Two Sides to Flipping the Volcker Rule
The onus will be on regulators to prove that banks are prop trading and not market-making.
This post originally appeared in Money Stuff.
The basic idea of the Volcker Rule is that banks should not be allowed to do proprietary trading (speculating on securities for their own account) but should be allowed to do market making (buying and selling securities from and to customers in order to facilitate those customers’ trading demand). There is a risk rationale for this—proprietary trading is risky while market-making is safe—that is mostly incoherent, but there is also a social-engineering rationale—banks should be in the business of serving society rather than just making bets for their own profit—that makes a lot of sense.
The basic problem with writing the rule is that market making is proprietary trading. I mean: People at banks use the terms “market making” and “proprietary trading” to mean different things, and they did so long before the Volcker Rule, and it’s mostly not that hard to know what they’re talking about. But in a strict literal sense market making consists of buying and selling securities for the bank’s own account, profiting when you can sell the securities for more than you paid for them and losing when you can’t. A market maker, said a federal court of appeals earlier this month, “seeks to profit from transactions in the securities by buying low and selling high,” just like a proprietary trader or, you know, anyone else.
So it took some subtlety to actually write the Volcker Rule, to come up with a set of characteristics that would distinguish the bad proprietary trading from the good market making. My impression is generally that the quite complex 880-ish-page rule does a decent job of drawing those lines in a sensible and intuitive way: If you run a desk that regularly buys at the bid and sells at the offer and keeps around enough inventory to respond to near-term customer demand, that is probably market making; if you run a desk that regularly crosses the spread to buy securities without considering customer demand and that pays its traders for market appreciation rather than flow, that is proprietary trading. There will always be some arbitrary lines; in particular, the Volcker Rule does not apply to positions held for more than 60 days. But basically it all seems reasonable. There is just a lot of it though. If you are a bank there are a lot of hoops to jump through to confirm that you are doing the good market making instead of the bad prop. “We are going to have to have a lawyer, compliance officer, doctor to see what their testosterone levels are, and a shrink, what is your intent,” as Jamie Dimon once put it, and while that is exaggerated, there are at least a lot of compliance officers.
But now the rule may flip:
In a much anticipated overhaul of Volcker, the Federal Reserve and other regulators are planning to drop an assumption written into the original rule that positions held by banks for less than 60 days are speculative -- and therefore banned, the people said. Instead, banks would have leeway to conclude that their trades comply with the rule, putting the onus on regulators to challenge such judgments, the people said.
Instead of the banks having to demonstrate that everything that their market-making desks do is market making, their market-making desks will be presumed to be doing market making, and regulators will have to demonstrate that anything they object to is not market making.
You can sort of imagine three categories of bank activity:
- Straightforward market making to satisfy obvious near-term customer demand.
- Running a proprietary trading desk that is set up to make large bets on the direction of the market.
- A trader on the market-making desk leaning into a few directional bets here and there.
Number 1, everyone agrees, is permitted. Number 2, everyone agrees, is not. Number 3 could go either way, but loosely speaking it seems fair to say that it was restricted by the old Volcker Rule and will be much less restricted by the new one. This seems fine to me? It depends on what you are going for. If you do not want banks to take any market risk in their trading operations, then you will be sad about Number 3, but if that’s really what you want then you’ll be sad about Number 1 too. You’ll be sad about banking, honestly; banks are in the business of taking risk. If on the other hand your worry about proprietary trading is that it created a bank culture in which every trader aspired to be an outsized risk-taker with a $100 million pay package, and in which trading managers aspired to set up shadowy hedge funds rather than to meet customer demand, then getting rid of the actual prop trading desks pretty much solves the problem, and giving the market-making traders a bit more flexibility to do their own risk management and decide on their own positions is probably fine.
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