Prop trading model weighed in the balance: John Kemp

John Kemp is a Reuters columnist. The views expressed are his own.

LONDON (Reuters) - Enron's abrupt implosion in October and November 2001 should have convinced everyone of the risk inherent in large-scale stand-alone proprietary trading operations.

But in the years since then, the model still seems to have seduced some of the grandest names on Wall Street and a rapidly proliferating universe of imitators in New York, London and round the world.

Intellectual glamour and the fountain of apparently easy money fuelled a growing number of ever-larger prop desks within banks, hedge funds and trading companies. Principal investment assumed a dominant profile while lower-margin brokerage and asset management were relegated to lesser status.

Even after the music stopped playing in August 2007, the large-scale prop trading operations staggered on. But the year-long credit crisis finally seems to be forcing a fundamental rethink.

The model's basic problem has been over-reliance on short-term funding from the money markets -- or investors with relatively short monthly or quarterly lock-ins -- to fund investments which are much more long term and less liquid. Like a commercial bank borrowing short and lending long, prop shops have been vulnerable to maturity mismatch and liquidity risks, and the ever-attendant danger that actual or threatened losses will spark a rush for the exit and a classic bank run.

But unlike a commercial bank, prop traders have not had access to a central bank to act as lender of last resort. The model had an inbuilt flaw.

In its death throes, and rebuffed by the U.S. Treasury, Enron unsuccessfully sought support from Chevron Texaco. Essentially, Enron was hoping to use the oil company as an alternative lender of last resort, using its vast stable cash flows from millions of ordinary Americans filling up each week to provide the liquidity and confidence that had evaporated from the trader itself.

Enron's demise highlights the inherent instability of prop trading operations and the need for access to some form of lender of last resort with a stable cash flow generated from non-trading operations.

It is no accident that most successful proprietary trading operations are now located within the major oil companies and utility businesses, ultimately back-stopped by millions of customers who fill the petrol tank and have to pay their quarterly gas and electricity bills come rain or shine.

Nor is it an accident Wall Street's big securities houses have either collapsed, been merged into large commercial banks with a stable retail deposit base, or turned themselves into deposit-taking bank holding companies with access to the Fed.

Free-standing prop operations are not stable enough to survive on their own without a cash-rich parent - preferably one with an explicit or at least implicit guarantee of state support through access to the central bank and being too big to fail.

Prop trading has also been a victim of its own success. A strategy that produced outsized returns for a small number of institutions at moderate risk began to yield diminishing returns as more players entered the markets using the same strategy.

The only way to sustain the returns was to take increasing amounts of risk and rely on increasing amounts of leverage.

Not everyone can be a prop trader and make money. Many markets are essentially characterised as a zero-sum game -- for every buyer who benefits from a rise in price there is a seller who loses, and vice versa. For a time the game was positive-sum because non-prop participants provided an underlying flow of business (issuance of equity and debt, hedging physical risk, premiums for bond insurance, guarantees etc.) and paid the prop trading bills.

But as the volume of prop trading ballooned relative to the underlying flow of service-related business, prop traders have been increasingly trading with one another, and the zero-sum nature of the game has become more evident.

ALPHA MISCONCEPTION

Finally, the broad quest for "alpha" is based on a misconception, and a certain amount of hubris. Not everyone can beat the market. In fact, by definition for every dollar of positive alpha, there must be a dollar of negative alpha somewhere else, since the average is by definition just that.

It would be nice to think that alpha would accrue to the brightest and the best intellects. Unfortunately the financial services industry is populated by brilliant talents; the chances of being smarter than everyone else are not that high. Very few prop traders can consistently outperform the market in the long run for reasonable risk.

In fact, there are only four sources of sustainable alpha-generating advantage:

(1) Superior access to information (both from greater proximity to the market and other players, as well as the type of "inside information" that the regulators frown upon but which has proved the lifeblood of markets and impossible to eradicate).

(2) The ability to dominate pricing by running large positions relative to the size of the overall market and therefore move the market in the traders' own direction (either taking big enough prop positions, or drawing a large volume of customers into reinforcing trades).

(3) The ability to run complementary and reinforcing positions in related markets (eg cash, physical and derivatives) so positions in one can be used to support positions in another.

(4) Using significant leverage to magnify marginal trading advantages on thousands of trades (the strategy of picking up nickels in front of steamrollers).

For the time being, the use of leverage to juice up returns is no longer an option, at least until memories fade again. Successful prop trading strategies will therefore be based around superior access to information, the ability to run large positions, and presence in multiple related markets.

The prop trading market, in commodities as elsewhere, is set for a shakeout. It will re-form around two poles. At one end, the winners are likely to be large firms with strong capital backing, able to run large and reinforcing positions. At the other, small niche players with deep expertise and access to superior information. Firms occupying the middle ground, many of which relied on large amounts of leverage, will come under much greater pressure.

Surviving prop traders will be located within commercial banks, oil companies and utilities, or own other physical assets such as mines that have the assurance of large stable cash flows from non-trading activities. Or they will be independent funds and traders that can lock-in funding for much longer periods (two to five years, returning to the original hedge fund model, rather than one to three months) and with guaranteed access to substantial credit lines.