Volcker Rule set to change market structure, says Shogi Group

Banks turning proprietary investment activities into hedge funds may not be able to trade as aggressively as they once did, says quant trading veteran Brian Brown.

Speculation is rife over what banks will do with their proprietary trading desks on the back of US reforms, with Goldman Sachs, JP Morgan and Morgan Stanley reportedly mulling whether to close, sell or spin-off such businesses.

The US Dodd-Frank financial overhaul bill was signed in late July and includes the so-called Volcker Rule, which curtails proprietary trading, private equity and other investments that banks make with their own capital.

Whatever firms decide to do, it is likely to have a major long-term impact on the structure of the markets, and may affect volatility in the short term. That is particularly true of big quantitative-trading operations, says Brian Brown, founder and head of algorithmic/high-frequency trading boutique Shogi Group in Hong Kong.

The largest prop desks have employed as much as $20 billion in capital at times, he says, but as they migrate into hedge funds they will have difficulty raising capital and using that kind of leverage without access to the bank's balance sheet.

“Banks enjoy tremendous leverage and minimal costs of execution,” explains Brown, who once served as director of pan-Asia systematic trading at Morgan Stanley in Hong Kong. “Thus, as hedge funds, they might not be able to trade as aggressively, which will change the market structure in the long term.”

Meanwhile, unwinding a desk could create severe short-term volatility, he adds, although it could also have no effect.

Brown cites the market impact of other large liquidations. In the aftermath of the Lehman Brothers collapse in September 2008, hedge funds with similar holdings experienced volatility as the liquidators unwound Lehman's books, he says, and there was a similar effect from the Bear Sterns fund bankruptcies in 2007.

“In any case, the effects on the market are uncertain and there could be no impact – investors should just be aware these events can contribute to volatility,” he says, adding that prop trading is just as significant in Asia, particularly Japan, as elsewhere.

It's certainly worth keeping an eye on how markets might move. “At the moment, we're monitoring a variety of indicators for potential inflection points that may be a good opportunity to long volatility,” says Brown, whose firm's research is used for in-house trading, as well as by private investors and macro hedge funds.

Still, these are only the early implications of the Volcker Rule, and it may be some time before the full effects are felt in the markets. “The window of compliance could be as much as four years down the road,” he says, “but many of the recent announcements are due to the employee's flight to hedge funds and the bank's awareness of the inevitable.”

JP Morgan, for one, will reportedly close all its prop desks globally, of which commodities trading is a major component. Yet this could be a relative drop in the ocean compared with other potential moves, given that JP Morgan has a relatively small prop operation.

Goldman and Morgan Stanley, meanwhile, are effectively the two biggest quantitative traders. They are examining the options open to them, whether that may mean transferring the business to an asset-management unit, seeding a hedge fund that would take over the prop activities or winding down the portfolio.

The latest reports say that Goldman will disband its principal-strategies business, one of its prop-trading units, which between them manage a total of around $9 billion. And Morgan Stanley may relinquish control of its in-house hedge fund, FrontPoint Partners, of which Christophe Lee, formerly of SHK Financial, is now Asia-Pacific managing director, as AsianInvestor reported last week. Both banks declined to comment on their plans.

No doubt some are waiting for further clarification on what will be required of them.

“Banks dabble in proprietary activities within many customer trading activities,” says Brown. “It remains undecided as to how the SEC [the US Securities and Exchange Commission] will define ‘proprietary trading’, and it will be interesting to see how and where regulators draw the line.”

Brown has authored a book, Chasing the Same Signals – How Black-Box Trading Influences Stock Markets from Wall Street to Shanghai.

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