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November 2, 2011

Volcker Rule a 'Challenge': FINRA

By Peter Chapman

Making sure brokers are in compliance with the proposed Volcker Rule is not going to be easy, according to an official with the Financial Industry Regulatory Authority.

Tom Gira

Tom Gira, a FINRA executive vice president in charge of market regulation, told attendees at a recent industry conference that "from a surveillance standpoint," the Volcker Rule is likely to be "challenging."

The problem, Gira said, will be separating those activities that are permissible under the rule from those that aren't. The executive was speaking at the Securities Industry & Financial Markets Association's annual market structure conference.

Once the Volcker Rule is approved, examiners from both the Securities and Exchange Commission and FINRA will be charged with auditing firms for compliance. Gira suggested brokers may have to provide more details than they already do about their trades for examiners to determine whether or not a particular activity complies with the rule.

The Volcker Rule, which was scheduled for release on Oct. 18 but circulated in draft form prior to that, is intended to curb risky trading by banks. The thrust of the rule is to eliminate proprietary trading, or betting firm capital on securities trades. And while the rule provides exemptions for such activities as market making and hedging, the definitions of these activities are proving difficult to nail down.

Definitions are the main problem, according to Gira and industry attorneys. "Hopefully, there will be some clear-cut standards," Gira said, "because there is the potential to impact legitimate activity."

Market making is especially vulnerable under the Volcker Rule. That's because distinguishing between it and prop trading is not always straightforward, sources maintain. Often, dealers will replenish their inventories in anticipation of potential demand. That demand, however, may not materialize for hours or days, creating the suspicion a trader was speculating.

The proposal sets out seven standards that need to be met for a trading activity to fall under the definition of market making. One requires trading positions to have "near-term demand."

"The definition of market making is going to be the important piece here," Kevin Campion, a partner with attorneys Sidley Austin, said at the SIFMA conference. "In the context of Regulation SHO, it is focused on the Exchange Act definition of a market maker, or holding oneself out by entering quotations." (The SEC's Regulation SHO governs short selling and exempts trades done for legitimate market making.)

At least one attorney is optimistic the definition will be all-encompassing. "As for equities market making, I would hope the definition will be consistent with the Exchange Act and include block positioning," said Vaishali Javeri, a director and counsel at Credit Suisse. "The indications are that there should be a sufficiently broad market-making exemption. But we will see."

Regulators may need more details from brokers to do their surveillance work, Gira said. "If a firm is using the same MPID for multiple types of activity," he explained, "it will be difficult to ferret out what is market making, what is hedging and what is block positioning."

Gira suggested that firms might have to use special-purpose MPIDs for their market-making desks or new modifiers for each trade. "That will make it easier from a surveillance standpoint," Gira said, "but will have consequences."

The Volcker Rule, which was championed by former Federal Reserve chairman Paul Volcker, will apply only to "banking entities." Some of the biggest stock dealers, including Knight Capital Group and Citadel Securities, will not be affected.


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