Research Highlights

Tripping up Proprietary Trading Violations

By William L. Silber, Marcus Nadler Professor of Finance and Economics & Director, L. Glucksman Institute for Research in Securities Markets
In the fog of trading, financial regulators trying to curtail banks’ risk-taking in compliance with the so-called Volcker Rule have a hard job distinguishing between market makers and speculators. NYU Stern Finance and Economics Professor William L. Silber provides a method to help authorities identify the kinds of proprietary trading violations that put financial institutions at risk.

What’s tricky is that traders can substitute risky speculation for less risky market making to reap potential payoffs. The Dodd-Frank Wall Street Reform and Consumer Protection Act, through the Volcker Rule, calls for banks to refrain from placing short-term trading bets, but guidelines are needed to help regulators implement those curbs.

In his article, “On the Nature of Trading: Do Speculators Leave Footprints?,” Silber writes that trading records describing the evolution of a market position over time can help regulators track the kinds of transactions that violate the law.

Balance sheets alone are insufficient to determine whether a trader acted as a market maker or a speculator, says Silber, but trading records combined with market information such as the prevailing bid-ask quotes at the time trades were executed can help identify the trading strategy. Knowing the trading strategy helps to evaluate contract compliance, risk exposure, and the capital requirements of trading firms.

Silber notes two provisos. First, trading records don’t always resolve the issue. Second, many traders combine elements of market making and speculation, so the record isn’t always clean. Still, the professor’s analysis shows how to track trader behavior. “Sometimes the footprints are clear and sometimes blurred,” he says. “But that is the nature of trading.”