- Volcker Rule Defined
The Volcker Rule which was passed as section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.1 The Volcker Rule (“Rule”) generally prohibits banks from using customer deposits to trade securities, derivatives, or commodities (collectively known as proprietary trading).2The Rule also carves out an exception for banks when they are engaging in market-making activities, which is when a bank quotes both the buy and sell side of a financial instrument with the intention of facilitating smooth transactions for investors.3
- Issues with the Current Rule
The issue with this Rule is summed up in a quote by Jamie Dimon, the CEO of J.P. Morgan, when he said, “you have to have a lawyer and a psychiatrist sitting next to you determining what was your intent every time you did something.”4 In other words, enforcement of the entire Rule hinges on the ability to analyze a trader’s “intent” between market making and proprietary trading. In addition, some of the biggest price swings that various securities make, particularly stocks, happen around earnings announcements. Taking earnings announcements as an example, they are well-publicized, analyzed, and usually result in an outsized move in stock prices compared to an average trading day. 5 These events also cause a large amount of supply and demand for the stock over the ensuing period after earnings.6 Therefore, how can a regulatory agency accurately determine whether the trader in question was buying the stock due to his anticipation of an increase in demand around earnings or whether he was hoping to make a quick profit by taking such a position.
Adding onto the confusion surrounding effective enforcement of the Volcker Rule, amendments passed in 2019 further weakened the government’s enforcement ability. Prior to the 2019 Amendments, there was a rebuttable presumption that any financial instrument held for less than 60 days was automatically considered part of the trading account. Before the 2019 Amendments, Banks would have to prove that any trade involving such instruments was not a proprietary trade.7 However as of January 1, 2020, that rebuttable presumption no longer applies which means the burden of proof has shifted from the banking entity to the government.8 The meaning behind this is that it is now on the government to prove that a trade was a proprietary trade. All trades start off with the assumption that they were non-proprietary. As such, any analysis would be largely subjective, and traders may use the guise of market making to continue the practice of proprietary trading.
- First-hand Experience with Issues of the Volcker Rule
To show a few examples for some perfectly legal reasons broker-dealers need to take on securities, here are some of the scenarios I experienced during my time as a trader which required the use of inventory. To start, when a client wants to liquidate a position, many banks may have no choice but to take it on their books. Several factors play into this decision such as the size of the client and how illiquid the particular name is. The more business the client does with the bank, the more likely the broker-dealer is to take on that risk to keep their business. Adding on, if the name does not trade frequently or often, then the more likely it is the broker-dealer would have to take it on our books. This stems from the fact that when the market sees a large order to buy or sell, market participants usually adjust the price of the security to try to take in the new information that the big order sends to the market (either a bullish or bearish view from a big trader). Therefore, to prevent this movement in price, a client will prefer the broker-dealer take on his entire order without the shares ever hitting the open market. In this case, taking the shares as inventory directly serves the needs of the client and prevents market prices from spiking in either direction. The result is a calm, slow moving market which adjusts gradually rather than in one harsh move.
Another example of when a broker-dealer must take on inventory comes from the rebalancing efforts of various indices. In other words, different companies have their own ways of tracking the equities market and these various “trackers” must adjust to new information such as size and pricing of the companies they track. This rebalancing can occur monthly, quarterly, semi-annually, or even annually. The date of these rebalancing efforts is very well-known but what is a mystery is the exact level of rebalancing for the names that are tracked.
At my previous employer, the trading desk at the broker-dealer would create sophisticated models to estimate how we believed the rebalancing would happen and subsequently purchase or sell equities to ensure adequate inventory on the day of rebalancing. Therefore, in order to further our clients’ needs on the rebalancing day, we sometimes had to take equities to our books as far ahead as days and sometimes weeks in advance. As a result, when the rebalancing day comes, we can satisfy all our client orders without having to push the stock price in either direction. In this scenario, taking inventory is necessary to fulfill our clients’ needs.
There are many outside events that require broker-dealers to have inventory of securities on hand. These events include, but are not limited to, earnings releases, product launches, litigation, and much more. Many of these events are well publicized and as a result, will have many investors watching the outcome and effect on the company. To try to minimize the post-announcement move on the stock and to satisfy client demand, it is essential that many broker-dealers take on inventory ahead of time. Trade desks at broker-dealers would anticipate what the most likely outcome of an event would be and position accordingly to be able to process all the client orders that would come in on the day of the event.
From the examples above, having inventory is a vital part of the business model for any firm that is looking to fulfill their clients’ orders. Keeping in mind all the reasons why holding securities on a firm’s own books is necessary, the question then becomes how can the SEC properly enforce this law and prevent banks from taking on risk against consumer deposits? The most egregious violations will be caught and prosecuted as some traders leave no doubt about their intentions. For the majority of traders where the position and timing can be explained away, there is no way to firmly tell whether they are adding securities before an earnings call in anticipation of client demand or to make a bet on earning. As a result, the law is left powerless. Therefore, a revision is needed where there is a clear line between what is and is not allowed. A simple subjective view of what a trader’s “intent” could have been at the time of the trade is an inefficient way to promote capital market efficiency and risk reduction.
In conclusion, as has been examined in this blog post, I believe that the Volcker Rule, as it currently stands, provides too much flexibility and question as to what does and does not violate its terms. From my time as a trader that was subject to this rule, I can say first-hand that taking positions in securities is a vital piece of being a successful broker-dealer and therefore, the uncertainty with violating an unclear law should not hamper down a trading desk. If a more clear law was passed, then traders can learn to do their job more efficiently and within the boundaries of the system.
Dodd-Frank Wall Street Reform and Consumer Protection Act, 12 U.S.C. §1851(d)(1)(B) (2010). ↩
Francine McKenna, Biggest Banks Prefer Full Volcker Rule Repeal, But a Rewrite Would Do, MarketWatch (Aug. 19, 2017, 4:19 PM), https://www.marketwatch.com/story/biggest-banks-prefer-full-volcker-rule-repeal-but-a-rewrite-would-do-2017-08-11. ↩
Owen Lamont & Andrea Frazzini, The Earnings Announcement Premium and Trading Volume 1 (2007). ↩
12 U.S.C. §1851. ↩