Proprietary trading and the Volcker Rule

In response to the 2008 financial crisis, new regulations were enacted with the hopes of preventing another such catastrophe. The Volcker Rule, one part of the new legislation, significantly limited banks’ ability to participate in proprietary trading.  

The Volcker Rule does not affect individual traders, independent proprietary trading firms, or hedge funds and private equity funds that aren’t owned by banks. 

What is proprietary trading as defined by the Volcker Rule? 

Proprietary trading is any trading that utilizes a firm’s own assets in an attempt to generate profits for the firm. To directly quote the rule itself, “Proprietary trading means engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments.”

The Volcker Rule focused only on banking entities that participated in short term proprietary trading, so banks were prohibited from trading on their own behalf in order to make a profit. 

For many years, investment banks and commercial banks had traders who traded on behalf of their clients, but they also had proprietary trading desks that used the bank’s assets to make trades for profit. These “prop desks” allowed traders to risk the bank’s capital in the hopes of making large profits for the bank and hefty bonuses for the traders.

The 2008 financial crisis demonstrated the dangers of proprietary trading when the prop desks at banks lost billions of dollars on speculative investments, and nearly brought down the global financial system in the process.

Since the Volcker Rule was enacted, proprietary trading has largely moved to independent prop trading firms. Prop trading still exists in much the same way as it always did, but since traders are no longer affiliated with banking entities, traders are no longer risking bank capital. Theoretically, this will keep the financial system safer going forward.

What is the goal of the Volcker Rule?

The Volcker Rule was designed to limit the amount of risk banking entities could take on by eliminating their proprietary trading desks. The argument was that when prop traders were successful only the bank and the traders themselves profited, but when they suffered substantial losses it would come out of the money belonging to the bank’s depositors. 

When banks start to fail, the entire financial system is in jeopardy.

This is more or less what happened during the 2008 financial crisis. Proprietary traders at commercial banks and investment banks such as Lehman Brothers had large positions in mortgage backed securities and derivatives based on the mortgage market. 

Financial instruments based on the housing market were considered safe, even though their value depended on increasingly risky underlying mortgages. Eventually, the US housing market collapsed and these financial instruments lost tremendous value. 

Banks like Lehman Brothers lost everything and had to declare bankruptcy. The shockwaves rippled through the worldwide financial system and created a crisis that impacted almost everyone.

Proprietary trading desks took a great deal of the blame. Clearly some proprietary traders had taken on tremendous amounts of risk and when their bets on the housing market went south the consequences were beyond dire.

The Volcker Rule was designed to prevent banks from taking such risks in the future. Regulators did not try to limit the risk taken on by individuals, hedge funds or private equity firms, but they drew the line at investment and commercial banks. Such banks should not be allowed to risk the capital of their depositors in search of corporate profits.

What does the Volcker Rule prohibit?

The Volcker Rule is pretty clear about proprietary trading. “Except as otherwise provided in this subpart, a banking entity may not engage in proprietary trading.” As mentioned above, the Volcker Rule defined proprietary trading as pretty much any trade in which the bank was the principal buyer or seller.

That’s a pretty definitive blanket statement, but of course there are a number of exemptions and grey areas. Recent amendments to the Volcker Rule have expanded the amount of proprietary trading allowed at banks, but have so far kept most of the restrictions in place.

Banks are still allowed to participate in a number of market activities including market making, serving as brokers, underwriting securities, and trading government securities. Most hedging is also still allowed.  

The Volcker rule also established new rules for the relationships between banks and certain investment funds. Banks were no longer allowed to own or have controlling interests in hedge funds and private equity funds along with other “covered funds.”  Beyond hedge funds and private equity funds, certain commodity pools and some foreign funds were banned as well.

Banks are still allowed to offer private equity funds, hedge funds and other funds to their clients, but can’t maintain any sort of ownership stake.  

Finally, the Volcker Rule required banks to disclose any potential conflicts of interest to their customers. If a bank engages in any transactions that are not explicitly forbidden by the Volcker Rule, but still may not be in the best interest of the bank’s customers, the customers must be informed.

When did the Volcker Rule go into effect?

The Volcker Rule is part of the Dodd Frank Wall Street Reform and Consumer Protection Act that was passed in 2010. The rule went into effect in 2014, and banks had until June 2015 to be in full compliance. 

The Volcker Rule has been amended in the years since, with the latest update issued in June 2020. 

Who enforces the Volcker Rule?

The Volcker Rule is enforced by five different federal agencies. The Securities and Exchange Commission (SEC), the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), the Commodity Futures Trading Commission (CFTC) and the Office of Comptroller of Currency.

Each agency is responsible for policing the companies that fall under its jurisdiction, for example, the Securities and Exchange Commission is responsible for companies registered as a broker/dealers or investment adviser, while the Commodity Futures Trading Commission is responsible for commodity trading advisors and commodity pool operators. 

Since most of the Volcker Rule is directed at banking entities, the agencies directly responsible for banking, such as the Federal Deposit Insurance Corporation and the Federal Reserve Board are tasked with the majority of the enforcement responsibilities.  

What are the penalties for violating the Volcker Rule?

Penalties for violation of the Volcker Rule vary depending on the responsible federal agencies. The Securities and Exchange Commission can levy different penalties from the Federal Reserve Board, for instance. 

In practice, most often when a violation of the Volcker Rule occurs, the violating bank is simply directed to unwind the transaction that caused the violation. For example, if a bank made a purchase of financial instruments that were found to be in violation of the proprietary trading ban, they would be given the opportunity to sell off those positions and come back into compliance with the rule.

Federal agencies can levy fines against offending banks, but this has only happened once. In 2017, Deutsche Bank was found to be in violation of the Volcker Rule and had to pay a fine of $157 million for certain prohibited foreign exchange transactions and the lax oversight of traders.

Theoretically, since the Volcker Rule was stapled on to the Bank Holding Company Act of 1956, criminal charges could be levied against offending traders if they knowingly violated the Volcker Act and attempted to “deceive, defraud, or profit,” but this seems very unlikely. Since the implementation of the Volcker Act, no criminal charges have been filed.

What changes have been made to the Volcker Rule?

In June of 2020, the five federal agencies responsible for implementing the Volcker Rule issued amended “Final Regulations.” These new regulations eased some of the restrictions that had been placed on the banks.

One of the biggest changes was that the rule permitting banking entities from having ownership interests in “covered funds,” such as hedge funds or private equity funds, was relaxed a bit. New exemptions allow banks to begin investing in venture capital funds and credit funds under specific circumstances.

Also included in some of the amendments leading up to the final regulations was a final rule that excluded community banks almost entirely from the Volcker Rule. 

Other amendments have sought to make market making activities easier and to provide some regulatory relief in the form of simplified compliance procedures.

Who was Paul Volcker?

The Volcker in the Volcker Rule refers to the former Federal Reserve Chairman, Paul Volcker. Volcker is known for guiding the US through several financial catastrophes. 

During the late 1970s and early 80s, Volcker used his position at the Federal Reserve to raise interest rates to unprecedented levels in order to curb inflation. The measures worked eventually and many credit Volcker with the nearly two decades of prolonged economic growth that followed. 

In 2009, then-President Barack Obama tasked Volcker, who was already in his 80s, to head the Economic Recovery Advisory Board. It was in this capacity that Volcker encouraged the drafting and passing of the legislation that would eventually bear his name. 

Other than his work saving Americans from economic crises, Volcker wrote nine books, recovered $1.25 billion worth of assets that had been stuck in Swiss bank accounts since the Holocaust, graduated from Princeton, got a Masters from Harvard, founded a non-profit to encourage public service, worked in the US Treasury Department, loved cigars, and lived to be 92. 

At 6’7”, ”Tall Paul” was also probably the tallest employee ever to don a suit at the federal reserve bank. 

He died in 2019.