by Mikala Sorensen, an analyst at Global Risk Insights
On April 1st, the Volcker Rule comes into effect. What does that mean for banks, businesses and markets?
The Volcker Rule is designed to address conflicts of interest in proprietary trading, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Proprietary trading, where banks trade for their own account and not on behalf of any client, has been known to cause some investment banks to ‘bet against their own clients.’ In particular, Goldman Sachs stands accused, but Deutsche Bank and Morgan Stanley have also allegedly practiced this dubious strategy.
Some types of trading may seem like proprietary trading. One such is market making, where the bank buys, sells and holds securities to facilitate any potential trade a client may wish to execute. This is a bit like a firm keeping some inventory and regularly adjusting its inventory in response to demand from clients. Market making is considered a beneficial feature, and thus is not the target of Volcker-regulation.
Another example is hedging. Since this is a method of mitigating risks there is no issue of conflicting interests, but the lines can become blurred. In the extreme case, hedging may look a lot more like gambling, as in the case of the London Whale incident in 2012, which caused JP Morgan to lose $6.2 billion – and cost the bank $920 million in settlement. Trading has become a pretty big generator of revenue, as shown in the figure below. The question is, how much of it is rotten, and how much will be curbed by the implementation of the Volcker Rule?
Source: Bloomberg
A significant part of blame for the ‘Too-Big-To-Fail’ problem was placed on the shoulders of the so-called Citigroup relief act, formally known as the Gramm-Leach-Bliley Act (1999). Until the 1990s, there had been a sharp division between investment banking, commercial banking and insurance, due to the Glass-Steagal Act, implemented in the wake of the Great Depression.
As noted by Bloomberg, “the financial crisis of 2008 had its seeds in bad mortgages, but what brought banks to the brink…wasn’t bad loans but the exotic trades they had made around them. The six largest U.S. banks made .6bn in trading profits during 13 of the 18 quarters that spanned mid-2006 to 2010.” Conversely, they accumulated even larger losses in the five other quarters. To Obama and Volcker, not to mention several others, it seemed prudent to consider regulation similar to Glass-Steagal, after the calamity of the Great Recession, to reign in the hybrid banks engaging in commercial as well as investment banking.
The question is whether the Volcker Rule achieves its objective or distorts markets to the detriment of the clients it is meant to protect. It has to focus on regulating transactions rather than the structure of the bank, due to the Gramm-Leach-Bliley Act, and because the global financial behemoths are ‘too big to break up.’ This, however, leaves it to the regulators’ discretion to define and recognize an illegal trade from a legal one – a feat which is often made difficult by fuzzy dividing lines.
There is pessimism about the ability of regulators to distinguish between legal market making and hedging against specific risk associated with loans and mortgages, on the one hand, and illegal proprietary trading, where client interests are not served at all, on the other. As a corollary, there are too many loopholes in the new legislation, despite its 900+ pages of text.
R. Rex Chatterjee from Columbia Law School argues that “the problem with the Volcker Rule is that it tries to regulate actions instead of structures. Structures are limited in nature and not easy to modify…Trading actions are vague, numerous, and easy to modify. Defining them, much less regulating them, is like drawing lines in the sand of the Sahara Desert during a sandstorm with 80 mile per hour winds—a futile task. The sand changes shape before the lines are fully drawn, just as trades can be reconfigured and redefined before regulations are set into place.”
In the long run, Chatterjee’s conclusion is valid, but in the short run, the Volcker Rule will have consequences – in fact it already has had some, with banks closing down trading desks used for proprietary trading. Furthermore, a number of traders from the large banks have quit and set up hedge funds independently, notable examples being Jean Bourlot from UBS, Nelson Saiers and Boaz Weinstein from Deutsche Bank and Deepak Gulati and Mike Stewart from JP Morgan.
Another worry is that liquidity will decrease in already quite illiquid markets, making it even harder to trade assets that change hands infrequently. Conversely, the Volcker Rule is expected to make liquid markets even more liquid, given the fact that liquid holdings are easier to justify in the face of the new legislation.
However, the Commodity Futures Trading Commission Commissioner Bart Chilton said to Energy Intelligence Finance, “I’m not concerned about liquidity whatsoever.” And Bill Hederman of Deloitte agrees: “Banks will be trading on behalf of customers and trading as a hedge, just not in a speculative manner…Liquidity will return…” Even if liquidity may experience a temporary drop, new hedge funds will pick up the slack over the medium term.
