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July 1, 2012

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Prop traders launching their own firms are facing adversities

By James Armstrong

Prop shops are on the rise.

With the financial crisis receding into history and new regulations targeting banks, the industry is witnessing a rebound in the number of new proprietary trading firms. And this could just be the beginning.

Refugees from big banks stung by the Volcker rule, as well as traders formerly with large hedge funds, are stepping out on their own. For many, however, it is not an easy task. According to data from hedge fund tracker HFR, the number of new funds has been streadily rising in the U.S. since the crash of 2008. Last year, a healthy 1,113 new funds were launched, compared to a 10-year low of 659 in 2008.

While new hedge funds continue to launch, the number of liquidations is stubbornly high, with 775 funds calling it quits last year. More and more traders are trying to set up their own shops, but it’s clearly far from easy for them to succeed.

Kevin Beadles, director of the execution solutions group at Wedbush’s Lime Brokerage, frequently deals with new firms. He said that over the past year, the number of startups launched by former prop traders has definitely picked up. There are all sorts of reasons prop traders strike out on their own, but at least 75 to 80 percent of the current shift is due to the Volcker rule, he said.

The Volcker rule, named for former Federal Reserve Chairman Paul Volcker who backed the concept, forbids banks from engaging in proprietary trading, though certain market-making activities are still allowed. The rule is required by the Dodd-Frank Act, and the Securities and Exchange Commission is weighing how to formulate its specific wording.

In spite of the fact the rule hasn’t even been written yet, banks have been losing traders from their prop desks in anticipation. Last year, Bennett Grau and Mark Mallon left Goldman Sachs to start a new global macro hedge fund together with fellow Goldman alum Marc Mezvinsky. Another Goldman prop trader, Daniele Benatoff, jumped ship to launch the London-based hedge fund Benros Capital.

Goldman is far from alone. Peter Muller, who founded a Morgan Stanley prop group, left the nest last year, and is expected to launch a new hedge fund seeded by Morgan. Todd Edgar, who got poached by Barclays from JPMorgan in 2009, left last year as well—again, to start his own hedge fund. Add to that list Kay Haigh, who left Deutsche Bank to launch Avantium Investment Management.

Of course, those are all highly respected traders able to attract large amounts of capital. Most prop traders are in for a whole new world when they attempt to get their new ventures off the ground. Suddenly, they find themselves without the support structure of a large bank, and often they are unprepared for the number of things they will have to do themselves, from selecting technology to raising capital to complying with regulations.