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Inside the Prop Trading Exodus

Despite being given plenty of wiggle room by regulators to comply with the Dodd-Frank Act's ban on proprietary trading, Wall Street's biggest banks are wasting no time dismantling their prop desks.

Despite being given plenty of wiggle room by regulators to comply with the Dodd-Frank Act's ban on proprietary trading, Wall Street's biggest banks are wasting no time dismantling their prop desks.

Officially, the Volcker Rule takes effect July 21, 2012. But even after that deadline passes, regulators will give firms two years to dissolve products that violate the law's requirements. In addition, the Federal Reserve Board has the power to grant up to three one-year extensions for banks to jettison their prop-trading operations.

In other words, it could be years before banks need to officially stop making risky bets with their own funds. Despite the grace periods, the practice is quickly falling out of favor at some of Wall Street's most venerable firms. In recent months, Goldman Sachs, Morgan Stanley and JPMorgan Chase announced plans to shut down or spin off their prop trading units.

Industry experts point to a variety of reasons for the closings, including the notion that banks are tired of their villainous image and want to generate goodwill; and the difficulties they'll face in retaining top traders, who will hear the siren call of lucrative hedge fund offers even louder in the new landscape.

"Having been objects of intense rage, and having everything about their business criticized and beaten up in the press, the banks want to appear to be cooperating with regulators and not being continually defiant," explains Roy Smith, a New York University finance professor and a former limited partner at Goldman Sachs until the firm went public in 1999.

"Second - and this may be most important - how do you keep your traders down on the farm once they've read Dodd-Frank? They can see the handwriting on the wall."

Let the Exodus Begin

Smith points out that hedge funds already have poached several Goldman Sachs traders. Noting that the upside to starring at a large bank is even more constrained than it was prior to the Volcker Rule's passage, he contends this could be the start of a new trend.

Last fall, three Goldman traders raised $500 million each to launch their own funds. And in April, Morgan Sze, the former head of Goldman's principal strategies group and reportedly the firm's highest paid trader, launched a $1 billion fund - taking a large team from Goldman's trading desk with him. Citigroup saw eight employees in its 22-person prop trading segment bail out, Bloomberg News reported in March. Looking to stem the talent drain, the firm pledged to boost the unit's trading limits and capital.

"The banks have to get out because the people behind these operations are about to jump ship and they might as well arrange an orderly jumping rather than wake up one day and discover that all the human capital walked out the door," says James Angel, a finance professor at Georgetown University. So in order to keep profits churning and talent in-house, the big banks have been shifting the bulk of their prop traders into market-making roles.

"The banks have been setting up the notion that they don't really do proprietary trading - what they do is market making," NYU's Smith says, noting Goldman's claim that prop trading never generated more than 10 percent of the company's total annual revenue. As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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