The Perils Of Citi: The Last Of The Eurodollars Part 1

Proprietary trading has taken on connotations that are extreme for some good reason owing to the events of 2008. It was there, called “principal transactions” on some balance sheets, that claimed the majority of accounting losses that perpetuated internecine banking struggles from liquidity to revenue and earnings. As with most things, there was much more to it than that rough abhorrence, particularly as prop trading is the byproduct of very useful financial function.

The distinction between bank and investment bank used to be more than shorthand for how a firm derived the bulk of its revenue. There were immense statutory as well as functional differences. For the most part, investment banks were securities firms that participated in bridging primary and secondary markets. The term “primary dealers” is derived from that perspective. These are/were firms that float issues and then take risks in warehousing before selling again into the secondary markets (to institutions and even the public).

Hedging is a legitimate exercise of risk control during that warehousing phase. There are also the origins of wholesale funding in the history of investment banking. Under an actual currency system, investment banks had to derive funding from somewhere given that they were not, mostly, depository institutions. The repo market, in particular, began as one of those versions of wholesale, including just the sort of fuzzy attachment to the Federal Reserve we appreciate too much today (the Fed was prohibited from directly lending to securities firms but not from buying UST securities, thus the central bank could agree to “buy” a security from an IB and then “sell” it back at a specified future date, which from the IB perspective was a “repurchase agreement”).

The problem for the eurodollar expansion from especially 1995 forward was the blurring of functions. An investment bank that holds securities from a UST auction with the hard intent to sell them off piecemeal to customers has legitimate risks that it can and should try to manage. It gets exponentially more complicated the further down the risk curve you travel, warehousing everything from vanilla corporate debt to highly complex structured mortgage pools. More complex still are the natural irregularities of both funding arrangements and how all of it is accounted.

The investment bank traditionally booked profit from what was a stretched bid/ask spread, primary to secondary – they bought at auction or direct placement at one price and sold into the secondary market at whatever mark-up they could “earn.” That revenue is proprietary. If the value of the underlying warehoused security should happen to rise over time while in transitory possession of the IB, then more proprietary revenue is “earned.” If the IB places particular hedges upon those securities in order to manage the potential risk of security prices moving and the prices of the hedges instead happen to move in the bank’s favor, that means even more proprietary revenue. At what point, however, does the legitimate warehouse function (including all the risk management add-ons) stop being investment banking and start heading too far into raw speculation?