T&R:  How does the final version of the Volcker Rule compare with previous iterations?

Bjorn Pettersen:  I didn't see anything there that was a huge surprise. Banks have seen the writing on the wall around the Volcker Rule, and a lot of the heavy lifting has already been done. Most banks have exited their proprietary trading desks, the area of the business that was purely doing proprietary trading. But they still have elements of proprietary trading in their market-making businesses. The question of what's a hedge versus what might be proprietary from a trading perspective is not always black and white.

T&R:  What's an example of a transaction that might fall into the gray area?

BP:  Look at step-up callable transactions. This market tends to be fairly one-sided, so in many cases, the banks end up buying the American-style option. Then they have to define and find the other side of that transaction. It's difficult, and they might use a European-style option to hedge an American-style option. Naturally, there might be a mismatch between the risk and payoff on those two transactions. There might not necessarily be any way to perfectly hedge the transactions. Over time banks can build up pretty significant exposures like that. Is this a proprietary position or just a hedge? That's one example, and there are hundreds more, especially as you get into the more sophisticated derivatives.

T&R:  Moving forward, what impact will the Volcker Rule have on banks?

BP:  The Volcker Rule will require banks to make changes in three key areas. First, the credit and rates businesses are going to get hit hard, so banks may need to restructure those businesses. They've been evaluating 'How do we set this up so we can be profitable? How can we earn a return that is higher than the cost of keeping these lines of business going?' They've done gap assessments, and they may have plans in place around the law, but they haven't necessarily done the restructuring of their businesses. Some are taking a wait-and-see approach in terms of how it's going to be implemented, but they've at least figured out what strategic options they have around some of their businesses.

Still, demonstrating that they're complying is going to take a while. They need to make changes to the business model, they need to train the front-office staff, they need to make changes to the compensation schedule because no compensation can be tied to anything that might look like proprietary trading. Then, to track and report on compliance, banks are going to have to make some technology changes; this is the second key area I see. They're going to have to collect new types of data. They may be able to leverage compliance technology they've already invested in, particularly trade surveillance systems. But their front-office systems will need to change so that traders have less ambiguity around whether a particular trade is a proprietary trade or a hedge, and those systems still need to be created. This is something that's been talked about for a long time, but it hasn't been implemented.

The last major impact of the Volcker Rule for banks is around governance. Given some of the requirements and some of the sign-offs that need to be made, there are definitely going to be changes in the banks' governance structure. I wouldn't be surprised if we started to see Chief Volcker Officers being established inside some of these organizations.

T&R:  Are these changes going to raise prices for corporate users of derivatives?

BP:  Well, this is speculation because the rule was just finalized a couple weeks ago, but somebody is going to have to pay for the cost of all this. The banks might have to tack it on to the end user market, so corporate treasurers might have to pay more for their derivatives transactions. It's possible they will see it in terms of widening bid-offer spreads—but there are no guarantees about what's going to happen.

T&R:  Are banks also likely to reduce the types of derivatives they offer on a bilateral basis?

BP:  When you run a trading desk, you typically run a book of transactions. You don't hedge transaction after transaction; you look at the whole portfolio of all the transactions that you have, and you make matches. Because of the Volcker Rule, banks may stop offering transactions where they aren't able to offset all the risk.

They need to figure out how they can make their derivatives business profitable, and they need to look at how derivatives fit within their larger relationship with a corporation. As a result of this analysis, I'd expect some banks to reduce the derivatives they offer. If I were a bank, I would want to steer clients who are looking for structured transactions toward exchange-traded products rather than bilateral products. Bilateral arrangements tend to be more expensive from a capital and a management perspective. The more banks can tie their derivatives business into exchange-traded products, the more attractive it will be.

T&R:  Has the shift toward exchange-traded products already started?

BP:  Yes, I think the banks have looked at their books and tried to figure out how to push more business into exchange-traded transactions. I'm sure many corporate treasurers have already been involved in those types of discussions.

When the banks do something like a regulated interest rate swap, it has a certain economic profile around it. If a bank can't make the business profitable, considering the capital constraints around both the market and counterparty credit risk, the natural thing to do is to look into putting the product on an exchange. In the past, bank trading desks that sold interest rate swaps came up with different types of arrangements. One person might have paid a fixed rate, the other paid a floating rate, and there were specific ranges of dates. Typically, the bank would do the transaction itself if it would be profitable. But today the amount of capital the bank has to allocate to it might be more than in the past, so the bank might be looking at alternative ways to conduct a lot of these transactions. If they were on an exchange, they would require initial margin, performance margin, which is a reflection of the counterparty credit risk and the market risk exposure of the transaction. But this might be less expensive for them from a risk-versus-return perspective.

Think about a forward rate agreement in futures contracts. I can create a forward rate agreement that will go over exactly the same dates as the futures contract, or I can go to the exchange and buy and sell the futures contracts there. Even though the transactions would be essentially the same, the risk exposures would be different. With a forward rate agreement, you're taking a market risk, of course, but you're also taking counterparty credit risk. On the exchange, you pay the initial margin and the performance margin, and those cover all that risk. Exchanges aren't risk-free, but the risks are reduced.

T&R:  Does this mean that companies are going to have fewer options in terms of derivatives that are available for hedging specific financial risks?

BP:  I do expect to see a narrowing of the types of products that banks are offering to clients, which means corporations might not necessarily have the same kind of liquidity they had before. I'm guessing there will be fewer players and fewer products and less appetite for larger transactions.

If you're running the treasury function for a large corporation, you probably want more flexibility in your derivatives options, not less flexibility, but it's going to come at a price. The future of the market will depend in part on how much companies are willing to pay for that flexibility. Of course, if the need is still there for a lot of these types of structures and the banks can't offer them given the constraints they have, that opens up the possibility that other players will come into the marketplace and fill some of those roles. There are a lot of different firms that could do this, possibly including hedge funds or private equity firms.

T&R:  Do you think companies will begin to have more options in terms of exchange-traded products, so that they will be able to find more precise hedges on the exchanges to offset their particular risks?

BP:  That's definitely a possibility. I would expect the exchanges are looking into what other kinds of products they can create. It all depends on whether they can create enough liquidity and enough instruments to create a strong trading market around it. In the past, there might have been more reluctance on the part of the banks to give up business to the exchanges, whereas now there might be more interest in having the exchanges take a larger role, and the banks might actually just begin trading on the exchanges. They have an incentive to do that.

T&R:  It seems there's some uncertainty over how the Volcker Rule will be implemented and enforced. Do you have any insights into how regulators will move forward?

BP:  One way to look at this is to consider the mandate of each agency. They all see the same thing from a little bit different perspective. The FDIC [Federal Deposit Insurance Corporation] is there to protect the deposit holder. The Federal Reserve is there to protect the financial systems. The SEC [Securities and Exchange Commission] is there to protect the investor. They're all going to look at the Volcker Rule from a different angle. But I think it's too early to say exactly how it's going to be implemented.

If you compare the Volcker Rule to the Federal Reserve Act or the Glass-Steagall Act, it's very long. The law itself is only 70 pages, but with all the writing around it, it adds up to more than 900 pages. Part of what they tried to do with the Volcker Rule is to be a bit more prescriptive in terms of how it should be used and interpreted, but there are still a lot of gray areas, and I'm sure lawyers are looking at that right now, trying to figure out how to interpret it.

T&R:  How concerned should treasurers be about the future of the derivatives markets?

BP:  I don't think there's any crisis looming for corporate treasurers. Treasurers may need to become a little more sophisticated in terms of how they use exchange-traded derivatives to create replacements of the transactions they used to be offered by banks. But that requires specialized skills and sophisticated software, pricing, and risk management models. So it's hard to say where this will end up.