"Central risk desks are getting out of control"

So you thought banks had stopped prop trading after the Volcker Rule?

You were wrong.

Big banks can always find away around regulation and for the moment - even while the Volcker Rule is being weakened - they're doing this via their central risk desks. Don't be fooled by the word "risk" in the name: a lot of these are actually prop trading desks.

Many are staffed with former star prop traders. These are people who know all about regulation and its circumvention. There are banks out there with huge central risk books - far bigger than you would have thought the case, and these books are quietly being used by the traders who run them to trade prop.

The secret behind central risk desks is client flow data. As the nexus of client activity, the desks have a high level of visibility across the market. They're not supposed to trade against that data - and many are explicitly forbidden from doing so, but these are traders. They will argue that they need the data for purely analytical purposes (maybe in a "strategy group") and yet quietly use it to trade against anyway.

I've seen it happen. Because central risk desks are automated trading teams, it's possible for them to analyze the client data they have access to and to incorporate the signals they find there into their trading models. Central risk is classified as an "internal trading desk" and as such it can often bypass rigorous model validation and control processes. Ultimately, the danger is that central risk desks will reverse engineer clients' transaction information and use it to trade against them. Needless to say, clients have no idea that this is going on.

It's time both banks and regulators wake up to the dangers. For the sake of stability and transparency in financial markets, central risk books need to be very heavily regulated. Central risk desks are supposed to be about risk internalization and monitoring and as such they don't need traders and trading "strategists". The more traders and "strategists" they employ, the greater the likelihood that these desks will simply become a foil for prop trading and the inappropriate use of client data. You have been warned.

Seb Palowski is a pseudonym

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