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Volcker Rule Could Hurt Investors

Despite its many benefits, the Dodd-Frank Wall Street Reform and Consumer Protection Act could drive up trading costs and soak up liquidity if the new rules are implemented as written.

MANY ASPECTS of the Dodd-Frank Wall Street Reform and Consumer Protection Act could go a long way toward safeguarding investors and taxpayers from a repeat of the 2008 financial crisis. But as written, some provisions of the law and proposed regulations could significantly harm investors by driving up trading costs and reducing liquidity.

These investors are not just hedge funds and the wealthy. The overwhelming majority are pension funds, 401(k) plans, annuities and mutual funds that benefit ordinary individuals and families — our clients, whose interests we are committed to protecting.

We estimate that the proposed regulations regarding proprietary trading and market making would drive up total trading costs in the U.S. by about $41 billion a year. That’s like paying a $41 billion annual insurance premium against a recurrence of the 2008 crisis. It’s quite possible that the proposed limits on market making could actually make a financial crisis worse by draining liquidity from the markets at times when it is most needed.

Dodd-Frank’s positives, in my view, include higher capital requirements for deposit-taking banking entities and the Volcker rule restrictions on banks’ ability to engage in risky activities, including proprietary trading and both sponsoring and investing in hedge funds and private equity. Through deposit insurance, taxpayers provide deposit-taking banks with lower-cost funding, so it makes sense to limit risky activities.

At issue is how Dodd-Frank treats proprietary trading versus market making — or more precisely, how similarly the proposed regulations treat two very different activities.

There is a clear distinction between proprietary trading (when banks and other financial institutions trade for their own accounts) and market making (when they provide liquidity to the markets). Liquidity means that investors can easily sell their securities or mutual funds for cash. It is crucial for proper market functioning; lack of liquidity deepened the recent financial crisis.

Unfortunately, the proposed regulations for the implementation of the Volcker rule define “prohibited transactions” so narrowly that they capture many market-making activities along with proprietary trading. The likely result is that banking entities will hold much smaller inventories of securities, especially those that are less liquid.

The vast majority of market making in the U.S. is now performed by banking entities. If they reduce or cease to hold inventories of various types of securities, investors will be less able to sell them on demand, and the spreads between the prices that market makers bid for securities and the prices they ask for them will widen, driving up trading costs. This scenario would also be likely to increase funding costs for the issuers of these securities.

The drafters of the proposed regulations seem to have understood the importance of liquidity when it comes to Treasuries and other government securities: They exempted these securities from the proposed limits on market making. Clearly, they recognized that the proposed rule changes would increase the government’s funding costs. 

The question is, why exempt government securities and not corporate securities? Why drive up investors’ cost of trading in corporate securities and corporations’ cost of funding?

I also believe that some of the assumptions underlying the proposed regulations are misplaced. For instance, the proposed rules assume that bonds are as liquid as stocks. This is simply not true. Typically, there are only one or two classes of any company’s common stock, and the shares are widely available (at least for large-cap companies). But businesses often have a large number of much smaller issues of bonds, each with different terms.

IBM Corp., for example, has $200 billion in common stock; all the shares are the same, and they can always find a buyer. That’s not true for its bonds: IBM has 28 different bonds, with varying terms. None of them is particularly large or as liquid as the company’s common stock.

The proposed regulations start from the principle that almost everything that market makers do should be prohibited and that the government should allow only a few specific exceptions to continue. This is a draconian way to change behavior and one we at Alliance­Bernstein believe is counterproductive. 

I’d like those who wrote the implementing regulations to make at least two changes: Extend the market-making rules proposed for government and agency securities to instruments like corporate securities. And treat what market makers do as mostly right (with exceptions) rather than as mostly wrong.

The agencies that proposed these regulations are accepting comments from the public until February 13. There’s still a chance that they will change the regulations. I hope they do.  •  •

Peter Kraus is chairman and CEO of AllianceBernstein.

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