As I expected, the FSOC’s Volcker Rule study (pdf) doesn’t provide a ton of guidance on the key issues, which are the definitions. It does provide some clues though. I don’t have a ton of time, but here’s what I think are some of the key takeaways:
1. Market-making troubles: Regulators are clearly having trouble figuring out how to define “market-making” for less liquid markets such as swaps. Just look at how vague the “indicia of market-making” they identify for less liquid markets are (on page 29). For instance, they identify “Holding oneself out as willing and available to provide liquidity on both sides of the market” as indicative of market-making. Um, ya think?
2. Inventory accumulation will be a problem: The fact that the statute explicitly permits the accumulation of inventory in anticipation of “reasonably expected near term demands of clients” is going to be a serious problem. The study doesn’t include any ideas for how to place meaningful limits on that exemption.
3. Risk-mitigating hedging activity: The FSOC did actually offer some specifics on how they think regulators should define “risk-mitigating hedging activities.” From page 30 of the study:
Risk-mitigating hedging is defined by two essential characteristics: (i) the hedge is tied to a specific risk exposure, and (ii) there is a documented correlation between the hedging instrument and the exposure it is meant to hedge with a reasonable level of hedge effectiveness at the time the hedge is put in place.The second prong has the potential to be a major flashpoint. If regulators insist that the effectiveness and proper correlations of hedges that fall under this exemption be rigorously documented, then I could see some real wars breaking out between the banks and regulators over whether a given trade is a legitimate hedge. That would be interesting.
4. Do members of the FSOC read my blog? Maybe. (Probably not.) In an earlier post on the Volcker Rule, I noted that the definition of “trading account” in the statute is very similar to the language used in accounting standards, and I wrote that, as a result,
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?Now look at what the FSOC study recommends with regard to the “trading account” issue: (emphasis mine)
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 is still prohibited.
To the extent that Agencies choose to incorporate some type of accounting or similar term in defining “trading account,” the Council recommends that Agencies carefully consider how they might ensure that the prohibition on proprietary trading cannot be avoided through changes in accounting designations (e.g., by designating a position as “available for sale” rather than “trading”). Additionally, if accounting standards are used as the basis for the definition of “trading account” for purposes of the Volcker Rule, it is important that Agencies monitor changes to those accounting standards. (pg. 25)Yep, that’s close enough for me. I’m going to go ahead and assume that the FSOC made those recommendations after reading my post.