The Volcker Rule contained in the Dodd-Frank financial reform act bans banks from proprietary trading. In order to implement the Rule, it is necessary to distinguish proprietary trading activities, which are proscribed, from market-making activities and other traditional banking functions, which are allowed.
Many traders at banks claim that this distinction is impossible to make in any rational way. Also that it will bury them in a maze of complex and arcane rules and costly compliance systems.
Distinguishing between proprietary trading and various other types of trading, such as hedging underlying commercial operations, is a standard, everyday responsibility of corporate management. It’s not rocket science.
I emphasize corporate management’s responsibility in order to highlight that this isn’t just a question about government regulation. Boards of Directors and senior management who have to supervise trading operations within a larger firm must define the objectives of the traders. Are the traders supposed to be hedging, or are they encouraged to do proprietary trades? What is allowed and what is not? What types of performance are rewarded, and what is penalized.
Investors are regularly told by corporate management that it is able to make these distinctions, as a look at many 10Ks and Annual Reports reveals. Here I report on just two examples.
Exelon is one of the largest electric utilities in the U.S. Its merchant generation subsidiary uses financial derivatives to hedge fluctuations in electricity and gas prices, among other risk variables. But it also runs a proprietary trading portfolio which it separately itemizes in its 10K for FY2010:
Generation also enters into certain energy−related derivatives for proprietary trading purposes. Proprietary trading includes all contracts entered into purely to profit from market price changes as opposed to hedging an exposure and is subject to limits established by Exelon’s RMC. The trading portfolio is subject to a risk management policy that includes stringent risk management limits, including volume, stop loss and Value−at−Risk (VaR) limits to manage exposure to market risk. Additionally, the Exelon risk management group and Exelon’s RMC monitor the financial risks of the proprietary trading activities. The proprietary trading activities, which included physical volumes of 3,625 GWh, 7,578 GWh and 8,891 GWh for the years ended December 31, 2010, 2009, and 2008respectively, are a complement to Generation’s energy marketing portfolio but represent a small portion of Generation’s overall revenue from energy marketing activities. Trading portfolio activity for the year ended December 31, 2010 resulted in pre−tax gains of $27 million due to net mark−to−market gains of $2 million and realized gains of $25 million. Generation uses a 95% confidence interval, one day holding period, one−tailed statistical measure in calculating its VaR. The daily VaR on proprietary trading activity averaged $140,000 of exposure over the last 18 months. Because of the relative size of the proprietary trading portfolio in comparison to Generation’s total gross margin from continuing operations for the year ended December 31, 2010 of $6,562 million.
The notes to Exelon’s Financial Statements separately itemize the mark-to-market value of its cash flow hedges and other derivative assets and liabilities from the mark-to-market value of the derivatives in its proprietary trading portfolio.
In addition to its merchant generation business, Exelon owns two local regulated utilities, ComEd (Chicago) and PECO (Philadelphia). Exelon’s 10K for FY2010 informs investors that
ComEd and PECO do not enter into derivatives for proprietary trading purposes.
If Exelon can be so categorical, then so too can banks.
E.ON is one of Europe’s largest electric utilities. One of its subsidiaries is E.ON Energy Trading, which markets the company’s electricity production and sources fuel supplies under the buzzword “optimization”, but which also runs a proprietary trading portfolio. In reporting trading results, E.ON separately itemizes the two activities:
If E.ON knows how much profit it’s earning on its proprietary portfolio and how much is due to optimization, then so too can banks.
Are Banks Different?
Exelon and E.ON are electricity companies. Maybe it is easy to distinguish proprietary trading in electricity from hedging electricity production. But it may be much harder to distinguish a bank’s market making activities from its proprietary trading activities.
This is nonsense, too.
There are differences, but they are not differences in kind nor of a large order.
The claim that banks are different trivializes the difficulty facing corporate management at these electricity companies as they try to make the distinction. There have been important cases of corporate management at electricity companies that have failed to appropriately distinguish proprietary trading operations from other trading operations, and shareholders have suffered for this. See this study of Constellation Energy, with information on earlier examples.
The claim that banks are different also overlooks the profound problem for bank shareholders themselves if it is true that the bank’s management simply cannot tell the difference between proprietary trading and market making activities. For if corporate management doesn’t understand its own internal operations and the very, very different ways in which two distinct types of operations generate profits, then it is impossible for corporate management to successfully incentivize and control those operations. See our earlier post on this.
Proprietary trading is a different line of business. Regardless of the regulatory rules, corporate management had better be able to know it when it sees it. This is equally true for banks and for non-financial companies with trading operations.