Volcker Rule To Scrap "Portfolio Hedging", Would Make Trillions In Excess Deposits Inert

As we have been covering for the past year and a half, most explicitly in “A Record $2 Trillion In Deposits Over Loans – The Fed’s Indirect Market Propping Pathway Exposed“, when it comes to the pathway of the Fed’s excess deposits propping up risk levels, it has nothing to do with reserves sitting on bank balance sheets as assets, and everything to do with excess deposits (of which there are now $2.4 trillion thanks to the Fed) which are used as Initial collateral by banks such as JPM and then funding such derivatives as IG9 in a failed attempt to cover a segment of the corporate bond market. These deposits originate at the Fed as a liability at the commercial banking sector to the excess reserve asset.

That much is clear and undisputed, and was admitted by none other than JPM itself.

Of course, before it was penalized hundreds of millions for Jamie Dimon’s tempest in a teapot comments, and implicitly lying before Congress, the party line is that when JPM’s CIO unit proceeded to use the $423 billion (at the time) deposit to loan gap as funds to sell IG9 protection, it was “hedging.”

It wasn’t, and instead it was merely putting on one of the largest prop trades in history which can be confirmed by the great bonus expectations of Bruno Iksli and pals. And since nobody expects to make an extra bonus on a hedge to an existing trade, but always on a new directional trade, one can ignore the lies that any such massive prop trade are covered up with.

Which is why the news overnight from the WSJ that the Volcker Rule (if and when it is implemented) will do away with such “portfolio hedging” trades may have major consequences.

The WSJ reports:

In a defeat for Wall Street, the “Volcker rule” won’t allow banks to enter trades designed to protect against losses held in a broad portfolio of assets, according to people familiar with the rule.  The practice, known as portfolio hedging, has become a focal point of regulators drafting the rule, a controversial plank of the 2010 Dodd-Frank financial law that seeks to prevent banks from putting their own capital at risk in pursuit of trading profits.

 

But it won’t contain language permitting portfolio hedging, which has been “expunged” from earlier drafts of the rule, according to a person familiar with the matter. Regulators decided to remove portfolio hedging from the rule after J.P. Morgan Chase disclosed billions of dollars in losses from its so-called London whale trades in 2012.

 

The bank initially described the trades as a portfolio hedge. Now, it is likely other Wall Street firms also will end up paying for J.P. Morgan’s slip-up. Regulators, in response to the J.P. Morgan disclosure, pushed to write a rule that would ensure banks couldn’t engage in such trades.

 

The move will come as a blow to banks, which lobbied regulators to keep language allowing portfolio hedging in the rule. Banks often hedge to offset the risks that accompany trading with clients. Sometimes, though, there is no perfect counterweight to those clients’ trades. Banks look to portfolio hedging to manage a broader array of risks.

 

What hedges don’t do, regulators wrote, is “give riseā€¦to any significant new or additional risk that is not itself hedged contemporaneously.” The excerpt reviewed by the Journal didn’t mention portfolio hedging.

For once regulators and politicians not only understood the underlying issues but did the right thing:

Critics said that opened the door for banks to make all manner of bets on the market because a bank might define the risk to its portfolio broadly, such as the risk of a U.S. recession.

And while we are confident the banks will find a way to delay the implementation or outright bring the “hedging” permissive language back, this change – unless remedied – has the potential to make a huge dent on bank P&Ls as it would mean the end of using the Fed’s excess reserves to buy up risk and to push the market higher through such instruments as buying ES, selling index protection and other marginable futures and derivatives.

In effect, should the “portfolio hedging” language be kept off the books, it would mean the permanent clogging of a pathway that allowed the Fed’s trillions in excess deposits to be used to push stocks higher.

We hardly need to explain the dramatic implications for stocks such a shift would create.


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/rlALIHYt27g/story01.htm Tyler Durden

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