As the Volcker rule continues to evolve, most banks and brokers have already adapted to the new reality, but the buy-side is still adjusting its trading strategies to take account of changes to liquidity.
JP Morgan Chase’s US$13 billion agreement with the Department of Justice last week was a reminder of the lingering effects of 2008 and the regulatory reaction embodied in the Dodd-Frank Act.
While many facets of Dodd-Frank have progressed, issues around the Volcker rule persist, although the market appears to have reacted years prior to the rule – which remains slated for a July 2014 implementation.
Debate amongst key Volcker rule makers emerged last week regarding its risk definitions, as in current draft form it would not prevent the activity that led to the ‘London Whale’ losses at JP Morgan Chase, which totaled US$6.2 billion. Banks have lobbied to finalise a more relaxed rule compared to what regulators are pushing for, which would require more strict accounting of risk management for hedging activity.
Despite Volcker’s delays, many global investment banks have already excised proprietary trading activities, achieving the rule’s aim of insulating investors from risky bank activity.
For the buy-side, however, ensuring they adapt trading and investment strategies in line with this new environment is key, explains Laurie Berke, principal at consultancy TABB Group.
“Although the large broker-dealers have moved to reduce prop activity in line with the aims of Volcker rule, the buy-side’s adaptation is very much in progress and asset managers are being forced to re-evaluate how they trade and in which asset classes,” Berke told theTRADEnews.com.
The long game
For asset managers, the larger traditional long-only firms may see minimal change from brokers, although services for smaller firms could be squeezed as broker-dealers withdraw capital-intensive market making.
“We’ve found the full service global investment banks will always provide capital for their top clients, but over the past 12-24 months those firms have gone through a far deeper, more precise process of identifying exactly who those profitable clients are,” she said.
“The reaction to the Volcker rule we’ve seen from banks and broker-dealers already has coincided with a squeeze on capital, which has rendered market making less appealing, which in turn makes block trading harder for the buy-side.”
Berke added that corporate bonds are beginning to experience the impact that equities have in recent years – that of the large, global investment banks flushing out previously held reserves.
One head of trading at a bulge bracket investment bank agreed Volcker’s impact had long been felt in terms of encouraging banks to limit prop activity, and indeed any activity that even resembled it. This trend, he said, would largely limit the impact of Volcker, but didn’t negate its existence.
“The market has already reacted to many of the aims of the Volcker rule and its application will touch many brokers in a limited way because so much of the core business is client facing,” he told theTRADEnews.com.
“For instance, when Volcker originally came out, firms in the industry were very strict about investing in new areas that resembled prop activity, like aggregation units. Some brokers’ market making activities can resemble prop activities, but they commit capital as a bone fide market maker, which comes under the Volcker umbrella,” he said.
Because of the slow progress to draw a final rule, the effects of inaction and an absence of clarity on these points could prolong the effects and associated risks of prop trading across the industry.