Volcker Rule — Banning Proprietary Trading at Banks
Background — Paul Volcker’s Argument
Paul Volcker, who served as Fed Chairman from 1979 to 1987, argued that the 2008 financial crisis proved that banks shouldn’t gamble with depositors’ money. When proprietary trades go wrong at a bank backed by FDIC deposit insurance, taxpayers are ultimately on the hook. His proposal was simple: if you want government-backed deposit insurance, you don’t get to run a hedge fund on the side.
What the Volcker Rule Prohibits
| Prohibition | Description |
|---|---|
| Proprietary Trading | Banks cannot trade securities, derivatives, or other instruments for their own profit (as opposed to on behalf of clients) |
| Hedge Fund Ownership | Banks cannot own, sponsor, or invest in hedge funds (with limited exceptions) |
| Private Equity Ownership | Banks cannot own, sponsor, or invest in private equity funds (with limited exceptions) |
| Covered Fund Relationships | Restricts transactions between banks and affiliated funds to prevent hidden bailouts |
Key Exemptions — What Banks Can Still Do
The Volcker Rule includes important carve-outs that allow banks to continue essential activities:
| Exemption | Description |
|---|---|
| Market Making | Banks can trade to provide liquidity to clients (buying and selling to facilitate client orders) |
| Hedging | Banks can hedge risks related to their existing positions and business operations |
| Underwriting | Banks can hold securities temporarily when underwriting new issues |
| Government Securities | Trading in U.S. Treasuries and government agency securities is exempt |
| Foreign Trading | Trading conducted solely outside the United States by foreign banking entities |
| Small Fund Investments | Banks can invest up to 3% of Tier 1 capital in covered funds, subject to a per-fund 3% cap |
The Gray Area Problem
The biggest challenge with the Volcker Rule is distinguishing prohibited proprietary trading from permitted market-making. Both involve banks holding positions, but the intent is different:
| Dimension | Proprietary Trading (Banned) | Market Making (Allowed) |
|---|---|---|
| Purpose | Profit from directional bets | Provide liquidity to clients |
| Holding Period | Hold for profit appreciation | Hold briefly, then sell to client |
| Risk Source | Speculative market risk | Inventory risk from client flow |
| Revenue | Trading gains/losses | Bid-ask spread capture |
| Client Nexus | No client demand required | Must demonstrate reasonably expected near-term client demand |
Impact on Wall Street
The Volcker Rule fundamentally changed how banks operate:
- Prop desks eliminated: Goldman Sachs, JPMorgan, and others shut down proprietary trading desks
- Revenue shift: Banks pivoted from trading profits to fee-based and advisory revenue
- Talent migration: Top traders moved to hedge funds that aren’t subject to the rule
- Reduced liquidity: Critics argue less market-making has reduced bond market liquidity
- Compliance burden: Banks must track trading intent and prove exemption eligibility
Volcker Rule 2.0 (2020 Revisions)
In 2020, regulators simplified and loosened the Volcker Rule:
- Removed the requirement to prove “reasonably expected near-term demand” for market-making
- Created a presumption of compliance for trades held under 60 days
- Simplified compliance for smaller banks with limited trading activity
- Expanded the types of funds banks can invest in (venture capital, credit, and certain loan securitizations)
Key Takeaways
- The Volcker Rule prohibits banks from proprietary trading and limits hedge fund/PE investments
- Key exemptions include market-making, hedging, underwriting, and government securities trading
- It partially restored Glass-Steagall’s spirit of separating speculation from deposit-taking
- The biggest implementation challenge is distinguishing proprietary trading from market-making
- The 2020 revisions simplified compliance and loosened some restrictions
Frequently Asked Questions
What is the Volcker Rule?
The Volcker Rule (Section 619 of Dodd-Frank) prohibits banks from proprietary trading — using their own capital for speculative market bets — and restricts their investments in hedge funds and private equity funds.
Why is it called the Volcker Rule?
It’s named after Paul Volcker, the former Federal Reserve Chairman who advocated for the restriction. Volcker argued that banks backed by taxpayer-insured deposits should not be allowed to engage in speculative trading.
Can banks still trade under the Volcker Rule?
Yes, but only under permitted exemptions: market-making (providing liquidity to clients), hedging existing risks, underwriting, and trading government securities. Speculative proprietary trading for the bank’s own profit is banned.
How is the Volcker Rule different from Glass-Steagall?
Glass-Steagall completely separated commercial and investment banking. The Volcker Rule is narrower — it allows banks to remain in investment banking but prohibits one specific activity: proprietary trading with the bank’s own capital.
Has the Volcker Rule reduced market liquidity?
This is debated. Critics argue that restricting bank trading has reduced liquidity, particularly in corporate bond markets. Supporters counter that the liquidity that disappeared was artificial and crisis-prone, and that markets are safer with less bank speculation.