Did You Forget About the Volcker Rule? – Part 4 : Capital Markets Advisors

Did You Forget About the Volcker Rule? – Part 4

In my last piece, I discussed the exemption-specific compliance requirements of the Volcker Rule (VR) for liquidity management and underwriting. In this article, I will focus on market-making and hedging.

All together, now – the operative language of the Act is, “Except as otherwise provided in this subpart, a [bank] may not engage in proprietary trading, and further defines the term; proprietary trading means engaging as principal for the trading account of the [bank] in any purchase or sale of one or more covered financial positions.”

Thus, unless a bank qualifies under the various exemptions provided in the rule, it may not do any principal transactions in any financial instrument for its own account except debt issued by the US government or a US municipality.

The Market Making Exemption

The market-making exemption is the most difficult to define and enforce, and the rule makes something of a mess in this regard. It starts out pretty simply, where Subpart B says this about the market-making exemption:

The prohibition on proprietary trading contained in §__.3(a) does not apply to the purchase or sale … that is made in connection with … market making-related activities.

But things immediately take a turn for the worse when the same subpart sets out the following unique requirements (among others):

A purchase or sale of a covered financial position shall be deemed to be made in connection with a [bank]’s market making-related activities only if:

…

(ii) The trading desk or other organizational unit that conducts the purchase or sale holds itself out as being willing to buy and sell, including through entering into long and short positions in, the covered financial position for its own account on a regular or continuous basis;

(iii) The market making-related activities of the trading desk or other organizational unit that conducts the purchase or sale are, with respect to the covered financial position, designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties;

…

(v) The market making-related activities of the trading desk or other organizational unit … are designed to generate revenues primarily from fees, commissions, bid/ask spreads or other income not attributable to:(vi) The market making-related activities of the trading desk or other organizational unit that conducts the purchase or sale are consistent with the commentary provided in Appendix B
(vi) The market making-related activities of the trading desk or other organizational unit that conducts the purchase or sale are consistent with the commentary provided in Appendix B

And Appendix B recognizes the difficulty of policing the market-making exemption when it says:

Because both permitted market making-related activities and prohibited proprietary trading involve the taking of principal positions, certain challenges arise in distinguishing permitted market making-related activities and prohibited proprietary trading, particularly in cases where both of these activities occur in the context of a market making operation. Particularly during periods of significant market disruption, it may be difficult to distinguish between (i) retained principal positions and risks that appropriately support market making-related activities and (ii) positions taken, or positions or risks not hedged, for proprietary purposes.

In connection with these challenges, [Agency] will apply the following factors in distinguishing permitted market making-related activities from trading activities that, even if conducted in the context of the [bank]’s market making operations, would constitute prohibited proprietary trading.

Risk Management
Source of Revenues
Revenues Relative to Risk
Customer-Facing Activity
Payment of Fees, Commissions, and Spreads
Compensation Incentives

There is extensive explanation under each of these headings, which banks should read.

The Market Maker Function

The language of this requirement refers to a bank hold[ing] itself out as being willing to buy and sell…the covered financial position. Thus the first question about the requirement is whether holding one’s self out to buy and sell the class of instruments, but not necessarily the specific instrument traded, qualifies as an exemption. Given the large number of securities or derivatives in existence, it is possible that a bank will not be asked to buy or sell a specific instrument for months, or even years. If a customer does request a market, bid, or offer in such an instrument, will that act be sufficient to make the bank a market-maker?

In Appendix B, the Agencies define market-making as passively providing liquidity by submitting resting orders that interact with the orders of others, or assuming the role of a counterparty … ready to buy or sell a position that the customer wishes to sell or buy. The Appendix further says a market maker generally only transacts with non-customers to the extent necessary (i) to hedge or otherwise manage the risks of its market making-related activities, including managing its risk with respect to movements of the price of retained principal positions and risks, (ii) to acquire positions in amounts consistent with reasonably expected near term demand of its customers, or (iii) to sell positions acquired from its customers. Finally, the Appendix says trades will not be exempt if the trading unit: (i) does not transact through a trading system that interacts with orders of others or primarily…to provide liquidity services; or (ii) retains principal positions and risks in excess of reasonably expected near term customer demands, unless certain factors are present, like sudden market disruptions or other changes causing significant increases in a trading unit’s hedging transactions with non-customers; or substantial intermediary trading required to satisfy customer demands and hedging management. Whether the Appendix B conditions really define market making is very much open to question, but the question may become moot if they become the new rules of the road.

Another question is what constitutes hold[ing] itself out as being willing to buy and sell an instrument. If the instrument trades on an exchange, SEF, ECN or dark pool, must the bank be active on that venue on a regular or continuous basis to be considered a market-maker? If the instrument trades on more than one venue, must the bank be active in all, some, or one to qualify? And, if the instrument trades very infrequently, how will the bank demonstrate that it is hold[ing] itself out on that instrument? These are all questions that the bank will want to discuss with its regulators before the VR is effective.

Whatever the answers to these questions, banks will have to be able to defend their market-maker status in any instrument they buy or sell under this exemption. For highly liquid instruments, the willingness to make markets may not be sufficient – the bank may have to regularly buy or sell the securities in question. As a comparison, the Federal Reserve, in determining a firm’s qualifications to remain a Primary Dealer in governments, looks at the percentage of daily trading volume with customers the firm does as the primary determinant. If the regulators adopt this approach for the VR, banks may have to monitor their volume of trades with customers as a percent of total volumes (a required metric anyway) so as not to have their trades deemed prohibited. In addition, as I pointed out in an earlier article, the bank will have to be a registered dealer in the product in question.

It goes without saying that establishing and maintaining the market-making function is critical to ensuring that principal trades done in that unit are exempt, so the bank will have to work closely with its regulators to make sure that it does not inadvertently jeopardize its standing as a market maker in their eyes.

Trading Volume

Subpart D says that the market making trading and position volume should be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties. This applies whether or not the trades and positions were established directly with customers or with other dealers. However, Appendix B has specific language about the volume of non-customer trades vis-à-vis customer trade volume:

In particular, a market maker generally only transacts with non-customers to the extent necessary (i) to hedge or otherwise manage the risks of its market making-related activities, including managing its risk with respect to movements of the price of retained principal positions and risks, (ii) to acquire positions in amounts consistent with reasonably expected near term demand of its customers, or (iii) to sell positions acquired from its customers. The appropriate proportion of a market maker’s transactions that are with customers versus non-customers varies depending on the type of positions involved and the extent to which the positions are typically hedged in non-customer transactions. In the case of a derivatives market maker that engages in dynamic hedging, the number of non-customer transactions significantly outweighs the number of customer transactions, as the derivatives market maker must constantly enter into transactions to appropriately manage its retained principal positions and risks as (i) market prices for the positions and risks move and (ii) additional transactions with customers change the risk profile of the market makers retained principal positions.

One perhaps unintended consequence of this language is to exclude short sales in anticipation of customer sell orders. Under the rule language, banks can acquire positions in anticipation of selling to customers, and sell securities bought from customers, but not sell in anticipation of buying from customers. Perhaps public comments on this language will prompt the Agencies to revise it. If not, banks will have to confer with their regulators as to whether short sales to non-customers in anticipation of customer sell orders are exempt transactions.

An additional implication of Appendix C is that the volume of transactions done away from customers must be consistent with the reasonably expected near term demands of clients, customers, or counterparties. In cases where the expected customer volume does not materialize, the bank is open to a finding that the non-customer volume was excessive, and thus not exempt. Therefore, it behooves banks to document their expectations of customer volume when they take anticipatory positions.

Revenue Sources

This requirement is the most potentially troublesome in the market making exemption. It says:

The market making-related activities … are designed to generate revenues primarily from fees, commissions, bid/ask spreads or other income not attributable to:

(A) Appreciation in the value of covered financial positions it holds in trading accounts; or
(B) The hedging of covered financial positions it holds in trading accounts;

The first thing to note about this requirement is that it refers to how the activities are designed, not how the revenues are actually generated. In other words, if the bank can demonstrate that its principal trading activities are “designed” to allow it to make markets for its customers it satisfies the first part of this requirement.

However, Appendix B also says [Agency] will base a determination of whether a trading activity primarily generates revenues from price movements of retained principal positions and risks, rather than customer revenues, on all available facts and circumstances, including: (i) an evaluation of the revenues derived from price movements of retained principal positions and risks relative to its customer revenues; and (ii) a comparison of these revenue figures to (a) the trading unit’s prior revenues with respect to similar positions, and (b) the revenues of other covered banking entities’ trading units with respect to similar positions.

In making these comparisons, the Agencies will utilize: Comprehensive Profit and Loss, Portfolio Profit and Loss, Fee Income and Expense, and Spread Profit and Loss quantitative measurements, as applicable, both individually and in combination with one another (e.g., by comparing the ratio of Spread Profit and Loss to Portfolio Profit and Loss), and any other relevant factor.(These are metrics I will discuss in the next article)

All that being said, it is axiomatic that the bulk of P&L in a firm’s principal trading business comes from appreciation in the value of covered financial positions it holds in trading accounts. Thus, on its face this requirement is counterintuitive and probably unenforceable. How the regulators will deal with this obvious mistake will be both interesting and crucial.

Risks

The market-making exemption also has a requirement relating to the management of risk. Appendix B says: [Agency] will base a determination of whether a trading unit retains risk in excess of the size and type required for these purposes … a comparison of retained principal risk to: (i) the amount of risk that is generally required to execute a particular market making function; (ii) hedging options that are available in the market and permissible under the [bank]’s hedging policy at the time the particular trading activity occurred; (iii) the trading unit’s prior levels of retained risk and its hedging practices with respect to similar positions; and (iv) the levels of retained risk and the hedging practices of other trading units with respect to similar positions.

In making its determination, the Agencies will utilize the VaR and Stress VaR, VaR Exceedance, and Risk Factor Sensitivities quantitative measurements, as applicable, among other risks measurements described in Appendix A and any other relevant factor. This assessment will focus primarily on the risk measurements relative to: (i) the risk required for conducting market making-related activities, and (ii) any significant changes in the risk over time and across similarly-situated trading units and banking entities.

At its most extreme, this requirement would force a bank to immediately hedge the risk of every trade done with a customer, and would potentially prohibit trades done in anticipation of expected customer activity. Obviously, this interpretation would adversely affect market liquidity and the legitimate functioning of banks as market-makers, so we can conclude that such an interpretation is too extreme. However, the wording leaves the after-the-fact determination by the examiners of what is acceptable risk in a rather subjective state, so banks will need to confer with their regulators about how much trading risk must be hedged and how quickly.

Other Requirements

There are several other requirements under the market-making exemption, like: Absent explanatory facts and circumstances, particular trading activity will be considered to be prohibited proprietary trading, and not permitted market making-related activity, if the trading unit: (i) generates only very small or very large amounts of revenue per unit of risk taken; (ii) does not demonstrate consistent profitability; or (iii) demonstrates high earnings volatility.

Or: Absent explanatory facts and circumstances, particular trading activity in which a trading unit routinely pays rather than earns fees, commissions, or spreads will be considered to be prohibited proprietary trading, and not permitted market making-related activity.

Neither of these conditions serves much in the way of useful purposes, and will be a nightmare to enforce.

The Hedging Exemption

The hedging exemption has garnered most of the recent press coverage, largely because people have pointed out that the losses run up by JPM’s London Whale would have been excused by the bank under this exemption. Given that the losses were realized in the Chief Investment Officer’s department, one could make a very good case that they were actually under the liquidity management part of the rule, but let’s see what this exemption is about.

Section _.5 of Subpart B covers risk-mitigating hedging activities. It allows the purchase or sale … by a [bank] … in connection with and related to … positions, contracts, or other holdings … and … designed to reduce the specific risks … in connection with and related to such positions, contracts, or other holdings. In addition, the VR requires that:

The purchase or sale:

(ii) Hedges or otherwise mitigates … specific risks, including market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, basis risk, or similar risks, arising in connection with and related to individual or aggregated positions, contracts, or other holdings of a [bank];
(iii) Is reasonably correlated, based upon the facts and circumstances of the underlying and hedging positions and the risks and liquidity of those positions, to the risk or risks the purchase or sale is intended to hedge or otherwise mitigate;
(iv) Does not give rise, at the inception of the hedge, to significant exposures that were not already present in the individual or aggregated positions, contracts, or other holdings of a [bank] and that are not hedged contemporaneously;
(v) Is subject to continuing review, monitoring and management by the [bank] that

Among the risks that fall under this exemption is lending risk, so a bank could use this exemption to purchase credit default swaps or sell securities short if the hedge is reasonably correlated to the risk. However, this exemption does not appear to cover a bank’s selling of CDS protection, unless the CDSs are used to offset a previous protection purchase.

An additional requirement for the hedging exemption is that the [bank] must, at a minimum, document, at the time:

(i) The risk-mitigating purpose of the purchase, sale, or series of purchases or sales;
(ii) The risks of the individual or aggregated positions, contracts, or other holdings of a covered banking entity that the purchase, sale, or series of purchases or sales are designed to reduce; and
(iii) The level of organization that is establishing the hedge.

In a recent article on Bloomberg, Cheyenne Hopkins and Jesse Hamilton said, “Administration officials have signaled that one provision that will be more restrictive than the rule’s first draft is its exemption for trades conducted as hedges against other risks. The revised rule is expected to require hedges to be taken against individual positions and limit broader hedges against a bank’s entire portfolio.” If so, that will be a major crimp in rational hedging practices, apparently brought about by a disaster that wasn’t a hedge at all.

In any event, banks will want to set up separate trading accounts exclusively for particular types of hedging, such as lending, loan syndication, liquidity management, underwriting, and market making, and possibly designated at a more granular level. Each account will be linked to the account being hedged. In addition, the bank will want to store and make available explanations of the hedging strategy for each account, in a form that can be included in any reports requested by the examiners.

In the next and last article, I will look at the metrics that the VR expects banks to keep and draw some general conclusions.

Capital Markets Advisors

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