Making the Dodd-Frank Act Restrictions On Proprietary Trading and Conflicts of Interest Work

Panel 1, Introductions:

Andy Rich,   Rob Johnson,   Congressman Brad Miller,   Senator Jeff Merkley

Panel 2, Combating Too Big to Fail:

Geoff Rubin,   Gerald Epstein,   Jennifer Taub,   Ty Gellasch

Panel 3, Fixing the Broken Financial Markets:

Michael Greenberger,   Wallace Turbeville,   Tim Duncan,   Josh Rosner,   Jerome Fons


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by Jeff Merkley, U.S. Senator and Carl Levin, U.S. Senator


Proprietary trading was one of the principal causes of the recent financial crisis and recession. Trading losses suffered by the major financial firms froze our financial system and decimated its ability to provide credit to the real economy. The results were devastating. Over the course of the financial crisis and recession, American families and businesses lost over $13 trillion in wealth and 5.5 million jobs.

Congress responded to this man-made disaster by enacting the broadest financial reform since the 1930’s. At its core, the Dodd-Frank Act seeks to ensure that taxpayers are never again called upon to rescue failed financial firms and that the nation does not suffer again from the debilitating economic effects of a financial crisis of this magnitude. Critical to those efforts are the Merkley-Levin provisions on proprietary trading and conflicts of interest, which we drafted.

This article details why those restrictions are needed, outlines what they do, and highlights some key issues for their successful implementation.

Need For Reform

Rise of the Traders (and Risk)
Congress responded to the last great financial crisis – the Great Depression – by passing the Banking Act of 1933 (the Glass-Steagall Act). The Glass-Steagall Act separated commercial banking, which is essential for economic stability and growth, from investment banking and trading, which are also important, but risky and conflict-ridden. Protecting commercial banks and the real economy from the risks of investment banking and trading was thought to be essential because those activities had just led to the collapse of the financial system.

The Glass-Steagall Act’s protections remained for decades, but with the rise of competition from the shadow banking system, commercial bankers increasingly pressed to engage in activities that had long been walled off. Throughout the 1980’s and 1990’s – and despite warnings to the contrary – the Glass-Steagall Act’s protections were steadily weakened. Ultimately, the Financial Services Modernization Act of 1999 (the Graham-Leach-Bliley Act) effectively repealed the remaining restrictions of the Glass-Steagall Act.

The commercial banks were now free to compete with investment banks and securities firms for outsized returns in risky trading businesses. As competition intensified, the largest firms used their low funding costs, large balance sheets, and implicit taxpayer backing to amass enormous, risky proprietary trading positions. In fact, since 2004, trading revenues have sky-rocketed at the largest banks, and by the end of 2009, accounted for all of their net operating revenues. (See graph below. )


Traders First, Everyone Else Second
Indeed, the largest financial firms became so focused on trading for themselves that some resorted to drastic – and sometimes unethical – measures that threatened their clients and their own firms. As highlighted before the Senate Permanent Subcommittee on Investigations, chaired by Senator Levin, at least one firm went so far as to design products to fail, sell them to unsuspecting clients, and bet on the products’ collapse. This practice has been analogized to a firm designing a car with faulty brakes and then purchasing a life insurance policy on the driver. While executives defended these practices on the grounds that the firm was merely acting as a “market maker,” in reality it was not market-making for clients but self-dealing.

Collapse, Bailout, and Return to “Business as Usual”
By the beginning of the financial crisis, the largest financial firms and their private funds had acquired – mostly with borrowed money – billions of dollars in proprietary positions. When a hedge fund managed by Bear Stearns collapsed in 2007, the markets suddenly called into question the value of those holdings. Firms, with similar holdings of their own, were forced to write down their values and record losses. As the crisis intensified, firms stopped lending to one another, and this highly leveraged world started to collapse. By April 2008, only a year into the crisis, the major Wall Street firms had suffered an estimated $230 billion in proprietary trading losses.

And by the end of 2008:
• Bear Stearns and Merrill Lynch had failed;
• Goldman Sachs and Morgan Stanley had converted to bank holding companies in order to gain access to emergency bailout funds;
• UBS was rescued by the Swiss government; and
• Trillions of dollars of taxpayer-backed programs were used to keep AIG, Bank of America, Citigroup, JPMorganChase, State Street, and the rest of the financial system from collapse.

Much like the Great Crash of 1929 and the collapse of Long Term Capital Management in 1997, proprietary trading losses had once again brought the financial system to its knees.

Lehman Brothers, the largest casualty in the crisis, provides a valuable case study. In 1998, the firm reportedly had $28 billion in proprietary holdings. Yet, in the run up to the financial crisis, it took increasingly large proprietary trading positions. By 2006, proprietary trading revenues reportedly accounted for 58 percent of the firm’s total revenues, and in 2007, its proprietary holdings reportedly reached $313 billion. When the crisis hit and the values of these holdings declined, Lehman Brothers reportedly lost $32 billion, more than double the $18 billion in common equity the firm had in late 2006. By September 2008, the firm had collapsed into the largest bankruptcy in history. Many of Lehman’s competitors pursued similar strategies, and faced similar fates.

Interestingly, some financial firms and industry insiders now claim that these collapses had little or nothing to do with their proprietary trading activities. Yet, the firms’ regulatory filings suggest the opposite and even a quick review of their disclosed trading revenues, profits, and losses confirms that inconsistency.

Furthermore, even after taxpayers provided trillions of dollars in support to keep these firms alive, the banks have attempted to return to their old ways. Indeed, all of the 2009 profits for the six largest U.S. banks (Goldman Sachs Group, Bank of America, JP Morgan Chase, Morgan Stanley, Citigroup, and Wells Fargo) were attributable to their trading revenues of nearly $60 billion. With the large investment banks either gone, acquired by banks, or converted to bank holding companies, these risky activities were now more deeply lodged within the commercial banking system.

And while trading revenues returned to profitability in 2009, the enormous risks have also remained. As recently as June 2010, one firm announced approximately $250 million in trading losses for the second quarter arising from bad bets on the price of coal. That followed another firm’s April 2010 announcement that its $8.8 billion private real estate fund had lost as much as $5.4 billion in value.

Something needed to be done to keep this boom and bust cycle – with taxpayer-funded bailouts – from simply repeating itself. Our families and businesses needed strong statutory protections against proprietary trading and conflicts of interest.

Dodd-Frank Restrictions

A Modern Glass-Steagall
During the debate over financial regulatory reform, Congress and the Obama Administration recognized the need for strong reform, along the lines of a modernized Glass-Steagall Act. While channeling the thrust of the Glass-Steagall Act’s protections, reforms also needed to take into account changes in the financial system and its regulation in the 75 years since the enactment of the Glass-Steagall Act. Hence, any modern version of the Glass-Steagall Act needed to cover both banks and systemically critical nonbank financial firms, and yet permit certain less risky, customer-oriented financial services. New risks and conflicts of interest in securitization also had to be addressed.

Former Federal Reserve Chairman Paul Volcker, in what is now called the “Volcker Rule,” outlined a proposal to achieve those goals. The Merkley-Levin provisions built on that proposal and were ultimately included in the Dodd-Frank Act (Sections 619 - 621). Those provisions generally set out to protect our economy and financial infrastructure in several ways.

First, with respect to commercial banks and their affiliates, the Glass-Steagall Act and Section 619 of the Dodd-Frank Act are similar: risky proprietary trading is prohibited. Unlike the Glass-Steagall Act, which prohibited nearly all securities-related activities, our provisions permit some, but only under significant restrictions. For example, banks will continue to be able to act as market-makers, hedge their risk, and maintain “skin in the game” in the funds that they manage for others.

Second, with respect to systemically critical non-bank financial firms, the Glass-Steagall Act and the Section 619 restrictions are quite different. The Glass-Steagall Act was focused exclusively on banks. However, as non-bank financial firms have taken increasingly critical roles in lending and within the overall financial infrastructure, we needed to also address them. Section 619 does that by requiring additional capital for and placing additional restraints on their proprietary trading activities.

Third, Section 619 also seeks to reestablish market discipline and integrity in private fund asset management. Banks are prohibited from bailing out their private funds, and systemically critical non-bank financial firms will have significant capital charges to account for the risk that they may end up bailing out their funds. Neither banks nor systemically significant non-bank firms should be put at risk of potential collapse because of private funds.

Fourth, in recent years, state and Federal banking regulators have allowed banks to make increasingly complex and risky long-term proprietary investments. Section 620 of the Dodd-Frank Act seeks to rehabilitate the traditional business of banking by directing regulators to review the investment activities currently permitted to banks and their affiliates.

Fifth, the Merkley-Levin provisions address the conflicts of interest that arise when a financial firm trades on its own account. Rather than focus on just one type of conflict of interest, such as front-running client orders, the broad language of section 619 provides badly-needed ethical boundaries for all proprietary trading activities by covered financial firms. In addition, section 621 addresses specific concerns in the trading of asset-backed securities. This provision is intended to prevent firms from assembling and selling asset-backed securities, and subsequently betting on their failure.

Collectively, these reforms fundamentally reduce the risks of proprietary trading and conflicts of interest in our financial system.

What Will Success Look Like?

As our predecessors sought more than 75 years ago, success will be a financial system that supports the real economy, rather than one that operates like a casino that stacks the decks in its favor.

If implemented correctly, we expect the changes in our financial system to be profound. Firms will no longer take advantage of their clients for their own proprietary trading interests. At a minimum, financial firms will no longer create products designed to fail, sell them to their unsuspecting clients, and bet on their failures. Banks will eliminate and the largest non-bank financial firms will limit their distinct proprietary trading desks. Their exposures to private funds will also decrease dramatically.

Implementation Considerations
Achieving our goals will require a partnership with regulators who are now tasked with implementing these provisions and enforcing them on a day-to-day basis.

Regulators should be readily able to ascertain whether a firm’s interest in any one fund exceeds the 3 percent ownership threshold. Moreover, they should also be able to prevent firms from evading these restrictions through unnecessarily large “seed” funds. They also should be able to determine whether a firm has more invested in private funds than the permitted aggregate of 3 percent of tier 1 capital or is guaranteeing or has bailed out a fund.

The early press reports suggest that the wind down process of distinct proprietary trading desks and interests in private funds may already be starting. While winding down trading desks and holdings in private funds may be early steps towards compliance, these steps are just the beginning.

A bank may shutter its proprietary trading desk, but that is a far cry from a bank ceasing to make proprietary trades. Financial institutions have long engaged in proprietary trading through their client-related operations, but the scale and scope of that trading has increased dramatically in recent years. Separating truly client-oriented trading from proprietary trading is going to be challenging, as market-making desks often operate both as a client service provider and as a means through which firms can take proprietary trading bets. As one banker reportedly explained, “I can find a way to say that virtually any trade we make is somehow related to serving our clients.”

Firms are likely to seek refuge in the “market-making-related” permitted activity. And we understand why. Because every trade has a counterparty, if market-making were defined to be any time a financial firm takes a position opposite a counterparty, then every principal trade would be market-making. While some industry participants may espouse this view, such an interpretation would render the Dodd-Frank protections meaningless, and is plainly not what Congress intended.

As millions of Americans saw when bank executives testified in the Senate, industry will not give up this argument easily. In fact, despite being forced to disclose more than $250 million in losses in the second quarter due to proprietary bets gone bad, an unnamed source at that bank almost laughably indicated that the group responsible for the trade would be unaffected by the our provisions. They seem to have missed our point.

We permit market-making, when firms earn profits without changes in the value of the underlying instrument, while prohibiting proprietary trading, when firms earn profits based upon changes in the values of the underlying instruments. Similarly, true “risk-mitigating hedging” activities that are designed to lower exposures for firms are permitted. Firms must hedge actual risks created by actual positions that left them with actual exposures.

To effectively separate otherwise hidden proprietary trades from true “market-making-related” activities and true “risk-mitigating hedging,” regulators will need to thoroughly collect and rigorously analyze a significant amount of trade-level data. Regulators will need trade and position-level tracking mechanisms for all types of financial products. At a minimum, regulators will need to know on a real-time basis who is making a trade, the size of trading positions, pricing information, how long the positions are held, and whether and how they are hedged.

In addition to trade-by-trade enforcement, which we expect to be largely overseen by the Securities and Exchange Commission and the Commodity Futures Trading Commission, the banking regulators should also review firms’ trading activities with an eye towards our provisions. This second-tier of review should act as both a check on trade-by-trade enforcement as well as ensure that the scope of our protections is sufficiently broad to guard systemic risk. This two-tiered approach will give regulators the ability to detect and prevent conflict-ridden and high-risk activities that threaten our financial system.


Proprietary trading and its inherent conflicts of interest made banks and the largest non-bank financial firms overly focused on their own trading, rather than on their customers. The Merkley-Levin provisions refocus our nation’s most important financial firms back onto their clients, help restore financial stability, and protect against the need for future bailouts.