LONDON May 21 Under intense pressure from the banking industry, U.S. regulators have already proposed a very generous interpretation of the Volcker Rule prohibition on proprietary trading which contains broadly drafted and ill-defined exemptions for hedging including portfolio hedging.
But even that was not enough for JPMorgan Chase and Co . The extent of the bank's hostility to restrictions on its use of portfolio hedging and asset-liability management is laid bare in a letter from Barry Zubrow, newly-installed executive vice president for corporate and regulatory affairs, to the Federal Reserve and other agencies on February 13.
In it, the bank dismissed the proposed regulation implementing the Volcker Rule as "too narrow" and urged regulators not to "hard code" the requirements for claiming a hedging exemption. Instead the bank wanted them relegated to an appendix, where regulators would merely take them into account as part of the general supervisory process.
The letter provides a fascinating insight into the interaction between the bank and regulators as JPMorgan fought to prevent curbs on its portfolio hedging. But more important, it provides a useful insight into how far the bank wants to stretch the concept to embrace a much wider and ambitious set of transactions with significantly more risk attached to them.
WHAT THE LAW SAYS
For all its famed length, the Dodd-Frank Act took less than 100 words to spark a furious debate about how to distinguish between proprietary trades, which are forbidden, from hedges, which are allowed.
The law simply states "a banking entity shall not engage in proprietary trading." But it goes on to create an exemption for "risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings" (12 USC 1851(a)(1)(A) and 12 USC 1851(d)(1)(C)).
With that, Congress left regulators from the Treasury, Federal Reserve, Securities and Exchange Commission, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation and Commodity Futures Trading Commission (CFTC) to come up with a workable way to differentiate prop trades from exotic hedges. Nearly two years and several missed deadlines later, the industry and its overseers are no closer to a consensus.
Parsing the statutory language, the three key phrases are "in connection with and related to," "individual or aggregated positions" and "designed to reduce the specific risks to the banking entity."
The first element makes it clear there must be some sort of relationship between the hedge and the underlying risk, though it is maddeningly vague on just how close that relationship must be.
The second element allows for an element of aggregation across the various separate transactions in a bank's trading and other books, though precisely how far this aggregation can go is also left for the hapless regulators to sort out.
The third element is at least clear that the hedge much actually reduce some specified risk. Positions which increase overall risk are clearly prohibited and the bank must at least be able to articulate what risk it is trying to cut.
WHAT REGULATORS WANT
The current set of proposals were published in the Federal Register on November 7 (76 Fed Reg 68948) and February 14 (77 Fed Reg 8427).
The draft rule would allow a transaction to count as a hedge only if the bank has established an internal compliance program and put in place appropriate documentation and records. In addition, the hedge must satisfy six substantive requirements.
The most important of these are that the hedge must be "reasonably correlated, based upon the facts and circumstances of the underlying and hedging positions and the risks and liquidity of those positions, to the risk or risks the purchase or sale is intended to hedge".
The hedge must not give rise, at least when it is first established, to significant new risk exposures not already present in the individual or aggregated positions. It must be continuously monitored to ensure it maintains a "reasonable level of correlation" and to ensure that it "mitigates any significant exposure arising out of the hedge after inception."
Finally, the compensation of hedging managers must not be designed to reward proprietary risk taking.
WHAT JPMORGAN DISLIKED
Reasonable is one of the vaguest words in law, which can be stretched to cover almost any eventuality. To an outsider, the idea that a hedge should be "reasonably correlated", be risk reducing, at least at the outset, and have some basic documentation to show it is a hedge rather than a prop trade might seem, well, reasonable.
But not to JPMorgan. The bank took strong exception to all these proposed requirements. "In several ways, the proposed rule would make hedging more difficult," the bank wrote in its February 13 letter ().
The requirement for prior written documentation "limits the ability of the firm to hedge unanticipated risks quickly."
JPM wasn't keen on the idea that hedges needed to be risk reducing at the start. It noted that it makes no allowance for hedging future risks that the bank doesn't face yet ("anticipatory hedging") which regulators appear to endorse elsewhere.
Even the idea of "reasonably correlated" comes under fire. The letter noted risk managers and regulators routinely evaluate exposure to "tail risks" (remote but potentially movements in asset prices).
But the bank noted "at inception, the correlation between a chosen hedge and a given tail risk may be relatively loose." Notwithstanding the low correlation at first, the bank should be able to claim a hedging exemption if it can "reasonably demonstrate through its stress program that the position reduces tail risks."
More than anything else, the bank appeared troubled that the ban on prop trading and relatively narrow definition of hedging might restrict its asset-liability management, including the activities of its chief investment office, which according to page 1 "is responsible for making investments to hedge the structural risks of our balance sheet on a consolidated basis."
"While some [asset-liability management] may be permitted by the proposed rule under its [hedging exemption] many legitimate ALM activities will not ... because that exception ... does not appear to have been drafted with ALM in mind, is subject to too many restrictive conditions, and is thus too narrow." JP Morgan complained.
As the bank noted, the hedging exemptions appeared to contemplate "the type of hedging that occurs when a market intermediary enters into transactions to hedge its risks with customers or meet anticipated demands of customers." But ALM hedging goes much further to meet possible future risks thrown up by forecasts and stress tests.
So JPM argued against the idea hedges should have to be connected or related to risks to which the firm is already exposed. The bank also objected to the idea that ALM hedges should be reasonably correlated. They could give rise to outright profits (rather than being P&L neutral).
In a phrase that may haunt the bank, it admitted "precise correlations amongst and across different asset classes used in asset-liability management are difficult to determine." Indeed. "The hedge will react somewhat differently than the underlying position to the same market conditions and hence generally but not necessarily precisely correlate to the underlying risk."
Nor was the bank keen on the idea that ALM hedges should be immediately risk-reducing. "Asset-liability management strategies may often use instruments that will expose the banking entity to a risk that is itself not present in the underlying position."
SUCCESSES, AND NOW A FAILURE
The bank cited several examples of successful ALM hedges that helped in the financial crisis but would have been endangered by the narrower definition of hedging being proposed. These include a case study on "managing credit risk by use of credit derivatives".
"To protect the firm against credit losses, that based on its analysis, the firm perceived were possible to occur in the near term, the firm's ALM team used credit derivatives to purchase protection on high yield credit default swap indices with short term maturities and to sell protection on high yield credit default swap indices with longer-term maturities, in effect taking a high yield curve flatting position in the credit derivatives market."
"Under the proposed rule, this activity could have been deemed prohibited proprietary trading," the firm wrote, because the actions were forward-looking and anticipatory, might not have been deemed reasonably correlated, and the profits from the hedges might have generated net profits for the bank (page 57).
Unfortunately, to go alongside these successful forward-looking hedges, the chief investment office now appears to have delivered a counter-example of an ALM hedge that did not go well for the firm.
The bank's proposed "alternative approach" is thin. It amounts to little more than stating ALM and liquidity portfolios should be managed within appropriate controls approved by the firm's board of directors, consistent with applicable regulatory guidance from regulators regarding ALM and liquidity management. It takes less than a page to set out (page 63).
The bank acknowledges the fear a "rogue trader" (more likely a rogue institution) might try to hide a covert prop desk within an ALM function, but thinks this would be difficult if not impossible and doesn't think regulators should be unduly concerned.
Following the reported losses and control problems surrounding the bank's CIO, it is clear the "hands off" approach to ALM hedging pressed by JPMorgan and other banks is no longer credible or viable. But it is equally clear the major banks will continue to push the boundaries as hard as possible.
In its current form, the proposed rule is too vague to stop them.
It needs to spell out much more clearly that "reasonably correlated" and "related to" do not leave the door wide open to massive portfolio ALM hedges and other transactions which have nothing in common with traditional hedging strategies except the name.