Tuesday, July 03, 2012

Better Markets Urges SEC to Test for Randomness of Returns to Determine Availability of Volcker Rule Hedging Position

In a letter to the SEC on implementing the Volcker Rule, the Better Markets group urged the Commission to include tests for randomness of the returns on claimed hedged positions as a metric for determining whether the positions are in fact hedged.  The Volcker Rule provisions of Dodd-Frank Act clearly state that the permitted activity is solely for risk-mitigating hedging activities. Thus, compliance requires ensuring that the trading activity is not disguised proprietary trading. Better Markets, Inc. is a nonprofit organization that promotes the public interest in the capital and commodity markets, including in particular the rulemaking process associated  with the Dodd-Frank Act.

Better Markets explained that bone fide risk-mitigating hedging is a strategy to insure against an adverse change in value of a position.  It is accomplished by holding a second position, the value of which is negatively correlated with the price of the first.  If the two values are perfectly correlated, and the value of the hedge is appropriately chosen, then changes in the value of one position will be offset by an opposite change in the value of the other.  The rate of return on the initial position and its hedge taken together will be zero.

To ensure that this is the case, and that the permitted activity of risk-mitigating hedging is not used to disguise illegal proprietary trading, reasoned Better Markets, one or more of the well-known statistical tests for randomness should be applied to the observed returns on claimed hedged positions.  The group pointed out that a number of operational versions of many such tests are described in a recent publication of the National Institute of Standards and Technology.