Macaskill on markets: Prop risk will always be inherent to sales and trading


Jon Macaskill
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The unexpected lurch towards tighter regulation by the Obama administration has focused an unwelcome spotlight for banks on the dirty secret of their sales and trading operations: exactly how much is made from proprietary risk-taking by business lines with a nominal client focus.


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

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
And if regulators are forced to look more closely into risk-taking in mainstream sales and trading they might feel obliged to clamp down on the dubious ways banks use clients to make sure their own proprietary trades pay off.

The focus in Washington on bank proprietary trading took many by surprise, including some members of the administration as well as bankers and their lobbyists.

What might have started as a knee-jerk reaction to the loss of the Kennedy Senate seat in Massachusetts quickly developed into a key policy platform for Obama.

Former Federal Reserve chairman Paul Volcker was recalled from political exile and his ideas on the need to split commercial banking from investment banking were dusted down.

It is not yet clear if the US move marked an end to the regulatory phoney war and a shift towards a serious change in the way banks operate.

Administration officials were vague on how they proposed to prevent banks with a perceived government guarantee from engaging in proprietary trading. There are also powerful global forces arrayed against a return to Glass-Steagall-style separation of commercial and investment banking, such as the integration of major European banks.

Battle lines were quickly drawn up over how to define proprietary trading, however.

Banks led by Goldman Sachs and JPMorgan tried to limit the definition of proprietary trading to distinctly managed trading desks, along with hedge funds and private equity groups that use bank capital.

Goldman Sachs CFO David Viniar said that about 10% of his firm’s revenue was proprietary. JPMorgan audaciously floated the idea that only 1% of its earnings would be affected by a ban.

This approach fed into an attempt by banks to frame the terms of a debate over how to apply the proposed Volcker Rule by focusing discussion on ways to hive off hedge fund and private equity operations. Goldman is the only bank with a genuinely significant private equity arm and most firms have already moved to split hedge funds from their main operations and to close or reduce the scope of distinct proprietary dealing desks.

In some instances they simply shifted proprietary trading activity back into client businesses, however.

There is also a limited appreciation outside investment banks of how much risk-taking is already blended with client market-making operations by dealers.

Battle lines drawn over prop trading

The biggest sales and trading operations all rely heavily on risk-taking – or proprietary dealing – to supplement the more mundane revenue from market-making.

This applies across all asset classes. Rate trading lends itself to embedded proprietary positioning as there are often clear directional trends and there is an informational mismatch between dealers and most of their clients.

There are fewer signs nowadays of outright manipulation of rates trades at the expense of clients than there once were. Spikes in swap rates just ahead of the settlement of large trades that involve fixed-rate payments by clients are seen less often and electronic systems have added some transparency to prices, at least when markets are steady. But major dealers still have enough of an advantage in visibility of market flows to trade profitably at the expense of clients, including smaller banks. The rates markets are sufficiently liquid to allow the placement of substantial bets, especially in shorter maturities, which reduces the need to add leverage to proprietary positions and masks the extent to which dealers trade on their own behalf.

Successful risk-taking is also still the fastest route to running rates at a bank. Many heads of rates at major dealers owe their positions primarily to a few successful directional bets or arbitrage plays, rather than to the laborious business of expanding a client franchise.

The same dynamic applies to activity in commodities. When banks look to mimic the commodities revenue streams of traditional market leaders Goldman and Morgan Stanley, they first try to break down the composition of the $3 billion or more that can be made by a top house in a year. The widespread assumption is that the market leaders derive at least 50% of their revenue from proprietary trading. Few rivals have the stomach for the profit-and-loss swings associated with a move to recreate this from scratch, but a widely used model attempts to build a client business providing 60% to 70% of an initial target for commodities revenue, to be followed by a gradual increase in proprietary earnings as scale is added.

Dealers rushed to cut credit instrument risk after the market ructions of 2008, but when banks claim proprietary dealing was not an important factor in the crisis, remember that the entire structured credit market came to rely on the assumption of proprietary exposure by dealers.

As the securitization boom developed in an era of tightening credit spreads, dealers realized that the delay between agreeing the composition of a portfolio and sourcing the risk included could result in an easy profit. As is often the case, a technique designed to facilitate client-based trades – warehousing – became a way to assume risk and maximize the profits from structured credit deals. Warehousing was also combined with untested basis assumptions to take on illiquid exposure. By the end of the boom houses such as Lehman and Merrill Lynch were simply sitting on the risk from much of their credit trading. Proprietary credit risk trading by banks was scaled back after 2008, understandably given the monumental scale of bank losses. It is starting to re-emerge in 2010, however, as dealers seek to augment a gradual increase in client flows.

Equity trading – at least in cash form – is the cleanest asset class in terms of limiting the ability of banks to profit from proprietary trades done alongside client deals. There has been regulatory scrutiny of techniques such as Goldman’s trading ‘huddles’ used to disseminate stock ideas to clients. Even if there is some front-running or favouritism for select clients, the core equity markets are liquid and transparent enough to reduce the impact of bank proprietary trading. This in turn lessens the impact of their activity, and appetite for big trades.

Regulators face a dilemma in determining how closely to monitor and restrict the proprietary dealing that banks embed in their client-based operations.

Bob Diamond, head of Barclays Capital, was unusually frank in reminding the Obama administration that any new rules that affect the market-making flexibility of dealers could hurt the ability of the US to service its debt.

The altitude in Davos might have influenced Diamond’s decision to issue what looked like a public threat to an elected politician, although he was only expressing openly the anger felt by his peers at a threat to their core income streams.

But while regulators will be aware of the need to tread carefully in reducing the risk run by banks they should not buy into the idea that client-based sales and trading operations are largely free of proprietary risk. That simply is not true.