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 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.

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?