On February 9th the Fed approved of the final version of the Volcker Rule, part of the Dodd-Frank Act, which is now scheduled to go into effect on April 1, 2011, though there is a 2 year window in which governed entities will be given to conform their behavior to its regulations. The Volcker Rule prohibits insured depository institutions (hereafter referred to as “banks”) from proprietary trading in securities and financial derivatives, as well as from acquiring a financial or governing interest in hedge funds. Activities by U.S. banks would be governed by the rule, regardless of where their activities take place, however activities by non-U.S. banks would only be governed if they occurred, at least in part, within the U.S.
The definition of activities that constitute proprietary trading is taking positions with the primary purpose of selling shortly thereafter. The ambiguity inherent in this definition is supplemented by the provision that allows government agencies, such as the SEC and CFTC, to implement rules that extend activities governed by the rule to any security or financial instrument that is deemed appropriate.
A major aspect of the Volcker rule that has garnered attention is its limitation to governing the activities of banks when they are acting as the principal, which many interested and informed parties believe would only apply when banks are using their own accounts/assets. Consequently, banks could still engage in many activities that are otherwise prohibited, as long as they do so “on behalf of clients.” This provision therefore leaves open the door (to some extent) for banks to engage in the questionable trading practices that endangered the stability of our financial system through internal reorganization. A study by the Financial Stability Oversight Council asserted that “permitted activities – in particular, market making, hedging, underwriting and other transactions on behalf of customers – often evidence outwardly similar characteristics to proprietary trading.” The former Fed Chairman, for whom the rule takes its name, is not concerned about this potential loophole, as be believes it will ultimately be the responsibility of the regulators in the field to ensure that banks are not engaged in proprietary trading in disguise.