Prop trading ban set to crimp market-making and hedging activities

To make the Volcker rule work, regulators will need to be able to spot proprietary trading. But although a range of indicators has been suggested, finding a way to catch prop trading without also catching some market-making and hedging activity won’t be easy, especially when it comes to derivatives

Putting a stop to prop

Alan Turing's famous test of machine intelligence asks a questioner to tell computer from human by the answers each provides. The assumption is that these outputs can be used to conclude something about what’s going on inside each of the respondents. US regulators now need to come up with a similar test, or series of tests, to tell the difference between market-making, hedging and proprietary trading, the last of which is outlawed by the so-called Volcker rule – part of the Dodd-Frank Act.

From the outside, market-making and hedging activity can look a lot like proprietary risk-taking. The real difference between them is intent, which is a notoriously tricky thing to test, says Heath Tarbert, Washington, DC-based head of the financial regulatory reform working group at law firm Weil, Gotshal & Manges.

“The regulators have to distinguish what is done for the benefit of the customer and what is done for internal profits. It’s going to be very difficult. This is not an objective standard but a subjective standard. What the regulators have to do is come up with objective approximations of subjective intent,” he says.

Regulators started to get to grips with the challenge in a study published by the Financial Stability Oversight Council (FSOC) in January, which has to be considered by the five US agencies charged with drawing up the detailed regulation – the Board of Governors of the Federal Reserve System, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency (OCC) and the Securities and Exchange Commission.

In some areas, the law is fairly black-and-white. The Volcker rule – named after its originator, the inflation-battling former Fed chairman Paul Volcker, who remains a fierce advocate – is supposed to ensure taxpayer money is not used to support proprietary trading, and also prohibits banks from sponsoring or holding equity stakes in hedge funds or private equity vehicles. Pure agency market-making businesses should be okay, while outright prop trading businesses and investments in private equity and hedge funds will have to be discarded. In some cases, banks have already begun making the necessary changes (see box, Dropping prop).

However, many derivatives desks find themselves in a grey area, and fear attempts to stamp out proprietary trading could hurt their business (Risk February 2011, page 9). As one New York-based derivatives head puts it: “We’re not a pure agency business or a proprietary trading operation – we’re a principal trading business. If a trader comes in first thing in the morning and sees that S&P 500 volatility is trading cheap, we’ll buy $10 million of it. Trading in advance to facilitate client activity is part of what we do.”

In a worst-case scenario, regulators could require market participants to hedge all client-facing transactions back-to-back with other offsetting client-facing trades. But if this were the case, it would be impossible to make money from derivatives activities, dealers complain.

While it might be possible to immediately hedge some risks stemming from a derivatives trade, it is essential banks have the ability to warehouse residual risk, says Guillaume Amblard, London-based global head of fixed-income trading at BNP Paribas. “You can do a strategic trade for a client and get rid of the first-order risk the same day, and the second-order risk within a week. But the third-order risk can remain for three months or longer. It’s not necessarily proprietary risk – but in our role of transferring risk from clients to the market, we do take residual risks and do need the capacity to manage this risk, until we find offsetting trades,” he says.

This is where the issue of intent comes in. Exposures held in advance to facilitate client trades – or which remain on the books because they can’t be hedged perfectly – might look like proprietary risk-taking. The FSOC’s answer is for banks to report quantitative metrics that help supervisors spot the difference between virtuous exposures and banned ones. “Such quantitative metrics would take advantage of the fact that proprietary trading may evidence different quantitative characteristics than permitted activities,” the study says.

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