Is Volcker Hurting Market Liquidity?

Paul Volcker, former chairman of the Federal Reserve, proposed the Volcker Rules.  Have they reduced liquidity in capital markets?

The Volcker Rule. That's the infamous rule adopted after the financial crisis that prohibited banks (deposit-taking financial institutions) from engaging in proprietary trading, trading for their own accounts, or adopting trading styles that mimicked some of the most risk-seeking hedge funds.

The Volcker Rule, an appendage of Dodd-Frank U.S. legislation in 2010-11, was supposed to ensure banks, big and small, would focus on the basics of banking and would never use customer deposits to support exotic trading positions.

Banks can engage in trading of securities (equities, options, swaps, corporate bonds, commodities, futures, etc.), but it must be done on behalf of customers. Any equity security that sits on a bank's balance sheet must be tied to customer-related trading, as if the security is inventory on a shelf, up for sale.  A bank can buy and hold, as long as it expects to sell a short time later to a customer. While it holds, it can report and enjoy the related trading profits. 

The onus is on banks to prove to regulators that trading positions exist to accommodate customers--and not to profit from their own views of whether a market is headed up or down. Volcker rules stipulate the bank must show securities and derivatives on the balance sheet (and positions off the balance sheet) have "customer demand." They most show proof there are customers who may come along and purchase what resides on the bank's balance sheet. More technically, banks must quantify "reasonably estimated near-term demand," known better among compliance officers as "Rent-D."

Banks have responded to the Volcker Rule by scaling back trading activities, reducing positions, and refocusing capital-markets strategies.  This has also meant withdrawal from several markets and downsizing balance sheets--responses, some say, that are exactly what regulators wished. Such withdrawals and wind-downs meant banks reduced trading positions by tens of billions, as well as winced as they watched trading profits wither away.

Large banks, having absorbed the regulatory punches, re-engineered and pressed on by adopting strategies that suited them.  Among the large banks, trading revenues continue to be substantial:  JPMorgan Chase and Bank of America (Merrill Lynch) reported $12 billion and $7 billion, respectively, in trading profits in 2017.  JPMorgan still reports over $400 billion in trading-related assets in June, 2017, even while complying with Volcker and rationalizing many trading desks.

But there is another big picture that bothers some market players:  As banks have had to withdraw and restrict trading assets and trading risks, has regulation reduced liquidity in certain markets?

Because banks agonize over Volcker compliance, has that hurt liquidity, volume and activity in certain markets?  In many fixed-income and derivatives markets, participants and investors could always count on big banks to act as dealers and counterparties--ready to make markets or take positions to accommodate their own trading schemes. And for sure, they had the capital and balance-sheet heft to take positions. A hedge fund or an insurance company always knew a big bank might be interested in assets they wanted to get rid of.

Diminished liquidity in securities and derivatives markets can have significant impact on costs, prices, and values.  Transaction costs rise; bid-ask spreads on financial instruments widen, and often traders, investors and dealers can't establish a true value of a security or a derivative.  In many ways, illiquidity leads to further reductions in liquidity.

The prevailing notion is that while the Volcker Rule has forced reductions in market risks at banks, liquidity in certain markets has dwindled. 

Or has it? Has Volcker really had that kind of impact? Are markets less liquid, or has the nexus of liquidity shifted away from many banks to a handful of core banks and a swath of other dealers, trading systems, hedge funds, and financial institutions. 

This year, the Securities & Exchange Commission decided it wouldn't guess at impact on liquidity; it would measure impact.  With the support of the U.S. Congress, it tasked its own Department of Economic and Risk Analysis to determine the truth.  In August, in a 300-plus-page report, it published its findings--which concludes on its first-page executive summary that the Volcker Rule has had no material impact on liquidity in most fixed-income and derivative markets.

The report examined both primary-issuance activity (underwritings and IPO's) and secondary markets (dealers, traders, investors, etc.).

In IPO and new-issue activity, it concluded Volcker impact has been "mixed."  Activity has fluctuated the last few years, but not because of Volcker restrictions. 

In corporate bonds, where many suspected there might be the most significant declines in liquidity, SEC examined market-makers, dealers, and electronic markets. It concluded banks' capital commitments to such activities had declined, but liquidity hasn't changed materially, and there has been negligible change in transactions costs and volumes. 

It examined complex bonds:  convertibles, putables, redeemables, and those with sinking funds.  It examined credit-default-swaps sales (CDS), derivatives that can be sold by dealers and traders to achieve the same economic position (and risk) of owning a corporate bond.  The SEC concluded there was no material impact on liquidity, reporting that banks' withdrawal from some of these activities has been offset increased activity from hedge funds.  And brisk activity in CDS has helped ensure corporate credit risks (reflected in bond and CDS prices) are priced fairly and up to date.

In structured products, the SEC studied activity in asset-backed securities of all kinds, particularly those tied to mortgages (RMBS, e.g.). Similarly, it examined activity, volumes, bid-ask spreads, transaction costs, and participant numbers.  It looked at "young bonds" (newer issuers) vs. "old bonds" (bonds issued long ago).  Its conclusions were the same:  not much impact on liquidity, it reported.

The SEC also looked at private markets.  That would include private placements of various kinds (financings subject to Regulation D, 144A, "JOBS" Act (for small issues), and popular crowdfunding processes in recent years).  Same conclusion. No noticeable, meaningful impact on liquidity.

Attempting to cover all grounds, it addressed stress scenarios.  Liquidity may be brisk in normal times, but, as market players know well, liquidity can dry up swiftly in distress.  Banks, traders, and dealers disappear because they can't absorb the risks of loss, want to avoid the uncertainty, and can't get true prices of assets or positions.  The SEC report concludes the Volcker Rule won't exacerbate how market players react in stress cases.  It observed some dealers will, in fact, sell assets to make room for customer purchases. 

So the 300-page, well-documented analysis will likely be used to rebut arguments from factions who believe the Volcker Rule must be watered down to permit banks to replenish market liquidity.

Banks and other proponents to abolish much of the Volcker Rule may have difficulty in finding flaws in the SEC analysis. They may now focus on other favorite tactics: (a) Volcker's ambiguity in what is defined as a proprietary trade and (b) the time-consuming, costly efforts banks expend to prove compliance in the rule in the first place.

Tracy Williams

See also:

CFN:  Volcker Rule: Point of No Return, 2013
CFN:  Volcker Rule: Here It Comes, 2011
CFN:  Volckerized, 2010