As the recent GAO report on proprietary trading shows, it's very hard to get to the truth when it comes to proprietary trading. The GAO was tasked by Dodd-Frank with analyzing prop trading at top Wall Street banks. But due to the complexity of taking a deep and comprehensive look at all forms of prop trading, the study limited itself to prop trading undertaken by standalone units-an approach that was roundly criticized. 

The results, however, were interesting in that the report found that over 13 quarters, these units lost money. That explains in part why Goldman Sachs and others were quite willing to give up on some of these units. The most profitable aspects of prop trading (principal activity excepted) appear to be embedded in other functions, like market making. 

For Wall Street, this raises some thorny infrastructure and compliance issues. The top banks are loathe to give up these embedded proprietary profits, hence the furious lobbying effort to shape the rule more to their liking. As or right now, the Volcker Rule will go into effect July 21, 2012. That leaves little time to prepare. 

The issues from an IT point of view are pretty severe--quite frankly a consultant's dream.

The bottom line is that the rule as stated permits a range of activities that allow for banks to risk their own money. Permitted activities include market making, investing in government securities, underwriting activities, hedging and other activities. Banks are loathe to give up these business lines. They are obviously critical to the functioning of the capital markets as well as to bank earnings. What would an investment bank be if it could not hedge?  Would a broker-dealer be if it could not make markets? The rules, however, stipulate that these activities must be carried out in a safe manner. And noncompliance might end up costly in terms of fines and possibly lost business. 

To ensure compliance, a significant amount of infrastructure activity will be required. The fact is that there is a fine line in some cases between a permitted activity and a prohibited activity, according to a highly relevant report from Deloitte, which based its report on the recent Financial Stability Oversight Council report released in January. Market making is an obvious example. In the course of business, banks will be risking their own capital to take the other side of clients trades. They certainly bear the risks of this inventory once acquired, every bit as much as if it were a prop trade. And then there's hedging. A perfect hedge may be difficult in some cases, leaving a residual amount of a prop investment perhaps. The FSOC has recommended some interesting metrics: revenue, revenue-to-risk based, inventory based, and customer flow based. Capturing that data in real time will not be easy and will require some heavy lifting programmatically. It is not too early to start thinking about all this. - Jim