How hard can it be to define one small word? Hard enough to delay a key part of Dodd-Frank, the contentious Wall Street reform law passed in 2010 that’s supposed to make the U.S. safer from future financial crises. Hard enough that regulators are warring over it not only with Wall Street but also with each other. And hard enough that President Obama has dispatched Treasury Secretary Jacob Lew to knock heads to get an agreement by yearend.
The tricky little word is “hedge.” One Dodd-Frank provision, the Volcker Rule—named after the former Federal Reserve chairman who pressed for it—prohibits banks from trading for their own profit and thus putting depositors and taxpayers at risk. But it carves out an exception for anything that qualifies as a hedge, traditionally defined as a financial transaction intended to offset the risk of another transaction rather than speculate for profit. For example, a put option on a stock rises in value when the stock goes down, making up for the loss. Trouble is, an instrument like a put could function as a hedge in one situation and speculation in another. Banks could attempt to get around the Volcker Rule simply by calling their speculative bets hedges.
There’s one pretty simple tell: A proper hedge should be expected to lose money, just as an insurance policy usually costs more in premiums than it pays out. A hedge that’s designed to make a profit isn’t a hedge at all. Of course, losing money on purpose is a hard concept for Wall Street to swallow. In its comments to the government on the Volcker Rule, the Securities Industry and Financial Markets Association (SIFMA) asked for lots of room for hedges that “incidentally” make money. “The fact that the organization hedges its risks in a manner that also provides incidental profits to the organization promotes—rather than jeopardizes—the safety and soundness of the entity,” it said.
Gary Gensler, chairman of the Commodity Futures Trading Commission, and Kara Stein, a Democrat on the Securities and Exchange Commission, want a narrow definition of “hedge” that leaves no wiggle room for banks, according to three people familiar with the negotiations who were not authorized to speak on the record. Supporters of that approach point out that JPMorgan Chase’s failed London Whale trade, which cost the company $6.2 billion, was originally described by traders as a hedge. Long-Term Capital Management, the big hedge fund that required a government-coordinated rescue in 1998, went bust by pursuing a trading strategy that looked a lot like hedging.
The banks are pushing for a broad definition of hedge, saying that construing the word narrowly would, in SIFMA’s words, “severely limit banking entities’ ability to hedge their own risk, thereby increasing rather than decreasing the risk.” Actually, the banks don’t want the word defined at all: “The many forms that risk-mitigating hedging takes would make any such definition underinclusive,” the group says.
The banks have gotten a somewhat sympathetic hearing from the three federal agencies primarily responsible for bank regulation—the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp. Unlike the SEC and CFTC, bank regulators prefer a rule that sets out a general principle—no speculation—and leaves it to them to monitor the thousands of transactions a bank has going at any given time.
Thanks to this back-and-forth, the Volcker Rule faces “the longest road to finalization” of all the lingering issues in Dodd-Frank, according to an August note by Isaac Boltansky, an analyst at Compass Point Research & Trading. Yet Comptroller of the Currency Thomas Curry heralds the vocabulary wars will soon be at an end. “Hell or high water,” he said in October, “we’re getting it done.”