The new rule is part of the Dodd-Frank Act, which is being crafted by regulators from five Washington agencies and could be released in October. It proposes that traders who are involved with market-making must meet at least seven criteria or principles. One principle would be that they get paid from fees and the spread on their transactions, rather than appreciation or profit from their positions.
This change in pay structure could drive traders out of the regulated financial industry into unregulated sectors, says one industry expert.
Many major banks such as JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley have already shut down or spun off their standalone proprietary-trading groups in anticipation of Dodd-Frank regulations.
Market-making traders, however, along with certain forms of hedging and underwriting, will be exempt from the Dodd-Frank rule providing they meet the seven criteria. The reason is that a broad ban on all of these activities could potentially bring a halt to some markets, since large firms like Goldman Sachs and Morgan Stanley serve a purpose as market-makers by accepting risk or holding shares of trades in order to facilitate client orders.
In addition to the restriction on traders’ compensation, other conditions require that trading positions have near-term demands and no large anticipation positions; have a revenue structure based on fees and commissions and not on making money on the positions themselves; and that firms fall under the Securities and Exchange Commission’s guidance of a “bona-fide” market-maker.
Banks would also be required to institute compliance programs to monitor when traders are moving toward banned positions. These internal controls are designed to ensure the firm does not place too much capital at risk.
The draft regulations may still change under intense lobbying pressure from members of the industry.
“The challenge inherent in creating a robust implementation framework is that certain classes of permitted activities — in particular, market making, hedging, underwriting, and other transactions on behalf of customers — often evidence outwardly similar characteristics to proprietary trading, even as they pursue different objectives,” according to a statement by the Financial Stability Oversight Council, a group of regulators established by Dodd-Frank.
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