January 2010

Prop Trading Ban Proposal: Desirability vs. Practicality

By Larry Tabb, Founder & CEO

In September 2008, within a few weeks of the fall of the house of Lehman,
I had written the following, which is excerpted from my research note
titled, “The Future of Investment Banking: Subprime and what it Means for
The Industry.”

A New Glass Steagall

As investment banks are consolidated into commercial banks and the fixed
income businesses look to tap into the lower cost of funding associated with deposits and
commercial banking endeavors, I also would not be surprised if we get a new Glass
Steagall-type of legislation which will again draw the lines between investment and
commercial banks.

While Glass Steagall mostly split investment and commercial banking across
equity/corporate underwriting (investment banking only) and fixed income (both
investment and commercial banking) lines, most if not all of the challenges stemming from
the subprime crisis occurred on the commercial banking side. It was not the equity side of
the business that blew-up; it was the fixed income side, which has historically been
thought of as the safer side. I don’t think that the government would split out the mortgage
or the loan business from the commercial banking side; however, besides better
managing the amount of leverage implemented on commercial banks, I could easily see
that various risk-type businesses being split from these US Universal Banks.

This may mean that while these new Universal Banks have both equity and fixed income
businesses, that the Universal Banks would be prohibited from proprietary trading, taking
sizeable risk positions, and or underwriting corporate securities (both equity and corporate
debt), leaving the Universal Banks’ role in capital market as more of a processor,
custodian, and agency trading operation rather than engaging in proprietary trading
capitalized by deposits, and naïve investor capital.

While I assume that President Obama and Paul Volker didn’t read this, I believe that the
direction is sound. Why are we allowing depository institutions to leverage inexpensive
and taxpayer-guarantee funding to take proprietary risks where both the shareholder and
by default the taxpayer bear the risk?

Now that said, implementing a policy like this will be extremely difficult. The banks of
course will fight it but even ignoring the fight – how do you practically implement this type
of strategy and even if you do, how will this impact the global financial markets?

2010 The Tabb Group, LLC, Westborough, MA USA

May not be reproduced by any means without express permission. All rights reserved.
1
Defining Prop Trading
Defining proprietary trading will be next to impossible. Investment banks take risks and
separating the proprietary risks from market making risks or client servicing risks will be
difficult. While there are people within the banks with proprietary trading roles, many of
the positions held by the proprietary traders would be virtually indistinguishable, from an
outside perspective, from market making / customer facilitation positions. For example,
how would the regulators distinguish the following positions?

▲ First, the bank sees an opportunity to buy $50 million of undervalued US auto debt, and
▲ Second, a large mutual fund wants to unload $50 million in US auto industry debt and the bank
offers to execute the trade using its own capital to facilitate the trade

While the first example is clearly a proprietary position and the second is not, how would
a regulator distinguish between these two positions? In both cases the firms has built up
a position in US auto debt. In both cases the amount is $50 million. The positions from
an auditor’s perspective would look identical. Today these positions are differentiated by
the trading accounts in which they are housed. While this is good for accounting
purposes, I am not sure this will pass muster with regulators.

So how do you ensure that firms do not take proprietary positions? Do you require that
the bonds be bought directly from a customer? If so, how do you police it? Proprietary
positions don’t need to be acquired only via inter-dealer brokers. Do you require a
recording of the client conversation? Do you just fire the proprietary traders? Do you
segregate proprietary and customer facilitation positions by a holding period test? What
if you can’t find the other side of the trade? Do you force the bank to sell the products at
a loss? Do you force the bank to only act in an agency position? If you do this then the
bank would need to either increase its sales force dramatically or lower the price of the
bonds to attract an immediate counterparty. I am not sure issuers, or investors would
care for either of these solutions.

If we look to tease proprietary trading from customer facilitation and market making by
holding period, many firms have a proprietary high frequency equity / options / futures
trading business. These businesses take very short term positions looking for liquidity
gaps. While many firms call this proprietary trading, much of this can also be called
market making. What is the difference?

Will we be able to tell what is proprietary from market making by the portfolio/trading
account they are traded out of? I am not sure that will be effective.

Liquidity
Properly defining the difference between market making, customer facilitation and
proprietary trading is critical. If the government makes it too difficult for banks to take
positions, then there will be less liquidity in the market, meaning fewer buyers and
sellers, wider spreads, and greater costs not only to trade but for companies, and for that
matter governments to raise capital.

2010 The Tabb Group, LLC, Westborough, MA USA

May not be reproduced by any means without express permission. All rights reserved.
2
The impact of this across asset class will be significant. Products that employ less
capital will be less impacted. Exchange-traded products such as equities, options and
futures will have little impact since these products are for the most part traded “as
agency” (meaning the banks don’t take big positions in these markets – except to hedge
other less-liquid positions) and the risk taking functions within these asset classes have
effectively migrated from banks to other market participants such as high frequency
traders. So if regulators could tease apart proprietary trading from market making and
customer facilitation and banks eliminated their proprietary trading, market liquidity may
change somewhat over the short-term but other players will quickly and easily fill in the
gaps.

The products I expect would be more severely impacted are over-the-counter (OTC)
traded products such as debt, currency, and all types of OTC derivatives. To support
these products, large banks leverage their balance sheet and capital to make these
products liquid. Separating market making, customer facilitation and proprietary trading
for these products is much more difficult and if done incorrectly would leave a huge void
in the market.

Without the dealers in these markets liquidity and turnover would initially dry up, spreads
would increase, and it would become much more expensive for companies and
governments to raise capital and manage risk. This would have a dramatic impact on not
only corporations but the government. The current debt ceiling is $14 trillion; a one basis
point (.01%) increase in funding would cost taxpayers $1.4 billion a year. Given 1basis
point is very small and global debt is huge, it will only take a small increase in interest
rates to significantly impact both issuers and taxpayers.

To court more liquidity and solve this gap we would need to draw more liquidity providers
into the markets. Since liquidity providers couldn’t be large banks, we would need to
adjust the products to enable smaller firms to partake in these markets. To accomplish
this, OTC products would need to be made more standardized, and trading would need
to be done in smaller denominations. By standardizing these products it would turn these
bespoke products from securities and derivatives created by corporations and
governments for specific capital-raising and risk management purposes into trading
products that may not benefit the financial end users. If a corporation needs specific
covenants on a bond to raise capital or needs to insulate themselves from an economic
event, how does a generic and standardized product help them accomplish this goal? It
just creates basis risk, forces the corporation to move toward private equity, ignore the
opportunity, or self-insure the risk – which will force corporations to reduce investment,
take less risk, and will eventually impact the number of jobs firms create.

Aversion
Assuming that we can define and ban proprietary trading from customer facilitation and
market making and can prohibit these practices, how will banks react?

First, banks will determine if they can avoid this regulation by changing their registration.
Goldman Sachs and Morgan Stanley were historically investment banks and not
chartered as Bank Holding Companies (BHC): what if these organizations dropped their

2010 The Tabb Group, LLC, Westborough, MA USA

May not be reproduced by any means without express permission. All rights reserved.
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BHC registration? These firms have paid back their TARP money and currently have
less reliance (possibly none) on the federal government. Would this mean they were
suddenly safe? Would they no longer be too big to fail? My guess is if either of these
organizations just dropped their BHC status, continued their business as usual, and
subsequently got into trouble, the government would just bail them out again. So just
dropping a firm’s BHC status would not be enough.

Second, banks would think about if they could switch their proprietary trading businesses
to overseas entities: say Switzerland or somewhere in Asia, maybe Singapore. If this
concept takes hold it would be likely that these organizations would create walled off
subsidiaries or switch their registrations to more loosely regulated jurisdictions where
these practices would be less regulated or maybe even encouraged. I am sure that
some country would be interested in importing thousands of bankers generating millions
of dollars in bonuses, which of course would generate huge tax windfalls and generate a
multiplier effect of support jobs.

Third, if neither of these cases were possible, then banks would spin off these
organizations, not shut them down. This would allow the proprietary traders to either buy
out these businesses using either their own capital, private equity, or carve out the
proprietary trading business through a spin off. The spin off and capitalization of new
trading businesses has been happening for years. Since the mid-1980’s, brokers and
banks have supported the spin off of traders and trading desks into separately
capitalized hedge funds and proprietary trading firms. Banks/brokers have developed
prime brokerage businesses to facilitate this. By spinning off these businesses it
transfers the trading risk to a separate entity while retaining a fee-based revenue stream
through trading commissions, lending and financing. So this may not be as awful a
problem as anticipated.

Risk Shifting
As hinted above, if banks just clove off proprietary trading operations, it won’t mean that
they won’t profit from prop trading or eliminate their exposure to proprietary trading.
Banks will just shift this exposure from direct to indirect exposure. While banks may not
trade for their own accounts unless investment banking and retail/commercial banking is
completely separated, the larger banks will continue to have economies of scale over
smaller shops. This scale allows larger banks to borrow and trade less expensively than
smaller prop shops. These economies of scale will allow the banks to lend money,
finance, and provide trading facilities for independent proprietary trading firms much like
they provide prime services today. So while a proprietary trading ban will reduce their
exposure to risky assets, it will not eliminate them altogether because these same risky
assets will be pledged as collateral to provide financing for independent providers. This
will reduce direct exposure to these assets; however if the assets go south, the banks
will still be left holding an empty bag.

A Better Solution
A much better solution would be to more carefully adjust / fine tune capital guidelines
within banks to promote or dissuade banks from taking risky positions. Capital allocation

2010 The Tabb Group, LLC, Westborough, MA USA

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4
could be employed to require banks to increase their capital ratios depending upon the
size and composition of their balance sheet. They could be forced to hold greater
amounts of capital for more risky, less liquid, and greater sized positions. By increasing
the capital ratios on these more risky positions it requires that the returns on these
positions be greater to justify their investment. In this case, banks must double-down
and take way more risk (which increases capital ratios even further) or eliminate their
risk and allocate to a much safer investment – which is more likely.

In addition to adjusting capital allocations, we should also look to see what type of
capital banks are holding. Currently tier-one capital is calculated on their total balance
sheet and not based upon the assets held. Tier-one capital may be in the form of illiquid
real estate assets, asset-backed securities, or for that matter US Treasury bonds. We
should look to ensure that the capital the firms are pledging/holding is not junky illiquid,
miss-marked, or unable to be accurately marked and make sure that pledged capital is
of good quality, liquid, and safe.

Washington Politics
While I believe managing capital is a more fundamentally practical solution than shutting
down proprietary trading, it is probably not politically practical. Washington needs scalps
and must show that they are in control of Wall Street and not visa versa. Washington will
not be able to declare victory by just saying that they kicked Wall Street’s “behind” by
changing capital ratios. That will not get anyone re-elected. The problem unfortunately is
that unless the government is much smarter than they seem, the politically expedient
solution may either have significant unintended consequences or be completely
unenforceable – with the latter being much better than the former.

The Bottom Line

While I am all for figuring out a way to reduce risk from the banking sector and
wholeheartedly agree with the idea that banks shouldn’t use taxpayer-guaranteed
deposits to fund risky trading practices in which banks and traders receive the bulk of the
upside potential and little if any of the downside risk – I am not sure that banning
proprietary trading as the de facto solution is the right answer.

Banning proprietary trading will be difficult to enforce and if made too draconian could
absolutely hurt corporations, governments, taxpayers, and Main Street by shrinking the
level of corporate financing.

While I am in favor of protecting the economy from another collapse, we need to think
long and hard about doing this in a practical way – otherwise the unintended, or for that
matter intended, consequences of a rash act may make the regulators feel better but
would hurt not just Wall Street, but Main Street, and the global economy as well.

2010 The Tabb Group, LLC, Westborough, MA USA

May not be reproduced by any means without express permission. All rights reserved.
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