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.