The Volcker Rule (section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act), depending on how it is interpreted and enforced by regulators, has the potential to significantly change the scope and scale of trading within federally insured depositories and their affiliates. A number of well-written articles by various law firms summarize the basic definitions and legislative requirements of the Rule. This article goes further, describing the relevant background of the Volcker Rule trading restrictions and offering insight on potential implementation expectations.1
Volcker Rule Background and Motivation
It has been said that there were no significant issues with respect to bank proprietary trading during the recent financial crisis, and therefore the Volcker Rule does not go toward solving any problems. However, looking back to the fall of 2007, it is historical fact based on SEC filings that significant financial company losses came from proprietary positions booked in trading accounts. More specifically, a large amount of trading losses came from holdings of mortgage-backed and asset-backed bonds that had been afforded high credit ratings (e.g., AAA) by SEC-approved NRSROs.2 Rapid mark-to-market losses on these trading positions led to the resignations of a number of prominent financial company CEOs during the fall of 2007.
Depending on the state of the markets, mark-to-market values have something—but not everything—to do with repayment prospects of a debt issuance. Though some mortgage security values declined to varying degrees as a result of unexpected housing price declines and increasing mortgage delinquencies in 2007, major changes in mark-to-market values over this period were also driven by more basic supply and demand issues. For example, US markets saw a broad-based and rapid flight from virtually all private-issue mortgage-backed securities (PIMBSs)3 during the second half of 2007. Lower demand for PIMBSs and widespread de-levering within the financial system served to depress mortgage security market values, separate from ultimate repayment prospects.
The 2007 market turmoil provides clear evidence that mark-to-market proprietary trading exposures have the potential to cause significant harm to bank earnings, liquidity, and capital. Such damage can contribute to a systemic reduction in the traditional banking services (e.g., commercial lending) needed to sustain the health of the so-called "real economy." Ultimately, a lack of credit availability from traditional financial intermediaries was a crucial factor behind the Federal Reserve's creation of several unprecedented lending programs. With programs such as the Commercial Paper Funding Facility and the Money Market Investor Funding Facility, the Federal Reserve effectively loaned funds directly to non-financial firms as diverse as Harley Davidson and Verizon, when banks could not.
As should be clear in the above discussion, an implicit concern of the Volcker Rule trading restrictions is the mark-to-market aspect of trading books. The trading book accounting choice tends to be popular with financial firms holding predominantly long positions while markets are trending up. Trading books have historically allowed firms to recognize earnings and traders to recognize compensation quickly. However, in declining markets, previously-paid dividends and bonuses are not available to absorb mark-to-market trading losses, which immediately reduce capital levels. Beyond the trading account itself and beyond the reach of the Volcker Rule, the increasing use of fair value by major accounting regimes poses similar risks in terms of the potential for rapid market moves to bring about insolvency or illiquidity in banking entities.4
While the full consequences arising from the Volcker Rule's new trading restrictions remain unclear, the motivation for the Rule is simple: Reducing insured banking entity exposure to significant and unexpected changes in financial markets will allow these entities to more consistently provide traditional maturity transformation (e.g., deposit-taking and lending) and other banking services, even during periods of market crisis.
Key Volcker Regulation Interpretations
The following section discusses three key areas of forthcoming Volcker Rule regulations, including likely interpretations and required actions. The discussion is informed by the legislation itself, the Financial Stability Oversight Council (FSOC) study,5 and related legislative and regulatory comments.6
- Designation of "Trade on Behalf of
Customer"
Any proprietary trading exposure that is undertaken to specifically meet the demands of a customer is permitted under the Volcker Rule. Given this, and the need for an audit trail, trading tickets and systems of record will need to include fields that allow the designation of customer-initiated trades. Designation of hedges to customer-derived trading exposure is also likely to become common practice.
The interpretation of what constitutes a customer-initiated trade must be broad. Market-making, which is largely a customer-oriented enterprise, and customer-mandated underwriting, are specifically allowed by the Rule. The concept of "customer solicited trades" as a potential safe-harbour is discussed in the FSOC study; however, "customer-solicited" will need to be defined loosely. If a financial advisor facilitates a customer trade or even makes a recommendation to a customer regarding a particular trade that is ultimately undertaken in a non-discretionary account, the trade (and resulting exposure) should be considered customer-initiated. Essentially, whenever a customer—whether a hedge fund, retail investor, or other party—authorizes a trade, any resulting banking entity trading exposure should generally be allowable, at least in the immediate term (see risk and conflicts discussion below). - Robust Trading Risk Systems and Conservative Suite of
Limits
For more significant trading firms, Volcker Regulations will effectively require highly robust trading exposure and risk systems that can drill down to the underlying trading position-level and calculate a number of metrics,7 some on an intra-day basis. Ultimately, each firm will likely be required to propose a set of modest net trading exposure and risk limits for regulatory approval. For each firm, the levels of allowable exposures and risks, deemed consistent with insignificant proprietary exposure, are expected to be based on factors such as financial condition, customer trading volumes, and quality of systems, risk-management, and governance.
In summary, banking entity trading under the Volcker Rule is likely to be constrained by a conservative set of firm-specific limits. The Federal Reserve, as the supervisor of most consolidated banking entities, will effectively set constraining limits for each firm. The above conclusion is supported by the following points:
- The Volcker Rule allows, and in fact expects, hedging of exposure derived from customer trades. Most of the hedging undertaken within trading books is performed at a portfolio, sub-portfolio, or risk-bucket level. This is recognized by the FSOC. However, it also recognizes that the lack of hedging of certain customer-derived exposures can serve to circumvent the prohibition of proprietary trading. The FSOC study states, "However, hedging, or alternatively, the flexibility not to hedge a position, also presents a potential avenue to evade the proprietary trading prohibition..." This should be read to mean regulators will not allow the existence of relatively large or concentrated trading exposures simply because they are acquired as a result of not hedging chosen customer-derived exposures. Similarly, imperfect hedging of customer-derived exposures, which results in significant proprietary exposures, are also implicitly targeted. To convince regulators that these "back-door" proprietary trading exposures are not being undertaken will require robust systems and adherence to conservative limits.
- Though market-making is understood to entail some long or short position-taking in an attempt to effectively service expected customer-demand, regulators recognize that such open positions represent proprietary trading risk. The FSOC makes clear that this form of trading exposure should be limited to what is necessary. Again, for a firm to prove there is not excessive proprietary trading position-taking within the business of market-making will require robust systems and adherence to conservative limits.
- The recently released bi-partisan report by the Senate Subcommittee on Investigations specifically recommends that regulators "Narrow Proprietary Trading Exceptions" under the Volcker Rule.8 The executive summary states, "any exceptions to that ban, such as for market-making or risk-mitigating hedging activities, should be strictly limited in the implementing regulations to activities that serve clients or reduce risk." To prove that risk is strictly limited, firms will need robust systems and conservative limits.
- Finally, given the FSOC recommendation that each banking entity
CEO certify that prohibited proprietary trading has not occurred,
one can only expect that trading systems and risk limits will be
relatively tight. Preventing outsized trading losses and gains will
become more important to CEOs seeking to avoid scrutiny and
potential penalties.
- Material Conflict of Interest Disclosures
The section of the Volcker Rule dealing with material conflicts of interest may be the least understood. "Under the Volcker Rule, permitted activities are prohibited if they involve or would result in a material conflict of interest."9 The FSOC study did not suggest a definition of material conflict of interest and did not provide significant interpretative guidance.
In a strict sense, almost every transaction involves some level of mis-alignment or economic conflict among parties, in part due to the profit motive of firms. However, beyond this, in most situations it is not possible for a banking entity to know if it is providing a client with a security or contract that results in a meaningful conflict of interest. Such a determination would require employees to have both ongoing and complete knowledge of the banking entity's own net positions, and complete knowledge of each client's net positions. Given this intractable hurdle, the material conflict of interest prohibition is likely to be both subjective and difficult to enforce.
To mitigate regulatory risk, banking entities may bolster existing compliance programs with initiatives such as:
- Providing standard disclosures to all clients affirmatively stating that the firm's own positions may currently or in the future conflict with an individual position provided to the client, or the client's net positions.
- Establishing additional policies and training for traders and
firm representatives that prohibit the implicit or explicit
communication of desk, individual entity, or consolidated banking
entity positions or exposures.
Conclusion
The motivation for the Volcker Rule is rooted in the simple idea of protecting bank utility functions. Its regulatory interpretation is likely to push banking entities with significant trading operations further in terms of the robustness of their trading and risk management systems and processes. The Rule is also likely to require heightened coordination between trading risk managers, compliance personnel, and regulators. Given recent commentary by various government entities, it appears the Rule's proprietary trading restrictions will be interpreted and enforced in a relatively strict manner. This will present trading risk managers with ongoing challenges, but may also increase their status within organizations.
Appendix
Figure 1. Banking Entity Trading – Volcker Rule Decision Tree10
Footnotes
1 This article focuses only on the aspects of the Volcker Rule that deal with Banking Entity trading.
2 Nationally Recognized Statistical Rating Organization: NRSROs are credit rating agencies approved by the SEC. NRSRO ratings are referenced by various financial company laws and regulations, and relied on by industry participants.
3 Private-issue mortgage securities are not supported explicitly or implicitly by the US Federal Government.
4 It is recognized that a mark-to-market value is not always equivalent to fair value under accounting interpretations.
5 Financial Stability Oversight Council. "Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds." January 2011.
6 Refer to Figure 1 in the Appendix for a Volcker Rule individual trade flowchart.
7 The set of approved risk and exposure limits may include various VaR, stress tests, notional net exposure limits, Greeks, etc.
8 Levin, Carl, and Coburn, Tom. "Wall Street and the Financial Crisis: Anatomy of a Financial Collapse." United States Senate – Permanent Subcommittee on Investigations: Committee on Homeland Security and Governmental Affairs, 13 April 2011, p. 639.
9 Financial Stability Oversight Council. "Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds." January 2011, p. 48.
10 The Dodd-Frank Wall Street Reform and Consumer Protection Act, "SEC. 619: Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds." Financial Stability Oversight Council, "Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds." January 2011.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
