The Volcker rule, which stipulates that US bank holding companies are not permitted to trade on their own books, could potentially trigger a shift in liquidity sourcing for bank-owned crossing networks.
The rule – named after the former Federal Reserve chairman that inspired it, but now part of the larger Dodd-Frank reform bill passed by the House of Representatives and awaiting a vote in the Senate – is intended to limit deposit-taking banks from engaging in risky proprietary trading.
Although the letter of the law and the timing of its introduction will be determined by regulators after the bill has finally been passed, the effects could be significant if the initial concept is upheld.
“Most of the dark pools that are run by the bulge bracket dealers in the US could be affected because they are part of bank holding companies,” said Justin Schack, director of market structure analysis at Rosenblatt Securities, a New York-based broker. “The actual effect would depend on the level of proprietary trading that goes on within the dark pool and that can vary.”
Proprietary trading makes up roughly 10% or less of the volume traded on most large brokers' dark pools, but for some firms this can reach up to 20%. Schack explains, “Those that have retail flow going to the dark pool can have higher levels of proprietary trading, as a general rule.”
Two business models have particularly high levels of retail flow. Some banks have an internal wholesaling operation, where retail order flow is paid for, and where the dark pool and wholesale operations are integrated. Others simply pay for flow that goes directly to the dark pool. Either way, trades are executed at a lower cost than on exchange, the bank earns the spread and secures a base of liquidity.
If a proprietary trading ban was effected, dark pools run by such banks would require new sources of liquidity.
That said, the lack of clarity in the law means that some trading activity will potentially be excluded from the ban says Adam Sussman, director of research at research consultancy TABB Group, “I think the big question is how prop trading is going to be defined. I believe that market making activity would be excluded.”
In Sussman's view, there is potential for banks to retain trading activity and therefore order flow. “Clearly it is accepted that there are different strategies within the banks where some of them are market making and some of them are doing more prop trading in the pure sense, that is, where they are not facilitating client flow. So it is up in the air as to whether the banks will be able to desegregate those businesses and put them under one umbrella so they would not be affected by the Volker rule.”
More immediately, Schack says that talent is already breaking off from the big banks as traders seek a simpler trading experience with hedge funds and other non-bank firms, “Even though there are a lot of loopholes and exemptions to the rule, it's just another thing they will have to contend within a bank as they work to confirm what is and isn't proprietary trading.”