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Sean Owens
Sean Owens
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Volcker on the Mind, But Will it Deliver?

Risk-based metrics are at the core of Volcker Rule compliance. But will firms be able to adequately evaluate risk?

Woodbine Associates has long held the belief that risk-based metrics are most relevant for assessing Volcker Rule compliance.

The goal is to eliminate proprietary risk taking. Identifying risk at the firm, book, product, or asset class level alleviates the need to individually validate each transaction and aligns rule implementation with regulator objectives.

Risk-based metrics are critical to the rule effectiveness. They allow for a clear distinction between market-making and hedging activities. We anticipate that these metrics will be included in the final rule and hope regulators will emphasize them when evaluating bank trading activities.

Woodbine Associates has steadfastly emphasized the relevance and importance of risk-based metrics over the past several years during which the rule has been formulated.

These points have been addressed in commentary we set forth in the past.

Herein is a recap of stringent points we have made over the past three-plus years emphasizing the importance of risk based metrics:

VAR-Based Framework

In The Volcker Rule Proprietary Trading Ban: A Practical Approach to Implementation (PDF), we advocated a straightforward, practical approach to regulatory oversight might involve the adoption of a risk-based framework (i.e.: emphasizing proposed risk-based metrics) to monitor and enforce what could be deemed excessive risk taking by regulated firms. By excessive risk taking, we mean risk beyond what is necessary to conduct customer related business.

Instead of attempting to trace speculative risk-taking to particular strategies, traders, or positions, regulators could instead focus on book or portfolio-level market risk using a Value-at-Risk (VAR) or unit of risk measurement. The objective would be to ensure that aggregate assumed risk falls within limits that are appropriate for the facilitation of customer business. Certainly, differences of opinion will exist in what will constitute "appropriate" risk limits. And getting it right is important: risk limits for market making and hedging that are too restrictive will unnecessarily restrict trading and liquidity; risk limits that are too loose will be meaningless. However, once completed, the cost, resources, and efforts needed to examine risk and intent at the transaction level will be alleviated. Books with "excessive" risk (or, regardless of the actual figure, simply the most risky books at particular institutions) can be examined. Positions exceeding the limit can be flagged, monitored and evaluated.

We detailed a novel and practical approach regulators could adopt for implementation in To Catch a Proprietary Trader. This entailed measuring and benchmarking a bank’s trading risk to the volume of customer risk intermediated by the organization. This approach eliminated the minutia involved with trade-by-trade evaluation.

So, how should regulators go about distinguishing proprietary trading from market making? One would expect a book of agency business to be hedged in such a way as to minimize market and basis risk. Return on the book is generated largely by volume of trading at the bid/ask spread and changes in inventory value. One would expect a book with embedded proprietary business to make more pronounced market risk plays to amplify returns. We would expect a book managed in a proprietary manner to display greater market risk, on an adjusted basis, than a pure agency book. We think normalized comparisons can be made across firms of various sizes by looking at the ratio of the total market risk relative to the amount of customer-generated market risk incurred over a specified period.


Regulators should be looking for a pattern of proprietary trading -- not "proprietary trades." Instances of suspected proprietary trading could best be identified by using a risk-based methodology to examine comparable books across institutions on a relative basis. Furthermore, the threat of investigation under this methodology would provide a deterrent that would not exist under a hard-limit paradigm. No method of regulation or oversight will eliminate the rogue trader seeking to make an individual bet for a quick buck. However, a method such as the one we propose would go a long way toward preventing large-scale sustained abuses, maintaining efficient market operations, and enabling regulators to flush out suspect trading activity, with the objective of reducing systemic risk.

Regulators Get It

In The Volcker Rule Rocks! we examined market-making and hedging requirements under the proposed Rule. Incidentally, we feel regulators did a thorough job in the proposed rulemaking in detailing permitted activities and what constitutes non-permitted proprietary trading and hedging. They left little (if any) doubt around their interpretation of the Law and intent of the Rule. A good example is the rules for hedging listed below.

Trading to hedge risk or inventory acquired through market making activity is permitted if it meets two criteria:

1) The hedging transactions must be to hedge risk incurred through customer market making.

2) The hedging transactions must also meet the criteria specified for general risk mitigating hedging, which include:
a) The hedging must be done in accordance with written rules and policy.
b) The hedging must be risk-reducing and specific to the risk being hedged; however, hedging is allowed to be done on an aggregated basis.
c) The hedging must be reasonably correlated with the risk being hedged.
d) The hedging cannot create new exposures at the time of execution.
e) The hedging must be subject to continuous and ongoing review.

A similar risk-oriented approach would be effective for monitoring and evaluating hedging programs and transactions.

Impact on Firms

We further examine the potential impact of the Rule on buy- and sell-side firms in the context of the new regulatory framework in our opinion Beyond Volcker: Seeing the Forest through the Trees. The end result being a more open and efficient market structure.

Most are in agreement that the near-term impact on many markets is likely to be a widening of bid-ask spreads that results from a pull-back in the amount of bank dealer liquidity supplied to the markets. For example: dealers have been holding less corporate bond inventory and taking less risk as indicated by wider spreads and general buy-side frustration. It is impossible to tell how much of this is attributable to paring risk in anticipation of pending regulation and how much is the result of market conditions. We have seen this over the last several months in various product areas.


Temporary structural imbalances from a reduction in bank liquidity will dissipate as the markets reach a new level of equilibrium. As new or different entities emerge and play a more active role in the markets, they should offset liquidity lost from bank dealers. Over time, and possibly not long given the resiliency of the financial markets, liquidity displaced by the Rule is likely to be mitigated by changes in buy-side behavior or replaced by firms outside the banking sector.


It is important not to forget how we got here. Our financial system was broken and needed government intervention to remain functional.

It is equally (if not more) important that we have a well designed regulatory framework with proper incentives in place to prevent a breach of the system in the future. In the case of the Volcker Rule, this means prudently assessing and monitoring bank trading risk on an ongoing basis. Tomorrow, we should have a much clearer picture how that will be done.

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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User Rank: Author
12/25/2013 | 9:00:14 PM
re: Volcker on the Mind, But Will it Deliver?
Ironically, the Volcker Rule was created to stop speculative proprietary trading, but its first legal test relates to a complex security held in bank portfolios. The American Banker Association has filed a lawsuit against government agencies that approved the Volcker Rule, claiming that it unfairly targets a type of CDO held by smaller banks. As many as 275 banks could have to unwind the CDOs (as did Zions Bancorporation) and take a $600 million hit to capital, reports the NY Times. terms of risk, banks have until July 21, 2015 to divest risky assets.
User Rank: Author
12/24/2013 | 3:46:39 PM
re: Volcker on the Mind, But Will it Deliver?
We're already starting to see unintended consequences of the Volcker Rule with respect to regional banks that used a certain financial engineering strategy. Zion's Bankcorporation announced it will take a $387 million charge on packages of collateralized debt obligations (CDOs), in what are called "trust preferred securities" (TrUPs) issued by banks and insurance companies. Zions entered the strategy 14 years ago to circumvent capital rules, according to a New York Times story. Zions said the Volcker Rule means it cannot hold these securities until they recover their full value. But regulators are indicating these securities may not be prohibited under Volcker and could be restructured so they could hold into them.
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