Goldman Finds A Way Around Volcker Rule To Continue Proprietary Trades

What would you do when someone bans you from entering into any short term trades? Well, you would just switch to long term trades. And what would you do if you are told that you cannot enter into any speculative trades, unless you are acting on behalf of a client? That’s simple too – enter into the same trade, claiming it is for hedging purposes. It doesn’t really take a genius to figure this one out. Why then, is Goldman Sachs (NYSE:GS), the only Wall Street bank to come up with this response to the proprietary trading ban, imposed by the Volcker Rule?

This is what Goldman’s Multi-Strategy Investing (MSI) division has been doing for quite some time now to make money off proprietary trades while staying clear of the fine print that goes into the Volcker Rule ban, according to one Bloomberg article. ^[1] Obviously, Morgan Stanley (NYSE:MS), JPMorgan (NYSE:JPM) or Bank of America-Merrill Lynch (NYSE:MS), lack the level of cheekiness required to pull a fast one like this on the regulators, even as they work towards tightening the rules for investment banks. But the more interesting question here is, whether Goldman’s top bosses CEO Lloyd Blankfein and CFO David Viniar were aware of the MSI game plan all along, as they publicly announced on multiple occasions that the bank no longer enters into proprietary trading? Any answer to this question leads to rather embarrassing conclusions about the way they run the premier investment bank.

We are in the process of updating our $126 price estimate for Goldman’s stock, in view of the recently announced relaxation in the Basel III capital requirement rules.

See the full Trefis analysis for Goldman Sachs

Goldman Sachs may have been forced to convert into a regular bank holding company, from an independent investment bank in the aftermath of the global economic downturn. But that doesn’t in the least change the bank’s identity. One has only to look at the chart above which illustrates Goldman’s business divisions, and how it makes its money to confirm this fact. Essentially two-thirds of the bank’s value comes from businesses that oversee trading activities.

So it is no surprise that the bank emerged as one of the most vocal opponent of the Volcker Rule that sought to curb risky proprietary investments – trades that banks enter into with their own money. Reluctantly, all the major investment banks have shut down their proprietary trading desks, which was once a major revenue source for them (see Citi Shuts Another Prop Group as Banks Prepare for Volcker Rule). Goldman also announced its own steps towards Volcker Rule compliance. ^[2]

But looks like there are some secrets Goldman has been tactfully keeping all these years – its Multi-Strategy Investing division, which is a part of its Special Situations Group. The Volcker Rule lays out rather strict and clear directives regarding proprietary trades – trading desks would be restricted from short term market speculation, and limited strictly to hedging and market-making activities (see Volcker Rule May Limit Banks’ Short-Term Trades). So the MSI, which worked with Goldman’s cash for well over a decade, switched to long term trading as a hedging activity.

As a result, Goldman continued to make millions off proprietary trading, which to emphasize, is completely legal. We represent the revenues from this unit as part of  ‘Securities Services & Other Investment Revenue’ in our analysis of the bank. You can make changes to the chart below to understand how a change in these revenues would affect Goldman’s total share value.

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1. Secret Goldman Team Sidesteps Volcker After Blankfein Vow, Bloomberg, Jan 8 2013 [↩]
2. Goldman Sachs Said to Close Fixed-Income Prop Group, Bloomberg, Feb 15 2011 [↩]