January 11, 2012
The Commission is considering today a Notice of Proposed Rulemaking (“Proposal”) to implement the statutory requirements of Section 619 of the Dodd-Frank Act (the “DFA”), amending the Bank Holding Company Act of 1956, commonly known as the “Volcker Rule”. Congress gave us a difficult mandate to separate proprietary trading from legitimate and essential market-making, underwriting and hedging responsibilities. However, establishing a bright line is far easier said than done.
Today’s Proposal sets in motion what Sheila Bair, the former Chairman of the Federal Deposit Insurance Corporation and a former Acting Chairman and Commissioner of the CFTC, aptly described as an “[u]nder…300-page Rube Goldberg contraption of a regulation….proposed by federal agencies [(the Joint Proposal”)] to implement the Volcker Rule.”1 The deadline for comments on the Joint Proposal was recently extended another thirty days until February 13, 2012. This extension is a byproduct of the unrealistic expectations placed upon the industry and the regulators to implement the will of Congress without completely decimating liquidity. In their current forms, both the Joint Proposal and the Proposal before the Commission today in their complexity fall short of providing an appropriate foundation for a rigorous and reliable rulemaking process, and it seems inevitable that we and our fellow regulators will have to engage in re-proposals that, at a minimum, reduce the complexity and clarify the regulatory roles for the five regulatory entities involved.
The Proposal seems to revisit many of the same challenges facing the Position Limit rule which attempts to limit large speculative or non-commercial positions without impacting legitimate hedging by commercial firms. The Position Limit rule was revised two times before being finalized, and, in my opinion, still imposes an unacceptable burden on commercial entities and hedgers who use these markets to manage risk. Like the position limit rule, which claims to target the roots of excessive speculation, but instead will maim commercial hedgers, I fear the Volcker Rule could have a similar impact on market-making. By imposing onerous facts-and-circumstances standards on what constitutes market-making, I fear this rule will deter smaller banks from continuing to serve this critical role in the markets while reducing the capacity of large dealers to provide liquidity. Admittedly, our job in implementing the Volcker Rule is difficult. It is a balancing act to ban proprietary trading (in most cases) while maintaining a robust market-making, underwriting and hedging program. Though I appreciate that the Proposal before us today seeks commenters’ input on even more issues than the Joint Proposal, this alone cannot justify a vote in favor of its release.
To begin with the obvious, the Proposal is overly complex. Firms must first assess whether they are a regulated banking entity, whether or not they are dealing in covered financial positions, evaluate whether their activities are legitimate market-making, underwriting, or hedging (which is different than hedging under the Commodity Exchange Act or “CEA”) and finally determine whether or not the asset is an acceptable interest. Once these parameters are defined, the regulated entity must establish a compliance program, which depending on their book of business, will be tiered accordingly.
Upon reviewing this Proposal’s discussion of the compliance metrics, I couldn't help but notice the number of questions inquiring whether or not these were the correct metrics. If I didn’t know better, I would say even the Commission has reservations about these metrics. I certainly do.
Another interesting element of the compliance metrics is the Commission's ability to oversee such standards. It appears there rules require self-reporting on a monthly basis. I am not sure as to how the Commission or other entities will be able to verify the validity of the complex metrics or whether there is a regular process to do so because the rule is noticeably silent on this point. For example, I don’t know how the Commission or other regulators will determine the appropriate bid-ask spread. At what point in time will we make the determination and using what price and how will we account for counterparty credit in a bilateral off-exchange swap? The fact of the matter is that the Proposal is drafted as if an agency model exists and is the norm, when, in fact, we are still dealing with a principal-to-principal market. Will the future be different? Possible, but that is not the reality we face today.
The rule relies heavily on a firm to establish its own compliance program and self-report any violations. I am instantly reminded of the current MF Global situation, which highlights our current rules for futures commission merchants (“FCMs”) that require the monthly filing of un-audited financial reports with the Commission and the designated self-regulatory organization.2 This monthly collection of data, accomplished via the Form 1-FR-FCM, includes, among other things, the amount held by the FCM in the customer segregation accounts as required by Section 4d of the CEA and Part 30 of the Commission regulations. I wonder if during times of market volatility, whether one month is too long a period between reports, and whether there is a way to improve the reporting scheme to ensure that the various regulatory entities have complete, readily-verifiable information. I don’t believe the Commission is any way prepared to perform this oversight responsibility.
Enforcement: No teeth, no deterrent
After publishing 300 pages of preamble and rule text, one would expect the Commission to have a very clear regulatory mandate and enforcement responsibility, but that isn’t the case. Broadly speaking, it is unclear what role the CFTC has in enforcing the gamut of rules that will ultimately comprise the Volcker Rule. As best I can tell, we will be responsible for overseeing our jurisdictional entities for compliance with Section 13 of the Bank Holding Company Act - an authority that does not apply to the Commission. It does appear, however, that Section 619(e) of the DFA provides the Commission with authority to, after due notice and opportunity for hearing, order a firm in violation of the restrictions under the Volcker Rule to terminate the violative activity and liquidate the position. Such authority is hardly a deterrent. Depending on the participant, asset or market, several jurisdictions will likely be involved and this will certainly challenge regulators to develop a clear regulatory oversight system.
Coordination and Consistency
I do know that this rule differs from several proposed and some final Commission rules including rules pertaining to entity definitions, conflicts with internal and external business conduct rules and raises extraterritoriality issues. The conflicts with the Commission’s proposed internal business conduct rules3 are especially glaring. For example, it appears that under the Proposal, the CEO of the banking entity has responsibility for review and approval of a compliance program - something a CRO (Chief Risk Officer) has responsibility for under the Commission's proposed rules. As well, I will be interested to see how the Commission proceeds to establish the appropriate compensation regimes for traders engaged in market making and underwriting as required by the Proposal. Also, we must not overlook the extraterritoriality applications. I am not aware of a jurisdiction that is or would consider subjecting their markets to such a regulatory scheme, but we must also be mindful of any regulatory retaliation as a result. More specifically, I am aware of strong objections by the Canadian Government to a proposal to only exempt U.S. government obligations from proprietary trading ban. The Canadians are justifiably concerned about treatment of Canadian securities and the impact on market liquidity for these products.
Hedging and Market Making
Finally, I have serious reservations about the hedging limitations and the related impact on liquidity as they may apply to the Commission’s jurisdictional markets. Not unlike the Position Limits rule, the Commission gave extensive consideration to the impacts to market liquidity in hedging risk. Using a far more simple definition of hedging, the Commission attempted to look through the dealer and not penalize the dealer for serving commercial hedgers. However simple, the Commission erred with the definition of hedging and will be hard-pressed to implement two definitions for hedging for the same body of market participants. Even the preamble to the Proposal acknowledges the challenge facing both the market and Commission to draw clear and objective lines with only an ad-hoc, ex post analysis to ultimately satisfy a Volcker determination. Such after-the-fact regulation will create uncertainty and cannot help but have a chilling effect on liquidity.
Despite my complaints about the complexity of the rule, I must admit, that the Proposal differentiates between market making and proprietary trading in a rational manner. This definition of market making appears to be superior to the proposed definition of market making being considered by the Commission in the upcoming entity definitions rulemaking on January 25th. The Commission should harmonize its definition of market making in both rules to promote regulatory certainty for market participants. That being said, I look forward to the continued and now further informed public discourse in this time of very complicated matters.
1 Sheila Bair, What We Need is a Volcker Rule That’s Simple and Makes Sense, Fortune, Dec. 26, 2011, at 48.
2 See Financial reports of futures commission merchants and introducing brokers, 17 C.F.R. §1.10
3 See generally, 75 FR 71397 (Nov. 23, 2010) (Regulations Establishing and Governing the Duties of Swap Dealers and Major Swap Participants (Duties NPRM)); 75 FR 70881 (Nov. 19, 2010) (Designation of a Chief Compliance Officer; Required Compliance Policies; and Annual Report of a Futures Commission Merchant, Swap Dealer, or Major Swap Participant (CCO NPRM)); 75 FR 70152 (Nov. 17, 2010) (Implementation of Conflicts of Interest Policies and Procedures by Futures Commission Merchants and Introducing Brokers (FCM/IB Conflicts NPRM)); 75 FR 71391 (Nov. 23, 2010) (Implementation of Conflicts of Interest Policies and Procedures by Swap Dealers and Major Swap Participants (SD/MSP Conflicts NPRM)); and 75 FR 76666 (Dec. 9, 2010) (Reporting, Recordkeeping, and Daily Trading Records Requirements for Swap Dealers and Major Swap Participants (Recordkeeping NPRM)).
Last Updated: January 11, 2012