naked capitalism

Although it was unclear how the high concept behind the Volcker rule would translate into legislation, we had doubts from the get-go. The idea is sound: firms that are ultimately playing with government money should be involved only in socially valuable transaction intermediation and fundraising (and all major dealers around the world are backstopped, pretenses about “living wills” and resolution regimes are fig leaves). Speculating or investing solely to boost profits for the house should be a no-no. The banks can raise funds on artificially cheap terms, thanks to government support, and they have incentives to direct them to high risk activities, the very sort that have the most upside to them and the most potential to leave the taxpayer with losses.

However comments from Volcker early on, which were picked up elsewhere, suggested an implementation that is close to useless: defining only trades not executed with customers as prop trades. This is just silly. Yes, it would make some minimal progress in eliminating in-house hedge and PE funds (although even that didn’t happen, dealers are still permitted to invest up to 3% of their equity in hedge and PE funds; only Goldman and Morgan Stanley will have to whittle down their commitments, and then over an extraordinarily long time frame, well beyond the typical 7 year life of a PE fund).

But the big problem is with the treatment of dealing desks. Firms could and did take proprietary exposures on customer desks long before the creation of formal prop desks; a lot of prop positioning still takes place on trading desks. And when a prop desk enters or exits a trade, the execution is on a customer desk. Exactly how often do you think the counterparty of that prop trade is a customer, as opposed to a dealer? Unless the prop desk is in a huge hurry to take or unload the position, the odds greatly favor the party on the other side being an customer.

The right way to have done this would to have been to use VaR or other risk metrics and to require customer desks to flatten positions taken on over a certain, not-very-long timeframe. Oversight would be somewhat intrusive, but it could easily use existing dealer management information systems. Reader MichaelC pointed this out earlier::

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….

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.

One early report contended that the Volcker rule would affect less than 1% of banks’ activities. A Wall Street Journal report indicates that financial firms are reconfiguring dealing desks to evade the Volcker rule. And what are they doing? Moving prop activities on to customer desks, as predicted. And this is all being presented as more innocent than it really is, that banks are “scrambling to find new positions for star proprietary traders”. Help me.

From the Wall Street Journal:

Citigroup Inc. is considering moving roughly two dozen proprietary traders onto desks that trade with company clients, according to people familiar with the situation. Other firms already have shifted proprietary traders to customer-focused trading operations.

The moves don’t necessarily mean that the days of wagering with a bank’s capital are numbered. Many expect an increase in risk-taking in trading operations that cater to clients as traders build an inventory of stocks and bonds to meet demand from hedge funds, money managers and other customers.

At Morgan Stanley, one proprietary trader whose desk was shut down after the financial crisis now trades using capital from a trading desk that serves stock-trading clients, said a person familiar with the matter. Another Morgan Stanley proprietary trader who left for Deutsche Bank AG also essentially bets with the German bank’s capital on a trading desk for clients, this person added.

In Hong Kong, a small group of Morgan Stanley proprietary traders who buy and sell securities using the firm’s capital started using “corporate derivatives” to describe their role earlier this year, according to a person familiar with the matter…

It isn’t clear if regulators will see the shifts as anything more than sleight of hand. The Volcker rule, named for Obama Administration adviser and former Federal Reserve Chief Paul Volcker and passed by the House last week as part of the financial-overhaul bill, directs federal officials to disallow most proprietary trading at banks unless the trades are meant to serve near-term client demand or reduce risk.

But does that mean a trader can’t buy a bunch of bonds in anticipation that investors would want to buy them a week later at a higher price? What if the trader holds the bonds for a month or two? Such scenarios make it difficult to draw a clear line between proprietary trading and the sort of client-centered trades typically handled by separate desks at most firms. Regulators could take years to establish clear rules. They expect Wall Street firms to push for more risk-taking as they test the limits of new rules, say people familiar with the matter.

Yves here. I would not wager in favor of the Volcker rule being interpreted strictly. History and bank friendly regulators argue against it.