We've nearly reached the end of the road with the Volcker Rule, but, to quote Boyz II Men, we can’t just let it go. At least not yet.
The final version of the Volcker Rule is due out next Tuesday, Dec. 10. This is the part of Dodd-Frank, remember, that’s designed to prevent banking entities from engaging in “proprietary trading” — transactions in which a bank uses its own capital to assume the principal risk in order to benefit from short-term price movements. Or, in plain English, it removes the parts of banks that gamble and act like hedge funds, because those parts can blow up quickly.
The Volcker Rule isn’t, however, supposed to interfere with “market-making,” or those activities in which a bank either matches buyers with sellers or acts as an intermediary by using financial instruments. The rule also isn’t supposed to mess with a bank’s ability to hedge against risk. The tricky part for regulators is figuring out how to tell the difference between “proprietary trading” and these latter, legal activities.
So when the final rule comes out, how will we be able to tell the difference between a strong rule and a weaker one? Here are a few areas to pay attention to:
Portfolio hedging: Back in March, JPMorgan’s “London Whale” division lost $6 billion in a set of bets on credit derivatives that eventually imploded. At the time, JPMorgan CEO Jamie Dimon argued that these trades were perfectly legal under the Volcker Rule, because they fell under the definition of “portfolio hedging.”
As Alexis Goldstein noted in The Nation, Dimon’s argument seemed to imply that any trade could count as legal, so long as it was a hedge against “bad outcomes” — a much broader version of “hedging” than the original definition, which merely implies offsetting against existing risk.
So this will be a key test for the rule. If the Volcker Rule couldn’t have stopped the London Whale trade, it’s fairly useless as a piece of reform. Early leaks suggest that portfolio hedging won’t be allowed under the final version of reform. Treasury Secretary Jack Lew has also explicitly said in recent remarks that “the [Volcker] rule prohibits risky trading bets like the ‘London Whale’ that are masked as risk-mitigating hedges.”
Hedging in general: Even under a strict implementation of the Volcker Rule, firms should still to be able to hedge against certain risks. Nobody has ever indicated otherwise. But how do you take the activity of hedging, which can often be used as a disguise to take giant risks, and ensure it is being used correctly?
This can be done. As MIT Professor John Parsons writes, “distinguishing between proprietary trading and various other types of trading, such as hedging underlying commercial operations, is a standard, everyday responsibility of corporate management.”
As Marcus Stanley, policy director of Americans for Financial Reform, told me, the definition of a hedge “must be linked with a specific position or positions, must reduce the risk of the position it is linked to and must not introduce a new risk, and this needs to be clearly measured and documented.” How tight this language is will give a sense of how well the Volcker Rule will work.
Market-making: Like hedging in general, the Volcker Rule has always been meant to allow for market making. But what is the correct way to distinguish between market-making and risky activities?
As Stanley told me, “You should also watch how much inventory build-up is permitted under the rubric of market making. Under normal market circumstances, higher volumes of inventory indicate more proprietary trading and more risk to the bank. Finally, keep an eye on which agency will actually enforce these rules for which part of the bank, and how the agencies will coordinate that.”
Implementation: Even if the Volcker Rule is strong, it still needs to be enforced. Ideally, the rule would also foster cultural and institutional change at these largest firms. So how can we measure this?
"The Volcker Rule ideally will point to actual concrete things we can look at in six months to see if the rule is having an effect,” former market-maker Caitlin Kline told me. In an early draft of the rule, the metrics were fairly poor and hard to measure. Figuring this out will be part of the final process.
Here’s another way we might be able to tell if the rule is working: “If the Volcker Rule works and banks focus more on market making and client services, we should expect to see the people focused on those activities thrive, while the traders and business models of betting big and taking huge gambles move externally to hedge funds where they can be rewarded for that activity,” says Kline.
Much of the reforms in the Dodd-Frank bill focus on giving regulators new ways of dealing with a crisis. But there are also pieces that change Wall Street structurally. For instance, there’s the roll-back of the over-the-counter derivatives market. There’s also a provision to remove hedge funds from our banks. In this sense, the Volcker Rule is one of the few attempts to actually change the legal structures of the largest banks. It is crucial it is done well, and enforced even better.
Further reading: Check out American Banker’s three-year timeline of the evolution of the Volcker Rule.
Mike Konczal is a fellow at the Roosevelt Institute, where he focuses on financial regulation, inequality and unemployment. He writes a weekly column for Wonkblog. Follow him on Twitter here.