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, 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 “pretty challenging.”
The problem, according to Gira, will be in separating out 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, scheduled for release on October 18, but already circulating in draft form, 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 the customer-focused activity and prop trading is not always straightforward, sources maintain. Often times dealers will replenish their inventories in anticipation of potential customer demand. That demand, however, may not materialize for several hours or days, creating the suspicion the trader was merely speculating.
The draft proposal sets out seven standards that need to be met in order for a given trading activity to fall under the definition of market making. One of them 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 one’s self out by entering quotations.” (The SEC’s Regulation SHO governs short selling and exempts trades done on behalf of legitimate market making.)
At least one brokerage 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,” Vaishali Javeri, a director and counsel at Credit Suisse, said at the conference. “The indications are that there should be a sufficiently broad market making exemption. But we will see.”
Regulators still may need more details from brokers in order to do their surveillance work, Gira said. “If a firm is using the same MPID (four-letter market participant identifier) for multiple types of activity,” the regulator 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. It will be challenging.”
The Volcker Rule, championed by former Federal Reserve Chairman Paul Volcker, will apply only to “banking entities.” It will not take in non-bank broker-dealers that engage in market making. Some of the biggest stock dealers, including Knight Capital Group and Citadel Securities, will not be affected.
