The government in 2007 published a very informative report on Amaranth's demise. Of note to curious investing types, so that the paper summarizes some great background information on the natural gas market and also some basic spreads / strategies employed by traders.
You can find the report here: Amaranth SEC - Excessive Speculation
For most of us not expert on the workings of nat gas, there's a few interesting sections: what drives natural gas demand, how do traders implement their views, the difference between winter and summer prices. The report also paper validates what I've heard from a few people in commodities - that Hunter's positions were enormous, not just compared to the normal volume in the natural gas market but relative also to the US annual natural gas consumption. If anything, Amaranth is a great practical example of what can go wrong when one player in a market tries to manipulate and squeeze out other participants. But to be fair to Hunter, he was successful in squeezing out and bankrupting a few funds on his way up (before he marched into his own Battle of the Little Bighorn).
Interesting enough, after the Amaranth meltdown, Hunter launched another fund called Solengo Capital Partners. It amazes me that he was able to even raise capital. Basically, if you invest, there is a chance you lose 100% of your money - so I guess you could call it a one-of-a-kind investing opportunity. Ironically, Hunter was also dismissed by Deutsche Bank after taking extreme positions and losing a ton of money (but not before he tried to convince a judge that he deserved a bonus from the money he made from previous reckless bets). But last from what I read on the news, he's fighting some regulatory charges, although one could speculate that he doesn't really need to work after his years at Deutsche Bank and Amaranth.
Got a few questions recently, so for students looking into entering finance, here's a quick tutorial on types of jobs on the "sell-side", in general referring to investment banks. Sorry if this turns out to be too basic, but nowadays with the regulatory scrutiny, everyone has to be careful what they write:
Prologue
There three main types of Front Office roles: sales, trader, and structurer. Salespeople manage relationships with clients of the bank. In general, clients will communicate with sales on trades or deals. Sales are usually judged by the amount of commissions or sales credit that their clients pay to the bank. Traders manage risk and positions for the bank. Usually traders are in charge of trading books and are measured by the profit & loss of their trades. In a flow based bank, the traders try to profit from market making. Lastly, a structurer is a hybrid between a sales and trader. The structurer is more technical that sales, and can help work with clients to efficiently implement their views; their role can become very important when dealing with bespoke derivatives and structured products.
Besides these main roles, there are two other quantitative roles in front office: derivatives modeling and algorithmic trading. Derivatives “quants” sit alongside the trading desk and help model or price exotic derivatives. Traditionally most quantitative analysts worked on derivatives modeling. Quants in algorithmic trading try to develop algorithms to minimize market impact or trade in a way to best match a benchmark like VWAP (Volume Weighted Average Price). Knowledge of exchange rules and market microstructure is important for this job. This area has been growing in recent years with the proliferation of electronic trading.
Types of Trading
There are three types of trading: proprietary, market making, agency
- Proprietary trading - bank uses its own capital to take make bets. The counterparty to proprietary trades are generally not clients of the bank.
- Market Making - Bank provides a bid price and ask price to clients looking to trade. If the bank has enough client flow, then the bank can slowly make profit by continually buying at the bid price and selling at the ask price to collect the spread. Most banks derive roughly 90% of its revenue from market making.
- Agency Trading - In this type of trading, banks do not take any principal risk. Instead, they do a trade and pass on the executed price to the client, and are paid on commission. Agency trading is more common in the equity markets, when clients allow traders to work orders on a best efforts basis to beat VWAP or minimize market impact.
Other Quantitative Jobs in Middle Office
Outside the front office, there are also positions in the middle office which require quantitative skills
- Market Risk: They attempt to quantify risks which the banks positions have. Some statistical measures such as Value-at-Risk are measured, and market risk also monitors limits on greeks and other mathematical risk measures.
- Credit / Counterparty Risk: This group helps calculate the credit exposure a bank has against other counterparties. If a bank has too much credit exposure to one counterparty (another bank or a fund), the credit risk team may prevent Front Office from transacting further with the counterparty.
- Capital Risk: The capital risk team would ensure that the bank fulfills certain capital ratios for regulatory reasons.
Commentary and Analysis
- Client Toxicity / Market Making
- Most large flow-oriented banks track “client toxicity” on certain clients. Client toxicity refers to the whether or not a certain client’s flow tends to hurt the bank; some clients might have insider information while others like Pimco tend to trade in such large size that they would move the market. For clients who tend to be right on their trades often, a bank (or even a market-maker) might choose to piggyback the clients’ trades. For example, if one hedge fund trades rate futures before every Fed Decision and is always right on whether or not the Federal Reserve changes the target rate, then the bank might trade in the same direction of the client after filling the client on his or her order. Also, other clients are so large that their trades would impact the market adversely and therefore, it is sometimes unprofitable to trade with such clients. To illustrate, many bank fixed income traders want to see a large institutional fund's flow, but never want to be done on a trade facing that institution. Therefore, when submitting bids for a large block trades, it is better always to finish second in the bidding, because it still shows the bank is competitive, while at the same time allowing the bank to “miss” a potentially toxic trade. Determining which clients have an edge is an important piece of information. Jeff Yass, founder of the successful option market making firm Susquehanna discusses in Market Wizards the importance of adjusting continually adjusting markets in market making in order to take into consideration new information. In fact, one of Jeff and Susquehanna’s principles is that one can never be sure of fair value and that the market is always smarter. Thus, it makes sense for all traders, even ones who trade mostly listed derivatives (for which the trader might not know their counterparties), to get information on who is doing what in the market.
- Dodd-Frank Regulation
- One topic frequently discussed on CNBC is the future Dodd-Frank regulation that banks will be subjected to. Dodd-Frank will initiate some large structural changes in financial markets which will impact banks. In market making activities, banks tend to make more money if markets are less transparent. Even in Foreign Exchange Spot markets, there are no “trade-through” rules similar to equities where there is a National Best Bid Best Offered. With opaque markets, clients be able to judge less if a bank is providing them a fair price. However, Dodd Frank requires the implementation of a swap executing facility (SEF), where trades must be reported within trading. This might erode the profits of large flow derivative houses, but should reduce slippage for clients and possibly also level the playing field for smaller niche banks.
