Regulation more worrying than contagion

News last month that JP Morgan Chase reported more than $2bn (€1.6bn) in trading losses brought to mind the fears of 2008, when the collapse of Lehman Brothers shook the financial world to its core. But the main difference between now and then is that participants in the derivatives market seem more concerned about new regulation than about the threat of contagion.

Although it remains unclear exactly how JP Morgan managed to rack up such enormous losses, a number of reports suggest they could be the result of some very large positions taken through a ‘flattener curve’ trade. Banks tend to use this strategy to hedge their portfolio, but it can also be seen as a source of profit.

At present, this explanation is little more than speculation, but that has not stopped regulators from suggesting that JP Morgan’s alleged use of the ‘flattener curve’ trade has somehow further blurred the line between hedging and pure trading.

Some derivatives experts fear that JP Morgan’s headline-grabbing losses will encourage Washington to bring even more rules within the ‘Volcker Rule’. At first glance, this would suggest further delays but because the implementation of the Volcker Rule - which prohibits banks from engaging in proprietary trading - has already been postponed several times, any further delays are unlikely.

According to Martin Higgs, senior vice-president of derivatives and collateral product management at State Street, the real question that seems to be looming in the background is whether the regulators will take into account all the lobbying that market participants have done so far, both in Europe and the US. “Will the losses revealed by JP Morgan mean that any potential watering down of the Volker Rule is now stopped and that it is pushed through with limited or no changes to what has already been proposed?” he asks.

Banks and hedge funds have argued that the Volcker Rule would be difficult to implement because of the blurred line between market-making and proprietary trading. But this argument no longer seems to hold water, as it constitutes one of the fundamental reasons why US regulators have deemed it necessary to prohibit proprietary trading - to avoid confusion. Lobbying or no lobbying, Washington could very well proceed with the implementation of the rule, demanding that banks clearly separate their activities.
“Furthermore,” Higgs also points out, “could the JP Morgan losses spur European regulators to introduce their own version of the Volker Rule?”

Brussels might indeed decide to implement a Volker equivalent within its EMIR Directive. However, because the European Parliament and the European Council have already approved the first part of the Directive’s text - which focuses on clearing obligation and risk mitigation techniques for contracts not centrally cleared - it seems improbable the European Commission would adopt such rules.

Obviously, the level-two details of the Directive - which focus on central counterparty requirements, where a number of provisions, including the temporary exemption for pension funds, need to be specified through technical standards - still need to be worked through as discussed in two consultations papers launched in February and March this year. But these cannot change the level-one regulation.

One thing is certain, however. If the European version of the Volcker Rule were to be implemented, it would happen years down the road, giving Brussels enough time to come up with a set of rules that match up with the US version, which is expected for 2014.


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