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Volcker Rule: New Legislation May Affect Hedge Fund Prime Brokers

Former-United-States-Federal-Reserve-Chairman-Paul-VolckerNew York (HedgeCo.Net) – As regulators prepare to vote on the proposed Volcker legislation that restricts banks from making risky bets, Albert Kyle at the University of Maryland says that the new rules may make hedge fund investments riskier unless their broker dealers ensure careful risk management.

“Restrictions on banks engaging in proprietary trading will move risk out of banks and into hedge funds.”  Albert Kyle of UM’s Robert H. Smith School of Business, said. “Since banks will remain the hedge funds’ prime brokers, risks associated with the disorderly collapse of hedge funds will spill back into the banking system unless prime brokerage has judicious, careful risk management.

“The 1998 collapse of (hedge fund firm) Long Term Capital Management is a model for what the Volcker Rule implies that future financial crises will look like.”

Kyle, UMD-Smith’s Charles E. Smith Chair in Finance, created the “Kyle Model,” regarded as a foundation for the modern theory of market microstructure. A NASDAQ economic advisory board member (2004-2007), he serves on the Financial Industry Regulatory Authority’s Economic Advisory Committee and the Commodity Futures Trading Commission’s Technology Advisory Committee.

“Banks to a certain degree have themselves to blame – given their inability to self-govern massive risk-taking.” Kyle said. “Ultimately such policymaking sets the financial sector on a potentially dangerous path toward limiting otherwise highly effective hedging tools from being applied. This would curtail critical consumer and commercial lending activities and preclude the availability of risk mitigation techniques to banks when needed at critical points in the business cycle.”

In order to get out from under the coming regulations, Citigroup has already sold more than $6 billion in private equity and hedge fund assets and Goldman Sachs has said that it is winding down most of it’s hedge fund businesses.

The Volcker Rule is a specific section of the Dodd–Frank Wall Act originally proposed by economist and former Federal Reserve Chairman Paul Volcker to restrict banks from making certain kinds of speculative investments that do not benefit their customers.

Volcker argued that such speculative activity played a key role in the financial crisis of 2007–2010. The rule is often referred to as a ban on proprietary trading by commercial banks, whereby deposits are used to trade on the bank’s own accounts, although a number of exceptions to this ban were included in the Dodd-Frank law.

Alex Akesson
Editor for HedgeCo.net
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