NEW YORK-The Volcker Rule, designed to ban investment banks from proprietary trading, has so many facets that it gives regulators the leeway to apply it overzealously.
And should regulators impose every single proposal in the Volcker Rule, market liquidity would be seriously impeded.
This was the warning coming from Investment Company Institute General Counsel Karrie McMillan, speaking at the 2011 ICI Equity Markets Conference here Tuesday.
"If regulators get this wrong, a significant part of our industry would fall off the cliff," McMillan said. "The Volcker Rule is complex and controversial-and funds should worry about it. It could seriously impede market makers in the debt and over-the-counter markets, resulting in less transparency and more costly trades."
State Street Global Advisors EVP and General Counsel Phillip S. Gillespie agreed. "Congress' purpose in the Volcker Rule limits on hedge fund activities of banks was to limit systemic risk of the type we saw when the Bear Stearns hedge funds that blew up in 2008," he said.
"It is understandable that Congress and regulators do not want insured depository institutions bailing out affiliated hedge funds," Gillespie said. "However, the rules as proposed limit banks ability to conduct ordinary market transactions with affiliated hedge funds, such as extending credit, even intraday, as well as securities lending or ordinary custody. These limits do not relate to any of the systemic risk concerns that drove the Volker Rules in the first place."
Gillespie is also concerned over the Volcker Rule's oversight of banks' investments in covered funds, which are funds insured by the Federal Deposit Insurance Corp. or the Securities Investor Protection Corporation. As it stands, the Volcker Rule only permits banks to invest seed capital in covered funds for one year, at the end of which they may apply for a two-year extension.
"Most strategies require at least a three-year track record, so it remains to be seen how the government will interpret this rule," Gillespie said.
The Financial Stability Oversight Council in October acknowledged industry criticism that the Volcker Rule's definition of hedge funds was too narrow-but by broadening that definition to now include commodity pools, the rule can now apply to any fund that trades futures, including mutual funds," Gillespie said.
On top of this, the rule may extend to any form of an offshore fund, he added.
The Volcker Rule will also directly translate to higher compliance costs since it will require firms to provide proof that every single trade they conduct is handled through a market maker, Gillespie said. "This places a heavy burden on compliance," he said.
"Firms will also have to write a trading mandate for every trading desk to stamp out proprietary trading," attested Robert Colby, a partner with Davis Polk and Wardwell.
All of these Volcker Rule restrictions will severely limit liquidity, said Colby, who likened the repercussions of the Volcker Rule to "a comet headed for earth."
"It will change life as we know it," Colby said. "This is what banks do: They make loans and they trade."
Annette Kelton, associate general counsel at Goldman Sachs, agreed that the rule "will impact liquidity and the cost of trading."
While Volcker will still permit banks to do principal trading for customers, as well as agency trading through third parties, a great deal of their business is proprietary trading, Colby said.
"Name the three largest dealers that are not bank affiliates," Colby challenged. "The first is Jefferies. The second is MF Global," he added, drawing laughter from the audience over the collapsed broker-dealer now being investigated by Congress and the Commodity Futures Trading Commission. "I cannot even name the third."
"The end result is that it will take time to develop new trading partners to recreate that abolished liquidity. In the meanwhile, banks on sell side, and the buy side as well, may move offshore," Colby said.
As market makers, banks create continuous liquidity and are critical to the efficient running of capital markets and investing, he stressed.
"Any impediment to trading will hit Main Street and the broader economy," ICI's McMillan agreed. "And in the end, less investments will mean lower GDP."
This is why the ICI is also concerned about the proposed financial transaction tax of up to three basis points on stock trades, McMillan said.
As so much of the Dodd-Frank bill centers on derivatives, swaps and options, the Chicago Mercantile Exchange has a number of concerns, as well, said Thomas LaSala, chief regulatory officer of CME Group.
CME is in favor of Dodd-Frank's higher capital and margin requirements for over-the-counter derivatives, thereby making trading with centralized counterparties more attractive, LaSala said. CME also applauds price transparency-including trade registration, real-time reporting and data warehousing-for over-the-counter derivatives.
However, CME does not believe central clearing of OTC derivatives should be mandatory, and CME is opposed to sharing pre-trade bids and offers for non-traditional futures, since this will reveal bidders' identities, LaSala said.
"Congress has also placed position limits on physically based commodities, due to the sharp rise in food and oil prices in 2008, when the financial crisis took hold. Congress wanted to deter artificial price manipulation," he continued. "But the data shows that there actually is no correlation between physically based commodities and the markets. The rule is not rational and will force many market participants, especially commercial hedgers, out."
Dodd-Frank would also require a minimum of 85% of the trading volume on futures and options contracts to be conducted on a centralized OTC market. "It is arbitrary to disallow off-exchange transactions in these securities, and will hinder futures exchanges from creating new products," LaSala said.
Additionally, CME is concerned Dodd-Frank may limit high-frequency trading, LaSala said. "We think high-frequency trading is beneficial to the markets. It has leveled the playing field between large and small firms and has not led to more volatility," LaSala maintained. "High-frequency trading actually reduces volatility, narrows spreads and increases efficiency. Regulators should not assert that speed and automation are a menace to the markets."
