Introduction

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees.  The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.

Thank you for giving me the chance to talk to you today about the Volcker Rule, which as you know, represents one of the most far-reaching, highly anticipated and, in some cases, feared regulatory initiatives affecting the banking and securities businesses in recent times.  Before going any further, I should remind you that my remarks today represent my own views, and do not necessarily reflect those of the Commission, Commissioners or my colleagues on the staff.

As you know, the Volcker Rule was a cooperative effort among five different agencies, and of course my remarks also do not necessarily reflect views of officials of other agencies.  On a personal note, though, I would add that this truly was a collaborative interagency effort, notwithstanding suggestions in the press that the agencies were at times working at cross-purposes.  I recall one story suggesting that banking regulators had to be lured to a meeting at the SEC with a promise of a “fried chicken dinner,”[1] which probably says a lot about the culinary standards of federal employees.

Somehow, I missed out on the fried chicken, but I can honestly say that the SEC staff and bank regulators worked well throughout the process, and I think each of us benefitted from the perspectives of the others.

I wanted to focus today on the market making exemption to the proprietary trading ban under the rule.  The Volcker Rule is much broader, of course, but I have limited time today and this particular aspect of the rule impacts directly the functioning of equity and fixed income markets, which are of vital concern to the mandate and mission of the SEC.  Likely for the same reason, this part of the rule attracted some of the heaviest volume of public comment.  For the most part, I will not try to address the broad policy objectives targeted by the Volcker Rule, or how the rule tries to achieve them.  Instead, I want to provide some general thoughts for practitioners who are interested in how the Volcker Rule relates to market making by bank affiliates.

Market making (along with other exemptions, including underwriting) was identified by the Dodd-Frank Act’s Volcker Rule provisions as needing an exemption from the proprietary trading prohibition.[2]  Market making is of course critical to the function that broker-dealers perform in supplying liquidity and helping to raise capital.  To me, that means, at a minimum, that the agencies were tasked with trying to implement the exemption in a way that honors the general proprietary trading ban, but preserves the public benefit that comes from active participation by banking entities in supplying liquidity to the securities and derivatives markets.

At the same time, separating market making, in particular, from proprietary trading is no easy task.  Consider that the Volcker Rule’s definition of proprietary trading roughly translates to trading in financial instruments on a short-term basis or hedging the risks of those activities.[3]  Of course, that could describe what all market makers do, and mostly what securities firms do in general.  Depending on how the exemption was drawn, it could have nullified the prohibition or it could have prohibited a substantial amount of socially beneficial activity.

The statute does provide some help by saying that market making is intended to service “the reasonably expected near-term demand of clients, customers, or counterparties.”[4]  In other words, market making activities under the rule are intended to serve the needs of market participants, not just the needs of a banking entity.  I’ll say more about this in a moment, but for me, this is the key point of distinction.  The rule therefore in broad brush seeks to protect outward facing activity that is driven by the needs of the marketplace. 

Description of General Approach

Let me make a few points about the general approach.  The exemption was crafted so that it could be usefully applied to trading in a broad range of securities and derivatives, without relying too much on the law and lore that has grown out of the regulation of market makers in equity markets.  If a purpose of the exemption is to encourage banks to supply liquidity to securities markets, it would not make sense to limit its use to markets where there is already plenty of liquidity. 

The exemption was also written to be applied holistically to activities by a trading desk in a group of related instruments, not judged on a trade by trade basis.  Commenters argued that judging compliance on a “now you see it, now you don’t” basis that looks at each individual trade to see if it fits would not be workable, and was not necessary in order to create an exemption that has teeth.  In this regard, the first sentence of the market maker section establishes that the exemption from the proprietary trading ban covers market making-related activities conducted in accordance with the rule.[5]

Another important point is that the requirements of the exemption are mostly applied at the level of the trading desk, and that is the way that compliance will be reviewed.  The Volcker Rule defines the term “trading desk” to mean “the smallest discrete unit of organization” that banking entities use to trade for their own account.[6]  That may sound mysterious, but it is actually pretty simple.  How does the firm itself organize and assign responsibility for its trading functions, at the so-called “bottom of the pyramid”?  Each discrete trading unit that handles an identified group or groups of instruments, and for which the firm tracks profits and losses, is a trading desk.

It is important to note that trading desks are not defined by reference to legal entities.  Thus, various transactions may be booked in different legal entities by a single trading desk, provided the transactions are all directed and managed by that one group.  By the same token, a trading desk can have employees located in more than one geographic location if they are all managed and supervised as a discrete group.

I see at least three reasons why basing the exemption at the trading desk level is good common sense.  First, because it reflects existing organizational structures, it should be easier for banks to apply than an approach that looks at trading in a top-down fashion.  Second, for the same reason, it should be easier for regulators to review for compliance.  And third, requiring that procedures be applied at each trading desk is consistent with good risk management.

Finally, the exemption requires that the banking entity must apply and enforce, at the trading desk level, a rigorous system of risk limits and other controls.  I’ll say more about that in a moment.

What Is a Market Maker under the Securities Laws?

As an initial matter, one has to answer the question, “What does it mean to make a market?”  As I mentioned, the rule is not strictly tied to the factors that have been considered important for exchange and liquid equity markets.  At the same time, previous Commission pronouncements and administrative decisions may be instructive in some respects, so I’d like to mention a few of those. 

One important factor is a dealer’s demonstrated willingness to buy and sell on both sides of the market.  For example, in one instance, the Commission discussed the exception for market makers from the so-called “locate” requirement from Regulation SHO.[7]  In that context, the Commission distinguished bona fide market making from “activity that is related to speculative selling strategies or investment purposes of the broker-dealer.”[8]  In particular, the Commission noted that where a market maker continually provides quotes at or near the best offer, but does not provide quotes at or near the best bid, the activities would not generally qualify for purposes of the market maker exemption from the “locate” requirement of Regulation SHO.[9]

There are numerous administrative decisions involving mark-ups, which sometimes consider whether a firm is entitled to treatment as a market maker, and therefore able to calculate its mark-ups based on interdealer trades or quotes, rather than its contemporaneous cost.[10]  In that context, it is important to consider whether the firm has shown a willingness to both buy and sell with other dealers.[11]  A pattern of only buying from other dealers for sale to retail customers does not qualify.[12]  In one case, for example (R.B. Webster Investments), the Commission found that the firm failed to make the case it was acting as a market maker where it deliberately set its ask quotations higher than any other dealer and as a result never sold stock to other dealers.[13]

How a dealer shows willingness to trade on both sides of the market depends on the characteristics of the market for the security.  Where quotes by multiple dealers are continually published and available, a dealer would need to be able to show that it participated in this way.[14]  But of course for some types of securities, this is often not the case.  In one of the mark-up cases, for example (Raymond James & Associates), the Commission noted that the firm did not publish quotations on an inter-dealer system because none existed but took other affirmative action to make its quotations available:  “Raymond James incurred market risk and added liquidity to a largely illiquid market.”[15]

A related question, which also concerns the willingness of dealers to trade in and out of positions, is how and when dealers trade out of block positions.  The Exchange Act definition of market maker includes firms acting as block positioners.[16]  That is relevant to Section 11(a), which prohibits a member of an exchange from trading on the exchange for its own account, but includes an exception for market makers.[17]  In issuing guidance on this question in 1979, the Commission said that a transaction liquidating some or all of a block position could be presumed to qualify as a block positioner’s transaction if the liquidation has not been delayed for tax purposes, investment purposes, or other purposes unrelated to the current state of the market.[18]

To summarize then, here are some of the principles that arise from previous statements about what it means to be a market maker under the existing securities laws, which I think have relevance to the way the term is used in the Volcker Rule.  First, market makers show a demonstrated willingness to trade on both sides of the market, taking into account trading with other dealers and with customers.  Second, they do not need to provide continuous and transparent quotations where those don’t exist in the context of the particular instruments being dealt in, but they do show ongoing affirmative efforts to trade both long and short.  Third, when market makers amass a large position on one side of the market in order to facilitate a customer trade, they seek to promptly unwind or trade out of the position, consistent with market conditions.

Elements of the Volcker Definition

Now I would like to turn to the Volcker Rule and how it addresses this question in that context.  To answer this question, the rule uses very deliberate language, and each element is important.

First, the desk must show that it “routinely stands ready” to buy and sell one or more types of financial instruments.[19]  The rule does not require trading on a “regular or continuous basis,” the phrase that has long been applied to exchange and equity market makers, in recognition of the fact that trading in many fixed income and derivative markets – and in fact some equity markets – is not continuous in the sense that there are always published quotes that can be accessed.[20]  By “routinely stands ready,” the rule suggests that the firm must be prepared to trade in the instruments in which it makes a market at all times, even if trading in the particular instruments is non-continuous.

Second, the desk must be “willing and available” to quote, buy and sell, or enter into long and short positions for its own account.[21]  There are various ways that dealers advertise their willingness to trade in particular instruments, the key point being that the banking entity needs to demonstrate that it is willing.  And it needs to make that showing on both sides of the market.  A firm that regularly amasses a long position in a type of bonds, for example, but rarely seeks to trade out of it, regardless of market interest, in my view would not meet the test.

Third, trading and quoting activity must be in “commercially reasonable amounts and throughout market cycles,” considering the characteristics of the particular market.[22]  Again, this language suggests there is no “one-size-fits-all” test, but the desk must show a willingness and ability to trade long and short under various market conditions.  I would not view firms that are willing to trade and provide quotes only when they deem market conditions to be favorable as market makers for purposes of the rule.

Reasonably Expected Near Term Demand

The last basic element of the definition is that the instruments and related risks that the desk carries at any point in time must be designed not to exceed “reasonably expected near term demand.”[23]  The term “market-maker inventory” refers to all the trading desk’s positions in instruments for which it is willing to make a market.[24]  In short, to qualify as reasonably expected near term demand, the amount of securities or derivatives positions held in inventory needs to be reasonably related to external demand, that is, what the desk needs to maintain in order to be able to trade with its customers, when and in the amounts they want to trade.

The rule says this factor is based on the liquidity, depth, and maturity for the market for the particular instruments in question.[25]  In some highly liquid equity markets, for example, market makers often, though not always, trade close to flat by the end of each day, because there is enough liquidity available in the market to satisfy customer demand without holding onto positions.  In contrast, trading in corporate bonds is a very different proposition:  a dealer likely will need to hold more risk in inventory in order to be able to trade with customers based on the level and nature of the market interest in the bonds traded.

Reasonably expected near term demand is obviously important, but how does the desk determine what demand means for this purpose?  The rule says that each trading desk needs to conduct an analysis that is both backward and forward looking.[26]  What are the historical trading patterns, including turnover in inventory, for the instruments the desk is trading?  More broadly, how much trading interest for those instruments has existed in the market at large?  Looking forward, what are the current and expected market conditions, and how will those impact the amount of expected demand?  These are some of the questions the desk should analyze, and the rule clearly says the analysis must be demonstrable.[27]  That, in my view, means it needs to be backed up by data and facts, not by conjecture.

All of that said, the rule does not require banking entities to make clairvoyant predictions of the future, and we all know that even well-grounded predictions of market trends sometimes don’t pan out.  I would put the test this way:  has the firm made a reasonable judgment, based on objective factors and analysis, as to the positions and risks it needs to carry in order to meet the needs of its customers? 

Conceptually, these ideas may be easier to apply to securities that can be readily bought and sold.  Derivatives are different, of course, since they represent contractual obligations between a dealer and its counterparty.  In particular, a dealer that structures a customized derivative for a customer may not be able to readily find another customer that is willing to take the opposite position in the same instrument and in the same amount.  The Preamble spends a fair amount of time addressing just this question, and I would recommend that you look at it closely.[28]  But at the risk of oversimplifying, I would summarize this way.  A firm that makes markets in derivatives is not precluded from taking a position in a customized instrument to meet a customer’s needs, even if it anticipates that it cannot readily enter into another trade that unloads the risk of that position.  In that case, however, while the position is held, the desk needs to manage the risk within its risk limits, and when it has the ability to reduce its inventory risks by trading with customers, it should do so.

Clients, Customers and Counterparties

Reasonably expected near term demand, under the text of the statute and rule, relates to trading with “clients, customers, or counterparties.”[29]  The rule defines this term in a functional way to refer to market participants that make use of the firm’s market maker services, for example by looking to the firm to provide quotations or to provide other services.[30]  For shorthand purposes, I’ll simply use the term “customer.” 

One important question is whether trading activity with another dealer counts as a trade with a customer.  The answer is “it depends.”  In many cases, one dealer may look to another dealer acting as a market maker to provide quotations or to serve as a source of liquidity.  In other words, one dealer can relate to another as a customer for particular types of instruments.  The rule does, however, create a presumption that another dealer that is part of a very large firm – with trading assets and liabilities of $50 billion or more – is not acting as a customer.[31]  That presumption can be rebutted, but a firm would need to be able to make the case that, in trading with one of the largest trading firms, the second firm is functioning as a customer of the first.[32]  On the other hand, any trade on an exchange or other anonymous trading platform can be treated as a customer trade.[33]

Although the rule requires a demonstrable assessment of the reasonably expected near term customer demand, as the Preamble recognizes, market makers can and often need to trade with each other in order to obtain inventory, reduce the risk of existing positions, and for other purposes.[34]  In fact, as mentioned earlier, a willingness to trade with other dealers on both sides of the market is one of the factors that the Commission has looked to in deciding whether a dealer is acting as a market maker.

Compliance Program and Timing

As just discussed, the market maker exemption provides a fair amount of room for firms to make markets in a variety of instruments, subject to compliance with the reasonably expected near term demand requirement.  The trade-off is reflected in the next part of the rule, the compliance program requirements.[35]

These requirements are connected to, but should be thought of as distinct from, the compliance requirements contained in Appendix B to the rule, particularly the enhanced requirements that apply to larger banking entities.[36]  First, Appendix B establishes requirements that apply to Volcker Rule compliance across the firm, not just trading functions.  Second, with regard to trading functions, Appendix B prescribes much more granular and specific requirements, which apply to trading under the market making exemption as well as all of the other specific exemptions provided by the rule.  So in considering the compliance program for market making desks, it is important to look both at the market maker exemption and the other compliance program requirements.

The nature of the compliance obligations and the timing for implementing them is tiered based on the size of the consolidated firm.  In brief, this is how the schedule works:

• All banking entities with more than $10 billion in consolidated assets need to have basic compliance procedures in place by July 2015.
• The largest firms, those with more than $50 billion in consolidated assets, are also required to have the enhanced and more granular procedures in place by July 2015.
• Firms with trading assets and liabilities between $25-50 billion have until April 2016 to put the enhanced procedures in place.
• Banking entities with between $10-25 billion in trading assets and liabilities are given until December 2016.
• The trading assets and liabilities tests exclude trading in Treasuries and agency debt.  Also, for these purposes, foreign banks count only the assets and liabilities of their U.S.-based operations.[37]

Elements of the Policies and Procedures

In general, the rule adopts a policies and procedures approach to compliance, which is to say each banking entity relying on the exemption is required to establish policies and procedures for each trading desk reasonably designed to address each of five elements.

What is the desk making a market in?  First, the procedures need to identify which financial instruments the trading desk is making a market in.[38]

Hedging and Risk Mitigation.  Second, they need to detail how the desk is going to manage and reduce the risks of its financial exposure.[39]  That includes information on techniques and strategies used to limit risk, the products and instruments that will be used as hedges, and the means and people who will be employed to ensure that risk management efforts are effective.

It is important to note that the rule does not require hedging by a market maker desk to separately comply with the hedging exemption, which contains additional, and in some ways more prescriptive requirements than contained in the exemption.  In general, compliance with the distinct hedging exemption is not required if the trading desk is hedging the risks of its own trading activity, is not hedging positions that are put on by any other unit, and if it is hedging in accordance with its own desk-specific procedures.

Risk Limits.  The third element is the establishment of specific risk limits that are unique to the instruments traded and exposures taken on by the desk.[40]  That means that limits must be set with respect to the positions held in the market maker inventory, and also with respect to the instruments and exposures the desk uses for risk management.  Most important in my view, limits must be set on the firm’s overall net financial exposure, taking into account both market maker inventory and hedging activity, and the limits need to apply to specific risk factors that are relevant to trading on that particular desk.  The rule does not attempt to name all of those factors, but all desks will need to set one or more limits on market risk, whether expressed in a value at risk or another method.  In addition, depending on the type of trading, limits on credit, currency, commodity price, and basis risk, may all be appropriate.  Finally, the risk limits need to cover how long a particular type of instrument may be held.

It is also very important to understand that the limits need to take account of the reasonably expected near term demand analysis conducted by the firm with regard to those instruments.  In other words, the trading desk needs to be able to show that the limits set are related to and appropriate for the nature and level of its customer-facing activity.  This point is critical to the integrity of the exemption, or else trading desks could establish limits that are arbitrary or disproportionate to the purpose of the exemption – to allow banking entities through market making to meet customer demand.  In this regard, one requirement of the Appendix B requirements that I mentioned earlier is a demonstration of why the limits set are appropriate to specific trading activity.

Internal Controls.  The fourth element is the specification of internal controls and ongoing monitoring and analysis of compliance with the risk limits.[41]  To make perhaps an obvious point, it is not enough to set the limits, there also needs to be a system to enforce them. 

The rule does not contemplate that limits may never be breached, or that doing so would eliminate the ability to rely on the exemption.  Unusual market volatility, unanticipated demand, or other factors could lead to a breach of one or more limits.  When this occurs, the rule requires that the trading desk takes action to bring its exposure back into compliance “as promptly as possible,” without prescribing the means to do so.[42]

Authorization and Escalation.  Another possibility is that individual limits could be increased, and that brings me to the fifth and final compliance element: authorization and escalation procedures need to be identified so that, if a trading desk wishes to seek an increase, it must first analyze and document the basis for the increase.[43]  For example, an increase may be appropriate if the firm has made a strategic decision to increase the amount of capital and personnel devoted to trading certain instruments.  In each case, though, any increase to risk limits needs to be independently reviewed and approved by persons independent of the desk itself.

My broader point is that the rule does not contemplate that risk limits will be static.  In fact, changes in the firm’s evaluation of the reasonably expected near term demand and other relevant factors may call for certain limits to be adjusted downward, rather than increased.  Hopefully, this is generally the way that firms already manage their market making risks, though for many the rule will undoubtedly require more rigorous procedures and more documentation than exists today.

Compensation

To claim the exemption, the rule also says that compensation arrangements of persons who are engaged in market making must be designed not to reward or incentivize prohibited proprietary trading.[44]  This language tracks the statute; the rule does not attempt to prescribe specifically how traders may be compensated. 

Over time, this requirement may be given greater definition through interagency guidance, but in the meantime, I would suggest that banking entities review their existing compensation programs for trading personnel with a view to evaluating how well, or not, compensation incentives help to make compliance with the rule more likely.  For example, a program that grants large bonuses based on individual trades that perform well, regardless of how they are hedged and whether they exceed risk limits, would not seem calculated to encourage compliance with the exemption or to discourage proprietary trading.

Metrics

It is worth spending a few minutes on the metrics that will be required to be reported, beginning in the summer of this year, for the largest firms.  The seven metrics identified in Appendix A[45] are required to be reported for all of a banking entity’s trading activities, but they will be particularly relevant to market making.  In particular, risk and position limits for each desk will need to be reported, along with market risk and risk sensitivity measurements.  Other metrics related to inventory turnover, inventory aging, and the customer-facing trade ratio, also will be relevant to understanding how a desk’s activity aligns with the conditions to the market making exemption that I just described.

One more metric deserves special note:  comprehensive profit and loss attribution.[46]  As the rule was first proposed, the exemption would have required that market making activities be designed to generate revenue mainly from fees, commissions, and spreads, rather than from price appreciation.  The agencies received a lot of comments to the effect that, for many instruments, commissions do not exist, and it is difficult or would be arbitrary to allocate revenue to “spreads.”[47]

The final rule does not include the proposed source of revenue requirement.  Instead of prescribing any particular formulation for revenue, the appendix includes a profit and loss attribution metric, which tracks for each day the gains or losses on positions that were acquired on that day, as compared to gains and losses on positions held longer than one day.  This should be an easier item to compute than the source of revenue calculation and a better measure of how much a desk is depending on longer-term price appreciation. 

Appendix A itself says that the metrics are intended in part to help the agencies and banking entities to understand whether particular trading activity is consistent with the market maker exemption.[48]  At the same time, it is important to stress that there are no pre-defined “good metrics” or minimum or maximum thresholds that determine compliance with the exemption, and one could assume that the metrics would vary a lot depending on the products traded. 

In fact, the agencies acknowledged that they will need to get experience from receiving this data before forming any views, and the appendix itself provides that the metrics will be revised, as appropriate, after September of next year based on review of the information collected by that time.[49]

Conclusion

I hope that I have been able to help clarify the major elements of this one specific, but very important, part of the Volcker Rule.  As with all the other provisions of the rule, I know that many questions will arise—some anticipated and some perhaps not.

The agencies are committed to addressing interpretive questions in a collaborative way and in fact have already set up an interagency group to help in doing so.  This will be an iterative process and should benefit from healthy two-way dialogue between the agencies and the industry.  I’m pleased to have been able to advance that dialogue just a bit further today.