The many studies that the summer's financial regulation bill required are beginning to roll in. One of the most significant this week was the new Financial Stability Oversight Council's report (.pdf) on how to make the Volcker Rule work. For those who aren't hip to the wonky finance policy jargon, this idea was proposed by former Federal Reserve Chair Paul Volcker, which sought to ban a practice called proprietary trading, when banks trade for profit rather than on behalf of clients. The study makes clear a problem that most critics of the rule already foresaw: it won't be easy to enforce it.

In particular, regulators want to ensure that banks are still able to make markets. In other words, they want clients to continue to be able to ask banks to create securities like derivatives. If all securities had two investors each wanting to take a different side of a trade, then market making would be easy. Then banks could readily sell off both sides of the risk to these two parties. Unfortunately, market making isn't always that simple.

Sometimes, banks need to hold onto the other side of a trade, even indefinitely. But banks often will be willing to perform a market-making service for a client anyway. Their willingness to do so creates liquidity for securities that otherwise would not be able to exist.

Why does all this matter to proprietary trading? A bank could sneakily use market making to mask its proprietary trading ambitions. For example, if a bank wants to bet that Apple's stock will decline, it can sell a bunch of call options on the company's stock to its clients. Then, it could just keep the exposure to itself, instead of selling it to different investors with a bearish view on Apple.

That example, however, would be pretty transparent to regulators. There's probably a pretty liquid market for investors who would like to bet for or against the stock of a company like Apple. But in the market for over-the-counter derivatives, it isn't so easy to find an investor to take on the exposure to a security that was highly customized for another client. That's where things get tricky.

The Volcker Rule study recognizes this issue, saying:

The ability to hold inventory in this context is a principal complexity: the same inventory built with the intention of facilitating liquidity for clients could also be built with the intention of engaging in impermissible proprietary trading. Consequently, a key challenge is the identification of inventory levels that are appropriate to facilitate client-driven transactions but not to take prohibited proprietary risks.

There are no clearly great solutions to deal with this problem, as it's pretty difficult to differentiate between legitimate market making and proprietary trading. But here are a few potential solutions, none of which are perfect.

No Solicitation

If a bank is really making a market for some security, then that implies that a customer has asked the bank for that security. That should be somewhat documentable. For example, if a copper mining firm wants a customized derivative to hedge its risk, then it can request that a bank make a market for that security. In doing so, it can be asked to sign a declaration that it requested the security, and that the bank did not solicit the firm to create it instead. Regulators could audit such declarations.

If a proprietary trading desk is hidden through market making, it would still need some ability to solicit in order to make the bets it believes in. If it can't solicit investors, then reaching its investment goals will be very difficult. While an investor may come around from time to time requesting precisely the opposite side of a trade that a prop trader is looking for, this won't always be the case. That will make executing a specific investing strategy relatively difficult.

Moreover, this wouldn't necessarily mean that market-making traders couldn't solicit any business. There could be an exception to this rule if a trade is made to offset exposure a bank already has in its inventory due to a previous transaction as a part of its market making function. And if the bank wants to generally advertise its market-making services, it can do so, as long as it doesn't suggest that its clients buy securities with some specific type of exposure.

Forced Hedging

But what about those cases where a bank does get lucky and investors do request precisely the sort of security that a hidden prop desk is aching to sell? The spirit of the Volcker Rule is to limit banks' risk-taking, so why not force them to hedge the risk they acquire through market making? If the market provides sufficient liquid for some given exposure, then it is pretty easy to identify a part of a market maker's inventory that could be hedged but isn't.

In cases where a bank's inventory exposure is due the other side of a trade facing a lack of investor demand, hedging could be difficult, however. In those cases, banks could document such trades, and regulators who understand the market should have some sense of how honest banks are being regarding this portion of inventory.

Inventory Risk Limits

Again, however, this could still allow a significant buildup of risk within a bank's market-making inventory. One way to mitigate this risk could be by creating stricter concentration limits on various types of exposure. For example, a bank could only have 5% of their inventory consist of risk to precious metals. This is just an arbitrary example, but regulators could impose more meaningful limits based on the various types and sizes of exposures that banks could reasonably expect to build up due to market making.

If a bank exceeds such a limit, one of two things could happen. First, the bank could be forced to turn away business, which would allow the risk to be spread around the industry to other banks instead. Second, it could allow any overconcentration to count towards the portion of its assets that it's already allowed to have dedicated to private equity and hedge fund activity under the Dodd-Frank regulation bill.


The imperfect nature of all of these suggestions demonstrates the fundamental flaw of the Volcker Rule: it's very hard to enforce. Market making is an essential function of banks. If banks ability to serve customers who want to buy customized securities is constrained, then the market will be less efficient. So if the Volcker Rule is to be enforced, very carefully constructed safeguards must be put in place to ensure that banks' market making function can still be effective.

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