The Volcker Rule Ban on Prop Trading: A Step Closer to Reality

The Volcker Rule is one of the more controversial pieces of legislation to emerge from the financial crisis. Attached to the Dodd-Frank Act, the rule was intended to limit banks’ ability to make speculative investments that do not benefit their customers. Translating this concept into functional regulation has turned out to be extremely difficult.

As enacted into law, Section 619 of the Dodd-Frank Act (what is termed “the Volcker Rule”) has three major effects on banking entities:

1. Prohibits meaningful investment in hedge funds, private equity funds, and similar vehicles
2. Prohibits separately organized “prop trading” desks in most asset classes
3. Allows market making, underwriting, and related hedging – but only if such activity does not involve prohibited proprietary trading

The first two effects are relatively easy to understand and, importantly, to police. It is the third that has proved so challenging. The core idea is that one could keep the “good” activities of capital markets dealers, such as providing market making and hedging services, while stamping out the “bad” practice of speculation by firms with access to the bank safety net. However, both sets of activities necessitate taking and managing market risks, with the possibility of gain or loss on market moves. Telling the two apart promised to be difficult from the outset.

US regulators, having spent over a year wrestling with this, have finally released proposed rules implementing the Volcker Rule. The regulatory agencies1 have realized that the prop trading ban will be nearly impossible to police from outside and, accordingly, have placed the onus on each banking entity to police itself through a complex compliance regime, monitored by regulators.

Critically, the proposed rule does not:

• Make market making impossible to pursue for banks;
• Make it impossible for banks to manage liquidity and firm-level interest rate risks;
• Make it impossible for banks to hedge risk dynamically at the portfolio level;
• Require trade-by-trade reporting and analysis to demonstrate compliance; or
• Mandate the same compliance regime for firms of all sizes and scope.

It does, however, have very far-reaching implications for banks. Complying with the Volcker Rule as proposed will require a major effort by nearly all bank-owned trading businesses worldwide, and will involve potentially profound changes to business activities and ultimately market structure.

1 The Fed, SEC, OCC and FDIC all collaborated on the proposed rule; the CFTC is reportedly waiting before considering its own implementation of the Volcker Rule.

To view the February 2012 report click here.

The Volcker Rule Ban on Prop Trading: A Step Closer to Reality