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In a defeat for Wall Street, the "Volcker rule" won't allow banks to enter trades designed to protect against losses held in a broad portfolio of assets, according to people familiar with the rule.
The practice, known as portfolio hedging, has become a focal point of regulators drafting the rule, a controversial plank of the 2010 Dodd-Frank financial law that seeks to prevent banks from putting their own capital at risk in pursuit of trading profits.
The rule, named after former Federal Reserve Chairman Paul Volcker, is expected to be approved next week, ending a three-year period of regulatory uncertainty for some of the securities industry's most-profitable businesses.
But it won't contain language permitting portfolio hedging, which has been "expunged" from earlier drafts of the rule, according to a person familiar with the matter. Regulators decided to remove portfolio hedging from the rule after J.P. Morgan Chase JPM +0.58% & Co. disclosed billions of dollars in losses from its so-called London whale trades in 2012.
The bank initially described the trades as a portfolio hedge. Now, it is likely other Wall Street firms also will end up paying for J.P. Morgan's slip-up. Regulators, in response to the J.P. Morgan disclosure, pushed to write a rule that would ensure banks couldn't engage in such trades.
The move will come as a blow to banks, which lobbied regulators to keep language allowing portfolio hedging in the rule. Banks often hedge to offset the risks that accompany trading with clients. Sometimes, though, there is no perfect counterweight to those clients' trades. Banks look to portfolio hedging to manage a broader array of risks.
A recent version of the Volcker rule, reviewed by The Wall Street Journal, defined hedging activity as "designed to reduce or otherwise significantly mitigate…one or more identifiable risks."
What hedges don't do, regulators wrote, is "give rise…to any significant new or additional risk that is not itself hedged contemporaneously." The excerpt reviewed by the Journal didn't mention portfolio hedging.
Portfolio hedging has drawn the ire of critics who say it opens a gaping loophole banks can use to make big market wagers. The proposal for the Volcker rule released in November 2011 said it would permit "the hedging of risks on a portfolio basis."
Critics said that opened the door for banks to make all manner of bets on the market because a bank might define the risk to its portfolio broadly, such as the risk of a U.S. recession.
Sens. Jeff Merkley (D., Ore.) and Carl Levin (D., Mich.), architects of the rule in Congress, wrote a letter to regulators slamming portfolio hedging as a loophole "big enough to drive a 'London Whale' through." Regulators, in response, say they have worked to make sure the Volcker rule wouldn't permit trading activity that led to the London whale losses.
Banks view portfolio hedging as an important tool in the way they manage trading risks. J.P. Morgan Chief Executive James Dimon said in June that he thinks banks "need to be allowed to portfolio hedge."
"My attitude on portfolio hedge would be if you look at what we did in the whale, we made a mistake," he said. "It was portfolio hedging badly done."
Regulators still are putting the finishing touches on the rule as they prepare to vote. Commissioners at the Commodity Futures Trading Commission received a new version of the rule Tuesday night. Staffers are combing the rule for typos and spelling errors.
In the past few weeks, regulators have been hammering out details such as how the rule should apply to trades executed overseas and which kind of funds banks can invest in, in addition to complex hedging restrictions, say people familiar with the talks.
The Securities and Exchange Commission, meanwhile, will vote on the rule Dec. 10 in "seriatim," in which commissioners vote on a rule outside of a public meeting.
While the agencies will breathe a sigh of relief after finishing the rule, for bank executives and their traders, the five government agencies' adoption of the rule may provide little closure.
Banks will have to interpret what those new rules mean and how they can ensure they remain in compliance.
"Volcker has morphed a bit, thanks to the Whale," UBS AG UBSN.VX +0.48% analyst Brennan Hawken said. "Now a big component of it has become about hedging. What can you hedge, and what can't you? It's really unclear."
Banks have been mum in recent days about the impact of the rule until they see the final product being voted upon.
But Bill Lockyer, California state treasurer, said Wednesday that he is concerned that state borrowing costs could rise because of the rule. If banks "don't make a profit…from leverage or proprietary trading, they have to make a profit [another] way," Mr. Lockyer said. "Borrowing costs may increase. It's what their fee is on a deal."
A strict interpretation of Volcker "would dry up liquidity," or make it more difficult for investors to trade, said Peter Tchir, founder of hedge-fund advisory firm TF Market Advisors.