The Volcker rule is law and has been endorsed by the SEC and CFTC. Much like other regulations, a timeline has been published with milestones, which differs for various types of banks based on the size or volume of trading business. The Volcker rule prohibits banking entities from engaging in proprietary trading for the purpose of selling financial instruments in the near term. In other words, it bans trading by commercial banks whereby deposits are used to trade on the bank's own accounts. The rule also restricts banks taking a stake in covered funds (e.g. hedge funds, private equity).
Here are some of the reporting requirements that banks must follow in order to comply with the Volcker rule. Reporting and record keeping guidelines require banks to furnish quantitative measurements of their trading desk activities on an ongoing basis. Any quantitative measure which shows excess risk or un-necessary adverse exposure is expected to be escalated within the banking entity for review and action.
Essentially, the reporting requirements could be classified into two areas: Risk and Source of Revenue.
RiskThis covers activities/reports to monitor excessive risk taken by trading desks. The reports are:
- Risk & Position Limits: Net open positions, VAR, position limits, stress VAR
- Risk Sensitivities: Changes in profit and loss with changes in the underlying variables like maturity, interest rates, volatility, etc.
These reports need to be generated at the trading desk level.
Source of RevenueThis area covers reports that try to infer if the profits from trades are not proprietary and if they are made from market making or for hedging purposes and not wagering the bank's money. The various reports are:
- Comprehensive profit and loss attribution: This is refers to sum of profit or loss from new trading positions (traded that day) including commissions and fees.
- Prior Positions: Positions held by the trading desk from the prior day.
- P&L: Residual profit or loss which cannot be attributed to the above two
- Inventory Turnover: This is the ratio of the absolute value of the transactions over a reporting period and value of the trading desk's inventory at beginning of the period. The reporting periods are 30, 60 and 90 days.
- Inventory Aging: This describes the schedule of the trading desks aggregate assets and liabilities and the amount of time they were held.
- Customer-Facing Trade Ratio: This is the ratio of the transactions involving a customer (who is a customer to a trading desk and with ones who are not a customer of a trading desk (trading entities who have trading assets/liabilities greater than 50 USD billion). The reporting periods are 30, 60 and 90 days.
All of these records are expected to be maintained for five years.
We already know that various types of risk reports are already generated in banks. It may need a few enhancements to get more fine-grained (at a trading desk level instead of a department level) to meet the Volcker rule requirements. These reports assess the risk being taken by the trading desks and serve as a warning.
Revenue Source ReportsThese reports may be new to banks, and they could be a bit challenging. But with recent changes in client-data/customer on-boarding regulatory requirements where customer profiling is enhanced, this may not be a big issue. My guess is that the other reports could be covered by a typical portfolio account tool.
These reports also seem more like 'common sense' and should have always been there. Trading desks have been prone for fraud and excessive risk taking and such quantitative measures can bring more transparency and alerts to the system. Some examples of recent events include the Delta-one incident at UBS and London Whale at JPMC.
The regulatory bodies still feel that the quantitative measures being gathered may not suffice and are likely make changes over the course of the year. It could be hard identifying prop-trading traits but there has to be starting point even if it's imperfect.
It is also worth noting that the calculation frequency is daily, but given that it's at a trading desk level it shouldn't be too cumbersome for most organizations.
Many banks are still unhappy about the Volcker rule. Recent events like the 'London Whale' incident where a desk required to hedge the bank's credit exposure had itself taken a big position have quelled some lobbying initiatives.
The lobbying battle over the Volcker Rule reminds me of car airbags. GM and Ford (World Number 1 and 2 in sales volumes at that time) persisted for years against airbag legislations which is a standard accessory in cars in other developed countries. Implementing the technicalities of the rule like putting new policies and procedures or extracting additional reports from sophisticated data-warehouses which most banks already have isn't going to be difficult.
Moving from a liberal and laissez-faire trading culture to a more conservative and closely monitored one is what's going to make it hard. A quote from Rene Descartes's (famous philosopher, mathematician) is something to think about in implementing the Volcker rule: "It is not enough to have a good mind. The main thing is to use it well."
About The Authors: Senthil Radhakrishnan has 16 years of experience in Investment Banking IT, including experience covering various instruments such as Equities, Listed Derivatives and Rates in Middle/Back-office and in Enterprise Risk. He is currently VP for Capital Market Solutions Practice at Virtusa Consulting Private Ltd.