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

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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