The Volcker Rule, which bans banks from participating in proprietary trading, is still worrying bankers.  Financial industry groups are now focusing on an exemption from the rule that allows banks to make certain investments as a part of a legitimate liquidity management program. Regulators will have to distinguish between liquidity trading and proprietary trading. Unfortunately, liquidity trading and proprietary trading are not such discrete activities, making regulators’ jobs difficult, if not impossible.

Banks and industry groups argue that the exemption is so narrow that legitimate liquidity trades could be mistakenly labeled proprietary trades by regulators. In any case, bankers know that the narrower the exemption is, the more trading activity they will have to defend to regulators down the line. According to Berkeley Law Assistant Professor, Stavros Gadinis, “The more flexibility [banks] manage at this stage, the less negotiation they will have to do at a later stage, so this is where it’s at stake, where they can nip it in the bud.” Bankers have to be able to hedge to protect themselves, and the exemption is an attempt to allow that activity while prohibiting the kinds of risky trades that destabilize the market.

Regulators take the opposite view, arguing that the exemption is too broad, and that banks will easily disguise proprietary trading activities as liquidity trading. They worry that the exemption will function as a loophole and allow for risky whale-like trades. But the Volcker Rule, Gadinis said, “would not have stopped the [London] Whale trades. The question of what is a hedge is subject to interpretation. There are things that are definitely hedges, but there are things where it could be, but it’s doubtful.” (more…)