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Merkley Levin Is a Joke

Merkley Levin Is a Joke

The Merkley-Levin Amendment (SA 3931) is a version of the Volcker Rule. The Volcker Rule, if youll recall, is a ban on proprietary trading at banks and bank holding companies (BHCs). If you ask Merkley and Levins offices, theyd no doubt tell you that their amendment significantly strengthens the existing Volcker Rule language in the Dodd bill (Section 619 of S.3712). Dont be fooled — it does nothing of the sort. I spent the majority of my career as a lawyer for one of the big investment banks, and my first thought after reading Merkley-Levin was: "Wow, this would be cake to get around." Wall Street is scared of the Volcker Rule, but believe me, theyre not scared of Merkley-Levin.

This requires a bit of explanation. To ban prop trading at BHCs, the law must distinguish between market-making trades and propietary trades. Market-makers stand ready and willing to buy or sell securities for their own account, at firm bid and offer prices. If an investor is looking to sell a security, the market-maker will buy the security using its own capital, and hold it in inventory until an investor whos looking to buy the security surfaces. Holding many inventories of securities (i.e., bonds, stocks, derivatives) exposes market-makers to all manner of short-term market risk, interest rate risk, foreign exchange risk, etc. This requires market-makers to do quite a bit of hedging in order to safely carry these inventories. We dont want to prevent banks from hedging the inventories they hold as market-makers, but we do want to prevent banks from entering into trades that arent intended to hedge a risk associated with its market-making activities — that is, purely speculative prop trades. This is a difficult and complicated task, but it can be done (Ive seen it done from the inside).

Ideally, what the financial reform bill would do is just say, "Proprietary trades are banned; market-making trades are allowed," and then let the regulators work out how to define "market-making trades" and "proprietary trades." This is something that simply cant be done at the statutory level; it has to be done at the regulatory level. Unfortunately, these days its fashionable for people to bash any sort of regulatory discretion as tantamount to letting Wall Street win. This is where Merkley-Levin comes in, because its clearly a response to this "anti-regulatory discretion" meme.

The biggest problem with Merkley-Levin is that its authors appear to confuse "definitions with more words" with "more specific definitions" (and thus less of that evil regulatory discretion). Merkley-Levin prohibits "proprietary trading," which it defines very broadly, and then creates 9 categories of "permitted activities" (listed in section (d)(1) of the amendment). The categories of "permitted activities," which function like exceptions to the definition of "proprietary trading," are so ridiculously broad that they completely swallow the amendments prop trading ban. The most important exceptions are sections (d)(1)(B), (C), and (G).

First, lets take section (d)(1)(B), which explicitly permits:

(B) The purchase, sale, acquisition, or disposition of securities and other instruments described in subsection (i)(4) in connection with underwriting, market-making, or in facilitation of customer relationships, to the extent that any such activities permitted by this subparagraph are designed to not exceed the reasonably expected near term demands of clients, customers, or counterparties.

Section (B) was obviously supposed to be the generic market-making exception — but notice, crucially, that the term "market-making" is still undefined. Instead of offering a more specific or more narrow definition of "market-making," Merkley-Levin actually weakens the Volcker Rule by creating a whole bunch of new categories of exceptions to the prop trading ban. Essentially, section (B) consists of three separate categories of permitted trades: (1) trades "in connection with underwriting"; (2) market-making trades; and (3) trades "in facilitation of customer relationships." Regulators still have to use the rulemaking process to define "market-making," which will no doubt encompass any trade which can be justified as a hedge against any risk the bank faces in its trading book.

But even if a trade cant be justified as part of the banks market-making activities, theres literally no trade that cant be justified as "in facilitation of customer relationships." As long as the counterparty on the trade has some sort of trading relationship with the bank (e.g., the counterparty is a prime brokerage customer, or has an ISDA Master Agreement with the bank), then its very difficult to see how the trade wouldnt come under the definition of a trade done "in facilitation of customer relationships." All counterparties are "customers" of the bank on some level, and because every trade has to have a counterparty, literally every trade could be justified as "in facilitation of customer relationships." And remember, the exception for trades "in facilitation of customer relationships" is in addition to the exception for "market-making" trades.

The limitation that any trades allowed under section (B) have to be "designed to not exceed the reasonably expected near term demands of clients, customers, or counterparties" isnt a serious limitation. At most, it would just require a trader to come up with a plausible explanation for why he decided to take on a certain position — which could be satisfied by a story about what the trader thought other market participants were going to do at the time.

Next, we have section (C), which permits:

(C) Risk-mitigating hedging activities designed to reduce risks to the banking entity or nonbank financial company.

Whereas the exception for market-making in section (B) will no doubt include trades which hedge risks in the banks trading book, section (C) goes one step further, permitting trades which can be justified as hedging any risk in the entire BHC, not just risks in the trading book. Also, Id expect the banks to argue that "diversification" reduces risks to the banking entity as a whole, and thus that trades which have the effect of diversifying the banks portfolio are permitted under section (C).

Finally, we have section (G), which permits:

(G) Proprietary trading conducted by a company pursuant to paragraph (9) or (13) of section 4(c), provided that the trading occurs solely outside of the United States and that the company is not directly or indirectly controlled by a United States person.

Section 4(c)(13) of the Bank Holding Company Act is an exemption which permits certain BHCs to own foreign bank subsidiaries (and certain foreign companies). Goldman, Morgan Stanley, JPMorgan, even CIT Group — they all own foreign bank subsidiaries under section 4(c)(13). To my knowledge, all the major BHCs own foreign bank subsidiaries under section 4(c)(13).

So essentially, section (G) allows BHCs to continue their prop trading through their London offices, provided they find non-US counterparties (shouldnt be too difficult), and the trading isnt being controlled by someone in New York (fine, just send all your prop traders to London). And this is in addition to all the prop trading the banks could do out of their New York offices under the ridiculously broad "permitted activities" in sections (d)(1)(B) and (C). Seriously, this would be like taking candy from a baby for the dealer banks.

Now, I should tell you that Im assuming that section (d)(2)(A)(i) of the Merkley-Levin Amendment will either be removed, or defined away by regulators. Its basically incompatible with the clear intent of the amendment, so Im pretty confident that itll be taken out (if not in the Senate, then in conference). Section (d)(2)(A)(i) prohibits even permitted activities if they:

(i) would involve or result in a material conflict of interest (as such term shall be defined jointly by rule) between the banking entity or the nonbank financial company and its clients, customers, or counterparties.

This is simply incompatible with market-making, which involves taking the opposite side of clients trades, and its the clear intent of Merkley-Levin to allow market-making. If for some bizarre reason this section doesnt get removed, regulators would have to consider the clear intent of the amendment to allow market-making in defining "material conflict of interest," and would effectively be forced to define "material conflict of interest" so narrowly that it might as well not exist as a limitation. The fact that this section is even in the amendment I think is indicative of how poorly it was drafted.

People often ask why I say that complicated financial regulations cant be written at the statutory level. The reason, sorry to say — which Merkley-Levin demonstrates quite well — is that Congress sucks at writing complicated financial regulations.

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