Market making versus proprietary trading; client versus counter-party

In theory, it should be easy to tell the difference between market making and proprietary trading.  As the discussion about the Volcker Rule shows, in practice it is not easy.

In theory, it should be easy to tell the difference between a client for which there is a fiduciary obligation and a counter-party.  In practice, due to the convergence between capital markets and banking it has not been easy.

For example, the Telegraph ran a series of articles on small businesses that believed they were required to enter into a derivatives contract in order to get a loan.

Is a small business borrower a client or a counter-party for the loan and derivative package?

If we were only to look at the loan, then the borrower is a client.  At a minimum, the bank has a fiduciary responsibility in the form of lender liability.

If we were only to look at the derivative contract, then the borrower is a counter-party.  They are taking a bet on interest rates.

As Frank Portnoy said about the confusion between client and counter-party in a Financial Times column

Both Mr Smith and Goldman stretch the word [client] to cover not only true client relationships in which the bank owes a fiduciary duty as an adviser but also pseudo client relationships in which the company is a market maker, trading with counterparties at arm’s length. 

Goldman’s “muppets” are pseudo clients at most – fellow gamblers around a poker table. Goldman will ensure that the rules of the game are accurately described – the financial equivalent of checking to be sure there are 52 cards in the deck. But it is not obliged to act in a disadvantaged counterparty’s best interests, any more than a savvy poker player is obliged to show a poor player his good cards.

It is clear from the Telegraph articles that the banks treated the small businesses as counter-parties and made the disclosures for counter-parties (the banks made available an individual from their capital markets area to answer questions from and market to the small businesses).

What was equally clear and far more important is that the small businesses did not know they were no longer being treated as clients, but rather had become counter-parties who the banks had the right to fleece.  It is one thing to be at the poker table knowingly.  It is quite another to be playing poker when you do not know it.