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Can Regulators Realistically Enforce the Volcker Rule?

As regulators gear up to phase in the Volcker Rule -- an element of the Dodd-Frank financial reform package -- experts say a myriad of obstacles may keep the law from functioning as intended.

When Does a Hedge Cross the Line?

Under the Volcker Rule, banks would be allowed to hedge their risk across multiple portfolios, which J.P. Morgan chief executive Jamie Dimon said would allow them to protect themselves against bad outcomes. But this concept is now at the center of a contentious debate and intense lobbying activity, with proponents of a stronger interpretation of the Volcker Rule arguing that this type of hedging will enable banks to covertly execute risky prop trades.

Shortly after the J.P. Morgan news broke, Senators Jeff Merkley (D.-Ore.) and Carl Levin (D.-Mich.) asserted that the London Whale trades were a sign that "too big to fail" banks can still have too much wiggle room to make risky bets under the Volcker Rule through hedging strategies. But the distinction between a hedge and a bet is a line that's nearly impossible to draw, underscoring the complexity of the puzzle that regulators must solve as they phase in the new law, according to University of San Diego law and finance professor Frank Partnoy.

"There are straightforward hedges, such as if I buy a bond and short the bond," Partnoy says. "There might be some counterparty risk, but I've got a hedge. But once you move away from that, there's always a question about whether you're well hedged."

In the case of portfolio hedging, Partnoy insists, it's nearly impossible for a bank to get a perfect hedge of its portfolio. "The whole line-drawing exercise is one that is almost doomed because how can you tell when someone is hedged and when they're not?" Partnoy asks. "What would you let me do if I owned 10 bonds? Would you let me short 10 of them? That seems like something that would clearly be eliminating the risk. Would you let me buy credit default swaps on 10 of them? ... It's not clear to me that regulators will be able to draw a line."

Otis Casey, the director of credit research at bond and CDS data provider Markit, agrees. "The question is, what's the threshold? What's good enough to qualify for saying the motive is a hedge versus a proprietary bet?" he adds.

"Are regulators going to interview traders and say, 'What were you thinking when you put on 'X' trade?' and enforce a concept where they're monitoring the diary of a trading journal?" Casey continues. "It basically sounds like running a constant, ongoing investigation. And what's the cost to regulators to monitor that? What's the cost to the industry to comply?

Staying One Step Ahead of Regulators

Beyond the mountainous challenge of finding the right mechanisms with which to ensure a bank's positions are properly hedged, or even pinning down the distinction between a hedge and a proprietary bet, is the notion of regulatory arbitrage. Experts say regulators are simply not sophisticated enough, quick enough or armed with enough technology -- or even properly incented -- to prevent banks from exploiting cracks in the Volcker Rule.

"Traders are nimble and quick and are paid 10 times more" than regulators, the University of San Diego's Partnoy says. "The traders are like jet skis running around an aircraft carrier. The aircraft carrier can try to move, but as they do that, the traders anticipate it and are off to the next race before the regulators have even figured out what the previous race was."

Historically, Partnoy says, whenever a regulation is thrust upon the financial sector, firms often opt for "window dressing-type" compliance measures wherever possible. "If you impose a regulation as of the end of the day or quarter, what's to stop firms from trading out of that position intraday or intraquarter in order to take on more risk?" he asks. "So you make your bed at the end of the day so it looks like everything is neat and tidy in your room. But who knows what's happening during the day?"

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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