Trading Around Volcker; A Trader’s Attempt at Gaming the System
The looming Volcker Rule is poised to be the key piece of financial regulation to decisively end Wall Street trading as we know it.
With banks expected to comply, beginning, for some by July of this year, the industry is getting dead serious about understanding exactly what compliance will look like. Virtually all trading desks, across business lines, will be impacted, and right now banks on Wall Street are facing the risk of wide gaps between comprehensive compliance programs and everyday business implementation realities on a desk level.
From the trader’s point of view, Volcker sounds more like “vulture” every day as it picks the bones of proprietary trading clean. This 300-page document should send shivers down the spine of any trader, who actually had the time or appetite to read it. In short, the Volcker Rule slaps a saddle on the back, and a bit in the mouth, of the trader and leads him, tethered and silenced, away from any inkling of proprietary trading or position taking toward a pure, customer- only driven, agency trading model. Can modern trading desks survive this type of leashing in a market where regulation will slash margins and substantially increase trading costs, or are we witnessing the last breath of Wall Street Swagger?
Here’s how Volcker catches prop trading
Regulators have gone to great lengths to attempt to assure through Volcker, that no profits are made across the nation’s FDIC insured bank trading desks, from a trader’s “view of the market”. That, in their opinion, is what got us into trouble in the first place. Washington has spent quite a bit of time deciding on metrics to determine when proprietary (prop) trading is evidenced, and plan on enforcing limits on such activity actively. Not only does the Volcker rule not want you to lose money “betting” on market trends, it doesn’t want you to make any money either. And here’s how they plan to catch you.
The Volcker Rule requires that all market participants falling under its jurisdiction report trading activity using 17 different indicators that loosely fall into four categories covering revenue based metrics, revenue to risk metrics, inventory metrics and customer flow metrics. By looking at such things as Daily Profit and Loss Volatility, Daily VaR Volatility, Open Inventory and Customer Flow Trade numbers, the folks at various federal agencies (including the Fed, FDIC, OCC and SEC) are out to see who’s been naughty or nice, and they intend to look quite closely.
Looking for loopholes
At first read, through the eyes of a trader, one might be encouraged as the rule seems to give a tad of flexibility in its interpretation and those in the trenches might be a bit buoyed in believing that perhaps there may be a way around this troll at the bridge. Those remaining optimists would be smart to look again, however. Volcker knows your game and is talking severe punishments for violators that dare to push the boundaries of this prop-trading killer.
Big brother is watching your bid/offers
For instance, under the rule there exists an exemption for “market making” which is described as a bank being “willing to buy and sell and quote markets on a continuous basis”*. Well, any trader knows that there are quotes and then there are quotes. If I were trader, wanting to look like I was complying with Volcker but in actuality wanting to take on a long position given my ‘view of the market’, my “bid” quote might just happen to be a lot better than my “offer” quote. As such, my buy quotes might get hit with much more frequency than my sell quotes and before you know it I am long even though I have kept “continuous quotes” in the market as per Volcker. Voila! A legitimate way around Volcker!
But not so fast. The federal agencies did not invest in hiring would be or ex-post traders for nothing. Let’s see what the Financial Oversight Committee (FOSC), in charge of birthing Volcker, has to say about such practices – “where a market maker posts continually at or near the best offer, but does not also post at or near the best bid, the market maker‘s activities would not generally qualify as bona-fide market making for purposes of the market making exception”* – Gotcha – Big Brother is watching.
Let’s take another loophole and see if we can hang ourselves. Under Volcker, amassing a position or “acquiring inventory and maintaining risk exposures to satisfy current or expected customer demand” is permissible as a necessary evil of market making or responding to customer needs to run your agency flow business. If I were trading and wanted to get long based on my view of the market however, I might “acquire my inventory to satisfy expected customer demand and then – “oops – excuse me Commissioner – my customer didn’t come in with the demand I thought he would or with the volume expected so looks like I was off on my idea of “expected customer demand” – but I was definitely NOT proprietarily trading – no sir – and I wasn’t doing it last week either!” Think again. On this subject the FSOC recognizes and documents, “proprietary traders that build inventory, but do so with the expectation that inventory will appreciate in the near term, rather than using the inventory to facilitate customer transactions as would a market maker” are using “practices that are clearly prohibited”.
But the directives around Volcker are not always crystal clear, making it difficult to set policy and guide employee protocols. The FSOC itself admits, “The ability to hold inventory in this context is a principal complexity: the same inventory built with the intention of facilitating liquidity for clients could also be built with the intention of engaging in impermissible proprietary trading and discerning between the two is a key challenge in implementing the Volcker Rule.” So the problem for the financial industry is two-fold; first, gaining a clear understanding of exactly what is being demanded from Washington and second, actually changing behaviors.
Clarity on change
Changing behaviors to this degree involves attempting to change the risk culture of an organization, which is extremely different than merely changing a risk limit or risk reporting. Let’s face it, most people are on a trading desk because it is in their nature to take risk and that’s why they choose their jobs. The fact that Volcker now is changing the game will leave institutions clamoring to explain the new roles to their trading staff. The fact that Volcker restricts “incentive-based compensation based on risk-taking” does not help matters. From a trader’s point of view, first they take the fun, and then they take the money.
At Capco, a leading financial services consulting firm, client needs regarding complying with Volcker have become so vast and intricate, the consultancy has created a Global Volcker Center of Excellence. Our clients rely on us to bring a deep knowledge of bank operations to bridge the gap between high level interpretation and individual desk implementation. We work very closely with them to drive a target operating model that will optimize desk structures, operational processes and infrastructural alignment in addition to refining reporting practices. Complying with Volcker will be a difficult path for most banks. Clarifying the change necessary to comply will be the first step in a long journey.