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Beyond Volcker: Seeing the Forest Through the Trees

Looking at the big picture, we see that Dodd-Frank leads to the removal of some of the structural barriers that exist in today's largely two tiered market structure, redistributes risk capacity within the capital markets and moves prop risk taking out of the banking system.

Congress determined that banks should be out of the proprietary trading business. Dodd-Frank became law. The law was handed-off to regulators who drafted the proposed rule that so many seem to dislike.

Despite continued lobbying, both politically and through the media, just about everyone now gets it - banks won't be allowed to prop trade. Bank executives are beginning to acknowledge that it is no longer about what will not be allowed, but their challenge is now to minimize the costs and burdens of trading for their customers under the requirements.

It isn't going away, even if the Republicans win the 2012 general election. The financial community must work with regulators to facilitate implementation.

The Volcker Rule will have a large and immediate impact on trading, risk and liquidity, but it is only one piece of a larger regulatory framework being implemented that will shape the financial markets and the way we do business.

WE NEEDED IT

It is important not to forget how we got here. Our financial system was near collapse and needed government intervention to remain functional. There is no argument that the system was broken and needed serious structural repair that superseded the individual and collective ability of industry constituents. Banks were failing - unable to manage their risk and liquidity. We needed the government to make the hard decisions where the markets lacked incentive. The justified and appropriate response: enactment of Dodd-Frank and restructuring the financial system through creation of risk mitigating safeguards, one of which is the Volcker Rule.

Banks are in business to make money for their shareholders. Regulators are tasked with preserving the stability and integrity of the financial system. Those objectives often conflict, which is what we have been observing over the past couple of years. As things stand, our message to Congress and regulators is to "hold the line." In the face of a substantial criticism and special interest lobbying, the rules being implemented remain necessary for the long term stability of our financial system.

WE GOT IT

It has been five months since the U.S. Securities and Exchange Commission released the draft proposal for the Rule. The accuracy and precision caught many by surprise. Regulators crafted a proposal that very clearly details what constitutes proprietary trading and what will and will not be permitted at banks and their affiliates going forward. It is also very clear in principal and leaves little doubt about their intent. Implementation, however, is proving to be difficult due to many market nuances that need to be addressed, and potentially costly shotgun approach proposed for its metrics.

Rather than rewriting the Rule, we think regulators are likely to simplify the current proposal. This could be done by moving away from many of the detailed prescriptive measures cited to broader risk-based measures. This places less focus on determining the intent of a transaction and more on the resulting risk and its relationship to customer-oriented business.

In the OTC markets we expect a broader application of the market-making rules, placing a greater emphasis on aggregate product risk viewed as a portfolio rather than that of individual transactions on a stand-alone basis. This should give banks the latitude to more freely manage the risk within their trading books, which will facilitate their ability to make markets more effectively.

We at Woodbine Associates have long held the belief that risk-based metrics are most relevant for bench-marking compliance with the Rule since the its goal is to eliminate proprietary risk taking (see: To Catch a Proprietary Trader – Feb 15, 2011). These are easiest to measure and readily available in most cases. Focusing efforts and position risk measurement at the book, product or asset class level, or firm as a primary metric, alleviates the need to validate the intent of each transaction on an individual basis.

We agree with critics that assert customer oriented market-making requires firms to maintain a functional level of risk on their books coincident with that activity. While the Rule allows for this, it lacks clarity in some areas, such as trading for price discovery and sizing the market, that are done to facilitate customer market-making. Focusing on risk-based metrics eliminates the need to evaluate these types of trades individually and allows their risk to be evaluated as part of the aggregate customer "flow" business.

Other metrics, of which there are many, are likely to be reduced to a more meaningful subset that focus on benchmarking firm risk to that of its customers. They should include those for assessing a firm's intraday risk levels and trade volume to ensure that permitted proprietary trading, such as market making, is done to facilitate customer transactions or reduce risk.

This measurement, in conjunction with oversight and self-regulation of the principal-based elements of the rule, would accomplish both the legal and regulatory objectives. It would do so in a manner that does not unduly constrain the ability of bank dealers to conduct truly customer oriented market-making. We expect the emphasis to focus on setting and monitoring risk limits that are benchmarked to the amount of customer risk traded, giving banks more latitude on how they operate intraday.

Although the final form of the Rule will ultimately determine the regulatory cost to banks and their ability to make markets, we expect little change in the underlying principals laid out in the proposed rule. Generally speaking: trading for customer facilitation or risk reduction are fine. There will surely be product and sector specific changes for market nuances, but what we see is likely to be pretty close to the framework we get.

Sean Owens is Director, Fixed Income at Woodbine Associates, Inc. focusing on strategic, business, regulatory, market structure, and technology issues that impact firm's active in and supporting global fixed income and derivative markets. View Full Bio

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