5 Controlling proprietary trading
by banks: the issues
The definitional issues
58. Many witnesses agreed that, in principle,
it would be a good thing if banks did not engage in pure proprietary
trading. Andy Haldane, Executive Director of Financial Stability
at the Bank of England, said:
In principle, there ought to be a sharp distinction
between directional bets made on one's own account and the provision
of liquidity services to customers and clients. Any commingling
of those two sounds as if is in some ways best avoided.[80]
Douglas Flint said "There is a case for not
having proprietary trading properly defined within regulated entities
or groups".[81]
59. Most witnesses who agreed with this principle
made clear, however, that any action to put it into practice would
have to overcome the significant challenge of defining proprietary
trading clearly and distinguishing it from other forms of trading
activity which should be allowed to continue. Sir John Vickers
said "I am not against the principle of Volcker; it is the
difficulty of implementation".[82]
Stuart Gulliver, Group Chief Executive of HSBC, said "as
long as we can distinguish proprietary risk, which is principal
risk, from proprietary trading, then, yes, it should sit in a
hedge fund".[83]
60. Stephen Hester told us:
In RBS, we tried to eliminate the bits of the previously
sprawling organisation that were truly distant from customer rationale.
In that sense, if the Volcker rule was capable of easy definition,
I would absolutely think that it is a terrific rule for a banking
industry that I believe should be centred around customers.[84]
The FSA noted:
Enforcing total separation of proprietary trading
alongside or instead of ring-fencing could provide a stronger
barrier against global market contagion to core financial services,
but the difficulty is in designing a proprietary trading prohibition
that works in practice.[85]
61. The main difficulty that most witnesses warned
of was in trying to distinguish pure proprietary trading from
market-making. Paul Sharma of the FSA warned that "a number
of people have tried and are trying [to define market-making versus
proprietary trading]. It is not clear that they will be able to
succeed [...] we do know for certain that it is extraordinarily
difficult".[86]
Asked whether he thought a definition was going to be found, Stephen
Hester noted that "in the United States, they are finding
it very challenging".[87]
The US legislation and supporting documentation, albeit reflecting
the US legalistic culture, already runs to 298 pages, and the
debate about implementation is still continuing despite the intended
July 2012 deadline.[88]
Martin Wheatley said "I do not think it is possible to do
it in a way that would not be gamed by the banks".[89]
Martin Taylor explained the nature of the challenge:
Banks are in the business of taking proprietary risk;
that is the problem. The distinction is made between the proprietary
risk taken because a trader comes in in the morning and decides
to put a position on, and the proprietary risk that arises because
a client rings up and says, "I'd like you to structure this
derivative for me" [...] One may be more socially useful
than the other, but in the end the bank has the same risk position.[90]
62. Andy Haldane warned:
we have moved to a market-making model which is radically
different from that which we had 10 or 20 years ago and which
conflates the act of making markets with the act of making money
on a proprietary basis. I see no realistic prospect of rolling
that back very quickly, which leads us to the problem that it
is very difficult in practice to differentiate these two sets
of activities.[91]
RBS made a similar point, noting how "there
is no bright line that can be drawn to differentiate between the
two types of activities".[92]
Finance Watch explained why market-making and proprietary trading
were so intimately intertwined:
Market-making necessarily involves taking a view
on how prices are going to move, and necessarily involves holding
an inventory. These are also the two essential elements of prop
trading. All market-making (as opposed to broking) involves an
element of prop trading. To make markets involves standing ready
to buy and sell, and communicating to others in the market the
prices at which you are willing to do so. Deciding on those prices
requires deciding how happy, or not, you are to have the instrument
in question on your book and adjusting your bid and ask prices
accordingly.[93]
63. HSBC gave some practical examples of how
market-making can lead to proprietary positions:
if there is a pattern of investment managers moving
into Japanese equities, a foreign exchange desk is likely to hold
a long Yen position in anticipation of the demand for settlement
currency, in exactly the same way as retailers adjust their summer
stock depending on projected weather patterns; the difference
is the bank is marking its open currency (stock) position to market
daily as opposed to the retailer marking down unsold stock in
the end of season sale. The point being highlighted is that banks
routinely have positions held as principal from which they may
gain or lose but a practitioner would regard only a very limited
and bespoke portion of these as 'proprietary trading'.[94]
Standard Chartered also explained how serving client
needs could result in them taking on market positions which look
from the outside like proprietary trading:
Often a market maker will need to run a risk after
trading with clients, either due to illiquidity or mismatch between
the client product and available interbank hedges. These issues
are particularly true in the emerging markets in which Standard
Chartered operates because the markets may not be sufficiently
liquid. So a market maker is forced to become an active risk taker
in order to facilitate quoting clients. The alternative is that
a client must wait until matching buyers or sellers have been
found, dramatically reducing liquidity.
For instance, if a mutual fund was looking to liquidate
a position in an emerging market bond to meet some redemptions
then they would require us to offer them a firm price to take
the bonds immediately. In turn, we may not be able to find a buyer
immediately at a reasonable price so we would purchase the bonds
on our own account and subsequently seek to sell the position
which would require us to take market risk until the bonds have
been all sold.
As another example, if we are helping a client hedge
the risk it faces from a large iron ore order it may take several
days to undertake the trades that are necessary to reduce the
risk we take on as a result of this trade, and we may still not
be able to eliminate the risk entirely. These subsequent trades
will be necessary for us to meet the needs of our clients but
they will not be as a direct result of an order from these clients.[95]
Professor Darrell Duffie set out his concerns in
a paper he wrote in 2012 that implementation of the Volcker rule
would have undesirable effects on market-making, namely that:
investors would experience higher market execution
costs and delays. Prices would be more volatile in the face of
supply and demand shocks. This loss of market liquidity would
also entail a loss of price discovery and higher costs of financing
for homeowners, municipalities, and businesses.[96]
64. Some witnesses considered that a workable
definition of proprietary trading could be achieved. Asked whether
the US authorities were going to solve the definitional problems,
Douglas Flint replied "Yes" and Stuart Gulliver said
"I think we can get 90 per cent of the way".[97]
Bill Winters thought that the US authorities had made significant
progress towards defining proprietary trading:
The bankers to whom I have spoken about this have
said that they think it is a pretty fulsome attempt to capture
the idea that you want to preclude purely discretionary, for-profit
proprietary risk taking and separate that from risk taking that
is incidental to the provision of liquidity in the capital markets.[98]
65. Paul Volcker explained that his preferred
approach would not be to monitor every single transaction for
compliance, but rather require banks to have appropriate policies
in place to prevent proprietary trading, and use a series of metrics
to check their effectiveness:
It is a fool's errand to look at every transaction
and say, "That's proprietary" or "That's a customer
trade" or "That's a market-making trade". But you
can tell over time [...] what you are going to do, which they
will do in the United States, is to have so-called metrics. They
will have maybe too many but they will have seven or eight metrics
that they will look at. Volatility would be very important. Your
ordinary customer trading operation is not going to have a lot
of volatility. The aging of the inventory, the size of the inventory,
the hedging of the inventory: there are certain things you can
look at that are going to give you pretty clear evidence as to
whether as a regular matter, proprietary trading is going on and
the guys are market-making. It does not mean that you catch every
transaction. You don't have to catch every transaction. I think
that can be effective. I have had a lot of traders tell me that.[99]
66. Lord Turner agreed that an approach based
on metrics would be more viable than a transaction-based approach,
and added that the FSA had even attempted a one-off exercise along
these lines in the past:
If you look at the frequency distribution of daily
profits and you find that every now and then there are some whacking
great losses and whacking great profits and there is not much
of this regular flow in the middle, it is highly likely that as
a post facto indicator, that tells you that they are more of a
proprietary trader. Indeed, I will not name names, but we did
that exercise four years ago, and you could compare different
banks, and it clearly lined up with what we knew about their philosophy
as to whether or not they were trying to make money out of prop
trading.[100]
HSBC and Lloyds Banking Group also both considered
how proprietary trading could be controlled in this way, suggesting
examples of the kind of metrics that were referred to by Paul
Volcker.[101]
67. However, Bill Winters warned that, although
such approach could be effective, it would still involve considerable
complexity:
A series of those sorts of measures could be put
in place, and by the time that is converted into a set of rules
of what you are allowed to do and what you cannot do, each of
the measures needs a number or some sort of algorithm attached
to it, and that needs to be implemented and monitored. It is very
complicated—bordering on impossible—but that is not
a good reason not to try if you have decided, from a policy perspective,
that banks will not do this particular thing. That is the process
that you would have to go through.[102]
RBS also noted the danger of an approach involving
complex metrics:
The US regulators preparing the detailed regulations
for the Volcker Rule have struggled with the problem of definition
for two years. The current draft implicitly recognises the difficulty
of identifying what is "pure" proprietary trading and
relies on complex analysis of 17 different indirect metrics they
have determined might be indicators of proprietary trading [...]
We believe that monitoring and tracking such indicators will be
expensive both for institutions involved and for the regulators.
[...] There is a danger that the implementation and subsequent
monitoring of highly complex rules across multiple metrics could
serve more to distract from ensuring that "pure" proprietary
trading is prevented (or controlled depending on the institution)
and that all own account trading is otherwise conducted in an
appropriately controlled way.[103]
The enforcement issues
68. Sir John Vickers voiced his concern that
such complexity could consume regulatory attention and distract
from more important tasks such as policing of the ring-fence.
If one had ring-fencing and Volcker, there would
then be two boundaries to police and the Volcker rule—as
its rather slow progress towards implementation in the United
States is showing—draws the line in a very, almost excruciatingly,
difficult place. There is a risk that if one added the Volcker
rule, a large portion of regulatory capacity, energy, distraction,
aggravation would be forced to be directed on that very difficult
set of issues, and regulatory capacity is finite.[104]
Mark Carney shared this concern when he recently
gave evidence to the House of Commons Treasury Committee:
I do not think you should overlay a Volcker Rule
on top of the Vickers recommendations. I think the ring fence
model is a superior model to the Volcker Rule, and I will not
make this a long answer but I would be very concerned. It is extremely
difficult to draw the line between market-making and proprietary
trading. The first cut of the US authority [...] shows how difficult
that is and it would unnecessarily, amongst many other things,
divert the supervisor's attention from amongst other things, not
just prudential responsibilities, but fulfilling that responsibility
on ensuring that the ring fence is respected.[105]
Finance Watch also warned about this risk:
In our view, the benefits of eliminating a small
amount of dedicated proprietary trading are likely to be outweighed
by the strong likelihood that gaps elsewhere in the ring-fence
would be systemically exploited. The complexity of defining and
enforcing such a ban could undermine the overall robustness of
the ring-fenced approach.[106]
69. Bill Winters noted that dealing with the
complexity would be particularly resource-intensive:
it is layering complexity on complexity. I can imagine
a lot of human beings needing to try to figure this out. All else
being equal, I think I would rather have either fewer human beings,
who were better trained, or those human beings focused on whatever
the most compelling problem of the day was. It may be proprietary
trading, in which case that is what they should focus on. I think
it is more likely to be the things that have caused recurring
banking crises through time[107]
70. Some witnesses also warned that such a subjective
approach to defining proprietary trading could be difficult to
enforce. Sir Mervyn King said:
I know that [Paul Volcker] said to you that a good
banker can tell the difference between market-making and proprietary
trading. That is true, but that is not the issue. The question
is whether the regulator or a court can tell the difference between
the two and whether it is possible to pull the wool over the eyes
of the regulator or to confuse the issue legally even if the banker
can understand exactly what the nature of the transaction is.
It's can you prove it?[108]
Sir John Vickers echoed this point that regulators
need objective rather than subjective measures in order to be
able to defend their actions against challenge.
Part of Volcker, as it is being implemented in the
US requires, in a sense, an investigation of the intent and purpose
of the building of a position: is it for resale within a 60 day
period, and so on? That for me brought to mind Queen Elizabeth
I on opening windows into men's souls-I think it's just a very
difficult business to get into[109]
[...]
For the law to work, it is the regulator who needs
to be able to know, and the regulator will be subject to a framework
of accountability in which it will need to be able to demonstrate
the facts, and so on. The senior bankers knowing is not itself
sufficient. To repeat a point that was made earlier, this Commission
has seen a number of senior bankers who were, it appears, less
knowledgeable about what was going on in their institutions than
the remark by Paul Volcker [...] suggests.[110]
71. The FSA also raised concerns about whether
it is possible to design a definition which is both enforceable
and straightforward for banks to follow:
There are two ways of addressing this issue. The
first way is through very prescriptive rule-making combined with
intensive supervision. The second way is through a purpose based
restriction. There are problems with both of these approaches
which is part of the reason why the ICB and Liikanen both avoided
trying to distinguish between proprietary trading and market-making.
A prescriptive approach is resource intensive to
supervise and banks, if they are so inclined, will eventually
find a way around the rules. A purpose based approach will not
provide clarity to banks or their clients about what is permitted.
It also does not provide supervisors with a clear consistent framework
for exercising their judgement, particularly as derivative trading
is a highly complex area where 'risk management hedges' can quickly
become sizable proprietary losses due to poor modelling of risk.
A combination of these approaches is currently being
considered in the US and it may be a number of years before we
can be sure that such a prohibition is possible to enforce in
a meaningful way.[111]
Other issues relating to a prohibition
72. Sir John Vickers warned that pushing proprietary
trading out of banks might simply move the problem to somewhere
else:
if proprietary trading is divorced from banking,
it will move elsewhere and there is no guarantee that elsewhere
will be a place where one need not worry about cultural and other
issues. Indeed, it may move to a less well-regulated place, which
could rebound adversely for the things that one cares about.[112]
Professor Darrell Duffie also raised this concern
in relation to implementation of the Volcker rule in a paper written
in 2012, suggesting that:
The financial industry would eventually adjust through
a significant migration of market-making to the outside of the
regulated bank sector. This would have unpredictable and potentially
important adverse consequences for financial stability.[113]
On the other hand, there may be cultural and even
prudential advantages in confining hedge fund activities to hedge
funds.
73. HSBC noted that attempting to introduce a
prohibition could delay implementation of the ring-fence:
We are concerned that adding at this stage in the
process a prohibition on proprietary trading in groups containing
a ring fence bank could lengthen the implementation timetable
for the current ring-fencing proposals because of definitional
challenges.[114]
74. Ken Costa raised a concern that banning proprietary
trading could drive talented individuals out of UK investment
banks, harming their global competitiveness. He suggested, given
wider reforms aiming to remove the possibility of an implicit
guarantee from investment banks, we should be more willing to
allow this activity to continue under proper controls:
to remove it completely would, in my view, take the
proprietary traders out of what is now going to be the investment
bank but without the very best talent, which was what investment
banks drew on, and into the hedge funds, new private equity funds
and other places in the market.[115]
75. The FSA noted that there could be obstacles
under EU law to measures aiming to prevent a group which contains
proprietary trading activity from being the owner of a ring-fenced
bank:
The exercise of the regulator's powers to prohibit
groups containing a ring-fenced bank from engaging in proprietary
trading is likely to be constrained by provisions of EU law which
limit the grounds on which a competent authority may object to
a proposal to acquire a qualifying holding in banks. These provisions
were introduced by the Acquisitions Directive [2007/44/EC] which
amended the BCD to provide that a competent authority may oppose
a proposed acquisition of a bank only if there are reasonable
grounds for doing so on the basis of specified criteria. [116]
This is the same obstacle as for a move to require
full separation which we discussed in our First Report.[117]
One of our conclusions then was that, ahead of the commencement
of provisions relating to electrification, the Government should
take the opportunity of the delay to implementation that we proposed
to "secure amendments to European legislation to ensure that
the provisions relating to full structural separation are compatible
with European law".[118]
Conclusions
76. We have received extensive
evidence from banks, and particularly from regulators and independent
experts, about the practical difficulties of establishing a definition
of proprietary trading which meets the standard necessary to support
effective enforcement. An individual proprietary trade may outwardly
appear to be similar or identical to trades arising from client
activity such as market-making, with the main difference relating
to the intent behind the trade.
77. Attempting to categorise
individual trades as proprietary or non-proprietary is likely
to be particularly challenging. Attempting to use a broad definition
would risk capturing activities which all would accept perform
a useful economic and social function, such as serving clients,
supporting markets or mitigating risk; in such cases supervisors
could be faced with a burdensome task of having to assess firms'
justifications for exemption on a case-by-case basis. However,
using a narrow definition, or setting out category exemptions
up-front, risks making it too easy for creative traders or firms
who wish to continue speculating to evade the rules by re-classifying
or disguising their activity. Another argument advanced by several
witnesses was that attempting to prohibit proprietary trading
in the UK would risk distracting attention from implementation
of the ring-fence.
78. An alternative way of enforcing
prohibition, as currently being developed by US authorities, would
be to use a range of metrics to monitor and track patterns of
trading activity in order to identify where it appeared to have
the characteristics of proprietary trading. Although this would
not identify which individual trades are proprietary or client-related,
such metrics could be able to signal which banks are engaged in
proprietary trading, highlighting risks to the regulator. While
this new approach appears more promising than attempting to categorise
individual trades, it remains unproven, relatively complex and
resource-intensive.
80 Oral evidence taken before the Parliamentary Commission
on Banking Standards Panel on Regulatory Approach on 21 January
2013, HC (2012-13) 821-ii, Q 178 Back
81
Q 3685 Back
82
Q 2595 Back
83
Q 3866 Back
84
Q 4173 Back
85
Ev w8 Back
86
Oral evidence taken before the Parliamentary Commission on Banking
Standards Panel on Tax, Audit and Accounting on 24 January 2013,
HC (2012-13) 881-iv, Q 279 Back
87
Q 4175 Back
88
"Volcker Rule, Once Simple, Now Boggles", New York
Times, 1 October 2011, www.nytimes.com Back
89
Q 4473 Back
90
Q 2914 Back
91
Oral evidence taken before the Parliamentary Commission on Banking
Standards Panel on Regulatory Approach on 21 January 2013, HC
(2012-13) 821-ii, Q 178 Back
92
Ev w20 Back
93
Ev w3 Back
94
Ev w12 Back
95
Ev w25 Back
96
Darrell Duffie, "Market Making Under the Proposed Volcker
Rule", Rock center for Corporate Governance, Working
Paper Series No. 106 (2012), p 2 Back
97
Q 3867 Back
98
Q 3684 Back
99
Q 68 Back
100
Q 4473 Back
101
Ev w12; Ev w17 Back
102
Q 3684 Back
103
Ev w20 Back
104
Q 2579 Back
105
Oral evidence taken before the Treasury Committee on 7 February
2013, HC (2012-13) 944, Q 136 Back
106
Ev w3 Back
107
Q 3693 Back
108
Q 1149 Back
109
Q 2580 Back
110
Q 2591 Back
111
Ev w8 Back
112
Q 2580 Back
113
Darrell Duffie, "Market Making Under the Proposed Volcker
Rule", Rock center for Corporate Governance, Working
Paper Series No. 106 (2012), p 2 Back
114
Ev w12 Back
115
Q 2737 Back
116
Ev w8 Back
117
First Report, para 89 Back
118
First Report, para 166 Back
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