The Volcker rule, the part of the 2010 Dodd-Frank Act that seeks to limit the threat that big banks’ high-risk trading poses to the entire financial system, is in trouble.
Named after former Federal Reserve Chairman Paul Volcker, the rule requires that bank holding companies stop proprietary trading, in which they speculate with the banks’ own money. The law specifically allows certain traditional, lower-risk transactions, including market making, in which banks trade in response to customer requests.
But banks are lobbying regulators to expand the allowable activities by redefining market making. Regulators shouldn’t be fooled: The banks want the right to continue prop trading, only under a different name.
Market making isn’t new; it has been around for centuries and has an established meaning. Market makers are intermediaries who continuously stand ready to buy or sell some financial instrument, often by providing bid-and-ask prices at which they are willing to trade. That is, they provide immediacy to their clients. They typically try to sell after they buy, and buy after they sell, avoiding the risk of harmful price changes by hedging and keeping inventories small. They make their income from the difference between the prices at which they offer to buy and sell, also known as the bid-ask spread. Done smartly, market-making spreads cover operating and risk-bearing costs.
For example, on any given day, a market maker may offer to buy a corporate bond for $100 and sell the same bond for $102. The $2 difference on the round trip is the bid-ask spread -- and the source of the market maker’s revenue. Such a trade could be done for a specific client or in anticipation of a client’s needs.
Proprietary traders, by contrast, take positions in hopes of profiting from price changes. If, for example, a trader expects the asking price of the same corporate bond to increase to $105, he could use the bank’s borrowing ability to acquire 1,000 bonds at $100 apiece, for a total of $100,000. The trader would be betting that he can make $5,000 in gross revenue when he sells the bonds.
In this example, the trader’s business is not providing immediacy to clients, and his income comes not from spreads but price appreciation on his holdings. This isn’t market making.
Proprietary trading can be very risky. When done on a large scale, it involves borrowing vast amounts of money and making huge bets on the price direction of securities or markets. If the bet pays, banks and their traders reap millions, if not billions, of dollars. If the bet is a bust, it can threaten the trader, the bank and the entire system, as we saw in 2008.
The agencies responsible for enforcing the Volcker rule understand that they must be able to distinguish between market making and other kinds of trading. Their proposal would require that trading desks generate revenue “primarily” from bid-ask spreads or other types of intermediary payment, including one-time fees or broker-type commissions.
Regulators are also proposing that employee compensation that “primarily reward[s] proprietary risk-taking” would be evidence that traders are not involved in market making. The regulators have published a set of metrics to allow after-the-fact determination of what traders have been up to.
The agencies understand the problem, yet their approach would put them at a huge practical disadvantage. Traders in pursuit of large bonuses would have an incentive to disguise proprietary positions as client-related inventories or risk-mitigating hedges. It would also be easy for traders to claim large spikes in revenue arose from unanticipated market volatility.
Under the proposed rule, regulators would be forced to reconstruct history to counter claims by traders and their lawyers that their money-making positions really were necessary inventory or hedges; that market circumstances really were unusual; or that in the long term their income really was “primarily” from acceptable sources. This is a prescription for endless and fruitless Whac-A-Mole forensics.
In their comment letters on the proposed regulations, large banks provide a taste of the enforcement battles to come. Morgan Stanley, for example, says that because market makers have to hold inventories of large or illiquid assets for “days, weeks or months,” they must necessarily have “substantial revenues from market movements in their principal positions.” Citigroup Inc. says that in “all but the most liquid portions of the equity, rate and foreign exchange markets, profitability from bona fide market-making-related activity is significantly derived from price appreciation of inventory positions.”
In other words, when bank supervisors try to enforce the rules, the banks are going to say their revenues are from client-driven inventory holding and hedging. Regulators will have the Sisyphean task of proving otherwise.
Fortunately, there are more effective ways to address these problems. For example, the rule must presume that only trading activity producing income from actual and observable spreads -- brokerage fees and commissions are suitable alternatives -- is true market making. This means that a trader who takes a successful speculative position, whether it was designated as client inventory or as a hedge, cannot claim he is earning money from market making. A crucial element of the incentive structure that currently motivates proprietary trading -- big bonuses -- would be eliminated as a result.
Still, changing the allowable compensation structure is not enough, given the outsized gains that can be realized on successful trading bets. Clever people will look for ways to game it. An effective enforcement program and substantial penalties are needed as deterrents.
Sadly, the enforcement provisions in the proposed rule are minimal. They merely state that when proprietary trading is found, the bank may be ordered to “restrict, limit or terminate the activity and, as relevant, dispose of the investment.”
This threat is likely to deter very little. If prop trading is detected, the bank may be told to stop it, and may even be required to unwind trades on its books. In other words, the consequences of a violation would be minimal. Moreover, the bank and its traders would keep any winnings from successful, but undetected, trading. This is a bet that many traders would gladly take.
A meaningful enforcement program must have financial penalties that are multiples of the gain from violating the rule, and must be assessed on the individuals, supervisors and executives who sought to benefit. Without that, the cost of the penalty could be shifted to stockholders.
Strengthening the proposed rule this way wouldn’t please the major Wall Street banks. Doing so would significantly curb their ability to make large, leveraged trading bets, which can produce very large profits and bonuses when things go well. But the social costs of allowing proprietary trading are just as large -- and unacceptable. An effective Volcker rule is essential to preventing a crisis from happening again.
(Dennis Kelleher is president and chief executive officer, and Marc Jarsulic is chief economist, of Better Markets Inc., a nonprofit advocacy group that promotes transparency in financial markets. The opinions expressed are their own.)
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