Volcker Rule Kicks Off Risky Bank Prop Trading

US regulatory authorities voted in new rules which will curb banks from speculating on the markets. The ruling comes on the back of trading in high-risk instruments which was deemed the culprit behind the global meltdown of 2008, and the demise of leading corporations such as Lehman Brothers and Bear Stearns.

Banks will no longer be allowed to transact in speculative positions under the new rules which will go live in 2014, however, the regulators have given banks an extended cooling period until summer 2015.

The five decision making institutions include; Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC). The SEC voted the measure through by a vote of 3-2, and the CFTC passed the rule by 3-1. The final ruling notification provides details of prohibited and exempted activities.

You CANNOT...

The final rules generally would prohibit banking entities from:

• engaging in short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for their own account.
• owning, sponsoring, or having certain relationships with hedge funds or private equity funds, referred to as ‘covered funds.’

You CAN (kind of)…

Under section 619 of the Dodd-Frank Act, the final rules, adopted under the Bank Holding Company Act, provide exemptions for certain activities, including;

• market-making,
• underwriting, hedging,
• trading in certain government obligations,
• organizing and offering a hedge fund or private equity fund,

The final verdict provides a detailed description of the exempted activities, e.g. under the market-making function firms have to use their discretion when measuring the scale of the activity, the guidelines state: “The trading desk’s inventory in these types of financial instruments would have to be designed not to exceed, on an ongoing basis, the reasonably expected near-term demands of customers based on such things as historical demand and consideration of market factors.”

The new rulings are expected to cause misery for some of Wall Street’s largest players with industry estimates suggesting a loss of 4% to 6% in income from prop trading. Several banks are expected to migrate their prop desks outside the Dodd-Frank-Volcker framework.

Michael Creedon, CEO of Traditum Group LLC, a Chicago-based proprietary trading firm, welcomed the ruling, as he believes the initiative to reduce non-centrally cleared instruments is a bright sign for the market. In a telephone interview with Forex Magnates he said: “Transparency is the key.”

Picking Up the Pieces

With proprietary firms accounting for a large share of trading volumes, activity is expected to be taken up by; hedge funds, private equity and proprietary trading firms. Mr Creadon added, “We welcome the ruling, it will open up the market for firms like Traditum.”

The largest banks with assets at $50 billion or more will be required to start their reporting requirements from June 30th, 2014.

The recession of 2008 is believed to be the worst economic crisis since the 1930s. A research paper written by the Federal Reserve Bank of Dallas in September 2013, outlined the cost of the crisis. The paper states that, “Our bottom-line estimate of the cost of the crisis, assuming output eventually returns to its pre-crisis trend path, is an output loss of $6 trillion to $14 trillion.”

The Dodd-Frank Act aims to reduce systemic risk witnessed during the crisis.