Volcker Rule Debate Kicks into High Gear

Terry Flanagan

Proposal could have far-reaching and unintended consequences, opponents say.

The Volcker Rule would reduce legitimate market-making activities by broker-dealers to a shell, and push them to the periphery of the financial system, where regulators would have even less visibility, opponents of the rule say.

The rule, issued by federal banking regulators and the SEC, prohibits banking entities from engaging in prop trading, i.e., in trading for their own account.

The proposed rule, whose comment period expires on Feb. 13, 2012, implements exemptions for underwriting and market making-related activities. For each of these permitted activities, the proposed rule provides a number of requirements that must be met in order for a banking entity to rely on the applicable exemption.

Industry participant are mounting a full-court press against the Volcker rule, saying that it could have far-reaching and unintended consequences.

The proposed implementation of the Volcker Rule would reduce the quality and capacity of market making services that banks provide to U.S. investors, said Stanford University professor Darrell Duffie.

Eventually, non-bank providers of market-making 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,” Duffie said.

The market making exemption is inherently ambiguous, since it assumes that a bright line exists between proprietary trading and market making, when in reality they are two sides of the same coin.

“Market making is inherently a form of proprietary trading,” said Duffie.

Duffie proposed instead rigorous capital and liquidity requirements for market makers, combined with effective supervisory monitoring, ensuring that banks have adequate capital and liquidity to cover their market-making risks.

Sifma said that it was “deeply concerned that the proposed regulations issues by the agencies take an overly prescriptive and granular approach,” which would endanger the liquidity of U.S. markets.

The Volcker Rule could reduce liquidity across a spectrum of asset classes and could ultimately cost investors as much as $90 billion to $315 billion in losses due to these assets booming less liquid, Sifma said.

CFTC chairman Gary Gensler said in congressional testimony this week that one of the challenges in finalizing a rule is achieving the dual objectives of prohibiting banking entities from proprietary trading while permitting market making,.

The banking regulators and the SEC proposed the joint rule in October, and the CFTC did so January 11.

The CFTC’s proposed rule would apply to the activities of banking entities’ CFTC-registered affiliates and subsidiaries, such as futures commission merchants (FCMs), swap dealers, and commodity pool operators.

For example, for a joint FCM/broker-dealer that is a banking entity, the CFTC has Volcker Rule jurisdiction over the FCM’s activities, while the SEC’s regulations would apply to the broker-dealer activities.

The CFTC’s limited enforcement authority under the Volcker Rule provisions includes recordkeeping and reporting, as well as examination of those books and records.

In addition, the CFTC could order violators of the proprietary trading prohibition to terminate the activity and dispose of their investment. The banking regulators, particularly the Federal Reserve, have broader enforcement authority under the Banking Holding Company Act. The Federal Reserve also has authority regarding the possible extension of the time period for conforming with the rules.

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