The very minute the Paul Volcker, who proposed the sound idea that government backstopped banks not engage in proprietary trading, said that trades done on behalf of customers were meant to be excluded from this proposal, anyone familiar with trading could see he’d just deep sixed his idea.
Proprietary trading existed LONG before banks decided to create separate “prop” desks to speculate with house money. And even in the era of prop desks, in the vast majority of cases when a prop trader puts on or exits a trade, who is the end buyer? A customer.
So the measure of whether a bank is making bets in its customer dealing book isn’t the composition of its counterparties, it’s how much in the way of bets it winds up carrying (traders, just like rug merchants, can shade the prices they buy and sell at to keep from accumulating too much inventory). It would have ben possible for regulators to devise rules, such as value at risk limits, requirements that dealers hedge or otherwise “flatten” their positions beyond a certain size level within a specified time period. Even with provisions like that in place, some desks will be exposed when markets turn chaotic, but it should be far fewer, with much less loss exposure.
Instead, as the New York Times recounts, life in big bank land continues more or less as it did before, including large losses when traders make bad bets:
But for all the talk of shutting down trading desks and reassigning employees to prepare for the Volcker Rule, proprietary-style trading will probably survive, if under a different name.
This year, for example, several large insurance companies approached Goldman Sachs, looking to bet that the markets would not stay quiet. Goldman gladly took the other side of the trades, but when the markets turned choppy in May, the firm was caught short and quickly lost $250 million.
Goldman, through a spokesman, declined to comment on its losses on that investment. But in a conference call with analysts last month, the bank’s chief financial officer, David Viniar, explained: “We didn’t hedge it fast enough. Things spiked really dramatically, really fast.”
Months before that trade, though, Goldman Sachs’s research department named a bet against volatility as one its top 10 trading strategies for 2010. Goldman followed its own advice and put its own money in play by failing to adequately hedge the trade with the client who wanted to bet on volatility, which would have given Goldman a neutral position. In this way, a client-oriented trade can effectively become a proprietary bet…..
“Goldman tends to have businesses that have a customer focus with a proprietary overlay,” said one hedge fund manager and Goldman alumnus who insisted on anonymity. “That overlay can effectively allow them to make directional bets by using the customer flow to get them there.”
But Goldman is hardly unique when it comes to walking the fine line between serving clients and taking positions.
Late last year, with clients eager to bet that coal prices would rise, JPMorgan took the other side of the trade and amassed contracts on hundreds of millions of dollars on coal — enough to dominate the European market.
Initially the trade went JPMorgan’s way and yielded profits, but in April the Morgan traders were caught off guard when European coal futures abruptly started rising. In fact, the wrong-sided bets erased all of the previous gains, and by the middle of June, it had turned into one of the commodities unit’s biggest losses — nearly $130 million.