Volcker Rule Puts Short-Term Trades Under More Scrutiny

U.S. banks seeking to gain from or hedge against short-term price movements in securities and derivatives markets would face restrictions under a proprietary-trading ban, according to a draft of the so-called Volcker rule.

The 205-page document, dated Sept. 30 and obtained yesterday by Bloomberg News, is the latest version of the rule to emerge as it’s being written by four federal banking regulators and is scheduled to be released on Oct. 11 by the Federal Deposit Insurance Corp. The rule would take effect on July 21, 2012.

The financial regulators didn’t define short-term in the draft, writing that “it is often difficult to clearly identify the purpose for which a position is acquired or taken and whether that purpose is short-term in nature.” Regulators would presume that positions held for 60 days or less are banned short-term trades unless a bank can prove otherwise, according to the document.

The proposal includes a series of exemptions for trades designed to hedge credit, interest rate or other specific risks. A bank could be free of the Volcker restrictions if it is hedging a specific position or a portfolio of risks across multiple trading desks. Hedging trades would need to have a “reasonable,” not a full, correlation with the underlying risk. Banks could also win exemptions if they are hedging a risk they are “highly likely” to face in the future.

“It’s slightly more lenient than the statute. They’ve taken a moderate course on hedging activities as the statute allows them to do,” Dwight C. Smith, a Washington-based partner at Morrison & Foerster LLP, said in an interview.

Risky Investments

The Volcker rule, which is named for its original champion, former Federal Reserve Chairman Paul Volcker, is intended to reduce the chance that banks will make risky investments with their own capital that put their deposits at risk. The provision was part of the Dodd-Frank financial overhaul enacted last year, and policy makers are drafting regulations to enforce it.

Banks including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley have shut or made plans to spin off stand-alone, proprietary-trading groups to prepare for the rule.

Foreign banks would be covered by the rule if they have U.S.-based staff involved in the restricted trades, according to the draft. Overseas lenders have complained to U.S. regulators that a strict interpretation of the rule may force them to fire or relocate U.S. employees who are involved in proprietary trading, even if no American money is at risk.

“The ‘solely outside the U.S.’ exemption is unbelievably narrow,” Douglas Landy, New York-based partner at Allen & Overy LLP, said in an interview. By limiting those who qualify for the exemption, the Volcker rule is now “extremely broad,” he said.

Related Regulation

The Sept. 30 draft was developed by the Fed, FDIC, Securities and Exchange Commission and Office of the Comptroller of the Currency. The Commodity Futures Trading Commission will vote on related regulation but it’s not on the schedule for the new few rulemaking meetings, Steve Adamske, agency spokesman, said today.

The latest draft “seems to have some complex and potentially burdensome provisions that may impede Congress’s stated intent to allow for traditional market-making activities and sponsorship of funds,” Kenneth Bentsen Jr., an executive vice president at the Securities Industry and Financial Markets Association, said in an e-mail yesterday.

“This is a proposed rule, and given its magnitude and impact on U.S. markets, it will be subject to significant comment and hopefully consideration by the regulators to ensure against undermining the depth, liquidity and viability of U.S. financial markets,” Bentsen said.

Banned Positions

Banks also would be required to institute compliance programs to monitor when traders are moving toward banned positions. Those internal controls are designed to ensure the firm doesn’t place too much capital at risk.

“There are presumptions of prohibited conduct. It’s almost Kafkaesque: You’ve got to prove you’re not prop trading even if you have no such intent. You’ve got to prove that you can come within these exemptions and the criteria are demanding,” Donald N. Lamson, a Washington-based counsel at Shearman & Sterling LLP, said in an interview.

Lawmakers who crafted the Dodd-Frank Act exempted market-making from the rule, along with certain forms of hedging and underwriting, because of concerns that a broad ban on proprietary trading could bring some U.S. and world markets to a halt. Firms including Goldman Sachs and Morgan Stanley, both based in New York, serve as market-makers when they accept the risk of trades to facilitate client orders.

At Disadvantage

U.S. Representative Spencer Bachus, chairman of the House Financial Services Committee, said the proposal puts the country 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 last month. “But the other countries have taken a whiff on this.”

Senators Carl Levin of Michigan and Jeff Merkley of Oregon, both Democrats who pushed for the rule, have urged regulators through comment letters, public speeches and staff meetings to maintain its maximum reach.

Merkley and Levin were responsible for including language in the Volcker rule that would ban transactions that result in a “material conflict of interest” between the banking entity and its clients, customers or counterparties.

Details from the Sept. 30 draft were published earlier by the American Banker.