In its present form, the Volcker rule has the potential to change compensation structures. Not only that, but the Volcker rule cares about what your intentions were when you executed a trade. Starting to worry? FT Alphaville takes a look at these aspects of the proposed rules then goes over some recommendations about what to focus on when writing those all important comment letters to regulators about how they are trying to kill your business.
To kick off, here’s the specific section on compensation (emphasis ours):
The proposed rule would require that the compensation arrangements of persons performing underwriting, market making-related, and risk-mitigating hedging activities be designed not to reward proprietary risk-taking. These proposed requirements are intended to reduce incentives for personnel of the banking entity to violate the statutory prohibition on proprietary trading and expose the banking entity to risks arising from prohibited proprietary trading.
This is very much in keeping of the way the proposed rules for implementing Section 6.19 of the Dodd Frank Act have been structured. The default position is pretty much that trading activities are proprietary and it’s up to the banks to prove to their regulators that such activities actually fall under one of the exemptions, e.g. underwriting, market-making, hedging.
Compensation is just one of the things that will be looked at when deciding whether something is prop or not prop. Here’s an example of the specific wording as it pertains to underwriting, but there are similar paragraphs for market-making and hedging.
..the compensation arrangements of persons performing underwriting activities at the banking entity must be designed not to encourage proprietary risk-taking. Activities for which a banking entity has established a compensation incentive structure that rewards speculation in, and appreciation of, the market value of securities underwritten, rather than success in bringing securities to market for a client, are inconsistent with permitted underwriting activities under the proposed rule. Although a banking entity relying on the underwriting exemption may appropriately take into account revenues resulting from movements in the price of securities that the banking entity underwrites to the extent that such revenues reflect the effectiveness with which personnel have managed underwriting risk, the banking entity should provide compensation incentives that primarily reward client revenues and effective client service, not proprietary risk-taking.
In other words, banks are going to have to somehow design rather clever systems that distinguish between profits that arose in service to clients versus those from unconnected “risk-taking”. But where and how do you draw the line? And if it’s too complicated to even try to draw it, will banks come up with another compensation structure completely?
Another thing that’s a bit mind-numbing about the proposed rule and what counts as a prop trade is that intent matters, specifically as it relates to “positions acquired or taken principally for the purpose of selling in the near-term (or otherwise with the intent to resell in order to profit from short-term price movements)”.
And as Douglas Landy of Allen & Overy has pointed out, intent is usually something that comes up in criminal cases, e.g. insider trading. With regulations it’s usually more like “do this, don’t to that, and if you do the thing that you’re not meant to do then that’s not ok.” Hence banks have to show that they are “not intending to violate the rule”, and are just engaging in activities covered under the exemptions. However, that’s a bit difficult considering that trades are often done for more than one reason, e.g. market-making and to take a view on direction.
Given this, PWC have a few recommendations about getting ready for the Volcker rule and for writing comments on the proposal to regulators, which are due in by January 13, 2012. (Emphasis ours)
Using the definitions of market making and proprietary trading included in the Proposed Rule, to more closely analyze the revenue strategies employed across your capital markets and trading businesses. Focusing a critical eye on exactly which components of the business are dependent on customer flow transactions versus positioning with a market view will help you to understand your vulnerability to the Proposed Rule.
Given the specific strategy of a trading desk or unit, evaluate how revenue is “really” earned.
Nice use of quotes. We salute you. A bit more from PWC on what things might be taken as signs of prop trading..
.. high levels of inventory with low turnover or long holding periods are particularly at risk. Further, high VaR limits for customer and market making business may, according to the Proposed Rule, be indicative of proprietary trading.
And PWC, bring forth the bomb:
Determine whether your firm may need to change its compensation agreements. The Proposed Rule provides that compensation incentives for permissible trading activities should not be based on what the Proposed Rule considers to be proprietary risk-taking. As written, we believe these strict requirements would differ significantly from the more holistic measurements utilized by most firms today.
We’re assuming that “holistic” isn’t a doughnut reference..
Finding Volcker rule metrics will be tough, dealers warn – Risk
The Volcker Rule As Price-Setting – Dealbreaker
Why Paul Volcker Soured on His Own Rule – The Curious Capitalist