Proposed regulations implementing the Volcker Rule provisions of the Dodd-Frank Act could impose comprehensive restrictions on market making and curtail liquidity, in the view of the National Association of Securities Professionals. In a letter to the SEC, the association urged regulators to redraft the proposed regulations to clarify that basic market making functions of covered institutions are not impacted by the Volcker Rule. The congressional intent of the Volcker Rule was to restrict proprietary trading, said the association, not to impose comprehensive restrictions on market making.
The original intent of Section 619 of Dodd-Frank is to prohibit U.S. banks with insured deposits from engaging in proprietary trading and limit bank holding companies from participating in hedge fund and private equity businesses. The first objective has largely been achieved, maintained the association, since most of the covered institutions have shut down or spun off their proprietary trading operations. But the expansive and granular regulatory framework put forward by the proposals implementing Section 619 runs the risk of restricting large institutions from fulfilling their beneficial market making functions. Broker-dealers are obligated to act as an agent for buyers and sellers by executing their orders in the market, noted the securities professionals, or act as a principal by supplying liquidity directly to clients. This role is particularly vital to US interests on a routine basis and even more so in times of crisis when natural buyers may be hard to find.
The securities professionals believe that liquidity is critically important to the health and vitality of the US financial system. Liquid markets promote efficient capital allocation. Wen liquidity dries up, there is less access to credit and the cost of capital goes up, hindering business growth and job creation. If implemented in an overly intrusive manner, contended the association, Section619 has the potential to curtail liquidity. Covered institutions, fearful that their actions will be second guessed by regulators, could become hesitant to fulfill their market making role.
One particular concern is how the proposed regulations covers the natural process of maintaining inventory in anticipation of client demand. As in any business, broker dealers manage inventory in anticipation of client demand. Section 619's metrics and granularity run the risk of inserting regulators into the process of building inventory. Inventory management -including managing inventory for profitable return -is not proprietary trading as it was thought of in the debate around the Volcker rule. The association urged the SEC redraft the regulations to ensure that such normal course market making functions are not subject to regulatory second-guessing.