According to Paul Volcker, head of US president Barack Obama’s Economic Recovery Advisory Board, banks should have little trouble distinguishing proprietary trading and facilitation of client trades. “Every banker I speak with knows very well what ‘proprietary trading’ means and implies,” he told the Senate Banking Committee on 2 February.
Volcker clearly hadn’t spoken to JPMorgan Chase’s chief risk officer Barry Zubrow or Goldman Sachs managing director Gerald Corrigan before testifying to the committee about the so-called Volcker rule, which, if enacted, would outlaw the prop trading activities of deposit-taking institutions, except where related to serving clients. Such firms would also lose the right to own private equity or hedge fund arms.
In his own testimony two days later, Zubrow told the committee, “Thus far, the [Obama] administration has offered few details on what is meant by ‘proprietary trading’. Any individual trade, taken in isolation, might appear to be ‘proprietary trading’, but in fact is part of the mosaic of serving clients and properly managing the firm’s risks.”
Corrigan’s testimony, also on 4 February, carried a similar message. “While the broad intent of the Volcker approach is quite clear there are a number of open definitional and important technical details that are yet to be clarified. One area of particular importance relates to the definition of proprietary trading and, in particular, the distinction between ‘prop’ trading and market making.”
Zubrow and Corrigan are not alone. “Nothing in this industry is black and white,” one broker told theTRADEnews.com. “Defining what is directly related to customer business is extremely difficult.”
Almost certain to fall under Volcker’s definition are the prop desks that some large banks establish away from their main trading floors, effectively run as small hedge funds within the bank’s structure. These units trade only on the banks’ own capital and are often on a different floor or different building from the main client-facing desks.
However, a great deal of prop trading also takes place on the main floors as part of the client facilitation business. Brokers, will for example, buy a stock from or sell a stock to a client who is struggling to find liquidity in the market and then try to offset that position later.
At first glance, this would appear to be straightforward facilitation, as the broker is simply liquidating a position acquired on behalf of a client. However, the lines are blurred if, for example, instead of trying to liquidate the position immediately, the broker retained the position either to divest at a more profitable time or conduct further trades against.
According to one broker, even those traders designated with an agency role within large investment banks run large prop books and have revenue targets to hit.
“Even if the desk is really there to focus on facilitating executions for clients, traders still run a very large book because they are taking those positions on board. The more sophisticated prop houses aren’t simply liquidating those as quickly as possible. They are managing the risk of that book,” the source said.
In many cases, proprietary trading and client facilitation can look identical. “Maybe it is slightly different in the way you gain those positions but the end-result is exactly the same and is being managed the same,” said another broker.
While some banks go to considerable lengths to isolate prop trading units, he added, many large banks now manage the risk from their trading positions centrally, regardless of which desk they originated from.
While banks’ separate prop trading facilities are not involved in client facilitation, they can indirectly benefit the buy-side. Much like the high-frequency traders and hedge funds they seek to imitate, these operations can act as providers of liquidity by making two-way prices in stocks in a bid to capture the spread. Some feel that, as a result, curbing banks’ prop trading would cause liquidity to dry up.
A common counter-argument is that the talented traders who once populated banks’ prop desks would simply set up their own prop shops or hedge funds, and so liquidity would continue to flow. However, as one source pointed out, some of the fledgling prop shops founded by departing traders were bankrolled by their former employers. Such houses may struggle without the financial muscle of the big banks. “The problem is, where do they source their capital?” said a broker.
Ultimately, if regulators are insistent that prop trading should be banned, they will need a crystal clear definition. As Laurie Berke, a principal at research and consulting firm TABB Group, said in a recent presentation on US institutional equity broking, “The onus is on those who made such proposals to explain very carefully what proprietary trading really is.”
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