Ladies and gentlemen, boys and girls, democrats and republicans, hold on to your hats. What I’m about to reveal will absolutely blow your minds. You will not hear this from Congress. You will not hear this from the regulators. You will not hear it from an industry being scapegoated, regulated to heretofore unforeseen levels and frightened to death that even more regulation is coming.
You’ve all heard about or read about the Volcker Rule. You’ve heard everyone from President Obama to Chairman Gensler denigrate the “outrageous” risk taking activities of big banks (namely prop trading, which is often described as taking directional bets or positions, especially through credit default swaps or by purchasing risky asset-backed securities) with other people’s money, which of course, in their view caused the financial crisis. They claim the Volcker Rule will stop banks from engaging in these activities and will prevent tax payers from having to bail out large banks in another financial crisis because they will not be able to engage in these risky activities and will instead be constrained to traditional bank activities like lending money and hedging risk. JPM’s recent missteps (as widely reported in the press) have called additional attention to this issue, which has been at the center of the regulatory debate since the Dodd-Frank Act was enacted.
So, here’s the startling revelation: extending a line of credit or otherwise lending money to an individual or an institution is a proprietary trade. Banks are engaged in the business of proprietary trading. Banks have always been engaged in the business of proprietary trading. The entire Volcker Rule and all of its premises are smoke and mirrors which do not address the fundamental underlying issues and root causes of the financial crisis. Don’t believe me? Think I’m blowing smoke? Think I’m a shill for the industry? Think again, this is cold, hard and simple logic.
Making a decision to extend a loan to an individual or institution is a proprietary trade because it is for the bank’s own account and it is a bet by the bank that the individual or institution will succeed sufficiently to repay the money (if it’s a secured loan, there’s less risk, but that doesnt alter the fundamental nature of the beast). In the case of an individual, it is a bet the individual will remain employed or will be able to find new employment such that he or she will be able to repay the loan. Indirectly, it is therefore a bet on an industry, a sector and perhaps even specific products vis a vis that individual’s role in the economy. Where it is something like a mortgage it is all of those things plus a bet that the value of the property will be suficient to cover any default, which is itself a bet on property values, which is in turn a bet on a region, which in turn is a bet on a portion of the economy, one or more industries, etc…
In the case of a loan to a large corporation, the same analysis applies on an extended basis. A loan to a big computer manufacturer, for example, is a bet on whether that enterprise will succeed or fail, which is in turn a bet on whether the computer industry will thrive or stagnate, which is in turn a bet on corporate and consumer spending, which is in turn a directonal bet on all or part of the economy or an industry or sector. Yes, some manufacturers will lead the pack and others will trail, but the point is that betting on any one of them to succeed is definitionally something of a bet on that entity’s businesses, which is a bet on many other things. It is thus indisputably, unequivocally and factually the case that such extensions of credit/lending activities, which are the historical bread and butter of banks, are proprietary trades, i.e. they are bets for the bank’s own account, using the bank’s (or, as lawmakers like to say, other people’s) money, that a particular individual or enterprise (along with related variables as mentioned) will succeed sufficiently to effect repayment, including the bank’s interest (i.e. its profit).
Selling credit protection on an entity with a $1B notional for a spread is likewise a bet on that entity’s performance and it’s ability to succeed in the market place, i.e. a bet that it will not experience a credit event–as well as a bet that the credit protection seller’s counterparty will pay it the relevant spread during the term of the contract (or that a credit protection buyer’s counterparty will surivive to pay the settlement amount). In the same way that people who loaned money to Greece made a proprietary bet on Greece’s ability to succeed in exchange for Greece agreeing to pay interest and repay the loans those who sold credit protection on Greece made a similar proprietary bet to earn a spread and those who bought such protection made the opposite bet (some players collateralized exposure just as some loans are secured while others did not just as some loans are unsecured). The substance was essentially identical, but the form of the bets was different.
In all cases (selling or buying credit protection, extending a loan, buying a bond or a common stock or a commodity or anything else for that matter), a directional bet is being placed. The issue is whether the risk represented by that directional bet is properly diligenced and properly managed not whether it is in the form of a bond, a loan or a swap. To focus on the form of the risk-taking and not the underlying decisionmaking and diligence processes absolutely, utterly and completely misses the point. Various government officials and certain pundits constantly whine that lending is stagnant and banks aren’t lending enough while at the same time chastizing them for engaging in risky proprietary trading.
Well, gee folks, with logic like that we might as well call it hocus pocus and see if Gandalf or Harry Potter can summon us a solution with a waive of the hands or a swipe of the wand. I submit that the reason it is impossible to create a workable definition of proprietary trading for purposes of the Volcker Rule is that banks are definitionally in the business of making proprietary bets whether in the form of a loan, a repo or, horrors among horrors, a swap. Focusing on the form of those bets rather than on the process by which the associated risks are managed is as pointless as it will be unrewarding. And, there you have it folks, startling revelations indeed.
you fail to point out that in a loan the incentives of lender and borrower are aligned. lender wants borrower to make money so borrower can repay the loan and lender can get its interest. not so with a CDS, which is a zero sum game where by definition of the counterparty is making money you are losing money. totally different incentive structure in a loan vs a cds
the author also fails to mention – or manages to deftly gloss over – the fact that, while he may be definitionally correct as to what is, technically, a prop trade (i.e., he’s found quirky linguistic inefficiency to exploit), the point of the differential is not to lay praise at the altar of english grammer, but rather provide separate designations for types of trades which are inherently different. Irrespective of whether the bank’s money is at risk, the author overlooks the broader social policy at work, namely that actual loans to actual borrowers are more valued by our society, whereas actual loans (i.e., cash at risk) to … well, therein lies the rub, doesn’t it? What’s the difference between an actual loan to an actual borrower? Well, for example, while it is true that “Selling credit protection on an entity with a $1B notional for a spread is likewise a bet on that entity’s performance”, that entity hasn’t had the benefit of receiving any credit – credit which it would then, presumably, put to work growing its business. What’s happend, in reality, is a horrible molestation of the purpose and function of credit. credit is an economic driver – modern economies cannot function without credit because economies are based on growth and a crack-like addiction to growth requires a crack-like addiction to risk-taking and there is no quicker way to curb risk taking than by requiring risk-takers to fund their own risk-taking. So instead, our patri/matri-archs have decided that risk taking is good and credit should be abundant. But what if risk taking didn’t result in growth? And there’s your problem. Whereas the real loan to the real creditor spurs risk-taking that results in growth (new market segments, inovation, jobs, etc.), and thus society has decided the risk/return profile is acceptable, the derivative trade is all risk and no return, because the societal benefit is minimal, if there at all. Further, the societal detriment is substantially worse – all the manager is doing is increasing its own returns through leverage; but society must forgo all of the benefits that Sal would have given by employing the masses. So, no matter what clever and technical argument the author prides himself on making, such argument is about as valuable as a Zimbabwean 100 Trillion Dollar Bill… The actual words aren’t remotely important – they could have been called “prop trades” “Fred trades”. The point is that some trades are valued by society and those trades will be fine. The “less” are the Volker, the “more” are the
Commenter #1: The interests of a lender and a borrower are not nec. aligned. The lender wants to be paid back with a fair interest. The borrower may have, and root for, better outcomes than that, whether defaulting, prepaying, or what have you. In any event, the no-prop-trade part of the ‘Volcker Rule’ doesn’t base its prohibition on any alignment-of-interests concept, so if you’re arguing for something, it’s not the ‘Volcker Rule’.
Commenter #2: You are right to try to shift the focus away from the concept of ‘prop trades’, essentially conceding the OP’s point that all of banking meets the definition of prop trade. Instead you wish to focus on some (other) subcategory of trades, which you paint as ‘trades we don’t value’. That’s nice, but that’s not the actual Volcker Rule. Also what you mean ‘we’? I (for example) think most of the trades that will end up getting swept up by the Volcker Rule are just fine. Finally, you seem to envision a ban on trades by trade-type. If you ‘don’t value’ the trade-type (say a CDS) you consider it fair game. Once again that’s nice but has nothing to do with the actual Volcker debate, which is not about trade-type, but *intent* of trade. Market-making of CDS is perfectly Volcker-ok for example, and indeed the entire current regulatory/capital regime depends on the continued existence of CDS. Like commenter #1, you may be arguing for *something* here, but it ain’t the Volcker Rule, or any other regulatory proposal on the table.
Thank you Jim and Gryphon. A rose by any other name would smell just as sweet.
When I say “we”, I mean it in the royal sense, as in “we, as a society”. My point was to say that there may (and I stress “may”) be a method to the regulators’ madness that the author overlooks – regulators are essentially charged from protecting society from the sectors which they regulate, irregardless of any scienter on the part of the regulated. So, definitionally, the author is right – calling certain assets “prop trades” is a distinction without a difference because substantively all of a bank’s non-domestic currency cash assets are substantively proprietary trades. But while the author is technically correct, he fails to see the forrest for the trees – whether the regulators call the “prop trades” or “class b trades” or “naughty child trades”, the point is that the regulators have determined that banks’ ability to engage in the however-designated trades need to restricted for the good of we (i.e., society). because while the author is 100% correct that making a loan to CORP A and selling credit protection on CORP A are both, substantively, prop trades, the comparison is disingenuous because the substantive point is that the regulators have decided its likely good for society if the bank loans the money to CORP A (presumably because CORP A will use it in some way to grow their business, thus add to GDP) but that it is likely bad (or, if not bad, all risk and no return) for society for the bank to assume the same credit risk but without the potential benefit to CORP A. In short, the regulators, through oh so convoluted and inefficient ways, are saying, look banks, if you go bust because you loaned all you money to real people and companies, we can tolerate bailing you out, but we aren’t in the business of backstopping hedge funds just because they’re held by an “N.A.”.