Paul Volcker: Here Are 5 Ways To Know Prop Trading When You See It

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Today, Paul Volcker sent his much anticipated letter to regulators concerning the eponymous rule he championed restricting proprietary trading, along with an accompanying essay.

The premise of the rule is notoriously simple: proprietary trading is not an essential financial service and should not be allowed at institutions that have any form of explicit or implicit government support.

But how do you implement it?

Sure, there’s out and out prop trading, which most banks who will be subject to the rule have by now jettisoned.

But what about the grey areas like market making, banks say? That’s a vital function we provide and the Volcker rule shouldn’t prohibit it. We have to buy and sell securities in anticipation of client demand, use our own capital to facilitate their trade views, etc., etc. 

Well, Paul Volcker had heard the banks. And he’s put the ball back in their court.

In his letter, he puts forward five metrics that both individually and in concert can be used to establish if a bank is violating the rule. 

Oh, but first say Volcker, banks will need attentive CEOs, watchful boards of directors, robust control and reporting systems and above all a culture that ‘puts clients first.’

But since there isn’t a bank in the country that would publicly say it doesn’t have any one of these things, let’s move to the five metrics Volcker outlines in his letter:

1. “trading volume, and its relation to size of the trading ‘book'”

2. “the volatility of earnings from trading”

3. “the extent to which those earnings are generated by pricing spreads rather than changes in price”

4. “the origination of trades (i.e. from customer initiative)”

5. “the close alignment of ‘hedging’ transactions with the composition of the trading positions”

The thrust of each of these metrics is that Volcker thinks it should be incumbent on banks to show that they’re not using market making activities to engage in proprietary position taking. No single one of these metrics would in isolation demonstrate that a particular trade or desk or division or institution is or isn’t prop trading.

But taken as a whole, they do get at many of the issues banks have raised with the rule.

Are banks holding a bunch of inventory on their books in the hope that it will rise in value, irrespective of whether they are even trading it that much? That doesn’t sound like market making. See #1. 

Do earnings from trading rise and fall dramatically from quarter to quarter? Market making in really liquid markets should a fairly steady, boring earnings generator. If not, see #2.

Is an institution making money on margin (spread) or asset value swings? The latter could be argued to be prop trading, with the customer used as a handy fall guy to exit a position. See #3.

Are banks doing a ton of trading but not really serving clients? Or are banks doing very little trading despite high volumes of client inquiry? In either case, see #4.

When does a hedge cease to be a hedge and become a proprietary position in and of itself? Re-watch the Goldman hearings chaired by Carl Levin. Actually, the answer is when the hedge is no longer connected to a risk embedded in a position and becomes a view on the price of securities in and of itself. See #5. 

Volcker’s message to banks: your serve.

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