Maybe this is just wishful thinking, yet slowly but surely, almost imperceptibly, I feel as though the Smart Commentariat may finally be showing signs of – well, not coming around, exactly – coming within shouting distance of my lonely, annoying refrain that there’s no such thing as “prop trading”. At the very least, the cracks in the Standard Economist Model Of Trading are starting to show, and people are starting to notice, or at least show signs of cognitive dissonance.
To make this definitive, let me lay out what (I am now convinced) appears to be the Standard Economist Model Of Trading (SEMOT):
- The traditional form of banking (take deposits, make loans) is a riskless operation. Nothing bad ever came from it and no banks ever failed doing it. It’s just ‘intermediation’ (which is a synonym for riskless). It certainly does not count as any sort of ‘trade’ or bet (to, um, rent money from one guy and then loan most of it out, locked up for a longer time, to some other guy, to try to earn a profit on the spread hoping the first guy doesn’t come back too soon) and thus it is a totally different animal from ‘trading’. It entails no risk, or at least no risk that isn’t as well understood and managed as Newton’s laws. (This pillar suggests that ‘get banking back to basics’ and ‘banks shouldn’t make bets!’ are reasonable views.)
- Market-making is riskless. In market-making you are like a switchboard operator who matches buyers and sellers, and you take a fee in the middle. Market makers never, ever have an actual position of in the thing that they trade. If they do, they hedge instantaneously, with perfect hedges. They never buy without having someone to instantaneously sell/hedge-perfectly to, and they never sell without having someone to instantaneously buy/hedge-perfectly from. (Belief in this pillar of SEMOT helps explain why some people are so puzzled that market-making even needs to exist.)
- Therefore, if a bank is observed to have had some risks on its balance sheet – by, for example, losing a lot of money during, say, a “The Financial Crisis™” – those risks must have gotten there via “proprietary trading”. Because “proprietary trading” – we are told – is any instance where a bank enters some risk or ‘bet’ for its own account, i.e. that it would profit from if the risk went their way. Per #1 and #2, that actually never happens, neither in the normal course of banking nor in the normal course of market-making. Thus if/when it does happen, that was “prop trading”.
Now, there is a neat thing with SEMOT, and an unfortunate thing. The neat thing is that it is logical and internally-consistent: #3 logically follows from #1 and #2, and that fact is what allows you to quickly and easily mentally categorize the various sorts of Trading (and to propose or endorse regulation of same, such as the ‘Volcker Rule’) that you, as the Economist, imagine take place within a broker-dealer. I am sure this comes in handy, particularly for those Economists who have never in their life set foot inside one. The unfortunate thing however is that each of #1 and #2 are false.
For a good long time, many Economists and/or most Smart Commentators seemed wholly unaware that #1 and #2 were false. On #1 I seem to still have an uphill climb, for example I had to remind (as far as I can tell) the entire rest of the internet that loans are risky. But some may be starting to notice problems with #2; they may not have fully come around to my no-such-thing stance on “prop trading”, but they are certainly struggling with some of the undeniable contradictions. And it is in that regard that this piece by Felix Salmon that I have belatedly noticed is a useful specimen.
First note he is praising a letter of comment from ‘Occupy SEC’ on the Volcker Rule as ‘amazing’ – so right away we see he is suffering from confusion and cognitive dissonance. Haha. Anyway, let’s look in detail at some his comments on this ‘absolutely astonishing’1 letter:
And then there’s the even bigger market-making loophole, which, unlike the repo loophole, actually exists in the original statute. [...] In the proposed rule, banks can claim to be “making a market” in illiquid instruments when they’re only on one side: buying and not selling, or selling and not bying [sic].
The fact that he calls this a ‘market-making loophole’, and not just market-making, means he still has some work to do. The fact that he subsequently complains that market-makers might be “unwilling to provide executable bids or offers at all” is pretty rich (um Felix, you’re the one that thinks market-makers should never buy without selling or vice versa and it’s a ‘loophole’ if they do – so in your version of market-making how could anyone provide an ‘executable’ bid/offer unless he happened to have the other side already?).
But encouragingly, although the gears may grind slowly in Salmon’s head on this issue, grind they do. One can almost hear him reasoning it out in his head: “You mean…that market makers…don’t just match buyers and sellers instantaneously 100% of the time? But that means…I mean prop trading is when a bank has nonzero risk…and if a market maker buys without selling, why….” So I’m optimistic, and am pretty sure that if we give Felix Salmon enough time to think this all through, say months, he’ll get to where I am: ‘prop trading’ per se does not exist.
In the meantime, it’s enough to observe that what Salmon is noticing and reacting to is simply the fact that Pillar #2 of SEMOT is false. Hence we get this:
It’s pretty easy to see how a market-maker’s inventory can morph into a proprietary trade, under such circumstances.
Why yes! It’s almost as if, on the relevant margins there is no meaningful economic distinction between the two. (Indeed, how can Salmon even speak of a market-maker’s “inventory” without cognitive dissonance? How can they get an “inventory” if all they ever do is buy-sell simultaneously?)
As the letter says, “an unfortunate consequence of the generalized language throughout the Proposed Rule may be the shift of risky practices out of liquid and transparent markets into the less regulated illiquid and OTC products” — there’s a real risk, here, that the Volcker rule could actually make bank trading more risky, rather than less.
Correct. As I said somewhere downthread here, Volcker Rule proponents are, in effect, seeking to enlarge the ‘shadow banking’ sector, without quite realizing it (presumably). So they are fixing a non-problem (The Financial Crisis™ was not caused by ‘prop trading’) by potentially, perhaps inevitably, introducing new ones.
But this is entirely predictable for people who are operating from a fatally flawed and ignorant understanding of how these markets work (the SEMOT). It may be too much to hope for that everyone suddenly sees that the SEMOT is wrong, but that so many are noticing that something doesn’t quite add up is, at the very least, encouraging.
1I was delighted to learn, from this ‘whip-smart’ letter, that there are institutions I had not previously suspected to exist called ‘inter-broker dealers’!