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When Is A Prop Trade A Prop Trade, And When Is It A Hedge: A KPMG Case Study

Tyler Durden's picture





 

Back in December 2009, before 99% of the world had even heard of the concept of "prop trading", and before the Volcker Rule existed, Zero Hedge ran a targeted campaign (which Goldman responded to), trying to warn our readers of precisely the risk posed by prop trading by scouring the books of one Goldman Sachs. Back then we said: "For those uninitiated with banker lingo, prop trading is basically the profit that Goldman makes by transacting exclusively as a hedge fund: this is not agency or facilitation revenue, but merely principal positions that represent balance sheet risk for the firm. Of course, with the Fed having made clear that America would fail before Goldman does, the definition of risk as it applies to Goldman is laughable. Yet considering that Goldman must disclose a trading VaR, or value at risk on a quarterly basis, which over the past year has averaged over $200 million, one can back into what the actual prop capital and revenue generated by prop strategies is (VaR is simply a statistical calculation of how much Goldman would stand to lose if a "one in twenty" event occurred. It is not the maximum loss risk that Goldman has exposure to - a good example of a terminal event, i.e., one which would leave the firm bankrupt overnight, or a VaR of infinity with a narrower confidence range, would be something like the recently notorious "what if" of an aborted AIG bankruptcy, courtesy of Tim Geithner)." In other words, we mocked the very definition of prop trading in a TBTF, heads we win, tails you lose world, as well as the meaninglessness of VaR when the bulk of trading is on the back of guaranteed moral hazard: in other words, we made a strong argument for the split between prop and flow trading, which however is technically impossible in a post Glass-Steagall world.

A few weeks later Paul Volcker came on the scene and suggest precisely this in the rule that carries his name. Since then nothing happened. Yet last week's flame out at JPMorgan proved us right. What happens next will be yet another reminder that nothing has been resolved in finance when it comes to prop vs flow trading. So to help things alone, we go back to what we posted back in 2009, namely a KPMG case study analysis looking at the duplicity in defining this very ambiguous split between "Prop trading" and "hedging." At the end of the day there is no simple answer, but every bank that routinely regurgitates the generic statements: "We are not a trader”, We do not speculate”, and "We run a flat book – No net open positions”, should be forced to answer at least 5 simple questions: i) How do you define market risk?; ii) Do you take fixed price positions?; iii) Are you exclusively a hedger or do you “optimize” your assets?; iv) Do you have a risk policy? and v) How do you monitor trading/hedging limits?.

So, to show that the argument of prop vs hedge has been analyzed exclusively in the past, at least in companies where it economically makes sense to have this split, such as energy producers, it is once again long overdue, now that the days of the London Whale are numbered, to have every single Wall Street firm come clean unless all US taxpayers have to pay for the perfectly legal sins of a handful of greedy traders.

 

 


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Sun, 05/13/2012 - 11:43 | Link to Comment Aziz
Aziz's picture

Damn plop traders taking a dump all over the taxpayer.

Sun, 05/13/2012 - 12:18 | Link to Comment AldousHuxley
AldousHuxley's picture

when you don't own the underlying assets that you are trying to hedge.

 

 

Sun, 05/13/2012 - 11:45 | Link to Comment Poetic injustice
Poetic injustice's picture

Answer of average Wallstreeter:

How do you define market risk?

It's when wall becomes red, uh oh.

Do you take fixed price positions?
Yes, I like fixed prices on cocain and whores.

Are you exclusively a hedger or do you “optimize” your assets?
I optimize my assets, I have car and house taken on credit. I am also sending my son to college on credit.

Do you have a risk policy?
Yes, it's somebody else's fault.

How do you monitor trading/hedging limits?.
There are limits?

 

Sun, 05/13/2012 - 11:47 | Link to Comment LawsofPhysics
LawsofPhysics's picture

Does it really matter?  Not as long as fraud, corruption, and fascism remains the status quo.  Prosecute the fucking fraud, restore the rule of law, and consequences for bad behavior.  Take you pick paper-pushers, what is it going to be 100% regulation or 100% transparancy?  Atlas will continue to shrug otherwise.

Sun, 05/13/2012 - 13:41 | Link to Comment Joe The Plumber
Joe The Plumber's picture

My solution below is transparent and requires no regulations or expensive bureaucracy

Sun, 05/13/2012 - 11:50 | Link to Comment l1b3rty
l1b3rty's picture

The Artist Formerly Known as American International Group...

http://silvervigilante.com

Sun, 05/13/2012 - 12:03 | Link to Comment Snakeeyes
Snakeeyes's picture

Good piece.

Here is my take on the JPMC story of $2 billion loss.

http://confoundedinterest.wordpress.com/2012/05/13/regulation-jpmorgan-chase-and-the-parable-of-the-titanic-and-eastland/

The problem is POLITICIANS make the laws without understanding what went wrong. And they will rush to judgement ... again. Like Levin, Trumka and Big Chief Hiyataxa (aka, Elizabeth Warren).

Sun, 05/13/2012 - 13:25 | Link to Comment LawsofPhysics
LawsofPhysics's picture

100% regulation or 100% transparancy, what is it going to be?  The paper-pushers had better pick one soon and start prosecuting the fucking fraud, because Atlas will continue to shrug otherwise.

Sun, 05/13/2012 - 12:05 | Link to Comment iamtheeggman wh...
iamtheeggman whooooooooooooo's picture

Big Chief Hiyataxa (aka, Elizabeth Warren). Too funny.

Sun, 05/13/2012 - 12:11 | Link to Comment Everybodys All ...
Everybodys All American's picture

a self described socialist at best. The democratic party is now on its way even further left if this jackass gets elected.

Sun, 05/13/2012 - 12:39 | Link to Comment prains
prains's picture

In the circle jerk of life, left and right end up pulling each others junk

Sun, 05/13/2012 - 13:21 | Link to Comment LawsofPhysics
LawsofPhysics's picture

Still don't recognize fascism yet do we?  Yet another useful idiot that still believes the two-party lie.

Sun, 05/13/2012 - 23:03 | Link to Comment DanDaley
DanDaley's picture

It's not just fascism that is the problem, it's statism in all of its forms -whether socialism/communism/fascism or lefty community organizing, you name it.  Stalin applied the term "useful idiots" to the left in the US who were too stupid to see that they were really working for him.  He also labled the National Socialists (NAZIs) as fascists to denigrate them and  make a distinction between his (international) socialism and the (national) socialism of Hitler. 

This is a distinction without a difference, however; socialists/communists/leftists and fascists are all statists who will be happy to squash you like a bug if you get in their way.  Happy trails.

Sun, 05/13/2012 - 14:46 | Link to Comment falak pema
falak pema's picture

don't bad mouth a woman with a sweet face and good tits at her age.

Sun, 05/13/2012 - 12:43 | Link to Comment Waterfallsparkles
Waterfallsparkles's picture

You need to seperate the Banking Business from the Trading Business.  Banks should not be allowed to gamble with depositors Money or for that matter Mortgage escrow accounts.  Period.  How many think that the Money in their Escrow account for Property Taxes and Insurance is safe?  That is a big pile of Money they get to play with.

With the crash of 2008  the TBTF Banks scooped up all of the Trading Firms.  Bank of America got Meryl Lynch.  JPMorgan got Bear Stearns. They also bought up Major Mortgage Firms.  In the process they wiped out all of the Shareholders and in most cases the Bond Holders.

This just made them Too Much Bigger to Fail.

They need to re seperate these enities.  Spin off the Trading arm and the Mortgage arm from the Banks into seperate Businesses so that they Moneys cannot be comingled and gambled with. 

Maybe then they would be willing to lend money to the American People as that would be their only Business.

 

Sun, 05/13/2012 - 12:46 | Link to Comment ItsDanger
ItsDanger's picture

It was funny listening to one bank exec (I think posted on this site) on CNBC defend the notion of hedging risk from financing clients.  Charging more strict terms or requiring more capital seemed like a foreign idea to him.  Regulation shouldnt be focused on what banks do as the top priority.  The focus should be mainly on capital requirements.  That is their biggest failing.  Paying out bonuses to every employee is insane.

Sun, 05/13/2012 - 13:02 | Link to Comment falak pema
falak pema's picture

when is a whore a socially quantitive good bet, an economic green card, as qualitative frustration easing tool, ensuring social addiction to new newtworked game organised by a Mafia?

When is a priest an inquisitorial shill, a man working for the power within the holy shower?

Observe the mindset, see the structure behind the facade, it tells it all as we are what we do, not what we pretend to be. Is sterile, uncontrolled, opaque, megamonstrous sized risk taking in naked derivative bets the reasons for having banks? 'Cos thats what the WS/City banks ARE today.

Its the same old song played again and again. 

Sun, 05/13/2012 - 13:08 | Link to Comment AAA
AAA's picture

i) How do you market defined risk?; to gullible rating agencies

 

ii) Do you take price fixed positions?; or manipulate the silver market

 

iii) Are you hedging exclusively or do your assets “optimize” ;while the vulture hedge funds wait for the kill

 

iv) Does your policy have a risk ? or Bruno the Whale swimming in a tea cup

 

and v) How do you limit monitoring of trading/hedging ?. by the SEC and those clowns in the congress

Sun, 05/13/2012 - 13:37 | Link to Comment Joe The Plumber
Joe The Plumber's picture

It looks like banks can get around FINRA easily. Here is a good solution

All financial instruments bought by banks for their own accounts are to be publicly disclosed within ten days. Bankscould only safely make properly hedged "investments"

No need to hire a bunch of regulators or have a bunch of complex regulations. The market would take care of bank trades that werent properly hedged

Sun, 05/13/2012 - 14:25 | Link to Comment James_Cole
James_Cole's picture

"All financial instruments bought by banks for their own accounts are to be publicly disclosed within ten days. Bankscould only safely make properly hedged 'investments'"

Huh??

Sun, 05/13/2012 - 14:37 | Link to Comment Jim in MN
Jim in MN's picture

vi) When did you stop beating your wife (and taking a tax credit for the effort)?

Sun, 05/13/2012 - 17:12 | Link to Comment CryingBear
CryingBear's picture

WTF, A HEDGE IS A BET THAT YOUR POSITION WILL GO BAD. IT'S A FUKING TRADE.  LIKE THOSE NATURAL GAS FUKERS WHO "HEDGED". THEY WERE BETTING THAT NAT GAS PRICES WERE GOING DOWN. WTF IS THE DIFFERENCE.

YOU KNOW WHAT ELSE I FUKING NOTICE, EVER SINCE THAT JPM SHIT, COMMODITIES WENT TO SHIT.  I MEAN PLATINUM IS AT 1465 AND READY TO HIT UNDER 1400 SOON.

OIL OF COURSE WONT STOP UNTIL 90 AND WHO KNOWS WHERE IT WOULD GO.

FUKING COPPER IS DEAD, I HAVE NO REASONS WHY BUT I KNOW FOR A FACT IT IS DEAD. 

PS, GOLD MINERS BETTER HEDGE SOON BEFORE GOLD GOES TO 800.

BUT WHO GIVES A FLYING RATS ANUS, WITH THE CHINKS CUTTING RRR LAST NIGHT, WE SHOULD RALLY UNTIL 2:00 PM WEDNESDAY WHEN FOMC MINUTES COME OUT AND DENT THIS DREAM THAT COMMODITIES WILL NEVER EVER GO DOWN.

Sun, 05/13/2012 - 17:14 | Link to Comment CryingBear
CryingBear's picture

I DONT GET IT, WTF WAS JPM TRYING TO HEDGE IN THE FIRST PLACE.

Sun, 05/13/2012 - 17:38 | Link to Comment Standard Deviant
Standard Deviant's picture

many businesses cannot remove bais risk.  Nothing trades that is truly comparable or the liquidity isn't there.   Then someone has to make a decision about what is the most reasonable instrument and is it priced reasonably.  But then discretion is in the picture.   That doesn't neccessarily make it speculation.

 

IMO, the best way to tell if it is speculation or hedging is to look at HOW THOSE RESPONSIBLE FOR THE FUNCTION are compensated.   Any bonuses raises, etc... tied to profit center or overall company profitability are suspect.  It's not perfect, but best I know.

Sun, 05/13/2012 - 19:23 | Link to Comment Dingleberry
Dingleberry's picture

This issue kinda reminds me of a quote I heard some years back by then Pres Clinton (on trial for perjury or some shit):

"It depends on what the definition of 'is' is...."

Like porn.....you may not be able to completely define a prop trade vs. hedge, but you will know one when you see it.

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