Five regulatory agencies in the US have voted to approve the Volcker Rule today. The measure establishes new hurdles for banks that engage in market timing and will limit compensation arrangements that previously provided incentive for high risk trading.
While the Federal Reserve Board and the Federal Deposit Insurance Corporation voted unanimously to approve the Volcker Rule, the Securities and Exchange Commission approved it in a 3-2 vote, the Commodity Futures Trading Commission approved it in a 3-1 vote, and the Office of the Comptroller of the Currency’s sole voting member also said yes. President Barack Obama praised the rule’s finalization. He believes it will improve accountability and create a safer financial system.
Named after ex-Federal Chairman Paul Volcker, the rule sets up guidelines that impose risk-taking limits for banks with federally insured deposits. It mandates that they show the way their hedging strategies are designed to function, as well as set up approval procedures for any diversions from these plans. Per the rule’s preamble, banks have to make sure hedges are geared to mitigate risks upon “inception” and this needs to be “based on analysis” regarding the appropriateness of strategies, hedging instruments, limits, techniques, as well as the correlation between the hedge and underlying risks.
Banks with federal insured deposits won’t able to take part in proprietary trading, which involves engaging in risky investment endeavors for their own benefits. They also won’t be allowed to take ownership stakes in private equity funds and hedge funds.
Unlike an earlier version of the rule, which gave an exemption to the proprietary trading ban involving US Treasury securities, this final rule lets firms trade foreign debt. That said, foreign banks in the US will have to contend with stringent trading restrictions and overseas banks with US offices won’t be allowed to sell, buy or hedge investments for profit.
According to CNN.com, advocates of reform believe that with the Volcker Rule’s restrictions taxpayers wont have to bail out these institutions In the future. Meanwhile, representatives of the industry are calling measure burdensome and too complicated.
Banks wanted the rule to protect market timing (with the firms hold the securities to engage in customer transactions). They also wanted to keep their ability to trade for hedging purposes.
Now, with the Volcker Rule, to show that they are taking part in market making (rather than speculation), banks will need to demonstrate that trades are being determined by customers’ “reasonably expected near-term demands,” and that historic demand and existing market conditions have been factored into the equation. Also, although banks will now have to contend with more limits on foreign bond trading, they can still take part in the proprietary trading of federal, state, municipal, and government-backed entities’ bonds.
As for hedging, firms will have to identify specific risks that such activities would offset. Bankers involved in hedging won’t be compensated in a manner that rewards proprietary trading.
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