The Hurt Volcker: Diffusing Proprietary Trading


By: Thomas Michael

The ongoing battle between regulators and the financial industry took a significant step forward last week, as the Federal Deposit Insurance Corporation (“FDIC”), the Federal Reserve, and the Securities and Exchange Commission (“SEC”) all unanimously approved an initial version of a regulation designed to prevent banks from trading for their own profit. This proposal, known as the “Volcker Rule,” has the potential to initiate a major overhaul of the banking industry and drastically change how trading on Wall Street is conducted. However, the initial draft of the rule released last week has proved to reveal more problems than solutions and it remains to be seen what, if any, new restrictions will actually be enforced.

What is it?

The Volcker Rule (“the Rule”), named for former Federal Reserve Chairman Paul A. Volcker, is a key part of the 2010 Dodd-Frank Act. The Rule’s primary purpose is to prohibit any banking entity from engaging in proprietary trading. Proprietary trading occurs when a firm makes a trade using its own money, as opposed to its customers’ money, for the purpose of making a profit for itself. The problem with allowing banks to engage in proprietary trading is that banks benefit from government insured deposits. So when a bank bets on risky investments that cause the firm to fail, it is the government that bears the loss and the taxpayer that is forced to bail them out. This was one of the reasons for the financial crisis in 2008.

Such a straightforward problem would seem to beckon a straightforward solution, but the Volcker Rule, in its most recent form, is a complex behemoth spanning 298 pages with nearly 400 questions for the public and industry professionals to answer. This long list of questions voices the competing concerns of the different agencies that are responsible for drafting the Rule and reveals the deep divisions concerning how best to implement it. The public has until January 13, 2012 to comment on the rule, which is then expected to take effect in July of next year. The fact that regulators have more questions then answers surrounding the Rule does not bode well for its reception by both the banking industry and consumers alike.

What do the banks say?

It may not come as a surprise to many, but banks do not like changes, especially changes that cost them money. Proprietary trading generates large profits for banks, profits that will essentially be eliminated if the Rule is put into effect as it stands today. The Rule would also affect bankers on an individual level, as it prohibits awarding bonuses that encourage or reward proprietary risk taking. On top of this, banks will be limited in investing in hedge funds and private equity funds. Under the Rule, banks may only own up to a 3% stake in any such fund and this investment may not exceed 3% of the bank’s total capital. The Rule requires that banks generate revenue primarily from fees and commissions rather than the fluctuating values of securities they hold. Market analysts estimate that these limitations may cost the big banks 2 billion dollars or more in revenue.

Some banks have anticipated the restrictive effects the Volcker Rule and have already begun closing their proprietary trading desks. Goldman Sachs, Bank of America, JP Morgan Chase, and Morgan Stanley are among those who would prefer to sacrifice this form of revenue rather than attempt to comply with the Rule’s confusing regulations. Goldman Sachs is considering dropping its bank holding status to avoid such expenses. Federal regulators estimate that banks will have to spend over six million hours putting the rule into effect.

The banks argue that restrictions imposed by the Volcker Rule will hinder the recovery of the still struggling U.S. economy, will burden their ability to adequately serve customers, and will be prohibitively costly to enforce.

What do the critics say?

At this point in the Volcker Rule’s existence, there are many critics. Banks, advocates, and regulators have a litany of gripes concerning the proposal. Proponents argue that overly vague language in the Rule and the exceptions provided therein will allow banks to easily side step the ban.

The proposed Volcker Rule includes an exception permitting banks to trade securities in connection with its underwriting activities, so long as it complies with an internal compliance program. Similarly, trades involved with market making activities are exempt from the Volcker restrictions. The problem with these exceptions is that routine market making involves buying securities from one customer with the intent of selling them to another customer, providing much needed liquidity in the markets. In practice it is very difficult to distinguish this type of client-based activity from the type of proprietary trading being banned.

Other exceptions include risk-mitigating hedging, which means banks will be allowed to trade securities for the purpose of reducing risks involved with carrying out a customer’s trade. Banks will also be permitted to engage in proprietary trading of government bonds, foreign currencies, and on behalf of clients. And, of course, there are exceptions to all of these exceptions.

The Volcker Rule has not only purposely created loopholes that banks will surely exploit, but has so blurred the line between what is and isn’t permitted that enforcing its provisions will be next to impossible.

How will it be enforced?

One of the issues spanning both sides of the argument is how to enforce such a sprawling yet ill-defined rule. The answer proposed by the regulators is to defer the burden of enforcement to the banks themselves. The Rule outlines an expansive internal control structure that banks will be forced to implement and monitor. Banks will have to turn over extensive data concerning trades and revenue in order to determine whether they are helping clients or trading for their own benefit. One version of the Rule proposed that bank executives would have to certify the legitimacy of their compliance programs. This “CEO attestation clause” was included in the draft released last week as a question for public review rather than a provision in the rule.

While these proposals represent enormous costs to banks in monitoring compliance and reporting figures to the regulatory agencies, the most glaring issue is the logic in having the banks enforce the Rule themselves. This is not to say that the banks will actively deceive the regulatory agencies, but with a rule as vague as the Volcker Rule is now it will not be difficult for banks to be creative in their compliance.

Why is this important?

Despite all of its issues, the Volcker Rule represents the single most important regulation to be proposed in recent history. In theory, the Rule will drastically change the way the banking industry conducts business and will safeguard the taxpayer from having to bailout banks in the future. It will refocus the priorities of the banking industry on benefiting the client, rather than maximizing profits. This transformation will promote private investing, decrease speculative risk taking, and insulate the government from volatility on Wall Street.

The proposal released last week, however, is only the beginning and it is unclear how the rule will change in the coming months. Will regulators respond to the critics arguing for tighter restrictions? Will they cave to the complaints of the bankers? Will the voices of those occupying Wall Street play a role in promoting more stringent regulations? There is a long way to go before the rule is implemented and even longer before it is adequately enforced. But the public release of the Volcker Rule is a significant move toward reforming the issues infecting the banking industry and is an important step in protecting the markets from the risks and liabilities of proprietary trading.


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Fordham Journal of Corporate & Financial Law