Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Is it a hedge fund or a proprietary trading firm?
A small but pedantic quarter of the finance internet has been discussing a question raised by Rupak Ghose on his Substack last week — Is Jane Street a prop trading firm, or a hedge fund? Was the hit it took during the Situational Awareness liquidation week the biggest trading loss in history, or just a medium-size fluctuation in AuM of the sort that happens from time to time?
One way to answer the question might be by means of a sandwich chart:
This feels unsatisfactory, though — the question deserves a deeper answer, as proprietary trading is in many ways more complicated and sophisticated than sandwiches. The definitive answer, as it is with so many of these kinds of questions (like “Are stablecoins banks?”) should really be something like “nobody who matters is confused about what it actually does, so why waste time on semantics”.
But as with most semantic debates, although the answer is almost always kind of unsatisfying, the process can be important.
That’s because people do think about prop trading firms in a different way from hedge funds (and stablecoins in a different way from banks), and identifying the criteria which define one against another can sharpen up your intuitions about what might actually be important to know about a firm like Jane Street.
-
Is it an open-ended fund structure? An extremely significant taxonomical principle for financial institutions is “those that are subject to something like bank runs” versus “those which aren’t”. If something faces liquidity risk, then it can be a source of contagion; a loss of confidence can force it into behaviour which would otherwise be economically irrational, and which potentially causes trouble for other market players.
-
Where does it get its leverage from? This question is related to the previous one, because there are two ways to be subject to liquidity risk — open-ended liability structures, and short-term borrowing. Hedge funds usually get their leverage through collateralised margin loans subject to immediate calls; prop trading firms generally try to only leverage up on longer-term debt, precisely so that they can’t be squeezed out of positions.
-
Does it close positions overnight? Most of the very most horrible things that can happen to an investment portfolio happen while the market is closed. There is a very big difference between risks which you can trade out of, and risks that you can’t.
-
And finally, does it earn a compound return? This is probably the most important one, because it determines whether it’s going to grow over time or not. Prop trading firms might have very high returns on capital, but that capital has to be distributed to the owners and shareholders rather than reinvested. If something is capable of compounding, then it’s doing something quite different from the historic prop trading model, which was limited to the size of its market niche.
These questions, particularly the last one, focus on the potential risks posed by the two kinds of firms to the rest of the market. Prop trading firms usually get a fairly light touch from regulators and are often treated by incumbent banks as useful counterparties rather than an existential threat, even when they take very large market share.
A large part of the reason for this is that the prop shop business model, in its traditional form, is intrinsically limited in its ability to do damage to the system as a whole. That’s the important thing to focus on when looking at entities like Jane Street — if, heaven forbid, they blew up, what would they take with them?
Further reading:
— Hedge funds and high-frequency traders are converging (FTAV)
