For Volcker Rule, The Devil Is in the Details

Peter S. Kraus

Many aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 could go a long way toward protecting investors and American taxpayers from a repeat of the 2008 financial crisis. But, as written, some provisions of the law and proposed implementing regulations could significantly harm investors by driving up trading costs and reducing liquidity.

These investors are not just hedge funds and the wealthy, either. The overwhelming majority are pension funds, 401(k) plans, annuities and mutual funds that benefit ordinary individuals and families—our clients, whose interests we are committed to protecting.

We estimate that the proposed regulations regarding proprietary trading and market making would drive up total trading costs in the US by about $41 billion a year. That’s like paying a $41 billion annual insurance premium against a recurrence of the 2008 crisis. Yet, it’s quite possible that the proposed limits on market making could actually make a financial crisis worse by draining liquidity from the markets at times when liquidity is most needed.

Dodd-Frank’s positives, in my view, include higher capital requirements for deposit-taking banking entities and the Volcker Rule restrictions on their ability to engage in risky activities, including proprietary trading and both sponsoring and investing in hedge funds and private equity. Through deposit insurance, taxpayers provide deposit-taking banks with lower-cost funding (insured deposits), so it makes sense to limit these risky activities.

At issue is how Dodd-Frank is treating proprietary trading versus market making—or, more precisely, how similarly the proposed regulations are treating two very different activities.

There is a clear distinction between proprietary trading (when banks and other financial institutions trade for their own account) and market making (when they provide liquidity to the financial markets). Liquidity comes when investors can easily sell their securities or mutual funds for cash. Liquidity is crucial for proper market functioning; lack of liquidity deepened the recent financial crisis.

Unfortunately, the proposed implementing regulations of the Volcker Rule define “prohibited transactions” so narrowly that it captures many market-making activities along with proprietary trading. The likely result is that banking entities will hold much smaller inventories of securities, especially those that are less liquid.

The vast majority of market making in the US is now performed by banking entities. If these entities reduce or cease to hold inventories of various types of securities, investors will be less able to sell them on demand, and the spreads between the prices that market makers bid for securities and the prices they ask for them will widen, driving up trading costs. This scenario would also be likely to increase funding costs for the issuers of these securities.

The drafters of the proposed regulations seem to have understood the importance of liquidity when it comes to Treasuries and other government securities: they exempted these securities from the proposed limits on market making. Clearly, they recognized that the proposed rule changes would increase the government’s funding cost and sought to avoid that outcome. 

The question is, why exempt government securities and not corporate securities? Why drive up investors’ cost of trading in corporate securities and corporations’ cost of funding?

I also believe that some of the assumptions underlying the proposed implementing regulations are misplaced. 

For instance, the proposed regulations assume that bonds are as liquid as stocks. This is simply not true. Typically there are only one or two classes of any company’s common stock and the shares are widely available (at least for large-cap companies). But companies often have a large number of much smaller issues of bonds outstanding, each with different terms.

IBM, for example, has $200 billion in common stock; all the shares are the same and they can always find a buyer. That’s not true for its bonds. IBM has 28 different bonds with varying terms. None of them is particularly large or as liquid as the common stock.

The proposed regulations also start from the principle that almost everything that market makers do is prohibited and that the government should allow only a few specific exceptions to continue. This is a draconian way to change behavior and one we at AllianceBernstein believe is counterproductive. 

I’d like the regulators who wrote the implementing regulations to make at least two changes:

  • Apply the market making rules proposed for government and agency securities to instruments to corporate securities as well.
  • Treat what market makers do as mostly right (with exceptions), rather than as mostly wrong.

The agencies that proposed these regulations are accepting comments from the public until February 13. There’s still a chance that they will change the regulations. I hope they do.

Peter S. Kraus is Chairman and Chief Executive Officer of AllianceBernstein.

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