While the final FinReg bill, which passed in July, contained only a watered down version of the so-called Volcker Rule, it is becoming increasingly obvious that the nature of proprietary trading operations at large U.S. financial institutions will change as a result of the new rule. Indeed, reports of prop traders leaving the large financial firms for more entrepreneurial endeavors have already begun. The question is whether these prop traders will find similar success as they set out into the world of hedge funds.
Proprietary trading, where traders make bets for the house rather than for a customer, came under particular scrutiny in the wake of the recent financial crisis. The main criticism of prop trading at large financial firms is that the firm could be using its FDIC-insured deposit base to make risky bets for the firm’s own account. This would be equivalent to a taxpayer subsidy on funds used solely to benefit the firm. Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), commonly known as the Volcker Rule, limits proprietary trading by U.S. banking entities that benefit from FDIC backing or access to the Federal Reserves discount window.
The Volcker Rule
During the debate leading up to the passage of Dodd-Frank, former Fed Chairman Paul Volcker, after whom the rule is named, advocated a return to the pre-1999 system that required a separation of investment banks from deposit-taking banks. The final provision contained in Dodd-Frank was not so harsh as to require the separation of investment banks and traditional deposit-taking banks completely, but it does require banks to cease most prop trading activity.
As enacted, the Volcker Rule still permits trading that represents core banking functions. This includes certain types of market making, asset management, underwriting, and transactions in government securities. To enhance these offerings, banks may organize and offer a hedge fund or private equity fund to its bona fide trust, fiduciary, and investment advisory customers. However, the banks ownership interest in any fund may not exceed 3%, and the banks aggregate exposure to fund investments may not exceed 3% of its Tier 1 Capital.
While government agencies work to finalize specific rules, banks have already moved to mask their trading activities under the guise of client trading rather than prop trading. Many of the major banks Goldman Sachs, Bank of America, and JP Morgan, among othersseem to be testing the limits of the law by shifting traders from prop trading units to asset management units, where the traders can focus on trading for client-related purposes.
Additionally, the same top banks continue to make principal investments with their own money because the executives do not believe the practice constitutes proprietary trading. Just recently, Goldman Sachs announced its intention to buy a 12.02% stake in Taiking Life Insurance, a Chinese company. These so called principal investments arguably do not fall under the same category as prop trading because they are regarded as longer-term investments and carry higher capital charges. The GAO and SEC will surely consider whether such investments and similar strategies should be allowed as the agencies roll out regulations to implement the Volcker Rule.
Where’s a Prop Trader To Go?
Though the major banks have sought ways to keep some of their prop traders and maintain a portion of the healthy trading revenues, in most cases banks have still been forced to eliminate or trim their prop desks, leaving scores of traders in search of new opportunities. Many of these displaced traders have found jobs at existing funds. Brevan Howard Asset Management, a $25 billion macro fund, has hired three of Goldman Sachs top global macro traders Karl Devine, Andrew Dausch, and Brad Lord. Similarly, Brazilian investment bank BTG Pactual, formerly a unit of UBS, recently announced it had enhanced its global macro hedge fund with the addition of Ben Rick and his team from Merrill Lynch’s credit trading desk.
Even private equity firms are jumping into the mix. KKR has just hired a team of nine traders from Goldman Sachs’s prominent Principal Strategies unit to help build-out its asset management platform. Likewise, Blackstone announced recently that the firm is planning to seed a group of former Credit Suisse commodity traders for a new fund led by George Taylor.
Other traders have left the prop desks of bulge-bracket banks to start their own funds, many times keeping a portion of the team from the old desk. While the long-term success of these upstart funds will surely be mixed, initial investor appetite has proved strong. Perhaps it is fortunate timing, as asset flows to private funds have begun to tick up, but several new funds which spun out of big bank prop desks have found notable success raising seed capital. The trend favors these managers as a recent survey from Deutsche Bank shows that the hedge fund industry is expected to add $210 billion in fresh capital in 2011, reaching a record high $2.25 trillion in total assets. Were the industry to reach that mark it would far exceed the previous high of $1.93 trillion in total assets reported by Hedge Fund Research in 2008.
As Stuart Hendel, UBS’ former global head of prime brokerage, stated: In the next 12 months, there is going to be much more of a startup phase than there has been in the last couple years. Early success stories include ex-Goldman Sachs stars Pierre-Henri Flamand and Morgan Sze who have quickly amassed capital, with Flamand raising $1.6 billion for his event-driven fund, Edoma Capital, and Sze raising $1.0 billion for his multi-strategy fund, Azentus Capital.
Despite the success stories, many former prop traders will find it tough to achieve the same investor interest. Traders that spin out of prop desks generally leave without the benefit of a marketable track record to show prospective investors. Since prop traders are employees of the financial institutions for which they work, their ability to claim prior performance as their own is often extremely limited. A mix of general property rights and securities rules work against a prop trader looking to strike out on his own. On the one hand, the bank that employed the trader may claim that the track record belongs to the bank because the trader was an employee and because the results were generated only through use of the banks research, technology, and other resources. The securities laws will not help in most situations either. The SEC has strict rules about the use of past performance in marketing a private fund. If the past performance was generated under a similar strategy and under circumstances similar to those proposed for the new fund then generally a hedge fund manager can show past performance so long as the manager includes some disclaimer language describing the differences between the past and proposed strategy and circumstances. However, if the strategy or circumstances are very different then a trader may not be able to use the past performance at all.
Even with a performance history to show investors, questions abound about whether these prop traders will be able to replicate their success once they strike out on their own. Experts in the industry suggest that even those traders who are successful in raising money may struggle as hedge fund managers. As Patric de Gentile-Williams of FRM Capital Advisors, a hedge fund seed investor, recently stated: It is not a complete slam-dunk for us (to invest in a spin-out). The transition from prop trader to hedge fund manager is not totally obvious.
There are a myriad challenges that new prop traders face in opening a private fund. At a bank, the traders have access to a host of resources, expertise, and infrastructure. Prop desks would often receive the benefit of the firm’s best ideas and industry-leading technology. Launching a private fund will likely mean leaving these advantages behind. When the resources of a big bank platform are gone, these traders may find it more difficult to generate superior returns.
Further, prop traders at large institutions received the benefits of an entire operational infrastructure that allowed them to concentrate exclusively on trading. In contrast, succeeding as a hedge fund manager requires significant organization and management expertise. As a rule, traders that launch hedge funds generally underestimate the amount of time they will need to devote to managing the business. While new fund managers will want to devote as much time as possible to trading, they will often find themselves distracted as they handle employees, implement internal control policies, negotiate agreements, deal with regulatory and compliance issues, and manage the fundraising process.
Finally, running a fund requires a different approach to managing the portfolio versus running prop money. Prop traders answer only to the bank and are ultimately judged on their and their desks P&L. Hedge fund managers, however, must manage to a much wider array of expectations. Hedge fund managers need to maintain adequate liquidity to meet redemption requests, may be constrained by concentration limits, must manage to investor expectations, and will generally find it necessary to justify their decisions to a wide swath of investors with varying interests. This places an added stress on managers trying to meet and surpass already high expectations with respect to return characteristics.
The impact of the Volcker Rule is already being felt in the hedge fund industry, but you can bet that there is more change to come. An influx of new traders plying their hand in the hedge fund game has resulted in the expansion of existing funds and the formation of many new funds. With more capital entering the industry and expectations of record asset levels, it seems reasonable to expect success for some. However, the complexities and challenges in running a hedge fund cannot be overlooked, and so it remains to be seen whether these new fund managers will be able to replicate the results which earned them so much fame and infamy during their high-flying days on Wall Street.
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