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February 2, 2012

What the Volcker Rule Has in Common with Your Next Flight

The plastic cup flew through the air and hit the flight attendant in the head.  The plane headed back to the gate, and a 37-year old Idaho mother of two was charged with assault.  What triggered her odd outburst of Dixie-cup chin music? 

She was forced to comply with the federal requirement that portable electronic devices be turned off.  She was not alone in her air rage-the rule has recently caused temper tantrums by celebrities and fistfights among passengers.  Even a U.S. Senator had to apologize in 2009 for calling a flight attendant a word you wouldn't often see in the Congressional Record, after she wouldn't let him finish an email.

To be worth all this angst, it must be an important safety precaution, right?  Well, not exactly.  The FAA itself admits that no plane crash, or even minor equipment malfunction, has ever been definitively attributed to the use of an electronic device.  A lab in California estimated that the emissions from most devices are less than a millionth of what it would take to mess up an airplane's controls. The whole thing makes no sense: when was the last time your cell phone messed up the GPS in your car, or caused the cruise control to go haywire?  Why would airplane electronics be so different?

And yet, the rule has been part of our lives for more than twenty years, primarily because there is no way to prove without a shadow of a doubt that electronic devices won't one day somehow cause a problem.  Wall Street now finds itself facing a similarly unnecessary "safety first" rule, one that is guaranteed to also cause much angst and wasted effort.  Known as the Volcker Rule  and signed into law in July 2010, it prohibits U.S. banks from engaging in proprietary trading as of July 2014. 

Proponents of the rule pitch it as a safety device.  The logic is that proprietary trading could create large losses that lead to a run on a bank, so they should not be allowed.  On the surface, that sounds logical.  But if the goal were just risk reduction, would a complete ban be necessary? Couldn't risk be reduced in a less disruptive way by just raising capital requirements further, or by limiting the total amount of risk a bank is allowed to take?

It seems that the logic behind the total ban is simplicity, similar to the reason given for the total ban on electronics in planes.  The FAA says that it would be too hard to certify each and every new electronic device, and the authors of the Volcker Rule similarly think it would be too hard to allow any proprietary trading.  Easier to turn it all off-better to ban that iPod Shuffle during takeoff, to make sure no one is broadcasting on a ham radio in seat 28E.  Similar logic leads to a ban on flipping shares of Intel, to make sure no one is making a $10 billion bet on hyper-leveraged exotic derivatives.

But far from achieving simplicity, the Volcker rule is one of the most complex ever dropped on the Street.  The initial rule runs 298 pages long, with prop trading being defined using a complicated series of tests that include the trader's earnings volatility, compensation scheme, sources of revenue, risk management, interaction with clients and more.  Based on its complexity alone, criticism has come from some surprising quarters. Mr. Volcker himself said in a New York Times interview, "I'd write a much simpler bill. I'd love to see a four-page bill."  Sheila Bair, the former chairman of the FDIC, described it as a "300-page Rube Goldberg contraption of a regulation."  And Scott O'Malia, one of the five CFTC commissioners, called it "an unworkable solution that is entirely too complex."

Beyond the complexity, Volcker differs from the electronic device ban in another respect.  Having to turn off your iPod on the plane is annoying, but it presumably doesn't harm anyone.  But the Volcker Rule has the potential to do significant damage to the capital markets.  The rule specifically exempts U.S. government securities.  Implicit in this exemption is an admission that proprietary trading adds liquidity, and Congress wisely did not want to damage liquidity in the financial instruments that are the lifeblood of our nation.

And yet other countries' bonds are not exempt.  This has created a diplomatic firestorm-within the past month, the governments of Canada, Japan, and the United Kingdom have written letters complaining that the Volcker rule would damage liquidity in their own government securities.  A letter signed by 13 major pension funds and mutual fund firms echoed this fear across all types of bonds, stating that Volcker could result in "reduced liquidity in the markets, higher trading costs, and reduced valuation of fixed-income securities."

Equities would also be impacted significantly.  By one estimate, broker-dealer prop trading makes up 11 percent of the current equities volume in the U.S.  Some of that trading would migrate to hedge funds and non-bank broker-dealers, but overall volume would clearly drop a lot.   Of greater concern to buyside institutions is the impact on capital commitment.  There are differing opinions among legal experts as to how much ability block traders would have to hedge facilitated positions under the rule.  Under most interpretations, it would be difficult to properly hedge block risk, and so the cost of block trading would increase.
As with any rule, there is a hodgepodge of exemptions.  In the electronic device rule, the FAA specifically allows pacemakers, hearing aids, and electric shavers to remain on at all times. Electric shavers?  Yes, look it up on the FAA's website. The lesson here is that bureaucratic rules typically end up with bizarre exemptions that often defy logic, usually the result of a political need to satisfy a particular constituency, or based on some historical quirk. Volcker has its own electric shavers, of course.  Fannie Mae, Farm Credits, and other securities received exemptions in round one.  Look for all sorts of other electric shavers to pop up as the lobbying continues.

Regardless of the final outcome, there will be many people that will be pleased with the Volcker Rule, but not for the official reason it exists.  As anti-Wall Street sentiment remains high, and "Occupy Wall Street" and "the 99%" remain in our daily lexicon, anything bad for greedy fat-cat bankers will be automatically embraced by a large segment of the population.  Similarly, many people support the ban on cell phones during flights, though not for the official reason it exists.  After a review of the cell phone ban was announced in December 2004, federal regulators were barraged with over 8,000 comment letters, the vast majority from people who didn't want to hear cell phone chatter during flights.  I support the cell phone ban too-I don't want to hear dozens of people jabbering on the plane while I try to enjoy my latest issue of Traders Magazine.   But by pretending it's about safety, we do a disservice to ourselves and end up needlessly banning silent devices like laptops and Kindles.   

Let's call it like it is: neither rule is really about safety.  The electronics ban is really about preventing people from being annoying with their cell phones, and the Volcker Rule is really about collectively punishing banks for the sins of the past.  And if anyone tells me traders can't flip a few Spyders because it endangers the financial safety of our nation, I may have to throw a plastic cup at their head.



Dan Mathisson is a columnist for Traders Magazine.  He is also Head of Electronic and Program Trading at Credit Suisse. The opinions expressed in this column are entirely his own, and do not represent the opinions of the Credit Suisse Group.

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