Wednesday, March 23, 2011

Goldman, the Volcker Rule, and Principal Investing

A report by BofA banking analyst Guy Moszkowski got a lot of attention yesterday, because Moszkowski claimed in the report that Goldman had a more aggressive interpretation of the Volcker Rule with regard to principal investing than the rest of the market. Specifically, Moszkowski said that:

“the market interpretation of Volcker rules is that [non-fund principal investing] will be off-limits ahead, but GS believes that many such investments will remain permissible, and will be closing on a ‘meaningful’ one in China shortly.”
I have no idea what Moszkowski is talking about. It’s absolutely not the “market interpretation” that the Volcker Rule will prohibit non-fund principal investing. Exactly the opposite. The Volcker Rule does not prohibit non-fund principal investing; it’s not even a close call. Nor, by the way, was it intended to. This was well understood during the financial reform debate.

So for all the analysts out there, I’ll walk you through it. The Volcker Rule, which is located in Section 619 of Dodd-Frank (pdf), contains the following prohibition:

(1) PROHIBITION.—Unless otherwise provided in this section, a banking entity shall not—

(A) engage in proprietary trading; or

(B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.
Since Goldman was specifically talking about non-fund principal investing, (B) doesn’t apply. The only way that non-fund principal investing could be prohibited by the Volcker Rule, then, is if it’s considered “proprietary trading” under (A).

So now we have to go look at the definition of “proprietary trading,” which is located in § 619(h)(4):

(4) PROPRIETARY TRADING.—The term ‘proprietary trading’, when used with respect to a banking entity . . . , means engaging as a principal for the trading account of the banking entity . . . in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instrument that the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures Trading Commission may, by rule as provided in subsection (b)(2), determine. [emphasis mine]
OK, so only transactions for the “trading account” are considered proprietary trading. Would non-fund principal investments be transactions for the trading account? Well, let’s look at the definition of “trading account,” which is found in § 619(h)(6):

(6) TRADING ACCOUNT.—The term ‘trading account’ means any account used for acquiring or taking positions in the securities and instruments described in paragraph (4) principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements), and any such other accounts as the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures Trading Commission may, by rule as provided in subsection (b)(2), determine. [emphasis mine]
Principal investing is, by definition, medium- to long-term, which means that principal investments would NOT be transactions for the trading account. In fact, the trading account definition is virtually identical to the “trading book” definition in the accounting rules (which was intentional). And, not surprisingly, principal investments are not typically part of the trading book. (That’s why Goldman distinguishes between “trading” and “principal investments.”)

So in sum, non-fund principal investments are not prohibited by the Volcker Rule because they are by definition medium- to long-term, which means they are not transactions for the “trading account,” and thus not considered “proprietary trading” under the Volcker Rule.

Is that simple enough for Mr. Moszkowski?

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