Market Making Under the Proposed Volcker Rule

Darrell Duffie
2012 Social Science Research Network  
This submission discusses implications for the quality and safety of financial markets of proposed rules implementing the market-making provisions of section 13 of the Bank Holding Company Act, commonly known as the "Volcker Rule." The proposed rules 1 have been described by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission. The Agencies' proposed
more » ... n of the Volcker Rule would reduce the quality and capacity of market making services that banks provide to U.S. investors. Investors and issuers of securities would find it more costly to borrow, raise capital, invest, hedge risks, and obtain liquidity for their existing positions. Eventually, non-bank providers of marketmaking services would fill some or all of the lost market making capacity, but with an unpredictable and potentially adverse impact on the safety and soundness of the financial system. These near-term and longer-run impacts should be considered carefully in the Agencies' cost-benefit analysis of their final proposed rule. Regulatory capital and liquidity requirements for market making are a more cost effective method of treating the associated systemic risks. . The opinions expressed here are entirely my own, and do not necessarily reflect the views of anyone else. In a section of the Dodd-Frank Act commonly known as "the Volcker Rule," Congress banned proprietary trading by banks and their affiliates, but exempted proprietary trading that is related to market making, among other exemptions. Proprietary trading is the purchase and sale of financial instruments with the intent to profit from the difference between the purchase price and the sale price. Market making is proprietary trading that is designed to provide "immediacy" to investors. For example, an investor anxious to sell an asset relies on a market maker's standing ability to buy the asset for itself, immediately. Likewise, a investor who wishes to buy an asset often calls on a market maker to sell the asset out of its inventory. Market makers handle the majority of trading in government, municipal, and corporate bonds; over-the-counter derivatives; currencies; commodities; mortgage-related securities; currencies; and large blocks of equities. (The Volcker Rule exempts currencies, United States treasuries, federal agency bonds, as well as certain types of state and municipal bonds.) Most market making, both in the U.S. and abroad, is conducted by bank-affiliated broker-dealers. Several federal agencies are now writing the specific rules by which they will implement the Volcker Rule, which comes into force in July, 2012. In particular, these agencies are charged with designing rules that implement the exemption for market making. I believe the restrictions on market making by banks in their proposed rules would have two major unintended consequences: 1. Over the years during which the financial industry adjusts to the Volcker Rule, investors would experience higher market execution costs and delays. Prices would be more volatile in the face of supply and demand shocks. This loss of market liquidity would also entail a loss of price discovery and higher costs of financing for homeowners, municipalities, and businesses. 2. The financial industry would eventually adjust through a significant migration of market making to the outside of the regulated bank sector. This would have unpredictable and potentially important adverse consequences for financial stability. I will elaborate on these consequences and suggest an alternative approach, of using capital and liquidity requirements to conservatively buffer market-making risks. Market making risks, and other risks taken by a bank, are unsafe whenever they are large relative to the capital and liquidity of the bank. 2
doi:10.2139/ssrn.1990472 fatcat:nog7kkl2anbmnnwm3crenhxguu