Ready for the Land Mines Embedded in Dodd-Frank?
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.