The Volcker Rule – aka one man’s trade is another man’s hedge
January 20, 2012
One of the PRMIA folks in New York kindly recommended this paper on the Volcker Rule, in which Darrell Duffie criticises the proposed this new US regulation design to drastically reduce proprietary ("own account") trading at banks.
As with all complex systems like financial markets, the more prescriptive the regulations become the harder it is "lock down" the principles that were originally intended. In this case the rules (due July 2012) make an exception to the proprietary trading ban where the bank is involved in "market-making", but Darrell suggests that the basis for what types of trades are "market-making" and what types of trades are more pure "proprietary trading" are problematic in this case, as there will always be trades that are part of "market-making" process (i.e. providing immediacy of execution to customers) that are not directly and immediately associated with actual customer trading requests.
He suggests that the consequences of the Volcker Rule as it is currently drafted will be higher bid-offer spreads, higher financing costs and reduced liquidity in the short-term, and a movement of liquidity to unregulated entities in the medium term possibly further increasing systemic risk rather than reducing it. Seems like another example of "one man's trade is another man's hedge" combined with "the law of unintended consequences". The latter law doesn't give me a lot of confidence about the Dodd-Frank regulations (of which the Volcker Rule forms part), 2319 pages of regulation probably have a lot more unintended consequences to come.