As regulators delay writing the final rules for the sweeping Dodd-Frank financial reforms, the Volcker Rule's ban on proprietary trading continues to cause confusion among the investments banks that must comply with the rule.
Analysts say there is a lot of uncertainty and angst in the industry over how regulators will distinguish between proprietary trading and other types of market making or principle trading in which the broker buys or sells a security with its own capital in order to match buyers and sellers.
"The challenge of the Volcker Rule is, how do you draw the line between who is doing proprietary trading versus positioning for a future customer transaction, because they look identical in some cases," says Sean Owens, director, fixed income, at Woodbine Associates.
Adds Bob Fitzsimmons, managing director and head of the derivatives business at Investment Technology Group, "Most firms know that under the Volcker Rule, commercial banks have to get rid of proprietary trading. And most firms have been focused on: How do you define proprietary trading versus the customer facilitation of customer orders?"
Several major investment banks - including Goldman Sachs, Morgan Stanley, JP Morgan, Citi and Bank of America - already have shed pure proprietary trading desks to begin to comply with the Volcker Rule. Some of the same firms, however, are waiting for the specific requirements to be finalized before spinning off all of their prop desks, hoping that the final interpretation of the rule will allow them to hold on to those businesses.
Increasing the confusion, the Volcker Rule includes exemptions for certain "permitted activities" - such as market making, hedging for risk mitigation, transacting in government securities and underwriting. But market observers say the lines are blurry. In fact, an 81-page study by the Financial Stability Oversight Committee (FSOC), published in January, warned regulators that proprietary trading could take place within these permitted areas.
Meanwhile, sell-side firms are left to wonder how regulators will monitor compliance with the rules. While hedging is permitted as a risk-mitigating transaction, for example, "That actually presents a potential dilemma since a bank could say a trade was undertaken as a hedge, and have a reasonable basis for arguing so, and the regulator could disagree.
It will be difficult for the regulator and the bank to make a perfect argument about what is a hedge," says Bernie McDevitt, VP of institutional trading at Cheevers & Co., an institutional agency broker in Chicago.
"They're still wrangling over definitions," notes Robert Hegarty, managing director and head of global market structure at Thomson Reuters. "So much of the legislation has been written in broad brush strokes. It's not until you get down to the writing of the rules where you get into some discrepancies of what the intent of the law is."