Corporate Advisory

Resurrecting the EU Volcker Rule

You probably remember, almost a year ago, when the European Commission (EC) proposed the EU version of the Volcker Rule. You don’t remember? Really? Actually, I almost forgot it myself, but it turns out that various bodies in the EU have been working on the proposal, and they have just released some documents, so we now have something to report, if not more clarity.

Before we go into the latest developments, it’s worth understanding what the original proposal was, and how its approach differed from the US version. The US VR has a very simple definition of proprietary trading, which is taking positions in a certain set of instruments for the bank’s account, and simply prohibits it. Then it lays out a series of exemptions; the most important four of which are: liquidity management, underwriting, market-making, and hedging. If a trade doesn’t fall under one of the exemptions, it’s simply prohibited.

The original EU version takes a somewhat different approach by defining proprietary trading as: “using own capital or borrowed money to take positions … for the sole purpose of making a profit for own account, and without any connection to actual or anticipated client activity or for the purpose of hedging the entity’s risk as result of actual or anticipated client activity. (emphasis added) So the EU attempted to incorporate the hedging, market-making and perhaps underwriting exemptions into the definition of proprietary trading, and then added some other exemptions as an afterthought.

So how did that definition fare in the negotiation phase? Well, the first place to look is the EC’s progress report dated 12/22/2014, which says, “Several Member States deem the definition of proprietary trading adopted by the Commission easy to circumvent. As for the ban of proprietary trading, … several countries prefer or are open to consider the separation of proprietary trading – appropriately defined – instead of its ban.” In other words, there was an interest in a simpler definition, more like the US one, but a preference to ring-fence the trading as opposed to banning it altogether. On the other hand, “The ECB Opinion expressed instead support for the ban of PT defined in a narrow way as in the Commission’s proposal.”

Of course, there was further negotiation on that. “The Presidency proposed some drafting suggestions along these lines at the last meeting of the working party. In doing so, the Presidency … defined proprietary trading by a list of “allowed trading activities” (i.e. provision of services to clients, market making, treasury management, hedging, clearing of financial instruments, buying/selling financial instruments acquired with the intention of holding them durably). Everything else would be proprietary trading, and can only thus be performed by a separate legal entity within the group. A large number of delegations showed support for the direction of the proposed changes.” That’s somewhat closer to the US version, except that everything not exempted must be ring-fenced.

At the same time (literally on the same day), the European Parliament (EP) issued its own draft report on the proposal, actually in the form of a resolution. Apparently, being upstaged is a cardinal sin in Europe. The EP report is actually a series of proposed amendments to the original language.

Here are a few of the changes the EP recommends:

The Original Text

The Proposed Text
proprietary trading means using own capital or borrowed money to take positions in any type of transaction to purchase, sell or otherwise acquire or dispose of any financial instrument or commodities for the sole purpose of making a profit for own account, and without any connection to actual or anticipated client activity or for the purpose of hedging the entity’s risk as result of actual or anticipated client activity, through the use of desks, units, divisions or individual traders specifically dedicated to such position taking and profit making, including through dedicated web based proprietary trading platforms; proprietary trading” means using own capital or borrowed money to take positions, in reaction to and with the motivation of exploiting actual or expected movements in market valuations, in any type of transaction to purchase, sell or otherwise acquire or dispose of any financial instrument or commodities for the sole purpose of making a profit for own account, and without any connection to actual or anticipated client activity or for the purpose of hedging the entity’s risk as aresult of actual or anticipated client activity, through the use of desks, units, divisions or individual traders specifically dedicated to such position taking and profit making, including through dedicated web based proprietary trading platforms. This definition includes any such transaction undertaken with the aim of making aprofit, irrespective of whether such profit would be realised in the short term or in the longer term, or is in fact realised at all;
market making means a financial institution’s commitment to provide market liquidity on a regular and on-going basis, by posting two-way quotes with regard to a certain financial instrument, or as part of its usual business, by fulfilling orders initiated by clients or in response to clients’ requests to trade, but in both cases without being exposed to material market risk; market making” means a financial institution’s commitment to provide market liquidity on a regular and on-going basis, by posting two-way quotes with regard to a certain financial instrument, or as part of its usual business, by fulfilling orders initiated by clients or in response to clients’ requests to trade, or in reasonable anticipation of potential client activity, and by hedging positions arising from the fulfilment of those tasks;
The prohibition in point (a) of paragraph 1 shall not apply to:[Several categories not changed] The prohibition in point (a) of paragraph 1 shall not apply to:The prohibition in point (b) of paragraph 1 shall not apply if the amount of those activities is below 2% of the core credit institution’s own funds, calculated on a consolidated basis. The amount of those activities above 2% of the core credit institution’s own funds, calculated on a consolidated basis, shall be phased outduring a period of five years after this Regulation enters into force.

There are other changes listed in the document, but these are the most important. Maybe some day the EU Presidency and Parliament will get together on something like this. Wait…that hasn’t happened in the US for years, so maybe not. Meanwhile, stay tuned as the European Volcker Rule wends its way through the maze.