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A Stronger Volcker Rule Is Law: Is this a Compliance Nightmare for Banks?

Now that regulatory bodies have voted for the Volcker Rule, there are a slew of new rules, definitions and exemptions that banks must build compliance mechanisms around to avoid violating the ban on proprietary trading.

Five regulatory bodies voted to approve a strengthened Volker Rule to restrict risky trading by banks for their proprietary accounts, adding to their compliance burdens.

“The devil is hugely in the details – hundreds of details describing how these exemptions work,” said Douglas Landy, a partner in the Financial Regulations and Leveraged Finance groups at Milbank, Tweed, Hadley & McCloy and a former staff attorney at the Federal Reserve Bank of New York in a phone interview.

Volker is a joint rule issued by the Federal Reserve, Federal Deposit Insurance Corporation, the Securities and Exchange Commission, the Office of Comptroller of the Currency, and the Commodity Futures Trading Commission.

The Volker rule was inserted into the Dodd Frank financial reform Act of 2010 to protect taxpayers from another bailout but it has met with fierce opposition from Wall Street and lobbyist who see it as cutting into their profits.. Big banks with $50 million in assets are the first group subject to the rule starting in Nov of 2015. Compliance for the other groups of covered banks stretches out to 2017, unless the Fed grants additional exemptions.

“There’s a lot of rules and compliance and reporting which is going to be a massive headache or nightmare,” said Landy. Each of these rules has hundreds of pages of definition, he said.

Wall Street is already sinking money into compliance. "Banks are writing new compliance manuals, training their traders and rewriting computer programs that effectively automate whether a trade is out of bounds under the Volcker Rule," according to a New York Times report.

One of the thorny issues for regulators and banks alike is that the lines between prop trade and market making can be blurry. “The burden now is how do you prove that the trades remaining are allowable trades and compliant under the Volcker Rule,” said Chris Ekonomidis, director in Sapient Global Markets who has been focusing on compliance and Dodd-Frank. “I think there are definitely impacts to compliance systems and technology. It kind of stems from certain trades being looked at from a guilty versus innocence” [perspective],” said Ekonomidis.

The definition of proprietary trading is a short- term position (60 days or less) taken in equities, fixed income, swaps, or backend loans, for the purposes of making money on price appreciation. It doesn’t apply to trading of loans or to a large group of FX, he said. However, Volcker doesn’t apply to long-term trading strategies of 61 days or more, which are permitted. Banks can still do short-term trading if it meets one of the exemptions for hedging, underwriting, market making, liquidity management, customer-driven trades or non-US trades done by foreign banks outside the U.S.

For example, banks can hold inventories on securities to facilitate customer trades or provide liquidity to customers. They can hold securities if they are underwriting to take securities to market and also banks are required to hold certain liquid assets for liquidity management. Banks can hold government securities such as Treasury bonds and municipals, which are exempt.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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User Rank: Apprentice
12/11/2013 | 4:19:29 PM
re: A Stronger Volcker Rule Is Law: Is this a Compliance Nightmare for Banks?
There is no question that the implementation of the technology for the Volcker Rule will be costly and messy. The better firms will be able to minimize the costs while hopefully providing some added value to the bank (rather than just implementing technology to meet a regulation).
User Rank: Author
12/11/2013 | 3:30:52 PM
re: A Stronger Volcker Rule Is Law: Is this a Compliance Nightmare for Banks?
In other words, what regulators have designed may be a mess to implement. I was wondering about how firms would implement the risk analysis, the "correlations of each hedged trade" and how they would store the data. Imagine doing this on credit default swap indexes? What happens if the market moves while the hedge is in place? Does a firm recalculate all the correlations? Perhaps this is something firms do anyway to make sure their hedge is effective. Data has to be stored as well. I also read there is no cost-benefit analysis for the Volcker Rule.
User Rank: Author
12/11/2013 | 12:26:41 PM
re: A Stronger Volcker Rule Is Law: Is this a Compliance Nightmare for Banks?
If only the technologists were at the table we might have gotten a realistic Volker rule, one that is implementable.

The Financial System is a "system" a huge, almost indescribable interconnected web of computers and networks. Financial institutions are huge technology factories. We have already exceeded the capacity of the "system" to absorb more incremental change of regulation. This on top of the crumbling infrastructure of the financial system and the Rube Goldberg legacy technology each financial institution lives with day by day.

We see the dysfunction every day in market shutdowns, stolen credit card portfolios, failed IPOs, swaps trades that overwhelm regulators computer capacity, false starts on trade audit trails, inability to aggregate data for systemic risk analysis because regulators failed to define data formats, inability to aggregate risk for each financial institution because of incompatible data across business silos, etc. etc. etc.

The only way the new information demands of the Volker rule i.e. not exceeding customer near term demands, or explaining trades that heighten compliance risk, can be implemented effectively is through technology. This, in turn, will require new stochastic methods for estimating client trading demand and correlations of each hedged trade. The volume is too huge and the speed of trading too fast to expect any of this to be done manually.

The feel good at-a-boy back slapping of regulators will surely be replaced by the reality of unintended consequences. I for one would not like to be the CEO signing off on the "attestation" provision under the Volker Rule requirements
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