Lots of questions, few answers and more questions: your guide to the Volcker rule

Since President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law in July 2010, few of the law’s rules have raised more questions, consternation and downright befuddlement than the Volcker rule.

So, in an attempt to clear up at least some of the confusion about a rule expected to have a sweeping impact on both physical and financial energy markets, we present what you need to know about a rule few seem to know anything about.

What is the Volcker rule?

The rule, named rule after former Federal Reserve chairman Paul Volcker, prohibits banks backed by federal deposit insurance and Fed discount window borrowing privileges and their subsidiaries from proprietary trading. The rule also limits their investments in hedge funds.
Banking regulators and the Securities and Exchange Commission released their proposed version of the rule in October and the Commodity Futures Trading Commission released their proposal on January 11.

That seems pretty straightforward, what’s the confusion?

Well, the devil really is in the details, as the old cliché goes, and this proposal, which stretches some 300 pages and includes roughly 1,400 questions for the public to weigh in on, certainly has a lot of details.

Perhaps the chief concern is how regulators will determine what proprietary trading is. The most basic concept behind the rule is stop banks from risky trading activity where they trade their own funds for profit. It appears though this won’t be that simple.

What trading activities will fall within the ban and which will fall outside of it, will be subject to endless debate and lobbying until the rule is finalized and even which markets will be impacted remains a source of contention.

“There are literally more questions than answers,” said Eugene Scalia at a US Chamber of Commerce event Tuesday.

Scalia, a partner at Gibson, Dunn & Crutcher and the son of US Supreme Court Associate Justice Antonin Scalia, was part of the legal team that successfully challenged the SEC’s proxy access rule in July.

The proposed Volcker rule contains “gigantic holes” and will likely need to be re-proposed in the future, Scalia said.

What will the impact be on energy markets?

The rule will likely limit proprietary trading by banks and their affiliates in energy derivatives markets, including futures and swaps trading, but it is also expected to extend into much of the physical market, including natural gas, oil and electricity trading, numerous sources claim.

According to an industry lawyer who has studied the proposal, if regulators narrowly interpret the rule, the ban could cover “almost everything” in energy markets.

However, it’s unclear how much trading currently done by banks in energy markets will be defined as proprietary trading. For example, JP Morgan, which would be subject to the rule, had the sixth highest number of total combined natural gas physical purchases and sales in 2010, according to the Federal Energy Regulatory Commission. But, how much of that trading would be subject to the ban is unknown, several sources said.

Why did the CFTC unveil its rule at a different time than everybody else?

CFTC Chairman Gary Gensler said his agency, racing to complete dozens of other derivatives reform rules, simply did not have time to consider it when it banking regulators began circulating a Volcker draft in October. The proposed rule unveiled by the CFTC this month is nearly identical to the one proposed in October, Gensler has said. The CFTC’s version of the rule would cover entities the agency regulates, such as futures commission merchants and swap dealers affiliated with banks.

Could this be a problem?

According to CFTC Commissioner Jill Sommers, a Republican, it certainly will be if banking regulators and the SEC decide to alter the rule they pitched in October.

“What will we do if they re-propose their rules?” Sommers asked at a CFTC meeting this month. “Will we be prepared to withdraw our proposal and join a re-proposed Volker Rule with the other agencies? It seems as if we have put ourselves on a separate track, which I fear will needlessly complicate an already convoluted and likely unworkable set of rules.”

What does Paul Volcker think about this rule?

During a speech in November at a Singapore university, Volcker said the rule was “much more complicated than I would like to see,” blaming financial industry lobbyists for complicating what he sees as relatively straightforward regulation, according to a Reuters report.

Are there exceptions to the rule?

The proposed rule contains a number of exemptions, such as allowing banking affiliates to continue to engage in market-making, underwriting and risk-mitigating hedging activities and allows these entities to continue to trade in many US, state and local government obligations.

So these exceptions are pretty clear cut then?

Not at all. Expect lobbyists to increase pressure on regulators to get more and more bank trading activity exempt from the rule. Several of these lobbyists believe that what constitutes market-making or hedging, for example, remains very much up to interpretation.

“This is all going to be fought and argued,” said John Parsons, the executive director of the Center for Energy and Environmental Policy Research at MIT. “There’s going to be a huge amount of arguing about this.”

How will regulators enforce the Volcker rule?

That’s a big unknown at this point.

CFTC Commissioner Scott O’Malia, a Republican, said it’s “unclear” what role the CFTC has in enforcing the rule, that it will require compliance with laws it has no authority to enforce and could create a number of jurisdictional battles.

As House Financial Services Committee Chairman Spencer Bachus, an Alabama Republican, put it at a hearing last week, regulators may be forced to “determine motive and intent” behind each trade a bank or banking affiliate does.

“Every trader is going to need a psychiatrist and a lawyer sitting next to them,” Bachus said.
The proposed rule is so vague and potentially unenforceable that Senator Bob Corker, a Tennessee Republican, half-heartedly wondered this week if regulators would need to resort to a bit of science fiction to make it work.

In order to tell if traders were prop trading or not, Corker suggested at the Chamber event Tuesday, regulators would probably need to plug wires into traders’ brains and connect them to government monitors.

When will the Volcker be in effect?

Dodd-Frank mandates the rule to be in effect by July 2012, but regulators and lawmakers are already taking about delays. Those delays could be weeks or months. If the rule is re-proposed it could be a year or more, according to numerous sources. 


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