So there's an example, of a dealer, that has a long position, in the security, and is therefore exposed to price risk, okay, that the price may fall. That, there, and, and, and, that the value of this stock okay, may in fact be lower than this, and as a consequence you lose money, because you have an inventory of that, of that stock. The dealer business is very competitive business. There is a lot of people doing this and as a consequence there's a lot of pressure to quote the best prices, okay to quote a narrower a narrower spread and things like that. One way that you can beat your competition okay, is by trading on much less capital than them using borrowed money. Okay so that you can the profit on your capital is multiplied by your leverage, okay so let's introduce. Leverage. [SOUND] Leverage refers to the, the ratio of your debt to your equity, of, of your borrowed, of your borrowed funds to your capital. Just as we saw at the beginning when I was talking about de-leveraging in, in European banking system was about reducing the debt relative to the equity. Okay. So now we're talking about dealers leveraging up. The dealer I showed you at first, I've erased that balance sheet, was not leveraged at all. It was all capital finance, right? It just had inventories of both kinds, and that might be this dealer as far as we know. because we haven't really really talked about it. It could be, it could be a capital-funded dealer. But, they are no capital funded dealers or rather the capital funded dealers are the value based traders. The capital funded dealers are like Warren Buffett, you know, you ask what his balance sheet looks like and he's always got, you know, 600 billion dollars worth of cash waiting to buy a railroad or something, you know. So, he's that, that's, that's him. That's, he's making the outside spread though. People making the inside spread, aren't doing it like that. Their balance sheets look more like this. So, [BLANK_AUDIO]. A leverage dealer, with, this is, this isn't, again, quite what dealers really look like, but we're building up. You could do this same business. By having securities on one side and loans on the other, okay. That's a bar, completely borrowed so your leverage to the hilt, you have infinite infinite leverage, okay. so that you're acquiring in a way your inventory of cash is your banker okay, who's just lending you the money. and you now have a long position in securities that you're funding with, with cash. So that position there, long position in securities, you're funding with cash. And if you were on the other side of the market, if you were short the securities market, okay, you would have you could list securities as a liability and cash as an asset. If you were, if you were running this sort of book here, and somebody came and wanted to sell securities to you, right. You would just add, securities, and you might use those securities as, as, as collateral for a loan from your banker. Okay. So the fluctuation in inventories that allows you to make markets, okay, involves fluctuation in the size of your balance sheet. Okay. As you get more and more inventories you get more and more leverage in a way. You're going to have to have some capital. To absorb fluctuations in price. I mean, you're facing price risk here, so you might have a thin layer of capital here somewhere but I'm, I'm showing that the way you absorb fluctuations in price a, and, and, and create market liquidity is by expanding and shrinking your balance sheet back and forth, okay. Okay. This, this, this kind of dealer is exposed to the changes in prices of the security, I suppose also changes in prices of the loans too,uh, on the, on the other side. The question is are there any regulatory constraints? >> [INAUDIBLE]. >> well, so are there any regulatory constraints on how much leverage you can take? there are constraints on banks I think on dealers, I'm not aware of any. Typically dealers are, are, a part of a larger organization that has more capital. So the balance sheet you see the dealer has doesn't necessarily have much capital on it. The Volcker rule, okay, that is being implemented now, okay, is, is an attempt to say banks, okay, cannot have subsidiaries that do this, okay. That banks have to have complete matched book. That is to say, they can be a dealer but they have to have net inventories of zero. So, just write Volcker Rule here, Volcker Rule matched book. Okay. And you're allowed to have long positions in the security and so you can have a balance sheet. It doesn't mean your balance sheet is zero. Your balance sheet could be very large. But you have long positions in the security, and you have equal and opposite short positions in the security, so you have no exposure to price risk, because whatever happens to you on the long side, the opposite happens to you on the short side, and you're flat. You're not exposed to price risk even though you're holding these securities. That's what, what the Volcker rule Is an attempt to say, well, that's okay. To have that on the balance sheet of a bank, okay? Because then they're not exposed to price risk. They are exposed to other kinds of risk. If you read my latest Money View blog Liquidity Risk. but that's a little advanced for now. Let's hold off on, on that. We'll, we're just focusing on price risk, right now. So there, there is a new regulation. The, and that comes from a theory. That one of the problems that this crisis revealed was that banks were taking so-called proprietary risks. They were acting as dealers. or they had subsidiaries that were acting as dealers. And, and that exposed them to risk which because they had FDIC insurance It basically exposed the tax payer to risk and we don't want to do that. So, there are some numerous regulations about that point. They're not, as you can say, as you can see, it's not so much about leverage as it's about the exposure to price risk because and you, it's actually kind of an interesting and deep point. Because a matched book dealer can be infinitely leveraged, but if they're really, really, matched, then it doesn't really matter. They're, they're not facing any risk. They're never, they don't need any capital. And they will certainly try to persuade regulators Of that fact, however, there's no such thing as an ideal hedge, this doesn't really exist. So, that, that's the problem, that in the real world, the nice, the nice cleanness of our theories don't, don't work.
