We have all heard about how ‘proprietary trading’ was considered to be the primary cause behind the US financial crisis in 2009. Proprietary trading, also called ‘prop trading’-is a kind of trading where investment banks and other financial institutions- instead of using their customers money, use their own money to invest in stocks, bonds, currencies, commodities, derivatives and other financial instruments.
This is done with the aim of “making short-term market trades to earn a profit for the company,” This is “in contrast to the normal business operations of investment banks, which include earning a commission through buying and selling investments on behalf of clients,” informs, eHow.com.
Rewards and Risks of Proprietary Trading
The reason why, eminent banks and prominent financial institutions have been ready to risk their own capital in such investments, is due to the fact that, “…it allows them to earn revenue outside of their normal business operations.” Additionally, they are also motivated by the belief that – “they possess a competitive advantage to earn substantial returns,” states, eHow.com.
However, “Proprietary trading is extremely risky and some banks have lost billions of dollars through investing in risky securities, which resulted in many financial institutions receiving government funds to remain viable,” the website claims.
Proprietary Trading Has Been Blamed for the Financial Crisis of 2008
Reporting on the financial crisis that happened in the US, five years back, The Economist says: “The collapse of Lehman Brothers, a sprawling global bank, in September 2008 almost brought down the world’s financial system. It took huge taxpayer-financed bail-outs to shore up the industry. Even so, the ensuing credit crunch turned what was already a nasty downturn into the worst recession in 80 years… With half a decade’s hindsight, it is clear the crisis had multiple causes.”
“To a certain extent, proprietary trading was the key driving force that was behind the disaster,” Jeremy Berkowitz, a finance professor at the University of Houston, states in an article by Stephen Gandel, in Time-Business and Money magazine. “For whatever the reason, Lehman and other banks decided to take positions in mortgages, and when those positions went south, so did the firms,” he says here.
“Academics and economists and even some Wall Streeters say proprietary trading and other principal investments played a much larger role in the losses that were at the heart of the financial crisis. What’s more, if the firms had been barred from using their own money to buy mortgage bonds, much of the credit-and-housing bubble might not have been able to form,” states Time-Business and Money magazine.
The Volcker Rule Ban on Proprietary Trading?
The US government, therefore, saw it fit to ban proprietary trading by banks, which came to be commonly known as, the ‘Volcker rule.’ Paul Volcker, the White House economic adviser, who was instrumental in drafting a proposal ban on proprietary trading by banks, “championed it as an adviser to President Barack Obama,” and believed, that it would “prevent deposit-taking banks from putting depositors’ money at risk,” states Bloomberg News.
“The Volcker rule is, in many ways, very simple: It prohibits the handful of biggest too-big-fail banks from making high risk speculative bets, typically very, very big bets, usually but not always with the banks’ own money as distinguished from investing and trading their customers’ money on their customers’ behalf,” the report quoted Volcker, as stating.
Was Proprietary Trading Really at the Heart of the Financial Crisis?
Many experts have questioned whether proprietary trading was really the central cause behind the 2008 financial crisis. One of them is, Max Abelson from Bloomberg News. In his report titled: ‘Prop Trading, the Bogeyman That Didn’t Take down Wall Street’- he narrates, how many were dissatisfied by the ‘Volcker Rule’ proposal. Reuters.com reports, how Paul Volcker also later acknowledged that the role of proprietary trading had not been central to the crisis. “Particularly, proprietary trading in commercial banks was there but not central” to the crisis,” he is reported to have said.
In conclusion, experts’ state that it is best to learn from the financial crisis of 2008 and the role that proprietary trading played in it. Whether its role was central or not, a cautious approach is needed to prevent another financial crisis from taking place. As a remedial measure, the New York Times reports, how the modified version of the ‘Volcker Rule,’ has now gained acceptance, even from those banks that had filed a lawsuit against it!
Image credit smartphotostock.com
article was written by Phil Steel, an experienced researcher and writer on finance and investment matters. His current area of interest is proprietary trading.