"I run risk management. It just doesn't seem like a natural place to start cutting."
--Eric Dale (Margin Call)
Interesting take on the rumored Volker Rule requirement that would not permit banks to engage in 'portfolio hedging' trades.
At first glance, one would think that this would cut into fiduciary duty to clients. After all, hedging can be a prudent risk management strategy, and disallowing seemingly ties the hands of money managers.
However, as ZH and the WSJ note, banks might frame hedging in ways that extend beyond traditional risk management practices. For example, a bank might rationalize that the 'risk' to be managed is a general economic recession and or portfolio underperformance. To 'hedge' against those events, banks might put on huge directional trades. that are not at all hedged in the traditional sense.
JP Morgan's (JPM) 2012 'London Whale' derivative trades that lost the firm $billions were initially described as portfolio hedges by management.
The Volker Rule without portfolio hedging language has not yet been passed. If or when it does, prop trading by the banks will be affected.
You see, unlike you or I, banks have to justify every investment position to bank regulators. Regulators do not like to see large directional bets in bank investment portfolios. However, banks are currently using more than $2 trillion in excess reserves as collateral for leveraged directional trades of all types. How are banks getting away with taking on so much risk? Simple. They justify the positions as 'portfolio hedging' to the regulators.
If regulators will not longer accept that rationale, then banks will either have to find other justification for their leveraged directional trades, or take the trades off.
Unwinding those trades off would...well, let's just say that unwinding those trades and prohibiting them in the future would significantly impact financial markets.
position in SPX