Interpretation of Volcker Rule That Muddies the Intent of Congress

The path to gaming the Volcker Rule has always been clear: Banks will shut down anything with the word "proprietary" on the door and simply move the activities down the hall.

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To look like they were ready to comply with the Volcker Rule, the part of the Dodd-Frank Act that aims to prevent banks from gambling on their own account with money that taxpayers insure, financial firms quickly spun off or shut down their hedge funds, private equity firms and proprietary trading desks.

But the suspicious-minded among us wonder whether it was all that simple. This is the specter raised by the news that a JPMorgan Chase trader in London, made instantaneously notorious thanks to his colorful nicknames ("Voldemort" or "the London Whale," take your pick), was amassing such huge positions in indexes related to corporate defaults that he was distorting the market. (Apparently, it wasn't just one trader but more than a dozen, according to a person at JPMorgan, but the nicknames are too good to let go.)

Bloomberg followed up with a powerful article about how Jamie Dimon, the chief executive of JPMorgan, has transformed the sleepy chief investment office, which takes care of the bank's treasury operation, into a unit that hires former hedge fund portfolio managers and slings around giant sums of money in what walks and quacks like prop trading. The chief investment office seems not to just be risk-mitigating, but profit-maximizing.

The Congressional authors of the Volcker Rule worried about this very thing, and you can trace their concerns through their drafts. The original language of the rule had a broad exception: banks couldn't trade for their own account, but they could hedge to mitigate their risks.

The authors quickly realized that the exemption was absurdly broad. After moving these businesses to other divisions, banks would then argue that their bets were either market-making activities or simply hedges that offset risks.

Such "hedges" could encompass a lot of trades that looked awfully proprietary. A trade could seem to hedge a large business risk, like suffering loan losses if companies they lent to went broke in an economic downturn. But that might just be a bet on companies going belly up.

So Congress tightened the language. It wrote that the hedges had to be specific. When the Dodd-Frank financial reform law came out, the Volcker Rule provision defined "risk mitigating activities" as trades that were "designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings." No macro-hedging, only micro-hedging. That is the will of Congress.

But then federal regulators got their hands on Volcker and set about interpreting the meaning of Dodd Frank. This has been a Talmudic exercise in reverse: It has taken the clear and simple intent and made it muddy and complicated.

Regulators decided that banks could say that they were hedging for an overall portfolio. And the banks could argue that a hedge was legitimate if it merely had a "reasonable correlation" with the security or position being hedged. It was as if the regulators had not only questioned the basis for the rules of being kosher, but had also served up a cheeseburger – with bacon on top – all very nonkosher.

"One of the great fears was that banks could avoid the rule by simply pretending that their prop trading was somehow their market-making or hedging," a Congressional aide told me. "Congress tightened the language to prevent this, and yet banks still may get away with this under the proposed rules."

The rules aren't finalized, so there's a chance the regulators will make adjustments. The authors of the Volcker Rule raised objections in a comment letter in February. "Banks could easily use portfolio-based hedging to mask proprietary trading," Democratic Senators Jeff Merkley of Oregon and Carl Levin of Michigan wrote in a letter to regulators. "There is no statutory basis to support the proposed portfolio hedging language, nor is there anything in the legislative history to suggest it should be allowed."

The problem of allowing a broad "portfolio hedging" exception is obvious. Follow the logic to its end, and you could expect to find a bank arguing that it needed to hedge its commercial banking business by buying an investment bank and hedge its banking business with an insurance company and so on.

And lo, JPMorgan says exactly what we might expect a bank that knows how the regulators are interpreting Volcker would say: that the trading of its chief investment office is merely hedging.

But the bank is unabashed: "The purpose of this is to hedge the macro risk of the company," a JPMorgan executive explained to me. "It's what we are supposed to be doing, we do it well, we write about it in the annual report and we show it to every regulator," he added.

Alas, it wasn't the regulators who brought this to light. Instead, it took hedge funds on the other side of trades. This has led to a cynical reaction: hedge funds are hardly the epitome of upright regulatory citizens, burning to bring violations of the Volcker Rule to light.

But just because a hedge fund is biased doesn't mean it's wrong. It can be simultaneously true that hedge funds have gotten themselves into a bad trade and that JPMorgan is doing something more than hedging.

And it matters what the banks' trading partners think because the banks invoke them constantly in order to protect themselves from the Volcker Rule. The big banks wrap themselves in the mantle of market-making. Without them, they warn, liquidity – or how easy it is to enter and exit trades – will dry up.

In the case of these JPMorgan trades, however, we can see how a huge position can undermine liquidity. A big bank can become the market. JPMorgan's big position now makes trading in these credit indexes less likely, not more, which could lead to more volatile markets.

So is this legitimate trading? The hedge funds don't really know what's going on at JPMorgan's chief investment office. Nor can the public tell from the bank's disclosures. The only ones who have a chance to get a true picture are the dozens of regulators who are sitting in the bank's office.

But given how bent the regulators are to subvert the will of Congress, it would take an act of extraordinary naiveté to believe they will actually get to the bottom of it.