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

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Eduardo's picture

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

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...

confimationbias's picture

Holy crap.  This is almost giving me hope.

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


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?

bingocat's picture

Thank you. It needed to be said.

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.

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)

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.

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?

AccreditedEYE's picture

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

LMAO!!! Whole post was fantastic Meph.

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.

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

Commander Cody's picture

You said it.  It must be true.

Buckaroo Banzai's picture


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


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...

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.

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.


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.

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.

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.

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. 

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.

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

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!