Waiting for Volcker

5-2-13_Vockler.pngIt has been nearly a year since the Volcker Rule was supposed to go into effect and there is still no agency rule to implement the Volcker Rule, which was passed as part of the Dodd-Frank Act. Regulators have shown few signals that a final implementing rule should be expected in 2013. 

The statutory provisions referred to as the Volcker Rule contain two main elements: a prohibition on proprietary trading by banking entities, and a prohibition on certain bank investments in private equity and hedge funds. The proprietary trading ban includes a number of exemptions, including for market making and hedging.

The statute itself leaves the interpretation of these terms to five regulatory agencies: the Board of Governors of the Federal Reserve System (Fed), The Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC).

In October 2011, the Fed, FDIC, OCC, and SEC jointly proposed implementing regulations.  In February 2012, the CFTC issued a substantially similar proposal. 

Under the Dodd-Frank Act, the five agencies are not required to issue rules jointly. Instead, the statute allows the Fed, FDIC, and OCC to issue joint rules with respect to insured depository institutions (IDIs); the Fed to issue rules for bank holding companies, nonbank systemically important financial institutions, and their subsidiaries; and the SEC and CFTC to issue rules for entities for which they are the primary regulators. 

To their credit, the regulators acted jointly at the proposal stage. But, this statutory construct shows the potential for the Volcker Rule to become a regulatory quagmire. It would hardly be efficient if a bank holding company had to separately comply with one rule by the Fed for the holding company, a second joint rule by the banking regulators for any IDI subsidiaries; and a third and fourth rule by the SEC and CFTC for broker-dealer, swap dealer, futures commission merchant, and other subsidiaries regulated by those entities. Aside from substantive requirements, each rule potentially could have different (maybe contradictory, maybe overlapping) compliance and data reporting requirements.

So it may be a victory alone if the regulators adopt a joint final rule. Rumors have circulated in Washington, D.C., that the agencies are prepared to go their separate ways.

Since the rule was proposed, market participants spent significant resources to comment on the rule. Although there have been calls from the political proponents of stricter rules for the agencies to make the final rule tougher than the proposal, many of the comments described ways in which the proposal could lead to significantly reduced market liquidity, increased costs for consumers and other end-users, and could make certain markets economically unviable.

One of the more difficult issues is how the Volcker Rule should distinguish between prohibited proprietary trading and permitted market making and hedging. The proposed rule uses what has been characterized as a trade-by-trade approach to determine whether a position is proprietary, or allowable under an exemption. Commenters noted that market making inherently involves principal risk, dynamic hedging, and that risk is not managed on a trade-by-trade basis. The proposed approach seems suitable for only the most liquid markets, and likely to create barriers to being an effective (and profitable) market maker in less liquid markets, where positions can be held in inventory for long periods, and hedges are not one-to-one. 

Thus, the question is how can the regulators proceed? There are two approaches they should consider. One, the agencies could use a safe-harbor approach, and identify specific activity that would be permitted under the rule. Of course, the danger with this approach is that the regulators draw the safe harbor too narrowly. Two, the regulators could define market making to include hedging that is done as a part of a market-making business, and could provide that the criteria to be a market maker would be fluid depending on the liquidity and other features of the market in which a firm was operating. The danger here could be a lack of legal certainty for any particular market.

In all events, it is almost certain that the final rule will require years of legal interpretation by private practitioners and the regulators before it works in the real world.

Don Lamson