But more explanation is required. If my guess about the MPC decision is correct, someone on the other side of the trade gets it wrong. This activity may be very profitable for particular individuals and firms, but the gains and losses should net out for the financial sector as a whole. How can proprietary trading have been a very large source of earnings and profits for a large industry?
I find it hard to believe that this proprietary trading is really the main source of revenue. Kay goes on to suggest explanations:
Explanations fall into three broad groups. First, the profits arise from government-created distortions, particularly state guarantees of the liabilities of financial institutions and opportunities for regulatory arbitrage. Second, profits are made at the expense of the customers of financial institutions. Corporate treasurers, pension fund managers and individuals mistakenly believe they can outwit dealers at investment banks. Trading firms that are also marketmakers use knowledge gained from one activity to profit in the other. Third, the profits are illusory; the reported gains are either borrowed from the future or from other segments of conglomerate financial institutions.
There are a few government distortions - obviously the GBP exit from the ERM was a classic example of that. Breaking of pegs is a big earner, but it does not happen very often and money is also lost when the peg is not broken. Some profits come at the expense of customers. However, this is mostly a high volume low margin business that is not really proprietary but serving customers. The larger firms have experienced treasury staffed by ex-industry people; the smaller firms pay but are also expensive to service because of the odd lots and small volumes. True proprietary profits probably are illusory: the come in the good times and disappear in the bad times. The carry trade and its unwind is a great example.
This also helps to explain the cyclical nature of the proprietary game: others are making money, it looks so attractive, we get into the game and then it blows up and we vow to keep out of this business until the next time.
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