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Goldman’s Prop Trading and Reputational Risk

Posted by Larry Doyle on March 12, 2010 2:52 PM |

On Wall Street, information is everything.

Timely access to information as to who is buying/selling what, how much they are buying/selling, and why they are buying/selling is absolutely invaluable. The Wall Street banks fight tooth and nail to protect their information franchises.

That said, there are supposed to be rules as to how information is handled and processed so that trading complies with the rules of the road. Banks are not supposed to front run clients. Banks are not supposed to give up client names. Do the banks practice what the regulators preach?  

Given the fact that Wall Street banks run both customer operations and proprietary desks, there are supposed to be Chinese walls in place to make sure that information is handled properly between desks. At the firms where I worked, the proprietary desks were either on a different floor from the customer desk or in an entirely different building.

Thank you to a friend of Sense on Cents for sharing a recently released report which would seem to indicate that the Chinese walls at Goldman Sachs would appear to be neither tall nor long (said in jest), but virtually non-existent.

Asset-Backed Alert, a Wall Street trade publication, reports:

Data-Sharing Worries Grip Goldman Clients
Investors are accusing Goldman Sachs of violating Wall Street code by permitting information-sharing between two types of collateralized debt obligation traders:those who work on behalf of clients and those who handle proprietary capital.

Goldman currently has the two desks situated next to each other in its Lower Manhattan headquarters. They also have a common supervisor, managing director Jerry Ouderkirk. Such a lack of separation is frowned upon by market players,and buysiders say the bank has committed an even graver transgression by allowing the traders to exchange information about CDO prices and dealflows.

Legally, investment banks don’t have to separate their proprietary and “client” traders. Most do anyway, as they don’t want to create the impression that they might be using insights into customers’ trades to their own benefits.

Virtually all banks have “firewall” policies in place between the two types of traders, and a majority of them also create physical barriers. Barclays, for example, keeps a CDO prop trader in Philadelphia and its client traders in New York. And J.P. Morgan has shuttered its CDO prop desk.

Goldman itself used to isolate its proprietary and client traders. But the bank united those personnel under Ouderkirk last year, perhaps to maximize the efficiency of efforts to unwind many of its on-balance-sheet positions in collateralized debt and loan obligations.

In the sector’s heyday, Goldman’s prop desk was among the
biggest buyers of subordinate CLO paper. It continued holding those positions through the 2007 creditmarket freeze, and began selling opportunistically late last year. The bank’s holdings appear to have fluctuated downward since then, from more than $1 billion.

With its proprietary traders mainly in selling mode, Goldman
might argue that it isn’t in a position to front-run customers who
are on both sides of similar trades.

A bank spokesman would say only that “Goldman Sachs has a strict framework in place to prevent the sharing of client information between our customers and proprietary dealers.”
Some investors, however, claim the close relationship between the bank’s proprietary and client traders creates an unlevel playing field. That’s mainly because the prop desk, regardless of whether it is buying or selling, could tap client traders for information about bond prices and the identities of others who want to do deals — privileged facts that aren’t available to the general buyside population. A few said they have cut off business with the bank, which is still doing some buying.

Separately, the fate of proprietary trading in general has been cloudy since President Obama said in January he would seek to implement a recommendation from former Federal Reserve chairman Paul Volcker that would push banks out of the business. Now industry players are waiting to see what parts of the so-called Volcker Rule make it into a financial-reform bill that Sen. Chris Dodd (D-Conn.) plans to introduce March 15. The issue, as one source put it, is an increasing lack of differentiation
between making markets and taking profits. “The line has been
more and more blurred over the years,” he said.

The proximity of these two desks is a clear indication that Goldman Sachs more highly prioritizes the benefits from timely information than the reputational risks associated with this questionable management decision.

I addressed this exact point of reputational risk and whether clients will want to do business with Goldman on my appearance on CNBC last week.


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