Volcker Rule Needs Narrow Hedge Exemption, CFTC’s Chilton Says

Banks including Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) should be prevented from skirting a ban on proprietary trading through an exemption for hedging, said Bart Chilton, a member of the Commodity Futures Trading Commission.

Five federal regulators are required by the Dodd-Frank Act to implement the ban, which must include the allowance for hedging to mitigate risks. Chilton, in a letter today to Federal Reserve Chairman Ben S. Bernanke, urged regulators to create a narrow exemption that doesn’t become a loophole.

“A too-expansive definition will significantly undercut the fundamental purposes of the rule,” said Chilton, a Democrat on the commission that is among the regulators writing the ban. “The final rule should encourage prudent risk management and not provide an incentive for banking entities to game the definition.”

The rule, named for former Fed Chairman Paul Volcker, is intended to reduce the chance that banks will put depositors’ money at risk. Dodd-Frank, signed into law in 2010, largely left regulators to define the provisions. They have said they intend to finish the rule by the end of the year and have given banks until July 2014 to implement it as long as they make a good- faith effort to comply.

The scope of the risk-mitigating hedging provision gained attention after JPMorgan Chase & Co. (JPM) reported trading losses from a credit-derivatives position Chief Executive Officer Jamie Dimon called a “hedge.” The loss this year stands at $5.8 billion. Regulators have been under pressure from lawmakers and consumer advocacy groups to respond to the loss by narrowing the hedging exemption.

Underlying Risks

Chilton said banks should be required to present an array of metrics for trades to demonstrate their compliance with the Volcker rule.

“If a banking entity’s risk-management program results in transactions that are not reasonably correlated to risks -- that is, gains on ‘hedges’ are greater than the loses on underlying risks -- then a strong presumption should be created that the hedge exemption may have been improperly claimed,” he said.

When comments on the proposal were due in February, U.S. and international banks criticized the measure for too tightly restricting hedging activities.

“The proposal, if implemented in its current form, will overly restrain our customer-facing market-making businesses and our risk-mitigating hedging activities to the detriment of our customers,” Colm Kelleher, co-president of Morgan Stanley’s institutional securities group, and Jim Rosenthal, the company’s chief operating officer, wrote in a Feb. 13 letter.

‘Narrow View’

John F.W. Rogers, Goldman Sachs’s chief of staff, said in a comment letter that regulators had taken a “narrow view” of market-making, underwriting and hedging activities.

“Without substantial revisions, the proposed rule will define permitted market making-related, underwriting and hedging activities so narrowly that it will significantly limit our ability to help our clients,” Rogers said in a Feb. 13 letter.

In addition to the CFTC, the rule-writing agencies are the Fed, Comptroller of the Currency, Federal Deposit Insurance Corp., and Securities and Exchange Commission.

To contact the reporter on this story: Silla Brush in Washington at sbrush@bloomberg.net

To contact the editor responsible for this story: Maura Reynolds at mreynolds34@bloomberg.net

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