The Dodd-Frank Act 2010

Signed into action by Barack Obama in 2010, the Dodd-Frank Act has four objectives:

  • Promote financial stability.
  • End ‘too big to fail’.
  • End bailouts.
  • Protect consumers from abusive financial services practices.

In 2007 the world began a recession. This was primarily caused by the sub-prime mortgage market, which stemmed from abusive financial practices and subsequently lead to bailouts of banks considered too big to fail. As a result we entered a period of intense financial instability.

As you can see from the paragraph above the objectives all have one thing in common, they derive from the financial crisis.

There are 16 titles for the dodd-frank act (a little extra reading), however instead of listing through each of the titles I thought I would focus specifically on title 6, which contains the foundations that created the Volcker rule.

The Volcker Rule

Implemented in 2012 and named after the former Fed chairman Paul Volcker, the Volcker rule prohibits:

  • Proprietary trading (where a bank trades for its own trading account. A firm might do this for profit or for market making).
  • Having an ownership interest in a hedge fund or private equity firm.
  • Sponsoring (e.g. sharing their name with a fund or serving as a trustee for a hedge fund).

Why introduce these rules?

The ban on proprietary (prop) trading is possibly the most radical of the rules implemented, so we’ll focus on that.

During the financial crisis it emerged that there had been significant conflicts of interest between banks and their clients. Famously Goldman Sachs were found to be aggressively selling collateralised debt obligations (CDOs) to their clients, whilst simultaneously having their prop desk take a short position on the same financial instruments (through the purchase of CDSs). It was found that Goldman Sachs made $3.7 billion in profit from the 2007 decline in the mortgage market, whilst their clients suffered the financial misery of having purchased the CDOs.

By banning prop trading the government hopes to reduce conflicts of interest, as above. However it is worth noting that some prop trading is still allowed, as it is an essential process of market making* (the main role of a broker-dealer firm**) as well as underwriting. Rather patriotically US debt trading is also still allowed.

The effect

It is believed that some banks could lose as much as $4.3 billion due to the implementation of this rule (source). However in my opinion that is nothing compared to the $7.6 trillion, believed to have been lost in USA economic output alone (source) from the financial crisis.

What are your views? Are the government and regulatory services getting too involved, or is this the right thing to do following an intense financial crisis? More importantly, will it prevent another crisis?

*Market making is the process where a bank accepts the risk of holding a specific security to ensure its liquidity and trading capability in the market. It is an essential role of most brokers.
**A Broker matches buyers and sellers in the market, and are paid a commission for this service. A Dealer (aka principal) provides liquidity to the market maker by buying and selling securities for the firm’s own portfolio (prop trading). Therefore, as the name suggests, Broker Dealers incorporate both roles.
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