Monday, January 10, 2011

Securities Industry Urges Cautious Recognition of Market Realities in Implementing Dodd-Frank Volcker Rules

The securities industry has asked the SEC and other federal financial regulators to implement the Volcker provisions of Dodd-Frank in a manner that is firmly grounded in market realities. Based on a recent SIFMA study, the industry said that regulators must be able to distinguish between prohibited proprietary trading and activities permitted under the Volcker provisions, which can vary substantially across asset classes, market practices, and market conditions. The Volcker provisions, codified in Section 619 of Dodd-Frank, distinguish between prohibited proprietary trading and permitted activities such as market making, securitization, hedging and underwriting related activities, which augment the effective functioning of US markets and ongoing access to capital

SIFMA noted that, for most securities, derivatives, and commodities markets, banks and their dealer affiliates subject to the Volcker provisions play a critical role as the central providers of liquidity to other market participants. Thus, a poorly constructed or indiscriminately restrictive regulatory implementation of proprietary trading restrictions could hamper that liquidity in a wide range of markets, and consequently impede the ability of businesses to access capital

Market makers play a key role in capital formation by providing liquidity that is the option to buy or sell at the market price, for a wide range of assets in nearly all market conditions. True market making generally requires a dealer to assume some level of principal risk on the underlying assets, whose value may rise or fall before the position can be closed.

The SIFMA study found that excessive or poorly implemented restrictions on market making may pose a serious threat to the strength of the US capital markets, the safety and soundness of individual institutions, and US financial stability. For example, a restrictive definition of market making or trading activity on behalf of customers may adversely impact liquidity and the ability of dealers to intermediate interest rate risk transfers from customers to the market.

Market making is provided predominantly by highly regulated financial institutions in the US. SIFMA cautioned that one consequence of tighter restrictions on principal risk taking within these institutions is the eventual migration of market making to less regulated financial institutions, such as hedge funds. This would merely shift risk into less transparent parts of the market and potentially reduce regulators’ ability to identify and manage systemic risks. Also, US-specific restrictions could shift activities offshore, leaving the US exposed to global systemic shocks while limiting US regulators’ ability to identify and manage those risks.

The scope of restrictions on proprietary trading in the ETF market also needs to be considered carefully given the special nature of market making activity for ETFs and the significance of the market itself.

A block trade is the purchase or sale of a significant position in the secondary market for any security. While the theoretical threshold for a block trade is any transaction of sufficient size to impact market prices, most exchanges set practical definitions that apply to all securities traded regardless of the liquidity of the individual position. A restrictive implementation of the Volcker provisions prohibiting trading gains or losses on positions in equities would effectively ban the facilitation of the most common form of block trades, the study found, eliminating a critical source of liquidity and dramatically increasing execution costs for institutional traders. These costs will be borne by the individuals, pension plans, and other investors in the form of reduced returns over time.

Dealers play a critical role in the US corporate bond market, including underwriting in the primary market, trade execution in the secondary market, and structuring credit derivatives to allow investors to hedge exposures and accept more tailored risks. All of these activities require dealers to take principal risk. An overly restrictive implementation of the Volcker provisions that restricts principal risk taking in the corporate bond markets will place significant constraints on market liquidity and may have broader effects on key players

Finally, the SIFMA study revealed that an overly restrictive interpretation of the Volcker restrictions on position taking in the interest rate swaps and related derivatives market would hamper the risk management capabilities of most corporations and financial firms, leaving a wide variety of US institutions more exposed to risk.