James Rundle: Whale for Breakfast

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James Rundle, Waters

JPMorgan’s losses from the ‘Whalegate’ fiasco have reignited debate on the Volcker Rule. Risk metrics, or the alteration thereof, are being blamed for this latest example of trading malfeasance, but James says it’s continued vagueness over regulation that causes holes such as this.

When is a hedge not a hedge? When it’s a hedge, apparently, or at least that seems to be how the argument goes on Capitol Hill. JPMorgan’s trading losses, caused by a lack of control over selling protection on a little-known index in its Chief Investment Office (CIO), performed rather questionably by trader Bruno “Whaldemort” Iksil, have re-opened debate into the Volcker Rule.

The argument for Volcker is thus: If banks can’t commit proprietary, risk-taking trades, then that will lead to more stability in the financial system that they underpin. Fine. The logic there, on the surface, is relatively sound.

The logistics, however, need a bit of work. Banks engaged in capital markets activity need to hedge their exposures in order to deliver profit to clients and ensure their own stability in the process. The way in which this is achieved involves a number of complex, technical formulae and calculations, risk management engines, and legions of staff across the world. How do you distinguish a hedging trade from a proprietary one, however? This seems to be the key grumble of industry argument against provisions in the Volcker Rule, and while it doesn’t carry the weight of, say, reducing systemic risk after a financial free-fall that nearly killed the Western economy, there is some truth to it.

Bluster and Bother
The problem is the vagueness of the regulators’ approach. If you’re going to regulate for the right reasons, then it at least needs to be comprehensive in its nature, and must take into account how capital markets operate. You can see this argument demonstrated in Europe and in the US. Take algorithmic trading, for instance, which has frightened people so much that overseers on both sides of the Atlantic are opening their arms wide and sweeping anything remotely automated under the same blanket umbrella. It doesn’t work.

Continual delays in important rulemaking do not help, either. Recently, the US Securities and Exchange Commission (SEC) published its roadmap to implementing derivatives reform, which went into detail on the order in which they intend to phase in the regulation, but didn’t include any timeframes. It’s like trying to run 10 kilometers on a treadmill without a dashboard—there’s a lot of effort and hot air, but in the end you feel exhausted and haven’t actually gotten anywhere.

The Commodity Futures Trading Commission (CFTC) has at least tried to set some dates, such as December 31, 2012, for derivatives reform and the establishment of swap execution facilities (SEFs), but the regulators aren’t just arguing with the industry over Dodd–Frank. There are at least five major agencies involved in Dodd–Frank within the US alone—the SEC, the CFTC, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp. and the Federal Reserve—as well as numerous other tangentially affected departments. Overseas authorities, too, are touched by the extra-territorial aspects of the law, or consulted on it.

The point is that the JPMorgan situation isn’t the most sensible peg on which to hang a cause for Volcker. We can only speculate as to the precise nature of the trades, but there’s not much a firm can do when hedge funds complain to the press about outsized positions when their forecasts aren’t panning out as planned. With that in mind, the explosion that Volcker would cause in the shadow banking system, with places like Morgan Stanley, Goldman Sachs and JPMorgan divesting anything that looks remotely like an internal hedge fund, could have far-reaching consequences.

There needs to be consistency. Regulators need to start adequately defining exactly what it is that they want the industry to do, and what they want to accomplish. Systems can then be put in place to ensure compliance, which keeps the vendors happy, and compliance spending can start to decrease, which keeps everyone else happy. Otherwise, the use of loopholes that eventually blow up in everyone’s faces starts to become depressingly commonplace.

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