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Why Market Risk Systems Are Vital to Volcker Rule Compliance

On December 10, 2013, five U.S. financial regulators approved a game-changing series of new rules that prohibit a broad array of financial risk activities that contributed to the near collapse of the world's financial system in 2008.

Known as the Volcker rule and codified as part of the Dodd-Frank Act, the rule’s provisions are applicable to all U.S. depository institutions, including those affiliated with or regulated as banks. The final rule prohibits banking entities from engaging in proprietary or own-account trading of certain securities, derivatives and options, among other restrictions. However, there remains significant difficulty in distinguishing market-making activity from proprietary trading.

The final provisions of the Volcker rule are a clear game changer for banks and affiliates that are involved in market-making and related proprietary trading activities. The breadth of coverage is much broader than market participants expected, and, as a result, the race is on to reconfigure or implement ongoing position management capabilities, specifically as it relates to extraneous agency positions. In this context, extraneous positions are those positions that are not an exact duplication of the original transaction.

Specifically, the rule allows for conditional exceptions for certain market-making activities, such as securities underwriting. However, even within the context of underwriting, it is necessary for banks to make an independent and ongoing analysis of whether any reclassification or inadvertent activity pushes a seemingly exempt activity into a prohibited activity, and to what measured level or degree. This will require a reconfigured process for banks, if not an entirely new one.

This is because while securities and derivatives dealers may continue to act as principal when making markets under the exemption, and the final rule does not mandate any substantive shift toward an agency exclusive model, there is a prescribed convergence with elements of the market risk rule. From a practical perspective, the rule requires that the banks qualify risk mitigation measures and in some instances liquidate an interest attached to an identifiable position in a timely manner.

In addition, in the final Volcker rule, the U.S. regulators have jointly adopted a view that broadens the statutory definition of trading account. For instance, under the statutory text, a “trading account” is primarily intent determinative. However, under the final Volcker rule, a “trading account” includes any account holding a position of any financial instrument that is relevant under the market risk capital rules or one that hedges another trading account position.

The breadth of the regulatory definition also extends to any account of a registered securities dealer, swaps dealer or security-based swaps dealer, which is also generally aligned with market risk provisions.

Taken together, this means that internal automation must be capable of identifying all positions that are considered residual to the originating transaction and calibrating them to certain market risk factors.

It is likely that because the regulators have referenced the market risk rule in their guidance, the applicable market risk automation processes will, if properly scaled, accomplish the monitoring of the continually changing risk bank of any residual position.

Covered banks may consider leveraging their market risk framework to comply with or properly leverage the exemptions commensurate with the market-making provisions of the Volcker rule — specifically those residual positions that are “designed to reduce or mitigate identifiable risks.”

To comply with new Volcker rule requirements, the necessary automation should consist of:

  • Accurate and objective profiling of any residual position, including a determination of potential changing characterization of the position 
  • Advanced screening capabilities that coexist with the market risk and liquidity factors in accordance with the final market risk rule 
  • A multi-level classification structure that provides a real-time identification that concurrently satisfies both the Volcker requirements as well as the market risk rule provisions



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