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Why the Volcker Rule Is Now 233% Longer – Shah Gilani – Money Morning

This is a syndicated repost courtesy of Money Morning. To view original, click here. Reposted with permission.

Let’s talk about the so-called Volcker Rule.

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When the Dodd-Frank Act was signed into law in 2010 – the bank-busting, save the system, “we’ll never again have a financial meltdown that could destroy the world” legislation – it was more of an outline.

The ostensible idea, in the aftermath of the credit crisis, was to give regulators time to write sensible rules and not throw the baby out with the bathwater. Yeah right.

Of course, the real deal was about giving banks and financial services institutions time to fight every rule and regulation, from first drafts to final implementation.

Along the way, it was proposed that banks should spin off their risky businesses into separately capitalized companies, in the form of what an investment bank or a merchant bank used to be. That way they could play hard and fast. And if they failed, tough luck, you’d be on your own. Meantime, the sister bank would have Federal Deposit Insurance Corporation (FDIC) insurance to cover its depositors and make loans and do traditional bank things. Boring and stuffy bank things.

The Obama administration didn’t go for that. President Obama, for all his bluster about bad banks needing a spanking, didn’t go for that.

Obama advisor Paul Volcker – himself one the most revered and celebrated Federal Reserve Chairmen in the institution’s 100-year history – wanted the separation of gun-slinging banks from insured depository institutions. He suggested banks stop proprietary (or “prop”) trading altogether. (That’s betting the house’s money to make outsized gains to enrich the homeboys who are pulling leveraged levers for fun and profit.)

That suggestion became known as the Volcker Rule.

There’s still no finished Volcker Rule. When I wrote about it 18 months ago, it was 300 pages long (see “Why the Volcker Rule Is a Cop-Out and a Joke“). There’s now a 1,000-page draft circulating with all kinds of marks and bruises all over it. But it’s not done, not nearly done. It’s one rule.

Part of the problem is that banks and bank lobbyists and Congressmen in the banks’ pockets are trying to stymie what they don’t like, meaning the rule itself.

But the bigger problem is this: No fewer than five regulatory agencies are collaborating on the rule.

The Fed and the U.S. Securities and Exchange Commission (SEC) want to cut banks as wide a highway as they can, so banks aren’t “hindered” from doing what they do that facilitates smooth-running capital markets. The U.S. Commodity Futures Trading Commission (CFTC) and the FDIC want to fill in the loopholes being written into the rule. The Office of the Comptroller of the Currency (OCC), they’re clueless anyway, so they’re just reading drafts over lunchtime martinis.

It all comes down to banks wanting to conduct “important functions” – such as market-making and hedging – without stupid restrictions. After all, market-making is not proprietary trading, they say, and hedging, well, that’s hedging, they say.

Of course, that’s all a load of BS. Here’s what’s really going on.

I was a market-maker (that’s an official stamp) on the Floor of the Chicago Board Options Exchange. And I was the hedge trader for one of the world’s biggest banks. Let me tell you what market-making is and what hedging is… really:

  • Market-making is when you are supposed to make a two-sided market. It’s your job to simultaneously bid and offer for a stock, an option, a commodity, whatever.

I’ll use stocks as an example. If you (supposing you’re a broker or dealer or floor trader) ask me for a “quote,” I have to give you a price I would buy the stock at and a price I would sell you the stock at and how much stock I am willing to buy or sell.

You might want to ask a bunch of market-makers what their quotes are (or these days you see what their quotes are on your computer screen), and you try to buy at the lowest price being offered by some market-maker or sell at the highest price some other market-maker is quoting.

Market-making is all about taking risks. Market-making is itself proprietary trading. You want to buy stock, and I sell you stock. I did that to facilitate you. But in doing so, I took a position, I sold you stock, maybe I sold you stock I didn’t own, so I shorted the stock to you. I am now short the stock. I have a position. I have a proprietary trade.

Let’s say you’re a big customer and you want to buy a ton of stock from me. I will go out and amass a huge position, because I’m going to facilitate you. I’m making a market for you. I’m taking a huge risk building up a position that you said you want to buy. What if you don’t buy that position I’ve built up? What if I made up the fact that I had a customer that I needed to facilitate? What if I just wanted to pretend I was making a market but really wanted to amass a huge position to make money for my trading desk, for my bank, for my bonus pool?

How on earth are regulators going to know if banks are taking proprietary positions and just calling them client-related positioning or market-making? They aren’t. It’s a giant loophole.

  • Hedging? Let me say this about that. Hedging is when you have an at-risk position and you don’t like the risk. So, instead of just dumping the risk position (which is better than hedging), which you may not be able to do or unwilling to do for any number of reasons, you put on a hedge. A hedge is another position that makes money if your other position loses money. A perfect hedge (which is very hard to accomplish) means you don’t lose any money. You don’t make money, but you don’t lose money. An imperfect hedge will result in you probably losing some money, and once in a blue moon, you can make a little money on a hedge.

If you’re a bank, though, you can make a ton of money on a hedge, or you can lose a ton of money on a hedge.

Why? Because you weren’t really hedging. You were saying you were hedging. But you were taking another position with a lot of risk to make money on that part of your hedge.

You weren’t hedging. You were lying about hedging. You were prop trading.

That just happened. The JPMorgan “Whale” trade in London, the one that lost them $6.5 billion, that was a “hedge” trade. Yeah, that’s what they called it. It was a hedge trade that went bad. That was a prop trade lipsticked-up and called a hedge trade.

Market-making and hedging are both loopholes. They will be used to prop trade. It’s that simple.

Treasury Secretary Jacob Lew is pushing hard to get the Volcker Rule done by year-end, this year. But the Fed now wants to give banks until July 2015, instead of 2014, to implement whatever it looks like.

If the rule ends up being 1,000 pages, you can guess why it’s that long. It’s that long so that there will be enough fine-print loopholes in it to give banks what they want… the ability to prop trade and not call it proprietary trading.

The only thing I can tell you for sure about this pending Volcker Rule is this: When it comes out, I will read it and I will spell out for you where the loopholes are and how banks will use those loopholes.

That much I can promise you.

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Wall Street Examiner Disclosure: Lee Adler, The Wall Street Examiner reposts third party content with the permission of the publisher. The opinions expressed in these reposts are not those of the Wall Street Examiner or Lee Adler, unless authored by me, under my byline. I curate posts here on the basis of whether they represent an interesting and logical point of view, that may or may not agree with my own views. Some of the content includes the original publisher's promotional messages. No endorsement of such content is either expressed or implied by posting the content. All items published here are matters of information and opinion, and are neither intended as, nor should you construe it as, individual investment advice. Do your own due diligence when considering the offerings of information providers, or considering any investment.

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