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.