Rarely have two short paragraphs on financial regulation excited so many column inches of reaction. US president Barack Obama’s plan to restrict the risk-taking activities of deposit-taking institutions in the US was short on detail, but the void was soon filled by shouts of delight and cries of despair. For every editorial denouncing the ‘Volcker rule’ as misguided and ill thought out, another hailed the proposal as forcing through necessary change that the banks could not deliver themselves.
Until more details are available the key sentence in Obama’s speech, made on 22 January beside Paul Volcker, the former chairman of the Federal Reserve Board referred to by the president as “this tall guy”, reads as follows: “Banks will no longer be allowed to own, invest, or sponsor hedge funds, or proprietary trading operations for their own profit unrelated to serving their customers.”
As far as equity broking clients of large banks are concerned, it is the third leg of this soon-to-be banished triumvirate – the prop desks – that will have the biggest impact on service quality. Across all financial markets, most brokers’ prop business is tightly entwined with their client-facing services and equity trading is no exception.
Stricter delineation between sales trading and prop trading desks in recent years notwithstanding, proprietary desks are a source of market intelligence and liquidity across a variety of channels, from capital commitment to dark pools. The line between taking a position as a market maker to serve clients’ needs and trading to make a profit on the bank’s own account is often a matter of interpretation. Moreover, it is the years of prop trading experience that brokers pour into the execution tools they provide to the buy-side that make algorithms and smart order routers effective. Separating out prop trading activity for profit from trading that serves customers may slow Obama’s plan as it makes its way through the US congress.
In his 2005 book, ‘The Greed Merchants’, ex-broker Philip Augar, described the cumulative benefit attained by integrated investment banks by operating in so many guises across so many markets as the ‘the edge’, a self-perpetuating, in-built advantage that comes with the territory for global banks. The Volcker rule will clearly weaken ‘the edge’. An investment bank is so much more than the sum of its parts that any attempt to curtail its field of action will limit its overall value proposition.
On the face of it, regulation may effect a levelling of the playing field for broking services that many over-optimistically predicted just over 12 months ago, when several mid-tier firms made a grab for market share from weakened bulge-bracket players. With prop trading sidelined, agency brokers may be at less of a disadvantage to full-service rivals.
But ‘the edge’ has been eroding for some time. Market-making duties are now performed by high-frequency traders as much as brokers and new generations of financial market talent are deciding that Wall Street is not the automatic choice. Such trends are slow to make themselves felt. Explaining why global banks were able to turn a profit so soon after reporting such calamitous losses, one banker recently observed, “Even if you hole a tanker under the water, it just keeps going.” His comments in the New York Times on 30 January suggest that ‘the tall guy’ has a complete change of course in mind: “We need to face up to needed structural changes, and place them into law,” wrote Volcker. “To do less will simply mean ultimate failure – failure to accept responsibility for learning from the lessons of the past and anticipating the needs of the future.”
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