US buy-side traders are optimistic that the Volcker rule will not lead to a deterioration of the execution services and liquidity provided to them by their broking counterparts.
The Volcker rule, named after former Federal Reserve chairman Paul Volcker, was included in the Dodd-Frank financial reform bill that was signed into law by US president Barack Obama on 21 July.
The rule prohibits deposit-taking institutions from engaging in proprietary trading and limits their investments in hedge funds or private equity vehicles to 3% of capital. However, the bill contains exceptions that enable US banks to conduct trading activities in support of client business and for market making activities.
Although the timeline for implementation is generous, some of the largest US investment banks have already started to scale down their proprietary trading divisions.
J.P. Morgan confirmed at the end of September that it plans to transfer its prop trading teams within its equity, emerging markets and structured credit businesses to a new alternative investment management group for clients of J.P. Morgan Asset Management, while Bank of America Merrill Lynch and Goldman Sachs are also reported to be selling prop divisions or cutting staff from them.
But market participants do not envisage a ban on proprietary trading to lead to a deterioration of the services buy-side traders receive from their sell-side counterparts.
By losing their proprietary trading desks, brokers may charge higher commissions as they look to claw back lost revenue. They could also suffer from a reduction in the amount of internal liquidity they have to offer their clients.
“The broker services valued by the buy side are things like execution quality, research, capital commitment and access to new issues,” said Justin Schack, director at boutique broker Rosenblatt Securities. “Complying with the Volcker rule should not inhibit any of these services, so I don't anticipate it having a huge impact on the buy-side.”
The final version of the Volcker rule could still be subject to change as US regulators the Securities and Exchange Commission and the Commodities and Futures Trading Commission draft the final rules based on the Dodd-Frank Act.
Madison Gulley, director of global equity trading at asset manager Franklin Templeton, believes that the exemptions, particularly for market makers, will also ensure buy-side service is largely unaffected.
“I expect the influence of the Volcker rule on execution quality to be limited,” said Gulley. “The exemption for market making activity, which is commonly found in brokers' internal dark pools for example, will ensure the buy-side still have access to significant liquidity.”
Gulley is in fact optimistic that the rule could benefit the institutional clients of investment bank.
“Restricting proprietary trading could mean there is greater capital allocated to client-facing services as banks look to increase the focus on customers to make up for lost revenues,” he said.
One of these areas, according to Mark Kuzminskas, director of equity trading at buy-side firm Robeco Investment Management, could be an increase in capital commitment.
“The Volcker rule could lead to a resurgence in the willingness of brokers to provide capital commitment if the most talented prop traders are migrated to client-facing units with the aim of increasing profits,” said Kuzminskas. “While we have moved a lot of our business away from high-touch and into low-touch channels in recent years, some US buy-side firms think the pendulum has swung too far. If there was an increase in capital commitment, I would definitely use it as another arrow in the quiver when executing trades.”
However, Schack observes that a potential revival of capital commitment in the US could be negated by Basel III, the third set of banking rules agreed by central bankers and regulators across the world following the recent financial crisis, which could reduce the proportion of the capital the bank has available for client services.
“New regulatory capital requirements may mean that banks have less capital available to facilitate customer trades. With capital less of a competitive weapon for large banks, agency execution quality, research and new issues could become more important,” he said.