Thursday, November 3, 2011

Here They Come, the Volcker Rules

Like it or not, the Volcker rules are coming. Ready or not, banks confront the new reality. Banks reported a gush of trading-related revenues in the 2000s. Going forward, they will not be permitted to engage in proprietary trading in the way they have done successfully the past decade.

Banks, including old commercial banks and investment banks that turned into bank holding companies,  maintained trading units and ran them like internal hedge funds. They were allowed to use capital to support trading in most any instrument they felt they had expertise in or perceived profit opportunities. They  traded equities, held positions long or short, traded equity derivatives, and traded equity-linked swaps. Big banks, like JPMorgan, Citi, or Goldman Sachs, reported profits, had substantial roles in all markets, and attracted talent. Small community banks shied away.

They could execute "black blox" trades, high-frequency algorithms, or deal in"exotics." Analysts described Goldman as a trading firm or hedge fund disguised as an investment bank. Morgan Stanley, for many years, operated a closed-doors proprietary trading group, featuring traders with doctorates with complex ideas about exotic trades and statistical arbitrage.

Banks organized and managed desks in bonds, structured notes, mortgages, foreign currencies, convertible bonds, options, and high-yield debt.  They traded in every imaginable derivative--from currency swaps to credit-default swaps and asset-backed indices. They took positions, took risks in market trends, and bet in the long term or short term.

And none of this trading was required to accommodate customers, although selling to or buying from investors who were clients was a significant part of the business.

Dodd-Frank and other bank regulation around the globe are curtailing prop-trading at commercial banks, at bank holding-companies, and at any financial institution that has a deposit-taking business in its vicinity.  For months, banks have been re-engineering their operations to comply with expected rules changes. More important, they are scrambling to figure out how they will replace profits from trading with other revenue sources to generate similar returns on equity. The clock is ticking.

Or perhaps they will learn to settle for lower returns on equity, but more stable performance from quarter to quarter.

Banks knew the rules were coming, ever since the frantic aftermath of 2008-09 when former Federal Reserve chairman Paul Volcker proposed the abolition of prop-trading at banks. He, as well as politicians, regulators and the public at large, reasoned prop-trading contributed to or exacerbated the crisis. A year after the passing of Dodd-Frank legislation, banks are hustling to offset expected loss revenues, make sense of the rules, and figure out what they can and cannot do.

The rules permit client-flow trading. Banks won't be forced to shut down their trading operations.  They can maintain trading positions if they exist to accommodate a client wishing to buy or sell securities or derivatives. That's not as easy as it sounds.

The rules that explain client-related flow trading are difficult to interpret and even harder to comply with:  If a bank purchases equities from a client and hold them for a week, is that client-related trading? If a bank purchases corporate bonds in anticipation of clients wanting to buy them, is that client-related trading? If a bank purchases securities and re-sells them for an above-normal profit within a day, is that client-related trading?

Banks are huddling among themselves to understand what the rules will permit or prohibit. Banks also are puzzled to determine what is an infraction. The rules, for example, let regulators infer that prop-trading exists if banks report excess trading revenues or volatile trading revenues, even if it appears all trading is tied to a client request.

Trades for hedging purposes will be permitted. Yet hedges are hard to interpret. When is a hedge really a hedge? What if equity positions are hedged 100 percent one day, but market movement causes the same position to be hedged 90 percent the next week? The rules are subject to interpretation. But no bank wants to be subject to a penalty or subpoena. Some banks will not want to absorb unusual legal costs to interpret every aspect of the rules. 

Some major banks (such as JPMorgan, Bank of America, and Morgan Stanley)--especially those with significant institutional and hedge-fund clients--will dig in, continue to maintain trading desks for client flows, and learn with difficulty to live within the rules.  They anticipate declining trading revenues, but hope other client business (e.g., equity IPOs, M&A mandates or cash-management services) will offset the declines.

Other banks--especially those that weren't major traders or those with negligible success in prop-trading--will abandon trading altogether.

The big banks that stick it must invest in systems and hire compliance people to monitor trading activity to make sure they obey rules. They prefer to invest in other revenue-generating projects, but if they choose to retain trading desks, they will learn to live with constraints, limits, and compliance costs.

Banks don't broadcast all the repercussions of limited trading, but there are other implications. Some analysts rationalize the disappearance of prop-trading revenues could push ROEs, customarily above 15%, down to 10% and below, even in the best of times, unless they find offsets or new products and services.

Bank trading arms attracted smart, talented traders, researchers, and black-box theorists. This group will now seek to work for hedge funds, private-equity firms, and broker/dealers.  Cynics argue that's fine, since the same group might have contributed to the exotic products that led to the crisis.

Bank trading units have long been centers of innovation, new ideas, and new products.  Hedge funds and private-equity firms spawn ideas, too. But the Goldmans and Morgan Stanleys with global networks, securities distribution arms, research groups, market intelligence, investing clients and capital often acted as incubators for new products or ways of trading. Lower profitability will discourage them from devoting resources to new products or trading ideas.

Again, cynics, regulators and many in the general public say that's fine. New trading products and ideas should be, they say, developed slowly, and their risks and impact on markets analyzed and studied in depth.

Bank trading units may scale down their market-making and dealing roles. Banks had capital and resources to act as market-makers across multiple products. They provided vast amounts of liquidity in derivatives, bonds, and currencies.  Will liquidity be jeopardized if banks de-emphasize trading? Will banks be less willing to assist institutional clients in hedging strategies or if it wants to avoid penalties lest regulators misinterpret the position?

Tough questions for big banks, but with solutions that might make them uncomfortable for a while.

 Tracy Williams
For more on the Volcker Rules, see also CFN post of June-2010:

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