Wall Street's Opacity Protection Team and the Volcker Rule

I owe readers of this post a confession.  By the time I had read a third of the proposed regulation to implement the Volcker Rule, my eyes were glazing over.  By the time I had read half of the proposed regulation, my head hurt.  It was at that moment when I realized that Wall Street's Opacity Protection Team had successfully completed its job with regards to the Volcker Rule.

What is Wall Street's Opacity Protection Team?

It is the response from Wall Street whenever one of Wall Street's opaque products or activities is threatened with disclosure and the disinfectant of sunlight.

Who is on Wall Street's Opacity Protection Team?

The Opacity Protection Team (OPT) is comprised of the individuals on Wall Street who owe their compensation package to the opacity of the product they sell (think structured finance securities) or activity they engage in (think proprietary trading desks).

So why do you think that OPT's fingerprints are all over the regulations proposed to enforce the Volcker Rule?

As a column in the Telegraph discussed, the proposed regulations are well over 200+ pages.

Absent from these 200+ pages is the requirement that each financial institution disclose at the end of each business day its positions to all market participants.  Instead, the proposed regulations go through all sorts of contortions in an attempt to define and then prohibit proprietary trading.

Not once do the proposed regulations look to Paul Volcker's guiding wisdom - 'I know proprietary trading when I see it'.

This seems like a less than subtle hint that disclosure is the solution.

On Tuesday the Federal Reserve published 298 pages of rules designed to implement a much bigger and more famous one named after Paul Volcker, the boss at the Fed before Greenspan. 

As a brief recap, the Volcker Rule was part of last summer’s Dodd Frank financial reform legislation and bans US banks from making bets with their money and imposes tight limits on the amount of capital they can invest in hedge funds and private equity funds. 

Supporters claim it will stop traders walking dangerous tightropes in the hunt for profits, knowing that the US taxpayer will be there to catch them should they fall. Opponents argue that regulators are aiming their bullets at the wrong target and that a ban on proprietary trading would not have prevented the reckless mortgage lending in the run-up to the crisis. 

Wherever you stand on the merits of the Volcker Rule, it’s been a fertile ground in the political battle over Wall Street’s future. It’s also proved a nightmare for those charged with drafting the rules to implement it and enforce it. A former Fed official says that Volcker would infuriate staff at the central bank with his apparent neglect of how to turn policy into regulations that worked. In May, Volcker said that proprietary trading would be relatively straightforward for regulators to spot. 

The almost 300 pages that the Fed posted on its website suggests that may not be the case. The document poses 383 questions that banks, consumer protection groups and other interested parties have until the middle of January to give their feedback on. The Volcker Rule then comes into effect in July, according to provisions of the Dodd-Frank Act, with banks being given a further two years to comply fully. 

There’s little wonder that staff at the Fed and America’s other four chief financial regulators are understood to be anxious. They’re being asked to peer beneath the bonnet of a financial system that has become vastly more complex since the repeal in 1999 of the Glass-Steagall Act by President Bill Clinton – a move that allowed Wall Street banks back into the business of gambling with their own money. 

Actually, with disclosure, the financial regulators get help in peering under the bonnet of the financial system.  Regulators can turn to other market participants for assistance in understanding each bank's positions.

In a letter to JPMorgan’s shareholders last year, Dimon helped illustrate the point when describing what the bank does. "We execute approximately 2m trades and buy and sell close to $2.5trillion (£1.6trillion) of cash and securities each day," investors were told.

The 2m trades are a red herring.  What is important is the positions that the bank takes.  The regulations should start with disclosure of the positions at the end of the day.  If this does not adequately reduce risk, disclosure could be required periodically during the day.

Distinguishing proprietary trading from say, market making in a particular set of securities or buying assets as a hedge against risks taken elsewhere inside a bank the size of JPMorgan, will not be straightforward....

With disclosure, regulators will have plenty of assistance from other market participants in distinguishing proprietary trading from market making.

More obvious is that the modern set of officials at the Fed, the Securities and Exchange Commission and the Federal Deposit Insurance Corporation will be pushed to their very limit regulating today’s financial system.

This is even more reason that they need to require disclosure.  It allows them to tap the best experts for help.