March 29, 2010

The Obama administration surprised the financial community in January when it suggested banning commercial banks from running proprietary trading desks that buy and sell securities for their own accounts. The rule is the brainchild of Paul Volcker, the former chairman of the Federal Reserve Bank who is serving as a senior economic adviser to the president.

The so-called Volcker Rule also would limit banks from owning or investing in hedge funds and private equity funds. The idea is to prevent commercial banks from betting on securities and engaging in risky trades that could lead to another taxpayer bailout in the event that market conditions deteriorate.

At first, the rule seemed to be a populist reaction to Wall Street's outsized bonuses at a time when many Americans are struggling to find work. But Volcker's proposal has gained traction among Wall Street's elder statesmen -- figures such as hedge fund manager George Soros, Citigroup's former chairman John Reed, Vanguard founder John Bogle and former SEC chairman William Donaldson. These men agree that the regulatory system needs an overhaul and that a good place to start is to restrict banks from trading for their own accounts.

While lobbying groups are working on defeating, or at least watering down, the proposal, the Volcker Rule needs to be considered seriously, as it could impact the supply of liquidity generated by proprietary desks that also function as market makers in equities, options, futures and other instruments. According to Nigel Kneafsey, CEO of Options IT, if the Volcker Rule were to pass Congress, it would lead to a major restructuring of the trading business.

Today, banks often fund prop trading. But under the terms of the proposed rule, banks wouldn't be able to engage in or supply capital to proprietary trading firms or hedge funds. The question is, will the capital that banks currently supply to proprietary trading operations evaporate from the market? While not participating in the market could insulate banks against market downturns, it also could create unintended consequences, including less-efficient markets, Kneafsey notes.

In addition, experts point out that it would be difficult to separate a firm's proprietary trading activities from its market-making operations. Even when banks trade on behalf of their customers, they often need to commit their own capital to secure stock for their clients. When they unwind these transactions, banks may or may not make money. Some sources suggest that even this activity should fall under the umbrella of proprietary trading.

Meanwhile, mere anticipation of the Volcker Rule is likely to cause spin-offs of proprietary trading desks, contend sources at high-performance trading technology and infrastructure providers. Already, some tech vendors are eyeing the Volcker Rule as an opportunity to supply integrated trading and operational services to hedge fund start-ups. The idea is that if investment banks are forced to spin off their proprietary trading desks and hedge funds, these new businesses will need technology platforms. For example, Progress Software has teamed with Statistical Research Laboratory to offer hedge funds a one-stop shop for building and hosting high-frequency algorithmic trading strategies, as well as for managing P&L, risk and back-office functions.

But there's still the uncertainty of how far the government may go to restrict the major banks from trading for their own accounts. It's possible that regulators will impose tougher capital requirements rather than force the banks to break up into smaller business entities. Ultimately, regulators may have to define proprietary trading to avoid any confusion.

In the meantime, there is no shortage of low-latency and high-performance infrastructure providers eager to house the black-box strategies of proprietary trading spin-offs. But they may have new competition -- there's always a possibility that the banks will look to replace lost revenue by becoming technology providers themselves.

ABOUT THE AUTHOR
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in ...