Proprietary trading: Volcker Rule starts to shake out prop trading

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JPMorgan to shut its commodities prop desk; Potential impact on trading profits

With 29,000 employees in the investment bank, JPMorgan’s decision to shut down a division staffed by just 20 would not normally cause a stir. That business, however, is a commodities proprietary business, making JPMorgan the first large bank to show signs of submitting to the Volcker Rule.

It’s a tentative move towards compliance with the rule, which would stop banks owning proprietary trading desks. No one seems to know whether the division will be closed down in three months or three years. Oral Dawe, the Asia-Pacific chief executive of the division, has just announced his retirement but Ray Eyles has been promoted to take over for now, so one imagines the shutdown is not imminent.

Furthermore, there seems to be no decision made on JPMorgan’s other proprietary trading businesses.

It seems that around 2% of total earnings or profits is the new rule of thumb that most large banks have settled on to designate as the contribution of their proprietary trading activities.

Goldman Sachs was rumoured in August to be spinning off its proprietary trading desk, although a source says no decision has been made yet. But something will have to give. "The Dodd-Frank Act is 2,000 pages, mostly of concepts, but legislators have left much less to the discretion of rule-makers on this issue," says one source. "Walled-off proprietary trading is not going to be allowed for us."

Similarly there has been talk of Bank of America Merrill Lynch selling its proprietary trading business to a private equity firm, but a person familiar with the business says it is too early to make such decisions.

In June Anshu Jain, CFO of Deutsche Bank’s investment bank, told Euromoney he would completely exit proprietary trading "in the next few months." (See Jain and Cohrs take Deutsche to a new level,  Euromoney July 2010)

The final rules are not expected to be set in stone for at least another 18 months, and will be subject to change over that time and maybe to subsequent review. For now, it’s not entirely clear what the proposal identifies as proprietary trading.

Marshall Lux, a senior partner at Boston Consulting Group, says senior management at investment banks should, in addition to thinking about proprietary trading, be concerned about reshaping other areas of their business rather than focusing on implications of a rule that is still developing. "Chief executives would be better off taking a long hard look at their business portfolios and working out what they make money on, and which parts they no longer need," he says. "They also should be looking at how risk is managed within the firm. This focus on prop trading detracts from more important issues."

Shubh Saumya, BCG

"Banks need to take their time and think about how best to retain these capabilities if they are going to exit the business"

Shubh Saumya, BCG

A senior banker says: "We have some concerns still about the treatment of business portfolio hedges. We’re thinking about firm-wide exposure if interest rates stay lower for longer or suddenly rise and I can’t sit here and say we have an answer on that. On our prop trading itself, we still haven’t decided what to do. It only accounts for 2% of the business anyway."

Banks are trying to put a brave face on it all but some sources suggest that the downside might be bigger than they are making out. Shubh Saumya, also a partner at BCG, points out that investment banks do need to be sensible if they are considering spinning off or shutting or selling their proprietary trading desks. "A lot of the trading flow that comes from prop desks is internalized. It’s a captive business that banks stand to lose," he says. With trading revenues greatly reduced in the second quarter, and little to suggest a better third quarter, can investment banks afford to lose that now?

In addition to losing trading flow, Saumya says banks stand to lose talent and research. "They could end up shutting a prop desk down, losing a revenue stream, losing talent, and the assets that they have invested in and come away with nothing. It would be interesting to see if the overall risk profile changes very much as well. I suspect not. So banks need to take their time and think about how best to retain these capabilities if they are going to exit the business."