Why Trade Prop When You Can Just High Frequency Trade?

Michael Lewis takes ont he abandonment of prop trading.In my recent writeup on the Myth of the Missing Volume I included a prelude to one of my recent thoughts: the notion that banks are abandoning proprietary trading not exclusively for regulatory compliance under the new Dodd-Frank Bill, but rather because it’s a failing business.  This is what I had to say:

As far as structural changes go, a funny thing happened on the way to global economic meltdown: prop desks who flipped stocks minutes at a time were replaced with computers who flip stocks by the second.  Major institutions like Goldman Sachs (NYSE: GS) are closing down their prop desks, while their HFT shops continue to rake in the profits.  Don’t believe all the rhetoric that this is solely a consequence of the Volcker Rule in the new financial regulations.  A lot of that discussion is political grandstanding in the quest for more favorable compromises out of regulators. Prop desks enjoyed a great run in the midst of the epic volatility storm that wreaked havoc on our economy; however, in the storm’s wake, these desks have struggled mightily.  In reality, this new transition has as much to do with the fact that proprietary trading takes on more risk and results in lower profits than the high frequency variety in today’s markets.  At the end of the day, it’s simply good business to shift to HFT.

Today, econ-journalist heavyweight, Michael Lewis is out with his own take on the “Mystery of Disappearing Proprietary Traders” that is absolutely worth a read.  The mystery begins as follows:

The 3 percent loophole amounted to an invitation for the big banks to keep on doing at least some of what they had been doing — which is why Levin felt compelled to remove it, and the banks fought so hard to keep it.

Yet in just the past few weeks news has leaked that Morgan Stanley, JPMorgan and Goldman Sachs all intend either to close their proprietary trading units or to sell their interests in the hedge funds they control.

So the banks had an opening to maintain a larger interest in proprietary trading; however, despite that regulatory loophole the big banks are not seizing the opportunity.  I repeat, DESPITE A LOOPHOLE, the banks are not seizing an opportunity.  And this is a sizeable opportunity to boot.  3% of capital for a big bank is a substantial sum.   You know what passing on this “opportunity” means?  It means obviously that there is not the opportunity there that many imagined.  Lewis offers two possible explanations for why exactly that is:

No. 1 — Having not merely preserved but bolstered their place at the heart of capitalism — with little banks failing everywhere, the big keep getting bigger and stronger — the major Wall Street firms have experienced an epiphany about their relationship to wider society. They don’t need to screw people!

Newly able to raise their prices, they want to return to serving their customers, rather than exploiting them.

No. 2 — The big Wall Street firms have looked anew at proprietary trading and seen a dying business.

And I largely agree on both fronts, particularly with the second point.  If the banks saw an opportunity to make money, they would seize upon that opportunity despite the ability to garner increased revenues from traditional investment banking operations.   I think to a significant extent what is happening right now, at least in equity markets in particular, is a transition from traditional “proprietary trading” to the more vague “market-making operations.”

And by market-making operations I am specifically alluding to high frequency trading.  A bank like Goldman can actually increase their VAR (value at risk) while taking less “real” risk using HFT and can remain as active as ever in equity markets without even having a proprietary trading division.  There are many types of HFT strategies (I urge you all to check out this great chart from Brandon on the six primary strategies of HFT) and it’s rather difficult for market participants and regulators alike to distinguish how exactly algorithmic volume is being dispersed across markets.  Why engage in “proprietary” trading when one can conduct a very similar business under the veil of “market making” and high frequency trading?

Since this “mystery” is in the early stages of its evolution, it remains to be seen exactly what big bank trading will look like in the coming months and years, but don’t be fooled into believing that banks are simply leaving the proprietary business because regulators told them to.  The banks had the opening they needed to maintain that line of business and that’s all it is to them: a line of business.  At the moment it is a particularly risky business with diminishing profits, and that alone is why banks are abandoning those operations.

Just a personal note to conclude my writeup for this morning: this weekend I will be getting married to my wonderful fiance Emily.  For the next two weeks the two of us will be off on our honeymoon; therefore, my morning write-ups will be on hold until my return.  Have a great couple of weeks!

Disclosure: No relevant positions.