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Dissenting Statement Regarding Adoption of Rule Implementing the Volcker Rule

Commissioner Daniel M. Gallagher

Dec. 10, 2013

Twenty-one months ago, I expressed my grave concerns regarding the rulemaking process for the implementation of the Volcker Rule, stating:

The aggregate impact of the rulemakings we and our fellow regulators are promulgating is massive, the costs are enormous, and we are doing so at a time when our economy is still hopefully limping towards recovery. These factors all argue for an approach that is careful, systematic, but most importantly regulatorily incremental...We must avoid regulatory hubris and should not regulate--particularly where the changes are so novel or comprehensive--with the belief that we completely understand the consequences of the regulations we may impose. In many of these areas, including Volcker, missing the mark could have dire and perhaps irreversibly negative consequences.[1]

The following week, my friend and former colleague Troy Paredes made a public plea for a reproposal of the October 2011 implementing regulations, which I echoed in a speech shortly thereafter – and have repeated publicly ever since.[2]

Today, three and half years after Dodd-Frank was enacted and over two years after the issuance of the proposed implementing rules, the Volcker rule is being finalized in the shadow of perhaps the greatest display of governmental hubris in our lifetimes, as millions of Americans struggle to navigate the unprecedented disaster arising from governmental intrusion into our health care system.  One would expect this catastrophe to be reason for caution and introspection as the government proceeds with other major incursions into private markets, but that apparently is not the case with the Volcker rule.  Regulators, including those that, like the SEC, are purportedly independent, have been commanded to "err on the side of doing a little more, and then correct it if you've gone too far" in implementing the mandates of Dodd-Frank.[3]

The nonchalant suggestion to "err on the side of" overregulation is fully in line with the staggering level of hubris reflected throughout this joint rulemaking process, which has culminated with a purely political insistence on a pre-year end vote.  In contradiction of our procedural rules for voting on major rule releases, including the longstanding guideline that Commissioners should be given thirty days to review a draft before a vote, we were given in early November not the draft final rule itself, but 18 separate documents that we were told would make up the final rule, along with two lists of "interagency staff-level open issues."  On the evening of November 27th, the night before Thanksgiving and less than two weeks before today's vote, we were presented with revised versions of those documents as well as a reminder that the "back-end" sections were still being negotiated and would be sent separately.  Not until five days ago did we have anything even resembling a voting draft, giving us less than a week to review the nearly one thousand pages of the adopting rule.  In short, under intense pressure to meet an utterly artificial, wholly political end-of-year deadline, this Commission is effectively being told that we have to vote for the final rule so we can find out what's in it.

Over the course of the past two years, I have repeated my calls for a reproposal many times.  And recently, when it became clear that my requests were falling on deaf ears, I even downgraded my request simply to ask for a “fatal flaw” reproposal period of two or three weeks in order to allow the millions of market participants who will be affected by this brand new rule text the opportunity to review it for the type of fatal flaws that riddled the original proposal. My request has been completely ignored by the mandarins at the banking agencies, who apparently believe there is nothing to fear from a massive, untested governmental intrusion into a vital segment of our economy.  Perhaps they can set up a '' web portal to implement the rule and provide reassurance that if you like your capital markets - still the deepest, fairest, and safest the world has ever known - you can keep them...period.

From the very beginning, the Volcker Rule has been a solution in search of a problem, a common situation throughout the Dodd-Frank Act.  To quote former Treasury Secretary Geithner, “If you look at the crisis, most of the losses that were material for the weak institutions — and the strong, relative to capital — did not come from [proprietary trading] activities.  They came overwhelmingly from what I think you can describe as classic extensions of credit.”[4]  Paul Volcker himself explained, “[P]roprietary trading in commercial banks was there but not central” to the financial crisis.[5]  When asked by the New York Times in 1923 why he wanted to climb Mount Everest, George Mallory famously replied, "Because it's there."[6]  That may or may not be a compelling reason to climb the world's tallest mountain, although I'll note that Mallory and his climbing partner disappeared during their 1924 Everest expedition, and his body wasn't discovered for 75 years.  

Even in the era of never letting a serious crisis go to waste, however, the mere fact that proprietary trading makes a segment of our policy establishment nervous[7] surely is not sufficient justification to potentially destroy the market-making system central to the liquidity and proper functioning of our capital markets.  Years from now, I fear, financial historians will marvel at how the Dodd-Frank Act forced regulators to proactively disadvantage American financial institutions as well as the strength and integrity of our capital markets to address such tangential - at best - matters as conflict minerals, resource extraction, and proprietary trading, but gave a complete pass to the main cause of the financial crisis -- decades worth of disastrous federal housing policy.

I believe that market making activities will be impacted most by this faulty rule.  The importance of market making to our capital markets - all of our capital markets, not just the markets for large cap, well-traded equities - cannot be underestimated.  Market makers play a unique role in providing liquidity to investors by buying, selling and building and holding inventory to meet anticipated future customer demand, and often provide the majority of the liquidity for a given security, especially in times of stress. 

What has often been lost in the argument over the scope of the Volcker Rule's market maker exemption to the prohibition on proprietary trading is that market making is a service provided by entities willing to accept the risk of holding positions in securities in anticipation of customer demand.  Like any other service providers, they expect to be compensated for their efforts - hence the potential confusion between market making and proprietary trading.  Like any other risk mitigators, they accept only as much risk as they can reasonably handle - hence the prevalence of larger, bank-affiliated broker-dealers in the market making space.  As explained in the FSOC study on implementing the Volcker Rule mandated by Section 619 of Dodd-Frank:

In principal makers commit capital to provide liquidity to their customers and ensure market continuity. In doing so, the market maker assumes risk by holding the purchased position on its balance sheet as "inventory" until such time that the transaction can be completed. Moreover, as some prior transactions are completed, other new transactions will be initiated such that the market maker will always be taking risk as long as the market making activity is performed. This activity is especially complex in illiquid markets or in a liquid market where an order is very large, as a market maker may be required to assume significant market risk between the time that the large order is purchased and sold back into the market.[8]

What makes today's flawed rulemaking particularly egregious is the fact that the financial institutions that are subject to the Volcker Rule have long since abandoned their pure prop trading desks.  Notwithstanding three years of fraught negotiations over the implementing regulations, the legislative text was clear from day one: banking entities and their affiliates are prohibited from proprietary trading, as well as from sponsoring or investing in “covered funds” such as hedge funds or private equity funds.  The financial institutions impacted by the Volcker Rule long ago accepted this fact and, from all accounts, have acted accordingly.  The banks targeted by the rule have long since shut down their pure proprietary trading operations and taken steps to ensure their compliance with the legislative text in anticipation of final implementing regulations.  Think of these institutions what you will, but even their staunchest critics would acknowledge that they are not suicidal.  They are well aware that an army of banking regulators, many situated on-site, will monitor their every move in connection with this high-profile rule. 

In short, pure prop trading by banking entities has almost completely disappeared, and what remains is to define and regulate the grey area activities that may or may not constitute prop trading – activities which encompass, crucially, virtually the entire field of market-making.  What we face, therefore, is the prospect of banning the market-making practices so central to our capital markets in order to make sure we capture every last activity that could potentially be characterized as prop trading.  One could say, in fact, that to ensure that the final 1% of potentially proprietary trading be hunted down and eliminated, the agencies are willing to place at risk 99% of all market-making activities.  Talk about the tyranny of the 1%.

We’ve been assured that we can always "correct" the implementing regulations for the Volcker Rule if it turns out they've gone "too far."  This assurance, however, is based on a bank-centric view of regulation and a dangerous misunderstanding of the Commission's regulatory program.  Prudential regulators such as the banking agencies can indeed employ their discretion in seeking to obtain their desired regulatory outcomes.  Their prudential regulation and statutory confidentiality protections, not to mention their embedded staff's constant interaction with regulated entities, allows them to bend their rules when they go "too far."  The Commission's rules-based regulatory regime, however, contains no such wiggle room.  Our rules are rules, and when our examiners come across a rule violation, whether egregious and intentional or peripheral and accidental, they are required to record such violations.  We cannot and should not be engaging in the recently vogue practice of selectively enforcing the law.  Call me old-fashioned, but I prefer my regulators to get the rules right, rather than to railroad them into effect while assuring me that there is nothing to worry about if they get them wrong.

Reassurances about the process of enforcing the implementing regulations, in any case, ring hollow in the context of the saga of developing those regulations, a procedural disaster capped by a headlong rush to meet a purely political deadline.  The original rule proposal included nearly four hundred distinctly numbered "questions," although the actual number is much higher given the multiple queries posed in most of the questions.  It generated nearly 19,000 comment letters, including unusually pointed criticisms from our foreign regulatory counterparts.  Asking questions in a proposing release is often an exercise in good government -- regulators should never assume they have all the answers -- but questions do not substitute for expertise.  Questions should help regulators with the finer points of rulemaking after the difficult decisions have been made.  Expertise should be used when crafting rule proposals, and what is actually being proposed should be reflected cleanly in proposed CFR text.  Regulatory humility should cause regulators to ask questions that can help in calibrating a final rule, but the questions should not be proposals in disguise.  The Volcker Rule proposal, it turns out, was simply a series of questions in search of a proposal.  Now that we have one, it should be noticed for comment.  Instead, we are promulgating this rule despite the fact that redlines of the proposed 2011 CFR text against the final CFR text are dripping from front to back with wholesale blocks of red.

While the Volcker Rule applies to “banking entities” and their affiliates, affecting a wide range of financial institutions regulated by the five different agencies tasked with drafting the implementing regulations, I have long argued that the Volcker Rule addresses a set of activities - the trading and investment practices of those entities - that fall within the core competencies of the SEC, and expressly envisions that quintessential market-making activity continue within these firms.[9]  In February 2012, I lamented the fact that, as CFTC Chairman Gensler said at the time, "The bank regulators have the lead role" in drafting the implementing rules,[10] which certainly shone through in the proposing release - indeed, the overwhelming volume of questions is an indictment of the backseat role the SEC played early in the process.  How many of those questions could have been answered by SEC staff?  How many were answered by our staff but were included in the proposing release anyway in the hopes of receiving from commenters answers more amenable to the banking regulators?

I have only seen this degree of interference in the affairs of ostensibly independent agencies once before, in last year’s blatant attempt by FSOC - including the leaders of many of the same agencies involved in today’s rulemaking - to dictate the timing and content of money market mutual fund rulemaking by threatening to usurp the SEC’s rulemaking authority.  This kind of interference is the product of an idealistic and ideological “book club” mindset unburdened by the knowledge of how complicated it is to establish and oversee regulatory programs, as well as the impact that those programs have on our capital markets.

Also less than reassuring is the meager, so-called economic analysis contained in the adopting release.  Our fellow regulators have argued that because this rulemaking is being promulgated under the Bank Holding Company Act, rather than the securities laws, we don't need the detailed economic analysis that our governing statutes and our own internal guidelines require us to perform for all of our rulemakings.  Apparently, our lawyers and a majority of the Commission agree with that legal analysis.  Perhaps that was the Commission's real mistake in connection with the shareholder access rule, which was vacated by the D.C. Circuit in 2011 on the grounds that the Commission had "acted arbitrarily and capriciously for having failed once again...adequately to assess the economic effects of a new rule."[11]  Maybe if we had promulgated Rule 14a-11 under another statute -- something like the Smoot-Hawley Tariff Act of 1930, for example -- we would have been able to parry the circuit court's concerns as easily as our regulatory colleagues have parried our insistence that we obey the tenets of good government and the letter of the law by including a real economic analysis in the Volcker Rule adopting release.

So do the final implementing rules improve upon the proposal?  The answer is, quite simply, that we don't know.  All we can say for sure is that the final rule set jettisons scores of flawed assumptions and incorrect conclusions in favor of new, unproven assumptions and conclusions.  The proposing release was so dominated by questions - there are a total of 1,347 question marks in the release - that it may as well have been a concept release, while the comment letters we received in response were of such volume and vehemence as to suggest that perhaps we should have asked more questions before setting forth the assumptions and conclusions railed against by commenters.  To move directly to adoption is poor judgment and the height of regulatory hubris. 

Notwithstanding all of the changes from the proposal to the final version of the implementing regulations, the final release retains the same fatally flawed approach, which lies at the heart of why this rule will be so damaging to our markets.  The regulations governing proprietary trading are still fundamentally predicated on the presumptions that trades are proprietary and funds are covered funds unless proven otherwise.  Guilty, in other words, until proven innocent.  The chilling effects of these presumptions cannot be understated - in a sense, they are the implementing rules.  The details of what criteria entities must demonstrate they meet to escape these negative presumptions, are just that - details.  What matters is that the de facto burden of proof lies with the banking entities, not the regulators. 

Before I conclude, I would like to note that at least one set of comments I made on the Volcker Rule process appears to have borne fruit - my vehement insistence that, following the marginalization of the SEC staff in the drafting of the proposing release, our staff must play a strong and vigorous leadership role in the rulemaking process.  I am pleased to say that Commission staff did indeed play a greater role as the interagency rulemaking process progressed, and I commend the staff for their hard work and for remaining faithful to the Commission's mandate to protect investors, maintain fair and efficient markets and promote capital formation in the face of constant pressure from the safety-and-soundness-focused banking regulators.  I also commend Chair White who, despite the difficult position she inherited, ensured that the voice of our staff continued to be heard at the negotiating table.  While it appears that, in recent weeks, pressure applied both from within and without the Commission has chipped away at the improvements made by our staff, that does not detract from the hard work and dedication the staff has once again displayed throughout the three-year slog of drafting implementing regulations for the Volcker Rule.

It is my hope that when, inevitably, changes need to be made to address the failures and shortcomings of the rules being promulgated today, the agencies choose to undertake a proper rulemaking process to correct its many errors.  I stand ready, willing, and eager to engage in such a process.  For the reasons discussed above, however, I strongly dissent from today’s rulemaking.

[1] Commissioner Daniel M. Gallagher, Remarks at the Credit Suisse Global Equity Trading Forum, February 17, 2012 (available at

[2] See Commissioner Troy A. Paredes, Remarks at “The SEC Speaks in 2012”, February 24, 2012 (available at; Commissioner Daniel M. Gallagher, Ongoing Regulatory Reform in the Global Capital Markets, March 5, 2012 (available at

[3]  'Volcker Rule' Faces New Hurdles, Wall Street Journal, November 19, 2013 (available at

).  In a July interview, Treasury Secretary Lew stated, "What I’m arguing is we need all the tools in Dodd-Frank to make sure we’ve ended too big to fail...It is unacceptable to be in a place where too big to fail has not been ended, and one of the things I guess I would say is that any efforts to delay or dilute the implementation of Dodd-Frank, if we get to the end of this year, and cannot, with an honest, straight face, say that we’ve ended ‘too big to fail,’ we’re going to have to look at other options because the policy of Dodd-Frank and the policy of the administration is to end ‘too big to fail.” Jack Lew answers Well Street’s questions (CNBC broadcast), July 17, 2013 (available at

).  This statement, which of course raises the question of how anyone could, "with an honest, straight face" suggest that the Dodd-Frank Act has anything at all to do with ending, rather than institutionalizing, too big to fail, was prelude for a remarkable intervention in August, when the President called the heads of the agencies charged with implementing the Dodd-Frank Act to the White House to convey "the sense of urgency that he feels" about the need for prompt implementation of the Act. Obama Presses for Action on Bank Rules, New York Times, August 19, 2013 (available at


[4] “Volcker Rule” is the Wrong Response to the Financial Crisis, Financial Services Forum ForumBlog, September 19, 2009 (available at


[5] Volcker: Proprietary trading not central to crisis, Kim Dixon and Karey Wutowski, Reuters, March 30, 2010 (available at:



[7] To quote former Chairman Volcker once again, “proprietary fact may often operate at cross purposes with [banks'] fiduciary responsibilities” Volcker: Proprietary trading not central to crisis, Kim Dixon and Karey Wutowski, Reuters, March 30, 2010 (available at:

) (emphasis added).

[8] Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds, Financial Stability Oversight Council at 19 (Jan. 2011) (available at

[9] Commissioner Daniel M. Gallagher, Remarks at the Credit Suisse Global Equity Trading Forum, February 17, 2012 (available at

[10] Testimony of Gary Gensler, Chairman, Commodity Futures Trading Commission, before the U.S. House Financial Services Subcommittees on Financial Institutions & Consumer Credit and Capital Markets & Government Sponsored Enterprises (January 18, 2012).

[11] Business Roundtable and Chamber of Commerce of the United States of America v. Securities and Exchange Commission (D.C. Cir. July 22, 2011).

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