The products I expect would be more severely impacted are over-the-counter (OTC) traded products such as debt, currency, and all types of OTC derivatives. To support these products, large banks leverage their balance sheets and capital to make these products liquid. Separating market making, customer facilitation and proprietary trading for these products is much more difficult and if done incorrectly would leave a huge void in the market.
Without the dealers in these markets, liquidity and turnover would initially dry up, spreads would increase, and it would become much more expensive for companies and governments to raise capital and manage risk. This would have a dramatic impact on not only corporations but the government. The current debt ceiling is $14 trillion; a one-basis point (.01%) increase in funding would cost taxpayers $1.4 billion a year. Given that one-basis point is very small and global debt is huge, it will only take a small increase in interest rates to significantly impact both issuers and taxpayers.
To court more liquidity and solve this gap, we would need to draw more liquidity providers into the markets. Since liquidity providers couldn’t be large banks, we would need to adjust the products to enable smaller firms to partake in these markets. To accomplish this, OTC products would need to be made more standardized, and trading would need to be done in smaller denominations. By standardizing these products, it would turn these bespoke products from securities and derivatives created by corporations and governments for specific capital-raising and risk management purposes into trading products that may not benefit the financial end users. If a corporation needs specific covenants on a bond to raise capital or needs to insulate themselves from an economic event, how does a generic and standardized product help them accomplish this goal? It just creates basis risk, forces the corporation to move toward private equity, ignore the opportunity, or self-insure the risk – which will force corporations to reduce investment, take less risk, and will eventually impact the number of jobs firms create.
Assuming that we can define and ban proprietary trading from customer facilitation and market making and can prohibit these practices, how will banks react?
First, banks will determine if they can avoid this regulation by changing their registration. Goldman Sachs and Morgan Stanley were historically investment banks and not chartered as Bank Holding Companies (BHC).
What if these organizations dropped their BHC registration? These firms have paid back their TARP money and currently have less reliance (possibly none) on the federal government. Would this mean they were suddenly safe? Would they no longer be too big to fail? My guess is, if either of these organizations just dropped their BHC status, continued their business as usual, and subsequently got into trouble, the government would just bail them out again. So just dropping a firm’s BHC status would not be enough.
Second, banks would think about if they could switch their proprietary trading businesses to overseas entities, say Switzerland or somewhere in Asia, maybe Singapore. If this concept takes hold, it would be likely that these organizations would create walled-off subsidiaries or switch their registrations to more loosely regulated jurisdictions where these practices would be less regulated or maybe even encouraged. I am sure that some country would be interested in importing thousands of bankers generating millions of dollars in bonuses, which of course would generate huge tax windfalls and generate a multiplier effect of support jobs.
Third, if neither of these cases were possible, then banks would spin off these organizations, not shut them down. This would allow the proprietary traders to either buy out these businesses using either their own capital, private equity, or carve out the proprietary trading business through a spin off. The spin-off and capitalization of new trading businesses has been happening for years. Since the mid-1980’s, brokers and banks have supported the spin-off of traders and trading desks into separately capitalized hedge funds and proprietary trading firms. Banks/brokers have developed prime brokerage businesses to facilitate this. By spinning off these businesses, it transfers the trading risk to a separate entity while retaining a fee-based revenue stream through trading commissions, lending and financing. So this may not be as awful a problem as anticipated.