Thursday, January 27, 2011

More on the Volcker Rule Study

A bit more on the FSOC’s Volcker Rule study (pdf). The FSOC makes a number of recommendations for designing an enforcement mechanism for the Volcker Rule — some better than others.

As an initial matter, the FSOC recommends that banks be required to give regulators certain information about each trading desk, most importantly:

- a listing of the types of products approved for transactions;

- a description of how positions are hedged; and

- a description of the activity typical of the customer base.
While I think this is a good idea, and it’s important for regulators to have this information, I wouldn’t focus too heavily on deviations from normal trading practices/procedures. If a bank wants to build up a proprietary position in equities, it’s not going to do it from the MBS desk; it’s going to do it from an equities desk. So there likely won’t be a deviation from the types of products used on the desk. And in fact, sometimes trading desks do actually use products for which they’re normally not approved as part of legitimate hedging strategies. For example, a fixed-income desk trying to hedge its largest counterparty exposure may have to resort to buying puts if, say, they can’t buy enough CDS protection to cover the counterparty exposure (or if they can’t get one of the bank’s super-sweet in-house lawyers to scare the counterparty into politely negotiate a better CSA).

More promising are the quantitative metrics. As I’ve noted before, “there are signals which are indicative of proprietary trades, and market-making trades can be distinguished from proprietary trades by looking at those signals.” The FSOC study proposes a surprisingly broad array of quantitative metrics, which I think is encouraging. If I was designing the Volcker Rule enforcement regime (which, thankfully for all of us, I am not), I would focus less on the risk-based quantitative metrics, and more on the inventory and customer-flow metrics.

The most straightforward — and, incidentally, most effective — metric will be “inventory turnover,” which the FSOC study discusses on pp. 39–40. For liquid instruments, inventory turnover should be relatively predictable over time, and if a trader decides to build up a proprietary position, it should usually show up as a deviation from the normal inventory turnover rate for that desk. Of course, it may be difficult for regulators to establish an accurate baseline inventory turnover rate, seeing as most market-making desks already operate with some level of proprietary overlay. I don’t have a good way for regulators to ensure that their initial baseline inventory turnover rates are accurate, unfortunately. (Or, at least, I haven’t thought of one yet. Don’t worry though — despite what they may think, traders aren’t that clever.)

Customer-flow metrics will also be reasonably effective in distinguishing proprietary trades from market-making trades. As the FSOC study notes:

These metrics evaluate the volume of customer-initiated orders on a market making desk against those orders that are initiated by a trader for the purposes of building inventory or hedging. Significant trader-initiated, rather than customer-initiated, order volume could indicate that impermissible proprietary activity has occurred.
“Customer-initiated flow to inventory,” which measures the volume of a desk’s inventory relative to the desk’s average customer-initiated trades, can be particularly revealing. The average volume of customer-initiated trades can provide regulators with a rough measure of how big an inventory the desk should be carrying, and a noticeable swelling of a desk’s inventory can be indicative of proprietary activity.

In any event, those are the metrics that I would focus on if I was designing the Volcker Rule enforcement regulations.

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