J.P. Morgan’s recent trading loss has refocused attention on the Volcker Rule, which prevents banks from making speculative investments that do not benefit their customers. The rule – part of the U.S.’ Dodd-Frank Wall Street Reform and Consumer Protection Act – was formulated in the wake of the 2008 Financial Crisis and began its conformance period last month.
More precisely, the rule disallows U.S. banks that provide dealing services (i.e. the buying and selling of financial instruments such as foreign currencies, equities, bonds, etc. to their customers) from also dealing for their own accounts. This is often referred to as ‘proprietary trading.’
The widely publicised rationale for the rule is that it will make banks safer by preventing them from taking risky bets which might go horribly wrong – as has been evident in recent years. It will therefore reduce the risk of U.S. banks failing and of the government facing the ‘moral hazard’ of having to bail them out using taxpayer money. Because banks would take smaller bets, there would also be fewer banks that would be deemed ‘too big to fail.’
While this is well and good, a less-discussed but arguably equally important benefit of the Volcker Rule is that it will help curb a widely prevalent form of market abuse known as ‘Front-running.’ Regulators around the world including in India have been notoriously unsuccessful at tackling this so far.
Front-running is the unethical practice adopted by some employees of investment banks of using proprietary and non-public information about their own customer’s future trading intentions, to trade for themselves (or their banks) ahead of their customers. Through this activity, they profit at the expense of their clients.
As an example, last year the U.S. Securities and Exchange Commission (SEC) fined Merrill Lynch $10 million for front-running. It found that Merrill operated a proprietary trading desk from 2003 to 2005 on the firm’s main equity trading floor in New York, which was the same location at which it received and executed orders for its customers. The SEC said that the firm’s proprietary desk improperly got wind of trades that its institutional clients were making and placed the same trades for its own account.
Front-running is difficult to detect or prove and its scale is difficult to establish, mainly because the activity is often passed off by guilty parties as proprietary trading. This is why there have been very few convictions for the offence despite the practice being illegal in most countries, including India. However, anecdotally from insiders and from the few studies that have been published, the practice is widespread. For example, a study by an anonymous former J.P. Morgan Trader dated 14 July, 2000 – estimates that the loss to customers and gain to dealers from Front-running in U.S. Treasury bonds alone (and that too, just a portion of the U.S. Treasury bond market) runs into many hundreds of millions of dollars per year.
Should regulators be particularly concerned about Front-running? After all, the practice simply results in some customers getting worse prices for buying and selling financial instruments from their banks than they might otherwise have been able to secure. And some banks and individuals do rather well from it. Many believe that participants in the traded financial markets are typically large institutions that know the dangers and should be able to look after themselves.
In reality, Front-running is simply a form of insider trading. It involves certain parties using non-public information to profit at the expense of others. The transfer of value can run into billions of dollars each year and, though it may appear otherwise, it is often vulnerable parties such as pensioners, local governments and small enterprises that are the losers. It also undermines confidence in financial markets.
How then, can it be contained? One way can be to regulate the structure of the industry in a way that reduces scope for the practice to occur in the first place. If the Volcker rule is implemented rigorously, it should substantially reduce the scope for front-running by U.S. banks because they will then be monitored to ensure they are not trading for their own accounts. By extension, if proprietary trading is reduced, front-running disguised as proprietary trading will also reduce. Once banks are not allowed to build up positions in advance of their customers’ business, customers will get fairer market prices when they come to placing their orders.
For this reason, India too should enact its own Volcker-type rule, and so should other countries – perhaps with the help of a global body such as the International Organization of Securities Commissions (IOSCO). In order to avoid the problem of regulatory arbitrage through which undesirable activity simply moves to countries where laws are weaker, to be truly effective, rules need to be implemented on a worldwide basis. The U.S. has made a start on this issue through the Volcker Rule but other countries need to follow suit by considering similar proposals. Not only will this prevent wrongdoing in those countries, such implementation will help U.S. agencies to enforce the rule with rigour in the U.S. as it will strengthen their hands against those who argue against the rule on the basis that it reduces the competitiveness of American banks.
The global financial crisis and the subsequent revelations of unethical behaviour at some of the world’s largest banks have led to a substantial loss of trust in the financial services industry. Regaining this will be a difficult task – but vital for both the ongoing robustness of banks and the economies that they serve. Successfully implementing the Volker Rule will have an important part to play in this process. It will increase confidence in the markets, and boost trading activity so that both banks and their customers can be winners.
Karan Bhagat is the former Managing Director and Country Head of Barclays Corporate, in India.
This article was exclusively written for Gateway House: Indian Council on Global Relations. You can read more exclusive content here.
For interview requests with the author, or for permission to republish, please contact outreach@gatewayhouse.in.
© Copyright 2012 Gateway House: Indian Council on Global Relations. All rights reserved. Any unauthorized copying or reproduction is strictly prohibited.