Woodbine Associates, Inc.
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Woodbine Opinion
April 4, 2012

Beyond Volcker:  Seeing the Forest through the Trees

Congress determined that banks should be out of the proprietary trading business.  Dodd-Frank became law.  The law was handed-off to regulators who drafted the proposed rule that so many seem to dislike. 

Despite continued lobbying, politically and through the media, just about everyone now gets it – banks won’t be allowed to prop trade.   Bank executives are beginning to acknowledge that it is no longer about what will not be allowed, but their challenge is now to minimize the costs and burdens of trading for their customers under the requirements.

It isn’t going away, even if the Republicans win the 2012 general election.  The financial community must work with regulators to facilitate implementation.

The Volcker Rule will have a large and immediate impact on trading, risk and liquidity, but it is only one piece of a larger regulatory framework being implemented that will shape the financial markets and the way we do business. 

We needed it.

It is important not to forget how we got here.  Our financial system was near collapse and needed government intervention to remain functional.  There is no argument that the system was broken and needed serious structural repair that superseded the individual and collective ability of industry constituents.  Banks were failing – unable to manage their risk and liquidity.  We needed the government to make the hard decisions where the markets lacked incentive.  The justified and appropriate response: enactment of Dodd-Frank and restructuring the financial system through creation of risk mitigating safeguards, one of which is the Volcker Rule.     

Banks are in business to make money for their shareholders.  Regulators are tasked with preserving the stability and integrity of the financial system.  Those objectives often conflict, which is what we have been observing over the past couple of years.  As things stand, our message to Congress and regulators is to “hold the line.”  In the face of a substantial criticism and special interest lobbying, the rules being implemented remain necessary for the long term stability of our financial system. 

We got it.

It has been five months since the US Securities and Exchange Commission released the draft proposal for the Rule.  The accuracy and precision caught many by surprise.  Regulators crafted a proposal that very clearly details what constitutes proprietary trading and what will and will not be permitted at banks and their affiliates going forward.  It is also very clear in principal and leaves little doubt about their intent.  Implementation, however, is proving to be difficult due to many market nuances that need to be addressed, and potentially costly shotgun approach proposed for its metrics.

Rather than rewriting the Rule, we think regulators are likely to simplify the current proposal.  This could be done by moving away from many of the detailed prescriptive measures cited to broader risk-based measures.  This places less focus on determining the intent of a transaction and more on the resulting risk and its relationship to customer-oriented business. 

In the OTC markets we expect a broader application of the market-making rules, placing a greater emphasis on aggregate product risk viewed as a portfolio rather than that of individual transactions on a stand-alone basis.  This should give banks the latitude to more freely manage the risk within their trading books, which will facilitate their ability to make markets more effectively.

We at Woodbine Associates have long held the belief that risk-based metrics are most relevant for bench-marking compliance with the Rule since the goal of the rule is to eliminate proprietary risk taking (see: To Catch a Proprietary Trader – Feb 15, 2011).  These are easiest to measure and readily available in most cases.  Focusing efforts and position risk measurement at the book, product or asset class level, or firm as a primary metric, alleviates the need to validate the intent of each transaction on an individual basis. 

We agree with critics that assert customer oriented market-making requires firms to maintain a functional level of risk on their books coincident with that activity.  While the Rule allows for this, it lacks clarity in some areas, such as trading for price discovery and sizing the market, that are done to facilitate customer market-making.  Focusing on risk-based metrics eliminates the need to evaluate these types of trades individually and allows their risk to be evaluated as part of the aggregate customer “flow” business.

Other metrics, of which there are many, are likely to be reduced to a more meaningful subset that focus on benchmarking firm risk to that of its customers.  They should include those for assessing a firm’s intraday risk levels and trade volume to ensure that permitted proprietary trading, such as market making, is done to facilitate customer transactions or reduce risk.

This measurement, in conjunction with oversight and self-regulation of the principal-based elements of the rule (see the Volcker Rule, Appendix B commentary), would accomplish both the legal and regulatory objectives.  It would do so in a manner that does not unduly constrain the ability of bank dealers to conduct truly customer oriented market-making.  We expect the emphasis to focus on setting and monitoring risk limits that are benchmarked to the amount of customer risk traded, giving banks more latitude on how they operate intraday.

Although the final form of the Rule will ultimately determine the regulatory cost to banks and their ability to make markets, we expect little change in the underlying principals laid out in the proposed rule.  Generally speaking: trading for customer facilitation or risk reduction are fine.  There will surely be product and sector specific changes for market nuances, but “what we see” is likely to be pretty close to the framework we get. 

Now what will it mean?

In reality, the larger and more important issue is the impact of the Rule on trading in the markets, both near-term and over time. 

Most are in agreement that the near-term impact on many markets is likely to be a widening of bid-ask spreads that results from a pull-back in the amount of bank dealer liquidity supplied to the markets.  For example: dealers have been holding less corporate bond inventory and taking less risk as indicated by wider spreads and general buy-side frustration.  It is impossible to tell how much of this is attributable to paring risk in anticipation of pending regulation and how much is the result of market conditions.  We have seen this over the last several months in various product areas. 

The pact of wider spreads and increased risk premiums will be more pronounced for large, block trades that significantly exceed normal market trading sizes.  Coincidentally, normal trading sizes are likely to shrink in some markets.  Bank dealers will face limits on the amount of risk they can hold and are likely to reduce the holding period over which they warehouse such positions.  It follows that block execution should become more expensive, reflecting increases in dealers’ cost and need to hedge that risk that is not offset by near term customer flow.  It is safe to say that we’ll see wider spreads and/or smaller trading sizes, or a combination of the two. 

We expect that customers, being savvy participants themselves, will change the way they trade and source liquidity.  Transaction sizes should fall and volume should increase as customers take on more execution risk.  They will be increasingly likely to execute block trades in multiple, smaller transactions over longer time horizons.  Those firms seeking instantaneous liquidity for trades that significantly exceed normal market sizes will pay more for it.  Others will be more likely to hold and execute risk over longer periods and will seek other sources of liquidity and new trading venues.  Ultimately, we anticipate that this will produce a more open market structure than exists today and provide an impetus for more multi-lateral trading. 

A further byproduct of the Volcker Rule will be the emergence of non-bank entities including regional dealers, well capitalized hedge funds and others that will play a greater role in the markets, both warehousing and distributing risk.  Wider spreads will prompt these entities into providing liquidity if the potential return is justified.  Over time we expect the markets to evolve into a modern day structure that is in some ways “Glass Steagall-esque.”  Risk distribution will be facilitated by entities outside the banking system, such as hedge funds, regional dealers or investment banks, some of which might be spin-offs from existing bank capital market groups.  One of the primary differences will be the role banks will continue to play intermediating risk, particularly in the bilateral OTC derivative markets, where they will continue to offer hedging customization, albeit at much greater cost under the Basel III framework. 

Temporary structural imbalances, such as wider spreads from a reduction in bank dealer liquidity, should dissipate over time as the markets reach a new level of equilibrium.  As new entities emerge and play a more active role in the markets, they should offset some of the liquidity lost from bank dealers.  Over time, and possibly not long given the resiliency of the financial markets, any lost liquidity is likely to be replaced by firms outside the banking sector. 

There is more.

Further catalyzing this change, particularly in the fixed income and credit markets will be the changes occurring in the OTC derivative markets.  Central clearing eliminates the need for a bilateral relationship and allows anonymity as well as the entry of new participants and new trading partners.  SEFs will bring participants together on centralized electronic platforms and concentrate liquidity at these venues.  A natural byproduct of electronic multi-lateral trading in the OTC markets is an extension of this style of execution to the underlying cash markets. 

Firms seeking liquidity will increasingly use a combination of the cash and OTC markets and will utilize electronic platforms to facilitate cross-product trading.  Initially, this is likely to be done through dealers on their proprietary platforms.  Several are preparing for this by upgrading their electronic single dealer platforms to access SEF liquidity in the OTC markets.  Over time, and it may not take very long, it is likely that more cash trading will be done multi-laterally and we’ll see a migration away from the current two-tiered market structure.  Numerous execution venues have emerged as potential SEFs in the OTC markets and ATSs in the cash markets to capitalize on expected market structure changes.

In a recent research report:  Buy-Side Corporate Bond Execution: Sourcing Liquidity under Dodd-Frank, we examined cash credit trading and how asset managers and traders plan to respond to changes in liquidity from the Volcker Rule and changes to the CDS markets.  Not surprisingly, many plan to change the way they source liquidity and increasingly use a combination of the cash and derivative markets going forward. 

Looking at the big picture, we see that Dodd-Frank leads to the removal of some of the structural barriers that exist in today’s largely two tiered market structure, facilitating a freer flow of liquidity among participants and across products and asset classes.  The Volcker Rule redistributes risk capacity within the capital markets and moves prop risk taking out of the banking system.  

When you include Basel III, banks (and the markets as a whole) face a regulatory triple “whammy”: a more open market structure, less risk taking capacity and increased capitalization.  The three combined will affect unprecedented change to the capital markets and the way we do business.

The real question is not the one being echoed by the media: will we be better or worse off under Volcker?  It is too soon to tell.

It is rather: how can I put myself in position to capitalize on opportunities that will be created from the new regulatory framework?  We have some ideas.  Feel free to give us a call.


Sean Owens
Director of Fixed Income
Phone:  203-274-8970 ext 204
Email: sowens@woodbineassociates.com 

For a printable copy of this opinion in pdf format please click here.

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