Debate about the causes of the Great Financial Crisis of 2008 brings to mind the tale of the five blind men trying to determine the nature of an elephant. One grabs the tail, another the trunk, a leg, an ear, or the body. Naturally, each of them comes up with a radically different idea about what an elephant is.
So too, some of the many books and articles written about the Great Financial Crisis think the whole thing resulted from too many poor people owning houses. For others, derivatives were the cause of it all. Some say poor lending practices or sloth and corruption at ratings agencies are blameworthy. The English Lord Turner of the former Financial Services Agency, in an influential piece, accused securitization for the global collapse, pointing out that by securitizing loans and then purchasing the securities manufactured in the process, banks managed to reduce their capital requirements to unsafe and dangerous levels.
But, in the opinion of the very sage ex-Fed Chairman Paul Volker, proprietary trading by banks caused their downfall. Chairman Volker, for those who have forgotten, is remembered most for the pragmatic application of the economic theories of Nobel-prize-winning Professor Milton Friedman to bring the double-digit inflation of the late 1970s under control in a few short years. Other Fed chairmen have been as powerful; few have been treated so kindly by historians. It remains to be seen whether the Volker Rule will burnish Chairman Volker’s legacy or leave it forever tarnished.
Chairman Volker has a point. As the financial services bubble expanded in the period between 2002 and 2007, banks in general, and investment banks in particular, found that proprietary trading activities were much more profitable enterprises than making money the old-fashioned way through underwriting or lending activities. The Economist among others commented on this trend and expressed concern that this was risky business. It is also true that the collapse of the markets where banks were most committed in their proprietary trading operations was the immediate cause of the banking industry bail out by the US taxpayer.
At the urging of Chairman Volker, Congress added a new section 13 to the Bank Holding Act of 1956 through Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank has been roundly criticized for its complexity, but Section 619 is a model of simplicity. It simply states that, "a banking entity shall not engage in proprietary trading." As far as non-banking entities that engage in proprietary trading are concerned, if they are supervised by the Fed, they will have capital requirements.
Lawyers know that simplicity in legislation is a mask for extreme complexity. The Ten Commandments, that great early piece of legislation, is extremely straightforward. Stephen Colbert had a lot of fun with a socially conservative Congressman who wanted them enscribed in courtrooms by asking him to name them. The Congressman couldn’t come up with any, although you would have thought he would see that one coming. In case you ever are asked, here are two: "You shall not murder." "You shall not steal." The entire ten fit easily on one page, double-spaced. On the other hand, the Talmud, many volumes of which are devoted to explaining the meaning of the Ten Commandments, is not simple or straightforward.
So also, when Congress wants to create simple, clear legislative commands, it leaves it up to the regulators to determine what is meant by murder, stealing or proprietary trading. In this case, the Dodd-Frank legislators decided that proprietary trading in government bonds, market making, and underwriting would be exempt from the ban on proprietary trading, but left it to the Fed and other federal banking agencies, the SEC, and the CFTC to determine what those exemptions mean.
As commanded, the federal agencies produced a proposed "Volker Rule" last October. The comment period for the "Volker Rule" generated by these agencies is now over, although they will no doubt consider other comments received until very shortly before the final rule is published. So far, thousands of comments have been received, many of them expressing great fury at various parts of the proposal. These comments must be digested before a final rule can be produced.
It seems to me that a lot of the furor over the Volker Rule is misdirected. The regulatory agencies do not have the power to repeal the Section 619 of Dodd-Frank, however unwise they may believe it to be. Congress has enacted it, and only Congress (or the Supreme Court in the highly unlikely event it finds the law unconstitutional) can revoke it. Some banks have lobbied heavily in favor of repeal, but this effort has been a great waste of campaign contributions in my opinion. Supposedly sympathetic Congressmen have required the heads of agencies to appear before them and admonished them to be gentle, but I have yet to see any serious legislative proposal to abolish Section 619.
Efforts to shape the scope of the Volker Rule by focusing on the regulators’ definitions are much more likely to be effective. For example, the breadth of the market making exemption will determine how many traders are employed in the next few years and perhaps for many decades. If the exemption is very narrow, then a lot of traders will have to find some other occupation. If it is broad, relatively few traders will hit the unemployment line.
There are some equity traders left at Fed-regulated institutions, primarily in the OTC equity markets. However, most proprietary equity trading desks have already been decimated by the overhaul of NASDAQ in the early part of the last decade and by Reg NMS in 2007. Therefore, the real impact of the Volker Rule will be felt on the bond and derivative trading desks. As compared to the miniscule profits available for equity trading, bond and derivative trading desks have historically been major profit centers for investment banks. A very narrow exemption for market making has the potential to reduce profits severely for these institutions.
Equity traders are familiar with regulatory attempts to distinguish "bona fide" market making from mere "proprietary trading." Generally, these rules start with the proposition that bona fide market makers make two-sided markets; that is, they publish both a bid and an offer in the securities for which they make markets. The difficulty is that the opportunity to profit from market making activities generally occurs only on one side of the market. Given a choice, market makers would prefer to quote only on one side. When required to provide two-sided quotes, market makers therefore stay as far away from the market on one side as possible. Most of the rulemaking in this area attempted to define how far away from the market a trader could stray without losing the cherished "market maker" status. These rulemaking attempts, a feature of NASDAQ market making in the 1990s, all failed to accomplish their objectives.
The Volker Rule goes at this definition in a different way. If a bank’s trading desk makes most of its profits from price increases in a security, as compared to customer facilitations, then it is engaged in unlawful proprietary trading. As a way to control this sort of thing, traders are not to be compensated for trading profits.
We talk a lot of customer accommodation in this industry, particularly when we are trying to convince customers how much we love them. But we are in it for the money. No firm will or can maintain an unprofitable or marginally profitable trading desk for very long. So, the Volker Rule’s proposed market making definition inevitably would result in the elimination of most trading desks at banks, as well as at broker-dealers and futures merchants with Bank Holding Company parents.
Is such a narrow market making exemption a good idea? It is, if like Chairman Volker you believe that proprietary trading was the principal cause of the taxpayer funded bailouts. He is not alone. Many commentators thought an even narrower exemption was called for.
But, the fact is that the ban on proprietary trading contained in Section 619 of Dodd-Frank was one of the more controversial parts of a very controversial piece of legislation. Moreover, Congress did create an exemption for market making, suggesting a legislative desire to regulate market making operations, rather than strike them from the face of the earth. This argues for a broader exemption for market making than the one contained in the Volker Rule, one which at least allows firms to profitably conduct those activities. As a starting place, the regulators might consider NASDAQ’s learning experience and create a more refined version of the two-sided market concept. There is no good reason to abandon entirely what was learned in that exercise.
A broader exemption will, of course, mean more proprietary trading. But, it seems to me that we can allow more proprietary trading without putting the taxpayers at risk. Proprietary trading is not, after all, the same as murder or stealing.
Stephen J. Nelson is a principal of The Nelson Law Firm in White Plains, N.Y. Nelson is a weekly contributor and columnist to Traders Magazine’s online edition. He can be reached at sjnelson@nelsonlf.com
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
