May 2014
MF Global is one of the more blatant examples of the danger of banks and brokers engaging in proprietary trading while also servicing client trading. In that case, monies from once seemingly secure customer segregated funds on the futures commission merchant side of the business were used to fund the firm’s broker/dealer proprietary trading – at least for a while. But those pesky regulators got in the way and the business collapsed, and along with it, customer funds went missing.
Would the so-called Volcker Rule have prevented the MFGlobal debacle from happening? No, though the Volcker Rule will reduce the chance of this happening within commercial banks. In the near-term while regulatory oversight remains heightened, another breakdown even from non-bank brokers not subject to the Volcker Rule seems less likely. MF Global and the dearth of trading left in its wake adversely impacted ALL market participants. The casual retail trader and the small hedge trader likely found the reduced liquidity somewhat annoying. Hedge funds, commodity trading advisors, prop shops and the universe of professional traders were significantly more debilitated.
PLAYING FAST AND LOOSE WITH INFORMATION
Although MF Global looms as a recent huge event illustrating the prop problem, plenty of other examples of “insider” prop trading exist. Back in 2006, part of the reason for the failure of the Amaranth hedge fund, other than Brian Hunter’s hubris and lack of risk controls, was that its clearing broker, JP Morgan, apparently used the knowledge the fund was in trouble to line its own coffers. When JP saw Amaranth’s dire position, Amaranth reportedly worked out an agreement with Goldman Sachs to take on the losing energy positions. The problem was their collateral was tied up by JP Morgan until they could review the deal. That pretty much quashedthe deal; and JP Morgan, armed with insider’s knowledge, used it to wind down the Amaranth positions along with their trading partner Citadel, each raking in a cool $725 million–while Amaranth customers were left hanging due to the failure of the $6 billion hedge fund.
And JP Morgan admitted to using client information. In a Wall Street Journal piece from Jan. 30, 2007, “Bill Winters, co-head of JP Morgan’s investment bank, said at a November conference that through its hedge-fund relationships, such as trade clearing, “we have the insight into what’s going on in these funds” and can “respond quickly to opportunities when they come up. Amaranth was one obvious example of that.” He added, “I imagine there will be others…where our ability to be both on the inside, but not compromised, is extremely powerful [as a way] to generate profits.”
Perhaps JP managers hold a different judgment standard from some of us about what it means to be compromised. For decades, mega banks touted the Chinese-wall theory about how there was a veritable wall erected in the institution isolating customer trading activity from the bank or investment bank’s proprietary trading activity. Apparently this separation was more illusory than real.
Another anecdote among the trading community involves a German bank FCM clearing for a large money manager. The bank had access to client futures volume and displayed, to a host of internal bank traders, that the money manager was selling bund futures. As the story goes, a cash trader for the bank saw what the money manager was doing and called them directly to say he was a buyer of cash bunds. The client immediately realized why they received the call and took aggressive steps with the bank to ensure their futures trading was kept private from the bank’s proprietary traders.
An additional blatant example stems from the late 1990s when an international bank’s FCM in Japan allegedly broadcast customer futures orders to the prop desk, providing them an opportunity to trade before (front-run) the customer. These may be isolated examples, and perhaps the problem is not pervasive, and it might be more difficult in today’s more rigorous regulatory environment; nevertheless, many big traders believe that information about their trading can be leaked from the clearing side of a firm to its proprietary trading operation.
More recently, an FBI bulletin stated that a US bank and a Canadian bank were front running Freddie Mac and Fannie Mae orders according to a Reuters story in January 2014: “Current and former employees at the US bank said that swap traders at the bank programmed their phones with different ring tones to identify when certain customers were calling, alerting traders that a large order was about to be placed, the FBI said.
According to the[FBI] bulletin, one employee at the US bank and the Canadian bank employee reported that senior bankers at the two banks ‘planned and encouraged this behavior because it led to higher revenue for their respective parent banks.’
Disclosure of the suspected manipulation and front running came in an FBI intelligence bulletin that was distributed last week by the bureau’s field office in Charlotte, North Carolina, to security officers at financial services firms.
The FBI said it had ‘medium confidence’ in the information, which the bulletin described as coming from “multiple corroborating sources with first-hand access.” However, it said it had “low confidence” that law enforcement could prosecute suspected traders because the trades concerned seem to be completely legitimate.”
The website ZeroHedge filled in its own blanks that the US bank was Bank of America, stating that according to the bank’s 10-Q, summarizing it had lost money only on nine days out of a total of 188. “Statistically, this result is absolutely ridiculous when one considers that the bulk of bank trading revenues are still in the form of prop positions disguised as ‘flow’ trading to evade Volcker which means the only way a bank could make money with near uniform perfection is if it either 1) consistently has inside information that it trades on or 2) it consistently front-runs its clients.”
COST OF DOING BUSINESS?
In light of these episodes, why do traders utilize brokers who also engage in proprietary trading? Several big traders responded similarly, “their balance sheet.” One large proprietary trading house clearing through Goldman Sachs responded they used the firm because of “access.” Goldman could clear all the markets the client needed including multiple exchanges around Europe and Asia. Is It possible that the cost of building out and maintaining the infrastructure necessary to trade and clear globally creates too expensive a hurdle to induce large companies into that arena on a strictly agency customer business? The lure of trading profits may be the only driver sufficient to warrant such a labor, capital and infrastructure build-out. A second reason the trader gave as her rationale for clearing Goldman was their attractive financing. She also stated she believed Goldman was successful at separating the prop side from its client side. She explained the prop desks were on different floors and one group didn’t have key cards to the other group’s elevator bank. “They assured us they made a great effort to make sure the prop side never sees client positions,” she said.
Some other big players agree. Richard Prager, Managing Director and head of trading and liquidity strategies at BlackRock, noted that FCMs having prop arms was “not material for us.” He added, “I don’t want to sound threatening, but if we found out any of our intermediaries were using our information in that way, we would stop using them. There are rules in place for our protection.”
One trading advisor downplayed the concern of prop traders using the information, calling it “paranoia” and stating “information flows both ways.” This suggests that he hears information from big bank employees about their prop trading and so he is ok with them knowing what he is doing.
A former executive at NewEdge said the reason NewEdge, which is owned by Societe General, set up their agency design was to separate the banks’ prop trading from the FCM. That set up may change going forward unless strong customer concerns require maintaining this separation.
Some FCMs decided to make changes even before they were mandated. Maureen Downs, President of Rosenthal Collins Group, noted that “after MF Global, no customers wanted to hear about FCMs having a prop arm.” As a result, RCG restructured, setting its prop arm Rosenthal Collins Capital Management completely apart from its FCM. “So we listened to our customers and restructured so the FCM is totally separated.”
Several firms agree this is a key question from clients. ABN AMRO Clearing Chicago notes in a marketing description that “We operate on a no-conflict basis with no prop trading.” An officer at ABN AMRO Clearing Chicago says the reason they state it clearly is although they are owned by a Dutch bank, “we do only agency business” and the firm has its own settlement bank.
Yet one prop house manager who clears with several major global banks, including ABN, and feels comfortable with them, points out that having the prop trading affiliate or parent increases the counterparty risk of dealing with them. There exists a chance that prop trading gone awry could take down the parent holding company, including the FCM. Financial history is littered with examples of firms crippled by their proprietary trading. Before the recent MF Global, there was Lehman, Bear Stearns and even Merrill Lynch was on its knees before Bank of America came to its rescue. Adecade before that flurry we saw the venerable Barings end its century-plus existence due to a rogue prop trader. Still further back, some may remember Kidder Peabody, Drexel Burnham Lambert, and E.F. Hutton, all disappeared at least in part due to proprietary trading losses.
The prop house trading manager continued to explain, “There’s two issues, one is from the perspective if they are reading the flow and reverse engineering the trade to see the strategy. Second, that with prop trading there is always counterpart risk. The brokers don’t know what’s going on over on the prop side.”
He also judges an FCM by its own client due diligence process. “I like when they go deep, because that means they are doing it with all clients,” he points out. “That means there’s less risk from another customer of the broker hurting the firm.”
He also says they clear through five global banks and each maintains a different level of due diligence. He says the ones that do the minimum due diligence get only a small portion of his business.
One asset allocator says there is definitely skepticism among big trading managers. She noted that hedge funds will complain when she wants to open a managed account with them because they are worried that she will be watching – and possibly front running–their trades. “If they say that to me, an allocator, then hedge funds must be questioning investment banks,” she says.
DEFINITION PLEASE
What exactly defines prop trading today? Perhaps any buying and selling for profit that benefits the shareholder–regardless of which related entity actually holds the position. As the Volcker Rule comes into play, more banks will pare back their proprietary trading. In addition, the Federal Reserve is tightening regulation of physical commodity trading by banks. Although Goldman Sachs (J. Aron) and Morgan Stanley are grandfathered in to keep their businesses, other firms already are shedding those operations, including JP Morgan, which reportedly sold its commodity trading group (minus LME arm) to Mercuria Energy Group. The European Union also plans to rein in bank prop trading. This will have no impact on the non-bank FCMs which continue to have prop arms, such as Interactive Broker’s Timber Hill and RCG’s Rosenthal Collins Capital Markets.
The launch of swap execution facilities (SEF) and more FCMs getting into the OTC business will increase the complexity of the playing field. Not only do we have the trading vs. clearing concern, we now have a new separation between those that execute for the OTC market and those that clear the markets. CFTC Rule 1.35 requires members of SEFs to comply with the same record keeping requirements currently applicable to members of designated contract markets. This means the member must keep “full, complete and systematic records, together with all pertinent data and memoranda, of all transactions related to its business of dealing in commodity interests.” In addition, all FCMs, IBs, retail forex dealers and members of exchanges or SEFs must keep all “oral communications that lead to the execution of transactions in a commodity interest or cash community,” according to a CFTC report. The rule also outlines procedures for end-of-day allocation of bunched orders.
However, with swap clearing comes the need for higher capital requirements by bank FCMs due to Dodd-Frank and Basel III. As Patrick Young, principal of Exchange Invest, noted in a recent newsletter regarding JP Morgan’s sale of its commodity trading unit, “In the beginning we cleared all over the place in exchange traded derivatives and gradually learned to trust big balance sheets, so banks reigned supreme. Trouble is, banks now have all sorts of demands on their balance sheets. They are under the pressure of being wooden timbered sailing ships in a mid-Atlantic storm with GPS monitoring their every move. Does Basel III et al mean it may be better to start looking for big balance sheets which aren’t banks? Hmmm…”
IS PROP TRADING A PROBLEM?
As noted, many big traders shrug their shoulders, stating safety mechanisms have been put in place and seepage is not an issue. One former industry exec quipped, “Clients know when an order is bastardized. There is law and lore,” meaning that a firm could be black-balled if there is seepage.
Mark Rosenberg, Chairman of SSARIS, notes, “I am not tremendously concerned with an FCM having a prop desk. Once I have my position on, I want the world to follow me. I am concerned that they try to determine my exit price or get information from the brokerage arm of my exit price. Most FCMs do not have the resources to move the markets to our stop-out positions. This is different with bank FCMs. They have unlimited monies and can move the markets. That is why I support a lot of Volcker. Risking client money to make money for yourself – not cool.”
And of course there is disclosure: few firms allow brokers to trade for their own account, and if they do, it has to be disclosed. In addition, every firm provides disclosures on their websites. On Goldman Sachs’ site is a disclosure: “Order Handling Practices for listed and Over-the-Counter Derivatives: while the firm is holding your derivative (e.g. options, swaps, futures, convertible bonds, warrants, preferred shares or other derivatives or combinations thereof) order, the firm or its clients may engage in trading activity in the same or related products, including transactions in the underlying securities. While such trading activity is unrelated to your order, it may coincidentally impact the price of the derivative that you are buying or selling.” They explicitly make the pledge that any trading is unrelated to your order–it is coincidence–let’s hope this is the case at all firms large and small!
While regulators attempt to ban or at least curtail prop trading by commercial banks, and with ever tighter reporting rules for trade executions, it seems obvious to acknowledge a problem exists or existed.
The asset allocator notes these firms are in the business to make money, and well, “people are innately greedy.” She adds that the Chinese wall sounds great in theory but, “people talk. It might not be the guys on the desk, but their higher ups.” That said, she says today’s client is most interested in the best execution and service they can find.
Others point out that electronic trading has reduced or eliminated the ability of prop arms to see customer orders unless they are very sophisticated. When asked about that, one prop house manager showed a healthy skepticism: “It’s not that hard (even with electronic trading),” he says. “You have some crazy smart kids these days who could easily” break down the orders. Imagine having a significant long position in any commodity. Once you begin to liquidate that position, you certainly hope your clearing firm is not racing to sell the market before you.
