The comment period on the Volcker Rule came to a close on January 13, 2012. Digesting those letters will take a lot of work and will inevitably impact the structure of the final rule.
Repos and securities lending are exempted from the Volcker Rule. The reasoning is that these activities are another way to transact a secured loan that, unto itself, should not be restricted. In addition, the argument that repo and sec lending transactions are not intended to create short term profits was used to support the exemption. (We think that anyone who has worked on a repo or sec lending desk will think that last presumption is somewhat suspect, but what the heck.) There is blow back on the repo and sec lending exemption and, as they say, it’s not over until it is over.
The Fed, in question 30 of their guidelines for public comment asked:
“Are the proposed clarifying exclusions for positions under certain repurchase and reverse repurchase arrangements and securities lending transactions over- or under-inclusive and could they have unintended consequences? Is there an alternative approach to these clarifying exclusions that would be more effective? Are the proposed clarifying exclusions broad enough to include bona fide arrangements that operate in economic substance as secured loans and are not based on expected or anticipated movements in asset prices? Are there other types of arrangements, such as open dated repurchase arrangements, that should be excluded for clarity and, if so, how should the proposed rule be revised? Alternatively, are the proposed clarifying exclusions narrow enough to not inadvertently exclude from coverage any similar arrangements or transactions that do not have these characteristics?”
Question 31 went on to ask if repo and securities lending are sufficiently similar to be treated in the same way. Question 32 asked for “input regarding why repurchase and reverse repurchase arrangements and securities lending transactions do not present the potential for abuse, namely, that a banking entity might attempt to improperly mischaracterize prohibited proprietary trading as activity that qualifies for the proposed exclusions.”
A comment letter from no less than Senators Merkley and Levin, primary authors of the legislation, ask that the repo exclusion be eliminated, saying that the exclusion has no basis in law. They say,
“….One of the most ill-advised aspects of the Proposed Rule is its creation of a raft of exclusions from the definition of “trading account” for a variety of transactions, including trades in…repurchase agreements and reverse repurchase agreements, and trades conducted pursuant to asset liability management. These exclusions were not contemplated by the statute, create new complexities, undermine the law, and should be stricken…”
“…While repurchase agreements and reverse repurchase agreements may, in normal market conditions, specify specific prices, quantities, and times for the trades, they still provide the parties with significant market, liquidity, and counterparty risks. Indeed, they are required to be covered in the trading account for bank accounting purposes and as such are subject to value-at-risk and other indices of market risk…”
“…As was seen during the financial crisis, repurchase agreements can be highly sensitive to fluctuations in market values, liquidity issues, and counterparty risks in ways that are only partially captured by current value-at-risk methodologies and regulatory risk analysis and oversight. They also may raise conflict of interest issues, since many repurchase agreements involve the pledging of client-owned collateral…”
Senators Merkley and Levin suggest that the exemptions be eliminated and repos and securities lending be subject to the general provisions of the rule. Presumably that would more strictly constrain repos and sec lending to trading that facilitates client transactions.
Merkley and Levin give a concise definition of prohibited activity: “If a bank is exposed to market risk for any significant period of time, then it is engaged in proprietary trading.” Repos facilitate client transactions but they also embed interest rate and, depending on the counterparty and collateral, a degree of credit risk. We have written before about how repo desks have a substantial proprietary component (a link is here). They use their repo flow to give them market intelligence to trade short term interest rates for short term gain. Under the best of circumstances, we wonder if that proprietary repo activity will survive. But if the repo and sec lending exemptions are softened or even removed, the playing field may morph again.
A link to the Fed’s comment guidelines is here.
A link to Merkley and Levin’s comment letter is here.
Even the Occupy Wall Street folks had their say on repo. The affiliate Occupy the SEC wrote this piece late last year, “Volcker Rule, Round One: What’s Wrong with the Repo Exclusion?”. A link to the article is here.