On July 21st, 2010, the Obama administration introduced Dodd-Frank in an attempt to prevent a repetition of the events of the 2008 financial crisis. Dodd-Frank brought with it the most radical changes to the financial services industry in over 50 years and was not limited to the traders on Wall Street; it covered almost every element of investment banks’ front, middle and back offices, encompassed insurance firms as well and even hit retail and commercial banking.
What the Volcker Rule Meant
One of the most significant of all changes introduced, and arguably the most monumental for traders on Wall Street, was the Volcker Rule which forbids banks or institutions which own banks from engaging in proprietary trading, which is speculating in the financial markets using the bank’s own balance sheet (ultimately deposits from clients) for financial gain which does not benefit the bank’s customers.
It went further and initially proposed to ban all banks from investing in any hedge funds or private equity funds, but after its rejection, the proposal settled by saying that any one bank could not represent more than 3% of the ownership interest in one of these funds and that the sum of a bank’s interest in any hedge funds or private equity funds could not exceed 3% of its Tier 1 capital.
Despite a couple of complications along the way, including issues with exiting illiquid investments, the rule came into effect on July 21st, 2015.
Whilst Wall Street’s biggest investment banks came back and said that this should not have a significant effect on their profits, there were worries of a significant ‘brain drain’ from their sales & trading divisions – the top prop traders would find their job becoming illegal, and accordingly almost all left to start up their own hedge funds.
Despite expectation that Trump would be tough on Wall Street due to his behaviour during the presidential race, including saying Hilary Clinton and Ted Cruz were “in bed” with Goldman Sachs, and that hedge funds were “getting away with murder”, he announced in January that he would launch a revisit to the ‘Obama-era’ financial regulation.
Many have spoken about the ethics of having the former COO of Goldman Sachs in a key advisory role in the Trump Administration and that the number of advisors with Wall Street interests is heavily influencing the effort to repeal regulations that limit Wall Street.
Assessing the probability of a specific part of Dodd-Frank being reversed is not particularly easy, so it is important to look at what was actually said by Trump and his team. Initially, the wording was vague and did not mention Dodd-Frank specifically; it effectively appeared to be just a comment that financial regulation needed revisiting, but in a press conference soon after, Trump specifically mentioned that some of his friends’ businesses had had issues borrowing money due to “the rules and regulations in Dodd-Frank”. He later went on to say that Dodd-Frank was a “disastrous policy” that was “crippling the US economy”. With this being the case, what can actually be done?
Financial Regulation 101
In order for any amendments to be made, they would need to pass through Congress which adds an extra flavour to things. The Volcker Rule took almost five years from proposition to execution, so it is clear that bureaucratically speaking, financial regulation is not as nimble as the rules of a playground game.
While many may be in favour of this particular bill, and significant lobbying from Wall Street is already happening and can only increase, it is undeniable that a vast majority of those in a position to vote on financial regulation bills will be strongly against any deregulation.
Furthermore, there are a number of ways it could play out which further complicates things – it will no doubt require a whole team to approach how best to even go about changing regulation. Would this come from a complete repeal of Dodd-Frank and its replacement with a new bill?
Would it mean particular rules, like the Volcker Rule would be reversed or reworded? As was seen in the initial introduction of the Volcker Rule, the language used is of significant importance, and each change takes time to be accepted and voted in.
Time for a Change?
Even assuming that Trump can reform the Volcker Rule during his tenure, there is still absolutely no guarantee that prop trading will return in full force. Firstly, as previously mentioned, any changes would likely be amendments to the current rule and not a complete repeal, at least as a starting point.
This would most likely happen in the form of heavily limiting the amount of capital banks can deploy for speculative purposes and would probably also extend into creating very strict ring-fencing of prop trading activities in an effort to reduce shockwaves inside a financial institution if large bets go sour, like banks such as J.P. Morgan experienced with single traders losing hundreds of millions or even billions of dollars for the bank.
This would also be necessary to stop absurd conflicts of interest on banks’ trading floors where one desk may know large client orders incoming, and on another, prop traders could be trading the same securities, potentially bringing back the risk of banks being able to front-run clients and profit from price increases as large orders come in.
The Kiss of Death
Whether or not prop trading returns in full force, or as a sugar-free version of the original beast, it could provide another significant blow to the hedge fund industry which has recently suffered huge capital outflows, partially due to underperformance in recent years of a large proportion of hedge funds, as well as a shift towards passive management and firms like BlackRock entrusting robots with stock picking.
This would happen perhaps as many ex-star traders from banks could see their old jobs come back as heads of prop desks in financial centres around the world, but this time their business cards would have an investment bank’s logo on it.