Opportunities to outsource the trading function will soon flourish as a means of creating value and improving return on equity.
And this can be the answer for those banks that want to act on behalf of customers but that also have the capital and risk appetite for some proprietary trading.
These are the banks that may not desire to compete head on with what could be called the global trading elite - companies like Bankers Trust, Goldman Sachs, and the Morgan Brothers (J.P. and Stanley).
Many emerging regionals and superregionals are in this position.
How It Used to Be
What's led to this juncture is the increasing difficulty of making a profit in the trading business.
Banks historically focused on three markets - taxable Treasuries and agencies, municipals, and foreign exchange. And they made money in three ways: serving customers, market-making, and position-taking.
The municipal market has certainly changed, with a greater emphasis now on public finance. But a balanced approach to customers, market-making, and position-taking still provides reasonable profit opportunities in this area.
The other markets have more radically changed, which requires an equally radical change in approach.
The customer business still offers some profit opportunities. While margins have shrunk for large, more sophisticated customers, the universe of customers has expanded and new products that offer larger margins, like mortgage-backed securities or swaps, are still attractive.
Disappearing Profits
Let's define market-making as buying on the bid, selling on the offer, and keeping the difference. Then let's admit that information technology, market liquidity, and competition have made profits in this activity all but disappear.
Let's further admit that the cost of traders and trading rooms has soared. Can't we, therefore, admit that no one - big or small - makes money this way anymore? (And, by the way, you cannot make it up with volume).
Position-taking is where the opportunity for a changed approach lies.
Traders hate to make those admissions about costs. But their market-making activities begin to look more and more like position-taking until they begin to openly discuss the "proprietary account" or the "proprietary group."
There are exceptions, but most of these efforts have produced higher overhead, inconsistent revenues (and therefore, unreliable net income), and more sleepless nights for management and directors.
Changes in Trading World
Let's look a little closer at this world of proprietary trading, which has changed much in the last five or 10 years.
For one thing, information technology has exploded. Every market has screens with bids and offers and trades. Market Vision Corp., Bloomberg Financial Markets, and others have put analytics at your fingertips. And news services offer instantaneous reports of news events that affect the markets.
Markets have gone global, with more of them trading around the clock. And commodity markets have become important as corporations have learned to participate. Do any of you remember customer conversations taking place five years ago about diesel fuel or copper prices?
One Affects the Other
The markets have gone from almost total independence to being almost totally interdependent. A change in German interest rates sends ripples through the foreign exchange and the U.S. stock and bond markets.
Volatility ebbs and flows from market to market. One market slows down and another picks up, and the profit opportunity in trading activity moves with it.
Short-selling is easy in most markets, allowing profit opportunity equally in a falling market or a rising market. Therefore, arbitrageurs and hedge fund operators are making good risk-adjusted returns.
The Big Players
And that global trading elite is making a lot of money in this new arena. How do they do it?
They are in almost all of the markets. And they are positioned to take advantage when profit opportunities arise, rather than pushing themselves when the opportunity is not there.
They are located in the market centers and use a variety of approaches. They employ the latest in fundamental, technical, quantitative, or arbitrage styles.
They have a large, established management and cultural infrastructure. They understand the various risks and regulations and can professionally manage a large, diverse team of very expensive people. And most of them have worked together for years and communicate well with each other.
And this elite group uses the best - and most expensive - trading and risk management systems.
Below the Top Echelon
If you are not among the global trading elite, you have five alternatives:
* You can take your capital and go elsewhere. Just say no to trading.
* You can do customer business and stop there. Use the liquidity of the markets to buy your product and sell it for a very thin profit margin, while emphasizing sales. Cut your staff, systems, overhead, and risk. This is a solid strategy for many banks, but it requires a steel-willed management because market folks are hard to stop.
* Compete with the elite, but without their tools; accept inconsistent returns on capital and overhead as you subsidize the market-making with whatever profit your customer activity gives you.
* Build the same infrastructure as the global trading elite and take them on. This is not a bad strategy, but only a few can succeed, and it will take a long time.
* Outsource some or all of your proprietary trading.
Outsource is clearly the new industry buzzword, as well it should be. Bank managers have come to the conclusion that if they cannot add distinctive value to a function, they can eliminate internal headaches and easily hire the best by letting somebody else do it.
This publication is now packed with stories about outsourcing everything from data and credit card processing to real estate management.
But how can you do that with trading?
New Investment Vehicles
The answer lies in the recent proliferation of investment vehicles, often in the form of partnerships.
Many of these use the liquidity and ease of execution of indexes and the futures markets to access many different markets, but without some of the complications of custody, such as local taxation.
These partnership vehicles can trade in a number of markets, including foreign exchange, domestic and foreign interest rates, foreign equities, and commodities.
The biggest demand fueling the growth of these vehicles has come from portfolio managers seeking to diversify out of traditional portfolios of U.S. currency, U.S. bonds, and U.S. stocks.
These vehicles offer access to other markets and styles that produce good term returns while lowering the risk of the overall portfolio through diversification.
Clearly a bank that views its asset ledger as a big investment portfolio funded with capital and leveraged with deposits would be interested in this approach, but that is not the point of this article.
A Trading Portfolio
My advice is to outsource. Pick several of these investment vehicles with a balance of cash and derivatives and a balance of markets - stocks, bonds, foreign exchange, domestic, and international.
Think of them as a portfolio and employ a"trading manager" to handle the portfolio monitoring, risk management, and administrative work.
The benefits are:
* You diversify - the markets you are in, the traders you use, and the trading styles.
* You "hire" traders you could never employ, and you can fire them by fax!
* You can "trade" in commodity and equity markets in the banks without Glass-Steagall problems.
* You can watch and learn from all of the relevant markets of the world.
* You can reverse course and get your money back without severance pay and equipment writeoffs.
* Your back office and overhead is almost nil because the partnerships and trading manager have to do all that stuff you hate.
* And, finally, you can make money on your capital when some of your other base businesses, like lending, are struggling.
The result is to get close to the results of the global trading elite without doing it yourself. I know it works because I've done it.
