Why Banks Will Not Be Prop Trading Anytime Soon

By Ted Holloway

I wanted to respond to the recent points raised by the editor of The Full FX in his Last Look column of 7 October 2024. The article specifically asked whether banks should be considering alternative means of making money in the FX market, and whether proprietary alternatives, such as the CTA route highlighted in his article, would or should be an option?

As someone whose background was in sales you may wonder why I felt compelled to try and respond to this point. Certainly I am not going to get into the semantics of trading as I am most definitely not qualified to do so, however, as someone who repeatedly built successful FX teams, whilst adding a great number of new clients to the banks I worked for, I feel I am in a good position to add a more holistic view.

Todays’ FX market, from a bank perspective, is far more complex than the one I first started in. In those days it was common place for banks to have proprietary trading desks, however, as the editor has alluded to, the well-documented problems the FX market ran into forced a re-think. This forced banks to focus more on their core offerings, given that some were starting to look more like hedge funds than banks.

This gave birth to what I like to call the three R’s, that, in my opinion, very much dictate how banks approach the FX market we see today. The first of these is Risk. Risk limits at most institutions have been reduced. Post crisis rule changes have meant that more capital has to be set aside to support “riskier” products such as FX.

The second R is Regulation. I do not propose to delve and deeper into this particular R other than to say it is not going away anytime soon, and therefore will continue to be a cost that any bank has to factor for when offering an FX service.

The last, and in my opinion most important R is Reputation, and it is one that cannot be underestimated. Given the problems and subsequent fines some banks encountered, the environment has simply not been conducive for a return to proprietary risk. As a result, banks have been forced to concentrate on their core products, with less emphasis on the trading and product areas such as FX.

This was very much the case for the last 10-12 years of my career. Any potential new clients I was looking to onboard had to have more than just one product line – in other words, standalone FX was unlikely to cut it. In a lot of cases, any potential new client business had to have some synergy with that of the economy of where head office was situated. If that was not the case it was very unlikely I would gain approval.

Even if the client ticked these boxes, I would have to make a strong case on a capital returns basis. One-off trades, for example, simply were not going to cut it, as capital is precious. If these were the lengths I was having to go to, what chance proprietary FX?

Even if you could manage both regulatory and credit risks, reputation wise I don’t believe a bank wants to be seen to be enhancing its returns from proprietary trading. Besides, even if they could, I believe the market has become too deep these days. What I mean by that is there many funds whose function is to try and drive Alpha from FX, and they are specifically set up to do so. They are, therefore, in a much better position to attract and reward those individuals capable of achieving those goals. This is one of the reasons banks have had to seek alternative sources of revenue – a good example being prime broking, which the editor mentioned. To be fair it makes sense, as a bank’s most powerful weapon is its balance sheet.

Looking forward it would be churlish of me to say this situation will never change, however, I think we are still a very long way from banks being able to use their own balance sheets for proprietary trading purposes. Quite apart from the reputation risk it carries it is also capital intensive given the VAR required to support a fully functional prop trading desk.

To me, supporting clients by providing the services that at the very least match, and hopefully at times, exceed, their needs, is what banks need to be focussed upon.