The Volcker Rule, as part of the Dodd-Frank legislation, intends to make the U.S. financial system safer by restricting investments and prohibiting proprietary trading at U.S. banks.  The consequences of the Volcker Rule, however, extend beyond specific bank behaviors and lead to concerns about reduced liquidity for many investments such as wider bid-offered spreads, higher debt costs for companies, and structural disadvantages for both U.S. banks and U.S. asset managers. 

The specific part of the Volcker Rule that causes these broader concerns is the prohibition of proprietary trading.  According to the legislation, “Proprietary trading means engaging as principal for the trading account of the [bank]…”  This broad definition could discourage even traditional market-making activity at banks for fear that regulators might interpret resulting positions as proprietary transactions.  Additional concerns that are likely to reduce bank activity relate to compliance requirements that may mandate explanations of how each trade benefited a client and why it does not qualify as proprietary.  Even without the confusion and compliance requirements, the mere absence of proprietary trading positions removes important players from corporate bond and convertible securities markets, impeding liquidity for a much broader universe of investors.

The intent behind the proprietary trading prohibition is to eliminate risky bets in a bank’s trading account that could jeopardize the financial stability of the bank.  While this is an appropriate objective, prohibiting such transactions leads to other consequences.  Importantly, banks under the Volcker Rule may now be either unable or unwilling to carry inventory, not only in their trading account but also as a part of their traditional market making and flow trading business. 

Inventory promotes transactions that enhance and broaden liquidity.  Without inventory, markets for securities such as corporate bonds will lose substantial liquidity.  The Volcker Rule is intended to limit bank trading desks primarily to transactions where they can match a buyer and a seller.  By restricting banks from trading while using their proprietary capital, the Volcker Rule will eliminate a significant source of liquidity for bond market participants.  It remains unclear whether other counterparties will be able to step in to provide the market liquidity previously provided by banks.  Inability to find a ready counterparty will likely force much wider bid-offered spreads as remaining market participants adjust their prices to command larger liquidity premiums to trade.  Wider bid-offered spreads drive up trading costs, which in turn reduce trading volume and the number of active market participants, perpetuating an illiquidity downward spiral. 

As many asset managers experienced during the recent credit crisis, dealer willingness to manage their trading book of securities inventory contributes meaningfully to the daily bond liquidity that is often taken for granted.  The unwillingness of many bank dealers to take securities positions during the recent credit crisis meant that bids were often simply unavailable, prices gapped lower, and many portfolio positions could not trade.  Even today, liquidity remains compromised by reduced bank capital to support trading and market-making businesses, combined with the effects of increased global political risks and economic uncertainty.  Further incentives, via the Volcker Rule, for banks to turn away from securities trading and market making may not ensure a return to the dramatic market freeze of 2008 and 2009, but a further reduction in liquidity and even wider bid-offered spreads seem almost certain. 

The reaction by asset managers to this new normal environment of reduced liquidity is already being reflected in their increased preference for highly liquid credits.  If this preference for highly liquid credits is accentuated, unhealthy portfolio concentrations could result.  It is important to remember that highly liquid is not synonymous with high quality, as holders of auto company debt and money center bank debt discovered in 2008.  Concentrations of liquid credits that become distressed can produce unexpectedly adverse portfolio results.  At the same time asset managers are exhibiting increased preference for highly liquid credits, they also are starting to demand a yield premium for less liquid names that may be difficult to exit.  The expansion of such yield premiums for less liquid credits will impact the debt costs of those who can afford it least, mid-sized companies that are borrowing to expand.  Further exacerbation of liquidity concerns may drive asset managers to maintain a larger cash cushion in portfolios that may be subject to investor liquidity needs.  As a result, investors may experience lower investment returns as asset managers may have to maintain larger allocations to lower-yielding cash-equivalent securities. 

These unintended consequences of the Volcker Rule, including reduced liquidity, wider bid-offered spreads and increased concentration in specific names, combine to produce another unwelcome outcome: increased volatility.  Recently investors collectively responded to global political and economic risk by reducing exposure to riskier securities.  If dealer banks had been prohibited from building positions and were instead forced to find a buyer for every security sold, prices would have fallen much further than they did.  Banks were able to absorb the avalanche of high-yield securities in their trading accounts and were at the same time able to perform a function that long-only asset managers could not: hedge the risk.  Whether through use of credit default swaps, high-yield bond index futures, or other measures, dealer banks can mitigate their exposure to this inventory while participating in the markets and, in the process, help to dampen market volatility.  If banks are skeptical of how such positions may be perceived by regulators under the Volcker Rule, then banks will no longer engage in these activities, further limiting liquidity and potentially increasing volatility.

Finally, because the Volcker Rule affects U.S. banks only, non-U.S. banks may be willing, in fact very interested, in providing liquidity via trading positions and hedging transactions.  U.S. banks will thus operate with a competitive disadvantage as foreign banks will take up transaction flow restricted from U.S. banks under the Volcker Rule and get the benefit of the investment banking activities that follow the market liquidity non-U.S. banks would uniquely provide.  However, exemption from the Volcker Rule requires that non-U.S. bank transactions must be with a non-U.S. entity.  Thus, the Volcker Rule could create a competitive disadvantage not only for U.S. banks but also for U.S. domiciled asset managers, as non-U.S. asset managers stand ready to capture the opportunities that are likely to be created.

Clearly U.S. banks and asset managers join regulators in seeking solutions that make the U.S. financial system safer stable and that address behaviors that may jeopardize bank financial stability.  However, the current design of the Volcker Rule seems capable of impeding the liquidity and availability of many fixed-income securities to the point where investors, issuers, dealers, and asset managers are all adversely impacted.  It remains hopeful that the comment period will produce compromise and clarity that can prompt U.S. banks to provide liquidity without concern that their activities will be misinterpreted or that compliance requirements make such business uneconomic.