In our upcoming July digital edition, Advanced Trading tackles the question of why enforcing the Volcker Rule could prove to be "Mission Impossible" for regulators. Not only will they have difficulty in distinguishing proprietary trading from everyday buying and selling of securities for customers, but authorities will also need to be able to track a banker's book to ensure they're not covertly conducting banned activity.
In an interview with Advanced Trading, Stephen Anikewich, the head of U.S. compliance for NICE Actimize, broke down why that may ultimately prove to be beyond their reach.
What happens to the way banks use credit default swaps under the Volcker Rule's ban on proprietary trading?
Stephen Anikewich: If and when Volcker does get implemented, unfortunately we've got a very recent vintage issue with respect to JPMorgan. Which hits right on your question. So CDS will be permitted as hedging transactions by the banks that are subject to Volcker. Not everybody will be subject to Volcker, just those financial institutions of a bank holding structure. But that's 99 percent of them anyway.
They will also be able to be involved in the market as a dealer in their capacity as a market maker in providing liquidity to the market and the end user. They're a critical part of that process. If they're taken out of that process then the market I think will collapse. It disappears.
They're the ones that have the expertise and the engineering abilities to create the product as it relates to the specific risk management needs of the person that's buying that product from them. What they won't be able to do obviously is take on any risk outside their role as a market maker. That's where the challenge comes in, much like the challenge of what everybody's dealing with right now with JPMorgan, which was presumably doing nothing more than hedging many hundreds of billions of corporate risk.
The challenge is being able to understand how that's done and being able to connect the dots between the CDS activities and the specific risk exposures that they were trying to mitigate. It's not a bright line test, and I'm not a quant, but when I think about how that all gets done, I kind of cringe. But that's one of the challenges the banks will have under Volcker Rule, is being able to have the structure in place to be able to draw the line of demarcation between their hedging and dealer market making activities versus their risk activities. I don't know that there's necessarily a bright line test. It's going to be a struggle for many of these firms to put the controls in place in order to effectively monitor that.
How difficult will it be for regulators to track a banker's book and make sure they aren't taking on risks that will be prohibited by the Volcker Rule?
Anikewich: It's safe to assume it's outside their bandwidth to do that. If you look at what happened with JPMorgan, the regulators live there on a day-to-day basis. They have to have a permanent shop there. They had all this transparency with respect to the activities that were going on in London, but even in that situation they weren't able to detect for this.
I could be wrong about this but my gut tells me the regulators largely do nothing more than piggy back onto the risk systems that the firms have developed internally. If indeed there's a fault with it like there presumably was with the metrics being used by JPMorgan, the regulators are not going to find it either.
The regulators in many regards are going to be dependent upon the systems that firms have and the data they're providing. Volcker has many different pieces to it, but part of it is that in addition to the firms needing to have robust risk management systems to be able to identify their risk, they need tools in place for creating certain metrics to be used in the assessment process as to whether or not they haven't crossed that line between hedging and market making to taking on risk.
Those metrics fall into 17 different buckets. Some relate to the revenue, some relate to the positions, but there are four different quantitative metrics that regulators have promulgated in their guidelines as to the data firms have to create and provide to their primary regulator. But again, it could be a situation where the analysis and the assessments of regulators is going to be based upon the integrity and the quality of the data that's being provided to them by the banks.
Does this hold any relevance to buy-side traders?
Anikewich: The Volcker Rule doesn't impact the buy-side trader. There's different categories of buy-side traders but they could be using it either as hedging or they can be using it as part of their trading strategies.
From the buy-user's perspective, nothing's changing except that perhaps there will be some additional transparency available to them with respect to where some of these products are being traded.