The Beginning Of The End For Wall Street's Various Prop Trading Desks

It appears that prop trading could soon be on its way out. Luckily, it only accounted for "just over" 10% of Goldman's revenue: it will therefore likely not be missed. Bloomberg writes: "President Barack Obama tomorrow will offer new proposals on limiting the size and complexity of proprietary trading systems as a way to reduce risk-taking, a senior administration official said." While this is not yet the formal end of prop trading which may or may not be a legal way to take advantage of the commingling between flow and prop trading, thus scalping clients in a perfectly acceptable manner (define the word "acceptable"), it has all the makings of the beginning of the end. And, much more importantly, this marks the long-awaited beginning of Glass-Steagall's return.

So with a delay of about six months since Zero Hedge started pounding on the topic of prop trading as the last bastion of perfectly legal front-running, which co-opts clients into "efficient" flow execution with the few remaining monopolist entities left on Wall Street in exchange for assorted prop trading desks taking advantage of complete flow visibility (i.e., the hedge fund nature of all modern Wall Street bail out recipients) which is simply a way to run alongside (or in front of) whale orders, thus providing guaranteed and risk free returns, the administration has finally realized what we have claimed for many months: that prop trading is nothing but a quasi-illegal operation, which was made explicitly and perfectly permissible with the adoption of the disastrous Gramm-Leach-Bliley act. As long as prop trading exists, Goldman (which is reporting earnings tomorrow, and we expect will announce another quarter of 90%+ profitable trading days only thanks to it taking full advantage of a thorough visibility of the FICC and equity flow market and a commingled prop and flow order book) will have record earnings, until such time as the Minsky Moment in Goldman's balance sheet arises again and blows up the financial system one more time.

Let's recap some of the milestone in our analysis of prop trading:

We have claimed:

Goldman's head of PR claims the Goldman's prop trading accounts for only 12% of net revenue. Zero Hedge disagrees, and we would like to pose a question to Mr. van Praag which we hope Goldman will answer for us in order to refute our observation that Goldman may be disingenuous in its public statements...

  1. Goldman disclosed that it had $352.2 billion in fair value of principal trading instruments at September 30, 2009. How much of this is considered allocated to prop if this is in fact a distinct strategy from principal?
  2. Does the firm's FICC revenue line have absolutely no prop trading embedded within it? Goldman made $20 billion in FICC year to date: is none of this $20 billion due to capital at risk, or is it all due to wide bid/ask spreads?
  3. What was the pro rata allocation to Goldman Sachs Foundation as a percentage of capital per each trading ticket in 2008? Does GSF have a dedicated trading silo within Goldman?
  4. Why did the Goldman Sachs Foundation not participate in Goldman's prop CDS trades?
  5. How much did Goldman's prop operations lose in 2008 trading Russell 1000 futures?
  6. How much did Goldman's prop operations lose trading all equity, credit and commodity products?
  7. When will Goldman clearly and distinctly segregate on its income statement the prop trading profit and losses, if these are in fact unique from "principal" trading as defined, and attach an MD&A to all relevant disclosure?
  8. Lastly, we are still hoping to get a seating chart of Goldman's trading floor (via legitimate channels) which clearly discloses flow and prop traders' seats in order to disclose to the general public that flow and prop traders do not share the same information flow, especially that emanating from core clients who tend to move markets the second they announce their trading axes to Goldman's flow traders.

Which prompted the following Goldman response:

We’ve said publicly that prop trading represents approximately 10% of this year’s reported net revenue.  Some of that revenue is reflected in the FICC line.

We generate the vast majority of our revenue in FICC by facilitating trading activity for our clients and nearly all our revenues in FICC are “due to capital at risk” (your phrase).  In periods  when capital withdraws from the market, bid-offer spreads tend to widen and we benefit to the extent that we are willing to commit capital and do so successfully. These activities necessarily involve risk taking.

Over the last 5 years, prop investing activities have represented about 12% of firmwide net revenues

We have delayed our counter-response, until just the upcoming Obama announcement, at which point we will share our resultant thoughts on Mr. van Praag's ruminations. Yet, as Goldman's managing director highlights, prop trading is merely 10% of Goldman's revenue stream - we anticipate the firm will therefore endorse any proposed prop trading curb initiative of President Obama in the matter wholeheartedly as it will not impact the firm materially.

For those readers, relatively new to the topic of prop trading, here is what former Fed Chairman Paul Volcker said of the practice:

Ownership or sponsorship of hedge funds and private equity funds should be among those prohibited activities. So should in my view a heavy volume of proprietary trading with its inherent risks. Some trading, it is reasonably argued, is necessary as part of a full service customer relationship. The distinction between “proprietary” and “customer-related” may be cloudy at the border. But surely by the active use of capital requirements and the exercise of supervisory authority, appropriate restraint can be maintained.

Zero Hedge first brought up the potential of prop trading abuse in the context of certain nebulous boilerplate disclosure by Goldman. From Section 4(f) of the Goldman Sachs and Spear, Leeds and Kellogg client agreements:

You acknowledge that we may monitor your use of the Services for our own purposes (and not for your benefit). We may use the resulting information for internal business purposes or in accordance with the rules of any applicable regulatory or self-regulatory body and in compliance with applicable law and regulation.

Sure enough this prompted another response by Goldman, this time by Mr. Ed Canaday:

Your suggestion that we monitor our web site to facilitate front-running is untrue and offensive

Too bad Mr. Canaday did not address the language in Section 4(f). Also, as Marla pointed out:

I also notice that you do not specifically address our question:

"...has Goldman has ever actually used 360 submitted information in the decision making process of its prop trading desk?" Could you give us a response there? Perhaps you might augment that to include the decision making process of any Goldman investment decisions rather than just the prop desk and all information Goldman collects about 360 users.

Lest we are accused of being the only opponents to potential abuse by underregulated prop trading practices at Goldman, we recall the article in the WSJ discussing the phenomenon of the Goldman huddle, which at last check was being investigated by the SEC.

Goldman Sachs Group Inc. research analyst Marc Irizarry's published rating on mutual-fund manager Janus Capital Group Inc. was a lackluster "neutral" in early April 2008. But at an internal meeting that month, the analyst told dozens of Goldman's traders the stock was likely to head higher, company documents show.


The next day, research-department employees at Goldman called about 50 favored clients of the big securities firm with the same tip, including hedge-fund companies Citadel Investment Group and SAC Capital Advisors, the documents indicate. Readers of Mr. Irizarry's research didn't find out he was bullish until his written report was issued six days later, after Janus shares had jumped 5.8%.

Sure enough, after not addressing the topic of prop trading being a covert way to simply take advantage of its biggest clients, Goldman, at long last, issued the following mea culpa a week ago:

The Fundamental Strategies Group is a group of cross-capital structure desk analysts employed by our Securities Divisions to assist our traders. They develop Trading Ideas in conjunction with traders. We may trade, and may have existing positions, based on Trading Ideas before we have discussed those Trading Ideas with you. We may continue to act on Trading Ideas, and may trade out of any position, based on Trading Ideas, at any time after we have discussed them with you. We will also discuss Trading Ideas with other clients, both before and after we have discussed them with you

And for those curious to see Goldman's prop trading in action, Zero Hedge performed a forensic reconstruction of Goldman trading as principal, courtesy of tax disclosure for the Goldman Sachs Foundation, which demonstrates the facility with which Goldman traded such products as E-Minis, Dow Jones Minis, Russell 1000 Futures, and many other products.

Lastly, if anyone believes in such things, a study performed last year, found evidence that prop trading is not just borderline illegal. In many cases, it is flagrantly illegal:

Though prior research finds that analyst activity garners attention for the issuing firms more broadly, we document a dramatic effect on trading activity for the issuing brokerage firms around both upgrades and downgrades. Our paper is the first to document increased trading at the recommending firm prior to the release of an analyst report, strongly suggesting that one of the ways brokerage firms recover costs is through enabling advanced trading, and that the advanced trading comes to the market maker of the recommending firm. This effect has real and significant monetary implications for these firms, as both trading commissions and execution fees from spreads are generated from increased trading volume. While market making volume is not a measure directly applicable to securities exchanges with other structures, it is likely that proprietary trading, relationships with institutional clients, and client reaction to analyst information releases would be similar across exchanges. Our results are consistent with analyst recommendations still having value to investors in a postregulatory environment, though some investors appear to receive more valuable information than others...

We do not find corresponding increases in affiliated sell volume on the downgrade days themselves, though sell volume is significantly and positively related to affiliated downgrades before the actual revision date. We find evidence that a portion of the disproportionate sell volume prior to the downgrade date is institutional volume, and at least some of the volume comes from clients of the firm. A provocative finding is the relation between the presence of proprietary trading and associated revenue measures with predowngrade sell volume, which is suggestive of Rule 2110-4 violations.

Indeed, for all those who claim all aspects of prop trading are perfectly legal, we suggest you refamiliarize yourselves with Rule 2110-4.

We eagerly look forward to President Obama's proposed limitations on prop trading, and the resultant response by Goldman Sachs. We are confident that Mr. Viniar will have ample opportunity to address this topic during tomorrow's Goldman Sachs earnings call.