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Article: Volker Rule Hedge Accounting

23 January 2014 | Sol Steinberg

Introduction

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

Sol is a seasoned financial executive with subject matter expertise in OTC derivatives, Market structure, Trade Lifecycle, Valuation,  Financial Technology Systems, Strategic Design, Commercialization of assets, and Risk Management.
 
Sol has a wide-ranging network of asset managers, analytic providers, execution venues, regulatory, and government contacts. Sol has used his
eco system to successfully commercialize analytics, data, and other non commercialized intellectual property. He has had significant monetization
success; brought to market several initiatives, including institutional and commercial risk engines such as SMART tool, Risk Explorer, Global Market Risk System for Citi: the largest VaR engine  in the world 2004-2006, as well as developing CCP2  – a derivative education & certification program for consultancies such as Deloitte and Accenture.
 
In 2012, he founded Partnerships & Alliances, a team responsible for managing SwapClear's strategy and relationships with key ecosystem partners including consultancies; execution venues and affirmation platforms; providers of technology systems and services; custodians; hedge fund administrators; data and valuation firms; and selected professional associations.
 
In 2011 Sol was responsible for LCH.Clearnet’s industry recognized clearing and default management policies for the cleared OTC swap markets.
Sol was also first to recognize and instrumental in correcting and project managing for changing LCH.Clearnet’s  risk analytics in times of low market rates, making our analytics robust enough to handle all market conditions. 
 
Sol specializes in commercialization agreements for risk models, risk data, market data, and collateral optimization, as well as developing and monetizing SME intellectual property. Sol was the recipient of Risk Magazine’s award “Best risk analytics initiative 2012” & “Best risk analytics
initiative (Sell Side)  2013” and FTF’s award for “Most cutting edge risk contribution 2013” for developing, project managing , and architecting the SMART risk analytics tool. Sol was also a global nominee in 2012 for “Best Practices in Global Financial Risk Management” from PRMIA, Professional Risk Managers International Association. He is a regular speaker and author for many industry groups. 

 

 


Comments

Thanks for this Sol.

As you say Volcker and hedge accounting rules may contribute to the withdrawal of banks from principal market making. My thoughts follow.

Hedge accounting is already part of the furniture already and so not a new constraint.

Market makers got the portfolio hedging flexibility they needed from the final Volcker ruling. Since the constraint on market making positions to "near term customer demand" has yet to have an agreed definition or metrics, I doubt banks have actually changed trading behavior in anticipation yet.

In my view it's Basel III that's mainly pushing banks to make market making more balance sheet efficient i.e. scarcity of risk weighted assets, leverage ratio exposure and funding liabilities with 30-days or less to maturity.

Whether the gap is filled by bank agency / riskless principal trading models or order-driven / eTrading platforms or broker dealers / hedge funds without access to the discount window is up for grabs. Certainly TABBfixed last week seemed to say "all of the above".

(See my post here: http://www.theotcspace.com/2014/01/18/fixed-income-trading-paradigm-uphe...)

Happy to discuss.