The true cost of the Volcker rule to brokers and their buy-side clients still hinges on where regulators draw the line between market making and proprietary trading, following the publication of implementation guidelines by the Financial Stability Oversight Board (FSOB) last week.
Depending on the quantitative tools used, and the strictness of the interpretation, some market making activities could be banned for deposit-taking institutions.
The FSOB's recommendations acknowledge that the market making activities of banks' brokerage arms currently include elements of proprietary trading. “Agencies therefore must be vigilant to ensure that banking entities do not conceal impermissible proprietary trading activities within larger market making operations,” it advised.
Although the FSOB identified “promising categories of quantitative metrics” that could be used to separate activities, its guidelines are intended to be “descriptive, not prescriptive” in nature. For example, the FSOB highlights the “key challenge” of determining whether inventory levels held by brokers are justified solely by the need to facilitate client transactions, but practical decisions on this and other matters will be the responsibility of the US's main financial markets regulators, the Securities and Exchange Commission and the Commodity Futures Trading Commission.
The Volcker rule, named after Paul Volcker, the former head of the Federal Reserve who first suggested limiting banks' principle business, is the common title given to Section 619 of the Dodd-Frank Act which bans banks from engaging in proprietary trading and limits investment into hedge funds and private equity funds to 3% of a bank's capital. Certain ”proprietary' or principle trading activities, including market making, are still allowed under the rule, primarily to assist in the execution of client business.
A European equity research note produced by UK stockbroker J.P. Morgan Cazenove on 12 January said that “Net net, [the Volcker Rule] will have a negative impact on liquidity and volumes, with the end users of all products ultimately bearing the increased cost.”
Lack of detail
For many, the FSOB proposals have left some of the biggest questions unanswered. “They have indicated they want to use a filter evaluation system to identify whether a trade was initiated by a client or the bank and then alluded to the risk that banks are taking, but they didn't go so far as to look at value-at-risk models,” said Sean Owens, director, fixed income research and consulting at capital market consultancy Woodbine Associates. “They have said they will only look in detail ”as warranted', rather than transaction by transaction. So the question is when will it be warranted? As it stands it is fairly inconclusive.”
The FSOB paper emphasised that banks should play a major role in monitoring their own trading activity and distinguishing between client-focused business and principle trading. In taking on this responsibility, banks have been told they will have to develop quantitative analysis based on revenue, revenue-to-risk, inventory and customer flow metrics.
The technology needed to comply with the proposals will add to the expenses of sell-side firms, but self-policing is the better option, says Alison Crosthwait, director, global trading strategy, at agency broker Instinet. “There will be cost involved in the banks developing their own internal controls, but weighed against the cost of somebody else telling you what you can and cannot do, most firms would prefer to regulate themselves,” she said.
The FSOB's guidelines will be of some relief to brokers, according to Crosthwait, who claimed that the quantitative analysis prescribed should be no more onerous for smaller brokerages than for larger firms. However all brokers still lack detail needed to calculating the regulation's cost. “It's not entirely clear what types of market making will have to be reduced and which will be OK,” she said.
J.P.Morgan Cazenove says that market making-related activity accounts for approximately 80% of FICC (fixed income, currencies and commodities), 60% of equity derivatives and 15% of cash equities revenues for most investment banking businesses.
It says that while European investment banks will not suffer the ban at home and could move business from US subsidiaries overseas, US broker-banks would be badly affected. It estimates that 10% of Goldman Sachs' investment banking revenues and 5% of Morgan Stanley's could be affected by a straight proprietary trading ban. If the ban included market-making activity this would make up 52% and 40% of the firms' estimated 2011 investment banking revenues respectively. A number of firms – including Goldman Sachs and Morgan Stanley – have already begun to hive off or adapt their proprietary trading activities.
Affected banks may look to offset lost prop trading revenues by increasing fees in other areas, but buy-side clients may also feel the impact of the Volcker rule through higher liquidity costs if market making by deposit-taking institutions is severely restricted. Partly to lower the costs of supplying liquidity, a number of large banks have developed significant technology-based market-making operations in recent years. But these could by impaired by a strict interpretation of the Volcker rule by regulators.
“Quantitative automated trading makes up between 33%-45% of all trading in the market, depending on your source of data. If regulators put pressure on automated market makers to shut down then that will seriously affect liquidity,” said Tony Nash, head of execution services, at investment bank Banco Espirito Santo, which acquired London-based agency broker Execution in late 2010. “You could see volumes drop significantly from where they are today and that could pose a real challenge for customers that need large orders to be executed in the market.”