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Association for Financial Markets in Europe

Volcker and the debt markets

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What is the Volcker Rule?

Prohibitions

• US rule (under Dodd-Frank) that prohibits commercial banks from proprietary trading and restricts their investment in hedge funds and private equity

Rationale

• To prevent certain “risky activities” from being undertaken by banks that have access to US Federal backstop facilities

Exceptions

• Market making, hedging, securitisation, and risk management are permitted

• Trading in US Treasuries; such proprietary trading is specifically permitted

Scope

• Covers the activities of all US banking firms and their affiliates, globally

• Covers all non-US firms in respect of their US activities and any of their global activities that have a connection with the US

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Why does it matter to Europe?

Impact on US firms trading European sovereign debt

• European sovereign debt is not excluded

• Narrow approach to permitted market making may result in US firms reducing their market making in some asset classes thereby resulting in a loss of liquidity which could increase funding costs. Why?

• Artificial distinction between market making and proprietary trading

• Negative presumption forces bank to prove it’s not prop trading

• Hard-coded criteria for market making that do not reflect differences among activities in different asset classes

• Transaction by transaction approach

• Overly specific and prescriptive; causes huge cost to firms to comply

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Why does it matter to Europe?

Impact on non-US firms trading European sovereign debt

• Firms cannot conduct proprietary trading activity with US residents

• Firms may trade with US residents or entities inadvertently (eg. blind electronic trading systems) or need to clear through US entities (eg. $ swap transactions)

• Firms therefore may reconsider legitimate market making activities in certain markets that could be deemed to be prop trading with US residents for fear of action against them in that jurisdiction

• This may reduce liquidity in certain markets

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What happens next?

Volcker Rule timeline

• 11 Oct 2011- US Federal agencies proposed Rule

• 13 Feb 2012- End of consultation period (additional consultation period for CFTC proposal ended 16 April)

• 21 July 2012- Official effective Date of Restrictions pursuant to Dodd/Frank and start date of two-year conformance period. It is unknown whether a final rule will be published before this date. However, regulators have clarified that they will not enforce the Volcker rule during the conformance period

• 21 July 2014- End of two-year conformance period; Volcker rule to be enforced

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What we believe should happen next

Recommendations

• Volcker rule exemptions should be expanded from US Treasuries to include foreign sovereign debt

• Alternatively, the market making regime should be more flexible to remove disincentives from participation by:

• Eliminating transaction by transaction approach in favour of viewing market making activity as a whole

• Eliminating negative presumption

• Allowing firms to develop internal guidance with regulators (principle-based approach) that indicates whether an activity is market making

• Recognizing the difference among asset-classes

• Actively monitoring compliance with the guidance by the regulator/supervisor that would investigate if breached