Volcker Rule: Grounds for Divorce?*

In a narrow 3-2 vote on 11 January 2012, CFTC Commissioners proposed their own version of the Volcker Rule, which prohibits proprietary trading activities of banks and limits their investments in private-equity and hedge funds in line with the restrictions already proposed by the Federal Deposit Insurance Corp., the Federal Reserve, the SEC and the Comptroller of the Currency in October, 2011. The intent of the Volcker Rule is to reduce risk in the US banking system by limiting the excessive risk-taking activities of banking entities, defined as any insured depository institutions and their subsidiaries.

The Dodd-Frank Act mandates the rule to be implemented by 21 July 2012. Banking entities must comply with the new requirement by 21 July 2014 for their pre-existing investments. However, the Federal Reserve Board can extend the deadline for compliance for up to three years.

Volcker Rule

The rule has basically two parts. The first part is related to restrictions on activities of banking institutions, except for non-US banking entities’ transactions outside of the United States with non-US residents. The rule prohibits proprietary trading, while allowing transactions related to underwriting, market-making, risk mitigating hedging, trading in certain US government obligations, and trading on behalf of customers. The statute defines proprietary trading as engaging in the purchase or sale of certain financial assets as a principal for the trading account of a covered banking entity.

Financial assets include securities, derivatives, commodity futures and options on these instruments, but do not include positions in loans, spot foreign exchange or spot commodities. The rule also explains what constitutes an entity’s trading account. The definition of trading account specifically includes positions taken principally for the purpose of short-term (less than 60 days) resale. The proposed rule calls for the establishment of internal compliance programmes and reporting requirements on banking entities. The rule further provides guidance on what banking entities must do to prove that they are not proprietary trading but engaging in permitted activities, such as market-making or trading on behalf of customers. Finally, the proposed rule provides detailed limitations on the permitted activities. For instance, if their permitted activity would endanger the safety or soundness of the banking entity or the financial stability of the United States, then it is considered proprietary trading and it is prohibited.

The second part of the proposed rule is related to banking entities’ relationship with private equity funds and hedge funds. In order to prevent a bank from indirectly engaging in proprietary trading through direct investment and also to prevent a bank from possibly bailing out such funds, the rule limits banking entities’ investment in such funds.

Concerns over the Volcker Rule

Market participants, including regulators themselves, argued that the proposed regulation is overly complex. Even Volcker himself said during a speech in November that the proposed rule was much more complicated than initially intended. Regulators have already admitted the difficulty in implementing the rule. The determination of what constitutes proprietary trading and what constitutes legitimate trading activity will be challenging. Although most banking entities already closed their proprietary trading desks, some argue that they are merely moving these activities to their market-making activities. Some market participants urge regulators to put more clarity on the scope of proprietary trading and on the exceptions for permissible activities. However, regulators argued that compliance with the rules will not be based on trade-by-trade enforcement but rather at policies and procedural levels. On the other hand, if the rule mistakenly identifies banks’ market-making trades as proprietary trades, this will have an impact on liquidity and thereby on the overall economy.

Foreign governments also raised concerns over the prohibition of US banks trading in foreign governments bonds. Since the US banks are one of the biggest bond buyers, prohibitions imply more costly borrowing for foreign governments. The proposed rule, rather than reducing risk, most likely will drive that risk into other places. The Japanese, Canadian and British governments have said the proposal aggravates the risk for their markets. Some further argue that if the Volcker rule does result in increased borrowing costs for European governments, which are already faced with higher borrowing costs, then the economic fallout may not be contained to the Continent.

Impact on Energy Markets

In its current proposed form, the Volcker Rule does not prohibit banking institutions from holding positions in spot commodities, in which case several reports suggest that some banks may become very active physical market players. However, the rule prohibits proprietary trading by banking entities and their subsidiaries in energy derivatives markets. Banking institutions have been active players, especially since the mid-2000s in energy derivatives markets, including in over-the counter (OTC) markets. In fact, most swap dealers in energy derivatives markets are either banking institutions or their affiliates; the latest Commitments of Traders position data suggests that 27.18% and 35.46% of the open interest on the long side and short side, respectively, of the WTI futures contracts are held by swap dealers. However, there is no estimate of how much of the swap dealers’ position could be considered as proprietary trading. It will depend on how narrowly regulators interpret the scope of the definition of market-making versus proprietary trading. The interpretation is much more important in the case of their trading activity in swaps markets, where they are generally counter-parties to commodity index traders, hedgers and speculators. If their trades with other parties are considered as proprietary trading, then the ban would cover almost every trade by swap dealers in the futures and swaps markets. However, we expect most trades to be considered as market-making or trading on behalf of customers, and therefore we anticipate limited impact on liquidity in energy markets.

*IEA Oil Market Report-February 2012