• K Squared Capital

Weekly Edition #57

In this edition:

The Moral Hazard Lessons

From Nickel Market Disaster

Last week there were unprecedented moves in the nickel markets. The price went from roughly $24,000 per metric ton to $80,000, well that’s before the exchange (London Metal Exchange) decided to halt trading and cancel an entire day’s worth of trades. They decided, after the fact, to halt trading when the price of nickel had surged 100% to $48,000. This was done because several very large traders were short, large amounts of nickel and were not able to meet margin calls. Essentially, large producers of nickel who were using the futures market to hedge their production did not have enough cash to deposit as margin at the exchange. Therefore, the exchange instead of forcing them to go bankrupt, decided to cancel the trades and spare them; at the cost of whoever was long the futures and had made billions in profits.

The exchange probably has the legal right to do this, it is a private company providing a service after all. However, this brings into question the validity of their markets. Arguably the price went up so much because traders were short and had to cover their positions, which drove the price even higher. The LME argued that the traded price didn’t reflect the underlying market dynamics. However, short squeezes are part of market dynamics and part of how markets work. Who is the LME to say what the “right” price is? If they knew this, then why have markets? Traders who were taking on too much risk were essentially bailed out by the exchange. What precedent does this set for risk management? Is the lesson to be learned here (and 2008, 2020, LTCM in the 90s, etc.) that if you’re a massive player and take on too much risk you will be bailed out if it doesn’t pan out? There’s a saying that goes, if you owe the bank $10,000 that’s your problem, if you owe the bank $100 million, that’s the banks problem. We guess that’s true then…

Hedge Fund Fir Tree Bets Big With Short of Stablecoin Tether

We’ve written several times before about Tether, a cryptocurrency which is intended to be worth $1 (a stable coin). The way that it is worth $1 is that it has assets that back every Tether (supposedly). However, there has been a lot of controversy as to whether there are enough assets to back it 1-1. The company has refused to get audited, claiming that no one wants to actually conduct the audit. The numbers they have released show a large investment in commercial paper. Its odd since the large commercial paper traders at banks claim to never have heard of them in the market. So, there are real doubts as to what exactly is backing Tether. There have also been many claims that Tether is used to manipulate Bitcoin and that increases in supply of Tether are oddly timed just when Bitcoin’s price is increasing; implying that Tethers were issued to buy Bitcoin and push up its price.

All these claims were just that, claims. Now the hedge fund Fir Tree has actually placed a bet that Tether is not backed 1-1 by financial assets and that when this comes to light the price will crash. The interesting thing about this position is that it is very asymmetrical. If they’re wrong then Tether will be worth $1 and they will not lose much money (just what they are paying to borrow and short Tether, or the price of the puts). However, if they are right and Tether crashes, they could make a lot of money. In an ideal scenario we would only invest in these types of trades, large positive payoff if we’re right, and small negative payoff if we’re wrong.

Options Traders Who Bet Against Russia Can't Unwind Positions as Markets Halted

The Russian invasion of Ukraine is causing havoc in many financial markets. From Ukrainian bonds dropping by around 50% in value, the Ruble collapsing, Russia not being able to access its foreign exchange reserves, and the Russian stock market closing. This last point is interesting and it’s what the linked article is about. There’s a US listed ETF which invests in Russian stocks (ticker: RSX). This ETF has been halted for several days now; therefore, there haven’t been any trade trades since around March 4th. And the last price of the ETF is the price at which it closed on that day, $5.65. If you had RSX in your portfolio, then it’s marked at this last sale price. And it will probably eventually resume trading or liquidate but you will get whatever it’s worth eventually (it may be worth $0, depending on how things play out).

However, there are options listed on RSX, and these options expiring this coming Friday, and the one after that and so on. Since the ETF is halted, these options haven’t traded either. If you hold any of these options, you should be getting worried about what’s going to happen. You cannot exercise the option since the underlying asset is not trading so you cannot buy or sell it. You can’t trade the option since the product is halted. So, what happens at expiry? Will they become cash settled and you will receive the difference between the strike price and the price of the ETF? What is the right price? If you had a put option of $5 you won’t get paid anything. But what happens if it resumes trading on Monday and the real price should be $3? Events like these are completely unpredictable. There are certain end of the world trades that we’ve heard about that would only pay off in extreme scenarios. The problem with these trades is that if the event happens, then the situation is so bad that your counterparty will probably not exist…

Greenwashing Is Increasingly Making ESG Investing Moot: Green Insight

We’ve talked several times before about ESG investing (environmental, social, and governance). In theory ESG is great, invest according to your values and earn higher returns with lower risk. Apart from the fact that we may disagree this is actually possible, there are companies taking advantage of the ESG trend. Recently a whistleblower called out DWS claiming they were taking advantage of the ESG trends to profit by claiming things they weren’t doing. There have also been cases where funds change their names to include ESG in the title but don’t change anything in their holdings or investment process. This only helps to attract investors who invest based on names and don’t do deep dives into what the fund is actually doing.

As with anything in investing we need to truly know what we are investing in and not just go by the name. Also, ESG is such a broad classification that it encompasses many things. No company scores 100% on ESG metrics; therefore, if we want an ESG focus we need to focus on the things which matter most to us. Are environmental policies more important than social impact or governance? The most important thing is that we invest in things we know and not just go by the name. If we want to invest in funds that don’t invest in oil, then make sure the fund doesn’t have oil companies. We need to actually study the funds we invest in.

Russia & The Rules Governing Indexes

Another interesting aspect about the Russia situation is what happened to investment indices. MSCI and FTSE both kicked Russia out of their emerging market indices. This means that many ETFs that track these indices will need to get rid of these shares, something they cannot currently do. The interesting point here is that even though indices are “passive” there are still rules they follow. Someone has to make those rules, and every decision is an active decision. In theory a completely passive index should invest in every financial asset in existence. In theory Russia should still be eligible for a completely passive index. But the real world is different than theory and there are very real practical limitations for owning Russian stocks right now.

Thanks for reading!

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