What is a hedge?

Life used to be so simple. If you said you were hedging an investment, there would be a sense that most financial professionals would know what your talking about, but that has changed. Unfortunately, the idea of defining terms becomes critical when you talk about laws.

The Dodd-Frank law, which has the Volcker Rule, stops banks from trading for a profit that may place shareholders and depositors at risk. Many could argue that this is a sensible provision, but then you get to the heart of all regulation, definitions. A bank cannot trade for a profit but it can hedge. So the simple question is just defining what is a hedge. Hedges are supposed to protect from a loss. Hence if the underlying investment does well, the hedge protection should lose money. It is not insurance, but it offers protection at a cost. If the underlying investment loses money, the hedge will make money. Since there is usually basis risk with any hedge because the hedging instrument and underlying investment are usually not perfectly correlated, the link between profit and loss may be murky.

Put even more simply, if a bank cannot profit from trading do all hedges have to lose money. A bank may make money on some hedges, but how do you define what that means. There has been some argument by SIFMA that would allow for "incidentally" making money from hedge. As if profits from hedges can be accounted for through dumb luck. The organization hedging may be able to make money if the hedging activity promotes the safety and soundness of the organization. Losing money on hedges does not seem to promote safety and soundness.

It seems like we want to have banks restricted in their activities, so that they can only make money on the interest rate spread between borrowing and lending. This simple firm design is workable in a textbook but does not seem to represent what modern banking is all about. Now if you allow the government to provide complete deposit insurance and you have the largest banks too big to fail, this simple model would seem to be a natural result. You do not want a complex firm taking bets with a government guarantee. 

As a regulators, you would want to simplify the business model so it is easier to monitor. perhaps it would be better to start with the underlying assumptions of deposit insurance and too big to fail. If we reduce or eliminate these policies, then it would not be necessary to micromanage banks. The objective of regulators should be to reduce regulator burden not enhance it.