2 What is proprietary trading?
4. The term "proprietary trading" when
applied to a bank could in theory refer to any trading activity
which results in a proprietary position for that bank—in
other words, where price movements in the relevant market affect
the bank's bottom line. However, such a definition would be so
broad as to be effectively meaningless. As HSBC pointed out:
Banks act as principal in virtually all transactions
and therefore all market price movements accrue to the stated
capital position of the bank either through the profit and loss
account or directly to reserves in defined circumstances.[5]
5. Some witnesses proposed a more restrictive
understanding of proprietary trading in order to focus on the
activities of greatest concern. Lloyds said:
We would define proprietary trading as the risking
of a bank's own capital by taking positions in financial instruments
in order to make gains from market movements, where such activities
are speculative or run as a specific business with the sole aim
of the bank making a profit for itself.[6]
RBS suggested that the defining characteristic of
what they termed "pure" proprietary trading was that
it was unrelated to any customer activity:
If the bank is using its capital for its own account
to generate profits (and risking taking losses) from illiquid
inventory, disconnected from customer activity, then that is "pure"
proprietary trading.[7]
6. This form of proprietary trading is the clearest
expression of so-called "casino" banking, where traders
are speculating on markets using the bank's capital and borrowed
money, for no purpose other than to make a profit and without
any connection to trading on behalf of customers. Prior to the
financial crisis, many global banks explicitly engaged in this
form of proprietary trading, setting up dedicated units or internal
hedge funds. One of the best known examples was Goldman Sachs'
"Principal Strategies" group, which was reported as
accounting for 10 per cent of the bank's revenue before being
shut down in response to the prospective Volcker rule.[8]
UBS put significant capital into an internal hedge fund called
"Dillon Reed" in 2005 in an attempt to stop star proprietary
traders defecting to external funds.[9]
Morgan Stanley wrote to shareholders in 2005 saying "we are
employing more of our own equity capital to work in principal
investing".[10]
Citigroup shut its "Equity Principal Strategies" business
which made proprietary trades only in 2012.[11]
7. However, even at the height of the boom, when
banks were expanding their proprietary trading, many banks made
only limited public disclosure about their proprietary trading
activity, instead including it within reports about total trading
revenues. It is therefore difficult accurately to gauge the scale
of such trading. The trend towards dedicated proprietary trading
units appeared to have been more a feature of US banks than UK-headquartered
banks. Most UK banks did not mention proprietary trading in their
public reports, and Bob Diamond, the then Chief Executive of Barclays
of Barclays, claimed in 2010 that Barclays "closed down our
proprietary trading in 1998".[12]
RBS's 2007 report simply noted that
The primary focus of the Group's trading activities
is client facilitation [...] The Group also undertakes [...] proprietary
activity—taking positions in financial instruments as principal
in order to take advantage of anticipated market conditions."
8. Some banks suggested in evidence that it was
dedicated proprietary trading units which should be the focus
of attention. Lloyds said that pure proprietary trading "would
typically be an activity that banking groups would undertake through
a dedicated unit, segregated from client-facing business areas
and often with segregated capital, limits and remuneration policies".[13]
HSBC echoed this point,[14]
while Barclays sought to distinguish proprietary trading conducted
by stand-alone desks from two other forms of "beneficial"
trading—namely market-making and risk-hedging.[15]
9. It is not the case that even "pure"
proprietary trades can only arise if there is a stand-alone desk
devoted to the activity. Parts of the bank which actively trade
for other reasons, such as the market-making or risk-hedging activities
mentioned by Barclays, could in theory use such activity as cover
to engage in market speculation in pursuit of higher returns.
For example, as HSBC and Standard Chartered pointed out, a market
maker might legitimately choose to take a long position in an
asset either in anticipation of client demand to allow the order
to be fulfilled quickly, or to facilitate a quick sale by a client
of an illiquid asset.[16]
Expectations about the direction of the market price would quite
reasonably factor into such a trading strategy. However, if traders
used these opportunities to take large positions on anticipated
market movements without any imminent expectation of unwinding
the trade, this could be regarded as "pure" proprietary
trading. Similarly, the treasury function of a bank will need
to engage in trades, for example to manage excess liquidity or
hedge the risk from selling fixed-rate mortgages while funding
with floating rate borrowing. However, over time the treasury
functions in some banks became more aggressive traders, with strategies
that could be seen as resembling proprietary trading. As Lord
Turner told us:
those treasuries had developed into huge profit centres
in themselves, which were not merely managing the natural consequences
of the balance sheets, naturally arising from customer activity,
but doing a set of activity in themselves.[17]
10. There is no commonly-accepted
definition of proprietary trading. Most activity undertaken by
banks results in some form of proprietary position. In principle,
the type of trading which causes the greatest concern is where
the bank is using its own funds, raised from shareholders, depositors
and creditors, to speculate on markets, without any connection
to customer activity. This has been the main focus of our consideration.
Some banks, particularly US investment banks, historically had
units dedicated to such activity. However, an examination of proprietary
trading which only considered such units would be inadequate,
because speculative activity can also take place alongside customer-related
trading.
11. The difficulty of moving beyond this theoretical
definition to being able to differentiate in practice between
what has been termed "pure" proprietary trading and
the other kinds of trading activity is considered in more detail
later in this Report. As will be seen, there is a wide range of
activities which may from the outside look like proprietary trading,
but which banks could attempt to justify as being related to customer
business or hedging. Equally, proprietary trading for the benefit
of the bank can be, and frequently has been, contrary to the interests
of its customers.
5 Ev w12 Back
6
Ev w17 Back
7
Ev w20 Back
8
"Goldman Sachs Said to Shut Principal Strategies Unit",
Bloomberg, 4 September 2010, www.bloomberg.com Back
9
"UBS's Investment Bank Chief Costas to run Hedge Fund (Update10)",
Bloomberg, 30 June 2005, www.bloomberg.com Back
10
"Letter to Shareholders", Morgan Stanley, 1 February
2006, www.morganstanley.com Back
11
"Citigroup Exits Proprietary Trading, Says Most of Unit's
Workers to Leave", Bloomberg, 27 January 2012, www.bloomberg.com Back
12
"Barclays' Bob Diamond says casino critics have 'no basis
in reality'", The Telegraph, 11 September 2010, www.telegraph.co.uk Back
13
Ev w17 Back
14
Ev w12 Back
15
Ev w1 Back
16
Ev w12; Ev w25 Back
17
Q 1007 Back
| 
