The Volcker rule: a modest proposal

By:
Jon Macaskill
Published on:

The final version of the Volcker rule is unlikely to give posterity phrases that echo through the ages in the style of the King James Bible, but the details of its wording are important to financial market participants, which helps to explain the extended bickering.

The example of foreign exchange dealers at banks in the City of London allegedly using knowledge of client flows to make illicit trades via their personal accounts might offer a solution to some of the thornier problems in implementing the Volcker rule.

Settling details for the Volcker rule to curb proprietary dealing by banks has turned into an epic of biblical proportions.

It is almost four years since former Federal Reserve chairman Paul Volcker made his proposal to eliminate proprietary trading by banks and over two years since legislation was passed to implement the rule, subject to agreement of details. But Washington’s fractious regulatory agencies are still battling over the terms of their 1,000-page draft of the Volcker rule and there are indications that enforcement will be delayed by at least another year.

To place this in historical perspective, the main work of the collation of the King James Bible was conducted over three years, in an era before the advent of email.

The final version of the Volcker rule is unlikely to give posterity phrases that echo through the ages in the style of the King James Bible, but the details of its wording are important to financial market participants, which helps to explain the extended bickering.

The latest conflict began when Kara Stein, a Democratic commissioner on the SEC, introduced four pages of proposed changes to toughen the language of the Rule.

One of these proposals was that CEOs of banks should be compelled to sign off on a commitment that their trading desks have not been engaged in proprietary dealing.

This did not go down well with banks and their lobbyists, who tried to communicate the message that a CEO would be hard pressed to make a blanket pledge that no prop trading whatsoever had taken place in one of the sprawling mega banks that dominate modern dealing.

But here is where the techniques developed by London’s ever nimble FX dealers might offer a way out in the form of a ‘don’t ask, don’t tell’ approach to prop trading.

The latest allegations against some FX traders are that not only have they been front-running client trades on behalf of their bank employers and manipulating benchmark fixes, but that they have been conducting secret trades via personal accounts that also profit from information about client flows. Some of this activity was allegedly facilitated by day-trading co-conspirators in rented offices on the fringes of the City.

Surely this entrepreneurial zeal can be channelled in a way that does not leave banks and their shareholders exposed to the vagaries of prop trading. After all, it seems increasingly clear that information about client trades and other flows simply cannot be kept confidential in the modern financial system: like water running downhill, it will always find an outlet.

If traders at the main investment banks are given tacit approval to place personal side bets based on their knowledge of client flows they will at least be risking their own money, for relatively small amounts. The temptation to set up an elaborate multi-billion dollar notional derivatives trading system that will qualify as a hedge or a market-making effort under the eventual Volcker rule language, while also allowing some light prop positioning, will be much diminished. Counterparty risk will be reduced, as traders taking a punt via their personal accounts will not qualify under Isda derivatives documentation. And shareholders of firms such as Goldman Sachs or Deutsche Bank will have less reason to wonder how ‘inventory management’ can cause a 50% plunge in fixed-income revenue in any given quarter.

Of course, clients will still suffer some exploitation of their legitimate customer activity. But that seems completely unavoidable.