Hedge fund metric could answer Volcker Rule riddle
By Rob Cox and Antony Currie
The authors are Reuters Breakingviews columnists. The opinions expressed are their own.
The central aim of the U.S. financial reforms put forward by former Federal Reserve chief Paul Volcker was quite simple: Stop banks from behaving like hedge funds. But turning a key piece of this noble goal — ending proprietary trading — into a workable framework is proving devilish. Yet there may be a partial solution. Regulators should treat Wall Street trading desks as if they were hedge funds.
That may sound like circular logic. But at present regulators are in a bit of a fix over how to distinguish risk-trading done on behalf of clients from proprietary trading. Volcker may be right in adopting Justice Potter Stewart’s “know it when I see it” definition of what constitutes a prop trade. But spotting such transactions efficiently among tens of thousands made on trading floors around the world every day is a Herculean task.
However, there may be a way to do it in aggregate by applying a measure, known as the Sharpe ratio, to bank trading businesses. The idea was even floated as a possible metric in the Financial Stability Oversight Council’s Volcker Rule recommendations in January. Regulators have until October to hash out the various ideas among themselves and with banks and implement these provisions of the Dodd-Frank Act.
Named for its creator, Nobel laureate William Sharpe, the ratio basically measures risk-adjusted returns. That’s why it is often applied by big investors like pension funds to the managers overseeing their assets. It calculates the excess return earned over the risk-free rate when taking the volatility of the relevant assets’ prices into account.
A market-making franchise executing trades for clients ought to be far less volatile than speculative prop trading. So a largely customer-focused business should have a much higher Sharpe ratio than a hedge fund — as a guide, the better hedge funds have Sharpe ratios somewhere in the region of 2.5. So a high Sharpe ratio should indicate profitable low-risk client business, while a relatively low one would more likely derive from prop trading.
The trick is to determine how high a ratio purely client-driven trading businesses should generate and how much leeway to allow for riskier client-related positions. One of the metric’s drawbacks is that losses incurred from non-proprietary trades could reduce a bank’s Sharpe ratio, producing what is known as a “false positive.”
There are ways to handle this. For example, when a bank’s traders score poorly, regulators could investigate the positions more closely — in effect, exercising the judgment that Volcker himself suggests is a relatively easy process of observation.
But as an early and broad warning sign about the level of proprietary risk a bank is taking with its capital, the Sharpe ratio might do the trick. Moreover, Sharpe’s calculation can be uniformly applied across all different trading platforms — from currencies and commodities to foreign exchange and equities — and from one bank to the next. That means regulators need not worry that the banks are using different formulas. It does mean having to trust some of their inputs — but regulators can always verify them.
It’s not foolproof, by any means. Trading is an enormous business. The top nine global securities firms raked in revenue of $100 billion in fixed income, currencies and commodities last year alone. Even with effective management, processes and controls, there will be occasions when traders take undue, non-client risks with bank capital.
And the Sharpe ratio is not a measure of systemic risk. Indeed, it suffers from the same flaws that caught regulators, investors and bankers off guard in the housing market crash that led to the financial crisis of 2008. Like the risk models that failed then, the standard deviation in a Sharpe ratio would use historic data on volatility and assume a normal distribution for market moves. So-called Black Swan events, like America’s first ever steep decline in house prices, can and will still occur.
Finally, it bears remembering that a low Sharpe ratio wouldn’t necessarily be proof of a slide into prop trading: a firm may simply be so inept that it keeps losing money on customer trades. Then again, that’s something regulators, investors and competitors might like to know anyway.
It may not be the whole answer. But treating bank trading floors like hedge funds and having them disclose their Sharpe ratios — whether in response to the Volcker Rule or not — seems like a sensible step forward.