Finding it hard to let go
Banks have been allowed to trade on their own books
for decades. Is a separation of proprietary trading from market making really necessary?
In this new
regulatory era characterised by the reduction of systemic risk and desire for
greater visibility across all banking activities, the often-murky world of
proprietary trading is a prime target.
trading scandals, including the most recent J.P. Morgan trading incident –
where credit derivatives trades made by Bruno Michel
Iksil, aka ‘The London Whale – through the bank’s Chief Investment Office hedging unit led to over US$2
billion in losses – have only whetted policy makers’ appetites further.
If trading done
purely for profit cannot be distinguished from hedging or market making – the essential
provision of liquidity that ensures trades can be completed – regulators have a
harder job identifying potential risks and the market is left open to systemic
The risks of prop
trading were recognised by the US and dealt with through the Volcker rule, part
of the country’s Dodd-Frank post-crisis financial reform package. The rule bans
deposit-taking institutions – which includes broking giants Goldman Sachs and
Morgan Stanley following their reclassification to bank holding companies after
the financial crisis – from engaging in proprietary trading and also limits
their ability to invest in private equity and hedge fund vehicles.
Sounds good in theory, but how hard is it to divide
prop trading from market making in practice?
Sell-side firms will
tell you that it can be almost impossible to tell the difference between the
two in some circumstances. The man behind the rule, former US central banker
Paul Volcker, claims the identification of different types of trading activity
can be easily achieved through a relatively simple modification of existing
Speaking at an
event held by the European Parliament, entitled ‘How to restructure the EU banking sector?’, Volcker pointed out that
despite the unwillingness of banks to worry about what is or isn’t proprietary
trading, it was in their best interests to do so.
He said this was best achieved
through collaboration between banks and regulators to create a practical method
for distinguishing between what is prop trading and what isn’t.
“We are not starting with a
blank sheet of paper,” said Volcker. “Every big bank has close controls on
their trading desks and they have all kinds of reports on daily trading
activity. This just needs tweaking so that these reports are sensitive to
indications of proprietary trading.”
He added that the
reduction in speculative activity by banks following recent rogue trading
incidents is evidence that firms have the ability to recognise the difference between
prop and other forms of trading.
Volcker cited the
recent scandal involving former UBS exchange-traded fund trader Kweku Adeboli –
who lost US$2.3 billion on speculative bets – and the subsequent reduction in
the Swiss bank’s delta one activity.
The debate is far
from over. At the start of the year, Republican representatives on the US House
Committee on Financial Services Authority called for the Volcker rule to be
ripped up and rewritten.
distinctions will be difficult, if not impossible,” said Spencer Bachus, the
Republican chair of the committee. “When we have to interpret people’s motive,
we’re on thin ice.”
So the US has attempted to tackle the problem, is
Europe following suit?
Commission has not so far stated any plan for its own version of the Volcker
The UK has
tackled the issue from a different angle, with proposals to ringfence retail
banking from investment banking gathering pace.
However, the UBS
incident, which led many to question whether a European version of the Volcker
rule would have prevented it, and the recent J.P. Morgan scandal, leaves the
door open for greater intervention from policy makers.
As both took
place in London, any attempt by Brussels to impose further restrictions could
increase EU-UK tensions further. But internal market commissioner Michel
Barnier has not closed his mind to the matter.
Barnier met with
US regulators in late February to discuss the EU approach to international banking
reform. But he has also criticised the extraterritorial reach of the Volcker
rule and the potential for reducing liquidity and increasing the cost of
borrowing and volatility.
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