As regulators delay writing the final rules for the sweeping Dodd-Frank financial reforms, the Volcker Rule's ban on proprietary trading continues to cause confusion among the investments banks that must comply with the rule. Analysts say there is a lot of uncertainty and angst in the industry over how regulators will distinguish between proprietary trading and other types of market making or principle trading in which the broker buys or sells a security with its own capital in order to match buyers and sellers.
"The challenge of the Volcker Rule is, how do you draw the line between who is doing proprietary trading versus positioning for a future customer transaction, because they look identical in some cases," says Sean Owens, director, fixed income, at Woodbine Associates.
Adds Bob Fitzsimmons, managing director and head of the derivatives business at Investment Technology Group, "Most firms know that under the Volcker Rule, commercial banks have to get rid of proprietary trading. And most firms have been focused on: How do you define proprietary trading versus the customer facilitation of customer orders?"
Several major investment banks -- including Goldman Sachs, Morgan Stanley, JP Morgan, Citi and Bank of America -- already have shed pure proprietary trading desks to begin to comply with the Volcker Rule. Some of the same firms, however, are waiting for the specific requirements to be finalized before spinning off all of their prop desks, hoping that the final interpretation of the rule will allow them to hold on to those businesses.
Increasing the confusion, the Volcker Rule includes exemptions for certain "permitted activities" -- such as market making, hedging for risk mitigation, transacting in government securities and underwriting. But market observers say the lines are blurry. In fact, an 81-page study by the Financial Stability Oversight Committee (FSOC), published in January, warned regulators that proprietary trading could take place within these permitted areas.
Meanwhile, sell-side firms are left to wonder how regulators will monitor compliance with the rules. While hedging is permitted as a risk-mitigating transaction, for example, "That actually presents a potential dilemma since a bank could say a trade was undertaken as a hedge, and have a reasonable basis for arguing so, and the regulator could disagree. It will be difficult for the regulator and the bank to make a perfect argument about what is a hedge," says Bernie McDevitt, VP of institutional trading at Cheevers & Co., an institutional agency broker in Chicago.
"They're still wrangling over definitions," notes Robert Hegarty, managing director and head of global market structure at Thomson Reuters. "So much of the legislation has been written in broad brush strokes. It's not until you get down to the writing of the rules where you get into some discrepancies of what the intent of the law is."
Prop Trading: 'You'll Know It When You See It'
Few would dispute, however, that the overall goal of the Volcker Rule, named after former Federal Reserve chairman Paul Volcker, is to prevent banks from speculating with their own money and causing another financial crisis. "The Volcker Rule is really about separating customer deposits from taking on risk," says Paul Zubulake, senior analyst at Aite Group. "The idea is to not have the firm speculating in different markets."
Like Volcker himself, Zubulake argues that it should be easy for Wall Street firms to determine which desks are conducting proprietary trading. "There should be no question what proprietary trading is at a big broker-dealer," he insists. "Proprietary trading is when a firm buys or sells securities for the firm's own trading account. They have no contact with the customers, they are not market making, they are basically trading with a strategy and they're using the bank to get credit or, if it's exchange-traded, they have to post margin."
Nonetheless, Zubulake acknowledges, there is confusion on the part of internal compliance departments as to what constitutes proprietary trading -- even if the business units are clear on this -- and that will be bad for business. "There is this misunderstanding of what proprietary trading is," according to Zubulake, who says compliance departments and lawyers are concerned that some of their firms' activities may be considered proprietary trading. "The business knows they are not proprietary trading, but their own compliance folks are putting questions into their heads."
Some sell-side firms that keep inventories in order to supply their clients with a security after an earnings call or an inital public offering such as Facebook or LinkedIn, for example, are being asked to explain why by their internal compliance departments. "The whole distribution process for certain products is going to be compromised," says Zubulake. While firms keep positions in certain circumstances -- including when market makers assume the role of counterparty in the absence of a ready buyer or seller on the other side of the trade, or in over-the-counter derivatives transactions, when the market maker provides the customer with a price and holds the instrument in its portfolio -- "How do you define what's the [acceptable] holding time?" asks Zubulake. Is it hours? Overnight? Days?
In January, the FSOC study called on banks to develop "robust internal controls and programmatic compliance regimes" to ensure that proprietary trading does not migrate into the permitted activities. The FSOC recommended that the banks use various metrics based on inventory turnover, trade volume relative to the amount of customer business and Value at Risk (VaR) to identify prohibited trading.
Woodbine's Owens, however, argues that regulators should look at a variety of risk metrics that capture intraday risk, as end-of-day metrics provide an inadequate risk picture. For example, he says, a firm could take huge intraday positions for day trading but end the day with zero risk on its balance sheet if it unwinds the positions.
"Ultimately, a combination of metrics will most likely be monitored," Owens comments. But, "The more closely you look at trade by trade, on a granular basis, it's harder to enforce; it takes more manpower and looking at more data," he adds, suggesting that a risk-based approach is more practical.
The Liquidity Impact
Beyond how regulators will define proprietary trading and enforce restrictions on sell-side firms, one of the biggest unknowns is how the Volcker Rule will impact liquidity for the banks' buy-side customers. If proprietary trading desks are shut down and their large positions are unwound, will the liquidity in the markets or in broker-owned dark pools plummet?
Thomson Reuters' Hegarty says buy-side firms could embrace the Volcker Rule because they don't want the sell side to trade against them. "The spirit of the rule is really to prevent investment banks from placing bets against their client accounts," he notes.
Hegarty points out that during the financial crisis, some banks took on huge positions in mortgages for their own accounts and bet against those positions with credit defaults swaps, while other parts of the investment banks actually pushed out these mortgage-backed products to their institutional clients. "That is a complete conflict of interest in the eyes of the Dodd-Frank Volcker Rule," he says.
On the other hand, a buy-side firm might need to unwind a large trade quickly, Hegarty notes. The Volcker Rule "will definitely reduce the ability of the sell-side firms to take on a position that they otherwise would be able to do" if they had a proprietary trading desk behind them, he explains.
But Hegarty doesn't think that the industry will see liquidity decrease due to the Volcker Rule. Instead, he predicts that liquidity will move to other places. "When firms like Citigroup and BofA shut down their proprietary trading desks, you see people in those businesses showing up elsewhere," he says. "So the liquidity is going to shift."
A hedge fund that trades with a large bank today may simply trade with someone else, including the groups that are spun off from the big banks, suggests Hegarty. "That may force buy-side firms to find the natural buyer or seller," he says. "The bigger dark pools can be another place to look for that." Hegarty also predicts that the Volcker Rule will be a boon for agency brokers, which don't participate in proprietary trading.
Other market experts agree that alternative players will take up the liquidity role vacated by prop trading desks. "If that trading had value, I would suspect that someone else would take up that trade," says Cheevers' McDevitt. "If that was a profitable business, that role would be undertaken at some level, perhaps by the hedge fund that [the bank] spun off."
Ultimately, overall liquidity isn't likely to experience a precipitous drop, Woodbine's Owens suggests. The banks will be allowed to continue to trade for customers, engage in market making and take on inventory in some circumstances, he notes. In addition, all of the high-frequency trading firms -- which serve as market makers and provide tons of liquidity -- can continue their proprietary trading, as they're not beholden to the Volcker Rule, Owens points out.
And in the end, Thomson Reuters' Hegarty says, the regulators will provide detailed definitions and clarity on the Volcker Rule, and Wall Street banks will be able to get back to business -- even if that business has been changed somewhat. "It will be divided along the lines of providing a service to your client versus if you are trading or taking a position with no benefit to your client," he adds. "There's going to be a lot of scenarios they're going to have to go through to determine, 'This is in or out.'"