How to Catch a Proprietary Trader
Who Decides if a Book's Proprietary?
Perhaps it is possible to create an expert committee of current or former buy-side and sell-side traders who have the expertise and lack an allegiance to any market makers. If there were sufficient evidence in the eyes of these experts that the book was being managed more as a proprietary book rather than a market-making book, that market maker could be subject to appropriate action.
However there is work to be done with specifics, like setting the industry baselines for the appropriate risk ratios, which will be accomplished over time. With proprietary trading defined for us in the Dodd-Frank Act, the challenge now lies in identifying proprietary activity at the institutional and trading book level.
The matter of setting criteria for what does and does not constitute proprietary trading is a topic many have views on, yet we believe that a majority of experienced traders, when presented with the facts, can determine when a book is being handled in a proprietary manner and in clear violation of the rule. Selecting the indicators, such as a measure of time that a book of business is "out of line" with other books on a VaR normalized basis, will take work.
However, at this time we believe that if it is done right, it would not be overly difficult or resource intensive. It should largely be an extension of existing internal risk management practices.
The too-difficult-to-model argument would also be out. We believe that existing VaR metrics should be utilized, as described previously. However, instead of setting some arbitrary "hard" quantitative risk limit upon which an investigation/audit would be triggered, we would advocate monitoring risk relative to the industry average for a particular type of product or asset class. This type of comparison is particularly useful since it eliminates the variability brought about by market movements, since all desks will likely hedge against anticipated risks. This approach would also substantially weaken the argument by any particular book manager aggressively "pre-hedging" customer business.
It is possible to raise the argument that trading audits could be made on an arbitrary basis if no "clear cut" standards are defined. But we believe that comparison to the industry norm is a tractable solution. This means that unless there is some kind of well-kept market-wide collusion, market risk levels across firms (on an adjusted basis) should be comparable. By examining books over time and on a risk-adjusted basis, suspicious situations could be individually audited on a more granular level. This would allow suspicious situations to be handled with a degree of care and responsibility not possible where hard limits are established.
In summary, regulators should be looking for a pattern of proprietary trading - not "proprietary trades." Instances of suspected proprietary trading could best be identified by using a risk-based methodology to examine comparable books across institutions on a relative basis. Furthermore, the threat of investigation under this methodology would provide a deterrent that would not exist under a hard-limit paradigm.
No method of regulation or oversight will eliminate the rogue trader seeking to make an individual bet for a quick buck. However, a method such as the one we propose would go a long way toward preventing large-scale sustained abuses, maintaining efficient market operations, and enabling regulators to flush out suspect trading activity, with the objective of reducing systemic risk.
Matt Samelson is Principal at Woodbine Associates, a Stamford CT-based capital markets research and consulting firm staffed by former mid- and senior-level industry practitioners. A former program trader with experience at Lehman Brothers, ITG, and Liquidnet, Samelson focuses on strategic, business, regulatory, microstructure, and technology issues that drive the equity markets.
Sean Owens is the Director of Fixed Income at Woodbine Associates, focusing on strategic, business, regulatory, market structure, and technology issues that impact firms active in and supporting global fixed income and derivative markets.
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