Wednesday, July 13, 2011

Dodd-Frank Mandated GAO Report Finds Challenge for Regulators in Obtaining Data on Proprietary Trading

In a report to Congress. a GAO study conducted pursuant to Section 989(b) of the Dodd-Frank Act concluded that that obtaining data on all potential proprietary trading by financial institutions and other entities was not feasible because the firms do not maintain separate records on these activities. As part of the study, the GAO collected available data on trading done by these firms’ stand-alone proprietary trading units or desks—those organized for the specific purpose of trading a firm’s own capital—as well as their hedge fund investments and private equity fund investments, including analyzing data on firm revenues, losses, and certain risk measures.

Section 619 of the Dodd-Frank Act,also known as the Volcker Rule, prohibits banking entities from engaging in proprietary trading—trading in stocks or other financial instruments using the institution’s own funds in order to profit from short-term price changes. It also prohibits these entities from investing in or sponsoring hedge funds, which are commonly understood to be investment vehicles that engage in active trading of securities and other financial contracts, and private equity funds. These restrictions were included in an effort to restrain risk taking at banking entities and to reduce the potential that these entities could require federal support because of their speculative trading activity within the banking entity. Section 989(b)required GAO to study the risks and conflicts of
interest associated with proprietary trading by and within covered entities.

While proprietary trading can generate revenue for firms, said GAO, it also poses a number of risks. One is market risk, which is the potential for financial losses due to an increase or decrease in the value or price of an asset or liability resulting from movements in prices. There is also liquidity risk, which is the potential for losses or write-downs to occur if an institution has to exit a position but either cannot do so or can do so only at a significantly reduced price because of an illiquid market. Another risk of proprietary trading is counterparty credit risk, which is the risk to earnings or capital arising from an obligor’s failure to meet the term of any contract with the bank or to otherwise perform as agreed.
There is reputation risk, which is the potential for financial losses that could result from negative publicity regarding an institution’s business practices that results in a decline in customers or revenues. Finally, there is operational risk, which is the potential for loss resulting from inadequate internal processes.

The GAO also noted that hedge fund and private equity fund investments can also pose risks to bank holding companies. Hedge funds, like proprietary trading operations, are subject to market and other types of risk that can result in significant financial losses, and private equity funds are additionally affected by broader changes in the economy that affect the companies in which they have invested. Some failures at other large financial institutions other than bank holding companies illustrate the potential for financial losses at hedge funds, said GAO, citing as an example, the 1998 near collapse of Long-Term Capital Management.

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