Three powerful and transforming currents swirling
through wholesale financial services - banks' increased
appetite for proprietary trading, the growth of hedge funds
and the trend to outsourcing - flowed together at a
compelling presentation by Deutsche Bank at Euromoney's
annual forex forum at the London Hilton last
month.
Deutsche Bank director Steffen Orben described how the bank
allocates capital to what it calls a non-franchise trading group.
Instead of employing large numbers of its own proprietary traders,
Deutsche sees a portfolio benefit in allocating credit lines to
hedge fund managers and allowing them to trade the markets on its
behalf.
There is a clear financial benefit in doing this. Deutsche has
to pay these hedge fund managers a management fee and a share of
its profits, but it would otherwise have to pay in-house traders
generous salary and bonuses. If external hedge fund managers stop
performing well - or if better ones appear - the bank can simply
withdraw its lines rather than bear the costs of making highly paid
employees redundant.
The bank also has the opportunity to construct an ideal
portfolio of proprietary trading styles across markets. It may have
very good in-house traders in certain disciplines and would not
look to double up its exposures by entering arrangements with hedge
funds pursuing similar styles. But it can match good external
managers to meet gaps in its in-house trading strength and gain a
style diversification benefit.
It's not only forex prop trading that banks are outsourcing. A
handful of banks already have outsourced, or are considering
outsourcing, equities prop trading.
Orben, who grew up as a trader and then as a manager of other
traders, simply extends those management disciplines to outside
investors, monitoring their monthly performance and rolling
12-month average performances. He looks first for successful
strategies and then screens for diversions from established
patterns of winning versus losing periods that might suggest style
creep.
How does Deutsche Bank find good external managers in the first
place? It looks to its customer base. It is the most successful
foreign exchange bank serving the hedge fund community, according
to our forex poll findings last month, and many of the external
traders to which it allocates lines will already have been
subjected to due diligence as customers of its prime brokerage
service.
Thus Deutsche Bank becomes a customer of its own customers. That
perhaps looks like a complication but it may tie in some of those
hedge fund customers that its bread-and-butter forex business
profits from trading with. And it may remove some of the suspicion
of potential conflict by running a proprietary trading business
almost at arm's length. Conventional forex users still harbour
suspicions of bank's prop desks front-running their trades, much to
the frustration of those banks that insist prop trading helps to
offer good liquidity. All banks engage in prop trading: some do
more than others. Deutsche Bank isn't the biggest player but it's
still in the game. Right now, investors in bank stocks are looking
for any source of revenue, nudging the more naturally cautious to
take more principal risk.
Deutsche Bank executives prefer to call this a trading
diversification strategy rather than outsourcing, though that is
exactly what it is.
It might seem remarkable for any bank to rely on outsiders'
intellectual capital to such a degree. But as an investment bank
CEO comments in Euromoney this month on the founding of the
boutique Integrated Finance Ltd by JPMorgan alumni Roberto Mendoza
and Peter Hancock with Nobel prizewinner Robert Merton, there is
now - following endless cutbacks and departures through weariness
and disgust at the business - probably more and better investment
banking talent outside the industry than within it.