Woodbine Associates’ Sean Owens explains how the Volcker rule will impact market liquidity and push market participants to take on greater amounts of execution risk and increase trade volumes in anonymity.
We expect changes in liquidity from the Volcker market-making rules to lead to changes in the way many customers approach OTC derivative trading. This will be compounded with the adoption a new market structure that utilizes central clearing and centralized SEF execution. The impact will be most significant on the least liquid products; however, it is likely to be meaningful for even those that trade actively. In these markets, customers are likely to respond to changes in dealer liquidity by taking on greater execution risk, trading in smaller sizes and adopting greater levels of anonymity.
Market-Making Rules
The Volcker Rule, as proposed, prohibits banking institutions and their affiliated dealers in the U.S. from taking proprietary risk positions in their market making activities. The rule places restrictions on market making operations across a broad spectrum of securities and asset classes, which include equities, corporate bonds and OTC derivatives. These restrictions are designed to ensure these institutions do not trade for their own account and transact primarily for the needs of their customers. Banks are required to:
• Ensure that transaction volumes and risks taken are proportionate to customer liquidity and investment needs. Positioning in anticipation of block trades is permitted, provided it is oriented toward risk intermediation
• Conduct their market making activity such that it does not exceed the “reasonably expected near-term demands” of their particular clients.
• Design their market making activity to generate revenues primarily from fees, commissions and bid-ask spreads, and not from changes in the value of position risk or related hedges.
• Ensure that market-making related hedging transactions are risk-reducing and specific to the risk being hedged. Hedging is allowed to be done on an aggregated basis.
Regulators go into a great deal of detail about what is and is not permitted for banks making markets in securities and derivatives and even requires institutions to structure compensation and incentives that reinforce its principal goal of liquidity intermediation for market making trading desks.
Wider Spreads
In its current form, the rule limits the ability and incentive of affected dealers to take or hold position risk that exceeds customer driven demand. In the swap markets, the result is likely to be a measurable drop in the risk taken by these dealers in addition to a meaningful increase in bid-ask spreads for transaction sizes that exceed conventional market-sized “flow” transactions. This is likely to have a pronounced effect on “block” trades, with an increasingly greater liquidity premium placed on larger transactions. Dealer pricing will reflect their role as a risk intermediator and the necessity for them to hedge and lay-off a greater amount of customer risk more quickly than they do presently to maintain “suitable” levels of risk in their trading books.
Customer Strategies
Over time it is likely that customers and other buy-side institutions will seek to avoid the greater liquidity premium associated with block transactions and will increasingly take on more execution risk as a way to reduce their trading costs. This is likely to manifest itself in two ways: decreasing transaction size and an increased desire for anonymity. Customers should find it cost effective to take on greater execution risk by trading smaller sized transactions with a larger number of dealers and liquidity providers, essentially distributing liquidity themselves. With this comes a need and desire for increased customer anonymity. While many firms feel they get better execution because of their dealer relationships, any such benefit is likely to be diminished going forward. As firms take on more execution risk they are likely to seek to limit the amount of information leaking to their trading counterparty and the markets, and anonymity will become a much more critical element of their trading strategy. In some cases firms are likely to increase their use of execution brokers to help fulfill the need for anonymity.
Dealer Response
The dealer response to the Volcker Rule is likely to center on increasing their amount of customer flow business. The market making business model becomes one entirely dependent on customer flow. By increasing customer volume, dealers should be permitted to increase the amount of position risk taken, since it will be benchmarked to the amount of risk traded for their customers. It is likely that dealers will increase their product coverage in the markets they trade to benefit from natural customer driven diversification across their businesses. This should include a deeper integration of cash and derivative trading and an increase in cross-product hedging.
Non-Bank Liquidity
Going forward, it is likely that non-bank entities will play an increased role in providing liquidity to the markets. Alternative investors, asset managers, non-bank dealers and other entities with the capacity and mandate to take trading risk should find sufficiently attractive returns on capital to opportunistically provide liquidity. Central clearing will level the playing field for firms to transact on market price rather than their own creditworthiness and should lead to increased participation in many of these markets. Thus, over time the market-making rules should lead to a redistribution of risk among market participants and change the way liquidity is sourced, rather than the aggregate liquidity available.
Clearing & SEFs
Under Title VII, most trading is expected to be conducted electronically on SEFs. While voice and hybrid trading will continue to be used for block trades and less liquid or non-standard swaps, the markets are expected to trade electronically for most standard transactions. Central clearing will remove counterparty considerations from the economics of a transaction and allow for greater anonymity among participants. This is likely to be aided by the added costs associated with bilateral trading going forward. Wider bid-ask spreads, and greater capital and margin required should compel many customers to use standardized, SEF traded swaps for hedging whenever possible. Centralized execution, central clearing and increased anonymity should greatly enhance customers’ ability to assume greater amounts of execution risk and distribute it according to their particular strategies.
Conclusion
Market-making under the Volcker Rule centers on reallocating risk: moving proprietary risk out of banks and their affiliated dealers to financial entities where it has been deemed more appropriate. The proposed market-making rules aim to do just that by relegating dealers to a role as an intermediary for their customers. By restricting the amount of risk dealers can hold, the rules will provide ample incentive for customers and non-bank liquidity providers to take greater amounts of execution and position risk. This will be accompanied by electronic SEF trading, in which participants are likely to transact in greater volumes and smaller size with increasing anonymity.
Woodbine Associates recently published a research report titled: Buy-Side Corporate Bond Execution: Sourcing Liquidity under Dodd-Frank. The survey-based report examines execution in the corporate bond market and how asset managers are likely to respond to changes in market liquidity from the Volcker Rule and changes to the CDS markets. See the link: http://woodbineassociates.com/uploads/Woodbine_Press_Release_-_Buy-Side_Corporate_Bond_Trading_-_Final.pdf
