Banks Hide Behind Clients to Gamble Own Money

Thursday, 22 Sep 2011 10:30 AM

 

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Investment banks continue to gamble their own money on financial markets, hiding behind clients, in a widespread practice that risks the wrath of regulators, particularly after Swiss bank UBS lost $2.3 billion in rogue-trading.

The official line from most, keen not to appear to be taking the same excessive risks that led to the global financial crisis in 2008, is that what takes place on their sprawling trading floors is largely on the back of client orders.

It is hard to get people working within the banks to talk about it, but traders say that much of what happens at "Delta One" desks — the focus of the UBS loss — and in other parts of the business is driven by banks betting their capital to make a profit in what is known as proprietary, or "prop," trading.

"Whenever you make a market, you are effectively at risk. Whether you define that as prop trading or client facilitation is sometimes quite a fuzzy line," one senior trader at a major investment bank said.

The United States has approved the so-called Volcker Rule which will restrict prop trading, and banks such as Goldman Sachs, Deutsche Bank, Morgan Stanley and JP Morgan have all spun off, or reduced, their stand-alone prop desks in anticipation.

Europe is not planning new rules to end such trading, and a spokesman for the UK's Financial Services Authority (FSA) said the practice remained "perfectly legal".

And while the term prop trading has gone out of fashion, "flow" business — the trading of relatively straightforward financial products on behalf of clients — has become the new buzz word for investment banks. But this is a low-margin, high-volume business that traders are often looking to spice up.

A trading desk may decide to hold a larger position in a market than is strictly needed in anticipation of providing the security to clients later on if it expects to make a profit.

Traders will often be well placed to know, because they have gleaned lots of intelligence from client orders, and could even be justified in calling their positions "client-driven."

"A good trader depends on inflow and understands what the client base is doing. If you don't understand that, you work with a patch over one eye," a veteran investment banker said, asking not to be named, because the subject is too sensitive.

Pension funds and hedge funds will also expect a view on where the market is going from their trading desk, and prop trading can be a good way to achieve that.

Hedging client positions can be a third reason for prop trades. U.S. regulators are wrestling with internal disagreements over how much leeway to give banks to hedge risk, according to people familiar with the negotiations.

Delta One

Regulators in Europe are wary of trying to define the line between servicing clients and prop trading, fearing U.S.-style rules would simply force trading into less regulated entities, and clamping down on lavish pay-outs instead.

But their main weapon against so-called casino banking are new global capital rules — known as Basel 2.5 — that make it far more costly to hold risky assets in trading books, and will lead banks to rethink any benefits of prop trading.

"It affects anything in the trading book, proprietary trading, any type of trading. It raises capital requirements across the board," a regulatory source said.

Choppy financial markets in recent months has made it much tougher to make money in prop trading, and bankers agreed that the new capital rules were another hurdle.

"Banks are looking at (their) inventory levels very closely and all banks will be reducing them. The increase in risk-weighted assets under new regulation, the bank levies reduce the ability of holding inventory," this person said.

But for now, Delta One desks are one corner where prop trading is still rife. UBS trader Kweku Adoboli—charged with fraud after the bank discovered the loss that involved allegedly fictitious trades—also worked on such a desk.

Lucrative Delta One desks are one of the most profitable areas on trading floors, together with high-volume computer-driven program and electronic trading.

"If you look round the City at the sector swaps guys on the Delta One desks ... it's safe to say that at least one or two are taking good-sized bets into the market on any given day," said a former Delta One trader at a large investment bank.

This is particularly the case in some of the more complex Exchange Traded Funds (ETF) positions which UBS said were at the heart of its trading debacle, where it is hard to find a position that exactly matches the exposure.

"You go for some sort of proxy hedge which adds a level of complexity which often the bank risk and compliance systems cannot handle," the trader said.

© 2014 Thomson/Reuters. All rights reserved.

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