On Monday, FT Alphaville alerted you to one potential hole in the leaked draft of the Volcker rule. That related to what one may be able to get away with in the name of managing a portfolio of positions, presumably via a central execution desk. Here, we bring you more detail on another potential hole to drive your prop trades through, courtesy of Economics of Contempt.
Before that, however, a little preamble from PWC (emphasis ours).
Rumors of selected content of the Volcker Rule Proposal have been the subject of recent stories in the financial press with references to a confidential multi-agency 174-page staff document. The one thing that everyone can be sure of is that the rules will be complex. The Volcker Section 619 of Dodd-Frank is one of the most challenging financial regulatory provisions ever written, dealing with highly technical complex legal matters crossing banking, capital markets and investment management rules. The proposal has been anxiously awaited because it is the type of legislation where a definition or phrase interpreted one way or the other can have significant impact. While on its own Section 619 would be a worthy study for Talmudic scholars, complicate this with five agencies having to write the rules and you have geometric expansion of complexity.
Oy vey!
PWC also note that at this stage, everything is subject to change, and a 60-day comment period is likely once the agencies come out with proposals (publicly, that is).
Jumping back onto the bandwagon though, here are a couple of points from Economics of Contempt on the hedging “on a portfolio basis” issue that was the subject of FT Alphaville’s previous post.
- The amount of leeway on the correlation between a hedge and the underlying risk. Short answer: the draft appears to be indicating it will depend on the facts and circumstances, but anything only “tangentially related” will not do.
- The allowances for (allowed) hedges to introduce new risk. The draft states that it recognises hedges introduce new risks, but that those hedges should not introduce “additional significant exposures”. EofC finds three potential holes in this: what constitutes the aforementioned significant additional exposures; how contemporaneous hedges to that additional exposure would need to be; and what constitutes mere counterparty or basis risk (which the draft indicates is acceptable).
This assessment was based on the “supplementary information” and not the alleged draft of the rule. The full September 30th draft of the proposals was leaked subsequently by American Banker (though various drafts have been floating around for weeks). Economics of Contempt says this doesn’t change his/her analysis. Indeed, concerning the above assessment, the main change between the two documents is that the term “portfolio” is replaced with “aggregated positions“.
If after reading the above, you are feeling concerned about that particular gap in the draft not looking as attractive as you first thought, worry not. EofC is here with a useful analysis of what constitutes ”bona fide liquidity management”. From the draft:
(C) For the bona fide purpose of liquidity management and in accordance with a documented liquidity management plan of the covered banking entity that:
(1) Specifically contemplates and authorizes the particular instrument to be used for liquidity management purposes, its profile with respect to market, credit and other risks, and the liquidity circumstances in which the particular instrument may or must be used;
(2) Requires that any transaction contemplated and authorized by the plan be principally for the purpose of managing the liquidity of the covered banking entity, and not 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;
(3) Requires that any position taken for liquidity management purposes be highly liquid and limited to financial instruments the market, credit and other risks of which the covered banking entity does not expect to give rise to appreciable profits or losses as a result of short-term price movements;
(4) Limits any position taken for liquidity management purposes, together with any other positions taken for such purposes, to an amount that is consistent with the banking entity’s near-term funding needs, including deviations from normal operations, as estimated and documented pursuant to methods specified in the plan; and(5) Is consistent with [Agency]’s supervisory requirements, guidance and expectations regarding liquidity management; or
(5) Is consistent with [Agency]’s supervisory requirements, guidance and expectations regarding liquidity management;
Economics of Contempt says using this exemption would remove the need to bother with more complicated exceptions and reduce the amount of trading data to provide to regulators:
The proposed rule requires that trades done under the liquidity management exclusion be done according to a “documented liquidity management plan” that meets five criteria. But none of the five criteria in the proposed rule appear to me to be prohibitive if a bank wanted to use the liquidity management exclusion for prop trades. The plan has to “specifically contemplate and authorize any particular instrument used for liquidity management purposes” — fine, just write a liquidity management plan that contemplates the use of a (very) wide range of instruments (a lot of instruments have reasonably liquid markets in normal times). The second criterion basically requires that an instrument used for liquidity management not be used “principally” for prop trading purposes, which is easy, since prop trading is prohibited regardless of whether it’s the “principal” purpose of the instrument.
The third criterion requires the liquidity management plan to be “limited to financial instruments the market, credit and other risks of which are not expected to give rise to appreciable profits or losses as a result of short-term price movements.” This criterion simply can’t be enforced terribly stringently — even Treasuries, which are the core of any serious liquidity pool, often experience significant short-term price movements. Fourth, the plan would have to limit liquidity management positions to “an amount that is consistent with the banking entity’s near-term funding needs.” This also can’t be seriously enforced, because it would directly conflict with Basel III’s new Liquidity Coverage Ratio (LCR), and cautious liquidity management in general. Finally, the plan would have to be “consistent with the relevant Agency’s supervisory requirements … regarding liquidity management.” Seeing as the new liquidity rules set a floor on a bank’s liquidity management, and not a ceiling, using instruments that don’t qualify for the LCR in a broader liquidity management plan would certainly still be “consistent with” the regulators’ liquidity requirements.
There you have it. If your prop desk hasn’t moved to Hong Kong or Dubai already, you may be in luck. Or they may change everything. O, those regulators – always keeping you on your toes!!
—- by Kate Mackenzie and Lisa Pollack
Related links:
Volcker rule may lose its bite – WSJ
Overcoming the Volcker rule, with ETFs - FT Alphaville
Volcker rule puts short-term trades under more scrutiny - Bloomberg