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http://www.nakedcapitalism.com/2010/01/quelle-surprise-proposed-restrictions-on-proprietary-trading-are-a-joke.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+NakedCapitalism+%28naked+capitalism%29

You can drive a supertanker though the loopholes in this proposal, which are:

1. If a firm does not own a bank, it can do proprietary trading 2. Trades with customers are not proprietary trades

These are so silly that I’m astonished anyone is treating this proposal seriously.

Let’s dispatch them in order. Whoever thinks that proprietary trading is just swell as long as the firm does not own a bank (meaning the kind that takes deposits) must have slept through the entire credit crisis (note I am not saying prop trading cause the crisis, but I guarantee there will still be reader who demonstrate in comments that reading comprehension is not one of their strong suits).

The implicit idea is that government backstops extend just to deposit-taking firms. That is patently ridiculous and is an attempt to hide from the public the reality of how the financial system works. Thanks to thirty years of deregulation, a very large portion of credit intermediation (finance speak for the process of providing loans) has shifted from banks to the capital markets. As most readers know, many types of loans are originated by a bank, combined with other loans, turned into bonds, and sold to investors.

For reasons too long to go into now, bonds are traded over the counter (this is not a nefarious plot; there are legitimate reasons why). Over the counter markets have economies of scale, and in particular, network effects. So trading of credit market instruments, over, time, is dominated by a comparatively small number of very large firms.

Credit is critical to the functioning of any economy beyond the barter stage. As economic activity became larger in scope and scale, and banks increasingly became the dominant credit providers, bank panics became a serious threat, and so various safety nets have been deployed under traditional banks, the biggest being deposit insurance and access to the central bank discount window. The quid pro quo was that banks were subject to strict limits on their activities and intrusive supervision. But those were eroded over time while the safety nets, if anything, became more extensive (consider unofficial support activities, such as Greenspan engineering a steep yield curve after the savings and loan crisis).

But now we have a world in which the credit markets are crucial to modern commerce, more so than banks. It would not be all that hard to break up the traditional commercial banking operations of Bank of America up. By contrast, once you get past hiving off non-capital-markets operations like asset management and commodities trading, it would be much more difficult to break up Goldman Sachs. And perhaps more important, absent regulation, it would tend to re-evolve back into its old format. A set of oligopolies, with information synergies among them to boot, is an extremely attractive business proposition. So any capital markets player of reasonable heft WILL be backstopped. That was the big lesson of the crisis just past and is not lost on the industry incumbents. Does anyone with an operating brain cell believe that if BofA divested Merrill and Merrill hit the wall again that it would be allowed to collapse? Look, we have twice had rescues of major non-banks, first LTCM, then AIG, due to the impact their failures would have ON CAPITAL MARKETS, not on depositors!

But the second one is even more of an insult to the intelligence, that proprietary trades and customer trades exist in neat, tidy boxes and a trade with a customer is therefore a pure act of mere passive order taking. When Goldman went net short subprime, was that not a proprietary position? And who do you think was on the other side of that trade? Hint: for the most part, not other dealers.

Why do you think institutional salesmen entertain clients so lavishly? Read Tetsuya Ishikawa’s How I Caused the Credit Crunch and find out how CDOs were sold. When a firm has a big position it needs to unload because it see market conditions change and it needs to change course, it will push it out to investors. The idea that putting on and unwinding prop trades takes place only with other dealers (which is what this is effectively saying) is bizarre.
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Clusterstock tells us how little impact the prop trading proposal will have (and it ran the very day the new proposals were announced):

Big banks have already begun poking the holes in Obama’s new rules—holes they expect their banks to pass through basically unchanged. The president promised this morning to work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

But sources at three banks tell us that they are already finding ways to own, investment in and sponsor hedge funds and private equity funds. Even prop trading seems safe. A person familiar with the operations of one big Wall Street bank said it expects that new regulation will affect less than 1% of its overall business.

And that’s before Congress waters the legislation down further. So much for change you can believe in….
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