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On Dodd Frank An Overlooked Provision Section 716 and the Volcker Rule

So what do I think of Dodd-Frank? Im glad you asked. Before I get to some of the specifics, let me just say that in terms of broad policy, I am, unlike the vast majority of commentators, quite happy with the way the bill turned out. Barney Frank and Chris Dodd deserve a tremendous amount of credit for shepherding such a massive and impactful bill through Congress, and I think naming the bill "Dodd-Frank" is much deserved. The political and legislative realities involved in getting a major piece of legislation through Congress (and this is an uber-major piece of legislation) are so daunting nowadays that I had been expecting a far weaker bill from the beginning. That Dodd and Frank were able to get as much as they did is an extraordinary accomplishment.

No, Dodd-Frank doesnt do anything as sweeping as 1930s reforms, but you know what? We already have deposit insurance, theres already a Securities and Exchange Commission, and the massively overrated Glass-Steagall would have done exactly nothing to prevent the Bear Stearns and Lehman failures. Also, the financial crisis, while bad, wasnt even in the same league as the 1930s banking crises. So spare me the disappointed historical analogies.

Okay, now on to some specifics.

Overlooked: Interest on Demand Deposits

By far the most overlooked aspect of Dodd-Frank is Section 627, which repeals the long-standing prohibition on paying interest on demand deposits. This was one of the centerpieces of the Banking Act of 1933 — one of the policies Sen. Carter Glass personally demanded (the other being the pseudo-separation of commercial and investment banking). This could have far-reaching consequences, and yet was barely even discussed.

Revised Section 716

Next, because several people have asked, heres my take on the revised Section 716. The compromise language allows banks to keep making markets in swaps based on rates or reference assets that are authorized for investment in the Bank Powers Clause of the National Bank Act. Essentially, were going back to the "look-through" approach to the Bank Powers Clause, but only for swaps. In practice, this means banks can keep their market-making desks in:

• Interest-rate swaps;
• FX swaps;
• Cleared CDS referencing investment-grade names (e.g., CDS on GE, CDX.IG); and
• Swaps on gold, silver, copper, platinum, and palladium.

Banks will have to spin-off (into their broker-dealer affiliates) their market-making desks in: equity swaps, any remaining commodity swaps, energy swaps, CDS on non-IG names, and uncleared CDS on IG names. In reality, the bank-permissible swaps in Section 716 represent well over 90% of the swaps market, so the provision will have very little substantive effect. But in that case, why have Section 716 at all? Why create yet another arbitrary bifurcation in the regulatory regime for derivatives — the same kind of arbitrary bifurcation which, by the way, gave rise to the OTC derivatives market in the first place (i.e., swaps vs. options/futures, and the infamous Swaps Exemption)?

The answer, as everyone knows by now, is that Blanche Lincoln wanted to get re-elected, and in the end couldnt bring herself to admit that she had inserted an extremely ill-advised provision into the Ag Committee bill at the last minute. Its not something to be proud of.

The drafting in the revised Section 716 is also horrible in several places. For example, § 716(i)(3) states:

NO LOSSES TO TAXPAYERS.—Taxpayers shall bear no losses from the exercise of any authority under this title.

First of all, what the hell does "taxpayers shall bear no losses" even mean? No outlays of government funds? Are "losses" being measured over a year? 5 years? 10 years? And who determines the value of the benefits taxpayers received (which is necessary to calculate net losses)? More importantly, this provision was clearly supposed to read, "the exercise of any authority under this paragraph," since the provision was a subparagraph of § 716(i), which addressed the treatment of a swaps entitys swaps and security-based swaps in FDIC receivership. But because of poor drafting, it applies to all of Title VII — is the CFTC going to be limited in its expenditures? Who knows. The frustrating thing is that § 716(i) is completely superfluous anyway (it just directs the FDIC to comply with applicable law), and was very obviously included for political reasons. This is the kind of thing that belongs in a press release, not actual legislation.

So in the end, the revised Section 716 is acceptable, despite being (a) bad policy, and (b) very poorly drafted.

Volcker Rule

I was highly critical of the Merkley-Levin amendment in the Senate, and unfortunately, the conference committee used Merkley-Levin as a template in their Volcker Rule negotiations. The final version of the Volcker Rule (sec. 619) is slightly better with regard to the prop trading ban, but its still essentially a joke. The Streets lawyers will make short work of the prop trading language.

The conference committee fixed the language that would have allowed banks to simply move their prop desks to London, which is a positive. They also eliminated the exemption for trades done "in facilitation of customer relationships," which was an almost comically broad loophole. However, theres still no limitation on the definition of "market-making," which is still merely one of several categories of exemptions.

The conference committee also added more words to the "risk-mitigating hedging activities" exemption (§ 619(d)(1)(C)), but did nothing to actually narrow the exemption. Now the risk-mitigating hedging activity has to be "in connection with and related to individual or aggregated positions, contracts, or other holdings of the banking entity." This changes absolutely nothing about the banks analysis under this exemption. Just as before, a bank simply has to identify a risk that its facing — which will necessarily arise from "individual or aggregated positions, contracts, or other holdings of the banking entity" — and then justify the prop trade as a hedge against that risk. For the life of me, I cant think of a trade that would have been permitted under the previous "risk-mitigating hedging activities" exemption, but isnt permitted under the final language. And finally, the bill still includes the "catch-all" exemption for activities that "promote and protect the safety and soundness of the banking entity."

The final version inexplicably retains the illogical "conflict of interest" provision, which attempts to prohibit trades that "would involve or result in a material conflict of interest . . . between the banking entity and its clients, customers, or counterparties." This is simply incompatible with market-making, which the bill clearly and explicitly allows. It betrays a serious lack of understanding of the very concept of market-making. As a result, the Fed will now be forced to define "material conflict of interest" so narrowly that it will virtually never be applicable. Apparently this was Sen. Levins pet provision, which, really, is embarrassing for Sen. Levin.

Finally, Dodd-Frank includes the so-called "hedge fund carve-out," which is really a "hedge fund and PE fund carve-out." It allows banks to invest 3% of their Tier 1 capital in hedge funds and PE funds. From a policy perspective, I think this is a bad idea. I had this argument with several people while the hedge fund carve-out was being debated. Proponents argue that it makes it much easier to raise money for a hedge fund if the bank thats promoting the hedge fund to investors is willing to invest some of its own money in the fund as well. I agree, thats true. Hedge funds are often "black box" investments — theyre unwilling to reveal too much of their trading strategies to potential investors, out of fear that potential investors will simply steal their idea. To get investors comfortable investing in such "black box" hedge funds, the bank raising money for the fund will often invest some of its own money in the fund, as a show of good faith. In that sense, the "hedge fund carve-out" ensures that banks can continue to raise money effectively for hedge funds.

I dont dispute any of that. But is it really necessary for the financial system that we keep the hedge fund start-up machine well-oiled? I think not. So maybe 30 hedge funds instead of 40 launch per month. I certainly wouldnt lose any sleep, and I doubt Ben Bernanke or Tim Geithner would either. One thing we do not suffer from is a dearth of hedge funds (and I have lots of friends in hedge funds). Would it harm the hedge fund community? Marginally, yes. But thats not the same as saying it would be bad public policy.

But alas, the hedge fund community won the argument in the conference committee. To be honest, I consider capping the carve-out at 3% of Tier 1 capital to be something of a win — going into conference, the consensus on the Hill and on K Street was that the hedge fund carve-out would be capped at 10–15% of Tier 1 capital, and Im legitimately surprised that it was scaled back so much.

Available link for download

On the Leaked Volcker Rule

The American Banker leaked part of a draft of the regulators’ proposed Volcker Rule (pdf) last week, which has caused quite a stir. The first thing to note is that the American Banker did not leak the most important part: the text of the proposed rule. Instead, they leaked the “Supplementary Information” (which I call just the “Supplement”), the core of which is a lengthy, section-by-section analysis of the proposed rule. In addition, the leaked portion does not include the Appendices to the proposed rule, which, from reading the Supplement, appear to be very important — Appendix B, for example, contains a “detailed commentary regarding how the Agencies propose to identify permitted market making-related activities,” which is a core issue.

First I’ll give some general thoughts on the proposed Volcker Rule, and then, because I’m such a generous guy, I’ll go ahead and highlight some of the most important pressure points in the proposed rule.

General Thoughts on the Proposed Volcker Rule

In general, the proposed Volcker Rule appears to be very good: it’s a serious effort by a group of smart, market-savvy people to draw a workable distinction between market-making and proprietary trading. The regulators recognize the importance of both market-making and hedging, but they also recognize (most of) the places where market-making and hedging can bleed into proprietary trading. And in those situations, the regulators realize that any effort to distinguish impermissible prop trading from permissible market-making or hedging will — quite appropriately — require a very fact-intensive inquiry. That said, I’m still going to have to withhold my final judgment until I see the actual text of the proposed rule.

Also, even though the WSJ keeps trying to gin up controversy over the proposed Volcker Rule allowing hedging on a portfolio basis, the regulators note in the Supplement that allowing hedging on a portfolio basis is “consistent with the statutory reference to mitigating risks of individual or aggregated positions” (emphasis in original). I explained this a couple of weeks ago; it is a faux-controversy. Moreover, prohibiting banks from hedging on a portfolio basis is a monumentally stupid idea in the first place — it would make risk managers’ jobs 100 times harder, introduce all sorts of new risks into banks’ books (counterparty risk would skyrocket), and dramatically raise hedging costs. This is one thing that the statutory text of the Volcker Rule actually got right.

Some Pressure Points in the Proposed Volcker Rule

Now, to the nitty-gritty of the proposed rule. Here some of the major pressure points in the proposed Volcker Rule that I see:

1. Hedges must be “reasonably correlated” to the underlying risk: In defining “risk-mitigating hedging activity,” the rule requires that the hedge be “reasonably correlated” to the underlying risk(s). The Supplement implies that the correlation must be reasonable at the outset of the hedging transaction, which is absolutely appropriate — a lot of times, you think a trade will be a good hedge when you put the trade on, but because of circumstances beyond your control, it turns out not to be a very good hedge (e.g., liquidity may unexpectedly dry up in either the underlying or the hedge, screwing up the normal correlation).

The real question here is: in normal market conditions, when does the correlation between the hedge and the underlying become “unreasonable”? In other words, how much leeway will banks have in determining how to hedge their books? Say a bank enters into a swap that only hedges 50% of the DV01 of the underlying bond. Would that be considered “reasonably correlated” to the underlying risk? (Obviously, I’m simplifying my examples for illustrative purposes.) After reading the Supplement, I strongly suspect that I know what the regulators’ answer would be: it depends on the particular facts and circumstances. If, for example, the swap was coupled with another transaction that hedged the remainder of the DV01 of the underlying bond, then both transactions would be permitted, because when viewed together, they were both part of a legitimate hedging strategy.

The Supplement also hints at what regulators would NOT consider to be “reasonably correlated” — it states that “[a] transaction that is only tangentially related to the risks that it purportedly mitigates would appear to be indicative of prohibited proprietary trading” (emphasis mine). I think it would be a stretch to say that regulators intend to consider any transaction that’s more than “tangentially related” to be a “reasonably correlated” hedge. But this at least indicates that regulators won’t simply accept a hand-waving, “trust me, they’re related” response to inquiries about the appropriateness of a hedge.

In the end, what we know is that a permissible hedge must be less than “fully correlated” but more than “tangentially related” to the underlying risk, and that if the appropriateness of a hedge is questioned, it will be a very fact-intensive inquiry. Which, by the way, is the way it should be.

2. “Additional significant exposures”: The proposed rule prohibits hedges that themselves introduce significant, unhedged exposures. However, the Supplement also states that:

“[T]he proposal also recognizes that any hedging transaction will inevitably give rise to certain types of new risk, such as counterparty credit risk or basis risk reflecting the differences between the hedge position and the related position; the proposed criterion only prohibits the introduction of additional significant exposures through the hedging transaction.”

There are actually three potential flashpoints in this prong. The first flashpoint is what constitutes “additional significant exposures.” How significant does the new risk that the hedging transaction is introducing have to be before regulators will require it to be hedged as well?

The second flashpoint is what constitutes mere “basis risk,” and what constitutes an impermissible residual risk. The Supplement says that a hedge that merely introduces counterparty or basis risk is permissible. Here’s what I would tell our trading desks if I were still working at an investment bank: start calling every residual risk a “basis risk.” Basis risk evidently doesn’t need to be hedged under the proposed Volcker Rule, regardless of how significant the exposure is. So if you want to profit from the price movement in a certain risk, then just partially hedge the risk with another transaction and call the residual risk “basis risk.”

The third flashpoint has to do with when the “additional significant exposure” must be hedged. The Supplement states that if a hedge introduces a significant new exposure, then the exposure must be hedged “in a contemporaneous transaction.” Assuming that regulators will allow banks some time to hedge the new exposure, the question becomes how much time will they have to hedge the new exposure? An hour? A day? A week? I strongly suspect that the regulators’ answer will be that banks will have to hedge the new exposure “as fast as humanly possible” (not in those words, obviously — the legislative language will probably be something like “as quickly as technologically practicable.”)

3. “Bona fide liquidity management”: This is where I would go first if I was trying to circumvent the Volcker Rule. The statutory text of the Volcker Rule defines proprietary trading in a very roundabout way, such that the real definition of proprietary trading is in the definition of a “trading account.” However, the proposed rule provides an exclusion from the definition of a “trading account” for accounts that are use “to acquire or take a position for the purpose of bona fide liquidity management, so long as [five] important criteria are met.”

The reason I would go here first if I was trying to circumvent the Volcker Rule is that if a trade could fit under the “bona fide liquidity management” exclusion, there would be no need to bother with any of the more complicated “permitted activities” exceptions, and evidently, no need to report nearly as much, if any, quantitative trading data to regulators.

The proposed rule requires that trades done under the liquidity management exclusion be done according to a “documented liquidity management plan” that meets five criteria. But none of the five criteria in the proposed rule appear to me to be prohibitive if a bank wanted to use the liquidity management exclusion for prop trades. The plan has to “specifically contemplate and authorize any particular instrument used for liquidity management purposes” — fine, just write a liquidity management plan that contemplates the use of a (very) wide range of instruments (a lot of instruments have reasonably liquid markets in normal times). The second criterion basically requires that an instrument used for liquidity management not be used “principally” for prop trading purposes, which is easy, since prop trading is prohibited regardless of whether it’s the “principal” purpose of the instrument.

The third criterion requires the liquidity management plan to be “limited to financial instruments the market, credit and other risks of which are not expected to give rise to appreciable profits or losses as a result of short-term price movements.” This criterion simply can’t be enforced terribly stringently — even Treasuries, which are the core of any serious liquidity pool, often experience significant short-term price movements. Fourth, the plan would have to limit liquidity management positions to “an amount that is consistent with the banking entity’s near-term funding needs.” This also can’t be seriously enforced, because it would directly conflict with Basel III’s new Liquidity Coverage Ratio (LCR), and cautious liquidity management in general. Finally, the plan would have to be “consistent with the relevant Agency’s supervisory requirements ... regarding liquidity management.” Seeing as the new liquidity rules set a floor on a bank’s liquidity management, and not a ceiling, using instruments that don’t qualify for the LCR in a broader liquidity management plan would certainly still be “consistent with” the regulators’ liquidity requirements.

4. “Near term” / “Short term”: The statutory text of the Volcker Rule effectively defines a proprietary trade as any trade done “principally for the purpose of selling in the near term.” While the Supplement doesn’t provide much detail on what constitutes “near term,” it does hint at an answer: 60 days or less. The proposed rule will apparently include a rebuttable presumption that any account used to take a position that is held for less than 60 days will be considered a “trading account.” Therefore, it stands to reason that accounts which are used (exclusively) to take positions that are held for longer than 60 days will not normally be considered “trading accounts,” and thus not subject to the Volcker Rule. But, of course, I strongly suspect that the regulators will say that this determination is ultimately going to be based on the particular facts and circumstances of the trade.

Anyway, there are a few more pressure points like this in the Supplement, but that’s all I have time for right now.

Available link for download