CFTC Holds Volcker Rule Roundtable
On May 31, the CFTC held a roundtable on the Volcker Rule featuring a panel of academics, advocacy groups, and market participants, including end users, where the hedging and market making provisions of the proposed rule were discussed. Robert Colby of Davis Polk participated on behalf of SIFMA.
Chairman Gary Gensler provided opening remarks where he highlighted three issues for regulators with regard to implementing the Volcker Rule. These include: permitting risk-mitigating hedging and prohibiting proprietary trading in a balanced way; permitting market making and prohibiting proprietary trading in a balanced way; and how best to apply proprietary trading bans to banking entities that transact in futures and swaps. Specifically, Gensler wanted to know whether a bank’s decision not to hedge or to only partially hedge open swaps positions would be considered prohibited proprietary trading under the rule. On a related note, Gensler also questioned if a separate trading desk with its own profit and loss statement could engage in risk-mitigating hedging.
Panel I: Hedging
Sheila Bair, former chairman of the Federal Deposit Insurance Corporation (FDIC), participated in the first panel and provided general observations of the rule from a banking regulator’s perspective. She noted how it is “extremely difficult” to distinguish market making from proprietary trading and said any “gray areas” should be taken outside of the insured bank by moving securities and derivatives into separate subsidiaries that are firewalled off from the insured deposit-taking side of the bank. She said regulators should distinguish activity that should be supported by insured deposits and then require firms to seek capital for all other activity in the private markets. Bair added that commercial banks should only be allowed to invest their excess deposits into government-backed securities and high-grade corporate debt, and that only “plain vanilla” derivatives should be allowed for certain hedging purposes.
Bair said a hedge should not be allowed under the Volcker Rule unless it is a hedge and that banks need to identify the specific risks they are hedging as well as show a reasonable correlation with such hedges. She also advocated for a greater disclosure regime by requiring banking entities to publicly disclose the methodology used to determine the reasonable correlation of their hedges as well as disclose, on a continuous basis, how the hedge is performing. In addition, Bair urged a tightening of the Volcker Rule’s compensation provisions. She said any compensation based on hedging profits should be banned and that risk management should be focused on whether hedges reduce risk not whether such transactions make a profit.
A number of participants echoed Bair’s calls for increased disclosure, noting that regulators would have “more eyes on what is going on” with regard to investors having more publicly available information on the hedging activities of market makers. The participants called for greater standardization of such disclosure requirements across the industry.
A number of participants also stressed the need to more clearly address the concept of correlation of hedges and said rules should spell out what would be a reasonable reduction in risk.
Participants brought up issues related to portfolio hedging and some panelists suggested that banks use portfolio hedging to describe trading in transactions that they cannot prove are hedges.
Josh Cohn of Mayer Brown, who participated on behalf of the International Swaps and Derivatives Association (ISDA), countered that portfolio hedging is practiced effectively for the most part and referred to the CFTC’s rulemaking on swap dealer recordkeeping and reporting requirements, which recognizes the virtue of consolidated hedging.
Some participants did warn against an “overemphasis” on correlation alone and suggested giving attention to the real economic connection of hedging transactions, noting that in stressed markets, such correlations disappear.
Participants also discussed concerns related to what types of entities would step in to fill the void if banks were constrained from providing risk mitigating products under the Volcker Rule. A number of end users discussed how their companies use hedging tools to properly manage future cash flow and support capital allocation decisions. These participants noted how the banks they transact with face every industry in the U.S. and are thus in the best position to meet the needs of end users as it relates to the flexibility, timing, and variety of hedging instruments.
Simon Johnson, Professor at MIT, asked why end users are so aligned with the positions of the large banking entities. He reasoned that end users were supportive of such firms keeping the activity because of the implicit subsidy enjoyed by large banks that are perceived by the market as “too big to fail” with regard to accessing cheaper capital relative to smaller banks, and noted that other firms are capable of providing hedging services to end users.
Gensler responded by reaffirming the need to implement regulations that provide a proper balance between allowing risk-mitigating hedging activity at banks (as it relates to a market maker taking on residual risk after combining parties with a long position and a short position) while prohibiting proprietary trading.
Panel II: Market Making
Market practitioners began the second discussion by emphasizing the importance of traders being provided with clarity over the rules. One participant said the Volcker Rule model should support providing flexibility over a market maker’s ability to hold inventory. Another participant noted the possibility that the Volcker Rule may result in less liquidity but said that firms with low turnover accounts may be able to profit over the long-term from such a decrease in liquidity.
One participant said the proposed rules are so narrow because regulators are trying to create a differentiation between market making and proprietary trading which will effectively eliminate banks from undertaking market making activity. Some participants suggested that shareholder equity provide a backstop to risk from market making activity as a way to resolve certain concerns that regulators attempted to address in the rule.
Participants also discussed compensation tied to market making activity. One participant noted that income generated from market making include fees, commissions, and bid/ask spreads, and suggested that the proposed rule strike the word “primarily” from the portion of the proposal that defines how compensation is tied to such types of revenue.
Dan Berkovitz, General Counsel for the CFTC, asked whether the CFTC should provide a different set of rules that give special consideration to the types of markets under the CFTC’s jurisdiction or whether this distinction would just add more complexity to the proposal. He also asked if participants are in favor of giving different asset classes different sets of metrics.
A number of participants said that the rules should differentiate between asset classes but advised against providing differing sets of rules, noting that the principles defining what is proprietary trading and what is not should be common across markets.
Colby also recommended regulators focus on a number of issues that have been addressed by SIFMA relating to the disqualifying factors of the proposed rule that would prevent certain activities from receiving an exemption, including the treatment of inter-affiliate swaps and forwards and the treatment of commodity pools. Colby said that, as currently proposed, the rule would result in overly restrictive compliance requirements that would inhibit the types of activities Congress intended to preserve. He noted how it is extremely difficult to attempt to identify ahead of time what is proprietary trading and what is market making, and said implementing the rule would be a very iterative process between market participants and regulators.
For more information on the roundtable, please click here.
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On May 31, the CFTC held a roundtable on the Volcker Rule featuring a panel of academics, advocacy groups, and market participants, including end users, where the hedging and market making provisions of the proposed rule were discussed. Robert Colby of Davis Polk participated on behalf of SIFMA.
Chairman Gary Gensler provided opening remarks where he highlighted three issues for regulators with regard to implementing the Volcker Rule. These include: permitting risk-mitigating hedging and prohibiting proprietary trading in a balanced way; permitting market making and prohibiting proprietary trading in a balanced way; and how best to apply proprietary trading bans to banking entities that transact in futures and swaps. Specifically, Gensler wanted to know whether a bank’s decision not to hedge or to only partially hedge open swaps positions would be considered prohibited proprietary trading under the rule. On a related note, Gensler also questioned if a separate trading desk with its own profit and loss statement could engage in risk-mitigating hedging.
Panel I: Hedging
Sheila Bair, former chairman of the Federal Deposit Insurance Corporation (FDIC), participated in the first panel and provided general observations of the rule from a banking regulator’s perspective. She noted how it is “extremely difficult” to distinguish market making from proprietary trading and said any “gray areas” should be taken outside of the insured bank by moving securities and derivatives into separate subsidiaries that are firewalled off from the insured deposit-taking side of the bank. She said regulators should distinguish activity that should be supported by insured deposits and then require firms to seek capital for all other activity in the private markets. Bair added that commercial banks should only be allowed to invest their excess deposits into government-backed securities and high-grade corporate debt, and that only “plain vanilla” derivatives should be allowed for certain hedging purposes.
Bair said a hedge should not be allowed under the Volcker Rule unless it is a hedge and that banks need to identify the specific risks they are hedging as well as show a reasonable correlation with such hedges. She also advocated for a greater disclosure regime by requiring banking entities to publicly disclose the methodology used to determine the reasonable correlation of their hedges as well as disclose, on a continuous basis, how the hedge is performing. In addition, Bair urged a tightening of the Volcker Rule’s compensation provisions. She said any compensation based on hedging profits should be banned and that risk management should be focused on whether hedges reduce risk not whether such transactions make a profit.
A number of participants echoed Bair’s calls for increased disclosure, noting that regulators would have “more eyes on what is going on” with regard to investors having more publicly available information on the hedging activities of market makers. The participants called for greater standardization of such disclosure requirements across the industry.
A number of participants also stressed the need to more clearly address the concept of correlation of hedges and said rules should spell out what would be a reasonable reduction in risk.
Participants brought up issues related to portfolio hedging and some panelists suggested that banks use portfolio hedging to describe trading in transactions that they cannot prove are hedges.
Josh Cohn of Mayer Brown, who participated on behalf of the International Swaps and Derivatives Association (ISDA), countered that portfolio hedging is practiced effectively for the most part and referred to the CFTC’s rulemaking on swap dealer recordkeeping and reporting requirements, which recognizes the virtue of consolidated hedging.
Some participants did warn against an “overemphasis” on correlation alone and suggested giving attention to the real economic connection of hedging transactions, noting that in stressed markets, such correlations disappear.
Participants also discussed concerns related to what types of entities would step in to fill the void if banks were constrained from providing risk mitigating products under the Volcker Rule. A number of end users discussed how their companies use hedging tools to properly manage future cash flow and support capital allocation decisions. These participants noted how the banks they transact with face every industry in the U.S. and are thus in the best position to meet the needs of end users as it relates to the flexibility, timing, and variety of hedging instruments.
Simon Johnson, Professor at MIT, asked why end users are so aligned with the positions of the large banking entities. He reasoned that end users were supportive of such firms keeping the activity because of the implicit subsidy enjoyed by large banks that are perceived by the market as “too big to fail” with regard to accessing cheaper capital relative to smaller banks, and noted that other firms are capable of providing hedging services to end users.
Gensler responded by reaffirming the need to implement regulations that provide a proper balance between allowing risk-mitigating hedging activity at banks (as it relates to a market maker taking on residual risk after combining parties with a long position and a short position) while prohibiting proprietary trading.
Panel II: Market Making
Market practitioners began the second discussion by emphasizing the importance of traders being provided with clarity over the rules. One participant said the Volcker Rule model should support providing flexibility over a market maker’s ability to hold inventory. Another participant noted the possibility that the Volcker Rule may result in less liquidity but said that firms with low turnover accounts may be able to profit over the long-term from such a decrease in liquidity.
One participant said the proposed rules are so narrow because regulators are trying to create a differentiation between market making and proprietary trading which will effectively eliminate banks from undertaking market making activity. Some participants suggested that shareholder equity provide a backstop to risk from market making activity as a way to resolve certain concerns that regulators attempted to address in the rule.
Participants also discussed compensation tied to market making activity. One participant noted that income generated from market making include fees, commissions, and bid/ask spreads, and suggested that the proposed rule strike the word “primarily” from the portion of the proposal that defines how compensation is tied to such types of revenue.
Dan Berkovitz, General Counsel for the CFTC, asked whether the CFTC should provide a different set of rules that give special consideration to the types of markets under the CFTC’s jurisdiction or whether this distinction would just add more complexity to the proposal. He also asked if participants are in favor of giving different asset classes different sets of metrics.
A number of participants said that the rules should differentiate between asset classes but advised against providing differing sets of rules, noting that the principles defining what is proprietary trading and what is not should be common across markets.
Colby also recommended regulators focus on a number of issues that have been addressed by SIFMA relating to the disqualifying factors of the proposed rule that would prevent certain activities from receiving an exemption, including the treatment of inter-affiliate swaps and forwards and the treatment of commodity pools. Colby said that, as currently proposed, the rule would result in overly restrictive compliance requirements that would inhibit the types of activities Congress intended to preserve. He noted how it is extremely difficult to attempt to identify ahead of time what is proprietary trading and what is market making, and said implementing the rule would be a very iterative process between market participants and regulators.
For more information on the roundtable, please click here.