Volcker rule still months away as CFTC prepares latest Dodd-Frank proposals

Prop trading ban delayed by inter-agency discussions and implementation challenges

Securities lawyers fear the US is still months away from clarity on the planned proprietary trading ban, as the Commodity Futures Trading Commission (CFTC) prepares for its next round of Dodd-Frank Act rule-making.

April 27 will see the fourteenth open meeting of the Commission to put forward detailed rules on product definitions such as 'swap' and 'mixed swap' under the Dodd-Frank Act, as well as prospective capital requirements for swap dealers and major swap participants that are not subject to supervision by prudential banking regulators.

It will be one of the last such meetings for the CFTC, which has presented proposed rules in 29 of the 31 rule-making areas it has identified under the Dodd-Frank Act. Not on the agenda, however, is proposed language for the implementation of the Volcker rule, which will ban prop trading and involvement with private equity and hedge funds for any institution that benefits from federal insurance on deposits or access to the Federal Reserve’s discount window.

“The Volcker rule is on a slower track on a statutory basis compared to some of the swap requirements. That may account for the delay, but the process of producing rules is tricky nonetheless, as the line between proprietary activity and market-making is both extremely vague and intellectually blurry,” says David Felsenthal, a partner specialising in derivatives at law firm Clifford Chance in New York.

The Financial Stability Oversight Council (FSOC) published a study and a series of recommendations on how federal regulators should attempt to enforce the ban in January, but since then, further insight into the progress of regulatory discussions has been hard to come by.

The FSOC study dwelt heavily on many of the intricacies regulators will have to overcome to establish a workable regime, including the difficulty of distinguishing legitimate market-making from proprietary trading, and the possibility that dealers can take a proprietary position by doing nothing and electing not to hedge a customer’s trade.

The fact that the study enumerated a number of supervisory problems has been taken by some derivatives lawyers to indicate that thrashing out a means to address these implementation difficulties may be the main factor in slowing down the process.

“The FSOC study was not very satisfying in providing a clear distinction between market-making and proprietary trading, but the onus will be on regulated entities to build models that will satisfy regulators that proprietary positions are not being taken. I can’t see how this can be done any other way, since the regulators are incapable of adopting bright line rules. The regulators will expect internal policies to be adopted to illustrate that banks are making their money through buying and selling rather than buying and holding,” adds Felsenthal.

The Volcker rule is part of an inter-agency process involving the Federal Reserve, the Securities and Exchange Commission (SEC), the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, with the CFTC primarily enforcing the rule on futures commission merchants, commodity pool operators and commodity trading advisers. The need for interagency discussion is no doubt also a factor in prolonging the process, but securities lawyers feel the complexity of the new regime would slow down the rule-making even if only one agency were involved.

“The delay is a function of co-ordination, and this is the issue that takes the most co-ordination and consensus with other regulators, with the Fed principally taking the lead and the SEC and CFTC in the back seat,” says Daniel Waldman, a partner at law firm Arnold & Porter in Washington DC and a former general counsel for the CFTC.

“Enforcement and compliance with the Volcker rule will be extremely challenging. The regulators feel they can make some progress in reducing the amount of open speculation by banks, and at the very least they are moving the ball somewhat forward even if they are recognising this will be a very tricky element to categorise. Defining hedging, for example, is difficult because virtually all risk mitigation involves some judgement about when and how the market is likely to move. None of these proposals are going to be easy,” Waldman adds.

Other lawyers speculate that there are also political concerns at play. Many market participants regard the Volcker rule as a largely political measure, as it was announced unexpectedly, the morning after the late Edward Kennedy’s Senate seat was lost to Republican Scott Brown in a January 2010 special election.

With pressure to include the measure in the Dodd-Frank Act coming from the White House and the US Treasury Department, rather than from Congress or regulators, some lawyers have concluded that the supervisors may be intentionally dragging their feet over a rule they neither wanted nor asked for, but are nonetheless obliged to develop a workable framework to enforce it.

“Bear in mind the changing political landscape right now. Given the Republican gains in the mid-term elections last November, the political enthusiasm for measures such as the Volcker rule may be somewhat diminished compared to when the rule was first proposed,” says Matthew Magidson, the New York-based chair of the derivatives practice group at law firm Lowenstein Sandler.

“With the shift in the leadership in Congress and the ongoing concerns about regulatory funding, I think these last outstanding issues may be tailored in their rule-making to be less burdensome for the regulators, or we could even see the rules written in such a way to allow certain measures like this to be cut in the future,” Magidson concludes.

The Dodd-Frank Act gives Federal regulators until September to release proposed rules on the proprietary trading ban.