December 18, 2013

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.

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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.