Ronald Reagan once said “I have wondered at times what the Ten Commandments would have looked like if Moses had run them through the US Congress.” For once, Reagan stands proven, as Paul Volcker is disappointed with the final version of the rule that bears his name. As first envisioned, the Volcker rule was designed to restrict banks’ proprietary trading activities and sponsoring hedge funds and private equity funds, an attempt to curb risk-taking that fueled the financial crisis. However, the provisions regarding bank proprietary trading ban and derivatives trading restrictions had been diluted compared to the Senate bill. The final version of the US Financial Regulatory Reform bill, which is a reconciliation between the House and Senate version, is expected to be presented to President Obama to sign into law before July 4th.

The key provisions that affect banks and hedge funds are:

Derivatives Trading

Derivatives trading and its oversight is a centerpiece of the bill. Most standard derivatives, such as credit default swaps, will be traded on exchanges and routed through central clearinghouses.  Customized swaps could still be traded over-the-counter, but they would have to be reported to central repositories so regulators could get a broader picture of the market. It would also impose new capital, margin, reporting, record-keeping and business conduct rules on firms that deal in derivatives. As a result of the derivatives reform, banks can trade FX, interest rate swaps, and gold and silver swaps.  Other derivatives transactions including commodities trading have to be spun off from bank’s books.

Volcker Rule

A compromise has been reached. The proposal was to prohibit banks from “owning, investing in, or sponsoring” hedge funds, private equity groups, and engaging in proprietary trading. Banks are allowed to invest in hedge funds and private equity investments, but those investments will be capped to 3% of the bank’s Tier One capital. The rule has fairly long phase-in period which is two years, with extensions possible of up to five year, such a long period will help prevent any fire sale of assets.

The chart above shows  the two most exposed banks to the properitary trading ban: Goldman Sachs and Morgan Stanley. Nonetheless, not all trading revenues are at risk as some will be from customer related activities. However, the bill tries to ensure that such revenues are truely customer related and not speculation on behalf of the Bank.

For a long period, the shadow banking system provided a lot of credit to the market since banks enjoyed access to large balance sheets. An important aspect of the financial reform bill is a provision that required issuers of privately issued asset backed securities to retain some styake in the products, a step to prevent going bank to the securitization situation of 2006 and 2007.

Hedge Funds and Private Equity Funds 

Hedge funds and private equity funds with AUM greater than $150 million will have to register with the SEC as investment advisers and provide information on trades to regulators. The Hedge Fund Association estimates that the annual cost of having the infrastructure in place for continual disclosure to be between $100,000 and $200,000.

The types of information that registered investment advisors need to report include:

(A) the amount of assets under management and use of leverage;
(B) counterparty credit risk exposure;
(C) trading and investment positions;
(D) valuation policies and practices of the fund;
(E) types of assets held;
(F) side arrangements or side letters,
(G) trading practices

Tags: financial reform bill, Paul Volcker, volcker rule

This entry was posted on Monday, July 5th, 2010 at 9:07 am and is filed under World. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.