Macaskill on markets: Goldman takes pole position for Volcker Rule 2.0


Jon Macaskill
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Goldman Sachs delivered strong first-quarter trading results that were followed by a reorganization of the management of its securities division.


Two of the three global securities co-heads will retire in a move that seemed to be partly timed to spare them the indignity of taking public blame for last year’s trading problems.

Management dynamics were also at play in the departures of Isabelle Ealet and Pablo Salame from their roles co-running sales and trading at Goldman.

In March, David Solomon was appointed sole president of Goldman Sachs and likely successor to long-standing chief executive and chairman Lloyd Blankfein. This could be viewed as a cue for a move to the exit by veteran trading heads of a similar age who were closer to Solomon’s rival and former co-president Harvey Schwartz.

Solomon’s appointment has been widely interpreted as a sign of a shift in power within Goldman from traders to bankers and the acceleration of a move to diversify revenue sources by expanding into unfamiliar areas such as consumer banking.

That doesn’t mean that Goldman’s remaining traders will not act aggressively to take advantage of a coming relaxation in the Volcker Rule that limits proprietary dealing. There are signs that the firm has already started to increase its exposure to trading risk.

One indication was its strong first-quarter performance. Goldman increased its equity sales and trading revenue by 38% compared with the same quarter in 2017, to $2.31 billion, while fixed income revenue was up 23% to $2.07 billion.

Goldman noted that “improved market-making conditions” had helped to boost revenues in foreign exchange, commodity and credit trading. This phrase can serve as a euphemism for the ability to turn a trading profit by managing client exposure when markets are moving and bid/offer spreads widen. 

There was a spike in equity volatility in February to prompt customer activity, but Goldman’s dramatic first-quarter revenue rise for equity client execution – up by 92% compared with the first quarter of 2017, for a total of over $1 billion – was higher than both listed market volumes and anecdotal evidence of client demand would suggest.

Aggressive trades

A second indication is the extent to which aggressive trades by Goldman are becoming visible to rival banks and fund managers. One example is the recent battle over default swaps on homebuilding firm Hovnanian.

Goldman is thought to have been a net seller of credit default swap protection on Hovnanian in what competitors believe was an attempt to profit from a view that a Blackstone-engineered default by the firm could either be thwarted or conducted at a level that did not create an unusually high payout once swaps were exercised.

Goldman reportedly closed the position after the Commodity Futures Trading Commission (CFTC) made an unexpected intervention in a dispute over whether or not the technical default that was created by Blackstone’s GSO unit might constitute market manipulation.

If Goldman sold Hovnanian protection when default swap quotes were elevated in late 2017 and closed the position after the CFTC intervention resulted in a dip in prices in late April and May, it may well have had little net impact on revenue. 

The dealing could still be characterized as a trading escape for Goldman, however, as there was a risk of a loss when Hovnanian bond and swap prices indicated that net protection sellers would be hit hard by GSO’s move to create debt that was deliverable for swap exercises at very low prices.  

A steady ratcheting up of risk exposure in search of increased trading profits at Goldman would not be a surprise given the green light being shown by supervisors 

This trade could demonstrate a tolerance for risk that is greater than can be measured simply by looking at the value at risk (VaR) number that is reported at the end of each quarter. Goldman’s daily average VaR rose substantially in percentage terms in the first quarter, with a move to $73 million from $54 million at the end of the fourth quarter of 2017.

The total number is not an outlier in terms of VaR during a first quarter, which is typically the busiest for traders at investment banks. The first-quarter number was higher than during the same period in 2017, which came in at $64 million but was only slightly higher than the $72 million in the first quarter of 2016.

A bigger question of whether or not Goldman can extend its recovery in markets revenue – and whether or not it decides to increase risk exposure – will come after the expected relaxation in the Volcker Rule.

The Federal Reserve was expected to begin the process of relaxing Volcker Rule enforcement at a board meeting at the end of May, after which changes designed to simplify monitoring of proprietary exposure would need to be approved by all five US regulators with joint responsibility for the supervision of bank trading.

This will not be a swift adjustment; nor are there plans to abandon the rule completely.

A move to shift the onus for proving that trades are not proprietary from banks to their regulators will nevertheless give firms with big trading operations much more leeway to increase the risk that they run in their client market-making businesses.

Reading signals

Goldman has previously proved adept at reading signals from regulators and increasing its risk exposure to increase trading profit. In 2009, when many banks were effectively in a state of shock in the wake of the credit crisis of late 2008, Goldman took a cue from regulatory indications that interest rates would fall and remain low to generate enormous dealing profits.

The trades were not especially complex, often involving dealing, such as going long US treasuries and futures; receiving fixed on interest rate swaps; and positioning for credit spread tightening. They were put on with enough gusto to produce $23 billion of fixed income revenue in 2009, or more than half the $45 billion generated across the firm that year, however.

Ashok Varadhan, who became sole global head of securities at Goldman after the recent departures of Ealet and Salame, was a key risk taker at the firm during the years of strong trading profits, first as an interest rate swap dealer, then in various fixed income roles, including head of macro trading from 2012.

A move towards a lightly policed Volcker Rule 2.0 is not likely to prompt Varadhan to sanction the placement of enormous trading bets of the type that helped him to become one of the youngest partners at Goldman and then establish himself as one of the highest earners at the firm.

He also may not remain sole head of securities at the firm for long, as a co-head structure has historically been preferred to minimize the potential impact of the departure of any one individual.

Goldman declined to comment on any potential impact from Volcker Rule relaxation.

But a steady ratcheting up of risk exposure in search of increased trading profits at Goldman would not be a surprise given the green light being shown by supervisors, who are influenced both by pressure from the Trump administration and by pleas from Wall Street.