Distinguishing proprietary trading from hedging

Good internal risk controls involve carefully distinguishing between different types of trading. Many companies that do significant trading to hedge their market risks explicitly forbid proprietary trading. Others explicitly try to profit from proprietary trading, but it is still important to keep the proprietary trading book separate and under proper control.

So, for anyone interested in this issue, it is instructive to watch the implementation of the Volker Rule — section 619 of the Dodd-Frank Act — which restricts the proprietary trading operations at the major banks. Last week, Politico’s Morning Money posted a study by Deloitte discussing how regulators might identify proprietary trading and the measures banks would need to take to clearly mark transactions as “market making” or other permitted activities as opposed to proprietary trading.

While the Volker Rule is about banks, and this blog is about end-users, it will still be informative to end-users to watch how this process plays out at banks. After all, proprietary trading is proprietary trading, wherever it is pursued, and the fingerprints of proprietary trading are likely to be similar, too.

Two other good reads on the telltale markers distinguishing proprietary and other trading are a paper by NYU’s William Silber, and an old paper by Braas and Bralver in the Journal of Applied Corporate Finance (paywalled).

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