[ By Larry Goldfarb ] J.P. Morgan’s trading strategy, as reported in the May 16th Wall Street Journal, utilized index derivatives and credit default swaps to hedge the bank’s exposure to the long expected recession in Europe.  According to the Journal, the trade had three legs: 1- Buy derivatives on indexes tracking high-yield corporate bonds.  The bank makes money on the indexes if the value of the corporate bonds dissipate; 2- Sell credit default swaps to offset the exposure from the index derivatives.  The improving European markets called for a reduction in derivative index exposure; 3- Buy protection on investment-grade bonds that expires at the end of 2012. While the specific trade was not cited, the article noted that it another type of index derivative product, unrelated to the first two. A number of interesting points are noted.  First, J.P. Morgan made money on the premiums between the different hedges.  This could be a troublesome development if it was the primary reason the bank entered into these types of hedge trades.  Second, the trade used different types of securities that didn’t necessarily move in tandem.  Thus a particular market move could cause the hedge trades to move together with the bonds it was trying to hedge and not offset the exposure.  Third the size of the trade, in excess of $100 Billion adds significant risk.  Large trades to take advantage of small moves in interest rates have caused banks to fail; it took down the Long Term Capital Hedge Fund and nearly the entire financial system in the late 90s. But the most concerning aspect of the trades is that there ultimate behavior of the trades versus the economic conditions are not well understood.  Credit Derivatives are based on both economic factors and the specific behavior of the credit derivative market.  Traders have been at a loss to model their behavior.  So to use these trades, ostensibly as a hedge, is irresponsible. It is extremely difficult to identify a hedge versus a proprietary trade.  As the regulators finalize the specific language of Dodd-Frank, it has been suggested that proprietary trading will be prohibited for banks, but hedging will remain intact.  Thus, it is in the bank’s best interest to obscure the 2 types of trades.  Traders who have reviewed J.P. Morgan’s trades seem to hold to the view that there is more to the trade than just a hedge. Expect the provisions of Dodd-Frank to look very closely at the developments at JPMorgan as they draft the final form of the regulation.