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Inside the Prop Trading Exodus

Despite being given plenty of wiggle room by regulators to comply with the Dodd-Frank Act's ban on proprietary trading, Wall Street's biggest banks are wasting no time dismantling their prop desks.

The Trouble In Spotting Prop Trading

"Market making is trading with your clients," Smith continues. "But as the banks move into that area, they can still accumulate straight trading strategies of certain types and inventories of certain exposures," he adds, suggesting there is a fine line between market making and proprietary trading.

Experts acknowledge this is where things can get tricky for regulators as they draft rules pinpointing exactly how the Volcker Rule will function. To a legislative watchdog, market making and prop trading could be indistinguishable from each other. According to guidelines set by the Financial Stability Oversight Council, which is tasked under Dodd-Frank with monitoring risks to the nation's financial system, any position without a hedge could be considered proprietary.

"The problem is when you start having inventories and you have traders who are making a market but also building an inventory position," explains former Lehman Brothers corporate bond trader Robert Wosnitzer. "This is how a lot of trading desks make money, by orienting the overall portfolio of the trading desk."

In order to weed out prop trading, Wosnitzer argues that regulators need a mechanism to track a trader's book to make sure their positions are always completely hedged. But even under the guise of market making, there are ways to covertly maneuver around the regulation, he says.

"If I really want to stay long and I'm a market maker, I might not make the best market," Wosnitzer contends, using the bond market as an example. "I might make a market that gives me the appearance of wanting to sell those bonds, but I'm offering them at a price nobody in their right mind would ever buy them. Therefore I don't have to sell them, and I can maintain my credit exposure in the hopes that it improves and I can make a profit."

Ulterior Motives

Of course, every decision made on Wall Street ultimately is reached with profits in mind, and industry experts say the rush to comply with the Volcker Rule isn't being driven merely by the pursuit of goodwill; it's also part of a push to curry favor from regulators with the idea they can extract lenience as the Dodd-Frank rulemaking process unfolds.

"It's like, 'Look, we shut these things down - why do you want to come down on us so heavily and make these restrictions so bright-lined? Let's make them gray so there's more room for us to do what we do.'" Wosnitzer says.

One factor that may create "room" for companies to operate is the lack of clarity on how regulators will implement the new finance reform law.

"We still don't know who's going to enforce the Volcker Rule," Wosnitzer says. "What happens when somebody violates it? What will they do then?"

Behind the scenes, Georgetown's Angel says regulators may be pressuring banks to wind down their operations even though publicly things appear otherwise. "In an environment where the regulators control your life and death, even if the law gives you five years, it doesn't matter what the law says," Angel asserts. "It matters what the regulators say. It may be that the regulators are saying get out as soon as you can."

One way or another, experts predict proprietary trading operations at banks will largely disappear in a year or two. Most will either be folded into hedge funds of which banks own a sliver, or parceled off into other departments.

"For all intents and purposes," says Sean Owens, director of fixed income at research and consulting firm Woodbine Associates, "there aren't going to be any major banks putting on a lot of prop risks. It's going to be unwound fairly shortly."

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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