Liquidity would hold up if bank prop desks chopped

LONDON (Reuters) - New players would soon fill the void in the markets if the U.S. government prohibits banks from proprietary trading, leaving trading activity, exchanges and interdealer brokers unhurt in the long run.

Concerns about the impact of proposals by President Barack Obama knocked share prices on Friday for the London Stock Exchange, Deutsche Boerse and interdealer brokers ICAP and Tullett Prebon.

Analysts cited uncertainty about regulation and trading volumes as the reason for the drop, but market players said the rule would not impair market liquidity.

"Do I think it will lead to less activity in the financial markets? No," said Rob Kitchin, senior managing director at interdealer broker BGC.

"It will lead to different people doing it."

Quantifying the amount of bank proprietary trading is not easy. One technical problem is defining exactly what is proprietary trading, versus trading on behalf of clients.

Banks take risk on their books routinely when they act as dealers, although they aim to balance trades to end up with a minimum net exposure to risk at the end of the trading day.

But the proposal appears to be aimed at bank trading desks that are specifically designated to take hedge fund-style risk.

"The President's words clearly imply that market-making will be exempt," UK-based analysts for Bank of America Merrill Lynch wrote in a note on ICAP.

Prop trading accounts for 4.9 percent of revenue at Credit Suisse, 4.3 percent at Deutsche Bank, 4.2 percent at Barclays, 3.1 percent at Societe Generale and 1.4 percent at BNP Paribas, UBS analysts estimated.

Even while bank shares fell on Friday, critics said their quality of earnings could improve if the volatile and potentially loss-making segment was removed.

"Most of the gains from taking these risks went to the staff rather than shareholders, so I suspect long term shareholders will actually be grateful," said Helvea analyst Peter Thorne.

Keith Skeoch, chief executive of Standard Life Investments, one of the biggest UK investors, said: "We support the principle of reducing the ability of proprietary desks to engage in speculative trading particularly during capital raisings."

LIQUIDITY EMERGES ELSEWHERE

BGC's Kitchin said Obama and his economic advisers aimed to change the way banks operate, not to stop proprietary trading from taking place at all.

"Maybe it will end up that the banks split into two parts: a deposit-taking and retail side that plays it safe and a prop bank that does not have taxpayer backing," he said.

More hedge funds or other proprietary risk-takers also could emerge to take their place.

For the interdealer brokers, the client base might fragment, which could be good for their business, Bank of America Merrill Lynch analysts said in the ICAP note.

"If banks are prevented from prop trading, we would presume that risk capital will be provided in other areas," they said.

As for the exchanges, the analysts estimated that about 20 percent of trading flow at Eurex comes from proprietary trading, and less than half of that figure comes from banks.

The majority is from large investors who are direct members of the derivatives exchange.

If a big player pulls out, other investors spot opportunity and jump in to fill the gap, said an executive at a multilateral trading facility (MTF) who did not want to be identified.

"Something like this is a blip. We don't expect it to affect volumes at all," he said.

(Additional reporting by Steve Slater and Raji Menon in London and Martin De Sa'Pinto in Zurich; Editing by Rupert Winchester)