Speculators in securities behave very differently. They resemble antique-car collectors more than used-car dealers. Antique collectors search for value, like a 1963 Chevy Impala, a 1965 Ford Mustang, or even a 1985 Nissan Maxima, because they expect prices to riseâand they store the cars until they make a profit. Speculators in stocks and bonds do the same thing, buying undervalued securities they think will rise in value, and holding them in inventory until they do.
But it gets much more complicated. Speculators and market makers can both disguise their intentions like secret agents. At financial institutions, speculators call themselves proprietary traders to sound respectable and often pursue mixed strategies to mask their behavior. They deal with customers when it suits their purpose, serving as ready buyers while accumulating a speculative position. They misrepresent themselves as low-risk market makers to reduce their capital requirements. And market makers often stray into speculation without permission, hoping to earn profits as prices rise by accumulating more inventory than they really need. Market makers speculate because it is more exciting, like buying a Lamborghini, and to earn a bigger bonus.
Regulators implementing a Volcker Rule that permits market-making and prohibits speculation have their work cut out for them. But they can follow the guidelines of managers at securities firms who monitor trader behavior. For example, when I traded as a market maker (called
a scalper) on the futures exchange, I belonged to a clearing firm that guaranteed my transactions with other members of the exchange. The manager of the clearing firm monitored every trader on his watch and would revoke trading privileges for violations of the guidelines. He checked my transactions every dayâhow often I bought, when I sold, how long I held a position, even the size of my inventory at various points during the day. I did not speculate.
Volcker sat back in his chair and said nothing after I had confessed to trading for a hedge fund. He then surprised me with “Maybe we can capitalize on your past indiscretions. I'd like you to write an op-ed piece for the
Times
or the
Journal
explaining how to distinguish market-making from speculation. They'll publish it.”
It was an opportunity and a distraction. “I'm flattered that you ask, but that takes time and I'm trying to write a biography, in case you hadn't noticed. I was supposed to finish a year ago.”
He did not hesitate: “The op-ed piece is more important.”
Volcker's preference for public over private goals forced a compromise. “I'll be happy to talk to the committee staffers and to reportersâbut no writing. I want to finish this book while you can still criticize it.”
He ignored the quip. “Okay, I'll send the rule makers to youâthat should be good enough. I've got other plans to pressure Congress in the press.”
“Like what?”
“I'm soliciting support for the Rule from former Treasury secretaries ⦠a letter to one of the national newspapers.”
“Anyone I know?”
“Blumenthal ⦠Brady ⦠O'Neill ⦠Shultz ⦠Snow.”
4
“Very nice,” I said. “Lots of Republicans ⦠and I'm sure Milton is turning over in his grave with George Shultz in your corner.”
5
Volcker smiled at the thought of Shultz defying the now-deceased Milton Friedman by supporting increased regulation.
6
And then he volunteered: “I called in some chips ⦠Brady owed me.”
“How is that?”
“I let him use my name for a horse.”
“Excuse me?”
“He owns a racing stable and asked for permission to name a horse after me ⦠I said, which end? When he said the whole animal, I gave my blessing.”
I laughed. “Is he any good?”
“He came in second a couple of times at Saratoga ⦠and then he got sick and died.”
7
“Ouch.”
“I expect to do better.”
By the end of May 2011, Volcker's persistence had paid off. He had lobbied personally in Congress for the ban on proprietary trading and then joined forces with Senators Jeff Merkley of Oregon and Carl Levin of Michigan, backing their amendment to the original bill proposed by Senate Banking Committee chairman Christopher Dodd. Volcker wrote a letter for public distribution to the two senators dated May 19, 2010: “Senators Merkley and Levin: I am fully in support of the Merkley-Levin amendment, which will clarify and enhance the proprietary trading restrictions contained within the Dodd bill.”
8
Merkley suggested only half jokingly that the legislation should have been called the Merkley-Levin-Volcker amendment.
9
Congressman Barney Frank of Massachusetts, the chairman of the House Financial Services Committee, told a reporter, “When the banks come to me opposing various things [in the financial reform bill], I say to them âIf I were you, I would go and see Paul Volcker. If you can persuade him, you might have a chance. I think you are not going to see anything in this bill that Paul objects to.' ”
10
Barney Frank told the truth, with one big exception.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed by President Obama on July 21, 2010, devotes Section 619 to the Volcker Rule.
11
This eleven-page prescription adopts the language of the Merkley-Levin amendment, which pleased Volcker, and begins with the two main prohibitions of the Rule, which he liked even more: “A banking entity shall not (A) engage in proprietary trading; or (B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.”
12
But the six words
preceding these restrictions, “Unless otherwise provided in this section,” gave him cause for concern.
Volcker had anticipated some exceptions to the Rule but thought the wording offered the bankers a giant escape hatch. None of the prohibitions against trading in Section 619 applied to government bonds, or to reducing risks through hedging, or to helping customers transact in any security, no matter how risky. Bankers would have little difficulty slipping their speculations through the cracks. To clarify the distinctions between permissible and forbidden activities, the Dodd-Frank bill mandated a study “not later than six months after the date of enactment ⦠[by] the Financial Stability Oversight Council ⦠[to] make recommendations on implementing” the statute.
13
Dodd-Frank established the Financial Stability Oversight Council (FSOC), chaired by Treasury Secretary Timothy Geithner, as a permanent committee with broad regulatory authority “to identify risks to the financial stability of the United States.”
14
Members of the FSOC included Chairman Ben Bernanke of the Federal Reserve Board, Chairman Mary Schapiro of the Securities and Exchange Commission, and other key federal regulators.
15
One of the commission's earliest responsibilities was to recommend “principles for implementing the Volcker Rule ⦠including an internal compliance regime, quantitative analysis, and reporting and supervisory review.”
16
In October 2010 the FSOC called for comments from the public to guide their recommendations. Volcker prepared as though this were the final battle for financial integrity. He wanted to avoid a last-minute setback.
“I don't want to get shafted again,” he said to me as we ate lunch at a corner table in a restaurant overlooking the skating rink in Rockefeller Center. He had just introduced me to David Rockefeller, seated at the adjacent table. The ninety-five-year-old retired chairman of Chase Manhattan Bank and grandson of Standard Oil founder John D. Rockefeller had been Volcker's boss during Paul's Chase Manhattan days, and had just congratulated him on the recent legislation.
“He didn't seem to think you got shafted,” I said, nodding toward Rocke feller.
“But he doesn't know how close to perfection we came.”
A congressional conference committee reconciling the House and
Senate versions of the Dodd-Frank bill on the final night of deliberation had diluted the restriction against banks owning and sponsoring hedge funds. After the negotiations, banks could invest up to 3 percent of their Tier 1 capital in hedge funds, rather than the $500 million maximum that Volcker had conceded.
17
JPMorgan Chase, for example, could invest about $3.9 billion, Citicorp $3.6 billion, and Goldman Sachs $2.1 billion without violating the law.
18
“Well, perfection is a high standard,” I said, “but compared with your prospects last February, you cannot complain.” I showed him a
Wall Street Journal
article dated February 3, 2010, with the headline “Volcker and Reform Defeated.”
19
He laughed. “They miscalculated.”
“Besides,” I said, “I've always thought that the ban on proprietary trading was more importantâand that went through unscathed.”
“I agree.” Volcker smiled like a litigator sensing an opening. “And that is why I want you to provide guidance to the committee on how to separate market-making from speculation. I've written a four-page letter in response to their call for public comments and added a footnote indicating they should expect a submission from you.”
20
“You don't give up, do you?”
“I may be old but I am persistent.”
“Are there any other surprises?”
Volcker smiled. “Maybe.”
“I can't wait.”
On Tuesday, January 18, 2011, the FSOC released an eighty-one-page report with detailed recommendations for regulators, but the exodus of proprietary traders from banks had already begun. The press reported as far back as August 2010 that JPMorgan Chase had begun “dismantling its stand-alone proprietary trading desk and is now preparing to wind down One Equity Partners, its internal private equity business,” to meet anticipated regulations, and Citigroup had sold “its Skybridge Capital hedge fund group” to comply with provisions of the new law.
21
On January 11, 2011, the
Wall Street Journal
reported that Morgan Stanley, the brokerage giant that had become a bank holding company during 2008, “reached an agreement with proprietary-trading chief Peter
Muller ⦠to form a new firm ⦠About 60 employees are likely to follow Mr. Muller out the door.”
22
The voluntary compliance with the Volcker Rule met with praise and skepticism. Brad Hintz, an analyst at the brokerage firm Sanford C. Bernstein, said, “This is the real stuff ⦠we really are squeezing Wall Street. Their business models are changing.”
23
But most observers thought traders could sell the Volcker Rule short with impunity. Jeffrey Harris, the former chief economist at the Commodity Futures Trading Commission, said, “The line between providing liquidity and proprietary trading is very thin. If people want to trade on prop accounts, they are going to find a way to do it.”
24
And the Bloomberg columnist and best-selling author Michael Lewis wrote, “Wall Street insiders [say] ⦠The banks have no intention of ceasing their prop trading. They are merely disguising the activity, by giving it another name.”
25
The FSOC recognized the problem and introduced its report with a warning to institutions planning to hide speculators behind market makers. “Although âbright line' proprietary trading desks are readily identifiable, in current practice, significant proprietary trading activity can take place in the context of activities that would otherwise be permitted by the statute. Therefore, an essential part of implementing the statute is the creation of rules and a supervisory framework that effectively prohibit proprietary trading activities throughout a banking entityânot just within certain business units.”
26
The attention to detail pleased Volcker as he reviewed the FSOC report, especially the precise metrics recommended to regulators to separate market makers from speculators. High inventory turnover, frequent transactions with customers, and consistent profits on a daily basis, would classify a trader more like a market maker than a speculator.
27
Low scores on these metrics would not prove that a trader had violated the Volcker Rule, but they would flash a warning like the Check Engine light on a car's dashboard, and require further investigation by the regulator. The report pointed out that regulators such as the Federal Reserve System would need “significant new and specialized resources” to implement the law.
28
The need for more resources had concerned Volcker all along. In February 2010 he testified, “The banks are all going to have a lot of twenty-six-year-olds ⦠[with] a lot of fancy mathematical training and
all the rest. The supervisors need a few twenty-eight-year-olds that have had the same kind of training.”
29
But he knew that talent flows to the highest pay scale, so that traders at Goldman Sachs, JPMorgan Chase, and Morgan Stanley could usually outsmart the regulators at the Federal Reserve Bank of New York. He had racked his brain to turn the tablesâand had hit upon a solution only after the Dodd-Frank legislation had passed.
Volcker waited until the request for public comments by the FSOC to present his idea. It appeared as the first substantive paragraph of his October 29, 2010, letter and focused on the role of a bank's chief executive officer (CEO): “In my view, effective compliance must start with clear understanding at the top of the regulated institution. As I have repeatedly stated both in public and in conversations with banking leaders, the relevant banking supervisor's first step in their examination and enforcement process should be the âcorner office.' The CEO's understanding and his instructions to other executives and staff regarding the prohibition on proprietary trading and compliance procedures for the new rules should be carefully reviewed ⦠to insure effective procedures for compliance with Section 619.”
30