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Prop Trading Goes Underground

The Volcker rule - which forces banks to cease proprietary trading - is likely to change prop trading rather than end it. The question is where will it go and are regulators going to find it?

The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July by President Obama, appears to have put to rest any worries that proprietary trading — betting with the house’s money— poses a risk to big banks and thus to the financial system. Or has it?

“We are not ending prop trading,” says Yale finance professor Gary Gorton. “We are just moving it. And the key question is, will regulators know where it has gone?”

Maybe even more worrisome is what sort of entities will arise to do the prop trading that banks used to do. And are they likely to provide for a more robust American financial system than the heavily regulated (albeit teetering) conventional Wall Street model?

The act, as written, largely implements former Federal Reserve chairman Paul Volcker’s recommendation that banks cease to engage in proprietary trading. (Nonbanks can continue to do so, subject to additional regulatory limits and capital requirements.) Of course, banks can continue to make markets and trade on behalf of their clients.

The argument made by the financial institutions formerly known as investment banks is that they have been largely exiting the prop trading business anyway, with Dodd-Frank merely providing a final push. It is undeniable that most banks have stumbled in recent years in their once-lucrative prop trading activities.

Take Morgan Stanley, which had a loss approaching $10 billion on its mortgage-backed-securities trading desk in 2007 and other setbacks in credit trading. As a result, the bank started to shut its proprietary mortgage- and credit-trading businesses that year, but retains two prop quant trading businesses. However, their future as “proprietary” in nature is doubtful — they contributed only 2 percent of the firm’s revenues in 2009.

Indeed, Morgan Stanley has been looking for outside investors for two years, says a source close to the bank.

Morgan Stanley is hardly alone: Bank after bank, from Goldman Sachs to JPMorgan Chase, has announced that it is dismantling its prop trading desks. (Several of Goldman’s prop traders are decamping to Kohlberg Kravis Roberts.)

Then, can we say that as a result of the firm hand of Dodd-Frank, along with adverse economic trends, prop trading’s excesses are truly over?

“Of course not,” contends Roy Smith, a professor at New York University’s Leonard N. Stern School of Business and a former president of Goldman Sachs International. “Dodd-Frank will not restrain banks from doing what they were doing before. They are just doing it in a different wrapping.” Smith argues that firms are simply transferring their prop units to market-making desks, where they can claim the positions are on behalf of clients. Ad prop traders who decamp to form hedge funds are likely to receive seed capital from the traders’ former banks.

“Prop trading isn’t going away,” Smith says. “It just won’t be called prop trading. The rules as written will have no real impact.”

Still, the rules will have an impact on where the trades take place, either hidden among market-making activities or redirected to hedge funds.

That is why some industry observers are concerned that the change is not necessarily for the better. Yale’s Gorton is among them. “It’s damaging for regulators not to know where prop trading is,” he says. “It’s naive to always think that if we get these activities out of banks we will be better off.”

Gorton sees the push of prop trading into the margins as merely obscuring future problems rather than diminishing them. Moreover, he points out, the trading ban is merely one in a string of new regulations — increased capital requirements chief among them — that threaten traditional investment banking. “This is a transition period for investment banking,” Gorton says. “Where does the business go and how will it work?”

Will whatever model that eventually emerges pose less systemic risk than the current investment banking platform? Hedge funds are not necessarily the best replacement.

For Smith, who was an investment banker at Goldman before joining Stern in 1987, the end of bank-domiciled prop trading is just part of an inchoate financial landscape that is highly uncertain and possibly threatening. “There are many snakes in the grass, waiting,” he says.

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