Free The New Market Wizards: Conversations with America's Top Traders by Jack D. Schwager Page A

assume that the majority are profitable for most years. Is this profitability due to the advantage of earning the bid/ask spread on customer transactions, or is it primarily due to successful directional trading?
     
    There have been a lot of studies done on that question. A couple of years ago, I read a study on the trading operations of Citibank, which is the largest and probably the most profitable currency trading bank in the world. They usually make about $300 million to $400 million a year in their trading operations. There is always some debate as to how they make that kind of money. Some people argue that Citibank has such a franchise in currency trading that many of the marginal traders and hedgers in the currency market immediately think of Citibank when they need to do a transaction—and Citibank can earn a wide spread on those unsophisticated trades. Also, Citibank has operations in many countries that don’t have their own central bank. In these countries, much or even all of the foreign currency transactions go through Citibank. The study concluded that if Citibank traded only for the bid/ask spread and never took any position trades, they probably would make $600 million a year.
     
    That would imply that they probably lose a couple of hundred million dollars a year on their actual directional trading. Of course, that would help explain the apparent paradox posed by my question—that is, how can all those traders make money? Am I interpreting you correctly?
     
    Personally, that’s what I believe. However, the argument within Citibank would probably be: “We doubt that’s true, but even if it were, if we weren’t in the market doing all that proprietary trading and developing information, we wouldn’t be able to service our customers in the same way.”
     
    That sounds like rationalization.
     
    Assume you’re a trader for a bank and you’re expected to make $2.5 million a year in revenues. If you break that down into approximately 250 trading days, that means you have to make an average of $10,000 a day. Let’s say an unsophisticated customer who trades once a year and doesn’t have a screen comes in to do a hedge. You do the trade at a wide spread, and right off the bat you’re up $110,000. You know what you do? You spec your buns off for the rest of the day. That’s what almost every currency trader in New York does, and it’s virtually impossible to change that mentality. Because if you are lucky, you’ll make $300,000 that day, and you’ll be a fucking hero at the bar that night. And if you give it all back—“Ah, the market screwed me today.”
     
    Bottom line: If it weren’t for the bid/ask spread, would the banks make money on their trading operations?
     
    Probably not in conventional position trading in the way you think of it. However, there is another aspect of directional trading that’s very profitable. Take Joe Trader. Day in, day out, he quotes bid/ask spreads and makes a small average profit per transaction. One day a customer comes in and has to sell $2 billion. The trader sells $2.1 billion, and the market breaks 1 percent. He’s just made $1 million on that one trade.
     
    In a lot of markets that’s illegal. It’s called frontrunning.
     
    It’s not illegal in the interbank market. He’s not putting his order in front of the customer’s; he’s basically riding his coattails.
     
    So he does the whole order at the same price?
     
    Generally, the first $100 million would be the bank’s. That’s just the way the market is.
     
    Is there any difference between that transaction and what is normally referred to as frontrunning?
     
    Yes, it’s legal in one market and illegal in the other.
     
    That’s the answer from a regulatory viewpoint. I’m asking the question from a mechanical perspective: Is there an actual difference in the transaction?
     
    The real answer is no, but I’ll give you the answer from a bank’s perspective. When I allow you to come in and