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Constraints Seen for Market Makers Under Volcker Rule on Trading

Under the Volcker proposal, UBS and Citigroup would face regulatory and compliance requirements their rivals may skip, increasing the cost of conducting those businesses. Photographer: Gianluca Colla/Bloomberg
Under the Volcker proposal, UBS and Citigroup would face regulatory and compliance requirements their rivals may skip, increasing the cost of conducting those businesses. Photographer: Gianluca Colla/Bloomberg

Confusion about what constitutes proprietary trading under the Volcker rule may spur banks to reduce market making for customers, according to Craig Pirrong of the University of Houston and Thomas Gira of the Financial Industry Regulatory Authority.

Firms will spend less to service clients, Pirrong, a finance professor specializing in risk management, said in a telephone interview. The proposals may have a chilling effect on some businesses, according to Gira, executive vice president of the oversight organization for the securities industry.

The rule, named for former Federal Reserve Chairman Paul Volcker, was part of last year’s overhaul to rein in risky trading by firms whose customer deposits are federally insured. Concern is growing among banks that it will sometimes prove impossible to distinguish between proprietary transactions and trading done for the benefit of clients.

“To the extent the rule constrains the ability of these firms to make profit, which is the whole idea, it will reduce the amount of capital the firms will put into their market-making business,” Pirrong said. “From the regulators’ perspective, that’s probably a feature rather than a bug.”

The Federal Reserve drafted the proposal, released on Oct. 11, with the Federal Deposit Insurance Corp., Office of the Comptroller of the Currency, and Securities and Exchange Commission. The public can comment until Jan. 13. A final version is slated to take effect on July 21, 2012.

Depositor Money

Banks shouldn’t take risks with depositors’ money and if market making shifts to independent institutions, that’s a price worth paying, according to Aaron Brown, chief risk manager at hedge fund AQR Capital Management LLC in Greenwich, Connecticut.

“Larger banks will have to ring-fence an entity to do their market making,” Brown, author of “Red-Blooded Risk: The Secret History of Wall Street,” said in a phone interview. “It will shake things up and open the field to new competitors because big franchises will have to reorganize.”

JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said on Oct. 13 that while banning proprietary trading is “fine,” market making by financial companies helps investors.

“The United States has the best, deepest, widest, and the most transparent capital markets in the world, which give you, the investor, the ability to buy and sell large amounts at very cheap prices,” Dimon said during a conference call. “That’s a good thing. I wish Paul Volcker understood that.”


Lawmakers who crafted the Dodd-Frank Act last year exempted market making from the Volcker rule, along with certain forms of hedging and underwriting, because of concern that banning all proprietary trading could bring some markets to a halt. Goldman Sachs Group Inc., Citigroup Inc. and Morgan Stanley serve as market makers when they accept risk to facilitate client orders.

Banks including JPMorgan, Goldman Sachs and Morgan Stanley have already shut or plan to spin off proprietary trading units.

The proposal allows trading for meeting the near-term needs of clients. Banks must have compliance, record keeping and monitoring programs to identify and root out speculation designed to profit from price changes which will no longer be permitted, the agencies said. In contrast, so-called “bona fide” market making supplies liquidity to clients and generates revenue mainly through fees, commissions and the difference between buy and sell prices, the document said.

Tests, Metrics

Distinguishing short-term speculative trading from market making based on customer needs will be difficult, the proposal states. To combat the problem, policy makers proposed tests aimed at identifying the trading and revenue characteristics of market making so that banned proprietary trading will be easier to spot. They said the metrics will improve based on public comment, experience and study.

MF Global Holdings Ltd., Jefferies Group Inc., D.E. Shaw & Co. and Citadel LLC may benefit as business migrates from rivals, Pirrong said. Maureen Young, a San Francisco-based partner at Bingham McCutchen LLP, said banking entities outside the U.S. whose market-making operations aren’t subject to the Volcker rule would be the main beneficiaries.

Abby Greenberger, a vice president at D.E. Shaw, said the Volcker rule would even the playing field between banks and firms such as hers. That’s “good news from our perspective,” she said at a Securities Industry and Financial Markets Association conference on Sept. 21 in New York.

25% Drop

Banks’ fixed-income desks could see revenue fall as much as 25 percent under provisions in the proposal, based on a draft circulated earlier this month, brokerage analyst Brad Hintz of Sanford C. Bernstein & Co. wrote in a note on Oct. 10. Moody’s Investors Service said the rule would be “credit negative” for bondholders of Bank of America Corp., Citigroup, Goldman Sachs, JPMorgan and Morgan Stanley, “all of which have substantial market-making operations.”

“The main battleground will be market making and hedging, where the Dodd-Frank statute is more ambiguous,” analysts led by Glenn Schorr at Nomura Holdings Inc. wrote in an Oct. 6 report. A “draconian form” of the Volcker rule may result in less liquidity, more funding costs for U.S. companies, higher trading costs and lower returns, the report said.

“There will be disagreements between companies trading and the regulatory agencies about whether or not they profited from holding a particular type of security for three months or whatever time it may be, if it appreciated in value,” Young said in a phone interview.

Value at Risk

The agencies proposed 17 metrics to help determine whether a bank market-making unit is engaging in prohibited activity that aims to profit from price changes. They include fee income and expenses, the volatility of the group’s profit and loss, and value-at-risk, a gauge of potential financial loss. Trading that generates unusually high or low revenue for the risk taken or yields higher earnings volatility may signal banned activity masquerading as market making, the rule proposal said.

The Volcker rule has the “potential to impact legitimate activity,” Gira of Finra, which oversees almost 4,500 brokers, said at the Sifma conference on Sept. 21. What constitutes market making is a “difficult question to get your arms around,” he said. “From a surveillance standpoint, this is a pretty challenging rule.”

Firms with more than $5 billion in trading assets and liabilities must run daily calculations of the 17 quantitative measures and report to regulators monthly, the proposal said.

Bloomberg Government

A Bloomberg Government study published Oct. 14 said 13 firms will fall into this category. They accounted for 98.4 percent of the total trading assets and liabilities among the 1,020 bank holding companies subject to the rule, the report said. They will need one compliance person per year in each subsidiary and trading unit to meet the monitoring requirements. Each bank may have dozens of trading units, the report said.

Banks that aren’t as big will have to conduct eight of the 17 checks, while the smallest will be exempt, the Volcker proposal said. The Bloomberg Government report said 12 firms will qualify for the second tier and 995 will be subject to the trading ban without having to run the calculations.

The compliance and monitoring requirements may cost the industry $2.1 billion a year, Nomura’s Schorr wrote. The fixed expenses wouldn’t impede most market making or cause banks to exit those businesses, according to Pirrong. Higher costs, particularly in less actively traded products such as mortgage-backed securities and illiquid stocks, would probably be passed on to investors in the prices they pay, he said.

Shifting Jobs

Young said curbs on pay may eventually hurt the operations and make them less competitive. Proposed limitations on compensation meant to discourage the employees of firms subject to the Volcker rule from taking inappropriate risk may spur traders to look for jobs elsewhere, she said.

“It’s quite possible if this resulted in constrained compensation for those on these desks, they’d go to higher-compensation sectors of the industry,” Young said. “But that’s down the road. It all depends on how the ultimate rules come out and how they’re enforced.”

According to the proposed rule, market makers on exchanges or similar venues must provide both bids and offers at or near the prevailing prices, while those supplying liquidity in less-active financial products must be willing to buy and sell on a regular basis. Among the quantitative measures banks and regulators must examine to ensure that trading activity justifies the exemption is the requirement that firms buy and sell roughly the same amount in liquid products.

Trading Decisions

Steve Crutchfield, chief executive officer of NYSE Amex Options, owned by NYSE Euronext, said at a Sept. 14 conference in New York that exchanges probably wouldn’t be hurt by a reduction in volume as long as the ban on proprietary trading doesn’t extend to bona fide market making. He raised questions about trying to govern the trading decisions of market makers, saying constraints may narrow what is allowed.

If a market maker is guided by his expectation that volatility will increase or decrease, “does that become proprietary trading and it’s suddenly an activity no longer valid for a bank to enter into?” Crutchfield said. “We hope the answer is no.” As market making has become more competitive, trading by only supplying bids and offers is also “no longer a viable business model,” he said.

Among the largest equity wholesalers, or market makers that execute orders from retail brokerages, two are bank affiliates and two aren’t. U.S. units of Citigroup and UBS AG compete with Chicago-based Citadel and Jersey City, New Jersey-based Knight Capital Group Inc., according to reports from TD Ameritrade Holding Corp., Charles Schwab Corp., Scottrade Inc. and E*Trade Financial Corp. that track where the brokers’ orders are sent.

UBS, Citigroup

Under the Volcker proposal, UBS and Citigroup would face regulatory and compliance requirements their rivals could skip, increasing the cost of conducting those businesses.

In asset classes and products that are less liquid, the pressure on market making may produce bigger changes as banks tally how much less profitable those units will be under the Volcker rule, Pirrong said. It may also not generate some of the risk reductions sought by banning proprietary trading in banks.

“You think you’re reducing risk but you’re shifting it around in ways that can come back and bite you,” Pirrong said. “Customers will go to other financial entities.” The Volcker rule “doesn’t make the problems go away. It just changes the location,” he said.

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