Risk, reward and regulation

A common criticism of regulators is that they simply don’t understand the concept of risk and reward and put safety above the ability of markets to deliver returns, but the US Securities and Exchange Commission (SEC) seems to be trying to change this view.

Speaking at the Investoregulation conference in London last week, James R Burns, deputy director, division of trading and markets at the SEC, said that the Volcker Rule could pose a significant risk to market.

The rule, which would ban proprietary trading activity for banks, runs the risk of also banning market making activity by banks.

Industry figures say a complete ban on market making would have a disastrous effect on liquidity as market makers play such a vital role in ensuring market participants can buy and sell when they need to. While not all market makers are banks, they do play a significant role.

Burns was sympathetic to the industry’s plight and said he was hopeful that the Volcker Rule would be agreed by the end of the year and would contain an exemption for market makers.

However, the SEC is one of just a number of regulators that must come together to agree on the final text of the rule. There is no centralised authority to guide these US regulators in their decision making and, as such, the rule must be formed on consensus, which is why it has taken such a long time to develop.

While the prudential bank regulators have been extremely focused on safety and ensuring banks and markets operate in a safe manner, Burns said the SEC’s job is not only to make sure that markets operate safely but that they run smoothly and to the benefit of the economy. As such, the complete removal of banks from the market making process would be a bad move for the SEC because the regulator wants to ensure the market can operate in the first place.

In a couple of weeks time, Gary Gensler, chairman of the Commodity Futures Trading Commission is to hold a meeting in which he hopes the Volcker Rule will finally be agreed. If it is, then US markets might finally see the certainty on this issue that has eluded them over three years.