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Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks |
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There is still likely to be a net reduction in liquidity, however. And shareholders should not expect a sudden smoothing of results from the sales and trading divisions of investment banks. The main dealers have already anticipated regulatory changes to ensure that they can continue to take risks by keeping hedging decisions intertwined with client flows. The collapse in equity sales and trading revenues at Goldman Sachs in the second quarter is unlikely to be the last nasty shock for shareholders from a botched hedging decision.
Goldman is among the US banks that have begun to send signals that their standalone proprietary dealing desks will be shut down well ahead of the schedule set by the portions of the proposed Volcker Rule that made it into the final Dodd-Frank legislation to overhaul financial services. With JPMorgan and Morgan Stanley hinting broadly at a similar move and individual traders anxious to get a head start on their peers in securing other sources of capital to bet, the last rites are being read for old-fashioned bank prop trading.
By leaking news of plans that are well under way, the big banks are playing their usual shell game with investors and regulators. The collapse in prop desk revenues in 2008 made senior managers painfully aware of the pitfalls of giving small groups of lightly supervised dealers permission to write leveraged trades with bank capital. Regulatory pressure in the form of adoption of the Volcker proposals in early 2010 came well after board members and outside shareholders suddenly found an interest in the activity of prop desks.
The incorporation of the Volcker proposals in the draft for legislative change in the US also came well after dealers, led by Goldman, had demonstrated the earnings potential of aggressively managed sales and trading operations. Some of the benefits of the sales and trading boom of 2009 resulted from temporary market dislocations in the form of reduced competition and wider bid-offer spreads. The main underpinning of the revenue bonanza was a combination of heavy client flows, particularly in key fixed-income markets, and adroit positioning around these flows by dealers.
Goldman’s equity derivatives hedging mishap in May demonstrated that even the best-run investment bank trading operations can make expensive mistakes when trying to maximize returns from client flows. And renewed aversion to risk-taking had a serious impact on client volumes all the way from June until mid-September – well after the end of the traditional summer slowdown.
This amounts to the worst of all possible worlds for bank sales and trading operations: an environment where there is a heightened risk that an aggressive approach to hedging will cause a blow-up, combined with lower client volumes to support vanilla revenues and enable offsetting of positions.
This prospect can be expected to prompt senior bank managers to take any steps possible to ease the path of their former prop dealers into positions where they can start to provide liquidity by assuming risk.
This is a well-worn path. The boom in the hedge fund industry in the early years of the century led to an exodus of bank prop traders seeking higher compensation and prompted dealers to take a role in seeding and facilitating fund launches by departing employees.
Some of those who departed – such as former CSFB proprietary trading head Alan Howard or one-time Goldman equity arbitrage manager Eric Mindich – started funds that came through the 2008 crisis in decent shape and are now key sources of liquidity and revenue for banks.
Brevan Howard is a particularly prized hedge fund counterparty among dealers because of its size and trading volumes and Mindich’s Eton Park fund is a leading example of a fund that combines substantial illiquid investments with active trading in more liquid markets to hedge its exposure.
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The coming regulatory limits on direct investments in hedge funds by banks will limit their ability to directly seed new ventures with their own capital. That will lead to a renewed effort within banks to ensure that other sources of financing can be arranged for their departing prop dealers. This effort will range from capital introduction under the umbrella of prime brokerage operations to fine-tuning of hedge funding financing techniques. Provision of leveraged financing facilities and other hedge fund derivatives is a business line with a mixed background for banks. Firms such as KBC that specialized in fund financing had long runs of healthy profits followed by serious difficulties whenever the broad hedge fund universe suffered a downturn.
Bigger dealers looking to ensure that their departing prop traders retain a link to their former employers, and supply both fees and liquidity, will look beyond traditional prime broking and fund financing to create enduring ties.
Not all of the traders leaving the investment banking fold will end up at hedge funds, which will require banks to look beyond prime-broking relationships. Energy firms are an obvious destination for commodities traders leaving banks, even though it is still not clear how much new regulation highly active traders among corporations will incur under coming changes in both the US and Europe.
Corporate end users of derivatives have been fighting a largely successful rearguard action to avoid being saddled with all of the new clearing and reporting rules that are proposed for banks that are big swap and option dealers.
But some energy firms, such as BP, trade as actively in oil and gas derivatives as big bank dealers and are able to exploit their superior insight into physical trading of commodities. They might end up facing similar regulatory constraints to dealers, although there is no immediate prospect of a Volcker-style move to prevent energy firms from risking their own capital on speculative trading.
Sovereign wealth funds are another potential destination for departing bank prop traders. Sovereign wealth fund assets are around $4 trillion, according to data from the Sovereign Wealth Fund Institute. This is roughly twice the core asset base of the hedge fund universe. Sovereign wealth fund assets are not typically leveraged and applied to tradable investments in a hedge fund style but wealth managers are gradually moving towards more aggressive deployment of their capital in structured investments and trading. That will require savvy traders who know how to avoid being exploited by banks. The members of the wave of departing prop traders certainly fit that description.
