Wednesday, January 7th, 2015
by GEORGE BOLLENBACHER
Although the regulators recently postponed some aspects of the covered fund requirements under the Volcker Rule (VR), there was no change in the proprietary trading requirements. As of now they still kick in on July 21, 2015.
Meanwhile, some of the regulators have already begun examining banks on their preparations for compliance. Based on those exams, and some instructions issued by one of the regulators, here is a set of questions senior management should be asking their compliance and business units in preparation. Crisp answers should give management some comfort, and weak answers should be a red flag.
- Entity Questions
1.1. How many entities in our consolidated organization are subject to the proprietary trading section of the VR?
1.2. If any other entity trades a VR-regulated product, how would we demonstrate that that entity isn’t subject to the rule?
- Trading Desk Questions
2.1. How many trading desks do we have across all the instruments subject to the VR?
2.2. Which ones trade for multiple legal entities?
2.3. If any other desk trades a VR-regulated product, how would we demonstrate that it isn’t subject to the rule?
- Compensation Questions
3.1. How many of our staff have compensation packages that incorporate trading profitability, at least in part?
3.2. How would we demonstrate that those packages are not designed to reward or incentivize proprietary trading?
- Conflict of Interest Questions
4.1. Where is (or are) our conflict of interest policy (or policies) maintained?
4.2. How (and how often) do we check to make sure that they are followed?
- P&P Questions
5.1. Where are each desk’s policies and procedures maintained?
5.2. How would we demonstrate that each desk is following them, particularly regarding new products?
- Training Questions
6.1. How do we train current and new front office staff on the requirements of the VR?
6.2. Do we test their knowledge of the rules?
- Liquidity Management Questions
7.1. Where is our liquidity management plan kept?
7.2. What instruments are allowed under the plan?
7.3. How would we demonstrate that liquidity management instruments were not bought for the purpose of short-term resale, benefitting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging a position taken for such short-term purposes?
7.4. What percent of our liquidity portfolio was sold before maturity over the last six months?
- Hedging Questions
8.1. How do we identify risks to be hedged?
8.2. How do we document the size and causality of the risk?
8.3. How do we document the correlation between the risk and the hedge?
8.4. How do we monitor the hedge during its life?
8.5. How do we account for hedge P&L?
- Metrics Questions
9.1. How do we determine the risk sensitivities required in the rule across all products?
9.2. How do we consistently apply, across all tradingdesks, methodologies for calculating risk sensitivities so that we can compare these sensitivities?
9.3. How do we attribute our daily P&L across the three categories?
- Customer-Facing Questions
10.1. How do we determine if a trade was customer-facing or not?
10.2. How do we tag customer-facing trades?
10.3. What percent of all trades should be customer-facing to stay within the market-making exemption?
10.4. How do we monitor that ratio, and what alerts are there if we get close to the limit?
- Market-Making Questions
11.1. Which trading desks qualify as market-makers and which do not?
11.2. How would we demonstrate that we routinely stand ready to buy or sell any illiquid instruments that we trade under the market-making exemption?
11.3. What is the average holding period for positions on the market-making desks?
- RENTD Questions
12.1. How do we determine RENTD for each product? How often do we update it?
12.2. How do we identify the RENTD for each applicable trade?
12.3. How do we verify that trading volume and positions are within RENTD?
- Alert Questions
13.1. How do we determine when transactions are near or at levels or types which are no longer exempt?
13.2. Who receives any warnings to that effect?
This list may look daunting, but it is only a part of what the regulators will be looking for. So how do you get some comfort that any examination will have a good result? One possibility is to engage an external provider to conduct a test examination. Once you pass that test, you might even approach your regulator to volunteer for the real thing. That should take them by surprise!
