Prop Trading Is Back: Fed Considers "Significant Rewrite" Of Volcker Rule

Nearly 7 years after it was first implemented, the Volcker Rule - which sought to put an end to prop trading by FDIC-insured banks (i.e., those who are funded with deposits among other sources of capital) - is about to be phased out, and prop trading is about to become one of the most desired jobs on Wall Street again.

As Reuters reports, the Fed's chief regulator said Monday the nation’s regulators are actively considering a significant rewrite of the "Volcker Rule."

In a Washington speech before the Institute of International Bankers entitled "The Federal Reserve’s Regulatory Agenda for Foreign Banking Organizations: What Lies Ahead for Enhanced Prudential Standards and the Volcker Rule" , Fed Vice Chair for Supervision Randal Quarles, told bankers that regulators want to make“material changes” to streamline and simplify several aspects of the ban on certain bank trading, put in place after the 2007-2009 financial crisis.

He added that certain foreign funds currently exempt from the rule’s requirements will likely remain exempt while changes are considered.

Here are the key parts from his speech:

Not to put too fine a point on it, but I believe the regulation implementing the Volcker rule is an example of a complex regulation that is not working well.

The fundamental premise of the Volcker rule is simple: banks with access to the federal safety net--Federal Deposit Insurance Corporation insurance and the Federal Reserve discount window--should not engage in risky, speculative trading for their own account. Whatever one's view of this basic premise, it is the law of the land. Taking that premise as a given, we have to ask how to improve the framework of the implementing regulation to make it more workable and less burdensome in practice from both a compliance and supervisory perspective.

I think we all can agree that the implementing regulation is exceedingly complex. As one example of specifics, among many, the statute and implementing regulation's approach to defining "market making-related activities" rests on a number of complex requirements that are difficult or impossible to verify objectively in real time. As a result, banks spend far too much time and energy contemplating whether particular transactions or positions are consistent with the Volcker rule.

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What are some of the improvements that we are thinking about that would be possible within the regulation itself? As an initial matter, it should be clearer and more transparent what is subject to the Volcker rule's implementing regulation and what is not. The definition of key terms like "proprietary trading" and "covered fund" should be as simple and clear as possible. It should not be a guessing game or require hours of legal analysis of complex banking and securities regulations to determine if a particular entity is a covered fund. It should not happen--although it has happened--that our supervised firms come to us and ask questions about whether a particular derivative trade is subject to the rule, and we cannot give them our own answer or a consistent answer across the five responsible agencies. Supervisors need to be able to provide clear and transparent guidance on what is covered by the Volcker rule and what is not. This would benefit not only the firms, but the supervisors at the agencies as well.

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As a final but no less important matter, we are considering broad revisions to the Volcker rule compliance regime. We would like Volcker rule compliance to be similar to compliance in other areas of our supervisory regime. As I noted earlier, we appreciate the broad extraterritorial impact of the rule in its current form on foreign banks' operations outside of the United States. Accordingly, we will be looking for ways to reduce the compliance burden of the Volcker rule for foreign banks with limited U.S. operations and small U.S. trading books.

While Quarles did not explicitly state it, his speech confirms what banks have known for over a year: prop trading will now be once again permitted, even if regulators pretend to be far more careful with it. Of course, what this means is that bank traders will just find new and improved ways to hide the risk they are taking, until eventually everyone is on the same side of the boat, and a big wave arrives, prompting new and improved demands for a bailout.

That said, prop trading's return is hardly a surprise: some banks, such as Goldman and Deutsche, have been quietly doing it for years, under the guise of "hedging", only to admit in quarterly earnings calls that their prop trades went spectacularly wrong resulting in "one-time" hits to the P&L.

Expect much more of that in the coming quarters now that the Fed has implicitly blessed risk-taking by depository institutions.