March 31, 2011

Despite being given plenty of wiggle room by regulators to comply with the Volcker Rule, Wall Street's largest banks are wasting no time in shutting down their proprietary trading operations.

Although the rule becomes official on July 21, 2012, regulators will give firms another two years to stop making risky bets with their own funds in accordance with the law. On top of that, the Federal Reserve Board could grant banks up to three one-year extensions to wind down prop trading segments.

Add it all up and it could take years before banks need to officially stop making risky bets with their own funds.

But in an interview with Advanced Trading, former Lehman Brothers corporate bond trader Robert Wosnitzer explains why Goldman Sachs, JPMorgan Chase and Morgan Stanley are shifting out of that business now, rather than later. He also argues that regulators will have their hands full detecting proprietary trading.

Why are banks getting out of the proprietary trading business now even though the regulation gives them ample time?

Robert Wosnitzer, NYU doctoral candidate and former Lehman Brothers corporate bond trader:

My sense is the risks they were taking on the prop-trading desk weren't worth having in terms of angering the lawmakers any more than they need to. There was probably a bit of horse-trading going on. Like look, 'we're really trying to work with you guys. We've already shut these things down. And why do you want to come down 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.'

As somebody who's worked in the business for a while, the people I talk to say it's still incredibly opaque as to how this thing is going to work and nobody quite knows.

So regulators have yet to clarify their definition of proprietary trading?

Wosnitzer:That's certainly part of the issue.

If you want to shut down prop trading and you define it as just those activities, ok shut it down and they are ready to do that. The problem is when you start having inventories and you have everyday traders who are ostensibly making a market but also building an inventory position. This is how a lot of trading desks make money. By orienting the overall portfolio of the trading desk.

How do you make money as a trader is really the question. If you make money as a trader by taking risk, you're prop trading. If you make money as a trader by arranging for buyers and sellers in space and time, you're not prop trading.

How tricky will it be for regulators to detect proprietary trading?

Wosnitzer: The formal prop-trading desk inside the bank could buy securities from anybody they wanted to buy them from. They weren't really talking to the pension funds, mutual funds and the big institutional accounts. They were really an account themselves. When you're on the corporate bond trading desk that deals with accounts, under the Volcker Rule logic, as long as you're buying and selling securities on behalf of a customer you're not prop trading.

But then the question is when you start running into a scenario like, if I buy $25 million of Phillip Morris from Calpers and I don't hedge it completely, and I own it for more than 14 days, am I prop trading? That's the issue. I'm complying by all standards, right? I'm buying them from an account. I'm hedging and I'm keeping an eye on how long I own it. But then I can start running the market in a particular way that if I really want to stay long and I'm a market maker, I might not make the best market.

I might make a market that gives the appearance of me wanting to sell those bonds, but I'm offering them at a price that nobody at their right mind would ever buy them. So therefore I don't have to sell them. I'd own them. I can maintain my credit exposure to this credit in the hopes that the credit improves and I can make a profit from it.

There's a million ways to Sunday you can start to configure this thing where you're not prop trading but you are. To me, prop trading isn't necessarily a highly technical practice. It's a cultural practice. It's a way of doing business that Wall Street has become accustomed to doing.

A year from now, will proprietary trading desks still exist in their current form at Wall Street's largest banks?

Wosnitzer:They'll probably still have some remnants of them and it'll be very idiosyncratic. But a year, two years from now they'll probably be gone. They'll either be folded up into hedge funds the banks own portions of, or it'll get melded into the everyday practice. It's still very unclear, especially with the recent election if there's even going to be funding to enforce the Volcker Rule.

The bigger question is even if the banks do roll up their prop trading desks and move personnel around, and the Volcker Rule does go into effect, we still don't know who is going to enforce it. What happens when somebody violates it? What are we going to do?

Editor's Note: A more complete version of this story will appear in the May digital issue of Advanced Trading.

ABOUT THE AUTHOR
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 ...