One of the changes in the final rule is that banks are no longer able to hedge against an unforeseen Black Swan, or general market event. Portfolio hedging is a term that’s been removed from the final rule in reaction to JP Morgan’s London Whale incident. According to Landy, banks are allowed to hedge individual positions or in the aggregate.
“News reports that say no portfolio hedging, miss the point,” said Landy. If a bank has a loan it can hedge with an interest rate swap, and if it has 100 loans, it can package up 100 loans and buy and IRS to hedge those loans. “However whatever it does, it has to be reasonably correlated to a recent set of risk from a set of positions,” said Landy. But, a bank can’t go out and hedge an earthquake next year.
Banks and investment arms will also be doing risk analytics and correlation analysis, and reporting on the back end to send information to the regulations.
Trade Warehouses to Prove Inventory is Based on Client Demand
Among the compliance steps banks will take is to understand how effective their hedges are and how the risk may be changing on a day-by-day basis, said Ekonomidis. Firms will have reporting requirements, which will involve measuring seven metrics on a daily basis. They will need to understand their value at risk and different sensitivities and how VaR positions are changing around the trading desk.
Banks must show they are compliant with market-making activities whether they are facilitating or holding securities to fulfill client demands. “You will see people take different approaches,” said Ekonomidis. One potential approach is to track holistically what inventory was needed or used by clients in the past and then use that to anticipate what their inventory might be, he said. Some firms will build up trade warehouses to prove they are market making or holding inventories based on client demand. “You can see how many shares of X was traded one month ago, and then six months ago,” illustrated Sapient’s consultant. “They can trade to maintain their own internal inventories based on anticipated client demand,” he added. Some firms may already have trade warehouses but they may have to expand the amount of data that can be held and the time frame for retention, he said. Other firms may have an existing trade warehouse for a different use case. “The compliance mandate is there. How they meet the compliance mandate may be different based on the bank interpretation and their existing technology,” said Ekonomidis.
According to Landy, “There will be lots of compliance, recordkeeping, and audit functions to make sure banks do things properly. "Yet, the regulation doesn’t require banks to use software or other systems, but obviously that may be very useful to them,” says Lundy.
Since firms have a year and a half to meet the mandate, they may bring in consultants to tackle different pieces, rather than hiring people full time. “It depends on the compliance mandates. If rules get pushed out, it can play havoc,” said Ekonomidis.