Props to ‘Ya: How Banks May Have Their Cake & Eat it Too With Proprietary Trading Post-Volcker Rule

6 Aug

Recently, there’s been a fair amount of speculation that the big banks are reorganizing their proprietary trading & internal alternative asset operations in response to the Dodd-Frank Financial Reform bill .  One such rumor is that Goldman Sachs is planning on moving its prop desk to its asset management division where the firm’s traders would manage client funds instead of the firm’s.  I find this painfully hard to believe, quite simply, because Goldman would be giving up a metric ton of money if they were to take that route.  The money Goldman would make on asset management fees would be a mere fraction of the profits from prop trading, which accounted for 76% of profits last year (pg 7), to the point that they’d have to raise an ginormous amount of money on which to generate fees to be even remotely close to the money they make from prop trading (note: this isn’t just prop trading, as it included principal investments as well).

What I think would  make more sense, and be (quasi-)legal within the framework of this new regulation, would be for Goldman (etc) to take their prop employees and form new, separate hedge/private equity funds in which Goldman would be the sole or at least primary investor (in the fund, not in the sponsor or management company).

Title VI of the Bill, specifically section 619 (see pg 250 in the link above) says:

‘‘SEC. 13. PROHIBITIONS ON PROPRIETARY TRADING AND CERTAIN
RELATIONSHIPS WITH HEDGE FUNDS AND PRIVATE EQUITY
FUNDS.
‘‘(a) IN GENERAL.—
‘‘(1) PROHIBITION.—Unless otherwise provided in this section,
a banking entity shall not—
‘‘(A) engage in proprietary trading; or
‘‘(B) acquire or retain any equity, partnership, or other
ownership interest”

This way, banks would avoid the additional capital requirements and other onerous regulatory limits imposed by paragraph (2) of that section, but still retain the economic benefits of their existing prop trading operations.  By reorganizing their prop operations in such a way, banks could also avoid completely the effort its going to take to convince regulators that activities that are effectively prop trades are actually part of firms’ market-making or hedging operations.  The only problem I can see with this approach would be that it may (I’m not exactly sure yet) a latter section (pg 256) of the  bill, which says:

‘‘(2) LIMITATION ON PERMITTED ACTIVITIES.—
‘‘(A) IN GENERAL.—No transaction, class of transactions,
or activity may be deemed a permitted activity
under paragraph (1) if the transaction, class of transactions,
or activity—
‘‘(i) would involve or result in a material conflict
of interest (as such term shall be defined by rule as
provided in subsection (b)(2)) between the banking entity
and its clients, customers, or counterparties;
‘‘(ii) would result, directly or indirectly, in a material
exposure by the banking entity to high-risk assets
or high-risk trading strategies (as such terms shall be
defined by rule as provided in subsection (b)(2));
‘‘(iii) would pose a threat to the safety and soundness
of such banking entity; or
‘‘(iv) would pose a threat to the financial stability
of the United States.”

The remaining language that discusses the limitations on permitted activities seems to have some vague/poorly-crafted language.  In one clause or section, the Bill says banks can’t (effectively) invest in hedge fund firms/sponsors, but later effectively says that firms can’t make (large, majority) investments in hedge funds themselves.  I’m not sure in the grand scheme of things how such rules/language will be interpreted by firms and their regulators, but a cursory read-through of the bill suggests that at least some of the rumors of prop desk restructuring don’t make much, if any sense.  If nothing else though, it seems we can rest assured the likes of Sullivan & Cromwell have plenty to keep them busy for the foreseeable future!

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13 Responses to “Props to ‘Ya: How Banks May Have Their Cake & Eat it Too With Proprietary Trading Post-Volcker Rule”

  1. Kid Dynamite August 6, 2010 at 8:46 pm #

    “The money Goldman would make on asset management fees would be a mere fraction of the profits from prop trading, which accounted for 76% of profits last year (pg 7),”

    huh? i thought GS says it’s 10%… again, this gets back to the root of the problem: DEFINITIONS. i believe that GS makes 10% of it’s PnL from pure, segregated “prop trading” (that means ring-fenced groups who sit completely separate from the client-facing desks in the broker dealer) and I also believe that firm (proprietary) positions on client related desks could account for 75% of the profits – but those “prop trading” activities will not be spun out – and they are largely the ones that actually caused the problems at the big banks….

    • Anal_yst August 7, 2010 at 10:54 am #

      Well its prop trading and principal investments, but agreed, there is a big semantic issue here if firms don’t have to or just plain don’t break it down further, and if regulators/legislators don’t do a good job clearly defining these things. Alas, my read of Title VI of the Dodd-Frank bill tells me they’ve really shat the bed on this one, and the new regulations will be expertly and deftly gamed by The Street & its lawyers.

  2. David Merkel August 7, 2010 at 1:15 pm #

    It will all depend on the regulations, which are as yet formless and void. The regulators are not materially different than those who were there pre-crisis, so I suspect things will change less than most anticipate.

    Lawyers are awfully good at producing more $$ opportunities for themselves. Give them a win, the rest of us a loss.

    • Anal_yst August 7, 2010 at 2:17 pm #

      Agreed. I fully suspect that given the threat of losing prop business, banks & their high-power lawyers will no-doubt outwit the regulators/regulations.

  3. Lawrence D. Loeb August 7, 2010 at 2:14 pm #

    Unless it is possible for the bank to be held at a subsidiary level while the prop desk is outside of the “bank” – so that a holding company holds the “banking entity” separate from the entity that runs the prop desk; I would expect $GS to drop its bank charter.

    • Anal_yst August 7, 2010 at 2:18 pm #

      As I said in my reply to David, above, I’m 100% certain the banks will largely out-wit the regulators/regulations one way or another. How they choose to do that, though, still seems a little unclear, but just from my cursory read of the Dodd-Frank bill, it won’t be that hard to find the loopholes…

      • Kid Dynamite August 7, 2010 at 10:44 pm #

        right – they don’t have to drop the bank charter because the regulations will be toothless. If Glass Steagall were reinstated, THEN they’d drop the bank charter.

    • Lawrence D. Loeb August 7, 2010 at 2:20 pm #

      Remember, $MS and $GS obtained their bank charters because their funding relied on overnight credit (repos, etc.) that dried up during the crisis. Those markets are generally liquid. An alternative to access to the Fed window would be to alter funding by layering the maturities, if they wanted to alter the ST funding structure w/o the Fed window.

  4. Downtown Josh Brown August 7, 2010 at 2:59 pm #

    I think they should put the Volcker Rule in place but be sure to exempt anyone who attended MIT or Wharton from having to follow it.

    That way, the Systemic Six can keep their prop desks and we don’t insult or aggravate our betters too much.

    Then we can all go back to watching The Real Housewives of Duluth and leave the decision-making to the people who began studying really hard in pre-school.

    • Anal_yst August 7, 2010 at 3:05 pm #

      No love for Harvard/Chicago? Awwww!

      • Downtown Josh Brown August 7, 2010 at 3:12 pm #

        Oh yeah, the adherents of the Chicago School have much to proud of. The chainsawing of the regulatory rulebooks mid-Bush Administration Era is their crowning achievement, I suppose.

        The Sword, contrary to what ANY economic movement believes, is still very much embedded in the Stone.

        No Kings here. A collaborative mass-failure instead, the “smarter” the more culpable.

  5. The Epicurean Dealmaker August 7, 2010 at 8:18 pm #

    I agree that it is well nigh impossible to define prop trading, and without a proper definition it will be difficult to enforce a rule like the Volcker rule. In addition, I agree with David that it is less important what the regs say than how the regulators enforce them. From what I can see, we have made no progress in this latter regard.

    Frankly, I like Volcker, but I thought this rule was flawed in concept from the beginning. Far better to impose harsh and tightly enforced leverage and liquidity limits on systemically important banks–which would require close realtime monitoring in situ–and then let the banks dick around within those limits however they like. Just as long as we let them fail when they blow up.

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