The Volcker Rule Explained
Recent reports from the media that Washington required more time to review to the Volcker rule, deferring it to the first quarter of 2013 gives some breathing space for financial institutions.
Whether you are an investor/trader or have an account with a US bank, the Volcker rule is something you should know about. In this article, we explain what is the Volcker rule and its implications on banks, their customers and traders.
The Volcker rule is a key component of the Dodd Frank Act that was implemented on July 2010. The basic essence of the Volcker Rule is to implement a ban on proprietary trading that banks currently engage in. What led to the Volcker rule proposal came out of the 2007 – 2010 financial crisis that engulfed many banks in the US.
Proprietary trading is when a firm trades stocks, bonds, currencies, commodities or their derivatives with the firms’ customer deposits. Proprietary trading is in fact an essential aspect of a bank’s business, but at the same time is risky, considering the speculative markets they operate in.
Further more, proprietary trading is usually undertaken in order to create a market, also known as market making that big banks usually engage in, especially when they are the underwriters for a new IPO.
The Volcker Rule – History and Context
The Volcker Rule or Volcker plan is the brainchild of former Federal Reserve Chairman, Paul Volcker, who currently holds the position as the chairman of the President’s economic recovery advisory board, which was formed to advise President Obama on matters of economic recovery.
The Volcker rule was essentially supposed to be passed into law by end of 2012. In April this year, the Federal Reserve issued a notice that banks would have a further two years in order to get their business activity in line with the Volcker rule. This includes restricting banks from engaging in hedge fund investments and private equity. It is estimated that the volcker rule would stop close to $15 billion in proprietary trading.
In order to complete the editing process of the rule, which has already swelled to more than 300 pages, it also requires five government instutions to sign off on it. These include the SEC (Securities & Exchange Commission), The Federal Reserve, Office of the Comptroller of the currency, the FDIC and the CFTC.
The Volcker Rule – Divided groups
As obvious, the Volcker rule has divided groups, one made up of consumer groups and backed by President Obama as well, while on the other hand, banks and financial institutions feel that the volcker rule could hit their bottom-line business. Indeed, the rule would affect financial biggies such as Goldman Sachs, JP Morgan Chase & Co, Bank of America to name a few.
Volcker Rule in Forex Trading Context
Undoubtedly, the current liquidity we see in the forex markets, be it currencies or commodities is by and large attributed to the institutional clients. This is also one of the reasons why some of the majors, and especially the EURUSD currency pair is so volatile.
From a speculative trader’s perspective, liquidity is good and market makers form an important element of trading as their provide the required liquidity to the said instruments. Another aspect of the volcker rule proposes changes to the current market making activity, where profits are derived out of price appreciation or depreciation. The proposed changes in the Volcker rule in regards to market making activity requires the revenue to be attributed from the fees, commissions and the spreads.
There are many questions still unanswered and it will definitely take quite some debate before the volcker rule is presented, especially considering how quickly it became such a complex process involving five government institutions. For the time being, the volatility and the liquidity is here to stay, which is good news for traders.