The ban on proprietary trading included in the Dodd-Frank US financial reform bill could see some brokers spin-off separately capitalised proprietary trading units while others move prop traders to client facilitation positions.
After months of negotiations between US policy makers, the Dodd-Frank bill is now expected to include a ban on proprietary trading for deposit-taking financial institutions. The ban is part of the so-called Volcker rule, championed by former Federal Reserve chairman Paul Volcker, which will also prohibit banks from investing more than 3% of their capital in either hedge funds or private equity firms.
According to the draft bill, prop trading will only be allowed if trading occurs solely outside of the US and if the banking entity or non-bank financial company “is not directly or indirectly controlled by a banking entity or non-bank financial company”.
This would have a significant impact of the revenue earned by many bulge-bracket brokers. Goldman Sachs, which had its regulatory status changed to a bank holding company shortly after the fallout from the financial crisis, derived $34.37 billion of its total revenue of $45.17 billion from trading and principal investments in 2009, according to the firm's annual report. For Goldman Sachs, trading and principal investments includes client facilitation, proprietary positions based on these activities, market making on equities and options exchanges and principal investments relating to its merchant banking and other investment activities.
Crucially, the bill is expected to make exceptions for banks that conduct proprietary trading activity to support client business, i.e. market making and facilitation. But more clarity will be required, according to a recent paper by consultancy Woodbine Associates.
“At a granular level, how will regulators differentiate between truly proprietary and client oriented transactions?” read a recent opinion piece issued by Woodbine, entitled, ”The Volcker rule ban on proprietary trading: a practical approach to implementation'. “Most likely, they won't. However, there are viable alternatives to transaction-by-transaction evaluation that can help shine a light on whether firms are complying with the ”spirit' of the rule, i.e., not engaging in excessive speculative risk taking.”
Pure prop traders at deposit institutions are likely to follow one of two paths according to John Edge, an ex-J.P. Morgan executive, currently chief strategy officer at market surveillance firm Redkite Financial Markets.
“Deposit-taking institutions may try to keep hold of their top talent by putting their best prop traders into client-facing or facilitation-type businesses,” Edge told theTRADEnews.com, “The challenge here will be monitoring what is pure prop and what is client facilitation. The other option is for these firms to capitalise separate vehicles for their prop traders, but as a separate entity, this may not be an economically attractive proposition for either the banks or the traders.”
Another former director at a bulge-bracket firm in London noted that a ban on prop trading could affect the buy-side's working relationships with sell-side counterparts.
“The buy-side have to get comfortable with former prop traders working in increasingly close proximity to the client facing businesses,” said the source. “Despite the Volcker rule, there remains an opportunity for regulatory arbitrage in the definitions of principal and proprietary trading. Customer discomfort could lead to a loss in market share for large institutions.”
The US House of Representatives has approved the bill and a vote on the final text of the bill could take place as early as this week.