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To Avoid Volcker, Goldman Goes All Flow, And Why This Could Be The Beginning Of The End For Goldman's Trading "Perfection"

Tyler Durden's picture





 

Yesterday Fox Biz' Charlie Gasparino had some unique perspectives into what Goldman's most recent trick to avoid the Volcker prohibition on prop trading is: "The big Wall Street firm has moved about half of its “proprietary”
stock-trading operations — which had made market bets using the firm’s
own capital — into its asset management division, where these traders
can talk to Goldman clients and then place their market bets." It is odd for the firm to jump through such hoops when it itself said, with a very serious face, that prop trading accounts for just 10% of revenue. And there is no reason to doubt that, is there: after all, ignore the fact that as we disclosed this weekend, Goldman would actually have had a ($2.8) billion short CDS position into AIG had its CVA group not intervened and netted off the counterparty risk, thereby the prop group saving the firm once again over and above the stupidity of its flow traders, and put all your faith in the latest piece of ARS prop (not as in Auction Rate Securities and not as in proprietary). Yet even if Goldman does follow through with this move, the logistics involved in this transition will dramatically impair the traditionally exception ROI for Goldman's prop which has generically been the firm's sophisticated version of a front running syndicate to whale flow orders as we have repeatedly claimed. Due to the collocation of prop and flow on the same trading floor, historically prop traders could "claim" they had a brilliant idea of buying X or shorting Y, just seconds after they heard flow sales guy Z shout across the floor that Fidelity was a better buyer|seller of X or Y. Now that the "prop" guys will be integrated into flow operations, the great internalities associated with collocation for big flow accounts will disappear as every trade ticket will have to provide allocation, and major trades that are prorated X to the account and Y to Goldman will draw far more attention if they continue to be 100% profitable, i.e. not trading alongside the failed trades, and only pocketing dimes on the successful trades. Bottom line, Goldman has just gone all flow, and it could well be the beginning of the end for the firm.

In other words, while Goldman had the option of pushing its prop traders into GSAM or any other client facing group before, it did not do so previously for a good reason, namely that it added one step of separation from the ultimate idea sourcer. Now this step will be gone, as ad hoc trades will raise many red flags and only client initiated trades will be kosher. Which simply means that Goldman will suddenly find itself with every single of its traders becoming a flow guy or gal. And as we have long claimed, Goldman's flow trading operation is a massive losing one: look no further than its Q2 results, which missed expectations merely due to one failed (vol) flow trade.

This is why we think that if this is indeed Goldman's response to the Volcker rule, it does in fact signify a victory for all those who still hold dreams of seeing an efficient and no-tiered market one day: the Goldman move simply means prop, for all intents and purposes, is truly dead. And just like the old sales model eventually gave way to trading in the early 2000s with everyone wishing to do flow, so with every trader doing the same trades for different clients will simply mark the latest point of diminishing marginal utility of market intermediation. Furthermore, as prop is to Goldman's "leading market indicator" signals, as Flash trading is to HFT frontrunners, the firm has just lost a huge competitive advantage in trading. In other words, look for margins to go down, coupled with the same move in bottom lines across the board, especially if all the other banks follow through in Goldman's footsteps.

As for actually fixing the prop/flow problem, the solution is so simple that we can see why so many banks continue to close their eyes to it, and prevent it does not exist: simply limit the amount of upside that a flow OTC position can generate - period. Banks are now utilities, courtesy of the SigTARP's latest disclosure of $3.7 trillion in backstops (and certainly much more), and as such, all upside should be capped. The downside can stay as is, since nobody is forcing banks to create markets: someone should remind banks that in addition to return, a concept known as risk does exist. Oddly enough, numerous banks already follow this route: bond flow traders at RBS for example have a limit on how far out from a given cost basis they can sell a given position for profit. Institute this protocol everywhere, and all the ongoing scandals over Volcker, its implementation, and associated loopholes become irrelevant. The banks are now utilities and should be treated as such.

 


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Wed, 07/28/2010 - 05:59 | Link to Comment Eduardo
Eduardo's picture

I am salivating just reading this ... after that JPM would be ideal

Wed, 07/28/2010 - 06:43 | Link to Comment Mercury
Mercury's picture

Hey, this "bank holding company" shit is getting old.  We ain't no stinkin' utility.  Time to morph back into a regular I-bank/broker/dealer.  Thanks for the TARP and the low cost of capital fellas, it's been real...

Wed, 07/28/2010 - 06:34 | Link to Comment confimationbias
confimationbias's picture

Holy crap.  This is almost giving me hope.

Wed, 07/28/2010 - 06:53 | Link to Comment French Frog
French Frog's picture

less of the "salivating" please!

next to hope, almost should be in bold rather than in italic.

this could have all the hallmarks of record profits for GS in the next quarter, along the same line of the S&P still being higher than where most rational observers think it should be;

when one starts thinking that his/her shorts are finally safe (GS, stocks....) it will turn and bite you one more time in the butt, just like it has so many times in the last 12 months

 

Wed, 07/28/2010 - 07:02 | Link to Comment Chemba
Chemba's picture

Oh, so that's how they did it.  The "prop guys" eaves dropped on the "flow guys".  Really.  How brilliant.

ZH, this is the most pathetic piece of false rubbish on GS posted since, well, I don't know, yesterday?

Wed, 07/28/2010 - 07:10 | Link to Comment bingocat
bingocat's picture

Thank you. It needed to be said.

Wed, 07/28/2010 - 07:15 | Link to Comment Chemba
Chemba's picture

thank you for seconding it.

all i will say is that I have about 1000x more personal experience and insights into the topic at hand than anyone at ZH.  I've been there, and this is just laughable garbage.

It is a shame when stuff like this is posted, because it erodes the credibility of what is often an interesting and insightful forum.  It would be like Porsche A.G. buying the rights to manufacture and distribute the 1979 Cadillac Cimmaron from GM.

Wed, 07/28/2010 - 07:22 | Link to Comment zhandax
zhandax's picture

Re-read the first sentence....this is from Fox's new 'crack' biz correspondent (nothing implied whether this is an adjective or a diagnosis)

Wed, 07/28/2010 - 07:26 | Link to Comment mephisto
mephisto's picture

Cool. So you interned there for 6 weeks. Tell us how it really works.

IMO everyone at GS is prop, as the culture is everyone maximises their own PnL. Call them what you like, they all punt.

Also (as a relic of the partnership) each desk head has a very clear idea of the firms view on each asset class and the overall market, and detailed infomation flows freely between these senior guys. So effectively there are no chinese walls, anywhere.

Wed, 07/28/2010 - 09:35 | Link to Comment zhandax
zhandax's picture

What could scream 'bullshit' louder on Wall Street than the concept of 'Chinese walls' in the same building; let alone between desks on the same trading floor?

Wed, 07/28/2010 - 11:38 | Link to Comment AccreditedEYE
AccreditedEYE's picture

Cool. So you interned there for 6 weeks. Tell us how it really works.

LMAO!!! Whole post was fantastic Meph.

Wed, 07/28/2010 - 07:23 | Link to Comment Tyler Durden
Tyler Durden's picture

Yes, really. And quite brilliant indeed. And due to your logarithmically greater experience, please remind the inexperienced ZH staff whether the minimum physical distance cutoff between a flow and a prop trader on the trading floor is 3 feet or 4 feet, and since when is wearing earmuffs for prop a part of required formal attire. Thanks in advance.

Wed, 07/28/2010 - 08:02 | Link to Comment Chemba
Chemba's picture

Let me try it this way.  If Goldman's business model is to front run its clients, to the detriment of its clients, then why does it have the leading market share across most equities and FICC products?  Are Goldman's clients stupid?  Fidelity, Wellington, SAC, Maverick, TIAA/CREF, Tudor, Paulson, DiamondBack, Citadel, Alliance, MassFi,...

Amazing to find out these firms are all populated by complete morons

Wed, 07/28/2010 - 08:17 | Link to Comment Commander Cody
Commander Cody's picture

You said it.  It must be true.

Wed, 07/28/2010 - 08:45 | Link to Comment Buckaroo Banzai
Buckaroo Banzai's picture

 

Morons? After they've been carpet-bombed with Ukrainian prostitutes, their IQs tend to drop a little.

 

Wed, 07/28/2010 - 08:52 | Link to Comment Tyler Durden
Tyler Durden's picture

Funny you should say that: it appears from your logic that everyone trading stocks without access to DirectEdge's flashing technology must be a complete moron for knowing full well that each and every submitted order is being front run in the open...

Wed, 07/28/2010 - 10:24 | Link to Comment Chemba
Chemba's picture

Well, ZH believes that is the case, and says so just just about every day, so I don't think we are tilling new ground here.

Wed, 07/28/2010 - 11:09 | Link to Comment Inspector Asset
Inspector Asset's picture

There are several methods that allow for the "prop" desk to communicate with the "flow" desk as I recall working on the CME floor.

Goldmans response sounds alot like commingling funds to me. Are they going to call the client every time they make a trade?

My view from "thePartnership" is that Goldman seeems to comingle "clients demands/trades" with their own trades.

It's like if the trade had a negative PR, they are quick to say stuff like "our clients demanded it."

 But otherwise, with PR neutraL OR positive, they are happy to take credit for the trade.

I would be really suspicious of this move by Goldman.

I thought they had 12 years to comply, and yet they are already finding loopholes. There must be something that smells of money here, simply because GS would not have made this move.

 

Wed, 07/28/2010 - 07:16 | Link to Comment emsolý
emsolý's picture

Ask not what your country can do for you, but why Goldman Sachs is a bank holding company -- i do it every morning, and i still don't know.

Wed, 07/28/2010 - 07:21 | Link to Comment Chemba
Chemba's picture

that is a legitimate question.  GS has banking operations but obviously they are small relative to the capital base and activities of the firm.

they became a bank holding company because of the confidence it gave markets in regards to GS' short term funding.

Is this appropriate?  Is it any less appropriate than JPM?  Shittybank?  Perhaps.   Will it change?  No.

Wed, 07/28/2010 - 07:29 | Link to Comment Cheeky Bastard
Wed, 07/28/2010 - 07:46 | Link to Comment mephisto
mephisto's picture

Thankyou Cheeky, I'll enjoy that.

What is surprising to me is the relatively few people who can take the next step and ask why the pure IBs changed their business model in this way. IMO they had to as JPM-Chase and Citi were squeezing every margin in every business. They felt it was 40xleverage or death. So in the end the story goes back to Citi/Travelers, Bob Rubin & the end of Glass-Steagal.

Wed, 07/28/2010 - 07:53 | Link to Comment Cheeky Bastard
Cheeky Bastard's picture

Bingo. At least someone gets it. It was either lever up or die for IBs at the end of the 90s. And they did the logical thing, they levered up. Paper is very interesting, especially the data sets in it. Some rather revealing point in there. 

Sat, 07/31/2010 - 17:47 | Link to Comment bingocat
bingocat's picture

Interesting piece on IBs. The "interesting" data sets are the ones which show the difference in ratios between survivors and non-survivors. However, while interesting anecdotally, I think those ratios are not the ones which are relevant. The problem with relying on simple ratios of accounting data is that those ratios do not reflect underlying risks to the firm. Part of the problem is that accounting rules are antiquated, are set by people who do not have adequate understanding of the issues in comparing. 

Looking at Balance Sheet...

Let's say an IB (let's use LEH because they are now gone) finds a US customer who wants to buy a structured note with principal protection and some measure of upside on EuroStoxx over 5 years. The IB effectively just purchases a 5yr zero coupon note for XXcts on the dollar and a call option with the remaining money (100-XX) from the street, and sticks it in a box and waits for maturity. Do this a thousand times on a thousand slightly different underlyings for $50mm each and you now have balance sheet of $50bn that you did not have before. This "balance sheet" usage has almost no risk to LEH. In most cases, it is a pass-through, with the investor buying something for $50mm which costs the IB $49mm to put together. IB "trader" gets $1mm of revenue. Customer gets his note. Balance sheet balloons. Look at those increased liabilities. Gasp! What happens when EuroStoxx goes up? Ouch! Liabilities go even higher!

This activity increases Debt/Equity ratios, and "leverage" even though it does not increase risk to the firm and does not use any money of the IB's shareholders to make it work (on the face of it). This was done hundreds of thousands of times, if not millions of times, across the Street, in EquityLand, FixedIncomeLand, CommodityLand, etc. All of those notes are on balance sheet as increased liabilities of the IB. All of the assets are "risk assets" on the firm's balance sheet. If a firm had ballooned its balance sheet this way, it would not have been a problem.

Looking at Funding...

The problem comes when some of those risks are then de-securitized and turned back into option liabilities and the assets used to hedge must be repo-ed in order to be funded (i.e. investor buys option on asset; IB must buy more $ of the asset to hedge the option than the IB received as premium for the option; IB buys asset using its own cash for 5% of asset amount, getting the other 95% from the repo market). This too is fine. Option makes money for IB (i.e. he makes money hedging it), and everything is peachy... UNTIL...

...some pension fund out there, who lost money on a real estate investment, or a pre-IPO investment in China, or a CDO-squared note, sees that they have less overall capital, so they have to reduce their risk investments (and reduce their cash pile) and stick more into US Treasuries. They sell their "bad asset", some stock (pushing the market down infinitesimally), and whatever else, raising cash to buy the Treasuries. The overall pension fund has declined in value by 1%. The allocation to cash may have declined by 2% (need to be more completely invested so as to make back the loss). That cash comes out of their account at BONY's cash management facility where it has been earning some cash rate slightly better than MMF rates in the tri-partite stock lending pool that BONY runs. Every counterparty lending stock into that pool is going to have their lines cut a little bit automatically, the IB included. This has nothing to do with who the IB is, it is just reflective of the fact that there is a little less money to go around. When it starts happening more often, if one particular IB is more present in that lending pool than others (as a percentage of their business), then they suffer more. The problem is that if someone gives them less cash, that IB cannot run its business. It HAS to fund itself short-term. The payoff on the risk doesn't belong to them - it belongs to the customer - but in order to hedge that payoff, IB has to own the asset. In order to own the asset, it has to fund it. If the customer is leveraged, so is the IB in its hedge.

I think if you were to dig into LEH and BSC, you would find that they were substantially more reliant on short-term funding from external re-hypothecation markets than most other IBs. You will probably also find that they had more outright risk on their books and less customer risk than the others (in terms of a percentage of their overall business). Others were reliant too, but less heavily. 

When everyone who had cash pulled it out of whatever program they were in (whether they were buying short-term CPs paying just above market issued by ABCP programs which funded longer-term assets, or putting cash into BONY's tripartite securities lending program (against stocks, corporate bonds, Treasuries, etc) and went to T-Bills "just because it was safer", it was that action which created a huge amount of the damage. IBs in that case are forced to unwind whatever trades they can which rely on that kind of funding. When they go to unwind it, they find that the would-be buyer is also affected; he has higher funding rates, so the IB has to accept a lower price because of his counterpart's higher funding cost.  

The lesson learned by IBs, some of which had not learned it before, was that long-term liabilities (i.e. 3-year options) can be dangerous when they are hedged by assets which cannot be re-hypothecated for the same term as the original liability. This has created a new emphasis on matching funding term to liability term, and on reducing leverage available to option counterparties (increasing margin rates means IBs can use the increased margin rates as a funding source - and margin has (by definition), the same term as the life of the option.  

 

Sorry for the longwindedness... I am sure most ZH readers are on top of this already. It is just that I don't think it is quite as cut-and-dried as "leverage ratios" or "Debt/Equity ratios", or what have you that most people use to explain what happened. A lot of the risk ratios which nearly killed IBs, such as the ratio of contractual term of liabilities vs contractual term of funding, are not available in the Annual Statement. These are things you have to know because you are involved in the business and you know that BSC and LEH are much more reliant on short-term funding. These are things that most CEOs didn't know, and many CFOs didn't know about their own firms, until it was too late.

Wed, 07/28/2010 - 07:34 | Link to Comment Dismal Scientist
Dismal Scientist's picture

Unless the entity is split up, so that the IB and the AM divisions are separate, then GS will find a way to circumvent whatever restrictions are put in place. They make so much money because its ALL they think about. The Terminator of Wall Street. I do not buy the story above, its unrealistic that they all suddenly became idiots overnight

Wed, 07/28/2010 - 08:43 | Link to Comment Buckaroo Banzai
Buckaroo Banzai's picture

 

oops

 

Wed, 07/28/2010 - 10:41 | Link to Comment Dang
Dang's picture

This is a "deck chair off the Titanic". Way back in '03 they instituted an "order sharing" system where any salestrader or salesman or prop trader can see the flow(customerorders) in any given stock. So what?! The real lying cheating and stealing is done in the back office. Now that the competitiion has dwindled( thanks to the "counter party risk" we only trade with other GS customers) and every major HF has prime GS...They see the flow, they see the aggregate positions of every small HF and large retail player and they give this info to SAC and the other thieves to shoot against! That is why they trade through GS. That is where the real lying and cheating and stealing takes place... Then you also need to realize the managers all have money in these HF's especially SAC!

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