December 18, 2013

Regulators Get It

In The Volcker Rule Rocks! we examined market-making and hedging requirements under the proposed Rule. Incidentally, we feel regulators did a thorough job in the proposed rulemaking in detailing permitted activities and what constitutes non-permitted proprietary trading and hedging. They left little (if any) doubt around their interpretation of the Law and intent of the Rule. A good example is the rules for hedging listed below.

Trading to hedge risk or inventory acquired through market making activity is permitted if it meets two criteria:

1) The hedging transactions must be to hedge risk incurred through customer market making.

2) The hedging transactions must also meet the criteria specified for general risk mitigating hedging, which include:
a) The hedging must be done in accordance with written rules and policy.
b) The hedging must be risk-reducing and specific to the risk being hedged; however, hedging is allowed to be done on an aggregated basis.
c) The hedging must be reasonably correlated with the risk being hedged.
d) The hedging cannot create new exposures at the time of execution.
e) The hedging must be subject to continuous and ongoing review.

A similar risk-oriented approach would be effective for monitoring and evaluating hedging programs and transactions.

Impact on Firms

We further examine the potential impact of the Rule on buy- and sell-side firms in the context of the new regulatory framework in our opinion Beyond Volcker: Seeing the Forest through the Trees. The end result being a more open and efficient market structure.

Most are in agreement that the near-term impact on many markets is likely to be a widening of bid-ask spreads that results from a pull-back in the amount of bank dealer liquidity supplied to the markets. For example: dealers have been holding less corporate bond inventory and taking less risk as indicated by wider spreads and general buy-side frustration. It is impossible to tell how much of this is attributable to paring risk in anticipation of pending regulation and how much is the result of market conditions. We have seen this over the last several months in various product areas.


Temporary structural imbalances from a reduction in bank liquidity will dissipate as the markets reach a new level of equilibrium. As new or different entities emerge and play a more active role in the markets, they should offset liquidity lost from bank dealers. Over time, and possibly not long given the resiliency of the financial markets, liquidity displaced by the Rule is likely to be mitigated by changes in buy-side behavior or replaced by firms outside the banking sector.


It is important not to forget how we got here. Our financial system was broken and needed government intervention to remain functional.

It is equally (if not more) important that we have a well designed regulatory framework with proper incentives in place to prevent a breach of the system in the future. In the case of the Volcker Rule, this means prudently assessing and monitoring bank trading risk on an ongoing basis. Tomorrow, we should have a much clearer picture how that will be done.

Sean Owens is Director, Fixed Income at Woodbine Associates, Inc. focusing on strategic, business, regulatory, market structure, and technology issues that impact firm’s active in and supporting global fixed ...