by Chidem Kurdas
As the old adage goes, be careful what you ask for, you might just get it. After the 2008 crisis it became fashionable to complain that too much trading is going on. There were calls in this and other countries to restrict financial transactions. And it happened. One example is the rule named after Paul Volcker in the 2010 Dodd-Frank law, banning depository banks’ trading on their own accounts (and also forbidding them from holding significant hedge fund or private equity interests).
Regulators are still in the process of determining how to implement the Volcker rule but the potential impact is already discernible. Likely victims include millions of Americans who save for their retirement and smaller companies that need to borrow money.
Banks are shutting down their proprietary trading. You may believe that is all for the best. But as people warned back when the Volcker rule first came up, there is no clear demarcation between prop trading and market making for clients. Regulators propose intricate sub-rules to make the distinction but it the end it will come down to their judgment, meaning that banks trading for clients will be in danger of violating the no-prop-trading rule. Given the legal risk, they’re reducing their market making.
The consequence is that there are fewer market players to match buyers and sellers. This is a particular problem in the bond market, which is not as deep as the stock market. It is becoming harder to buy or sell bonds. The effects can be wide-reaching.
Mutual funds managers are concerned that transaction costs will rise. The Volcker rule as written could impede market making and raise transaction costs, says Karrie McMillan, general counsel to the Investment Company Institute, the mutual fund trade organization. It is hard to imagine what fixed income markets will look like if the rule goes into effect as proposed, she said, speaking at an ICI conference.
Mutual funds cannot be brushed aside as serving the 1%—on the contrary, most Americans who save for their retirement invest via mutual funds. Higher transaction costs translate to lower returns on retirement savings. So Dodd-Frank, if the rules are implemented as proposed, will in effect rob nest eggs.
Another consequence concerns businesses, in particular smaller companies. A report from Barclays Capital on the credit outlook contains a telling graph: turnover in investment-grade bonds is down for smaller deals while it is up for over-$1 billion deals. That is, liquidity is evaporating for smaller issues.
With various regulatory changes in the works, including the Volcker rule and Basel III, dealers are not making markets, says Jeffrey Meli, head of global credit strategy at Barclays Capital.
As the secondary market for bonds becomes less liquid, potential bond investors face additional risk especially with smaller company debt. If they need to sell, what will the market for the bonds be like? Mr. Meli said this is a time of transition but small and infrequent debt issuers could face a permanently higher liquidity premium.
In other words, Dodd-Frank is making it more expensive for smaller businesses to borrow. That can’t be the way to a stronger economy. It certainly is not the way to encourage job creation.
Did members of Congress and the Obama administration do this because they do not understand what they’re doing? Or was it a deliberate shenanigan to serve some political or personal interest? Put simply, are they fools or knaves?
ThinkMarkets 
Just because depository banks are forbidden from certain types of trading does not mean that other companies, ones that are not depository banks, cannot provide these services. Wasn’t that the case before Glass-Steagall was repealed? Yes, transaction costs will rise, but isn’t this to be expected when financial firms must fully cover the risks they take on, without being back-stopped by the tax-payer?
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Excellent post, Chidem. Even if non-depository institutions pick up some of the slack, the net adverse effects on trading will likely still be positive and get played out as you suggest. In any case, the free flow of capital will be affected and further detached from market forces and become increasingly subject to bureaucratic ruling-making and all the vagaries that comes with that.
Stuhlmann seems to miss the entire point of the article. Restricting banks from participating in the bond market on behalf of clients reduces the number of participants in the bond market PERIOD. With fewer participants any “other company” trading in the bond market faces the liquidity problems the article focuses on.
Wow, did Stuhlmann completely miss the key concept in the article or what?
This post overlooks the rationale behind the Volcker rule. Banks, especially the major ones doing the proprietary trading, are a product of policies producing moral hazard and too-big-to-fail institutions.
The only serious justification for portecting banks is protecting the payments system. There is no connection between taking deposits and proprietary trading. It is an unjustifiable risk (certainly not the only one).
Banks are privileged institutions and analyzing something like the Volcker rule as an attack on natural rights is absurd. I hasten to add I am talking about what Paul Volcker proposed, not what was enactecd in DFA and much less the obscenity being produced by the regulators.
Jerry O’Driscoll–
Yes, that is the rationale. But it is not clear why prop trading got singled out. The hundreds of smaller commercial banks that have been liquidated since the crisis did not engage in any prop trading anyway. They went under for the same old reason banks have under for centuries–they made bad loans, largely for real estate developments that defaulted once the air started coming out of the real estate markets. What’s prop trading got to do with that?
More on Jerry’s comment–
Re what Paul Volcker versus what the regulators are doing: they’re supposedly putting his notion into practice. It was not operational in the abstract form he proposed.
Bill Butos–
That’s an important point: this is another handicap placed on market forces. Deliberately so, judging from the calls for greater government control.
In order to understand the Volcker rule, it should be compared to another rule: the Spooner rule, according to which legislation is “an absurdity, a usurpation, and a crime.”
To the extent that banks “are a product of policies producing moral hazard and too-big-to-fail institutions,” the solution is to repeal the absurdities, usurpations, and crimes (i.e., statutes) from which they spring. Starting with the granddaddy of them all, federal deposit insurance and the FDIC, and also mowing down the GSEs and other state-created institutions that lead to moral hazard and institutional elephantitis. This gets at the root of the problem and leaves the free market to operate in accordance with natural law.
As for prop trading, the shareholders (and ultimately the customers) of banks should be the ones that determine whether they engage in that. Prop trading at banks started after the demise of Bretton Woods and the creation of forex markets to trade government-issued currencies and to support the forex operations of banks. It grew as markets in derivatives later developed.
In a free market, the payment system would be protected by a free banking system and the development of clearinghouses. No legislation or Volcker rule would be required. This would put an end to moral hazard and a smile on Spooner’s face, even if he didn’t quite understand banking.
Big banks are the problem, so any rule to curtail their risk must address the specific risks they take. It’s the Willy Sutton theory of regulation.
The regulations are complex because the banks lobbied for carve outs and exceptions. We know what trading for customers is versus proprietary trading. The former is what a pure discount broker does. No one suggested it was the end of the Western world because not every participant in financial markets takes positions.
Markets do not leave money on the table. Other actors will step in when banks depart. I don’t care what hedge funds do. I do care what institutions with banking licenses and FDIC insurance do.
And leaving it to the owners and managers is precisely what you cannot do. With government backing, they will take too many risks.
With that, I wish everyone a Merry Christmas.
Agreed that with government backing they will take too many risks, which is why we want the separation of bank and state.
Merry Christmas and a good New Year.
Have a great Holiday and Happy 2012.
[…] So far, the starve-the-fat-banks Volcker Rule treatment is not going well. While regulators still try to determine how to implement the rule, unintended consequences have already shown up. Banks’ trading on their own account is intertwined with market making for clients. As the prop desks shut down, there are fewer market players to match buyers and sellers. That increases the cost of transacting in particular in the bond market, adding to the expense of mutual funds and small businesses. […]
Serbest piyasada, ödeme sistemi özgür bir bankacılık sistemi ve takas gelişimi ile korunacaktır. Mevzuat veya Volcker kuralı gerekli olacaktır yok. O da oldukça bankacılık anlamadı bile bu, ahlaki tehlike ve Spooner yüzünde bir gülümseme için son verecek.
[…] Goldman Sachs credit managers expect sharp price movements in high-yield bonds if there are substantial outflows from funds holding such debt. The volatility is greater than it would be otherwise because bank prop desks and broker-dealers have responded to impending regulatory changes, in particular the Volcker Rule of the Dodd-Frank Act, by …. […]