The Volcker Rule Ban on Prop Trading: A Step Closer to Reality

October 21, 2011
Industry Trends
North America

Abstract

Report Previously Published by Oliver Wyman

The Volcker Rule is one of the more controversial pieces of legislation to emerge from the financial crisis. Attached to the Dodd-Frank Act, the rule was intended to limit banks’ ability to make speculative investments that do not benefit their customers. Translating this concept into functional regulation has turned out to be extremely difficult.

As enacted into law, Section 619 of the Dodd-Frank Act (what is termed “the Volcker Rule”) has three major effects on banking entities:

  1. Prohibits meaningful investment in hedge funds, private equity funds, and similar vehicles
  2. Prohibits separately organized “prop trading” desks in most asset classes
  3. Allows market making, underwriting, and related hedging – but only if such activity does not involve prohibited proprietary trading

The first two effects are relatively easy to understand and, importantly, to police. It is the third that has proved so challenging. The core idea is that one could keep the “good” activities of capital markets dealers, such as providing market making and hedging services, while stamping out the “bad” practice of speculation by firms with access to the bank safety net. However, both sets of activities necessitate taking and managing market risks, with the possibility of gain or loss on market moves. Telling the two apart promised to be difficult from the outset.

US regulators, having spent over a year wrestling with this, have finally released proposed rules implementing the Volcker Rule. The regulatory agencies have realized that the prop trading ban will be nearly impossible to police from outside and, accordingly, have placed the onus on each banking entity to police itself through a complex compliance regime, monitored by regulators. (The Fed, SEC, OCC, and FDIC all collaborated on the proposed rule; the CFTC is reportedly waiting before considering its own implementation of the Volcker Rule.)

Critically, the proposed rule does not:

  • Make market making impossible to pursue for banks;
  • Make it impossible for banks to manage liquidity and firm-level interest rate risks;
  • Make it impossible for banks to hedge risk dynamically at the portfolio level;
  • Require trade-by-trade reporting and analysis to demonstrate compliance; or
  • Mandate the same compliance regime for firms of all sizes and scope.

It does, however, have very far-reaching implications for banks. Complying with the Volcker Rule as proposed will require a major effort by nearly all bank-owned trading businesses worldwide, and will involve potentially profound changes to business activities and ultimately market structure.

Lead Author John Lester is a Partner in the North America Public Policy and Finance & Risk Practices at Oliver Wyman.

Celent is a research and advisory firm dedicated to helping financial institutions formulate comprehensive business and technology strategies. Celent publishes reports identifying trends and best practices in financial services technology and conducts consulting engagements for financial institutions looking to use technology to enhance existing business processes or launch new business strategies. With a team of internationally based analysts, Celent is uniquely positioned to offer strategic advice and market insights on a global basis. Celent is a member of the Oliver Wyman Group, which is a wholly-owned subsidiary of Marsh & McLennan Companies [NYSE: MMC].

Media Contacts

North America
Michele Pace
mpace@celent.com
Tel: +1 212 345 1366

Europe (London)
Chris Williams
cwilliams@celent.com
Tel: +44 (0)782 448 3336

Asia (Tokyo)
Yumi Nagaoka
ynagaoka@celent.com
Tel.: +81 3 3500 3023

Table of Contents

Introduction

2

Who Will Be Affected

3

What Compliance Will Involve

4

Timeline

5

Implementation Challenges

6

Strategic Impact on the Industry

7

What Affected Institutions Need to Do Now

8

Conclusion

8

Appendix – Reporting Metrics Defined

9

 

Risk-Management Measurements

9

 

Source-of-Revenue Measurements

9

 

Revenue-Relative-to-Risk Measurements

10

 

Customer-Facing Activity Measurements

10

 

Payment of Fees, Commissions, and Spreads Measurement

11

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