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LONDON WHALE TRADE REVISITED – A Look At The CDS Skew, Net Notional And Curve


CDX.NA.IG.9 10Y series shows an unusual spike in net notional level

The skew for CDX.NA.IG.9 10Y as a % of par spread rises to a level that goes against the arbitrage limits and stays there

The skew for CDX.NA.IG.9 5Y shows negative spikes signaling a curve flattener trade

Hedge funds jump in to cash in on the arbitrage opportunity,suffer huge losses initially, create noise that is picked by financial mediawho investigate and pin it down to JPMorgan traders. Regulators take notice.

ECB introduces the LTRO program that goes against the flattener trade and JPMorgan takes its biggest ever loss

After 4 long years of litigation, the London whale case resurfaced in the financial media in 2017 with the U.S. prosecutors deciding to drop criminal charges against two former JPMorgan Chase & Co. derivative traders – Javier Martin Artajo and Julien Grout. The charges were dismissed as the DoJ said that it no longer believes that it can rely on the testimony of Bruno Iskil, a cooperating witness who had been dubbed the “London whale” by the Wall street Journal. Bruno Iskil, who was fired from JPMorgan during the aftermath of the trade that cost the firm a whopping $6.2bn, was granted immunity by U.S. Law in exchange for providing testimony against his two former colleagues. As per reports, Bruno Iskil has since been residing in his home country –France and is in process of writing a book about the whole affair.

The London whale trade was a trade in the CDS (credit default swap) market that went horribly wrong and led to JPMorgan realizing a loss of $6.2bn + fines and some hedge funds marking their best ever performance year.

In this article, I attempt to provide the readers with another high level perspective on what transpired during the 2011-2012 London whale trade by looking through the lens of the CDS index net notional, spread levels, skew and credit curve. 

A CDS index is an index that, at origination, is composed of the single name CDS prices of 125 companies (known as the “Underlyings”). It goes by the name of CDX in North America and iTRAXX in Europe, Asia, Australia and Japan. Both these indices are created every 6 months and owned by Markit Group Limited (“Markit”).  Each new construction of the CDS index is given a new series number. The new index when created is known as the “on-the-run” index (similar to treasuries) and has the effect of attracting maximum liquidity before a new index is created in 6 months and liquidity migrates to that new index. This is termed as “liquidity migration”. There are CDS indices for investment grade and the high yield CDS contracts. For e.g. CDX.NA.IG.5 means a CDS index comprising of investment grade names in the North American market and is the 5th such series created. On top of this, each index has a maturity attached to it, which is derived from the maturity of the underlying CDS contracts.

The spread on the index is the premium associated with gaining default exposure on the basket of underlying firms. It is generally equally weighted i.e. the spread is derived by equally weighing all the single name CDS spreads constituting that index. Since the index is a separately traded entity, there can be divergences between the index spread and the average CDS spread of the underlyings - known as the intrinsic spread of the index. This divergence, in absence of arbitrage opportunity, generally is a few basis points that takes care of the minute technical differences in the covenants associated with the index and the single name contracts. In trading parlance, this divergence is called the skew and is defined as:

                         Skew = Intrinsic spread – Index spread

The net notional, different to the volume, is similar to “open interest” in options and is a measure of the total economic interest.

Credit curve in the CDS world is a term structure of CDS spreads for maturities ranging from 1 year all the way to 30 years.

Now that we have a basic understanding of what the terms mean, let’s dive in to see what happened in them during the trade in 2011-2012.

The CDX of interest in this particular case is the CDX.NA.IG.9 10Y which means the CDS index for North America investment grade names and maturity of approximately 10 years from origination. It was launched in September 2007 and was the 9th such index created. This series also had another important property. It was the last on-the-run series before the financial crisis. A lot of CDO’s were active before the crisis and this series provided a neat way for the traders to construct and hedge their positions in such CDO tranches. Since the CDO activity died down during and after the crisis, the later index series could not be used to get exposure to the CDO tranches.

The chart below shows the net notional on each index series including series 9 and the ones created after it. The black line shows the total net notional across all series. Almost in all series, we observe the net notional first rises at inception of each series, since it’s the de facto on-the-run series, before coming down as liquidity shifts to the new on-the-run index in 5-6 months. However the series 9 (purple line) is the only exception. The net notional on series 9 stays steady across time and in fact explodes to the upside sometime in July-August 2011. 

The steadiness of the net notional in series 9 is understandable given our earlier arguments of it being the only index used to hedge CDO tranches. However, the upside explosion in the net notional is something strange. The chart below shows the net notional on the series 9 alone to better understand the rise in activity. (Source:DTCC)

The net notional almost doubled in the period from October 2011 (~$80bn) to March 2012 (~$150bn). This was enough to signal the traders in the market that there was definitely something going on here.

From the picture till now, it is clear that there was a lot of interest arising in this particular series but was unclear whether it was buying or selling interest. The charts below show the skew and the spread level of this CDS index.


As we can see, the skew of this index was around 25-30 bps on the overall spread level of roughly 160 bps. That is around 15-20%. Such a magnitude in skew is enough to confirm the belief of traders that there was distortion in the market and get ready to take the opposite side of the trade. The positive sign of the skew signaled that the intrinsic spread was higher than the index spread and thus there was selling occurring in the index that led to compressed index spread levels. However, when we talk about putting on opposite trades with such magnitudes in this highly liquid market, there are some sanity checks in order. 

One sanity check for the traders was to look at the skew of another index which had a similar maturity to the CDX.NA.IG.9 10Y which matures in December 2017. That index was the CDX.NA.IG.17 5Y index (maturity December 2016). The chart below shows the skew levels as percentage of par spread for both these indices.

The chart clearly shows the elevated levels of skew in the CDX.NA.G.9 10Y series as compared to the CDX.NA.IG.17 5Y index which was more within the arbitrage limits.  The arbitrage here being the differential earned by buying/selling CDS on all individual underlyings and selling/buying the index spread.

Another sanity check was to compare the net notionals in another market CDS index. The chart below shows the net notionals of several index series in the European market tracked by the iTRAXX index.

There was no significant jump in the net notionals for series 9 in this market.

All these signals conveyed that the distortion was, in particular, in a specific North American index.


Macro Play:

Meanwhile the CDX.NA.IG.9 5Y index with maturity December 2012 showed another interesting picture.

The skew as a percentage of par spread showed unusual negative spikes during the same period that the CDX.NA.IG 9 10Y showed positive spikes. This signaled that the trade was in fact a curve trade with the position being short credit in the short term (buying CDS short term) and long credit in the long term (selling long term CDS). This is commonly known as the flattener trade and is based on the expectation that the term structure of CDS spread will become flat or possibly inverted in the future. This usually happens when the near term risk is high and long term prospects are better, given that the company survives the short term risk.

From a trader standpoint, who is willing to bet against this trade, there are 2 possible ways he can do so:

  1. Counter directional (contrarian view): Since this trade was based on the flattening of the CDS curve, a contrarian trader could take the view of the curve steepening (“Steepener trade”). This was however too risky as this is a pure directional play on the credit risk in the market.
  2. Index vs underlying basis arbitrage: The index gives access to the default exposure to a basket of single name CDS. Since the skew was high enough on the positive side, meaning that the index was trading cheaper than the underlying firms CDS, the counter trade was to buy the index CDS and sell CDS on each of the underlying single name CDS constituting the index. This trade. Though operationally a lot more difficult to execute, was more comfortable for the traders it relied on the arbitrage bounds and did not involve any discretionary bet on the market.

So the stage for the battle was set, where there was this possibly one huge trader or a group of traders that were creating this distortion in the market and putting on a directional bet on the credit risk of the economy and on the other side were traders (mainly hedge funds) that were relying on the skew to correct and had taken a pure arbitrage play.

The chart below shows the CDX.NA.IG.9 10Y skew as a percentage of par spread during the entire period.


It’s a common saying that the markets can remain irrational for as long as you can remain solvent. Many hedge funds entered the arbitrage play during the period from September 2011 to December 2011, but the skew % on this index refused to come down. This led to huge mark to market losses for the hedge funds taking the opposite side of this big trade. Initially, when the hedge funds were putting on the trade, they did it secretively as no one wants to let out their big cash generating trade. But as time went by and they suffered big losses, they started to create noise about this trade in the market.

The downfall:

The noise created by the hedge fund community was enough fuel for the financial media to create a forest fire. The media was particularly interested in this story as it involved the financial giant JPMorgan. In the months that followed, there were several articles written, investigations done and it was revealed that there was in fact one unit in JPMorgan that was solely responsible for this huge distortion in the CDX.NA.IG.9 10Y series.  This then spread to the regulators notice who started actively pursuing the investigation of JPMorgan’s risk books. Meanwhile, another the ECB (European Central Bank) announced the LTRO (Long term refinancing option) program that cooled the short term rising credit risk in the market. This went against the flattener trade.

So the whale was cornered by the media, regulators and the mounting mark to market losses on the flattener trade. The chart below shows the skew as a % of par in the months following the period that JPMorgan unwound the trade.

The skew/spread level fell down to as low as 2%. Many hedge funds that were seriously in red earlier but somehow sustained their position, were heavily in green now. As JPMorgan continued to unwind the trade, they announced a series of losses over that period with the final figure adding up to $6.2bn.

Finally, the chart below shows the flattener performance during that period and highlights the area where the losses were booked.

Acknowledgement: I'd like to thank my professor Mr. Deepak Agrawal from MFE UC Berkeley for the key insights that helped me put this article together.