06/21/2012 04:08 pm ET Updated Aug 21, 2012

Prop Trading: Gaming the Gamers

Investment is a form of parimutuel betting involving corporations. Yes, corporations are ultimately the creations of people working as a team to achieve a competitive advantage in order to beat other corporations.

Prop trading at investment banks is to parimutuel betting what craps is to casino betting. Proprietary trading is the most complicated bet, but unlike craps, winning at proprietary trading is not a matter of luck.

Cheating parimutuel bettors

Casino games involve inanimate objects subject to the law of probability, i.e., "chance." Parimutuel betting on contests between living beings requires human "smarts" and the ability to use knowledge to make correct predictions. Intelligence, not luck, is what wins in investing.

For example, in horse racing there are many factors for the experienced bettor to consider. These factors include the horse, its lineage, its trainer, its jockey, its age, its competitors, the kind of race it is in, the state of the track, the weather, etc. Or take Moneyball. This movie shows the kinds of "smarts" needed to build a winning baseball team. Investing is an even more complicated parimutuel sport.

Parimutual cheating does not depend on messing with objects used in the game; it relies on messing with observers' minds. "Smarts" doesn't just mean objective knowledge of the game; it means understanding human expectations. For example, in hybrid casino games that have a parimutuel aspect to them, (Texas hold 'em), or hybrid scams ("three-card monte"), the player with unlucky cards can deceive others and still win.

In the casino game of craps, casino owners game the gamers by the odds offered on each number in the game. If you know the probabilities of each number coming up on a toss of two dice, you can reduce your losses and win more money at craps. However, even in craps, the unlucky toss of the dice means you lose. You can't "fake out" other players' expectations to win at craps.

Cheating investors

In the boiler room scam, a con man takes the name of a legitimate business, copies its website, and cold calls investors offering them an expensive investment that is worthless. This scam was depicted in the HBO series The Sopranos. Tony Soprano put his nephew, Christopher, in charge of an office of workers selling bogus investments. Christopher complained loudly about the amount of work involved in managing employees. He wanted "easy money."

This scam is very close to what Goldman Sachs and John Paulson's hedge fund did when creating and marketing an investment called Abacus. Abacus was a derivative based on worthless mortgage-backed securities. Abacus' creator and its seller bet against it. Goldman Sachs claimed innocence because it let customers know it bet against Abacus in order to "hedge risk." But "shorting," i.e., betting against an investment, wasn't the real issue.

According to Reuters, Goldman Sachs received "proprietary" information from John Paulson. Goldman kept secret about Paulson's involvement in creating and betting against Abacus. The word "proprietary" implies "secret" or "exclusive" knowledge. Prop desk trading involves possession of secret knowledge by those who create investments, like Abacus, and profit at the expense of their own clients. That's because in parimutuel betting, perceptions are nearly everything, not luck.

Regulating proprietary trading

"Prop desk" is a great name for the unit in investment banks that sells derivatives to rich suckers who don't understand what those derivatives are based on. Proprietary trading is a play, a staged drama, where sophisticated observers can be conned out of millions of dollars.

The proposed solution, ancient and modern, for prop trading was to "ringfence" prop desks with a "Chinese wall" or "firewall." Obviously this solution doesn't work. There was no "wall" within Goldman Sachs, or between Goldman and John Paulson's hedge fund. Ringfencing isn't enough!

A far better solution would be to require that every single investment broker must put the interests of clients first or else go to prison.