On December 10^th, 2013, five US federal agencies adopted a final rule to implement the Volcker Rule.  The effective date of the Volcker Rule is April 1^st, 2014.  However, the agencies have extended the compliance deadline until July 21^st, 2015.

Introduction

On December 10^th, 2013, five US federal agencies adopted a final rule to implement the Volcker Rule.  The effective date of the Volcker Rule is April 1^st, 2014.  However, the agencies have extended the compliance deadline until July 21^st, 2015.

Background on Volcker Rule

The Volcker Rule was originally included in the 2010 Dodd-Frank Act.  The Volcker Rule prohibits an insured depository institution and its affiliates from the following activities:

• Engaging in “proprietary trading”
• Acquiring or retaining any equity, partnership, or other ownership interest in a hedge fund or private equity fund; and
• Sponsoring a hedge fund or a private equity fund

The ban was originally slated to be implemented on July 21^st, 2012.  Due to the complications of the legislation, the ban was not finalized until now.

Hedge Accounting

There exists a large chasm between front office performance indicators and accounting methods.  This difference becomes exacerbated when hedge accounting is considered.  Hedge accounting utilizes past market performance in order to project future expectations.  The front office employs financial modeling to measure risks and assess the loss exposure of a portfolio.

A recent example of the stark contrast between hedge accounting and the front office is the JP Morgan Chase $6.2 billion trading loss in 2012, formerly known as the “London Whale”.  The bank claimed that the hedge was a broad hedge against a portfolio of corporate loans.

Hedge accounting says otherwise.  FAS 133, an accounting rule under the Financial Accounting Standards Board, requires banks and other publicly traded companies to classify hedges according to the risks they are meant to offset.  Companies need to identify a hedge as either mitigating cash flow risk, interest-rate risk, or a combination of the two.  In other words, a “broad hedge” does not qualify under FAS 133.

The Volcker Rule offers different guidance on whether or not the “London Whale” incident was a true hedge.  The Volcker Rule only requires that a transaction be “reasonably” correlated to the risks it is intended to hedge.  Federal agencies did not propose a “high” correlation was necessary in order for a transaction to fall under the hedging exemption.  Furthermore, risk management tools – for example, Value at Risk – that are utilized to display correlations among securities have their shortcomings.

Reduced Liquidity

Banks may decide to avoid the multiple risks and liabilities associated with the conflictive nature of hedge accounting and the Volcker Rule.  As a result, proprietary trading may transfer to shadow banking, an area that is outside financial regulatory jurisprudence.  Banks have become reluctant over the years to take on inventory positions due to the Volcker Rule’s hindrance on market making activities.  This can result in reduced liquidity in the financial markets.

The foreign exchange markets have exhibited evidence of this reduced liquidity.  Buy-side participants have reported that market-making banks are trimming risk appetite and becoming less willing to warehouse overnight positions.  Due to this inactivity, there is reduced liquidity in non-deliverable forwards (NDFs), options, and swaps.  As a substitute to warehousing positions, asset managers within the FX markets have stated that the same banks are acting more like brokers.  They simply take an order and pass it on.

Buy-Side Opportunities

Sourcing liquidity will become fragmented and expensive in the future.  Banks will likely take on a heavier brunt to understand and navigate the differences between the Volcker Rule and hedge accounting.  Asset managers can expect banks to transfer these costs to them.  Furthermore, the demand for triple-AAA rated securities will outstrip supply as Basel III and other legislative rules are implemented. 

Liquidity is still necessary.  Buy-side firms are starting to rely on each other for liquidity sources via peer-to-peer trading platforms.  This is an opportunity for vendors.  Vendor firms can start to understand the liquidity needs of this segmentation by interviewing asset management firms.  Upon completion of their market research, vendors can create new trading platforms and strengthen present ones to allow buy-side participants to connect with each other within shorter time frames.  Designated software should be able to match buyers and sellers within seconds. 

Asset managers may also start sourcing liquidity from non-US instruments.  Vendors can seize the moment by constructing new platforms that enable buy-side participants to access financial securities outside of US borders.

Third, anonymity is essential.  A buy-side participant may want to purchase a large block of a security without anyone knowing.  If opportunistic traders learn about the aforementioned purchase, they may want to seek to profit off the price momentum.  This issue becomes more problematic in the FX markets because of the dynamic nature of FX prices.  Vendors that are able to anonymously facilitate block orders will be able to gain market share and credibility among the buy-side segmentation.

Conclusion

The combination of the Volcker Rule and hedge accounting will further transfer proprietary trading to the shadow banking sector.  However, buy-side participants will need liquidity as the details of the Volcker Rule are ironed out and future legislation looms.  Vendors can help asset management firms and even partner with them to facilitate satisfying their liquidity needs.

Sol Steinberg (LinkedIn)