The path to gaming the Volcker Rule has always been clear: Banks will shut down anything with the word “proprietary” on the door and simply move the activities down the hall....
But the suspicious-minded among us wonder whether it was all that simple.
This is the specter raised by the news that a JPMorgan Chase trader in London ... was amassing such huge positions in indexes related to corporate defaults that he was distorting the market....
Bloomberg followed up with a powerful article about how Jamie Dimon, the chief executive of JPMorgan, has transformed the sleepy chief investment office ... into a unit that hires former hedge fund portfolio managers and slings around giant sums of money in what walks and quacks like prop trading. The chief investment office seems not to just be risk-mitigating, but profit-maximizing.
The Congressional authors of the Volcker Rule worried about this very thing ... So Congress tightened the language. It wrote that the hedges had to be specific.
When the Dodd-Frank financial reform law came out, the Volcker Rule provision defined “risk mitigating activities” as trades that were “designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.” No macro-hedging, only micro-hedging. That is the will of Congress.The only way for a bank to demonstrate compliance with this provision to market participants is if the bank provides ultra transparency and discloses its current asset, liability and off-balance sheet exposure details.
With this information, market participants can see the specific positions, contracts or other holdings that the bank is suppose to be hedging.
It is for this reason that your humble blogger suggested that the financial regulators adopt requiring ultra transparency as the simple, straightforward method for implementing the Volcker Rule.
But then federal regulators got their hands on Volcker and set about interpreting the meaning of Dodd Frank. This has been a Talmudic exercise in reverse: It has taken the clear and simple intent and made it muddy and complicated.Of course, the regulators had some help from the banks and their army of lobbyists (also known as, the Opacity Protection Team).
Regulators decided that banks could say that they were hedging for an overall portfolio. And the banks could argue that a hedge was legitimate if it merely had a “reasonable correlation” with the security or position being hedged....
“One of the great fears was that banks could avoid the rule by simply pretending that their prop trading was somehow their market-making or hedging,” a Congressional aide told me. “Congress tightened the language to prevent this, and yet banks still may get away with this under the proposed rules.”...
The problem of allowing a broad “portfolio hedging” exception is obvious .... And lo, JPMorgan says exactly what we might expect a bank that knows how the regulators are interpreting Volcker would say: that the trading of its chief investment office is merely hedging.
But the bank is unabashed: “The purpose of this is to hedge the macro risk of the company,” a JPMorgan executive explained to me. “It’s what we are supposed to be doing; we do it well, we write about it in the annual report and we show it to every regulator,” he added.
Alas, it wasn’t the regulators who brought this to light.
Instead, it took hedge funds on the other side of trades....
And it matters what the banks’ trading partners think because the banks invoke them constantly in order to protect themselves from the Volcker Rule. The big banks wrap themselves in the mantle of market-making. Without them, they warn, liquidity — the ease of entering and exiting trades — will dry up.By definition, without the trading partners, liquidity will dry up for the big banks too.
In the case of these JPMorgan trades, however, we can see how a huge position can undermine liquidity. A big bank can become the market. JPMorgan’s big position now makes trading in these credit indexes less likely, not more, which could lead to more volatile markets.
So is this legitimate trading?
The hedge funds don’t really know what’s going on at JPMorgan’s chief investment office. Nor can the public tell from the bank’s disclosures. The only ones who have a chance to get a true picture are the dozens of regulators who are sitting in the bank’s office.Here is another example of the regulators' information monopoly having a negative effect on the financial markets.
In this case, the information monopoly prevents market participants from knowing if JP Morgan is complying with the intent of the Volcker Rule and legitimately hedging its exposure or whether it is violating the rule and taking a proprietary bet.
But given how bent the regulators are to subvert the will of Congress, it would take an act of extraordinary naiveté to believe they will actually get to the bottom of it.