Wall Street's Perfect Quarter: Easy Money and a Big Vacuum
Four big banks announced this week that their trading desks had pulled off the impossible -- 63 winning days in a row without a single loss. This is roughly equivalent to four major league teams pitching perfect games all on the same night. Of course, there is no brilliant strategy behind this bold news. It's the result of a potent combination: easy money from the government and pennies on the dollar from the rest of us.
When Goldman Sachs' (GS) trading desk announced that it had completed a perfect quarter, many commentators took it as just another sign that Goldy knows something the rest of us don't. But when JP Morgan (JPM), Bank of America (BAC) and Citigroup (C) also announced perfect quarters, it became clear that some fundamental, structural shift had occurred. As Bloomberg columnist Jonathan Weil wrote,
This isn't the way "trading" works in the real world. A simple exercise in measuring probabilities is instructive here. Let's say you manage a highly leveraged, diversified investment fund, and have become so skilled at playing the markets that you have a 70% probability of making money any given trading day. This would be a remarkable achievement in most markets. The odds that you would post a daily net gain 63 times in a row, though, would be about one in 5.7 billion.A big part of the trading desk success, of course, is their ability to borrow money from the Fed's discount window at 0.75%, then turn around and use that money to buy government paper that pays anywhere from 3-4%. As my colleague Barabara Correa pointed out, borrowing in this way used to be a shameful sign of weakness that the big banks avoided. But in the post-bailout world, it's a simple way to book profits.
The other important factor here is a shift by these "trading" desks away from what most people understand as trading. Picking individual stocks, buying them low and selling them high, is not an easy way to make a living, and it is absolutely not the most reliable way to make money every single day. Considering that the market has been volatile recently, the idea that all these big firms rode this roller coaster perfectly is preposterous.
But many of these firms no longer count on their traders to pick stocks. Goldman's chief operating officer, Gary Cohn, explained this puzzle. The banks incredible record, Cohn told Bloomberg, stems from the fact that the GS trading desk is moving away from proprietary trading to become a, "largely global market-making businesses."
This is banker speak for middleman, and here's how it works. These firms use computers to buy and sell huge volumes of stocks in milliseconds. They don't intend to hold the stocks, but to use the advantage of speed to make a few pennies, or fractions of pennies, off each transaction. As Stephen Gandel of Time put it:
It's less profitable, but it is reliably profitable. High frequency trading is just that--market making. So if Wall Street firms are doing more of that kind of trading--more high speed, less proprietary--than their perfect quarters are less impressive, and less suspicious, than the original headlines suggest.Gandel goes on to point out that at three of the four firms who recorded perfect quarters, the numbers seem to bear this out. Their Value-at-Risk measurement, which represents the amount a firm can stand to lose in a single day, all fell.
With an open ended supply of money from the government and the ability to outmaneuver the majority of investors, trading desks at these big firms are no longer players in the market. They have officially become the house. And while this may irk some small investors, on the bright side, that means less of the ultra risky behavior that led to the financial crisis.