment Office (CIO) when the first quarter of 212 was released, but it did not change the calculation model of the investment banking department, which made the risks faced by CIO have different assessments before and after the model change. The different price confirmation methods in the model are also considered as the main reasons for JPMorgan Chase's huge losses, and the US Securities and Exchange Commission is also reviewing the accuracy and timing of these changes disclosed by JPMorgan Chase.