Update: 298 Page Volcker Rule Proposal Leaves Much To Be Desired (And Decided); Issue #1: Market Making

On October 12th the Federal Reserve, FDIC, Office of the Comptroller of the Currency, and SEC submitted the long-awaited proposal for implementation of Section 619 of the Dodd-Frank Act, widely referred to as the “Volcker Rule.” Legislators included this section in the Dodd-Frank Act in order to divide commercial banking and depository functions, which are federally insured, from banks’ investment activities (commonly referred to as “proprietary trading”). Given the fact that many large commercial banks, such as Bank of America and JP Morgan Chase, derive a significant portion of their revenue (8% and 9%, respectively) from their trading desk, the details of the rule could have enormous implications for the future financial strength and stability of depository institutions.

The proposal has several large exceptions to its prohibition on proprietary trading in order to allow banks to continue to provide important financial services to their customers. One of the largest exceptions is for market making. Market making can involve a number of activities, but at its core it consists of financial institutions accepting client requests to purchase (or sell) any given security without that financial institution immediately going out into the market and finding a seller (or buyer). In order to facilitate this process, financial institutions involved in market making may maintain a stock of various securities that they buy and sell to clients as needed to meet client demand. Under the new proposal, banks would be allowed to purchase and sell securities under the premise of market making so long as: a.) the bank “holds itself out” as being willing to buy and sell those securities to and/or from clients, b.) the purchases or sales do not exceed “reasonably expected near term demands” of clients, c.) the activities are primarily intended to generate income from fees, commissions, and bid-ask spreads (as opposed to appreciation or depreciation in the securities themselves), and d.) the compensation arrangements of employees engaged in market making is not designed to reward large returns that may result from the appreciation or depreciation of the securities themselves.

Critics argue that the current exception for market making is sufficiently vague that it would still allow commercial banks to engage in excessively risky investments with insured deposits. It would be exceedingly difficult, if not impossible, for regulators to effectively examine whether the amount of securities a bank is holding is “disproportionate” to expected client demand or whether that demand is sufficiently “near term” to justify the holdings. In the same vein, it’s unclear exactly how a regulator would be able to determine when a bank is “primarily” profiting from the fees it charges on market-making transactions, as opposed to the appreciation of those securities.

It’s worth noting that Goldman Sachs and Morgan Stanley have expressed an intention to shed their designation as a bank holding company in light of the Volcker Rule. These companies had previously been considered securities investment groups, but after the financial crisis they sought and attained the status of a bank holding company in order to gain access to the Fed’s discount window, “in case” they should face a liquidity crisis. Other large commercial banks are expected to spin-off their trading desks, providing current shareholders with a proportionate stake in the new venture.

Under Dodd-Frank, the final implementation of the Volcker Rule is supposed to go into effect in July 2012. The document the agencies produced recently poses hundreds of questions for observers to respond to, with commentary being accepted until mid-January 2012 and the final version of the rule to follow thereafter. Given this timeframe, one could reasonably question whether the regulatory agencies will have sufficient time to agree on the final language, and whether the commercial banks will have enough time to conform their activities to the final rules, within the preordained time frame.