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Ready for the Land Mines Embedded in Dodd-Frank?

Jennifer Parker | Special to CNBC.com
Thursday, 15 Nov 2012 | 4:10 PM ET

While legislators finalize provisions of the Dodd-Frank law that take effect in the spring, Wall Street is preparing to take a financial hit. Why? Because Dodd-Frank is expected to be especially costly at a time when investment banks are already laying off thousands of workers.

Saul Loeb | AFP | Getty Images

As a result, both regulators and bankers say that rules intended to bolster the U.S. financial system could instead undermine it.

Dodd-Frank's Volcker rule and "Title 7" derivative rules are at the heart of the controversy. Both provisions target trading activities in an effort to curb unrestrained leverage and protect banks' ability to lend. But at what price?

"There are definitely questions about what the profitability of trading activity will be in a Dodd-Frank world. Trading operations are being radically resized throughout Wall Street in response to the regulatory environment," said Dean Ungar, financial services analyst for UBS . The Swiss bank announced plans to fire 10,000 bankers last month, as it abandons much of its fixed income trading operation, and joins a long list of banks in radical downsize mode, including RBS, Deutsche Bank, and Bank of America.

The potential cost as banks adjust to the new regulations is not yet known, but some experts say it could range into the tens of millions of dollars. Line items, however, are starting to add up: hundreds of compliance lawyers, new computer systems and IT personnel.

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"Wall Street has spent enormous resources in direct costs of Dodd-Frank," said Ken Bentsen, executive vice president of public policy at the Securities Industry and Financial Markets Association. "Broker dealers and asset management companies will spend millions on interpreting what the rules may mean, and then adjusting their systems, documentation, and trading to comply."

For instance, regulations prompted Goldman Sachs to launch "GSessions," an electronic trading system for corporate bonds this year, and plans to add more platforms tailored to equities and fixed income, according to CEO Lloyd Blankfein.

The explicit costs of new hires or new trading systems are ones banks can anticipate. The implicit costs, however — like a loss of liquidity and narrower profits margins — are unknown, and may ultimately be most onerous.

For example, derivatives reforms under Dodd-Frank's Title 7 are likely to be costly to the largest banks, according an International Monetary Fund report.

"Customized derivatives, which have been a product with high profit margins, will be replaced to a large extent by standardized derivatives, which will tend to have lower profit margins as a result of the greater competition and transparency," according to the IMF report.

They may have put it mildly. New derivatives regulations under Title 7 mandate that all over-the-counter (OTC) transactions must be moved onto an exchange and cleared through central clearinghouses, which will require counterparties to post collateral — or in finance parlance, margin.

"The OTC derivative requirements are the biggest costs of Dodd Frank. If they go through as planned, the costs of margin requirements will dwarf by orders of magnitude the legal fees and hiring compliance people," said Bruce Kraus, a former officer at the SEC, now partner at law firm Kelley Drye & Warren.

Dodd-Frank targets derivatives because they are characterized by high leverage, and OTC derivatives in particular because they have never been regulated. This means large pockets of financial activity were happening in the dark. The concern is what we'll find when the lights turn on.

"Mandated OTC swap [derivatives] clearing is coming, but clients aren't ready for it," reads November's Morgan Stanley research report, which also calls related margin costs "a critical area of investor concern."

If that's not concerning, read the Volcker rule.

Signed into law in 2010 as part of the Dodd-Frank Act, the Volcker rule prohibits banks from proprietary trading, and caps bank ownership in hedge funds and private equity funds at 3 percent.

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Writing the law was one thing — but enforcing it is quite another. The government agencies tasked with the law's enforcement, including the Securities and Exchange Commission, the Federal Deposit Insurance Corporation and the Federal Reserve Board, had to define proprietary trading and decide how to police it.

"Applying Volcker is like doing surgery. It's a really delicate operation. Too much or too little, and you're going to kill the patient," said Kraus.

Bankers are now reviewing the proposals, due to take effect next spring. Their worry is that standard business activities such as market making, hedging and risk management — originally permitted by Congress — will become suspect because they entail trading with the bank's money (as does proprietary trading).

"The rule as proposed would inappropriately curtail market making," said Bentsen. "They think by this rule they can go after what may be 1 or 2 percent of the problem, but it affects 97 percent of allowable activity."

Market-making is the matching of buyers and sellers of non-exchange traded securities. To put it in context, if the practice were to go away tomorrow, so would the entire bond market, from Treasurys to the mortgage-backed securities that underpin the U.S. housing market. Market-makers keep the financial markets running because they are the middlemen, quoting bid and offer prices.

Though regulators have tried to draw separating lines, the only agreed-upon distinction between prop trading and other activities is intent, which, short of a "prop desk" sign on the door, is difficult to detect.

In bankers' simplest terms, the intent of a prop desk is to take risk and make money. The intent of a market maker is to match buyers and sellers, and earn a fee off each transaction. The intent behind hedging is to protect against losses.

The problem: the transactions look the same, even if intents change.

Take the JPMorgan's London Whale, for example. The scandal behind the $2 billion loss was that a trader with "prop desk" intent was operating under the auspices of hedging.

"Prop trading and normal market making are virtually indistinguishable," said Phillip Swagel, co-chairman of the Bipartisan Policy Center's financial regulatory reform initiative. "If they can find a border between them, the Volcker rule will be a useful risk management tool. But my worry is that regulation done poorly could make the market less liquid, and ultimately hurt people relying on the financial system."

If you can't define it, you can't regulate it, but either way, the law is passed, leaving the burden of proof to fall on regulators, and the burden of costs on Wall Street.