The winding down of proprietary desks and subsequent decline in trading activity anticipated under the proposed Volcker Rule could force investors to put higher risk premiums on assets in order to mitigate what they expect will be a reduction in liquidity and less ability to exit positions, according to sister magazine International Financing Review.
With two months left until the period for comment closes, investors are voicing growing concerns about the possible consequences of the Volcker rule on the fixed-income market. In what Larry Fink, chief executive officer of Blackrock, described as a probable disaster for all investors, the proposed Volcker Rule will have a profound impact not only on banking operations, but also on capital market liquidity.
The 300-page proposed version of the rule, due to come into force next year, was released last month by the Federal Deposit Insurance Corp. and other federal regulators. The overall goal of the Volcker Rule, named after former Federal Reserve Chairman Paul Volcker, is to prevent insured depository institutions from undertaking speculative trades for their own profit.
The rule says that banks cannot engage in principal transactions or establish principal positions in securities or derivatives. And while it is designed to keep banks from taking proprietary risks with customer deposits, it really comes down to what constitutes a proprietary bet. Prop trading is something everyone understands but it is difficult to define, said Joseph Mayo, a managing director in Conning Asset Management’s research group.
There is a lack of certainty over how regulators will distinguish between proprietary trading and other types of market making activity and hedging for risk mitigation. Actions by the big banks to comply with the Volcker Rule would certainly reduce revenue streams and change the business model of fixed income, according to Brad Hintz, a brokerage analyst at Sanford C Bernstein & Co.
He said he believes fixed-income trading desks could suffer a 25 percent decline in revenue and margins would fall by a third if market-makers are forbidden to amass positions in expectation of future price appreciation for customer accounts that trade debt securities. Some sell-side firms keep inventory positions in order to supply their clients with a security in certain circumstances, such as when market makers assume the role of counterparty in the absence of a ready buyer or seller on the other side of the trade.
Under the Volcker Rule as proposed, banks might be discouraged from providing such market-making trades for fear they would be engaging in what the regulator considers proprietary trading. Dealers are unsure how their positions would fit into the definition of the Volcker Rule and hence are hesitating to make commitments.
Given the fact that they are not being effectively paid for the risk of holding positions, there is a keen focus to reduce leverage. As a consequence there is a pressure on all the trading desks to lower their inventory positions, Mayo said.
Federal Reserve data show that primary bond dealer inventory dropped to an eight-year low during the time when many of the banks proprietary desks have closed. Primary dealers held $51.329 billion of corporate debt with maturities beyond a year as of Nov. 2. That sum was down 46.3 percent from May 25, according to the Federal Reserve Bank of New York.
The reduction in market liquidity is among several unintended consequences of the rule with fewer large players in the market.
We think there is a distinct risk that the infrequent – less liquid – issuers will have to pay more when they come to the market. It will be much more difficult for our clients to transact in larger sizes, Mike Rogers, a senior banking sector analyst and director in Conning’s credit research group.
The gap between where dealers buy and sell securities will also be affected. By definition, they are going to have to have wider bid/ask spreads just for the utilization of their balance sheet, Blackrock’s Fink said in an address at a Bank of America Merrill Lynch conference.
Insurance companies such as AIG are still exempt from the rule, and municipal as well as U.S. government securities are free from the ban on proprietary trading. Expectations were that the rule would not restrict the trading activity of foreign domiciled investment banks.
In actuality, the rule effectively will apply to every bank with a meaningful trading business, regardless of domicile. Foreign banks are eligible for exemption from the prop trading ban and associated compliance regime only if trading activity occurs completely outside the U.S. and does not involve a U.S. counterparty.
Moody’s Investors Service said the Volcker Rule would be a credit negative for bondholders of Bank of America, Citigroup, Goldman Sachs, JP Morgan and Morgan Stanley, all of which have substantial market-making operations. The Volcker Rule will diminish the flexibility and profitability of banks’ valuable market-making operations and place them at a competitive disadvantage to firms not constrained by the rule, the agency wrote.
Concern about the Volcker Rule impact on revenue could force firms like Goldman Sachs and Morgan Stanley to consider shedding their status as bank holding companies to avoid the regulations. Both companies converted to holding companies from securities firms in 2008 to be eligible for the government bailout programs.
(John Balassi is an analyst for for Reuters IFR in New York.)