The Volcker Rule Ban on Prop Trading: A Step Closer to Reality (2024)

As enacted into law, Section 619 of the Dodd-Frank Act (what is termed “the Volcker Rule”) has three major effects on banking entities:

1. Prohibits meaningful investment in hedge funds, private equity funds, and similar vehicles
2. Prohibits separately organized “prop trading” desks in most asset classes
3. Allows market making, underwriting, and related hedging – but only if such activity does not involve prohibited proprietary trading

The first two effects are relatively easy to understand and, importantly, to police. It is the third that has proved so challenging. The core idea is that one could keep the “good” activities of capital markets dealers, such as providing market making and hedging services, while stamping out the “bad” practice of speculation by firms with access to the bank safety net. However, both sets of activities necessitate taking and managing market risks, with the possibility of gain or loss on market moves. Telling the two apart promised to be difficult from the outset.

US regulators, having spent over a year wrestling with this, have finally released proposed rules implementing the Volcker Rule. The regulatory agencies1 have realized that the prop trading ban will be nearly impossible to police from outside and, accordingly, have placed the onus on each banking entity to police itself through a complex compliance regime, monitored by regulators.

Critically, the proposed rule does not:

•Make market making impossible to pursue for banks;
•Make it impossible for banks to manage liquidity and firm-level interest rate risks;
•Make it impossible for banks to hedge risk dynamically at the portfolio level;
•Require trade-by-trade reporting and analysis to demonstrate compliance; or
•Mandate the same compliance regime for firms of all sizes and scope.

It does, however, have very far-reaching implications for banks. Complying with the Volcker Rule as proposed will require a major effort by nearly all bank-owned trading businesses worldwide, and will involve potentially profound changes to business activities and ultimately market structure.

1 The Fed, SEC, OCC and FDIC all collaborated on the proposed rule; the CFTC is reportedly waiting before considering its own implementation of the Volcker Rule.To view the February 2012 report click here.

The Volcker Rule Ban on Prop Trading: A Step Closer to Reality (2024)


What is the Volcker Rule for proprietary trading? ›

The Volcker Rule generally restricts banking entities from engaging in proprietary trading and from owning, sponsoring, or having certain relationships with a hedge fund or private equity fund.

What did the Volcker Rule prevent? ›

The Volcker Rule was part of the Dodd-Frank Act enacted into law by the Obama administration in 2010 as a response to the Global Financial Crisis. It prohibits banks from engaging in proprietary trading, or from using their depositors' funds to invest in risky investment instruments.

Is proprietary trading still allowed? ›

The Volcker rule generally prohibits banking entities from engaging in proprietary trading or investing in or sponsoring hedge funds or private equity funds.

What activities are prohibited by the Volcker Rule? ›

The final rule prohibits banks from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments, for their own account. The final rule also imposes limits on banks' investments in, and other relationships with, hedge funds or private equity funds.

Is prop trading allowed in banks? ›

Institutions such as brokerage firms, investment banks, and hedge funds frequently have proprietary trading desks. However, there are restrictions against large banks engaging in prop trading, designed to limit the speculative investments that contributed the 2007-2008 financial crisis.

Who is exempt from the Volcker Rule? ›

A bank may be excluded from the Volcker Rule if it does not have more than $10 billion in total consolidated assets and does not have total trading assets and liabilities of 5% or more of total consolidated assets.

Is the Volcker Rule still in effect? ›

Relaxation, 2020-present

On June 25, 2020, the Volcker Regulators relaxed part of the rules involving banks investing in venture capital and for derivative trading.

Why is proprietary trading bad? ›

Personal Risk: One of the significant drawbacks of prop trading is the potential personal financial risk. If a trader doesn't perform well, they may lose their deposit, and in some cases, their job. Loss Limitations: Prop firms often implement daily loss limits to protect their capital.

Is prop trading regulated? ›

Prop trading firms are less heavily regulated than regular brokerages and broker-dealers. However, if such laws apply, you must still properly register your business and get licensed.

Is prop trading worth it? ›

While prop trading is one of the most profitable opportunities, it is affected by asymmetric risk. This means that the profit-sharing ratio may be from 75% to 90%, but you bear 100% of the risk of your trades. When becoming a prop trader, you often need to deposit an amount of money known as your risk contribution.

Can you prop trade stocks? ›

Proprietary trading firms, or prop firms, are specialized financial entities that engage in trading assets with their own capital across various financial markets. These can include stocks, currencies, commodities, crypto-assets, and other financial instruments.

What happens if you lose prop firm money? ›

Proprietary trading firms often provide evaluation accounts where you prove your trading skills. Usually, you pay a one-time fee to enter this “challenge.” If you lose money during this evaluation, you won't owe anything beyond the initial fee.

What is subject to the Volcker Rule? ›

The Volcker Rule generally prohibits a banking entity from entering into transactions with a related fund that w ould be a covered transaction under section 23A of the Federal Reserve Act if the banking entity w ere a member bank and the fund w ere its affiliate.

What qualifies as a covered fund under the Volcker Rule? ›

Loosely put, the Rule defines a covered fund as anything considered an investment company in the Investment Company Act, including private equity and hedge funds, as well as commodity pools with certain exclusions, and funds sponsored by a US banking entity where the affiliate holds ownership interests.

What is the conflict of interest in proprietary trading? ›

Conflicts of Interest in Proprietary Trading

Another conflict that might occur is that when the proprietary traders buy securities that have been performing badly. In this instance, the investment bank might instruct their institutional sales staff to call clients to try and convince them to purchase these securities.

What is the proprietary trading rule? ›

The Volcker Rule on Proprietary Trading

The rule aims to restrict banks from making certain speculative investments that do not directly benefit their depositors. The law was proposed after the global financial crisis when government regulators determined that large banks took too many speculative risks.

What is the proprietary trading technique? ›

Proprietary Trading is the practice of a firm trading its own money, rather than that of its clients, to profit from market movements. Financial institutions engage in proprietary trading by deploying their own funds to actively participate and profit from financial markets.

How does proprietary trading work? ›

Proprietary trading, commonly referred to as prop trading, involves financial firms, especially those specializing in securities, equities, derivatives, forex, and the futures markets, trading their own money for direct profit, rather than earning commission by trading on behalf of clients.

What is proprietary trading when an investment bank trades for? ›

Proprietary trading (also known as prop trading) occurs when a trader trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money (instead of using depositors' money) to make a profit for itself.

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