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Kelleher Says Volcker Rule Misperceives How Market Makers Profit

Kelleher Says Volcker Rule Misperceives
Morgan Stanley signage is displayed outside of company headquarters in New York. Photographer: Peter Foley/Bloomberg

Morgan Stanley, owner of the world’s largest brokerage, said the Volcker rule suffers from a misunderstanding of how banks earn returns from market making and threatens to curb profitable services.

“There appears to be a real misconception about how principal market makers generate revenues,” Colm Kelleher, who runs the bank’s trading business, and Chief Operating Officer Jim Rosenthal, wrote in a comment letter posted to the Commodity Futures Trading Commission’s website today. “The proposal should be revised to reflect the realities.”

Morgan Stanley, which generated about 44 percent of its revenue last year from trading, focused its criticism of the proposal on language distinguishing between permitted market making and prohibited proprietary trading, as well as on a provision that requires market makers to generate most of their revenue from commissions, fees and bid-ask spreads.

Market makers often must hold positions for months to serve clients’ needs and derive the “preponderance” of customer-facilitation revenue from changes in the value of inventory holdings, the executives wrote. Bid-ask spreads are often unavailable in illiquid markets and fees and commissions from principal market making made up less than 5 percent of Morgan Stanley’s trading revenue over the last three years, they said.

“Some of the criteria for market making in the proposal are more characteristic of agency trading and principal market making in certain highly liquid, exchange-traded markets, rather than the more common situation of principal market making in less liquid markets,” the executives wrote.

‘Customer-Facing’ Business

The rule, named for former Federal Reserve Chairman Paul Volcker, was included in the Dodd-Frank Act to restrict risky trading at banks that operate with federal guarantees. The Fed and three other regulators released the 298-page proposal in October, seeking comment on how it would affect market-making and liquidity. The CFTC released its proposal separately in January. The proposal has drawn more than 14,000 responses from commentators including regulators, banks and trade groups.

To differentiate market-making from prohibited proprietary trading, regulators should mandate that the activities are part of a “customer-facing business,” Morgan Stanley wrote. Characteristics including sales coverage, dialogue with clients, and research distribution should be used to determine whether the unit is “customer-facing,” they wrote.

Morgan Stanley argued that the rule should be implemented over a two-year period for U.S. operations, while an extra year should be given to bring international operations in line.

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