US Banks Can’t Prop-Trade, says the Approved Volcker Rule

No Comments » Written on December 11th, 2013 by
Categories: Banks
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The Volcker Rule is in. US Banks can no longer engage in proprietary trading. The rule was proposed by the 86-year old Paul Volcker who is famously credited for destroying inflation in the late 70s/early 80s and is now Obama’s advisor. The rule restricts banks from doing proprietary trading to earn profits, because much of the crisis was caused by large banks with a one-sided bet on housing prices taken through massively leveraged instruments.

But like every rule, there are exceptions.

Like @carney says (CNBC):

The simple part: Banks are banned from engaging in prop trading. The complex part: That ban is subject to several exemptions intended to allow banks to facilitate customer trading and hedge their own risks.

The rule that allows customer trading is basically about market making - where a bank takes on securities in its own books in order to easily sell them to customers. Otherwise, banks would have to find a seller when their customers want to buy securities, and those sellers may then be unavailable or provide unreasonable prices. Market makers must be allowed some inventory, they have argued successfully.

But such holdings will now have to be justified with the Volcker rule, with some degree of historical analysis (how much do I need to have, based on historical transactions, to satisfy short-term customer demand?). This is not a fixed percentage or limit, and a regulator will need to be satisfied that such holdings indeed are churned into customer hands, and are not sold back into the market when prices change.

The other way to cut banks down to size is to limit compensation for the people in market making. Banks cannot pay people just based on profits made in the market making, when your inventory was bought at a lower price than it was sold to customers. They have to be based on the market making as a goal. This, supposedly, is not very different today in market making desks, but for a bank trying to disguise prop-trading as market making, it makes life difficult.

The rule also allows hedging. If you offer a customer a hedge on the dollar in a loan that’s converted to euros, the bank must hedge out the risk. This is allowed, but it has to be justified in the overall context of the bank’s exposure. The “london whale” scandal cost JP Morgan over $6 billion, when the trader said he’d taken the exposure to offset the overall risk in the bank’s positions, but the position he took was way oversized. The Volcker rule requires the bank to independently ensure that such oversized positions are not taken (because they are not hedges anymore), and keep such positions “recalibrated” as positions change over time.

Further the Volcker rule restricts bank investments in hedge funds or private equity pools to 3% of their Tier 1 capital.

Does it impact India?

It could. While the Volcker rule impacts all banks in the US, including overseas banks with operations there, overseas banks are exempt on trades made outside the US if the employees making those trades are outside the US. But the rule could really impact US banks with operations abroad.

Specifically, foreign sovereign securities are exempt. So a primary dealer in India, of a US based bank like Bank of America (see full list) will have to stock up on Indian government bonds during weekly auctions. Such positions may not qualify for market making, and also may not be hedges. But such security purchases are exempt in the books of the US Bank (Bank of America, like many US banks, operates only a branch in India, not a full fledged subsidiary).

But then it affects such a primary dealer’s operations in the remaining markets, like in forex derivatives, bond and currency exposure etc. Foreign banks have a significantly large share in the bond, currency and derivatives markets, including US Based banks such as Citibank and BoA. This could impact market depth, but should help other Indian banks increase their activity.

The Volcker Rule only applies from July 2015, which is atleast one large election and one dysfunctional government away, in Indian terms. While it’s a long way away, we might see some of these banks hand over their market positions and substantially contract their position exposures, in anticipation, and our markets may turn more shallow.

In India, there is no such equivalent rule, largely because banks haven’t yet blown up. (Many have tried) But now if they do, we have a blueprint.

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