David Dredge, Founder and CIO, Convex Strategies

[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange, where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry. David Dredge, Founder and CIO of Convex Strategies, has spent his career in derivatives markets on the long side of optionality and seeking value in convexity.

[00:00:29] It was great to learn more about the role he plays in fortifying client portfolios with insurance and to have him reflect on how periods of market stress expose limitations in traditional risk methodologies. Our conversation focuses on volatility supply and the structural forces that generated.

[00:00:48] Here, David discusses the growth of structured products across equities, rates, and FX markets and explains how regulatory frameworks, accounting treatment, and yield-seeking behavior contribute to the persistent creation of short volatility exposures throughout the financial system. David describes Convex Strategies as a value investor in volatility, focused on sourcing efficient insurance rather than trading vol for profit.

[00:01:14] He explains how the firm seeks to identify areas where volatility is supplied at attractive prices and where convexity can provide meaningful diversification during times of market stress. We also explore the role of leverage, correlation assumptions, and risk management frameworks in amplifying market dislocations. David discusses examples ranging from LTCM and the GFC to the rate volatility repricing of 2022.

[00:01:41] The conversation concludes with perspectives on Japan, global bond markets, and the importance of pricing when constructing hedges. Throughout, David emphasizes that the effectiveness of any hedge depends not simply on the instrument itself, but on the value at which the protection is acquired. I hope you enjoy this episode of the Alpha Exchange, my conversation with David Dredge. My guest today on the Alpha Exchange is David Dredge.

[00:02:10] He is the founder and CIO of Convex Strategies, and someone who I'm really eager to talk to. I've seen David your name for so many years, and so it's fantastic to finally have met and connected, and I'm eager to host this conversation with you. It's great to be with you. I love your stuff, particularly when you're talking to friends of mine like Hari Krishnan and guys like that. I'll never miss an episode, so it's exciting to be with you, Dean.

[00:02:35] I was just saying we're absolutely in each other's wheelhouse here on all things vol and convexity, so this is going to be an excellent conversation. I was just reviewing a little bit of the notes on the Convex Strategies website. I see that your core team has been in place now for 15 years, so we're going to get into what you are doing on behalf of the investors who provide you with capital. Give us a little bit of your own career history. You've been in the derivatives markets for quite some time now across asset classes.

[00:03:04] Give us a little bit of background. We've only got an hour, so I'll try to keep that short. Somewhat famously, it's part of my story. I'm a simple kid from Salt Lake City, Utah. Went to the University of Utah and managed to slide my way into the master's MBA program at University of California, Berkeley.

[00:03:24] Came out of there and turned down some job opportunities in New York to take one with Bank of America in San Francisco because I wanted to stay close to home, stay close to Salt Lake City. That was my number one priority, and New York was just too crazy far away. I couldn't imagine it. And after the three-month training program, MBA grads, the boss said, okay, we want you to go to Singapore. I got shipped to Singapore the first Monday of October 1987.

[00:03:54] It dogged on me that my ability to predict or even manage my own future was awfully short of effective, so I was already a little curious about how to plan. And then about two weeks after getting here, what you guys in America called Black Monday happened. In Asia, we call it Blocker Tuesday. And after the S&P was down 23% in a day, the Hanks-Hang Index and the Sydney Index were down 50% in a day.

[00:04:23] Nikkei was down 15%, best performing index in the world, because it was the only index that had a circuit breaker at the time, which led to everybody having a circuit breaker eventually. And so, again, it was sort of laid bare to me that risk wasn't necessarily something that you measured inside a bank, even a sophisticated bank's rules and methodology and operating procedure. You can imagine what that morning would have been like in Asia, Dean. I don't know what you were doing in October 1987.

[00:04:52] And just started college. Yeah, but after what had happened overnight, so this is pre-value at risk. This is risk limits. We're bucket limits with stop losses and drawdowns. You come in that morning in Asia after what's happened in the U.S., every position in the dealing room has to get cut immediately. Whether you're long or short or interest rate curve or FX carry trade or credit mark, everything must be cut.

[00:05:17] In every dealing room from Sydney to Tokyo, Hong Kong, Singapore, all sides of every trade lost money because everyone else was doing the same thing. That was sort of the first introduction I had to there was something other than just probabilistic risk going on and the simplicity of how banks look at it. Anyhow, that eventually transpired that I did various things for Bank of America.

[00:05:40] Some of those may come up in our storytelling, but I got to go around and help set up kind of how they ran their emerging market branches and treasury and trading as the emerging markets in Asia started deregulating in the late 80s. Another exposure to a bunch of businesses that made a little bit of money, made a little bit of money, and then lost a whole bunch when there was a default cycle, capital controls, devaluation, whatever it was.

[00:06:07] And I came up with this concept of the importance of convexity in a world where historical volatility and correlation was kind of meaningless, where the concept of efficient market pricing just didn't exist. And I proposed that to my bosses and bank of America, and they wheeled out the literal three ring binder of operating procedures and said, that's not what we do. We do this. But then I got the good fortune of telling this story to the guys at Bankers Trust.

[00:06:34] You need to build positive convexity in the complexity of risk, and then you can go out and very aggressively cultivate these new markets and new product opportunities. And the boss guy at Bankers Trust said, F me, that's a good idea. And so in 1991-ish, we started what would become the emerging market trading and sales business for Bankers Trust.

[00:06:55] And that business was on this premise that if we could construct positively convex risk, we could be much more aggressive than in market making and derivative structuring and underwriting and stuff. And we wouldn't blow up every time something happened. In fact, it would be a benefit for us if we could be much more aggressive in between.

[00:07:14] Of course, the problem there, and then this gets to where we are today, was there were no equity option markets in Taiwan or interest rate option markets in Korea or FX option markets in Indonesia, et cetera. So we needed to figure out a way to create that convexity. And we came up with this idea, or people came up with this idea of monetizing the financial repression that was prevalent across all these countries, high-growth, high-savings countries that had pegged their currencies to the dollar.

[00:07:41] And you created yield-enhanced investment products that embedded short volatility, aka structured products. And so we started all of that across Korean pension funds doing callable Bermudan swaps and interest rate structures and Taiwanese insurance companies doing auto-callable type equity structures and corporate treasuries doing target redemption notes and target redemption forwards in FX and then stripped the optionality out of it and carried that as a pool of stuff.

[00:08:10] And then went and started all the market making onshore, offshore, forward curves, option markets, interest rate swaps, equity derivatives, et cetera. And now that rolls all the way through to today. And after retiring from the banking industry, we run a business that is embedded in that food chain of the recycling of all of this volatility supply that is still dominated by Asia,

[00:08:36] but it has grown since zero interest rates in QE in the West to include European and US markets where structured products have become prevalent as well. And it's a massive supplier of volatility.

[00:08:48] And we work on behalf now of our clients instead of my old bank business where we accumulate and work with the recycling of that vol and try to accumulate these efficient, structured, long convexity, long volatility portfolios that allow our investors to free capital that traditionally has been tied up in very ineffective diversifying strategies,

[00:09:10] these bonds, so that they can go out and participate more aggressively in the participating compounding side of their investment strategies. I've been here in Asia for quite a long time and somewhat familiar with a lot of these markets. And our small team here looks for good value investment opportunities in convexity, in volatility. I saw that specifically on your site that you consider yourselves value investors involved.

[00:09:37] And I think that's a great starting point because we all want to be long vol. Vol is a great asset. The market is wise to it and the market charges you for it. At least stateside over here, there's certainly a lot of ways to buy vol that are not optimal. You can bleed for long periods of time. There's an industry, of course, that's sort of out there to monetize the VRP, as it were, the vol risk premium.

[00:10:04] This is where I really wanted to maybe start the conversation, just to get your big picture thoughts on, you kind of referenced it there, that there is this world of vol supply. Sometimes it's orchestrated by banks that are creating product like the autocallable universe that effectively creates different kinds of vol supply.

[00:10:28] And so they're sort of orchestrating these products, pitching them to retail and finding ways to essentially source vol at interesting prices. I think in your world as well, and this is where maybe we could start, governments are also a part of this ecosystem of vol supply. I think that's not really well understood because it's not really a U.S. thing as much. It seems to be more around, you've talked about the life insurance industry.

[00:10:56] Can you give us just a big picture overview of some of the features and characteristics of that market or those markets? That's a pretty big, broad subject that I could go for quite some dive on it, but. Maybe starting with 30,000 feet, just so we can get a starting point. Let me preface with sort of one core philosophical thing. Our business, we're not trying to make money. We're trying to help our investors make money.

[00:11:20] One of the things that allows us to be very patient and disciplined in how we look for value is that I'm not chasing an idea. I'm not chasing a trade. I'm simply evaluating the value of the convexity that the machinery of vol supply is bringing to us. And so that, for the uniqueness of what we do, takes away timing and betting and views and trades and stuff.

[00:11:47] We've redefined for ourselves simply trying to maximize the potential negatively correlating asymmetry of our book through time. Our objective is have the largest potential asymmetry right before our investors need it the most.

[00:12:01] And we would always evaluate ourselves on how our investors are performing as they go out and participate in compounding assets and trying to capture uptails and convexity to the upside with the additional capital they can use because they have much more efficient brakes on their race car. They could drive faster because they've got better brakes. So one of the things that makes us a little bit unique in a sense, though, we're not vol trading for a profit.

[00:12:26] We're convexity owning insurance owning for our investors and trying to do that very efficiently. Having said that, that allows us to be very selective in what we buy and how we buy it. And this machinery, which, as you noted, for things that many people are familiar with nowadays, I guess probably in 1992, people probably weren't that familiar with autocallables. But things like autocallables, which are heavily driven, as you mentioned, by retail, private banking type clients.

[00:12:55] In that case, that's an end client that may or may not fully understand the exposed tails in the structures that they're doing. You'll see these things are regularly marketed as capital protected down to 30%, down 30%. Without realizing they're a shorted out than my put that just knocks in at 30%, they're actually exposed to the full 100% potential downside. Just doesn't tick in until they get to down 30%. So in a lot of cases, there's misunderstanding.

[00:13:20] But far more important than that, and particularly relevant across other asset classes, most especially interest rates, but also FX, is really the regulatory construction of the participants in that food chain.

[00:13:34] Of course, we're all very aware of the thing that I've probably been most vocally critical of since the early mid-90s is BIS regulatory capital guidelines, Basel 1-2-3, where they use something simplified in terms of risk, like value at risk, which naturally hides tails.

[00:13:55] It's making the usual simplifying assumptions inside what I derogatorily call sharp world of Gaussian distributions and linearity and ensemble averages, ignoring time, ignoring power law distributions, ignoring the mathematic of geometric compounding.

[00:14:14] And so the system has the accounting and regulatory capacity, whether the end client is a retail client doing an auto callable or more, even better, if it's a insurance company doing a callable note structure with embedded Bermudan swaptions, where he's given accounting treatment or a LDI pension fund in the UK that can lever gilts five times and counted as risk reducing in his portfolio.

[00:14:41] So all this regulatory stuff is really the bulk of uncapitalized tails in the system and the management of how these vol supplies flow through. As everybody knows, in sharp world and banking space, anybody that's using methodologies like value at risk, lower volatility means less risk. And in that world, the lesser risk means you can apply more leverage to it without creating more risk.

[00:15:09] So something you may have heard me say before, if you've listened to podcasts, one of my many famous dredge-isms, banks don't go out of business taking risk. Banks go out of business leveraging that which they can account for as riskless. The biggest risk in the system, at least in the modern history of time, are zero RWAs. The super senior tranches of some prime CDOs that you could lever infinitely and hold no capital.

[00:15:36] So there's a massive uncapitalized tail risk embedded in those structures, which in that case was the correlation assumption that went into the credit rating that you could tranche up and get to the zero RWA and monoline insurance and all the games to get there. And then you didn't have to have any capital. And then when the correlation changed just slightly, wiped out the entire banking system. Well, likewise, in more recent times, sovereign bonds, the zero risk was zero risk weighted assets that put Silicon Valley Bank out of business.

[00:16:05] Riskless. It's that leverage that gets applied either explicitly through those types of examples on bank balance sheets or implicitly through the ball selling, which is implicit leverage in the system and builds on capitalized tails outside of the sharp wind risk methodology. So let me make sure I understand this. So the first one is just around the assets that are deemed riskless.

[00:16:31] They basically become over consumed in a lot of ways. The system sets them up as riskless. Those are the rules of the game. And then the outcomes are over consumption, over leveraging on the embedded optionality. So you talked about the life insurer that is effectively a seller of vol. That life insurer is solving for something. The life insurer doesn't wake up and say, hey, I want to sell some vol today.

[00:16:58] They've found a way to do so probably with the help of financial engineers at places like Bankers Trust who are helping them solve something from a regulatory standpoint through vol. Can you just speak a little bit more to that vol supply and how it effectively is trying to get at a, whether it's a capital requirements, you know, a risk weighted asset requirement? How does that kind of ultimately materialize?

[00:17:25] The regulatory construction for any number of reasons. Now, if we want to get really into the details to a great extent from a financial repression standpoint, there was a regulatory desire to subsidize mortgages to increase homeownership in the U.S. And so Basel I, the U.S. people involved in negotiating that said, we want this. We want this special treatment for mortgages.

[00:17:55] And that will incentivize banks to lend against houses. And we can expand homeownership as the baby boomer population peaks into their working age earnings percent of the economy. They need to own houses. Obviously, government debt has been subsequently the biggest tool of regulations and banks and insurance companies and pension funds, right?

[00:18:18] One of the reason pension funds can account for levered bonds as risk reducing is because who else is going to own bonds is five times levered at zero yield. Only a regulated entity, what I call rational accounting man. A rational economic man would never buy that.

[00:18:33] So you need to create rational accounting man whose circumstance, whose environment is a small world that operates under these rules of Gaussian distributions, linear regressions, ensemble average, single time periods, etc. Because nobody's going to buy a zero yielding or negative yielding 30-year bond for their retirement. So you need to regulate a rational accounting man who gets paid compensation on an annual basis to hold it on their behalf at zero.

[00:19:03] And so that creates throughout the system sort of this plethora of uncapitalized tail risk. That in the vol space is, again, the mismeasurement using things like value at risk and something that I'll talk about with some of my close trendfallen friends. We all know that the underlying market is not normally distributed. It's a power law distribution.

[00:19:26] But then layered on top of that is a power law distribution of leverage and volatility. And so you have this assumption of two standard deviations, pricing of volatility outside of that, where the guy selling it isn't necessarily reflecting it with capital to protect that risk, but does get to reflect the calendar year revenue of that enhanced income stream.

[00:19:54] And so what happens in the example of, say, Taiwanese insurance companies or pension funds that are doing the Bermudan swaps and embedded callable note structures, eventually they want to do that because they need duration. Because the central banks are jamming interest rates down, which is growing the duration of their liabilities at lower and lower interest rates. They need more and more duration, but they can get that duration through these 50-year, five-year call structures. But they're losing money on those as interest rates go down because, of course, they always get called.

[00:20:24] They say, well, this makes us look dumb. We would be better off buying the 50-year bond. Well, then eventually what happens is regulators say, OK, we'll let you book that as a five-year bond. So you won't count the duration and you won't count the short options in your book. And then eventually in 2022, rates go up and everybody's five-year duration bonds explode to 50-year duration, which they don't mark to market. And they've got these massive unrealized losses, just like the ultimate maturity books in the U.S. banking system or everybody's banking system.

[00:20:51] And so it's those types of tales and this proliferation of this stuff is why it keeps coming and coming. Because when it's working, rational accounting man gets to count the revenue as performance related. But the institution doesn't have to capitalize the risk. Obviously, the decision maker doesn't have skin in the game. It's not his money. And so it proliferates. And as volatility gets lower, you can add more leverage. You can do more.

[00:21:18] The product can become more complex, more levered, more exotic, more duration. And as that keeps happening, we're hopefully in our role helping recycle that in forms and formats that are conducive to how we're trying to carry the most efficient insurance through time. We want insurance that costs the least when you don't need it, pays off the most when you do. Very simple.

[00:21:41] And if you go back to the bad old days of ZERP kind of practiced nearly worldwide, maybe not, well, at least negative interest rates, not in the U.S., but I was just looking at the German 10-year, even before COVID touched down to minus 65 basis points. I remember looking at that and talking to a number of people about it as just a head scratcher because it's not a policy rate, right? It's a market-cleared price for 10 years.

[00:22:06] And what I came across, and I think this is consistent with some of what you're saying, there was a BIS report that talked about the circularity of trying to solve for duration mismatch and that there was massive demand from German pensions, Swiss pensions for duration at negative 65 basis points. Just trying to get to even and solving for these math problems, irrespective of the, quote, value proposition.

[00:22:34] We don't really live in that world anymore, at least in terms of there's no negative 65 basis point yield out there anymore. And even Japan has emerged from this. What does that look like in the world of financial repression today versus 2018, 2019 and COVID? What's that look like and how does it set up in your world? Something that I talk a lot about. So as I mentioned earlier, I'm good friends with Hari Krishnan and with Mike Green.

[00:23:03] And as you're familiar, I think both of those guys are super smart guys and have done a lot of work on this passive investment issue in equities. And I always remind them that the passive or price insensitive market participants was a much bigger problem in bond markets and has already peaked.

[00:23:22] It peaked at the peak of zero negative interest rates in late 2020, at the all-time lows of interest rates in basically everywhere and the all-time lows of volatility. By our measures in that passive flow, price insensitive flow isn't just what Mike focuses on in terms of index passive investing. It's all those rational accounting events. It was central banks doing QE.

[00:23:47] That guy wasn't thinking about the terminal real wealth in 30 years for his retirement when he bought those bonds. It was FX reserve managers all over the world. It was regulated pension funds that could treat five times levered guilts as risk-reducing. The whole world doing risk parity in some form or another, levering bonds as a portfolio risk reducer.

[00:24:10] It was banks holding zero risk-weighted assets and hold to maturity and available for sell accounts, paying annual compensation on accrual, including Silicon Valley Bank on accrual booked items that had bankrupted the bank. They still got to pay bonuses in the year. So that accumulation of that massively overwhelmed any active management of those risks by that peak in 2020.

[00:24:33] And so now one of the big things driving the market is we're past that peak now, and the clog in the system, you know, the clogged arteries are all these unrealized losses because these regulated institutions don't have any capital to absorb the losses. The Fed's not cutting their position and taking a loss. The banks aren't cutting their hold to maturity positions. They can. In fact, Mike Green wrote a great sub-stack on it just a couple weeks ago saying we need to think of a way to clean out this clog in the arteries of the banking system.

[00:25:01] And so that's a big part of what's still kind of happening in the world, makes the world, particularly the bond market, government bond market world messy. What I've dubbed the hunger games of bond issuance as everybody could issue all the government bonds they wanted while up to that peak. And then when 2022 came and price stability became an issue again and interest rates went up and it clogged the system, now it's a competition to issue bonds. Everybody's your competitor.

[00:25:30] And literally that competition to issue bonds becomes a trade competition, becomes a resource competition, and becomes build up your military competition. Everybody's got to stack their technology stack and resource stack while they can still fund it. Because now Germany's not buying French bonds. Germany's issuing their own bonds. Japan's not going to be buying everybody's bonds. They're going to need to buy their own bonds.

[00:25:53] And so this is a big part of what's undergirding the challenge as our traditional client base, traditional investors, have been caught in this with 60-40 type mindset and a long history of depending on bonds as your risk mitigation subset of a portfolio, of a balanced portfolio.

[00:26:14] And now they're trying to solve that in the whole what the sophisticated institutional investment world's talking about in terms of total portfolio approach and how to sort of cleanse that capital that's clogged up in ineffective diversifiers and find efficient diversifiers so they can participate in more risk. And so that's a big picture in the world that sort of drives the demand for what we do.

[00:26:37] And then how we do it, you still have all the fall supply across multi-asset classes as people try to find ways to mitigate negative real rates in Japan, negative real rates in Korea, negative real rates in Taiwan, negative real rates in Singapore. The appetite for yield is still there.

[00:27:23] And that's a big time period where that dock input hasn't been triggered. Surprise, surprise. But if you drag that a bit of a longer period, you might find out it has before. But certainly, if you project it forward, it will tell you it for sure will. I mean, it absolutely for sure will in any rational distribution of the future where, as Nassimo says, the tails get fatter in the future. It's math. So that proliferation goes on. And so we fly our wares.

[00:27:51] And at any given point in time, the opportunity set, the appetite, the supply will ebb and flow across geographies, across asset classes. And it's just our job to make sure we're in touch with the supply and how it's coming and how the important dealers are managing it and work with them. Because, again, we're buying it because they want to sell it. They're coming to us wanting to recycle this risk. And it's on us to understand it well enough and understand where there's value and where there's not value.

[00:28:20] So the dealers have effectively sourced this risk. They've likely sourced it at a price that they like, but they've sourced a lot of it. So this is where a firm like yours comes in. I'm certainly remembering in my own universe back to the pre-GFC era, there was just a tremendous amount of risk recycling and things like correlation and elongated variants where banks had risks that they loved at the right price. They were just so large.

[00:28:48] To some extent, Dodd-Frank has changed that because it's now since forced the bank to recycle much more. So as you said, when we created this stuff at Bankers Trust out here, the whole point was for us to warehouse the risk we wanted. But then, of course, the fee income became the banking business for all of Asia, for the world, and then spread globally.

[00:29:08] But a lot of the Dodd-Frank rules that said the banks can't carry prop risk to the same way they used to, in fact, encourages a more active recycling of it than even existed pre-GFC. Let's just run with the pre-GFC period for a bit because it's such a fascinating episode. The unwind of these highly leveraged positions, which use the term riskless. Things were priced as riskless that clearly weren't riskless.

[00:29:36] There's a famous scene in the big short, the book, where I think it was Greg Libman's trader at Deutsche Bank was buying some super senior protection from a counterpart at, I want to say, Morgan Stanley for five basis points. They end the transaction exchange like $2 million or something. And they end the conversation by saying, we both know that there's no risk in any of this stuff. And of course, it couldn't have been further from the truth as they did this trade.

[00:30:03] What are those periods like where the VIX is mired at 10, the CDX IG is at 20 for a couple of years? Risk is building up, but it just won't materialize for long periods of time. For every Michael Burry or Greg Libman that kind of timed it right, there were folks that got excited about buying convexity in 05 and 06, and by 07 just kind of ran out of chips.

[00:30:29] What's that period of waiting like where you're warehousing it and trying to carry it properly? I'm sure that is a constant conversation for you and your colleagues. Our enemy, in a sense, is time. We're always fighting time. We're committing to our investors to maintain and grow sensitivity. But given what we do, if we don't do anything tomorrow, we're less sensitive than we were today. So we've got to think of something to maintain that.

[00:30:57] And obviously, we're paying a price for that. It's like the liability side of a bank's balance sheet. It costs money to be long deposits. Now, of course, no bank would be profitable without their deposits. It's the entire reason for their existence. So we need to maintain the sensitivity and duration of it. The good news is, in those tough times, hopefully, is when the investor's additional risk taking is performing its best. They're compounding very, very well.

[00:31:25] And they're enthusiastic if they can see that we're efficiently constructing, adding, growing, maintaining efficient convexity on their behalf. If we get greedy or impatient and we try to make money, we try to time something, we try to bet on something, we try to load up on some view of something, we'll put ourselves out of business.

[00:31:48] Or if we get uncomfortable with the persistent cost and try to offset that by selling something over here to make up for the carry here, that'll put you out of business. If you go and sell yourself to a guy as a defensive, as a goalkeeper, but then you think, well, it's a quiet time and I'm getting tired of not making any money, I'm going to run up and try to score some goals. That's almost certainly the time that somebody hoofs the ball back down to the other side of the pitch. So you've got to stick by your guns.

[00:32:17] The answer to the problem is, again, always working in the interest of your investor. We're not trying to earn performance fees. We're not trying to make money. We're just trying to optimize. Our biggest fear, to be honest, Dean, is after something like March this year, is that we're going to come in one day and nobody will sell us anything. And it's going to be a problem now to maintain the duration and sensitivity of the book over the subsequent months and years. And so we're always nervous when that stuff happens because we're afraid we're not going to be able to buy anything.

[00:32:46] When in fact, most people have the perception, oh, you guys must be happy because you're making money. We're not happy because in that scenario, yes, we're making money, but our investors, I assure you, are not happy. We're fighting to figure out how to protect them as it's getting complicated, not high-fiving because it's our turn. It's the liability side of the balance sheet's term to make the money. But the good news is, and this is, I guess, probably what's really interesting for you and unique in a way for us,

[00:33:14] is that we have a pretty broad universe to go hunting in. And we're very agnostic and our investors understand and we understand that the risk everybody really needs protection from and the risk that we're protecting is correlation, is the spreading of risk throughout the system. People's diversification will protect them from the lightning strike. The lightning strike only sets one tree on fire.

[00:33:38] It's the risk if that tree spreads from that tree to the next tree to the next tree because of the interconnected dry brush leverage, that's the problem. And so our job is to find where the brush is the thickest. And we can do that in any asset class in any market in the world where there's vol supply that's creating that very dry brush that we covet. So I jokingly say all the time that as hard as our job is exactly to what you're pointing at, these long periods of calm,

[00:34:05] the one thing that makes it bearable is that the cheapest insurance lines up precisely with where the biggest risk is. Run with that a little bit more. I think that's a fascinating statement. When something is priced as riskless, in some ways, if the market reflects it that way, the behaviors will also follow and the leverage will follow. I think that's what you're saying, but I'd love for you to just explore that a little bit more. It's exactly that.

[00:34:32] The financial system, again, sharp world value at risk, says that risk is volatility and correlation. And the lower the volatility and more beneficial the correlation, the more leverage you can apply to it. But in reality, the risk is the leverage. One of the things I'm sure you've heard a thousand times, probably more, when markets crash, correlation goes to one, which is wrong. It's the other way around. When correlation starts to go to one, markets crash. I like that.

[00:35:00] Because the entire system is so dependent around their correlation assumptions. Everybody lives in a world of diversification. That's the most obvious way to protect yourself from lightning strikes is to diversify so that one lightning strike doesn't put you out of business. But your assumptions about how much of your broad umbrella of your portfolio is protected by your small nugget of capital is based around an assumption of how that correlation behaves.

[00:35:31] And when that correlation starts misbehaving, you've got too much risk. And so you have to reduce the risk, which then messes up the next guy's correlation, which then messes up the next guy. So if you go back, I could tell stories about just about everything, Dean. But you go back to LTCM famously in 1998, where you could see the correlation breaking in their portfolios. I was at Bankers Trust on the other side of a lot of, if not virtually all of their derivative trades in Asia.

[00:35:59] And you could see their P&L deteriorating well before the first margin call that meant you were going to run them out of everything they had. Much like the systemic shocks in August 2007. You could see the correlation breaking down before that crashed the entire market.

[00:36:17] So our job is to go and find where that correlation and volatility assumption has resulted in the deemed safe thing that they can apply leverage to in the form of implicit leverage and sort volatility and help absorb and manage and carry that. In the event, not betting on, I'm not betting on a lightning strike or kids playing with matches. I'm just saying if a fire spreads throughout the forest, it's going to do a lot of damage right here.

[00:36:44] And the way the system works, it says the safest part of the forest is the part that's gone the longest without a fire. We actually know that's the opposite in the real world. And that's our job. You mentioned LTCM. In the aftermath, of course, of the unwind, there was a CFTC investigation, tons of research reports.

[00:37:03] And one was by an academic, Philip Dryan, who did a great analysis of a lot of what you're saying, which is one of their trades was the off the run, on the run bond.

[00:37:15] And he basically makes the point that when two assets are as highly correlated as those would be, the 29 and a half versus the 30 year treasury, you're just going to get so big in a pairs trade that if you take the correlation from 99.9 to 93, it's going to wreck havoc because the trade got so big because effectively the net correlation was zero going in. And this is underpinning a lot of what you're suggesting.

[00:37:44] I'd love to get your thoughts, David, on the big question of the time variation of risk premium. I use the VIX as just a proxy for the price of vol, whether it's in swaptions, whether it's an FX vol. Let's just call that the VIX for any asset class. You know, it goes through periods of high or low, but it also goes through periods, I think, where there might be more value versus less value.

[00:38:12] In the unwind of COVID, there was a massive amount of capital that got destroyed in equity derivatives. Firms went under and never recovered. And so in 2021, the VRP in equity derivatives was just enormous because the market just had no capital. And so it took a while to repair. It took two years.

[00:38:34] Are there periods where you're kind of looking at the deal that's offered by markets as either more appetizing or less? How does that impact how you set up the portfolio of convex trades? We're always looking at it that way. That is all we're doing all day, every day. And if something's not attractively priced, we need to stay away from it because a hedge that's not priced attractively will not work.

[00:39:03] It's that part of the forest that the fire will go around because it's protected. People have paid. So after COVID, the supply-demand relationship at equity vol that was so beneficial prior to COVID and prior to GFC went away. There was virtually no, relatively speaking, a significant reduction in equity vol supply. And therefore, equity vol was not priced attractively.

[00:39:28] In particular, S&P vol, which is the landing platform for most hedging strategies, was extraordinarily expensive. As such, S&P vol was not an efficient hedge for the equity market sell-offs in 2022. Now, obviously, on the other side of that, maybe arguably the cheapest, best value in volatility, most particularly in convexity, vol of vol, ever in all of history, was the other side of that bond market bubble.

[00:39:56] Interest rate vol, where you had all-time lows in bond, all-time highest passive ownership of bonds, all-time high of volatility supply in the form of structured products to enhance duration that was allowed with dodgy regulatory risk and accounting treatment for the biggest institutions in the world that take duration risk, meant that you were at the lowest vol, lowest term structure, lowest skew, cheapest price of vol of vol ever in history.

[00:40:26] From mid-2020 to end of third quarter 2021. So that was the part of the forest where you wanted to own your insurance. And then in 2022, which wasn't really an equity sell-off, it was a correlation breakdown. And when correlation breakdown, where did you make the money in your hedge? It was an interest rate vol. It was really in the vol of vol of interest rate vol. Across, that could be US, Europe, Japan, Korea, Australia.

[00:40:56] All those markets that had been massive recipients of these Bermudan swaps and supplies and the way the banks went around and hedged those and those things have very complicated second order Greek dynamics, Vanna and Volga stuff that then pay off when they try to manage them. Because nobody was obviously pricing into those 500 basis points of rate hikes in a matter of months. You've got to go in our business, we've got to go where the price is right.

[00:41:24] And that means hopefully we own the thing that is sensitive to a fire should it start without us trying to guess where the fire is going to start. If you look at our book in 2021, we're not betting on interest rates going up, but we're trying to construct efficient insurance that says volatility of volatility will go up if interest rates go up, which was a pretty good bet at the all-time low of rate, all-time low of vol, all-time low of vol.

[00:41:52] And so very cost efficient and interest rate vol markets are far bigger than any other vol markets and far more complicated because you're living in a cube instead of a matrix and takes a little more experience and knowledge. And it's not that easy to transition from being a spot FX option trader or index option trader to being a swaption trader.

[00:42:15] But in that world, there's all kinds of dynamics and opportunities that obviously are that unique mother of all bubbles, as I call it, in interest rate space. Can I just say that I'm very happy that you said the words Volga made my day. There was something about the 2021. We're not even thinking about thinking about tightening. It was such a fascinating period and perhaps predictable that the Fed was going to, in some ways, overdo it with its promises.

[00:42:44] The way I was likening the pricing regime there, I think the move index, I know it's kind of a dirty measure, but I think it got down to 40 or something like that. Massive suppression of both rates and, by extension, rate vol and the promises of the Fed. It was kind of a pegged regime, at least for a period of time. Again, your background, you spent so much time in Asia. We talked about LTCM, of course, the year before was the Southeast Asian financial crisis.

[00:43:11] Also, in some ways, a peg break, maybe not incredibly officially, but certainly a breakout of capital that just moved fast the other way. You had the Swiss, the Euro-Swiss peg in 2015.

[00:43:25] How much of what you're trying to do is, I don't want to say forecast, but look for periods, look for prices that are enforced by governments or by regulatory regimes that you can kind of see are becoming vulnerable to a sudden repricing by markets? People who know me know I've been around a long time and have been sort of front row to a lot of these things.

[00:43:54] And they say, oh, you know, Dave, will you go around and figure out where the tail risks are and then you buy options on it? I say it's exactly the other way around. We buy options because the supply comes to us. Once we've bought enough, we get a pretty good idea of where the tail risks are. That vol selling, that application of leverage is part and parcel, and hopefully if we're doing it right, we're at the tail end when it's at the most extreme, of the imbalance that's getting created by the peg currency, by the YCC.

[00:44:24] I mean, think about it. I will argue. Obviously, the U.S. rates started moving already in early 2021, but really the thing that kicked it off was when the geniuses at RBA, Reserve Bank of Australia, held on to their 10 basis point, three-year bond YCC cap all the way through the end of September 2021. So think about how high inflation was by that time.

[00:44:48] It was already well above 5% into high single digits in most places, and they were still sticking to it and still sticking to forward guidance that we're not even thinking about thinking about into years ahead. I mean, what nonsense. And then when that broke, they were going to buy more bonds than existed, which Bank of Japan eventually did themselves. Literally the next day, it dawned on Europe that, wait a minute, remember the European ECB deposit rate was still at minus 50 basis points. People said, wait, these yields are going to move too.

[00:45:18] And then that fall market blew up, and then it just ratcheted through until finally in March of 2022, the Japan volatility market, interest rate volatility market blew up. So one of the things we talk about all the time, as crazy as interest rates were in Europe and the U.S. in 2022, by far the biggest relative change in volatility pricing was in Japan.

[00:45:39] To your example about the move index being at 40, but the equivalent in Japan, because of the multiple years of zero QE, QQE, ZERP, NERP, and YCC, that equivalent vol in normal rate vol terms was 10 nuts.

[00:45:56] And so in Japan, you could, going back even prior to COVID, much less in 2020, 2021, you could easily create strips, in essence, replicate variance type payouts, where you were isolating vol-a-vol at zero. Now that's a good insurance policy. Someone like yourself really respects uncertainty, and that's the business that you're in.

[00:46:20] When you're in a trade at the right price, you've sourced vol-a-vol or vol at a really good price, and it actually starts performing. You get that asymmetric move in markets. The repricing on a mark-to-market basis is exactly what you're looking for. But you don't know in advance if this is a VIX to 40 or, good God, a VIX to 80, which has happened twice. And we could throw in the big one, the 87 crash, so maybe three times.

[00:46:47] But we don't really know what the stopping point is going to be in advance. How do you think about the monetization scheme? That maybe is the ultimate question, in a sense. And so, number one, it has to do with what you've agreed with your investors. So what are you protecting for them? Are you trying to protect inside of two standard deviation, monthly or quarterly accounting P&L? In our case, we're certainly not.

[00:47:14] We're trying to protect something far more extreme than that and building a portfolio accordingly. In what we're trying to do and how we try to run the book, we think in terms of layering convexity. So we want to have some allocation to convexity that is probably lower level convexity, higher probabilistic, more monetizable in a smaller move.

[00:47:37] But we're really only doing those things to recover costs, to fund owning things with much higher convexity further out the surface, further on the wings, that will provide really, really highly asymmetric payouts in the thing that matters. In our case, we're protecting from the thing that matters. We're protecting from the, we can't recover from this sort of thing. We're not trying to help people capture three-week V bottoms and back.

[00:48:05] We're trying to help them make sure they could carry risk through that because they've run a lot more risk in the preceding months and years. And they don't want to get forced out of that like everybody else who's causing the V. So they need to be able to see that they've got the protection, insurance, and sensitivity. They don't necessarily expect us to trade it. In fact, if anything, they want to have the capacity to trade it. They want to be able to take advantage of the long gamma, in essence, of their portfolio.

[00:48:31] They want to be able to buy the dip seeing that we've got the protection because, of course, the benefit of that accrues to them without fees. That's a big part of what we try to offer to people. Make the money on your side. Don't pay somebody else for the positively correlated risk. Let's optimize to that. Now, having said that, when the time comes, it's fairly easy, in a sense, for us to know when to monetize.

[00:48:54] So just like we want to add exposures on our book when the system is pushing it to the extremes, indicative that there's a lot of risk in the forest, when they call back wanting to buy it back because much of what they did, they did because their risk methodology said it was safe to do it. When it goes outside of those very compressed, low distributions, usually the risk methodology will say it wasn't safe to do that.

[00:49:24] Go buy it back. And when they're buying back, by definition, that means the risk is coming out of the system. The brush is burning. The forest is less risky. And the price of insurance is higher. And so we want to give it back to them. So we work very closely, again, with our key partners, the banking counterparties. When they want to provide it, we want to be there. When they want to take it back, we're not trying to hose them. We're like, okay, here, I have it back.

[00:49:50] And just working through that through times, decades of cycles, you hope that you're consistently on the side of owning something that's efficient, giving your investors confidence to run the additional risk, and managing it efficiently through your layering structure and your cooperative working arrangement with the people who provide it to you, that you help them when they need it back. Using as a simple example, you mentioned earlier the dream product that we would always want to own, variant swaps.

[00:50:20] The ultimate in efficiency and investment in positively convex structure. People don't generally want to sell your variant swap because it's very risky to be on the other side of it if something goes wrong. In particular, when vol is high, nobody wants to sell variant swaps because it's outside of your risk limit when you see that convexity. So the guy who has sold it needs you to be cooperative and sell it back to him because it's very hard for him to source it elsewhere in the universe. We do that through time and we've got to think long-term.

[00:50:48] We've got to think about it from our investor's perspective. And we're not trying to monetize to optimize our performance. We're trying to manage for a multi-year, multi-decade compounding objective for our clients. The answer to the problem is know what you're going to do when you put the position on. Know what asymmetry you're trying to capture relative to the vol supply and the risk management of it within the system,

[00:51:15] where those sensitivity points are around Vanna and Volga and things like that, where barriers, knockouts, digitals that have been hedged with vanillas, where are these sensitive points so that you understand where the asymmetry exists that you want to own and where the asymmetry is realized and you want to capture it. So I wanted to end with getting some of your perspectives in the here and now on being in Singapore,

[00:51:42] having a real front row seat in terms of what's happening in Japanese rates. So we talked a little bit about that, but I can't help but think back on the, I just call it the VIX event of August of 2024. The VIX goes from 18 to 50 in a couple of days on August 5th, largely attributed to some kind of chaos, what was happening in the yen. How do you think about Japan and its interest rate market, the yen,

[00:52:12] and how that might be some transmission mechanism? I certainly don't feel like I have a good enough handle on those interconnectivities. I'd love to get some of your thoughts on that. People who know me know, Japan is near and dear to my heart. Back in my Bank of America days, I went up there in 1990, set up their first yen interest rate derivative, so option books and stuff. I did my first yen interest rate trade in 1988.

[00:52:39] Somebody told me that there's no way yen interest rates would stay below German interest rates, so you should definitely pay them here. That wasn't very good advice. So Japan, I think, is a critical, critical cog in this global hunger games. They've been the biggest provider of capital to the rest of their biggest foreign net creditor in the world. They're the largest foreign owner of pretty much every bond market in the world. They've been forcing capital out for three decades, three and a half decades.

[00:53:09] They've manipulated the most important price longer and more than anybody, the price of money, interest rates. That's had obvious implications now most visible in the currency, which the Ministry of Finance has to step in and intervene to keep it from spiraling out of control. I asked a Bank of Japan friend of mine where he thought their inflation indices would be, if you took away all the government subsidies that are keeping them where they are,

[00:53:37] factored in where dollar yen would be without the multiple rounds of FX intervention over the last three years. So what would actual inflation be without government? Muting of it would be a lot higher. And it's been, obviously, the place that went to zero and negative interest rates and QE before everybody else has been the largest provider of volatility and yield-enhancing structured products over the last 35 years.

[00:54:03] The domestic structured product machinery developed into stuff that the rest of the world still hasn't even seen yet. These callable, no, Bermudan swaption structures that we were talking about that proliferated across Taiwan insurance companies and German pension funds and et cetera, well, push right down to the retail deposit base in Japan. So a retail deposit in Japan for decades now could walk into their local bank branch in

[00:54:28] Fukuoka and do a 20-year, one-year call deposit and treat it like it was a one-year deposit with a slightly higher yield than the one-year. Instead of getting zero, you got 40 basis points. And every year you went and redeemed because the rates never went up. And so you got called. You learned. You came to believe it was a one-year deposit. And then last year you went and the guy said, no, it's a 20-year deposit. You can't get your money back for 20 years. Of course, the guy who's rolling deposits now 95. So 20 years is a long time to him.

[00:54:56] So he breaks the deposit and then the whole system has to go and buy the vol back. And so Japan's very complicated. I've long said that I think people ask me and I say, well, I don't know and I don't really care what starts the next fire. Is it going to be lightning on this side of the forest or kids playing with matches on that side of the forest? I don't know. I don't care. But if you push me for an opinion, I'd say it'll probably be Japan. Japan's the likely next trigger because it is the last provider into the global hunger games. It's the last guy still buying everyone else's bonds.

[00:55:26] Like Japan's balance sheet is still absolutely ginormous. And you can see the impact of that on capital flows. Japan's running, particularly now, massive trade surplus. And yet they have to intervene against their currency every day. Not every day. At least verbally every day. And that's because capital must be flowing out, obviously. If that ever reverses, it becomes a big issue for the rest of the world who are desperate to sell their bonds, to roll over their bonds, to sell more bonds, to fund building up security,

[00:55:56] to fund ever-growing aging demographics with ever fewer working age populations and taxpayers and savers. And so I think Japan is absolutely the number one most important thing everybody should be paying attention to and watching how it's working. And still embedded in its various complexities of its markets is still a huge amount of volatility dynamics that are not necessarily well understood outside of the expertise in that world.

[00:56:25] And so it's still a place where we're very active in trying to understand that supply and demand dynamic, both in terms of current flow and the residual positioning and complexity of how that is managed in the system. So I implore all of your listeners to learn more about Japan. It's an interesting place. And it's a fantastic opportunity because it's a little bit unique in this credit dynamic where, yes, it has the highest government debt to GDP of any modern country in history.

[00:56:55] But unlike all the other places who have government debt to GDP problems, it does not have a private sector debt problem. It does not have over-levered companies and over-levered households. The corporate sector and the household sector are net savers. And so they all benefit from higher interest rates. It's only the government that it's a disbenefit for. And that's not the case in most places where you have not just fiscal dominance in terms of

[00:57:21] the central bank's ability to raise rates relative to the capacity of the government to cover their rising interest costs, but you also have financial dominance where you have weak financial systems and banking sectors because of exposures to credit and households and corporates and private credit and stuff, which isn't necessarily the same problem in Japan, which creates some opportunity in Japan. If the government could shrink, they could crowd in private sector borrowing that other people don't necessarily have as much opportunity to do.

[00:57:50] So I think you're describing in some ways a competition for capital. Nowhere is that more of a conversation than in sort of the AI theme. This build-out is costing a lot. It's going to cost a lot more. You have, again, a front-row seat in terms of what's happening in South Korea with companies like SK Hynix. I've been following the leveraged ETF on SK Hynix. It's just a beast of a product.

[00:58:17] It's really fascinating to see the incredible spot-up vol-up episode that the large swaths of the market are in. A lot of them are chip companies. And I'm just curious when you factor in AI and the demands for capital and then what you see in derivatives markets associated with companies that are linked to chips and memory and so forth. What do you see there? In equity markets in general, we've seen for really the last couple of years, two years,

[00:58:47] since summer of 24, consistent, persistent cheapness of topside volatility, whether that's driven by the proliferation of auto-callable structures that have the knockouts on the topside or covered call structures, more simple and explosive ETF-covered call space, et cetera. Very prolific in Korea. Leveraged structure. All this stuff, as markets blow through, the underweighting, you're losing your weighting as market rallies, people chase it.

[00:59:14] Because it's not just down markets that cost people money. It's underperformance to benchmarks. If you thought you could outperform your benchmark by selling some calls to buy puts in March when you got a little scared, by April, you were finding out you were chasing that market price up, ball up. Not just in Korea and tech stocks, but in the US. And we were looking at AMD today and ARM and some of these names today and the flipping and the calls

[00:59:44] since March. It's a thing. Again, I'll argue, and I'm a simple guy. It's all driven by positioning. It's all driven by the structured vol supply and how it impacts and reflects when something happens. It's a natural magnet for the market. That's where the pain is. That's where the leverage is. And in a way, that leverage can be on the topside of the market and the call selling dynamic.

[01:00:08] If you want to find a bid for vol out here in Asia, call the guy who's managing those levered ETFs on Hynex and Cepso. He's a good bid for one week vol every day, all day, because it's almost impossible to manage. The volatility is so big and those things have gotten so big and smart guys, famous, well-named market makers come hedge funds are adept at front running some of that kind of stuff in the markets.

[01:00:33] There's few things more wild right now than the one week and in option market on Samson and Hynex in Asia time. It is a fight to the death every day as the big players are trying to figure that out every day, but it's a firm bid for vol. You can sell all the one week Hynex ball in the hundreds that you want. I wouldn't recommend it. And again, it just gets back to fundamentals matter, things like earnings matter, but boy,

[01:00:59] financial products live and breathe within the markets and the positioning that materializes as a result matters a lot as well. David, you've given us a really interesting perspective on how to think about convexity in the context of vol supply, maintaining a balance over time. It's been really great to finally have this conversation. I'm really glad we kind of met more recently.

[01:01:26] I think our viewers who are especially adept at thinking about all things vol and convexity are going to especially enjoy this one. So thanks for being a guest. I really appreciate it. It's just awesome to talk to you. And I do podcasts, but rarely do I do one quite as specific on what we actually do. And so it's quite interesting for me. I'll just stress to your listeners, volatility is a big space. And I think too often people get blinded on that say volatility is equity vol and even more

[01:01:55] so volatility is S&P vol. And that's certainly not the case. Certainly in the US, people in the recent years have learned that volatility is very much single name vol, not just index vol. As the single name vol markets have exploded and much of the structured product has shifted there over the last two and a half, three years away from the index products. The volumes in NVIDIA options are every bit as big as S&P volumes most days and more and more, but that goes for the globe.

[01:02:22] And so I love that we're talking about Samsung and Hynex and we're talking about interest rates in Japan and we're talking about FX markets and credit markets. And there's a plethora of volatility opportunities. One of my pet peeves when people say, well, vol didn't work in 2022. Well, what do you mean vol didn't work? Vol worked great 2022 if you owned interest rate vol. But the price of the hedge matters. If you just say, well, owning puts or owning these VIX structures worked in 2020, so it

[01:02:51] should have worked in 2022, you're missing the point. The price before 2020 was very different to the price before 2022. If somebody is selling you a hedge that is based on a pack test that shows this worked in that environment, you need to understand how it's priced today. Because if it's not priced attractively today, it won't work like it did when it was priced attractively. And more often than not, the thing that will work today doesn't backtest well.

[01:03:20] Imagine if you'd backtested as hedges, super senior tranches of subprime CDOs in 2006. It would have said you're wasting your time and money. And so to your Japan story or the Japan thing, the best hedge in that environment turned out to be Nikkei. Because the Nikkei sell-off was a hell of a lot bigger and the change in skew was a hell of a lot larger in Nikkei than it was in the S&P price. Finding Value in Vol by David Dredge. Price matters. Awesome.

[01:04:12] Thanks again and catch you next time.