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One last prop trade for Goldman?
August 24, 2012 / 5:00 PM / 5 years ago

One last prop trade for Goldman?

NEW YORK, Aug 24 (IFR) - As US regulators put together the final touches to the controversial Volcker Rule, Goldman Sachs’ third-quarter results are likely to reflect the benefits of one last proprietary trading hurrah from the purchase - and subsequent sale - of Knight Capital’s accidental stock portfolio.

Knight’s trading algorithms suffered a catastrophic glitch earlier this month, buying stocks worth several billion dollars. The brokerage turned to Goldman for help and the investment bank is understood to have bought the portfolio at a discount. Analysts expect Goldman to pocket profits of between US$100m and US$230m after unwinding the portfolio.

Analysts have been steadily revising Goldman’s third-quarter earnings estimates higher in part on the expectation of big profits from the Knight transactions.

According to Rochdale Securities bank analyst Dick Bove, the deal could be worth 15 cents a share to Goldman this year. Morgan Stanley has raised its third-quarter estimate for Goldman by 32 cents - in part on trading the Knight portfolio.

Goldman’s third-quarter results will also be enhanced by trading non-US sovereign debt, the high-yield market and performance fees from its asset management division. The boost is a welcome one given the weak trading environment.

Still, the deal between Goldman and Knight Capital is controversial. The final Volcker Rule comes into effect in January and will ostensibly limit the ability of big banks to place market bets with their own money - and the Knight deal represents such a bet, say some.

“Would Goldman have been able to buy the portfolio if Volcker were in place? I don’t think so,” said Bove. “Clearly they didn’t buy this stuff for clients, they bought it for their own accounts and they are not allowed to do that under Volcker.”

Not everyone agrees. “We don’t know because the final rule isn’t in place,” said one banker. Others insisted that the Knight trade was essentially Goldman buying and temporarily holding a large risk position - essentially an equity block trade, which it sold down.

“It’s not proprietary trading,” argued Donald Lamson, a bank attorney with Shearman & Sterling, who believes it would not run afoul of Volcker.

This is not the type of transaction where a firm buys and sells securities on the open market with the aim of making a quick profit, he said. Lamson argues that since the transaction took place outside of the open market, it was a form of financing. “No one is going to turn this type of transaction into a business line,” he added.

MURKY DEFINITIONS

The varying opinions are indicative of how difficult it is for the industry to interpret the draft Volcker Rule and why there have been delays in the implementation of the final rule. The final rule is expected to be released by year-end, according to lawmakers and Treasury officials.

The rule was supposed to be published by July 21, but regulators failed to meet the deadline. JP Morgan’s troublesome trades in its chief investment office slowed progress, as politicians and regulators debated whether the losses were the result of hedging or propriety trading.

“JP Morgan’s speculative trades were like a turd in the punch bowl,” said Tony Plath, a professor at the University of North Carolina Charlotte. Until then, it appeared that the final rule would be softer than the draft rule. “Now, the rules will be tighter,” he said.

However, many are doubtful that a final rule will be released by year-end. Discussions will not resume until after Labor Day, which is September 3. The presidential election in November is likely to slow down progress further.

The most contentious issue deals with proprietary trading, and how it differs from market-making. The industry and regulators have yet to see eye-to-eye on what constitutes prop trading.

The 298-page draft rule, which was released in October 2011, also reduces the ability of banks to invest more than 3% in either a private equity or hedge fund.

There remain many harsh critics of the Volcker Rule in Congress. House Financial Services Chair Spencer Bachus said earlier this month that the Volcker Rule would devastate the US economy and undermine the country’s ability to compete.

The Fed has granted banks a two-year period to comply with the rule, which began on July 21.

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