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Volcker Rule compliance – Differentiating between proprietary trading and market-making
Publication date: 19 April 2012
Author: George Michaels of G2 FinTech
Identifying proprietary trading versus legitimate market-making can be quite complex. There is a valid reason for market-making to remain with banks and brokerages. For example, in the case of derivatives trading, when a client wishes to place an order, there might not be an immediate, natural counterparty, nor might there be one for an extended period of time. This forces the market-maker to take a position in the derivative to facilitate the client order. These positions are both necessary and valuable because, on the whole, they help the markets operate in an orderly fashion. If everyone was forced to wait for a natural counterparty before they were allowed to trade, market swings would be greatly magnified and panics more commonplace. The problem is that these market-making positions make it incredibly difficult for an outsider to distinguish between legitimate client-related activity and proprietary trading for the firm’s own profit.
The real goal of the Dodd-Frank Act and the Volcker Rule is for proprietary trading risk to be held by hedge funds. This means that both the financial institutions and the agencies that regulate them need a simple, yet effective metric to help separate market-making from proprietary trading.
To determine if the firm is primarily doing market-making or proprietary trading, instead of looking at positions, we suggest that financial institutions should look at how the bonus pool for the front office is allocated. In the world of proprietary trading, traders are compensated purely on their P&L. For a proprietary trader, customer activity is, at best, irrelevant. In the world of legitimate market-making, the compensation is based on commissions, and keeping customers happy is the trader’s entire focus. Every trader knows what drives his or her bonus. If the driver is P&L, then they can be said to execute proprietary trades. If the driver is commissions, then they will generate customer flow and can be said to be market-making. You simply need to ask each trader how they get paid and you will know whether the firm is doing proprietary trading or market-making.
This is a simple, two-step process:
- The sell-side will need to classify personnel as back office and front office. Then, they need to categorize all compensation paid to the front-office personnel as either commission based or P&L based.
- If the amount of money that is paid based on P&L is greater than the amount of money paid based on customer flow (commissions), then you are looking at a proprietary trading operation, and the firm should be held in violation of the Volcker Rule.
With this simple process (Michaels Metric) to ascertain whether a firm is doing market-making or proprietary trading, firms and regulators will have the clarity they need to comply with the Volcker Rule.
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