Brief Introduction of Volcker Rules

1. Written by Kaushik Pramanik
Volcker Rules - Is it going to be the end of
Proprietary (Prop) trading in the bank?
Through Proprietary trading (also "prop trading"), a firm trades stocks, bonds,
currencies, commodities, their derivatives, or other financial instruments using it’s own
money, as opposed to depositors' or customer’s money, so as to make a profit for itself.
Proprietary traders may use a variety of fundamental and technical strategies much like a
hedge fund to make a trade to gain profit within short-term. In a major and big investment
bank, Prop trading is a hot stuff because bank can make huge amount profit within a short
time frame but also can loose huge amount of money because of the wrong trading strategy.
Prop trading has been responsible for some large losses and there is a risk of moral hazard
(the trader is using the firm’s capital and therefore may take more risks) but is also usually
the most profitable part of an investment bank. Prop traders usually have access to
extremely sophisticated software and information to enable them to gain a competitive edge.
Many people believe that prop trading was responsible for 2008 credit crisis globally; hence
regulators have started looking into this matter deeply.
The Volcker Rule developed by former United States Federal Reserve Chairman Paul
Volcker as part of Dodd-Frank act to restrict United States banks from making certain kinds
of speculative investments that do not benefit their customers, which is actually targeting the
proprietary (Prop) trading.
As part of the Dodd-Frank Act, Congress adopted a ban on
proprietary trading and restricted investment in hedge funds and
private equity by commercial banks and their affiliates, the so-called
"Volcker Rule." The Rule also capped bank ownership in hedge
funds and private equity funds at three percent.

2. In a summary Volcker rules restrict,
• engaging in short-term proprietary trading of securities, derivatives, commodity
futures and options on these instruments for their own account.
• owning, sponsoring, or having certain relationships with hedge funds or private
equity funds, referred to as 'covered funds.'
Many people applaud the spirit of the rule. Banks were vilified when the public learned that
they bet against their own customers as a way to profit on their own. The banks argued that
this role was consistent with market making, but opponents weren't convinced.
Institutions were given a seven years timeframe to become compliant with the final
regulations as it will not be a straight forward implementation like other regulatory reforms. It
requires cultural and structural changes in the bank, policy changes, high-level of
compliance, quantitative reporting, and trade level monitoring.
Depending on their size, banks must meet varying levels of reporting requirements to
disclose details of their covered trading activities to the government. Larger institutions must
implement a program to ensure compliance with the new rules, and their programs will be
subject to independent testing and analysis. Smaller institutions are subject to lesser
compliance and reporting requirements.
“Volcker rules” has suggested following quantitative reporting requirements for various
trading activities performed by banks and financial institution.
• Risk and Position Limits and Usage
• Risk Factor Sensitivities
• Value-at-Risk and Stress VaR
• Comprehensive Profit and Loss Attribution
• Inventory Turnover
• Inventory Aging
• Customer Facing Trade Ratio
The rule allows banks to continue market making, underwriting, hedging, trading of
government securities, insurance company activities, offering hedge funds and private
equity funds, and acting as agents, brokers or custodians. Banks may continue to offer
these services to their customers and generate profits from providing these services.
However, banks cannot engage in these activities if doing so would create a material
conflict of interest, expose the institution to high-risk assets or trading strategies, or
generate instability within the bank or within the overall U.S. financial system.

3. The second part of the rule attempts to put a limit on the size of the bank. This would keep a
bank from becoming too big to fail. Although a 1984 rule limits a bank to a maximum of 30%
of the nation's deposits, the Volcker Rule attempts to take this further so taxpayers won't have
to give banks another bailout as they did in the recent crisis.
After the implementation of Volcker rules, some believe that the cost of trading stocks
could rise, and lower trading volume, as a result of less institutional buying, could lead to
less efficient markets. With less income from trading activities, the lost revenue will have
to be recouped somehow. As customers found with the CARD Act, when banks lose income,
they often raise consumer fees to recoup the loss.
In a nutshell, the future of investment bank and its prop trading arm will face very tough
time through Volcker rules.
About the Author:
Kaushik Pramanik is a seasoned, capable, effective, result-driven banking and finance
professional who boasts an exemplary track record of leading and managing transformational
change and regulatory multi-million USD projects to large high profile organisations like
Citigroup, Credit Suisse, UBS, SIX, PMI etc., utilising over seventeen years of business
and IT experience to do so effectively and efficiently. Experienced in the development and
execution of solutions on both a global and regional level, encompassing critical analysis,
strategic development, and process re-design in order to achieve tangible business benefits
which add value and maximise profitability. Offers a comprehensive end-to-end
understanding of the change processes, all relevant methodologies and displays advanced
skills in problem solving, stakeholder management, decision making and communication to
formulate a shared business vision which fulfils organisational overall objectives.