Finding it hard to let go

The division of proprietary trading and market making has been identified as a post-crisis reform that will improve visibility across different kinds of banking activity, but debate on how this could be achieved continues to rage.

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.

Recent rogue 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 shocks.

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 practices.

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.

“Making 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? 

The European Commission has not so far stated any plan for its own version of the Volcker rule.

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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