Proprietary trading (Wikipedia): The term used in investment banking to describe when the firm’s traders actively trade stocks, bonds, options, commodities, or other items with its own money as opposed to its customers’ money, so as to make a profit for itself.
Not so easy anymore says former Sempra Metals-economist turned Reuters columnist John Kemp.
Prop desks largely depend on four different strategies to outperform the market.
(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).
With the leverage factor now crossed out, existing operations are inevitably going to have to depend on strategies 1-3. Without corresponding access to short-term cash, a choke is possible at any given moment.
Kemp refers to Enron as a case in point. Unable to tap the Fed window, when capital ran dry they had no alternative but to seek help from cash-rich Chevron Texaco. The group’s demise, he writes, highlights the inherent instability of prop trading operations - the need of some lender of last resort with access to stable cash-flow generated from non-trading operations.
According to Kemp, it’s no surprise therefore that most successful prop desks are now located within the major oil companies and utility businesses. These groups naturally have superior access to information via control of commodity production and infrastructure. They tend to be cash-rich. They can dominate pricing via their natural long positions. And they can easily backstop derivative positions with the physical. Kemp writes:
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.
No surprise Morgan Stanley has been actively building up physical infrastructure positions in the commodities sphere for years.
Meanwhile, he warns, times could get harder for merchants and physical commodity trading houses as credit dries up, and surging volatility and margin calls force positions to be cut. Higher funding costs are already shaping the forward curve in commodities, he says. The intensification of the contango (where futures prices trade above the cash market) shows the cost of carrying crude oil has risen to as much as 13 per cent, aluminium 11 per cent, zinc 10 percent. It should reflect storage, insurance and funding costs usually. Although, it’s worth pointing out others suggest the curve could be reflecting concerns over supply going into the future. Nevertheless, on the matter of prop desk Kemp concludes:
Once again, the industry looks set to polarise around the largest best funded firms, and at the other end niche players with deep expertise and secure finance for smaller books.
Related link:
Prop trading model weighed in the balance - John Kemp
