2023 New Value Report

The Volcker Rule’s Impact on Market Making

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Paul Volcker

The Volcker Rule bans speculative trading for banks. Photo: Harvard

The most regulated industry on the planet became even more so in the wake of the financial crisis. In the US, Dodd-Frank was signed into law in 2010, but its most influential rule come into play for another half-decade, reports The Economist.

Named after former Federal Reserve chairman Paul Volcker, who served as chairman of the Economic Recovery Advisory Board under President Barack Obama from 2009 to 2011, the Volcker Rule, which went into effect last week after years of delays, is designed to stop banks from participating in speculative trading.

That’s harder to implement than it sounds—hence the delays. As The Economist explains:

The aim of the rule is to stop banks (and their worldwide affiliates) with the implicit support of the American government from indulging in speculation and becoming enmeshed in conflicts of interest. In reality, distinguishing such activities from more beneficial financial operations has proved daunting. “It’s impossible for banks to know if they are completely in compliance with the rule, because there are so many interpretive questions remaining,” says Gabriel Rosenberg of Davis Polk & Wardwell, a law firm.

In the case of big banks, the most notable exception to the rule, naturally, is market making, which inherently comes with a bevy of complex gray areas. The Economist continues:

Banks have created compliance systems designed to ensure that every single transaction meets the Volcker standard. This has not been easy. Every time a bank buys or sells a security it is in effect taking part in a proprietary trade. This is also true, for example, when it expands its holdings of foreign currency in anticipation of demand. Bank examiners will not only have to judge assets and liabilities, but also intentions. Some foreign banks, judging that they simply lack the political clout to navigate such a complex regulatory environment, have cut back their American operations, to the delight of their American competitors.

As such, compliance costs have skyrocketed in anticipation of the Volcker Rule. The OCC estimates that the seven largest market-making banks have collectively spent over $400 million in the last year alone in order to become compliant though the total cost of the new rules are ultimately unquantifiable.

One result, however, is how the Volcker Rule will impact the market making landscape. For big banks, market making for the sake of market making will become increasingly less attractive due to compliance costs. Many banks are already scaling down their departments aside from trading activities that tie back specifically to customer needs. It also serves as a barrier for smaller banks who might have otherwise been interested in getting in the business.

Perhaps most importantly, non-bank market makers now become more competitive since they aren’t required to deal with the Volcker Rule. This, of course, tracks the larger long term trend of the slow but steady unbundling of traditional bank services by more nimble upstarts.

Read the Economist report on the Volcker Rule

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