The Volcker rule bans banks including New York-based 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 rule, 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.” The rule instructs banks to determine that demand based on historical data and other market factors. Further, the rule 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.
Fed Governor Daniel Tarullo said the rule had been “simplified somewhat, particularly by reducing the number of metrics that will be used in the reporting and analysis of trading data.”
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.
In the final rule, regulators require banks to demonstrate on an ongoing basis that their trades hedge specific risks in order to win an exemption from the Volcker rule.
The banks must analyze and independently test that their hedges “may reasonably be expected” to reduce the identified risk, the draft says. Banks will need to show that a hedge “demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks,” the rule says.
The final rule requires banks to have an “ongoing recalibration of the hedging activity by the banking entity to ensure that the hedging activity” is not prohibited.
The hedging provision became central to the Volcker rule debate after JPMorgan lost $6.2 billion last year in bets on credit derivatives known as the London Whale. The trades, conducted in the U.K. by the bank’s chief investment office and nicknamed for their market impact, were described by JPMorgan executives as a portfolio hedge. The bank’s synthetic credit portfolio produced about $2.5 billion of revenue in the five years before 2012, according to a Senate subcommittee report on the bets.
Bart Chilton, a Democratic CFTC commissioner who said Nov. 20 that he planned to vote against the rule because it was too weak, said today that it had been strengthened enough since to win his support.
“The language has been solidified tightly to avoid loopholes,” Chilton said in a statement. “When people say this version of the Volcker rule will stop circumstances like the London Whale, this ongoing recalibration provision is exactly what will help avoid similar debacles.”
Senator Carl Levin, 79, the Michigan Democrat who leads the Permanent Subcommittee on Investigations, joined other Democrats and some regulators in pushing for a narrower definition of hedging after the JPMorgan trades. Tarullo, the Fed governor responsible for financial regulation, called the trades a “real world” case to be considered as the rule was drafted.
Three months after the losses were disclosed in 2012, JPMorgan Chairman and Chief Executive Officer Jamie Dimon, 57, told lawmakers that the Volcker ban “may very well have stopped parts of what this portfolio morphed into.”
Still, Wall Street pressed regulators to allow banks leeway in how they manage assets and liabilities with hedges. “An overly restrictive Volcker rule would curtail market liquidity, harm investors and dampen economic growth,” said Kenneth Bentsen, president of the Securities Industry and Financial Markets Association, Wall Street’s biggest lobby group, in a Dec. 5 e-mailed statement.
The buying and selling of securities backed by a foreign sovereign will be permitted trading under certain circumstances, according to the rule. That exemption includes securities issued by foreign central banks and applies to U.S. banks with overseas operations as well as foreign firms with affiliates in the U.S.
The initial Volcker rule draft drew international criticism for its reach into banks based overseas as well as for its impact on foreign sovereign debt markets.
The push-back started in late 2011 after the Volcker proposal exempted trading in U.S. government securities while covering debt issued by foreign countries. Officials from Canada, Japan and the U.K. sent letters to U.S. financial regulators and the Treasury Department saying the measure would harm their ability to fund governments.
Michel Barnier, the European Union’s financial services chief, complained to then-Treasury Secretary Timothy F. Geithner about the rule’s “extraterritorial consequences.” Canadian and Mexican bankers and government officials said the proprietary trading ban would violate the North American Free Trade Agreement’s guarantee that banks be allowed to deal equally in U.S. and Canadian debt obligations.
Regulators also allowed more flexibility for overseas banks. They will be exempt from the ban for trades accounted for outside the U.S. and so long as their employees deciding to buy and sell contracts are also located outside the country. The final rule also frees overseas banks from the ban for trades they conduct on U.S.-based exchanges and clearinghouses, and for trades they have with foreign operations of U.S. banks.