Judge the trader, not the trading.
That’s the advice George Michaels, head of an industry software vendor, is offering regulators trying to stamp out proprietary trading by banks.
Their vehicle, the so-called Volcker Rule, has created an uproar in the industry because it characterizes some market making as prop trading. If passed in its current form, brokers complain, it will hurt liquidity and their customers.
At issue is the definition of market making. The proposed rule distinguishes the making of a market for the benefit of a customer from trading for the house’s account by the length of time a position is held. If a trader takes on a position and then disposes of it quickly, the rule considers the act to be market making. If the trader holds the position for a relatively lengthy period of time, it’s prop trading.
Brokers complain the distinction is arbitrary as some positions, taken on behalf of customers, will take longer to liquidate than others.
Michaels, chief executive of G2 FinTech, a recently launched vendor of tax software for hedge funds, maintains it is too difficult to distinguish between the two types of trading by looking at the positions they generate.
Michaels offers what he considers a simpler solution.
In a comment letter sent to the six authors of the Volcker Rule-Treasury, Fed, SEC, CFTC, OCC, and FDIC-Michaels suggest they look at trader compensation rather than trader behavior.
If the trader’s bonus is based on the profit and loss account of his department, then he’s a prop trader. If his bonus is based on the level of customer commissions, he’s a market maker.
“In the world of proprietary trading, traders are compensated purely on their P&L,” Michaels told the Feds. “For a proprietary trader, customer activity is, at best, irrelevant. In the world of legitimate market making, the compensation is based on commissions, and keeping customers happy is the trader’s entire focus.”
The authors of the Volcker Rule received about 15,000 letters from industry and the general public during the comment period that ended Feb. 13. In general, the bank-affiliated brokers did not fight the idea of a ban on prop trading. Their beef was with the rules surrounding market making. Michaels takes their side.
“You simply need to ask each trader how they get paid and you will know whether the firm is doing proprietary trading or market making,” Michaels told the Feds.
