December 10, 2013

Five regulatory bodies voted to approve a strengthened Volker Rule to restrict risky trading by banks for their proprietary accounts, adding to their compliance burdens.

“The devil is hugely in the details – hundreds of details describing how these exemptions work,” said Douglas Landy, a partner in the Financial Regulations and Leveraged Finance groups at Milbank, Tweed, Hadley & McCloy and a former staff attorney at the Federal Reserve Bank of New York in a phone interview.

Volker is a joint rule issued by the Federal Reserve, Federal Deposit Insurance Corporation, the Securities and Exchange Commission, the Office of Comptroller of the Currency, and the Commodity Futures Trading Commission.

The Volker rule was inserted into the Dodd Frank financial reform Act of 2010 to protect taxpayers from another bailout but it has met with fierce opposition from Wall Street and lobbyist who see it as cutting into their profits.. Big banks with $50 million in assets are the first group subject to the rule starting in Nov of 2015. Compliance for the other groups of covered banks stretches out to 2017, unless the Fed grants additional exemptions.

“There’s a lot of rules and compliance and reporting which is going to be a massive headache or nightmare,” said Landy. Each of these rules has hundreds of pages of definition, he said.

Wall Street is already sinking money into compliance. "Banks are writing new compliance manuals, training their traders and rewriting computer programs that effectively automate whether a trade is out of bounds under the Volcker Rule," according to a New York Times report.

One of the thorny issues for regulators and banks alike is that the lines between prop trade and market making can be blurry. “The burden now is how do you prove that the trades remaining are allowable trades and compliant under the Volcker Rule,” said Chris Ekonomidis, director in Sapient Global Markets who has been focusing on compliance and Dodd-Frank. “I think there are definitely impacts to compliance systems and technology. It kind of stems from certain trades being looked at from a guilty versus innocence” [perspective],” said Ekonomidis.

The definition of proprietary trading is a short- term position (60 days or less) taken in equities, fixed income, swaps, or backend loans, for the purposes of making money on price appreciation. It doesn’t apply to trading of loans or to a large group of FX, he said. However, Volcker doesn’t apply to long-term trading strategies of 61 days or more, which are permitted. Banks can still do short-term trading if it meets one of the exemptions for hedging, underwriting, market making, liquidity management, customer-driven trades or non-US trades done by foreign banks outside the U.S.

For example, banks can hold inventories on securities to facilitate customer trades or provide liquidity to customers. They can hold securities if they are underwriting to take securities to market and also banks are required to hold certain liquid assets for liquidity management. Banks can hold government securities such as Treasury bonds and municipals, which are exempt.