A US trade body, the Securities Industry and Financial Markets Association (SIFMA), and consultancy Oliver Wyman have warned against onerous restrictions for market makers as US regulators finalise the Volcker Rule.
The Volcker Rule, which was included in the Dodd-Frank financial reform bill that was signed into US law last summer, prohibits deposit-taking institutions from engaging in proprietary trading and limits their investments in hedge funds or private equity vehicles to 3% of capital. Crucially, the bill contains exceptions that enable US banks to conduct trading activities in support of client business and for market-making activities.
The finer points of the Volcker Rule are currently under debate by the Financial Stability Oversight Council (FSOC), a body established by the Dodd-Frank Act to provide comprehensive monitoring of the US financial system. The FSOC issued a public request for information relating to the Volcker Rule in October 2010, and is expected to make public its initial proposals in the coming weeks.
The SIFMA paper, entitled ”The Volcker Rule: Considerations for implementation of proprietary trading regulations', assesses the potential impact of the Volcker Rule on market making across a range of asset classes and cautions that “a poorly constructed or indiscriminately restrictive implementation of proprietary trading restrictions could hamper liquidity … and impede the ability of businesses to access capital”.
According to the research, a potential reduction in liquidity caused by the Volcker Rule would reduce the willingness of investors to provide capital to businesses because of greater difficulties in exiting those investments, increase trading costs and reduce returns for pension and mutual funds. It could also restrict the ability of companies to transfer risks to other market participants more willing and able to bear them via derivatives.
Looking at individual asset classes, the study notes that instruments such as corporate bonds can require dealers to hold them – and therefore be exposed to changes in market value – for an extended period in order to make effective markets.
Block trading risk
For equities, the study considers the role of principal trading in facilitating block executions, emphasising that arduous rules that limit the use of capital commitment would eliminate a critical source of liquidity and dramatically increase execution costs for institutional traders. It further notes that principal trading in exchange-traded funds and their underlying stocks is required to maintain efficient pricing linkages between the two types of instrument.
To prevent the Volcker Rule from having an adverse impact, the paper recommends that the definition of market making incorporated within the rule should not be too burdensome and clearly distinguish between prohibited proprietary trading and permitted types of principal trading that are crucial to the provision of liquidity.
“The Volcker Rule was meant to address the safety and soundness of banking entities, not interfere with the orderly functioning of capital markets for businesses, consumers and our economy,” said Tim Ryan, president and CEO of SIFMA. “As part of our ongoing efforts to provide regulators with the best information and data as they implement the Dodd-Frank Act, we've submitted this study for consideration in developing regulations that effectively implement the proprietary trading ban while not undermining the fundamental operations of key markets. In addition, restricting banking entities' ability to provide necessary liquidity will harm companies and issuers and push transactions to firms not subject to the same regulatory protections and restrictions.”
According to press reports, the FSOC could suggest a tiered approach to monitoring firms' proprietary trading activities, similar to techniques used to prevent money laundering.
The tiered system would first involve the identification of a trade's characteristics – such as size and risk – by firms' compliance departments. Then, if required, internal compliance and risk management departments would question traders further on the type of position and its risk exposure. Both sets of information would then be made available to regulators, which would monitor the processes by both traders and compliance departments.