Wall Street: Money Never Sleeps, Oliver Stone's unconvincing sequel to his classic 1987 film, gets one detail spot on. Whereas in the original film, Charlie Sheen plays a stockbroker cashing in on the surge in public share ownership of the 1980s, Shia LaBeouf, Sheen's 2008 alter ego, plays a proprietary trader. "Prop trading" was a defining feature of banking over the past decade and is now a target of US financial regulation in the form of the "Volcker Rule", put forward by Paul Volcker, chairman of Barack Obama's Economic Recovery Advisory Board. When histories of the financial crisis come to be written, prop trading will be up there with sub-prime mortgages as one of the principal causes.
Historically, a bank's role was to "make markets" in the securities that it originated, providing liquidity to investors in newly issued shares and bonds. Banks would take a spread, running little risk in the process. But the growth of hedge funds in the early years of the past decade posed problems for banks.
First, hedge funds made their money by arbitrage: exploiting inefficiencies in the market. This was often at the banks' expense. Second, hedge funds offered the smartest traders more money and freedom than they were allowed at the banks. Many of the brightest lights began to leave the banks, bored with being mere middlemen in the markets. And as the banks could see that hedge funds were making staggering sums of money, they wanted a piece of the action.
Flash and crash
Prop trading is when a bank uses its own balance sheet to take positions in shares, bonds or commodities; prop desks are like hedge funds that operate from within banks. Most banks set up five or six of these desks, competing with each other as well as with the outside world. In 2009, Goldman Sachs made over $5bn - 10 per cent of its revenue - from prop trading.
The trading strategies of prop desks are as varied as those of the hedge funds they are up against. Merger arbitrage is a common tactic: prop desks buy the shares of takeover targets, shorting potential acquirers against them. Commodity arbitrage, meanwhile, seeks to exploit pricing differentials between different markets; for instance, buying wheat in the Russian market and selling it in Canada. Prop desks were among the guilty parties in the flash-trading crash of 6 May, when US equities lost nearly $1trn in a matter of minutes. Flash trading employs sophisticated computer models to spot and exploit minute price inequalities in the market, applying huge amounts of leverage to these positions in order to make meaningful returns.
In the end, banks found themselves with numerous unwieldy proprietary trading operations pursuing similar or, even worse, contradictory strategies. When the crash hit, many of these desks went under. Now, even the survivors look doomed.
In the past few weeks, bosses at Goldman Sachs, JPMorgan and Morgan Stanley have announced that they will be closing their proprietary trading units. Regulatory scrutiny appears to have forced the banks' hand. Though a bill proposed by Senator Carl Levin to ban prop trading outright was defeated after panicked lobbying by the big banks, the Volcker Rule will limit banks' ability to pursue speculative activities with their own cash to a mere 3 per cent of tier-one capital (just $2.1bn for Goldman Sachs; $1.5bn for Morgan Stanley). News stories have started to appear about prop traders leaving to join hedge funds. Three ex-Goldman Sachs prop traders have apparently raised $1.5bn for their newly established hedge funds.
So how did the prop dream sour so swiftly? Prop desks ran at a significantly higher VaR - value at risk - than their market-making peers. VaR measures how much a desk stands to lose if things go wrong. Prop desks were not only holding much larger positions than conventional traders, they were also applying leverage to these positions. In order to magnify the relatively small margins that their arbitrage strategies generated, prop desks ran VaR figures ten times larger than the lowly market-makers who sat beside them.
Howie Hubler was the head of one of Morgan Stanley's largest prop desks. In 2007, he was blamed for a $9bn trading loss - the second-largest ever (the biggest was by traders at Quebec's state pension plan). Boaz Weinstein, a star prop trader at Deutsche Bank, lost $1.8bn in 2008. Richard "Chip" Bierbaum was 26 and had been working on Calyon's prop desk just three months when he ran up losses of $353m in 2007.
But some prop desks were hugely successful. Goldman Sachs's principal investments team has consistently beaten the market, turning
in astonishing profits even at the worst stage of the 2008-2009 crash. JPMorgan's prop desk was buying up AAA-rated collateralised loan obligations when no one else would touch them, making a killing when the markets recovered in late 2009. Even given increased government meddling, why would banks give up these cash cows so easily?
I joined ABN Amro as a market-maker. After some lucky bets, I found myself sitting on a large profit. Within weeks, I was prop trading in addition to my market-making - in competition with three other desks doing more or less the same thing.
This is how the banks will get around the Volcker Rule. They don't need prop-desk prima donnas any more. Conventional trading desks have always taken proprietary positions besides their usual market-making activities. So banks will shift prop trading back to their market-makers, where the size of their proprietary investments will be lost in the noise generated by more orthodox trading activities.
Alex Preston's column appears fortnightly. His novel "This Bleeding City" is published by Faber