Wall Street Whispers: A Proprietary Problem

The real issue with prop trading is that no one seems to know what it is.
Author:
Publish date:

NEW YORK (

TheStreet

) - The real problem with proprietary trading is that no one seems to know what it is.

It's becoming increasingly clear that the so-called "Volcker rule" that seeks to end proprietary trading will raise sticky questions for regulators. Chatter surrounding the new law - which won't be fully implemented for several years - is full of bluster, conspiracy theories about Wall Street and misinformation regarding the various roles that major firms play in the markets.

At its core, Volcker aims to prevent banks from putting taxpayer dollars on the line with risky, speculative bets. By extension, lawmakers also sought to ensure that banks wouldn't be able to "bet against" clients using in-house funds.

Some parts of these notions are pretty simple. For instance,

Goldman Sachs

(GS) - Get Report

et al. will not be able to employ people who take money from the firm's balance sheet and make bets with for sheer profiteering. They also shouldn't be making any more

"sh*tty" deals.

That's right about where the simplicity ends.

Banks with a major presence on Wall Street also act as market makers, pairing up counterparties with opposing views on the direction of a trade. In the past, market makers have essentially attempted to remain "flat," not taking a position on either side, just facilitating the trade. But market making could present a new opportunity with the absence of proprietary trading.

For instance, let's say a

Bank of America

(BAC) - Get Report

client wants to place a big bet, but there's not enough liquidity to support the other side. And let's say BofA-Merrill is happy to take the counterparty trade itself. That serves a client need, doesn't it? But it also uses in-house funds.

Finally, banks filter billions of dollars' worth of requests for hard assets on any given day. Airlines buy oil futures to lock in prices; multinational corporations need currency swaps to keep a lid on exchange costs; and sometimes, speculative traders outside of the bank simply want to take big positions betting that gold prices will soar, orange juice prices will fall or milk prices will tumble. Other clients place even more sizeable bets - literally worth trillions of dollars in notional value - that interest rates will go one way or another.

As a main filter for such commodities and derivatives, wouldn't it help clients if

JPMorgan Chase

(JPM) - Get Report

could act as a wholesale buyer and keep such assets as "inventory"? The bank could seize on opportunities to purchase contracts when prices are down, and keep prices down by the sheer size of its buys. But JPMorgan would have to use its giant balance sheet to do so.

"The goal of the Volker Rule is to limit the speculative nature of large bank balance sheets," says Mark Williams, who teaches finance at Boston University's School of Management and has experience on Wall Street and in Washington. "To be effective, regulators need to clearly define what is speculative."

During the financial-reform proceedings, Volcker went through some interesting twists and turns.

Wall Street brushed it off at first, when former

Federal Reserve

Chairman

Paul Volcker suggested that banks hatchet off their entire investment banking divisions. ("Fuhgeddaboudit," they implied. "That old kook wouldn't know a credit default swap if it hit him in the back of the head!")

But as the rule

gained favor in Washington - with support from the president and lawmakers - Wall Street became a little more wary. The proposal eventually became lenient enough to woo regulatory support, too, by targeting just "proprietary trading" as well as hedge funds and private equity investments. Then Wall Street started to panic. ("There's no way we can separate our own investments from clients'!" they cried. "And what about hedging?!")

Ultimately, an even more watered-down version was signed into law. Hedging activities will get a pass. Banks will be able to maintain a small stake in alternative investments. As far as other market activities go, Section 619 of the Dodd-Frank law simply says: "A banking entity shall not engage in proprietary trading."

Now, it's up to regulators to decide what that means. In the meantime, banks are figuring out what to do with their outright prop desks - particularly Goldman Sachs, whose trading operation is huge - and testing the waters with regulators to gauge what activities will be frowned upon.

Unfortunately, some of the discussion surrounding proprietary trading has been a little off-point. For example, one

prominent article this week seemed to mingle the idea of outright prop trading with the other types of activities described above.

Joseph Schenk, managing partner of the prop-trading firm First New York Securities, says that, in general, people "

don't seem to understand the distinction between market-making and prop trading. I do think that there's a little bit of a sensationalism going on with it."

Trading faux pas at JPMorgan and Goldman Sachs during the second quarter have also been cited as foreboding signs of what's to come. Yet the financial reform bill wasn't even passed until July. Trading activity through June had little to do with the post-Volcker world.

Furthermore, the amount of money involved in the bad trades was relatively small. JPMorgan lost $100 million on a bad coal bet, while Goldman lost $250 million on a poor hedging strategy on volatility. Those trades compare with net earnings of $4.8 billion and $613 million, respectively, during the quarter.

As Schenk points out: "You see they lost $100 million, and that looks like a lot of money. Well, what they don't tell you is that they could have made $200 million the day before."

The confusion has also been fueled by commentators who promote nefarious conspiracy theories about Wall Street's ability to game the system. It's true that banks have talented "loophole lawyers" who come up with creative ways to get around regulations. But the criticism fails to acknowledge that Wall Street

is

the system and it's trying to figure out how to make money in a new world order.

Going forward, Williams thinks regulators will have to limit the definition of "proprietary trading," to encompass risky, speculative activities. Otherwise, not only will a key pillar of revenue and profit go "the way of the dodo bird," he says, but a huge source of capital that drives the economy will go to waste.

"If a bank takes its own capital and invests in AAA securities, clearly that's speculative, but is it risky?" Williams points out.

Schenk and his partner, Donald Motschwiller, generally agree with Williams' assessment. Nonetheless, they've been contacted by scores of job applicants and recruiters in what Motschwiller calls "the poke and probe phase" before bonus season. Even though big Wall Street banks have been looking for ways to retain their best and brightest, some are out greener pastures just in case.

But it seems that "prop trading" is so hard to define, even Wall Street isn't sure what it means.

"Invariably, we have people who show up here and say, 'Oh gee, I was a great prop trader,'" says Schenk. "You kind of pry a little, pry a little, pry a little and find out they were actually a great market maker."

--Written by Lauren Tara LaCapra in New York.

>To contact the writer of this article, click here:

Lauren Tara LaCapra

.

>To follow the writer on Twitter, go to

http://twitter.com/laurenlacapra

.

>To submit a news tip, send an email to:

tips@thestreet.com

.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.