The Volcker Rule: Return of the Fabulous Fab

Regulatory 20 Feb 2012

The comment period has closed on the “Volcker Rule,” that is, the Securities and Exchange Commission’s proposed rule implementing the Dodd-Frank Act’s mandate for curbs on the proprietary trading of commercial banks and their affiliates.

From our point of view at AllAboutAlpha, some of the more intriguing comments came from parties addressing an issue that was briefly on the front-burner of national politics in the spring of 2010 due to entertainingly worded e-mails written by Goldman Sachs trader Fabrice Tourre. In one of them, Tourre refers to himself as the “Fabulous Fab,” and as someone who didn’t understand “all of the implications of these monstrosities.”

The monstrosities in question were the ABACUS trades, in which Goldman offered to serve as the bookie and allow customers to take bets for or against the credit worthiness of homeowners, but through which Goldman ended up placing its own money heavily on the short side of that bet. As Tourre wrote in June 2006, “ABACUS enables us to create a levered short in significant size.”

Because of the furor over ABACUS and analogous transactions, the legislative mandate of the Volcker rule came to include a section 619, telling the SEC to ban underwriters or sponsors of asset-backed securities from engaging “in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity.”

Deadline-Beating Comments

The comment deadline arrived with a bang, 140 comments arriving at the SEC on Monday, February 13. Among them are the arguments and observations of the American Bankers Association, the Managed Funds Association, the CME Group, a Mexican regulatory body, and… the rule’s namesake, former Federal Reserve chairman Paul Volcker.

Much of the debate involves the continued participation of covered banks in legitimate market making activities. Richard Baker, former congressman and now president of the MFA, for example, said in his letter Monday, “[I]t is critical for banks and broker-dealers to continue to be able to maintain sufficient levels of inventory and engage in appropriate hedging activities in connection with their market making functions.” Baker is concerned that a rigid formulation of the Volcker rule will make it impossible for the market makers to meet reasonably anticipated demand for the range of assets trading in contemporary markets.

A comment from the American Securitization Forum hit at the ABACUS furor more directly. It asked that the rule be re-worked to make clear that a short position is lawful so long as “the conflict is managed through meaningful disclosure” and is designed to manage risk exposure on a delta-neutral basis. It quotes Senator Carl Levin’s observations in the Congressional Record (July 15, 2010):

“But a firm that underwrites an asset-backed security would run afoul of the provision if it also takes the short position in a synthetic asset-backed security that references the same assets it created. [Emphasis added by ASF]. In such an instance, even a disclosure to the purchaser of the underlying asset-backed security that the underwriter has or might in the future bet against the security will not cure the material conflict of interest.” This reflects a narrower concern than the “broad-based prohibition on synthetic ABS” that ASF sees in the SEC’s “proposed interpretive framework.”

Foreign Banks

Extra-territorial consequences are also much on the minds of many commenters. Mexico’s Comision Nacional Bancaria y de Valores, that country’s regulator of “deposit-taking institutions, broker-dealers, mutual funds, and securities markets” expressed concern that “certain provisions within the rule may entail unintended consequences that could very well have a negative impact on U.S., Mexican, and international financial markets….”

It is concerned in particular that foreign banks will not be able to use the Fed’s discount window when they (the foreign banks) act as “swap entities.” Many foreign banks operate uninsured branches in within the U.S., which engage in swap dealing, and thus are required to register with either the SEC or the Commodity Futures Trading Commission, and to deprive those banks of access to the discount window is, according to this Mexican agency, “asymmetric and detrimental to the strengthening of either the US or global financial markets’ stability.”

Volcker

As noted, Paul Volcker also stepped up to the plate Monday, and restated the reason for the creation of a rule that seeks to close down the prop desks of commercial banks. In the financial crisis of 2007-08, although proprietary trading was not the sole precipitating factor, it did undermine “some of our most systemically important institutions” and it is “not an essential commercial bank service that justifies taxpayer support.”

Volcker acknowledges that defining the character of “market making” vis-à-vis prop trading is in conceptual terms a thorny issue. Nonetheless, he is confident that both bankers and those who must regulate them know which is which when they see it.

“Holding substantial securities in a trading book for an extended period obviously assumes the character of a proprietary position, particularly if not specifically hedged.” Furthermore, the problem of protecting the market makers has been over-emphasized, since Volcker writes, “only a very few very large banking organizations engage in continuous ‘market making’ on any significant scale.”

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