Hedge exemption should not be layup

The heads of the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) both stated that there are specific criteria for banks to meet the hedge exemption allowed under the Volcker rule of the Dodd-Frank Act, stating that a hedge must be used “to mitigate specific risks."

 SEC Chair Mary Schapiro and CFTC Chair Gary Gensler were testifying before the Senate Committee on Banking, Housing and Urban Affairs. The hearings were titled “Implementing Derivatives Reform: Reducing Systemic Risk and Improving Market Oversight” but most of the questioning had to do with the recent $2 billion plus loss incurred by JP Morgan involving its use of Credit Default Swaps (CDS) and CDS indexes in a “hedging” transaction by its chief investment office (CIO).

The Volcker rule restricts banks from certain proprietary trading activity but allows them to hedge.

Schapiro said “there is a strong criteria needed to be met for the hedging exemption under the  Volcker rule, adding that she was not sure whether the JP Morgan trades in question would qualify for the hedge exemption.

While the Volcker rule allows for portfolio hedging both Schapiro and Gensler stressed that hedges must be tied to specific risks. “It must be real and significant risk mitigation,” Schapiro said.

Gensler stated, “it is easy for portfolio hedging to morph into something else,” adding, [it must be] tied to a specific risk of an aggregate position. If you set it up as a separate unit it is prone to morph.”

They also both cited how traders are compensated as a criteria in judging portfolio hedging. Gensler said it is important that “the compensation [structure] doesn’t encourage taking bigger risks.”

JP Morgan Chairman and CEO Jamie Dimon had been pushing for a very broad interpretation of portfolio hedging prior to reporting losses in the CIO unit.

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