May 14, 2012
The right lessons of JPMorgan Fiasco—A Commentary by Jonathan Macey ’82
The following commentary was posted on Politico.com on May 14, 2012.
The right lessons of JPMorgan Fiasco
By Jonathan Macey ’82
When JPMorgan Chase announced Thursday that it had incurred $2 billion in trading losses, everyone fell in love with the "Volcker rule." It now appears to be political suicide to oppose it and politically incorrect even to criticize.
This regulation purports to prohibit banks from buying and selling securities in their own names, meaning any proprietary trading - presumably to reduce the risks associated with this practice.
JPMorgan's immense losses are a gift from heaven for the Securities and Exchange Commission. It's about to unload on the financial markets the final version of the enormous and impenetrable set of regulations it says it needs to implement the Volcker rule. Best of all, from the SEC's viewpoint, Jamie Dimon, the chairman of JPMorgan, has been one of the few Wall Street big shots brave enough take on the commission through his strong opposition to new regulations - particularly the Volcker rule.
As attractive and simple as the Volcker rule's ban on proprietary trading looks, it has two fatal flaws: Implementing it would inhibit both hedging and market making, which, in turn, could fatally wound the very capital markets it purports to save.
So it's an essentially silly idea. It should be consigned to the scrap heap - not resurrected and deified.
The attempt to solve the rule's inherent problems can be easily traced. The rule has metastasized from a three-page letter from the respected former Federal Reserve Chairman Paul Volcker to President Barack Obama, to a 10-page provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act, to a 298-page rule proposal that required answers to 1,300 questions on 400 topics from lawyers, lobbyists, bank consultants and other regulation mavens. It emerged from this process in a state of confusion.
In its complicated form, the rule is incoherent because it assumes that banks can somehow operate core businesses, like underwriting and creating secondary markets for securities, without proprietary trading.
In its simplest form, it is unusable because it would ban essential financial activities like hedging and market making that cannot be performed without taking proprietary positions. Sometimes massive proprietary positions in securities. Even under the Glass-Steagall Act, hedging and market making for this reason were legal for entities like the Chief Investments Office unit of JPMorgan Chase - the division that lost the $2 billion.
Hedging means buying or selling an asset to offset losses associated with the price movements of other assets you own. The financial instruments most used in hedging are stocks, insurance futures and forward contracts, swaps, options and various derivatives.
In this era of too-big-to-fail banking, there are only a limited number of ways to reduce the risk posed to financial institutions. Two tactics that are actually effective are hedging and banning banks from doing anything that poses risk. The latter means putting the banks out of business - not so good for the economy, to say the least.
Hedging is impossible to do unless the hedger owns the asset used to offset the price movement of its other assets. So as long as banks can engage in any activity - like, say, making loans - a strict implementation of the Volcker rule would increase rather than decrease the riskiness of even the best-managed banks, for it would limit their ability to do the one thing that can curb or eliminate their exposure to risk.
Market making is also vital to the survival of U.S. capital markets and to the ability of business to raise capital. Market making firms create a "continuous, two-sided market" in a security - simultaneously quoting both a bid price (say, $100 per share) and an offer price (say $101.25 per share).
Financial markets cannot exist unless the securities that trade in them are liquid. Market makers are key to this in three ways.
First, market makers solve temporal problems in trading because buyers and sellers usually don't magically appear at the same moment to transact business. So market makers may sell now to a buyer, and then buy later from a seller solving the time-inconsistency problem for both counterparties.
Second, market makers solve investors' age-old spatial problem. Where do you go to buy or sell a security? The answer is the market maker - in the New York Stock Exchange, they're called specialists.
The third, related, problem that market makers solve is one that traders face because buyers and sellers usually aren't looking for the same amounts. Unless investors somehow miraculously show up in precisely the same place, at exactly the same time and for the purpose of buying and selling exactly the same amount of securities, trades don't happen without market makers. That's why true capital markets can't function without them.
Hedging and market making are not luxuries: They are the essence of what financial markets are supposed to do. Neither can be done without doing what JPMorgan Chase did - take proprietary positions in financial assets.
It turns out, ironically, that trades that led to this immense loss were fully compliant with the Volcker rule as it is now understood. So the rule could wind up being far more strictly interpreted in future.
This would be most unfortunate. JPMorgan's $2 billion loss is a hiccup. Essentially banning vital hedging and market making with a stricter interpretation of the Volcker rule could be a catastrophe.
If you think unemployment is high now, just wait until investors stop investing because there are no secondary markets and U.S. businesses are unable to raise capital.
Demonizing the banks and touting the Volcker rule are in vogue. Skyrocketing unemployment? Not so much.
Jonathan Macey is a professor specializing in finance and banking at Yale Law School and a member of the Hoover Institution's Task Force on Property Rights at Stanford University.