UK
My friends working in proprietary trading won’t look kindly on me for saying this, but as far as I’m concerned Paul Volcker is right – their jobs should be separated out from the banks they work for. It’s time for them to function on their own.
The newly designated Volcker Rule, if implemented, would disallow proprietary activities from those institutions taking consumer deposits. This implementation would effectively reinstitute the Glass-Steagall Act which was rescinded in 1999.
The proprietary activities most often highlighted by those in the banking community are investment and trading activity within private equity, hedge fund and prop trading desks. The banks are screaming that these activities should not and need not be separated from their overall operations because these activities did not cause our economic crisis. They would be correct on one hand, but how convenient that their definition of proprietary is not truly comprehensive. How so?
I raised the question as to what constitutes proprietary trading when I wrote, “Mr. President, Are SIVs Considered Prop Trading?” What is a SIV? A structured investment vehicle. How did they work?
A separate entity would be set up off balance sheet, typically funded through the commercial paper market, with a spread made between the differential in funding cost and return on assets purchased. These SIVs were often viewed as very low risk because they invested in AAA if not AAA+ assets. How can an asset be rated AAA+? Easily . . . rating agencies provided that rating to certain bonds in selected deals which had a better risk profile than that of the AAA bond. These AAA+ bonds were also called super-senior bonds.
The brain surgeons running the banks viewed these SIVs as cash cows. Given the liquidity in the commercial paper market and the AAA+ rating on the bonds, the banks would typically accrue 20-25 basis points (.20-.25%) on the SIV and go back to managing the real risks in their other business units.
So let’s get this straight. The SIV borrowed money through the commercial paper market and purchased assets from other banks or from its own broker-dealer operation. In the process, the SIV generated what appeared to be low returns, but also with low risk.
Would you call this a proprietary business? I would. Well, what happened to these supposed low risk vehicles?
Funding dried up given the highly suspect quality of the assets purchased into the SIVs. The value of the assets themselves dropped like a rock. The banks owned hundreds of billions of assets in these SIVs. The losses brought Wall Street and the US to its knees.
Let’s stop with the nonsense that proprietary activities did not bring down Wall Street. A SIV is and was very much proprietary.
When will the crowd in Washington and Wall Street be honest with themselves and America and acknowledge this?
Larry Doyle has worked as a senior banker at Bear Stearns, JP Morgan, UBS and Bank of America. He is author of the financial services blog, Sense on Cents.
There are plenty of european banks who are small in the prop world and had there rating slashed for poor risk management. LLoydsTSB, SocGen, RBS, BNP amongst others
Nonsense. You are completely wrong on this.
Americans killed WS and it is only fair that they have to pay to fix it!
OK, the article has a point but following this logic, isn’t lending also a proprietary activity? A bank uses clients’s cash or its capital to finance third party businesses that potentially can be very risky. And, in fact, it was reckless lending (and borrowing) that created a problem in the first place. I have a fantastic idea – let us ban lending all together. Noone will lose any money. Although… hold on one sec… we actually want banks to lend, don’t we?
The problem I have with the proposed rule is that any prop trading position is deemed riskier than a loan. It is fundamentally wrong. Lending is in fact very risky because most positions are illiquid. Agree banks should be more conservative with both trading and lending but it can probably be influenced through capital requirements.
By the way, ban on prop trading will not kill SIVs. In theory, banks may still lend like there is no tomorrow (lending is good, remember), put bad assets into SIVs and sell units to – oh well, maybe, not other banks, but to insurance companies, pension funds, municipal governments. How will Volcker rule change that?
The point is prop trading needs to incorporate the fact that SIVs by their very nature promoted massive leverage and drove irresponsible lending.
As such SIVs should be highlighted as truly proprietary activities and included in the definition of proprietary. After months of debate and discussion on this topic, I have yet to see SIVs included.
wrong again!!
It was NOT irresponsible lending, but irresponsible borrowing!!
Granted, I do not work in securitization, but aren’t Fannie Mae and Freddie Mac the larget “SIVs” in the US market? How different are they from thousands of smaller special purpose entities set up by banks across the globe?
If the US government classifies SIV activities as prop, what should it do about trades with Fannie Mae and Freddie Mac?
“It was NOT irresponsible lending, but irresponsible borrowing!!”
It takes two to tango. Also, can I ask you a question – who gets longer jail sentences – drug users or drug dealers?
wrong again!!
It was NOT irresponsible lending, but irresponsible borrowing!!
Same difference. You say potato, I say pohtato.
In regard to Freddie and Fannie, the manner in which they grew and managed their internal portfolio was very much equivalent to an SIV.
Those ‘internal hedge fund’ also played a very real role in our entire fiasco. The fact is F/F should package and immediately sell MBS into the secondary market rather than running large internal portfolios.
Larry your article is fine and brings a point but proprietary trading ?? Proprietary trading did not cause this problem and you can argue definitions all day long – what you are referring to is structured credit , ratings based vehicles. Of course we should look into /ban these highly leveraged vehicles but how can you tell me that is prop trading. Prop trading is a macro desk or an options trader – someone TRADING equities, options, currencies , futures, curve steepners – all this rubbish you are referring to of ratings and loans should be looked at extensively / banned. BUT how can you tell me prop guys who trade macro themes caused all this – its simple structured credit derivatives needs to be curtailed
Larry, what you are describing is an off-balance sheet vehicle , arbitraging rating longer dated AAA+ paper against short end CP paper. This has alway been bank business to borrow short and lend long. i.e. standard liquidity trading and management. The SIV’s should have been on balance sheet, the ratings agencies should be shot and banks should have kept a closer watch on such activities but this is not what would be classed prop trading in any sense. Your article totally misses the point. Prop trading desks, in its pure sense, rarely if ever will take down a bank. Like any other business with in a bank it adds to diversification of the business. Mostly these days prop traders work under capital allocation and returns on that capital , like any hedge funds. Rarely would it ever get to the stage where one or two guys are going to bust so far through their drawdown limits that it blows up a bank. Most areas in a bank would do well to have their risk monitored as closely as the prop desks. Sorry Larry , you are way off the mark.
arbitraging
The prior comment highlights the above key term as being the nature of a SIV.
What is prop trading other than a form of arbitrage? SIVs are another part of overall proprietary activity.
You made my point and I respectfully appreciate it.
“What is prop trading other than a form of arbitrage? SIVs are another part of overall proprietary activity. ”
Larry, cannot agree with your logic. ALL banking activity, including traditional lending that everyone loves so much these days is some kind of arbitrage. Banks borrow short term money (e.g. by attracting customer deposits) and invest some of it long term (either via loans – which is deemed good – or through buying bonds and equities – which is currently deemed bad). Why should we ban prop trading but encourage lending? Could you please explain the difference between the two? Why is third party lending not considered a prop activity?
In other words, we are looking at 3 possible businesses – structured credit, prop trading and lending. Agree all of them need to be regulated (for instance, through capital requirements) but I really do not see the point in trying to artifically aggregate the first 2 (structured credit and prop) while leaving the third one (vanilla lending) out.
Larry, you are wrong. Stop being so bitter and go hunt for the bucks yourself
In regard to the last two comments. All SIVs are merely a form of proprietary activity.
In regard to the latest comment, check my bio at my site…and then feel free to get back to me.
In regard to the last two comments. All SIVs are merely a form of proprietary activity.
.
So now the terminology has changed to proprietary activity?? Well that is very different from proprietary trading since by definition proprietary activity encompasses SO much more hence why you give the SIV example.
Yes, SIVs were dangerous both to borrowers and lenders (who turned out to be some of the biggest borrowers) however, to lump proprietary trading in with that is completely illogical as if you are going to do that, you might as well throw in anything that lets a financial instituion exploit an imbalance, be it long term rates vs short term, or spot fx rates vs cross rates.
Also, what is prop trading? If a desk runs certains positions AFTER they have taken the other side against a client, is that prop trading? what about if that desk needs some positions as it expects high volume, so it buys/sells some products, is that prop trading? You need to define what is prop trading? you revert to proprietary activity and give the example of SIVs and then claim prop trading should be stopped. that is like claiming “a horse has bolted, it is because it wasn’t tied up, let’s knock down the stable to stop it happening again!” why not just tie the horse up next time??
Protium? Who mentioned Protium? Not I.
These readers comments here are mostly by people who think they know a lot, but don’t.
Me – you wrote “wrong again!! It was NOT irresponsible lending, but irresponsible borrowing!!” – this is a great arguement, you should do really well as the “Riddler” on the next Batman movie
Scott P – you wrote “Prop trading desks, in its pure sense, rarely if ever will take down a bank” – mmm .. what about Nic Leeson from Barings, Jerome Kerviel from Soc Gen, John Meriwether from LTCM, Mr Copper from Sumitomo, and the list goes on and on – you should get yourself a job with Gordon Brown – you seem qualified
Lis – almost every comment you have made here is false and juvenile, and seems to suggest a fundamental lack of knowledge of the issue.
Lis, your statement “Why should we ban prop trading but encourage lending? ” is a good example. You know that this country would virtually grind to a halt if there was no lending, and you would be out of a job, relying on food parcels from your relatives in the Congo
Anon – Claiming the author is ‘bitter’ is not really a persuasive rebuttal, is it? It’s like me saying you have buck teeth and bad breath, so you shouldn’t be on this forum
Three main reasons for the downfall in the Wall Street is:
1. Excessive Leverage
2. Lack of Humility in Bankers (Need Vs. Greed)
3. Destructive creativity (Derivatives)
The lesson here is “Some people are less fortunate they learn from their own mistakes and some people are more fortunate they learn from other’s mistake. Wall Street is one category who blame others for mistakes and is least interested in learing from it.
“Lis, your statement “Why should we ban prop trading but encourage lending? ” is a good example.”
Xanthus – does the word “irony” mean anything to you? Of course, my point was not about banning lending. What I was saying is that there is no fundamental difference between the 2 activities. Buying a bond is in fact similar to granting a loan. If one activity (lending) is a good thing, so is the other (prop). Of course, they both need to be regulated.
“…and you would be out of a job, relying on food parcels from your relatives in the Congo…”
Isn’t it funny – when people run out of arguments, they start discuss personalities of their opponents. It is particularly true on anonymous internet forums :). By the way, how would ban on prop have prevented Jerome Kerviel’s incident? Right, it wouldn’t have. All Jerome’s positions were “hedged” by client trades… too bad those clients did not exist.
Its simple seems to have a grasp…
I am amazed how people can loose themselves in endless discussions that completely miss the point.
I myself worked in securitization and surely know how the structures work.
Lis – Re: “Isn’t it funny – when people run out of arguments, they start discuss personalities of their opponents. It is particularly true on anonymous internet forums :).”
Yes, true. Please accept my apologies. I probably did get carried away – I did not mean to offend, but I probably did. Sorry. Thanks (hopefully) for being a good sport about my mistake.
Bye