The five federal regulators responsible for implementing the Volcker rule have been inundated with comment letters whose resounding message is that the rule, as proposed, simply won’t work.
At its heart, the proposal is based on the presumption that any possible risk-taking activity conducted by a financial institution in service to clients is prohibited proprietary trading until the institution can prove otherwise. That is backward reasoning. It also conflicts with Congress’s explicit exemption for market making by banks and their affiliates.
Reduced financial-market liquidity is one of the securities industry’s biggest concerns. When banks provide consistent and ample liquidity (the ability to buy or sell a security at a reasonable price in a timely fashion), they strengthen financial markets and benefit investors and issuers who rely on capital and credit. Without it, businesses can’t grow and create jobs. Since the Volcker rule, adopted by Congress in the 2010 Dodd-Frank Act, will apply to the vast majority of institutions that regularly provide liquidity to the markets, it is crucial that we not inadvertently curtail such activity. But that’s what the rule, as currently proposed, would do.
Market makers provide immediacy by selling assets to investors who wish to buy them, and by buying assets from investors who wish to sell when there isn’t a willing investor on the other side of the trade. The proposed regulation’s overly narrow definition of permitted market-making activity, along with its compliance requirements, would discourage market makers from playing that important role.
The bigger or riskier trades requested by investors would often be shunned by market makers, out of fear that they will be violating the Volcker rule, leading to thinner markets and more price volatility.
Thinner markets are less liquid, which means transactions are more expensive to conduct, and less capital is available. A study by management consulting firm Oliver Wyman concludes that the current proposal may result in one-time costs of $90 billion to $315 billion for corporate-bond investors. Additionally, corporate-debt issuers might incur $12 billion to $43 billion in increased borrowing costs.
Paul Volcker, the former Federal Reserve chairman after whom the rule is named, asserts in a recent essay to federal regulators that there is too much liquidity in the markets, which inflates asset values. This isn’t the case; the best evidence can be seen in recent comments by foreign governments and central banks. Japan, Canada and the U.K., along with the European Commission, have expressed concerns that the rule may hurt the ability of financial institutions to make markets for their sovereign bonds.
Yet Volcker is dismissive of these concerns. Having deep and liquid markets for sovereign bonds is essential to any country. Given the current state of many European nations’ finances, impeding market making in sovereign bonds will ultimately achieve what Volcker’s idea sought to prevent: systemic risk. There has to be a better way.
In submissions to federal regulators, the Securities Industry and Financial Markets Association outlined a number of recommendations to improve the proposal. The rule, for example, should explicitly permit market making that is customer-focused, by which we mean trades that meet or anticipate customer demand. Firms should also be allowed to develop quantitative metrics -- which regulators would oversee -- that would raise red flags if anything went amiss.
These metrics could include position limits and other measurements of risk. Trading units should be presumed to be engaging in bona fide market making as long as the metrics are in appropriate ranges for the specific asset class.
Additionally, the rule should not analyze market making on a transaction-by-transaction basis. The proposal should instead focus on allowing financial intermediation -- standing between buyers and sellers, which is what market makers do -- permitted by the statute.
In the end, what must truly be changed is the underlying assumption that any activity conducted by a financial institution to make markets is considered prohibited proprietary trading. As noted above, market making is an important function for capital formation, economic growth and job creation. Traders will not perform such essential functions if they fear that regulators, after the fact, could deem activities as banned proprietary trading.
As regulators take in thousands of pages of comments, they should re-propose this rule and do so with the assumption that customer-facing market-making activities are permissible until proven otherwise.
(Tim Ryan is the president and chief executive officer of the Securities Industry and Financial Markets Association. The opinions expressed are his own.)
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