Proprietary trading ”“ that rarefied world of playing with the company”™s money ”“ has been rescripted by the Volcker rule, which impedes those whose money is federally insured from overly delving into the practice.
The result ”“ part of the Sen. Christopher Dodd-sponsored Wall Street reforms that were signed into law last month ”“ may sprout new hedge funds in Connecticut.
“It comes down to the fact that these regulations are ultimately limiting what the banks can do with prop (proprietary) trading,” said Scott Witkin, president of Elevation Search, a private headhunting company that specializes in connecting talent with private banking and wealth management positions with location in Norwalk, New York and Miami.
Proprietary trading is when traders of institutions actively trade stocks, bonds, currencies, commodities, their derivatives or other financial instruments with the institution”™s own money as opposed to its customers”™ money, so as to make a profit for itself. The original Volcker rule, named for the economist and former Federal Reserve Chairman Paul Volcker, would have banned bank proprietary trading altogether.
The problem with the type of trading, and the catalyst for the formation of the rule in the reform, is that it encourages banks to take risks for profit with government-insured deposits. The new rule instead limits federally insured banks proprietary trading with up to 3 percent of their assets; it had been an undefined number before. The banks cannot have more than a 3 percent ownership stake in any hedge fund or private equity group.
The rule was amended to allow banks to invest in hedge funds and private equity funds at the request of Sen. Scott Brown, R-Mass., whose vote was needed to pass the bill in the Senate. “This is going to drive all the bonus-driven, performance-motivated traders to hedge funds and ultimately to Connecticut from New York because of the better tax rates,” said Witkin.
Proponents of the Volcker rule are already nervous that big banks have found ways to trade taxpayer-backed money for their own in opposition to the intention of the new law. Trading overseas and amending the roles of proprietary trading desks are conceivable targets of future regulations. The Connecticut Department of Banking declined a request to provide an outlook as to whether the Volcker rule would be effective.
“The traders are all paid by how much profit they bring in,” said Witkin. “It”™s going to push all the good traders to go to hedge funds and all the really good, entrepreneurial traders to open up new hedge funds. Off the bat, if you open in Connecticut instead of New York you”™re saving 15 percent right off the top.”?According to a published report, in response to the rule, Goldman Sachs remade hard-charging traders into asset managers, including half of its proprietary trading operation. The asset management positions allow the traders, who once would play the market with no consultation, to talk with clients before acting and therefore complying with the Volcker rule, which defines proprietary trading as operations completely unrelated to customer operations.
The original legislation has since been amended to address this specific way around the rule, a federal ability that seems to be keeping those options from being explored. Witkin said rather than trying to circumvent the law, the majority of major banks do seem to be complying.
“Financial reform is not thorough enough,” said Witkin. “The irony is that hedge funds will all move toward regulation eventually.”
For banks and financial institutions not willing to skate the thin bounds of proprietary definition, Sandy Gross, managing partner and founder of Pinetum Partners in Greenwich, said there”™s a large possibility that banks”™ proprietary trading desks will end up being outsourced in some form, taking the proprietary compliance responsibilities off the shoulders of the banks. Pinetum Partners is an executive search company specializing in hedge funds, investment banks and other securities firms.
“This is a great opportunity for some professionals to get together and handle the prop trading as a separate entity for banks,” said Gross. “It would be a private securities or brokerage firm that would act as vendor to the bank”™s prop trading needs.”
Gross said it is not clear if the reform means that banks”™ proprietary talent will head to hedge funds, start their own operations, or stay with their current operations; though each is a feasible option.
“I think many firms are still trying to figure that all this out,” said Gross. “I”™m not seeing people jump ship yet and,I”™m not hearing that everyone is being downsized at the banks. It only came out a week ago, so I think a lot of people are still trying to make sense of what this is going to mean.”
As for the future: “It looks to be a whole new wave of types of companies setup by people who don”™t want to be completely regulated by the government and prefer to be taking the risk,” said Gross. “I do talk to compliance officers and they are getting a lot of calls right now to join the hedge funds.”
