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The Volcker Rule: Comments and Questions

Posted by Larry Doyle on December 10, 2013 6:02 AM |

The big news on Wall Street today is the reemergence of the Volcker Rule intended to make our banking system safer from the perils of proprietary trading activity.

The question that America will hear bandied about until it makes your head spin is “What exactly defines proprietary trading?”

My ‘sense on cents’ response is that not unlike pornography, proprietary trading might be hard to define but you know it when you see it. Let’s review and cross-examine The Wall Street Journal’s take on this newly proposed rule which attempts to accomplish the following:

. . . bans banks from making bets with their own money and limits their ability to invest in certain trading vehicles, such as hedge funds and private-equity vehicles.

LD’s cross: I can tell you that proprietary trading is NOT a trader who makes markets for customers selling one security, say a 10 year Treasury, and then buying another, say a 5 year Treasury, to manage his risk. Proprietary trading is more aptly described as a trader or group of traders off in the corner, allocated balance sheet and capital, and typically using highly quantitative strategies (black box) to play the market. JP Morgan had one such group engaged in this very sort of activity that was dismantled when talk of this rule was first broached. The “London Whale’ trade emanated from within the firm’s chief investment office.

One other question. Does this Volcker Rule apply to the regulator FINRA which in its most recent annual report indicates that it has 20 per cent of its own internal investment portfolio in alternative investments? What’s good for the goose should be good for the gander, no?

The approval would bring to an end a 2½-year effort to complete the 2010 Dodd-Frank provision.

LD’s cross: Let’s see here. Dodd-Frank, including a mandate to implement a rule against proprietary trading, was passed in 2010. What year is it? Oh yeah, 2013. Two and a half years? Those at the WSJ may want to check their math.

What does it say about our government and financial regulators that it takes them three and a half years to implement a regulation that is presented as a cornerstone of financial regulatory reform legislation? It says that many of the participants and related parties were and still are warmly and snugly in bed with each other.

Multiple new requirements in the recent copy of the rule reviewed by the Journal are designed to discourage traders from hunting for loopholes to engage in proprietary trading.

LD’s cross: Wall Street firms employ armies of lawyers to find and/or create just such loopholes. The fact that regulators have told firms that this rule will not be enforced until 2015 means that these lawyers will be very busy. Give a Wall Street lawyer a year’s head start and there are very few regulators that might have a chance of catching up.

Bank chief executives, meanwhile, will be required to “attest in writing…that the banking entity has in place processes to establish, maintain, enforce, review, test and modify the compliance program” set up for the Volcker rule.

LD’s cross:Attest in writing?” Let’s see here. What was the last law that required financial executives to attach their name to the integrity of their reports? Oh yeah, Sarbanes-Oxley. The pols, regulators, and financial execs ran roughshod and made a mockery of that Act in the midst of dealing with the crisis. Now we’re supposed to believe that the execs’ signatures are supposed to mean something? Hmmm.

What do you think a 2007 Lehman Annual Report with Dick Fuld’s signature attached might currently fetch on eBay?

In conclusion, the Wall Street oligopoly has the ability to hoard information and will continue to do so. They will profit from that info by allocating their own capital accordingly. How that is defined will be for their lawyers to determine. As much as I believe a Volcker Rule properly drafted and implemented might be marginally helpful in protecting our economy, the MUCH BIGGER ISSUE remains that our banks are still ‘too big to fail.’

Let’s go about dismantling the ‘too big to fail’ banks by reestablishing Glass-Stegall, and the Volcker Rule becomes a moot point. Then we might just have a chance of bringing true free market capitalism back to our shores.

What do you think?

Navigate accordingly.

Larry Doyle

Please pre-order a copy of my book, In Bed with Wall Street: The Conspiracy Crippling Our Global Economy, that will be published by Palgrave Macmillan on January 7, 2014.

For those reading this via a syndicated outlet or receiving it via e-mail or another delivery, please visit the blog  to comment on this piece of ‘sense on cents.’

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I have no business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

  • From American Banker, we get the following release:

    “Following are how regulators tackled various issues in the final rule:

    Proprietary Trading

    Although the final rule bans proprietary trading, it carves out several exemptions, including one to allow banks to engage in trades that are designed to buffer against losses in a portfolio of assets, known as “portfolio hedging.”

    Financial institutions typically use hedges to help manage risks that often come from trading with clients. But it’s widely acknowledged that matching one-for-one is often difficult to attain, thus banks have used portfolio hedging to manage a broader swath of risks.

    In the final rule, the agencies specified that exemptions would be applied to hedging activity that is “designed to reduce, and demonstrably reduces or significantly mitigates, specific, identifiable risks of individual or aggregated positions of the banking entity.”

    Going forward, banks will be required to document each transaction, explaining the rationale for “certain transactions that present heightened compliance risk.” The provision is designed to prevent trading losses like the $6.2 billion fallout from JPMorgan Chase’s infamous “London Whale.”

    Financial institutions will also be required to keep a close eye on the effectiveness of their hedges, and monitor and recalibrate as necessary on an ongoing basis, regulators said. Firms will be required to analyze its hedges along with performing a correlation analysis for each trade.

    The final rule will allow banks to trade on behalf of their customers in a “fiduciary capacity or in riskless principal trades and activities of an insurance company for its general or separate account.”

    ‘Market Making’

    Regulators also granted institutions some discretion in figuring out whether certain trades are permissible as market-making activities. In drafting the final rule, regulators sought to avoid constraining markets where policymakers would still like banks to participate with the caveat of ensuring firms’ acted in accordance with certain risk-management procedures.

    Regulators have largely agreed market making is a good thing, but they have faced a challenge in defining such activities, where banks buy, sell and hold securities to fulfill demands by clients.

    In prescribing the language, U.S. agencies put some boundaries on the exemption, specifying a “firm’s trading desk’s inventory in these types of financial instruments would have to be designed not to exceed, on an ongoing basis, the reasonably expected near-term demands of customers.”

    Firms will be required to demonstrate in their analysis “historical customer demand” and provide the current inventory of financial instruments they hold.

    Banks had been critical of how regulators tightly defined market-making, claiming by doing so it would hurt their ability to serve clients and negatively impact the overall functioning of the markets.

    Covered Funds

    The final rule prohibits banks from owning and sponsoring private equity funds referred to as covered funds. The definition of a covered fund includes any issuer that could be an investment company. It also includes certain foreign funds and commodity pools.

    The final rule excludes, however, certain covered funds such as wholly-owned subsidiaries, joint ventures, and acquisition vehicles, as well as Securities and Exchange Commission-registered investment companies.

    Regulators also set a cap on the amount of investment that a banking entity may hold up to 3%. It also established the aggregate value of all ownership interests of the banking entity not to exceed 3% of the Tier 1 capital requirement.

    CEO Certification

    Under the final rule, bank executives of the largest firms will now be required to certify annually that their firm is in compliance with the regulation. Executives from smaller sized entities that are engaged in modest activities would be subject to a much more simplified compliance regime.

    Regulators added the so-called “CEO attestation” to the final rule as a means to heighten accountability at firms by forcing top executives to be aware of the kinds of trades happening inside their institution.

    Banks will now have to maintain documentation so that the “agencies can monitor their activities for instances of evasion.”

    The requirement was not envisioned in the initial plan even though the Financial Stability Oversight Council, an interagency group headed by the Treasury Secretary, had recommended it as part of a study undertaken ahead of the release of the 2011 proposal.

    Foreign Entities

    Foreign institutions and their governments, including France, Germany, Japan and others, had expressed alarm at regulators’ initial proposal, arguing the U.S. was overstepping its jurisdiction. They argued that the proposal would harm liquidity, widen spreads and increase volatility at foreign institutions.

    Outside observers have been keen to see whether U.S. regulators would change course on a proposed exemption in the plan for banks operating “solely outside of the U.S.” Foreign entities have argued that the exemption was meant to be broader, including non-U.S. risk exposure, even if the institution had U.S. operations in some other form.

    Without changes, they argued, the scope of the rule could end up covering a wide range of non-U.S. trading and fund activities that go far beyond the intent of the statute.

    In the final rule, U.S. regulators agreed not to prohibit trading by foreign banking entities as long as the trade and associated risks either occurs or is held outside of the United States.

    They also offered three specific cases where exemptions would be permitted: those that occur with foreign operations of U.S. entities; those that are cleared transactions with unaffiliated market intermediary acting as principal; and those cleared transactions through an unaffiliated market intermediary acting as agent, conducted anonymously on an exchange or similar trading facility.

    Under political pressure by foreign governments, U.S. regulators also agreed to exempt sovereign bonds from the trading ban “in more limited circumstances,” offering it partial equal treatment to U.S. Treasury bonds, agency and municipal debt that are allowed.

    Compliance Deadline

    Regulators agreed to provide institutions with an additional year to comply with the new rule until July 21, 2015. If additional time is necessary, regulators could opt to extend it twice more under one-year periods.

    The five agencies modified their initial 2011 proposal winnowing down the 20 proposed metrics that would be used to assess a firm’s compliance with the rule to only seven. Regulators said they would continue to monitor and review whether the current handful of metrics would be appropriate.

    As a result, regulators staggered the schedule for when banks would have to begin being tested against the metrics, starting with the largest institutions that have $50 billion of assets on June 30, 2014.

    A second batch of banks with assets of at least $25 billion, but less than $50 billion, will be subject to the requirement on April 30, 2016. Those firms between $10 billion and $25 billion in assets won’t have to meet it until Dec. 31, 2016.

    Regulators said the rule will not be applied to community banks engaging in such trading activities.”

  • Bud

    I’m with you, LD. How much simpler could it be. Just re-implement Glass-Stegall. We need to re-establish trust again. This would do it. So simple.

  • HarlemTwist

    What about your 10-year note trader if he stays short overnight as a purposeful risk position? Or he buys 5s and stays long the 5-10 curve? Isn’t that really proprietary trading as well?

    • No. If we take away the ability to take risks within some known position limits we might as well stop calling it free market capitalism. The key here is what are the position limits and making sure there is meaningful oversight in that process.

      • HarlemTwist

        In context of our system, you are 100% correct about position/risk limits vs capitalization being the key.

        One thing though: the Federal Reserve framework of our financial system by it’s very nature has never been any form of ‘free market capitalism’. There is a central planning board that ‘sets interest rates’ and a group of privileged members who can issue a nearly infinite amount of Central Bank script vs any kind of loan or derivative that they can think of.

  • Jim

    Love the part about Dick Fuld signing annual report.

    I interviewed the Lehman bankruptcy examiner Tony Valukus and I’m still pissed his recommendation to go after them criminally for Repo 105 balance sheet fraud was never pursued.






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