PRIMER: the Volcker Rule - proprietary trading

Author: John Crabb | Published: 25 May 2018
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Two of the main provisions of the Volcker Rule prohibit banking entities from proprietary trading, and from attaining or retaining an ownership interest in or sponsoring a covered fund. This primer will look at the proprietary trading specific aspects of the rule, click here for a more general account of the Rule from IFLR.

What is proprietary trading?

Proprietary trading is defined as engaging as principal for the trading account of the banking entity in the purchase or sale of a financial instrument, which is determined by specific definitions of trading accounts and financial instruments. The Volcker Rule, in its current guise, prohibits this kind of activity.

It occurs when a bank or a firm makes an investment from its own balance sheet that is set to directly benefit only itself, rather than through a commission from its clients on behalf of a trade on their behalf. The firm or bank will profit from the market and not the margin of commission. It is likely to result in enlarged profits, as the bank or firm will retain the entirety of the profit, hoard securities, and has the ability to become a market maker using its increased liquidity.

There are exemptions that mean the ban does not apply trading does not apply to certain permitted underwriting and market making-related activities.

Is there a problem with proprietary trading?

At a high level, proprietary trading has been blamed for the collapse of the financial sector during the crisis in 2008. While this opinion is up for debate, there is an element of truth that the risk carried by such an activity caused substantial losses that led banks to fail in a spectacular way. The trades use more leverage - often borrowed money - than regular ones and are by definition riskier.

"What we are really trying to do is discourage banks from taking on market risk on to their own books...The focus on that really goes to the heart of the regulation"

How the Volcker Rule handles proprietary trading has been debated ever since the legislation was originally drafted. The market has expressed concern over the complexity of the Rule’s definition of proprietary trading, which generally applies when a banking entity engages as principal for its trading account in the purchase or sale of a financial instrument.

A Volcker compliance officer at a US bank does not think that under the current definition it is enforceable, and that it is extremely difficult to think like a trader when they have any element of digression. Once a financial institution gets an option in its books, while it can rely on the trader’s services, they are in a variable position that requires them to hedge.

“Whenever you are hedging some non-money instrument, which every single interest rate instrument is, then you have to rebalance your hedges,” he says. “So, unless the trader has a perfectly prescribed hedging programme that is basically automated, then there is digression.”

From a compliance perspective too it is hard to judge. In a legitimate instance, the trader could leave the position open because they wanted to stay short, so then its legitimacy could be called into question down to the minute, or even every second in the procedures.

“You can’t do that, you would have to automate hedging completely and there is no way that can be done. It is unwieldy, and it is a very slippery slope to try and find it,” he said. “If it is designed to prohibit proprietary trading and that is what it is doing then, then what is wrong?”

Paul Volcker
Should Volcker's landmark rule be amended?
Other feel that proprietary trading should be defined with respect to the amount of market risk that a banking entity takes in connection with a given transaction. “What we are really trying to do is discourage banks from taking on market risk on to their own books,” said an in-house counsel at a bank. “The focus on that really goes to the heart of the regulation.”

What steps are being taken to simplify things?

There are steps in place to radically overhaul much of the Volcker Rule, including the much debated definition of proprietary trading.

Defining key terms like proprietary trading should not be a guessing game that requires hours of legal analysis of complex banking and securities regulations to determine if a particular entity constitutes a trade, argued Federal Reserve vice chairman for supervision Randal Quarles in a recent speech, He has been championing Volcker reform since his appointment earlier this year.

“It should not happen - although it has happened – that our supervised firms come to us and ask questions about whether a particular derivative trade is subject to the rule, and we cannot give them our own answer or a consistent answer across the five responsible agencies,” he said.

Extensive proposals are expected to be released in the coming weeks. From a market and regulatory respective and from a bipartisan point of view, the Volcker Rule is probably one of the easiest conceptual changes that could be made coming out of the change in the leadership in Washington, suggested Michael Alix, principal at PricewaterhouseCoopers. “If these suggested changes are made there will be get a lot of savings throughout the industry, as well as clarity, without need for a material change in the underlying risk that the Volcker Rule is trying to address,” he said.

Last year, the Department of the Treasury issued a number of reports outlining suggestions to the financial industry, and in the June report entitled ‘A Financial System That Creates Economic Opportunities Banks and Credit Unions’ outlined its specific intentions for Volcker with substantial amendments.

The report made two suggestions for simplifying the definition of proprietary trading, purporting that it should be limited to allow banks to more easily hedge their risk and conduct market making activities; which are to eliminate the 60-day rebuttable presumption and assessing whether to eliminate the purpose test from the definition of proprietary trading.

The purpose test is an enquiry that determines if a trade was made for short term resale that benefits from short term price fluctuations, which created the so-called rebuttable presumptions that holds for trades of less than 60 days.

“This presumption, however, simply replaces one problem with another—exchanging subjectivity for overbreadth. The 60-day presumption places the burden on firms to justify the permissibility of their trading, creating undue pressure on compliance programs and leading to excessive conservatism in firms’ trading activities,” reads the report.

One US in-house counsel went as far as to call the rebuttable presumption ridiculous, and says it should be eliminated.

“If they want to keep it, drop it from 60 days to one or two,” he says. “Taking it for what it is worth, if you want to make a quick buck and you think you know better than the market you are going bet on an economic number, a Fed rate, something like a war starting or not starting. You are not going to take a position and leave it open for 59 days, that is ludicrous.”

The Federal Reserve is set to meet on May 30 to look through a proposal to relax the Rule.

See also:

PRIMER: the Volcker Rule

A user’s guide to the Volcker Rule