The Volcker Rule As Price-Setting

Today in Volcker Rule coverage: now you can read the whole thing. Get on that. Many people find it confusing.

Much of the meat of the rule is a bunch of qualitative and quantitative information that banks must collect and hand over to regulators, each piece of which tends to indicate whether a trading desk is more prop-y or flow-y. So if 90% of your trades face customers, that looks like market-making; if 90% of your trades face other dealers, that looks like prop. But there are no bright lines on what is and is not allowed – you just report statistics and hope that the regulators are okay with it.

One important complex of tests involves the distinction between revenues that come from “portfolio profit and loss,” i.e. securities going up or down in value, and “fee” and “spread” income. Fees and spreads are okay. Portfolio is not okay. Or okay only in moderation. Unspecified amounts of moderation.

I continue to have an unhealthy fascination with exactly how the regulators draw those lines. Here’s some of the definition of “Spread Profit and Loss,” from Appendix A, Part IV.B.4 (page 259 of the Fed’s release):

Description: For purposes of this appendix, Spread Profit and Loss is the portion of Portfolio Profit and Loss that generally includes revenue generated by a trading unit from charging higher prices to buyers than the trading unit pays to sellers of comparable instruments over the same period of time (i.e., charging a “spread,” such as the bid-ask spread).

General Calculation Guidance: Spread Profit and Loss generally should be computed using data on the prices at which comparable instruments are either bought or sold by the trading unit, as well as the turnover of these instruments. Spread Profit and Loss should be measured with respect to both the purchase and the sale of any position, and should include both (i) the spreads that are earned by the trading unit to execute transactions (expressed as positive amounts), and (ii) the spreads that are paid by the trading unit to initiate transactions (expressed as negative amounts). Spread Profit and Loss should be computed by calculating the difference between the bid price or the ask price (whichever is paid or received) and the mid-market price. The mid-market price is the average of bid and ask.

For some asset classes in which a trading unit is engaged in market making-related activities, bid-ask or similar spreads are widely disseminated, constantly updated, and readily available, or otherwise reasonably ascertainable. For purposes of calculating the Spread Profit and Loss attributable to a transaction in such asset classes, the trading unit should utilize the prevailing bid-ask or similar spread on the relevant position at the time the purchase or sale is completed.

For other asset classes in which a trading unit is engaged in market making-related activities, bid-ask or similar spreads may not be widely disseminated on a consistent basis or otherwise reasonably ascertainable. . . . In such cases, the trading unit should calculate the Spread Profit and Loss for the relevant purchase or sale of a position in a particular asset class by using whichever of the following three alternatives the banking entity believes more accurately reflects prevailing bid-ask or similar spreads for transactions in that asset class . . . .

And then there are some methods for getting at “typical” bid-ask spreads.

At some level this is very sensible. If you have a 104-104.5 market, get hit, buy a bond at 104, don’t resell immediately, your market drifts up to 106-106.5, and you get lifted at 106.5, your profit is 2.5 points, 2 of which are intuitively attributable to price appreciation and 0.5 of which are attributable to spread. (The rule would treat that 0.5 points as two profits versus mid levels: you made 0.25 spread profit on the purchase and 0.25 on the sale.)

But on another level it’s kind of disturbing, as it only attributes to spread income the “prevailing” spread. In other words, it tells banks that the amount that they can get paid for providing liquidity is the amount that everyone else gets paid for providing liquidity in that particular product.

In liquid markets – listed equities, say – where spreads are small and standardized, this doesn’t do much damage. If everyone’s market is $0.01 wide, then attributing $0.01 (or, technically, half of that, since the “spread” is measured from trade level to mid) to spread is just arithmetic.

But for a high-yield bond that trades once a month, notions like “spread” are pretty loose – banks want to talk sellers down to the lowest price they can get, and then talk buyers up to the highest price they can get. The difference between those is in some sense “spread,” and a good trader is one who is good at maximizing it by persuasion, cajoling, strategic use of information, etc. The reason that dealers make markets in illiquid securities is because they have some chance of buying for a lot less than they sell – not because of broad-market price appreciation, but because they can find the cheapest seller and highest-paying buyer.

It would be, let’s say, unusual to suggest that Apple should only make as much profit on an iPhone as the average manufacturer makes on the average smart phone. But standardizing spreads does much the same thing for market making activities. Penalizing banks, even in some loose holistic facts-and-circumstances way, for making profits beyond the “prevailing” spread reduces the incentives to make markets – to find the cheapest seller and the highest-paying buyer – in less liquid markets. And if market makers serve a social function, it’s to make markets in securities that are less liquid – to find the buyers and sellers who would otherwise be hard to find.

Proposed implementing regulations for Volcker Rule [Fed, pdf]

Comments (8)

  1. Posted by MeVC | October 11, 2011 at 7:38 PM

    Come on Matt…at least find a new picture so I know that this is a new article……God knows I don't want to try reading it.

  2. Posted by Spanishmoon | October 11, 2011 at 9:07 PM

    Or, investment banks could trade and make markets; banks could make loans and take deposits.

    Matt: Why is this so difficult for you to understand?

  3. Posted by guest | October 11, 2011 at 10:46 PM

    Our trades happen so fast we can't keep track! GS quant

  4. Posted by Another Guy | October 12, 2011 at 1:32 AM

    +1

    Matt: You're being disingenuous.

    Does the The Volcker Rule suck? Absolutely. But doing nothing would suck even more.

    The other real alternative is to reinstate Glass–Steagall, but that is taboo.

    Arguably, for new guys starting out Glass–Steagall would benefit the industry b/c it would create more competition between the investment banks (more smaller investment banks versus a handful of large banking conglomerates) hence more need for bodies.

  5. Posted by Alex J | October 12, 2011 at 1:33 PM

    Spanishmoon,

    The cause and effect of regulating what a bank does with the money that customers entrust it with, or the capital they raise from willing participants in their common stock, is delving into an area for which the regulators and policy makers can’t possibly know the real consequences of. Especially given their past history with not examining the full plate of consequences. They are just taking the easy way out of solving the problem of a fiscally irresponsible financial culture that they help create by telling the banks what they can and can’t do. Do they somehow just know how banks will react to recoup what they possibly lost in potential revenue. Not to mention the extensive regulatory costs that will go along with this. The reason these banks are able to have free checking accounts, fantastic credit card rewards, offer lower rates as a form of staying competitive in an extremely competitive market, etc. is because they make that money up elsewhere. Trading would happen to be one of those “elsewhere’s”, and that includes prop trading. Plus, the more people you have trying to make the market, the more liquid will be, regardless of whether they are trading between customers and other dealers. The repurchase agreement market is a prime example of such, because there is a lot of prop trading in that market between banks. The entire prop trading market still serves an important purpose, and taking players from that market is government mandated market manipulation that can have any number of unintended consequences especially with such inept and overtly confusing policy making. So unless you are completely OK with banks making up that lost revenue and increased costs elsewhere, such as debit fees, no free checking, no lucrative rewards, or other hidden on the surface fees, then your point is irrelevant and simplistic. Given the backlash at Bank of America’s new fees for what has been deemed “evil profit mongering”, I can’t say the public would agree that this is what they should do if they knew the truth behind what it will push the banks to do. Moral or not, these banks are still free to make plenty of other decisions that will effect their business model at the expense of the consumer. The Durbin Amendment is an example of just that. The government has a history of pushing the financial sector to do what it wants, yet no blame seems to fall on regulators and policymakers for pushing sub prime loans, which is the whole reason they are now trying to regulate the banks in the first place. The anger from those in the Occupy movements is unfairly one sides. It’s not only the banks that are causing the problem, it’s also thoughtless policy making. For which the recent regulatory coup against banks, which isn’t limited to this policy in the slightest, falls neatly into that category. Doing nothing may be worse, but its a foolish assumption to say that this is the best we can do to help prevent a situation like 2008.

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