In the wake of the 2008 U. S. financial crisis, new legislation was ushered in to avoid a reoccurrence. Passed in 2010, Dodd­Frank imposes myriad new rules on the financial industry that will irreversibly change the industry’s market behavior and client interactions. In particular, Dodd­Frank has focused on safeguarding consumers. One tool created to do this is the Volcker Rule. Named after the former Federal Reserve Board Chairman, Paul Volcker, this rule is designed to prevent banks from using consumer deposits, on its own behalf, in speculative deals with high gain and loss potential. The final rule was passed in 2013 and also includes compliance program and reporting requirements.

 

Prior to Volcker, commercial banks, brokerages, or other financial institutions could engage in trading with their own financial resources for the sole purpose of making a significant profit. That is, buying and selling stocks, bonds, commodities or other financial instruments for the bank’s own trading book. Such transactions are called proprietary trading, prop trading ​for short.  

 

Prop trading was previously prohibited through the passing of the 1933 Glass­Steagall Act, which was promulgated during the depression era and repealed in 1999 during the Clinton administration. Essentially, Glass­Steagall limited speculative transactions by commercial banks. This act also gave birth to the Federal Deposit Insurance Corporation (FDIC), which guarantees consumer deposits of up to $250,000. As such, the Volcker Rule incorporates many of the prohibitions of the repealed Glass­Steagall Act. It is sometimes referred to “Glass­Steagall­lite”

 

Not only is prop trading curtailed, but also commercial banks cannot own, invest, or partner with either hedge or private equity funds. However, the Volcker rule does allow banks to trade in U.S. securities such as bonds, make trades on behalf of customers, and prevent against bank

losses, or ​hedge. Banks hedge to guard against potential losses using complex data points in order to make educated guesses on the direction of specific market activity, for example interest rates. Permissible hedging relies upon a large collection of data that is used to make educated guesses about the direction of market activity. However, hedging may sometimes be hard to separate from prop trading because of their common techniques. Nevertheless, the Volcker rule attempts to do just that.

By: Dr. Sheryl Smikle

Sources:

​http://lexicon.ft.com/Term?term=proprietary­trading

http://blogs.wsj.com/marketbeat/2010/03/15/proprietary­trading­finally­a­definiton/

http://www.iflr.com/pdfs/a­users­guide­to­the­volcker­rule.pdf