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Explainer: Paul Volcker’s rule

Paddy Hirsch Dec 4, 2013

Banks are bracing themselves. Next Tuesday we may finally witness the rollout of the completed Volcker Rule … and so …

Q. What’s the Volcker Rule, again?

Back in 2010, former Fed Chairman Paul Volcker proposed curbing excessive risk-taking by banks by banning proprietary trading. Nice and simple, he thought: A policy that should be about four-pages long.

Q. 2010? That’s nearly four years ago! Why hasn’t it happened yet?

Today, the Volcker Rule looks a bit like a neutered dog: It has swollen to a tremendous size – nearly 1,000 pages covering 400 regulations – and it has lost almost all its aggression against the banks. Almost everyone complains that the rule doesn’t define two key terms: Hedging or market-making. This effectively means that there is a giant loophole in the law, through which any half-decent banking lawyer will be able to drive a battle tank.

Q. Hedging and market-making? What are they? And why are they so important?

Hedging and market-making are two key functions performed by banks of all sizes all over the world.

A hedge is essentially an insurance contract: In the same way that I make an investment (paid monthly to an insurance company) to protect myself if something goes wrong with my car (like if it gets stolen); so too do banks insure themselves by making investments (say, buying gold) that they hope will do well in the event other investments do badly (like the stock market collapses).

Market-making is what the banks do to assist their clients who want to buy or sell stocks and bonds. The banks want to be sure that they can find the securities their clients want – or find a buyer for stuff clients want to sell – and at a reasonable price. To make that happen, banks sometimes “make the market,” by buying those securities themselves, in order to ensure supply or demand.

Q. How are these different from proprietary trading?

Proprietary trading is different from both hedging and market-making (also known as principal trading), because it’s done purely to generate profits for the bank. Prop trading will look similar: The bank will make an investment, but the motive will differ. The motive for hedging is insurance; the motive for market-making is to better service clients; the motive for prop trading is purely to make a profit for the bank.

Q. So if they all look the same, how can you tell the difference?

By following the money. In this story about the JP Morgan London Whale scandal, professor Andrew Lo says by looking at how the people who make these investments are compensated, you can see what their motives were, and thus determine whether they’re hedgers, market-makers or proprietary traders.

There is one very simple question that you can ask — which has a definitive answer — about the small number of individuals who were responsible for managing this group at JP Morgan and putting on the specific trades that lost these large amounts of money. That question is: How were they compensated on an annual basis? Were they paid a salary and a bonus, and was the bonus a function of the profitability of the group, or was the bonus a function of the hedging ability of the group? If you can answer this question — and it definitely has an answer to it; it’s not a metaphysical question — you will have your answer as to whether it was proprietary trading or hedging. I don’t know the answer, but I know the answer exists, and I know that certainly the government can get that answer with a single phone call.

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