Fears over Volcker impact on buy-side liquidity

Tighter restrictions on proprietary trading may limit asset managers’ ability to execute in certain markets and result in higher costs linked to sell-side compliance.

Tighter restrictions on proprietary trading may limit asset managers’ ability to execute in certain markets and result in higher costs linked to sell-side compliance.

Last week, US regulators agreed the Volcker rule’s final text, causing some relief among banks that crucial market making and hedging services will remain intact. But asset managers may bear the brunt of the sell-side’s compliance burdens.

Nanette Buziak, head of equity trading for ING Investment Management, told theTRADEnews.com the Volcker rule has the potential to significantly alter the buy-side’s relationship with banks it affects, and cites changes over recent years to market making in equities as an example.

“We see more and more bulge bracket brokers reluctant to commit capital to trades or if they do, it is in diminished amounts than in the past,” she said, adding that greater scrutiny of banks’ fixed income activity would have a significant knock-on effect for asset managers.

“Banks’ reluctance to take on an inventory of positions may enable more of the peer-to-peer trading platforms to prosper as the buy-side sources liquidity from one another rather than using the sell-side as the conduit,” she said.

The final text agreed upon by the five regulatory bodies, including the Commodity Futures Trading Commission and Securities and Exchange Commission, comes two years after the initial draft, and three years after President Obama signed into law the Dodd-Frank Act, the Volcker rule’s overarching legislation.

Despite this long lead time that has let banks’ wind-down prop trading business, Buziak said there was a legitimate fear that restrictions on market making and hedging that fall under the prop trading definition could reduce the ability of asset managers to find liquidity in certain markets.

“Sourcing liquidity will become more and more fragmented and in times of volatile market conditions, the costs to find liquidity will likely increase significantly,” she said.

An increase in expenditure linked to compliance with Volcker’s final text – in particular in IT and legal bills – will hurt banks and result in higher implicit costs for asset managers, according to Andrew Olmem, partner, financial services for US law firm Venable, and former Republican chief counsel and deputy staff director at the Senate Banking Committee.

“The Volcker rule will trigger a significant rise in compliance costs for banks, but it will likely be investors that ultimately bear these costs in the form of wider spreads and less liquid markets,” he said, adding some buy-side firms may focus on non-US instruments.

“Asset managers with a global outlook may focus investment activity outside US markets, or chose to deal with non-banking entities that are not covered by the Volcker rule,” Olmem said.

With such significant and demanding regulation – which spans 71 pages and over 800 pages of additional material – market participants including asset managers are only just beginning to sift through the details.

Ari Burstein, senior counsel for buy-side trade body the Investment Company Institute, told theTRADEnews.com his organisation remained concerned over the wider impact on capital markets.

“Mutual funds and their counterparts around the world depend on liquid markets in which to trade efficiently on behalf of their shareholders,” he said.

“We will be watching this aspect of the Volcker rule carefully and will communicate with regulators and Congress about any adverse effects on registered funds and their shareholders.”

Meanwhile, Europe’s equivalent to the Volcker Rule, which has been driven by Finnish central banker Erkki Liikanen, has stalled while passing through the European Commission. It is thought that the Liikanen Review’s recommendations have encountered opposition from vocal French and German banks.

In the summer, France passed a banking reform law requiring banks to do proprietary trading through a ringfenced subsidiary – a move that falls far short of Liikanen’s guidance. Despite the ringfencing, significant trading activity still takes place in French banks. The banks argue this is vital market making activity, while critics label such activity prop trading.