Unintended consequences of a prop desk’s extinction

FT Alphaville attended an introductory course to securities lending and shorting the other day.

And amongst the interesting snippets divulged — especially in light of Michael Lewis’ recent article on the mysterious disappearance of prop traders — was a chart, from the International Securities Lending Association (which we’ve since been told we can’t show you).

It showed how capital/leverage employed by prop desks had falled from about $4,000bn in 2008 to, $400bn in 2009 and about $500bn in 2010. The equivalent fall for hedge funds was from $5,000bn in 2008 to $2,800bn in 2009 and $3,600bn in 2010.

From a securities lending point of view this is important, because it potentially accounts for the sharp decline in securities lending business over the same period, as the following chart from FinTuition demonstrates:

But here’s the thing.

Even the securities lending business is not really hedging its bets for the return of prop trading operations anytime soon.

Just as Michael Lewis notes in his article, not only are banks seemingly giving up on proprietary trading desks, they may have been making such moves way before regulators even hinted they might have to.

But that’s not to say they’re giving up on the prospect for prop-style returns.

Indeed, as Lewis notes, those efforts are seemingly being redirected towards so-called‘client-facing businesses‘:

After all, you don’t need a proprietary trading desk to engage in the two activities that any proprietary trading ban would seek to prevent: 1) running huge trading risks, and 2) taking the other side of the customers’ stupid trades. Goldman Sachs’ infamous Abacus program — the one that talked American International Group into selling vast amounts of cheap insurance to offset subprime mortgage risk, and then shorted the instruments they themselves had created — wasn’t dreamed up by the prop trading desk. It was the brainchild of what customers knew as the “Client Facing Group.”

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The answer may be none of the above or some mixture of the three. But what’s really striking is how little ability the outside world retains to find out what is going on inside these places — even after we have learned that what we don’t know about them can kill us. It would be nice to know, for instance, if the big banks are making these moves with the tacit understanding that the regulators, going forward, won’t be looking too closely at the activities of the “Client Facing Group.”

With that in mind, it’s interesting to note which trends are actually emerging in securities lending.

One, for example, is the preference towards of ETF stock borrowing in lieu of traditional single stocks. From one of the course’s power point slides:

Many prime brokers report a “lack of conviction” among their clients

Brokers also report that ETFs currently make up an unusually high percentage of short demand (substituting for stock)

Another is the preference towards non-cash collateralised positions:

Lehman default added to deteriorating liquidity conditions in money markets

Many cash collateral re-investment vehicles were required to impose redemption restrictions as a result

Clients moved away from cash collateral to focus on non-cash / ‘intrinsic value’ trading

These are interesting developments if you consider that instead of borrowing stocks for cash collateral, short-sellers are increasingly borrowing ETFs for non-cash collateral — which, depending on your counterparty can include everything from bonds, corporate bonds to equities.

This is a pretty important capability if you happen to be an ETF authorised participant, or for that matter a client-facing market maker in index funds generally — since you’re constantly dealing and managing stock inventory.

It’s also good business for custodians.

Which brings us to the latest piece by Paul Amery of Index Universe — a very insightful account into the power that lies behind the back-office plumbing in an ETF structure generally and the role of the custodian.

He notes, for example, that “fund custodians and administrators are no longer in the back seat”.

Furthermore, he suggests, it’s actually becoming the type of business former prop traders are keenly looking into:

For example, Paul Stillabower, head of business development for HSBC’s London securities operation, talked about how his desk is currently overflowing with CVs from former proprietary traders – a comment that rather neatly answers Michael Lewis’s latest Bloomberg piece (“The Mystery of Disappearing Prop Traders”).

Stillabower noted, tongue in cheek, that he might even employ some of them, though they’d need to be “re-educated” in fund accounting. But, whatever you might think of prop traders, they’re usually a fairly bright bunch, and their current interest in back and middle office roles tells you a lot, not just about where the regulatory wind is blowing, but also about the complexities involved in administering and running funds, which now requires a real variety of skills.

Which definitely makes sense. Put it like this. If collateralisation and over-collateralisation are key (and possibly permanent) side-effects of the crisis, it makes sense that the new ‘hot’ banking areas of tomorrow be the businesses that work with collateral, inventory and custody. And especially those that can sweat those assets best.

As Amery sums up, citing market sources:

Other speakers yesterday, such as Roger Fishwick, former fund manager and now a consultant at Thomas Murray, a global custody ratings and research firm, and Phil Brown, head of client relations at Clearstream,mentioned the increasing trend towards collateralisation.

“In five years’ time, everything will be collateralised,” said Fishwick. This rings true for those of us following the ETF market, as we’ve already seen issuers starting to overcollateralise swap exposure in their funds (i.e., they’re competing to do better than the 90% minimum required under UCITS), as well as the collateralisation of products that previously operated with raw credit exposure to the issuer (many ETCs, for example).

No surprise then that there’s been such a run on collateral, eh?

Related links:
Overcoming the Volcker rule, with ETFs - FT Alphaville
Did Socgen use ETFs to liquidate Kerviel positions? – FT Alphaville
Prime custody, and the business of collateral – FT Alphaville
All eyes on broker-dealer internalisation - FT Alphaville