When Congress passed a new financial regulation bill last month, it sought to prevent federally insured banks from making speculative bets using their own money. But that will not stop banks from making bets that some critics deem risky, even as the rules go into effect over the next few years.
That is because many such bets — on the direction of the stock market or the price of coal, for example — are done on behalf of clients. So, the banks say, they will continue to be allowable despite the new restrictions.
Indeed, several trades that were made on behalf of clients went bad for the banks even as the new rules were being debated in Washington this year. JPMorgan Chaseand Goldman Sachs, for example, each lost more than $100 million on transactions handled for customers in the period from April to July.
Blowups like these, only larger, contributed to the financial crisis and forced the federal government to spend billions of dollars to bail out financial institutions. Yet analysts are quick to point out that many of those transactions were handled by the banks, ostensibly to serve clients.
“You can use client activity as a cover for basically anything you are doing,” said Janet Tavakoli, who runs her own structured finance consulting firm. “It’s very problematic that losses like this are showing up. It’s a prime example of what the financial reform bill doesn’t address.”
That ambiguity could have broad consequences for the future of trading on Wall Street.
Given the size of the banks, these recent losses were relatively small. But they highlight how banks will continue to be able to make bets where their own money is at risk — a practice that has yielded huge profits on Wall Street in recent years.
Though these trades were made on behalf of clients, they subjected the banks to the kind of risk that Congress sought to curtail when it devised the Volcker Rule, which banned banks from speculating with their own money. That practice is known as proprietary trading.
Even before the new rules were passed, Morgan Stanleyand JPMorgan began dismantling their stand-alone “prop desks” and shifting those traders into client-related businesses. Goldman is considering changes that could turn some of its star proprietary traders into asset managers who rely on capital from outside investors.
But for all the talk of shutting down trading desks and reassigning employees to prepare for the Volcker Rule, proprietary-style trading will probably survive, if under a different name.
This year, for example, several large insurance companies approached Goldman Sachs, looking to bet that the markets would not stay quiet. Goldman gladly took the other side of the trades, but when the markets turned choppy in May, the firm was caught short and quickly lost $250 million.
Goldman, through a spokesman, declined to comment on its losses on that investment. But in a conference call with analysts last month, the bank’s chief financial officer, David Viniar, explained: “We didn’t hedge it fast enough. Things spiked really dramatically, really fast.”
Months before that trade, though, Goldman Sachs’s research department named a bet against volatility as one its top 10 trading strategies for 2010. Goldman followed its own advice and put its own money in play by failing to adequately hedge the trade with the client who wanted to bet on volatility, which would have given Goldman a neutral position. In this way, a client-oriented trade can effectively become a proprietary bet.
To be sure, in some cases it is necessary for a bank to take a financial risk in order to execute trades quickly and preserve market liquidity.
What is more, it can be difficult even for Wall Streeters to draw the line between holding securities as inventory for clients and owning them with a view toward where the market is going.
Goldman Sachs, for example, derived about $37.3 billion from trading activities in 2009, according to a Citigroup research report. Perhaps $1.5 billion, or about 4 percent of that revenue, came from dedicated proprietary trading desks. Were other Goldman traders essentially making proprietary bets in the process of serving clients? Likely, analysts and traders say — though it is very hard to tell.
“Goldman tends to have businesses that have a customer focus with a proprietary overlay,” said one hedge fund manager and Goldman alumnus who insisted on anonymity. “That overlay can effectively allow them to make directional bets by using the customer flow to get them there.”
But Goldman is hardly unique when it comes to walking the fine line between serving clients and taking positions.
Late last year, with clients eager to bet that coal prices would rise, JPMorgan took the other side of the trade and amassed contracts on hundreds of millions of dollars on coal — enough to dominate the European market.
Initially the trade went JPMorgan’s way and yielded profits, but in April the Morgan traders were caught off guard when European coal futures abruptly started rising. In fact, the wrong-sided bets erased all of the previous gains, and by the middle of June, it had turned into one of the commodities unit’s biggest losses — nearly $130 million and counting.
JPMorgan would not disclose the names of the clients and would not comment for this article. But in an internal conference call, Blythe Masters, who oversees the commodities unit, said that the bank made an error in judgment taking a risk on its own behalf.
“We made a bit of a rookie error,” she said, according to parts of a recording first published by Bloomberg News. “We got overexposed in the market and made ourselves vulnerable to a squeeze.”
Over the years, banks have shifted from being intermediaries who match buyer and seller to middlemen who put their own capital at risk.
When a trade request comes in from a customer, traders have the option of handing it off to a second party that wants to take the other side.
But if a second investor cannot be found, or if the trading desk has a market outlook that aligns with the bet, the trader can take the opposing position using the bank’s own account. The bank can then either hold on to that risk or hedge the investment so that its position is effectively neutral.
In the case of Goldman’s bet on volatility, the investment soured before the bank could sell it or reduce the risk.