Thursday, July 29, 2010

Prop Trading

Felix Salmon:
If everybody on Wall Street knew that Goldman was short volatility, it’s pretty obvious what was going on. Goldman was selling a lot of volatility to clients, it thought that the price of volatility was more likely to go down rather than up, and so it happily sat on its short-vol position over most of the quarter, looking to make money as the price went down. Instead, the price went up, and it lost an estimated $250 million on those trades.

That’s prop trading. Yes, the equity derivatives desk was indeed meeting client needs, but it was also taking a proprietary directional position on where it thought volatility was headed. Viniar, on the conference call, was essentially saying to regulators, “you can’t prove this is prop trading, we’re just going to say that it was all on behalf of clients, and there’s nothing you can do to stop us.” I suspect he’s right.

FLG said from the beginning that this concern about prop trading is fruitless. Salmon explains it pretty simply, you just can't separate trades to service clients from trades taken to give the bank a position.

But, and FLG has said this again and again, this is all a distraction from the important issue - leverage. The concerns about prop trading are that it's risky, and consequently puts the bank at risk, which in turn puts the financial system at risk. Well, instead of saying this trade is good and bad, which involves all sorts of value judgments without a consensus, let's just worry about how exposed they are in general, i.e. the leverage. Capital and collateral requirements simultaneously decrease the size of the position that can be taken (because you have to put a correspondingly larger portion captial on the table to take a large position) and also decreases the risk that a single bank failure will lead to systematic failure (because the collateral would make the counterparty at least partially whole.) It's both futile and a distraction from the real issue to try and determine about whether a trade is proprietary or not.

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