Exemptions for market making by US banks as outlined in proposals for the Volcker Rule officially released by regulators today are too restrictive and could create a two-tier regime for liquidity providers, market participants have warned.
The Volcker Rule – part of the Dodd-Frank Wall Street Reform and Consumer Protection Act – seeks to ban US deposit-taking banks from engaging in proprietary trading and limits their ability to invest in private equity firms and hedge funds. The US Federal Reserve proposed its first version of the regulation today in conjunction with the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange Commission and the Commodity Futures Trading Commission. It will seek public comment until 13 January 2012.
But while the rule contains exemptions for market making and specific types of risk-mitigating hedging, some have warned of the detrimental impact it could have on some of the largest US banks.
An analysis by credit ratings agency Moody’s suggested that the Volcker Rule would “diminish the flexibility and profitability” of banks’ market-making operations and place them at a disadvantage to firms not captured by the rule, i.e. high-frequency trading firms and the non-US operations of foreign banks.
It added that this would most affect Bank of America Merrill Lynch, Citi, Goldman Sachs, J.P. Morgan and Morgan Stanley, which all derived over 20% of their H1 2011 revenue from trading, with Goldman Sachs obtaining around 52% of its first-half net revenues from trading.
Following the financial crisis in 2008, both Goldman Sachs and Morgan Stanley took the decision to become bank holding companies rather than investment banks, allowing them to take deposits from retail investors.
To be considered as market makers under the Volcker Rule, banks must adhere to criteria including: making markets through long/short, buy/sell decisions on a continuous basis; ensuring that market making does not “exceed the reasonably expected near term demands of clients”; ensuring that market making revenues are generated from commissions, fees and bid/ask spreads rather than asset appreciation; and not rewarding traders engaged in market making to take risks.
Market making will no longer be regarded as a profit centre for US banks if the present rules are enacted, according to Michael Kurzrok, director, equities at consultancy Woodbine Associates.
“The changes to the compensation structure of market makers will lead to a change in personnel in the market making divisions of US banks,” he told theTRADEnews.com. “These banks will also struggle to keep up with electronic market makers who only make razor-thin margins.”
The new market making requirements also came under fire from US trade body the Securities Industry and Financial Markets Association (SIFMA), which claimed that a rigid interpretation could damage economic growth.
“SIFMA’s primary concern is the potential negative impact of the proposed rule on market liquidity,” read a statement from the trade body. “As proposed, the rule’s narrowly-crafted exemption for permitted market making activity exceeds Congressional intent and overly prescriptive and burdensome compliance requirements could well depress the market making functions of banks and their affiliated broker-dealers as well as the asset management alternative fund business. Restrictions on the ability of firms to make markets will reduce market liquidity, discourage investment, limit credit availability and increase the cost of capital for companies.”
However, Kurzrok suggests that US banks will not withdraw from the market making business altogether.
“Market making will not be a significant source of revenue for banks, but is still likely to remain a part of the overall service they provide to customers as part of their investment banking activities,” he said.