Thursday, August 05, 2010

Key Senators Advise SEC and Fed on Implementation of Volcker Provisions of Dodd-Frank

In a letter to federal financial regulators, including the SEC and the Fed, Senators Jeff Merkley and Carl Levin urged the strong implementation of the Volcker provisions of the Dodd-Frank Act, particularly provisions limiting conflicts of interest and high-risk proprietary trading. The senators said that firms are responding to some of these new restrictions by taking what amounts to two approaches: (1) burying their proprietary trading in their market-making accounts, and (2) reassigning their proprietary traders into asset management units managing client money. Banks seeking to bury their proprietary trading desks in their market-making operations are likely attempting to evade the Volcker restrictions, reasoned the senators, while banks who move traders to separate asset management businesses to manage client funds are likely taking laudable steps towards compliance.

Done properly, market-making is not a speculative enterprise, they noted, and firms’ revenues should largely arise from bid-ask spreads and associated fees, rather than from changes in the prices of the financial instruments being traded. Regulations seeking to distinguish market-making from proprietary trading activities will require routine data from banks on the volume of trading being conducted, the size of the accumulated positions, the length of time positions remain open, average bid-ask spreads, and the volatility of profits and losses, among other information.

They also importantly noted that the term “in facilitation of customer relations” was removed from the final version of the Act out of concern that the phrase was too subjective, ambiguous, and susceptible to abuse. According to the senators, this means banks will have to establish that their market-making-related purchases and sales are not designed merely to facilitate customer relationships, but are intended to meet the reasonably expected near term demands of clients for specific financial instruments.

They explained that the Volcker provisions on proprietary trading and conflicts of interest, sections 619-621 of the Dodd-Frank Act, are designed to achieve five main objectives. First, they will protect the economy from high-risk, conflict-ridden financial activities by barring depository banks and their affiliates from engaging in proprietary trading and making large investments in hedge funds and private equity funds. Second, they will rein in dangerous risk-taking by subjecting critical nonbank financial institutions to strict capital charges and quantitative limits on any proprietary trading and investments in hedge funds and private equity funds. Third, the provisions will reestablish market discipline and integrity by restricting the ability of banks and critical nonbank financial institutions to bail out sponsored or advised hedge funds and private equity funds. Fourth, they will rehabilitate the traditional business of banking by conducting a significant review of the long-term investment activities currently permitted to banks and their affiliates. Fifth, they will end the conflicts of interest that arise when a financial firm designs an asset-backed security, sells it to customers, and then bets on its failure.

Some of the most intense negotiation over the Volcker provisions concerned the extent to which banks that provide client asset management services would be permitted to invest in hedge and private equity funds. Dodd-Frank’s final language includes strong protections to ensure that the limited exceptions intended to preserve asset management functions do not become backdoor proprietary trading operations. The senators advised that preventing these exceptions from becoming such a loophole will require careful implementation and vigorous enforcement. Banks are limited to a de minimis amount of money that can be invested in any given fund (at most, 3% in each fund) and in all funds in the aggregate (at most, 3% of Tier 1 capital). This de minimis allowance is permitted only to enable banks or their affiliates to provide asset management services to clients, explained the senators, and not to open the door to proprietary trading.

These investments, and the banks’ relationships with them, cannot be allowed to jeopardize the banks, emphasized the senators, and thus implementing regulations should only allow for a bank investment as necessary to seed a fund or align the interests of the bank with the fund investors. Seeding funds should be limited to the minimum amount necessary to attract investors to the investment strategy of the fund and must not serve principally as a proprietary investment. Regulators should issue rules treating hedge and private equity funds with large initial investments from the sponsoring bank and funds that are not effectively marketed to investors as evasions of the restrictions. Similarly, co-investments designed to align the firm with its clients must not be excessive, and should not allow for firms to evade the intent of the restrictions.

The provisions also prohibit banks from bailing out their sponsored or advised funds or investors in those funds, or from having relationships or engaging in transactions that make such bailouts more likely. For example, investments by officers and directors could create inappropriate incentives to bail out funds. Similarly, maintaining lending and derivatives relationships with sponsored funds would make such bailouts possible. Both are generally prohibited. Senators Merkley and Levin emphasized that regulations implementing these restrictions should be strict, and the penalties for violations, severe.

Another critical factor to minimize bank risk from hedge funds and private equity funds is to require the bank to deduct investments in hedge funds and private equity funds on, at a minimum, a one-to-one basis from capital. As the leverage of a fund increases, the capital charges should be increased to reflect the greater risk of loss. The senators said that regulations implementing these capital charges should discourage these high-risk investments and limit them to the size necessary to facilitate management of client assets.

Section 619(d)(2) prohibits what might otherwise be permitted activities, if such activities would involve or result in material conflicts of interest with clients, customers, or counterparties. This conflicts of interest prohibition seeks to restore integrity and stability to the financial marketplace, making it safe for clients to place their investments with firms that are required to work on their behalf instead of betting against their interests. Unlike section 621, section 619(d)(2) is not limited to asset-back securities, but applies to all types of permitted trading activities.
According to the senators, regulations implementing section 619(d)(2) should pay particular attention not only to the financial activities of a bank’s own traders, but also to the hedge funds and private equity funds organized and offered under subparagraph (G) to ensure that that they are not taking unfair advantage of information on the trading flow of the banks’ other clients. Hedging activities should also be particularly scrutinized to ensure that information about client trading is not improperly utilized.

Section 621 also addresses conflicts of interest, but only in the context of asset-backed securities. This section prohibits firms from packaging and selling asset-backed securities to their clients and then engaging in transactions that create conflicts of interest between them and their clients. The senators noted that the Permanent Subcommittee on Investigations’ hearing on Goldman Sachs highlighted a blatant example of this practice where the firm assembled asset-backed securities, sold those securities to clients, bet against them, and then profited from the failures. Regulations implementing section 621 should put an end to those conflict-ridden practices.

Finally, the senators advised that the conflict of interest prohibition in section 621 is not intended to prevent firms from supporting an asset-backed security in the after-market. But this activity must be designed to support the value of the security, not undermine it. Further, the utility of disclosures must be carefully examined, and not be seen as a cure for the conflicts. They pointed out that Dodd-Frank provided the SEC with sufficient authority to define the contours of the rule in such a way as to remove conflicts of interest from these transactions, while also protecting the healthy functioning of the capital markets.