We've talked a bit before about the Volcker Rule and how it's going to have creepy unintended consequences because it is really hard to distinguish "market making," which is what bank-broker-dealers are supposed to do, from "proprietary trading," which is evil and destroyed the world. Today we have an excuse to talk about it again because (1) Uncle Vikram sort of shrugged off a question or two on it on this morning's Citi earnings call, though he's not quite in the Jamie Dimon camp of "I can't hear you there will never be a Volcker Rule shut up shut up SHUT UP"; and more relevantly (2) Stanford finance professor Darrell Duffie just put out a study saying that the Volcker Rule is going to have creepy unintended consequences because it is really hard to distinguish "market making," which is what bank-broker-dealers are supposed to do, from "proprietary trading." Don't be distracted from the rightness of this study (obvs!) by the fact that securities industry trade organization SIFMA paid Duffie to write it.* Instead, let's focus on the important questions, like: where is my $50k check from SIFMA?
Much of this paper is a full-throated, conventional defense of Grossman-Miller market-making, which is nice and will bring a tear to your eye if you're a market maker:
As opposed to a broker, who merely matches buyers and sellers, a market maker itself buys and sells assets, placing its own capital at risk. The service that it provides is "immediacy," the ability to immediately absorb a client's demand or supply of an asset into its own inventory. At any given point in time, the set of other investors who would in principle be prepared to bid competitively for the client's trade is not generally known or directly accessible to the client. The client could conduct an auction or a search for another suitable counterparty, but this takes time. Even if interested counterparties could be quickly identified, they would not necessarily have the infrastructure or balance-sheet capacity required to quickly take the client's trade. The client is therefore often willing to offer a price concession to a market maker in order to trade immediately rather than suffer a delay that exposes the client to price risk.
If you like paying a reasonable price for your immediacy, you'll hate the Volcker Rule, since its effect is (arguably!) to punish dealers who carry a lot of inventory and/or make a lot of their money from price moves on their inventory:
Under the proposed implementing rules, market makers would retain the ability and incentive to absorb only moderately sized demands for immediacy. It is precisely through their ability to service heightened demands for immediacy, however, that market makers mitigate the most significant associated price distortions and execution costs to investors. The ability of market makers to buffer unexpectedly large supply and demand imbalances depends on significant and flexible market making capacity and on the incentive to prot from expected price changes. Were the proposed rule to be implemented, market makers who absorb large demand and supply shocks into their inventories would experience a "deterioration" in the proposed metrics for their market-making risk, and the associated threat of regulatory sanction. They would also be less inclined to absorb the associated risks given the likely sanctions for significant profits from price changes. Further, under the proposed rules for trader compensation, market making traders would have significantly lower incentives to accept trades involving significant increases in risk or profit.
With banks pushed away from the traditional market-making function, it will move to non-FDIC broker dealers (either current independents or spin-offs/de-bankifying from existing banks), shadow banks, hedge funds, etc. etc. That is a bad thing because (1) we want FDIC-insured banks to make markets (why?) and (2) shadow banks are all shadowy and unregulated and moving our financial system to their shadowy clutches makes it shadowier and more systemically risky, which I guess is true.
In general, if you come at things with the perspective that all the things are also the other things, you are left in a bit of confusion with current and proposed bank regulation. Like, okay, so market making is maybe safe when it's teeny-tiny and time-appropriate and paid based on commissions rather than risk-taking, and big and scary and systemically dangerous when it's prop-looking. Let's say that's true though count me convinced by Duffie that that's a basically nonsensical statement. In any case, though, why is the relevant category of "companies that can't take the big scary risks in their market making" "bank holding companies that own FDIC insured banks"? Similarly, okay, so runs on banks are terrible and cause depressions so we should guarantee deposits and regulate depository assets - but why are the things called "bank deposits," as opposed to the similarly money-like claims that fund much of our economy, the things that we guarantee and regulate? The pattern of heavily regulating one obvious target while also really clearly pushing the Bad Scary Thing to the unregulated sector is, at this point, recognizable enough that even Congress shouldn't get a free pass for repeating it.
Anyway. One neat trick in the Duffie paper:
The resulting increase in investors' execution costs and loss of market liquidity would also cause issuers of securities to be harmed by lower prices. The fact that the Volcker Rule exempts U.S. government securities is a recognition by Congress that it would harm the U.S. government as an issuer if it were to apply the Rule to its own debt issues. The Bank of Japan and Japanese Financial Services Agency have written to the Agencies about their concern "that the proposed Restrictions would have an adverse impact on Japanese Government Bonds (JGBs) trading. ... We could also see the same picture in sovereign bond markets worldwide at this critical juncture. We would appreciate your expanding the range of exempted securities substantially, to include JGBs."
So, that bolded sentence - no, right? Or not entirely. Like, the reason that the Volcker Rule says "go ahead, buy US government bonds prop all you want, no problem" is that banks have money, and they need to do something with it, and buying Treasuries is no worse than any other risk-free-ish thing they could do with it, like triparty repos or whatever. There's some irreducible minimum of things that banks have to be allowed to do with their money, and if you're a regulator one of your goals might be to encourage them to do safe things with their money, and so you shouldn't forbid them from owning and making a profit on the safest thing you can think of.
But still, this scores a good point. One suspects that the Congress that cooked up the Volcker Rule and the agencies that are implementing it maybe had a little chat at some point with the folks in Treasury who actually fund the Treasury, and that those folks said something along the lines of "don't blow up all the primary dealers who buy our bonds and pay our salaries and stuff." Sensible enough, but it doesn't really inspire confidence in the wisdom of the Volcker Rule. The one place that the writers of the Volcker Rule touch market-making directly - not as regulators but as customers - is the one place that they went out of their way to exempt from the rule.
* Technically they paid his favorite charity. Conflict disclosure in academic papers makes me feel weirdly uncomfortable, in a way that say comp disclosure in proxies doesn't, possibly along the lines of "academic politics are so vicious because the stakes are so low" although fifty grand isn't nothing either.