"The report of my death was an exaggeration." Mark Twain
Portfolio hedging, which quite simply involves hedging on multiple trading positions, was a culprit in JPMorgan Chase's "London Whale" debacle. JPM's chief investment office suffered over $6 billion in trading losses on outsized positions involving complex credit default swap indices. JPM justified these gargantuan positions by claiming that they were not proprietary in nature, but, rather, portfolio hedges against defaults in the broader economy.
A Senate investigation found this claim to be untenable, observing that a true hedge results in lower risk, whereas JPM's "hedges" actually magnified risk. The findings determined that JPM had utilized the concept of "portfolio hedging" as a subterfuge behind which to disguise massive principal positions. A subsequent Justice Department lawsuit against JPM resulted in a record $13 billion settlement.
The Volcker Rule, as first proposed in October 2011, prohibited proprietary trading, but contained a broad exemption for portfolio hedging. The proposed regulatory language was so loose that the "London Whale" trades might have been permissible under the initial Volcker proposal.
Indeed, Occupy the SEC warned banking regulators about the potential for misuse of the portfolio hedging exemption as early as February 2012, months before the "London Whale" beached itself onto the public consciousness. In the summer of 2012, after a series of hearings and investigations into the "London Whale" losses, government officials began exhorting banking regulators to excise or severely limit the proposed Volcker Rule's exemption for portfolio hedging.
Before December 10, 2013, it seemed like the regulators in charge of finalizing the Volcker Rule would accede to those exhortations. Unfortunately, the actual text of the final rule reveals quite a different story.
Portfolio hedging is alive and well under the now-final Volcker Rule. In fact, as a matter of law, the regulators could not have completely eliminated portfolio hedging from the regulations even if they had wanted to. Section 619 of the Dodd-Frank of 2010, which defines the statutory template for the Volcker Rule, specifically crafts an exemption to the proprietary trading ban for "risk-mitigating hedging activities in connection with and related to individual or aggregated positions."
Regulators implementing the Volcker Rule were bound to work with this template, and so it comes as no surprise that the final rule likewise permits hedging of "individual or aggregated positions." The bank lobbyists won a big part of the battle over portfolio hedging in 2010, even before the battle had begun.
That said, the banking regulators were still given a wide swathe of authority to define exactly what kind of trade would constitute a permissible portfolio hedge. An analysis of the final hedging regulation reveals a mixed bag. On the one hand, the final rule commendably requires extensive, contemporaneous hedging documentation as well as ongoing monitoring, testing and internal controls designed to ensure that hedges mitigate or reduce risks.
On the other hand, banks remain largely responsible for their own compliance. The key drivers of enforcement are "written policies and procedures" and "internal controls." JPM's extensive pre-Volcker written policies and controls were of little use in averting the $6 billion trading loss. Would such tools necessarily prevent another such loss in the post-Volcker era?
The final rule requires "independent" testing of a bank's hedging strategies, yet it permits the consultants or auditors doing the testing to be employed by the very bank being tested. It also permits portfolio hedges "across two or more trading desks" a concession to big banks that was not mandated by the Dodd-Frank statute. And the rule does little to countervail the pervasive view among many traders that written supervisory procedures are mere impediments and inconveniences to be ignored or evaded.
The death of portfolio hedging was billed as one of the Volcker Rule's major coups. The actual regulatory language reveals a rather more benign restriction.
The Volcker Rule is a veritable leviathan in size and complexity, but the jury is out on whether it can truly avert another "London Whale"-type fiasco. Don't hold your breath.
Akshat Tewary is an attorney practicing in New Jersey, a Finra arbitrator and a co-founding member of Occupy the SEC, a group of financial activists.