I wanted to resist commenting about the "Volcker Rule" until the details were finalized, but let me just spit out a few things. First of all, I spent time on both sides of the business on Wall Street - on the "sell side," on a customer-related trading desk, and on the "buy side" at an internal hedge fund at the same firm - a large, generally commercial bank.
The second part of my job description would be pretty clearly banned under the proposed rule changes.
"The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit."
You know what - it's kinda hard to argue with that. I was just discussing it with a friend of mine who trades in a purely proprietary group (when I say pure prop, I mean it's completely segregated from all customer businesses - it's even in a different building usually) at a large commercial bank. He wrote to me, "but there is very little risk in a group like this - you think we caused the financial crisis?" And no - neither his group or any group like his caused the crisis, but I explained to him that the higher level concept of the group was the problem - he was trading MY deposits - that's just not what The People want. Never mind the issue of if my friend trading merger arb with my deposits is any more or less risky than his bank instead taking the money and lending it out to small businesses and homebuyers (cause that's what they do!) - I think the past few years have cemented the fact that mortgage lending is not necessarily less risky, but it certainly looks better on paper, in terms of subjective categories like benefit to society.
Now the real issue is in my original job - on a customer related trading desk. We would make a lot of money, like all other trading desks, on risks we took trading around customer flow. We would provide capital and take risk from clients who wanted to unload portfolios, and then the risk would be on our books. Trades were coded as "agency," - that's a customer order, "customer facilitation" - that's when we take the other side of a customer order (thus establishing positions of our own), or "principal," - that's when we trade out of the customer facilitation trade. Yet, not all principal trades are proprietary - in fact, most of them aren't - MOST of them are customer related. When do you draw the line? What if I want to hold that customer related position for a day, or three days - at some point does it cease to become a customer related trade, even though it was established as a result of customer orders?
When an S&P index change was announced, we'd usually buy the stock. First, because we hoped it would go up, and second, because then we'd have inventory to sell to our customers. We were willing to take the risk of buying the stock early, while they were not. Fixed income syndicate desks are the same - when underwriting a new bond issue, of, say, $300MM for XYZ corp, the desk may sell $315MM worth of bonds to its customers and end up short the issue, so it can go out and actively bid for bonds, since it knows that some customers will want to sell their allocation quickly. It's part of being an intermediary.
Are these activities proprietary trading? That's the real question. People are talking a lot about Goldman Sachs, a firm who makes most of its money from "trading." GS, however, claims that roughly 10% of its revenues are from purely proprietary trading. The remainder is from customer related desks. Are these desks taking principal positions? Of course - and how do you pick and choose which to allow based on customer flow interactions? You can't be a little bit pregnant, and you can't kinda-sorta ban proprietary trading. John Hempton brings up a few more easy dilemmas on the difference between prop trades and hedges: "You do a big equity underwriting. To hedge your risk you go short the market because you can't go short the specific." Is that a prop trade? "How about guaranteeing a customer VWAP on a trade. Is that prop risk?"
Unfortunately, it seems like this policy is more populist reaction from an Adminstration that screwed it up the first time. Take Goldman Sachs (And Morgan Stanley for that matter) - why on Earth are they allowed to borrow from the Fed under Bank Holding Company charters when (to the best of my knowledge) neither of them has any commercial banking deposits? (EDIT: EconomicsOfContempt points out that both GS and MS actually do have bank deposits. I think the gist still holds here though - try opening up a retail depository account at either of these institutions. The Fed window is designed for capital needs related to retail deposits in order to avoid runs on the bank) In addition to trying to separate commercial banking and prop trading, wouldn't a good first step to be to actually separate the commercial banks from the non commercial banks? People aren't mad because GS is making money trading - they're mad because GS is making money trading with what they (the people) think is taxpayer money or taxpayer backstops. The decision to allow non-banks access to (near zero cost) Fed funds resulted in these non-banks making extreme amounts of money which angered the populace.
As I said, I fully understand the desire to implement a situation where commercial banks do not engage in proprietary trading. However, the real problem isn't proprietary trading - it's leverage - it's actual risk. Even if/after we successfully separate proprietary trading from commercial banking, what are we doing to prevent the next Long Term Capital Management blowup? I guess LTCM is no big deal anymore - after all, it was a mere $5B in bailouts - chump change in today's land of large bailout numbers...
-KD
26 comments:
"Take Goldman Sachs (And Morgan Stanley for that matter) - why on Earth are they allowed to borrow from the Fed under Bank Holding Company charters when (to the best of my knowledge) neither of them has any commercial banking deposits?"
Uh, yes they do. Goldman's commercial bank is called Goldman Sachs Bank USA (total deposits: $35.6 billion), and Morgan Stanley's commercial bank is called Morgan Stanley Bank, N.A. (total deposits: $56 billion).
The statement that people are pissed at them being able to borrow at .05% however is right on the money. Excuse the pun. Close the window to them or make them pay something that is in the realm of fair.
KD,
would love your take on Jesse's Cafe Americain's posts on FED frontrunning, very interesting stuff.
gysc: i'm not sure how the Fed executes - it's clear from Jesse's piece that the accusation is not that the Fed calls broker dealer X to trade, who first trades in their own account and then executes the Fed trades - that would be pretty easy to prosecute, but rather that the broker's trades are executed well in advance. this would imply that someone at the Fed is leaking information, which should be prosecuted. Also, if the Street drives the prices out of whack, the Fed should buy the cheaper security! Some firms would do the equivalent version of this when they did share buybacks - they'd buy whichever class of stock was cheaper at the time of the buyback.
i do remember reading something related to this topic many months ago that basically said it wasn't hard to figure out what the Fed was going to buy and when they were going to buy it - and thus it was something that could be traded profitably (note: that is NOT frontrunning in that case)
economics of contempt - those are not retail deposits though - are they? i will look into it. that doesn't sound right at all. can i open up a bank account at GS or MS? not to my knowledge...
Perhaps it's the terminology that is causing all the hangups. What exactly is a bank versus a commercial bank versus an investment bank? Shouldn't one intent be to carve out and isolate FDIC back assets from pure investment and prevent an investment organization from being able to access the FED? If you can do that, regulate the derivative market, and require that the mortgage industry retain some skin if they sell mortgages, it seems that alot of the major risk wil be reduced.
I don't believe that any of the supposed financial innovation has produced any tangible benefits to society beyond enriching a select few, so I don't care if much of it becomes unprofitable or goes away.
@ mike K - is that you Rortybomb? thanks for the accurate comment in any case. But regarding your last sentence - you don't think that financial "innovation" enabled millions of people to obtain mortgages that they otherwise would not have been able to obtain, and thus have the OPPORTUNITY to own a house they otherwise never would have had? Many people would say that has a benefit for society. (although yes, i realize that lending money to people who cannot afford to pay it back does NOT benefit society - unless of course we get the banks to eat the losses while allowing people to keep these homes which is what is happening with principal reductions. it's pure wealth redistribution. I don't like it, but i bet society does)
but in general, i agree with you. spreadsheet math seems good oftentimes, for a while, until it blows up
"unless of course we get the banks to eat the losses while allowing people to keep these homes which is what is happening with principal reductions."
Kid, the banks don't even recognize their losses (mark to whatever). It's taxpayers eating the losses. I don't think society should tolerate a financial system that can only sustain itself by stealing from its grandchildren.
BTW, no clue who Rortybomb is.
we don't disagree. but mortgage principal reduction programs are banks eating the losses - that's not something that's subjective - it's a fact. i hear you on the taxpayer angle, and i'm not in favor of it - note what i wrote - it's pure wealth distribution. from Taxpayer Kid Dynamite to Johnny Defaulted On His Mortgage
rortybomb is another blogger with the name Mike K.
Why is everyone talking as if borrowing costs are positive?
Hold your Required Reserves (or, these days, an order of magnitude-plus more than required) and get paid 25 bp.
Nice situation when you're only paying savers 1 bp at best.
Excellent Data Digging As Always! Between Calculated Risk and The Big Picture a guy can make some serious $ with your inside insights. We had to expect that Volcker would hammer down on TBTF with the tax payer outrage and lack of retail lending.
Charlie Rose which not enough people watch because he is on PBS did an excellent interview with Prince Alwaleed. I have known of the Prince for sometime because of his massive ownership stake in Citigroup. But most recently they purchased The Four Seasons Hotel brand along with Bill Gates. The interview is wide ranging from the Middle East, his investments, global change, China. Take a look. If you get bogged down with the Mid-East political talk Charlie draws him into, just skip ahead as there are some real insights here.
www.thegreatloanblog.com
Mr Jumbo Mortgage
"why on Earth are they allowed to borrow from the Fed under Bank Holding Company charters when (to the best of my knowledge) neither of them has any commercial banking deposits? ..." - KD
This stuff is beyond me, but I think in the fall of 2008 the Fed needed a market maker that could operate aggressively to provide large amounts of liquidity for customers, and Goldman Sachs fit the bill.
What is Prop Trading?
That’s an easy question to answer.
Any position that ends up in the Var exposure is prop trading.
Var measures exposure to market risk. Var is the measure of market risk used to determine the amount of capital required to support the trading activities at banks under the BIS capital framework. There is no uncertainty about what constitutes trading risk (prop trading) . Indeed, the market risk capital requirements were designed to enable the prop desks at banks the flexibility to manage the market risks of their prop activities free of regulatory interference regarding the component pieces, provided they held capital against the books..
Market Risk exposure (which includes credit risk translated into market risk through capital market and derivative activities (i.e CDO and CDS) arises through the trading activities of the institution.
The “who can tell what’s customer driven and what’s prop trading “ argument is completely bogus. If the activity leaves the institution with net market risk exposure, that activity is prop trading. I believe this is Volcker’s view.
To determine what is appropriate prop trading for an institution, review the var exposure by trading desk at each institution, then determine which prop trading desk rightfully belongs in a federally backstopped institution. To be precise, review the positions feeding the Var. The risk calculation methodology issues are irrelevant for this argument.
For example, if the structured products desk at GS generates market risk and thus var, and if it’s a major profit center, GS needs to convince us that this is an activity that should be supported by any type of govt support.
As another example, Volcker was pretty clear that CITI shouldn’t have a commodities desk. He was a factor in the Phibro spinoff. I don’t think he will consider GS’s commodity trading (a big profit center) as an good commercial banking activity.
GS's defense that the prop trading represents a sizeable but small % of their revenues is nonsense. They may make the lions share of their trading profits on transaction spreads, but the additional % they designate as prop trading on the residual exposure is a piece of the whole trading activity that is considered as “prop’ trading under the global banking standards.
I’m exasperated by the press coverage, especially in the NYT and WaPo which seems to be perpetuating the myth that the bankers are just too clever and any attempt to regulate is guaranteed to be gutted and dead on arrival.
Bullshit. Your recent reporting is a clear sign that that mythology has lost its power to mesmerize.
That plus the fact that Volcker is nobody’s fool, that he can deflect Barney and Dodd like mosquitos , he’s now O’s boss, and that he sees the bankers for what they are.
Wow, great comments section on this one, plenty of info.
KD,
Thanks fo your take on the article I mentioned. Interesting indeed.
Looking forward to the vegas story.
A fact is this: Bank holding companies have a lower cost of funds. Most likely even more in the future because the Gov has said they will always bail these guys out.
Another interesting fact is that GS in particular always has a hard time competing on vanilla transactions because they had a higher cost of funds then --lets say--DB JPM.
It is indisputable that the tax payer is subsidizing profits. This is a bank and it does not lend (in the traditional sense) or take deposits. If that is the case then they should be paying a hefty price for this gift
My impression of what GS is saying is they are not borrowing from the discount window, and not been for much of the year. I guess people won't believe that.
anon @ 4:09pm: you wrote: "If the activity leaves the institution with net market risk exposure, that activity is prop trading. I believe this is Volcker’s view."
i don't think that's the view at all, and it's absolutely false. The administration even mentioned that market making desks would not be effected - of course, they have no idea how or where to draw the line between market making and trading desks (fixed income syndicate desks are a GREAT example of this fine line)
you touched on VAR - and it's an important point. I believe we need to separate church and state - re-enact Glass Steagall, which renders all this prop trading nonsense moot. THEN, in addition to that, we need to limit risk - via VAR, or probably more reasonably, LEVERAGE limits...
i believe this:
"For example, if the structured products desk at GS generates market risk and thus var, and if it’s a major profit center, GS needs to convince us that this is an activity that should be supported by any type of govt support." is the problem. the trading desks will always be smarter than the regulators, and able to lobby for exemptions or explain away their risk positions. that's what i meant when i said you can't be a little bit pregnant - it's all or none - so why not just put Glass Steagall back in place? i think that's the most reasonable solution.
That was the facile response I was expecting. Thank you.
I said I'm pretty sure it's Volker's view, not the conventional view, so I'm not sure what you mean when you say that's 'absolutely false'.Can you clarify?
My staement was premised on the idea(s) that:
1.Volker knows what he's dealing with and he's (at 82. and not a virgin) sanguine enough to realize wisdom will prevail.
2. The politics are being orchestraed by boys Barney, Dodd, and Obama) who don't have an icecube's chance against the like of Llloyd B et al.
And 3.
From a global regulatory perspective there's little doubt that banks shouldn't be in the financial system destruction business.
You're right that the admin has no idea where to draw the line. But the global guys at the BIS have been trying to draw that line for the last 20 years.VAR is extremely relevant for making the story comprehensible to every reader of NYT/WSJ/even USA today.
Re-implementing Glass Steagal has always been a non starter. BIS thought they had devised a more elegant version of Glass steagel. Their solution has proven to be a disappointment.
As you say.
"the trading desks will always be smarter than the regulators, and able to lobby for exemptions or explain away their risk positions"
That was Greenspan's insight. and fatal flaw.Can you seriously be supporting that view today?!
hi anon -
when i said it's "absolutely false" it's because it is: activities that increase VAR need not be proprietary trades - really, it's a simple fact and it's not even debatable. example one: customer A comes into Citi and asks to sell a portfolio of bonds. Citi, in their role as intermediary (you can call it market maker, if you wish) buys the bonds from the customer. Citi's VAR goes up. This is not a proprietary trade, and i think the Administration has even made it clear that they agree with me, when they mentioned that the rule would not effect market making (remember, there's more to market making than some guy sitting at a nasdaq terminal making a 1c wide market in MSFT and trading out of positions as he gets hit/lifted).
HOWEVER - my point, again, is, what if Citi can't unload the bonds, or if they DECIDE to hold them on the books? at SOME point, might it become more of a proprietary bet? of course - but it's impossible to tell when that point is, and it's why the "“who can tell what’s customer driven and what’s prop trading" is NOT bogus.
I didn't say it was completely false that Volcker had the same view as you regarding VAR - i said i THINK that he differs, and that your statement of VAR and prop is simply not true (actually, i said absolutely false)
i'm also not sure why you're taking little shots at me for a "facile" response - the administrations ban on prop trading is a facile response - it's a populist policy that doesn't address the issue. There is little reason they couldn't re-install Glass Steagall if they wanted to, which would have actual teeth - and no reason they can't address the real issue - LEVERAGE. Instead, they'll attack the populist item: the fact that GS is making money trading off of taxpayer funds. I don't like GS doing that either - but it's not the real problem - it just sucks.
finally, your last statement: "That was Greenspan's insight. and fatal flaw.Can you seriously be supporting that view today?!"
no no no - i think you're confused or misread me - Greenspan's fatal flaw was that he thought markets are self regulating and that the big boys were smart enough to NOT trade themselves into oblivion. in other words, if something was going to blow up the financial world, the financial world would be smart enough to NOT have every bank on the same side of the trade. That's completely different from what i said - which is that the big boys will always be able to outsmart the regulators. In fact, that's probably a big cause of the crisis - again, the big boys convinced the regulators that they needed MORE leverage to trade these supposedly super safe triple A instruments...
If i'm a trader, and some actuary/ accountant/lawyer regulator comes in to ask my the nexus of a particular trade, i will always be able to explain the client relationship, no matter how indirect it is - because i know the business 100x better than he does. that's the point.
One point I'm trying to make with var is that the market making function will result in a var of zero since there is no residual position.
If var is greater than zero then they have a trading position.
So var can be used to provide some insight into the pure trading/customer facilitation split.
Flat Var indicates the market maker function dominates. Large Var indicates trading.
In your CITI example, the var is zero, or close to it if the goal is purely intermediation.
I realize zero is an oversimplification, but the market making function would be expected to have a very small var limit.
You said "of course, they have no idea how or where to draw the line between market making and trading desks (fixed income syndicate desks are a GREAT example of this fine line)"
I suggest the banks do draw that line in the Var limit allocation.
"Flat Var indicates the market maker function dominates. Large Var indicates trading."
yes - and that's the core of it - a better plan than trying to crack down on "prop trading" would be to severely limit VAR that banks can take on. or limit it to zero and re-enact glass-steagall. customers would be seriously effected by this though.
HOWEVER, i still strongly disagree with your claim that in the Citi example the VAR would be zero - of course it wouldn't. surely you realize that "market making" doesn't mean you instantly liquidate positions - and thus we're back to the crux of the issue. In my CITI example, where CITI has a customer come in and sell a portfolio of bonds, CITI might claim they are acting as market maker - this is surely a client driven trade at least. However, the VAR is absolutely not zero, and it may take them days or weeks or longer to trade out of the position. At some point, does it become a prop position? that's impossible to say.
my former business was program trading. one of our biggest functions was to take risk that our clients didn't want - they'd come in and sell us a portfolio (sometimes two sided, sometimes not) of stocks which would then go on our books. For us this was certainly a principal trade - we were committing capital and taking risk - but was it a "proprietary" trade? it was PURELY customer driven - yet it absolutely increased VAR. We usually tried to trade out of the position (the tails at least) in a matter of several days - but not always - sometimes we wouldn't mind carrying inventory so that when the NEXT customer came in for a "risk bid" we could hope that some of it crossed with our inventory.
KD
you said "surely you realize that "market making" doesn't mean you instantly liquidate positions -and thus we're back to the crux of the issue"
I surely do realize that. In a perfect world the market maker book is flat, in the real world a pure market making book should be as flat as possible, else its a trading book, and the position's origin as a customer facilitation becomes irrelevant.
The larger point is that market making's objective is to capture spread.
In the CITI example you ask
"what if Citi can't unload the bonds, or if they DECIDE to hold them on the books?"
If they can't unload them and its a true market making book, they will hedge the market risk exposure till a buyer is found. Result:negligible var.
In the event they DECIDE to hold them on their books (I assume you mean they decide to take them into their position) it will be reflected in their Var.
That decision should be exceptional for a market maker and should trigger a request for a trading limit allocation to support it.
And finally you say
"If i'm a trader, and some actuary/ accountant/lawyer regulator comes in to ask my the nexus of a particular trade, i will always be able to explain the client relationship, no matter how indirect it is"
Classic
That's exactly why regulators don't really give a shit what the trader thinks.
They understand the concept of fungibility and so their concern is focused on where the risk ends up, and whether its an appropriate risk for the institution to take.
Not 'absolutely false' at all , I think
anon - if you need any more evidence of why VAR doesn't show the proper metrics, just look at the last two crisis - 1) LTCM, and 2) the last few years. LTCM blew up on supposedly super safe bets that would show negligible VAR, just like in the most recent crisis the instruments of destruction were supposedly super safe AAA items. VAR just doesn't do it. but that's a separate debate.
you still seem to be missing the concept that the Citi example i illustrated is EXACTLY the business every one of these desks are in.. every one of them. if you don't want them in that business, ok, fine - but i think glass-steagall is a better way to do it. Also, realize the law of unintended consequences - things get a lot harder for customers who now lose counterparties who are taking risk from them.
regarding your last statement - again - the politicians do NOT understand the difference, as is evidenced by the Administration having ALREADY EXPLICITLY STATED that market making business would be exempt, despite the fact that this is where a lot of the risk originates from. I have just given you two simple examples (bond and stock - you ignored my stock example) which are purely customer driven trades that result in VAR increases. the regulators will have to inquire repeatedly as to the nature (customer related ?!?!?!) of trades - "That's exactly why regulators don't really give a shit what the trader thinks." is again totally wrong - they are ALREADY constantly inquiring as to trades they find suspicious, or which may have a conflict with other trading in other areas of the bank, to see if you're doing something you shouldn't be. In the "customer only" trading platform, they'd have to be constantly asking the traders how each trade related to a customer. the traders will explain it away.
i guess we can just wait until formalized details come out and then debate what happens.
KD thanks for a great article. Interesting to read through the comments, especially from "anonymous" who obviously is a jealous state employee who hasn't really understood any of this even though he thinks so.
I can add two more examples of "prop trading":
1) electronic market making - here liquidity is provided to service/facilitate for clients. This is very beneficial for society! Greasing the system. However, as soon as one client "hits" a quote, the market maker will end up with a "prop" position (will show as VaR). Scary stuff? dangerous?
2) index/ETF arbitrage - if it wasn't for proprietary arbitrage desks and firms, the prices on many instruments would be completely off/incorrect/under-over valued. In these trades which can amount to millions and billions of USD, the net trade (VaR) is zero.
VaR is bollocks in many cases.
Great comment section here. I also feel compelled to side with KD over Anon, though I appreciate that Anon is trying to figure things out like the rest of us.
The yet unmentioned risk of society going long on "Var" or any other simplification is a lot of basis and correlation risk. Managers of these customer-driven utility businesses which target zero-Var will not know or care, and the system will be more unstable.
KD - I also don't see why Glass Steagall. Maybe it should have been kept when in place, but now, is it really the exact solution?
We agree generally on the need for narrow banking though. Why not say FDIC-backed deposits can only be in US treasuries? That's it. Mortgages and everything else are risky and there NO LINE between intermediation and prop.
Financial firms might then compete for funding by paying a market price, and they might reduce that market price through transparancy and third-party verified accounting. What prevents banks/traders/hedge funds from releasing marked-to-market financials EVERY DAY? I think the cost would be lower than having lawyers looking at every trade and categorizing it based on the new 1,000-page law that would be required to draw the line between intermediation and prop.
Anyone experience anything about the easy google profit kit? I discovered a lot of advertisements around it. I also found a site that is supposedly a review of the program, but the whole thing seems kind of sketchy to me. However, the cost is low so I’m going to go ahead and try it out, unless any of you have experience with this system first hand?
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