NEW YORK (Thomson Reuters Regulatory Intelligence) - In the first U.S. enforcement action brought against a bank for violation of the Volcker rule, the Federal Reserve said on Thursday that it had found inadequate controls at Deutsche Bank over perhaps the most controversial part of the regulation: determining what is and what isn’t proprietary trading.
The Federal fined Deutsche Bank AG $156.6 million for violating Volcker and foreign exchange rules. The German bank failed to detect and halt its traders from using chat rooms to communicate with competitors, the Fed said in a statement.
In a statement, the bank said, “we are pleased to resolve these civil enforcement matters with the Federal Reserve.”
Large banks subject to the Volcker rule, which went into effect in July 2015, have had to provide the Fed with reporting metrics to demonstrate whether they are in compliance with a complex number of requirements. Among them is information concerning whether the inventories trading desks are holding in various securities are reasonable relative to the expected demand from their customers. The specific requirement under the rule is called RENT-D, or “reasonably expected near-term demand of customers.”
For a trading desk’s market-making activities, there is the expectation to hold an inventory of securities that is reasonable relative to short-term customer demand. If those inventories are found to be much higher than what’s considered reasonable, then questions arise as to whether they are being held for proprietary trading.
The description of the Fed’s action suggests that Deutsche Bank lacked sufficient oversight and controls to monitor such inventories.
“Significant weaknesses existed in Deutsche Bank’s demonstrable analyses showing that its proprietary trading is not to exceed the reasonably expected near term demands of clients, customers, or counterparties, required for permitted market-making activities,” the Fed said in its 10-page enforcement action.
In addition, the Fed said the bank “did not subject trading desks’ RENT-D methodologies to sufficient review or challenge by internal control groups.”
Moreover, Deutsche Bank’s “metrics reporting and monitoring process suffered from weaknesses which, together with the absence of sufficient internal controls, limited the Bank’s ability to adequately monitor trading activity to detect impermissible proprietary trades,” according to the Fed.
In sum, the bank failed to have adequate controls in place to determine whether trading desks where engaged in activities that constituted trading for its own book versus making markets for customers. This “grey area” as many have called it, stands as perhaps one of the most difficult and controversial aspects of the regulation.
Even before the rule went into force, legal experts called into question how banks would be able to demonstrate whether their trading activities were solely to serve their clients versus placing proprietary bets, particularly when markets are volatile.
“Many firms are finding the most difficult aspect of developing such controls to be ‘proving the negative’—demonstrating to regulators that they are not engaging in trading activities that would violate the proprietary trading provisions,” said the law firm Davis Polk in a research note in June 2015.
Deutsche still faces a probe by New York’s Department of Financial Services into whether its automated trading platform was programmed to manipulate foreign exchange rates, a person familiar with the matter said on Thursday.
The New York regulator has been investigating whether the bank used algorithms on trading platforms to front-run or otherwise take advantage of clients. Renee Calabro, a spokeswoman for Deutsche, declined to comment on the status of the New York probe.
QUESTION OF INTENT
Banks may well argue that if their trading positions seem out of sync with near-term customer demand, there are numerous factors at play to explain such a discrepancy. These might include expected short-term price movements in the securities they are holding as well as judgments about relative supply and demand conditions in the market.
In the end, as Fed governor Jerome Powell said in January in answer to a question about the Volcker rule, much of this comes down to a question of intent, which is very difficult to ascertain.
“What the current law and rule do is effectively force you to look into the mind and heart of every trader or every trade to see what intent is,” said Powell after a speech. “Is it proprietary trading or something else? If this is the test you set for yourself, you are going to wind up with tremendous expense and burden.”
Reacting to Powell’s doubts over intent, some legal experts supported the notion that such a determination might be a step too far.
“We think that Governor Powell is right that the intent-based focus in the proprietary trading portions of the Volcker Rule is a fundamental flaw; discerning intent in a complex, rapid trading environment is effectively impossible,” lawyers at Davis Polk wrote in January. “We, and many others, have always worried that an intent-based approach, impossible to objectively measure, would chill the legitimate liquidity-providing activities of banking organizations expressly permitted by the statutory Volcker rule.”
Federal Reserve consent order: here
(This article includes material from Reuters)
(Henry Engler is a North American Regulatory Intelligence Editor for Thomson Reuters Regulatory Intelligence. He is a former financial industry compliance consultant and executive, and earlier served as a financial journalist with Reuters. Email Henry at henry.engler@thomsonreuters.com)