Volcker Rule Could Limit Market Making

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 the cost of trading 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. While regulators have been eager get the rule passed and implemented, the banks have wanted more time and clarity on these terms, to help them assess the rule’s financial implications.

"The Volcker rule is like a comet heading toward Earth," said Robert Colby, partner at Davis Polk & Wardwell and former deputy director of the Securities and Exchange Commission’s Division of Trading & Markets. "It’s a big deal for the equities markets-just not as big a deal as it is for the fixed income sector."

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. Dealers will often replace inventory ahead of expected demand. The problem here is that investor demand might not come for days, creating the suspicion a trader was speculating.

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 to support taking any such position in a security. The rule permits market-making activity where the market maker holds positions for very brief periods of time in stable yet active markets. They make their profits from trading at their published bid and offer.

The Volcker rule as written does provides an exemption for banks to make markets or hedge in securities that would keep a bank from losing money on a transaction made to accommodate a client’s 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. Not so in the equity world, as positions can be entered and exited quickly and have less impact on the banks’ bottom line.

So while the fixed income markets are scrambling to adjust to the Volcker rule, the equities markets can better use these exemptions to continue trading and making markets.

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

According to a recent AllianceBernstein research note on the Volcker rule, the inability to confidently engage in market-making activities on a principal basis under the proposed rule, along with the "onerous record-keeping and compliance burdens required," "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 to investors and other stakeholders."

C. Annette Kelton, general counsel at Goldman Sachs, said at an Investment Company Institute confab that there’s a lot of complexity in the Volcker rule and that the difficulty in compliance lies in just what certain terms mean, such as how regulators and the rule actually define market making. She said that perhaps the current working definition of market making is too narrow, given current market structure and new changes in structure that haven’t been taken into account. 

She added that her firm is engaged with the Securities Industry and Financial Markets Association on any potential comment letter and that Goldman Sachs is still listening to input from its clients.

"If we don’t get this right, it will affect liquidity and eventually the cost of trading," Kelton said.

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, the SEC appears to be listening to the banks’ concerns to a degree and is seeking more comment. At the Institute of Investing’s December equity market conference, David Shillman, an associate director in the commission’s Division of Market Regulation, said the regulator wants more comments on Volcker and conceded that it is a very complicated piece of rule-making. However, he stopped short of saying the regulator would extend any comment period.

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