Proprietary trading

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See also Volcker plan

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Overview of proprietary trading

Proprietary trading, proprietary trading desk, or "prop desk" are terms used in investment banking to describe when the firm's traders actively trade stocks, bonds, options, commodities, derivatives or other financial instruments with its own money as opposed to its customers' money, so as to make a profit for itself.

Although investment banks are usually defined as businesses which assist other business in raising money in the capital markets (by selling stocks or bonds), in fact most are also involved in trading for their own accounts as well.

They may use a variety of strategies such as index arbitrage, statistical arbitrage, risk arbitrage, fundamental analysis, volatility arbitrage or macro trading, much like a hedge fund.

Many reporters and analysts believe investment banks purposely leave ambiguous the amount of non proprietary trading they do versus the amount of proprietary trading they do because it is felt that proprietary trading is riskier and results in more volatile profits.

Firms begin to end their prop trading

JPMorgan Chase & Co. told traders who bet on commodities for the firm’s account that their unit will be closed as the company, the second-biggest U.S. bank by assets, starts to shut down all proprietary trading, according to a person briefed on the matter.

The bank eventually will close all in-house trading to comply with new U.S. curbs on investment banks, said the person, who asked not to be identified because New York-based JPMorgan’s decision hasn’t been made public.

Closing the proprietary trading desk for commodities affects fewer than 20 traders, one in the U.S. and the rest in the U.K., the person said. The unit is based in London, and traders there were given notice on Aug. 27 that their jobs were at risk as required by U.K. law, according to the person. Proprietary traders in fixed-income and equities, who account for 50 to 75 employees, will need to find jobs when those desks are shut down, this person said.

Congress passed restrictions on financial firms this year designed to prevent a recurrence of the 2008 credit crisis, which almost caused the banking system to collapse. Proprietary trading involves transactions made on behalf of the bank rather than its customers. The curbs are known as the Volcker rule, named after former Federal Reserve Chairman Paul Volcker, who campaigned for limits on risk-taking by lenders.

The Volcker rule may cost JPMorgan as much as $1.4 billion in annual profit, analysts at Barclays Capital led by Jason Goldberg estimated in a June 28 research report.

Levin and Merkley propose prop trade ban

Senate Democrats are proposing that a highly lucrative type of trading by large banks be prohibited, and that a ban be placed on conflicts of interest within the banks.

The latest proposals, part of the debate over the financial-regulation bill being considered in the Senate, would impose new restrictions on the way Wall Street banks invest and interact with their customers. The measures are supported by the Obama administration.

Sens. Jeff Merkley (D., Ore.) and Carl Levin (D., Mich.) have proposed an amendment to the bill that would ban "proprietary" trading at large banks. Proprietary trading refers to an institution using its own capital, instead of a client's money, for speculative trading.

The amendment nearly mirrors a White House proposal from earlier this year, known as the "Volcker Rule" because it addresses concerns raised by former Federal Reserve Chairman Paul Volcker. The pending Senate legislation also would restrict proprietary trading, but it would give regulators the flexibility to waive restrictions under certain circumstances. The new amendment would essentially remove that regulatory flexibility.

"Taxpayers ended up holding the bag when those bets didn't pay off," Mr. Levin said, referring to the role of banks' proprietary trading in the recent financial crisis.

The amendment has the backing of the Treasury Department and Senate Banking Committee Chairman Christopher Dodd (D., Conn.), which could make it more difficult for the banks to defeat.

Mr. Volcker, currently a presidential adviser, has argued that banks' proprietary trading can destabilize the financial system, because they make risky bets with their own capital and rely on their position as federally insured banks to escape the full consequences of bets gone sour.

Opponents of the Volcker Rule have said it unfairly limits the operations of banks in an area that hasn't caused problems, and wasn't to blame for the financial crisis. They add that the rule doesn't give regulators the flexibility to decide what is best for each bank.

Senate hearing on prop trading - Feb 2, 2010

Hearing: Tuesday, February 2, 2010 , 02:30 PM 538 Dirksen Senate Office Building

The witness will be: The Honorable Paul Volcker, Chairman of the President’s Economic Recovery Advisory Board.

Senate hearing on "Volcker rule" - Feb 4, 2010

Thursday, February 4, 2010, 10:00 AM 538 Dirksen Senate Office Building

The witnesses will be:

  • Mr. Gerald Corrigan, Managing Director, Goldman Sachs;
  • Professor Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, Sloan School of Management, Massachusetts Institute of Technology;
  • Mr. John Reed, Former CEO, Citigroup;
  • Professor Hal Scott, Nomura Professor of International Financial Systems, Harvard Law School;
  • Mr. Barry Zubrow, Executive Vice President, Chief Risk Officer, JPMorgan Chase.

Additional witnesses will be announced at a later date.

House amendment on prop trading

  • Text from House Financial Services Committee press release, January 21, 2010

To further manage risk in the financial system, Congressmen Brad Miller (D-NC) and Ed Perlmutter (D-CO) authored an amendment that was included in H.R. 4173 to give the Federal Reserve the authority to prohibit systemically designated companies from engaging in proprietary trading.

Proprietary trading is defined as trading securities, commodities, derivatives and other financial instruments with the company’s own money for its own account.

Rules will be written jointly by the primary regulators of banks and bank holding companies.

The Fed will have authority to exempt activities depending on the nature of such trading and the degree of threat it poses to the company or the financial system.

Obama to propose new rules on proprietary trading

President Barack Obama tomorrow will offer new proposals on limiting the size and complexity of proprietary trading systems as a way to reduce risk-taking, a senior administration official said.

Obama, who is meeting tomorrow with former Federal Reserve Chairman Paul Volcker, will propose the new rules as a part of an overhaul of financial regulations to help limit the size of financial institutions, the official said on the condition of anonymity before the announcement is made.

“We’ve got a financial regulatory system that is completely inadequate to control the excessive risks and irresponsible behavior of financial players all around the world,” Obama said in an interview with ABC News broadcast tonight.

Obama in June proposed an overhaul of U.S. financial regulations to fix lapses in oversight and excessive risk-taking that helped push the economy into a prolonged recession.

Volcker, who is chairman of the President’s Economic Recovery Board, has criticized as “reform light” efforts by the financial industry to weaken financial regulation proposals in Congress.

A year ago, he issued a report from the Group of Thirty, a panel of former central bankers, finance ministers and academics, calling for separation between commercial banks and businesses that engage in speculative risk-taking such as hedge funds and proprietary trading.

The House of Representatives passed a package of new rules in December while members of the U.S. Senate continue to work on legislation that has the support of Republicans and Democrats.

Trading income versus commercial banking income

John Kemp, columnist at Reuters, admits there is no easy way of identifying how much money the major banks make from prop trading.

However, he points out there is a way to breakdown which banks depend most heavily on trading income rather than investment or commercial banking activities.

This, he says, is a clue to their prop trading revenues.

In which case, the two banks most exposed to a prop trading ban are: Goldman Sachs and Morgan Stanley.

Although Kemp does caution:

Not all those trading revenues are at risk. Many will be from “customer-related” activities. But if the administration’s proposed “Volcker Rule” separating banking from proprietary trading is enacted by Congress and enforced by bank examiners it is these banks that face the largest dent in their revenues, or at least the most intrusive regulation to ensure revenues really are customer-related and not speculation on behalf of the house.

A useful indicator nevertheless. And does this make Goldman the world’s biggest market-maker?

Prop trading versus market making

"Here is an interesting account of what happened in 1998 when the Federal Reserve orchestrated the primary dealers to bail out Long Term Capital Management…

~~ ” … I want to talk about the word “liquidity” as it applies to the bond market.

I want to focus on what has happened over the last three or four months. How do we assess Long Term Capital and its relationship to the bond market? Where do we go from here? The financial press has not done a good job in my opinion in telling the story of what happened in the financial markets, primarily fixed income. This is all my opinion.

The unraveling of the emerging markets really started with the Russian debt deal. The Euro dollar debt financing in June of a billion plus. Three, four or five weeks later the owners of this paper realized that they have some paper that could possibly have a default or a very major devaluation. The problem was what do you do with that paper? You go back to the Goldman or Salomon or Morgan trading desk and say, “Make a bid”. We are talking now about the emerging markets desk. The trader says, “Make on bid on what?” The trader is very shy about being too aggressive. They got hung, as the expression goes. This started the whole stampede of the emerging markets becoming unraveled.


That desk trades all the emerging market paper. This incorporates the Eastern European, the Russian, the Asian and the Latin American papers. If that trader is forced by his salesmen or firm to make a bid, that trader has to short something to neutralize his position. The real dynamic was that there was no paper to short in the Asian market. All the financing in Asia was through the banks. This was the disequilibrium. Also, because everything was done through the banking system in Europe there was very little paper that you could short there. So you are back to Brazil, because the Brazilian “C” bond , the Brady, which is the sovereign credit risk of Brazil, is the paper of real liquidity. You can only short one emerging market paper and that was the Brazilian “C” bond.

The fixed income market is nothing more than a spread relationship. Everything is linkage. All Brady bonds interrelate. The Argentine Bradys and the Mexican Bradys all relate to the Brazilian Bradys. The corporate paper relates to the sovereign credit because there ought to be a stated relationship or spread.

Then you had the Long Term Capital situation which further unraveled the market. They owned some of this paper but that really wasn’t the issue. The issue was the real big money made by the big guys was through their proprietary book. I am talking about the five, six or seven major firms. The proprietary book, their prop book as it is called, is nothing more than the firm capital. It is run on a hedge fund basis.

In other words, a firm in its prop book was doing nothing more than replicating everything that LTC had in its book. It set up its positions or its models and strategies as a global macro player. These are not stock hedge funds where its long against shorts or the pairings or any of those particular strategies. These are the global macro games where it is currency, debt, equities.

LTC certainly had this mystique about them. There wasn’t any black box as it later turned out. It was the same kind of trades that anybody could do. As a matter of fact, a ten year old could have done them. There was no great science to any of this. This really disturbed a lot of people on the street because they paid a lot of money to have an insight into what they were doing. As it turned out, there was nothing that arcane or exotic that gave them a particular edge.

In any event, all these street firms had the same trades on. That is why these firms had to step up and bail out LTC. They would have been pulled under in the same way. We didn’t dodge a bullet here, we dodged a bazooka. This is not my original statement. There is no doubt in my mind we would have had the financial apocalypse. Absolutely the financial apocalypse. This is strong language. I understand that. But any number of firms would have gone under. There would have been sheer paralysis in the financial markets if the New York Fed had not stepped up and brokered this transaction. I happen to think it was the Fed’s greatest day.

It really hasn’t been fully appreciated in the marketplace what the Fed did. Every firm on Wall Street, the big guys, had the same trade. There was no liquidity in the market. The reason there was no liquidity is simply this. You have the prop book over here. You are trying to protect your positions in your prop book and you know that you are going to have to be selling some of these positions to reduce your exposure. Over here you have your market making.

Market making means that I am taking an inventory. There is no way in the world I want to be positioning any bonds during this period of tremendous stress in the marketplace. I am more worried over here with respect to my proprietary book and getting out of these positions with honor over time. What you do is you tell your traders who are the ones responsible for market making, “Do not take on any inventory.” As a result, the street started to trade on an agency basis. This is what dried up the liquidity. The interplay between the prop book and the market making.

There was absolutely nothing wrong with the underlying credits. Fundamentally these are all very sound credits. You had a wide spread as the yield levels backed up from 7 ½ or 8 percent to 10 percent. You had an extraordinary opportunity of 240 or 250 points over 500 basis points. What is happening now is that prices are gapping up the same way they gapped down. They are gapping up because there are no offerings in the market. Liquidity is coming back into the market on the bid side but there aren’t any offerings. It is the same thing in the emerging markets. You can’t buy good corporate credits in Argentina, Brazil or Mexico.

We are getting to a position now where the market is healing. The recovery has been way beyond expectations. Market making will recover because there is money to be made in the market. The salesmen are making tremendous sums of money today in brokering these trades because nobody knew where the levels were. Now the levels are starting to return to some normalcy….” ~~

Sen Kaufman - isolate prop trading from commercial banking

"...In other cases, the major banks have built their own internal proprietary trading desks. These divisions often use their own capital to “internalize,” or trade against, customer order flow.

Such a practice poses inherent conflicts of interest: brokers are bound by an obligation to seek the best prices for their clients’ orders, but, in trading against those orders, firms also have a potential profit-motive to disadvantage their clients. Both of these arrangements are evidence of a greater problem: Wall Street has become heavily centered on leverage and trading.

Undoubtedly, short-term strategies have paid off for banks. In fact, much of the profits earned by our nation’s largest financial institutions have been posted by their trading divisions.

But an emphasis on short-term trading is cause for concern, particularly if traders are taking leveraged positions in order to maximize their short-term earning potential. By doing so, such high frequency strategies, which execute thousands of trades a second, could pose a systemic risk to the overall marketplace.

In short, Wall Street once again has become fixated on short-term trading profits and has lost sight of its highest and best purposes: to serve the interests of long-term investors and to lend and raise capital for companies – large and small – so they can innovate, grow and create jobs.

As I’ve spoken about on the Senate floor previously, the downward decline in Initial Public Offerings for small companies over the past 15 years has hurt our economy and its ability to create jobs.

While calculated risk-taking is a fundamental part of finance, markets only work when investors not only benefit from their returns, but also bear the risk and the cost of failure. What is most troubling about our situation today is that on Wall Street, it is a game of heads I win, tails you bail me out.

The size, scope, complexity and interconnectedness of many financial institutions have made them “too big to fail.”

Moreover, the popularity of the “financial supermarket” model further raises the risk that insured deposits of banks can be used to finance speculative proprietary trading operations.

Unfortunately, these risks have only been heightened by recent decisions by the Federal Reserve: the first to grant Bank Holding Company charters to Goldman Sachs and Morgan Stanley; the second to grant temporary exemptions to prudential regulations that limit loans banks can make to their securities affiliates.

There are a number of ways we can address these problems.

The major financial reform proposals being considered in Congress propose some entity for identifying systemically risky firms and subjecting them to heightened regulation and prudential standards, including leverage requirements.

In addition, these proposals also include an orderly mechanism for the prompt corrective action and dissolution of troubled financial institutions of systemic importance that is typically based upon the one already in place for banks.

Although both of these ideas are vital reforms, they are not sufficient ones. Instead, we must go further, heeding some of the sage advice – as President Obama has today – provided by Paul Volcker.

Chairman Volcker has said: “[Commercial banking] institutions should not engage in highly risky entrepreneurial activity. That’s not their job because it brings into question the stability of the institution…It may encourage pursuit of a profit in the short run. But it is not consistent with the stability that those institutions should be about. It’s not consistent at all with avoiding conflicts of interest.”

I strongly support the ideas Chairman Volcker has recently put forward regarding the need to limit the proprietary trading activities of banks.

Indeed, they get at the root cause of the financial meltdown by ensuring Wall Street’s recklessness never again cripples our economy.

We can reduce the moral hazard present in a model that allows banking to mix with securities activities by prohibiting banks from providing their securities affiliates with any loans or other forms of assistance.

While commercial banks should be protected by the government in the form of deposit insurance and emergency lending, Chairman Volcker states: “That protection, to the extent practical, should not be extended to broadly cover risky capital market activities removed from the core commercial banking functions.”

Such a reform would completely eliminate the possibility of banks even indirectly using the insured deposits of their customers to finance the speculative trading operations of their securities affiliates.

In addition, we can bar commercial banks from owning or sponsoring “hedge funds, private equity funds, and purely proprietary trading in securities, derivatives or commodity markets.”

As Vice President Biden aptly and succinctly put it: “Be a bank or be a hedge fund. But don’t be a bank hedge fund.”

Mr. President, that is why I am pleased to be a co-sponsor of the bill introduced by Senators Cantwell and McCain to reinstate Glass-Steagall, because I thought it was a start to this very important conversation.

Separating commercial banking from merchant banking and proprietary trading operations is an important step toward addressing banks that are “too big to fail.”

Additionally, we need to impose restrictions on size and leverage, particularly on the reliance on short-term liabilities, and give regulators additional powers to break apart firms that pose serious threats to the stability of the financial system or others.

Reducing the size and scope of individual entities will limit risky banking behavior, minimize the possibility of one institution’s failure causing industry-wide panic and decrease the need to again rescue large failing institutions.

Together, all of these reforms will create a financial system that is “too safe to fail.”

Simon Johnson on prop trading proposal

Paul Volcker, legendary central banker turned radical reformer of our financial system, has won an important round. The WSJ is now reporting:

President Barack Obama on Thursday is expected to propose new limits on the size and risk taken by the country's biggest banks, marking the administration's latest assault on Wall Street in what could mark a return -- at least in spirit -- to some of the curbs on finance put in place during the Great Depression.

This is an important change of course that, while still far from complete, represents a major victory for Volcker - who has been pushing firmly for exactly this.

Thursday's announcement should be assessed on three issues.

  1. Does the president provide a clear statement of why we need these new limits on banks? The administration's narrative on what caused the crisis of 2008-09 has been lame and completely unconvincing so far. The president must take it to the banks directly - tracing the origins of our "too big to fail" vulnerabilities to the excessive deregulation of banks following the Reagan Revolution and emphasizing how much worse these problems became during the Bush years.
  2. Are the proposed limits on the total size (e.g., assets) of banks, or just on part of their operations - such as proprietary trading? The limits need to be on everything that banks do, if they are to be meaningful at all. This is not a moment for technocratic niceties; the banks must be reined in, simply and directly.
  3. Is there a clear strategy for (a) taking concrete workable proposals directly to Congress, and (b) win, lose, or draw in the Senate, running hard with this issue to the midterm elections?

Push every Republican to take a public stand on this question, and you will be amazed at what you hear (if they stick to what they have been saying behind closed doors on Capitol Hill.)

The spin from the White House is that the president and his advisers have been discussing this move for months. The less time spent on such nonsense tomorrow the better. The record speaks for itself, including public statements and private briefings as recently as last week - this is a major policy change and a good idea.

The major question now is - will the White House have the courage of its convictions and really fight the big banks on this issue? If the White House goes into this fight half-hearted or without really understanding (or explaining) the underlying problem of unfettered banks that are too big to fail, they will not win.

The relationships between trading and investment banking

Investment banks are defined as companies that assist other companies in raising financial capital in the capital markets, through things like the issuance of stocks and bonds. Trading has almost always been associated with investment banks however, because they are often required to make a market in the stocks and bonds they help issue.

For example, if General Store Co. sold stock with an investment bank, whoever first bought shares would possibly have a hard time selling them to other individuals if people are not familiar with the company. The investment bank agrees to buy the shares sold in order to find a buyer.

This provides liquidity to the markets.

The bank normally does not care about the fundamental, intrinsic value of the shares, but only that it can sell them at a slightly higher price than it could buy them. To do this, an investment bank employs traders. Over time these traders began to devise different strategies within this system to earn even more profit independent of providing client liquidity, and this is how proprietary trading was born.

The evolution of proprietary trading at investment banks has come to the point whereby banks employ multiple desks of traders devoted solely to proprietary trading with the hopes of earning added profits above that of market-making trading.

These desks are often considered internal hedge funds within the investment bank, performing in isolation away from client-flow traders.

Proprietary desks routinely have the highest value at risk among other desks at the bank.

Investments banks such as Goldman Sachs, Deutsche Bank, and Merrill Lynch are known to earn a significant portion of their quarterly and annual profits through proprietary trading efforts.

Unlike other type of auctioneers, the traders in investment banks are allowed to bid shares while conducting the auction. If you think a trader's ability to see the incoming orders for the trade gives him a built in advantage when trading for himself, you are not wrong. It is like being in the card game in which only one of the players got the ability to see everyone else's hand.

Frontrunning the markets

From James Rickards, The Frog, The Scorpion, and Goldman Sachs:

"Now consider another example of data mining, not done by retail firms, but by giant investment banks such as Goldman Sachs. These banks have thousands of customers transacting in trillions of dollars in stocks, bonds, commodities and foreign exchange daily. By using systems with anodyne names like SecDB, Goldman not only sees the transaction flows but some of the outright positions and whether they are bullish or bearish. Data mining techniques are just as effective for this market information as they are for Google, Amazon, Wal-Mart and others. It’s not necessary to access individual accounts to be useful. The data can be aggregated so that the bank can look at positions on a portfolio basis without knowing the name of each customer.

One need not be a market expert to imagine the power of this information. You can see which way the winds are blowing before the storm hits. You get a sense of when momentum is draining out of a trade so you can get out of it before the market turns. You can see when bullish or bearish sentiment reaches extremes, suggesting it may soon turn the other way. This use of information is the ultimate type of insider trading because it does not break the law; you are not stealing the information, you own it.

So what do Goldman and others do with this mountain of market information? Do they send coupons to customers or text them with great trading ideas? A few lucky customers, usually giant hedge funds, may get a call on some insights, but this mountain of immensely valuable market information is used mainly to power their giant proprietary trading desks allowing them to rack up consistent excess returns. Economists have a name for this also. It’s called “rent seeking,” which means taking value from others without any contribution to productivity. The difference between value-added behavior and rent seeking is like the difference between Amazon trying to sell me a book or planning to steal my library. In nature, the name for a rent seeker is parasite.

The ideal existence for a parasite is symbiosis, or balance, where it offers some minimal service to the host, (some parasites devour insects which annoy the host), while extracting as much sustenance from the host as possible without killing it. But sometimes the symbiosis is disturbed and the parasite takes too much and actually destroys the host, which can end up destroying the parasite as well. This recalls the fable of the scorpion and the frog. Both are on the edge of a river looking for a way to cross. The scorpion cannot swim and asks the frog for a ride on its back. The frog at first says, “no,” for fear of being stung. But the scorpion assures the frog it will not sting him because they would both drown. The frog agrees to carry the scorpion. Once they reach the middle of the river, the scorpion stings the frog and they begin to drown. The frog cries, “why did you do that?” and the scorpion replies, “it’s my nature.”

And that is the nature of Goldman. Gather up as many customers as possible, aggregate the available information to achieve a superior market view and then relentlessly extract rents from the marketplace. Better yet, tell yourself you’re smarter than everyone else and you’ve earned the rents from the symbiosis."

How does it continue? Like the bailout of AIG, the stewards of the public trust are choosing to turn a blind eye. The politicians are the beneficiaries of huge campaign contributions. The regulators are overwhelmed, and desirous of Wall Street positions. The other traders are jackals, seeking to follow the lions as they tear into the flocks of sheep and cattle. The economists are timid, adverse to anything but painfully granular analysis of carcasses of other people's ideas and orthogonal scenarios.

Conflicts of interest in proprietary trading

There are a number of ways in which proprietary trading can create conflicts of interest between a trader's interests and those of its customers.[1]

Some suspect that traders engage in "front running", buying shares in companies the traders' customers are buying so as to profit from the price increase resulting from the customers' purchases and thereby harming the customers' interests.

Some suspect that investment bank salesmen (who encourage customers to buy particular securities) assist their firm's proprietary traders by encouraging customers to buy securities performing poorly after the proprietary traders have bought them for the firm.

Lastly, because investment banks are key figures in mergers and acquisitions, a possibility exists that the traders could use prohibited inside information to engage in merger arbitrage.

Investment banks are required to have a Chinese wall separating their trading and investment banking divisions, however in recent years, dating most recently back to the Enron saga, these have come under great scrutiny.

One example of an alleged conflict of interest can be found in charges brought by the Australian Securities and Investment Commission against Citigroup in 2007. [2]

Famous trading banks and traders

Famous proprietary traders have included Robert Rubin, Steven A. Cohen, Edward Lampert, and Daniel Och.

Some of the investment banks most historically associated with trading was Salomon Brothers and Drexel Burnham Lambert, and currently Goldman Sachs.

Nick Leeson took down Barings Bank with unauthorized proprietary positions.

Another trader, Brian Hunter, brought down the hedge fund Amaranth Advisors when his massive positions in natural gas futures went bad.

References

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