Earlier this month on CBS’s "60 Minutes," Federal Reserve Chairman Jerome Powell sat down for an interview with longtime correspondent Scott Pelley. While the interview was light on actionable investment advice, it did offer a unique look into the mindset of the 71-year-old chairman.
Powell was reluctant to celebrate a victory over inflation and noted his concerns over rising debt. The Fed’s tight money policy has echoed the era of Paul Volcker, who served as Fed chair from 1979 to 1987 and faced a similar task in defeating inflation. But Volcker’s tenure at the Fed isn’t why prop traders should know his name — it’s the banking rule that bears his moniker.
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Separating Speculation From Banking
The Bank Holding Company Act of 1956 was designed to prevent large national banks from taking market share from smaller local banks by defining which institutions could operate across state lines. The legislation gave the Federal Reserve more authority over the banking industry and has been altered several times. Still, prop traders will be interested in one of the more recent changes.
After the Great Recession, the Dodd-Frank Act implemented financial reforms that attempted to strengthen the United States’s financial plumbing. Dodd-Frank created several new federal offices, like the Consumer Financial Protection Bureau (CFPB), and altered several existing pieces of legislation. One of the Dodd-Frank reforms was attached to the Bank Holding Company Act, initially proposed by Volcker in 2010.
In a New York Times op-ed, Volcker questioned the role speculative trading played in the significant bank disruptions during the Great Recession. Appointed by President Barack Obama to his 2009 Economic Recovery Board, Volcker argued that too many banks (including the so-called Too Big To Fail institutions) engaged in risky investments and trading practices, few of which were in the best interest of the banks’ clients. According to Volcker, proprietary trading and complex derivative investments weren’t suitable for these institutions, which the public depended upon as a source of safety, not speculative excess.
Implementation And Criticism
Dodd-Frank officially adjusted section 13 of the Bank Holding Company Act, which was then nicknamed the Volcker Rule after its initial proposer. The Volcker Rule severely limited the types of speculative investments banks could make. Proprietary trading systems were to be shuttered, and risky bets using derivatives like collateral debt obligations (CDOs) were to be unwound. Additionally, bank investments with hedge funds and private equity were to be limited or prohibited altogether.
The Volcker Rule was hotly criticized by banks that didn’t want their investment options limited, but it went into effect in July 2015 and set dates for when banks needed to unwind their riskier trades. However, the backlash was swift, and many banks immediately began requesting extensions or loopholes to allow some types of riskier trading to occur.
Efforts to neuter parts of the Volcker Rule have been successful in recent years. In June 2020, the Federal Deposit Insurance Corp. (FDIC) voted to allow commercial banks to invest in venture capital funds. However, regulators did achieve their goals — commercial banks and proprietary trading went their separate ways as many of the industry’s most prominent traders left their banks to form hedge funds.
Commercial banks and proprietary systems may not mix, but plenty of other firms are still seeking top trading talent. Prop trading programs have become popular for experienced investors to get their feet wet in this field. For example, Trade The Pool’s Funded Trader Program provides paper capital to prospective traders for a small upfront fee and then offers tools, training and analysis to maximize profit potential. But remember — only the top traders will make it through the evaluation phase into the funded account phase.
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Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act added a new section 13 to the Bank Holding Company Act of 1956 ("BHC Act"), commonly referred to as the Volcker rule, that generally prohibits insured depository institutions and any company affiliated with an insured depository institution ...
The Volcker Rule was part of the Dodd-Frank Act enacted into law by the Obama administration in 2010 as a response to the Global Financial Crisis. It prohibits banks from engaging in proprietary trading, or from using their depositors' funds to invest in risky investment instruments.
The Volcker Rule's purpose is to prevent banks from making certain types of speculative investments that contributed to the 2008 financial crisis. macroprudential regulation characterizes the approach to financial regulation aimed to mitigate the risk of the financial system as a whole (or "systemic risk").
The Volcker rule generally prohibits banking entities from engaging in proprietary trading or investing in or sponsoring hedge funds or private equity funds.
A bank holding company could operate branches in multiple states. These branches could be considered independent banks and therefore in compliance with the law. Bank holding companies had another advantage—they could own nonbank firms, such as manufacturing, transportation, or retail businesses, in addition to banks.
A bank may be excluded from the Volcker Rule if it does not have more than $10 billion in total consolidated assets and does not have total trading assets and liabilities of 5% or more of total consolidated assets.
The Volcker Rule generally prohibits a banking entity from entering into transactions with a related fund that w ould be a covered transaction under section 23A of the Federal Reserve Act if the banking entity w ere a member bank and the fund w ere its affiliate.
The final rule prohibits banks from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments, for their own account. The final rule also imposes limits on banks' investments in, and other relationships with, hedge funds or private equity funds.
Personal Risk: One of the significant drawbacks of prop trading is the potential personal financial risk. If a trader doesn't perform well, they may lose their deposit, and in some cases, their job. Loss Limitations: Prop firms often implement daily loss limits to protect their capital.
The Volcker Rule generally restricts banking entities from engaging in proprietary trading and from owning, sponsoring, or having certain relationships with a hedge fund or private equity fund.
Proprietary trading occurs when a financial institution trades financial instruments using its own money rather than client funds. This allows the firm to maintain the full amount of any gains earned on the investment, potentially providing a significant boost to the firm's profits.
The final rule is broadly similar to the proposed rule from January. The Volcker rule generally prohibits banking entities from engaging in proprietary trading and from acquiring or retaining ownership interests in, sponsoring, or having certain relationships with a hedge fund or private equity fund.
CFA Institute supports the general goal of the Volcker Rule — to prevent financial institutions from taking advantage of government-insured deposits and the capital of depository banking institutions to engage in proprietary trading or investing in hedge funds and private equity funds.
Loosely put, the Rule defines a covered fund as anything considered an investment company in the Investment Company Act, including private equity and hedge funds, as well as commodity pools with certain exclusions, and funds sponsored by a US banking entity where the affiliate holds ownership interests.
Bank holding companies are corporations that own controlling interests in one or more banks and manage their operations. Advantages of a bank holding company can include reduced overall risk and increased access to funding. Examples of bank holding companies include JPMorgan Chase & Co., U.S. Bancorp and Citicorp.
Section 13 of the Bank Holding Company Act establishes prohibitions and restrictions on proprietary trading and on investments in or relationships with covered funds by certain banking entities, including state member banks, bank holding companies, savings and loan holding companies, other companies that control an ...
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