When is Prop Trading Not Prop Trading?

This is the question that is exercising the minds of regulators in the United States and will soon be exercising more than just the minds of compliance officers, traders and logistical technicians in US banks globally.

The issue stems from the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act which seeks to learn the lesson of the financial crisis and prevent another disaster in years to come. Paul Volcker, a man with a brain far bigger than my own and former chairman of the Federal Reserve, fervently believes that banks engaging in risky proprietary trading imperil society at large. He therefore concludes that these banks should be banned from engaging in these types of activity.

This principle has come to be known as the “Volcker Rule” and is supported in legislation which requires detailed rules to be approved in the US that convert this principle into reality.

Those of you operating in these markets know only too well that it is very difficult to distinguish proprietary trading from positions exposing a firm to market risk which are taken to assist clients.

This challenge has been embraced in the “Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds” published by the Financial Stability Oversight Council.

The contents bring a new dimension to rule-making and enforcement gone mad! I suppose this is the world we now live in.

The paper proposes to prohibit banking entities from engaging in proprietary trading. For this purpose, a banking entity is a bank that benefits from federal insurance on customer deposits or access to the discount trading window. This bar will apply to operations in the US and overseas.

The ban is defined as “acting as a principal in order to profit from near-term price movements”. Clearly the issue of long term investments remains to be resolved.

Some proprietary activities will continue to be permitted, namely marketing making, asset management, underwriting and transaction in government securities.

The rest of the paper focuses on an elaborate mechanism for distinguishing between these activities conducted for the firm as opposed to for customers.

Before going into the detail of the framework recommended, the document provides regulators with a “back-stop”. Anything that meets the following criteria is banned, namely material conflicts of interest, material exposure to high-risk assets, high-risk trading strategies, threats to the safety and soundness of the banking entity or threats to the financial stability of the United States.

The paper goes on to recommend a 4-part implementation and supervisory framework:-

Programmatic Compliance Regime

Banking entities will be required to develop robust internal controls and programmatic compliance regimes. These will include internal policies and procedures, monitoring controls on the trading function, record-keeping and reporting systems, independent compliance testing by an internal audit function and a Board and CEO attestation regime (the odour of SOX!!).

Analysis and Reporting of Quantitative Metrics

Banks will need to create and analyse the following types of data:-

• revenue-based metrics;
• revenue to risk metrics;
• inventory metrics;
• customer-flow metrics.

Compliance functions in collaboration with senior management will need to analyse this data and assess whether the trading function is engaged in permitted or non-permitted proprietary trading.

Some of this data will also need to be delivered to the regulatory authorities.

Supervisory Review & Oversight

Regulators will need to develop procedures to supervise banks’ compliance with this regime.

Enforcement Procedures for Violations

Regulators will be required to develop mechanisms to force the termination of non-permissable trading and for related investments to be liquidated.

Other measures to be developed will include increased oversight, reductions in risk limits, increased capital charges and monetary penalties.

Risk Audit will be running a one hour webinar explaining the contents of the paper in more detail and examining the compliance and control challenges that stem from a regime that is likely to be implemented from the beginning of next year.