FYI | Apr 06 2006
This is a discussion about conflict of interest. As disclosure is a big part of conflict of interest resolution, let me introduce myself.
I write for FN Arena News. I previously wrote for Australasian Investment Review and The New Investor. I have also, in the past, contributed to the Australian Financial Review. However my early career was as a proprietary trader for Macquarie Bank, where over time I traded in forex, gold, interest rates, equities, futures, options, warrants, convertibles and other instruments in Australia and overseas. My last position at Macquarie was as a director of Equity Derivatives Trading. I have since consulted on derivative instruments, and written a book on the subject.
Alan Kohler is a journalist with a distinguished career that I can only admire. He is also a breath of fresh air in his astute and pragmatic reports on ABC television. But Alan Kohler is not an investment banker.
“They all get up to it, but the idea that proprietary trading is an essential part of investment banking is nonsense…” said Alan in the Fairfax press, and “In general there is little doubt that proprietary trading by all financial institutions that are meant to be there to serve clients is excessive.”
Get up to it? You would think they were smoking behind the bike sheds. And speaking of sheds, let’s shed some light on what Alan’s bleating about before we let the air out of his tyres.
Out of the blue, and bypassing, as Alan nicely puts it, a fireside chat, ASIC has commenced civil proceedings against Citigroup for breaching conflict of interest laws with respect to a proprietary trade in shares of Patrick Corp (PRK) the day before Toll Holdings (TOL) launched its takeover bid back in August last year. In simple terms, ASIC has accused Citigroup of “insider trading”.
“Proprietary trading”, also known as “house trading” or “risk trading”, refers to the participation by an investment bank in the trading of any financial instrument not on behalf of a client or other third party, but solely on behalf of the bank itself. It is a bank’s intention to profit from proprietary trading.
A bank’s proprietary desk is separated from the bank’s client service desks (broking, corporate finance, M&A) by “Chinese walls”. The expression is derived from there being no greater wall than a Chinese one.
A Chinese wall, while figurative, ensures there is no exchange of information between conflicting desks, whether in the dealing room (and usually such desks are separated by literal distance – perhaps different room, different floor, different building, or even different city) or in the pub.
Proprietary traders do not want to know what’s going on elsewhere in the bank, because if they do not only is their trading capacity compromised, so is their job. There are rules in place that only an idiot would breach at the risk of losing his or her career, or indeed going to gaol.
The obvious question then is why do investment banks have proprietary desks? Why do they trade for themselves and risk their employees acting as aforementioned idiots? Aren’t investment banks, as Alan puts it, meant to be there to serve clients?
Of course they’re meant to serve clients, and that, indirectly, is why many have proprietary desks. Alan is implying that a prop desk is staffed only by cowboy punters, and that every trade executed is gamble with the bank’s money – buy, sell, see how you go – and if you lose, well it’s only the shareholders’ money. This is a reactionary perception of prop desks, and it is an ignorant one.
The simple buy/sell of an instrument (let’s stick with shares) is part of what prop desks do, and part of a much wider scope of activities. As well as “traders”, prop desks are also “market-makers” in large lines of (often illiquid) stock, in stock portfolios, in options, warrants, futures, options on futures, convertible instruments, and many more exotic “structured products”. These instruments provide clients with the opportunity to move positions, to hedge, and to generally manage risk.
When the prop desk trades with a (usually unspecified) client (via a broker) it is taking on that client’s risk. In order to dissipate that risk it will trade back and forward with many parties, being interbank or other clients, and this means trading in the underlying instrument, such as shares. It means trading the underlying instrument a lot.
When I was a prop trader in the 80s/90s such house activity could amount to 70%+ of the ASX daily turnover. Aghast? Consider then that 90% of trading in the Aussie dollar, even today, is usually from proprietary trading. Since the growth of retail involvement in the market since that time, and the expansion of the number of prop traders which has led to tighter margins and more competition, that stock market figure is not often reached today. But on any given day it could be.
In all prop activity the intention is to ultimately make a profit. So does this mean the client must be screwed? No. It means the provision of risk management opportunity for the client is not going to be able to be provided unless the prop desk can at least come out square. And gains and losses from one prop desk are dissipated into an enormous market pool, such that it renders it unrealistic to suggest that a prop desk benefits specifically from every client trade.
It is also in the interest of clients for a prop desk to make ultimately make a profit. Otherwise investment banks would not continue providing risk management opportunities, but more importantly, there would be a significant drop off in market liquidity.
It is proprietary trading that provides liquidity in any instrument, in any market, in any country. Without it, buyers would almost have to go looking for sellers, and price volatility would be rife. Proprietary trading can come from all sides – in a range from large global investment banks to individual speculators. Liquidity is the essence of an efficient market. (And that’s why 90% prop trading in forex is a good thing).
But let’s take a moment to return to the idiots. Alan Kohler rightly points out that the National Bank (NAB) forex option loss was a debacle perpetrated by a prop desk. The problem in NAB’s case is that it did not have sufficient internal controls to prevent a group of ingenuous “rogues” from building up a dangerous risk position. In short, NAB management was oblivious, and clearly at fault.
When I traded for Macquarie Bank, there was very little legislation in place to counter potential conflicts of interest, but the bank’s internally devised rules and limits were so stringent that I was often forced to argue vainly for greater trading capacity with (then deputy, now CEO) Alan Moss.
I am confident to assume Citigroup’s internal controls are not dissimilar. Citigroup issued a statement in response to the ASIC proceedings:
“We adhere to well-established policies, which prohibit communications between those involved in advisory services and those engaged in proprietary trading activities. We believe that our robust information barriers, or Chinese walls, are the most appropriate way to manage potential conflicts of interest, and our approach is consistent with the requirements of the regulatory regimes of the key markets in which we operate.”
That’s the best I could get out of Citigroup. However, I was able to learn from an industry source that the trader under fire – he of the Patrick position – was totally oblivious to Citigroup’s pending involvement in advising Toll Holdings on its takeover strategy. In fact the trade in question was a sell trade, executed such that the trader might remain within strict internal limits. It was only a small trade by comparison to the total long position established previously.
Was the long trade a punt? I don’t know. Was it an offset against Citigroup’s warrant book that might be at risk if Patrick were suddenly to be bid for at a much higher price? I don’t know. Citigroup was not going to tell me, but no doubt they will now divulge the answer in court.
So what is ASIC up to? Rest assured they weren’t going to tell me anything either. One comment I heard around the traps was that ASIC was smarting from its loss on the Vizard case and was looking for a new target to justify its existence. Perhaps cruel.
I tried to get something out of my old shop – Macquarie – but spokespeople there weren’t about to comment either. Suffice to say Macquarie is supremely confident of its own controls, but it will be forced to watch this case with more than a passing interest.
ASIC was able to tell me it intends to release a “discussion paper” on the subject of proprietary trading and conflict of interest soon. This was not news, but it was something Citigroup had previously found out in the papers, which must have left management wondering why “discussion” was something that never preceded the launch of a civil suit.
It is important to note that ASIC have, in the last few years, instigated more stringent legislation regarding the activities of stock brokers who might advise a corporate client in M&A on one side, and advise market trading clients in the next breath on the other side. The legislation came about due to flagrant conflict of interest breaches in the US. And fair enough too.
It would now appear ASIC is going after proprietary trading. You won’t get an argument here that proprietary trading doesn’t have all the potential for conflict of interest, and that it hasn’t ever been abused in the past. The dangerous assumption is that everyone’s getting up to it (to borrow from Alan), and that hence proprietary trading, by its very nature, is insidious.
I doubt ASIC intends to outlaw prop trading, but it may have a misguided agenda to enforce rules that would have the same effect anyway.
Let’s say a prop desk is carrying positions in a stock or stocks – significant positions – that offset derivative positions set by clients for the purpose of hedging against, let’s say, a takeover. To second-guess ASIC, I would suggest we might be looking at enforced freezing of that prop position, and no further trading. If that were the case, the prop desk would be buried.
Result? Prop desk closes. Reality? No more prop desks.
Alan Kohler suggest were this to happen prop traders around the country would “stampede…through the departure lounge at Mascot” except for the fact, as Alan notes, that the rest of the world’s regulators are also taking an interest in the Citigroup case. (Don’t forget Citigroup is the biggest investment bank in the world).
This could mean the end of prop desks globally. And a lot of prop traders buying vineyards. Except for one fact Alan has overlooked.
If investment bank prop desks closed then said banks would simply spin off a hedge fund operation, or the traders would join existing hedge funds, or start their own. Hedge funds are just prop desks in their own right, trading everything from shares to soybeans with the sole intention of making a profit. While bank shareholders might be hoping the prop desk makes a quid, hedge fund investors are backing the traders to make a quid. Doing exactly what prop desks do without all that other banking distraction.
The scope and number of hedge funds in the world is growing exponentially. This is good news for the market in general, as they provide liquidity. Many a hedge fund will die in the process however, and many a hedge fund investor will be a victim. But that’s the market – caveat emptor.
In the meantime, everyone from corporate clients to mums and dads will be at the mercy of the market (or cowboy hedge funds) when they look for ways to pass on risk other than to an experienced, trustworthy entity at a competitive, realistic price.
Alan Kohler says the idea that proprietary trading is an essential part of investment banking is nonsense. I agree – you don’t need a prop desk to be an investment bank. However those prop desks that do exist are – indirectly – servicing both clients and the market in general. Alan Kohler says there is little doubt prop trading is excessive. Funnily enough, it is actually the excess that provides the benefit.
We have a test case. It might drag on for a long time. Let’s just hope ASIC actually knows what it’s doing.