The rule is shot through with similar “do the right thing” diktats that boil down to judgment calls. The words “reasonable” and “substantial” appear often. For example, to receive an exemption to conduct market-making, trading desks must both buy and sell contracts or enter into both long and short positions of the instruments they trade for their own accounts. The trades, however, can’t exceed the “reasonably expected near-term demands of clients.”
Some parts lack clarity and may need further refining. To receive an exemption for trades meant as hedges, banks must demonstrate that they are reducing “specific, identifiable” risks, but it isn’t clear by how much.
Nor is it clear what regulators mean when they say banks can hedge an “aggregate” position. This would seem to allow hedges for entire portfolios of, say, corporate loans, though certainly not the way JPMorgan conducted its “London Whale” portfolio hedges. Those positions, which were supposed to protect the bank against a deterioration in corporate credit, instead morphed into a huge bet that caused the bank to lose $6.2 billion.
Regulators relaxed other parts of their 2011 proposal. Buying and selling the securities of foreign governments won’t be considered proprietary trading after all — largely a response to criticism from European officials who said that such a prohibition would harm their sovereign debt markets.
Regulators also allowed overseas banks more flexibility. They won’t have to comply with the prop-trading ban so long as those doing the buying and selling are physically outside the U.S.’s borders.
Beyond prop trading, the Volcker rule limits bank investments in private equity, hedge funds and commodity pools. Here, regulators granted broad exemptions for some types of activities, including joint ventures, the issuance of asset- backed securities and wholly owned subsidiaries. Regulators may need to revisit these exemptions later.
What if the unexpected happens, as it’s bound to? They thought of that. The rule prohibits anything that would “substantially increase the likelihood that the banking entity would incur a substantial financial loss or would pose a threat” to financial stability. That’s good. Regulators need to hedge sometimes, too.