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
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
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
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
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
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
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
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
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
"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
"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
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
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