The question of how to define trading done with banks’ own funds is one of the thorniest for the US authorities in the post-crisis regulatory overhaul as it is difficult to differentiate such activities from market-making on behalf of clients.
The “Volcker rule”, proposed by the former Federal Reserve chairman Paul Volcker and included in last year’s Dodd-Frank law, aims to reduce banks’ risk-taking by forbidding them from placing short-term trading bets.
Draft guidelines for the Volcker rule are being circulated among members of the Financial Stability Oversight Council, the body of regulators charged with defining the rules of the road for the financial system. Publication of a final version is planned in the next two weeks.
After months of internal discussions and talks with banks, which have mounted a vigorous lobbying campaign, regulators are leaning towards a “multi-tiered test” like those used to detect illegal money transfers.
The first tier would involve automated “tripwires” that alert banks’ compliance departments.
People involved in the talks said that, depending on the market and the trade, “tripwires” could be the length of time a trader holds a position, its size, riskiness, or other measurable criteria. In detecting money laundering, banks look at “filters” such as size and provenance of a transfer.
The second tier would see internal compliance and risk management departments quiz the trader on the nature of the position. Finally, regulators, that keep inspectors on banks’ premises, will also be able to see the “tripwires” and monitor both traders and compliance departments.
Banks are likely to welcome this approach, after arguing that a strict definition of proprietary trading based on one-size-fits-all metrics would have cut off liquidity to large swaths of global capital markets.
“We have been advocating that whatever test they put out is a multi-part test that takes into account the huge difference among markets and products,” said Tim Ryan, chief executive of Sifma, the securities industry’s lobby.
“I’d be surprised if, as the regulators come up with their . . . recommendations, they didn’t include a tiered approach to defining the Volcker rule.”
William Silber, a New York University professor who is a trading expert, said a multi-tiered test would make sense if coupled with surprise visits to trading desks by regulators.
“Spot checks by regulators should be part of the package. Regulators should make sure traders know they are not waiting to act until after the cow is out of the barn,” he said.