Trading desks help drive profits for the large Wall Street dealer banks—but not in the way most people think.
Rather than betting on high-risk investments to reap outsized rewards, these specialized trading desks profit by charging fees to match buyers and sellers of securities. Since post-financial crisis rules took effect a decade ago, these intermediaries have become “toll booths,” extracting fees for banks while bearing little risk.
The toll booth business is really profitable per unit of risk because there’s lots of volume with little aggregate risk.
That finding challenges longtime thinking about the health of large dealer banks—a crucial part of the financial system—and their role in holding risk tied to the transactions they facilitate, explains Harvard Business School Assistant Professor Jonathan Wallen.
“The toll booth business is really profitable per unit of risk because there’s lots of volume with little aggregate risk,” Wallen says. “Why would you put dynamite in your toll booth?”
The role of trading desks shifted in the wake of the 2008 financial crisis, when regulators passed the Volcker Rule to prohibit big banks from using in-house trading desks for proprietary trading. Now, dealers formerly paid to bear risk using a bank’s balance sheet—opening these systemically important institutions to risk—now earn fees based on building client lists, Wallen says.
The Volcker Rule sought to stabilize the industry after several high-profile bank failures roiled the economy. While banks’ trading fee revenue has surged under the rule, some critics have questioned its effectiveness. The research findings come as new government leaders and sweeping changes across regulatory agencies might reshape industry oversight.
Wallen teamed up with Lina Lu, a senior financial economist at the Federal Reserve Bank of Boston, to probe the question “What do Bank Trading Desks Do?” in a recent working paper.
How profitable are trading desks?
In 2023, dealer banks reaped $133 billion in trading revenue, fees, and commissions, on $2.2 trillion in trading assets that include Treasuries, mortgage-backed securities, loans, debt instruments, derivatives, equities, and other assets, the paper finds.
Put another way: roughly 500 trading desks across Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, and Morgan Stanley took in approximately $1.65 billion a week for matching buyers with sellers across these specialized desks, with little or no danger tied to the risk of the assets they trade. The average dealer bank in the study had 86 trading desks, with varying profits, the researchers note.
On average, the dealer banks reap 38 percent of their trading profits from the equity markets, 18 percent from the credit markets, and 17 percent from the interest rate market. Foreign exchange, mortgage-backed securities, and commodities make up the rest.
Is the Volcker Rule working?
The authors analyzed transaction data from the Federal Reserve, focusing on daily volumes of securities and derivatives traded through five major US dealer banks from January 2014 until December 2020. They also examined secondary market trading volume for corporate bonds through the Trade Reporting and Compliance Engine, or TRACE, from July 2014 until September 2023.
In eliminating proprietary—or “prop”—trading, the Volcker Rule sought to shield banks and their customers from wrong-way bets. That means the big banks instead rely on the fees charged for matching buyers and sellers for profits. From January 2020 to September 2023, daily bank trading profits rose 50 percent to $429 million compared with $283 million from January 2014 to December 2019, the authors write.
Other types of intermediaries, such as commercial banks and hedge funds, may be very exposed to this. They’re taking directional risk.
“It was a bit of a toss-up as to whether or not we would think that the Volcker Rule would work, partly because, in some ways, it is difficult to tell the difference between market making and prop trading,” Wallen says. “Our work suggests that it has been implemented rather well.”
For example, Wallen says the price and yield curve of a 10-year Treasury used to loom large for policymakers. Those shifts matter less for dealers now because their compensation isn’t tied directly to the rise or fall in price, Wallen says.
“They’re earning tolls, and they’re not exposed to changes in the level of the yield curve,” Wallen says. “Other types of intermediaries, such as commercial banks and hedge funds, may be very exposed to this. They’re taking directional risk.”
The rise of non-banks
Wallen’s findings raise questions for policymakers about the long-term effects of regulating risk. Specifically:
Is there a tradeoff between regulating safety and competition?
Competition is important for a well-functioning financial market, Wallen says. The toll-booth business exhibits properties of a natural monopoly: if a dealer bank is known for attracting buyers, they are better able to attract sellers, and vice versa. Wallen finds that for the same market activity, dealer banks that do more trade with customers earn more per unit of risk.
“We’ve regulated financial intermediaries to a point where they are very safe now in their market making,” he says. “But that does not necessarily mean they are as competitive as they once were.”
Has the rise of hedge funds increased risk in the financial system?
In the wake of the Volcker Rule, market risk has shifted from bank trading desks to hedge funds, insurance companies, and other “non-bank” institutions. As a result, these firms now play a broader role in determining prices for risky investments.
In follow-up work, Wallen and coauthors show how hedge fund leverage has created fragility in the Treasury market and make policy recommendations on how the central bank may best mitigate this.
Image: HBSWK with assets from AdobeStock
