Prop Trading – Do Not Try This at Home

The GAO last week released a report on Proprietary Trading of banks. The headlines feature a conclusion from the report that the six largest US banks did not make any money our of Prop Trading over the 4.5 years of the study period.

The analysis looks pretty straightforward.  But it is difficult to see if the conclusions are quite so obvious.

First and most important for a risk manager to notice is that this is a post facto analysis of a risky decision.  Risk Managers should all know that such analysis is really tricky.  Results should be compared to expectations.  And expectations need to be robust enough to allow proper post facto analysis.  That means that expectations need to be of a probability distribution of possible results from the decision.

Most investments had performance that was vaguely similar to the pattern shown above during that time.  Is the conclusion really anything more than a 20-20 hindsight that they should have stayed in cash?  That is true everytime that there is a downturn.   Above is a graph of a steady long position in the S&P.

On the other hand, traders in such situations seem to generally get paid a significant portion of the upside and share in very little, if any of the downside.  In this case, the downside cancelled out all of the upside.  The good years had gains of over $15.6 B.  If the traders were getting the usual hedge fund 20% of the gains, then they were paid 3.9 B for their good work.  In the bad years, banks lost $15.8 B.  That means that the gains before bonus were $3.7B.  Incentives were over 100% of profits.

The one other question is why investors need banks aas intermediaries to do prop trading?  Why can’t investors do their own prop trading?  Why can’t investors go directly to the hedge funds or mutual funds or private equity funds?

Ultimately, the report says that prop trading was not really significant to bank earnings and not a real diversifier of bank volatility.  So in the end, is there any reason for banks to be doing prop trading?

It seems that the banks are reaching that conclusion and exiting the activity.

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