May 31, 2012
Welcome to the Commodity Futures Trading Commission (CFTC) roundtable on the proposed Volcker Rule. Thank you, Dan, for that introduction, and thank you for working with the rest of the team, particularly Steven Seitz from your office and Steve Kane from the Office of the Chief Economist, to put together this important roundtable.
I’d like to thank the Treasury Department staff and the staff of the financial regulators tasked with implementing the Volcker Rule for joining us for this roundtable and for your efforts in coordinating with the CFTC on the rule. I’d also like to thank Sheila Bair, the former Chair of the Federal Deposit Insurance Corporation, for participating today.
Former Federal Reserve Chairman Paul Volcker was unfortunately on international travel today, but I’d like to acknowledge his many years of public service.
In 2008, the financial system and the financial regulatory system failed. The crisis – caused in part by the unregulated swaps market -- plunged the United States into the worst recession since the Great Depression with eight million Americans losing their jobs, millions of families losing their homes and thousands of small businesses closing their doors. The financial storms continue to reverberate with the debt crisis in Europe affecting the economic prospects of people around the globe.
In 2010, Congress and the President came together to pass the historic Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), to promote transparency in the markets and to lower risk to the public from large, complex financial institutions. Amongst these protections is the Volcker Rule, which prohibits banking entities from proprietary trading, an activity that may put taxpayers at risk.
This is the CFTC’s 17th roundtable on important topics related to Dodd-Frank reforms. These roundtables are an additional opportunity – beyond the 30,000 comments we’ve received and 1,600 meetings with the public we’ve held -- for dialogue and helpful input from market participants and the public. Our 18th roundtable related to promoting the price discovery function on designated contract markets and related issues of swap execution facilities will be on June 5.
In adopting the Volcker rule, Congress prohibited banking entities from proprietary trading while at the same time permitting banking entities to engage in certain activities, such as market making and risk mitigating hedging. One of the challenges in finalizing this rule is achieving these multiple objectives.
I’m looking forward to a lively discussion. I’d like to highlight three main issues that I’m particularly interested in getting feedback on today.
First, as prescribed by Congress, the Volcker rule prohibits proprietary trading while permitting risk-mitigating hedging. These two provisions are consistent with each other in that they are both meant to lower the risks of banking entities to the broader public. The question is how we as regulators achieve both of these risk-lowering provisions in a balanced way.
Some commenters have said if we’re too prohibitive in one area, we may limit banking entities ability to engage in risk-mitigating hedging. On the other hand, if we follow comments of some of the banking entities, then the rule’s allowance for permitted hedging might swallow up Congress’ intent to limit the risk of proprietary trading.
Specifically, under the statute, banking entities may engage in “risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings.”
To qualify as hedging, these activities must be “designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.”
The criteria for the hedging exemption as included in the proposed Volcker Rule are the following: hedges must mitigate one or more specific risks on either individual positions or aggregated positions, they cannot generate significant new exposures, they must be subject to continuous monitoring and management, compensation for hedging cannot reward proprietary trading, and the hedges must be reasonably correlated to the specific risks of the positions.
A further question about hedging activity that was asked by the agencies ( question 109 of the CFTC’s proposal) is whether “certain hedging strategies or techniques that involve hedging the risk of aggregated positions (e.g. portfolio hedging) create the potential for abuse of the hedging exemption.”
A related question on which it would be helpful to hear from the panel: is it possible, and if so how, could a separate trading desk with its own profit and loss statement engage in risk-mitigating hedges?
The further removed hedging activities are from the specific positions the banking entity intends to hedge, is it not more likely that such trading activity is prone to express something other than hedging?
As Dan will explain in a moment, we’re not going to be speaking about the specifics of the credit derivative product trading of JPMorgan Chase’s Chief Investment Office. I do think, though, it may be instructive for regulators as we finalize key reforms.
Second, in addition to hedging, Dodd-Frank permits market making, which is important to well-functioning markets as well as to the economy. The question for regulators once again is finding a balance, but this time between prohibiting proprietary trading and permitting market making. The agencies ask in the proposal (question 89 in the CFTC’s proposal): “Is the proposed exemption overly broad or narrow? For example, would it encompass activity that should be considered proprietary trading under the proposed rule?”
The criteria for market making in the proposed rule included seven requirements. A number of commenters suggested that these requirements may be more applicable to the listed securities markets than to the swaps market. During the second panel today, we are looking for your input on this issue. If some of these requirements are not appropriate, what would be more appropriate with regard to market making in swaps?
Third, I’m particularly interested in hearing about how the prohibition on proprietary trading should best be applied to banking entities transacting in futures and swaps. The CFTC’s role with regard to the Volcker Rule and banking entities is primarily with regard to these derivatives traded by swap dealers and futures commission merchants within the banking entity.
In particular, banking entities’ market making in swaps is likely to leave them with significant open positions for many years in customized swaps. When would a banking entity’s decision not to hedge or to only partially hedge open swaps positions be considered prohibited proprietary trading? We at the CFTC will benefit from your input on how the Volcker Rule can best protect the public against risk in the swaps and futures markets.
Thank you again for coming, and I’ll turn it back to Dan.
Last Updated: May 31, 2012