Volcker Rule eases market-making while hedges face new scrutiny

Agencies set to sign off on ban

U.S. financial regulators, taking a landmark step in the five-year effort to rein in Wall Street, decided to curb some types of trading while largely freeing chief executives from personal responsibility in the final version of the Volcker rule.

The Federal Reserve, the Federal Deposit Insurance Corp. and three other agencies are set to sign off today on the proprietary trading ban, which has been contested by Wall Street banks JPMorgan Chase & Co., Goldman Sachs Group Inc. and their industry allies for more than three years.

Wall Street’s lobbying paid off in part. Regulators granted a broader exemption from the ban for banks’ market-making desks, on the condition that traders aren’t paid in a way that rewards proprietary trading, according to a draft of the final rule. The final version also exempts securities tied to foreign sovereign debt from the ban. At the same time, regulators gave banks less leeway for bets considered hedges for other risks.

“It prohibits risky proprietary trading while protecting economically essential activities like market-making,” Treasury Secretary Jacob J. Lew said last week. “Regulators have worked hard to find the right balance that protects our economy and taxpayers while also leaving room for well-functioning financial markets.”

Volcker’s Idea

The rule is named for Paul Volcker, the former Fed chairman credited with taming rampant inflation in the 1970s and who served as a top adviser to President Barack Obama. Volcker proposed the ban as a means of restoring stability to Wall Street following the 2008 financial crisis, arguing that banks that benefit from federal deposit insurance and discount borrowing shouldn’t be permitted to take risks that could trigger a taxpayer-funded government bailout.

The rule, enshrined by the Dodd-Frank Act of 2010, allows exemptions for market-making and some hedging, and defines limits for banks’ investments in private equity and hedge funds.

Bill Issac, a former FDIC chairman who is chairman of Cincinnati-based Fifth Third Bancorp, said the rule will pinch revenue and income at the biggest banks and some regional lenders, limiting their ability “to fulfill the full range of needs of their largest and most consequential customers.”

“These companies will turn elsewhere for these services, including foreign banks and non-regulated firms,” Isaac said in an e-mail.

Fine Print

With Wall Street banks having already shut proprietary trading desks in anticipation of the rule, its impact rests largely in the fine print -- how regulators address other banking activities, primarily market-making and hedging.

The final version set for approval by the Fed, FDIC, Securities and Exchange Commission, Commodity Futures Trading Commission and Office of the Comptroller of the Currency sets parameters for how banks may buy and sell financial products for clients and manage their own risks in the process.

Wall Street’s five largest firms had as much as $44 billion in revenue at stake on the outcome of just one part of the debate -- how market-making is defined and exempted -- according to data for the year ended Sept. 30. JPMorgan, the biggest U.S. lender by assets, had as much as $11.4 billion riding on the answer.

What follows are summaries of five of the rule’s major provisions:

Making Markets

The Volcker rule bans banks including Goldman Sachs and Morgan Stanley from trading to profit for their own accounts, while allowing them to continue making markets for clients. Distinguishing between those two practices has been one of the most difficult tasks for regulators.

In the final draft, the regulators eased the criteria banks must meet to qualify for the market-making exemption. To receive the exemption, a trading desk must both buy and sell contracts or enter into both long and short positions of those instruments for its own account.

The trades must not exceed, on an ongoing basis, the “reasonably expected near-term demands of clients.” Further, the final draft also requires that compensation arrangements not be designed to reward prohibited trading.

Bankers became concerned about the rule’s potential to ban big parts of their business almost immediately after Dodd-Frank was passed in 2010. The 2011 draft included a list of criteria to be met for trading to be exempted as market-making.

Industry lobbyists urged the exemption be widened, saying regulators needed to recognize that banks routinely buy and sell stocks, bonds and derivatives and build up inventories to help clients when they eventually place orders. Restricting those practices would hurt companies selling bonds, for example. Banks were joined by asset managers such as Vanguard Group Inc. and AllianceBernstein Holding LP in warning that a narrow exemption could unsettle markets.

Next page: Portfolio Hedging

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