Continuing my Volcker rule theme, the current issue of Risk has an article titled, “Dealers Confident on Volcker Exemptions,” which quotes various banking lawyers talking about how easy it will be to get around the final Volcker rule language in Dodd-Frank. From the article: (emphasis mine)

“Last month, we sat down with our counsel and after an hour of question-and-answer, the lead counsel turned to me and said ‘it is not going to be absolutely clear how the provision will work until the rules have been written, but given so much of proprietary trading has a client nexus to it, I’ll be embarrassed if I don’t manage to exempt all your activities from the rule’,” says one head of equity derivatives structuring in New York.
Early reports on the Volcker rule caused astonishment in the banking industry, with predictions of massive changes to the structure and business of certain dealers. Now lawyers have had some time to absorb the clause within Dodd-Frank, many feel the prop trading requirement will be relatively easy to negotiate.
This is exactly what I said Wall Street’s real reaction to the Merkley-Levin version of the Volcker rule would be. (“Merkley-Levin” was the amendment that the conference committee based the final Volcker rule language on.) As I wrote way back in May, when the Senate bill was still being debated: “I spent the majority of my career as a lawyer for one of the big investment banks, and my first thought after reading Merkley-Levin was: ‘Wow, this would be cake to get around.’ Wall Street is scared of the Volcker Rule, but believe me, they’re not scared of Merkley-Levin.”

To be fair, Merkley’s office fixed some of the most glaring problems that I talked about in that post, so the final language is at least an improvement over the original version of Merkley-Levin. (You’re welcome, by the way.) Unfortunately, the final language still has several major flaws, some of which I’ve discussed previously.

The Risk article talks about other problems with Merkley-Levin as well:
[The lawyers’] confidence stems from the language used in section 619. Prop trading is defined as a sale or purchase conducted as a principal on behalf of the trading account of the firm. The trading account is described as any account used for acquiring or taking positions in securities with the main purpose of selling them in the near term or the intent to resell them to profit from short-term price movements.

Lawyers say these few sentences are riddled with ambiguities. “There are many possible unintended exemptions in this definition - it is just not clear at all,” says Scott Cammarn, special counsel at Cadwalader, Wickersham & Taft in Charlotte, North Carolina. “For instance, what happens if the trade occurs outside of the trading account? The definition explicitly states the transaction must be booked in the trading account, so I would argue that if any trade is transacted in a different account, it is not prop trading.”
I don’t think the “trading account” issue is as simple as Cammarn makes it out to be, but it definitely is another potential loophole. I have no idea why Merkley and his staff decided to define prop trading by reference to a trading account, and then include the real definition of prop trading in the “trading account” definition. The real definition of prop trading under Merkley-Levin is “taking positions ... principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements).” So why not just use that as the definition of “proprietary trading”? Why force regulators to regulate accounts rather than trades? It’s bizarre, frankly, and ultimately detrimental to the overall rule.

For instance, seeing as the language in Merkley-Levin’s definition of “trading account” was lifted directly from the Form Y-9C definition of “trading account,” and the Form Y-9C definition is explicitly based on accounting treatment, it’s possible that banks could put on prop trades outside of a “trading account” as long as they agree to use a different accounting treatment for the prop trades. And what if accounting standards change? What if FAS 115 is overhauled in the future? What happens to the definition of “trading account” then?

Also, are we talking about the account where the trade originated? What if a trade is originated in the “banking book,” and then subsequently transferred to the trading book? Since the banking book is (obviously) not a “trading account,” it's not clear if the trade still prohibited. What is clear is that using this incredibly roundabout definition of prop trading was entirely unnecessary, and just created more loopholes for banks to exploit.

Now we get to the real flashpoint, which is how you distinguish “market-making-related activities” from trades done “principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements).” As the Risk article notes:
By far the biggest ambiguity centres on the use of the word ‘intent’. The rule only seems to apply if banks had the intention from the start to sell a position to profit from short-term price movements. “How on earth do you police motive? It is almost impossible. A bank could claim to enter into a five-year put option on the S&P 500 and intend to hold the contract until maturity. If the index then drops 20% in two days and the bank monetises the gain by selling the option, it is arguably not prop trading. The intent was never there to profit from a short-term price move,” says Cammarn.
This is where I disagree. Obviously traders can lie to you about their intent in putting on a trade. But there are signals which are indicative of proprietary trades, and market-making trades can be distinguished from proprietary trades by looking at those signals. For instance, was the position opened on the bid side or the offer side of the market? If the position was opened on the offer side and was legitimately related to market-making, then the trader should also be able to identify the specific risk that he was hedging.

Also, how long has the security been held in inventory? Ace Greenberg, the legendary Bear Stearns trader and former CEO, famously used to require traders on his desk to cut any position that they’d been holding for longer than, say, 30 days. I’m not saying that this should be the hard-and-fast rule for every market — every market really does differ in terms of how long the securities need to be held in inventory. I’m just saying that this is absolutely a legitimate tool, and the inevitable claims from the Street that this would be the end of the world, and would prevent them from effectively managing their risk, etc., should be ignored. This was a risk-management tool for Greenberg, who knows a little something about trading.

Unfortunately, Merkley-Levin exempts not only “market-making-related activities,” but also “risk-mitigating hedging activities,” so even if the Fed writes a perfect definition of “market-making-related activities,” most prop trades will probably still be able to fit under the “risk-mitigating hedging activities” exemption. And this is before we get to the problem of banks setting up Section 2(a)(13) “employees’ securities companies” to do their prop trading. Merkley-Levin inexplicably misses those, which creates a loophole big enough to drive a truck through.

Don’t look for these issues to be mentioned in the notice-and-comment period though; the Street doesn’t generally tip their hand there. Better to make policy arguments during the rulemaking process, and save the legal arguments for the no-action letters. But just be aware that these issues are out there, and if they’re not dealt with during the rulemaking process, then they will be exploited by the Street.


faustroll said...

Very well thought out and well written. And perfectly to the point. The rulemaking process *is* naive and the street *will* exploit that fact.

“Risk-mitigating hedging activities” and sundry euphemisms are well-worn defenses for the most speculative of financial positioning indeed.

Sandrew said...

Can you explain the Section 2(a)(13) "employees' securities company" loophole in more detail?

I thought the idea of an employees' securities company was that all the risks and rewards of such an entity need be borne by a group of employees (of some common company). If so, I don't see how this achieves a loophole in the Volcker Rule, which is meant to bar banks (and their agents) from making "prop" bets with the banks' money (i.e. funded by debt/equity of the bank itself). If bank employees want to pool their money to make prop bets, how does that put the bank's capital at risk? If I misunderstand what is meant by an employees' securities company, please correct me.

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Almost everything I've read about Dodd-Frank makes me think we're going to move seamlessly from this crisis to the next, and this post is another confirmation of that. The drafting language that you point out here seems exceptionally bush league, almost to the point of sabotage by lobbyists and other moneyed interests.

Chard said... new Milton Friedman you are! I followed MF for a decade to universities he was at...then became close when we met at The White House in 1993.

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In closing, besides saying Thank You, I would like to ask if I may send you a short essay?

Respectfully and gratefully yours, I am

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