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Keeping Your Eye on the Volcker Rule Ball

George Bollenbacher

Turtle Bay Advisory Services


When the lighted ball dropped recently in Times Square, one of the muffled sounds in the background was the ticking away of precious minutes until the proprietary trading parts of the Volcker Rule (VR) go into effect on July 21st. Although banks in the US have been working feverishly on some parts of their preparations, it is now time to prioritize. Some things must be done by July, and some other things may not make it. Knowing which is which will be essential for planning out the rest of the first half of 2015. That’s the ball to keep your eye on, now that New Years is past.

Understanding the VR Approach

In order to properly prioritize our work, we need to understand the VR approach, both in the language of the rule, and in its enforcement.

The Rule Language – The approach the VR itself takes is to prohibit proprietary trading outright and then allow for exemptions. The actual prohibition language is: “Except as otherwise provided in this subpart, a [bank] may not engage in proprietary trading.” The rule further defines the term; ”proprietary trading means engaging as principal for the trading account of the [bank] in any purchase or sale of one or more covered financial positions.” Finally, the rule includes in the definition of a trading desk any holdings that count as assets for the Basel capital calculations. It does exclude from the prohibition spot FX, US treasuries and municipals, and foreign sovereign debt in the country where a foreign bank is domiciled.

So the rule is quite specific: US banks that are subject to Basel capital rules can’t trade in any instruments not excluded unless the trade has an exemption. In other words, every trade in a non-exempt instrument must fall under an exemption or it is prohibited. The exemptions themselves have hundreds of pages of description, including a set of metrics for one exemption, the market-making one.

The Rule Enforcement – As specific as the rule language is, that’s how non-specific the enforcement is. Some things we know already. The enforcement will be handled by the examiners of the primary banking regulators – the Fed, the OCC and the FDIC, with ancillary enforcement by the CFTC and the SEC. However, the rule gives these examiners little or no concrete guidance on how to determine if an exemption claimed for a specific trade is valid. We know for a fact that some of the examiners are unsure about what qualifies and what doesn’t, which only complicates the preparations by the banks.

One of the regulators, the OCC, has issued a set of instructions to its examiners, focused on pre-compliance exams (to be conducted before the July compliance date) and these give us some insights into what they will be looking for, even after compliance becomes mandatory. But nowhere is there any guidance as to what levels of which activity are acceptable, nor the desired levels for the metrics. Thus we have to read between the lines.

Reading Between the Lines

  1. The first thing that peeks out from between the lines is a heightened concern that banks will try to bury prohibited trading inside packages of exempt trades. The examination instructions place a heavy emphasis on how many trading desks the bank has, how they are organized, what legal entities each desk trades for, who the counterparties are, and what instruments can be traded in. So one of the highest priorities will need to be demonstrating tight controls over the activities of any and all trading desks. This includes policies and procedures (P&Ps) as well as monitoring.
  2. The second thing we can discern is that, although a lot of ink has been spilled by both the regulators and the press on the subject of market-making, this exemption is still far too murky for clear findings on the part of the examiners. In particular, the rule attempts to determine trade intention by metrics and trade types, which simply isn’t possible. Furthermore, with no benchmarks given for the metrics, neither the banks nor the examiners really know how to use them.

As a result, banks’ best practice in the market-making sphere will be to demonstrate a commitment to their role as market-makers and an exercise of good risk and position management, which is what the VR was actually designed to foster. Thus, nobody outside the traders’ heads will be able to determine if, for example, they shorted some securities because they thought customers would want a lot of bids, or because they thought the market was headed down, or even if there is any difference between those two reasons. What will be important is that banks do provide liquidity to the market and that their position sizes are commensurate with the overall liquidity of the instrument and the bank’s own risk guidelines. That’s what banks will have to demonstrate.

  1. The third thing we can discern is that the hedging requirement is much more concrete and involved than the way most banks currently do it. To begin with, under the rule the only thing that can be hedged is a risk, not a position or a portfolio. Conversely, any risk can be hedged as long as it can be quantified. So a bank can hedge such diverse risks as mortgage pipeline or deposit runoff, as long as it can demonstrate quantification – in two parts, determining causality and measuring the coefficient of correlation. Those have to be in place for every hedge – before it is put on.

Once the hedge is in place, the rule requires close monitoring of both the hedge and the risk, and adjustment of the hedge if the tracking reveals a change in the coefficient. So putting it on and leaving it won’t be acceptable in the new world. In addition, both accounting for the hedge and compensating staff will both have to be done holistically. No accounting for a profit on one side without including the loss on the other, and no paying a trader on one side of the trade only. All in all, making sure your hedging practices comply with the rule will be one of the highest priorities over the first half of 2015.

  1. The fourth item between the lines is liquidity management. This is because the regulators are well aware that the London Whale’s trades were all booked under the Chief Investment Officer, at least initially. Thus the rule about liquidity management is very clear that: 1) there must be a plan that specifies (among other things) what instruments can be purchased, 2) that the intent is to hold those instruments to maturity, and 3) unexpected or unexplained activity in the liquidity portfolio is a red flag. As with market-making, it may be impossible to impute motive to specific liquidity trades, and the rule does allow for higher levels of activity due to changes in liquidity requirements, but regulators will be on the lookout for portfolios where longer term securities are routinely purchased and then sold before maturity.

This area is further complicated by two things: 1) the very low short term interest rates currently in effect, and 2) the impending liquidity coverage ratio (LCR) and the supplementary LCR being mandated by the Fed, among others. When we take these two factors into account, we can see the extraordinary performance pressure that will be placed on the mangers of liquidity portfolios, and thus the extra vigilance they will have to exercise to stay within the exemption. So getting your liquidity exemption in order is another high priority.

  1. The fifth between-the-lines factor is technology. For virtually all the exemptions, having new functionality in your technology is pretty much essential. For example, every trade in non-exempt instruments will have to be tied to an exemption. Many instruments, such as FX forwards or 5-year corporates, could be traded under several exemptions, so a bank needs a place in the trade entry function to include which exemption applies to which trade.

At the same time, many exemptions will rely on stored records and documents. To name a few, hedges must be tied to records of correlation, market-making trades must be tied to records of the reasonably expected near-term demand (RENTD) at the time a trade was made, and trades in support of an underwriting have to be tied to the underwriting itself. Most trade processing and position management systems have no provision for storing these elements, which makes booking trades under the VR a manual nightmare. When we recognize that an examination could happen a year or more after the trade, we see how important these system links are.

One final technology requirement will be some form of monitoring and alert functions. For example, if the liquidity plan excludes certain kinds of securities, the booking system should filter for acceptable or prohibited instruments, and issue an alert if the wrong ones are booked. A more sophisticated capability would be an alert if more than a certain volume of liquidity securities are sold before maturity, or a risk position is closed while the hedge is left open. Unless the technology can do these things and others, management will have to rely on manual monitoring, which is both expensive and error-prone.

Getting the Priorities Right

The common denominator in what’s between the lines is that banks may not be focusing on the right areas. The overall priority is successful examinations, and we have to understand that the first exams will be a learning experience for everyone. We can, however, make some predictions with confidence.

  1. A comprehensive catalog of trading desks, their allowed instruments, the entities they trade for, and their risk and position limits is an absolute first essential. Having tight P&Ps, a rigorous training program, and a reasonably mature testing program will make a major difference in your exam. On the other hand, having an examiner find a bunch of trades by a desk not identified and cataloged will be the kiss of death. This is a particular risk in deliverable FX forwards, where business can be done all over the bank, such as in trade finance or wealth management, so searching out those hidden pockets is the first priority.
  2. Demonstrating compliance will be heavily dependent on technology. Trade records will have to contain elements indicating which exemption applies, and systems will have to tie trades to other trades and/or stored documents. Market-making trades and positions will have to reflect the RENTDs in effect at the time the trade was done, and which are done with customers. All these connections will have to be preserved for years, and will need to be accessible long after the trades themselves are forgotten. If a bank relies on external vendors for trading systems, it will have to know, if it doesn’t already, how those vendors will support VR requirements. If the vendors won’t be ready, the bank will have to build its own or depend on manual processes. So technology readiness is the second priority.
  3. Hedging, which can happen anywhere in the bank, will become a tightly controlled process. Most banks will have to revamp almost every aspect of their hedging, from before the hedge is put on until after it is closed out. Since the practice can be widespread within a bank, and often done by people who aren’t generally involved in trading, banks will have to either spread a very wide net, or centralize hedging into a small number of practitioners. Either way, the VR will involve a significant culture change in the practice of hedging, which is the third priority.
  4. Although the market-making exemption has gotten the most press by far, the most far-reaching exemption is liquidity management, which applies to virtually every bank in the US. Even if a bank has a liquidity management plan, it must be reviewed for compliance with the VR, and the ongoing management of the liquidity portfolio is now a controlled process. Either systems or people will have to ensure that there are no instruments or transactions that violate either the plan or the rule requirements, and activity will have to be monitored to ensure that it doesn’t look like there is excessive trading in the account.
  5. Finally, the VR contains compensation language, requiring that, “The compensation arrangements of persons performing [the exempted] activities are designed not to reward proprietary risk-taking.”  It could certainly be construed that any trader compensation package based in part on trading account profitability, particularly if it doesn’t actually penalize the trader for losses, rewards proprietary risk-taking. Since neither the rule nor any interpretation makes that statement any clearer, this is one case where banks may want to initiate a conversation with their regulators. If the interpretation is that profit-based bonuses reward proprietary risk-taking, the banks will need some time to restructure and renegotiate compensation packages.

It should be clear, then, that assuming the prop trading components of the VR go into effect as stated in July, banks may have to decide very soon where to put their most valuable resources. In the same way that a batter doesn’t swing at every pitch, so as not to strike out, banks will have to prioritize their efforts. If home runs aren’t in the cards for them, at least they can string together some base hits and score some runs.