Case 7
Chipping Away at Dodd-Frank’s Volcker Rule?

“No one has been able to distinguish between market-making and prop trading.” Hal Scott, Professor, Harvard Law School

MARY JO WHITE, COMMISSIONER OF THE SECURITIES AND EXCHANGE COMMISSION (SEC) sat down to breakfast at 6 am on October 19, 2016. It was her custom to eat early and quickly, allowing her chauffeured limo to beat the traffic downtown to the office. However, this morning a story in The Wall Street Journal stopped her in her tracks. There was the headline:

“How one Goldman Sachs trader made more than $100 Million. The gains from big trades are a Throwback to an Earlier Era.”1

White quickly perused the article. A Goldman trader named Tom Malafronte had apparently made large gains on junk bonds he purchased and sold in 1Q 2016. In some cases Malafronte sold the bonds within days of having purchased them. Others were held on Goldman’s books for weeks. Further down, White came across this quote:

“Tom is a tremendous risk taker,” said Jeff Bahl, who headed Goldman’s high-yield trading desk and worked with Mr. Malafronte. “In any opaque market, such as high-yield, the value of a skilled risk taker will always be there.”2

The article concluded by noting that on certain days Malafronte accounted for one-third of total trades in certain bond issues.3

White frowned as she put the paper down. This looked like a very questionable case of “market-making.” In fact, it looked more like proprietary trading, a practice now prohibited by the Dodd-Frank (D-F) law’s Volcker Rule. Investment banks like Goldman had helped precipitate the Financial Crisis by taking huge speculative bets using over-leveraged, bloated balance sheets. When some bets went wrong, both the speculating banks and those just lending money used for the bets were burned. Eventually the U.S. Treasury had to rescue almost all the big banks to stem a contagion of defaults.

To prevent a reoccurrence, Section 619 of D-F called for a rule specifying that banks which took deposits and benefitted from government deposit insurance could not speculate using their own capital, i.e., proprietary trading. The banking sector argued vehemently that it was impossible to distinguish “prop trading” from the kind of securities ownership necessary to “make a market.” The controversy prompted a long process before a final, detailed Volcker Rule was issued. In fact, the Rule was not even fully in effect some six years after D-F’s passage. Attachment 1 provides the initial wording of Dodd-Frank, Section 619.

White was not surprised that a bank was now testing boundaries set out in the Volcker Rule. Proprietary trading had been a huge money maker for Wall Street prior to the crisis. Its curtailment was contributing to dismal results across the sector; almost all major banks now sported single-digit Returns on Equity. It was only a matter of time before a bank tested how the government would interpret and enforce the Volcker Rule. Apparently, Goldman had decided to be that bank.

Unfortunately, it was not clear which government agency would lead the charge on enforcement. Five different agencies, including White’s SEC, had potential roles here. An “Inter-Agency Group” was charged to figure out who would take the lead or be involved in what kinds of situations.4

Well, the test case was here. The SEC would be involved in deciding whether to and how to respond. As she headed towards her car, White resolved to review the Volcker Rule details and ready her agency to make a recommendation on whether/how to react.

Proprietary Trading, Market-Making and the Volcker Rule

Market-making is a fundamental activity on Wall Street. Banks and Broker/Dealers routinely act to enable their clients to buy and sell securities. However, these actions vary in the amount of risk taken by the bank and the capital required.

Acting as an agent is the simplest form of market-making. In such situations, the agent firm simply intermediates. If a client wants to sell a security, the agent firm lines up a buyer before giving the seller a firm price. The process works in reverse when a client enters a buy order. Agents require little of their own capital for such activities. Agents typically “take out” a small commission between what the buyer pays and what the seller receives.

Underwriting is similar, but a bit more risky. Underwriters agree to purchase securities from an issuer at a specified price in the expectation of reselling them to investors shortly thereafter at a higher price. In most underwritten deals, the firms may own the securities for 1–10 days. Underwriters typically “build a book” in advance of purchasing the securities. This usually gives them strong indications of who is prepared to buy at what price levels. On occasion markets may move between when the underwriting syndicate prices securities and when it can dispose of all it purchases. Such instances can erode or even wipe out bank’s underwriting commission.

Acting as a Principal is a third form of market-making. Here banks may purchase and hold an inventory of securities which they can draw upon to accommodate client buy/sell orders. For example, a bank may buy 1 million shares of GM in a declining market from a client eager to shed its position. The Principal bank will act without any assurance of immediate resale on the other side. Instead it will give the seller a discounted price which offers the bank reasonable prospects of profiting when shares rebound. This kind of market-making is critical to efficient capital markets. On one hand, it means that security prices go down in a more or less orderly fashion when markets turn bad. Principal firms’ buying ensures sellers find a market and thus avoids panic selling. Principal firms also are important players in positioning “bloc trades,” i.e., the sale or purchase of large orders whose size would overwhelm normal trading volume in a security.

Conceptually proprietary trading is quite different. Here the bank takes “a view” on a security and puts its own capital at risk. This is a pure speculative bet and it seeks big gains commensurate with the risk taken. There is no notional time limit on the bets—some may be liquidated in a day while other positions may be held for months. Proprietary trading does have one characteristic in common with Acting as a Principal. In both cases, the firm will carry substantial amounts of securities on its balance sheet. What differs is the motive and means for profiting. Principal trading aims to accommodate clients and profit as a by-product. Proprietary trading seeks to gain purely from betting correctly on the future.

The Volcker Rule’s intent is to curtail proprietary trading while accommodating Acting as a Principal. The Rule declares an outright prohibition on proprietary trading by firms which benefit from government deposit insurance (e.g., FDIC) or have access to the Federal Reserve’s discount window. During the Financial Crisis, classic investment banks like Goldman and Morgan Stanley converted to bank holding companies. This gained them access to Federal Reserve funding. That fact also makes these banks subject to the Rule. As a second consequence, the Volcker Rule’s proprietary trading prohibitions also prohibit such firms from owning hedge/private equity funds which would engage in speculative investing.

To accommodate Acting as a Principal, the detailed Rule created several “safe harbors,” i.e., defined activities that resemble otherwise prohibited activities but are allowed. This list of exceptions includes: 1) market-making, 2) risk-mitigating hedging; 3) dealing in government securities; 4) underwriting and 5) other transactions on behalf of clients. A more general safe harbor of permitted trading activities is initially set at 3% of a firm’s Tier 1 capital. Within this boundary, regulators will “ask no questions.” For trading beyond it, firms must be prepared to demonstrate that their trading is for one of the permitted exceptions. In all cases, permitted trading is subject to a “macro-prudential” standard, i.e., it must not expose the firm to material conflicts of interest, high risk securities or activities which pose a threat to the soundness of the firm or the financial system. Should regulators deem that they do pose such risks, they are empowered to impose further capital requirements, fines and other penalties.5

Writing these rules took years. However, writing them might prove the easier part compared to enforcing them. The principal challenge will be distinguishing proprietary trading from Acting as a Principal. A 2011 U.S. Treasury study examined how the permitted activities resemble those prohibited by the Rule, and how to distinguish between them. The study enumerated core principles for telling one from the other. A key passage reads:

“… bright line proprietary trading is that activity that involves the use of the banking entity’s capital and is organized and conducted for the purpose of benefiting from future price movements. In addition, bright line proprietary trading is typically characterized by one or more of the following additional characteristics:

  1. Organized to conduct trading activities for the sole purpose of generating profits from trading strategies; or
  2. No formal market-making responsibilities or customer exposure (or customer exposure that is commensurate with the level of trading); or
  3. Physical and/or operational separation from market-making and other operations having customer contact; or
  4. Trades with or utilizes the services of sell side analysts, brokers and dealers.
  5. Compensation structures similar to those of hedge fund managers or other managers of private pools of capital.6

The study goes on to detail other means for distinguishing permitted from prohibited activities, and recommends thorough auditing of bank conduct by bank examiners. Attachment 2 provides additional details from the Treasury study. Attachment 3 outlines recommended practices in this area for bank examiners.

What Happened in the Market?

Malafronte’s trading focused on junk bonds, which suffered a rout in December 2015 that extended into the New Year. Late in 2015 oil prices and other commodities fell precipitously. Many independent oil producers relied heavily on junk bond financing. As prices fell, default risks rose. In response, high yield, hedge and private equity fund managers bolted for the sidelines. Malafronte apparently got a green light from Goldman risk managers to provide these clients with a willing buyer. It appears that in a limited number of cases, Malafronte found a resale within a couple of days, but the bulk of his position was held longer and must have reflected a view that commodity markets would rally.

They did. Oil prices bottomed below $30/b by mid-1Q’16, and rallied back north of $40/b by mid-year. Junk bond prices followed suit. Interestingly, Goldman’s 1Q earnings were marked by a notably poor performance in fixed income, currencies and commodities trading. This would make sense if traders like Malafronte were buying bonds through the period which continuously declined in price. Malafronte’s profits came later as bond prices recovered.

Goldman likely will defend its actions as effective market making. Indeed, they did provide a buyer for fund managers heading for the exits. The questions will be 1) whether the bonds in question were excessively risky, and 2) whether Goldman bought with a realistic expectation of near-term resale demand. If so, Goldman will argue that should satisfy the definition of Principal Trading.7 Attachment 4 provides an indication of how such trading has been in decline since the Volcker Rule appeared. Note that the definition of Principal Trading is buying securities without the expectation of a resale within 5 days.

Considering an SEC Response

The politics around the Volcker Rule are not easy for the SEC. For starters, the Commission has to contend with four other agencies for jurisdiction: the Federal Reserve, Controller of the Currency, the Commodities and Futures Trading Commission, and the FDIC. Any one agency attempting enforcement on its own can be sure that the bank in question will accuse it of a) lacking jurisdiction and b) taking an approach different from that of another relevant agency.

A second factor is that both the D-F statute and the adopted rules are fuzzy as regards penalties for violations. Clear authority exists for requiring the prohibited activity to cease. Beyond that, specific penalties are not enumerated. Agencies attempting to enforce the rule can anticipate extended litigation from the targeted bank, within which there will be no prior Volcker Rule jurisprudence to guide the judicial outcome.

Finally, the SEC itself has come under withering fire from key Democratic Senator Elizabeth Warren. Senator Warren recently wrote to President Obama calling for Mary Jo White’s replacement due to her unwillingness to prioritize having public companies report to shareholders on their political contributions. Commissioner White has resisted Senator Warren’s requests, arguing she has higher priority enforcement matters. Attachment 5 contains key passages from Senator Warren’s letter to the President.

Her car arrived at the office. Mary Jo White had already called ahead, asking key staffers to gather and consider what to do next.

Attachment 1

Section 619 of Dodd-Frank, The ‘Volcker Rule’
Excerpts

SEC. 619. PROHIBITIONS ON PROPRIETARY TRADING AND CERTAIN RELATIONSHIPS WITH HEDGE FUNDS AND PRIVATE EQUITY FUNDS.

The Bank Holding Company Act of 1956 (12 U.S.C. 1841 et seq.) is amended by adding at the end the following:

“SEC. 13. PROHIBITIONS ON PROPRIETARY TRADING AND CERTAIN RELATIONSHIPS WITH HEDGE FUNDS AND PRIVATE EQUITY FUNDS.

IN GENERAL.—

“(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 ip interest in or sponsor a hedge fund or a private equity fund.

“(2) NON-BANK FINANCIAL COMPANIES SUPERVISED BY THE BOARD – Any nonbank financial company supervised by the Board that engages in proprietary trading or takes or retains any equity, partnership, or other ownership interest in or sponsors a hedge fund or a private equity fund shall be subject, by rule, as provided in subsection (b)(2), to additional capital requirements for and additional quantitative limits with regards to such proprietary trading and taking or retaining any equity, partnership, or other ownership interest in or sponsorship of a hedge fund or a private equity fund, except that permitted activities as described in subsection (d) shall not be subject to the additional capital and additional quantitative limits except as provided in subsection (d)(3), as if the nonbank financial company supervised by the Board were a banking entity

“(b) STUDY AND RULEMAKING.—

“(1) STUDY.—Not later than 6 months after the date of enactment of this section, the Financial Stability Oversight Council shall study and make recommendations on implementing the provisions of this section so as to—

“(A) promote and enhance the safety and soundness of banking entities;

“(B) protect taxpayers and consumers and enhance financial stability by minimizing the risk that insured depository institutions and the affiliates of insured depository institutions will engage in unsafe and unsound activities;

“(C) limit the inappropriate transfer of Federal subsidies from institutions that benefit from deposit insurance and liquidity facilities of the Federal Government to unregulated entities; …

Attachment 27

Financial Stability Oversight Council Report on Proprietary Trading – Excerpts

INDICIA OF MARKET MAKING

The Volcker Rule provides an explicit exception for market making-related activities but requires that they be—designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties. To ensure that — market making does not mask prohibited proprietary trading, Agencies should provide guidance that will assist banking entities in determining what constitutes prohibited trading activity, and will establish the basis for considering subsequent determinations as to whether a violation occurred. Accordingly, set forth below are some of the indicia of permitted market making that could be used to distinguish it from impermissible proprietary trading. To ensure full compliance with permitted activities, banking entities would likely need to change their business practices and implement comprehensive compliance programs….

The Council recommends that Agencies consider the SEC’s guidance set forth in its 2008 Release, SEC Release No. 34-58775 (Oct. 14, 2008), which established indicia of bona fide market making in equity markets, including:

  1. Making continuous, two-sided quotes and holding oneself out as willing to buy and sell on a continuous basis;
  2. Making a comparable pattern of purchases and sales of a financial instrument in a manner that provides liquidity;
  3. Making continuous quotations that are at or near the market on both sides; and
  4. Providing widely accessible and broadly disseminated quotes….

In its 2008 Release and a predecessor release, SEC Release No. 34-50103 (July 28, 2004), the SEC also discussed activities that would not be considered market making:

Bona-fide market making does not include activity that is related to speculative selling strategies or investment purposes of the broker-dealer and is disproportionate to the usual market making patterns or practices of the broker-dealer in that security. In addition, where a market maker posts continually at or near the best offer, but does not also post at or near the best bid, the market maker’s activities would not generally qualify as bona-fide market making for purposes of the exception. Further, bona-fide market making does not include transactions whereby a market maker enters into an arrangement with another broker-dealer or customer in an attempt to use the market maker’s exception for the purpose of avoiding compliance with Rule 203(b)(1) [the short sale rule] by the other broker-dealer or customer.8

Attachment 39

Controller of the Currency Guidelines on Volcker Rule Enforcement – Excerpts

After the final version of the Volcker Rule was published in December and banks began to prepare for the July 15, 2015, effective date, the only remaining question was how it would be enforced. That enforcement is up to the examiners of the various agencies. Recently, the Office of the Comptroller of the Currency (OCC) published a 26-page Volcker Rule examiners’ manual, which may be an inside peek into how the regulators are going to approach enforcement.

The Objectives

Here are some of the objectives it sets for examiners:

  • Assess the bank’s progress toward identifying banks that engage in activities subject to the regulations.
  • Assess the bank’s progress toward identifying its proprietary trading.
    • The bank must identify purchases and sales of financial instruments for specified short-term purposes.
    • The bank must identify the trading desks (the smallest discrete unit of organization) responsible for the short-term trading. Trading desks may span multiple legal entities or geographic locations.
  • For each trading desk, the bank must determine on which permitted activities the desk will rely to conduct its proprietary trading.
    • Assess the bank’s progress toward identifying its ownership interests in covered funds.
    • Assess bank’s progress toward identifying the covered funds that the bank sponsors or advises.
    • Assess the bank’s progress toward identifying its ownership interests in and sponsorships of entities that rely on one of the regulations’ exclusions from the definition of covered fund.
    • Assess the bank’s progress toward establishing a compliance program.
    • Assess the bank’s plan for avoiding material conflicts of interest and material exposures to high-risk assets and high-risk trading strategies.
  • Specific Instructions: Within the document, there are specific instructions … both pertinent and … informative of the general approach. For example:
    • Under a section entitled, Assess the bank’s progress toward reporting, we see: Some banks may combine previously delineated trading desks into a single trading desk.
      • Multiple units with disparate strategies combined into a single desk, however, could suggest a bank’s attempt to dilute the ability of the metrics to monitor proprietary trading. Relevant factors for identifying trading desks include whether the trading desk is managed and operated as an individual unit and whether the profit and loss of employees engaged in a particular activity is attributed at that level….
    • Assess bank’s progress toward using the metrics to monitor for impermissible proprietary trading.
      • Determine whether the bank consistently applies methodologies for calculating sensitivities to a common factor shared by multiple trading desks (e.g., an equity price factor) so that these sensitivities can be compared across trading desks.

Attachment 4

Source: TRACE, Barclays Research

Percentage of Market-making trades which achieved an offsetting trade within a specified period of minutes/days.

The higher percentage of short-term offsets suggests more agency “matched trades” and fewer “Acting as a Principal” transactions.

Attachment 5

Partial Text of Senator Elizabeth Warren’s October 14, 2016 Letter on SEC Commission White

President Barack Obama

The White House

1600 Pennsylvania Avenue Washington, DC 20500

Dear President Obama:

Corporations are flooding our elections with millions of dollars in secret political contributions, drowning out the voices of working families. Yet two weeks ago, Republican leaders successfully forced a rider into must-pass legislation to fund our government that prohibited the Securities and Exchange Commission (SEC) from issuing a final rule requiring public companies to disclose these political contributions. As the White House Press Secretary noted, the rider “essentially protect[s] the ability of special interests to funnel money into political campaigns without having to disclose it.” Democrats will continue to fight to remove the rider when Congress considers the next government funding bill in December, and I urge you to make clear in advance that you will veto any bill that includes it.

But the rider is not the biggest barrier to making progress on this critical issue. For years the Chair of the SEC, Mary Jo White, has refused to develop a political spending disclosure rule despite her clear authority to do so, and despite unprecedented and overwhelming investor and public support for such a rule.

This brazen conduct is merely the most recent and prominent example of Chair White undermining your Administration’s priorities and ignoring the SEC’s core mission of investor protection. From the beginning of her tenure, Chair White has made clear that she is concerned that companies disclose too much to investors—a presumption directly counter both to the view of investors themselves and the animating purpose of this agency for more than eighty years. She has failed to complete disclosure mandates Congress enacted in the wake of the 2008 financial meltdown, while simultaneously devoting the SEC’s limited discretionary resources to a far-reaching, anti-disclosure initiative cooked up by big business lobbyists seeking to reduce the amount of information public companies must make available to their investors. And she remained conspicuously silent when your Administration has issued veto threats against anti-disclosure bills, providing cover to those in Congress who seek to roll back disclosure requirements and compromise the transparency and safety of our markets.

Enough is enough. To address your concerns on political spending disclosure, and to advance other priorities of your administration and investors, I respectfully urge you to exercise your unilateral authority under 17 C.F.R. § 200. l 0 to immediately designate another SEC commissioner as Chair of the agency …

Author’s Note

This case asks whether the legislated solution to the Financial Crisis is going to suffer erosion as the events which precipitated the Crisis recede into history.

Proprietary trading was one of the biggest contributors to that crisis. It became the prime profit motor for Wall Street investment banks, and made subprime mortgage securities irresistible as product to purchase and trade. The banks thus became enablers of a securitization process peddling increasingly problematic mortgages. In the process, the banks reached balance sheet leverage ratios that left them vulnerable to falling security prices. When the downdraft came, one bank after another saw its thin capital base erode. Threatened and actual bankruptcies followed. To prevent a recurrence, Dodd-Frank crafted the “Volcker Rule” prohibiting proprietary trading. Many banks shut down their “prop trading” desks in response. However, this Rule is complex to administer and enforce. Given how significant a contributor “prop trading” was to bank profits, it was not hard to anticipate that some firm would test the government’s willingness to enforce its Rule.

A test case has now arisen. How should regulators respond? This case details the complexities inherent in enforcing the Volcker Rule. It also reviews U.S. Treasury thinking on interpretation and enforcement. Finally, it provides an overview of political pressures operating on the SEC. The SEC is chosen as a focus of the case because the firm in question is both a bank and a publicly listed company under that Agency’s jurisdiction. Students should stand in Commissioner White’s shoes and consider if, when, and how to evaluate Goldman’s actions. Important questions include whether the reported facts justify an investigation, what issues should be explored, what kind of sanctions might be contemplated and whether the SEC should team up with another agency or go it alone.

This case is based on news reports of Tom Malafronte’s trading success at Goldman Sachs. It also relies on the Financial Stability Oversight Council’s 2011 Study and Recommendations on Prohibitions on Proprietary Trading. The thoughts attributed to Mary Jo White regarding Malafronte’s trading activity are imagined. There is as yet no public document indicating she considers this a test case of the Volcker Rule or seeks to mobilize the SEC to investigate. Interested observers await the SEC’s response to this case, which only entered the public domain on October 19, 2016.

The U.S. Government’s legislated solution to the Financial Crisis relies on comprehensive and complex regulation. Dodd-Frank is a massive law and the detailed regulations it called for add extensively to this framework. Criticism of this approach comes from two directions. One critique calls for a more principled, less detailed regulatory approach. The second critique distrusts most regulatory approaches on the grounds that inevitably rules are “wired around” or the regulators are captured by the industry they supervise. Whether either of these critiques is valid will depend upon how the agencies charged with enforcement react when rules are tested. Rules not enforced can become dead letters, as the Sarbanes-Oxley criminal liability associated with false CEO financial statement representations is fast becoming. Goldman Sachs’ exploration of the Volcker Rule’s boundaries does seem to be a first test on proprietary trading. Will the regulators step up?

Notes

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