Spectacular first-quarter results posted by the likes of Goldman Sachs and JPMorgan may have eased immediate concerns regarding the health of the global banking sector, but take a second look at the financial reports and policy-makers are faced with an uncomfortable truth: prop trading, that hub of high-octane risk-taking, has resumed centre stage.
Regulators and policy advisors have taken a very dim view of this so-called 'casino capitalism' - in which banks, it is argued, make big bets with other people's money - and with good reason. In 2008 alone, banks' trading desks on average made a 25% loss, according to data provided by Dow Jones. But even as the global authorities debate the role of the prop desk in fuelling the crisis, and procrastinate about the most effective way to restrain it in the future, the former titans of Wall Street are out on the block making fast money all over again. The casinos, it is clear, are still open. Are these desks trading on borrowed time, making one last dash for profits before their activities finally get closed down? Or do they signal a return to business as normal?
The future position and structure of the prop desk is now a matter of furious speculation. Morgan Stanley, for example, is rumoured to be oscillating between two extremes regarding the future of one of its leading quant desks: hiving it off to the desk's head trader to be run as an independent but Morgan Stanley-owned hedge fund, or taking the audacious step of moving it closer to its asset management business in order to garner outside investments. JPMorgan, on the other hand, has axed a number of prop traders and is relocating some of its operations within client franchises "in order to insulate them", reports one trader at the bank. Citi and UBS, meanwhile, are staging a full-scale retreat from the business.
Which model will win out in the new regulatory landscape? Can a contemporary investment bank be chopped up into neat little parcels in a modern-day version of the Glass-Steagall Act that some critics are calling for? Where prop ends and pure broking begins is unclear and investment banks have always operated a system of cross-subsidy between trading and flow businesses with surplus capital allocated all over the bank. The recent resurgence of the prop desks suggests that the model is far from dead: but in what way and to what extent will it be allowed to live on in the new regulatory order?
Artificial intelligence
It is often said that the bulge bracket prop desks act as an important centre of intelligence, watching fast money moving in the markets, devising alpha-boosting strategies that ultimately pump up shareholder returns. Certainly many banks' return on equity was inflated by this activity during the boom years: in 2004, for example, UBS was reporting record group revenues driven, it was proud to highlight, by increased risk taking in its trading businesses - and it was playing catch up.
But were the prop traders as clever as everyone thought? Did these results reflect superior trading intelligence, strategy and execution or did they merely mimic the direction of the stock markets as they entered their stratospheric bull run? Scott Eaton, an independent consultant and formerly the global head of principal trading at ABN Amro, now questions the extent to which he and his colleagues were genuinely generating alpha during this buoyant period.
"We used to think that there was a lot of value creation in the prop arena. But what we're really finding, looking back at performance, is that what we thought was a lot of alpha turned out to be really just leveraged beta," he says. As spreads began to contract, trading desks had to take on more risk to sustain their profitability, he continues. "Everybody still had return hurdles that they wanted to clear, so in order to chase that return in a declining return environment you just lever up," recalls Mr Eaton.
In the short-term, prop desk activity will be frustrated by the massive readjustment to the cost of capital, forcing many high-velocity prop desks to down-gear. Future adjustments to the trading book capital allocations anticipated in revisions to the Basel II capital framework will, however, deal a long-term blow. Under the current proposals, regulators may increase capital charges against the trading book by as much as 4.5 times current levels, according to Fitch Ratings. "The mere act of correcting the Accord to put an appropriate amount of capital against those activities would be enough to cause significant de-leveraging and reduce the profitability of prop trading," says Bob Penn, a partner at Allen & Overy.
This development, combined with the threatened caps to remuneration, will provide ample motivation for banks to revisit their prop operations. Under typical prop compensation schemes, traders will be rewarded with a percentage of the revenue they generate for the bank. In this respect, the prop desk was traditionally the sell-side's answer to talent retention, as it allowed the bank to ring-fence its best traders within a specific remuneration scheme. Prop traders may well prove the primary casualty of US and European policy-makers' designs to cap what are perceived to be excessive salaries and bonuses, which have already prompted an exodus of talented senior bankers from many firms, says Mr Penn.
To spin, or not to spin?
Bob Penn, a partner at Allen & Overy
Take Morgan Stanley for example. Concerns among top prop traders at the bank's leading quant desk regarding Federal Reserve-imposed pay and recruitment restrictions have prompted the bank to rethink the desk's future structure, according to the Wall Street Journal. The Banker understands that Peter Muller, who runs the desk, has been in discussions with the firm for the past two years regarding the possibility of growing the operation outside the firm. Recent developments, however, may have brought a renewed urgency to these discussions, particularly since such internal desks will have reached a capital ceiling. By restructuring the prop desk into what might effectively be a part-Morgan Stanley-owned hedge fund, the bank may be able to reward and retain its best traders in the manner and scale to which they have become accustomed. The new entity may also avoid the more onerous capital requirements due to be levied against the trading book, although this may only be the case if the new entity is technically transformed into a hedge fund.
In a more daring move, the bank may consider positioning the desk within or closer to its struggling asset management business. If the desk were to remain within the overall banking structure it would likely be hit by increased capital charges, but the additional third-party investment it might garner through the asset management division may compensate for this charge. Returns from the desk would, in turn, pump up the returns to asset management clients. It seems unlikely, however, that the closer integration of prop trading activities with the asset management business would be feasible under a regulatory architecture championed by president Barack Obama's Paul Volcker-led Economic Recovery Advisory Board, since Mr Volcker has been so critical of the over-integrated bank model and, more pointedly, the co-mingling of private pools of capital with client funds. Any such development would almost certainly require explicit approval from the Federal Reserve, which now has staff sitting inside the former investment bank. To this extent, the bank may have to wait for the new regulatory restrictions to become clearer before it is able to make a move. Mark Lake, the bank's New York-based spokesperson, said Morgan Stanley has not come to any firm conclusions over the future of the desk.
Whatever the eventuality, it seems highly unlikely that Morgan Stanley would reduce its interest in the highly profitable desk, which has earned the bank some $6.5bn in pre-tax income since its creation in 1993, according to the Wall Street Journal. The Banker understands that the discussions regarding the future of the prop quant outfit reflect the bank's ongoing commitment to grow the desk, rather than a desire to exit the business. The bank has publicly stated that it is pruning back several other prop operations, however, and it has already exited the mortgage prop business and dramatically scaled back fixed income, neither of which have traditionally been the bank's specialist areas.
This retreat was reflected in the bank's trading revenues for the first quarter 2009, which trailed behind those of its chief rival Goldman Sachs. To this extent, Morgan Stanley and other Wall Street players may opt to remain in those prop businesses in which they believe they have a competitive edge, a development that will make the retention of strategic skills sets and staff members all the more important. Morgan Stanley may focus in future on building out its commodities prop business, for example, an area in which the bank has traditionally boasted strong expertise.
What about the clients?
As with other Wall Street firms, JPMorgan has axed some 70 prop traders, and was one of the first banks to announce the scaling back of several of its prop businesses. According to one trader at the firm, the bank has begun to bring certain desks within client-facing franchises in order "to insulate" them. "The management hopes that the revenue from [the client-facing franchises] will even out lumpy returns on the prop desk," he reports. Moving the desks within client-facing franchises will likely make for smoother cashflows and increase efficiencies with regards to payments shuffling and other treasury work. It may also allow the bank to share traders across both client-facing and some prop functions. But the move marks a reversal of the developments witnessed around 2005, when many banks moved to explicitly split out their prop desks from client-facing franchises in order to avoid any perceived conflict of interests, in particular the long-held presumption that prop desks enjoy access to privileged information on client investment strategies. As such, JP Morgan's move to reintegrate its prop desks may further obscure the relationship between risk-taking and client-facing services, another concern held by the regulators.
The bank's record fiscal first-quarter results for 2009, boosted to a large extent by the bank's trading operations, indicate, however, that trading remains, at least for the moment, an important profit centre. According to reports, Jamie Dimon, the bank's CEO, is eager to pay off its Troubled Asset Relief Programme (TARP) loan in order to disentangle the bank from the Federal Reserve, which may indicate that heavy trading is a short-term response to satisfy immediate rather than long-term strategic goals. Likewise, Goldman Sachs' first-quarter results indicate that the bank is still trading heavily and taking on risk, following a stellar performance in its fixed income, currency and commodities business (FICC), which reported net revenue for the first quarter greater than all of the prior four quarters combined, according to data provider Morningstar. Little, it seems, has changed at Goldman Sachs, at least for the immediate future. Goldman Sachs declined to comment.
Like JPMorgan, however, Goldman Sachs' first-quarter revenues, as the bank's spokesperson was quick to highlight, were boosted by a sudden widening in trading spreads: this allowed both banks to profit by taking on risk for their clients and making markets at an increased spread. That it was precisely Goldman Sachs' FICC division that suffered so disastrously in the final quarter of 2008 will not be lost on those market-watchers that believe regulatory attention to prop trading and short-term risk-taking activities is not only misplaced but has yet to be properly defined. Practically all fixed income trading on behalf of clients, for example, is market-making and, to this extent, driven by proprietary risk: where prop ends and pure facilitation begins is a tricky if not impossible delineation, as Goldman's results demonstrate. "If you take prop out of the bulge bracket firms then everyone becomes an agency broker, and that is clearly inefficient," remarks one prop trader.
As this remark indicates, scaling back on prop, or banning it from investment banking divisions altogether, will directly affect the quality and profitability of client-facing businesses. Take the equities execution business, for example, in which risk-taking through capital commitment has traditionally served as an important source of liquidity to buy-side firms. The recent decline in capital has dramatically reduced the capacity of bulge bracket brokers to help execute client orders, says Guy Sears, director of the Investment Management Association. While some equities prop activity remains, he notes, market-making activity has been scaled back and is unlikely to return to full strength when the financial environment picks up: rather, banks will be expected to prioritise mortgage and small and medium enterprise lending over risk capital, he says. "All of this is pushing towards the reduction of the use of the prop desk for simple liquidity provision and brokers back to being wide-ranging solution providers once again," he adds.
Larry Tabb, founder and CEO of trading advisory firm Tabb Group, says that bulge bracket banks actually take losses on the trades against which they put up their own capital, in order to encourage agency flow. To this extent, the broken model relies on using risk-taking to cross-subsidise profitable pure agency trades. And it is not only up-front capital commitment where this occurs: The Banker understands that in some bulge bracket banks, the equity prop desks act as market-makers on the execution businesses' internal dark crossing networks in order to inflate matching rates and increase the firm's attractiveness, as a liquidity venue, to buy-side clients. Bulge brackets will find it much harder, if not impossible, to cross-subsidise internal liquidity pools if risk capital is restricted long term, or were prop flow to be entirely separated from the client-execution business.
Market developments already suggest that this is the case. Poor execution quality at the bulge bracket is already prompting buy-side firms to divert flows to agency businesses which tend to specialise in high-touch execution services. In a low-flow and capital-constrained environment, the cost-structures of these bulge bracket client-facing businesses become very hard to sustain. Andrew Sharpe, a partner at Reburn Partners, an agency broker, reports that some major bulge bracket banks are now considering spinning out and selling off their equities broking arms as pure agency operations in order to divest themselves of low-return businesses. In the current environment, and for those banks bearing government injections, selling off the pure broking business may be a quick source of cash. But in the long term it may also indicate that a bulge bracket without the bulge is a decreasingly sustainable business model.
A satisfactory riposte?
Where does this leave the investment banks: is it possible or even desirable to extract all proprietary activity and risk-taking? Does the dramatic turnaround at Goldman Sachs' trading division deal a satisfying riposte to those detractors that have claimed the bank's model, and others like it, is effectively broken? Possibly not: analysts question whether the dazzling results from JPMorgan and Goldman Sachs are sustainable in the long-term, despite the protestations from certain bank business heads that they represent a return to true form. Regulators, meanwhile, may need more than one quarter's results to convince them that prop is not the problem.
It is clear that activities in which banks are effectively taking oversized bets using the firm's capital, particularly positions that are highly over-leveraged, will be restrained, especially where that organisation is regarded as 'systemically' risky. "If the management of those banks decides that that model doesn't work for them they have the option of spinning off or restructuring businesses so that they may cease to be systemically important," explains Stuart Mackintosh, executive director of the Group of 30, the board of high financiers chaired by Mr Volcker, whose influential report 'A Framework For Financial Stability' is shaping regulatory responses worldwide.
It would be nearly impossible, however, for policy-makers to devise a regime in which banks could take on no proprietary risk, thereby destroying their capacity to act on behalf of clients and facilitate order flow. Even pure agency brokers, for example, have to trade on principal when facilitating orders. Moreover, as Mr Mackintosh's observation suggests, banks may opt instead to divest themselves of those appendages that prevent them from pursuing risk taking. Or, they may choose instead where the funding and capital models are best suited, to spin out certain successful prop activities into new hedge-fund like entities. Either way, prop is likely to live on, but not at the scale and velocity of past years.
