Dear Economists: Please Check Your Assumption That There Is Such A Thing As “Prop Trading”

It’s always disorienting and a little scary to observe Big Important Economist People opining on banking while suffering from delusions one knows to be factually incorrect. I speak of the delusion that there is a distinct and separate form of trading known as ‘proprietary (“prop”) trading’. (See here for example)

I know this to be false. But I also always see B.I.E.P.’s regularly writing and speaking as if it is obviously true. So, I have no choice but to conclude that they don’t know what they are talking about, in a literal sense. They do know a lot of Economics, I am sure. But they don’t know a lot about the thing they purport to weigh in on, opine on, offering their regulatory advice for – i.e., trading. Something or someone, perhaps some textbook, has put the idea into their heads that there are two kinds of trading: “prop trading”, and the other kind. They took this at face value and have proceeded to formulate all sorts of theories based on this premise. There is one problem. The premise is false.

People who disagree with me will write back with non sequiturs such as ‘well howcome we had to bail out banks then?’ or ‘are you saying banks don’t take huge levered risk?’ Of course they do. Of course banks take risk. And of course they got underwater and were bailed out. None of that, however, speaks to the basic point about “prop trading”. None of that establishes that you can cleanly and neatly somehow separate “prop trading” from the other kind.

As I have said before, the main thing that got banks underwater was exposure to mortgages. Mortgages are not “prop trades”. Mortgages are bread-and-butter, your-grandpa’s-banking. Maybe you say “aha! so the prop trade was that they got too levered to mortgages”. Okay, but what is “too”? Where is the line?

You can make up a line, in your head, draw it, and call everything above it a “prop trade”. That’s what the government is effectively doing with its “Volcker Rule”. But I don’t know what you are accomplishing, other than setting up yet another arbitrary boundary that will need to be defined, evolved, monitored. What is the boundary for? To separate out the “prop trades” from the other kind?

But there are no “prop trades”. Like I said. There are just trades. Risk. Some riskier than others. Some more levered than others. Some more “exotic” (i.e. hard to understand/explain, I guess) than others. Where do you cross the line from an intelligent “macro hedge” into a “prop trade”? I guess that it’s when you lose money on it instead of make money on it.

This is not a real definition. It is not a real distinction. It is not a real concept. There are no “prop trades”. Or, to put it another way, all of banking is a “prop trade”. The essence of banking is to borrow short, and lend long. To sell 1-day rollable money and use it as collateral against which to buy, e.g., 5-year money. People seem to get confused into thinking that it is a non-risky activity because it is called by the dry term, ‘intermediation’. “That’s not risky! It’s just plain old intermediation!” Oh, okay, genius. But news flash: that is a BET. It could go in your favor, or against you. So by the (dumb) ‘definition’ most people seem to be have in mind, it’s a “prop trade”.

There are no “prop trades” unless all of banking is a “prop trade”.

Will someone please inform the Economics profession?

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4 Responses to Dear Economists: Please Check Your Assumption That There Is Such A Thing As “Prop Trading”

  1. Pingback: The Greek Problem And Its Many, Many Solutions « Rhymes With Cars & Girls

  2. Pingback: Suzy Khimm Gets It On “Prop Trading” « Rhymes With Cars & Girls

  3. Pingback: Cracks In The Standard Model (Of Trading) « Rhymes With Cars & Girls

  4. Pingback: Latest Economic Research: Banks Try To Earn A Spread | Rhymes With Cars & Girls

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