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.