So, Goldman Sachs’ high yield trader Tom Malafronte made the bank $100m in profits earlier by buying billions of dollars of junk debt in January and selling it for a higher price days and weeks later. Well done Tom. He’s a much needed reminder of how things used to be.
Under the Volcker Rule, a lot fewer people like Tom exist. Tom’s ex-boss described him as a, “tremendous risk taker.” That’s nice for Tom, but banks aren’t supposed to employ tremendous risk takers any more. They’re supposed to employ machines. And those machines are supposed to match up buyers to sellers. Human beings are only there to oversee that process. Old-style risk takers like Tom are supposed to be dead and gone. In fact they are, in liquid markets like FX – and those markets are much worse because of it.
Last week’s ‘flash crash‘ in the pound wouldn’t have happened if Toms were still trading spot FX. The thing is that Tom and all prop traders aren’t just about taking risk- they’re liquidity specialists. The high yield markets Tom trades in are opaque; sometimes the liquidity is there, sometimes it’s not. That’s why Tom’s needed – he knows the market and he actually creates the liquidity.
Compared to high yield, spot FX markets are as liquid as you get. Clients are left to access the market themselves and to trade electronically. That’s fine – until the liquidity drops away. And then no one knows what to do. No one knows about liquidity now.
Instead, today’s electronic markets are all about the spread. Liquidity is celebrated as the difference between the bid and the ask; no one gives any thought to depth. In the old days, trading was all about liquidity and maintaining liquidity. Nobody was hiding behind the machines. Nobody was taking liquidity for granted. It was at the front of our minds every day. Creating liquidity was what we did.
You could argue that the old-style prop traders were “lenders of the last resort.” When liquidity dried up, we were the people who accepted the residual risk of getting stuck with a security that couldn’t be sold – and we were paid for that and so were the banks we worked for. Now we’ve gone, no one exists to provide order during chaotic times. Everyone expects someone else to provide the liquidity. What happens when they won’t?
Without the Toms, without the old school prop traders, the markets are full of players without commitment. Machines will make markets as long as the price suits them. If it doesn’t – if something happens so that the machines exceed their tiny risk limits, the machines are out. It’s nobody’s job to provide liquidity in these electronic markets. No one is paid for that. This is the huge mistake regulators have made in clamping down on prop. TOO BAD.
The thing is that thousands of risk adverse computers will never replace experienced humans like Tom who have proper mandates to provide liquidity and to take sensible risks doing so. Take Tom out of the equation and you’re left with machines that auto-stabilize the market close to current levels, but that make the market a dangerous place when it moves too far. And now that most of the prop traders are retired, the only people left to deal with the resulting carnage are inexperienced technicians who know everything about algorithms and nothing about creating liquidity when liquidity has disappeared.
Philippe Ersatz is the pseudonym of a senior derivatives trader, now retired