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Update May 15, 2012 By Steven Greer, MD
The JP Morgan prop trading disaster is just another example of the incompetence in wall Street that make trading of derivatives an unacceptably risky business.
Update September 17, 2011
Since first writing about the “Volcker rule” almost two years ago, the problem of risky in-house betting by hedge funds masquerading as “banks” has hit the headlines once again. Most recently, the Swiss bank UBS will lose at least $2 Billion from what UBS described as a “rogue trader” making large derivative bets.
The Dodd-Frank law was passed creating the Volcker Rule banning this in-house trading, or “prop-trading”, but the Volcker rule has been successfully delayed again by the banking lobbyists. Moreover, the regulation of derivatives never made it into the final Dodd-Frank law at all. Financial “derivatives” are the same “weapons of mass destruction” that have cost UBS and Société Générale tens of billions in losses and were at the root cause of the global financial collapse that has caused the persistent global depression and high unemployment. (Elizabeth Warren, who championed Dodd-Frank and was supposed to head up the newly formed Consumer Financial Protection Bureau which she created, was never appointed to this post and is now trying to run for Senate in the State of Massachusetts.)
To learn more about the perils of risky prop-trading conducted by incompetent bankers, please refer to the January, 2010, article, below.
A Case for Banning Prop Trading
Op-Ed January 24th, 2010 By Steven Greer, MD
President Obama surprised the markets last week by proposing new regulations that would ban proprietary trading by commercial banks (as opposed to “Wall Street” broker dealers) and limit the size and market share of these banks. In the wake of the Massachusetts election of a Republican Senator, the President was clearly changing focus to the more popular topic of attacking “fat cat” bankers.
Advising the President was Paul Volcker and Bill Donaldson, among others. Mr. Volcker has not had much of a voice in policy until recently. Proponents of the ban on prop trading say this risky investing is what caused the financial crisis and that it should not be allowed to happen again.
Prop trading is the practice whereby units of banks use bank capital to borrow more cash in order to invest in stocks and derivates for the purpose of making a profit for the banks, not for the clients of the banks. Prior to 2008, it was common for banks to borrow ten to thirty times their own assets and risk this highly leveraged money on complicated financial instruments including common stock, options, CDO’s, etc. Leverage like this makes any loss in the investment portfolio magnified.
There are other less appreciated reasons that prop trading could be considered bad for the health of the financial system. The people executing the actual trades for the “prop desks” often either sit amongst the traders executing trades for clients, or are a short walk away. Prop traders have been accused of “front running”. The newest way that a large bank can essentially front run clients is by using “high-speed trading”.
One of the most common and riskiest investment styles within prop desks is called quantitative trading, or “Quant” for short. Wall Street Journal reporter Scott Patterson has a new book, “Quant”, that describes the risks of this style and how it brought down the financial system. The programmed selling by quant desks can trigger excessive stock declines, such as was seen last week, or on a grander scale in late 2008. Moreover, it is these quant trading desks that are now doing the high-speed trading which Senator Schumer wants to ban.
Perhaps least understood by outsiders is the level of incompetence among some of the senior directors of prop desks. Within banking culture, loyalty and cronyism are often rewarded more than competence and honesty. For examples, it is now clear that Stan O’Neal, the former CEO of Merrill Lynch, or Ken Lewis, former CEO of Bank of America, or even Robert Rubin and Sallie Krawcheck of Citigroup, all had little understanding of their respective banks prop trading portfolios and risks.
Lower in the ranks, the actual prop traders are frequently people who have never worked outside of the bank on the “buy side” amongst real investors in hedge or mutual funds. Quite often it is a case of, “Hey Joe over in fixed income, wanna manage a billion dollars trading equities even though you have never done it before?”
The weak job security of prop trading attracts the lesser valued within the banks willing to gamble, or former failed buy-side money managers who took bad risks in previous funds. A stint on a prop desk not uncommonly is the last stage a banker goes through before being fired. Of course, successful prop traders profit well, but they usually leave the bank for the higher pay of external hedge funds.
Even skilled prop traders are handicapped in many ways from being able to make optimal investments. The banks usually do not give them a staff of analysts and they are relegated to sitting on a noisy desk just day trading, rather than making long-term fundamental investments. Because the cash at risk is so leveraged, any small downturn in the portfolio causes the bank to force liquidations from the portfolio. This makes smart investing almost impossible and contributes to a riskier investing style.
A case study on prop trading was found within the Merrill Lynch Strategic Investment Group, a $10 Billion in assets prop trading outfit set up in 2004. Director of daily operations was Sudeep Gupta: someone with little to no experience at a buy side hedge fund or mutual fund, and limited experience at prop trading. However, Mr. Gupta was a loyal soldier for the head of trading, Rohit D’Souza. Both Gupta and D’Souza left Merrill Lynch approximately three years after joining from Morgan Stanley and the prop trading operations were shut down shortly afterward. Mr. D’Souza held a brief position at hedge fund Citadel before leaving there as well.
One could argue that the Obama proposals are too watered down. They would only ban commercial banks from prop trading and not the broker dealers. Goldman Sachs, for example, could easily divest its small $36 B bank division and still be a large prop trading organization. Bank of America could spin off Merrill Lynch as well, etc. The systemic risk of prop trading would remain under the current regulation proposed by President Obama, albeit shifted away from federally insured commercial banks into pure broker dealers.
This report was written with the assistance of multiple former senior executives within proprietary trading desks.