Implementation vs. Intent II: The Volcker Rule

What constitutes legitimate market-making?

When it comes to judging implementation vs. intent in the world of financial regulation, there is perhaps no post-crisis legislation so significant to financial services – and relevant to trading in particular – as the Volcker Rule.

Part of the Dodd–Frank Wall Street Reform and Consumer Protection Act passed by the Obama administration in 2010 (in reaction to the Financial Crisis of 2008), the rule was originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker, though final constitutive elements of the Volcker Rule component were only agreed upon in 2013.

In short, the rule is designed to restrict United States banks from engaging in proprietary trading. Its intent is to curb reckless bank behaviour by barring them from engaging in trading exclusively for their own gain, with no direct incentive stemming from their clients’, lenders’ or counterparties’ needs and demands.

The basic idea is that taxpayers, whose money ultimately bailed out the banks following the financial crisis of 2008, should never again be penalised for financial speculation undertaken for the express purpose of producing bonuses for traders and executives. Crucially, however, some exemptions were made, the most significant of which for the purposes of our discussion was the exemption for market-making.

Market-making is generally defined as the provision of two-sided liquidity on a given security, designed to facilitate the trading of that security. Many markets have formalized market-making arrangements, whereby a market participant (often a broker-dealer firm) is provided with privileged market access in return for meeting certain obligations. These obligations are intended to improve market stability – for instance by requiring a market-maker to be present at the best price for a threshold percentage of the trading session. In spite of the privileges enjoyed by certain types of market-maker, the activity is not without risk.

The exemption for market-making activity under the Volcker rule was more limited in scope, in that a trade desk seeking to qualify had to ensure that its activities were so constituted as not to exceed the reasonably expected near-term demands (RENTD) of clients, customers and counterparties.

So one could say that the Volcker Rule is not primarily concerned with addressing the inherent risks of trading per se, but instead seeks to limit bank exposure to those activities required to provide sufficient liquidity to meet market demands.

As such, it is something of a landmark piece of legislation (certainly in light of the events of the Financial Crisis), so the degree to which its implementation can be said to match its intent is of unparalleled significance.

The New York Times’ editorial board understood this when they wrote in 2013 that “the success of the Volcker Rule, unveiled this week, depends on federal regulators doing what they failed to do in the run-up to the financial crisis and have done only haltingly since then: Enforce the spirit as well as the letter of the law against the wishes of powerful banks.”

What is of further significance with this historic piece of legislation is that its core precepts are presently under reconsideration. The Trump administration has not been shy about its intentions to water down – or revamp, depending on one’s interpretation – many of the Volcker Rule’s key requirements. Jerome Powell, a member of the Federal Reserve Board of Governors who is in charge of financial regulation, said “in our view, there is room for eliminating or relaxing aspects of the implementing regulation that do not directly bear on the Volcker rule’s main policy goals.”

In other words, the Volcker Rule’s implementation can be revised without harming the intent, or spirit, of the law. Indeed, the implication is that the implementation should be revised in order to improve the chances of its intent being fulfilled. Some banks complain that the regulation inhibits their ability to engage in legitimate market making.

The key question here is this: what exactly constitutes legitimate market-making under the Volcker Rule?

There is certainly no easy answer to this question. If there were, the Volcker Rule need never have been implemented in the first place. The most essential is that healthy discussion take place both between firms and regulators about this very question. As we highlighted in last week’s blogpost, the first in our series on ‘Implementation vs. Intent’, regulation works best when it is subjected to ongoing analysis of its impact on the markets it regulates.

Given that much of Select Vantage’s trade activity falls under the general definition of market-making, we are eager to see how this discussion develops, not just for the definition of market-making under the Volcker Rule, but also more broadly.

As the Volcker Rule’s implementation may soon be revised, what is also certain is it is too soon to judge its success. There are two further reasons for this. Firstly, while many aspects of the Dodd-Frank act require cost-benefit analysis, the Volcker rule does not (though some cost-benefit estimates have been provided by the OCC). Secondly, the rule only formally took effect on July 21st this year, though it had an impact on banks’ planning ahead of that date (having been declared in 2010, this made The Economist remark that its implementation period is equal to the length of a modern British Parliament, or one of Stalin’s economic plans.)

Like the impending implementation date of MiFID II, the Volcker Rule should be viewed as the beginning of a process, not the occasion of an event.

Hugo Kruyne, November 29, 2018.