As readers know, this blog has LOOONG been a critic of the Treasury Department’s stance towards big dealer banks, both in the Paulson era and from the very get-go of Geithner’s tenure. So on those all-too-rare occasions when Treasury seems willing to meddle in a real way with the “heads we win, tails you lose” arrangement the financial services industry has managed to devise with broader society, it’s important to applaud those efforts.
Admittedly, it is premature to declare victory, but the fact that Treasury is even taking a serious stance on the so-called Volcker rule is a surprise. Conventional wisdom on financial reform, and it is being borne out in the backroom wheeling and dealing on derivatives regulation, is that despite the length of the Dodd-Frank bill, numerous key details remained to be worked out in detailed provisions which were to be negotiated with industry incumbents. That looked to be a way to retrade the deal, since the legislation could be interpreted as narrowly as possible, with the end result that the industry incumbents would be merely inconvenienced, as opposed to required to do business in fundamentally different ways.
We had doubted from the outset that one widely-touted reform plank, the so-called Volcker rule, would amount to much. Not that we disagreed with the high concept; indeed, the general precept is correct. Major financial firms have government support because they provide essential social services. The various forms of support should not be used to subsidize activities that do not have broad social benefits and/or are profitable enough so as not to require subsidies for private actors to fulfill those functions. The Volcker rule thus sought to restrict banks from speculating with house funds for the purpose of padding their own bottom lines, so called proprietary trading.
That sounded all well and good. But what, pray tell, was a proprietary trade? It ought to encompass any in-house investment, such as hedge funds and private equity funds (sadly, those are still permitted, although the banks are restricted as to how much capital they can commit to them). But the big question lay with what to do with so-called proprietary trading desks, traders that played with the house’s money, typically in dedicated business units that were not obligated to trade directly with pesky customers.
But the Volcker rule, at least as presented by Volcker himself, drew a spurious distinction: any trade with a customer was to be considered a non-proprietary trade. That was misguided. Prop traders don’t make markets with customers, but the vast majority of their trades are with end-users, not with professional dealers at other firms (the prop desk will often hand an order off to be worked on another desk).
However, as reported by the Financial Times, Treasury appears to have embraced what Volcker intended at the outset, as opposed to his non-trader-savvy further formulation. One encouraging element is that they appear to be looking at multiple considerations in judging what is a prop trade; single rules are much easier to game.
From the Financial Times:
US regulators are pressing for strict definitions of proprietary trading activities to be banned under the Dodd-Frank financial reform law in a move that could anger bankers and some of their toughest critics…
But the US Treasury, which chairs the regulatory panel drawing up detailed rules, wants to base the definition of proprietary trading on measurable metrics to prevent banks from getting around the law.
Wall Street executives said government officials indicated they were interested in looking at the length of time a bank holds a trading position, its size and risk, when deciding whether a transaction constitutes proprietary trading or market-making on behalf of customers.
Now this is admittedly Treasury’s opening position; given how the Obama administration has repeatedly engaged in bold talk and then caved to vested interests, it’s premature to conclude that we will see a taxpayer-favorable outcome here. But this is a tougher stance than I had envisioned they would take.
Of course, there are simpler approaches, namely keep the rules a bit mysterious but make the consequences of violating it draconian. Economics of Contempt supplies an elegant solution:
The proposal: If a trader is found by regulators to have violated the Volcker rule more than once in a calendar year, his pay cannot be more than $100K for that year. No exceptions. No million dollar bonuses. If the trader has already received more than $100K in base salary for the year, then he has to pay back any amount over $100K. Believe me, once a trader has violated the Volcker rule once, he’ll be falling all over himself to document why and how every trade is related to market-making.
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It’s important to understand that TBTF banks are the extension of state, not bona fide private institutions.
Also financization of the economy (aka “casino capitalism”) is the trend that is difficult to oppose as in part it constitutes a reaction to the loss of competitiveness of other sectors of the economy.
In this sense there is no reason to expect excessive zeal in enforcing Volker Rule.
I have to ask this question: How does one regulate an inherently dishonest business, government backed fractional reserve banking?
The government obviously fears to kill the goose that lays the golden eggs. However, a more apt metaphor is government collusion with the fox that STEALS the golden eggs.
“Of course, there are simpler approaches, namely keep the rules a bit mysterious but make the consequences of violating it draconian.”
This sort of rule and enforcement should be used liberally throughout the entire financial industry. But our Supreme Leaders errrr Court would never allow that kind of treatment of corporations or their agents.
The distinction between prop trading and market making is absurd. Derivative trades with customers must be laid off somewhere. Prostitution and gambling don’t become safer through regulation. They just feel safer, until the disease emerges as an epidemic.
In other news, JP Morgan currently holds 50% of all the LME’s copper stockpile. So it looks like they are not too worried about this
“Of course, there are simpler approaches, namely keep the rules a bit mysterious but make the consequences of violating it draconian.”
This is especially ironic in a week that the Justice Department is trying to prosecute lobbyists for whatever honest services fraud is, and Assange is prosecuted for an obscure crime in Sweden. Prosecutors abuse their discretion? To borrow an obnoxious term, Hoocoodanode?
I agree this sounds like a good development, not sure its a sign Geithner has grown a pair though.
The Volcker rule in principle is consistent with the BIS trading book/banking book distinction.
Dodd Frank throws a bit of a wrench into the harmonization process, so this bit from the FT article is important:
But the US Treasury, which chairs the regulatory panel drawing up detailed rules, wants to base the definition of proprietary trading on measurable metrics to prevent banks from getting around the law
Treasury is also working with global regulators to coordinate the implementation, so this signals (to me at least) that the US reg proposals are being driven by that process.
Metrics are the key. Its a relatively simple task to establish and monitor reasonable market maker limits. Geithner seems to be signaling that he concedes this point.
But we’ll need to see the proposed metrics before we decide if he’s following through or using the metrics negotiations to game the law.
“The proposal: If a trader is found by regulators to have violated the Volcker rule more than once in a calendar year, his pay cannot be more than $100K for that year.”
This penalty strikes at the root of the problem quite nicely. The financial system at this point in time can be thought of as a large scale mechanism for extracting money from current and future taxpayers and transferring it to the pockets of senior executives. It’s large, efficient and functions very well, particularly now that TBTF has been validated as official policy. The mechanistic nature of government and regulation in the US also makes it easy to maintain and difficult for voters or anyone outside the industry to change. Any remedy that has a hope of succeeding must interrupt this basic flow of money.
The public, I think, gets this by now. The financial sector may be a black box to them, but they can see what goes in, what comes out and who benefits, and draw the obvious conclusions.
The following soundbite “Wall Street executives said government officials indicated they were interested in looking at the length of time a bank holds a trading position, its size and risk, when deciding whether a transaction constitutes proprietary trading or market-making on behalf of customers” may make for good optics on paper, but the banks should as Yves often says “be able to drive a truck through it.”
Any trading/investing position established by an institution or person is accompanied by a cusip number.
Assume that a person or institution builds a large position over time with 100s of cusip #s for the same product,e.g. JPM holding 50% of all outstanding copper futures contracts (this large a position of anyone institution or person appears to also be in a violation of normative CFTC rules and regs regarding position limits but hey JPM Is above the law right?)
Now, for tax purposes an individual or institution can sell any cusip number attached to those contracts it wishes to for tax purposes. Or in the case of TBTF institutions, for the purposes of getting around Volcker rule. The TBTF can claim that they are simply rearranging the furniture as they buy and snip cusips on the Titanic.
I’m scratching my head here.
First, isn’t a “market-making” trade defined as a trade which happens because a customer needs a trading partner for its own trading ideas? If so, shouldn’t the customers be required to sign affidavits that they trade with these banks only on their own initiative and with their own trading ideas, and if it is later discovered that a trade was really the bank’s idea, that customer is then subject to sanctions along with the offending bank?
Second and more importantly, are “market-making” trades really any less risky than proprietary trading? I thought they could be MORE risky, especially if they are truly market-making in the sense that the market maker has to buy (or sell?) when nobody else is willing. Though I’m guessing that’s not what we’re actually talking about here.
There was NOTHING WRONG WITH Glass-Steagall. Transactional/deposit type bank accounts should be low-risk, low-stress, and low-return. That means government backstopped – and restricted to the most boring, low-risk investments possible.
Whatever rule might be adopted, the question is will it be enforced?
Today’s NYT Dealbook blog about the DOJ (which has been MIA) and who they’re going after for financial fraud:
“… in the two years since the peak of the financial crisis, the government has not brought one criminal case against a big-time corporate official of any sort.
Instead, inexplicably, prosecutors are busy chasing small-timers: penny-stock frauds, a husband-and-wife team charged in an insider trading case and mini-Ponzi schemes.”
http://dealbook.nytimes.com/2010/12/06/pulling-back-the-curtain-on-fraud-inquiries/?ref=business
Pulling Back the Curtain on Fraud Inquiries
BY ANDREW ROSS SORKIN