Saturday, March 3, 2012

Commodity trading sheds light on how Wall Street gains proprietary trading edge

Reuters ran an interesting article discussing the struggle between Wall Street's biggest banks and the Federal Reserve over Wall Street being able to retain their investment in warehouses, storage tanks and other hard assets.

Why is Wall Street fighting so hard to retain and expand their physical commodity operations?

For the same reason that they purchased mortgage origination and servicing operations in the years leading up to the financial crisis -- information.

Not just any type of information, but information that is the equivalent of having tomorrow's news today.

For example, mortgage originators provide information on both the mortgages they fund and the mortgages they decline and someone else funds.  It is useful to know who funded loans that did not meet your credit standards if you would like to short the market and not use mortgages you originated.

For example, mortgage servicers provide current information on mortgages because their data reflects all observable events that have occurred with the mortgages through the close of business yesterday.  This data provides an informational advantage when investors access to this same data lags by several days.

"The truth of it is that having access to the physical markets is about optimization and knowledge - it gives you the visibility of the market to make far more successful proprietary trading decisions in both physical and financial markets," said Jason Schenker, President and Chief Economist at Prestige Economics in Austin, Texas. 
"That's why for many years the most successful traders had access to both markets, and why we've seen little sign they're moving quickly to divest these assets now. It's trading with material non-public information - the difference compared with equity markets is that it's perfectly legal."
Mr. Schenker's point bears repeating.  There are markets like structured finance securities and commodities where it is legal for Wall Street to trade with material non-public information.

In the case of structured finance, there is a simple solution for leveling the playing field.  The solution is to require all structured finance securities to disclose all observable events involving their underlying collateral  one hour before the beginning of the business day following the business day on which the observable event occurred.

In the case of commodities, there is a simple solution for leveling the playing field.  The solution is to require the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  This way, market participants could see what these firm's trading positions are and adjust their exposures based on their assessment of these trading positions.

3 comments:

Anonymous said...

Not true. When I was at Lehman we bought mortgage originators and servicers so that we could save money. Why pay a premium to a third party originator/servicer when you could keep it in house?

Richard said...

I guess you have explained why Lehman went bankrupt and Goldman made a fortune shorting subprime mortgages.

Goldman understood the value of looking at the performance of the mortgages that they originated and serviced and using this information to trade on.

Richard said...

Anonymous,

Thanks for your insightful comment.

While I have written several posts on how trading benefits from having access to information, I have neglected to mention that businesses like origination/servicing or commodity warehousing are actually profitable in their own right.

As you point out, by owning these businesses, their profits can be shifted - who gets credit for the 'premium' once the originator/servicer has been purchased.