“V” Is for Volcker: All Investors Have a Stake in Prop Trading Rule’s Outcome

We at CFA Institute are half-tempted to revise that slightly and say that “V” is for “Voluminous” and “V” is for “Victory” — after successfully trudging through the complexly convoluted 300-page Volcker Rule proposal aimed at banning proprietary trading at banks. Comments on the proposal are due this week.

Knowing how we struggled with the massive proposal, we can only surmise that the vast majority of people with any interest in investing or financial markets don’t have the foggiest idea what all the “V” (as in “Volcker”) talk is about.  However, we believe we’ve managed to frame the key issues for public consumption.

To start with, the proprietary trading ban was proposed as part of the 2010 Dodd-Frank regulatory reform overhaul that followed the credit crisis and government bailout. At the time there was momentum to put protections into place that would prevent large banking institutions from finding themselves in the same perilous condition as in the days following the housing bubble — and from gravely endangering the banking system and the  “mom-and-pop” banking customers that rely on it. Simply put, Volcker said banks should be banks. They should no longer engage in speculative trading on their own investment accounts that places the entire bank and customer deposits at risk — particularly with the government (i.e. taxpayers) on the hook to insure those deposits via the FDIC. Thus the lingo, “No proprietary trading by banks.”

Two things have happened since the heat of the crisis. Memory and regulatory urgency have faded, and banks have pulled out all the stops in trying to water down the Volcker concept as the July deadline for formulating a final rule approaches. Quite simply, those banks want to preserve as much of the trading flexibility as they can muster. This is not entirely for self-serving reasons, as you might expect. There are some legitimate concerns that defining the ban on proprietary trading too broadly will seriously curtail another part of the bank’s business as a broker-dealer of securities. They match buyers and sellers of a vast range of fixed-income and other types of securities, which is known as “market making” in this debate. Often these broker affiliates of the bank will buy and hold these securities (as the middleman “market makers”) in anticipation of customer demand. 

The potential problem arises when this affiliated broker can potentially build up huge inventories of these securities, and if it misjudges expected customer demand, or we encounter a market collapse ala 2008, all hell can break loose. Imagine the faint sound of “Reveille” from the Federal Reserve if you need a reminder of just how high the stakes are. Moreover, a skeptic might observe there is a fine line between misjudging demand and speculating in and out of these positions in a fashion nearly identical to proprietary trading. 

It is not hard to see the delicate balance this rule-making situation requires. Too strict a “V” rule and important players in providing market stability and liquidity are impaired to the detriment of properly functioning markets. Too loose and the banks will exploit the flexibility to effectively conduct banned proprietary trading in the name of market making.    

In our letter to the regulators on this rule, we expressed the important need to eliminate any and all proprietary trading, particularly that disguised as market making. One can view this policy debate as the choice between trusting Wall Street to “play it straight” under vague market-making guidelines versus implementing exceedingly clear and properly restrictive definitions of banned proprietary trading.  

In the end, this is a very complex issue. But it also is so fundamental in its potential impact on investor protection that it deserves the awareness of both professional and average investors alike. You might even consider a quick call of support to your elected representatives. 

After all, this is an election year, and as regulators sort through public comments and work toward a final Volcker Rule, you can imagine this topic as a strong pressure point for the financial lobby. We are hopeful that the best interests of investors — and improved systemic protection for markets— is not drowned out by commercial self-interest in the process.