Prop trading? What prop trading?

July 23, 2010
Matt Cameron picks up on an interesting tidbit from the most recent Goldman Sachs earnings call:

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Matt Cameron picks up on an interesting tidbit from the most recent Goldman Sachs earnings call:

“As a result of meeting franchise client and broader market needs, we had a short equity volatility position going into the quarter. Given the spikes in volatility that occurred during the quarter, equity derivatives posted poor quarterly results,” Goldman’s chief financial officer, David Viniar, told analysts on a quarterly earnings conference call on July 20 …

Goldman’s results back up widespread rumours that have been circulating among rival dealers since May …

One exotics trader says the whole Street would have struggled in May to a greater or lesser degree. “This move caught people by surprise. Look at the Vix – it moved from 25 points to 40 in two days. It took two weeks to spike that much after Lehman – it’s a huge move. I can tell you every dealer on the Street was probably short skew and short volatility,” he says.

This is what Goldman does: it takes big positions in things like equity derivatives, and then it makes money when those positions rise in value. Or, less frequently, it loses money when those positions fall in value.

But note how careful Viniar was to characterize Goldman’s short-vol position as “a result of meeting franchise client and broader market needs.” This, of course, is a way of signaling to the market that his trading desk’s profits aren’t going away any time soon: they’re client-related, and they’re not the result of the kind of proprietary trades which are going to be banned under the Volcker rule.

I’m sure it’s true that in the second quarter Goldman sold a lot of volatility to investors wanting to hedge the risk that their stock portfolios would fall. But it’s a broker-dealer, and it’s entirely possible to engage in that kind of market-making without having an overall short-vol position over the quarter as a whole. Remember how markets are supposed to work: when everybody wants to buy something, its price goes up to the point at which there’s a genuine two-way market again.

If everybody on Wall Street knew that Goldman was short volatility, it’s pretty obvious what was going on. Goldman was selling a lot of volatility to clients, it thought that the price of volatility was more likely to go down rather than up, and so it happily sat on its short-vol position over most of the quarter, looking to make money as the price went down. Instead, the price went up, and it lost an estimated $250 million on those trades.

That’s prop trading. Yes, the equity derivatives desk was indeed meeting client needs, but it was also taking a proprietary directional position on where it thought volatility was headed. Viniar, on the conference call, was essentially saying to regulators, “you can’t prove this is prop trading, we’re just going to say that it was all on behalf of clients, and there’s nothing you can do to stop us.” I suspect he’s right.

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