By Dave Clarke and Jonathan Spicer
(Reuters) – Regulators hashing out the details of a new ban on proprietary trading are wrestling with internal disagreements over how much leeway to give banks when it comes to their ability to hedge risk, according to people familiar with the negotiations.
The ban is known as the Volcker rule, named after former Federal Reserve Chairman Paul Volcker. It will prohibit banks from trading for their own profit in securities, derivatives and certain other financial instruments, and ban their investing in or sponsoring hedge funds or private equity funds.
The rule was one of the most controversial parts of the 2010 Dodd-Frank financial oversight law.
Some supporters of the ban have pointed to last week’s arrest of a UBS London rogue trader — whose unauthorized trades resulted in a $2.3 billion loss — as evidence of urgent need for the Volcker rule.
A key focus for Wall Street has been the exemption for trades used to hedge against risk from the various positions and assets held by banks.
Proponents of the measure want the hedging exemption drawn as narrowly as possible for fear it will serve as a loophole for proprietary trading, while banks argue a broader interpretation is needed so they can hedge against an array of risks.
As five regulatory agencies prepare a proposed rule, expected in early October, there have been internal disagreements over how broadly the exemption should be crafted.
The Office of the Comptroller of the Currency has pushed to give banks more leeway to hedge against the overall risks facing portfolios, such as those related to the economy and market risk, said three people with knowledge of the discussions.
On the other side of the debate the Federal Deposit Insurance Corp, the Commodity Futures Trading Commission and the Securities and Exchange Commission have advocated for a tighter interpretation of the law that would, for the most part, require banks to more closely map a hedging position to an individual or small group of trades done on behalf of customers, according to these people.
Draft language on the rule being circulated in August laid out the two sides but left the issue unresolved, said a person who viewed the language.
The Federal Reserve, whose position is now seen as having the most weight, has been less committed to one side but agency officials appear to be leaning, along with the Treasury Department, toward the broader interpretation advocated by the OCC, according to these people.
The agencies declined to comment before the rule has been released.
It is possible regulators will punt on the issue when the proposed rule is released in October, and instead seek more public comment on hedging.
The Volcker Rule will have the most impact on the biggest U.S. banks which dominate the trading business, such as Goldman Sachs, JPMorgan Chase and Bank of America.
Billions of dollars are potentially at stake.
Trading revenue, already falling this year, tallied $17 billion in the second quarter for bank holding companies, according to a recent report by the OCC.
THE UBS EFFECT
Adding a new element to the debate is last week’s arrest of Kweku Adoboli, a London-based UBS trader, on charges of fraud and false accounting dating back to 2008.
Supporters of the Volcker rule have pointed to the incident as evidence of lax internal bank oversight, and reason for U.S. regulators to take a tough stance on proprietary trading.
“Banks and brokerage firms were doing a great job of convincing congressmen, the media and other people that the rules have gone too far,” said Andrew Stoltmann, a Chicago-based securities lawyer and investor advocate, at Stoltmann Law Offices. “Now that the UBS trading bomb went off, I think the attention has been shifted back to a need to implement these regulations.”
With the U.S. economy still struggling to recover from a deep recession, regulators are also staring down the argument from banks and Republicans that a tough Volcker crackdown will further restrict lending and limit chances for growth and new jobs.
Banks have called the ban on proprietary trading unnecessary and exceedingly difficult to implement because it is hard to distinguish between trades being done for clients as opposed to solely for the bank’s profit.
Supporters of the ban say it will make banks, which enjoy government support through deposit insurance and access to Fed funding, less risky and force them to focus more on their customer needs.
When drafting the law, Volcker supporters recognized the need to allow hedging but tried to narrowly draft the exemption so that such trades directly offset client trades.
“Regulators must monitor and evaluate the hedging activities that firms claim to have undertaken at risk mitigating measures to ensure that they are not used as vehicles for hidden proprietary trades,” Democratic senators Jeff Merkley and Carl Levin, who drafted the Volcker rule language in the law, said in a letter to regulators in November 2010 when government agencies first started working on the rule.
Banks have pushed back, arguing that it will be very difficult to do any type of “one-to-one” hedging and that institutions need to be able to hedge against broader risks facing their portfolios. Such “portfolio” hedging is common now on Wall Street.
“Few transactions present only a single risk; most present a series of risks that may include, among others, market risk, interest rate risk, credit risk and currency risk,” the Securities Industry and Financial Markets Association wrote regulators in November 2010.