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Perhaps I should expand on why I keep pounding home my refrain that there’s no such thing as “prop trading”. After all, no one seems to be able/willing to dispute me (and it can’t just be that I have only 2.3 readers, who don’t know/care what I’m talking about. Can it??). So one would think that everyone just acknowledges I am correct. And yet, contra moi, the public discourse is essentially 100% saturated with people who do think there is such a thing as “prop trading”. So where are they all? Am I just not saying it controversially enough? Have I just not written enough dumb things to finally put my foot in my mouth obviously enough that someone shows up to say ‘Duh here’s why you’re wrong’? Let’s remedy that.
I want you to think about two trading situations.
- A ‘market-making’ trader is responsible for making markets in the bonds of Acme Corporation. Based on broker quotes and whatever else, he thinks they are trading at around 95 points so he sends out a “run” showing 94/96 (“I’ll buy some for 94, I’ll sell some to you for 96″). A client calls needing cash and wants to just hit him (=sell to him at his bid price, 94) for $2 million of bonds. That’s not too much, so, he stands by the market he showed, and buys the bonds for 94. He would be happy to turn them around for a profit (and he’s naturally less eager to buy them and more eager to sell them than before) so he lowers his offer price to 95 – in fact he’d probably be happy to sell them for 94 1/8 but may as well at least try for the 95. Indeed, part of why he set the bid price at 94/ was because he thought he knew of someone willing to pay 95. But when he checks that lead doesn’t pan out, and trading in Acme is not that active, and he doesn’t find a buyer for a while. (It’s partly to cushion against this that he was showing a 2-point-wide market. If the trading were more active and liquid, he would probably have shown a tighter market.) Near the end of the day he hedges their interest-rate risk by shorting some U.S. Treasuries and goes home owning $2 million of Acme bonds. He does have his sales force try to find a buyer but it’s around 3 weeks by the time he finds a buyer at a decent price (maybe because some positive news happened to Acme Corporation, i.e. positive earnings report). After selling them, net of hedges he makes 1 point of profit, having owned Acme Corporation bonds for 3 weeks.
- A relative-value “prop trader”, at the same institution let’s say, thinks that Acme Corporation bonds are too cheap compared to similar companies/bonds. “We should buy these”, he thinks, “this is a price displacement and will probably normalize in a few weeks, especially since they are due to report earnings in 3 weeks”. He shops around, haggles, etc., and buys $2 million of them for the best price he can find, say 94 1/2. Now he owns $2 million of Acme Corporation bonds. 3 weeks later decent earnings come out the prices do indeed go up and he is able to sell them for a 1-point profit.
Economically, what is the difference between these to cases, the ‘market-maker’ and the ‘prop trader’? Answer: there is none. Absolutely none whatsoever.
Each bought a security, and held its risk for a while, the same while, and then later sold it at a profit, the same profit. Each was equally exposed to the risk of that security, e.g. (most significantly) the risk of Acme Corporation going bankrupt and their holding losing more than $1 million of value. Each tried to buy for the best price they could get and sell for the best price they could receive. Each was aware of, and profited by, whatever market factors (e.g. earnings report) could affect this security. A risk manager (or, regulator) going through the books and looking at these two traders’ positions wouldn’t possibly, even in principle, be able to tell the difference between them. So how can one be ‘prop trading’ and the other not? How can one draw a line between the two?
Yet the Volckerites insist that one is normal market-making activity, while the other is evil and risky ‘prop trading’. Can anyone explain why with a straight face?
The line on ‘prop trading’ is that it is ‘highly risky, speculative activity’ that ‘threatens to blow up banks’. Well that sure does sound terrible! But if that’s the case then so is market-making. After all, in the normal course of market-making, as the above example shows, you can get into the same exact sorts of trades/risk as in ‘prop trading’. I gather there is a myth out there that in all ‘market-making’, the market-maker does nothing but match buyers and sellers instantaneously, and if that were the case then I guess ‘prop trading’ as a separate and distinct category would be coherent. But, I know that not to be true. Does Paul Volcker? Do other Volcker Rule proponents? Or you might think that instantaneously-matching-trades should be all that these dealers are allowed to do, which is maybe fine, if you’re prepared to live with a world of zero liquidity whatsoever (because the instantaneous-trade world is completely unrealistic and unworkable for many of the securities we’re talking about). Or you might just think that my example is simplistic and oversimplifies things. And of course that’s true because…well actually, you know what? Not really. It’s not oversimplified very much at all.
So factually, the only difference I can discern between the two cases is what is going on in the trader’s mind. The ‘prop trader’ took on the risk because he wanted to. The ‘market-maker’ took on the risk because he had to (i.e. to show liquidity for clients, keep clients happy as part of their normal client-service business). I hope I don’t have to add that, in practice, the ‘market-maker’ and the ‘prop trader’ tend to have the same types of thoughts – i.e. they will both be equally aware of the upcoming earnings announcement, and have a view on the company. Part of why the market-maker bid 94/ (and was the best bid) may have been for the exact same reason that the ‘prop trader’ wanted to buy the bond, namely that he thought they were too cheap. Yet basically, this huge cleft we are all supposed to perceive between ‘prop trading’ and the other kind is fundamentally premised on mind-reading the supposed differences in the thoughts the two are having. Trading while having the wrong inner thoughts is ‘prop trading’, and should be banned. You can only trade while having the right inner thoughts.
You might think that sounds absurd, and that surely the philosophy behind the Volcker Rule is premised on something more substantial than that, but in fact the notion of mind-reading is actually built into the proposed rule, as you surely know if you read the Davis-Polk summary I linked to awhile back (and I know you did!). Specifically in Step 2A on page 6, banks will have to answer for themselves/regulators whether a trading desk’s activity is “designed not to exceed the ‘reasonably expected near term demands of clients'”. Basically, you can do the trade if you think clients will have demand for it in the ‘near term’ (whatever that means!), but not if you don’t. Who knows, some banks may even decide to satisfy this rule by implementing an EULA-style fine-print agreement with a radio button for all traders to click daily, ‘YES, I affirmatively and solemnly swear that all the trades I did today were meant to meet what I reasonably think will be the near-term demands of clients’. Mind-reading.
Mind-reading, needless to say I hope, cannot possibly be the basis for a sound piece of objective, enforceable financial regulation.
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