Hedge funds have been suffering indirectly from the Volcker Rule, regulation put in place after the 2008 financial crisis, according to researchers from the University of Manchester in England.
Asset flows to hedge funds have declined and their “flow-performance sensitivity” has risen since the regulation was implemented, University of Manchester’s Michael Bowe, Olga Kolokolova, and Lijie Yu wrote in a recent paper. They found hedge funds have become less willing “to take on liquidity risk,” shifting their “market-making activities from illiquid to liquid stocks.”
The Volcker Rule, a provision of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, is one of the “most prominent and far-reaching financial regulations of recent times,” according to the researchers. The rule, which banned proprietary trading by banks, has led to the unintended consequence of drying up liquidity in the market, the paper said.
“Facing a deterioration in both market and funding liquidity, hedge funds appear to rebalance their portfolios towards more liquid holdings,” wrote Bowe, Kolokolova, and Yu. “The retreat of hedge funds from less liquid investments after the Volcker Rule is likely to further worsen market liquidity and negatively affect market efficiency.”
This phenomenon was stronger for managers with connections to U.S. banks, as well as firms making bets in the “equity-market neutral” and “relative value” categories. “These strategies aim to exploit price differences between related financial instruments, thereby helping to reduce mispricing,” the authors said.
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Following the Volcker Rule, the “average bid-ask spread of common stocks increases, and the returns from supplying market liquidity become negative,” the researchers said, “suggesting a deterioration of stock market liquidity following the regulation’s implementation.”
Hedge funds, faced with uncertain asset flows, have moved away from their role as “liquidity re-distributors,” according to the paper. As a result, they are no longer helping to balance out the market.
These findings, according to the researchers, “provide a prescient warning of the possible unintended consequences of future financial market and banking regulations.”