Proprietary trading and the rise of casino banking: what private investors should know

Before the financial crisis, the biggest banks in the world were not just facilitating trades for their clients. They were doing it for themselves, with their own money, in markets they also controlled. That arrangement ended badly — for everyone except the bankers who left before the walls came down.

Proprietary trading, or prop trading as it is known in the City, is when a financial institution uses its own capital to take positions in markets. Not money held on behalf of clients. Not fees earned from advisory work. The bank’s own balance sheet, placed directly into stocks, bonds, derivatives, currencies or commodities in the expectation of profit.

For much of the 1990s and 2000s, proprietary trading became one of the most profitable activities inside the major investment banks. Goldman Sachs, Deutsche Bank, Barclays Capital, Lehman Brothers and others ran large and semi-autonomous prop desks that generated returns uncorrelated with the fee-earning businesses around them. These desks recruited the best mathematicians and traders they could find, paid them handsomely, and gave them considerable latitude to run positions that had nothing to do with serving clients.

The problem, as became clear in 2007 and 2008, was that this was being done with borrowed money at extraordinary levels of leverage. When the structured credit markets that had been so profitable for so long began to unravel, the losses were not contained to the prop desks. They spread across entire institutions, because the same balance sheet that funded speculative bets also underpinned the bank’s obligations to depositors, counterparties and clients. The distinction between a client-facing commercial bank and a proprietary trading operation had, in practice, almost completely dissolved.

The regulatory response in the United States was the Volcker Rule, named after former Federal Reserve chairman Paul Volcker, who had long argued that deposit-taking institutions had no business speculating with their own capital. Introduced as part of the Dodd-Frank Act in 2010, the rule prohibited US banks from engaging in short-term proprietary trading of financial instruments for their own account. In practice, implementation proved enormously complicated. The line between making markets for clients and speculating on your own behalf is not always obvious, and banks spent years arguing about where exactly it fell.

In the United Kingdom, the response took a different form. Rather than a direct ban on specific activities, the approach was structural separation. The 2013 Financial Services (Banking Reform) Act, drawing on the recommendations of the Independent Commission on Banking chaired by Sir John Vickers, required retail banking operations to be ring-fenced from investment banking activities. The idea was that if a bank’s prop trading book blew up, the damage would not automatically flow through to the accounts of ordinary depositors. HSBC, Barclays, Lloyds and NatWest all had to restructure accordingly, at considerable expense and complexity.

What happened to the prop traders themselves tells its own story. Many of them did not disappear. They moved. The years after 2010 saw a significant migration of talent and capital from bank prop desks into hedge funds, multi-strategy asset managers and internal principal investing operations that sat at one remove from the regulated entity. Citadel, Millennium Management and a handful of other multi-strategy platforms absorbed a generation of former bank prop traders and gave them something close to the same structure they had known, without the new regulatory constraints. The activity did not end. It relocated.

For private investors, two things matter here. The first is what ring-fencing was designed to protect against: the socialisation of losses from speculative activity. Before 2008, the implicit guarantee behind the banking system meant that the risks taken by prop desks were not borne entirely by the banks themselves. When things went wrong at the scale they did, governments stepped in. Taxpayers covered the gap. The reforms of the subsequent decade were an attempt to break that link, so that casino risk-taking did not automatically become a public liability. Whether they have fully achieved that is a question serious people continue to disagree about.

The second issue is more immediately practical. Even after the Volcker Rule and ring-fencing reduced the scale of direct proprietary trading within banks, conflicts of interest between market-making and principal trading have not vanished from the financial system. A firm that makes markets in a particular share, posting prices at which it will buy or sell, accumulates information about order flow. It sees who wants to buy and in what size. It knows where the pressure is building. That information does not need to be formally shared with a prop desk to create a structural advantage. The act of being in the middle of markets is itself a form of informational edge.

For a private investor placing a trade in a thinly traded small-cap stock, this is not an abstract concern. The spread between the buying and selling price is partly the cost of market-making services. But it also reflects the commercial interests of the firm on the other side of the trade. Understanding that the entity facilitating your transaction has its own book, its own positions, and its own profit motive is simply an accurate description of how these markets work.

The era of full-scale in-house casino banking may be largely behind us, constrained by regulation and reshaped by crisis. But the instincts that created it, the belief that being closest to the markets confers advantages that should be exploited, have not gone away. They have adapted, as they always do.

This post is drawn from The Street-Smart Trader by Ian Lyall. Republished with permission.

Street Smart is a series drawn from first-hand experience of the City of London, updated as each new chapter arrives.

Disclaimer: The value of investments can go down as well as up, and you may get back less than you invest. This article is for informational and educational purposes only and does not constitute financial advice. Always do your own research and consider seeking independent advice before making any investment decision.