U.S. banks would have to change the way they compensate traders involved in market-making activities under one of the proposed restrictions of the so-called Volcker rule, according to a draft circulating among regulators.
The rule, which aims to ban most proprietary trading by banks with federally insured deposits, would exempt trades related to market-making as long as the activity met at least seven standards, or principles. One principle would be that traders get paid from fees and the spread of the transactions rather than the appreciation or profit from their positions, according to a copy of the draft reviewed by Bloomberg News.
The Volcker rule, part of the Dodd-Frank Act, is being written by regulators in five Washington agencies and may be released as early as October, according to three people briefed on the discussions. It aims to reduce the chance that banks will make risky investments with their own capital that put their deposits at risk.
A forced change to pay structure “could have the effect of driving people out of the regulated industry to the unregulated industry,” said Douglas Landy, a partner at Allen & Overy LLP who once worked at the Federal Reserve Bank of New York.
Banks including JPMorgan Chase & Co. (JPM), Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) have shut down or made plans to spin off standalone proprietary-trading groups to prepare for the rule, which is named for its original champion, former Federal Reserve Chairman Paul Volcker.
Lawmakers who crafted Dodd-Frank in 2010 chose to exempt market-making from the rule, along with certain forms of hedging and underwriting, because of concerns that a broad ban on proprietary activities could bring some U.S. and world markets to a halt. Firms including Goldman Sachs and Morgan Stanley serve as market-makers when they accept the risk or hold shares of trades in order to facilitate client orders.
The 174-page draft, dated Aug. 11, shows among other things how regulators including the Federal Reserve and Federal Deposit Insurance Corp. are working to define market-making. Besides compensation, the principles outlined in the draft would require that trading positions have near-term demands and no large anticipation positions; have a revenue structure based on fees and commissions and not on making money on the positions themselves; and that firms fall under the Securities and Exchange Commission’s guidance of a “bona-fide” market-maker.
Banks also would be required to institute compliance programs to monitor when traders are moving toward banned positions. Those internal controls are also designed to ensure the firm does not place too much capital at risk.
Lobbying the Fed
Lawyers and executives from firms including Goldman Sachs, Citigroup Inc. (C) and Morgan Stanley have met with regulators to discuss how to craft the definition, according to disclosures posted on the Fed’s website.
Market-making is “critical to the liquidity of financial instruments particularly in times of financial stress and, by consequence, the financial stability of the United States,” Richard Whiting, the executive director and general counsel of the Financial Services Roundtable, a Washington-based trade group representing the largest banks, wrote in a November comment letter to regulators.
The draft proposal may still change, the people briefed on it said. Each of the draft’s sections is followed by dozens of questions, hundreds in all, from regulators seeking more details before writing the final draft language. Those questions will remain open when the proposal is released by regulators for public comment in the coming weeks, said one person with knowledge of the plans.
The Fed, FDIC and SEC, as well as the Office of the Comptroller of the Currency and the Commodity Futures Trading Commission, each must approve the proposal. The Treasury Department is responsible for coordinating the regulation.
Standalone proprietary trading accounted for as much as 12.4 percent of trading revenue at the six largest U.S. banks in a quarter, and as much as 3.1 percent of total revenue, according to a July report by the Government Accountability Office. In the fourth quarters of 2007 and 2008, the groups accounted for about 66 percent and 80 percent of total trading losses, according to the report, which did not take into account proprietary trading in other parts of the bank.
The Financial Stability Oversight Council, a group of regulators established by Dodd-Frank, acknowledged the complexity of finding the line between a bank’s proprietary trading and its activities on behalf of clients.
“The challenge inherent in creating a robust implementation framework is that certain classes of permitted activities -- in particular, market making, hedging, underwriting, and other transactions on behalf of customers -- often evidence outwardly similar characteristics to proprietary trading, even as they pursue different objectives,” the council said in a January report. The council said regulators should aim for flexibility in their identification of illegal activity.
“To the extent the proposal relies on internal compliance mechanisms rather than hard and fast rules, I think that’s better,” said Satish Kini, co-chairman of the Debevoise & Plimpton LLP’s Banking Group.
Internal compliance programs, even with strong regulatory oversight, will end up falling short, according to former Senator Ted Kaufman, a Delaware Democrat who pushed to separate investment and commercial banking during the 2010 Dodd-Frank debate.
“This is trying to figure out how many angels can dance on a pin,” Kaufman, now a professor at Duke University, said in a phone interview. “I flat out do not believe you can monitor the conflict of interest.”
As regulators write the Volcker rule they have also come under pressure from lawmakers.
Representative Spencer Bachus, the chairman of the House Financial Services Committee who voiced concerns over the reach of the rule in a November comment letter, said the proposal places the U.S. at a disadvantage. When the bill was crafted, the premise was “that Europe and the rest of the world were going to prohibit all sorts of banking activities, therefore we didn’t have to worry about competitiveness,” Bachus, an Alabama Republican, said in a telephone interview. “But the other countries have taken a whiff on this.”
Levin and Merkley
Democratic Senators Carl Levin of Michigan and Jeff Merkley of Oregon, who pushed for the regulation during the congressional debate, have urged regulators through comment letters, public speeches and staff meetings to maintain the rule’s maximum reach.
Merkley and Levin were responsible for the inclusion of language in the Volcker rule that would ban transactions or an activity that results in a “material conflict of interest” between the banking entity and its clients, customers or counterparties.
Levin, the chairman of the Permanent Subcommittee on Investigations that conducted a two-year investigation of the financial crisis, said the provision targeted the actions of firms like Goldman Sachs during the crisis.
The rule “breaks new ground in the area of conflict of interest,” Levin said on the Senate floor on July 21, the anniversary of Dodd-Frank. “It prohibits firms from assembling an asset-backed security and selling it to clients while betting against that same security, acting not as a market-maker, but as an investor for its own profit.”