WASHINGTON (Reuters) - U.S. banks have reason to think that regulators will put out a moderate proposal restricting proprietary trading, analysts said after a draft of the Volcker rule was leaked.
Analysts said in research notes on Thursday that regulators appear to understand that if the rule is too restrictive, it could hurt market liquidity and place U.S. financial companies at a disadvantage.
In particular, financial players are watching whether the rule still gives banks flexibility to hedge risk, and whether it has a broad enough exemption for market makers.
“Early in the proposal, regulators suggest they understand the need to ensure banks remain in the market-making business and retain the ability to hedge their risks,” said MF Global policy analyst Jaret Seiberg in a note.
A roughly 200-page draft proposal of the Volcker rule was posted online by the American Banker publication late on Wednesday. The staff draft could change before the Federal Deposit Insurance Corp officially releases the proposal, scheduled for October 11 at a board meeting.
The Volcker rule, named after former Federal Reserve Chairman Paul Volcker and part of last year’s Dodd-Frank financial oversight law, is designed to avoid a repeat of the 2007-2009 financial crisis.
It aims to prevent banks from recklessly engaging in risky trades by prohibiting them from trading for their own profit in securities, derivatives and certain other financial instruments.
Seiberg said the draft document is long, complicated and difficult to interpret. He also noted that it includes more than 100 questions that regulators are seeking comments on.
He sees the number of questions as a positive and said it could show regulators want to establish a clear record to justify a less onerous interpretation of the Volcker rule.
Nomura Equity Research said in a note on Thursday that regulators appear sensitive to the impact of the rule.
“A draconian form of the Volcker Rule will likely have unintended consequences, such as reduced liquidity, higher funding costs for U.S. companies, less credit for small businesses, higher trading costs and lower investor returns,” among other things, the note said.
The Nomura analysts concluded that the rule is more significant for Goldman Sachs and Morgan Stanley than for Citigroup, based on the companies’ current trading activity.
It said main battlegrounds for shaping the final proposal will be market making and hedging.
On hedging, supporters of the ban have pushed for regulators to create a very narrow exemption for hedging against risk arising from trades done for customers. They fear too broad of an exemption could leave room for banks to engage in proprietary trading.
At issue is whether this hedging can be done on a portfolio basis or tied more closely to specific trades.
The draft rule would allow hedging against portfolio risks, which is common now on Wall Street.
Dwight Smith, a partner at law firm Morrison Foerster who focuses on regulatory issues, said he sees problems in the lack of clarity on what hedging would be allowed.
“These hedging strategies don’t come out of nowhere. They are part of the way a bank manages its risk,” Smith said. “If you are now taking away a part of what they have used to manage their risk, that is a big impact in their overall risk management process.”
For market-making activity, the draft proposal lays out six criteria that banks must satisfy for an exemption to the rules, including confining revenue to fees, commissions, and the spreads between bid and ask prices.
Market makers are key to ensuring market liquidity by standing ready to buy or sell on behalf of customers. Many dealers fear that the Volcker rule will prevent them from performing market-making functions.
“The issue remains whether in practice banks will feel comfortable engaging in market making given the penalty for prop trading violations,” Seiberg said in his note.
The draft proposal did not include specific details on penalties. It said generally that banks that violate the Volcker rule would have to stop the activity and possibly dispose of the investment.
The document, which is subject to change, said the regulators will seek comment through December 16 and then move to finalize a rule. Its effective date would be July 2012.
Reporting by Karey Wutkowski and Alexandra Alper in Washington, D.C.; Editing by Steve Orlofsky