The so-called Volcker Rule would limit the size and scope of banks and other financial institutions with the goals (according to a White House press release) of “rein[ing] in excessive risk-taking and protect[ing] taxpayers.” With respect to size, the Rule would seek to limit the market share of liabilities at the largest financial firms. And with respect to scope, the Rule would impose two prohibitions of note to the hedge fund industry. First, it would prohibit any bank or bank holding company from owning, investing in or sponsoring a hedge fund or private equity fund. Second, it would prohibit the same institutions from engaging in “proprietary trading operations.” See “Senate Banking Committee Hears Testimony from Hedge Fund Industry Experts and Academics on ‘Volcker Rule
,’” Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 10, 2010); “Senate Banking Committee Holds Hearings on ‘Volcker Rule’ Designed to Limit Banks’ Ability to Own, Invest In or Sponsor Hedge or Private Equity Funds
,” Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010). We plan to explore the potential prohibition on bank sponsorship of hedge funds in an upcoming issue of the Hedge Fund Law Report. This article focuses on the proposed prohibition of proprietary trading by banks and other financial institutions. In particular, this article focuses on the threshold issue of defining precisely what proprietary trading is and is not. This definition bears directly on the likelihood that the proprietary trading ban will become law because one of the chief objections to the ban is impracticability. That is, opponents object that such a ban is not practicable because proprietary trading cannot be defined in a manner that reflects market practice and enables consistent regulatory enforcement. (Even if proprietary trading can be defined, opponents argue that the ban may be superfluous, moot or counterproductive: superfluous because capital or liquidity requirements or a systemic risk regulator may better effectuate the same goals; moot because bank proprietary trading desks may be waning in their contributions to bank revenues and in number; and counterproductive because proprietary trading by dealers enhances liquidity in markets required to fund government operations, such as the markets for Treasury and agency bonds.) The definition of proprietary trading – and its effect on the likelihood of passage of the proprietary trading ban in the Volcker Rule, as well as the shape that any such ban takes – matter greatly to hedge funds because bank proprietary trading desks interact with hedge funds in at least three important ways: as counterparties, competitors and sources of talent. See “As Banks Close Prop Desks and Traders Move to Hedge Funds, Hedge Fund Managers Focus on Permissible Scope of Use of Confidential Information
,” Hedge Fund Law Report, Vol. 2, No. 18 (May 7, 2009). Accordingly, an outright ban of the sort contemplated by the Volcker Rule could be expected to: reduce competition in certain hedge fund strategies (at least in the short term between hedge funds and prop desks, though in the medium term it may increase competition between existing and new hedge funds); increase the supply of investment talent available to hedge fund managers; potentially reduce average hedge fund manager personnel compensation (depending on the elasticity of demand for investment talent); further enhance hedge fund entrepreneurship; increase the number of sales of hedge fund advisory businesses; diminish liquidity in a variety of financial instruments, especially government-issued fixed income securities (in which prop desks currently play a central role); and reduce bank profitability. On some of the foregoing points, see “How Can Start-Up Hedge Fund Managers Use Past Performance Information to Market New Funds?
,” Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009) (hedge fund entrepreneurship); “IRS Issues Guidance on Compliance with Section 409A Requirements Applicable to Deferred Compensation Plans of Hedge Fund Managers
,” Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010) (hedge fund manager compensation); “For Managers Facing Strong Headwinds, Sales of the Advisory Business Offer a Means of Preserving the Franchise While Avoiding Fund Liquidations
,” Hedge Fund Law Report, Vol. 2, No. 11 (Mar. 18, 2009) (hedge fund adviser M&A). But will such a ban become law? This article seeks to clarify and deepen the proprietary trading debate as it relates to hedge funds. In particular, this article: provides background and context of the proposed ban; highlights a provision in the Restoring American Financial Stability Act of 2009 (RAFSA) that may yield a legislative definition of “proprietary trading”; most importantly, discusses the three potential approaches to a viable definition of proprietary trading, while highlighting the shortcomings of each approach; discusses the recent retrenchment among investment banks with respect to proprietary trading; and explains the offsetting potential for “prop creep.”