Understanding The Volcker Rule: What All Prop Traders Should Know About The Bank Holding Company Act

Earlier this month on CBS’s "60 Minutes," Federal Reserve Chairman Jerome Powell sat down for an interview with longtime correspondent Scott Pelley. While the interview was light on actionable investment advice, it did offer a unique look into the mindset of the 71-year-old chairman. 

Powell was reluctant to celebrate a victory over inflation and noted his concerns over rising debt. The Fed’s tight money policy has echoed the era of Paul Volcker, who served as Fed chair from 1979 to 1987 and faced a similar task in defeating inflation. But Volcker’s tenure at the Fed isn’t why prop traders should know his name — it’s the banking rule that bears his moniker.

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Separating Speculation From Banking

The Bank Holding Company Act of 1956 was designed to prevent large national banks from taking market share from smaller local banks by defining which institutions could operate across state lines. The legislation gave the Federal Reserve more authority over the banking industry and has been altered several times. Still, prop traders will be interested in one of the more recent changes.

After the Great Recession, the Dodd-Frank Act implemented financial reforms that attempted to strengthen the United States’s financial plumbing. Dodd-Frank created several new federal offices, like the Consumer Financial Protection Bureau (CFPB), and altered several existing pieces of legislation. One of the Dodd-Frank reforms was attached to the Bank Holding Company Act, initially proposed by Volcker in 2010. 

In a New York Times op-ed, Volcker questioned the role speculative trading played in the significant bank disruptions during the Great Recession. Appointed by President Barack Obama to his 2009 Economic Recovery Board, Volcker argued that too many banks (including the so-called Too Big To Fail institutions) engaged in risky investments and trading practices, few of which were in the best interest of the banks’ clients. According to Volcker, proprietary trading and complex derivative investments weren’t suitable for these institutions, which the public depended upon as a source of safety, not speculative excess.

Implementation And Criticism

Dodd-Frank officially adjusted section 13 of the Bank Holding Company Act, which was then nicknamed the Volcker Rule after its initial proposer. The Volcker Rule severely limited the types of speculative investments banks could make. Proprietary trading systems were to be shuttered, and risky bets using derivatives like collateral debt obligations (CDOs) were to be unwound. Additionally, bank investments with hedge funds and private equity were to be limited or prohibited altogether.

The Volcker Rule was hotly criticized by banks that didn’t want their investment options limited, but it went into effect in July 2015 and set dates for when banks needed to unwind their riskier trades. However, the backlash was swift, and many banks immediately began requesting extensions or loopholes to allow some types of riskier trading to occur. 

Efforts to neuter parts of the Volcker Rule have been successful in recent years. In June 2020, the Federal Deposit Insurance Corp. (FDIC) voted to allow commercial banks to invest in venture capital funds. However, regulators did achieve their goals — commercial banks and proprietary trading went their separate ways as many of the industry’s most prominent traders left their banks to form hedge funds. 

Commercial banks and proprietary systems may not mix, but plenty of other firms are still seeking top trading talent. Prop trading programs have become popular for experienced investors to get their feet wet in this field. For example, Trade The Pool’s Funded Trader Program provides paper capital to prospective traders for a small upfront fee and then offers tools, training and analysis to maximize profit potential. But remember — only the top traders will make it through the evaluation phase into the funded account phase.

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