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Zero Risk Trading

Brandon over at Trading Wall Street is out with a great post on Goldman Sachs spotless trading in 1Q 2010 and I think his conclusion deserves repeating:

I don’t want to make any outlandish conjectures but I cannot help but have a great deal of skepticism towards these results. In a world of ever-increasing efficiency, I don’t see how a firm can go full quarters without a single day of losses while clearing hundreds of millions of dollars. At the very least investors must know what they are buying when they purchase shares of GS. It is a proprietary trading firm that has done exceptionally well in recent years. Whether those returns can continue, I do not know but the sheer enormity of the returns makes me cautious. While this stance on my part may be foolish, I would rather stay away without a much clearer picture of how they are making so damn much money and never losing.

It is possible to run such a record in the short-run; however, in the long-run there are only three ways to trade each and every day without a loss:

  1. There is a major market inefficiency to exploit
  2. The trading strategy has an inherently large tail risk, with a very real chance of blowing up
  3. Some form of either illegal fraud, (or the exploitation of a loophole in the letter of the law, which is incorporated into #1: a market inefficiency).

I believe some combination of #1 and #2 to be the most likely explanation for Goldman’s flawless quarter of trading.  Although it is unkosher, it seems unquestionable that Goldman as some combination of a market-maker and position-taker has access to more information as to the sentiment and directional bias in the trades of a large swath of the investment community.  Whether they explicitly make use of this information in their trading is irrelevant.  It is impossible for someone who knows a fact to ignore it when making consequential decisions.  It’s basically like asking a jury to disregard a defendant’s confession in a contested trial due to a procedural rule.  Sure they can “pretend” to not have heard that decision, but can one reasonably expect that fact to not weigh on the subconscious of the members of the jury in gauging the preponderance of the evidence?  Call me a cynic, but I surely don’t think so.

I think there has to be some sort of latent risk to Goldman’s trading strategy.  As Brandon pointed out, we don’t know what proportion of their trading profits resulted from their market-making as opposed to their proprietary trading; however, we do know that Goldman is substantially involved in the high frequency trading arena.  I am very interested to learn about the impact of May 6th on their trading performance.  Was that an immensely profitable day for the firm?  Or, did the computers shut off because something went incredibly wrong first?  Generally speaking, non-stop large profits come with some sort of tail risk.  At this time, we just might not know the full extent of Goldman’s risk.  Irregardless of May 6th, at some point, a competitive advantage of that sort is either minimized through improved competition or regulatory action.  For this very reason, trading profits are valued far lower than investment banking earnings in calculating a share price (i.e. the trading profits receive a lower p/e than do real earnings).

I think this to be the beginning, rather than the end of the story with regard to Goldman.  We are certainly dealing with a company that is as much a hedge fund as it is an investment bank and that has serious consequences for a variety of reasons.  To guess at the end-game right now is just impossible.  There are just far too many moving parts considering the state of markets and the proposed regulatory reforms.  Only time will tell…

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