US president Barack Obama’s proposed rules to curb large banks’ proprietary trading activities could limit liquidity provision, but clearer definitions will be required
to make legislation workable.
Obama’s proposal, announced yesterday, aims to restrict the amount of risk taken on by banks by preventing banks or financial institutions containing banks from owning, sponsoring or investing in hedge funds, private equity funds or trading operations that are unrelated to serving customers and are for their own profit. If the law is passed, many expect similar legislation to be adopted in Europe and other jurisdictions.
At present, the proposal to limit the size of banks and the size of the risks they manage is limited to two paragraphs. This means it is currently unclear how broad a definition will be permitted for banks’ trading activities that serve clients. Proprietary trading by banks has become increasingly segregated from trading on behalf of clients in recent years. But prop trading is still considered important to the service offered to clients for a number of reasons, including the insights it provides into market activity, the tools developed in prop trading that are later used to effect client trades and the trading volumes that provide liquidity to clients in banks’ crossing networks and dark pools.
To illustrate the potential confusion, one sell-side source gave the example of a client-facing broker that, in response to bad news about a particular industry sector, ensures his bank is short in the relevant sector in anticipation of handling client sell orders later in the day. “Is that pure prop trading, or is it pre-positioning by a client-facing trader and therefore not prop trading?” he asked.
Without more precise definitions, the proposed rules may be difficult to enforce and may struggle to be passed into law. “With the ability to provide market marking functions to facilitate client trades, policing restricted activities could be difficult and this leads me to believe this proposal is unlikely to come into force in its current form,” said Simmy Grewal, senior analyst in the institutional securities and investments practice at research and consulting firm Aite Group. “Prop desks provide a significant amount of liquidity to the market and loss of this will be detrimental to clients.”
Many are expecting banks with large proprietary trading operations, such as Goldman Sachs, to be hit hard by the new ruling. Bank stocks have taken a beating as a result. Goldman Sachs’ stock price fell 4% to $167.79 at yesterday’s close from Wednesday’s closing price of $160.87.
Goldman Sachs made a net profit of $13.39 billion in 2009 and net revenues of $45.17 billion. Trading and principal investments accounted for 76% of the bank’s 2009 revenue, up from 41% in 2008 and 68% in 2007.
Clarification is expected before any legislation is put before the US legislature, but even a narrow definition of proprietary flow could inhibit liquidity to the buy-side. “Obama’s proposal hasn’t restricted prop trading where banks provide market making functions for clients if there is insufficient liquidity on exchanges or in the over-the-counter market, which is a positive for the buy-side. On the pure prop trading side there is going to be a loss of a significant amount of capital so there is likely to be an impact on liquidity,” said Grewal.
But any reduction in liquidity caused by the new rules may be short-lived. “You may see a dip in liquidity initially but it will probably recover with high-frequency firms and the big market-makers such as Knight Capital, Citadel and Getco taking up the slack and banks’ internal prop desks setting up independently,” said Grewal.
Some feel that any reduction in volumes caused by the new rules could be offset by benefits. Adrian Fitzpatrick, head of investment dealing at Aegon Asset Management UK, believes limiting banks’ investment in hedge funds could restrict their activity, thus smoothing volatility.
“There is an impact on volumes, but maybe it means the volumes are more transparent than they used to be as their will be less risk in the market and the hedge funds may not be able to short stocks to the same extent as before,” he said. “Maybe some of the bubbles that have been created will now be squeezed out of the market.”
Observers also expect that large any interruption to large banks’ profit expansion to be temporary. “Obama is addressing a community that is extremely adept at sidestepping obstacles and figuring out how to do things differently,” said the sell-side source. “It’s a little like a balloon – you squeeze one end and the capital will pop up somewhere else.”