Week 3 – Derivatives Workshop (held in week 4)

Refer to the article which appeared in Fortune magazine on the 4 June 2018, titled, “It’s
time to just kill the Volcker Rule” By Norbert J Michel. Questions 1-4 are based on this
article.

http://fortune.com/2018/06/04/volcker-rule-repeal-dodd-frank/

1. What is the Volcker Rule?

RISKY PRODUCT: HEDGING FUNDS
Answer:
The Volcker Rule is essentially the ban on many forms of short-term trading by federally
insured banks. The rule prohibits banks from using customer deposits for their own profits.
Investment in hedge funds, private equity funds and other forms of risky trading operations are
prohibited. The rule is section 619 of the Dodd-Frank Wall Street Reform Act of 2010.

The Volcker Rule, however, allows trading in circumstances where it is necessary for banks to
run their business (currency trading and to offset interest rate risk for example) and where
banks trade on behalf of their clients.

2. Why and when was it introduced?

TRANSPANRENCE OF THE FINANCIAL STABILITY ;CONSUMER’S PROTECTION
Answer:
The initial idea was proposed by Paul Volcker, the former U.S. Federal Reserve chairman, in
2009. It was supposed to come into effect in July 2012. However, delays caused by bank
lobbyists meant that the rule was only approved in December 2013 and came into effect in
2015.

Under the Glass-Steagall Act, investment banking and commercial banking were separated.
When the Act was repealed, Citigroup and other major banks started big trading operations
using deposits from customers.

Volker noted when he proposed the idea that the second factor which led to the 2008 financial
crisis was the exotic trades made around the bad loans, hence the need to ban such risky trading
behaviours.

The Volcker Rule aims to reverse the damages done when the Congress repealed the Glass-
Steagall Act by make depositor’s money safe again and limit risky trades by banks. It also
reduces the likely hood of the government having to bail out banks in distress.

3. What have been come of the key problems identified with the Volker rule?
 COST.? IMPACT OF CORPORATE BOND MARKET(IMORTANT IN US)
Answer:
One key problem stated in the article by Norbert J Michel is that “nothing is inherently safe
about traditional commercial banking” and that every single commercial loan is essentially a
long-term bet funded with short-term funds. As a result, by limiting securities trading, banks
end up assuming more risks due to less diversification benefits.

Another key problem with the rule is that identifying short-term trade is too subjective, with
banks arguing that it would require second-guessing traders’ intention. The Volcker rule
categorizes purchases and sales of instruments within 60 days as proprietary, with the
exemption for trades for purposes of hedging or market making.

4. The article refers to the fact that it will be better off “killing the Volcker rule all together “. Do
you think this will be a solution to Wall Street? (150 words)

Answer:
Although the Volcker Rule may not be the perfect solution to limiting banks’ risk taking
behaviours, it is still essential in keeping banks in check. Speculative trading is still inherently
risky and if the Volcker Rule were to be removed altogether, banks would assume more risk
and ultimately it is a gamble on depositor’s funds.

The impact of the Volcker Rule was felt when Goldman Sachs reduced its risk-taking in 2011,
closing down its Sachs Principal Strategies and Global Macro Propriety Trading desk divisions.
In addition, the firm limited investment in private equity and hedge funds to 3% of each fund.

According to the Office of the Comptroller of the Currency (OCC), benefits of the Volcker
Rule is largely unquantifiable but includes better risk management, fewer conflicts of interest,
greater safety, better supervision and reduced likelihood of another financial crisis. Albeit the
high compliance costs which in 2014 alone amounted to $400m for the 7 biggest banks, the
benefits would arguably still outweigh the costs.

5. Similar to the Volcker rule, the regulators in the US introduced the “Swap push out rule in 2010
and there was a “Repeal” of the Swap push out rule in 2014.
PUSH IN RULE
(i) What was the original Swap push out rule about? (100 words)
The original swap push out rule forbid providing Federal sustenance to Federal
depository institution (swap dealer or swap bank dealer) unless that hedging by
using swaps and some dealing activities were limited. The dealing activities are the
activities refer to some interest rate swaps, some credit default swaps. The Swap
Dealer Bank was required to push out all the activities which were not meet these
limitations into independent entity that not in line with Federal assistance. The aim
of this statutory was prevent the taxpayer regard the bailout of Congress as the
riskiest swap activities which manipulated by Swap Dealer Bank.
 (ii) How did it change in 2014? (100 words)
The limitations of some types of swap activities conducted by Swap Dealer Bank
were eased in 2014. The amended Swap Push-Out rule requires Swap Dealer Bank
to push out swap activities only among some specific structured finance swaps. The
push out of structured finance swaps is not required anymore. However, the ability
that swap dealer bank use swaps will not be affected. The Swap Dealer Bank can
also use structured finance swaps for hedging in order to reduce risk.

6. What role did derivatives play in triggering the 2007 financial crisis? (150 words)
Unregulated OTC derivatives activities are one of the major causes of the global financial crisis.
Back then in 2007, financial institutions that lend money to homebuyers would then sell the
mortgage to another financial institution that packages the mortgage with other mortgages to
form a mortgage-backed security, which its underlying value is the mortgages to the
homebuyers. These mortgage-backed securities are then traded between financial institutions,
forming a web of interconnectedness and interdependence among the financial institutions,
creating a systemic risk. Hence, when the federal reserves started raising the fed funds rate,
most of the underlying mortgages-holders, the homebuyers, couldn’t afford to pay back the
rising interest payments as their mortgages are mostly adjustable-rate mortgages. Hence, when
the underlying mortgage-holders could not pay back, a chain of financial institutions are also
affected due to the mortgage-backed securities that they bought, which triggers the financial
crisis. Moreover, due to the option of packaging the mortgages into a mortgage-backed security,
bank gets more liquidity to lend to more homebuyers, increasing exposures of the financial
institutions to a very large number of these sub-prime mortgages, contributing to the escalation
to the financial crisis as this creates an even worse derivatives bubble which are invisible to
individual investors.

7. What are the benefits of central clearing?

Central Clearing provides a better and improved risk management to the OTC derivatives
trading activities. This is possible as centre clearing would provide a focus to supervise the
derivatives market better in regards of the management of market participants and credit and
counterparty risk, which would strengthen resilience of the financial market. Moreover, central
clearing facilitates trading that acts as counterparty to both buyer and seller and guarantees the
terms of trade even in the event of the buyer or seller become unable to fulfil the terms of
agreements, by incurring fee and charges to both buyer and sellers in exchange for this
guarantee. This effectively reduces credit risk and counterparty risk.

References:
Amandeo, K. (2018, May 31). Volcker Rule Summary: Six ways the Volcker Rule protects
you (and why banks hate it). The Balance. Retrieved from
https://www.thebalance.com/volcker-rule-summary-3305905
Amandeo, K. (2018, June 25). The role of derivatives in creating mortgage crisis. The Balance.
Retrieved from https://www.thebalance.com/role-of-derivatives-in-creating-mortgage-crisis-
3970477

Hera, R. (2010, May 12). Forget about housing, the real cause of the crisis was OTC derivatives.
Business Insider Australia. Retrieved from https://www.businessinsider.com.au/bubble-
derivatives-otc-2010-5?r=US&IR=T

Reserve Bank of Australia. (2011). Central clearing of OTC derivatives in Australia – June
2011. Retrieved from https://www.rba.gov.au/publications/consultations/201106-otc-
derivatives/central-clearing-otc-derivatives.html

Schroeder, P. & Price, M. (2018, June 15). Volcker ‘fix’ may cause new headaches for Wall
Street. Reuters. Retrieved from https://www.reuters.com/article/us-usa-regulation-volcker-
analysis/volcker-fix-may-cause-new-headaches-for-wall-street-idUSKBN1JB0DX

The Economist. (2015, July 25). Volcker Rule much ado about trading. Retrieved from
https://www.economist.com/finance-and-economics/2015/07/25/much-ado-about-trading