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RBC faces few options but to spin off U.S. trading unit

A Royal Bank of Canada sign in downtown Toronto.

MARK BLINCH/REUTERS

It is decision time for Royal Bank of Canada on what to do with its proprietary trading group, with the bank likely to spin off a group of traders who have for years brought in an outsized chunk of revenue.

Tuesday brings a long-awaited final draft of the Volcker rule – containing almost 1,000 pages of rules and explanations – the nub of which is that banks operating in the U.S. will be banned from proprietary trading, ie. trading the house money for profit.

So far, RBC has said little about what would happen to its proprietary trading group, which includes about 125 people working in its capital markets business in New York and which consistently generates between 1 and 3 per cent of the bank's annual revenue. In fiscal 2013, the bank's revenue amounted to $31-billion; the group currently generates close to $600-million a year. The group uses a dozen strategies and trades a range of asset classes. With the rule now finalized, a spinoff is the most likely option. Of the big Canadian banks, RBC is the one with meaningful exposure to prop trading in the U.S.

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RBC has looked at ways to retain the business, and defended the trading operation. Chief executive officer Gordon Nixon said in 2010, at the bank's annual meeting, that proprietary trading was not one of the root causes of the crisis, as he criticized regulators for their reaction. Last year, Doug McGregor, who heads capital markets for the bank, said proprietary trading "is an important outlet for us to manage our liquidity and to profitably deploy surplus capital."

But with regulators signalling lately that the rule is likely to be even tougher than expected, it appears the business has got to go. Once the bank has the final draft in its hands, it can start to figure out just how to structure an amicable separation from what the firm calls its global arbitrage and trading operation. That means everything from a financial split-up to a physical demarcation. At the moment, the traders sit on RBC's huge dealing floor at the World Financial Center on Manhattan's lower west side.

The bank will want to try to minimize the impact of losing proprietary trading, but the options are limited. The business is essentially a hedge fund operating in the bank, with the bank as its sole investor. One of the other issues posed by financial reforms is that banks will not be able to invest in hedge funds. Keeping any significant relationship after any spinoff may prove impossible.

It's a process every bank with a proprietary trading group will have to undergo, assuming the rule can't be defeated or seriously watered down between now and its implementation, in what's expected to be 2015. There are some U.S. banks that are reported to be eyeing litigation to try to do that.

In the meantime, contingency planning that has been bubbling along for a few years at RBC now must really get going.

One option that got a look from RBC and was declared unworkable was moving the traders to Canada, where there is no such prohibition on proprietary trading.

Nice as Toronto is (and the taxes are pretty competitive these days), the traders would be unwilling to leave New York, not least because many trade in the U.S. market and need to be near the information flow. Proximity to the New York-based stock exchanges is also crucial, because speed is crucial in trading and being hundreds of kilometres away means longer trips for orders down electronic pipelines. Extra fractions of seconds in such transactions can mean missed opportunities.

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Asking the employees to buy the business from RBC is similarly fraught with problems. Why would they purchase a business when they could just as easily leave the bank and set up on their own?

The next few months will be a scramble to interpret the Volcker rule, with the long-time co-head of RBC's capital market business, Mark Standish, taking a leading role. RBC said last week that Mr. Standish would be leaving the bank next year, and in the interim "will work with RBC's trading businesses to facilitate transition under the changing regulatory regime in the United States."

Mr. Standish came up through the proprietary trading business. He joined RBC in 1995 as head of proprietary trading in equity derivatives, and retained responsibility for the in-house trading operation as he climbed the ranks at the firm.

With him leaving the bank at about the same time as the global arbitrage and trading unit is likely to be spun off, it would not be surprising to see Mr. Standish running the business as an independent trading shop.

Editor's note: This story stated that RBC's proprietary trading group's contribution to the bank's annual revenue can go as high as $1-billion a year. The group currently generates closer to $600-million a year.

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