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January 2, 2012

Market Makers Eye Volcker Rule

By John D'Antona Jr.

The Volcker rule as currently written will affect market making on equities trading desks by limiting their abilities to facilitate trading. Subsequently, this will raise trading costs and hinder liquidity, sources tell Traders Magazine.

Part of the recently enacted Dodd-Frank legislation, the rule will place strict limits on prop trading and market making, both of which are seen as contributing to the recent financial crisis, said rule proponent and namesake Paul Volcker, former chairman of the Federal Reserve.

Both activities, though, have been extremely profitable for banks-thus the push-back from the financial industry.

"The Volcker rule is like a comet heading toward Earth," said Robert Colby, partner at Davis Polk & Wardwell. "It's a big deal for the equities markets-just not as big a deal as it is for the fixed-income sector."

Robert Colby

The rule includes an exception for market making, but doesn't make it easy to qualify for the exception. The language of the exception recalls the equities market, industry sources argue, making it easier for stock market makers, but not fixed-income dealers, to qualify.

The proposal sets out seven standards that need to be met for a trading activity to fall under the definition of market making. One requires trading positions to have "near-term demand." Another provision of the rule prohibits banks from trades for themselves and using their own capital to place speculative market bets that are not related to serving customers.

Market making is especially vulnerable under the Volcker rule, sources said, because distinguishing between it and prop trading is not always straightforward.

According to the rule, market makers cannot hold a position in a security for an extended amount of time for its own inventory. Also, the market maker cannot enter into a position for its own profit-it must have a customer order.

The rule as written provides an exemption for banks to make markets or hedge to keep from losing money on a client trade.

Because the rule uses an equity market-maker approach, it will be much easier to qualify for the market-maker exception for stocks than for fixed income securities. In the fixed-income markets, positions usually must be held for extended periods of time and price movements have a major impact on market makers' profit and loss.

Banks, already reeling from lower trading volumes and decreased commissions, fear that the rule will decrease equity market liquidity and increase volatility.

According to an AllianceBernstein letter to regulators on the Volcker rule, the inability to engage in market-making on a principal basis under the rule, "will have a material and detrimental impact on the ability of covered banking entities to engage in market-making activity."

As drafted, the rule will "likely dramatically reduce market liquidity, increase costs and in some cases impact the ability of market participants to meet their legally required obligations."

Vaishali Javeri, a lawyer in Credit Suisse's equities group, said at October's SIFMA conference that her firm wanted more details on how the regulators would define terms and how metrics would be measured for the different asset classes.

"Because trading is so different in liquid versus illiquid products," Javeri said, "I hope the definitions will be consistent with the Exchange Act."

Given all the brouhaha over the rule, David Shillman, an associate director in the Commission's Division of Trading and Markets, said at a recent conference regulators want more comment on Volcker, and he conceded that it is a very complicated piece of rule-making.

"The SEC is trying to make the Volcker rule workable in terms of what is market making," Shillman told attendees.


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