This Risk article (subs.) lays out in more clarity the Volcker rule impacts and in particular market-making and CVA trading. Given the rule runs to 900 or so pages, no doubt there are more unintended consequences, buried footnotes and hidden gotchas to crawl from the woodwork as we proceed towards compliance in July 2015 (with full compliance possibly phased through July 2017). For now though in outline this is starting to make sense.

This Risk article (subs.) lays out in more clarity the Volcker rule impacts and in particular market-making and CVA trading. Given the rule runs to 900 or so pages, no doubt there are more unintended consequences, buried footnotes and hidden gotchas to crawl from the woodwork as we proceed towards compliance in July 2015 (with full compliance possibly phased through July 2017). For now though in outline this is starting to make sense.

The basics

As you've heard proprietary trading and portfolio hedging are prohibited for US banks globally and for US operations of non-US banks. Banks however can trade if it is a. in government securities; b. on behalf of customers i.e. agency execution; c. in connection with underwriting or market-making (with compliance burden) or d. within the risk-mitigating hedge exemption (with associated compliance burden). The associated metrics are reduced from 17 to 7 and no thresholds or limits apply to the metrics.

Wait…how do you do market making without portfolio hedging?

Some details follow to clarify:

• How do you show hedges are risk-mitigating? Show that they are related to "identifiable risks of identified positions at the organization" and limits the hedges to "reasonably correlated instruments" – a considerable reporting burden.

• Any exemptions from risk-mitigating hedge compliance? Market making hedges.

• What hedges fall within the market making exemption? Those done by the market making desk itself but not hedging by another desk of risks arising from market-making desk positions. So e.g. a centralized CVA desk hedging aggregate counterparty risks for the bank as a whole still has to comply with the risk-mitigating hedge exemption. Here you can see the regulators approach to alleviating market making compliance burdens whilst keeping a tight focus on cases like the famous JP CIO / London Whale case where a firm-wide hedge stopped being a hedge at one point.

• How do you show you are market-making? Show the positions do not exceed near term demands of clients, customers, or counterparties.

• OK so how does market-making hedging work? Some semantic clarification: whilst portfolio hedging in a broad / vague sense is not allowed, aggregate hedges applied to a market making portfolio providing the market making positions condition is satisfied. 

Loose ends

Unfortunately, how you show positions do not exceed near term demands of  clients, customers, or counterparties is not set out precisely.  e.g. What does near term mean … a week, a month, a quarter?  How do you quantify the demands … trailing execution volumes, RFQ volumes etc.?