From Trading to Lending: How Big Banks Have Changed Their Tune
The Volcker Rule and post-crisis regulations have pushed banks out of proprietary trading and into the business of financing hedge funds.
How Big Bank Trading Has Evolved After the 2008 Crisis
The landscape of big bank trading has undergone significant changes since the 2008 financial crisis. Traditionally, banks engaged in both customer facilitation trading (buying/selling securities for clients) and proprietary trading (taking positions on their own behalf).
However, the Volcker Rule implemented after the crisis restricted banks’ ability to engage in proprietary trading. This led to a decrease in their market-making activities, which involves providing liquidity and facilitating transactions.
While customer facilitation remains a key function, several factors, including stricter regulations and a more risk-averse culture, have prompted banks to take a less active role in market making.
This gap has been filled by other players, primarily hedge funds. Hedge funds often possess similar skills and risk appetite to former bank proprietary traders, making them a natural fit for taking directional bets and providing liquidity.
Furthermore, recent regulations in the US aim to categorize certain hedge funds as securities dealers, reflecting their increased involvement in activities traditionally performed by banks.
The Rise of Prime Brokerage: How Banks are Shifting from Trading to Lending
Since the 2008 financial crisis, regulations have restricted banks’ ability to engage in proprietary trading (using their own capital to take bets on securities). As a result, banks have increasingly focused on prime brokerage, which involves lending money and providing other services to hedge funds.
Hedge funds often leverage borrowed money to amplify their returns, similar to how banks used to operate. However, the level of leverage employed might be lower than pre-crisis levels, aiming for a balance between risk and reward.
Banks as the New Lenders:
In the past, bank trading desks used the bank’s capital to trade. Today, they increasingly lend money to hedge funds who then conduct the actual trading. This shift reflects a strategic move by banks towards a more stable and fee-driven business model.
Prime Brokerage: A Growing Business:
Prime brokerage revenues for banks have been steadily increasing, fueled by the growth of the hedge fund industry. This trend suggests that financing could become the core function of bank trading divisions in the future.
Is This Model Safer?
While some argue that banks shouldn’t have been involved in trading in the first place, there is a broader perspective. Traditionally, banks lend money to businesses to support various activities. This lending, in theory, is considered safer than directly engaging in those risky businesses themselves.
Similarly, some believe that lending to hedge funds could be a safer and more sustainable business model for bank trading divisions compared to proprietary trading. However, this is a complex issue with ongoing debate and potential risks to consider.
