Restrictions on hedge funds and banks’ proprietary trading operations, as envisaged by the European Commission’s proposed Directive on Alternative Investment Fund Managers and the UK Financial Services Authority’s Turner Review, could limit the supply of liquidity in Europe’s equity markets, say market observers and participants.
“Equities could go from being a flow-based business to one based on bids and offers,” Bob McDowall, research director, Europe at research and advisory firm TowerGroup told theTRADEnews.com. “Smaller transactions would continue to be done electronically, but the market may revert to being a phone-based business for large transactions.”
McDowall suggested that a general reduction in liquidity could also push more trading off-exchange. “That could be a problem given the recent murmurings in the US about dark pools and equality of access,” he said.
The European Commission’s draft directive, published on 29 April, aims to improve risk management and investor protection by introducing harmonised regulations for fund managers that fall outside the current Undertaking for Collective Investment in Transferable Securities directive. While it acknowledges firms in this category – which include hedge funds and private equity houses – were not the cause of the financial crisis, the commission argues that events have placed them under “severe stress”.
The directive proposes limits on the amount of leverage alternative fund managers can use, and will require managers to report regularly to the relevant competent authority detailing the markets it trades in, its exposures, performance data and concentrations of risk.
In addition, the Turner Review – Financial Services Authority (FSA) chairman Lord Turner’s recommendations for banking regulation reform in the wake of the financial crisis – published on 18 March, calls for new capital and liquidity requirements “to constrain commercial banks’ role in risky proprietary trading activities”. Any increase in the cost of prop trading could lead to a contraction of the number of banks trading on their own books, resulting in a double-whammy for liquidity levels if hedge funds reduce their European trading activities.
There are also efforts at the European level to boost banks’ capital requirements for prop trading. On 13 July the commission proposed amendments to the existing Capital Requirements Directives, which would force banks to hold more capital against investments in re-securitisation instruments.
Greater hedge fund restrictions of any type could have a negative impact on market liquidity, according to Evan Graj, managing director, cross-asset algorithmic trading at broker Newedge. “If we continue to limit hedge fund activity, whether through the recent craze on banning ‘flash’ orders or tighter regulation, I do think that liquidity could start to dry up,” he said. “These operations, particularly statistical arbitrage funds, are big providers of liquidity – they rest orders on the book waiting to be hit, albeit for short periods of time.”
However, some are unconcerned by the proposed restrictions and support their objectives. “It is unlikely that either the FSA or any of the European powers will look to suppress volumes in any way. Their aim is to ensure an appropriate regulatory environment, and there is nothing wrong with that,” said Tony Whalley, head of dealing and derivatives at Scottish Widows Investment Partnership.
While initial reactions to proposed regulations tend to be negative, he added, the reality is often different from detractors’ fears. “If you have got a better regulatory environment, that is likely to encourage an increase in volumes,” Whalley said.
Graj at Newedge is less concerned about limits on
prop trading by banks. He points out that several large banks have already closed their prop trading divisions, yet liquidity has remained unaffected. “There are only a few proprietary trading desks left,” he said. “However, various stat arb funds continue to operate and provide that liquidity, and are doing pretty well. Trading ideas and strategies don’t just disappear – it’s simply a case of them finding a new home.”
Despite the concerns, any changes could be a long time coming. The European Commission says that if political approval of its alternative investment proposals
is received by the end of this year, a directive could come into force in 2011. The FSA expects changes to banks trading book capital to be in effect by December 2010.
“We have a sense that regulation is coming but it could take longer than we expect,” said McDowall at TowerGroup. “Financial regulation and politics are inextricably linked and therefore it will take a while longer for restrictive legislation to come in.”